A second method is to restrict theamount of the aggregate issue. The limit may be absolutely fixed at so many milliards, as in France or Germany, or be limited according to the gov- ernment debt or the issuing bank's capital, as in the United
States. The limit fixed may or may not be elastic—the 5 per
cent tax on the excess as used in Germany, or the Aldrich- Vreeland Currency Associations formerly used in the United
States, illustrates the elastic limit. Indirect limitations maybe imposed in variousways, suchas by:
1. Allowing only large denominations which will not circu- latefreely—forinstance, theBankofEnglandnoteand the national bank note are relatively large denomina-
tions.
2. Requiring immediate clearance and redemption, as in
Canada.
3. Limitingthe areaof circulation.
4. Guarding the nature of loansand assets andsupervising the banks' practices through legal restraints, regula- tions, examinations, and reports. These methods of indirectlimitationarecombinedinvaryingdegreesand ways.
Athirdgroupofmethodsof protectingnoteholders withulti-
matesecurityistopledgespecial assets. Thesegregationofthese assets,usuallythoseofbetterqualitythan therest,forthespecial securityofbanknotesismadetothedetrimentofthe securityfor deposits. This partiality is showntonotes becauselegislatures, for previously mentioned reasons, regard the noteholder as a more immediate wardofthe state.
Theparticular assets set aside for the protectionofthenote- holders are usually high-quality assets, such as mortgages or governmentbonds, andarepledged with thegovernment, which
isauthorizedtosell thebonds and redeemtheoutstandingnotes.
Commercialpapers,such as notesandacceptances of tradesmen andmanufacturers,areveryserviceable assetsforuseasapledge against notes, because they open a waytoprocure elasticity.
Another systemofaffording securityis tohaveagovernment or other large institution orgroupof institutionsstand guarantor of the notes issued. The security of the notes is then that of both the commercialworldandthe government or guaranteeing institution. Thebestexampleofthissystemisournationalbank system,for the notes ofwhichourfederal Treasurystands prac-
tical guarantor.
3. Elasticity of Note Issues
Thegreatdangerinany systemofprotectionofnoteissuesis
that therestrictionsmaybe sorigid as todestroy orunduly cir-
cumscribeelasticity of issue. Anote issueshouldbe capableof
expanding suddenly and greatly in case of emergency, and of contracting as readily when the emergency subsides. It should alsobeable to increase and decrease with the seasonaldemands
for money. The term "elasticity" is strictly applicable to the latter case only. Elasticity of the currency is desirable so that:
1. Accommodation, particularly to deserving and efficient borrowers, can be extendedfreelyandthe continuity of business maintained.
2. The marketrateof interestmaybestabilizedandfluctua- tionsofcredit reduced.
3. The quantity of money rather than the price level may
fluctuate seasonally.
It ishighlydesirable that anexpansionor contraction of the volume of bank notes should be unmistakably in response, re- spectively, to an increased or lessened demand of the legitimate businessworld—ademandnotbased, excepttoarelativelysmall
degree, on speculative operations but on actual industrial and
PROTECTION OF BANK NOTE HOLDERS 11
7
commercial operations. This correlation may be most surely achieved by issuing bank notes only to borrowers who use the funds onlyforsuch legitimatepurposes. Inpractice thepersons
who decide whether the purpose alleged is legitimate, and who watch to see that the loans are used for the alleged purpose, are the loaningbankers.
Methodsof Attaining Elasticity
One method for bringing about the desired correlation be- tween theexpansion or contractionof the volume of banknotes and the increased or lessened demand of the business world is to allocate the issue function to a central body and require the pledge of strictly defined commercialpaper, bearing evidenceof itscommercialoriginand use, as theba^is ofnotesissued. Ifthe quantity of such eligiblepaper increasesin response to seasonal development of trade, more maybe pledgedas security forbank note issues. When business again slumps, the payment of the commercial paperwill recall the banknotes.
It is evident that such seasonal responsiveness is defeated if
the volume of bank notes depends upon long-term investments insteadofself-liquidatingpaper,forthereisnoassurance thatthe funds arebeing used for thealleged original purpose, or, having beenso used, thatthey arenot being usedin subsequentillegiti-
mate operations. Moreover the loaning bank, feehng amply securedandperhaps therefore indifferent as to the uses towhich the loanisput, mayfreelyrenew the loan until it becomes prac- tically a continuous loan; the request for renewal would never have been made, however, if the loan had beenself-liquidating.
The ideal collateral for bank note issues is, therefore, strictly self-liquidatingcommercial andindustrial paper of short usance.
Itisnotimpossible,ofcourse,toeffect elasticity,even though thebanknotesaresecuredbypledgeofstocksand bondsorother permanentinvestments,provided bankersassure themselvesthat the funds areusedinshort-termcommercial andindustrial ways
and that they are withdrawn from circulation when those uses haveceased. Infact, itmaybe verydesirableto issuebanknotes freely upon the basis of promissory notes secured by pledge of
bonds and other investment securities. In the United States duringthe latewar, the great disturbancesof the money market occasioned by war financing were very much alleviated by the legal possibility of rediscounting such war paper and procuring in thiswayfederalreservenotesorcreditwith thefederal reserve banks. In this case the need for currency was oftentimes too suddenly and too greatly increased to place dependence upon pledgingstrictlycommercialpaper,thevolumebeingtoosmallor tooconstant,anditwasexpedient, therefore, toprovidefordirect loansbythe federal reservebanksagainstgovernmentsecurities, or for rediscounting war paper given to member banks by loan subscribers.
Ifnolimitationsare laidby law on creditissues, the bankers will of theirown accordnormally provide elasticnoteissues and
elasticdeposit currency. Theneeds of thebusinessworld willbe indicated by the aggregate of applications for loans and by the rates ofinterest that borrowersare willingtopay. Asloansand discountsexpand, deposits andnoteissues willexpand inpi©por- tion; and subsequently, when business men sell their stores of goodsor realizeupon theircustomers' accounts, the loans at the
bank will be lifted, the deposits canceled, and the notesretired.
Ifthe state requiresaminimumpercentagereserve ingold against notes or deposits, or both, it is evident thata maximum for the issueisfixedbythe goldinthebank's reserves. Ifthe stategoes further and allows issues only against certain assets specifically pledged, a morerigidlimit isput on the issueand, asin thecase of our national bank note, all elasticity may be forfeited. The
federalreserve systemhas a planforpledging commercial papers as collateralfornoteswhichachieveselasticityof issue.
Elasticitycannotbeattainedsimplybyprovidingameansof expandingtheissue;itmustalsoprovideforcontracting theissue