This second discount is what is known as a rediscount. The Federal Reserve Banks are, therefore, bankers' banks, and they do for the individual member banks precisely what the individual banks do for their customers generally. This ability to convert paper into cash and thereby increase its reserve enables the Joliet bank to extend loans to its customers even under severe financial pressure.

Suppose that a bank in a rural community in the Chicago district finds, in the face of an emergency, that there is a heavy demand for loans in the form of bank notes. How can the increased quantity of notes be obtained? Under the new law elasticity of note issue is gained by permitting the issue of notes secured by commercial paper or bank assets. The country bank desiring to issue more notes sends some of the promissory notes of customers to the Federal Reserve Bank in Chicago for rediscount. The latter may upon this paper as security have printed new bank notes and send them to the country bank. This gives an elastic bank-note currency because the demand for more money itself brings into existence the commercial paper that is to be the security for the new notes. A farmer, for example, wants money with which to pay his laborers. So he gives his banker a promissory note, which is secured by the crops soon to be marketed. His banker rediscounts the promissory note and turns the necessary bank notes over to the farmer. But when the need is passed this currency is contracted. The farmer sells his crops and pays his promissory note at the bank. The bank now pays these notes over to the Federal Reserve Bank in Chicago to meet the obligation which had resulted from the rediscount. Bank notes equal in quantity to the amount issued have now come back to the place of issue. The payment of the obligation which brought them forth has automatically retired them.

By these means panics can be substantially checked if not prevented altogether. In the face of a heavy pressure of loans at a time of crisis, any bank can avail itself of the process of rediscounting. This enlarges the loaning power of the banks, makes it possible for legitimate business concerns to secure bank accommodations when needed, and thereby prevents failures. A business which is unsound or mismanaged is not entitled to and cannot obtain loans from a bank. It deserves to fail, and its early failure will be distinctly beneficial. But the business concern which is fundamentally sound and well managed ought to be able to secure banking accommodations. The new currency law permits this; and at the same time the ability of the banks to provide more currency and to expand loans enables banks to meet all obligations, forestall runs, and escape failures.

128. Emergency Elasticity of Note Issue35

BY FRED M. TAYLOR

From the beginnings of agitation for currency reform the advocates of elasticity have recognized more or less clearly two kinds: (1) that which we may call seasonal or ordinary elasticity, and (2) that which we may call emergency elasticity. By the latter is meant the power of a note issue to adjust its volume to those extraordinary changes in need which connect themselves with the typical banking panic.

Passing over the question of the adequacy of the new note issue in respect to seasonal or ordinary elasticity, let us consider its adequacy in respect to emergency elasticity. Broadly speaking, it is certain that at this point the new law will get a fairly favorable verdict. The banking panic, when fully developed, gives rise to three-difficulties and to three needs: (1) funds to relieve the antecedent stringency which threatens a complete collapse of the credit structure; (2) a circulating medium for ordinary financial trade when a general suspension of payments by the banks has brought on a money famine; and (3) a prompt and thoroughgoing contraction of the circulation in the depression which follows the panic.

There can be doubt that under the new law the availability of an issue sufficient in volume instantly to relieve the antecedent stringency, and so to put a stop to the panic before it has developed to serious proportions, is assured. In fact it is not at all improbable that the new reserve banks will be able to check the development of such a panic at the very outset without increasing at all their note issues. But, if this does not prove true, there seems no doubt that the new system will insure the forthcoming of such currency both of a quality and in a quantity which will be fully adequate for the task put upon it. (1) The notes to be issued, being obligations of the Federal Treasury, will be as acceptable as gold even on the eve of a panic. (2) There is no limit to the absolute amount of these notes. (3) The practical limit set by the requirement that discounted paper shall be furnished as the basis for their issue is of no real significance, since such paper will undoubtedly be vastly greater in volume than any need which could arise.

Let us pass to the second need which is to be met, that of an ordinary circulating medium for trade when banks have by common consent suspended payment. In the first place, if we are right in supposing that the new law will prevent any panic from reaching

85

Adapted from "The Elasticity of Note Issue under the New Currency Law," in the Journal of Political Economy, XXII, 454, 460–463 (1914).

such a degree of intensity, it is obvious that we shall not have occasion to meet this particular difficulty. If, however, this does not turn out to be correct, if panics can still go so far as to suspend payments, as to hold on to every form of reasonably solid money, and as to try to satisfy the public with substitutes, our verdict for the new currency will be less favorable. The new law does little or nothing to relieve such a situation. Broadly speaking, the new money will be altogether too good to meet this particular need. Banks that had reached a stage of panic sufficiently intense to cause them to suspend payment would be sure to hoard money as good as these notes are bound to be. The new issue would immediately pass into hoards and, therefore, would bring little if any relief to the currency famine which had developed. In fact it is almost impossible to conceive any form of note fitted to this particular task except one so bad that there was no danger of its being hoarded. The only proper way to meet this particular need is to make sure that it does not rise at all.

