The mystery of money (1929)

The mystery of money

How modern methods of making payments economize the use of money.

The role of checks and bank-notes

The enormous edifice of credit

The Book of Popular Science (1924; revised 1929) New York: The Grolier Society.

Group IX Ch. 31:4231–40

For a long time, it was the habit of writers on the subject of money to picture an imaginary stage of barter which continued for a long period before it became possible to agree to use one particular commodity as the medium of exchange or measure of value, and thus to adopt money.

This view of things, that men invented money in order to rid themselves of the difficulties and inconveniences of barter, belongs, along with much other conjectural history, on the scrap-heap of discredited ideas. Men did not invent money by reasoning about the inconveniences of barter any more than they invented government by reasoning about the inconveniences of some mythical primitive state of anarchy. The use of money, like other human institutions, grew or evolved. Its origins are obscure. It is, nevertheless, fairly certain that at no period in his history has man ever conducted any considerable volume of trade by means of barter. There was a very small gap, perhaps no gap at all, between the beginnings of trade and the origin of money.

Of course, traders dealing with regions where civilization has scarcely appeared may even now find it possible to exchange beads, cheap bright-colored calicoes, knives, mirrors, etc., for goods which are in modern markets vastly more valuable. But the trader, unless he be a trained observer, is likely to disregard the fact that the savages with whom he barters have some crude, primitive monetary system of their own. In fact, it is not at all uncommon for the beads, or other (to them) rarities, which the savage tribe obtains by way of barter from civilized peoples, to become, by reason of their scarcity and desirability, the money, for the time being at least, of the tribe.

A host of different commodities have been used at different times, and by different peoples, as money. If we scrutinize a list of such commodities ever so carefully, we shall find it difficult to see that they have any common characteristics beyond the fact that, for various reasons, the commodities have all had, at a given time and place, an assured market or outlet.

Consider the fact, noted by the great German historian of Rome, Mommsen, as well as by other observers, that the peoples of the early civilizations of the world, like the moderns, almost uniformly selected for use as money commodities that were ornamental rather than useful. This fact calls for explanation, and the explanation may throw some light upon at least one of the mysteries of money. If there is any one clear-cut and fundamental difference between necessary commodities and luxuries, it is that human wants for necessaries are satiable, while the desire for ornaments, as for other goods that minister to the love of distinction and display, is insatiable. Of course, it is not true that normal men place luxuries above necessaries. It is simply true that when one is provided with the necessaries of life, the normal man, in adding to his goods, will increase his stores of luxuries rather than his supplies of necessaries. To use a technical phrase explained in earlier chapters, the demand for ornaments, and consequently the demand for the metals from which ornaments are made, is elastic, while the demand for the necessaries of life is, by comparison, inelastic. There is a surer market and a surer outlet for ornaments and for their materials. Their value is less variable than that of necessaries. Especially is this true in communities with little foreign trade. Wheat might be a drug on the market; but such could never be the case with respect to precious stones or ornaments of gold.

The definition of money and its essential characteristic

Money may be defined as a commodity or group of commodities customarily paid and received in exchange for other commodities and services without reference to the personal credit of the one who offers it. That is, a personal note is not money, but a bank-note is. It is necessary to observe further, however, that not only the credit of the one who offers it, but also the desires and intentions of the persons who receive it, have an important bearing upon the question of what is and what is not money. The person who receives money in exchange for commodities or services takes it with no other thought than that of passing it on again in exchange for other goods and services. No one, except the miser, values or wants money on its own account, even though the materials of which some forms of money are made may have utility and value of their own.

The one really essential characteristic of money is that the holder should be able to get rid of it without undue loss. Other commodities have their ultimate consumers; money never finds an ultimate destination or resting-place: it is tossed about from person to person until finally, worn out, lost, or melted down, it passes out of use.

