ACO 1081 MODERN BUSINESS THE PRINCIPLES AND PRACTICE OF COMMERCE, ACCOUNTS AND FINANCE PREPARED AND EDITED UNDER THE DIRECT SUPERVISION OP JOSEPH FRENCH JOHNSON, A.B., D.C.S. DEAN NEW YORK UNIVERSITY SCHOOL OF COMMERCE, ACCOUNTS AND FINANCE AUTHOR "MONEY AND CURRENCY," "SYLLABUS OF MONEY AND BANKING," ETC. MONEY AND BANKING A DISCUSSION OF THE PRINCIPLES OF MONEY AND CREDIT, WITH DESCRIPTIONS OF THE WORLD'S LEADING BANKING SYSTEMS BY EARL DEAN HOWARD PROFESSOR OF FINANCE IN NORTHWESTERN UNIVERSITY SCHOOL OF COMMERCE; AUTHOR OF " INDUSTRIAL PROGRESS OF GERMANY " IN COLLABORATION WITH JOSEPH FRENCH JOHNSON DEAN OF NEW YORK UNIVERSITY SCHOOL OP COMMERCE, ACCOUNTS AND FINANCE ; AUTHOR OF " MONET AND CURRENCY," " THE CANADIAN BANKING SYSTEM," ETC. MODERN BUSINESS VOLUME V DE BOWER-ELLIOTT COMPANY CHICAGO NEW YORK COPYRIGHT, 1910 BY DE BOWER-BLLIOTT COMPANY fflWVERSITY OF SOUTHERN CALIFORNIA EDITOR'S PREFACE This volume discusses questions in which the American people have been forced by events to take a deep and personal interest. The rise of prices and resultant in- crease in the cost of living since 1897 have provoked uni- versal discussion and even called forth proclamations of disapproval from mayors, governors and other public men. The panic of 1907, which caused the temporary suspension of cash payments by many banks in the United States, is now recognized to have been mainly due to the defects of the American banking system. It is doubtful if any other scientific questions have been the subject of so much popular debate as those which are treated in this volume on Money and Banking. It goes without saying that no man is fit to plan the digging of a tunnel or the construction of a railroad, to mend a clock or repair an automobile, unless he has had a certain amount of scientific training. In mechanics the world recognizes the need and practical value of science. In finance the same need exists, but it is not yet generally acknowledged. Everybody thinks he un- derstands the money question, or that it is not worth understanding, and the average man is inclined to think that the business of banking is so simple that if our banks have in any way fallen short of their duty, the men who manage them must either be very ignorant of their business or very selfish and speculative in their methods. As a matter of fact, the science of money and credit, EDITOR'S PREFACE while almost as exact in its nature as mathematics, is one of the most difficult in the whole field of economics, and the business or profession of banking, which is founded upon that science and should be conducted in accordance with its principles, is one demanding the keenest and clearest brain. Industry furnishes the red blood of the economic organism. Trade and commerce are its circulatory system. Finance is its nervous sys- tem. If the banker is incompetent and fails in the per- formance of his task, the entire business world is para- lyzed. In the present volume the effort has been made to give the reader in the clearest possible language a scien- tific knowledge of money and credit and an accurate description and analysis of the various banking systems with which the world is now having experience. The subject is difficult and no reader can expect to get en- lightenment from this book unless he is willing to think as he reads. If he will do that, I feel certain that he will quickly grasp all the principles expounded and in the end discover that many business problems which have perplexed him have been made easy of solution. The editor cannot too strongly advise that this volume be read carefully by the general business man. The banker, of course, should understand the subject. If he does not, he is conducting his business by rule of thumb, and is courting disaster. But the business man should not think that Money and Banking are matters with which he is not concerned. On the contrary, they treat of matters which immediately concern him. The relation of money to the upward and downward swings of prices is something which the average business man does not perceive, yet it is something which he ought to understand, for his prosperity often depends on causes EDITOR'S PREFACE affecting merely the demand for and supply of money. The prices of commodities are merely an expression of the value of money and they change whenever money changes. The business man who knows only the con- ditions which govern the value of the commodity which he handles is only half protected against loss. If he would be safe he must know also the conditions which determine the value of money. JOSEPH FRENCH JOHNSON. New York University. TABLE OF CONTENTS PART I: MONEY. CHAPTER I. FUNDAMENTAL ECONOMIC CONCEPTS. SECTION PAGE 1. Reasons for the Study of Money and Banking ... 1 2. Warnings of the Late Panic 3 3. Science 3 4. Finance 3 5. Technology and Business 4 6. Business the Result of Specialization of Labor ... 5 7. Production 5 8. Production by Change of Ownership 6 9- Tardy Recognition of Value of Exchange .... 7 10. Private Property 8 11. Property and Wealth 8 12. Integration of Industry 10 CHAPTER II. EXCHANGE. 13. Beginning of Exchange 11 14. Barter 12 15. Money 12 16. Money Represents Incomplete Exchanges . . . . 13 17. Credit 14 18. Credits as Media of Exchange ... .... 15 19. Money and Credit Representatives of Wealth . . .17 20. Classification of Wealth 18 21. Entrepreneur System 19 22. Capital 20 23. Capitalization 21 vii viii MONEY AND BANKING SECTION PAGE 24. Demand for Capital Goods 23 25. Money Incomes 23 26. Methods of Investment 24 27. Real Investment 25 CHAPTER III. VALUE. 28. Value a Register of Economic Forces ..... 27 29- Meaning of " Value " 28 30. Definition of the Dollar 29 31. Exchangeability the Sole Utility of Money .... 29 32. Gold not an Ideal Standard 29 33. Determination of Value 31 34. Utility Theory of Value 31 35. Marginal Utility 32 36. Marginal Utility to the Individual 33 37. Reconciliation of the two Theories 34 CHAPTER IV. EVOLUTION OF THE MEDIUM OF EXCHANGE. 38. Primitive Ideas of Value 35 39. Ornamental Stones Early Used as Money .... 36 40. Three Functions of Primitive Money 36 41. Wampum 36 42. Beaver Skins 37 43. Agricultural Products as Money 38 44. Tobacco 38 45. Summary of Principles 40 46. Divisibility 41 47. Uniformity 41 48. Cognizability 42 49. Stability of Value 42 CHAPTER V. EVOLUTION OF THE STANDARD OF VALUE. 50. Metal Standards the Fittest to Survive 44 51. Good Qualities .44 CONTENTS ix SECTION PAGE 52. Platinum Unsuccessful as Money .......... 45 53. Objections to Gold and Silver 45 54. Coinage 46 55. Names of Coins 46 56. Requirements of Good Coinage .47 57. Standard of Value 48 58. Double Standard Possible Until Last Century ... 49 59. Gresham's Law 50 60. Mistakes of Early Legislators 51 61. Experience of England with Double Standard ... 52 62. Adoption of Single Gold Standard Unintentional . . 53 63. Mintage 54 64. Legal Tender ... 55 65. History of Coinage in the United States 56 66. First Ratio of Silver to Gold 15:1 . . .. . . . 56 67- Inaccuracy of the Ratio and its Effects . . . . . 57 68. Disappearance of the Silver Dollars 58 69- Change of Ratio to 16:1 60 70. Legal Tender Acts Created a Paper Standard 60 71. Single Gold Standard after 1879 61 72. Act of 1900 62 73. Summary 62 CHAPTER VI. STANDARD OF DEFERRED PAYMENTS. 74. Defects of Gold 64 75. Definition of Deferred Payments 65 76. Effect of Legal Tender Laws 66 77. Constitutionality of Legal Tender Acts 66 78. Debtor Class Injured by an Appreciating Standard . . 68 CHAPTER VII. SUPPLY AND DEMAND IN RELATION TO MONEY. 79- Price 69 80. Prices Depend Upon the Money Market 70 81. Utility of Money 71 82. Distinction Between Desire and Demand 71 x MONEY AND BANKING SECTION PAGE 83. Three Varieties of Money 72 84. Fiat v. Credit Money , . 72 85. Demand for Money Analyzed 73 86". Rapidity of Circulation 73 87. Effect of Population 73 88. Effect of Division of Labor 74 89. Special Demand for Gold 75 90. Payment of Contracts .......... 75 91. Store of Value 75 92. Insecurity of Property and Contracts . . . . .76 93. Special Demand for Money as a Store of Value ... 76 94. Hoarding 77 95. Decline of Hoarding 77 96. Bank Reserves not Hoards . ., . . 78 97. Government Hoarding ........ .. ,. 78 98. Discrimination in Demand for Money ....... 79 99- Seasonal Demand for Money 80 100. Demand for Money in International Trade .... 80 101. Premium on Gold 81 102. Uncertainty of the Demand for Money 81 103. Supply "of Money . . 82 104. Varieties of United States Money 82 105. Supply of Gold 83 106. Factors in the Supply of Gold ....... 83 107. Peculiarity of the Supply of Gold 84 108. Historical Illustrations 84 109. Temporary Results of Change of Money Supply . . .85 110. Effect of Increased Supply of Gold Traced Out . . . 86 111. Limit to the Price-Raising Effect of Gold .... 87 112. Alternative Uses of New Gold ....... 87 113. Widespread Effect of New Gold ....... 88 114. Comparison of Effect of Increase of Supply of Gold and Paper Money 89 115. How Much Money is Needed in a Country? .... 90 116. Price Changes not Synchronous 91 117- Stimulating Effect of Rising Prices 91 118. Reaction 92 119. Swings of Prices . . 92 120. Cumulative Effect of Economic Forces . .... 93 CONTENTS xi CHAPTER VIII. THEORY OF PRICES. SECTION PAGE .121. " Short " Sales of Money , ,.. ... ,.. 95 122. " Squeezing the Shorts " . . . .... .., . . .. 95 123. Forced Selling ... 96 124. People Becoming Better Educated . . ., ... ... . 96 125. General Price Level 97 126. Price Tables 97 127. Many Commodities . . . . . . ., . . . .97 128. Example of Price Table . .... ,., ,., ,., . 98 129. "Weighting" of Price Tables . . . .,.,... 99 ISO. Advantages of Weighting 100 131. Falkner Price Table ... 100 132. High Prices During the Civil War 104 133. Foreign Price Tables . . . : . . .... .106 134. Economic Forces to be Observed .. ,., ,., . 107 135. Saving and Investing ,., . . . . 109 CHAPTER IX. DOMESTIC AND FOREIGN EXCHANGE. 186. Relation Between Foreign and Domestic Exchange . . 112 137. Payments by Means of Credit Balances . . ... .112 138. Function of the Bank in Making Payments . . .113 139. Payments at a Distance . . . ., . . ... .113 140. Exchange on New York 114 141. How the Banks Handle New York Exchange . . .115 142. Settlement of Accounts Between Banks 116 148. Cost of Currency Shipments 117 144. Settlements Through the Sub-treasuries 117 145. Rate of New York Exchange 118 146. Significance of Rates of Domestic Exchange . . . .119 147. The Clearing House Principle 121 148. Settling Balances by Use of Credit 122 149. Gold the International Medium 122 150. Function of the Dealer in Foreign Exchange . . . .123 151. Example of Foreign Exchange 123 152. Why Bankers are Willing to Purchase Foreign Drafts . 124 153. Progress of Draft . . . ., 125 Xll SECTION PAGE 154. Quotations for Foreign Exchange 125 155. The Pound Sterling 125 156. Cost of Shipping Gold 126 157. The Minimum Gold Point for Sterling Exchange . . 127 158. Maximum Gold Point for Sterling Exchange . . .127 159. Why Sterling Exchange May Fall Below $4.8465 . .128 160. The Gold Market 129 161. Bank of France 130 162. Gold Shipments 131 163. Our Foreign Commerce .... . 131 164. Invisible Items of Foreign Trade 132 165. Movements of Capital 133 166. Interest and Dividend Payments to Foreign Stockholders 134 167. Freight ................. 134 168. Tourists . ,., ,., ., . . . ..... . . . 134 169- Foreign Exchange Market . . t ., ,., . ,., ,. . . 135 170. Explanation of Articles ... .. . .136 171. Cables 136 172. Varieties of Foreign Exchange 138 173. Demand Sterling 138 174. English Banking Customs . . .139 175. Finance Bills 140 176. Profit on Finance Bills ., . . 141 177. Foreign Department of a Bank 143 178. Traveler's Letters of Credit 145 179- Commercial Letters of Credit 146 180. Buying Foreign Exchange for Investment . . . .147 181. German and French Exchange 149 182. Arbitrage ... . ,., .... ,. . ,., ,., . . 152 CHAPTER X. PRODUCTION OF THE PRECIOUS METALS. 183. World's Stock of Gold 153 184. History of the Precious Metals 153 185. The Feudal Period 154 186. Discovery of America 155 187. Effect of Silver from America 156 1 88. Increased Circulation of Money ....... 157 CONTENTS xlii SECTION PACB 189. Discovery of Gold in California 157 190. Effect of California Gold 158 191. South African Gold 159 192. Production of Gold ..159 193. Origin of Gold 159 194. Sources of Gold 160 195. Improvements on Placer Mining 160 196. Dredging . . . . '- 161 197. Quartz Mining l6l 198. The Comstock Lode 162 CHAPTER XI. BIMETALLISM. 199. Bimetallism Defined ........ ,. . . 164 200. Difficulties of Bimetallism 164 201. Advantages of Bimetallism 165 202. International Bimetallism 166 208. Disadvantages to Commerce of Different Standard . .166 204. Early Attempts at Inflation 167 205. Demonetization of Silver . . 168 206. The Latin Union 169 207. Demonetization of Silver by the United States . . . 171 208. The Silver Purchase Acts 172 209. Sherman Act One of the Causes of the Panic of 1893 . 172 210. Silver Would not Circulate 174 211. Attitude of Banks toward Silver 175 212. Silver Certificates , 175 213. Currency Situation in 1890 176 214. The Treasury Gold Reserve . .177 215. Repeal of the Sherman Act 178 216. Authority to Issue Bonds . . . .179 217. Successive Issues of Bonds 179 218. Belmont-Morgan Syndicate 180 219. Silver Question . . 182 220. Origin of the Free Silver Movement .183 221. Arguments for Free Silver 184 222. Argument to the Workingman 185 228. Arguments of Advocates of Gold 186 XIV SECTION PAGE 224. The 50-cent Dollar , , . ,., 186 225. Probable Results of Free Silver . . ... .., ,.. ... . 187 226. The Real Debtor Class .. : > : . ... 189 227. Solution of the Silver Question . . ... ,., ... ,.. .. 190 228. Gold Exchange Standard in Mexico . . . ,., ,.. . 191 PART II: BANKING. CHAPTER XII. NATURE OF CREDIT. 229. Origin and Kinds of Credits .....,,. ,. ,. 193 230. Use of Credit in Industry ...... ,., ,., . . 194 231. Function of Commercial Banking . . . .... .195 232. Mortgages and Bonds . ,., . . 196 233. Example of Timber Industry 196 234. Advantages of Timber Bonds . .198 235. Interest Rates on Bonds 198 236. Long-time Borrowing . .199 237. Credit Economizes the Use of Gold 199 238. Liquidation of Credit 200 239- Commercial Paper Houses and the Credit Situation . . 201 240. Use of Credit as a Medium of Exchange 202 241. Bank Credit 202 242. Deposit Credit 203 243. Elasticity of Deposit Credit 204 244. Gold the Basis for all Credit ......... 205 245. Reserve 207 246. Effect of Reserve Requirements . . . ... . . 207 247. Danger of Use of Credit in Panics . . . ,., . . 208 248. Importance of Credit 209 CHAPTER XIII. EFFECT OF CREDIT ON PRICES. 249. Increasing Need of More Efficient Money . . . .211 250. Effect of Non-Circulating Credit 211 251. Cancellation of Credit . . 212 CONTENTS rv SECTION PAGE 252. How Lessened Demand for Money Causes Rise in Prices 213 253. Effect of National Bank Notes . . . . . . .213 254. Bank Notes and Checks Differentiated . ... . .214 255. Effect of Government Credit Money 215 256. Credit and Speculation 216 257. How Speculation May Be Both Cause and Effect of a Rise in Prices 216 258. Defect of our Currency System . . . . . . .217 CHAPTER XIV. GOVERNMENT CREDIT CURRENCY. 259. Classification of Government Credit Currency . . . 220 260. Fiat Money Defined 220 261. Factors Determining the Value of Credit Money . .221 262. Risk in Free Use of Credit Money 222 263. Regulation of Credit Money 222 264. Devices to Maintain Value of Credit Money .... 224 265. Argument for Government Credit Money .... 224 266. Difficulties of Adjusting Supply 225 267- Prejudices Against Government Credit Money Before 1861 226 268. Financing the Civil War . . 226 269- Disadvantage of Government Debt 227 270. Government Debt 228 271. Demand Debts a Weakness 229 272. Provisions for Retiring Debt ......... 230 CHAPTER XV. ECONOMIC FUNCTION OF THE BANK. 273. Productive Industries Classified 231 274. Recapitulation of Fundamental Principles .... 232 275. Credit 233 276. Bank a Dealer in Credits 233 277. Banks Supply a Medium of Exchange 235 278. Banking is a Quasi-Public Function 235 279. The Bank a Distributor of Capital 236 280. Banking Principle 237 xvi MONEY AND BANKING SECTION PAGE 281. Double Function of Commercial Banks 237 282. Peculiar Privilege of Bankers 289 283. Banks Do Not Create Capital 242 284. Source of Capital and Credit of Bank 243 285. Operations of a Bank 244 286. Responsibility of the Banker for Proper Distribution of Capital 245 CHAPTER XVI. DEPOSIT CURRENCY. 287. Analysis of Credit 248 288. How Credit Promotes Industry 249 289. Banks Create Credits 249 290. Bank Credit Preferable to Cash 251 291. Shifting of Bank Credit Without Liquidation . . .251 292. Similarity of Checks and Bank Notes . . . . . . 253 293. Limits of Earning Power of the Bank 253 294. Difference Between a Cash and Credit Loan .... 254 295. Cash a Precious Commodity at Times 254 296. Problem of the Reserve of Greatest Importance . . . 256 297. Lack of Cooperation Causes Banks to Lose Reserves . . 257 298. Methods of Increasing Reserves 257 299. Secondary Reserve 258 300. Unreliability of Bonds as Reserves 259 301. Aldrich-Vreeland Act 259 CHAPTER XVII. BANK STATEMENT RESOURCES. 302. Combined Statement 260 303. Proof of the Deposit Currency Theory 261 304. Double-Entry System 262 305. Alterations in Value of Resources 263 306. Concealed Assets 264 307- Loans and Discounts 264 308. Overdrafts 265 309- United States Bonds to Secure Circulation .... 266 310. United States Bonds to Secure United States Deposits 266 CONTENTS xvii SECTION PAGE 311. United States Bonds on Hand 266 312. Premiums on United States Bonds ....... 266 313. Bonds, Securities, etc '. ..... 267 314. Banking House Furniture and Fixtures 267 315. Other Real Estate Holdings 267 316. Due From National Banks 268 317. Due From Approved Reserve Agents . . . . . 268 318. Checks and Other Cash Items Exchanges for the Clearing House 269 319. Bills of Other National Banks . . . ... . .269 320. Legal Tender Notes . . . . . ... . .269 321. Redemption Fund . 269 322. Due From the United States Treasury ... . . 270 CHAPTER XVIII. BANK STATEMENT LIABILITIES. 323. Capital Stock Paid In . . 271 324. Double Liability of Stockholders 272 325. Surplus Fund 273 326. Undivided Profits 275 327. National Bank Notes Outstanding 275 328. State Bank Notes Outstanding 276 329. Individual Deposits 276 330. United States Deposits and Deposits of United States Disbursing Officers 277 331. Bonds Borrowed ..... . ... . . 277 332. Notes and Bills Rediscounted 277 333. Bills Payable . . . . . . 278 334. Certified Check .......'.... 278 385. Cashier's Checks Outstanding 278 CHAPTER XIX. ORGANIZATION AND BUSINESS OF THE BANK. 336. National Banks 280 337. State Banks 280 838. Private Banks 280 839. Underwriting 281 xviii MONEY AND BANKING SECTION PAGE 340. Trust Companies . . ... . . ,., ., . . 282 341. Banking Department ........ ,. ,., . 282 342. Deposits of Trust Companies ...... ... . ... . 283 343. Trust Department . m ... A . 283 344. Individual Trusts 284 345. Corporate Trusts 284 346. Savings Banks 285 347. The Organization of a Bank . . . 286 348. Evolution of the Bank ..,.,.. 286 349. Stockholders 286 350. Directors 287 851. Considerations Governing Choice of Directors . . .288 352. Briggs v. Spaulding 290 353. Ignorance No Excuse 29 1 354. Supplementary Examinations Necessary 291 355. Opinion of Comptroller Ridgely 292 356. The President 293 357. The Cashier 293 358. Paying Teller .294 359. Receiving Teller 295 360. Note TeUer 295 361. Discount Clerk 296 362. Bookkeeping Department 296 863. Laws Relating to Collections 297 364. Liability of Collecting Bank 299 365. Collection of Out-of-Town Checks 300 366. English Method of Country Collections 301 CHAPTER XX. DEPOSITS AND DEPOSITORS. 867. General Deposits 303 368. Special Deposits 303 369- Safety Deposit Vaults 304 370. Inducements to Depositors 304 371. Difficulties in Establishing a New Bank 306 372. Value of a Banking Connection 306 373. Kiteing Checks and Drafts 307 374. Method of " Kiteing " 307 CONTENTS xix SECTION PACK 875. Title to Deposited Checks, etc 308 376. Case of Disputed Ownership to Deposited Check . . 308 377. Accepting Deposits when Insolvent is Criminal . . . 309 378. Drawer Released from Responsibility After Reasonable Time . 309 379- Local Banks 310 380. Holder of a Check Cannot Sue Bank 310 S81. Revocation 310 382. Insufficient Funds 311 383. Forgeries 311 384. Post-Dating ... 311 385. Set-Off 312 386. When a Depositor Fails, His Note Not Being Secured . 312 387. Advantage to Depositor 812 888. Set-Off Makes Failures Appear Worse 313 389. Illustration 313 390. Form of Note 318 CHAPTER XXI. LOANS OF THE BANK. 891. Two Qualities Necessary to the Making of a Banker . . 315 392. Investment Loans 315 393. Conditions Under Which They Are Good Banking Loans 316 894. Industrial Loans 316 395. Capital Loans 318 396. Capital Should Come From Stock and Bond Issues . .318 397. Mortgage Loans 319 398. Loans Reported to the Comptroller 320 899- Demand Loans Have Increased 321 400. Double-Name Paper 321 401. Single-Name and Brokers' Paper 321 402. Judgment Note 323 403. Collateral Note 323 404. Risk in Collateral Loans 324 405. Usury Laws 325 406. Call Loans Exempted 326 407. Loans on Open Book Accounts 327 408. Providing Temporary Capital ........ 327 xx MONEY AND BANKING CHAPTER XXII. LOANS AGAINST COLLATERAL. SECTION PAGE 409- Collateral for Bank Loans 329 410. Merchandise as Collateral 329 411. Advantages of Good Warehousing Laws 330 412. Loans on Merchandise a Legitimate Function of Banks 330 413. Statement of a Bank President 331 414. Law of Warehouse Receipts 332 415. Uniform Law 332 41 6. Risk Involved in Loans on Warehouse Receipts . . . 333 417. Under the Present Law 333 418. Issue of Receipts Safeguarded 334 419. Protection to Holders of Receipts 334 420. Garnishment not Allowed 335 421. Penalty for Illegal Use of Receipts 335 422. Transfer of Title to Lender 336 CHAPTER XXIII. CREDIT DEPARTMENT OF A BANK. 423. Credit Department of a Bank 337 424. Sources of Credit Information 837 425. Credit Agencies 339 426. Duties of Credit Man 340 427. The Commercial Note-Broker 341 428. Change in the Business 341 429. Demand and Supply of Commercial Paper .... 342 430. Areas of High and Low Rates 343 431. Discount Offer by Dealer 343 432. Credits , 344 433. Size of Notes 345 CHAPTER XXIV. HISTORY OF BANKING IN THE UNITED STATES. 434. Characteristics of Early Banking 347 435. Relations with Government 347 436. Historical Periods 348 437. Some Early Banks ..... ... . .. ... . . . 348 CONTENTS xxi SECTION PAGE 438. Loaning on Bank Stock .., ,., . 349 439. First Bank of the United States ., ,., . 350 440. Success of the First Bank ,., .., ,., ,., 351 441. Opposition to Recharter .., .352 442. Second Bank of the United States 353 443. Redemption of Notes in Specie 353 444. Mismanagement of the Bank 354 445. Jackson Opposed to the Bank . .... .., . . .355 446. State Banking , . , . 356 447. Suffolk Bank System . ., .., . ,., . ,., ,.. . . 357 448. New York Systems ...... .., . ... ... . . 359 449. Safety Fund System ............ 359 450. Bond Deposit System 359 451. Mistakes of the System 360 452. Free Banking System ........... 361 453. Experience in Other States ......... 363 454. Indiana and Ohio . . . ., ., ... ., ,., ,., ... . 363 CHAPTER XXV. NATIONAL BANKING SYSTEM. 455. The National Bank Act 365 456. Market for United States Bonds . ., 366 457. Early History of the Act 366 458. Comptroller of the Currency .367 459- Summary of National Bank Act 367 460. Circulating Notes 369 461. Evils of the National Banking System 370 CHAPTER XXVI. PRESENT CONDITIONS OF BANKING IN THE UNITED STATES. 462. The Development of Bank Deposit Currency . . . .371 463. Limitation of Deposit Currency 372 464. Seasonal Demands 373 465. Depletion of Reserves 374 466. Government Deposits 374 467. Inelasticity 375 468. Expansion of Bank Circulation 376 xxii MONEY AND BANKING SECTION PACK 469- Lack of Unity in Our System 377 470. Savings Banks 877 471. Postal Savings Banks ,. 378 472. Guarantee of Bank Deposits 378 CHAPTER XXVII. RELATION OF BANKS TO WALL STREET. 473. Market for Securities in the United States . . . .381 474. Working Capital of Dealers in Securities . . . .382 475. Details of the Collateral Loan 383 476. Certification ... 383 477- Restrictions on Collateral 384 478. Call Loan Rate 384 479- Responsibilities of the Loan Clerk 385 480. Undigested Securities 385 481. Close Relation Between Reserves and Prices .... 386 482. Plan for Remedying the Danger in Redepositing Re- serves 387 483. Commercial Banks 387 484. Financial Banks 388 CHAPTER XXVIII. BANKS AND THE UNITED STATES TREASURY. 485. Responsibility of the Secretary of the Treasury . . . 390 486. Treasury Causes Stringencies 391 487. Defective Currency Laws 393 488. Expedients of the Secretary 393 CHAPTER XXIX. EUROPEAN BANKING SYSTEMS. 489. Bank of England 395 490. Development of the Use of Checks 896 491. Bank Act of 1844 398 492. Character of Bank of England Note 399 493. The Bank of England Private . . .... . .400 494. Banking in France 401 CONTENTS xxiii SKCTIOK PACK 495. Bank of France ...... 402 496. Deposit Currency Little Used . , , . 403 497. Asset Currency 403 498. Branches 404 499- Imperial Bank of Germany 406 500. Influence of Government 406 501. Modeled on Bank of England 407 502. Reserves 407 CHAPTER XXX. CANADIAN BANKING SYSTEM. 503. The Bank and the Government 409 504. Security of Note Issues 409 505. Redemption Fund 410 506. System Very Elastic 411 507. Reserves 411 508. Branch Banking 412 509- Canadian System in Actual Operation 413 510. Moving the Crops 414 511. Grain as Security 415 512. Fluctuations in Note Circulation 41 6 CHAPTER XXXI. SUMMARY OF CURRENCY AND BANKING PRINCIPLES. 513. Elasticity 419 514. United States Currency 420 515. Sub-Treasury System 420 516. Reserves 421 517. Guarantee of Deposits 422 518. State Banks and Trust Companies 423 519- Unity of Action 424 520. Speculation 425 521. Credit Necessary 426 522. Financial and Commercial Banks 427 523. Function of Commercial Bank 427 MONEY AND BANKING PART I: MONEY CHAPTER >I FUNDAMENTAL ECONOMIC CONCEPTS 1. Reasons for the study of money and banking. The study of money, currency and banking is necessary to every person who desires a thoroughgoing knowledge of business. Every one who has to deal with prices, whether he be a producer or a consumer, a working man selling his services or a capitalist receiving interest on his investments, in order to conduct his affairs intelli- gently must understand the forces affecting prices of the commodities or the services in which he is inter- ested. Every fluctuation of price affects the welfare of every person who buys or sells, and the ability to foresee these fluctuations enables the business man to avoid loss and gain profits. The science of money and banking deals with prices, and attempts to explain their fluctuations so far as the cause of these fluctuations is due to changes in the con- ditions of currency and banking. The influence of cur- rency and banking upon prices is much more important than is generally supposed. Every business man understands the fluctuations of price that are brought about by alterations in the supply of or the demand for commodities or services. He VII 1 2 MONEY AND BANKING knows when five men are bidding for one article that the price will go up, and that when five sellers are offering their goods to one man the price is likely to go down. He is not likely to understand, however, how prices in general may go up in consequence of a new discovery of gold in the Klondike or an increase in the amount of bank credit outstanding. Yet these latter forces are just as potent, and even more enduring, than the former in affecting prices. To offset the enormous damage chargeable against the panic of 1907, we must place on the credit side of the account an item whose importance is becoming more and more apparent. This item is the education of the American business man in the science of currency and banking, at least to the extent that he appreciates as never before the relation between a defective currency system and his own prosperity. He feels that much of the loss and suffering of that disaster was unnecessary, and that in the future repetitions may be considerably mitigated. If an architect should plan the construction of a building which collapsed in the first severe storm, he would probably be held for criminal neglect in disre- garding the laws and principles of scientific construc- tion. Should not the architects of our currency and banking systems be held equally responsible for the col- lapse of their structures when they have disregarded scientific principles clearly established? The study of the science of currency and banking is not only obligatory upon the architects of our monetary system, but it is also profitable to those who must adapt their business to existing systems. If the system is de- fective, they must know how to escape the consequences of such defects ; they must know enough to move out of FUNDAMENTAL ECONOMIC CONCEPTS 3 the building when the first cracks appear in the walls, or when evidences of a storm are manifest. 2. Warnings of the late panic. During the winter of 1906 and the summer of 1907 the economists and students of finance had sent out bulletins of warning and displayed storm signals of the approaching trouble. The intelligent navigator of business craft who could understand the significance of these signals sailed close to the shore or kept in port, while the heedless and igno- rant put up full sail to take advantage of the breeze of prosperity, and found themselves caught unawares in the squall of October. 3. Science. Science is the study of the relation of cause and effect. Man has an inborn curiosity to know the reason for things, in order that he may be master of his environment and that he may know how to produce desired effects through his power over the causes pro- ducing those effects. Therefore, our ultimate aim in studying the science to which we have addressed our- selves is to be able to make use of such knowledge in increasing our business efficiency, and avoiding waste of effort in materials through ignorance. Money and Banking is a part of the science of finance, which in turn is one of the branches of the more general subject of Economics or political economy. 