Chapter XXX (1)

THE WEAKNESSES OF OUR BANKING SYSTEM PRIOR TO THE ESTABLISHMENT OF THE FEDERAL RESERVE SYSTEM

CONFLICTING OPINIONS

[249]For fifty years the United States has lived rather happily under the National Bank Act, born in the strife of the Civil War and developed in the period of the nation's greatest expansion and growth. This act has, by its record, earned for itself a place as a great piece of constructive legislation; and the recognition of this fact is responsible for the preservation of our national banking system almost intact under the Federal Reserve Act. The National Bank Act removed the ills of wild-cat banking, which so afflicted the country prior to the Civil War; gave us an absolutely safe form of money which, although not legal tender, is taken without question by everyone; and has made possible an enormous expansion in the banking resources and facilities of the country. In spite of the denunciation and abuse which have been heaped upon it, the act has been reasonably satisfactory in operation. Anyone who reviews the figures of the material growth and prosperity of the nation and the rise of its financial power will be forced to the conclusion that no act that was fundamentally unsound could have been an integral part of the achievement of such a notable record.

Designed for the purpose of encouraging a system of independent banks, the act has been responsible, directly and indirectly, for the creation of some twenty-five thousand banking institutions in this country, practically all of which are independent of each other. Instead of a small banking class and an equally small group of banks, all under the domination of one or a very few interests, we have developed a system of banking which has sprung from the people, and which is closer to the people than that of any other country.

[250]We have grown and prospered in spite of an imperfect, repressing, and perilous banking and currency system. We have grown as a vine sometimes forces its way through a crevice in a wall, our very growth inviting disaster and death, our wonderful vitality hastening catastrophe.... Over fifty years of growth under the old banking act has been forced by the generosity of the soil of a new land, by the unconquerable energy and resiliency of a virile and courageous people; yet it has been interrupted by periods of business depression and stagnation; our progress punctuated by panics, discreditable, appalling--to many ruinous.... The immediate results ... have been crashing of banks and commercial houses, the wholesale stoppage of industries, the wiping away or cruel draining of the results of honest thrift, denial to willing and hungry labor of the opportunity to earn bread and shelter.

[251]A physician would probably say that what primarily ails our currency system and causes panics and desperate stringencies is something akin to _arteriosclerosis_. The veins and arteries of credit, which in order to function properly ought to be elastic and contractile like rubber, are hard and brittle as glass. When subjected to unusual strain they can yield but little and are very liable to rupture, and when once stretched they are apt to remain over-enlarged....

The temporary act of May 30, 1908, which relaxed the rigor of the law in moments of critical emergency [as to note issues] by permitting additions to the currency to be based upon other security by payment of a heavy and increasing tax, was no real solution of the situation. It contained no provision to render the currency responsive to ordinary fluctuations in currency demand, and resort to its provisions in times of great stress might easily precipitate a panic if one did not already exist. It was only enacted for six years, and was only regarded by its sponsors as a temporary palliative pending the preparation of a permanent cure. _One universally recognized essential ... of a proper banking and currency plan is provision for a more flexible and responsive note issue_.

INFLEXIBILITY OF LEDGER BALANCES

When we turn to credit in the form of ledger balances or "deposits" and enquire as to the causes of their inflexibility, the explanation also rests in quite familiar facts. There are two peculiar features of our banking system which are practically without counterpart in other important countries, and which render ledger balances or deposit credits in this country less flexible and responsive than such balances or credits are elsewhere. The _first_ is the rigidity of our reserve laws, and the _second_ is the lack of any bankers' bank or similar institution, with ample resources and lending power, from which the banks can replenish their own reserves when necessary.

RIGID RESERVE REQUIREMENTS

Outside of the United States I know of only one other country in which the law requires a cash reserve to be held against deposits. That country is Holland, and the law applies to only one institution, the Bank of the Netherlands, and that institution does not hold enough deposits to make it worth mentioning in this connection (less than $3,000,000). Our national banking law, however, and the banking laws of most of the states are unreasonably and unsoundly rigorous in this regard. Not only must stated proportions of all deposits be held by the banks in reserve, but these reserves, according to the law, can never under any circumstances be used. It is very much as if the Government, having established naval and military reserve forces in times of peace, were to insist that these forces should not be used in time of war, in order to maintain them intact as reserves. Whenever the cash held by a bank has fallen to the required minimum, the bank cannot legally continue to extend accommodation. It cannot issue more notes unless it has additional government bonds to deposit for their security, and it cannot enlarge its ledger balances unless it has additional reserves. No matter what may be the stress of an emergency, or whether it is due to war, catastrophe, or unreasoning fear, there are no legal means for relaxing this requirement. And so, in moments of great sensitiveness and anxiety, legal spokes are apt to be suddenly thrust into the wheels of credit, and the whole machinery of business brought crunching to a standstill. _A second essential then of any adequate currency plan is some provision which will render the reserve requirements pliable and the reserves of possible use._

NEED OF BANKERS' BANK

Our banks also have less flexibility in their power to lend ledger balances than the banks of practically all other countries for another reason, because of the lack of any permanent institution or institutions which can perform for them services similar to those which they perform for their customers. An individual bank makes the money of each and all of its customers flexible in amount, by rendering it of mutual service, and available to those who most need it, when they most need it, and, in order that the money of individual banks may be similarly flexible in amount, of mutual service to each other and available to those institutions which most need it, when they most need it, they require in their turn some agency which will do for them severally and jointly what they do for the general public....