Illustrations showing money is not primarily valued for itself

If, with these fundamental principles in mind, we survey such facts as are available respecting the monies of the primitive peoples and the diverse types of money used even by modern peoples, we shall find that they have just that one essential characteristic. The precious metals, almost from earliest times, have been used as the materials of ornaments, and so also from almost the earliest times, they have been used as money. The precious metals could always be passed on to the man whose wealth and standing in the community were estimated, as today in some parts of India, by the number and the weight of the silver and gold ornament worn by his wife. An elastic demand in itself creates a safe outlet. Why was tobacco used as money in early colonial Virginia; or furs in some of the northern colonies and in Canada? Or rice in the Carolinas? Why did the New England colonists sometimes use the Indians’ ornamental strings of beads—wampum—as a medium of exchange in certain of their own transactions?

Utilizing again our unifying principle, the answer to each of these questions is obvious. Tobacco was the most important Virginia product for export. It was the medium by which English goods, of which the colonists were in sore need, could be obtained. It was the one product for which there was, for the time being, a certain and undisputed market. What more natural than that accounts as between the colonists themselves should be transferred by means of this particular commodity, their best embodiment of purchasing power? And so with furs, obtained by trappers or bought from the Indians, and sold in the export market: they also came to have a local currency as a means of getting other things. They could be passed on from hand to hand with the certainty that the holder for the time being could pass them on again when he so desired. The case of wampum is a little different. There was, of course, no European outlet for it; but it had purchasing power in dealings with the Indians, and it is very likely that, for that reason, some of the colonists were not unwilling to accumulate a stock of it. All of these illustrations serve to make it tolerably clear that money is not primarily a thing that is valued for itself. The value of money is its purchasing power. Just so far as any commodity serves as money, it is because it is wanted, not for personal or permanent use, but for passing on. The material of which money is made may have its own use. This merely makes it all the more certain that money itself may be passed on, that someone may always be found who is willing to take it in exchange for goods or services.

With respect to another problem—the economic functions of money—there has also been unnecessary confusion of thought. Money is an important part of our commercial mechanism. The “functions” of any piece of mechanism are properly determined, not by what we think that particular bit of mechanism ought to do, but by what it actually does. In economics, as in the natural sciences, we shall see farther and see more clearly if we consistently try to avoid the use of loose, vague and general terms, and fix our attention upon concrete facts, upon what actually takes place in this complicated world.

The money price of commodities is final criterion of relative values

Money is often said to be a medium of exchange and a measure of value. Taken loosely, these descriptive phrases are not objectionable, but when we use them we should try to see back of them into the actual facts they loosely summarize or describe. Otherwise we are likely to forget that after all the “values” of things are their money prices. We do not, in actual fact, determine the relative values of different kinds of commodities and services, and then bring in money as a means of “measuring” the different values or of reducing them, as General Francis A. Walker preferred to say, to a common denominator. The general exchange values of the commodities that are bought and sold in modern markets are, in fact, merely relations that we derive or infer from their money prices. The money price of a commodity is the fundamental original fact with which the economic scientist must deal. Interpreted generously and understood, however, there is no real difference between the two functions of serving as a medium of exchange and as a measure of value.

It is only in the actual exchange of goods for money, or in deciding whether or not to make such exchanges, that we really use money as a “measure of value.”

In the same way, of course, it is proper to say that a yard-stick is both a measure of length and an instrument used in measuring. Anyone would say at once that these two alleged functions of the yard-stick are really but one function. Precisely so with money: measuring values and serving as a medium of exchange are only one function, not two.

It is better to avoid these word-wasting controversies over the meanings of terms by recognizing money for just what it is, namely, a means of payment. The prices of goods and services are stated in terms of money and we pay for them with money. Debts are promises to pay money, and we pay our debts with money.

Money is sometimes said to serve also as a standard of deferred payments.

