Section III.: Of Banks of Circulation or Discount, and of Bank-notes, or Convertible Paper.

There is another kind of bank, founded on totally different principles; consisting of associated capitalists, subscribing a capital in transferable shares, to be employed in various profitable ways, but chiefly in the discount of promissory notes and bills of exchange, that is to say, the advance of the value of commercial paper not yet due, with the deduction of interest for the time it has to run, which is called, the discount.

These companies, with a view to enlarge their capital and extend their business, commonly issue notes, purporting to bear a promise to pay to the bearer on demand, the gold or silver specified on the face of them. Their security for the due discharge of these engagements is, the commercial paper held by the bank, and subscribed by individuals in solvent circumstances; for the company gives its notes in discount, or, what is the same thing, in purchase of this paper.

The private commercial paper, indeed, having a term to run before it falls due, can not be available in discharge of notes payable on demand; for which reason, every well-conducted bank of circulation confines its advances of cash, or notes payable in cash on demand, to the discount of bills at very short dates, and is careful to have always in hand a considerable amount of specie, probably a third, or as much as the half of the total amount of their circulating notes; and, even with all possible caution, it is at times greatly embarrassed, whenever a want of confidence in its solvency, or any untoward event, causes a sudden run upon the bank for cash. The bank of England has been obliged, on an occasion of this kind, to scrape together as many sixpences as it possibly could find, to gain time by the delay inseparable from payments in such a diminutive coin, until a part of the paper in its possession had fallen due. The discount bank of Paris, in the year 1788, being then under control of government, had recourse to similar paltry expedients.

The profits of banks of circulation are very considerable; that portion of the notes, which is issued on the credit of private commercial paper, continues running at interest; for the advances have been made with the deduction of the discount. But the portion of the paper, issued on the credit of the specie in reserve, brings no profit; the interest lying dormant in the specie thus withdrawn from circulation.

The banks of England and France make no advances to private persons, except on bills of exchange, and give no credit beyond the funds in hand. They indemnify themselves for the trouble of receiving and paying on account of individuals by turning to account the floating balance left in their hands. These two establishments have, besides, undertaken the business of paying the interest upon the respective national debts, receiving an allowance for their trouble: furthermore, they occasionally make advances to the governments.

From these various operations, they derive a great increase of their profits. The one last mentioned, however, is completely at variance with the purposes of their establishment, as we shall presently find. The advances made to the old government of France by the then bank of discount, and those of the bank of England to the English government, compelled those bodies to apply to the respective legislatures to give their notes a compulsory circulation; thus destroying their fundamental requisites of convertibility. The consequence has been, that the former of these banks went all to pieces.

The establishment of several banks, for the issue of convertible notes, is more beneficial than the investment of any single body with the exclusive privilege; for the competition obliges each of them to court the public favour, by a rivalship of accommodation and solidity.

Banks of circulation issue their notes either in the discount of promissory notes or bills of exchange, that is to say, in giving their notes payable on demand, and circulating like cash, in exchange for private paper payable at a future date, upon which interest is deducted; which is the course pursued by the present bank of France, and by all the English banks, public and private; or else in lending at interest to solvent individuals, like those of Scotland. Merchants of good credit are, in the latter way, supplied with the sums necessary for their current expenses and payments, and each of them is thereby enabled to embark his whole capital in his commercial enterprises, without being obliged to reserve any part to meet the calls upon him in the course of business. The merchant of Paris or London must contrive matters, so as to have always on hand either in his private coffers or in the bank, a sum sufficient to face the demands upon him; whereas, the merchant of Edinburgh is relieved from this necessity, and at liberty to invest the whole of his funds, in the confidence that the bank will advance him the money he may happen to require.

A bank of circulation affords the advantage of economizing capital, by reducing the amount of the sum, kept in reserve for the current and contingent expenses of the individuals it accommodates.