It does not matter what such an agency may be called. It may be a discount bureau, or a rediscount bureau, a national clearing house, or a national or regional reserve association. Out of deference to those great financial experts who write the banking clauses of political platforms and whose bans and edicts are blessed with sacerdotal infallibility, when such an institution is proposed for this country, it must not be called a central bank. Such an institution is perhaps most plainly designated if it is called a "bankers' bank," but by whatever name it is referred to, the need of such an institution is the fact of primary importance in the American banking situation.

Just as an individual bank economizes and mobilizes and makes flexible in amount the funds of individual members of a community, so a bankers' bank mobilizes and economizes and makes flexible in amount the money of the banks. It collects money from institutions and localities when and where they do not need it, and lends it to others when and where they do. In like manner the active deposits of the various banks, as they are not all wanted simultaneously, furnish the bankers' banks with a large surplus reserve of lending power, which in turn is an invaluable source of flexibility to the individual banks. By its means they can, if need be, rediscount their commercial paper, exchange their unmatured assets for actual cash, and secure its still better known credit in place of their own. By its means their reserves can be replenished and their lending power made responsive to the needs of their communities. A bankers' bank makes it possible for the money of the individual banks to do many times the work it would do if left in the separate institutions, and to do it far more effectively. It is the only ultimate safeguard, the only scientific deposit guarantee, the only sound basis of flexibility in any banking system. As some philosopher once said of God--if such an institution did not already exist, people would certainly have to invent one, and, as we have no such institution permanently and legally established in America to-day, _the prime essential of any sufficient banking plan is the equipment of our system in some way or other with the facilities of a bankers' bank_.

THE PARCELLATION OF RESERVES

[252]If the absolute certainty of ability to pay all depositors in money on demand be taken as the _summum bonum_ of banking, an idea which quite generally prevails among the unthinking, it is interesting to reckon the cost. A bank has no fairy wand with a wave of which it can transmute into gold the amounts due it, whether represented by borrowers' notes or balances due from other banks. Such repayments have an element of uncertainty which pervades all human affairs. All uncertainty could be eliminated only by having in money on hand an amount equal to the total of liabilities to depositors. A deposit with a bank would then be simply a warehousing transaction.

If a readjustment to such a condition were accomplished, and if we consider only the ultimate result, and not the cataclysm of the process, it would clearly prove such an extinguishing restriction of commerce as would cost fabulously more than the value of the advantage gained. It would be like preferring the constitution of a jelly-fish to that of a human being in order to avoid the hazard of fracturing a bone.

Only by having banks which employ in loans a part of depositors' capital lodged with them, can the best interests of the whole people be served, even if this entails something less than an absolute certainty of power to liquidate deposits on demand. That banking system must then be best which combines equally the largest measure of each of two elements: the use in commerce of funds deposited, and the certainty of paying depositors in money on demand.

Turning now to the vast system of banks throughout the country, if the separate reserves of all the banks were gathered into one mass, available to meet the demands of depositors for payment in money, whether made in Maine or Texas, New York or California, the banks of the whole system would be able to operate with the highest degree of safety by having a total sum of money equal to only a small percentage of the aggregate amount owing to depositors, and consequently would be able to lend for use in the commerce of the country the greater proportion of the funds deposited. The total of deposits and withdrawals made throughout the country would very nearly offset one another. Very little of the reserve money would actually be used. A special requirement of one section would represent only a small percentage of the total massed reserves. The country has such vast area, and the requirements in different parts so vary in season that a deficiency of money in some sections would find a measurably offsetting surplus in others.

While theoretically an institution so constituted would be strongest and most efficient, none such exists, and no one would advocate such a system. Omniscience and omnipotence would be required for its wise administration.

But the conclusion seems clear that only in proportion to the massing of reserves can efficiency in lending for commerce be combined with strength to pay depositors. The greater the proportion of the entire reserves gathered into one mass, the greater the efficiency and strength rendered possible. This principle is fundamental.

The fundamental defect of our banking system, then, is the parcellation of the entire reserves among the separate self-independent banks, necessitating either a wastefully large proportion of reserve for assured ability to pay, with correspondingly inefficient service to commerce, or efficient service with the hazard of unexpected exhaustion of reserves and consequent inability to make good the contracts to pay depositors in money on demand.