Properly understood, again, there is nothing objectionable in this statement. It merely emphasizes the fact that debts which run for many years, like short-time debts, are usually made payable in money. The farmer who borrows money on mortgage security and agrees to pay off the loan at the end often years, will gain or lose according as prices in general, especially the prices of agricultural products, move upward or downward during the ten-year period. If prices move downward, he has to pay his creditor in money which costs more, which will buy more, and which therefore is worth more than the money he borrowed. If the debt had been contracted in terms of bushels of wheat, the relative positions of the creditor and debtor at the end of the transaction would have been very different. If prices move upward, rather than downward, it is, of course, creditors who lose and debtors who gain. In saying that money serves as a standard of deferred payments we are really doing little more than calling attention to the importance of this particular problem. As a matter of fact, this function of money, like the others, is really covered by the simple statement that money is the ordinary means of payment.

It would be possible, of course, to divorce the standard of deferred payments from the ordinary means of payments. Thus, the law might prescribe that debts stated in terms of money should be increased or decreased according as the general purchasing power of money declined or advanced. In such case, although money would remain the means of payment, the standard of deferred payments would really consist of the list of goods whose prices were taken and compounded to measure the general purchasing power of money. Or, as some have proposed, the cost of money, or the amount of labor required at different periods to earn a specified amount of money, might be made the basis of a standard of deferred payments. The problem of the standard of deferred payments has had in the past a very large political as well as economic importance, as we shall see when, in a later chapter, we examine some of the outstanding facts in the monetary history of the United States.

What gives different kinds of money its value

We now pass to the consideration of certain problems associated with the coinage of money. There is a widespread illusion that the essential characteristic of a coin is the government stamp, that it is the power and authority of the government which give the coin its value. This notion has done a vast amount of harm, and more than once it has been used by governments as an excuse for unsound monetary policies. On some peculiar kinds of coins, as we shall see, as well as on most kinds of paper money, it is the government’s stamp which, in a sense, gives money its value. But in precisely the same way, it is the solvent debtor’s name on his promissory note that gives the note its value. We must distinguish carefully between two wholly different kinds of coins: standard coins and subordinate coins.

Put a ten-dollar gold piece upon an anvil and deface it with a heavy sledgehammer. The shapeless lump of gold you will have left will not be a coin, but it will be worth precisely ten dollars. By defacing the coin, you will have removed merely a useful and convenient label. But treat a silver dollar in the same fashion, and you will have left sixty cents’ worth of silver or more, the exact value depending upon the price of silver at the time. In defacing the government stamp you will undoubtedly have destroyed some of the value the coin had.

The fact is that the coinage of standard coins, such as the gold eagle, is nothing but a dependable official certification of their weight and fineness. They are in reality nothing but pieces of precious metal.

Anyone can take gold to the United States mint, and if it is of the required standard of fineness, the government will pay him for it at the rate of one dollar for 23.22 grains of fine gold. Silver coins, however, are made from metal purchased by the government. There is less than a dollar’s worth of silver in the silver dollar and in a dollar lot of smaller silver coins, just as there is less then five cents’ worth of metal in the nickel and less than one cent’s worth of bronze in the cent. The details of the process by which these coins are kept at a parity with gold will be discussed in a later chapter. We may note here, however, that just so far as the government in its own transactions does not discriminate among these different types of coins and, in particular, just so far as it remains able and willing to exchange any one type of coin for any other sort, just so far will the business world accept these coins as of identical value per dollar. But it is important to observe that in foreign trade the subordinate coins are at a disadvantage. Save in exceptional cases, such as in border trade with neighboring countries, the general rule is that they will be taken only at the value of their bullion content. Gold also passes in foreign trade at its bullion value, but in its case, as we have seen, bullion value and coined value are identical. For this reason, gold, whether in coins or in bullion form, is the international monetary standard and the means of paying the final trade balances between different countries.

