 How such "notes" first got into circulation along with coins in various countries and at different times is an interesting historical question well worth studying. But the answer is lengthy and not material to our present purpose. It will suffice to suggest a few of the reasons why a demand arose for such a currency. Sometimes the demand arose from the bad state of the coinage. When base coin was common and originally good coins were liable to be much clipped without immediately being rejected by the next person to whom they were offered, and when all sorts of good and bad foreign coins found their way into each country, the inexpert person never knew what he would actually get if he accepted say £50 or £100 tendered to him by a buyer or a debtor, and even an expert would take some time examining, weighing, and perhaps assaying some of the coins. What more natural in such circumstances than that a person, having once got a quantity of coin, should hand it over to some expert man or institution with a reputation for honesty to be examined and certified as amounting to a certain sum? And then what more natural than that having got the certificate he should use it instead of the coin itself to make his next big payment with? Instead of offering a doubtful heap of metal which may or may not amount to what he says it does, he is able to offer a certificate or note which will entitle the holder who accepts it to something much more definite: all that is required is that the certificate or note should be made out in such a form that handing it over from one person to another--delivery--will transfer the ownership of the certified quantity of money, and the certificate is then an actually better medium of exchange than the coin itself, and there is very naturally a demand for it, it becomes generally acceptable, it is "paper currency."
But even if the coinage is above reproach, a demand for paper currency can scarcely fail to arise. To keep a large amount of money in coin is to keep a bulky article which offers peculiar attraction to thieves on account of its retaining its value when it has lost its form, so that it cannot be identified. It is natural that any man who has no convenient strong-room will wish to deposit any considerable sum in some safe place and take a receipt for it; as one good coin is as good as another, he will not ask the person with whom he deposits the coin to promise to give him back the actual coins deposited--a promise to pay "the sum" deposited will suffice. Provided the written promise is in such a form that handing it over will transfer the owner's claim on the person who has the coin to the new holder, it is evident that when the owner wants to make a large payment he will do well to hand over the promise instead of fetching out the coin from deposit, and the person whom he is paying will do well to accept it.
The person who "issues" the notes makes his profit by lending out most of the coin deposited, knowing full well that it is vastly improbable that many of the note-holders will all at once want to exchange this new currency for the old heavy bulky and inconvenient coins. Bold competitors will start in the business: on the strength of a little capital, or the pretence of a capital, they will issue notes by way of loan to borrowers without waiting for deposits, and the demand is soon fully supplied.
In some such ways redeemable notes get into circulation. At this stage it is natural to say that the notes owe the fact that they circulate to the fact that the issuers must redeem them if required. But something more than redeemability is required to make them circulate; when a note is redeemed it is at the end of its circulation, and what we want to know is rather why notes are not presented for redemption at once instead of circulating. They are kept circulating not because they are redeemable, but because other people than the issuer will take them. That is, because they are convenient to keep in hand in order to make future payments with; there is, in fact, a demand for this kind of medium of exchange, so that people like to have it in preference to an equal amount of coin.
That redeemability, or "convertibility" as it is commonly called, is not essential in order to make notes circulate is shown by the fact that notes which the issuers will not in fact redeem and which are therefore called "inconvertible" notes will circulate, and an inquiry for the cause of their circulation shows it to be a demand, although often what is called "an artificially created demand," for notes.
In order to be able to put convertible notes into circulation an individual, or company of individuals, must have a considerable reputation for solvency. Notes not payable on demand but only payable at some future date without interest will not be accepted even from a solvent person or institution at their face value, and if issued at a discount so that they bring interest, they will not pass from hand to hand like coin and ordinary notes, because the discount at which they must be taken is always diminishing. Notes not bearing interest and not payable either on demand or at any future time, if offered by an individual or company of the most undoubted solvency as something new and fresh, would only be laughed at.
But when notes have got into circulation as convertible notes and people have become thoroughly accustomed to accept them and to find them acceptable by others, their convertibility may sometimes be taken away without destroying this general acceptability of the notes and the consequent demand for them. Of course, if the public receive a rude shock by being told that such and such a bank is insolvent and its assets will not be sufficient to pay its notes in full, the notes will cease to be acceptable. But some less disquieting explanation may be given for "the suspension" of convertibility. of its resources, and that it did not think it could ever resume the practice, the notes would have ceased to be generally acceptable and consequently ceased to circulate and lost their value at one blow. But instead of doing that the Bank directors went to the Government and secured the passing of a law restraining them from redeeming their notes. The public thought little of this: the notes looked just the same as before, and continued just as convenient, and every one except Lord King long afterwards went on taking them just as before. The demand for them was unaffected, and the supply for the moment continued just, or nearly, as much limited as before.