4. Finance. Political Economy is the science of business; that is to say, the science of the relations of men with each other in the production, consumption, distribution and exchange of goods. Finance, one of the subdivisions of the field of economics, deals with control of property, especially with that form of prop- erty which economists call the production goods, i. e., land, natural resources, factories, railroads, machinery, etc. Control of property is attained 'through changes 4 MONEY AND BANKING of ownership, or possession of the highest efficiency in production goods. Finance, therefore, is a science which treats of the assembling and management of cap- ital, using the term in the broadest sense. It also treats of the methods and instruments used necessary to this end, hence including money and banking. Money and banking deals with the instruments and methods, through the agency of which the exchange of property of all kinds is accomplished. The ultimate object of all busi- ness is to produce the largest amount of wealth, and to distribute this product to the consumers. Wealth is the general term which includes all material things which satisfy human wants. In other words it includes those things which possess the quality called utility, which is simply the power to satisfy human wants di- rectly or indirectly. In order to create this quality of utility in material things it is necessary to bring together three things ; labor, natural resources, and capital goods. This latter term includes all the artificial instruments of production tools, buildings, railroads which have been made by men. 5. Technology and business. In every enterprise there are two distinct sides, that is, a technical and a business side. The manufacturer must not only have knowledge of the best methods and processes for turn- ing out his product, but he must know how to buy his materials, hire his labor, secure and invest his capital and sell his product. Economics has nothing to do with the technical side of industiy. It is not concerned with the best methods of treating the soil in agriculture nor with the construc- tion of machines in manufacturing. It confines itself solely to the study of the organization and relations of the three factors of production, land, natural resources, FUNDAMENTAL ECONOMIC CONCEPTS 5 and capital goods. If everybody provided for his own wants first, by producing what he consumed, there would be no such thing as business and economics. Business begins the moment one person produces some- thing for another but depends upon another to supply him by exchange with the things he needs. Since prac- tically nobody is economically self-sufficient in these days, everybody is concerned with business problems. 6. Business the result of specialization of labor. This fact of the universal division of labor or specializa- tion of labor is the very foundation of our economic sys- tem. The procedure of a modern man in supplying his wants is very indirect. If he hasn't some already, his first move is to supply himself with money which he ex- changes for the goods with the merchant. The mer- chant has previously acquired the goods in a roundabout way through the channels of trade from the producers. The producers are organizations of men who take the materials from their natural state and work them up into finished goods capable of satisfying human wants. The work of the world, in which we observe nearly everybody so busily engaged, is production. Sometimes it requires very close analysis to discover how some occupations assist in preparing goods for consumption and use. At first sight such occupations as banking, brokerage, accounting, etc., seem to have little to do with the production of goods, and yet as we shall see further on, they are as necessary and effective to this end as agriculture and manufacturing. 7. Production. To create the greatest utility in goods that is, to give them the maximum power to sat- isfy human wants, they must be given the proper form; they must be ready for consumption at the proper time and in the proper place; and lastly they must be in 6 MONEY AND BANKING the possession of the consumer, to whom they afford the highest gratification, or at least in the possession of the person who is willing to sacrifice the most for them. Thus production consists not only in changing the form of material things, such as changing the chem- ical elements of the soil into wheat and finally into bread, or transforming the standing timber into a dwell- ing house. It consists just as truly in changing the locality of the goods ; for instance, wheat in Dakota has very small utility to the people, but after it has been transported to New York City it gains immensely in utility. Still further the mere holding of goods from one time to another may increase their utility. It is the function of merchants and warehousemen to hold goods until they shall be called for by the consumers. These persons create utility just as truly, though not as ob- viously, as the farmer or the manufacturer. 8. Production by change of ownership. Lastly util- ity of goods is increased by changing the ownership of them. It is with this last phase of production with which we are concerned in the study of money and bank- ing. Under our system of specialized industry, prod- ucts have very little utility to the producer. While the products of other producers have very high utility, by exchanging his own for products of others, each gains in the amount of utility at his disposal. This opera- tion of exchange is relatively simple when the producers and consumers are close to each other, but when the pro- ducer is a Chinese tea grower and the consumer an elderly English lady several thousand miles away, the process of getting the tea from one to the other is a very complicated affair, requiring for its accomplish- ment a vast number of institutions and ingenious de- vices. FUNDAMENTAL ECONOMIC CONCEPTS 3 All our modern material civilization is practically due to the extension of the principle of the division of labor. It is only within the last century or two that the whole population is engaged in producing things which they do not intend to consume. The enormous increase in efficiency of this method over the method of each pro- ducing for himself is instantly apparent when we reflect on what portion of the wealth which we consume daily would be ours if we were obliged to produce it by our own unaided efforts. Now this whole system of divi- sion of labor depends upon the exchange of goods. The products must find the consumers, and this involves from one to one hundred changes of ownership. There- fore we see that our modern civilization has been de- pendent upon the growth of commerce, and future developments in the division of labor will depend upon the facility with which its various classes of commodities can be exchanged. 9. Tardy recognition of value of exchange. It is a curious fact that this most vital part of civilization and commerce, money and banking, has not been understood and appreciated until recent times. A few centuries ago, the merchant was regarded with suspicion and placed not far above the thief in the social scale. The merchant who bought an article for $1 and sold it for $1.50 was thought to have robbed the purchaser of 50 cents. The banker who loaned money at interest vio- lated one of the laws of the church which forbade taking of usury, as interest was called at that time. It is only in very recent times that the persons who perform this most vital economic function of exchange the bankers, financiers, brokers and merchants have been understood and appreciated, and even yet we find the medieval idea still prevalent among a large class of peo- 8 MONEY AND BANKING pie that these persons are non-producers and parasites. 1 Such persons fail to see that without the activity of these non-producers, the labor of the working man in field and shop would probably be less than one-tenth as ef- fective in producing real wealth as it now is. 10. Private property. The most fundamental insti- tution of our economic system is that of private prop- erty. If we take a sweeping survey of the world we shall perceive that those countries which have advanced farthest in civilization and economic well-being are those in which the rights of private property and in- violability of contracts are most strictly enforced. The world knows no other way to secure the preservation and utilization of its resources, or the production of increasing quantities of industrial equipment or the full efficiency of human effort, whether of hand or brain, than by the protection of property rights. 11. Property and wealth. Wealth and property are not synonymous terms. Wealth signifies material things possessing utility; property is a claim which con- fers control over the use of wealth. When we say a person is wealthy, we mean that he has property rights over a considerable amount of utility-bearing things. These property rights are of great variety, from abso- lute ownership, subject only to the police power and em- inent domain of the government, to temporary posses- sion of the tenant or borrower. A great many things popularly classified as wealth are not real wealth at all, but representatives of wealth, A deed is not wealth; it is simply an evidence of prop- erty rights, as a bond is simply evidence of a claim for money payment, usually secured by a mortgage. A i Even so profound a philosopher as Lester Ward in his Dynamic So- ciology written in 1875, fails to appreciate the economic service of the mer- chant and financier. FUNDAMENTAL ECONOMIC CONCEPTS 9 share of corporation stock is a claim to a certain portion of the earnings of a corporation set aside by the direc- tors as available for dividends, and in case of the dis- solution of the corporation, to a portion of the assets. A United States note or greenback is simply an evi- dence of a claim against the Government for payment of a certain number of dollars on demand. The fact that it is readily accepted by everybody in exchange for wealth does not make it real wealth. A gold coin is real wealth to the extent to which the metal it contains has utility. In the case of all the other forms of money we are confronted with a prob- lem whether to classify them as real or representative wealth. Money undoubtedly has an indirect utility in so far as it assists in production, and would seem to go along in the same category as railroad cars, which in- crease the utility of goods by moving them from place to place money increases the utility of goods by mov- ing them from owner to owner. We have seen how the division of labor, where nearly everything is the subject of private property, requires continual exchanging of wealth in order that it may come under control of the persons who can best utilize it. There is another consequence of the division of labor: It requires that the factors of production be organized in great groups, in order to be most effec- tively utilized. As the result of this tendency, we have the United States Steel Corporation, with its 150,000 men working with a billion dollars' wortK of natural resources and capital goods, and with the production of iron and steel. This grouping together of a large number of industries, originally independent and separate, has eliminated a vast number of exchanges. From the iron 10 MONEY AND BANKING ore at the mine to the finished steel rail there is no change of ownership of the materials. 12. Integration of industry. As a consequence of this integration of industries there is much greater sim- plicity and much less risk of industrial maladjustment than before. The economy of this integrated tendency will be more apparent when we have learned how indus- trial crises, speculation or trade depressions are caused by failure of the mechanism of exchange to work prop- erly. As we decrease the number of exchanges in the normal production, we reduce by so much the oppor- tunities for breakdowns. These fundamental economic facts and principles are mentioned here to give the student a proper idea of the relation which money and banking bear to our whole industrial system. Money is an instrument and bank- ing an institution to assist production of wealth and thereby increase the material welfare of the people by facilitating the indispensable operations of exchange, without which all other productive effort would have but a fraction of its efficacy, without which we would still be in the state of industrial barbarism. The idea of private property is not as a great many would imagine, innate in the human mind; it is a prod- uct of centuries of slow evolution developed by neces- sity. Among the most primitive peoples communism is general, except in things peculiarly personal. The first exchanging was not between individuals, but between tribes, and originated in mutual gifts rather than any contract of quid pro quo. CHAPTER II EXCHANGE 13. Beginning of exchange. Regular exchange did not exist until one tribe had a surplus of particular com- modities which were desired by the tribes having no facilities for producing them. These articles, which were superfluous in the tribe producing them, had a pe- culiar value to other tribes which perhaps could not produce them at all. If these commodities happen to be of an imperishable nature, as pottery, weapons or furs, they might easily come to have a use as a medium of exchange for home products. The necessity of ob- taining such commodities from other tribes gave them a kind of fixed value, and thus they became the most convenient standard by which the value of all other things could be compared. In the evolution of money a vast number of things have been used for the purpose of fixing values, but practically all of them represent surplus products which could be exchanged with foreign tribes or nations for imported wares. Exchanging of goods within the tribes was a very slow development, and when it did develop it was most natural for these articles of foreign origin with a fairly definite exchange value already fixed to become the common medium of exchange and standard of value. By some authorities economic history has been di- vided into three stages, according to the method by which exchanges were made: Barter, money and credit. 11 12 MONEY AND BANKING In the first or "barter" stage goods were exchanged for goods. In the second stage certain goods had acquired an exchangeability greater than others, and were ac- cepted not only because they had utility for human uses, but also because they had this additional utility of ex- changeability. People accepted them not because they desired them to use, but because they knew they could get by trading things they really did want for use. Thus these special commodities, such as beaver skins, beads, tobacco, etc., came to have a value quite apart from their commodity utility. We shall see when we come to the study of "value" that one of the principal factors which confers value on goods is utility. This extra exchange utility is the most important element in the value of money. 14. Barter. The limitations of exchange by barter are obvious. The two objects to be exchanged must be of approximately equal value or the difference must be made up by adding smaller articles until an equivalence of value is reached ; otherwise no exchange can be made. If one man has a skin which he wishes to trade for food, he must find somebody with a surplus of food who wants a skin. If the skin is very valuable the owner might be compelled to take a large quantity of food at one time, perhaps much more than he wanted. In the barter stage, therefore, exchange was so clumsy and un- certain that it was of necessity incidental rather than essential in economic life. It was hazardous for men to set about manufacturing articles for which they had no use themselves and expect by exchange to obtain the necessities of life. In this stage the market for prod- ucts was very uncertain and could not be depended upon. 15. Money. Money is a commodity, as we have seen, EXCHANGE 13 but when it is exchanged for other commodities we do not call the operation barter, although it is an exchange of goods for goods. The fact that one of the ex- changed articles is accepted solely because it can so easily be exchanged for something else which the holder really wants for use or consumption, introduces an en- tirely new principle. Trading, which was so limited, clumsy and uncertain in the stage of barter, now becomes easy and regular. If I have something of value I do not have to look about to search out the person who not only wishes to possess it but who has something which I need. I have simply to find a person who has money, because I know that by accepting money I can get whatever I wish with it. Exchanges, therefore, become three-sided. First, the trading of goods for money, and then of money for goods. The first part of the operation, the exchanging of goods for money, is but the first half of the complete exchange. Until the money has been spent there is a suspended exchange, which must be completed sooner or later by the exchange of the money for goods. Therefore, all trade is finally barter, and the use of one commodity in this peculiar way as money compli- cates, but also greatly facilitates, exchanging of goods for goods. 16. Money represents incomplete exchanges. All money existing at this moment represents incomplete exchanges. Every possessor of it will sooner or later offer it for goods, because money has no use except to be spent. There is no utility to be had from it until it is parted with. The miser perhaps realizes a certain satisfaction from the mere possession of money, but with the rational person the possession of money repre- sents a postponed satisfaction. Quite naturally the an- 14 MONEY AND BANKING ticipation of future satisfaction to be obtained is quite pleasurable, but to say that the money rather than the anticipation is the source of the satisfaction is to fall into confusion of thought. The boy with the circus ticket in his hand is filled with joyous sensations when- ever he gazes upon it. A railroad ticket to California conjures up the smell of orange groves and other de- lightful things. But neither of these things is the real source of the gratification. The miser is the boy who prefers to miss the circus rather than to give up the ticket. 17. Credit. There is still a third stage of economic evolution beyond the stages of barter and money. This we call the credit stage. Just as exchanges were limited and clumsy in the barter stage, necessitating the inven- tion of money before men could specialize in production to any great extent, so the time arrived, in the Middle Ages perhaps (although the use of credit was not un- known in the ancient world) , when money, even the most refined forms and systems of money, became too cum- bersome. In this last stage exchanges can be made without the use of money at all. A man may be able to buy and sell without possessing any money, or even any property. The consideration he gives may be merely a promise to pay money or its equivalent value at a future time. In this last stage exchange frees itself entirely from former limitations and under specialization of industry can ex- tend until scarcely any man produces the thing he him- self consumes. Everything is produced for the market, and the market does not fail so long as the machin- ery of credit is working smoothly. Unfortunately, credit is like fire, and its use is attended with risk, but nobody would think of foregoing the use of fire be- EXCHANGE 15 cause Houses sometimes burn down, nor would anybody advocate the abolition of credit because sometimes its abuse brings on commercial disasters and panics. Throughout this book the word "credit" will be used in a strictly technical sense, that is to say, with the fol- lowing meaning: Credit is a postponed payment of money. The word is employed in ordinary usage to mean the ability to borrow. Thus, a person has good credit when his reputation for financial integ- rity makes it easy for him to borrow the funds or prop- erty of others. Much of the difficulty and confusion in- herent in the discussions of credit grow out of this vague usage of the word. If it is kept in mind that a credit is a perfectly definite tiling, i. e., a postponed payment of money, clear thinking will be possible. Our definition implies an incomplete exchange. One side of the exchange has been completed, but so far no equivalent has been rendered. The payment has been postponed. It is convenient, however, to regard the credit as itself an equivalent and a thing having value. If a merchant sells a bill of goods to a customer and agrees to postpone the payment for three months, he has received for the goods a promise, which is valued by him as the full equivalent of the goods. If this prom- ise is put in the form of a promissory note (which is simply a documentary evidence of the promise) this promissory note is a concrete object of value and can be itself exchanged for other things of value. 18. Credits as media of exchange. The fact that a promise to pay money is a valuable thing in itself sug- gests immediately the possibility of using such promises as a medium of exchange if they can be put into such form that the ownership in them or the title to them can be transferred from hand to hand. Just as the 16 MONEY AND BANKING value of money is an artificial quality, created by its ready exchangeability, so credit may come to have a value for the same reason. People accept money read- ily in exchange for anything else because they know that it gives them command over any piece of property that is for sale. In other words, because it is converti- ble into property practically at all times, in all places and under all circumstances. Likewise, credit has value as a medium of exchange only to the extent to which it is convertible into money or directly into property. Con- vertibility is therefore the very essence of the value of money and credit. Money we saw was simply an indirect barter, the op- eration being lengthened by the use of an intermediate thing called money. With the use of credit the opera- tion is still further lengthened, and the steps in the com- plete transaction may run as follows : Goods are traded for credit; credit is traded for money; money is ex- changed for goods. Suppose a merchant buys a bill of dry-goods from a wholesale establishment and gives his three-months note therefor. The wholesale house may take this note to the bank for discount, receiving a credit on its deposit ac- count. When the note is due the bank may receive a check from the retail merchant who made it. This check may be cashed at another bank and may be paid out again to a manufacturer, who has received a check from the wholesaler drawn against his deposit at the bank. The manufacturer may use this cash to buy cotton from the customer of the merchant who consumes the dry-goods first bought. Reduced to its simplest terms, the cotton grower has bartered his cotton for cloth, but the transaction has involved a very compli- cated series of exchanges in order to accomplish it. EXCHANGE 17 This complexity introduced by the use of money and credit would seem to increase the difficulty of exchang- ing goods for goods, but in reality it facilitates the proc- ess immensely. While seemingly the most expensive mode of making exchanges, in reality it is the most eco- nomical. The profits and salaries paid to the merchants and bankers are added to the cost of the finished cloth, and the planter must give so much more raw cotton for it, but if these middle men did not exist it is likely that the planter would have to manufacture the cotton and the cloth himself at a hundred times the real final cost. This is a case where the most indirect route is in reality the shortest and cheapest. 19. Money and credit representatives of wealth. Money and credit are representatives of wealth rather than real wealth. This statement seems to involve a paradox because of the habit which has been acquired of regarding as wealthy a person who has control over a large sum of money or credit. The popular concep- tion of a wealthy man is very likely to approximate the cartoonist's idea of a rotund individual wearing a silk hat and a costume with a dollar-mark pattern and sur- rounded by bags of specie. The wealthy person in reality is one who has control over a large amount of goods or real wealth. How- ever, in estimating wealth we find it convenient to reduce it to a sum of dollars' worth rather than to enu- merate all the items of goods contained in it. A mil- lionaire is not a person who owns a million dollars in money, but whose property rights are estimated in terms of dollars. The millionaire may rarely have in his per- sonal possession more than a thousand dollars in money, but because his property rights are more or less con- vertible into money we fall into the error of carelessly VII 9 18 MONEY AND BANKING considering him as possessed of a million dollars. Un- less we think clearly on this point and rid ourselves of this error, we are likely to find ourselves blocked in dealing with problems in money and banking. The value of money, except in the case of metal coins, which have a commodity utility, is dependent upon its convertibility from property into goods. If everybody attempted to convert the money and credit in the world into goods simultaneously, money and credit would lose its value entirely. It is only because there is a real need for this particular kind of utility in making exchanges that the value of money and credit is maintained. The value of money and credit, then, is dependent entirely upon a habit which people have of accepting them in exchange. When there is any reason to doubt that money and credit will be accepted, we find its value shrinking away and are confronted with the phenom- enon of a depreciated currency. 20. Classification of wealth. There are two kinds of economic goods: "Consumption goods," which have direct utility and satisfy a human want, and "production goods," which have indirect utility and assist in pro- ducing consumption goods. The value of production goods is entirely dependent upon the consumption goods which they help to produce, just as the value of labor is derived from its product. If production goods or labor is so limited that it can produce only goods which have no market value, they are themselves valueless. Work- men may be ever so skilled in certain lines of work, but if the product is unmarketable they will look in vain for employment. The machine may have cost $10,000, but nevertheless may be thrown upon the scrap heap to-mor- row if the product ceases to be purchased by consumers, EXCHANGE 19 or if another machine is invented for doing the work more cheaply. 21. Entrepreneur system. Production requires the employment together of land, labor and capital goods. Under the cooperative system the owners of the capital goods and of the land unite with the laborers in the production of a certain commodity and divide among themselves the product or the proceeds of its sale on the market. This system of industry has been found less satisfactory as a rule than the entrepreneur system, so called, by which one man, the entrepreneur, under- takes the responsibility for the industry. He contracts at a fixed rate of compensation for the use of capital and land, and hires his labor at fixed wages. He en- deavors to realize from the enterprise a larger net sum than the payments he must make to the workingmen, the capitalists and the landlords. The difference he keeps for himself as his profit. If there is a deficit he suffers the loss. As a rule the entrepreneur, before he can make contracts, must have a certain amount of cap- ital of his own as a margin against loss. Otherwise, the capitalists, workingmen and landlords must have an ex- tra remuneration for the risk they take. In dealing with a capitalist the entrepreneur does not borrow ma- chines or other forms of capital goods, but he borrows a certain sum of money or purchasing power which he can convert at will into production goods. The cap- italist has funds or purchasing power to loan to the entrepreneur. This purchasing power represents a claim on goods in general which are for sale on the market. When the entrepreneur borrows these funds he immediately uses them to claim whatever he needs in his business. It was not the money he wanted, but 20 MONEY AND BANKING the buildings, the machinery, raw materials, etc. Money is not necessary in production ; it is simply the most con- venient way of getting control of the things needed. 22. Capital. The conception of capital is one of the most difficult and confusing in the whole science of economics. Just as in the case of wealth, most people's idea of capital is a sum of money. Until recently most economic writers used the word "capital" to include not only money, but everything we have called production goods. The fundamental idea in the word "capital," if it be analyzed closely, seems to be this: a source of in- come. The Eskimo would call his canoe a part of his capital because he could attribute to its use in fishing a certain proportion of the day's catch. This propor- tion might be measured by the amount of fish he could have obtained without the use of the canoe. If he could catch five fish without the canoe and ten fish with it, the canoe might be regarded as the source of the income of five fish. Capital, therefore, has economic impor- tance only as a source of income, and its value is en- tirely proportionate to that income. When men reached the stage of calculating income in dollars' worth instead of in specific commodities, then capital, the source of the income in dollars' worth, be- gan to be regarded as a sum of value rather than as a machine or building, etc. Therefore, we might say that capital is an abstract concept of the value or dollars' worth appertaining to the source of an income, whether such source is tangible or intangible. The merchant regards as his capital his stock of goods, his store building, and fixtures, because they are the source of his money income. If he were asked to make a statement as to his capital, he would sum up the values of his business in terms of dollars. EXCHANGE 21 23. Capitalization. The word "capitalization" pre- sents a difficult conception unless we hold in mind the root meaning of the word "capital": Capitalization represents the relation between income and capital, which may be made clear by an illustration. Suppose a manufacturer has a plant which yields him a net in- come beside his own salary and a reasonable profit for undertaking the business of say $10,000. Suppose this $10,000 is the average for a number of years, which can be made a safe basis for future calculation. If this manufacturer were asked to fix a price on his establish- ment, how would he go about it? Perhaps the whole plant, machinery, building, etc., did not cost more than $10,000 originally, but that its high earning power is due to the possession of a patent on certain of the ma- chinery. Obviously he would not be willing to sell the business for $10,000, or even $20,000. What he is really selling is the right to an income of $10,000 per year. The price which he would demand for his busi- ness would not be much less than he would have to pay to obtain the $10,000 income from another source. If the only income he could buy with the proceeds of the sale of his business were bonds yielding 5 per cent per annum, he must needs receive at least $200,000 in order not to be a loser in the transaction. He could not de- mand more than $200,000 because no purchaser would be willing to buy a $10,000 income at a price which would purchase a $11,000 or $12,000 income in the se- curity market. If the owner of the plant thought of incorporating a company and issuing shares of stock, he would be con- fronted by the same problem of placing a valuation on the business in order to properly capitalize the corpora- tion. In this case if the income were practically fixed at $10,000 and there was a wide market for the shares, it is likely that at a capitalization of $200,000 the shares would sell at somewhere near par. That is to say, the total sum of their market value would be about $200,- 000. Capitalization, therefore, is the process of placing a valuation upon the source of an income. If a corpora- tion is overcapitalized, the valuation which has been placed upon its assets or the source of its earning power has been too high ; in such cases the shares sell below par. This may happen not only because the net earnings are too small as compared with the capitalization, but because of the uncertain future, or because the de- mand for them is very limited. Corporations which have been overcapitalized at the beginning may find that the overcapitalization has disappeared in the course of time because the earnings have increased in amount and stability. In the language of finance, "the water has been squeezed out of the stock." This subject of capital and capitalization belongs to the broader science of finance, but so intimate is the relation between capital and currency that it is best to get a clear idea of capital at the outset. Capital in its various forms like consumption goods must change hands in order to realize the greatest economies in pro- duction and the most efficient use of all forms of pro- duction goods. To be most effectively utilized, the land, machinery, buildings, materials, etc., must find their way into control of those entrepreneurs who can most efficiently organize and manage them. This very intricate process gives to finance its mysterious and difficult character, so that many students are frightened away at the outset. The movement of cap- ital is so intimately related to money and banking that EXCHANGE 23 one cannot be understood without mastering the other. 