We have assumed thus far that the government makes no charge for the coinage of gold. Such, in fact, is the case in most modern countries. The United States, like most other countries, makes a necessary charge for assaying and refining the gold if it does not conform to the required standard. France and a few other countries make a very small additional charge called “brassage” to cover all or a part of the actual expense of coinage. The operations of the English mint, in principle, are gratuitous like those of the United States mint. There is the essential difference, however, that in England one who takes gold to the mint would supposedly be asked to wait until his bullion had been converted into coin. In practice, the Bank of England acts as intermediary between the mint and the public. An ounce of gold suffices to make £3 17s. 10 1/2d. in English gold coins. The Bank of England will at all times buy gold at the price of £3 17s. 9d. and it may give somewhat more than this price when it desires to strengthen its own gold reserves.

Seigniorage and its results

Modern nations, it is clear, view the maintenance of the coinage as a public function to be performed in large measure at public expense. Very different has been the attitude of governments in earlier times. The monopolistic power of coining money was often held as a prerogative of the sovereign not because in this way only would the people have the advantages of a uniform and dependable currency, but rather in order that the sovereign might use his prerogative as a means of securing profits. A common practice was that of making a high seigniorage charge—a charge much more than covering the expenses of coinage. When seigniorage is charged, more bullion must be deposited at the mint than is contained in the coins received for the bullion. The surplus bullion went as profits to the sovereign to be made into coins for his own use. A more flagrantly unfair practice was that of calling in all coins in circulation for recoinage into smaller coins.

Royal monetary legerdemain

One who had thus been forced to turn his money into the mint was repaid the same number of coins, and the coins were of the same denomination, but they were of lighter weight. The bullion taken out of the coins of the people was made into money for the sovereign. It is probable that in purpose and principle these transactions were not thought to be the barefaced robbery which to us they seem to have been. Kings, like other men, were misled by the notion that it was the royal stamp that gave value to the coin. They believed and were often told by their advisors that the new light-weight coins would be worth as much as the old, and that they could thus reap profits without imposing any real burdens upon their peoples. Of course such doctrines were and are no better than pernicious nonsense. By no sort of monetary legerdemain can wealth be created, as it were, out of thin air. The recoining operations, it will be noted, resulted in an increase in the number of coins in the country, just as when seigniorage was charged, a given volume of metal was made ultimately into a larger number of coins than would otherwise have been minted. The sovereign obtained purchasing power that he otherwise would not have had. It is absurd to suppose that he could have expended this purchasing power for goods and services without correspondingly reducing the purchasing power remaining in the hands of his subjects. The king’s shillings, or florins, or whatever the coins might be, came into the market, we may say, as new competitors of the coins of the king’s subjects. Prices rose to a level which they otherwise would not have reached.

Seigniorage, like the debasement of the currency, thus operated as a tax upon the people. Coins subjected to a seigniorage charge always fell in value. Their purchasing power was determined, in the long run, not by what they cost at the mint, but by the amount of bullion they actually contained. Under such conditions, bullion was not brought to the mint except under compulsion.

The fact is that a seigniorage charge of any magnitude is not practicable. The point is important, not so much because seigniorage is today a live issue, but because precisely the same principles are involved in various proposals to substitute for gold another type of standard money consisting of irredeemable paper currency, that is, paper currency which involves no promise to pay on the part of the government, nor any governmental responsibility for maintaining its value. Such paper money, sometimes called “fiat money,” is very much like metallic money subjected to a 100 per cent seigniorage charge, if such a thing can be imagined.

Precisely the same considerations which counted so heavily against the policy of charging seigniorage on the coinage of standard metal hold with really fatal force against any proposal for a standard money of irredeemable paper.

Credit and its big role in business

We shall find it convenient at this point to set aside for the moment these problems of money, properly so called, and turn to the related subject of credit.

Nine-tenths of the business transactions in a country like the United States are performed with the aid of credit rather than of money. From the purely quantitative point of view, credit is vastly more important than money. And yet that should not blind us to the fact that credit without money is impossible.

