Frank Albert Fetter.

Modern Economic Problems Economics Volume II online

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Domestic exchange involves just the same principles as foreign
exchange of funds, except that in the latter, usually, two different
units of standard money are used. In connection with the discussion of
foreign trade below, foreign exchanges will be explained and further
light will be thrown upon the adjustment of the money supplies and
levels of prices of the various sections of a single country as well
as between different countries.

§ 9. #Issue of notes#. The issue of bank notes as a mode of lending a
bank's credit calls for consideration here. Yet it must be observed
at once that comparatively few banks in the world have now the legal
right to issue their own notes. In some cases the right has been
granted as a monopoly to certain banks in return for specified
payments and services. But in general the function of bank note
issue has come to be treated as so closely connected with that of
the coinage and regulation of the standard money that it has been
increasingly limited in each country to a central national bank,
or group of banks, which is in many respects practically if not
technically an organ of the government. This public nature of bank
note issues has been strikingly evident in Russia, England, France,
Germany, and other countries since the outbreak of the war in 1914.

No two countries have quite the same system and kind of bank notes.
It is well to consider first, therefore, the qualities of typical bank
money. This consists of notes issued by banks on the credit of their
general assets, without special regulation by law. With such a form of
note we have had until 1914 no experience in the United States since
1866, at which time a federal tax of 10 per cent on state bank notes
made their issue unprofitable. Since the passage of the Federal
Reserve Act we have temporarily two kinds of national-bank notes, the
old bond-secured notes, in use since 1863 (very different from the
typical form),[10] and the new kind of Federal reserve notes very
nearly typical in character but issued only by the Federal reserve
banks, not by individual banks.

A bank, by the issue of notes, puts into circulation as money its own
promises to pay. The customer, in borrowing money or in withdrawing
deposits or cashing checks and drafts from other banks, is paid with
the bank's notes instead of with standard money. These notes may be
returned to the issuing bank either to be redeemed in specie or to be
paid in some other form of credit, such as deposits or exchange. The
limit of the issue of such notes is the need of the community for that
form of money, and if they are promptly redeemed in standard money on
demand, they never can exceed that amount. A holder of a note (in the
absence of special regulations) has the same claim on the bank that
a depositor has. As it is to the interest of the bank to keep in
circulation as many notes as possible, there is a temptation to abuse
the power of note issue, to which many banks in America yielded in the
period of so-called "wild-cat" banking before the Civil War.

§ 10. #Divergent views of typical bank notes#. Some persons seeing in
bank notes but a form of ordinary commercial credit (like a promissory
note or an individual's check) have contended that their issue should
be entirely unlimited and unregulated except by the ordinary law of
contract which makes the bank liable to redeem the notes on demand.
Such bank notes would not be legal tender, and every one would be free
to take or refuse them as he pleased. Each bank would thus put into
circulation as many notes as it could, and as they would constantly
be returned for redemption when not needed as money their volume would
expand and contract with the needs of business.

It may be conceded that there is much truth in this view, but not the
whole truth. For, in reality, when bank notes are in common use, every
one is compelled to take the money that is current. This offers a
constant temptation to the reckless and unscrupulous promotion of
banking enterprises, as has been repeatedly shown (notably in America
in the days of "wild-cat" banking before 1860). The average citizen
cannot know the credit of distant banks, and thus has not the same
power of judging wisely in taking bank notes that he has even in
making deposits in the bank of his own neighborhood. Between bank
notes and ordinary promissory notes there are other differences. Bank
notes pass without endorsement and thus depend on the credit of the
bank alone, not, like checks, on the credit of the person, from whom
received. Unlike ordinary promissory notes, they yield no interest
to the holder. They go into circulation and remain in circulation for
considerable time by virtue of their monetary character in the hands
of the holders. Thus they approach political money in their nature,
and the banks are near to exercising the sovereign right of the issue
of money.