24. Demand for capital goods. Capital goods are produced by industry for the market, just as are con- sumption goods. They are produced either to fill a demand already existing, as when the manufacturers work on contracts, or they are made in anticipation of a market when they are ready for sale. The demand for capital goods comes from entrepreneurs who wish to use them in industry for the production of more goods. Before the entrepreneur can take capital goods off the market or give orders for their manufacture, he must have purchasing power. This purchasing power he may acquire in a variety of ways. First, he may pos- sess the purchasing power or capital as his own prop- erty; second, he may be entrusted with the purchasing power or capital of other men on various terms, either for a fixed compensation per annum or for a definite share in the profits of the business. This purchasing power exists in the form of money or credit ; in most cases it is bank credit in the form of a deposit, against which checks can be drawn to make payments. It has its origin in income which has not been spent for consumption goods but which has been saved. Incomes are derived originally solely from pro- duction. Those who gain a personal income without producing or assisting in the productive process appro- priate the incomes of others ; but originally every income was the product of someone's productive industry. 25. Money incomes. Under modern conditions very few of the producers take a share of the product as their income. They prefer to convert the product into purchasing power, that is, money or credit, and dis- tribute the proceeds as money income. This money in- come, however, is simply representative of the products, 24 MONEY AND BANKING and is convertible into any goods for sale on the mar- ket. Therefore, if these income-receivers prefer to save this purchasing power rather than assert their claim to a certain amount of consumption goods, they enlarge the fund of capital. iThe motive for this abstinence from consumption is normally not for the purpose of abstaining from spend- ing indefinitely, but for the purpose of spending di- rectly or indirectly for production goods in the hope of receiving an income. This conversion of purchasing power into production goods rather than consumption goods is real investment. If it were not for this saving and investment there would be no demand for capital goods and none would be produced. Saved income, therefore, represents a claim to a certain quantity of production goods which have been made and are await- ing a market somewhere in the world. The prospec- tive investor is the man who determines how much and what kind of production goods shall be taken off the market, thus leaving a vacuum to be filled by subsequent production. 26. Methods of investment. A very small propor- tion of the savers or of the original creators of capital are capable of investing it themselves. The merchant may use a part of his income to increase his stock, or the farmer to buy new implements, fences, etc., but probably the greater part of all saved capital is turned over to other entrepreneurs for investment. There are a number of methods by which the capital is transferred from the saver to the control of the entrepreneur who gives the orders for production goods. First, the saver may deposit his savings in a savings bank, thus making the bank his agent for the investment of the sum. The savings bank will perhaps buy bonds of a railroad, EXCHANGE 25 which thus obtains the capital and expends it in rails and equipment. Secondly, the saver may deposit his savings in a commercial bank, in which case the capital finds its way into the hands of commercial borrowers of the bank and is used as working capital to buy raw ma- terials, to pay wages and to carry customers' accounts for short periods. Thirdly, the saver may himself buy stocks and bonds from a bond house or a trust company, and thus make these institutions his agent for invest- ment. Fourthly, the saver may hoard actual cash, which simply means that investment is postponed for the time being. 27. Real investment. In the ordinary use of the term the purchase of stocks and bonds in the market would be called investment, but it is not, however, true investment. In this case the saver has simply shifted to the seller of the bonds the responsibilty for the real investment of the capital, i. e., the responsibility for converting it into production goods. It is only when the capital is in the hands of the entrepreneur that an investment can take place. Entrepreneurs are con- stantly bidding for the use and control of this new capital which is as constantly accumulating. The en- trepreneur who can offer the best rate of interest or the highest dividends with the best security has the ad- vantage in this competitive bidding. Under our modern conditions of industry the large corporations are likely to be able to use this capital to the best advantage, and hence are in a position to make the most attractive offers to savers. Therefore, we find an ever increasing percentage of the savings of the community flowing in that direction. This is to the public advantage, in so far as the corporation is able to utilize the production goods to which the capital gives 26 MONEY AND BANKING them claim, and the final result is an increased amount of product. For this reason, any system which facili- tates the flow of capital from the savers into the hands of the most efficient entrepreneurs is a distinct economic gain. All the highly specialized financial institutions perform this economic service, and their productivity, indirect though it be, is to be measured by the increased efficiency of the capital which they have diverted into the most productive field. The stock exchanges, the financial and commercial banks, trust companies, under- writing syndicates and all the machinery of high finance are economically beneficial to the country in the degree that they perform this function. Furthermore, this high development and delicate ad- justment of financial institutions is only possible when the currency of the country is of the soundest and most scientific character. Every defect in the currency sys- tem makes it more difficult or hazardous for such insti- tutions to do business and is a handicap, the effect of which can be measured by the diminished efficiency of all the industries of the country. The man who says that currency and banking questions are no concern of his would probably be surprised to learn that his wages are smaller or the prices of the goods he buys are higher on account of some weakness or defect in the system which the currency reformers are striving to mend, yet such is the case. Causes which are the most potent in producing effects are frequently the most obscure and unappreciated. CHAPTER III VALUE 28. Value a register of economic forces. Since in our modern civilization every man satisfies his wants through exchange of what he produces or helps to pro- duce, for what he consumes, every man is perforce a dealer in values. Specific commodities are reduced to terms of abstract value, and are dealt in as such. The workman sells his labor, say, at $100 a month, and re- ceives an income of $100 worth of goods and services of his own choosing from the market. His economic welfare is entirely a matter of the relation between the effort required to earn the wage, and the amount of utilities which can be obtained with that wage. Either a fall in the rate of wages or an increase in the prices of goods has the same effect in altering the relation to the disadvantage of the wage earner. Economic changes therefore always appear as changes in values. Value is simply a register or index of economic forces. The reward of the entrepreneur for his productive efforts comes in the shape of profits. Profit is simply the difference between the cost of the product and the selling price. Any change of values which alters the cost or the selling prices has its effect on profits, either diminishing or increasing them. We may call profits the mainspring of industry, because they are the mo- tive which induces the entrepreneur to organize industry by borrowing capital, employing labor and renting land. When the expectation of profits is small, the entrepre- 27 28 MONEY AND BANKING neur has little inducement to encourage any new enter- prises or to extend the old. From such circumstances dull times are likely to ensue, low rates of interest and smaller wages, or nonemployment of workingmen. On the contrary, when the expectation of profits is good there is likely to be a season of great prosperity, with every resource utilized to the utmost, and labor in great demand at the highest wages. Alternate periods of de- pression and prosperity are therefore the effects of cer- tain conditions of value. The fact that currency and banking have a most intimate relation to values, and therefore to profits, gives to the study of these subjects a high practical utility. The man who understands the effect of currency and banking conditions on values is in a position to fore- tell with scientific accuracy the future course of prices, and hence may prepare himself for changes in general business conditions. 29. Meaning of "value" A distinction must be made between the terms "value" and "price." The value of an article is its exchange relation to all other articles. The value of this book, for example, can be determined only by comparison with something else hav- ing value, as for instance a bushel of wheat. The value of the book might be expressed by saying that it is worth five bushels of wheat. This would be entirely satisfactory to anybody who had a definite idea of the worth of five bushels of wheat, but to another person it might mean nothing whatever. In order to make com- parisons which will be readily understood by everybody, it is necessary to have a common measure or denomina- tor of value, just as it is necessary to have an arbitrary unit of weight or length. In the Bureau of Weights and Standards at Washington are kept certain yard- VALUE 29 sticks, weights and vessels which are the standard units of length, weight and capacity. 30. Definition of the dollar. Just as Congress has declared that a certain length shall be a yard, so it has also declared that the unit of value shall be a dollar, of 23.22 grains of pure gold. The only definition for a dollar is that it is 23.22 grains of gold. All other dol- lars are so called because they are convertible into the standard gold dollar. In this convertibility lies their value. They are not standard dollars, but representa- tive dollars. Price is simply value expressed in terms of dollars. If I say this book is worth $5, 1 mean that it is exchangeable for five times 23.22 grains of gold, or its equivalent. If we speak of a person as being worth $50,000, therefore, we mean that he has a legal title to property consisting of various forms of wealth having a total exchange value of fifty thousand times the ex- change value of our unit of gold, or its equivalent. In order to realize this exchangeability, however, it is first necessary to convert the wealth into money, which is ordinarily very difficult to do at the market price, and then convert the money into goods desired, which is very easy to do. 31. Exchangeability the sole utility of money. The desirability of money as a form of property is due solely to its ready exchangeability; for any other purpose it is inferior, producing no income, as do factories, stocks, bonds, etc., and requiring extra precautions against theft. Its loanability is simply another form of its exchangeability. The borrower purchases the in- come-yielding wealth and promises to divide the income with the lender. 32. Gold not an ideal standard. Gold is very far 30 MONEY AND BANKING from being an ideal standard of value. Suppose the yard-stick had the objectionable habit of shrinking and expanding, being thirty inches one year and forty inches the next. The merchant contracting to take one thou- sand yards of cloth a year hence would run the risk of losing on the deal merely on the fluctuations of the yard-stick. The dollar is just such a measure. Its value is changing constantly. This fact is concealed from the ordinary observer, who attributes all fluctua- tions in prices to commodities rather than to the dollar itself. Value is a ratio between 23.22 grains of gold in a dollar and the value of the thing to be measured. The ratio can be altered by the changes in the value of gold as well as by changes in the value of goods. If wheat falls to 50 cents per bushel it may be because of an alteration in the relation of demand to supply in refer- ence to wheat, or it may be because of a change in the value of money. If the price of wheat alone has changed, while the prices of all other commodities re- main stable, the conclusion must be that the changes were due to causes affecting wheat alone. However, if all prices have shown a tendency to move in the same direction, especially when it is reasonably certain that there have been no changes affecting the relation of sup- ply and demand of these goods, the explanation of the fall in prices must be sought in money itself. The Free Silver Party was right in 1896 when it at- tributed the general fall of prices to an increase in the value of gold, the sole standard of value. Their remedy, bimetallism, or a double standard of both gold and silver, would have raised prices, but it would have caused such a disturbance of prices and credit, both VALUE 31 temporarily and permanently, that many think the cure would have been ten times worse than the disease. A discussion of this principle, however, belongs to a later chapter on the Standard of Deferred Payments. The idea that the value of the dollar is a constantly fluctuating thing is so novel to most people that it is worth while making it very clear. In order to do so it is perhaps advisable first to consider the general prin- ciples which govern the value of anything, whether it be commodities or money. 33. Determination of value. How are values de- termined and what forces govern the fluctuations thereof? The statement of the older economists is: Value is determined by Cost of Production. A thing is worth what it costs to produce. The insufficiency of this explanation is apparent when we consider the great num- ber of things whose value is widely different from or has no connection with its cost of production; land, for ex- ample, which has no cost of production, or buildings of unsuccessful enterprises which may sell for one-tenth of their cost. 34. Utility theory of value. A modern theory holds that value is determined by "utility." Usefulness or desirability rather than cost is the quality which gives a thing power to exchange for other things. Useful- ness, however, is a matter of personal estimate and va- ries infinitely with different individuals. Since "value" is expressed by the market price, and there can be but one market price for the same thing in one community under the same circumstances, the utility theorists were forced to find a utility which was usefulness to the whole community or a sort of average utility. This they named "marginal utility," and gave the world an ex- 32 MONEY AND BANKING pression which has been found extremely useful. The term is coming into common use and is therefore worth understanding. 35. Marginal utility. In a small city there might be one person who would be willing and able to give any amount up to $10,000 to possess a machine; there might be another whose limit is $9,500; and another at $9,000 and so on. As we go down, the number of possible purchasers increases so that there might be several hundred at a price between $500 and $1,000. This potential demand for automobiles might be repre- sented by the following diagram: 8,000 fi nnn A B C 4,000 3 000 D E F G 1,000 H The height of the columns represents the money equivalent of the demand for automobiles, and the breadth of the columns represents the number of auto- mobiles which would be bought at the different prices. Suppose under these conditions three cars were brought to that city for sale. The man A would pay $10,000 for one if he had to, but he knows there are three to be sold, so he refuses to pay as much as he would if there were only one for sale. To dispose of the three auto- mobiles, the dealer must not demand more than $9,000 ; at that price A, B, and C will supply themselves and thus establish the market price in that city. The auto- mobiles may not have cost more than $1,000 to produce, but that fact would have no weight in fixing the price. The price is determined by the "marginal utility," that is, by the utility of the automobile purchased by C, who VALUE 33 is called the marginal purchaser. Margin means "edge" and C is the purchaser who is on the edge of the market. If there had been only two automobiles, he would not have been supplied; if there had been four instead of three for sale, the price would have had to be reduced to $8,500 and then D would have been the purchaser on the margin. This example is of course highly the- oretical and would probably never happen in this way in real life, yet the principle is true and works out with greater precision, as there are a greater number of buyers and sellers, and as the knowledge of each others' real desires increases. 36. Marginal utility to the individual. In the illus- tration we have assumed that each buyer desires but one unit of the article for sale. With many classes of goods, each buyer may desire more than one unit, cigars for instance. Some wealthy men might give a dollar if they had to for one cigar a day but they would not give so much for a second. From this fact we derive the "law of satiety," that every unit of a com- modity consumed yields successively less satisfaction and has less utility to the consumer than its predeces- sor. The demand of any one consumer for units of a given commodity within a given period may be repre- sented by the following diagram: SLOO- PS .50 .25 .00 1, 2, 3, 4, 5, 6th cigar. To make a chart showing the demand for cigars, it would be necessary to combine the charts representing the demand of each consumer. Suppose for the sake of simple illustration there were one hundred consumers VII 3 MONEY AND BANKING of cigars in the market, each with a potential demand represented by the foregoing diagram, a chart showing the general demand would be thus : $1.00 .75 .25 .00 1st, 2nd, 3rd, 4th, 5th, 6th one-hundred. Suppose the makers of this particular quality of cigar could make a fair profit by selling them at 25 cents. They would produce five hundred because they could find purchasers for that quality at 25 cents each. They could not get more because there can be but one price in the market, and the buyers assuming that they understand the situation, will pay no more than neces- sary. If the manufacturers make more then five hun- dred cigars and attempt to sell say five hundred and fifty, they would force the price below 25 cents and de- stroy their profit. 37. Reconciliation of the two theories. It is easy to understand now why the value of anything that can be easily produced coincides with the cost of production. If the value is much above the cost there will be an ab- normal profit in it, producers will be attracted to the business, the supply will be increased, and the price brought down by the competition of the sellers until it coincides with the cost. Conversely, if the value is below cost, the supply will be reduced on account of producers leaving the business and the price will rise to the cost. If the supply of the thing is fixed, the market price and cost of production may have no relation to each other. CHAPTER EVOLUTION OF THE MEDIUM OF EXCHANGE 38. Primitive ideas of value. In the preceding chapter we have described how the necessity for the ex- change of goods was first felt. Long before the rights of private property were recognized within the tribe, there was exchanging of articles, usually luxuries, or ornaments or goods of an ornamental character between the tribes ; first in the nature of gifts, later growing into the regular systematic exchange. This trade was direct barter, no medium of exchange being used. Later when private property rights became more definitely recognized within the tribe, intra-tribal ex- change sprang up. The first articles of this traffic were the imported goods, to which a more definite value was ascribed, influenced by the limitations in the supply. It was most natural that these articles with their defi- nite value should become the measure of the exchange value for the goods domestically exchanged, and thus we have the beginnings of the idea of a standard of value, still very crude and ill-defined but serving the pur- pose. Furthermore these imported goods were as a rule highly desired by everyone, and were, therefore, much easier to dispose of in exchange for other things than domestic commodities. This gave to them an additional utility quite aside from their usefulness or their ability to satisfy the wants of their possessors. We call this utility, "exchange utility." 35 36 MONEY AND BANKING 39. Ornamental stones early used as money. Articles first used as money in any definite way of which we have knowledge were ornamental stones. An ex- travagant love for ornament is one of the most universal characteristics of savages. They are likely to estimate ornaments at a much higher value than the more neces- sary commodities. The utility of these ornamental stones or shells was so constant and universal that the demand for them was likely to be highly stable. The savage was quick to realize that if he could possess himself of a supply of these articles he had at his com- mand the power to get anything else of which he might be in need. Hence these stones took on an additional function of a store of value, easily exchangeable for other values. 40. Three functions of primitive money. Thus in the earliest form of money we have the three functions well developed, the function of Exchangeability, of a Measure of Value, and of a Store of Value. In all the more primitive nations this function of store of value was more important than in modern times. Jewish women of the Old Testament carried about their per- son their doweries in the form of ornaments and jewels. The East Indians of to-day convert their surplus wealth into silver and carry it about with them, not so much from an extravagant love of ornament as from the more practical motive of having always at hand the means of obtaining the necessary articles of livelihood. As we shall see later this custom is a very formidable obstacle in the path of economic development. 41. Wampum. The American Indians were in this stage of cultural development when the American set- tlers first came in contact with them. They had elimi- nated all forms of ornamental money except wampum, EVOLUTION OF THE MEDIUM OF EXCHANGE 37 which consisted of strings of beads cut from shells. These beads were of two colors, white and black, the black being worth double the white. In trade with the Indians the settlers found it convenient to use wampum, and it therefore acquired a very definite value in the colonies. The colonies lacking a supply of gold and silver coins were compelled to make payments among themselves in wampum, and it was at one time receiv- able as legal tender for payment of debts to the amount of ten pounds sterling, or about $50. The disad- vantages of this form of money were manifest when some clever but more unscrupulous Europeans invented a method of dyeing the white beads black and doubling their value by the operation. So difficult was it to de- tect this primitive counterfeiting that wampum soon came into discredit, and at length was discarded. 42. Beaver skins. The next form of medium of ex- change to be adopted for trading with the Indians had the merit of being impossible to counterfeit. The steady demand for beaver skins for manufacturing into hats in England gave them a very stable value among the col- onists, and they early acquired the quality of exchange- ability in addition to their ordinary utility. When a tribe passed from the hunting to the pastoral stage of cultural development, it was natural that they should adopt a commodity for money which existed in greater and more constant supply than the products of the chase. Thus we find among the ancient Hebrews and Arabs that cattle were used for the purpose. However, it is doubtful whether they attained any great circulation as a medium of exchange; it is more likely that they per- formed the function of a measure of value. In the book of Genesis we constantly read statements of the wealth of individuals as measured in the size of their 38 MONEY AND BANKING flocks and herds. The great disadvantage of the use of live stock as money arose from the considerable value in each indivisible unit and its perishability. 43. Agricultural products as money. In the next stage of cultural progress, namely the agricultural, we find the products of the earth used as money. Grain, tobacco and rice formed the currencies of agricultural people. The disadvantage encountered in this variety of money was the uncertainty of the supply. In years of good crops, the value of the commodity would fall very low and vice versa in periods of scarcity. This instability of value was a great disadvantage in these currencies. Furthermore the fact of their rapid de- terioration when stored was also against them. One of the most instructive experiments in currency was that of the early American colonists who in default of an inadequate supply of metallic money to which they were accustomed in England, were forced to make use of forms of currency belonging to much more primitive peoples. We have already spoken of wampum and beaver skins. The early settlers in Massachusetts and Virginia were in need of almost every kind of manufac- tured articles, and they were forced to import such merchandise from England. Unable to afford metal- lic money, they were compelled to pay for their imports with commodities salable in the European markets. For the Northern colonists, beaver skins furnished such a commodity, and since everybody wanted the English goods, the beaver skin was highly desired on account of its purchasing power. 44. Tobacco. In the Virginia colonies, tobacco was the commodity most available for export to England. It is but natural that it should come to have an artificial value as a medium of exchange. The history of the EVOLUTION OF THE MEDIUM OF EXCHANGE 39 tobacco currency in Virginia reveals a great many of the principles underlying the science of money. The story is very well told by Mr. Horace White in his book, "Money and Banking" : In 1642 an act was passed forbidding the making of contracts payable in money, thus virtually making tobacco the sole cur- rency. The Act of 1642 was repealed in 1656, but nearly all the trad- ing in the province continued to be done with tobacco as the medium of exchange. In 1628 the price of tobacco in silver had been 3s. 6d. per pound in Virginia. The cultivation increased so rapidly that in 1631 the price had fallen to 6d. In order to raise the price, steps were taken to restrict the amount grown and to improve the quality. The right to cultivate tobacco was restricted to 1500 plants per poll. Carpenters and other mechanics were not allowed to plant tobacco "or do any other work in the ground." These measures were ineffective. The price continued to fall. In 1639 it was only 3d. It was now enacted that half of the good and all of the bad should be destroyed, and that there- after all creditors should accept 40 Ib. for 100; that the crop of 1640 should not be sold for less than 12d., nor that in 1641 for less than 2s. per pound, under penalty of forfeiture of the whole crop. This law was ineffectual, as the previous ones had been, but it caused much injustice between debtors and creditors by impairing the obligation of existing contracts. In 1645 to- bacco was worth only l^d. and in 1655 only Id. per pound. These events teach us that a commodity which is liable to great and sudden changes of supply is not a desirable one to be used as money. In the year 1666 a treaty was negotiated and ratified between the colonies of Maryland, Virginia, and Carolina, to stop plant- ing tobacco for one year in order to raise the price. This tem- porary suspension of planting made necessary some other mode of paying debts. It was accordingly enacted that both public 40 MONEY AND BANKING dues and private debts falling due "in the vacant year from planting" might be paid in country produce at specified rates. In 1683 an extraordinary series of occurrences grew out of the low price of tobacco. Many people signed petitions for a cessation of planting for one year for the purpose of increasing the price. As the request was not granted, they banded them- selves together and went through the country destroying tobacco plants wherever found. The evil reached such proportions that in April, 1684, the Assembly passed a law declaring that these malefactors had passed beyond the bounds of riot, and that their aim was the subversion of the government. It was enacted that if any persons, to the number of eight or more, should go about destroying tobacco plants, they should be adjudged traitors and suffer death. In 1727 tobacco notes were legalized. These were in the na- ture of certificates of deposit in government warehouses issued by official inspectors. They were declared by law current and payable for all tobacco debts within the warehouse district where they were issued. They supply an early example of the dis- tinction between money on the one hand, and government notes, or bank notes, on the other. The tobacco in the warehouses was the real medium of exchange. The tobacco notes were orders payable to bearer for the delivery of this money. They were redeemable in tobacco of a particular grade, but not in any specified lots. Counterfeiting the notes was made a felony. In 1734 another variety of currency, called "crop notes," was intro- duced. These were issued for particular casks of tobacco, each cask being branded and the marks specified on the notes. 