Bank bills or notes, payable on demand, and circulating as cash, play so important a part in the progress of national wealth, and have engendered such important errors in the brain of many writers of repute and information on other topics, that it will be worth while to examine their nature and consequences in a very particular manner.

I should premise, that the residue of this section applies exclusively to bank-notes, depending solely upon the credit of the bank for their currency, and convertible at pleasure into cash or specie.

It is a matter of no less curiosity than of importance, to inquire whether bank-notes, or paper destitute of intrinsic value, be any addition to the stock of national wealth, and what, if any, is the possible extent of that addition; for, were there no limits to it, there could be no end to the wealth, that a state might acquire in a short time by the mere fabrication of some reams of paper. The solution of this grand problem may be set down as one of Smith's happiest efforts; yet it is not every body that comprehends his reasoning; I will try to render it more generally intelligible.

The wants of a nation require a certain supply of such particular commodity, and the extent of that supply is determined by the relative prosperity of the nation for the time being. A surplus of each of those commodities beyond this demand is either not produced at all, or, if produced, must occasion a decline of relative local value: it, therefore, naturally finds its way out of the country, and goes in quest of a market, where it may be in higher estimation.

Money is, in this respect, like all other commodities; it is a convenient agent, and, therefore, employed as such in all operations of exchange; but the intensity of the demand for it is determined in each community, by the relative extent and activity of the exchanges negotiated within it. As soon as there is a supply of money sufficient to circulate all the commodities there are to be circulated, no more money is imported; or, if a surplus flow in, it emigrates again in quest of a market, where its value is greater, or where its utility is more desired. It is seldom or never that any body keeps in his purse or his coffers more specie than enough to meet the current demands of his business or consumption. Every excess beyond these demands is rejected, as bearing neither utility nor interest; and the community at large is fully supplied with specie, as soon as each individual is possessed of the portion suitable to his condition and relative station in society.

It may be safely left to private interest, to make the best use of the excess of specie beyond the demand for circulation. The notion that every item of specie, that crosses the frontier, is so much dead loss to the community, is just as absurd as the supposition, that a manufacturer is so much the poorer, every time he parts with his money in the purchase of the ingredient or raw material of his manufacture; or that individuals, the aggregate of whom makes up the nation, present foreigners gratuitously with all the money they part with.

Taking it for granted, then, that the specie, remaining in circulation within the community, is limited by the national demand for circulating medium; if any expedient can be devised, for substituting bank-notes in place of half the specie or the commodity, money, there will evidently be a superabundance of metal-money, and that superabundance must be followed by a diminution of its relative value. But, as such diminution in one place by no means implies a contemporaneous diminution in other places, where the expedient of bank-notes is not resorted to, and where, consequently, no such superabundance of the commodity, money, exists, money naturally resorts thither, and is attracted to the spot where it bears the highest relative value, or is exchangeable for the largest quantity of other goods: in other words, it flows to the markets where commodities are the cheapest, and is replaced by goods, of value equal to the money exported.

The money that can emigrate in this manner, is that part only of the circulating medium, which has a value elsewhere than within the limits of the nation; that is to say, the specie or metal-money. Since, however, specie does not emigrate without an equivalent return; and, since its value, which before existed in the shape of specie, and was exclusively engaged in facilitating circulation, thenceforth assumes the form of a variety of commodities, all items of the reproductive national capital, there follows this remarkable consequence, that the national capital is enlarged to the full amount of all the specie exported upon the introduction of the substitute. Nor is the internal national circulation at all cramped for want of money by this export; for the functions of the specie, that has been withdrawn, are just as well performed by the paper substituted in its stead.

