( Originally Published 1909 )
THE exchange of a hat for a sovereign is a quite commonplace proceeding, but when we begin to exchange a hat for a piece of paper, which is only accepted because it is believed to be convertible into gold, the element of belief, that is to say of credit, enters into the transaction, and we have moved up a step on the ladder of economic civilization.
The first stage, as we have seen, was from barter, by which goods were exchanged for goods, to purchase, by which goods were exchanged for one commodity of universal acceptability. And a process of painful evolution finally. decided that gold was best fitted to be that commodity. But an enormous expansion of trade was made possible when it was discovered that gold could be economized by the use of paper which represented and multiplied it, and when confidence in a banker became sufficiently established to induce the community to circulate his promises to pay instead of pieces of metal.
The process of this evolution, also, was painful enough, and the Ioss and uncertainty caused by the bad and debased coin currency of the Middle Ages were rivalled by the ruin and disasters of the early days of banking, when notes were issued without any regard for the assets which were behind them, or the ability of the issuer to meet them on presentation. Nevertheless, the appearance of the bank-note marks the first step in the development of banking as we understand it nowadays, that is, of a machinery for the manufacture of credit.
Before the bank-note won its way into circulation, such bankers as existed were chiefly gold- smiths and bullion dealers ; they were sometimes loan mongers, collecting coin from one set of customers to lend it to another, or to discount bills for another, but it was only when they began to ' induce those who borrowed from them to take the cash advanced in the form of notes that the economy of metal became possible and the wheel of the credit machine began to turn to any purpose. The original goldsmith's note was a receipt for metal deposited. It took the form of a promise to pay metal, and so passed as currency. Some ingenious goldsmith conceived the epoch-making notion of giving notes, not only to those who had deposited metal, but to those who came to borrow it, and so founded modern banking.
As long as the bankers took care of coin and ingots for Jones and lent them to Smith, the commercial community was given a certain convenience, by knowing where dealers in money were to be found, but the convenience was severely restricted.
When the bankers lent Smith not coin but a promise to pay corn, they soon discovered, since their promise to pay did not at once come back to them for presentation, that in the mean time they might safely accommodate Brown, Robinson and Williams with a similar number of similar promises to pay ; and so they hit on the great device by which modern commerce transacts its business by means of evidence of mutual indebtedness between it and its bankers.
At first sight there is something whimsical in the process of stimulating production and expanding trade by an agreement between two parties to owe one another something ; but this agreement is an important part of the structure of the modern edifice of credit.
Let us see it at work in the case of the primitive bank which we are now supposing to be emerging from the bullion-dealing to the note-issuing stage. At first, we supposed it engaged in taking care of metallic money for Smith and lending it to Jones, and its balance-sheet would stand thus, if we leave out its capital for the sake of simplicity :
Due to Smith . . £10,000 Loan to Jones . £10,000
After it had made the momentous step of inducing Jones to take its notes instead of metal, the balance-sheet would show the following development :
Due to Smith . £10,000 Cash in hand . £10,00
Notes outstanding 10,000 Loan to Jones £10,000
Total £20,000 Total £420,000
You will observe that since Jones has taken his loan in notes the cash originally deposited by Smith remains in the bank's hands, and the loan to Jones is represented by a liability of the bank to meet the notes which it has passed over to him.
These notes, being a promise to pay by the bank, are in effect a loan by Jones to it, and thus Jones and the bank have become mutually indebted. The bank has lent £10,000 to Jones, and he, by taking payment in the bank's promises to pay, is lending it £10,000 as long as he refrains from presenting the notes and demanding cash for them. Jones and the bank are thus mutually indebted, and by their agreement to owe one another money the currency has been increased by £10,000, and to that extent Jones is enabled to hire and load a ship for foreign trade, or otherwise to engage in productive enterprise.
When the bank finds that the notes which Jones borrowed are not quickly presented, but are accepted by the commercial community for the payments that he makes in loading his ship, and passed on from hand to hand and remain outstanding, it proceeds to the next step of making advances to Brown, Robinson and Williams, and the balance-sheet will be amplified.
The great principle of currency based on mutual indebtedness has thus been extended ; the bank is liable.for £40,000 of its promises to pay on demand, and its customers are indebted to it for £40,000. And this £40,000 is in circulation, quickening the wheels of trade, increasing production and profitable commerce. And the mutual indebtedness of the bank and its customers has brought this new currency into being.