45. Summary of principles. The experience of the world with these various commodities as currency has brought out some fundamental principles, which we have mentioned but which it would be well to summarize, as constant use must be made of them in stating the more complex phases of the subject. One of the most essential requirements for money as a medium of ex- EVOLUTION OF THE MEDIUM OF EXCHANGE 41 change is general acceptability. It is this quality which distinguishes the money commodity from all others. As a rule a commodity becomes more acceptable in exchange, the less its other utilities are considered, and the wider its use as a medium of exchange. This qual- ity of acceptability depends either upon a well-estab- lished tradition or upon an ultimate market where it is esteemed for its want-satisfying power. Ornaments possessed this quality to a high degree because this hu- man desire was almost universal among primitive peo- ples. In the case of beaver skins and wampum, the insatiable demand maintained their acceptability of ex- change. 46. Divisibility. It is highly desirable that the money commodity should be capable of division into small units in order to serve as a medium in small trans- actions. This quality of divisibility was absent in beaver skins and cattle. Commodities which contain small value in large bulk, which with the amount of them necessary to make even a very ordinary transaction rep- resents so great a volume as to be difficult of transporta- tion, are unsuited for the purpose of money. When the value of tobacco fell, the difficulty of transporting it added to its other disadvantages as money. The Chi- nese bronze coins of the present day, called "cash," oc- casion great inconvenience to travelers who must carry a moderate sum with them. Their bulk is so great that separate conveyances must be used, and it is only a ques- tion of time when they will be eliminated on account of their cumbersomeness. 47. Uniformity. Uniformity is another highly nec- essary quality in money. When the estimates of value were only approximate it was not so necessary that the units of the currency should be uniform, but when the 42 MONEY AND BANKING exchanging became more general, the lack of uniform- ity in the units became a serious obstacle to their gen- eral acceptability. The lack of this very necessary qual- ity made their values very indeterminate and uncertain. Beaver skins were unsuited for the purpose largely on this account. Tobacco was less so. 48. Cognizability. Closely connected with the qual- ity of uniformity is that of cognizability, that is, the possession of certain qualities which are distinctive and easily recognized, either on account of color, texture or weight. Wampum which possesses so many of the other qualities desirable in money failed in this important par- ticular; they could be easily counterfeited. Lack of this quality of cognizability can be overcome by the use of some mark which is either difficult to counterfeit or which can be protected by severe penalties. The old laws which made counterfeiting a capital crime, pun- ishable by death, were justified when the necessity for maintaining the quality of cognizability in the currency is appreciated. Most of the early currencies were un- fitted for that use because of their liability to deteriora- tion. A commodity which has this defect is unsuited as a store of value, and the moment the deterioration be- gins to take place, it loses the quality of acceptability. 49. Stability of value. Most of these defects in money have been eliminated by the use of metallic coins, and later by the use of credit. There is one quality, however, which metallic currencies fail to possess, that is, stability of value. The whole question of the stand- ards and the whole controversy over silver and gold arises out of this characteristic lack of stability of value, a principle which we shall discuss at length presently. The final result of this process of evolution in money, the gradual discredit of the unfit and the extension of the EVOLUTION OF THE MEDIUM OF EXCHANGE 43 use of commodities possessing more of these desirable qualities, was the universal use of the metals as money. Beginning with the commoner varieties of metals like bronze and iron in the form of the utensils which serve a useful purpose other than exchange, we may trace down the development to the coin which has no other purpose than to be used as a medium of exchange. Adam Smith speaks of a village in Scotland in his day where nails were used as money. The general use of bullets among the American pioneers in the chase and in warfare against the Indians made them good "change" in the early days of New England. In the histories of Greece, we read of the huge and heavy iron coins of Sparta, which survived beyond their time on ac- count of the hostility of the Spartans to trade. They seemed purposely to have retained a most unsuitable form of money for the purpose of hindering exchange. The developments of better methods in mining and smelting the commoner metals such as bronze, iron and tin made them unsuitable for the currencies in any form. Their defect was in their cumbersomeness and in the difficulty of carrying them about. The process of elimination began with the cheaper and the heavier met- als, until at last the sole survivors were silver and gold, except for the very smallest of coins. CHAPTER V EVOLUTION OF THE STANDARD OF VALUE 50. Metal standards the fittest to survive. The his- tory of money has illustrated very faithfully the law of evolution and the survival of the fittest. After all the commodities mentioned in the preceding chapter had been tried and found wanting, the world finally settled upon silver and gold as the most suitable materials for money. In the first place they have always had a great attraction in the eyes of mankind for use as ornament because of their natural beauty. Their scarcity and the difficulty with which they are produced gives them a certain stability of value, which was wanting in most of the earlier forms. Either of the metals in its pure state is homogeneous and practically of one quality, so that every single quantity, no matter whether it is mined in the Klondike or in South Africa, is almost the same as any other for all practical purposes. Unless the metal is mixed with alloys, there is no uncertainty as to its quality. 51. Good qualities. Both metals are fairly durable, although not so much so as iron. This defect is par- tially remedied by the mixing with gold or silver of some harder metal in manufacturing coins. Gold and silver may be divided into the smallest parts without sacri- ficing any of its value, thus fitting it for peculiar use in making transactions of varying magnitude. They have large value in small bulk, although the increasing cheapness of silver led to its partial discontinuance as a 44 EVOLUTION OF THE STANDARD OF VALUE 45 money metal within recent years. These metals are peculiarly adapted to the process of coinage, and capa- ble of being changed in form, size and shape without a specially difficult process of manufacturing. To avoid the division of silver and gold into quantities so small as to be impracticable in handling, the baser metals are generally used for coins of minor value where the defect of small value in large bulk does not apply. 52. Platinum unsuccessful as money. Of the more expensive metals platinum is the only one which has been tried as money. In 1828 the Russian Government, which owned the principal platinum mines, began to coin this metal into pieces of three, six and twelve ru- bles, a ruble being worth approximately 50 cents. Platinum has several qualities which fit it for use as money, particularly its durability and its great density, which makes it easily distinguishable on account of its weight. Furthermore it oxidizes very slowly. The ex- periment, however, revealed several fatal objections to its use as coin. There is no great amount of it in use in commerce, hence the value of it is likely to be very unstable. Because of its extremely high melting point, the cost of manufacturing the coins was very great, and it could not be easily converted from bullion to coin and from coin to bullion, a feature which renders gold and silver very suitable for money. These objections in- duced the Russian Government to abandon the experi- ment in 1845. 53. Objections to gold and silver. Gold and silver in bullion form are by no means the ideal money. They are difficult to identify at sight without the use of tests, which are too elaborate for ordinary use, so that it is easy to counterfeit them. They also are affected by wear and the question of loss of weight in handling has 46 MONEY AND BANKING at times been a serious one. In recent times especially, their lack of stability of value has created monetary problems of a serious nature, as for instance the Free Silver agitation during the last quarter of the past cen- tury. 54. Coinage. The first two defects named, i. e., the susceptibility to wear and counterfeiting, have been overcome to a certain extent by coinage. The first at- tempts at coinage were probably the simple stamping of a quantity of metal with a symbol or character, indicat- ing its weight in order to avoid a repeated weighing. To Pheidon, king of Argos, is generally attributed the first coinage of the modern form. He is reported to have stamped both copper and silver money in the Island of .ZEgina, in order to facilitate commerce; and having the word of authority from Mr. Grote we may rest as- sured as to the truth of the account. 55. Names of coins. The name of the English unit of money the pound sterling clearly indicates that it was originally a pound weight of silver, just as the old French coin, livre (the French word for pound) meant a similar weight of silver. The symbols stamped upon some of the earliest coins indicated that they were the equivalent of some earlier standard, as for instance the ox stamped upon the Grecian coins pointed back to the use of cattle as the standard of value. It was probably not long before this convenient method of stamping pieces of metal led to abuses. It is quite likely that the less scrupulous merchants placed the stamp upon smaller quantities of the metal or sub- tracted from the stamped pieces part of their substance. This practice soon made the stamp very unreliable. To circumvent this lucrative practice, the stamp upon the coin was elaborated to cover the whole face of the metal, EVOLUTION OF THE STANDARD OF VALUE 47 so as to make difficult the abstraction of any portion of it, and besides to inscribe on the coin the name of the person certifying the weight. To prevent the wearing away of the metal, it became customary to mix in the coin some harder metal, called alloy. Again this con- venient device was abused, and it was found profitable to introduce into the coin a greater amount of alloy than was customary. Thereupon it became necessary to in- dicate in some way the fineness of the metal. 56. Requirements of good coinage. At this stage of coinage three considerations had to be observed : It was necessary that the stamp upon the coin should certify that there was a certain amount of metal of a certain fineness in the coin, that none of the metal had been ab- stracted after the stamping of the piece, that the de- vice cover the whole face of the coin, that it was guaranteed by some reliable person, and that it should be difficult to counterfeit. The great advantage to com- merce in having good coinage led to the gradual restric- tion of the right to coin money to a few reliable persons, and finally to the sovereign himself. This restriction of coinage, however, did not elim- inate the abuses which we have mentioned, for the royal authorities for many centuries made large profits by debasing the coinage, both by reducing the size of the coins and by increasing the amount of the alloy in them. This fact can be easily demonstrated by reference to the coins of to-day. The English pound sterling, which originally represented a pound of silver, finally came to represent about half that amount. The people became so accustomed to receiving coins according to their face and without reference to their weight that the debased coin of similar weight had the same purchasing power as ever, The needy monarch could melt up the old coins 48 MONEY AND BANKING and recoin the metal into a considerably larger number of new pieces bearing the same name and thus increase the resources of his treasury at slight expense. This was equivalent to a tax upon the people, but it was so indirect that it passed without protest. Henry VIII of England distinguished himself by repeated in- dulgence in this profitable practice. Fraudulent abrasion and clipping of coins were a great nuisance in the seventeenth century. The silver coins circulating in the American colonies were chiefly Spanish dollars sometimes called "pieces-of-eight," be- ing of the value of eight reals and their fractions. They were brought in by trade with the West Indies. Some were coined in Spain and others in the Spanish- American colonies. At their best they were not uni- form in either weight or fineness, and they had been much tampered with by sweating and clipping. The heavier ones were constantly culled out to make remit- tances abroad, since they were received in England by weight only. Those which remained in the colonies grew lighter and lighter, until, in 1652, the pieces in circulation had lost about one-fourth of their original weight. 57. Standard of value. Up to this point we have studied the subject of metallic money from the stand- point of its function as a medium of exchange. The principal points involved have been the convenient size of the coin, its genuineness, accuracy, composition and weight. The question of the function of metallic money as a standard of value involves quite different principles. By a standard of value we mean the use of a metal as a measure for the values of all other commodities. The one essential quality which fits a metal to be used as a EVOLUTION OF THE STANDARD OF VALUE 49 standard is stability of value. Since value is the result of adjustment between supply and demand, it is obvious that our standard metal must not be subject to excessive fluctuations in either of these particulars. The prin- cipal monetary problems of the past century have arisen out of controversies regarding the standard. In ancient times both gold and silver were used as a standard, and no difficulty arose therefrom, principally because there were no great changes in the supply of these metals and because trade was so poorly developed that divergencies in values were not important enough to create serious inconveniences. It is only in communi- ties where industry and commerce are highly organized that small changes in the measure of value are notice- able. The case is similar to that of engineering; for example, in earlier times of cruder construction there was practically no need of very accurate measuring ap- paratus. Differences of a fraction of an inch or milli- meter could be disregarded. With improved technique and finer problems, it is necessary to have the utmost accuracy in measurement. The standard of value is a measuring apparatus for values, and it is only under highly developed commercial conditions that minute ac- curacy is essential. 58. Double standard possible until last century. During the Middle Ages, gold became so scarce that sil- ver was practically the only coinage, and so the Eu- ropean nations were on a silver standard. The fall in the value of silver about the fifteenth century and on created a demand for coins of greater value in small bulk, and as there was a greater production of gold at this time, the use of gold coins together with the silver became more common. It is impossible to understand the intricacies of the Vii-4 50 MONEY AND BANKING standard question until we know just how the values of the coins are determined. Both silver and gold are used to such an extent in the arts that their value is deter- mined in large measure by the demand for them there in relation to the supply. The mints are always obliged to draw their supply of bullion from the open market, and unless they offer the market price they are unable to obtain any. Suppose, for example, that the supply of silver grad- ually diminishes while the demand for it in the market is maintained. Naturally, the producers of silver will be able to obtain better terms for it than before. Jewelers and other persons wishing to use silver in their business will melt up silver coins instead of purchasing the bullion at the higher price in the coinage. Under these condi- tions, people would begin to discriminate between silver and gold coins, selling the silver coins to the jewelers at a slight premium which they would probably offer for them. The Government would be unable to get silver for coinage purposes unless they gave a much larger sum in gold for it, and if they simply gave back the silver in the form of coins, these coins would quickly retire from circulation. 59. Gresham's Law. This principle is called Gres- ham's Law, named from an official in the reign of Queen Elizabeth, who first observed this tendency of people to discriminate between two coins of the same nominal value. The simplest statement of this law is that the cheaper money tends to drive out the dearer, that is to say, when the people for any reason begin to discriminate between two coinages, they will invariably pay out the inferior and will hoard the better, thus re- moving it from circulation. The only remedy for this condition would be for EVOLUTION OF THE STANDARD OF VALUE 51 mints to constantly alter the amount of metal in the coins to correspond to their commodity value in the mar- ket. Gold and silver are so easily transported from one country to another that changes in their value at any particular place will quickly spread throughout the com- mercial world. For example, if a new silver mine is discovered in South America, the increased supply of silver at that place will lower its value; the producers will offer it on easier and easier terms in exchange for gold or anything else of value. Silver will again begin to be exported, for it commands a higher price abroad than it does at home, but the result of thus increasing the supply in other countries will lower its value there until a new equilibrium is established. It is of course impossible for the mints to continually alter the quantity of metal in the coins to correspond to their market values. Even if they did so, the old coins in circulation would have a value either greater or less than their face, which would cause one or the other of them to retire from circulation. 60. Mistakes of early legislators. This tendency of metals to fluctuate in value was not understood until re- cently, and the governments were constantly trying va- rious expedients to force the circulation, of both metals in the face of natural laws to the contrary. As is usual with legislators and officials who are dealing with a mat- ter which they do not understand, they sought to deal with the symptoms rather than the cause of the trouble. To this end they passed laws forbidding trade in the precious metals. They placed obstacles in the way of export and import. They made melting the coins a criminal offense. As is usual with unscientific laws of this character, they were impossible of execution, and were constantly evaded. 52 MONEY AND BANKING 61. Experience of England with double standard. The true solution of these difficulties was first reached in England. This country had had her share of the loss and vexation due to changes of the ratio. She had also visited cruel punishments on individuals for melting and exporting the precious metals. All attempts to en- force these foolish laws were eventually abandoned, and it came to pass in the reign of Charles II that the guinea of gold, although proclaimed by royal authority to be the equivalent of 20s. in silver, passed in trade for 21s., and no attempt was made by the government to inter- fere. The guinea remained as a trade coin till the third year of George I (1717), when another proclamation was issued making it legally equal to 21s., at which fig- ure the ratio to silver was about 15 1-5 to 1. As gold was slightly overrated at the ratio of 15 1-5, there was a tendency to export silver ; and for this pur- pose the full-weight coins were selected. So it came about in the course of half a century that the only silver coins remaining in circulation were those which had been much reduced in weight by abrasion or by fraudulent clipping. The evil became so intolerable that Parliament, in 1774, passed a law providing that silver coin should not be legal tender for more than 25 in one payment, except by weight at the rate of 5s. 2d. per ounce. It was enacted at the same time that gold coins deficient in weight should be called in and recoined, and that thereafter such coins, if under a certain weight, should not be legal tender at all. The restriction of the legal tender of silver was to continue two years. The expectation of Parliament was that some effectual and permanent steps would be taken to deal with the evil of light coins in that interval, but since nothing was done, the act of 1774 was renewed in 1776 for two years EVOLUTION OF THE STANDARD OF VALUE 53 more. In 1778 it was renewed for seven years, and then by repeated renewals it was carried forward to 1798. Another clause was now added that no more silver should be coined at the mint for private persons. 62. Adoption of single gold standard unintentional. The significance of this legislation was not perceived at the time. It had not been the intention of Parlia- ment to establish the single gold standard. The ques- tion of standard was not under consideration at all. What Parliament did in 1774 was: (1) to put gold coin in a state of perfection by recoining the defective pieces and making light coins unavailable in payments thereafter; (2) to limit the legal-tender faculty of the silver money then in circulation. The mint was still open, and anybody could have silver bullion coined into money of full weight and full legal tender. But since silver was undervalued at the ratio of 15 1-5, nobody would take it to the mint. Thus all the conditions of the single gold standard were in practical operation without any fixed intention of Parliament to bring it about, or any knowledge that it had been done. It was noticed, however, that the inconveniences of a shifting ratio had disappeared. There was plenty of gold money for large transactions and of silver money for small ones. Although the silver coins were de- ficient in weight, they answered the purposes of small change. After the experience of a quarter of a cen- tury, Parliament and people were convinced that the Act of 1774, although adopted as a temporary measure, ought to be made permanent. Accordingly it was made so in 1799. Yet it was not until 1816 that the true philosophy of the step was well enough understood to secure its en- actment into a settled law. In that year it was enacted 54. MONEY AND BANKING that the gold coin of the realm, when of full weight, should be full legal tender and should be coined for private persons to any amount, and that silver coin should not be legal tender for more than 40s. in one payment, and should be coined only on government ac- count and should be reduced in weight 6 per cent. This law, which established the single gold standard, remains in force to the present day. It seems to be the singular good fortune of England to blunder upon or have thrust upon her good institu- tions which other countries acquire only after much conscious effort and perhaps revolution. Besides the gold standard a great many excellent features of gov- ernment the dual houses of Parliament, the respon- sibility of the Cabinet to the Commons, republican gov- ernment under the form of a monarchy, etc., might be cited on this point. 63. Mintage. The key to the understanding of the complex problems of the standards is a clear conception of the minting of coinage and of the influence of the mints upon values of the precious metals. A mint is a place where certain definite quantities of the precious metals are stamped with a device or inscription, indi- cating the exact quantity of metal in them. As before mentioned, the earliest inscriptions were literal state- ments of the weight of the metal contained therein ; the English pound was a pound of silver, the English penny, a pennyweight of silver. The sole function of the mint was to put the metal into a form more con- venient for circulation. It affected the value of the metals only so far as this stamping increased their utili- ity as a medium of exchange and created an additional demand for them. The precious metals have a market value exactly the EVOLUTION OF THE STANDARD OF VALUE 55 same as any other commodities, and this market value fluctuates according to the laws of supply and demand. When there is only one metal in use as money, the fluc- tuations in its market value can be measured only by the rise and fall of values of other things. The name "dollar," "pound sterling," "franc," "mark," etc., are simply terms indicating weight, not value. The name . "dollar" for example is merely another name for a cer- tain definite weight of gold, i. e., 23.22 grains of pure gold. A confusion of thought arises because the values of everything else are indicated by comparison with the dollar of gold. Because the amount of gold in the dol- lar never changes except by legislative enactment, peo- ple come to think of the value of gold as being fixed and unchanging. In a later chapter on the relation be- tween gold and prices, we shall work out this idea more exhaustively. 64. Legal tender. In the Middle Ages when there were a great variety of coinages in concurrent circula- tion, it was necessary that there should be some under- standing as to the relative values of this heterogenous coinage. Accordingly the duty was imposed upon the government of prescribing the value of all other coins in terms of some one particular domestic coin. These royal proclamations of the value of coins really had a force of legal tender enactments, because a creditor was compelled by courts to receive any of these coins at its posted value. Legal tender means any medium of ex- change which may be tendered in payment of debt, and which must be received by the creditor whether he is willing or not. It was observed early that there was a tendency for certain classes of coins at certain times to disappear from circulation. They were either hoarded or melted 56 MONEY AND BANKING up for use in the manufacture of jewelry or plate or they were exported. In order to prevent this the mints frequently reduced the amount of metal in the coin or attempted to check the tendency by laws prohibiting ex- porting or melting of the coins. Only the former of these measures was efficacious in checking these tend- encies. Before, however, the constant altering of the coinage induced great confusion in trade. 65. History of coinage in the United States. The history of the coinage of gold and silver in the United States is one of the most instructive illustrations of the laws which govern the fluctuations in value of the pre- cious metals. The first secretary of the treasury and of the Constitution was Alexander Hamilton, upon whom devolved the duty of creating a plan for a mon- etary and banking system for the new country. The medium of exchange in circulation at that time was principally Spanish and English silver coins, or paper money of the colonies. The power given to Congress by the Constitution of regulating the value of foreign coins was more important at that time because of the great variety in circulation. It was necessary to have some authoritative valuation in order that payments might be made without requiring the parties to come to agreement as to the precise means of payment. 66. First ratio of silver to gold, 15:1. It was part of the plan of Hamilton to establish an United States mint, so that the country might be supplied with an adequate amount of United States coins in the shortest possible time, and thus do away with the confusion of the miscel- laneous coinage. He thought it necessary to coin both gold and silver in order that this purpose might be con- summated as rapidly as possible. He fixed upon the ratio of 15 to 1 as approximating most closely the mar- EVOLUTION OF THE STANDARD OF VALUE 57 ket values of the metals at that time. The unit of value, the dollar, was decided upon because of the familiarity of the people with the Spanish dollar, and their custom of quoting prices in that standard. The opening of the mints to the coinage of silver and gold at the ratio 15 to 1 meant the free coinage of both metals. The mint stood ready to accept gold and silver, to convert it into coins, and return these coins to the person bringing the metal, charging him a very small fee for the alloys used to harden the coins. 67. Inaccuracy of the ratio and its effects. The plan did not work out as Hamilton had intended. In the first place the ratio of 15 to 1 had ceased to represent the market ratio, when the mint was finally ready for coinage about two or three years later. According to the great European authority on the market values of the precious metals, Soetbeer, the actual market ratios were as foUows: 15.37 to 1 in 1794, 15.55 to 1 in 1795, 15.65 to 1 in 1796, 15.41 to 1 in 1797, 15.59 to 1 in 1798, 15.74 to 1 in 1799, 15.68 to 1 in 1800, 15.46 to 1 in 1801, and 15.26 to 1 in 1802. This change in the market ratio meant that silver had declined in value rel- ative to gold. Under these circumstances nobody would be so fool- ish as to take gold to the mint to be coined. It would be much more profitable to take that gold and pur- chase silver with it in the market, and then to take the silver to the mint and have it coined into more dollars than the gold would have made, and each capable of purchasing the same amount of commodities as a gold dollar. To make this proposition as clear as possible, let us take a concrete example. Suppose a dealer in bullion has one pound of gold. If he wishes to convert it into a means of payment, he 58 MONEY AND BANKING may do one of two things; first, he may take it to the mint and have it coined into approximately 250 dollars ; second, he may exchange the gold bullion for silver bul- lion in the European market. If the market ratio hap- pens to be 151/2 at this time, he will get in exchange 15% pounds of silver. This silver he may take to the mint and have it coined into approximately 260 dollars, each of which is just as good as any gold dollar for the pur- pose of trade. Under these circumstances, why should anybody take gold to the mint when there were always dealers who were eager to make the profit which could be had by purchasing his gold bullion for silver dollars, exporting the gold to buy foreign silver, and then hav- ing the imported silver coined in order to buy more gold bullion? Here we have an endless chain, automatically causing an export of gold and an import of silver. Un- der these circumstances no gold was coined, of course. 