At the other extreme of view have been those who consider bank notes
to be essentially of the nature of political money. If they are so, it
is argued, the power of issue should not be exercised by any but the
sovereign state. In this view it is overlooked that bank notes, unlike
inconvertible paper money, depend for their value on the credit of the
bank, not on their legal-tender quality and on political power.[11]
They must be redeemed on penalty of insolvency; government notes need
not be, and yet will circulate at par if properly limited. Adequate
provision for the prompt return and redemption of bank notes makes
them "elastic" in their adaptation to monetary needs, which fluctuate
with changes in commerce and industry from season to season and even
from day to day.

The predominant opinion to-day is that in their economic nature bank
notes share to some extent the character both of private promissory
notes and of political paper money. They stand midway between the two.
Everywhere it has come to be held that the issue of paper money of any
kind is in its nature a public monopoly, and yet everywhere the
bank note policy has come to be that of permitting the issue only to
certain institutions, under strict public legislation and regulation,
and of requiring in return for this privilege some substantial
services or payments to the government.

§ 11. #Banking credit as a medium of trade.# The credit which, in five
ways, banks sell (see above, section 3) serves, in most cases, the
purposes of money to their customers. This is least true of time
deposits, for the motive of the depositor in such cases is usually to
_invest_ his funds for a time rather than to keep them available as
money. However, there are many cases in which persons save for some
moderately distant use - such as the purchase of furniture, of a piano,
of a house. The safety and convenience of time deposits, combined
with the reward of a small rate of interest, cause great sums, in the
aggregate, to be deposited as _temporary_ savings, which otherwise
would be hoarded in the form of money and thus withdrawn from
circulation. In all such cases the time deposit is serving both as
an investment and as a monetary fund for future use. This is a great
economy in the use of money, for experience shows that in the savings
banks of America the average reserves of actual money kept against
deposits are only about 1-1/2 per cent. In countries where banks are
little known, the amount of actual money hoarded is therefore vastly
greater than it is in the United States where there are $5,000,000,000
of individual deposits in _regular_ savings banks, besides large sums
in time deposits in commercial banks.

Demand deposits, while not money, clearly perform the function of a
reserve of purchasing power for depositors and reduce by so much the
amount of money each must keep at hand to meet his current needs of
purchasing power. If the depositor's credit balance bears no interest,
he has no motive to keep a balance greater than he would require
of actual money, and he has the motive to spend it or invest it in
income-bearing capital whenever his balance (plus his cash in hand)
exceeds his monetary needs.[12] Thus demand deposits are often spoken
of (somewhat inaccurately) as "deposit currency," being funds at
the command of depositors which are as disposable and as active and
current for the monetary function as so much actual money would be.
It is estimated that the rate of turnover of deposits in the United
States is about 50 times a year. We may view the demand deposits
subject to check as either a substitute for money or as a means by
which the rapidity of circulation and the monetary efficiency of
actual money held in bank reserves is multiplied many fold.[13]

The method of payment by bank drafts in domestic exchange reduces the
need for, or increases the efficiency of, money in just the same way
as does the use of checks. By the mutual credit of banks in different
parts of the country, very large payments may be made in both
directions with the movement of only the comparatively small amount
of physical money needed to pay the balance after the cancellation of
drafts, bills of exchange, and checks.

The use of bank notes reduces the amount needed of other kinds
of money more directly, tho not more effectively, than do deposit
accounts. Bank notes _are_ money, and so long as their amount is
limited by prompt redemption they circulate _instead of_ so much of
other kinds of money. Redemption is possible by the use of a reserve
of standard (or of legal tender) money very much smaller than the
amount of notes outstanding.

