Front Page Titles (by Subject) CHAPTER III: INFLUENCE OF DEPOSIT CURRENCY ON THE EQUATION AND THEREFORE ON PURCHASING POWER - The Purchasing Power of Money, its Determination and Relation to Credit, Interest and Crises
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CHAPTER III: INFLUENCE OF DEPOSIT CURRENCY ON THE EQUATION AND THEREFORE ON PURCHASING POWER - Irving Fisher, The Purchasing Power of Money, its Determination and Relation to Credit, Interest and Crises 
The Purchasing Power of Money, its Determination and Relation to Credit, Interest and Crises, by Irving Fisher, assisted by Harry G. Brown (New York: Macmillan, 1922). New and Revised Edition.
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INFLUENCE OF DEPOSIT CURRENCY ON THE EQUATION AND THEREFORE ON PURCHASING POWER
WE are now ready to explain the nature of bank deposit currency, or circulating credit. Credit, in general, is the claim of a creditor against a debtor. Bank deposits subject to check are the claims of the creditors of a bank against the bank, by virtue of which they may, on demand, draw by check specified sums of money from the bank. Since no other kind of bank deposits will be considered by us, we shall usually refer to "bank deposits subject to check" simply as "bank deposits." They are also called "circulating credit." Bank checks, as we have seen, are merely certificates of rights to draw, i.e. to transfer bank deposits. The checks themselves are not the currency; the bank deposits which they represent are the currency.
It is in the connection with the transfer of bank deposits that there arises that so-called "mystery of banking" called "circulating credit." Many persons, including some economists, have supposed that credit is a special form of wealth which may be created out of whole cloth, as it were, by a bank. Others have maintained that credit has no foundation in actual wealth at all, but is a kind of unreal and inflated bubble with a precarious, if not wholly illegitimate, existence. As a matter of fact, bank deposits are as easy to understand as bank notes, and what is said in this chapter of bank deposits may in substance be taken as true also of bank notes. The chief difference is a formal one, the notes circulating from hand to hand, while the deposit currency circulates only by means of special orders called "checks."
To understand the real nature of bank deposits, let us imagine a hypothetical institution,—a kind of primitive bank existing mainly for the sake of deposits and the safe keeping of actual money. The original bank of Amsterdam was somewhat like the bank we are now imagining. In such a bank a number of people deposit $100,000 in gold, each accepting a receipt for the amount of his deposit. If this bank should issue a "capital account," or statement, it would show $100,000 in its vaults and $100,000 owed to depositors, as follows:—
The right-hand side of the statement is, of course, made up of smaller amounts owed to individual depositors. Assuming that there is owed to A, $10,000, to B, $10,000, and to all others $80,000, we may write the bank statement as follows:—
Now assume that A wishes to pay B $1000. A could go to the bank with B, present certificates or checks for $1000, obtain the gold, and hand it over to B, who might then redeposit it in the same bank, merely handing it back through the cashier's window and taking a new certificate in his own name. Instead, however, of both A and B visiting the bank and handling the money, A might simply give B a check for $1000. The transfer in either case would mean that A's holding in the bank was reduced from $10,000 to $9000, and that B's was increased from $10,000 to $11,000. The statement would then read:—
Thus the certificates, or checks, would circulate in place of cash among the various depositors in the bank. What really changes ownership, or "circulates," in such cases is the right to draw money. The check is merely the evidence of this right and of the transfer of this right from one person to another.
In the case under consideration, the bank would be conducted at a loss. It would be giving the time and labor of its clerical force for the accommodation of its depositors, without getting anything in return. But such a hypothetical bank would soon find—much as did the bank of Amsterdam25 —that it could "make money" by lending at interest some of the gold on deposit. This could not offend the depositors; for they do not expect or desire to get back the identical gold they deposited. What they want is simply to be able at any time to obtain the same amount of gold. Since, then, their arrangement with the bank calls for the payment, not of any particular gold, but merely of a definite amount, and that but occasionally, the bank finds itself free to lend out part of the gold that otherwise would lie idle in its vaults. To keep it idle would be a great and needless waste of opportunity.