68. Disappearance of the silver dollars. Hamilton's idea of supplying this new country with coins of its own mintage was further frustrated by another peculiar con- dition. It was very soon noticed that in spite of the coin- age of silver dollars at the mint they did not seem to re- main in circulation for long. Instead the old Spanish coinage continued to be the current money. Of these Spanish and other foreign coins, only those which were clipped and mutilated were current. Perfect coins were either soon reduced to this same condition or disap- peared from circulation. The Spanish silver coins were at this time full legal tender along with the United States coins. In their perfect condition they were slightly heavier than the American coin. Both in this country and in the West Indies, with whom at that time we had a very extensive trade, both coins passed at their face value without any discrimination. Shrewd traders EVOLUTION OF THE STANDARD OF VALUE 59 found, however, that they could make a profit exporting the new United States silver dollars, exchanging them in the West Indies for the heavier Spanish dollars, melt- ing these heavier dollars into bullion, bringing the bul- lion to the United States and having it coined into more than the original number of dollars. When the officers of the mint discovered that the coinage of silver dollars was simply adding to the profit of these bullion dealers instead of supplying the coun- try with currency, they suspended the coinage of the sil- ver dollar in 1806. This unsatisfactory state of the me- tallic currency of the country was not so serious because of the almost universal use of paper money at that time. FLUCTUATIONS OF MARKET RATIO BETWEEN GOLD AND SILVER.! Year. Ratio. Year. Ratio. Year. Ratio. 1803 1830 .... 15.82 1858 15.38 to 1831 .... 15.72 1859 15.19 1804 15.41 1832 .... 15.73 1860 15.29 1805 15.79 1833 .... 15.93 1861 15.26 1806 15.52 1834 .... 15.73 1862 15.35 1807 15.43 1835 .... 15.80 1863 15.37 1808 16.08 1836 .... 15.72 1864 15.37 1809 15.96 1837 .... 15.83 1865 15.44 1810 15.77 1838 .... 15.85 1866 15.43 1811 15.53 1839 1867 15.57 1812 16.11 to 1868 15.59 1813 16.25 1840 .... 15.62 1869 15.60 1814 15.04 1841 .... 15.70 1870 15.57 1815 15.26 1842 .... 15.87 1871 15.57 1816 15.28 1843 .... 15.93 1872 15.65 1817 15.11 1844 .... 15.85 1873 15.92 1818 15.35 1845 .... 15.92 1874 16.17 1819 15.33 1846 15.90 1875 16.62 1820 15.62 1847 .... 15.80 1876 17.77 1821 15.95 1848 .... 15.85 1877 17.22 1822 15.80 1849 .... 15.78 1878 17.92 1823 15.84 1850 .... 15.70 1879 18.39 1824 15.82 1851 15.46 1880 18.04 1825 15.70 1852 15.59 1881 18.24 1826 15.76 1853 15.33 1882 18.25 1827 15.74 1854 15.33 1883 18.65 1828 1855 15.38 1884 18.63 to 1856 15.38 1885 19.39 1829 15.78 1857 .... 15.27 1886 20.73 i Compiled by the Director of the United States Mint. 60 Year. MONEY AND BANKING Ratio. Year. Ratio. Year. Ratio. 1887 21.13 1894 32.56 1901 34.68 1888 21.99 1895 31.60 1902 39.15 1889 22.09 1896 30.59 1903 . 38 10 1890 19.17 1897 34.20 1904 35.70 1891 20.92 1898 35.03 1905 33.87 1892 . . 23.72 1899 34.36 1906 . 30 54 1893 26.49 1900 33.33 69. Change of ratio to 16:1. The monetary system was, therefore, on a strict silver basis during this period, all the gold having been exported, hoarded or diverted into the arts. In 1834, Congress, in an attempt to rem- edy the condition, reduced the weight of the gold dollar from 24.75 grains to 23.2 grains of pure gold. This represented a ratio of approximately 16 to 1. The com- mercial ratio in 1834 was 15.73 to 1, nor did it reach the mint ratio until forty years later. It was probably as nearly correct, however, as any arbitrary ratio which could have been settled upon. It will be seen, in fact, in a subsequent chapter on "Bimetallism" how ineffectual any attempt must be to establish by enactment in a single country a ratio of value between two such commodities as gold and silver, which have universal utility and a world market. Just as gold was driven out of circulation when the ratio was too low, so after 1834 silver was driven out because it was too high. Silver was worth more as bullion than it was at the mint, and the country soon found itself on a gold basis. In 1834 the ratio was changed to 15.98 to 1, but the difference was so slight that it had little ef- fect. 70. Legal tender acts created a paper standard. Gold continued to be the standard until the legal tender acts of 1862-1863. The first of these acts, passed in February, 1862, authorized the issue of $150,000,000 of non-interest bearing United States notes, payable to EVOLUTION OF THE STANDARD OF VALUE 61 bearer. These notes were to be receivable for all dues to the Government and to be legal tender for all debts, public and private, within the United States. They were, furthermore, exchangeable for the 6 per cent twen- ty-year bonds of the United States at the option of the holder. The first bill was followed six months later by a second measure authorizing $150,000,000 more notes, and in January, 1863, the total was increased to $400,000,000. Thus there was injected into the circulating medium of the country $400,000,000 of promissory notes, the early redemption of which at least depended on the success of the Federal army in the field and the reestablishment of peace and order. In accordance with Gresham's Law, gold began to disappear from circulation after the first bill was passed, and prices were soon expressed entirely in terms of the new standard. The situation was further complicated in July, 1863, by the repeal of the provision for the exchange of the notes into United States bonds, and before the end of 1864 gold was quoted at 280 in the New York market. In other words, the "green- backs" were worth but 35 cents on the dollar. It is obvious that the country was no longer on a gold basis. The unit of value was now the Government's promise to pay $1 in gold, a unit which fluctuated with the fortunes of war. 71. Single gold standard after 1879. This condition lasted long after the conclusion of the war, but naturally as it became evident that the nation was to endure and the Government finances improved, the divergence be- tween gold and the paper standard gradually decreased until it was completely destroyed when in January, 1879, the treasury offered to redeem its legal tender notes, In 1873 an act was passed which made gold the sole le- 62 \ MONEY AND BANKING gal standard. This act accomplished the demonetiza- tion of silver and was vigorously attacked by the friends of that metal. In 1878 the treasury was authorized to purchase sil- ver bullion for the purpose of coining it and in 1890 the Sherman Act authorized the purchase of silver by the issuing of legal tender notes. Neither case, how- ever, represented a retreat from the gold standard be- cause neither provided for the free coinage of silver. In spite of these efforts to remonetize silver and in spite of the even greater effort of the Silver Party to elect Mr. Bryan to the Presidency in 1896 on a double stand- ard platform, gold has remained the single legal stand- ard since the Act of 1873 and the actual standard since the redemption of specie payments in 1878. 72. Act of 1900. In 1900 an act was passed au- thorizing the secretary of the treasury to maintain all forms of money issued or coined by the United States at a parity of value with the gold standard. How this was to be done, however, the act did not provide. In- asmuch as this binds the Government to receive both silver and greenbacks at par with gold in payment of dues to itself, it indirectly provides for their redemption. Although the act was a specific acknowledgment on the part of the Government of the intention to maintain this parity of value, it is to be regretted that some means of doing so in case of stress and decreased gold reserves was not provided. 73. Summary. To sum up the evolution of the standard in the United States: From 1792 until 1873 the legal standard was a double one, gold and silver. The actual standard, however, during this period changed considerably. From 1792 until 1834 it was silver; from 1834 until 1862 it was gold. Then came EVOLUTION OF THE STANDAKD OF VALUE 63 the legal tender acts, and greenbacks became the actual standard, to continue until 1879. In 1873 gold was made the single legal standard; and from the resump- tion of specie payment in 1879 it has been the actual standard as well. CHAPTER VI STANDARD OF DEFERRED PAYMENTS 74. Defects of gold. The next function of money to be considered is its use as a standard of deferred pay- ments. Obviously this differs from its function as a standard of value only because it introduces the time element. For this purpose, also, gold is a defective standard, but it is by far the best that is known. Gold is durable. Once mined, it is added to the productions of the past, to remain always a part of the world's supply. For this reason the amount mined in any one year cannot bear large enough proportion to the total amount in existence to cause great changes in its value. Even with an annual production of $400,000,000 the amount in existence is so large that its value is much more stable than anything else which could be used for the pur- pose. Although the same was formerly true of silver, its production has so greatly increased during the last thirty years that a single silver standard of deferred payments would be very unsatisfactory. In 1876 and 1890 to 1894 it fell 50 per cent. Changes as violent as this would not have taken place had not silver been de- monetized in the United States and had not the nations of Europe also discarded it during the last half century. It is evident, however, that these fluctuations unfit silver to act as a standard of deferred payments. We have already seen the impracticability of the 64 STANDARD OF DEFERRED PAYMENTS 65 double standard, but shall reserve that subject for more careful consideration in a subsequent chapter. In the absence of a better, we are therefore forced to the con- clusion that gold is the best standard for deferred pay- ments. 75. Definition of deferred payments. Deferred pay- ments are usually the result of contracts. When we stop to consider that contracts play a part in nearly all business transactions, the importance of the subject is appreciated. Our investments, bank deposits, notes, currency, in fact, a large proportion of our wealth con- sists of contracts. If economic prosperity is to con- tinue, these contracts must be enforced. To this end the Constitution of the United States declares that "no state shall pass any law impairing the obligation of con- tracts." Although the provision prevents the direct impair- ment of contracts, the same end may be accomplished indirectly by unwise monetary laws. Anything, in fact, that causes great changes in prices will alter the effect of contracts. Practically all contracts are payable in terms of dollars, and some of them run for long periods. In order to secure perfect justice between debtors and creditors it is necessary that the dollar should mean the same at the maturity as at the beginning of the con- tract. Speaking accurately, this is impossible, for even when the contract is specifically made payable in gold, the purchasing power of that gold after a period of years may have changed considerably. Contracts payable in gold, however, have always been the most highly re- garded, because no matter how distant the date of ma- turity it is generally felt that the value of gold will approximate its present value. The risk that it will be VII--5 66 MONEY AND BANKING greater or less is only the ordinary business risk which every business man must take and for which he must make allowance in his calculations. A great many contracts, however, are payable in terms of "dollars," without specifying the kind of dollar that is meant. While the statutes define a dollar as 23.22 grains of pure gold, yet debts may be legally paid by other forms of dollars. The law makes certain forms of currency legal tender in payment of debts. The sil- ver dollar and the treasury notes are full legal tender. Greenbacks are full legal tender. National bank notes are legal tender in payment of any debt to a national bank and are receivable by the Government for all dues except duties or imports. Subsidiary silver is legal ten- der, but for convenience sake only to certain maximum amounts. 76. Effect of legal tender laws. So long as all the forms of currency are interchangeable and of the same value, legal tender laws have no particular significance, but if some form of currency is depreciated it is obvious that no creditor will care to receive it and every debtor will want to pay in that form of currency. For in- stance, when the greenbacks depreciated to 35 cents on the dollar in 1864, they were still legal tender unless otherwise specified in the contract. No debtor would think of paying his debt in gold dollars because with 35 per cent of that amount of gold he could buy de- preciated greenbacks that would fully satisfy the debt. 77. Constitutionality of Legal Tender Acts. The right of the Government to pass the Legal Tender Acts was in fact declared unconstitutional by the Supreme Court because it violated the clause of the Constitution which forbade the impairment of the validity of con- tracts. This decision was reversed, however, by a sub- STANDARD OF DEFERRED PAYMENTS '67 sequent Supreme Court which declared the statute con- stitutional under the authority given to Congress to provide means for carrying on war. Waiving the question of constitutionality of legal ten- der acts, it may be well to consider whether under any circumstances there is any advantage to be gained by adding the legal tender feature to the various forms of circulating media. Does the medium become more val- uable because of the legal tender stamp? Obviously, if a country adopts the gold standard, making gold legal tender, it increases the value of gold somewhat because it increases the demand for it. But this is be- cause gold is needed as a medium of exchange. The legal tender feature adds nothing because it will circu- late at its actual metal value. When a country attaches the legal tender stamp to two metals we have already seen that the cheaper will drive out the dearer and that the cheaper metal will also circulate at its metal value. In the case of the greenbacks the legal tender feature added nothing to their circulating power, as is shown by the fact that they fluctuated in value as the time of their redemption seemed early or remote. The legal tender feature, is, therefore, of value solely to the debtors, who can take advantage of laxity of their con- tracts to pay their debts in depreciated currency when they should pay in the standard metal. It adds little, therefore, to the circulating power of the medium to which it is attached, and what little it does add inures to the advantage of a single class. The whole free silver agitation was an attempt to change the standard because it was believed that in re- gard to its use as a standard of deferred payments gold was defective. It is apparent that it is to the advantage of the debtor class to have a standard which is con- 68 MONEY AND BANKING stantly depreciating in comparison with goods ; in other words, that goods should be apparently rising in value. 78. Debtor class injured by an appreciating standard. From 1860 to 1896 there was a large debtor class in the country composed of farmers who had gone West and purchased land on mortgage. These farmers bought the land agreeing to pay a certain price in the future and a certain rate of interest each year. This price and interest rate were based upon the value of crops, particularly wheat, which in the early 70's was worth as high as $2 per bushel. The price of wheat gradually declined until in 1894 it was worth less than 50 cents per bushel. The farmers found themselves unable to meet the interest payments, much less to pro- vide for the paying off of the principal. They were told that this condition was due to the appreciation in the value of gold following the demonetization of silver in 1873. They were also told that if silver could be re- monetized, that is, made the standard of value along with gold, that the quantity of standard money would be doubled, that the value of standard money would be reduced one-half and the value of everything else doubled. This debtor class composed the backbone of the Silver party in 1896. Fortunately before another election was held the question had been settled to the satisfaction of everybody by the unexpected increase in the production of gold. CHAPTER VII SUPPLY AND DEMAND IN RELATION TO MONEY 79. Price. There is a distinction between the use of the words "value" and "price" which it is well to under- stand clearly. Value is the expression of a ratio of importance between two commodities. If, for example, one wishes to express his estimate of the worth of a pair of shoes it is necessary to make a comparison with some other commodity. Thus the value of a pair of shoes may be expressed as equal to two hats, or the ratio ex- pressed is one to two. Price is a ratio expressing a comparison of value, but one of the terms of the ratio is money. The use of a standard of value which is familiar to everybody enormously simplifies the expression of values. In order that price may have a clear and definite meaning it is necessary that the money standard fluctuate as little as possible. If, however, there is a change in the value of the standard, it alters the real meaning of every quoted price. i That the prices of goods depend quite as much upon the value of money as upon the value of the goods themselves, is a truth that the reader must fully grasp. It may be a little puzzling at first, for it is natural to think of money as a fixed and stable thing, with respect to which other things fluctuate. To many men the idea that money changes in value is as novel when first presented as the notion that the ocean changes its level. The reason for this misapprehension with regard to the value of money lies in the fact that men think of price as being identical 69 70 MONEY AND BANKING with value, and since the "price" of gold (and of silver in a country where it is freely coined into money) never changes, it is assumed that the value of gold is unchanging. The common belief in the stability of money is analogous to the illusion exist- ing among primitive peoples with regard to the solar system. They think the earth is stationary. It is their view point, and all changes on the screen of the firmament seem to them to reflect changes in the heavens, not in the position of the earth. The analogy, like all analogies, is imperfect, but it is suggestive. The fact that changes in price reflect changes in the value of money as well as changes in the values of goods is very im- portant. 1 Every man of business who buys and sells property has a deep interest in the fluctuation of prices. Most of them are thoroughly familiar with the causes which produce fluctuations so far as they are caused by in- fluences affecting commodities. Only those who have made a special study of the subject comprehend the influence of the fluctuations of prices on the conditions affecting the money side of the ratio. 80. Prices depend upon the money market. A long continued and steady rise of prices may take place in the face of conditions of supply and demand for com- modities which would seem to warrant quite the opposite tendency. On the other hand there may be a very great fall of prices notwithstanding the fact that conditions of supply and demand for commodities justify higher prices. The explanation of this must be sought for in the money market. The value of money as of everything else is the result of an equilibrium between supply and demand. How these forces produce the result so far as goods are con- cerned we have already seen in the chapter on value. i Johnson, " Money and Currency," p. 31. SUPPLY AND DEMAND 71 The value of money is determined in the same way, but the conditions of supply and demand are so complex as to require a special study of them. 81. Utility of money. Money is utility in the form of immediate universal acceptability. Its utility lies in its exchangeability in the same manner that nutrition is the basis of the utility of food. Money is demanded because of the need felt by men for this particular kind of utility. The name which we give to this conscious need of men for anything is "desire." The failure to distinguish between desire and demand has been a fer- tile source of error in economic thought. Some of the most eminent of earlier economists, observing that the desire for money was universal among men, concluded that therefore the demand for money was unlimited. If that were the case it would be absolutely impossible to analyze the forces determining the value of money. It would be the same as the attempt to find the point of equilibrium which would be the result of several phys- ical forces if one of these forces was infinite. 82. Distinction between desire and demand. De- mand as used in an economic sense is "desire" backed up by the willingness to sacrifice or give up something in exchange. The only method we have of measuring demand is by the amount of value which will be sacri- ficed in order to obtain the object of the demand. The demand for money can be measured only by the amount of other valuable property which will be given in ex- change for it. Under the foregoing definition the demand for money is limited, definite, and liable to fluctuate from time to time. If a man offers $300 for a horse it is evident that his desire for the horse is greater than his desire for $300. The seller of the horse would desire 72 MONEY AND BANKING the money more than the horse. The question of the demand for money may be reduced to this: Why do people desire money? 83. Three varieties of money. In the first place it is necessary to distinguish between different varieties of money. There are three kinds of money: standard money, fiat money, and credit money. The demand for these different varieties is not uniform and under various circumstances shifts from one to the other. Standard money or commodity money is some ma- terial which because of its proprietary qualifications has been adopted by any particular group of people as a common medium of exchange, as explained in the pre- ceding chapter on the Evolution of Money. Its supply is regulated automatically, being dependent on the cost of production. Fiat money is the medium of exchange, the value of which has no relation to the worth of the material com- posing it. Its value is derived from its utility as a medium of exchange. Its supply is regulated artifi- cially by legislative enactment. Credit money is simply a promise to pay the money which is in such form that it can be used as a medium of exchange. A promise to pay money by some re- sponsible party may be just as valuable or even more valuable than the money itself if it serves the purpose of money. 84. Fiat v. credit money. The distinction between fiat and credit money is an exceedingly difficult one to make in practice. In practically every case of fiat money, there is a promise either expressed or implied to pay the amount in standard money at some indefinite time; if not a promise at least an expectation or ac- ceptance of the money in payment of taxes and other SUPPLY AND DEMAND 73 sums due the government issuing it. It would be diffi- cult indeed to imagine fiat money which the government itself would not accept in payment or which it never expected to redeem. 85. Demand for money analyzed. The demand for money may he studied by analyzing the various forms of desire for money. 1. People desire money for the purpose of exchang- ing it for other commodities within a short time. 2. People desire money that they may have a store of value which for the time being is preferable to goods which have a (1) direct utility, i. e., those affording satisfaction by their use, or (2) indirect utility, i. e., the use of which produces more value, as in the case of all capital goods. In some rare instances the money is esteemed for itself alone without reference to its ex- changeability, as in the case of a miser's hoard. 3. People desire money as a reserve basis for credit. These three classifications cover all the desires for money and changes in the intensity of these desires have their effect on the value of money. 86. Rapidity of circulation. The extent of the de- sire for money for the purpose of exchanging it for goods within a short time determines the rapidity of circulation. The measure of the rapidity of circula- tion of money is the form of exchanges, which is de- pendent upon four factors; 1. The number of popu- lation. 2. The production and distribution of wealth per capita. 3. The extent to which division of labor or specialization of employment prevails. 4. The ex- tent of the integration of industry. 87. Effect of population. Other things being equal, doubling the population would double the demand for a circulating medium. There would be twice as manjr 74 MONEY AND BANKING producers and twice as many consumers. Therefore it would require just twice as much money to circulate the goods required for their consumption. In a country of increasing population, therefore, there must be a pro- portionate increase in the quantity of money. Other- wise the increased demand upon the supply will tend to raise the value of money, bringing with it falling prices. Even with a stationary population, advancing civiliza- tion inevitably brings an increase in the production and consumption of wealth, the circulation of which puts a greater demand upon money. 88. Effect of division of labor. Along with the in- creased production of goods per capita comes the in- creasing division of labor. In fact, the greater special- ization of employment is one of the most potent causes of increase of wealth. In primitive communities where the producer consumes a large part of his product there is little demand for money, not at all in proportion to the productivity of each man. Whenever men begin to confine themselves to fewer occupations, especially if at the same time the variety of their wants increases, they are under the necessity of obtaining their supplies by means of exchange, and this exchange requires a medium. Hence it is that division of labor requires an increase in the supply of money out of proportion to the increase of product per capita. Opposed to this tendency and lessening somewhat the demand for money is the integration of industry. When a number of individuals or corporations engaged in the various processes of the manufacture of a line of goods combine so that the several processes are con- ducted under one ownership, the necessity for a large number of exchanges is eliminated. It may even go so far that no exchange takes place after the raw ma- SUPPLY AND DEMAND 75 terials are purchased until the finished product is sold to the consumer. 89. Special demand for gold. Under present condi- tions in this country all the forms of money described above perform the function of exchanging goods equally well, with possibly a slight advantage on the part of paper credit money on the score of convenience. In our trade with foreign countries, however, if there is a balance of imports over exports one way or the other which must be settled with money, there is only one form which will serve the purpose, i. e., gold. Increase of demand from this source, may under some circum- stances tend to enhance the value of gold, independently of the value of the other forms. This phenomenon ap- pears in the form of a premium on gold, of which we shall speak later. 90. Payment of contracts. Another demand for money is in the payment of contracts. Unless there is a disparity in the value of the different forms of money the demand for money to liquidate contracts is likely to fall on all equally. Sometimes the demand for money for this purpose is artificially interfered with by the Government, as in the case of legal tender laws which force the creditor against his interest and inclina- tion to accept certain forms of money such as the green- backs. The tendency in such a case as this is to shift the demand from gold to credit or fiat money, and thus eliminate the disparity. 91. Store of value. The demand for money as a store for value without the intention of exchanging it for goods within a short time depends largely upon the habits of the people and the stability of the Govern- ment. Money as a store for value is at a disadvantage when compared with productive property, and under 76 MONEY AND BANKING normal conditions prudent people will regard stores of money as very unprofitable investments. 92. Insecurity of property and contracts. Under certain conditions, however, it may be advantageous to hold property in the form of money. In countries such as Turkey where the government is unable to protect property and where it is liable to heavy taxes or even to confiscation, the profit derived from the investment of money in productive enterprises, although very great, may be so risky and uncertain as to be unattractive. In such a country those citizens who are least protected by the government are inclined to safeguard their future welfare by hiding away their wealth in the form of money. The satisfaction they derive from the con- sciousness of being protected in their old age and being relieved from the fear of loss of property more than compensates them for the loss of even a large income. According to the extent to which property is protected and contracts are enforced as well as the amount of in- come that can be derived from investments, will the people of any country be disinclined to hoard accumula- tions of money. 93. Special demand for money as a store of value. In every country, however, no matter how stable the conditions, there are times when money is more highly esteemed than any other form of property. When there is a prospect of falling prices of commodities it is advantageous to exchange property for money because the value of money rises in exact proportion as com- modities fall. At the end of periods of prosperity when prices of all property have been inflated and there is a prospect that the culmination of the boom is approach- ing, this state of affairs is likely to be perceived sud- denly by a large number of people, who at once become SUPPLY AND DEMAND 77 eager to exchange their property into cash; the desire of a large number to sell at the same time of course brings a sudden fall in prices which we call a panic. The converse of this takes place at the beginning of a boom period, when people realize that prices are too low and that purchases will yield large speculative profits. There is a rush to buy, that is to say, a desire to convert money which is about to fall in value into forms of property which will increase in value. The desire to convert property into money is only one of the causes and symptoms of a panic. In a later chapter on credits a fuller discussion of this will be given. The liquidation of credits, either forced or vol- untary, at the beginning of a panic accounts for a large part of the sudden demand for money and is the prox- imate cause for the liquidation of property. 