We come finally to the third need which is to be met, that of a prompt and general contraction of the circulation when the panic has passed and the inevitable business depression consequent upon such a panic has set in. Here again, though not in the same degree as in the last case, if the new law proves as successful as anticipated, the need in question will be little experienced. We shall usually escape the extreme business inflation of the ante-panic period; the panic itself will be much abated, if not completely eliminated; and, in consequence, the trade reaction which naturally follows a panic will be much diminished in intensity. Yet, it can hardly be doubted that, after even an incipient panic, there will be some reaction, and consequently a more or less plethoric condition of the currency will follow. Will the new issue have sufficient contractility to meet the need? In general the conditions attached to the new issue are not favorable to contractility. They do not provide for either the prompt driving home or the prompt drawing home of the notes when the necessity for their issue is past. Outsiders lack adequate motives for sending these notes home; issuers lack adequate motives for calling them home. The case for emergency contractility is, however, strengthened by one or two peculiar conditions. First, it is probable that the homing power of the note will prove greater at such a time than in an ordinary year, for, at such a time, outside banks will not be able to find investments for their funds, since speculative trading will disappear and business generally will be at a very low ebb. Again, it seems that the issuing bank will, in this case, have more than the usual motive for bringing about a contraction of the circulation. In ordinary times a bank will gain more by using the funds in

its possession to make loans rather than to retire notes, assuming that the interest charge made by the Federal Reserve Board is not placed excessively high. Consequently banks will not be eager to retire their own notes. But, in the depression that follows a panic, no reserve bank will have opportunity for keeping all its funds busy; and since in this case the interest charge, however small, will be a dead loss, the bank will have adequate motive for effecting, as promptly as possible, an adequate contraction of its note liabilities. This motive would be still further strengthened if the glut proved sufficient to cause a decided drain of gold, since, in that case, the reserve banks will find difficulty in maintaining the required 40 per cent reserve. On the whole, then, we seem warranted in affirming that, as respects emergency elasticity, the new notes will give no serious disappointment.

CONTROL OF THE INDUSTRIAL CYCLE

129. Panic Rules for Banks 36

BY WALTER BAGEHOT

In time of panic, advances, if they are to be made at all, should be made so as, if possible, to obtain the object for which they are made. The end is to stay the panic; and the advances should, if possible, stay the panic. And for that purpose there are two rules:

First. That these loans should be made only at a very high rate of interest. This will operate as a heavy fine on unreasonable timidity, and will prevent the greater number of applications by persons who do not require it. The rate should be raised early in the panic, so that the fine may be paid early; that no one may borrow out of idle precaution without paying well for it; that the banking reserve may be protected as far as possible.

Secondly. That at this rate these advances should be made on all good banking securities, and as largely as the public asks for them. The reason is plain. The object is to stay alarm, and nothing, therefore, should be done to cause alarm. But the way to cause alarm is to refuse someone who has good security to offer. The news of this will spread in an instant through all the money markets at a moment of terror; no one can say exactly who carries it, but in half an hour it will be carried on all sides, and will intensify the terror everywhere. No advances indeed need be made by which the banks will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business. That

"Adapted from Lombard Street, 10th ed., 199-200 (1873).

such a degree of intensity, it is obvious that we shall not have occasion to meet this particular difficulty. If, however, this does not turn out to be correct, if panics can still go so far as to suspend payments, as to hold on to every form of reasonably solid money, and as to try to satisfy the public with substitutes, our verdict for the new currency will be less favorable. The new law does little

or nothing to relieve such a situation. Broadly speaking, the new money will be altogether too good to meet this particular need. Banks that had reached a stage of panic sufficiently intense to cause them to suspend payment would be sure to hoard money as good as these notes are bound to be. The new issue would immediately pass into hoards and, therefore, would bring little if any relief to the currency famine which had developed. In fact it is almost impossible to conceive any form of note fitted to this particular task except one so bad that there was no danger of its being hoarded. The only proper way to meet this particular need is to make sure that it does not rise at all. We come finally to the third need which is to be met, that of a prompt and general contraction of the circulation when the panic has passed and the inevitable business depression consequent upon such a panic has set in. Here again, though not in the same degree as in the last case, if the new law proves as successful as anticipated, the need in question will be little experienced. We shall usually escape. the extreme business inflation of the ante-panic period; the panic itself will be much abated, if not completely eliminated; and, in consequence, the trade reaction which naturally follows a panic will be much diminished in intensity. Yet, it can hardly be doubted that, after even an incipient panic, there will be some reaction, and consequently a more or less plethoric condition of the currency will follow. Will the new issue have sufficient contractility to meet the need? In general the conditions attached to the new issue are not favorable to contractility. They do not provide for either the prompt driving home or the prompt drawing home of the notes when the necessity for their issue is past. Outsiders lack adequate motives for sending these notes home; issuers lack adequate motives for calling them home. The case for emergency contractility is, however, strengthened by one or two peculiar conditions. First, it is probable that the homing power of the note will prove greater at such a time than in an ordinary year, for, at such a time, outside banks will not be able to find investments for their funds, since speculative trading will disappear and business generally will be at a very low ebb. Again, it seems that the issuing bank will, in this case, have more than the usual motive for bringing about a contraction of the circulation. In ordinary times a bank will gain more by using the funds in