[253]If after a prolonged drought a thunderstorm threatens, what would be the consequence if the wise mayor of a town should attempt to meet the danger of fire by distributing the available water, giving each house owner one pailful? When the lightning strikes, the unfortunate householder will in vain fight the fire with his one pailful of water, while the other citizens will all frantically hold on to their own little supply, their only defence in the face of danger. The fire will spread and resistance will be impossible. If, however, instead of uselessly dividing the water, it had remained concentrated in one reservoir with an effective system of pipes to direct it where it was wanted for short, energetic, and efficient use, the town would have been safe.

We have parallel conditions in our currency system, but, ridiculous as these may appear, our true condition is even more preposterous. For not only is the water uselessly distributed into 21,000 pails, but we are permitted to use the water only in small portions at a time, in proportion as the house burns down. If the structure consists of four floors, we must keep one-fourth of the contents of our pail for each floor. We must not try to extinguish the fire by freely using the water in the beginning. That would not be fair to the other floors. Let the fire spread and give each part of the house, as it burns, its equal and inefficient proportion of water. _Pereat mundus, fiat justitia!_

REDEPOSITED OR OVERLAPPING RESERVES

[254]If we are to understand the radical change which will be worked by the Federal Reserve Act in the reserve situation in this country it is necessary to examine at some length the system heretofore prevailing. Under the National Bank Act these banks were divided into three groups or classes, referred to as the country banks, the reserve city banks and the central reserve city banks.

There are three central reserve cities: New York, Chicago, and St. Louis. Every national bank in these cities is a central reserve city bank. The reserve cities are forty-seven in number and include the larger cities of the country. Every bank not situated in any one of the three central reserve cities or the forty-seven reserve cities is a country bank. This last term includes all the national banks of the smaller cities in the country, of the manufacturing towns and communities of New England and the Middle States and thousands of national institutions doing business in the agricultural sections.

~The Country Banks.~--The country banks, by the terms of the National Bank Act, are required to keep a cash reserve at all times equal to 15 per cent. of their deposits. Under the old law the country bank must keep only 40 per cent. of this required reserve in its own vaults, while it is allowed to deposit 60 per cent. of the required reserve on call in such national banks in any of the reserve cities or central reserve cities as may be approved as "reserve agents" for it by the Comptroller of the Currency....

~The Reserve and Central Reserve Cities.~--The second class of national banks, known as reserve city banks, includes all national banks located in forty-seven cities of the country, which from time to time have been designated as reserve cities. Every national bank in them is required to keep a reserve at all times equal to at least 25 per cent. of its deposits. It must be borne in mind that the deposits of a reserve city bank include not only what the banker refers to as individual deposits--the deposits of individuals, firms, partnerships, and corporations--but also deposits which have been made with the reserve city bank by country banks, for which it is the reserve agent.

A reserve city bank is permitted by the National Bank Act to keep one-half of its required reserve on deposit, subject to withdrawal on demand, in a national bank or banks in a central reserve city, approved by the Comptroller of the Currency, as its reserve agent....

Every national bank within the central reserve cities must keep a reserve equal in amount to at least 25 per cent. of its deposits, including not only individual deposits but deposits by bankers for whom it acts as reserve agent or correspondent.

~The Reasons for the System.~--This rather complicated system of reserves was authorized by Congress because it was necessary to allow the banks of the country districts or smaller cities to keep reserves in other banks in the larger centres of trade in order to facilitate the commercial exchanges of the country; and also because it was necessary to have some means by which banks of the larger cities could finance payments for their customers in the great centres of the country, especially in New York, Chicago, and St. Louis....

~Its Weaknesses.~--Our system of deposited reserves has failed miserably in times of stress, although it has worked reasonably well in ordinary times. It is contended that it has, to a large degree, built up the great centres, and more especially New York City, at the expense of country districts. It has been responsible for the seasonal withdrawal of money which was at one time a most serious embarrassment to business, especially in New York, Chicago, and other large cities in the fall months, but which has practically disappeared in New York City since the panic of 1907.... It was not until the system of deposited reserves brought about the panic of 1907 that the country at large became convinced that this feature of the national banking system was vicious, dangerous, and likely to produce trouble at any time. With this conviction began the movement which finally ended in the enactment of the Federal Reserve Act.

~Much of Our Reserve Fictitious.~--As a matter of fact, the actual available reserves of the three classes of national banks in the country are much less than is indicated by the percentage specified in the act quoted above.... This condition is referred to frequently as the pyramiding of reserves, which means, in substance, that the national banks of this country, omitting from consideration the state banks where the same conditions exist in an even more aggravated form, are doing business largely upon a paper reserve, which experience has shown is utterly useless in times of panic. The seven thousand five hundred and nine national banks held cash and paper reserves on October 21, 1913, as follows:

_Cash in vaults._ _Due from banks._

Country banks $294,000,000 $534,000,000 Reserve city banks. 251,000,000 258,000,000 Central reserve city banks 381,000,000 ------------ ------------ $926,000,000 $792,000,000

As a matter of fact the national banks of the country held $926,000,000 in cash as against total deposits subject to reserve requirements of $7,172,000,000, or about 12.8 per cent. of the liabilities subject to the requirements.