94. Hoarding. When the storing away of money becomes excessive we call it hoarding. It would be ex- ceedingly difficult to attempt to draw the line where hoarding begins. The amount of money which prudent people will have ready for necessary purchases and the payment of debts will vary widely under different cir- cumstances. In the panic of 1897 the country banks all over the country withdrew their deposits from the New York banks in order to be amply protected in case of large sudden demands from their depositors. A great many banks carried this practice to an unreason- able extent and filled their vaults with money for which they had no use and for which there was likely to be no use except in the case of most extraordinary disaster. Such storing away of money we can properly call hoard- ing. 95. Decline of hoarding. Steady progress in the direction of improving the financial and banking sys- 78 MONEY AND BANKING terns and the widespread education of the people in the advantages of dealing with banks has diminished hoard- ing in this country until under normal conditions in the present era it is practically limited to persons in rural districts and to a few eccentric individuals who are will- ing to run the risk of robbery in order to enjoy the satisfaction of an occasional view of a pile of yellow coins or of green paper. It is extremely easy, however, to frighten people out of their banking habits and cause them to revert to the more primitive methods. The failure of a prominent bank or the exposure of unsavory methods in high finance will induce a great many timid persons to with- draw their deposits from banks and stow away the money in safety deposit vaults or in some hiding place in their homes. 96. Bank reserves not hoards. The enormous sums of money stored in the vaults of banking institutions are not hoards in the sense in which we are using the term. These dollars are really supporting the credit of the country, which as a substitute is doing the real money work. In fact, an idle dollar in the reserve backing up credit is really doing four or five times as much work as its brother in circulation. The full explanation of this point is deferred to the chapters on credit. 97. Government hoarding. While the great sums of money in bank reserves are not hoards unless they should be excessive, there are at times huge amounts in the Government treasury and sub-treasuries which are really hoards. The law requires that $150,000,000 in gold shall be maintained in the treasury as reserve against the greenbacks outstanding. This sum is a true re- serve and not at all a hoard. Furthermore, the gold and silver, both coin and bullion, which are held in the 79 treasuries and against which gold and silver certificates are circulating are not hoards. The paper money which represents them is doing the work by proxy. Unlike the bank reserve, however, which through its substitutes does four or five times the amount of money work, the gold and silver certificates do no more than gold and silver itself could have done. The only advantage de- rived from the system is the greater convenience and the saving of the wear and tear on the metal. Another part of the money held by the Government represents a store of cash ready for future expenditures. This is the sum necessary to be kept on hand in order to provide for purchases within a short time, just as individuals find it necessary to keep a certain amount of cash on hand for the same purpose. Any amount of money held in the treasury beyond the sums mentioned above is a hoard, representing purchas- ing power which is withheld from circulation and for the time being absolutely useless. 98. Discrimination in demand for money. The dif- ferent forms of demand for money which we have out- lined above do not apply at all times equally to all the different varieties of money. There are sometimes cir- cumstances when the demand falls upon one kind alone. So long as all the different forms are kept at parity the demand for a circulating medium to exchange goods or to liquidate debts is satisfied with either form. Then sometimes the question of convenience plays a part, as in the case of the silver dollar after the silver purchases in the 80's. These silver dollars refused to circulate in the quantities desired because the people had learned to prefer paper on the score of convenience. They would refuse to take them from the banks and would deposit them freely; the banks would turn them back 80 MONEY AND BANKING into the Government treasury in exchange for paper which their depositors demanded. The Government even went so far as to pay express charges to dis- tant points in order to keep the silver dollars in circula- tion and finally the ingenious plan was hit upon of stor- ing away the silver dollars and issuing in their stead silver certificates of one and two dollar denominations which were circulated in their place. 99. Seasonal demand for money. For 90 per cent or more of the domestic exchanges no money is required at all, bank credit in the form of checks and drafts serving the purpose. This relieves the money of the country of most of the demand but there are circumstances when this bank credit fails to do its work. During the crop moving season in the South and West there is a demand for a medium of exchange which cannot be supplied by bank credit. Every autumn there is likely to be a de- mand for about $150,000,000 of extra money to finance the crop moving. This sum must ordinarily come out of the reserves of the banks, causing a contraction of credit, after credit has been expanded and giving rise to dangerous stringencies in the financial centers. This special seasonal demand for cash and the monetary prob- lems which it occasions will be the subject of special dis- cussion later in this volume. 100. Demand for money in international trade. The exchanging of goods between this country and abroad requires the use of but a minimum of money; only the differences between the exports and imports are required to be settled in cash. The only possible form of money which can be used in making this inter- national settlement of trade balances is gold. Some- times the difference between the imports and exports is so great, or there has been so much international bor- SUPPLY AND DEMAND 81 rowing that the resulting movement of gold in or out of the country is a question of extreme importance because of the effect it has upon bank or Government reserves and the maintenance of credit. It is this demand for gold to be used in making foreign settlements that ac- counts for the appearance of a premium on gold under certain circumstances. Whenever foreign banks find that they cannot exchange other forms of money for gold they are driven to procure it wherever they can by offering a premium for it. 101. Premium on gold. Experience has shown that the appearance of a small premium on gold is attended by such serious disturbances in the credit situation of the country that such an event is to be avoided if possible. The seriousness of this matter led President Cleveland in 1894 to put out several issues of bonds and to deal with the syndicate of New York banks in order to pre- vent a premium on gold, or in other words to maintain a parity among all forms of money in the United States. The President did this in the face of popular disapproval by the mass of citizens who did not comprehend the necessity of these actions. All forms of money (except national bank notes in national banks themselves) serve the purpose of bank reserves equally well, although gold is preferable be- cause it assists the Government in supporting the cir- culating credit. It was proposed in recent currency bills to compel the banks to maintain their reserves in gold in order that there shall always be a satisfactory basis, for the credit of the country. 102. Uncertainty of the demand for money. The demand for money is a very uncertain quantity. The uncertainties of its substitute, credit, may cause very sud- den and very great changes in the demand for money. 82 MONEY AND BANKING The growth of population increases specialization of em- ployment and the increasing volume of industry per capita causes an increasing demand for a medium of exchange. On the other hand, however, the perfection of the credit machinery and the extension of banking facilities economize the use of money and lessen the de- mand. The suddenness with which any derangement of the financial machinery will cause a shift of demand from one form of money to another is one of the com- plexities of the subject. 103. Supply of money. In contrast with the insta- bility of the demand for money the supply of money is so stable as to give rise to the problem of "elastic cur- rency." The only uncertain element in the supply is found in credit, which is a substitute for money and does the same kind of service. 104. Varieties of United States money. In the United States at the present time there is in circulation, first, the United States notes or greenbacks. The sup- ply of this form of money is absolutely unchanging, amounting to $346,000,000. Second, the gold and silver certificates, representing actual metal deposited in the treasuries. The supply of these certificates varies with the amount of gold and silver deposited in Washington and the increase or de- crease in their amount is offset by a correspondingly opposite change in the supply of metal money. Third, National bank notes are somewhat elastic, but are so limited by the amount of bonds which banks can acquire to deposit as security for them that the supply can be regarded as fairly stable. Fourth, The supply of silver coinage in the country is regulated by arbitrary action of the Government. SUPPLY AND DEMAND 83 Outside the subsidiary coinage its use is so limited that it cannot be regarded as an elastic element. Fifth, Gold is the only really elastic element in our country at the present time. The amount in the country for monetary purposes at any time is influenced by our financial and trade relations with foreign countries. In the chapter on foreign exchanges the causes of increase or decrease in the quantity of gold in the country is explained in all its details. 105. Supply of gold. The quantity of gold actually produced in the country has very little effect upon the supply in that country. Gold is so easily transported that it equally distributes itself throughout the world according to the laws of the distribution of gold. The distribution of gold may well be illustrated by compar- ing it with water poured into one of a series of vessels connected by pipes. Water poured into one vessel dis- tributes itself through all the connected series so that one level is maintained throughout the whole. If the pipes are small or clogged up there may be considerable delay in the distribution of the water. In the case of gold there may be for short periods of time inequalities in the distribution of gold which are to be accounted for by disturbances in the machinery of exchange; ulti- mately, however, gold will find its level throughout the world. 106. Factors in the supply of gold. The supply of gold is determined by the same factors which determine the price of any other commodity. There is always a tendency for the supply to be increased so long as there is a profit in its production. If the cost of producing gold is considerably below its value there will be a strong inducement to enlarge the operation of mines and to 84 MONEY AND BANKING prospect for new mines. However, as the quantity of gold in circulation increases, the effect will be to raise prices as shall presently be explained. This rise of prices, affecting as it does all the implements and ma- terials used in mining as well as the wages of the miners, increases the cost of production and thus diminishes the margin of profit made in the production and the value of gold until all the profit of mining may disappear in the mines which have the highest cost of production, causing them to shut down and cease contributing to the supply. In this way the production of gold is auto- matically regulated. 107. Peculiarity of the supply of gold. There is a peculiarity in connection with the supply of gold which distinguishes it from any other commodity. The sup- ply of a commodity may be considered as a sum of util- ities which satisfy human want. The supply of wheat when analyzed means the number of units, each of which has -a certain power to satisfy hunger. Two bushels of wheat have twice as much power in this respect as one. In the case of gold, however, the utility consists of its power to exchange other commodities. Now there is no reason at all why one grain of metal might not do just as much work of exchanging commodities as one ounce. If the quantity of gold in the world is doubled at the same time that the prices of goods in general are doubled, the increased quantity of gold will do no more money work than the original amount, and the money supply of the world has not been increased at all when measured by its effectiveness. 108. Historical illustrations. There have been three periods in history which illustrate this general proposi- tion very clearly. The great increase in the amount of SUPPLY AND DEMAND 85 silver in the world after the discovery of America and the opening up of South American and Mexican silver mines by the Spaniards in the sixteenth century caused a tremendous change of prices for every commodity. The discovery of gold in California and Australia in the middle of the nineteenth century was followed by a similar rise in general prices. At the present time we are undergoing a period of increased gold production, especially in South Africa and accompanying high prices. In each of these periods the great enlargement of the stock of standard money in the world produced a pro- found social effect and radically altered the relations between debtors and creditors. The small quantity of money metal in existence before these discoveries were made would to-day do just as much work if there had been no increase, but the level of prices would be very low indeed. The value of the dollar would easily be ten times what it is to-day and 25 cents would be a fair day's wage for the unskilled workingman. This ridiculously low level of prices, however, would not mean anything at all if all values were in the same proportion. If the necessities of life cost one-tenth of the price which we are paying to-day, 25 cents per day wages would be as satisfactory to the laborer as $2.50 is under present conditions. 109. Temporary results of change of money supply. While it makes little difference whether the absolute price level is high or low so long as relative values are unchanged, yet changes in the price level are likely to have great economic results because the price of every commodity that is bought and sold does not change equally or simultaneously. Therefore a change in the general price level is likely to cause a general change in 86 MONEY AND BANKING the relative values. Especially is this true of credits. If a debtor has promised to pay a creditor $100 in ten years, and if within that period prices have changed so that the $100 at maturity represents the equivalent of only half the quantity of goods, the creditor has in real- ity received only half as much in value as he loaned. The fact that he received the same number of dollars does not mean anything because the dollars to him are valuable only as he can exchange them for things that he wants. 110. Effect of increased supply of gold traced out. The principles which have been stated above will be better understood if we examine the effect of the addi- tion of a certain quantity of gold to the stock already on hand. Let us follow the output of a mine and trace out the ultimate effects of the new gold. When the gold has been refined and made into bricks it is sent to a Government assay office, where it is tested to determine its purity, and then turned over to the mint. Theoretically, under a system based on the free coinage of gold anybody can take the metal to the mint with the proper amount of alloy needed to harden it for purposes of circulation and can have it transformed into coins. Practically, however, the gold bricks are taken to the mint, but instead of waiting until the gold has been made into coins the owner receives at once the money equivalent for its value. The person who brought the gold to the mint now has the corns or their equivalent in some other form. He will either spend this money or deposit it in a bank. If he goes into the market to purchase goods of any sort his buying will have the effect of bidding up prices proportionately and the gold which was mined will be responsible for whatever effect has been produced on prices. The mer- SUPPLY AND DEMAND 87 chant who received the money uses it to replenish his stock and his buying will tend to raise the prices of his purchases. As the money circulates from hand to hand, at every exchange it will tend to raise prices. This continuous process of price raising, spreading through all the dif- ferent markets, would seem to have no end. It would seem that if we took one dollar and gave it time and rapidity of circulation enough it might raise the general price level to any height. 111. Limit to the price-raising effect of gold. This reductio ad absurdum is answered by another proposi- tion which counteracts it. Every rise of price reduces the purchasing value of the dollar, so that as the dollar continues to circulate it lose its power to exchange goods in the exact proportion as they have risen, so that if we conceive prices to have exactly doubled it will require $2.00 to exchange them where it only required one be- fore. The result will be that there will be an equilib- rium of prices established at a higher level than before the increase in the quantity of money. If the quantity of money should be diminished in amount, or if the quantity of goods to be exchanged should be doubled, there would be a lowering of prices to correspond on account of the increase in the offering of goods for sale without the corresponding amount of bidding from the owners of cash to pay for them. The result would be the formation of a new level of prices at a point where the offerings of goods and the bidding of the holders of cash would balance. 112. Alternative uses of new gold. If the miner who has increased the money supply of the country with the product of his mine should choose to hold the gold coins or the paper money equivalent for the gold, there 88 MONEY AND BANKING would be no effect whatever on prices, and it would be as though he had stored away the gold bricks or had never produced the gold at all. However, if he deposits it in the bank its effect there will be to increase the loaning power of the bank and thereby to increase the purchasing power of the bor- rowers of the bank and thus affect prices even more. 113. Widespread effect of new gold. An increase of prices on account of any large addition to the money supply would have more than local effect. We have seen how purchases from the retail dealers would tend to increase wholesale prices in the central markets on account of the additional purchases of the retailer to replenish his stock. In the same way the influence would extend from the central markets to the producing centers in this country and abroad. The demand for imported goods would be increased and unless our ex- ports happened to increase at the same time the result would be an export of gold to foreign countries. If the general price level was raised in this country there would be an increased profit in importing goods, and a corresponding decrease of profit in exporting them, un- til, if the gold production or other increase in the supply; of money was great enough, there might be no exports at all and we might be forced to settle for all our im- ports with gold. Following out this principle we may conclude that the only advantage which a country derives from a large production of gold is simply that it is the first to feel the effect on prices; it cannot expect to retain perma- nently any more than its proper share of the new gold so long as trade is free between it and foreign countries. It would be impossible to increase permanently the sup- ply of gold in this country without giving the other SUPPLY AND DEMAND 89 countries their proper proportionate share of it unless we used it as a substitute for other forms of money which were retired from circulation to make a place for it. 114. Comparison of effect of increase of supply of gold and paper money. Following out this principle further in connection with fiat and credit money it will appear that it is impossible for a country to increase its supply of these forms of money and keep them at a parity with gold unless there has been an increase in the demand for money due to enlarged volume of business, increased population, etc. Suppose the Government were to issue $500,000,000 new United States notes in addition to the $346,000,000 already outstanding in circulation. Suppose these notes were paid out by the Government for extraordinary expenditures occasioned by some great public enterprise, such as the building of a canal or for materials to carry on a war. These notes would go into circulation and cause the same rise in prices as an equal output of gold. The higher prices would attract imports and discourage exports and there would be credited against us a debit balance which would have to be settled in gold sooner or later. In this way the issue of notes would continue to drive gold out of the country by attracting into the country an equivalent amount of goods from foreign countries until a new equilibrium of prices throughout the world were established. When so much gold has been driven out that it becomes difficult for the bankers to find gold for export, the Government would probably be unable to maintain the new notes on a par with gold, and there would appear all the phenomena which accom- pany a depreciated currency, about which we shall have much to say in a later chapter. 90 MONEY AND BANKING 115. How much money is needed in a country? Fif- teen years ago we heard a great deal in this country about the scarcity of money, and one of the strongest arguments of the Silver Party was that the country needed more money to do business properly. They said that goods were unsalable because there was not the money to purchase them. If the principles which we have worked out above are true, it would be of no use whatever to increase the quantity of money in the coun- try because if we increased the amount we should dimin- ish its exchanging power proportionately and the net re- sult would be that our $2.00 would do no more work than the $1.00 did before. We might even go so far as to say that a country always has enough money to take care of its business needs; however, such a statement would be misleading if we did not take into consideration the effect of fluctuating prices upon industry. The real difficulty of which the silver reformers com- plained was not the insufficient quantity of money, but the low level of commodity prices. They pointed to the western farmer, who was compelled to accept less than fifty cents a bushel for his wheat. There was plenty of money in the country to pay for the wheat and the farmer was really complaining because of the low price rather than because of the lack of a market for the wheat. If everything the farmer had to purchase with the proceeds of his crops supplies for the family, wages of his hired labor, taxes, interest and principal on borrowed money, were diminished proportionately, he would have had no reason to complain. The trouble was that the prices of these things did not diminish pro- portionately with the price of wheat. In the course of time values would adjust themselves in the same pro- portions as before. SUPPLY AND DEMAND 91 116. Price changes not synchronous. In the long run the quantity of money has little effect in altering relative values; for a short period of time, however, it has a very great effect. The reason of this is that some commodities are very susceptible to money influences and respond quickly to changes in the money supply, while others respond very slowly. Stocks and the spec- ulative commodities, such as wheat, cotton, copper, iron, etc., are very easily and quickly influenced; wholesale prices probably feel the effect much sooner than retail prices, in which the influence of custom plays a greater part. Wages feel the change considerably later, so that during a general rise of prices the workingman is at a disadvantage in having to pay more for the food and other necessities before his wages are increased cor- respondingly. Contracts for the payment of money in- crease not at all. The question of the supply of money is an extremely vital one because of its bearing upon our business rela- tions due to the variation in the response of various values to the change in the quantity of money. Changes in the supply of money alter the relation of one class to their advantage and to the disadvantage of another class. An increase in the supply of money puts cred- itors at a disadvantage and favors debtors; it increases the profits of the producers of raw materials at the ex- pense of the wage earners, more especially to the disad- vantage of the recipients of fixed incomes. 117. Stimulating effect of rising prices. There is one effect of increased money supply, the benefit of which has no corresponding disadvantage for the time being. Rising prices of commodities stimulate industry and increase the demand for labor for the materials which enter into capital goods. This increase in indus- 92 MONEY AND BANKING trial activity leads to the greater production of wealth in the form of consumption goods and means a greater per capita distribution. Therefore, economists have concluded that a condition of gradually increasing prices is the ideal one for any community and since it is within the power of a community through the agency of Gov- ernment to regulate the rise and fall of prices through the manipulation of the supply of money, it is possible to make great economic improvements by this means, as we shall discover in a more detailed examination later. 118. Reaction. There is as much to fear from rising as from falling prices if the tendency toward higher price levels is allowed to run into speculation, the over- expansion of credit and the inevitable collapse which fol- lows. Whether it is possible for a Government to so regulate the rise of prices through the manipulation of the supply of money that the evil consequences can be avoided is a matter which may one day become of great importance, especially if the unregulated production of gold should go on increasing at too great a rate. In the present chapter we have seen that the value of gold and conversely the general level of prices is de- termined by the supply of and demand for money. The value of money at any particular moment represents the equilibrium between these two forces. Each of the forces, however, is composed of a great number of tend- encies. Sometimes there may be a particularly large demand for gold in order to exchange a large volume of produce, while at the same time the demand for gold as a store of value may decline; the force of demand therefore is the final result of a number of tendencies and countertendencies. 119. Swings of prices. An estimation of the strength of the demand for money at any particular SUPPLY AND DEMAND 93 time or a prediction as to a future demand is facilitated by the fact that the changes occur, not abruptly, but in great swings. These great swings in the value of gold are simply manifestations of that great law of nature by which all progress occurs rhythmically and not stead- ily in any given direction. The course of prices on the stock exchange, the recurring periods of depression and prosperity, the great cycles of rainfall, are examples of this great natural law which is found to prevail gener- ally throughout the universe. 120. Cumulative effect of economic forces. The ex- planation of these great economic swings of prices and values is to be found in the cumulative effect of the economic forces. We are all familiar with the general pessimism that hangs like a cloud over the community during an economic depression. The obvious fact that the existing supply of goods is steadily diminishing, that the savings deposits of the people are increasing in amount in consequence of the hard lesson of thrift which the people have learned in the hard times, in spite of the steady deterioration in the industrial equip- ment of the country, the wearing out of the rails and rolling stock of the railroads all these factors instead of inspiring confidence for the future among business men are even used as an argument for continued hard times. When the inevitable demand for goods which has tem- porarily been delayed finally begins to assert itself, at first slowly, the business community gradually begins to hope that prosperity is returning. As the prosperity continues the cumulative effect of returning confidence makes itself felt in increasing prices, and since increas- ing prices mean larger profits to anybody owning any kind of property except money itself, there arises an 94 MONEY AND BANKING enormous demand for income yielding property of all sorts, even that which promises to return only a specu- lative profit. When industry is at its height and prices have been put to record breaking levels everybody is optimistic and hopeful of still better conditions. It is at a time like this that the careful observer will note that the produc- tion of both consumption and production goods has in- creased tremendously and will likely soon surpass the needs of the community. He will note that the higher prices go the smaller is the prospect of still further ad- vance and the greater the prospect of a recession to lower levels. He will note that the rate of interest is very high, indicating a scarcity in the supply of loanable funds. His conclusion from this state of affairs will be that in the near future there must inevitably be a greater demand for money and a consequent increase in its value. He also will remember from previous experi- ence that the cumulative effect of human cupidity and optimism which has carried prices to abnormally high levels will have exactly the reverse effect when it is turned in the opposite direction. When the turn comes and the downward tendency begins a corresponding scramble to dispose of goods and to get money in order to realize the increase in value will set in. These great swings in prices offer an explanation of the fact that for long periods of time an increased demand for money has seemed to be accompanied by a fall in value of money instead of a rise. The natural effect of demand in this case is simply suspended for the time being, but when it again asserts itself it will do so with far more than the ordinary consequences and values will be carried much lower than they otherwise would be. CHAPTER VIII THEORY OF PRICES 121. "Short" sales of money. Every buyer and seller whatsoever is a speculator in money, though he may not realize it. Every debtor and creditor is not only a speculator in money but he is a speculator in "fu- tures." Every debtor has sold money short in exactly the same way as a speculator on the board of trade has sold wheat short when he has contracted to deliver a cer- tain number of bushels at a given price at a future time. He gains or loses as the price at that time of delivery has fallen or risen. It is an axiom in the speculative markets that there is no better guaranty for the maintenance of prices than the existence of a large short interest, the reason being that those persons are potential purchasers who must buy within a given time whether they wish to do so or not. Thus in times of credit expansion when peo- ple are going into debt in order to extend their business or for the purpose of buying something which they hope to sell at a higher price later, a large short interest in money is being created and as the time of maturity ap- proaches it is inevitable that there must occur a scram- ble for money with which to satisfy the credit contracts. 