The inelasticity of bank reserves the real crux

All of these defects of the old system—decentralized reserves, rigid reserve requirements and inelastic note issues—were merely different aspects of the single defect which we have placed second in the foregoing list, namely, the inelasticity of bank reserves. It is worth while, therefore, to further emphasize this particular point and to try and see its relation to the other defects of our old banking system.

The only reason for requiring that a bank shall maintain reserves equal to a certain specified per cent of its deposits or its note issue is to insure that the bank will be able to meet sudden demands for cash from its depositors and on the part of other banks. The rigid reserve requirements that we have already discussed provided that when reserves fell below 15 or 25 per cent, as the case might be, the bank should immediately cease lending until its reserves had been restored. This adequately served the purpose of protecting depositors. But so far as the extending of credit was concerned such a reserve was not a true reserve at all: it was a dead line beyond which the bank could not go. It might have to stop lending at the very time when courageous lending, even if at higher discount rates, was the only thing that would forestall a general crisis. In the practice of most other countries bank reserves are allowed to vary, the variation in the reserve ratio being accompanied by a sliding scale of discount rates fixed not by law but by the experience of the bank.

It is easy to see how this fundamental defect was linked up with others. If reserves were truly elastic it would not make much difference whether they were centralized or parceled out among individual banks. The real difficulty is that it is impossible that bank reserves should be elastic unless they are centralized. Again, if bank reserves had been elastic, the absence of elasticity in bank-note issues would not in itself have done any harm. The New York banks, for example, could have taken money from their vaults every autumn and shipped it to the West, knowing that in the course of the normal cycle of trade it would return in a relatively few months. For the time being, during the crop-moving season in the West, reserves might be low. But what of it? It would have been understood by everyone to have been a normal situation for that particular time of year, and one which would in a short time remedy itself.

But why, the reader may ask, did not the New York banks and the other large banks which held the major portion of the reserves of the country normally hold more reserves than were required by law? If the New York banks had normally held 40 or 50 per cent reserves, they could have absorbed the ordinary strains resulting from the movement of gold into the West, into the government treasury, or even to Europe, while retaining the ability to meet the real needs of the business community for loans. For such reserves would never, except in years when gold exports were large, have fallen to the legal minimum of 25 per cent.