~Dangers of the System.~--So conclusive are the lessons to be learned from the experience of the last half century with the system of redeposited reserves, that there is a practical unanimity among bankers and financial experts that the reserves of our banks, with the exception of the money actually held in the vaults, are, in the words of William Ingle, vice-president of the Merchants and Mechanics National Bank of Baltimore, "A great deal of a delusion and a snare." In every panic, the country banks and the reserve city banks have found that it has been impossible for them to secure the return of the portion of these reserves which has been redeposited in New York, Chicago, and St. Louis. At a time of great stress, when the banks have been subjected to a drain, they have been suddenly bereft of the support which, in theory, should have been forthcoming from their reserve agents, and have been forced to depend upon the 6 per cent. or 12-1/2 per cent. reserve, which was contained in their own vaults. What is even worse, the outbreak of a panic in New York City, where every panic of the last half century has started, was the signal for the suspension of cash payments by every bank in the country, within a few hours.... Thus a local panic, in many cases occurring when business conditions were exceedingly prosperous and healthy, has completely disorganized the exchanges of the country and brought business to a standstill.

THE PERVERSE ELASTICITY OF NATIONAL BANK NOTES

[255]... It is not quite correct to call our national bank notes inelastic. They are decidedly elastic. The trouble is that their elasticity is of a wrong sort; they expand when there is need of contraction, and contract when the need is for more currency. By calling the notes inelastic we mean that their volume does not correspond automatically to the need for currency. This is true, and is one of the most serious defects of the bond-secured notes....

The demand for currency depends upon the volume of business to be transacted, and is continually in a state of fluctuation. Various causes have only to be mentioned to explain the unequal demand at different times. We have thus the payments of salaries, bills, etc., coming usually, on the first of each month. Then there are the quarterly payments of dividends, interest, etc., falling generally on the first of January and at intervals of three months thereafter during the year. Above all, we have in this country a regularly recurring seasonal change in the volume of business, due to the harvesting and moving of the crops every fall and early winter. Besides these normal fluctuations in the demand for currency there are of course such abnormal circumstances as business emergencies, panics, depressions, etc., which at irregular intervals call for expansion or contraction of the currency. To meet all these varied demands an elastic currency is a necessity.

The most serious evils of inelasticity in this country are seen in connection with the annual handling of the crops. It may be safely said that for this purpose the United States needs every fall at least one hundred and fifty million dollars of extra currency. Since our monetary system contains no really elastic element, this extra business of the fall has to be done with little or no increase of the country's currency. The crops must be handled by means of a shifting of currency from one part of the country to another. In the spring and early summer the agricultural districts are apt to have more money than they need. Accordingly, the country banks are in the habit of depositing part of their reserves in banks situated in the reserve cities. A large part of these sums eventually finds its way into the money markets of New York and other Eastern cities, where a low rate of interest is paid to outside banks for such deposits. Now comes the harvest season, and a demand goes up from the country banks for the return of their deposits. Every fall the clearing-house banks of New York City alone give up about fifty millions of "lawful money" to meet this demand.[256] Of course this means a tight money market. In the spring and summer the funds obtained from the country banks were loaned out or used as reserves for deposits. Money was in excess, interest rates were low, and speculation was encouraged. Now loans must be called in and deposits reduced. This sudden contraction is a hard blow to all business interests. It is especially hard on the speculators, and their desperate demands cause the enormous rates on call loans which are witnessed every fall on the New York money market....

It has ... been suggested that the inelasticity of the national bank notes does not mean that their volume never changes. As a matter of fact, the circulation has been marked by enormous fluctuations, and these fluctuations, having no relation to the demands of business, have simply aggravated the evils of inelasticity which have been described. Thus, between June 1, 1880, and June 1, 1891, the total volume of bank notes outstanding declined from $345,000,000 to $169,000,000, a decrease of $176,000,000, or 51 per cent. This retirement of half the circulation came during a decade marked by large growth in population and wealth, and by remarkable industrial expansion and business activity. The reason for this decline lies in the fact that the Government was using part of its large surplus revenue to pay off the debt. In eleven years the Treasury paid $1,105,000,000, reducing the debt by more than half, something without parallel in the history of public finance. The retirement of half the debt caused a scarcity of United States bonds, and their prices went soaring. Four per cents of 1907 rose from 103-113 in 1880 to 125-130 in 1888. The inevitable result was the decline of circulation. The opposite course of events has been seen in recent years....

[The subjoined diagram (suggested by a similar one for
1902-1906, accompanying the article a part of which is here
reproduced) illustrates the comparative seasonal elasticity
of the notes of our national banks and the circulation of
the chartered banks of Canada for the period 1910-1914. The
marked expansion of national bank notes in 1914 was due to
the crisis brought on by the outbreak of the European war.
The Aldrich-Vreeland notes which were issued in that
emergency were retired in a few months and the volume of
national bank notes assumed normal proportions.