Proposals to do away with money and to use credit only as a means of payment reveal a complete misunderstanding of the nature of credit and of its relation to money. There is, in fact, so much confusion respecting the real nature of credit that we shall do well to observe that credit is in fact a very simple thing. Credit is merely the other side of debt! In a borrowing transaction what appears to the lender as a credit, appears to the borrower as a debt. Much confusion would be avoided if, in discussing monetary problems, we should use the word “debt” in place of “credit.” The real facts discussed would be unchanged. But the mode of discussion would necessarily steer us clear of a number of dangerous fallacies. For example, who would be willing to say that we could dispense with money and get along very well by the use of debts as means of payment? The objection is obvious. A debt can hardly be a means of payment, for it itself is something to be paid.

Institutions which deal in debts

Nevertheless, we shall see that there is a certain sense in which we may speak of making payments by means of debts. But this is a misleading way of stating the matter unless it is clearly understood that we are using the words “making payments” in a rather loose way. Debts, very naturally, are means of avoiding, rather than of making, payments. And the greater the extent to which we can avoid immediate payments by utilizing credit, the more we will be able to avoid the necessity of making final payments, not because we fail to honor our debts, but because the accumulated debts of persons in the community are offset or canceled one against another. This cancellation or offsetting process is accomplished easily and inconspicuously by the mechanism of banking.

A bank is an institution which deals in debts. It buys the debts of its customers and sells its own debts. Its customers’ debts come to it in the form of promissory notes and bills of exchange. A promissory note is, of course, a promise to pay money either on demand or, more usually, on or before a certain date. A bill of exchange or draft is an order to pay, drawn by a creditor upon a debtor. When acknowledged or accepted by the debtor, as by writing his name upon it, it becomes an “acceptance”, and then, for all practical purposes, is like a promissory note.

Growth in use of bank acceptances

A bill of exchange drawn by a jobber or manufacturer on account of a shipment of goods and accepted by the buyer—a retail merchant, perhaps—is called a “trade acceptance.” It may happen however, that instead of accepting the bill of exchange on his own account, the buyer will arrange with some bank to accept the bill of exchange on his behalf.

The bank, of course, will be fully protected by the deposit of securities or by some other satisfactory arrangement. The bank gets a small commission for thus lending the use of its name and the buyer may get better interest rates or more favorable terms of sale because he can furnish an acceptance so satisfactory to the creditor.

Such “bank acceptances,” as they are called, have a large and growing use in financing international trade.

In exchange for its customers’ debts, in the form of notes and bills of exchange, the bank gives its own debts in the shape of bank deposits and bank-notes. It will be worth our while to examine these two forms of banking indebtedness rather carefully, for they play a very large part in modern economic life. We are accustomed to think of a bank deposit as “money in the bank.” In fact, however, it is nothing but a claim or credit,—a right to receive money on demand from a bank. A bank deposit is the depositor’s credit or asset and the bank’s debt or liability. It often happens that when some rumor, true or false, has started a run upon a particular bank, the depositors who have stood in line, perhaps for hours, in order to withdraw their deposits before the bank collapses, are perfectly satisfied when they find the bank is able to pay them. They do not want their money, they merely want the assurance that “their money is still there.” Of course this shows a profound ignorance of the nature of banking. No bank could afford to have on hand at any one time cash sufficient to satisfy all of its depositors. A certain amount of cash must be in its vaults or must be easily available elsewhere,—somewhat more than enough to meet the ordinary day-to-day demands of its depositors and creditors. This relatively small amount of cash—10, 15, or even 25 per cent of the bank’s debts to its depositors—is the bank’s “cash reserve.” The proportion it should bear to the bank’s total deposit debts is regulated in the United States by law, but in many countries it has been found wiser to leave it to be decided by the practical experience of the banks themselves.