122. " Squeezing the shorts"- When the credit ex- pansion has extended to an extraordinary degree there are not lacking shrewd bankers and experts in finance who realize the approaching demand for money before the ordinary business community; these men quietly ac- 95 96 MONEY AND BANKING cumulate a store of funds. They may do this to such an extent that there suddenly develops a condition which might almost be called a corner in money and a squeez- ing of shorts follows. This process of "squeezing" the money shorts is more familiar under the name of a money panic. A man who finds himself obliged to make a payment at a certain time has a choice of one of two courses; he may either borrow or he may sell something he possesses in order to provide himself with funds. In a severe money panic it is practically impossible to borrow money, even upon the most select collateral, and there have been days on the stock exchange when call money ran as high as 186 per cent per annum. 123. Forced selling. Under such conditions the only recourse of the debtor is to sell whatever property he possesses at the best price obtainable. This sudden pressure of selling upon a market which is disinclined to buy will permit prices to descend to a level which would have seemed absolutely ridiculous a few months previ- ous. There are not wanting at such times shrewd peo- ple who realize that there are extraordinary bargains to be found, but it is only a few of these shrewd people who have the means to buy at such times. The great majority of people, however, do not recognize these bar- gains, even if they have the funds ; and instead of buy- ing in a market which offers them a practical certainty of an increase of 25 to 100 per cent on their investment, they prefer to keep it stored away until the stringency as well as the bargains have become a thing of the past. 124. People becoming better educated. There is evi- dence, however, in the panic of 1907 that the people in general are learning to take advantage of the occasional opportunities which tHese great swings of prices offer THEORY OF PRICES 97 them. The books of the great corporations such as the United States Steel Corporation, the Pennsylvania Rail- road and hundreds of others, show a great increase in the number of stockholders after October, 1907. This is a most hopeful sign that in the future as the people be- come better educated in financial affairs the fluctuations in values will become less and less pronounced. It would be impossible to overestimate the great effect in this direction which the recent large output of literature on financial subjects has brought about. 125. General price level. Whenever we have spoken of the effect of changes in the value of money on prices we have always spoken of it as a change in the "general price level." The rising or falling of prices due to a change in the money supply or demand is slow and gradual, while the changes in prices due to causes af- fecting the supply and demand for goods may be sharp and sudden. Furthermore, the prices of some goods may be rising while the prices of others are falling. 126. Price tables. In the first place, therefore, it is necessary in estimating the effect of money to eliminate all those causes which account for changes in the prices of goods. In order to observe the changes in the gen- eral price level price tables have been constructed. The ideal price table would of course represent the average price changes of all the commodities, the exchange of which creates a demand for money. Since this is im- possible the most practical method is to take a certain number of representative commodities. 127. Many commodities. Such a table must not be confined to a few commodities nor to one class, because there might be special causes for an advance of prices of that particular class. An instance of this would be in commodities representing natural resources and raw VII 7 98 MONEY AND BANKING materials. A price table composed of wheat, corn, lum- ber, coal, cotton, would show a rise in price in the last ten years much greater than could be attributed to any change in the value of money. The reason for such a change would be the increase of population relative to the supply of natural resources or the area of land producing them. On the other hand, if we made a price table composed of solely such articles as silk cloth, watches, articles man- ufactured from fine metals, etc., we should find that the average price had probably fallen within the last ten years, the reason being that with the improvement in labor-saving machinery and the greater skill of modern workmen the cost of production was considerably dimin- ished, so that the fall in price would more than offset any diminution in the value of money. 128. Example of price table. It is therefore clear that a price table should be composed of such a variety of commodities that the influences affecting the value of the particular classes will counterbalance each other. The proposition has been stated above that a general rise of values is absolutely impossible in the nature of things, since value is a ratio, and it is impossible to alter the relation of things by equal changes on each side. We give below a sample in outline of a price table con- structed to show the price changes over a period of two years: 1890 % 1892 % Wheat , $ 1.00 100 $ 1.10 110 Cattle 50.00 100 60.00 120 Knives , 20.00 100 15.00 75 Silk cloth , 150.00 100 120.00 80 4) 400 385 100 96-% In this table we have made a hypothetical list of the THEORY OF PRICES 99 prices in 1890 and another for the year 1892. These prices should preferably represent an average for a pe- riod of time in order to avoid any accidental fluctua- tions due to the season or other temporary causes. The prices for 1890 have been made the basis at 100 per cent and the increase or decrease calculated with reference to this base. This table will show that while some prices have advanced others have fallen so that the general level is diminished 3% per cent. 129. "Weighting" of price tables. It may be ob- jected that in this table we have given exactly as much importance to knives as we have to wheat, whereas we know that a change of a cent a bushel in wheat would have vastly greater effect on the demand for money than a change of 100 per cent in the value of knives. To cor- rect this difficulty a system has been devised for "weight- ing" the various items in a price table. The principle of "weighting" is to find some basis of estimating the amount of the particular items and exchange either on the basis of total production or consumption. To weight our price table above it would be necessary to arrange the four items so that wheat would have an influence on the result let us say one hundred times as great as knives; that cattle would have an importance fifty times as great as knives; that silk cloth has an im- portance say ten times as great as knives. The table modified to conform to this weighting arrangement is given below: 1890 1892 Wheat 100 X $ 1.00 = 10000 $ 1.10 = 110000 i Cattle 50 x 50.00 = 5000 60.00 = 6000 Knives 1 X 20.00 = 100 15.00 = 75 Silk cloth . , 10 X 150.00 = 1000 120.00 = 800 161 16100 17875 100% 111 4-161% While the weighting of the price table seems to pro- 100 MONEY AND BANKING duce a very great effect upon our sample table, yet in making actual tables where the number of commodities is much greater the differences shown by simple and weighted price tables are very slight, and since the total result of any price table is but an approximation, it is doubtful whether the weighted price tables are more nearly accurate than the simple price tables. 130. Advantages of weighting. The principle of weighting is important when changes in the price level for certain purposes are desired. For instance, if we desire to know whether the average cost of living for the workingman's family has increased or decreased, the price table should not only show the items which enter into the consumption of the family but they should be weighted to show their importance in the family budget. Tables constructed upon this principle were prepared by Professor Falkner in the most elaborate investigation of prices that has ever been undertaken in this country. The report was prepared for a Committee of the Sen- ate. 1 131. Falkner price table. For this table lists of prices of 90 commodities were covered from 1840 to 1891 ; and 223 commodities were covered for the period from 1860 to 1891. The investigation was conducted with great care and expense, the prices being ascertained from an examination of merchants' accounts. Several tables were prepared from this data which are repro- duced herewith. In the first table the average per- centage of prices for various groups of commodities is given separately, the year 1860 being taken as a basis, or 100 per cent. The average prices of all the com- i Report by Senator Aldrich for the Committee on Finance, March 3, 1893, Senate Document, 52nd Congress, second Session, No. 1394, "Wholesale Prices, Wages and Transportation." THEORY OF PRICES 101 modities taken had decreased to 92.2 per cent in 1801, an average of 7.8 per cent. FALKNER PRICE TABLE 3 o fc M> C 1 T3 i 1 Food and Lighting . . . Metals and Implements Lumber and Build- ing Materials Drugs and Chemicals. House Furnishing Goods Miscellaneous AU Articles | 1840 .... 96.6 1107 395 8 1235 110 145 8 116 4 147 1 116 8 1841 .... 94.4 113.4 2089 123 7 111 8 141 3 1164 147 1 115 8 1842 .... 82.9 100.9 202.0 118.7 1088 131 6 1164 170.6 107 8 1843 .... 79.3 99.9 187.5 114.7 105.4 121.4 100.3 1235 101.5 1844 .... 81.6 105.0 119.7 1333 1030 119 7 1023 129 5 101 9 1845 .... 87.3 97.1 239.6 110.8 106.7 1210 1023 1148 1028 1846 94.6 953 143.8 116 9 1062 1239 111 111 106 4 1847 .... 94.7 97.6 110.7 120.6 108.2 112.5 120.3 121 7 106 5 1848 .... 83.5 87.5 106.1 119.7 105.3 113.0 121.7 125.6 101.4 1849 79.0 82.2 100.0 1249 976 111 1205 109 8 987 1850 .... 85.5 91.3 102.6 114.8 102.2 123.6 125.6 107.7 1023 1851 90.6 94.7 973 1192 972 125 8 1200 102.7 1059 1852 88.7 88.7 93.5 117.7 100.4 111.8 111.9 1005 102.7 1853 101.2 98.6 101.6 122.8 103.2 107.0 118.7 109.2 109.1 1854 105.9 97.4 106.8 125.6 114.1 110.7 121.2 1084 112.9 1855 111.8 94.7 121.1 117.8 103.4 129.2 121.2 115.2 113.1 1856 110.4 100.6 126.4 115.3 102.8 135.5 115.5 121.6 113.3 1857 117.5 106.0 113.3 110.4 105.0 126.8 116.8 110.0 112.5 1858 94.6 98.0 111.4 101.3 103.8 116.0 108.7 97.1 101.8 1859 98.8 101.1 98.8 100.1 98.7 104.2 103.2 100.8 100.2 1860 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 1861 95.8 94.9 103.5 102.5 108.9 101.3 96.8 100.7 100.6 1862 110.4 124.1 97.2 117.2 149.2 116.4 89.5 103.7 117.8 1863 133.0 191.6 107.1 140.0 177.1 146.5 123.1 129.1 148.6 1864 165.8 260.7 180.2 179.8 221.3 170.3 164.6 154.4 190.5 1865 216.5 299.2 237.8 191.4 182.1 271.6 181.1 202.8 216.8 1866 173.8 226.6 280.5 171.1 186.9 230.2 185.3 171.0 191.0 1867 163.9 179.9 196.3 161.3 178.8 211.2 159.1 161.4 172.2 1868 164.2 146.8 218.7 150.5 174.3 177.9 134.9 164.1 160.5 1869 162.9 147.5 206.8 141.3 165.9 160.9 120.7 162.3 153.5 1870 153.8 139.4 196.5 127.8 148.3 149.6 121.6 148.7 142.3 1871 169.3 133.3 144.1 122.2 151.4 139.4 128.5 148.8 136.0 1872 133.3 143.0 149.2 128.0 166.9 134.0 123.2 132.7 138.8 1873 129.8 136.9 134.6 129.8 171.9 141.5 109.1 134.4 137.5 1874 131.5 127.9 149.6 121.1 154.9 146.8 109.5 129.8 133.0 1875 130.5 120.1 156.5 117.5 143.7 144.2 95.0 122.9 127.6 1876 123.1 107.5 144.6 108.4 137.3 121.8 87.2 114.2 118.9 1877 120.3 101.8 108.0 100.0 125.8 122.3 79.0 118.2 110.9 1878 107.0 93.2 93.0 92.1 116.8 114.2 74.3 111.7 101.3 1879 97.6 91.1 95.3 88.4 115.1 110.9 68.6 102.1 96.6 102 MONEY AND BANKING 60 : 3 * q bO c 13 B SO i 9 *3 03 C o J3 B JS O & -M * Sij B 6 CO 1 1 i T3 1 a 03 B 9 tu S (3 t h TJ J3 3 a 00 1 8 < 8 O V 1 1 3 * 2 oO -H h fc h s i-l Q K i < 1880 107.6 104.5 100.2 96.3 130.9 113.1 85.2 109.8 106.9 1881 110.9 99.9 113.7 91.1 131.3 1104 776 1088 105 7 1882 118.8 98.7 110.1 91.2 137.5 107.6 78.1 114.6 108.5 1883 118.8 94.8 114.2 87.5 134.3 981 77.5 1173 106 1884 108.9 88.9 102.4 81.0 129.5 95.7 76.3 111.9 99.4 1885 98.7 84.8 89.6 77.4 126.6 86.9 70.1 97.5 93.0 1886 99.5 85.1 86.2 75.8 128.5 83.9 68.4 91.3 91.9 1887 104.2 84.7 88.6 74.9 126.5 83.6 66.4 88.6 92.6 1888 109.4 84.7 94.9 74.9 124.8 86.0 66.9 89.3 94.2 1889 111.9 83.6 95.3 72.9 124.0 88.8 70.0 88.8 94.2 1890 104.6 82.4 92.5 73.2 123.7 87.9 69.5 89.7 92.3 1891.. . 103.9 81.1 91.0 74.9 122.3 86.3 70.1 95.1 92.2 In the second table we have a tabulation of the same data in weighted form. In the column headed III the percentage given represents the average for all articles according to their importance in the budgets of the average family. In the column headed IV the author attempts to reach a still higher point of accuracy by assuming that the articles covered in the data represent over 68.6 per cent of the total expenditures of each fam- ily. The difference in results produced by these dif- ferent methods seems to be rather small. FALKNER PRICE TABLE WEIGHTED 1* "O A 6o J a I uu sa s 3* o ^^ j a^ ~* &!2^ C8 S HH bfi 3 Si *j OD *e * W 5 . ^"* i 1-1 'C w H c *j ; g f_5 * to*** JJ 9* * & . ^3^ |ig g 1-1 HT! 1^5 ^ ** jy ' o t S 2 'H o *s |j f 5 3 Jj O x C * w o t 1 r^ ^ , %j P_, CO ^ "5 1844 101.9 89.8 85.0 1845 102.8 92.1 B&9 1846 106.4 96.7 95.2 1847 ,, 106.5 96.7 95.2 1848...... 101.4 92.0 885 1849 98.7 88.9 83.5 1850 102.3 92.6 89.2 1851 105.9 99.1 98.6 1852 102.7 98.5 97.9 1853 109.1 103.4 105.0 1854 112.9 103.4 105.0 1855 113.1 106.3 109.2 1856 113.2 108.5 1125 1857 112.5 109.6 114.0 1858 101.8 109.1 113.2 1859 100.2 102.0 102.9 1860 100.0 100.0 100.0 1861 100.6 95.9 94.1 1862 117.8 102.8 104.1 1863 148.6 122.1 132.2 1864 190.5 149.4 172.1 1865 216.8 190.7 232.2 1866 191.0 160.2 187.7 1867 172.2 145.2 165.8 1868 160.5 150.7 173.9 1869 153.5 135.9 1525 1870 1425 130.4 144.4 1871 136.0 124.8 136.1 1872 138.8 122.2 132.4 1873 137.5 119.9 129.0 1874 133.0 120.5 129.9 1875 127.6 119.8 128.9 1876 118.2 115.5 122.6 1877 110.9 109.4 113.6 1878 101.3 103.1 104.6 1879 96.6 96.6 95.0 1880 106.9 103.4 104.9 1881 105.7 105.8 108.4 1882 108.5 106.3 109.1 1883 106.0 104.5 106.6 1884 99.4 101.8 102.6 1885 93.0 95.4 935 1886 91.9 95.5 93.4 1887 92.6 96.2 94.5 1888 94.2 97.4 96.2 1889 94.2 99.0 98.5 1890 925 95.7 93.7 1891 92.2 96.2 94.4 104. MONEY AND BANKING 182. High prices during the Civil War. It will be noticed that the prices during the Civil War Period are extremely high, the percentage for the year 1865 being 216.8 per cent. The reason for this extraordinary rise is due to the fact that the prices were calculated in depre- ciated paper money. We have inserted Table No. 4 showing the average prices reduced to a gold basis dur- ing the period when greenbacks were depreciated. This table will show to what extent the extraordinarily high prices of the Civil War were due to the inflated paper currency. As we have explained elsewhere, most of the people at that time did not regard the paper currency as depreciated, but thought gold was appreciated. 1 The fact that there was nothing connected with the sup- ply and demand for commodities in general which could account for the more than doubling of the prices in the year 1865 is evidence that the extreme fluctuation of prices was to due to money rather than to goods. The figures we have spoken of as percentages are usually called index numbers. These price tables pre- pared by Professor Falkner are continued in the "Bul- letin of the Department of Labor," 2 and the index numbers for the simple table for the period from 1891 to the present time are given on the following page : iThe demand for the greenback as money in 1862 must certainly have been much less than had been the demand for gold in preceding years, for the country had been split in two, so that the monetary demand brought to bear upon the greenback came, for the most part, from only one sec- tion. Johnson, " Money and Currency," p. 276. 2 See " Bulletin for the Department of Labor " for March of each year. A continuation of Professor Falkner's Tables is found in Bulletin No. 27. The Department of Labor has maintained a price table in its bulletins arranged on a basis different from that of the Falkner tables. THEORY OF PRICES COMPARISON OF VARIOUS PRICE TABLES 105 3-> O to 5 'S * S '-' ll ~ (American) (English) to (German) 1860 100. 99 122 121.0 1861 100.6 98 124 118.1 1862 114.9 117.8 101 131 122.6 1863 102.4 148.6 103 159 125.5 1864 122.5 190.5 105 172 129.3 1865 100.3 216.8 101 162 122.6 1866 136.3 191.0 102 162 125.8 1867 127.9 172.2 100 137 124.4 1868 115.9 160.5 99 122 122.0 1869 113.2 153.5 98 121 123.4 1870 117.3 142.3 96 122 122.9 1871 122.9 136.0 100 118 127.0 1872 127.2 138.8 109 129 135.6 1873 122.0 137.5 111 134 138.3 1874 119.4 133.0 102 131 136.2 1875 113.4 127.6 96 126 129.8 1876 104.8 118.2 95 123 129.3 1877 104.4 110.9 94 123 127.7 1878 99.9 1015 87 116 120.6 1879 96.6 96.$ 83 100 117.1 1880 106.9 88 115 121.9 1881 105.7 85 108 121.0 1882 108.5 84 111 122.1 1883 106.0 82 106 122.2 1884 99.4 76 101 114.2 1885 93.0 72 95 108.7 1886 91.9 69 92 104.0 1887 92.6 68 94 102.0 1888 94.2 70 101 102.0 1889 94.2 72 99 106.1 1890 92.3 112.9 72 102 108.1 1891 92.2 111.7 72 101 109.2 1892 87.6 106.1 68 97 1893 87.2 105.6 68 96 1894 79.3 96.1 63 95 1895 77.2 93.6 62 87 1896 74.6 90.4 61 91 1897 74.0 89.7 62 88 1898 77.1 93.4 64 86 1899 83.9 101.7 68 87 1900 91.2 110.5 75 97 1901 88.5 108.5 70 97 1902 93.2 112.9 69 89 1903 93.7 113.6 69 91 1904 935 113.0 70 100 (American) (American) (English) 106 MONEY AND BANKING 133. Foreign price tables. The index numbers given in the last three columns of the table are reproduced from the most important foreign investigations. The Sauerbeck and Economist tables are English, the Soet- beer tables are German. The table of Mr. Augustus Sauerbeck was published in the Journal of the Royal Statistical Society. His indexes are computed by a simple unweighted arithmetical average. He has en- deavored to arrange a limited number of commodities, all of which represent raw products, in classes in such a way as to be equivalent to weighting. The Economist tables have the distinction of being the first to be compiled. Twenty-two articles only are employed in this table and the quotations are those of a given date, either the first of January or the first of July on the averages for the year. The commodities are chosen disproportionately, there being out of the twenty-two, four in which cotton is the principal ele- ment. The German table of Soetbeer was frequently re- ferred to in the Silver Controversy in this country in 1896. The number of commodities was over three hun- dred and the result represents the simple unweighted arithmetical average on the basis of the years 1847 to 1850. As we have indicated before, the value of the study of the science of money and currency is the understand- ing it gives us of the significance of price changes and the data from which predictions as to the course of prices can be made. It is therefore important to get clearly in mind the main points of the two preceding chapters. In the first place a general rise in the prices of all commodities and services indicates that the reason is to be found in a change in the value of money as compared THEORY OF PRICES 107 with other things, since we know that a general rise of values is an impossibility. The rise and fall of general prices is best indicated by means of price tables which correct the errors which a limited observation would be likely to incur. The most convenient and acceptable price table for the average business man is that pub- lished in the bulletins of the Department of Labor. A study of price tables will give the student an idea as to the stage of the swing at which the observed prices are. 134. Economic forces to be observed. Observing the present tendency of prices he will endeavor to find the reason for the tendency. He will find almost any time a number of reasons to account for a rise and also a number of reasons to account for a fall. This makes it necessary for him to estimate quantitatively the potency of each one of these forces and to balance one against the other, in order to discover in which direction the re- sult of these forces tends. The most important of these permanent forces are as follows : 1. Production of gold. At the present time it will be found that the annual production of gold is increas- ing. This in itself means a lower value for gold inas- much as only a very small quantity of gold that is once brought into existence disappears. Nearly all of it is added to the stock already on hand. It is estimated that only about 20 per cent of the gold annually produced is used in the arts. Even this amount is not permanently withdrawn from monetary uses, since it is so easy to re- duce old jewelry and plate to coin. 2. Use of substitutes for money. An increase in the supply of fiat or credit money has the same effect on prices as an increase in the supply of gold. The in- crease in Government issues is purely an arbitrary mat- ter and if it occurs in only one country at any given 108 MONEY AND BANKING time it is likely to displace the proportionate amount of gold, which will be exported from the country as a re- sult of the effects produced upon the foreign exchange market by a rise of prices. The first result of an in- crease of Government paper money is likely to be a rise of prices, but after the equilibrium is established in the course of a few years, other things being equal, the prices are likely to return to their former level. The increase in the amount of credit which serves the purpose of a medium of exchange is highly important. This medium depends upon the degree of perfection to which the banking machinery of a community has been developed. An increase in the number of banks and trust companies and in the capitalization of old institu- tions indicate increased credit facilities which are equiva- lent to an increase in the supply of the medium of ex- change. For short periods of time the periodical infla- tion and deflation of credit, producing the alternate booms and panics, must be taken into account. In the year 1908 there was a considerable reduction in the amount of credit over the year 1906, while the number of banks and the amount of capitalization actually in- creased. The total bank clearings of the principal cities of the United States are a much better index of the volume of credit doing money work than the number of banks or their capitalization. 3. Volume of production. It is obvious that the greater the amount of goods produced the greater will be the number of bidders for money, offering goods in exchange. Under modern conditions practically all the goods produced represent a demand for money, as they must change hands before they are consumed. The producer nowadays very rarely consumes his own prod- uct. THEORY OF PRICES 109 An increase of population means simply an increase in the amount of goods produced and consumed and means a greater competition for the existing supply of money. 4. Extravagant expenditures of the people. During the financial difficulties following the panic of 1907 a great deal was said about the effect of the growing ex- travagance in personal expenditure on the part of the people of this country during the preceding four or five years. This was held by some to be the cause of the stringency of the money market. Of course the more extensive purchasing by the peo- ple represents an addition to the bidding for goods and the offering of money, so that we might conclude that a rise of prices would be the result. On the other hand extravagant expenditure could not have appeared unless incomes had been considerably increased. Increased in- comes are due to a greater productivity. People pro- duce more goods and hence have a larger amount to sell before they can realize their income. This enlarged production of goods causes a bidding for money, which counterbalances the enlarged bidding for goods, that follows immediately upon it. Thus the influence upon prices is diminished. 135. Saving and investing. If instead of spending their incomes in living expenses these people had em- ployed them in any other way except hoarding either depositing them in banks or investing them in securities the producing power would simply have changed its form and instead of causing a bidding up of prices of consumption goods would have had a similar effect in connection with production goods. Money deposited in banks or invested in securities is simply turned over to industrial and business enterprises, when it is spent for 110 MONEY AND BANKING goods, thus having the same effect on the general level of prices. The effect of the expenditure of incomes for con- sumption goods instead of for production goods has no immediate effect on general prices, but it has an im- portant effect upon the future production of goods. Expended upon consumption goods, the effect is to di- minish the supply on the market and encourage indus- trial activity to replace them. If incomes are generally saved and invested they lead to a considerable enlarge- ment of the productive capacity of industries and even- tually lead to an increase in the quantity of consumable goods to be marketed when the factories and machines and equipment begin to run a product. The deductions from this are that extravagant per- sonal expenditures tend to raise prices of consumption goods and to retard future over-production. Saving and investment are far more likely to be the immediate cause of a panic and depression on account of the larger quantity of goods upon the market after the production goods have been installed and before the consuming ca- pacity of the country has caught up with the productive capacity. A much more reasonable cause for a panic than ex- travagant expenditure is to be found in the unreasona- ble expansion of credit, which is likely to be brought about by rising prices and larger profits which induce men to undertake productive enterprises far in excess of the present consuming power of the people. The in- creased bidding for money which such over-production brings about gives the impulse to a cumulative demand for money and a rapid rise in its value compared with other things. THEORY OF PRICES 111 The rule therefore, upon which predictions as to the future course of prices can be made is this : Do existing and future conditions, taken as a whole, warrant the conclusion that the bidding for money or the offering of goods will be stronger than the offering of money and the bidding for goods? CHAPTER IX DOMESTIC AND FOREIGN EXCHANGE 136. Relation between foreign and domestic ex- change. In a preceding chapter mention has been made of the process by which the gold produced in any part of the world is distributed throughout the world. In the present chapter it is proposed to study a little more closely the details of the process of the distribution of money and the methods of making payments between distant points. The subject of foreign exchange is usually regarded as exceedingly complex and technical. The reason for this is that some of the fundamental principles are but little understood. The principles of foreign exchange are exactly the same as those of domestic exchange, the only difference being that there is in foreign exchange the added element of translation from one coinage basis to another. 137. Payments by means of credit balances. The handling of actual currency in transactions of any size, even though the currency be in paper notes of large denominations and the transaction takes place locally, is inconvenient. It is one of the functions of banks to obviate the necessity of making payments in currency, by means of a checking system. The whole idea of making payments and settling accounts without the use of cash depends upon the fact that under certain circum- stances a creditor is just as willing to receive in payment 112 DOMESTIC AND FOREIGN EXCHANGE 113 the right to demand money as he is to receive the cash itself. In cases of large transactions it would be con- sidered a great hardship on the part of the recipient of the payment to be required to accept the currency. 138. Function of the bank in making payments. A bank is an institution which permits persons to create credits either by the deposit of cash or by borrowing at the market rate of interest. Furthermore it permits these creditors to draw orders upon it for any amount up to the limit of their credit. These orders or checks give the holder the right to demand the cash or to create credit for himself by a deposit of the checks. These credits on the books of the banks in favor of their pa- trons furnish a means of payment which has almost superseded the use of cash in transactions of any size. If there were only one bank in a town all the checks drawn against it would return to it, either for payment or deposit. If there are several banks in the city some sort of clearing system is required for settling the debit and credit balances among the different institutions. 139. Payments at a distance. When payments are to be made between distant localities the matter of dis- tance increases the complexity of making the settle- ments, but the principles remain the same. If a busi- ness man in Chicago wishes to pay a bill in Cincinnati he will probably draw a check on his local bank exactly as though his creditor did business in the same city. The Cincinnati man will deposit the check in his local bank and put upon it the burden of making the col- lection. When the banking system of the country was not so well organized as at present the charge for making collections of local checks was so heavy that the creditors frequently refused to take local checks. Under these circumstances the debtor was obliged to apply to his VII 8 MONEY AND BANKING bank for a draft which would be acceptable in the city where the amount was payable. The fact that New York is the commercial and finan- cial center of the United States and that business men in every city and town are likely to have financial relations with that city, either purchasing goods from it or selling goods to it, has made it advisable for banks throughout the country to maintain deposits in banks of that city. Thus it happens that there are always payments to be made in New York by merchants buying there and pay- ments to be made from that city by merchants selling there. 