We must be careful not to fall into the mistake of imagining that because a note-issue circulates at a par with coin, as for example a five-pound Bank of England note before the war would readily exchange for five sovereigns, therefore everything in regard to the value of money and prices is just as it would be in the absence of the issue. The extent to which notes take the place of coin is commonly very much overrated. Writers have sometimes supposed that every issue displaced an amount of coin equal to its own total amount less any reserve kept against it by the issuers. This is very far from being true, since the superior convenience of notes for the higher denominations of currency--that is for sums above five shillings or perhaps something rather less--leads to a much larger quantity of currency (coin plus notes) being kept on men's persons than if there are no notes. Nevertheless it is true that all or most note-issues do to some extent economize or "displace" coin, and thereby reduce the demand for it. We may certainly take it that the general tendency of noteissues, especially when the notes are for small sums and therefore compete with coin much more than with other machinery for paying money, is to reduce the demand for coin, though they need not displace coin to their full amount.
Where the coin is restricted and has a much higher value than its metallic contents, a note-issue, although it retains its par value in coin, may thus have a considerable influence upon the value of money, reckoned as it is in this restricted coin. But that is not all. An issue, convertible or inconvertible, although circulating at par with the coin tends to reduce the value of the coin and raise prices even when that coin is like the English soverreign before the War, always on a level with its metallic contents, or like the Indian rupee in the case just imagined has already been driven down to a level with its metallic contents. It does so even when the coin may be melted down and exported because it tends to reduce the value of its metallic contents: the demand for coinage being reduced, the demand for and therefore the value of uncoined bullion will be reduced, so that the meltability of the coin will not altogether save it from being pulled down by the diminution of demand for it caused by the competition of the notes. This, however, though important in any large view of the subject, is negligible when the effect of a note issue confined to any one country is concerned: the bullion of which the value is depressed is a mundane commodity not likely to be very appreciably affected by any probable single change in the demand for the coin of any one country.
At this point the power of a convertible issue to depress the value of money and raise prices stops, provided the coin may be melted and it or bullion may be exported. Money is still reckoned in a coin which is convertible into bullion, and therefore cannot go below its bullion value. The conditions of the supply of the convertible notes prevent the value of any of them from going below the value of the coin, and the coin cannot go below the value of its contents because the supply of it would then be reduced by melting.
That the supply of the convertible notes of any denomination cannot be so large as to cause a gap to appear between their value and that of the coin they promise to pay is so obvious as to scarcely need explanation. If there was such a gap any one who had one of the notes would run to the issuers to get it redeemed: the note by hypothesis is circulating at par: a pound note pays a pound debt and buys an article priced at a pound, and "the change" for it is twenty shillings, which all the arithmetic books agree in making a pound. Any gap between it and sovereigns would therefore appear in the form of a sovereign being worth more than a pound, and if a sovereign could be openly sold for more than a pound, notes would be rushed in for redemption by holders anxious to make a profit, until parity was reached again, or all the notes paid off, or the issuers bankrupt and the notes out of circulation. Convertible notes thus cannot be kept outstanding in numbers which would lead to their being less in value than the coin they promise to pay, and a fortiori they cannot be issued in such numbers: it follows that no more can be put into circulation than will be compatible with their keeping their par value. The bankers may try to get more into circulation by paying all their own household bills with them, but if there are enough out already, this will only end in the tradesmen presenting the notes for redemption. It may occur to some banker before breakfast, when the intellect is weak, that it would be a fine thing to encourage people to take his notes by offering them at a small discount, but after breakfast he will remember that this would cause an enormous demand for his notes, but that they would all be immediately presented for redemption so that more might be asked for and he would be ruined by the discount. There is, in fact, no possibility of the convertible note being below the value of the coin which it promises, and therefore it cannot drag the value of money--the unit of account of money--below the value of the bullion contents of the coin, when that coin itself is protected by free convertibility into bullion from being so dragged down.
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