Let us suppose, then, that the bank decides to loan out half its cash. This is usually done in exchange for promissory notes of the borrowers. Now a loan is really an exchange of money for a promissory note which the lender—in this case the bank—receives in place of the gold. Let us suppose that so-called borrowers actually draw out $50,000 of gold. The bank thereby exchanges money for promises, and its books will then read:—
It will be noted that now the gold in the bank is only $50,000, while the total deposits are still $100,000. In other words, the depositors now have more "money on deposit" than the bank has in its vaults! But, as will be shown, this form of expression involves a popular fallacy in the word "money." Something good is behind each loan, but not necessarily money.
Next, suppose that the borrowers become, in a sense, depositors also, by redepositing the $50,000 of cash which they borrowed, in return for the right to draw out the same sum on demand. In other words, suppose that after borrowing $50,000 from the bank, they lend it back to the bank. The bank's assets will thus be enlarged by $50,000, and its obligations (or credit extended) will be equally enlarged; and the balance sheet will become:—
What happened in this case was the following: Gold was borrowed in exchange for a promissory note and then handed back in exchange for a right to draw. Thus the gold really did not budge; but the bank received a promissory note and the depositor a right to draw. Evidently, therefore, the same result would have followed if each borrower had merely handed in his promissory note and received, in exchange, a right to draw. As this operation most frequently puzzles the beginner in the study of banking, we repeat the tables representing the conditions before and after these "loans," i.e. these exchanges of promissory notes for present rights to draw.26
Clearly, therefore, the intermediation of the money in this case is a needless complication, though it may help to a theoretical understanding of the resultant shifting of rights and liabilities. Thus the bank may receive deposits of gold or deposits of promises. In exchange for the promises it may give, or lend, either a right to draw, or gold,—the same that was deposited by another customer. Even when the borrower has only a promise, by fiction he is still held to have deposited money; and like the original cash depositors, he is given the right to make out checks. The total value of rights to draw, in whichever way arising, is termed "deposits." Banks more often lend rights to draw (or deposit rights) than actual cash, partly because of the greater convenience to borrowers, and partly because the banks wish to keep their cash reserves large, in order to meet large or unexpected demands. It is true that if a bank loans money, part of the money so loaned will be redeposited by the persons to whom the borrowers pay it in the course of business; but it will not necessarily be redeposited in the same bank. Hence the average banker prefers that the borrower should not withdraw actual cash.
Besides lending deposit rights, banks may also lend their own notes, called "bank notes." And the principle governing bank notes is the same as the principle governing deposit rights. The holder simply gets a pocketful of bank notes instead of a bank account. In either case the bank must be always ready to pay the holder—to "redeem its notes"—as well as pay its depositors, on demand, and in either case the bank exchanges a promise for a promise. In the case of the note, the bank has exchanged its bank note for a customer's promissory note. The bank note carries no interest, but is payable on demand. The customer's note bears interest, but is payable only at a definite date.
Assuming that the bank issues $50,000 of notes, the balance sheet will now become:—
We repeat that by means of credit the deposits (and notes) of a bank may exceed its cash. There would be nothing mysterious or obscure about this fact, nor about credit in general, if people could be induced not to think of banking operations as money operations. To so represent them is metaphorical and misleading. They are no more money operations than they are real estate transactions. A bank depositor, A, has not ordinarily "deposited money"; and whether he has or not, he certainly cannot properly say that he "has money in the bank." What he does have is the bank's promise to pay money on demand. The bank owes him money. When a private person owes money, the creditor never thinks of saying that he has it on deposit in the debtor's pocket.
It cannot be too strongly emphasized that, in any balance sheet, the value of the liabilities rests on that of the assets. The deposits of a bank are no exception. We must not be misled by the fact that the cash assets may be less than the deposits. When the uninitiated first learn that the number of dollars which note holders and depositors have the right to draw out of a bank exceeds the number of dollars in the bank, they are apt to jump to the conclusion that there is nothing behind the notes or deposit liabilities. Yet behind all these obligations there is always, in the case of a solvent bank, full value; if not actual dollars, at any rate dollars' worth of property. By no jugglery can the liabilities exceed the assets except in insolvency, and even in that case only nominally, for the true value of the liabilities ("bad debts") will only equal the true value of the assets behind them.