§ 12. #Productive services of banks.# There have always been some
erroneous ideas regarding the magic power of banks to multiply the
power of money. But there should be no more of mystery about
banking credit than about the nature of money itself. Banks are the
labor-saving machinery of finance. They gather loanable funds, reduce
hoarding, make money move more rapidly, and create a central market
between borrowers and lenders for the sale of credit. While not
creating more physical wealth directly, they add to the efficiency
of wealth; they simplify and quicken the movement of nearly all
commercial transactions. Banks perform incidentally a further service
in developing better business methods in the community. They enforce
promptness and exactitude in business dealings. In supplying credit to
enterprises, banks are constantly passing judgment on the collateral
security presented to them and on the soundness of the enterprises
that are seeking support. This gives to bankers great economic power,
capable at times of misuse in political and social affairs, especially
where a group of selfish men come to exercise a practical monopoly of
business credit in any community.

§ 13. #Income of banks.# The income of banks is drawn from different
sources, according to the size of the community and the nature of the
banks. While in the villages and smaller cities the commercial banks
perform a number of functions, in the larger cities they usually
specialize in a far greater degree. The trust companies, however, with
their greater versatility, are increasing in number. The income
of banks is derived from discounts, interest on their own capital,
charges for exchange and collection, dividends, interest and rents on
investments, and profit from their bank notes. The capital with which
a bank starts in business[14] could be loaned with less trouble and
more cheaply without starting a bank, but used as a banking capital it
can be loaned in part while still serving to attract deposits, which
are the main source of the income of banks to-day. Charging smaller
customers for exchange is a source of income to some banks, but in
many cases this service is freely performed for regular customers and
becomes a considerable expense. Banks make few investments in real
estate or other physical property; it is, in fact, their duty to keep
out of ordinary enterprises, but they are forced sometimes to take for
unpaid debts things that have been held as security. Profits on
bank notes have at times been the main, almost the sole, motive for
starting banks; but that is not the case to-day when the right of
issue is so strictly limited.

[Footnote 1: These are classified as follows:

_Number_ - _Per Cent_ -
_National charter_: 28.56
National banks 7,404 28.56
_State charter_: 67.52
State banks 14,011 54.05
Loan and trust companies 1,515 5.84
Savings banks 1,978 7.63
_Private_: 3.92
Private banks 1,016 3.92
- - - - - - - - -
25,924 100.00 100.00
]

[Footnote 2: Opinion favors prohibiting the use of the word bank
to any except regularly incorporated organizations, or at least
subjecting private banks to the same supervision as the chartered
banks.]

[Footnote 3: Not to be confused with a trust in the sense of a
monopolistic enterprise, with which it has no connection except by
mere verbal accident, through the word trust.]

[Footnote 4: See next sec.]

[Footnote 5: The Federal Reserve Act of 1913 has given encouragement
to this practice by reducing to 5 per cent the reserve required to be
kept against time deposits. See ch. 9, sec. 7.]

[Footnote 6: Usually with deduction of interest in advance; a process
called discount. See Vol. 1, pp. 275, 302.]

[Footnote 7: The legal requirements as to minimum reserves vary
greatly from no specific per cent to 40 or more in different
countries, for different classes of banks, and for different purposes.
Some examples of legal reserve requirements in the United States occur
in the two following chapters.]

[Footnote 8: See above, ch. 4, sec. 5.]

[Footnote 9: See below, sec. 10.]

[Footnote 10: Including, now, some Federal Reserve bank notes secured
by United States bonds.]

[Footnote 11: In some cases, as during the bank restriction in
England, 1797-1821, bank notes become inconvertible - practically
political money.]

[Footnote 12: Payment of interest on credit balances reduces the
motive to withdraw for investment elsewhere any such excess, and
mingles in the depositor's thought monetary and investment motives.]

