July 1962
F ED ERA L R ESE R VE B A N K O F R I C H M O N D
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JULY 1962
July 1962
The Note Issue Function of . . .
GENTRAL BANKS
This discussion o f the note issue function, ivith special reference to the F ed ­
eral Reserve System, is the second in a series o f articles on central banks.
T h e function of issu in g bank notes is alm ost u n i­
versal w ith cen tral banks. In m ost cases the banks
have had th is p riv ilege from the b e g in n in g ; indeed,
in m an y instances the p rim a ry purpose of estab lish ­
in g the bank w as to provide a paper m oney issue,
and often the term “bank of issu e” w as used syn o n y­
m ously w ith “cen tral b an k.” One scholar has stated
that “T h e p rim a ry definition of cen tral b an kin g is a
ban kin g system in w hich a single bank has eith er a
com plete or a re sid u a ry m onopoly of the note issu e .”
T h e im portance of the note issue function has
v aried g re a tly over tim e and am ong countries. It is
a m ajo r function of v irtu a lly a ll cen tral banks since
th eir notes m ake up a v e ry larg e p art of the circ u lat­
in g cu rren cy. It is the dom inant function in those
countries w here the note issue is the d yn am ic or
d eterm in in g elem ent in the total m oney supply. In
the m ore advanced countries of the W e ste rn W o rld ,
how ever, dem and deposits m ake up the bulk of the
m oney supply and are the m edium through which
most changes in that supply are brought about. The
note issue function is correspo n din gly less im portant
in such countries.
T he m odern bank
note had its b eginn ing in the seventeenth cen tu ry at
about the sam e tim e the e arlie st cen tral banks w ere
being established. In the m ore d en sely populated
and econom ically advanced countries, use of the notes
sp read rap id ly because paper offered obvious ad v an ­
tages over the h eavy and b ulk y coins of the day.
A nd, of course, banks prom oted the trend since
assets acquired by the issue of notes w ere the m ajo r
source of th eir profits.
DEVELOPM ENT OF BANK NOTES
2
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E a rly bank notes often ran into com petition from
another form of paper m oney— tre a su ry notes issued
by governm ents. Such governm ent issues proved
to be a convenient sub stitute for taxatio n and w ere
u su ally m ade by governm ents in p ressin g need of
funds. T h e size of the issues bore no relatio n sh ip
to the econom y’s m o n etary requirem en ts, but rath er
depended on the size of the issu in g govern m en ts’
deficits. M o n etary students soon noted tw o im por­
tan t disad van tages of such m oney. F irst, the issues
seldom reduced the govern m en ts’ deficits. Instead,
by d riv in g up the prices of the th ings the g o v ern ­
m ents bought th ey tended to perp etuate the deficits,
th ereb y req u irin g furth er issues, w hich frequen tly
led to an in flatio n ary sp iral. Second, such issues
w ere not “elastic” ; th at is, they contained no features
w hich caused them to expan d when the m o netary
needs of the econom y rose or to contract when those
needs declined.
On the co n trary, under a p ro p erly reg u lated s y s ­
tem , bank notes w ere p aid out only when there w as
a dem and for them — when the econom y required
m ore m oney. If requirem en ts declined, the notes
w ere brought back to the issu in g bank for redem ption
or for use in rep ayin g bank loans. In eith er case the
notes w ere retired from circulatio n for the tim e being.
O ver the y e a rs repeated instances of inflation
caused a loss of confidence in trea su ry-issu ed paper
m oney and a realizatio n th at a w ell-regu lated system
of bank note issue provided a sup erio r m o netary a r ­
rangem ent. S lo w ly and in vario u s w ays system s of
bank note issues cam e to replace, at least in larg e
p art, tre a su ry paper issues.
July 1962
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DEFECTS O F COM M ERCIAL BANK NOTES
The a r­
rangem ents under w hich banks cam e to issue notes
developed d ifferen tly in different countries. In some
there w as no cen tral bank for a long tim e and notes
w ere issued so lely by com m ercial banks. W h ere
cen tral banks had been established, they u su a lly had
110 m onopoly of the note issue but rath er issued
notes w hich com peted w ith those of com m ercial
banks.
M an y difficulties and problem s developed w ith note
issues by com m ercial banks. W ith o u t ad equate re g ­
ulation, some banks abused the issue p riv ilege, o ver­
issued notes, and failed. E ven when the notes w ere
redeem able a t p ar by the issu in g bank, th ey som e­
tim es fell to a sign ifican t discount at d istan t points
if there w ere no arran gem en ts for redem ption at
convenient locations. T h is w as quite im portant in
larg e countries, esp ecially those w ith inadequate com ­
m unication and transp o rtatio n facilities, because it
resulted in v a ry in g valu es for different com ponents
of the m oney supply. F u rth er, the notes frequen tly
w ere not uniform as to size, shape, color, or q u ality
of p rin tin g or en gravin g. T hese differences often
encouraged co un terfeitin g w hich som etim es becam e
a m a jo r problem . M o reover, system s of com m ercial
bank note issues failed to provide for “em ergency
e la s tic ity ” ; th at is, arran gem en ts for susp en din g for
short periods of tim e the norm al regulatio n go vern ­
in g note issues to allow la rg e r am ounts to be issued
to m eet public dem ands caused by panics or other
abnorm al situ atio n s. L o n g and painful experience
has shown that such arran gem en ts a re essen tial,
esp ecially if there is less than com plete confidence in
the b an kin g system .
