There is nothing remarkable in the fact that money substitutes, as completely liquid claims to money against persons whose capacity to pay is beyond all doubt, have a value as great as the sums of money to which they refer Admittedly, the question does arise: Are there any persons whose capacity to pay is so completely certain as to be quite beyond all doubt? And it may be pointed out that more than one bank, whose solvency nobody had dared to call in question even the day before, has collapsed ignominiously; and that so long as the remembrance of events of this sort has not entirely vanished from human memory, it must evoke at least a small difference between the valuation of money and that of claims to money payable at any time, even if, as far as human foresight goes, these latter are to be regarded as completely sound.

It is undeniable that such questions reveal a possible source of a certain lack of confidence in notes and checks, which would necessarily result in money substitutes having a lower value than money. But, on the other hand, there are reasons which might cause individuals to value money substitutes more highly than money, even if demands for the conversion of money into money substitutes were not always satisfied immediately. We shall have to speak of this later. Furthermore, quite apart from all these circumstances, it should be clearly pointed out that doubts as to the quality of fiduciary media are hardly tenable nowadays. In the case of money substitutes of medium and small denominations, among which token coins occupy the most important place, doubts of this nature do not come into consideration at all. But in the case also of the money substitutes that are used to meet the requirements of large-scale business, the possibility of loss is as good as nonexistent under present conditions; at least the possibility of loss is no greater in connection with the money substitutes issued by the large central banks than is the danger of demonetization that threatens the holders of any particular kind of money.

Now the complete equivalence of sums of money and secure claims to immediate payment of the same sums gives rise to a consequence that has extremely important bearings on the whole monetary system; namely, the possibility of tendering or accepting claims of this sort wherever money might be tendered or accepted. Exchanges are made through the medium of money; this fact remains unaltered. Buyers buy with money, and sellers sell for it. But exchanges are not always made by the transfer of a sum of money. They may also be made by the transfer or assignment of a claim to money. Now claims to money which fulfill the conditions mentioned above pass from hand to hand without those who acquire them feeling any need for actually enforcing them. They completely perform all the functions of money. Why then should the bidders burden themselves with the trouble of redeeming them? The claim which has been set in circulation remains in circulation, and becomes a money substitute. So long as confidence in the soundness of the bank is unshaken, and so long as the bank does not issue more money substitutes than its customers require for their dealings with one another (and everybody is to be regarded as a customer of the bank who accepts its money substitutes in place of money), then the situation in which the right behind the money substitute is enforced by presentation of notes for redemption or by withdrawal of deposits simply does not arise. The bank-of-issue may therefore assume that its money substitutes will remain in circulation until the necessity of dealing with persons outside the circle of customers forces holders to redeem them. This, in fact, is the very thing which enables the bank to issue fiduciary media at all, that is, to put money substitutes in circulation without maintaining in readiness the sum that would be necessary to keep the promise of immediate conversion that they represent.

The body which issues the fiduciary media and is responsible for maintaining their equivalence with the sums of money to which they refer must nevertheless be able to redeem promptly those fiduciary media which their holders present for conversion into money when they have to make payments to persons who do not recognize these fiduciary media as money substitutes. This is the only way in which a difference between the value of money on the one hand and of the notes and deposits on the other hand can be prevented from coming into existence.

The view has sometimes been expressed that if an issuing body wishes to secure equivalence between its fiduciary media and the money to which they refer, it should take precautions so as to be able to redeem those fiduciary media that are returned to it through lack of confidence on the part of the holders. It is impossible to subscribe to this view; for it completely fails to recognize the significance and object of a conversion fund. It cannot be the function of a conversion fund to enable the issuing body to redeem its fiduciary media when its counters are besieged by holders who have lost confidence in them. Confidence in the capacity of circulation of fiduciary media is not an individual phenomenon; either it is shared by everybody or it does not exist at all. Fiduciary media can fulfill their function only on the condition that they are fully equivalent to the sums of money to which they refer. They cease to be equivalent to these sums of money as soon as confidence in the issuer is shaken even if only among a part of the community. The yokel who presents his note for redemption in order to convince himself of the bank’s capacity to pay, which nobody else doubts, is only a comic figure that the bank has no need to fear It need not make any special arrangements or take any special precautions on his account. But any bank that issues fiduciary media is forced to suspend payments if everybody begins to present notes for redemption or to withdraw deposits. Any such bank is powerless against a panic; no system and no policy can help it then. This follows necessarily from the very nature of fiduciary media, which imposes upon those who issue them the obligation to pay a sum of money which they cannot command.1

