Chapter II.—Of the Operation of Banks of Circulation

CHAPTER II.

OF THE OPERATIONS OF BANKS OF CIRCULATION.

IN a former part of this treatise* it was shown, that under a metallic currency, it is not possible to retain in any country, for any length of time together, a larger amount of coin than that which is requisite to place its currency upon a level with the currencies of other countries; and it was also shown, that if by any extraordinary cause a greater amount should at any time be brought into any country, it would continue but for a short time, and would gradually disappear by exportation, in the manner there described, until the equilibrium should be restored.

What is true of a metallic currency, is equally true of a mixed currency, consisting of coin and paper exchangeable for coin on demand. The aggregate amount of the two component parts cannot exceed for any great length of time, the amount of coin which would circulate if there was no paper, as I shall now proceed to show.†

Let us suppose that, in a particular country, enjoying a metallic currency, the quantity of coin requisite to circulate its products and commodities, and to maintain its currency upon a level with the currencies of other countries, is ten millions of dollars, and that the balance of trade and payments is such at the time of our supposition, that the exchange is at par. A bank of deposit, discount and circulation is established upon the corporate or joint-stock principle, with a capital of one million of dollars in coin, which amount is of course to be taken from the ten millions in circulation. We will suppose this capital all to be paid in before the bank commences its operations. The effect of this would be a temporary pressure for money, by withdrawing one million of dollars from circulation. This pressure, however, would be gradually relieved, as the bank commenced discounting, and would wholly disappear after it had loaned out a million of dollars.* Now it is manifest, that up to the period at which the loans of the bank do not exceed one million of dollars, its operations have been simply those of a bank of discount, for it has only loaned the amount of its capital, that is, of money previously existing. It may indeed, have issued notes, or given credits on its books for loans made, instead of paying out the identical gold and silver received from the stockholders; or, it may have given notes, or credits, on a deposit of coin for the convenience of the public; but such notes and credits in such cases would be mere certificates that corresponding amounts of gold and silver were lying in the vaults of the bank, belonging to the owners of such notes or credits, held subject to their order, precisely as in the case of special deposites. It might even happen, that millions of dollars in the form of notes and credits might be issued by the bank in exchange for specie, without thus far exercising one single prerogative of a bank of circulation, or influencing in the slightest degree the state of the currency, any more than the Bank of Hamburgh, already described, influences the currency of that city.

From this view of the subject, how clear is to be seen that what the bank has thus far performed, is nothing more than what the individuals who own the capital of the bank, could themselves have performed more cheaply, quite as securely, and perhaps more advantageously to the public, seeing that loans to unskilful and imprudent borrowers, of which individuals are not so apt to be guilty as corporations, lead to a diminution of the wealth of a country, whether it result from injudicious voyages, or from any species of enterprise which converts productive capital into properly which is not equally productive, or, from improvident sales of merchandise to persons not entitled to credit. Incorporated or joint stock banks, it is thought, owing to their directors not having a deep personal interest at stake, and owing to their liability to be influenced as a board, by considerations which do not operate upon individuals, and especially owing to the absolute impossibility of their devoting any large share of their time to the investigation of the characters of all applicants for loans, cannot, in the nature of things, exercise the same discrimination in the choice of its borrowers, as individual capitalists do.*

The circulating principle is now put into operation by our supposed bank, by lending its credit in addition to its capital. In other words, without having any more money to lend, it undertakes to discount notes at short periods, by giving to the borrowers not coin, or notes or credits absolutely representing coin in its vaults, as in the case of its original loans, but notes or credits promising to pay gold or silver on demand, founded upon a presumption that no such demand will be made, until the notes, in the discount of which they were issued, or some of the other notes discounted by the bank, will be paid, and thus bring into its coffers an equal amount of specie. In other words, the bank lends its credit, and as this credit is just as valuable to any of the parties who are indebted to the bank for the first million, or for any subsequent sum loaned, as gold or silver, any of them will be willing to receive it in payment of debts or for merchandise sold, as readily as coin, and the notoriety of this fact, added to the right of conversion on demand, gives the notes and transferable credits of the bank a circulation with the public equivalent to coin. Every emission, however, of these bank notes and credits is an augmentation of the currency, and depreciates it below the general level.* Let us, for the sake of argument, suppose the amount of this augmentation to be extended in a given time to one million of dollars, that being the sum requisite, we will further suppose, to occasion the degree of depreciation that must exist before it is profitable to export coin. The amount of the currency will then be eleven millions of dollars, that is to say, ten millions of coin, and one million of paper. The effect of this would inevitably be what is called a plenty of money. The prices of all commodities would rise, because there would be eleven purchasers in the market, where before there were but ten, or, what amounts to the same thing, because the former purchasers would possess one tenth more means to purchase with, than they possessed before. This rise of prices, operating upon foreign as well as domestic commodities, would lead to the importation of additional quantities of foreign merchandise. But no corresponding export of domestic products would take place, on account of their artificially high price, upon which bills could be drawn to pay for the foreign imports; and the consequence would be, that money would be sent abroad in their stead, as presenting the most profitable species of export. But of the money in circulation, it is evident that nobody would think of exporting the paper, which would have no value abroad, and consequently, all the exports that would take place, would be of coin.