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F in a lly , as the th eo ry and practice of cen tral b an k­
in g developed another problem em erged. T he ab ility
of a cen tral bank to control the total m oney supply
(in clu d in g dem and d ep o sits) depends in p art on the
supply of coin and cu rren cy, w hich includes note
issues. W h en a larg e p art of the cu rren cy supply
is m ade up of com m ercial bank notes, th at sup p ly is
sub ject to e rratic and un predictable fluctuation de­
pending on actions taken by the banks and w him s
of the public resu ltin g from changes in confidence or
other factors. T h us, the use of com m ercial bank
notes com plicated the p rin cip al task of cen tral banks.
W HY A CENTRAL BANK M O N O P O LY?
T he dis­
ad v an tages described above can, in larg e m easure,
be overcom e by g iv in g the cen tral bank a m onopoly
of the note issue. T h e cen tral bank w ill not fail, so
note holders w ill not lose for th at reason. In a d d i­
tion, the notes are u su a lly m ade legal ten der and
g u aran teed by the n atio n al governm ent. T he best
facilities and w orkm anship av ailab le are used in
p rin tin g and en grav in g the notes so th at co un terfeit­
in g is disco uraged. If redem ption is p erm itted and
is significant, redem ption points are established at
vario u s places so th at the notes do not go to a d is­
count because of distance. E m ergen cy elasticity is
provided because the cen tral bank can safely be en­
tru sted w ith the pow er to suspend norm al regu latio n s
for lim ited periods of tim e. T h e pow er to control
the note issue, even though incom plete, sim plifies the
cen tral b an k’s task of co n tro llin g the whole m oney
supply. F in a lly , since the note issue is the source
of larg e profits, w hich come from the ex ercise of one
of the sovereign pow ers of governm ent, it is g en era lly
3
July 1962
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believed th at it should be concentrated in one o rg a n i­
zation not operated for profit and clo sely sup ervised
by the governm ent so th at the bulk of the profits can
m ore e a sily be recouped by the governm ent.
T he d esirab ility of co n centrating the note issue in
the cen tral bank cam e to be realized slo w ly, m ostly
d u rin g the nineteenth cen tu ry. B u t accom plishing
th at step w as not an easy m atter. T h e com m ercial
banks w an ted v e ry m uch to retain the rig h t to issue
notes, both because of the profit it conferred and be­
cause of the p restige it carried . T h e process of
tran sfe rrin g the note issue pow er w as long and in ­
volved. One m ethod w as to deny the note issue to
new com m ercial banks and allow the cen tral bank
to assum e an y issue pow ers possessed by banks
w hich w ent out of existen ce.
In the U nited
S tates com m ercial banks issued notes u n til 1935.
T he F ir st and Second B an ks of the U n ited S tates,
w hich functioned to some exten t as cen tral banks,
issued notes alo n g w ith state-ch artered banks. From
the end of the Second U n ited S tates B an k (1 8 3 6 )
until the C ivil W a r , state bank notes w ere the only
paper m oney in the coun try. W h ile some states
devised safe and sound system s of note issue, m any
states w ere la x in th eir regulatio n and m an y banks
abused the note issue p riv ilege, cau sin g losses to the
public.
In 1863 the N ation al B an k in g System w as estab­
lished, p ro vid in g for a safe and uniform bank note
issue under F ed eral supervision and secured by the
pledge of certain U n ited S tates G overnm ent bonds
w hich had the “circulatio n p riv ile g e.” A F ed eral
ta x on state bank notes first levied in 1865 soon
drove them out of existen ce, leav in g the note issue
so lely to n atio nal banks. T he only other form of
THE UNITED STATES EXPERIENCE
4
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paper m oney then in circulatio n w as the U n ited
S tates note ( “G reenback” ) but the gold certificate
and silv er certificate w ere added a little later.
N ational bank notes represented a g re a t im prove­
m ent in th at th ey w ere uniform and safe. T h ey w ere
g re a tly lack in g, how ever, in elasticity, both o rd in ary
and em ergency. T h is, alo n g w ith other defects in
the system , w as p rim a rily responsible for the re ­
c u rrin g m oney panics w hich scourged the co un try
from 1870 un til 1907. T hose panics did m uch to
stim u late the reform m ovem ent w hich culm in ated in
the estab lish m en t of the F ed eral R eserv e S ystem in
1913.