The history of the last two centuries contains more than one example of such catastrophes. Those banks that have succumbed to the onslaughts of noteholders and depositors have been reproached with bringing about the collapse by granting credit imprudently, by tying up their capital, or by advancing loans to the state; extremely serious charges have been brought against their directors. Where the state itself has been the issuer of the fiduciary media, the impossibility of maintaining their redeemability has usually been ascribed to their having been issued in defiance of precepts based on banking experience. It is obvious that this attitude is due to a misunderstanding. Even if the banks had put all their assets in short investments, that is, in investments that could have been realized in a relatively short time, they would not have been able to meet the demands of their creditors. This follows merely from the fact that the banks’ claims fall due only after notice has been given, while those of their creditors are payable on demand. Thus there lies an irresolvable contradiction in the nature of fiduciary media. Their equivalence to money depends on the promise that they will at any time be converted into money at the demand of the person entitled to them and on the fact that proper precautions are taken to make this promise effective. But—and this is likewise involved in the nature of fiduciary media—what is promised is an impossibility insofar as the bank is never able to keep its loans perfectly liquid. Whether the fiduciary media are issued in the course of banking operations or not, immediate redemption is always impracticable if the confidence of the holders has been lost.

• 1See Ricardo, “Proposals,” in Works, ed. McCulloch, 2d ed. (London, 1852), p. 406; Walras, Études d’économie politique appliquée (Lausanne, 1898), pp. 365 f.

Recognition of the fact, which had been pointed out before the time of Ricardo, that there is no way in which an issuer of fiduciary media can protect itself against the consequences of a panic or avoid succumbing to any serious run, may lead, if one likes, to a demand that the creation of fiduciary media should be prohibited. Many writers have adopted this attitude. Some have demanded the prohibition of the issue of such notes as have no metal backing; others, the prohibition of all clearing transactions except with full metallic cover; others again, and this is the only logical position, have combined both demands.2

Such demands as these have not been fulfilled. The progressive extension of the money economy would have led to an enormous extension in the demand for money if its efficiency had not been extraordinarily increased by the creation of fiduciary media. The issue of fiduciary media has made it possible to avoid the convulsions that would be involved in an increase in the objective exchange value of money, and reduced the cost of the monetary apparatus. Fiduciary media tap a lucrative source of revenue for their issuer; they enrich both the person that issues them and the community that employs them. In the early days of the modern banking system they played a further part still by strengthening the credit-negotiating activities of the banks (which in those times could hardly have proved profitable if carried on for their own sake alone) and so brought the system safely past those obstacles which obstructed its beginnings.

Prohibition of the issue of all notes except those with a full backing and of the lending of the deposits which serve as the basis of the check-and-clearing business would mean almost completely suppressing the note issue and almost strangling the check-and-clearing system. If notes are still to be issued and accounts opened in spite of such a prohibition, then somebody must be found who is prepared to bear unrecompensed the costs involved. Only very rarely will this be the issuer, although occasionally such a thing happens. The United States created silver certificates in order to relieve the business world of the inconveniences of the clumsy silver coinage and to remove one of the obstacles in the way of an extended use of the silver dollar, which it was thought desirable to encourage for reasons of currency policy. Similarly for reasons of currency policy, gold certificates were created, so as to bring gold money into use despite the public preference for paper.3

Sometimes the public may be willing to use notes, checks, or giro transfers for technical reasons, even if it has to make a certain payment to the bank for the facility. There are sometimes objections to the physical use of coins, which are not involved in the transfer of claims to deposited sums of money. The storage of considerable sums of money and their insurance against risk from fire and flood and from robbery and theft are not always a small matter even for the individual merchant, and still less so for the private person. Warrants payable to order and checkbooks whose folios have no significance until they have been signed by an authorized person are less liable to dishonest handling than are coins, whose smooth faces tell no tales of the methods by which they have been acquired. But even banknotes, which retain no relationships to individuals, are yet easier to preserve against destruction and to secure against depredation than are bulky pieces of metal. It is true that the large accumulations of money deposited in the banks constitute all the more profitable and therefore attractive an objective for criminal enterprise; but in their case it is possible to take such precautionary measures as will afford almost complete safety, and it is similarly easier to safeguard such large deposits against the risk of accidental damage by the elements. It has proved a more difficult matter to withdraw the coffers of the banks from the grasp of those in political power; but even this has eventually been achieved, and such coups de main as those of the Stuarts or Davousts have not been repeated in modern times.