However valuable an acquisition the national capital may thus receive, it must not be rated above its real amount. I have supposed, for the sake of simplicity, that half the specie might be replaced by circulating notes: but this is a monstrous proportion; particularly if it be considered, that paper cannot retain its value as money any longer than while it is readily and instantly convertible into specie; I say, readily and instantly, because otherwise people would prefer specie, which is at all times, and without the least hesitation, taken for money. To insure this requisite convertibility, it is necessary, that, besides having at all times a fund in reserve, in private bills or securities, or in specie, sufficient to meet all the notes that may be presented, the bank itself should be at all times within the reach of the holders of its notes. Therefore, if the territory be of any extent, and the notes so generally circulated, as to form half of the circulating medium, the subordinate offices of the bank must be greatly multiplied to place them within reach of all the note-holders.

But, granting the possibility of such an arrangement, and admitting, that paper might supplant as much as half the requisite national currency of specie, let us see what would be the amount of the acquisition to the national capital.

No writer of repute has ventured to estimate the requisite circulating specie of any nation, higher than 1/5 of the annual national product; some, indeed, have reckoned it as low as 1/30. Taking the highest estimate, viz. 1/5 of the annual product, which, for my own part, I consider greatly above the reality in any case; a nation, whose annual product should amount to 20 millions, would need but 4 millions of specie. Therefore, in case the half, or 2 millions, were supplanted by circulating paper, and employed in augmenting the national productive capital, that capital would be once for all augmented, by a value equal to 2/20 or 1/10 of the annual product of the nation.

Again, the annual product of a nation would, probably, be much overrated at 1/10 of the gross national productive capital; but let it be set down at that rate, allowing 5 per cent. interest on productive capital, and 5 per cent. wages and profits of the industry it sets in motion. On this calculation, supposing the paper substitute to add to the national capital, in the ratio of 1/10 of its annual product, this addition will not at the highest estimate exceed 1/100 of the previous capital.

Although the practicable issue of bank-notes procures to a nation of moderate wealth an accession of capital, much less considerable than people may fondly imagine, this accession is, notwithstanding, of very great value; for, unless the productive energy of the nation be extremely great, as in Great Britain, or the national spirit of frugality very general and persevering, as in Holland, the annual savings withdrawn from unproductive consumption, to be added to productive capital, form, even in thriving states, a very inconsiderable portion of the gross annual revenue. Nations, whose production is stationary, as every body knows, make no addition to their productive capitals; and the consumption of those on the decline annually encroaches on their capitals.

Should the paper-issues of a bank at any time exceed the demands of circulation, and the credit enjoyed by the establishment, there follows a perpetual reflux of its notes, and it is put to the expense of collecting specie, which is absorbed as fast as collected. The Scotch banks, though productive of great benefit, have been obliged, upon such trying occasions, to keep agents in London constantly employed, in scraping specie together at a charge of two per cent., which specie was instantly absorbed. The bank of England, in similar circumstances, was under the necessity of buying gold bullion, and getting it coined; and this coin was melted again as fast as it was paid by the bank, in consequence of the high price of the metal, which was itself the effect of the constant purchases made by the bank, to meet the calls upon it for specie. In this manner, it sustained the annual loss of from 2 ½ to 3 per cent., upon a sum of about 850,000l., more than 20 millions of our money. I say nothing of the situation of this bank of late years, since its notes have acquired a forced circulation, and, consequently, altered their nature entirely.

The notes issued by a bank of circulation, even if it have no funds of its own, are never issued gratuitously; and, therefore, of course, imply the existence, in the coffers of the bank, of a value of like amount, either in the shape of specie, or of securities, bearing interest; upon which latter only the whole real advance of the bank is made; and this advance can never be made upon securities that have a long time to run; for the securities are the fund, that is to provide for the discharge of another class of securities, in the hands of the public at large, payable at the shortest of all possible notice, namely, on demand. Strictly speaking, a bank can not be at all times in a condition to face the calls upon it, and deserve the entire confidence of the public, unless the private paper it has discounted, be all, like its own notes, payable on demand; but, as it is no easy matter to find substantial assets, that shall bear interest, and at the same time be redeemable at sight, the next best course is to confine its issues to bills of very short dates; and, indeed, well-conducted banks have always rigidly adhered to this principle.