But it will be observed that the bank now owes £50,000 in all, and holds only £10,000 in metallic cash against all these liabilities on demand. This will probably be a safe proportion for it to work on in ordinary circumstances, but if it continued to increase the amount of its note issue without a proportionate increase in the amount of cash held against it, the day would come when some unforeseen accident brought in an unusual number of notes for presentation, and its fate would be sealed. In the early days of banking this sort of disaster was common enough, and folk found that they had sold their goods and services in return! for notes which they had believed to be as good as gold and discovered too late to be worth only the paper that they were printed on. The manufacture of currency out of mutual indebtedness had proved too easy and simple a process, and the necessity for a proportionate backing of gold had been ignored.
Disasters of this kind not only reduced the number of note-issuing banks in England, but produced a body of opinion which aimed at making the bank-note a mere bullion certificate, only to be issued against a backing of gold to its full value. In London, the Bank of England had, since its very early days, possessed the monopoly of note issue as far as joint-stock companies were concerned, and the private banks had already ceased to issue notes when the question of the regulation of the note issue was taken in hand in 1844.
The body of opinion above referred to then pre-, vaned, and it was decided by the Bank Act of 1844 that in future any expansion in the Bank of England's note circulation must only be based on 'metal. Up to £14,000,000 it might issue notes against securities, and it was arranged that if any country note issues lapsed, two-thirds of them might be added to the amount of notes that the Bank of England might so issue, and this arrangement has since then raised the amount of bank-notes based on securities to nearly 18 1/2 millions. By the terms of the Act, the metal held against any notes that might be issued above this line might be four-fifths gold and one-fifth silver ; but the Bank has long ceased to hold silver against its notes, and any increase in their amount can now only be based on an increase in its gold store.
Such are the conditions under which Bank of England notes are now issued, and since country issues are in these days a small item in the volume of currency in England, the only notes that need here be considered are those of the Bank of England, which are, like sovereigns, legal tender to any amount. The value of a bank-note arises from the belief that it can be converted into gold and will be accepted as payment for goods. It therefore follows that since the Bank of England note is legal tender in England, it will be accepted in payment for goods as long as the British Government is strong enough to enforce the law of the land ; and it is obvious that it can be converted into gold as long as the Bank of England is solvent, that is to say, keeps sufficient gold in its vaults to meet its notes on presentation ; and it is compelled to keep the gold equivalent of every note that it issues above the £18,450,000, which it is allowed to issue against Government securities. The strength of the Bank of England note thus depends on the power of the British Government to enforce the law, and on the solvency of the Bank of England. It is thus as strong as any mere promise to pay can be made, and is, for practical currency purposes, as good as gold.
The consideration of the bank-note has thus already taken us over the wavy and very ill-defined line which separates cash from credit. For a bank note is both. It is cash in that it is immediately convertible into gold, and it is credit in that it is a promise to pay, and is only acceptable in payment for goods because it is believed to be as good as gold. Its use, in economizing gold and multiplying the effectiveness of the gold retained in the hands of the banker, has already been demonstrated, and it has also been recorded that the disasters which followed from its abuse, in days when bankers had not grasped the necessity for keeping an adequate proportion of gold to meet notes presented, and for keeping the rest of their assets liquid and realizable, led to a reaction. This reaction prompted the passing of measures, in England which prohibited this economy of gold by means of the bank note, and laid down that any increase in the Bank of England's issue was to be based on an equal amount of gold in its vaults, each £5-note being actually represented by £5 in gold.
If the apparent intentions of the Act of 1844 had been carried out, the subsequent enormous development of English trade, if it had been possible at all, must have been accompanied by the heaping up of a vast mass of gold in the Bank's vaults.
But its intentions were evaded by the commercial community, which had already appreciated the advantages of a currency based on mutual indebtedness between itself and the banks. The commercial community ceased to circulate bank-notes under the new restrictions, developing the use for daily cash transactions of a credit instrument which had already acquired some popularity, namely, a draft or bill on its bankers payable on demand, and now commonly called a cheque. The drawing of cheques was not in any way limited by the Act of 1844, and the cheque was in many ways a more convenient form of currency than the bank-note. For the strength of the Bank of England note was in itself an inconvenience in one respect; since the nature of the note is such that any one who holds it can present it and be paid in gold for it at sight, a roll of them in one's pocket is as valuable a burden as so many sovereigns or gold bars, with the additional merit of being more easily carried by the owner, and the serious disadvantage of being more easily carried off by any one else. This danger is avoided or enormously reduced when the community adopts the habit, not of carrying or sending bank notes, but of drawing a cheque on its bank for every transaction that it wishes to complete by payment.