These assets, as already indicated, are largely the notes of merchants, although, so far as the theory of banking is concerned, they might be any property whatever. If they consisted in the ownership of real estate or other wealth in "fee simple," so that the tangible wealth which property always represents were clearly evident, all mystery would disappear. But the effect would not be different. Instead of taking grain, machines, or steel ingots on deposit, in exchange for the sums lent, banks prefer to take interest-bearing notes of corporations and individuals who own, directly or indirectly, grain, machines, and steel ingots: and by the banking laws the banks are even compelled to take the notes instead of the ingots. The bank finds itself with liabilities which exceed its cash assets; but in either case the excess of liabilities is balanced by the possession of other assets than cash. These other assets of the bank are usually liabilities of business men. These liabilities are in turn supported by the assets of the business men. If we continue to follow up the ultimate basis of the bank's liabilities we shall find it in the visible tangible wealth of the world.
This ultimate basis of the entire credit structure is kept out of sight, but the basis exists. Indeed, we may say that banking, in a sense, causes this visible, tangible wealth to circulate. If the acres of a landowner or the iron stoves of a stove dealer cannot circulate in literally the same way that gold dollars circulate, yet the landowner or stove dealer may give to the bank a note on which the banker may base bank notes or deposits; and these bank notes and deposits will circulate like gold dollars. Through banking, he who possesses wealth difficult to exchange can create a circulating medium. He has only to give to a bank his note—for which, of course, his property is liable—get in return the right to draw, and lo! his comparatively unexchangeable wealth becomes liquid currency. To put it crudely, banking is a device for coining into dollars land, stoves, and other wealth not otherwise generally exchangeable.
It is interesting to observe that the formation of the great modern "trusts" has given a considerable impetus to deposit currency; for the securities of large corporations are more easily used as "collateral security" for bank loans than the stocks and bonds of small corporations or than partnership rights.
We began by regarding a bank as substantially a coöperative enterprise, run for the convenience and at the expense of its depositors. But, as soon as it reaches the point of lending money to X,Y, and Z, on time, while itself owing money on demand, it assumes toward X,Y, and Z and its cash depositors risks which the depositors would be unwilling to assume. To meet this situation, the responsibility and expense of running the bank are taken by a third class of people—stockholders—who are willing to assume the augmented risk for the sake of the chance of profit. Stockholders, in order to guarantee the depositors against loss, put in some cash of their own. Their contract is, in effect, to make good any loss to depositors. Let us suppose that the stockholders put in $50,000, viz. $40,000 in cash and $10,000 in the purchase of a bank building. The accounts now stand:—
The accounts as they now stand include the chief features of an ordinary modern bank,—a so-called "bank of deposit, issue, and discount."
We have seen that the assets must be adequate to meet the liabilities. We now wish to point out that the form of the assets must be such as will insure meeting the liabilities promptly. Since the business of a bank is to furnish quickly available property (cash or credit) in place of the "slower" property of its depositors, it fails of its purpose when it is caught with insufficient cash. Yet it "makes money" partly by tying up its quick property, i.e. lending it out where it is less accessible. Its problem in policy is to tie up enough to increase its property, but not to tie up so much as to get tied up itself. So far as anything has yet been said to the contrary, a bank might increase indefinitely its loans in relation to its cash or in relation to its capital. If this were so, deposit currency could be indefinitely inflated.
There are limits, however, imposed by prudence and sound economic policy, on both these processes. Insolvency and insufficiency of cash must both be avoided. Insolvency is that condition which threatens when loans are extended with insufficient capital. Insufficiency of cash is that condition which threatens when loans are extended unduly relatively to cash. Insolvency is reached when assets no longer cover liabilities (to others than stockholders), so that the bank is unable to pay its debts. Insufficiency of cash is reached when, although the bank's total assets are fully equal to its liabilities, the actual cash on hand is insufficient to meet the needs of the instant, and the bank is unable to pay its debts on demand.
The less the ratio of the value of the stockholders' interests to the value of liabilities to others, the greater is the risk of insolvency; the risk of insufficiency of cash is the greater, the less the ratio of the cash to the demand liabilities. In other words, the leading safeguard against insolvency lies in a large capital and surplus, but the leading safeguard against insufficiency of cash lies in a large cash reserve. Insolvency proper may befall any business enterprise; insufficiency of cash relates especially to banks in their function of redeeming notes and deposits.