For the Canadian statistics involved the editor is indebted
to Mr. G. W. Morley, Secretary of the Canadian Bankers'
Association.]

NATIONAL BANK NOTES UNSOUND AND UNSAFE

[257]... Any correct system of credit currency must be based on a foundation of gold. Bank credit is issued in the two forms of deposits and notes. The former are based on a reserve of gold, the latter are not. We have here a fundamental weakness of our bank-note system. Under proper banking methods, deposits cannot expand without a proportional increase of the gold reserves of the banks. This furnishes the natural and necessary check to inflation. Our bank notes, however, have no such connecting link with the business and the monetary stock of the world. The basis of the American bank-note currency is the government debt, a very inferior kind of foundation. Such a system carries with it the possibility of paper money inflation of a peculiarly dangerous kind, because its real meaning is apt to be concealed. For example, between January 1, 1900, and January 1, 1908, the volume of national bank notes outstanding increased from $246,000,000 to $690,000,000, an expansion of $444,000,000. In other words, the circulation nearly trebled in eight years. The cause of this great increase was not the need of more currency but the changes in the National Bank Act made in 1900, changes which made the establishment of national banks easier and the issue of notes more profitable.... The future is likely to witness further expansion, unless some change is made in our system.... It is undoubtedly the present intention to give ... to future [bond] issues [the privilege of being used as security for notes]. Indeed, unless this privilege is given, there will be no market for the 2 per cent. bonds. We may expect, therefore, to see each issue made the basis of a further increase in the volume of bank notes.

All this means inflation, and inflation by means of a circulating medium having no connection with the gold stock of the world. To make room for the additional currency, gold must be forced to leave the country, and our whole monetary system, by no means too strong to-day, will be weakened at its foundation. This is the fundamental difference between expansion of credit by means of deposits and expansion by means of national bank notes. The one is based on gold; the other is based on the government debt. When deposits expand, the reserves of the banks must increase proportionately and, if carried far enough, the result must be to bring in gold rather than to force it out. In like manner, deposits cannot for any considerable time be in excess of business needs. But bank notes may be increased indefinitely, if the Government only borrows enough, and the result will be the expulsion of gold whenever the currency becomes redundant. That this is an actually present danger is sufficiently demonstrated by the recent action of the Secretary of the Treasury, who has seen fit to add to the national debt at a time when the Treasury had a surplus of over 250 millions, for the sole purpose of increasing the circulation of the national banks. Our currency system can never be sound until the bank circulation is entirely divorced from the government debt.

The danger of inflating our monetary system with bank notes having no gold reserve back of them is all the more serious from the fact that the notes of the national banks are used as reserves by state banks, private banks, trust companies, etc. They are part of the "cash reserves" on which these banks base their deposits. Thus we have a system of credit based on credit, and any weakness in the national bank note is carried over and multiplied in the deposits of other banks.

The complete _reductio ad absurdum_ of this multiple credit system came when at a recent convention of the American Bankers' Association it was seriously proposed that it be made lawful for national banks to count their notes as "lawful money" in their own reserves. There is good reason to believe that this is actually practised to some extent by national banks to-day, though the practice is, of course, illegal.

The safety of the national bank notes is seldom questioned. Whenever the evils of our currency system are pointed out and plans for asset currency or other reforms are proposed, the reformer is apt to be met by the reply that, at any rate, our bank notes are perfectly safe, and we had better put up with their other shortcomings rather than launch out on new schemes which may possibly sacrifice that safety which we now enjoy. The foregoing discussion should already have cast some suspicion on this complacent attitude. It will be further weakened by a closer analysis of the basis of the national bank circulation.

National banks may issue their notes up to the amount of their paid-up capital, and up to 100 per cent. of the par value of United States bonds deposited with the Treasury, but never in excess of the market value of the bonds. The notes are engraved by the Government and issued to the banks. When signed by the proper officers of the bank, they become the bank's promise to pay upon demand and may be issued for circulation. The United States Treasury is also required by law to redeem on demand all notes of national banks presented to it. For this purpose each bank must keep with the Treasury a reserve fund equal to 5 per cent. of its circulation. The duty of the Treasury to pay notes on demand, however, is not limited to the amount of this reserve, but applies to all notes properly presented. In case of the failure of a national bank, the Treasury is required by law to immediately redeem all its notes. The Treasury is secured against loss by the bonds deposited, by the 5 per cent. cash reserve, by its prior lien on the assets of the banks, and by the personal liability of the stockholders for an amount equal to their stock investments.

It is thus seen that the popular idea that the holder of a national bank note is secured against loss by the government bonds deposited in Washington is not strictly correct. What protects the holder of a note is the absolute responsibility of the Treasury to redeem all notes on demand. The bonds are to secure the Treasury, not the individual noteholder, against loss. The noteholder is secured so long as the Treasury is able to meet its legal obligations.