[Footnote 13: In the United States in 1914 there were individual
deposits reported in banks other than savings banks to the amount of
about $13,400,000,000

In national banks .................................. $6,000,000,000

In state banks ..................................... 3,250,000,000

In loan and trust companies .......................... 4,000,000,000

In private banks ..................................... 150,000,000

Nearly all these were doubtless demand deposits (what proportion were
time deposits we have no data for determining), and were available as
immediate purchasing power for the depositors. The total money (other
than bank notes) in the commercial banks of the country was hardly 11
per cent of this amount. In that year the total amount of money of all
kinds in circulation (and in banks) in the United States (outside the
Treasury), including gold and silver and certificates represented
by bullion in the treasury, United States notes of all kinds, and
national bank notes, was about one fourth of the amount of these
individual deposits in commercial banks. This may suggest the enormous
influence that banking has in determining the average efficiency of
the circulating medium of the country.]

[Footnote 14: See above, sec. 3.]




CHAPTER 8

BANKING IN THE UNITED STATES BEFORE 1914

§ 1. The First and Second Banks of the United States. § 2. Banking
from 1836 to 1863. § 3. National Banking Associations, 1863-1913.
§ 4. Defects of our banking organization before 1913. § 5. Lack of
system. § 6. Inelasticity of credit. § 7. Periodical local congestion of
funds. § 8. Unequal territorial distribution of banking facilities.
§ 9. Lack of provision for foreign financial operations. § 10. The
"Aldrich plan."


§ 1. #The First and Second banks of the United States.#

A knowledge of the history of banking is helpful to an understanding
of the present banking system in our country. The form of our present
banking system has been affected by various economic and political
events which will be sketched here in broad outline to give a
background for our present study.

Alexander Hamilton, the great first Secretary of the Treasury in
Washington's cabinet, advocated the charter of a central national
bank as one portion of his larger plan of national financiering. His
purpose was realized in the chartering, in 1791, of the First Bank of
the United States, for a period of twenty years. The capital for this
institution was in small part subscribed by the government, but mostly
by private capitalists. The management of the bank was left almost
entirely in private hands. The central bank established branches
in many parts of the country, issued bank notes which circulated
everywhere without depreciation, acted as the governmental depository
of funds and as governmental agency in various ways. It seems to
have been successful and useful as a banking institution until
the expiration of its charter in 1811, but it was touched by the
contemporary controversies over state rights and was from the first
opposed by those who feared the growth of a strong central government.
This opposition prevented the extension of its charter.

In 1816, however, after only a moderate discussion, the Second Bank
of the United States was chartered for a period of twenty years. This
also, in its purely banking aspects, seems to have been distinctly
successful, conducting numerous branches in various parts of
the country, maintaining at all times the parity of its notes,
facilitating domestic exchange throughout the country, and enjoying
unquestioned credit and solvency. However, this bank became, even in
a greater degree than did the First Bank, the creature of political
rivalries. In the period of rising democratic sentiment typified
and led by Andrew Jackson, the bank came to be looked upon as the
embodiment, or the stronghold, of plutocratic interests, and Congress
permitted its charter to expire by limitation in 1836, near the close
of Jackson's administration.

§ 2. #Banking from 1836 to 1863#. The Federal Government, which up to
that time had deposited its funds in the central bank and its branches
and in local state banks, established the "independent treasury," in
1840 (abolished in 1841 and re-established in 1846). By this plan the
government kept its money of all kinds in various depositories (or
sub-treasuries) in charge of public officials. While from 1792 to 1836
almost continuously a central banking system was in operation, other
banks, organized under state charters, were steadily increasing in
number. They received deposits, issued bank notes under state laws,
and cared for local commercial needs. The abolition of the central
national bank in 1836 left to the various state banks for twenty seven
years all the banking functions of the country. The banks of some
states (notably those of New England and New York), under careful
regulation and held to strict standards by public sentiment, for the
most part maintained a high credit; but many banks, under lax laws and
regulations, were guilty of great abuses of credit and of downright
dishonest practices. The evils were more especially evident in
connection with excessive issues of bank notes.