Three ways of obtaining a bank deposit

One may purchase a bank deposit in any of three different ways. In the first place, one may from time to time turn surplus cash over to the bank as many merchants are accustomed to do daily. This may seem like actually depositing money in the bank. But the real transaction is an exchange: the depositor’s cash is paid into the bank, not with any understanding that the cash shall be kept intact and separate, but in exchange for the right to demand the same amount of cash, or any part of it, from the bank at any time. Or, in the second place, a bank deposit may be obtained by turning over to a bank checks signed by depositors in the same bank or in other banks. It is clear that transactions of this type merely result in transfers of deposit credits from one depositor to another and, incidentally, from one bank to another. The total volume of bank deposits within the community is not affected by these transfers.

In the third place, depositors’ credits are created by banks in favor of their borrowers. The business man brings to his bank, let us say, his own promissory note for $10,000, payable at the end of 90 days. Or it may be a note which the business man has taken from one of his customers and to which he has added his own endorsement, or it may be an accepted bill of exchange representing a shipment to the customer. The bank discounts the note or bill of exchange. In other words, it buys it and pays for it, not its face value, but a somewhat smaller sum. The amount of the difference or discount is substantially like interest, except that it is deducted in advance from the face value of the loan instead of being added to the principal of the loan at its maturity. In the imaginary case under discussion, if the rate of discount were 6 per cent per annum, the note or bill of exchange for $10,000, running for three months, would be subjected to a discount of $150 (one-fourth of 6 per cent of $10,000), so that the business man would receive credit for $9850 and would be obligated to repay $10,000. But it must not be supposed that the bank dips down into its vaults and advances cash to every borrower. The common practice is that the borrower is given the right to draw checks upon the bank up to the agreed amount,—in this case $9,850. In other words, he is given a bank deposit. The bank grants him the right to demand money from it at any time in exchange for the right to demand from him or from some third party a somewhat larger sum of money at a definite future date.

Eighty-five per cent of aggregate United States bank deposits due to borrowing

We may have gone into unnecessary detail in describing these elementary business practices, but it is because it is important that the reader should understand the real nature of the operations of depositing and discounting. These are the fundamental things in banking and are, moreover, the fundamental facts that determine the amount and the nature of the bulk of our present-day media of payment. This third method of securing deposit credit at a bank is vastly more important than the other two. Actual cash is continually flowing out of the bank, just as it flows in, so that except in unusual periods, the first method of making deposits referred to above does not have a large net effect. The second method, as we have seen, involves merely the transfer, rather than the creation, of deposits.

Probably as much as 85 per cent of the aggregate volume of bank deposits in the United States (amounting to nearly $13,000,000,000 in national banks alone in 1921) have been created by discounting and by similar methods of making advances to borrowers. If we should examine the books of any one individual bank we should hardly find as much as 85 per cent of its deposits represented by advances to borrowers. But we must take into account the fact that the deposits of any one individual bank are created in no small part by transfers from other banks, and if we should trace these transfer deposits back to their ultimate origin we should find that in the beginning many of them started as borrowings. Thus, although our statement is approximately true of the banks of the country taken as a whole, it is not necessarily true of any one individual bank.

The banks’ issuance of promissory notes

The other important form in which the banks utilize or sell their debts is that of bank-notes. A bank-note, like a bank deposit, is a bank’s promise to pay on demand. There are important differences, however.

The bank-note passes into general circulation; it passes from hand to hand without indorsement; it is engraved and printed in a way that makes it a convenient and a safe medium of exchange; in short, it really serves in hand-to-hand payments as part of the money of the community. Banks issue notes in very much the same way they make deposit credits, with, however, a few differences of detail. Some borrowers, as for example the manufacturer who has a large payroll to meet, may want cash rather than the right to draw checks. Or it may be that borrowers and other depositors are drawing so many checks upon a bank that its cash reserve is becoming dangerously low; in such a case, the bank may find it desirable to pay out its own notes over the counter in lieu of other money. In this case, what really happens is that a depositor who asks for cash is satisfied by having his deposit claim against the bank exchanged for another form of claim—the bank-note—which will serve his purpose as well as would any other sort of money.