A further motive for the introduction of payment through the mediation of the banks has been provided by the difficulty of determining the weight and fineness of coins in the ordinary course of daily business. In this way debasement of the coinage led to the establishment of the famous banks of Amsterdam and Hamburg. The commission of one-fortieth percent which the customers of the Bank of Amsterdam had to pay on each deposit or withdrawal4  was far outweighed by the advantages offered by the trustworthiness of the bank currency. Finally; the saving of costs of transport and the greater handiness are other advantages of banking methods of payment that have similarly entered into consideration, especially in countries with a silver, or even a copper, standard. Thus in Japan as early as the middle of the fourteenth century, certain notes issued by rich merchants were in great demand because they offered a means of avoiding the costs and inconveniences involved in the transport of the heavy copper coinage.5  The premium at which banknotes sometimes stood as against metallic currency before the development of the interlocal check-and-clearing business and the post-office-order service can most easily be explained along these lines.6

It is clear that prohibition of fiduciary media would by no means imply a death sentence for the banking system, as is sometimes asserted. The banks would still retain the business of negotiating credit, of borrowing for the purpose of lending. Not consideration for the banks, but appreciation of the influence of fiduciary media on the objective exchange value of money; is the reason why they have not been suppressed.

• 2See for example, Tellkampf, Die Prinzipien des Geld-und Bankwesens (Berlin, 1867), pp. 181 ff.; Erfordernis voller Metalldeckung der Banknoten (Berlin, 1873), pp. 23 ff.; Geyer, Theorie und Praxis des Zettelbankwesens, 2d ed. (Munich, 1874), p. 227.
• 3See Hepburn, History of Coinage and Currency in the United States (New York, 1903), p. 418.
• 4See Dunbar, Chapters on the Theory and History of Banking, 2d ed. (New York, 1907), p. 99.
• 5See Kiga, Das Bankwesen Japans, Leipziger Inaug. Diss., p. 9.
• 6See Oppenheim, Die Natur des Geldes (Mainz, 1855), pp. 241 f.

A person who holds money substitutes and wishes to transact business with persons to whom these money substitutes are unfamiliar and therefore unacceptable in lieu of money is obliged to change the money substitutes into money. He goes to the body that is responsible for maintaining equivalence between the money substitutes and money and proceeds to enforce the claim that the money substitutes embody. He presents the notes (or token coins or similar form of currency) for conversion or withdraws his deposits. It follows from this that whoever issues money substitutes is never able to put more of them into circulation than will meet the needs of his customers for business among themselves. All issues in excess of this will return to the issuer, who will have to accept them in exchange for money if he does not wish to destroy the confidence on which his whole business is built up. (In view of what has been said in the preceding chapter and remains to be said in the following chapter, it should not be necessary to state expressly in this place also that this is true only when several coexisting banks issue money substitutes which have a limited capacity of circulation. If there is only a single bank issuing money substitutes, and if these money substitutes have an unlimited capacity of circulation, then there are no limits to the extension of the issue of fiduciary media. The case would be the same if all the banks had a common understanding as to the issue of their money substitutes and extended the circulation of them according to uniform principles.)

Thus, in the circumstances assumed, it is not possible for a bank to issue more money substitutes than its customers can use; everything in excess of this must flow back to it. There is no danger in this so long as the excess issue is one of money certificates; but an excess issue of fiduciary media is catastrophic.

Consequently the chief rule to be observed in the business of a credit-issuing bank is quite clear and simple: it must never issue more fiduciary media than will meet the requirements of its customers for their business with each other. But it must be admitted that there are unusually big difficulties in the practical application of this maxim for there is no way of determining the extent of these requirements on the part of customers. In the absence of any exact knowledge on this point the bank has to rely upon an uncertain empirical procedure which may easily lead to mistakes. Nevertheless, prudent and experienced bank directors—and most bank directors are prudent and experienced—usually manage pretty well with it.