Let us illustrate insufficiency of cash. In our bank's accounts as we left them, there was a reserve of $140,000 of cash, and $200,000 of demand liabilities (deposits and notes). The managers of the bank may think this reserve of $140,000 unnecessarily large or the loans unnecessarily small. They may then extend their loans (extended to customers in the form of cash, notes or deposit accounts) until the cash reserve is reduced, say to $40,000, and the liabilities due depositors and note holders increased to $300,000. If, under these circumstances, some depositor or note holder demands $50,000 cash, immediate payment will be impossible. It is true that the assets still equal the liabilities. There is full value behind the $50,000 demanded; but the understanding was that depositors and note holders should be paid in money and on demand. Were this not a stipulation of the deposit contract, the bank might pay the claims thus made upon it by transferring to its creditors the promissory notes due it from its debtors; or it might ask the customers to wait until it could turn these securities into cash.27
Since a bank cannot follow either of these plans, it tries, where insufficiency of cash impends, to forestall this condition by "calling in" some of its loans, or if none can be called in, by selling some of its securities or other property for cash. But it happens unfortunately that there is a limit to the amount of cash which a bank can suddenly realize. No bank could escape failure if a large percentage of its note holders and depositors should simultaneously demand cash payment.28 The paradox of a panic is well expressed by the case of the man who inquired of his bank whether it had cash available for paying the amount of his deposit, saying, "If you can pay me, I don't want it; but if you can't, I do." Such was the situation in 1907 in Wall Street. All the depositors at one time wanted to be sure their money "was there." Yet it never is there all at one time.
Since, then, insufficiency of cash is so troublesome a condition,—so difficult to escape when it has arrived, and so difficult to forestall when it begins to approach,—a bank must so regulate its loans and note issues as to keep on hand a sufficient cash reserve, and thus prevent insufficiency of cash from even threatening. It can regulate the reserve by alternately selling securities for cash and loaning cash on securities. The more the loans in proportion to the cash on hand, the greater the profits, but the greater the danger also. In the long run a bank maintains its necessary reserve by means of adjusting the interest rate charged for loans. If it has few loans and a reserve large enough to support loans of much greater volume, it will endeavor to extend its loans by lowering the rate of interest. If its loans are large and it fears too great demands on the reserve, it will restrict the loans by a high interest charge. Thus, by alternately raising and lowering interest, a bank keeps its loans within the sum which the reserve can support, but endeavors to keep them (for the sake of profit) as high as the reserve will support.
If the sums owed to individual depositors are large, relatively to the total liabilities, the reserve should be proportionately large, since the action of a small number of depositors can deplete it rapidly.29 Similarly, the reserves should be larger against fluctuating deposits (as of stock brokers) or those known to be temporary.30 The reserve in a large city of great bank activity needs to be greater in proportion to its demand liabilities than in a small town with infrequent banking transactions.
Experience dictates differently the average size of deposit accounts for different banks according to the general character and amount of their business. For every bank there is a normal ratio, and hence for a whole community there is also a normal ratio—an average of the ratios for the different banks. No absolute numerical rule can be given. Arbitrary rules are often imposed by law. National banks in the United States, for instance, are required to keep a reserve for their deposits, varying according as they are or are not situated in certain cities designated by law as "reserve" cities, i.e. cities where national banks hold deposits of banks elsewhere. These reserves are all in defense of deposits. In defense of notes, on the other hand, no cash reserve is required,—that is, of national banks. True, the same economic principles apply to both bank notes and deposits, but the law treats them differently. The government itself chooses to undertake to redeem the national bank notes on demand.
The state banks are subject to varying restrictions.31 Thus the requirement as to the ratio of reserve to deposits varies from 12½ per cent to 22½ per cent, being usually between 15 per cent and 20 per cent. Of the reserve, the part which must be cash varies from 10 per cent (of the reserve) to 50 per cent, being usually 40 per cent.