Let us examine the character of our government bonds as security to enable the Treasury to meet its obligations. To understand the situation, it should be remembered that the leading purpose in the establishment of the national banking system was not the creation of a scientific currency system. The National Bank Act was a war measure enacted largely for the purpose of improving the market for government bonds during the Civil War. It was for this purpose that the circulation of state banks was forced out of existence by a 10 per cent. tax and the right of issue restricted to national banks on condition of the deposit of government bonds as security. In the accomplishment of this purpose the act has been eminently successful. United States bonds have been given a new utility over and above their utility as an investment. From the very beginning, this has given them an added value and enabled the Government to borrow at lower rates of interest than it would otherwise have had to pay. The act of March 14, 1900, made provision for the ultimate refunding of all the United States debt into 2 per cent. bonds, and gave an added inducement to the use of these bonds as note security by lowering the annual tax on circulation from 1 per cent. to one-half of 1 per cent., provided the notes were secured by the new 2 per cent. bonds. All bonds issued since 1900 have borne 2 per cent. interest. Yet the market value of these bonds has always stood above par.... Obviously, this value is not based on earnings. British consols paying 2-1/2 per cent. are to-day quoted in the neighborhood of 85, which makes them yield about 3 per cent. on the investment. The French and German 3 per cent. loans are both considerably below par. United States bonds have been given an artificial value through their use as security for bank circulation. The national banks to-day hold for this purpose about two-thirds of the total funded debt of the United States. Remove this privilege from the national debt, and we should see the 2 per cent. bonds (which compose two-thirds of the interest-bearing debt of the United States) fall to perhaps seventy cents on the dollar, very likely even lower.

Here we have a remarkable situation. Our national bank notes are safe because they are secured by government bonds, and our government bonds are valuable because they are security for national bank notes. This looks very much like lifting oneself by one's bootstraps.

If we are to cling to the bond-secured note system, this matter of the artificial value of government bonds will become an important practical problem whenever it becomes necessary for the United States to make any addition to its debt. Either the rate of interest will have to be raised to 3 per cent. or higher, or, if that alternative is rejected, means will have to be found to induce the banks to use the greater part of the new loans as security for additional note issues.[258] In practical effect, this is only a thinly disguised resort to the time-honored but now thoroughly discredited practice of compelling the people to use the government debt as a circulating medium.

The bearing of this matter on the safety of the national bank note is simple. The burden of the ultimate redemption of the bank notes has been placed on the shoulders of the Treasury, to add to its other burdens of maintaining the value of the greenbacks and of the silver dollars. If loss of confidence in the bank notes should ever lead people to demand their wholesale redemption, the Treasury would have to meet the demand in gold. But the moment it tried to sell the bonds, it would find there was no market for them except at a discount of perhaps 30 or 40 per cent. It is true that the Treasury would still be able to recoup itself for this loss in the value of the bonds by exercising its prior lien on the assets of the banks. But this leads us to the important conclusion that the final security for our bond-secured notes rests on the assets of the banks after all. A more striking argument for asset currency could hardly be discovered.

It must be remembered, however, that the foreclosure by the Government of its claim on the assets of the national banks would cut into the wealth on which deposits are based and so have a most disastrous effect on the deposit system. The pressure upon the Government to refrain from such a crushing blow to credit would be overwhelming. It is almost inconceivable that in time of panic or a national crisis the Government would resort to such a procedure. Almost any alternative would be preferred. It would not be too difficult a matter for the Government to persuade itself that the wiser and safer course would be to suspend specie payments, perhaps even declaring the bank notes a legal tender. A more plausible case could be made out in favor of such action than was found sufficient to justify the issue of the greenbacks of the Civil War. Yet such action would mean the breakdown of our financial system.

This is, of course, looking into the future and anticipating a state of disaster which may never come. But a system which bids fair to break down in time of disaster should be remodelled before disaster comes. And we should not rest too confidently in the notion that disaster can never reach us. It is only thirteen years ago [1895] that the burden of supporting its paper and silver currency brought the United States within twenty-four hours of suspension....

SPECULATION INVOLVED IN THE ISSUE OF NOTES

[259]When a banker takes out currency he engages in two distinct transactions and enters upon two different hazards. In one transaction he assumes the risk and holds the expectation of greater profit for taking out circulation. Since buying bonds and taking out circulation most of the time shows some theoretical profit over loaning direct, presumably if there were no other consideration, most of the time our bankers would keep outstanding all the notes they could. In the other transaction, however, the banker engages in a speculation in government securities. As a matter of fact, if the price of government bonds advances, the profit from taking out circulation declines; but our banker is pretty likely to view with equanimity the declining circulation profit when he considers the profit he is making in his speculation in bonds. On the other hand, as the price of government bonds declines, circulation grows more profitable. The banker is likely to view this with sour satisfaction when he looks on his loss in his bond speculation. Profit or loss in the bond speculation is likely to outbalance loss or profit in the circulation transaction.[260]