It is only exceptionally that the clienteles of the credit-issuing banks as such extend beyond political boundaries. Even those banks that have branches in different countries give complete independence to their individual branches in the issue of money substitutes. Under present political conditions, uniform administration of banking firms domiciled in different countries would hardly be possible; and difficulties of banking technique and legislation, and finally difficulties of currency technique, stand in the way also. Furthermore, within individual countries it is usually possible to distinguish two categories of credit banks. On the one hand there is a privileged bank, which possesses a monopoly or almost a monopoly of the note issue, and whose antiquity and financial resources, and still more its extraordinary reputation throughout the whole country, give it a unique position. And on the other hand there is a series of rival banks, which have not the right of issue and which, however great their reputation and the confidence in their solvency, are unable to compete in the capacity for circulation of their money substitutes with the privileged bank, behind which stands the state with all its authority. Different principles apply to the policies of the two kinds of bank. For the banks of the second group, it is sufficient if they keep in readiness for the redemption of those money substitutes which are returned to them a certain sum of such assets as will enable them to command on demand the credit of the central bank. They extend the circulation of their fiduciary media as far as possible. If in so doing they exceed the issue that their customers can absorb, so that some of their fiduciary media are presented for redemption, then they procure from the central bank the necessary resources for this by rediscounting bills from their portfolio, or by pledging securities. Thus the essence of the policy that they must pursue to maintain their position as credit-issuing banks consists in always maintaining a sufficiently large quantity of such assets as the central bank regards as an adequate basis for granting credit.

The central banks have no such support from a more powerful and distinguished institution. They are thrown entirely upon their own resources, and must shape their policy accordingly. If they have put too many money substitutes into circulation so that holders apply for their redemption, then they have no other way out than that provided by their redemption fund. Consequently, it is necessary for them to see that there are never more of their fiduciary media in circulation than will meet the requirements of their customers. As has already been said, it is not possible to make a direct evaluation of these requirements. Only an indirect evaluation is practicable. The proportion of the total demand for money in the broader sense that cannot be satisfied by fiduciary media must be determined. This will be the quantity of money that is necessary for doing business with the persons who are not customers of the central bank; that is, the quantity required for purposes of foreign trade.

The demand for money for international trade is composed of two different elements. It consists, first, of the demand for those sums of money which, as a result of variations in the relative extent and intensity of the demand for money in different countries, are transported from one country to another until that position of equilibrium is reestablished in which the objective exchange value of money has the same level everywhere. It is impossible to avoid the transfers of money that are necessary on this account. It is true that we might imagine the establishment of an international deposit bank in which large sums of money were deposited, perhaps even all the money in the world, and made the basis of an issue of money certificates, that is, of notes or balances completely backed by money. This well might put a stop to the physical use of coins, and might in certain circumstances tend to a considerable reduction of costs; instead of coins being used, notes would be sent or transfers made in the books of the bank. But such external differences would not affect the nature of the process.

The other motive for international transfers of money is provided by those balances that arise in the international exchange of commodities and services. These have to be settled by transfers in opposite directions, and it is therefore theoretically possible to eliminate them completely by developing the clearing process.

In foreign-exchange dealings and the related transactions that in recent times have been united with them, there is a fine mechanism which cancels out nearly all such transfers of money. It is only exceptionally nowadays that two ships meet at sea, one of them taking gold from London to New York and the other bringing gold from New York to London. International transfers of money are controlled as a rule merely by variations in the ratio between the demand for money and the stock of money. Among these variations, those with the greatest practical importance are those which distribute the newly mined precious metals throughout the world, a process in which London often plays the part of a middleman. Apart from this, and provided that no extraordinary cause suddenly alters the relative demand for money in different countries, the transference of money from country to country cannot be particularly extensive. It may be assumed that, as a rule, the variations that occur in this way are not so great as those variations in stocks of money that are due to new production, or at least that they do not exceed them by very much. If this is true—and it is supported only by rough estimates—then the movements which are necessary for bringing the purchasing power of money to a common level will consist largely or entirely of variations in the distribution of the additional quantity of money only.

It is possible to estimate on empirical grounds that the relative demand for money in a country, that is, the extent and intensity of its demand for money in relation to the extent and intensity of the demand for money in other countries (this phrase being interpreted throughout in the broader sense), will not decrease within a relatively short period to such an extent as to cause the quantity of money and fiduciary media together in circulation to sink below such and such a fraction of its present amount. Of course, such estimates are necessarily based upon more or less arbitrary combinations of factors and it is obviously never out of the question that they will be subsequently upset by unforeseen events. But if the amount is estimated very conservatively, and if due account is also taken of the fact that the state of international trade may necessitate transfers of money from country to country if only temporarily, then, so long as the quantity of fiduciary media circulating within the country is not increased beyond the estimated amount and no money certificates are issued either, the accumulation of a redemption fund might prove altogether unnecessary. For so long as the issue of fiduciary media does not exceed this limit, and assuming of course the correctness of the estimate on which it is based, there can arise no demand for redemption of the fiduciary media. If, for example, the quantity of the banknotes, treasury notes, token coins, and deposits at present in circulation in Germany were reduced by the sum deposited as cover for it in the vaults of the banks, the money and credit system would not be changed in any way. Germany’s power to transact business through the medium of money with foreign countries would not be affected.7  It is only the notes, deposits, and so forth, that are not covered by money that have the character of fiduciary media; it is these only and not those covered by money that have the effects on the determination of prices which it is the task of this part of our book to describe.