Such legal regulation of banking reserves, however, is not a necessary development of banking. In Canada, the law makes the notes practically coördinate with the deposits. Indeed, banking may exist without government regulations at all. "George Smith's money" furnishes an illustration. George Smith, Alexander Mitchell and others established in 1839 an Insurance Company which, though forbidden to exercise "banking privileges," issued certificates of deposit payable to bearer, and these certificates were actually circulated like bank notes.32
The study of banking operations, then, discloses two species of currency: one, bank notes, belonging to the category of money; and the other, deposits, belonging outside of that category, but constituting an excellent substitute. Referring these to the larger category of goods, we have a threefold classification of goods: first, money; second, deposit currency, or simply deposits; and third, all other goods. And by the use of these, there are six possible types of exchange:—
For our purpose, only the last two types of exchange are important, for these constitute the circulation of currency. As regards the other four, the first and third have been previously explained as "money changing" and "barter" respectively. The second and fourth are banking transactions: the second being such as the selling of drafts for checks, or the mutual cancellation of bank clearings; and the fourth being such operations as the depositing or the withdrawing of money, by depositing cash or cashing checks.
The analysis of the balance sheets of banks has prepared us for the inclusion of bank deposits or circulating credit in the equation of exchange. We shall still use M to express the quantity of actual money, and V to express the velocity of its circulation. Similarly, we shall now use M' to express the total deposits subject to transfer by check; and V' to express the average velocity of circulation. The total value of purchases in a year is therefore no longer to be measured by MV, but by MV + M'V'. The equation of exchange, therefore, becomes:—
MV + M'V' = SpQ = PT.33
Let us again represent the equation of exchange by means of a mechanical picture. In Figure 4, trade, as before, is represented on the right by the weight of a miscellaneous assortment of goods; and their average price by the distance to the right from the fulcrum, or the length of the arm on which this weight hangs. Again at the left, money (M) is represented by a weight in the form of a purse, and its velocity of circulation (V) by its arm; but now we have a new weight at the left, in the form of a bank book, to represent the bank deposits (M'). The velocity of circulation (V') of these bank deposits is represented by its distance from the fulcrum or the arm at which the book hangs.
This mechanism makes clear the fact that the average price (right arm) increases with the increase of money or bank deposits and with the velocities of their circulation, and decreases with the increase in the volume of trade.
Recurring to the left side of the equation of exchange, or MV + M'V', we see that in a community without bank deposits the left side of the equation reduces simply to MV, the formula used in Chapter II; for in such a community the term "M'V'" vanishes. The introduction of M' tends to raise prices. That is, the hanging of the bank book on the left requires a lengthening of the arm at the right.
Just as E was used to denote the total circulation of money, MV, so we may now use E' to denote the total circulation of deposits, M'V'.
Like E,M, and V, so also E', M', and V' are sums and averages of corresponding magnitudes pertaining to different parts of the year, or different persons.34
With the extension of the equation of monetary circulation to include deposit circulation, the influence exerted by the quantity of money on general prices becomes less direct; and the process of tracing this influence becomes more difficult and complicated. It has even been argued that this interposition of circulating credit breaks whatever connection there may be between prices and the quantity of money.35 This would be true if circulating credit were independent of money. But the fact is that the quantity of circulating credit, M', tends to hold a definite relation to M, the quantity of money in circulation; that is, deposits are normally a more or less definite multiple of money.
Two facts normally give deposits a more or less definite ratio to money. The first has been already explained, viz. that bank reserves are kept in a more or less definite ratio to bank deposits. The second is that individuals, firms, and corporations preserve more or less definite ratios between their cash transactions and their check transactions, and also between their money and deposit balances.36 These ratios are determined by motives of individual convenience and habit. In general, business firms use money for wage payments, and for small miscellaneous transactions included under the term "petty cash"; while for settlements with each other they usually prefer checks. These preferences are so strong that we could not imagine them overridden except temporarily and to a small degree. A business firm would hardly pay car fares with checks and liquidate its large liabilities with cash. Each person strikes an equilibrium between his use of the two methods of payment, and does not greatly disturb it except for short periods of time. He keeps his stock of money or his bank balance in constant adjustment to the payments he makes in money or by check. Whenever his stock of money becomes relatively small and his bank balance relatively large, he cashes a check. In the opposite event, he deposits cash. In this way he is constantly converting one of the two media of exchange into the other. A private individual usually feeds his purse from his bank account; a retail commercial firm usually feeds its bank account from its till. The bank acts as intermediary for both.