§ 3. #National Banking Associations, 1863-1913#. The next step in
federal legislation was taken in 1863 in the midst of the Civil War by
chartering local "national banking associations." The purpose was in
part to provide banks under national charters for banking purposes
(both of deposit and of issue), and in part it was to make a wider
market for United States bonds at a time when government credit was
at low ebb. The plan adopted followed the experience of New York state
(1829 on) with a system of bond-secured bank notes. Congress provided
that every bank taking out a national charter must purchase bonds of
the United States and deposit them with the treasurer of the United
States, in return for which it would receive bank notes to the amount
of 90 per cent of the denomination or of the market value of the
bonds.[1] Bank notes issued on this plan, being secured by the bonds,
rest ultimately on the credit of the government, not on the credit of
the bank. They are not promptly sent back for redemption to the banks
issuing them, as should be done if they were typical bank notes. They
may circulate thousands of miles away from the bank that issued them,
and for years after the bank has gone out of business. They are not
an "elastic currency," increasing or diminishing with the needs of
business. The changes in their amount depend upon the chance of the
banks to make more or less in this way than by any other use of their
capital, and this in turn depends largely on the price of bonds and on
the rate of interest they bear. From 1864 to 1870, fortunes were made
from this source, but thereafter banks could make little more from
note issues than they could by investing the same amount in other
ways. Many banks for a long period did not avail themselves in the
least of their privilege of issue. The notes were subject to a tax.[2]

A national bank (as the law now stands) may be organized, with $25,000
capital in towns not exceeding three thousand population, with $50,000
in towns not exceeding six thousand, with $100,000 in cities not
exceeding fifty thousand, and with $200,000 in large cities. Three
cities, New York, Chicago, and St. Louis, have long been designated as
central reserve cities, and some 47 other cities as reserve cities,
in which the reserves of banks were required to bear a considerably
larger proportion to their deposits than in other cities.[3] Other
banks might count as part of their legal reserves their deposits in
reserve city banks, up to a certain proportion. The national banks in
the larger cities thus became the great capital reservoirs of cash for
the whole country.

National banks have been subject to stricter inspection than have been
the banks in most of the states, a fact which has strengthened public
confidence in their stability. Except in this and the other respects
above mentioned, a national charter offered few, if any, attractions
to small banks, a majority of which have found it more advantageous to
operate under state charters because of less stringent regulations as
to amount of capital, reserves, and supervision.

§ 4. #Defects of our banking organization before 1913#. Taken
altogether, the banks in the United States since 1868 have represented
great banking power and very efficient service for the community in
times of normal business. But in several respects it long ago became
evident that our banks were operating less satisfactorily than those
of several other countries. American banking organization had failed
to keep pace with the increasing magnitude and difficulty of its
task. Especially at the recurring periods of financial stress, such as
occurred in 1893, 1903, and 1907, our banking machinery showed itself
to be wofully unequal to the strain put upon it. Financial panics
were more acute here than in any other land, and the evil clearly
was traceable in large part to defects in the banking situation. In
academic teaching and in public conferences of bankers, business men,
publicists, and students, the subject was continually discussed
after 1890. At length Congress in 1908 created a "National Monetary
Commission" to inquire into and report what changes were necessary and
desirable in the monetary system of the United States or in the laws
relative to banking and currency. After the most extended inquiry
and discussion that the subject had ever received, the commission
submitted its report in January, 1912. The defects to be remedied,
as enumerated in the report,[4] may be reduced to the following five
headings: (a) Lack of system, (b) Inelasticity of credit, (c) Periodic
local congestion of funds. (d) Unequal territorial distribution of
banking facilities. (e) Lack of provision for foreign banking.

§ 5. #Lack of system#. Only in a loose sense could the banks of the
United States be said (before 1914) to constitute a system at all.
Both national and state laws dealt with individual banks only. It was
not legal for a bank to establish branches in another city as is done



Online LibraryFrank Albert FetterModern Economic Problems Economics Volume II → online text (page 9 of 40)