If the amount of fiduciary media in circulation were kept at a level below the limit set by the presumable maximum requirements of foreign trade, then it would be possible to do without a redemption reserve altogether, if it were not for a further circumstance that enters into the question. This circumstance is the following: if persons who needed a sum of money for foreign payments and were obliged to obtain it by the exchange of money substitutes could do this only through numerous money-changing transactions, perhaps involving an expenditure of time and trouble so that the procedure cost them something, this would militate against the complete equivalence of money substitutes and money, causing the former to circulate at a discount. Hence, if only on this account, a redemption fund of a certain amount would have to be maintained, even though the quantity of money actually in circulation was enough for trade with foreign countries. It follows from this that the fully backed note and the fully covered deposit, originally necessary in order to accustom the public to the use of these forms of money substitute, have still to be retained nowadays along with the superficially similar but essentially different fiduciary medium. A note or deposit currency with no money backing at all, that is, one which consists entirely of fiduciary media, still remains a practical impossibility.

If we look at the redemption funds of the self-sufficing banks, we shall observe in them an apparently quite irregular multifariousness. We shall observe that the kind and amount of cover of the money substitutes, especially those issued in note form, are regulated by a series of rules, constructed on quite different lines, partly by mercantile usage and partly by legislation. It is hardly correct to speak of different systems in this connection; that ambitious designation is little suited to empirical rules that have for the most part been founded on erroneous views of the nature of money and fiduciary media. There is, however, one idea that is expressed in all of them; the idea that the issue of fiduciary media needs to be limited by some kind of artificial restriction since it has no natural limits. Thus the question underlying all monetary policy, whether an unlimited increase of fiduciary media with its ineluctable consequence of a diminution in the objective exchange value of money is a thing to be encouraged, is implicitly answered in the negative.

Recognition of the need for an artificial limitation of the circulation of fiduciary media is, both on strictly scientific grounds and also on grounds of practical expediency, a product of economic inquiry during the first half of the nineteenth century. Its triumph over other views ended decades of such lively discussion as our science has seldom known, and at the same time concluded a period of uncertain experiment in the issuing of fiduciary media. During the years that have since elapsed, the grounds on which it was based have been subjected to criticism, sometimes ill founded, sometimes founded upon real objections. But the principle of limiting the issue of uncovered notes has not been abandoned in banking legislation. Nowadays it still constitutes an essential element in the banking policy of civilized nations, even if the circumstance that the limitation only applies to the issue of fiduciary media in the form of notes and not to the constantly growing issue in the form of deposits may make its practical importance less than it was some decades ago.

Limitation of fiduciary media also forms part of the money and credit system in India, the Philippines, and those countries that have imitated them, although in a different garb. No direct numerical proportion has been set up between the redemption fund administered by the government and the quantity of fiduciary media in circulation; any attempt to do this would have met with technical difficulties if only because it was impossible to calculate exactly what the quantity of fiduciary media was at the time of the transition to the new standard. But the further issue of fiduciary media in the form of legal-tender coinage is reserved to the state (it mostly requires special legislation) in a similar fashion to that in which the issue of token coinage and the like is regulated elsewhere.

• 7This example assumes the circumstances that existed before 1914.

The expressions solvency and liquidity are not always used correctly when they are applied to the circumstances of a bank. They are sometimes regarded as synonymous; but orthodox opinion understands them to refer to two different states. (It must be admitted that a clear definition and distinction of the two concepts is usually not attempted.)

A bank may be said to be solvent when its assets are so constituted that a liquidation would necessarily result at least in complete satisfaction of all of its creditors. Liquidity is that condition of the bank’s assets which will enable it to meet all its liabilities, not merely in full, but also in time, that is, without being obliged to ask for anything in the nature of a moratorium from its creditors. Liquidity is a particular sort of solvency. Every enterprise—for the same is true of any body that participates in credit transactions—that is liquid is also solvent; but on the other hand not every undertaking that is solvent is also liquid. A person who cannot settle a debt on the day when it falls due has not a liquid status, even if there is no doubt that he will be able in three or six months’ time to pay the debt together with interest and the other costs in which the delay is meanwhile involving the creditor.