The use of the cheque, however, involves the element of belief to a much greater extent than that of the bank-note. We have seen that the latter is certain of being taken in payment for goods or converted into gold as long as the British Government stands and the Bank of England is solvent, but the exchangeability of the former depends on the solvency of the drawer of the cheque probably a private individual and of the bank on which it is drawn. A shopkeeper who takes a cheque in payment for a pair of boots is liable on presenting it through his banker to have it returned marked with ominous signs, which are interpreted" to mean that the customer's alleged bank refuses to meet it, because his account is overdrawn, or perhaps because he never had an account with it at all. Or it is barely possible that he may be informed that the bank on which the cheque was drawn has put up its shutters, though this possibility is happily one that need not be practically considered in these days, owing to the stability which centuries of experience and the light of publicity have given to British banking.
But these two risks, one a practical one and the other theoretically in being, make the extensive use of cheques possible only in a community which has reached a high stage of economic civilization, and is also blessed with a high level of general honesty among its members. And these features in the character of a cheque also made it obviously impossible that it could be given the privilege of legal tender, that is, that any one could be bound by law to accept a cheque in payment for goods delivered or services rendered. No one could be compelled to take a piece of paper signed by an unknown person and purporting to be an order on a bank of which perhaps he had never heard. So that the cheque has had to fight its way to its present supremacy without this advantage, and to drive gold and notes out of circulation, except in small and special transactions, in spite of the fact that they were legal tender and it was not. This it was enabled to do by its safety and convenience, and the power of the drawer, by varying the form in which he makes it out, to hedge it about with safeguarding restrictions, or to leave it convertible into cash by any one who presents it. A cheque is merely an order on a bank from one of its customers to pay some of the money which it holds on his account to a third party, or to himself if he wants to take out cash:, It can be manufactured with a piece of notepaper and a penny stamp, but it is much more usual to use one of the well-known regular forms supplied by banks to their customers.
The convenience of the cheque follows from its safety ; if bank-notes are being sent, it is necessary to note all the numbers and register the packet ; a cheque, protected by being crossed and marked not negotiable," goes safely in an ordinary envelope. The words " not negotiable" do not make a cheque not negotiable, but their effect is, that no holder of a cheque so marked can pass on a better title to it than he has himself; consequently, if it is stolen, any one who takes it from the thief cannot claim on it. Further, the fact that it can be drawn t to the exact amount required is a great advantage, and its return to the drawer through his bank, when it has done its work and been cancelled, is an additional convenience, and makes the cheque a record and receipt, as well as a form of payment.
But in considering the qualities of the cheque it must never be forgotten that it also, like the Bank of England note, is a certificate immediately convertible into legal tender cash, gold or notes.
It need hardly be said that the great majority of cheques are never presented to be turned into cash; they are paid into banks by those who receive them, and crossed off against one another in the Clearinghouse, where representatives of all the banks meet and exchange claims against one another ; and cheques thus for the most part merely act as indicators in the transactions which result in the daily transfer of an enormous amount of credit from one hand to another, the whole affair being finally reduced to a matter of book-keeping exchanges between the various bankers and between the various accounts in their books. But the fact that every cheque gives the holder, or his bank, the right to demand legal tender, gold or notes, from the bank on which it is drawn is highly important ; without it, the cheque could not have won its way to general acceptability, and could not be treated as cash, as it is rather heretically treated here, on the ground that it is, in the vast majority of cases, readily accepted in exchange for goods or services in ordinary transactions. And the immediate convertibility into gold or notes, which is behind every cheque, means that an adequate supply of gold or notes to meet them on presentation is as necessary to bankers who supply their customers with cheque-books as to those who formerly made advances to them in the shape of notes, or promises to pay. In these days when a banker lends money, he lends the right to draw a cheque and promises to meet it on demand, so that the principle of mutual indebtedness as part of the basis of modern commercial currency is again evident. And since the right to draw a cheque implies the right to call for gold or notes, the extent to which credit can be created by bankers will depend, among other things, on the amount of gold or notes that bankers hold against possible demands. A banker who has £10,000 in gold or notes at his command would be running too great a banking risk if he advanced ten millions to the most unexceptionable customers against the most unexceptionable securities ; for by doing so he would give them the right to take out ten millions in gold and notes, and if even a thousandth part of the right were exercised, the banker's gold and notes would all be gone. And since, as we have seen, notes are mere bullion certificates, themselves immediately convertible into gold, we come back to gold as an element of first importance in the creation of banking credit. Or we can express the matter more simply by saying that the amount of gold held by the banking com- munity as a whole will be a leading influence among those which determine the amount of the cheques that it can allow the commercial and financial community, as a whole, to draw. All this is perhaps a little premature in a chapter which purports to be dealing with cash transactions. But the cheque, like the bank note, is at once cash and credit,-and it cannot be too early stated and understood that every credit operation implies a possible cash transaction, and that prudent banking consists in making due allowance for cash demands involved by the creation of credit,