The difference between deposits and bank-notes will concern us in other connections in later chapters. It is well that we should observe at this point, however, that, although they are alike liabilities or debts of a bank, the ways in which deposits and notes respectively are actually used creates problems peculiar to each. Thus, the depositor has an opportunity to acquaint himself with the bank’s reputation and with the character of its officials, and to learn what he can about its probable solvency before he intrusts his funds to the bank’s care. But if banknotes are to be in common use, if they are to pass from hand to hand, they must come into the possession of persons who have no knowledge of the particular banks which are responsible for them. It is for this reason more than for any other that certain governments, including that of the United States, have thought it wise to impose certain restrictions upon the issue of bank-notes while leaving the creation of bank deposits subject, within reasonable limits, to the discretion of the banks themselves.

Some of these matters we have been treating may be made clearer if the reader will glance for a moment at the statement of the condition of a typical national bank in a city of moderate size.

Most of the stated resources and liabilities are self-explanatory. In the list of assets there will be noted United States government securities.

Table 33.1 Statement of the condition of a National Bank:

September 12, 1925

Resources

Loans and discounts

United States government securities

Other bonds, investments and real estate

Cash and exchange, exclusive of lawful reserves

Lawful reserve with federal reserve bank

Other assets

Total Resources

$655,920

165,150

53,400

65,151

30,816

27,565

997,565

Liabilities

Capital

Surplus and undivided profits

Circulation

Demand deposits

Time deposits

Due to banks, and all other liabilities100,000

74,426

100,000

167,062

542,524

13,553

Total Liabilities 997,565

Some of these this bank, as a national bank, is required by law to hold to cover its note issue of $100,000, which appears among the liabilities under the name “circulation.” In the cash the bank has on hand there is included its “exchange,” consisting of checks payable by other banks and other similar claims against them. Its “lawful reserve” under the present laws does not include all of its actual cash on hand, but consists wholly of deposit credit which this particular bank has in a federal reserve bank. Loans and discounts, it will be noted, constitute the most important item of the bank’s assets. This item designates the sum total of the bank’s holdings of the notes and bills of exchange of borrowers. Deposits, classified as demand and time, bulk as large in the bank’s liabilities as do loans and discounts in its assets.

Capital represents the original investments of the bank’s shareholders. The undivided profits are accrued earnings not yet paid out in dividends. For these, of course, the bank is liable to its shareholders. Profits come largely as the result of discounting and other lending and investment operations. Profits which the bank’s officials have not decided to pay out in dividends, thus reducing their cash or their other resources, but which instead they have determined to retain in the business as further investments of capital, are called “surplus.” Banks are required by our law to accumulate a certain amount of surplus. A large surplus is, generally speaking, a sign of strength. Where surplus is large the depositors’ claims are a smaller proportion of the bank’s liabilities than would otherwise be the case, and thus the depositor is better protected.

But sometimes a large surplus is a sign of weakness rather than strength. Bank officials, knowing that some of their loans are non-collectible, or that some of their other assets are not really worth the amount at which they appear on the statement, may be unwilling to put an increased strain upon the bank by paying dividends. The accumulated profits—really only paper profits because they depend upon an over-valuation of the bank’s assets—may be “passed to surplus” without arousing suspicion or without affecting the bank’s strength or weakness.

A surplus as large as or somewhat larger than a bank’s capital is not uncommon and is, in general, an indication of sound banking. But a bank with an abnormally high surplus, four or five or even ten times its capital, is one that should be investigated rather carefully by a depositor before he intrusts his funds to the bank’s keeping. In general, however, we can congratulate ourselves that the standards of honesty in the conduct of the banking business are, as they should be, somewhat higher than the standards which prevail in most other types of business.

This is as it should be, we say, because the bank is in a very real sense a public trustee, performing an important and necessary public function.