Let us examine the situation more closely. Just what is the profit or loss from taking out circulation? In the first place the bank gets the regular current money rates on the loans it makes through issuing notes. Also it gets the interest on the government bonds it buys. This, of course, means the real interest, or income on the investment, called basis, taking into consideration coupon interest, price paid, and date of maturity. Excepting for the tax of 1/2 per cent. on the circulation taken out (1 per cent. if taken out on the 3's or 4's) and for the expenses attendant on taking out circulation, which the government actuaries compute to average $63 on the $100,000, this interest on the government bonds looks like clear "velvet." It would be, too, if the banker did not have to pay more for the bonds than the amount of circulation he can take out against them. To figure his net profit he must deduct from the gain items just stated what he would have made if he had loaned his funds direct instead of investing in bonds.

Expressed as an algebraic equation the situation becomes much clearer. Let

x = current money rate;
y = basis rate at which government bonds are bought;
z = price of government bonds;
b = circulation received ($100,000 used as basis of calculation);
c = taxes, redemption, and other circulation expenses.

(As already stated, government actuaries have calculated that circulation expenses average to cost the banks $63 on the $100,000 of circulation taken out. Taxes depend on whether the 2's, in which case the tax is 1/2 per cent., or the 3's or 4's, in which case the tax is 1 per cent., are bought. Taxes, then, amount to either b(.01) or b(.005). We can take b as a constant in our calculations and base all our computations on taking out $100,000 of circulation.)

The equation of profit or loss on taking out circulation then reads:

yz + bx - xz - c = profit or loss.

But circulation taken out (b) can never be greater than the amount of money paid for the bonds (z).

If government bonds should be at par or at a discount, the nominal profit would always be just the basis interest on the bonds, less the tax and the cost of taking out circulation, or a constant advantage in the case of the 2's of 1.437 per cent. For the purpose of this discussion we will consider only the 2's of 1930.

In the regular case, then, the money paid for the bonds (z) is greater than the amount of circulation received (b). With that statement in mind we can draw certain very definite conclusions about our circulation direct from the equation we have formed; z is greater than b.

Repeating the equation in order to have it directly before us:

yz + bx - xz - c = profit or loss.

Then as the current interest rate (x) increases, if all the other quantities remain constant, the negative influence in the equation grows greater, or profit from circulation decreases. We can, then, make definitely:

STATEMENT I

_If all other circumstances remain the same, circulation grows less profitable as the current money rate advances._

As business increases and the demand for both credit and money increases, as reflected in the rising interest rates, taking out circulation _caeteris paribus_, with the inexorability of a mathematical law, becomes _less_ profitable.

Further, there is an intimate relationship between y and z. If the price of bonds (z) declines, the basis rate (y) must advance. As a matter of fact as z declines yz grows greater. If, then, x remains constant and z declines the influence of the negative quantities of the equation is growing less. Then follows:

STATEMENT II

_As the price of bonds declines, if the current interest rate remains constant, the profit from taking out circulation increases._

That gives the absolute mathematical basis for such general statements as that "the price of bonds is too high to make circulation profitable."

These two facts set out in Statement I and Statement II place the banker who has taken out circulation between the devil and the deep, blue sea. If the price of bonds remains the same and the current interest rate rises, his circulation grows steadily less profitable. A decline in the price of bonds affords the only offset to an increasing interest rate. But if the price of bonds declines enough to offset the advance in the current interest rate, the banks must mark off enough profits to cover the loss on the capital value of the bonds.

Speculating in securities properly forms no part of a bank's business. It is an anomalous situation that in order to fulfil a proper function of note issue a bank should have to undertake such an improper speculation.

THE LACK OF ADJUSTMENT BETWEEN BANK NOTES AND DEPOSITS

[261]Under our present currency system the volume of money in circulation is perfectly flexible. It constantly expands and contracts in automatic adjustment to the requirements of trade and the convenience of the people. An increase in the volume of cash transactions brings promptly an increase in the volume of currency in circulation through the current withdrawals of money exceeding the current deposits of money. A lessening in the volume of cash transactions promptly drives unneeded currency out of circulation through the deposits of money exceeding the withdrawals. No other system could provide a currency which would adjust its volume in circulation more exactly to the needs of trade and the preferences of the people. There is a ceaseless flow of the money in circulation into bank reserves, and of money in bank reserves into circulation--ceaseless except in an occasional crisis when the natural flow of money from bank reserves into circulation is arbitrarily stopped by banks refusing, for self-protection, to continue paying out to the point of exhausting reserves.