In a given community the quantitative relation of deposit currency37 to money is determined by several considerations of convenience. In the first place, the more highly developed the business of a community, the more prevalent the use of checks. Where business is conducted on a large scale, merchants habitually transact their larger operations with each other by means of checks, and their smaller ones by means of cash. Again, the more concentrated the population, the more prevalent the use of checks. In cities it is more convenient both for the payer and the payee to make large payments by check; whereas, in the country, trips to a bank are too expensive in time and effort to be convenient, and therefore more money is used in proportion to the amount of business done.38 Again, the wealthier the members of the community, the more largely will they use checks. Laborers seldom use them; but capitalists, professional and salaried men use them habitually, for personal as well as business transactions.
There is, then, a relation of convenience and custom between check and cash circulation, and a more or less stable ratio between the deposit balance of the average man or corporation and the stock of money kept in pocket or till. This fact, as applied to the country as a whole, means that by convenience a rough ratio is fixed between M and M'. If that ratio is disturbed temporarily, there will come into play a tendency to restore it. Individuals will deposit surplus cash, or they will cash surplus deposits.
Hence, both money in circulation (as shown above) and money in reserve (as shown previously) tend to keep in a fixed ratio to deposits. It follows that the two must be in a fixed ratio to each other.
It further follows that any change in M, the quantity of money in circulation, requiring as it normally does a proportional change in M', the volume of bank deposits subject to check, will result in an exactly proportional change in the general level of prices except, of course, so far as this effect be interfered with by concomitant changes in the V's or the Q's. The truth of this proposition is evident from the equation MV + M'V' = SpQ; for if, say, M and M' are doubled, while V and V' remain the same, the left side of the equation is doubled and therefore the right side must be doubled also. But if the Q's remain unchanged, then evidently all the p's must be doubled, or else if some are less than doubled, others must be enough more than doubled to compensate.
The contents of this chapter may be formulated in a few simple propositions:—
[25.] See Dunbar's Theory and History of Banking, 2d ed., edited by O. M. W. Sprague, New York and London (G. P. Putnam's Sons), 1901, pp. 113-116.
[26.] In the ultimate analysis, and outside of its function of insuring credit, a bank is really an intermediary between borrowers and lenders. It is by virtue of bringing borrowers and ultimate lenders together and providing the former with a supply of loans which would not otherwise exist, that a bank simultaneously tends to lower the rate of interest and increase the supply of credit currency. See paper by Harry G. Brown, in the Quarterly Journal of Economics, August, 1910, on "Commercial Banking and the Rate of Interest."
[27.] See Irving Fisher, The Nature of Capital and Income, Chapter V.
[28.] Cf. Ricardo, Works, 2d ed., London (Murray), 1852, p. 217 (Principles of Political Economy and Taxation, Chapter XXVII).
[29.] Victor Morawetz, The Banking and Currency Problem in the United States, New York (The North American Review Publishing Co.), 1909, pp. 36 and 37. Also Kemmerer, Money and Prices, 1909, p. 80.
[31.] "Digest of State Banking Statutes," in Reports of the National Monetary Commission, 61st Congress, 2d Session Senate Document, No. 353.
[32.] See Horace White, Money and Banking
[33.] The equation of exchange is also stated by Kemmerer, Money and Credit Instruments in their Relation to General Prices, so as to include bank credit, although in a somewhat different way. That credit acts on prices in the same manner as money is by no means a newly established principle. See, for example, Mill, Principles of Political Economy, Book III, Chapter XII, §§ 1, 2.
[34.] The mathematical analysis of E', M', and V' in terms of "arrays" of e"s, m"s, and v"s, etc., is precisely parallel to that of E,M, and V, given in the Appendix to Chapter II. See also §§ 1 and 2 of Appendix to (this) Chapter III.
[35.] An almost opposite view is that of Laughlin that normal credit cannot affect prices because it is not an offer of standard money and cannot affect the value of the standard which alone determines general prices. See the Principles of Money, New York (Scribner), 1903, p. 97. Both views are inconsistent with that upheld in this book.
[36.] This fact is apparently overlooked by Laughlin when he argues that there is not "any reason for limiting the amount of the deposit currency, or the assumption of an absolute scarcity of specie reserves." See Principles of Money, p. 127.
[37.] The convenient expression "deposit currency" is used by Laughlin, The Principles of Money, p. 118.
[38.] See Kinley's "Credit Instruments," Report of the National Monetary Commission, Senate Document, 399, 61st Congress, 2d Session, 1910, p. 188.