The effect just described would as certainly take place as that water would find its level, and would continue until the export of coin was equal to the amount of the paper issued, that is, to one million of dollars, when the level would be again restored, owing to the fact of the aggregate of the coin and paper united being only ten millions of dollars, that is, nine millions of coin and one million of paper.* Further emissions of bank notes or credits might then take place with precisely the same results, and provided that the extent to which the issues are carried is not so great as to drive out of the country too great a portion of the metallic currency, by which the convertibility of the paper into coin in case of a sudden panic occasioned by foreign war or domestic disturbance, or by fear of insolvency, might be endangered, the operations of the bank are decidedly beneficial to the country. It has disengaged from a comparatively unproductive employment, a capital capable of producing an annual profit to the nation equal to the average profits of capital, or, in other words, has substituted an expensive instrument of commerce by one costing less. And yet, by this operation, no permanent depreciation of the currency takes place, because the total quantity of coin and paper united is only equal to the quantity of coin that would have circulated had there been no bank.

From these positions two conclusions are self-evident: first, that banks of circulation are only beneficial to a country when they occasion the exportation of coin; and secondly, that paper is only beneficial when its quantity does not exceed the quantity of coin which has been removed from the currency by exportation. The actual extent to which this substitution may take place with safety to a banking system is a matter which cannot be determined by any fixed proportions. Some persons fancy that the extent to which a bank may loan without danger of reaction depends entirely upon the extent of its capital, and reason thus: if a bank with one million of dollars capital can with safety loan a million and a half, which is fifty per cent. increase, one with a capital of ten millions of dollars can loan to the extent of fifteen millions. Others imagine that the power of expansion in a bank always bears a fixed proportion to the average amount of its deposites and circulation; whilst others again entertain the idea that it depends upon the amount of coin it has in its vaults, and that if this be large, the amount of its issues may be proportionally large. All these hypotheses, however, are fallacious. The real truth is, as has been shown, that the channels of circulation will only hold, without depreciation, a certain quantity of paper in addition to the quantity of coin that must needs exist as the basis of the mixed currency, and this is equally the case whether the paper be issued by one bank or by one thousand. All attempts to increase that quantity permanently beyond the quantity requisite to preserve an equivalency with the general level, must, in the nature of things, be futile. If the channels are made to overflow, depreciation of the whole mass (for where convertibility exists the coin is involved in the depreciation in common with the paper) will necessarily take place, followed by an exportation of coin as a necessary effect from a cause, and all redundant issues of notes will return upon the issuers for payment, with the same unerring certainty as the fabled stone of Sysiphus rolled back upon the wretched struggler. It may, however, be here remarked, that the possible case might occur of a favorable balance of trade existing at the same time that an expansion of the currency has taken place, the consequence of which would be, that the former, by occasioning a low rate of exchange, would arrest the tendency of the depreciated currency to relieve itself by exportation. But such a state of things could not long continue, and it is merely referred to as presenting one of the phenomena which we occasionally witness, and which sometimes puzzle the heads of superficial reasoners so much that they deny the existence of all fixed principles in political economy.

There is, however, one circumstance connected with the corrective power of exportation, which is of vast importance, and which renders the paper currency of the United States more liable to excessive depreciation than that of any European country. I allude to the effect produced by a war with any powerful maritime nation, which by augmenting the rates of freight and insurance on specie, prevents the application of the remedy against over issues by the banks, at as early a stage of depreciation as would take place in time of peace. Thus in a time of peace, one per cent. would cover those charges between North America and Europe, whereas in a time of war, five or ten per cent. might be required, the inevitable result of which would be, that the paper currency, although convertible on demand into coin, might be depreciated to the extent of five or ten per cent. below the general level, and foreign bills of exchange might rise to that extent above the real par, before the merchants, having remittances to make, would find it advantageous to ship specie, and consequently before any reaction would be felt by the banks. This fact ought to have weight with our public men, as being one of the most fatal of the elements which make up the aggregate of national suffering, arising from a state of war, as may be well remembered by those who witnessed the suspension of specie payments in 1814 during our war with England, and its disastrous consequences.