While the volume of money in circulation is thus perfectly and automatically adjusted to trade requirements, it is to be noted that this flexibility arises from the flow back and forth, between the mass of money in circulation and the mass in bank reserves. In this lies the main economic defect of our present currency system. An expansion in the volume of money in circulation entails a corresponding contraction in the volume of bank reserves, and necessarily a corresponding contraction in loans. A period of expanding business would naturally be attended by both an increased volume of loans and an increased volume of cash transactions, such as increased pay-rolls, increased retail sales. Increased cash transactions cause a larger volume of money to flow into circulation. But this flow is out of bank reserves, thus contracting them and necessitating a contraction of loans depending upon them, at the very time when loans would naturally expand. Obviously, if business becomes very active, the effect upon bank reserves is so adverse, and the contraction of loans depending upon reserves so important, that embarrassment is widespread and panic ensues.

The main defect, then, of our present currency system is that the volume of currency in circulation has its adjustment in the flow from bank reserves into money in circulation and from money in circulation into bank reserves, causing a contraction of bank reserves and the loans depending on them as business expands.

A remedy would be the use of bank notes through which the volume of currency in circulation would have its adjustment in the flow from bank deposits into bank notes in circulation, and from bank notes in circulation into bank deposits, thus protecting from disturbance both bank reserves and the loans based on them.

THE COMMERCIAL PAPER SITUATION IN THE UNITED STATES

[262]... At the present time the commercial paper situation in the United States is peculiar. "Commercial paper" in the old and strict sense is little used in this country. "Trade paper," as it is now called, arises in less than 3 per cent. of the credit transactions in the United States.[263] In some lines of trade, especially where a local wholesaler does a large business with small tradesmen, the wholesaler will extend credit by taking the retailers' notes; but in obtaining credit for himself the wholesaler will not surrender control of the bundle of retailers' notes, preferring instead to give simply his own note on a general understanding with his banker that the personal note rests on, and is fully covered by, the retailers' notes.[264] The wholesaler hesitates to surrender to the banker the notes that he receives because he fears that his competitors might get some inkling of his trade connections, etc. In general, "trade paper" is used to settle accounts only when the credit terms are still long, that is, four months or more.[265]

What generally passes as "commercial paper" in the United States is single-name paper. As in the case of the wholesaler referred to above, the borrower of bank credit in these days offers for discount simply his own promissory note. Some of this paper, particularly corporation notes, carries indorsements, but these are largely "accommodation" indorsements, which may buttress the security of the paper but which indicate nothing as to its purpose.

The wide use of single-name paper in this country is largely explained by the fact that the prevailing terms of payment in business transactions are net in 30 or 60 days, with a discount for payment in cash within variously from 10 days to one month. The cash discount allowed is usually so large that a purchaser can ill afford not to take advantage of it. Two per cent. discount for cash within 10 days, for example, with "60 days net" is equivalent to a return of 12 per cent. per annum on one's capital. In actual practice the allowance is often even more liberal. Hence where competition is at all keen the business man is practically forced to adopt the system of cash payments, depending upon his bank to advance to him, on his own notes, the necessary funds. Moreover, so broadly has the custom of taking cash discounts spread that a failure to take advantage of them is generally regarded as an indication of weakness, and tends to undermine general confidence in the business man's credit standing. Hence the necessity for maintaining his credit rating, as well as competition, virtually forces the business man into making anticipatory cash payments and thus, more or less as a consequence, into the general practice of discounting his personal paper.[266]

Furthermore, as business operations have grown to a larger and larger scale, especially in the case of large corporate enterprises, the credit needs of business have in many cases expanded beyond the capacity of the local banks to supply them. The necessity arose, therefore, to go elsewhere for accommodation. This was met in some cases by the opening of bank accounts in other centers, but obvious difficulties and restrictions attend this method of procedure. More elastic possibilities and fewer difficulties grew out of the employment of middlemen to market the paper over the country as a whole on the best available terms. Hence the note-broker is to-day an important factor in the discount market. As a result of the note-broker's activities there has come to be established an extensive open market for commercial (single-name) paper in this country, and the rates at which such paper is discounted are regularly reported in the daily newspapers.

This development of a commercial-paper market reflects, of course, a considerable development of the demand of the banks for this form of investment.[267] "Country banks" especially have in the last few years heavily increased their purchases in the open market, because the necessity of writing off heavy losses due to the shrinkage of bond values has tended to make them more timid about investing in securities, and because they have also learned by experience that paper purchased through a broker does not have to be renewed, as does most of the purely local paper.[268]

This development has, of course, tended to put an increasingly heavy responsibility on the note-broker and has brought about, at least to some extent, a readjustment of his business methods. At first note-brokers simply solicited paper from merchants and charged a brokerage fee. Latterly, the custom has grown up for the broker to buy up the paper outright.[269] This forces the broker "to stand between the maker and the bank," and to the extent that any given piece of paper may be left on his hands, even though he does not indorse the paper that he sells, it compels him to be very circumspect about the paper that he purchases. Moreover, some banks now purchase paper with an option of return within a specified period, making it a point carefully to inquire about the maker of the paper before the option expires. In the last few years banks as well as brokers have established carefully organized credit departments, the purpose of which is, through careful inquiry into the character and standing of sellers of paper, to enable both brokers and bankers to select paper with sounder discrimination.