Since ancient times commercial law has imposed on everybody the obligation to have regard to liquidity throughout the whole conduct of his business. This requirement is characteristically expressed in mercantile life. Anyone who has to approach his creditor for permission to defer the payment of a debt, anyone who allows matters to reach the point of having his bills protested, has imperiled his business reputation, even if he is afterward able to meet all his outstanding obligations in full. All undertakings are subject to the rule that we have already encountered as the business principle of the credit-negotiating banks, that steps must be taken to permit the full and punctual settlement of every claim as it falls due.8

For credit-issuing banks, regard to this fundamental rule of prudent conduct is an impossibility. It lies in their nature to build upon the fact that a proportion—the larger proportion—of the fiduciary media remains in circulation and that the claims arising from this part of the issue will not be enforced, or at least will not be enforced simultaneously. They are bound to collapse as soon as confidence in their conduct is destroyed and the creditors storm their counters. They, therefore, are unable to aim at liquidity of investment like all other banks and undertakings in general; they have to be content with solvency as the goal of their policy.

This is customarily overlooked when the covering of the issue of fiduciary media by means of short-term loans is referred to as a method that is peculiarly suited to their nature and function, and when the appellation “characteristically banking type of cover” is applied to it,9  because it is supposed that consistent application of the general rule about liquidity to the special circumstances of the credit-issuing banks shows it to be the system of investment that is proper to such banks. Whether the assets of a credit-issuing bank consist of short-term bills or of hypothecary loans remains a matter of indifference in the case of a general run. If the bank is in immediate need of large sums of money it can procure them only by disposing of its assets; when the panic-stricken public is clamoring at its counters for the redemption of notes or the repayment of deposits, a bill that has still thirty days to run is of no more use to it than a mortgage which is irredeemable for just as many years. At such moments the most that can matter is the greater or lesser negotiability of the assets. But in certain circumstances, long-term or even irredeemable claims may be easier to realize than short-term; in times of crisis, government annuities and mortgages may perhaps find buyers more readily than commercial bills.

It has already been mentioned that in most states two categories of banks exist, as far as the public confidence they enjoy is concerned. The central bank-of-issue, which is usually the only bank with the right to issue notes, occupies an exceptional position, owing to its partial or entire administration by the state and the strict control to which all its activities are subjected.10  It enjoys a greater reputation than the other credit-issuing banks, which have not such a simple type of business to carry on, which often risk more for the sake of profit than they can be responsible for, and which, at least in some states, carry on a series of additional enterprises, the business of company formation for example, besides their banking activities proper, the negotiation of credit and the granting of credit through the issue of fiduciary media. These banks of the second order may under certain circumstances lose the confidence of the public without the position of the central bank being shaken. In this case they are able to maintain themselves in a state of liquidity by securing credit from the central bank on their own behalf (as indeed they. also do in other cases when their resources are exhausted) and so being enabled to meet their obligations punctually and in full. It is therefore possible to say that these banks are in a state of liquidity so long as their liabilities as they fall due from day to day are balanced by such assets as the central bank considers a sufficient security for advances. It is well known that some banks are not liquid even in this sense. The central banks of individual countries could similarly attain a state of liquidity if they only carried such assets against their issues of fiduciary media as would be regarded as possible investments by their sister institutions abroad. But even then it would remain true that it is theoretically impossible to maintain the credit bank system in a state of liquidity. A simultaneous destruction of confidence in all banks would necessarily lead to a general collapse.

It is true that the investment of its assets in short-term loans does make it possible for a bank to satisfy its creditors within a certain comparatively short period. But this would prove adequate in the face of a loss of confidence only if the holders of notes and deposits did not apply simultaneously to the bank for immediate payment of the sums of money owing to them. Such a supposition is not very probable. Either there is no lack of confidence at all or it is general. There is only one way in which liquidity of status might be at least formally secured with regard to the special circumstances of credit-issuing banks. If such banks made loans only on the condition that they had the right to demand repayment at any time, then the problem of liquidity would of course be solved for them in a simple manner. But from the point of view of the community as a whole, this is of course no solution, but only a shelving, of the problem. The status of the bank could only apparently be kept liquid at the expense of the status of those who borrowed from it, for these would be faced with precisely the same insurmountable difficulty. The banks’ debtors would not have kept the borrowed sums in their safes, but would have put them into productive investments from which they certainly could not withdraw them without delay. The problem is thus in no way altered; it remains insoluble.