From the preceding considerations may be deduced a conclusion, fatal to abundance of systems and projects, viz. that credit-paper can supplant, and that but partially, nothing more than that portion of the national capital performing the functions of money, which circulates from hand to hand, as an agent for the facility of transfer; consequently, that no bank of circulation, or credit-paper of any denomination whatever, can supply to agricultural, manufacturing, or commercial enterprise, any funds for the construction of ships or machinery, for the digging of mines or canals, for the bringing of waste land into cultivation, or the commencement of long-winded speculations; any funds, in short, to be employed as vested capital. The indispensable requisite of credit-paper is, its instant convertibility into specie; when the sum total of the paper issued does not exist in the coffers of the bank, under the shape of specie, the deficit should at least be supplied by securities of very short dates; whereas, an establishment, that should lend its funds to be vested in enterprises, whence they could not be withdrawn at pleasure, could never be prepared with such securities. An example will illustrate this position. Suppose a bank of circulation to lend 6,000 dollars of its notes, circulating as cash, to a landholder on mortgage of his land, presenting the amplest security. This loan is destined by the landholder to the construction of necessary buildings, for the cultivation of the estate; for which purpose he contracts with a builder and pays him the 6,000 dollars of notes advanced by the bank. Now, if the builder, after a short lapse of time, be desirous of turning the notes into specie, the bank can not pay him by a transfer of the mortgage. The only property the bank has to meet the 6,000 dollars of notes is a security, ample beyond doubt, but not available at the moment.

The securities in the hands of a bank, I hold to be a solid basis for the whole of its issues of notes, provided those securities be of solvent persons, and have not too long to run; for the securities will be redeemed either with specie, or with the notes of the bank itself. In the first case, the bank is supplied with the means of paying its notes; in the second, it is saved the trouble of providing for them.

If, by any circumstance, the notes be deprived of their power of circulating as specie, the task of replacing the metal for the paper-money does not devolve upon the bank; nor was it at the first saddled with the business of turning to account the metal-money its notes rendered superfluous. For, as we have already observed, the bank can extinguish the whole of its paper with the private securities it holds. The inconvenience falls upon the public, which is under the necessity of finding a new agent of circulation, either by a re-import of the metal-money, or by the substitution of private paper; but probably the public would, in such circumstances, apply again to a bank conducted on sound principles.

This will serve to explain, why so many schemes of agricultural banks for the issue of circulating and convertible notes on ample landed security, and so many other schemes of a similar nature, have fallen to the ground in very little time, with more or less loss to the shareholders and the public. Specie is equivalent to paper of perfect solidity, and payable at the moment; consequently it can only be supplanted by notes of unquestionable credit, and payable on demand; and such notes cannot be discharged by a bare security, even of the best possible kind.

For the same reason, bills of exchange in the nature of accommodation-paper, as it is called, can never be a sound basis for an issue of convertible paper. Such bills of exchange are paid when due by fresh bills, that have a further term to run, and are negotiated with the deduction of discount. When the latter fall due, they are met by a third set payable at a still later date, which are discounted in like manner. If the bank discounts such bills, the operation is no more than an expedient for borrowing of the bank in perpetuity; the first loan being paid with a second, the second with the third, and so on. And the bank experiences the evil of issuing more of its notes, than the circulation will naturally absorb, and the credit of the establishment will support; for the notes, borrowed upon such bills, do not help to circulate and diffuse real value, because they represent and contain no real value themselves; consequently, they continually recur to be exchanged for specie. It is on this account, that the discount-bank of Paris, while it continued to be well administered, did, as the present banks of France and England do still refuse, as far as it is able, to discount accommodation-paper.

The consequences are similar and equally mischievous, when a bank makes advances to government in perpetuity, or even for a very long period. This was the cause of the failure of the bank of England. Not being able to obtain payment from government, it was unable to withdraw the notes in which the loan was made. From that moment its notes ceased to be convertible; and until the resumption of cash payments in 1822, enjoyed a forced circulation. The government, being itself unable to supply the bank with the means of payment, discharged that body from its liability to its own creditors.