F ed eral R eserv e B an ks issued notes from the be­
g in n in g, and it w as expected th at those notes w ould
soon displace n atio nal bank notes. P ro visio n s w ere
m ade w h ereb y national banks could retire th eir notes
e asily w ithout loss, but th ey w ere not req u ired to do
so and few did. In fact, in 1932, w hen the R eserv e
B an ks w ere ex p erien cin g difficulty in m eetin g the
g reat dem and for cu rren cy caused by w idesp read
bank failu res, n atio n al banks w ere allow ed to in ­
crease th eir note issue su b stan tially for a short tim e.
O nly a few banks took ad v an tag e of the law' and the
in crease in notes w as m odest. S h o rtly afterw ard s
the regu latio n s go v ern in g the issue of F ed eral R e­
serve notes wrere lib eralized so th at R eserv e B an ks
could m eet the cu rren cy need. In 1935 a ll U nited
S tates bonds w ith the “circu latio n p riv ile g e ” w ere
retired and natio nal banks ceased issu in g notes. Since
then the notes have been g ra d u a lly retired and nowT
F ed eral R eserv e B an ks have a m onopoly of the issue
of bank notes.
REGULATION AND COLLATERAL
In the past the
m ost im portant features of a system of bank note
issue w ere provisions settin g the m axim u m am ount
July 1962
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th at could be issued, in su rin g the secu rity or value
of the notes, and g iv in g e lasticity to the issue. W h ere
notes constitute the larg est and m ost d yn am ic p art of
the m oney sup p ly, those provisions are still of m ajo r
im portance. A lso, in countries which m ain tain an y
form of the gold stan d ard it is g en era lly considered
n ecessary to req u ire some reserve ag ain st notes in
the form of gold or gold certificates, or, in m an y
countries, foreign exch an ge assets.
V ario u s m ethods
o r devices, togeth er writh m odifications and com bina­
tions of them , are em ployed to lim it the m axim um
am ount of notes w hich m ay be issued.
In m an y go ld -stan d ard countries it is custo m ary
to req u ire a m inim um reserve in the form of gold or
gold certificates. T h e rem ain in g co llateral m ay be
in the form of discounted paper, governm ent bonds,
or g en eral assets of the bank. T h e gold reserve re ­
quirem ent sets a lim it to the total am ount of notes
w hich m ay be issued.
A n o th er m ethod, long used in E ngland, is to p ro ­
vide for a lim ited “fid u ciary ” issue of notes secured
by governm ent bonds and to require th at all notes
beyond that be fu lly backed by gold. T h a t system
w as quite in elastic and is not used an yw h ere today.
S till another m ethod is to req u ire that the notes
be secured by certain specific issues of governm ent
bonds w hich are lim ited in am ount. T h is m ethod
w as used in p art to lim it the volum e of natio nal bank
notes in this country.
A w id ely used m ethod of control is for the go v ern ­
m ent to prescribe a m axim u m am ount of notes w hich
m ay be outstan din g. T h e governm ent, of course, is
free to raise or low er th at m axim um from tim e to
tim e as it sees fit.
F in a lly , reserve and co llateral requirem ents m ay
METHODS OF LIMITING VOLUM E
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•
be abolished or in defin itely suspended, leav in g the
notes sub ject to the sam e regulatio n as the deposits
or other liab ilities of the bank. T h is m eans that the
am ount of notes o utstan din g is left to the discretion
of the cen tral bank or, m ore lik ely, to the autom atic
operation of the b an kin g system as explain ed below.
T h is situ atio n p revails in m an y countries of the
w orld today.
M ost
bank notes are now issued by cen tral banks, and
there are few problem s in in su rin g th eir secu rity
since a governm ent cannot allow its cen tral bank to
fail or to default on its obligations. In fact, in m ost
countries it m ight be said th at there can be no prob­
lem of secu rity or redem ption since no m eaningful
redem ption is allow ed and the cen tral bank note is
in p ractice the u ltim ate form of m oney.
U su a lly vario u s form s of co llateral are pledged to
secure the notes. If no specific assets are so pledged,
note holders have a claim ag ain st the gen eral assets
of the bank, and m ay have a p referred status, ahead
of depositors. F u rth er, the secu rity of cen tral bank­
notes (in term s of the co u n try’s m o netary u n it) is
fu rth er assu red by the fact that th ey are u su ally m ade
legal ten der and are g u aran teed by the n atio nal gov­
ernm ent. W h ere n ecessary, the m aintenance of the
notes at a uniform value throughout the co un try is
assu red by the establishm ent of a num ber of redem p­
tion centers.
SECURITY AND REDEEMABILITY PROVISION S
T h e F ed eral R eserv e
note w as designed to add “auto m atic e la s tic ity ” to
the un ifo rm ity and safety w hich had ch aracterized
the national bank note. T h is w as to be accom plished
by req u irin g “eligib le p ap er” as the p rin cip al form
THE FEDERAL RESERVE NOTE
(Continued on page 8)
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