Regulation of Note Issues

While metals were the basis of currency at the time this book was written, there was far more paper money than gold coins in circulation, largely due to the issuance of credit money. The value represented by notes was not resident in the vaults of banks (much of it was loaned out) and the value represented by bills was explicitly unavailable at present.

So while gold was the basis of currency, it was only nominally so - there never was an equal amount of gold in the vaults to back all the notes and bills written against it. A few statistics are provided to illustrate the degree of the problem: in all of England, there was enough specie to cover 15% of notes and bills, and in the city of London it was less than 1%.

This is of little practical concern because banks need only enough capital to back notes when they are presented for redemption, and as many notes and bills remain in circulation, few would be redeemed. Still, there is the effect on confidence: a person who does not mean to redeem his note still wants to feel secure in the knowledge he could do so at any time. When confidence wants, the most fearful begin to redeem their notes for specie - and as specie dwindles and notes cannot be immediately honored, more people before fearful and it can escalate into a crisis.

When banks were independent, each managed its own stock of specie to maintain confidence in its notes, but this responsibility has largely been removed from banks and subjected to legislation. This legislation pertains only to notes (which represent a right to specie that is ostensibly in storage) and omits bills (which represent a right to payment of specie on a future date), for which there is no regulatory protection.

Regulations generally require banks to retain a certain capital reserve for the redemption of notes, which is less than the full amount of the notes issues. While the latter would create certainty in the availability of funds for redemption, it would remove from the economy a significant proportion of circulating capital. It's mentioned that the fractional reserve system works well "under ordinary circumstances."