The holders of the notes of a bank issuing convertible money run little or no risk, so long as the bank is well administered, and independent of the government. Supposing a total failure of confidence to bring all its notes upon it at once for payment, the worst that can happen to the holders is, to be paid in good bills of exchange at short dates, with the benefit of discount; that is to say, to be paid with the same bills of exchange, whereon the bank has issued its notes. If the bank have a capital of its own, there is so much additional security; but, under a government subject to no control, or to nominal control only, neither the capital of the bank, nor the assets in its hands, offer any solid security whatever. The will of an arbitrary prince is all the holders have to depend upon: and every act of credit is an act of imprudence.

As far as I am capable of judging, such is the effect of banks of circulation and of their paper issues upon individuals and national wealth. This effect is described by Smith in a quaint and ingenious metaphor. The capital of a nation he likens to an extensive tract of country, whereupon the cultivated districts represent the productive capital, and the high roads the agent of circulation, that is to say, the money, that serves as the medium to distribute the produce among the several branches of society. He then supposes a machine to be invented, for transporting the produce of the land through the air; that machine would be the exact parallel of credit-paper. Thenceforward the high roads might be devoted to cultivation. 'The commerce and industry of the country, however,' he continues, 'though they may be somewhat augmented, cannot be altogether so secure, when they are thus, as it were, suspended upon the Dædalian wings of paper-money, as when they travel about upon the solid ground of gold and silver. Over and above the accidents, to which they are exposed from the unskilfulness of the conductors of this paper-money, they are liable to several others, from which no prudence or skill of those conductors can guard them. An unsuccessful war, for example, in which the enemy get possession of the capital, and consequently of that treasure, which supported the credit of the paper-money, would occasion a much greater confusion in a country, where the whole circulation was carried on by paper, than in one, where the greater part of it was carried on by gold and silver. The usual instrument of commerce having lost its value, no exchanges could be made except by barter or upon credit. All taxes having usually been paid in paper-money, the prince would not have wherewithal either to pay his troops, or to furnish his magazines; and the state of the country would be much more irretrievable, than if the greater part of its circulation had consisted in gold and silver. A prince, anxious to maintain his dominions at all times in the state in which he can most easily defend them, ought upon this account to guard, not only against that excessive multiplication of paper-money, which ruins the very banks which issue it, but even against that multiplication of it, which enables them to fill the greater part of the circulation of the country with it.'

Forgery alone is enough to derange the affairs of the best conducted and most solid bank. And forgery of notes is more to be apprehended, than counterfeits of specie. The stimulus of gain is greater. For there is more profit to be made by converting a sheet of paper into money, than by giving the appearance of precious metal to another metal, that has some though very little, intrinsic value, especially if it be compounded or covered with a small portion of the counterfeited metal; and perhaps, too, the materials for the former operation are less liable to discovery. Besides, the counterfeits of specie can never reduce the value of the specie itself, because the latter has an intrinsic and independent value as a commodity; whereas, the mere belief that there are forged notes abroad, so well executed, as to be scarcely distinguishable from the genuine, is enough to bring both forged and genuine into discredit. For which reason, banks have sometimes preferred the loss of paying notes they know to be forged, to the hazard of bringing the genuine ones into discredit, by the exposure of the fraud.

One method of checking the immoderate use of notes is, to limit them to a fixed and high denomination of value; so as to make them adapted to the circulation of goods from one merchant to another, but inconvenient for the circulation between the merchant and the consumer. It has been questioned whether a government has any right to prohibit the issue of small notes, where the public is willing to take them; and whether such limitation be not a violation of that liberty of commerce, which it is the chief duty of a government to protect. But the right undoubtedly is just as complete, as that of ordering a building to be pulled down, because it endangers the public safety.