• 8See pp. 263 ff. But the fact is often ignored that this “principle of the banking adequate cover” is valid not only for banks but similarly for all other undertakings. See, for example, Schulze-Gaevernitz, “Die deutsche Kreditbank,” Grundriss der Sozialökonomik, Part V, section 2, pp. 240 ff.
• 9See Wagner, System der Zettelbankpolitik (Freiburg, 1873), pp. 240 ff.—The “golden rule” found its classical expression with regard to the business of credit banks in the famous “Note expédiée du Havre le 29 Mai 1810, à la Banque de France, par ordre de S. M. l’Empereur, et par l’entremise de M. le comte Mollien, ministre du Trésor” (I quote from the reprint in Wolowski, La Question des Banques [Paris, 1864], pp. 83-87): “Il faut qu’une banque se maintienne en état de se liquider à tout moment, d’abord, vis-à-vis des porteurs de ses billets, par la réalisation de son portefeuille, et, apres les porteurs de ses billets, viv-à-vis de ses actionnaires, par la distribution à faire entre eux de la portion du capital fourni par chacun d’eux. Pour ne jamais finir, une banque doit etre toujours prête à finir“ (p. 87). All the same, Mollien had no doubt on the point that a bank that does not issue its notes otherwise “qu’en échange de bonnes et valable lettres de change, à deux et trois mois de terme au plus” can only call in its notes from circulation “dans un espace de trois mois“ (ibid., p. 84).
• 10In the United States, before the reorganization of the banking system under the Federal Reserve Act, the lack of a central bank in times of crises was made up for by ad hoc organizations of the banks that were members of the clearinghouses.

Credit-issuing banks as a rule give preference to short-term loans as investments. Often the law compels them to do this, but in any case they would be forced to do it by public opinion. But the significance of this preference has nothing to do with the greater ease with which it is generally, but erroneously, supposed to allow the fiduciary media to be redeemed. It is true that it is a policy that has preserved the bank-credit system in the past from severe shocks; it is true that its neglect has always avenged itself; and it is true that it still is important for the present and future; but the reasons for this are entirely different from those which the champions of short-term cover are in the habit of putting forward.

One of its reasons, and the less weighty, is that it is easier to judge the soundness of investments made in the form of short-term loans than that of long-term investments. It is true that there are numerous long-term investments that are sounder than very many short-term investments; nevertheless, the soundness of an investment can as a rule be judged with greater certainty when all that has to be done is to survey the circumstances of the market in general and of the borrower in particular for the next few weeks or months, than when it is a matter of years or decades.

The second and decisive reason has already been mentioned.11  If the granting of credit through the issue of fiduciary media is restricted to loans that are to be paid back after a short space of time, then there is a certain limitation of the amount of the issue of fiduciary media. The rule that it is desirable for credit-issuing banks to grant only short-term loans is the outcome of centuries of experience. It has been its fate always to be misunderstood; but even so, obedience to it has had the important effect of helping to limit the issue of fiduciary media.

• 11See above, pp. 313 f.

The solution of the problem of soundness is no more difficult for the credit-issuing banks than for the credit-negotiating banks. If the fiduciary media are issued only on good security and if a guarantee fund is created out of the bank’s share capital for the purpose of covering losses, for even under prudent management losses cannot always be avoided, then the bank can put itself in a position to redeem in full the fiduciary media that it issues, although not within the term specified in its promises to pay.

Nevertheless, the soundness of the cover is only of subordinate importance as far as fiduciary media are concerned. It may disappear entirely, at least in a certain sense, without prejudicing their capacity of circulation. Fiduciary media can even be issued without any cover at all. This occurs, for example, when the state issues token coins and does not devote the seigniorage to a particular fund for their redemption. (Under certain circumstances, the metal value of the coins themselves may be regarded as partial security. And of course the state as a whole has assets that provide far greater security than any sort of special fund could offer) On the other hand, even if the fiduciary media are completely covered by the assets of the issuer, so that only the time of their redemption and not its ultimate occurrence is open to question, this cannot have any sort of influence whatever in support of their capacity for circulation; for this depends exclusively upon the expectation that the issuer will redeem them promptly.

To have overlooked this is the error underlying all those proposals and experiments which have aimed at guaranteeing the issue of fiduciary media by means of funds consisting of nonliquid assets, such as mortgages. If those money substitutes that are presented for redemption are immediately and fully redeemed in money, then, beyond the cash reserve necessary for this redemption, no stock of goods is needed for maintaining equivalence between the fiduciary media and money. If, however, the money substitutes are not fully and immediately redeemed for money, then they will not be reckoned as equivalent to money just because there are some goods somewhere that will at some time be used to satisfy the demands that the holders of the money substitutes are entitled to make on the ground of the claims that the money substitutes embody. They will be valued at less than the sums of money to which they refer, because their redemption is in doubt and at the best will not occur until after the passage of a period of time. And so they will cease to be money substitutes; if they continue to be used as media of exchange, it will be at an independent valuation; they will be no longer money substitutes, but credit money.

For credit money also, that is for unmatured claims which serve as common media of exchange, “cover” by a special fund is superfluous. So long as the claims are tendered and accepted as money, and thus have obtained an exchange value in excess of that which is attributed to them as mere claims, such a fund has no bearing on the matter. The significance of the regulations as to cover and the funds for that purpose lies here, as with fiduciary media, in the fact that they indirectly set a limit to the quantity that can be issued.12

• 12See Nicholson, A Treatise on Money and Essays on Present Monetary Problems (Edinburgh, 1888), pp. 67 f.

Since it is not the object of a redemption fund to provide for the redemption of such money substitutes as are returned to the bank because of lack of confidence in their goodness, but only to provide the bank’s customers with the media of exchange necessary for dealing with persons who are not among its customers, it is obvious that such a fund might be composed at least in part of such things as, without being money, can be used like money for dealings with outsiders. These things comprise not only foreign money substitutes but also all such claims as form the basis of the international clearing business, primarily, that is to say, foreign bills, that is, bills on foreign places. The issue of money substitutes cannot be increased beyond the quantity given by the demand for money (in the broader sense) of the customers of the bank for intercourse within the clientele of the bank. Only an extension of the clientele could prepare the way for an extension of the circulation; for the national central bank-of-issue, whose influence is limited by political boundaries, such an extension remains impossible. Nevertheless, if part of the redemption fund is invested in foreign banknotes, or in foreign bills, foreign checks, and deposits at short notice with foreign banks, then a larger proportion of the money substitutes issued by the banks can be transformed into fiduciary media than if the bank held nothing but money in readiness for the foreign dealings of its customers. In this way a credit-issuing bank may even transform into fiduciary media almost all the money substitutes that it issues. The private banks of many countries are now no longer far removed from this state of affairs; they are in the habit of providing for the prompt redemption of the money substitutes issued by them by holding a reserve itself consisting of money substitutes; only so far as these covering money substitutes are money certificates do the issued money substitutes not bear the character of fiduciary media. It is only fairly recently that the central banks-of-issue also have begun to adopt the practice of admitting money substitutes and foreign bills into their conversion funds.

Just as the goldsmiths once began to lend out part of the moneys entrusted to them for safekeeping, so the central banks have taken the step of investing their stock of metal partly in foreign bills and other foreign credits. An example was set by the Hamburg Giro Bank, which was accustomed to hold part of its reserve in bills on London; it was followed during the last quarter of the nineteenth century by a series of banks-of-issue. It was with regard to their profits that the banks accepted this system of cover The investment of a part of the redemption fund in foreign bills and other foreign balances that could be easily and quickly realized was intended to reduce the costs of maintaining the reserve. In certain countries the central banks-of-issue acquired a portfolio of foreign bills because the domestic discount business was not sufficiently remunerative.13  Generally speaking, it was the central banks-of-issue and the governmental redemption funds of the smaller and financially weaker countries that tried to save expense in this way. Since the war, which has made the whole world poorer, their procedure has been widely imitated. It is clear that the policy of investing the whole redemption fund in foreign claims to gold cannot become universal. If all the countries of the world were to go over to the gold-exchange standard and hold their redemption funds not in gold but in foreign claims to gold, gold would no longer be required for monetary purposes at all. That part of its value which is founded upon its employment as money would entirely disappear. The maintenance of a gold-exchange standard with the redemption fund invested in foreign bills undermines the whole gold-standard system. We shall have to return to this point in chapter 20.

• 13See Kalkmann, “Holland’s Geldwesen im 29. Jahrhundert,” in Schmoller’s Jahrbuch, vol. 25, pp. 2249 ff.; Witten, “Die Devisenpolitik der Nationalbank von Belgien,” in ibid., vol. 42, pp. 625 ff.