140. Exchange on New York. Without the use of exchange it would be necessary to pay for every ship- ment of goods by forwarding cash and to receive pay- ment for every consignment by transporting cash in the opposite direction. With the use of credit the shipper in the inland town receives payment for his consignment by either drawing a draft upon the consignee or await- ing the receipt of a draft upon a New York bank. Either of these instruments he deposits in his local bank which forwards it to New York and receives a credit there upon the books of the bank against which it was drawn. The bank has then the right to receive a certain sum of money in New York and can realize upon this right either by requesting the shipment of cash or by drawing a draft against it. Merchants who have made purchases from New York must provide a means of payment in New York when the bills are due. The local banks having deposits in New York are quite willing to sell orders upon the New York bank. Thus by means of buying and selling the right to sums of money in New York the payments DOMESTIC AND FOREIGN EXCHANGE 115 which are necessitated by the movement of goods in and out are made. 141. How the banks handle New York exchange. New York exchange or orders upon deposits in New York hanks are acceptable everywhere ; in the first place, because there are so many persons wishing to make pay- ments in that city, and in the second place because every banking institution in the country deals either directly or indirectly with some New York bank. How the local banks get their power to sell drafts on New York can best be shown by a concrete illustration. We will suppose that a bank in Aurora, Illinois, has on deposit $10,000 with the First National of Chicago. Let us suppose that an Aurora manufacturer has sold stoves to an eastern dealer and has received in payment a check for $1,000 on the Corn Ex- change bank of New York. He will deposit this check in his Aurora bank, which will send it to its Chicago correspondent, and thereby increase its credit balance to $11,000. The Chicago bank will send the check to its correspondent in New York, and so increase its credit balance in New York by $1,000. By an arrangement with the First National Bank of Chicago the Aurora bank is able to sell drafts on the Corn Exchange of New York, using for the purpose blank drafts furnished by the First National. It is quite possible that on the same day a merchant in Aurora, who has bought goods from New York, will call upon the Aurora bank for a draft on New York. He may not want a draft for exactly $1,000, but that does not mat- ter. The Aurora bank is able to sell him a draft to any amount up to $11,000, for its credit balance in the Chicago bank gives it a right to "draw" upon New York for that amount. Thus, on account of New York's trade relations with all parts of the country, banks everywhere are usually able to sell drafts on that city without being compelled to ship currency. New York exchange is used not only for payments between 116 MONEY AND BANKING New York and other parts of the country but also for payments between points in the United States outside of New York. A man living in Buffalo who owes $1,000 to a man in New Or- leans can best pay the debt by remitting a draft on New York City. This method is the one usually employed, for Buffalo banks maintain no balances in New Orleans, and so cannot sell drafts on that city. They can, however, sell a draft on New York, and that will usually be accepted by New Orleans banks at par. When the reader takes into account that New York checks and drafts are every day being used in this way for the cancellation of debts in all parts of the United States, he will understand why New York exchange is deservedly called the "business man's money." 142. Settlement of accounts between banks. While in the long run the movement of goods from New York and to New York must practically balance, yet it would be a rare coincidence if the commodities sent from any given locality to New York exactly balance the goods received from that city. Any particular bank, there- fore, has occasion to purchase more New York exchange than it needs to sell, or it has a demand for more than it has occasion to buy or receive on deposit from its cus- tomers. Unless the country bank wishes to shift its deposit account from a New York bank to some other bank it must make a shipment of currency if it wishes to reduce its deposit. In case a country bank has a deposit with its New York correspondent which it considers large enough it will accept deposits of checks on New York only with the intention of making shipments of cash to reimburse itself for the sums paid out. The shipment of currency involves expense and it is quite likely that it will not accept superfluous New York exchange unless it re- i Johnson, " Money and Currency," pp. 79-80. DOMESTIC AND FOREIGN EXCHANGE 117 ceives a fee which will cover the cost of collecting the same in cash. This cost depends upon three items : first the express charge, second insurance, and third the loss of interest. The charge for transportation is usually combined with the charge for insurance by the express company. The moment the New York bank delivers the cash to the express company for shipment to the country bank upon its order it ceases to pay interest upon that sum. The country bank therefore loses the interest upon the same until it receives it and uses it as a basis for interest paying loans. 143. Cost of currency shipments. The cost of cur- rency shipments between New York and Chicago is in the neighborhood of 50 cents per thousand dollars; be- tween St. Louis and New York it is 60 cents; between New Orleans and New York it is 75 cents, and between San Francisco and New York it is $1.50. 144. Settlements through the sub-treasuries. The cost of shipping currency from one city to the other is frequently saved to the banks by the Treasury Depart- ment of the Government. For a good many years pay- ments to be made between the Treasury at Washington and the sub-treasuries in the various large cities were all conducted by cash shipments. It happened very fre- quently that at the same time that the treasury was for- warding considerable sums of cash between two cities, the banks would be shipping currency in the opposite direction. An ingenious cashier in New Orleans early in the seventies suggested to the Secretary of the Treas- ury, McCullough, that a saving both to the Government and the banks might be effected if the banks when they wished to transmit money to a city in which a sub- treasury was located would ascertain whether the Gov- ernment at the same time did not wish to send money in 118 MONEY AND BANKING the opposite direction. If this proved to be the case it would be profitable to the banks and to the Government to allow the banks to deposit the money in the Treasury and receive an order upon the Treasury in the other city. The Treasury office in the first city would receive the currency it required from the depositing bank and the bank in the other city would receive the currency from the Treasury instead of from its correspondent and all cost of transporting the money would be eliminated. 145. Rate of New York exchange. Suppose there was a great demand for New York exchange in any city on account of the heavy bills of merchandise falling due at some particular season of the year. The banks will discover that the demand for New York exchange far exceeds the supply of checks and drafts deposited by customers. Their deposits with their New York cor- respondents are reduced and in order to continue sell- ing New York exchange they must ship currency to that city. In that case they will be justified in charg- ing at least 50 cents premium for every $1,000 of New York exchange sold in order to reimburse themselves for the actual cost. Competition between the local banks will not permit a much higher charge than this. On the other hand if the receipts of New York ex- change exceed the demand for it, on account of heavy shipments of grain or produce to the chief exporting city of the country, the banks will find their deposits in New York larger than they care to maintain. They will be forced to order shipments of currency to them. To reimburse themselves for the expense they will sub- tract from the face value of the exchange bought or received on deposit, the cost of doing the business. Thus it is possible for exchange on New York in San DOMESTIC AND FOREIGN EXCHANGE 110 Francisco to be sold at a premium of $1.50 or to be offered at a discount of the same amount. 146. Significance of rates of domestic exchange. The premium or discount on domestic exchange is pub- lished in the principal dailies and is useful to the busi- ness man as indicating the volume and direction of trade at any particular time. An unusually high premium on New York exchange or an unusually prolonged pre- mium will indicate that the purchases of local merchants has been unusually heavy in that year if there are no unusual transactions to affect the price of exchange. Why does it not happen that under certain circum- stances a community may buy more goods than it sells during any particular period and thus be forced to part with all of its currency in settling the balance? Since each trader is simply looking out for his own private profit and does not concern himself with the question of the amount of currency there seems to be no reason why a community might not be drained of its currency. This brings up the question of the balance of trade, the principles of which are the same whether the exchange of goods is between two separate nations or between two localities within the same nation. Suppose for any reason that there should be an un- usually heavy purchasing of goods by the merchants of a western State in any particular year. The merchants would buy from the banks New York exchange with which to pay their bills. The banks, after having ex- hausted their credits in New York would be obliged to ship currency in order to cover the drafts on New York sold to the merchants. There is never any danger that a community will be stripped of its money or cash as a result of its purchases of goods from 120 MONEY AND BANKING other communities. No matter how freely Chicago and the country tributary to it may purchase goods from the East, those purchases can never make any serious drain upon the cash supply of Chicago. No matter how extravagant the people of the West may be, their purchases of eastern goods can never be greatly in excess of their sales to eastern customers. Should the people of Chicago for extraordinary reasons at any time in- crease their purchases from New York and other eastern cities, the first effect in Chicago would be an increase in the demand for New York exchange and in bank shipments of currency from Chicago to New York. The loss of currency in Chicago, since it would reduce the lending power of Chicago banks, would tend to cause a rise in the rate of interest and a rise in the value of money. The prices of commodities named would begin to de- cline; not of all commodities, but of those which are subjects of speculation, such as stocks, wheat, corn and pork. Most of the speculators in these articles are borrowers, and the interest they pay is an important item in the expenses of their business, so that when the interest rate rises they are obliged to contract their operations. Chicago would thus become a good place to lend in and also a good place in which to buy stocks and bonds, wheat, and other speculative commodities. In other words, the value of money would rise in Chicago, and people in other parts of the country would increase their purchases in Chicago mar- kets, remitting New York exchange in payment. The reader must not suppose that those changes in price or in the rate of interest heed be so great as to attract general attention. Never- theless it cannot be doubted that such changes do take place, and that as a result the sales of Chicago to other parts of the coun- try are so adjusted that in the long run they furnish a supply of New York exchange equal to the demand. Thus it happens throughout the country that in the course of a year the debts of every community are always practically balanced by its credits on account of sales, so that large ship- ments of currency are never necessary. Indeed, if our monetary and banking systems were perfect, no shipment of currency from DOMESTIC AND FOREIGN EXCHANGE one part of the country to another would ever occur as a neces- sary result of trade transactions. Money or currency would only be shipped to a community as a result of an increasing need for it as a medium of exchange or as a basis for the expansion of bank credits. In Canada, for example, on account of the elasticity of its bank-note circulation, seasonal variations in the demand for currency are easily provided for by the local banks and their branches. 1 147. The clearing house principle. Domestic ex- change as we have seen, is simply a banking device to avoid the unnecessary shipment of money by settling bal- ances only. The principle is exactly the same as that on which clearing houses are based. The banks in any one city find at the end of the day that they have re- ceived from their depositors a great number of checks drawn on neighboring banks. Before the days of the clearing house each bank sent a messenger to all the others with the items against them and received the cash in payment. At the same time that each of the banks were sending out messengers to make collections they were paying cash over the counter to the messengers of other banks in settlement of the checks against them. By having a common place of meeting the messengers could deliver the items to the debtor banks and could receive the checks representing the credits due them all at one time and could easily figure up the difference be- tween the debits and the credits. Settlement could then be made by payments representing the differences which were likely to be less than 10 per cent of the total trans- action, thus saving the handling of 90 per cent of the cash represented by the checks handled. The clearing house principle has not yet been applied to its fullest extent in the settling of accounts between i Johnson, M Money and Currency," pp. 83-84. 133 MONEY AND BANKING banks in different localities. The forwarding of the checks to a central point, together with other difficulties which will be discussed later, has up to this time made the establishment of a clearing institution for out of town collections an impossibility. The same result, however, is accomplished by the custom of country banks keeping balances in the city banks and drawing against such accounts instead of shipping currency. 148. Settling balances by use of credit. Methods have been found for eliminating the shipment of cur- rency, even in order to pay balances. Banks which be- come debtors to others through the settlement of accounts may borrow the balance due from the creditor bank and pay interest thereon. This of course is not a final settlement of the balance, but simply postpones the settlement, yet if in the near future the balance happens to run in the opposite direction the loan may be liqui- dated by a credit balance instead of by the payment of cash. 149. Gold the international medium. In the case of domestic exchange ultimate payments may be made in any form of currency but in the settlement of balances between different nations gold is the only acceptable medium. Since gold is the ultimate basis of credit in all civilized countries, and since a volume of currency from six to ten times its amount is erected upon it, the movements of gold from one place to another are of vastly more importance than movements of any other form of cash. Exports and imports of gold in and out of a country are likely to disturb the money situation and to necessitate frequent readjustments of credit condi- tions at new rates of interest. The movements of gold are the result of foreign exchange operations, and it is DOMESTIC AND FOREIGN EXCHANGE 123 this fact which causes business men to scrutinize so carefully daily quotations for foreign exchange. 150. Function of the dealer in foreign exchange. The service to the business community of the interna- tional banker who deals in foreign exchange is not only that he does away with over 90 per cent of the shipments of gold which would otherwise be necessary, and thus causes a great saving of expense and risk in settling commercial transactions, but of far greater importance is the service that he renders in steadying the credit con- ditions the world over. His function is more than to eliminate the shipments of money back and forth to make payments he still further decreases such ship- ments by borrowing and lending in foreign markets, so that the final and absolutely necessary shipments of gold are reduced to a very low minimum as compared to the total amount of business transacted. 151. Example of foreign exchange. Let us take a typical case in foreign commerce and show how the in- ternational banker facilitates the transaction. Armour & Company receive an order from a British dealer in meats for a shipment of beef. After the beef has been loaded on the cars Armour & Company draw a draft on the English consignee which in effect requests him to pay to the Chicago National Bank or anybody else designated by them, the sum of .1,000 sterling. Armour & Company might have waited until the English customer had received the meat and remitted to them a check which Armour & Company could have collected through their bank. If this were the custom Armour & Company would be required to tie up an enormous amount of capital in this export business. It is the almost universal practice of British business men, 124 MONEY AND BANKING however, to draw upon their customers for the amount of goods sold as soon as they are shipped and the American exporters find this very advantageous because they can realize the proceeds of a sale of goods very quickly and it relieves them from the necessity of bor- rowing so much working capital. The Chicago National Bank is willing to purchase or give credit to Armour & Company for the draft im- mediately, although it cannot reimburse itself for sev- eral weeks unless it sells the draft outright to another bank, in which case it simply shifts the burden to the other bank. It is the business of a bank to provide com- merce with working capital for a consideration; in this case the consideration comes to them in the form of a discount which they deduct from the face of the draft in purchasing from Armour & Company. 152. Why bankers are willing to purchase foreign drafts. The bankers are willing to purchase the draft, even though they have never heard of the English firm on whom it is drawn, for the following reasons: (1) The reputation of Armour & Company assures them that the draft would not be drawn unless a shipment of merchandise had been made. (2) Armour & Com- pany as drawers of the draft under the universal law of negotiable instruments, endorse the payment of the same and may be held for payment if the English drawee fails to accept it. (3) In most cases there is attached to the draft a negotiable bill of lading which vests the right to receive the goods in the possessor of the bill of lading. The English bank to whom they have assigned the draft will not deliver the bill of lading until the consignee has accepted or paid the draft. (4) To still further guarantee the banks against loss there is attached to the draft beside the bill DOMESTIC AND FOREIGN EXCHANGE 125 of lading an insurance policy which entitles the banker to receive reimbursement if the consignment should be damaged or lost in transit. There may also be attached to the draft certificates of Government inspection certi- fying the quality of the meat and also an invoice of the shipment. 153. Progress of draft. These safeguards are so effective in guaranteeing payment of the draft that it is extremely rare that even a dispute occurs in trans- actions of this kind. The Chicago National Bank, if it has no correspondent in England, may sell the draft in New York. The New York bank will send the draft to England for collection and credit the same to its ac- count. New York banks are always willing to purchase these foreign drafts and to create credits abroad in order to be in a position to sell foreign exchange to importers and others who are required to make pay- ments abroad. The foreign trade of this country is so large that there is always a demand as well as a sup- ply of foreign exchange. The international banker who deals in it is exactly like a merchant who buys and sells any commodity. 154. Quotations for foreign exchange. The quota- tions for sterling exchange are the prices at which the right to receive certain sums in England is bought and sold in New York and varies like everything else ac- cording to demand and supply. 155. The pound sterling. The monetary unit of England is the pound sterling, which contains 118 grains of pure gold. Since our monetary unit is the dollar, composed of 23.22 grains of gold, it is easy to calculate that the English sovereign, which is the name of the coin containing a pound sterling, is exactly equiv- alent to $4.8665. In other words an English sovereign 126 MONEY AND BANKING can be taken to a United States mint and recoined into 4.8665 American gold dollars. There is a great difference, however, between the right to receive gold sovereigns in England and the possession of gold sovereigns in the United States. A gold sovereign in England will not pay a debt in America unless it is first imported into this country and coined into legal tender. Therefore it is worth to its American owner $4.8665, less the cost of bringing it to this country, unless he can realize upon it by selling the right to receive it in England to some one who wishes to use it there. 156. Cost of shipping gold. The cost of shipping gold across the Atlantic varies slightly from time to time. The fol- lowing figures, showing the cost of shipping $1,000,000 in gold from New York to London were furnished by the representative of one of the largest New York banking houses : Invested in fine bars, 23,220,000 gr $1,000,000 Assay office premium on bars 4 cents per $100 . .,. . 400 Freight 5-32 per cent 1,562 Insurance 1-16 per cent 625.50 Packing and cartage. . 70 $1,002,657.50 The Bank of England's price of gold varies 77s. 9^2^. to 77s. Wy 2 d. per ounce, English standard, 913 3-3 fine. The mint coins an ounce of gold, English standard, into 77s. lO^d. ; but the Bank of England, with which it is the custom of the bullion brokers to deal, usually pays a fraction less than this sum, thus saving itself from loss of interest while the bullion is being coined. It is assumed below that the Bank pays 77s. lOd. per ounce: 48,375 oz. fine equal 52,772.7 oz. 916 2-3 fine, DOMESTIC AND FOREIGN EXCHANGE 127 52,772.7 oz. at 77s. lOd 205,374 Deduct sundry expenses , 4 Net receipts in London 205,370 Cost of sovereign (1,002,675.5 -:- 205,370) $4.8822 Mint par in the United States 4.8665 Cost of shipment per sovereign .$ .0157 No loss of interest is included in the foregoing. The New York banker who furnished the figures held that no such item was involved, for he sold sterling exchange as soon as he made shipment and so was never out his money in consequence. If we include interest, we raise the cost of shipment to $.0197 per sov- ereign. 1 157. The minimum gold point for sterling exchange. Calculating the total cost of shipping gold between America and Europe at the lowest figure of two cents per pound sterling, it is easy to understand why $4.8465 is called the minimum gold point for foreign exchange. If there should be an extraordinary supply of foreign bills for sale their price under normal conditions could never go far below this figure because there would al- ways be some international banker who would be willing to pay for them the moment there was any profit in buying them, for the purpose of exporting the gold, after they had been cashed in England. This mini- mum price does not mean that the value of foreign bills is an exception to the law of supply and demand, but that when the price falls below a certain minimum there arises automatically an unlimited demand. 158. Maximum gold point for sterling exchange. i Johnson, " Monejr and Currency," 128 MONEY AND BANKING On the other hand the price of sterling bills may not rise above $4.8865 under normal conditions because at that figure there is always an unlimited supply, so that no one who wishes to buy need pay any more. The reason for this unlimited supply is this: The interna- tional bankers, seeing a chance for profit, will sell foreign exchange above the maximum gold point whether or not they have a credit balance abroad. Lacking such a balance, they buy gold with the proceeds of the bills. As soon as they have been issued they ex- port gold to Europe so that it will arrive at the same time the bills are presented for payment, thus closing the transaction as far as the issuer of the bills is con- cerned. 159. Why sterling exchange may fall below $4.8465. We have seen that theoretically the price of demand sterling cannot fall much below $4.8465 because of the great demand on the part of the bankers when it tends to fall below. There are conditions, however, under which the price may fall considerably lower without call- ing into existence this demand. In March, 1907, the price fell to $4.83 for a time, and in the autumn it fell still lower. There were several reasons for this. (1) The rate for call loans in New York was very high and the bankers who would otherwise have pur- chased the exchange did not do so because it was more profitable to loan the money than to invest it in the exchange which would have tied it up for at least two weeks, the time required to send the bills to London, exchange them for gold, and ship the gold to this country. (2) The reluctance of the American bankers to with- draw gold from England at a time when it was needed there and when there was danger of a rise in the dis- DOMESTIC AND FOREIGN EXCHANGE 129 count rate if the reserve in the Bank of England were endangered. (3) The difficulty in getting gold for export. The bills could be paid in notes and although the Bank of England must redeem all notes when asked to do so, they have the right to pay out coins of less than full weight and make a difference of a cent in the in the profit of the exporter. (4) The high price of gold bullion in London. To avoid the loss incidental to shipping coins, the abrasion and the light weight, bars of gold must be purchased in the market. Gold bullion is marketed in London as a commodity but with fixed limits to fluctuation of price. (5) The premium on currency in New York in No- vember, 1907, due to the suspension of cash payments by the banks. 160. The gold market. The bulk of the gold pro- duced in the world comes from South Africa direct to London to the amount of about $2,500,000 per week. The bullion brokers meet on Mondays to trade. Some of them have certain amounts of bullion to dispose of; others have buying orders. They begin by comparing notes and quite a variety of interesting situations may be disclosed. There may be a big amount to offer and a few small buyers, or vice versa. At present there is a keen competition for the gold. The Bank of England is required to pay out notes for gold (to buy gold) at the rate of 77s 9d per ounce and this fixes the minimum price. On the other hand, the Bank is under legal obligation to redeem its notes for gold at the rate of 77s 10%d per ounce. This ap- pears at first sight to limit the selling price, but on account of the right of the Bank to pay out light weight coins for the notes the maximum is raised to practically VII 9 130 MONEY AND BANKING 78s per ounce. There is a tacit understanding that the Bank is to have preference when it is willing to pay the best price offered by any other bidder. The fact that the bank of England must buy and sell all the gold offered at the prices fixed by law, makes it very difficult for England to hold her supply of gold when other nations are bidding high for it by maintain- ing high interest rates. England for this reason is called a "free" gold market. The Bank of England exercises control over the gold supply by manipulating the rate of discount, a rise in the rate discourages both foreign and domestic borrowing not only at the Bank but from all other banks who are forced to follow the lead of the Bank in the rate. This means of control is effective, but it is expensive to the business interests of the country to whom the difference of 1 per cent in interest payments means a great deal. 161. Bank of France. During 1907, the system of France seems to have been superior; while there were stringencies in all other markets, while the rate of the Bank of England was held for a long time at 6 per cent, customers of the Bank of France could always get funds at 3 per cent. The Bank of France has a monopoly of note issue, but it is not compelled to redeem its notes in gold. When it desires to protect its gold reserve, the Bank of France refuses to pay out gold in quantities for export except at a premium. This premium is never so high that would-be exporters are induced to gather up the outside gold at considerable expense, but it is high enough to discourage lending in foreign markets by French capitalists without interfering with foreign trade. Proximity of the quotations for demand sterling to the minimum or maximum gold points indicates an ap- DOMESTIC AND FOREIGN EXCHANGE 131 preaching export or import of gold. High quotations indicate exports, while low quotations indicate imports. 162. Gold shipments. Shipments of gold interfere with the basis of credit and are therefore carefully watched by everybody whose interest can be affected by changed conditions in the credit market. The rate of interest and especially the rate of call loans is some- times changed quite suddenly on this account. A sud- den weakening of the call loan rates is very likely to lead to a calling of loans based on securities as collateral with the result that stocks are likely to be thrown on the market for sale, thus depressing prices. This ex- plains the close relation between the foreign exchange market and the stock exchange. 163. Our foreign commerce. It is a well-known fact that according to the official figures given out at the Custom House our exports considerably exceed our im- ports. The figures for the past ten years appear as follows : STATISTICS OF FOREIGN TRADE OF UNITED STATES.i Twelve months ending June 30. Total Imports. 1898. $ 616,049,654 1899 697,148,489 1900 849,941,184 1901 823,172,165 1902 903,320,948 1903 1,025,719,237 1904 991,087,371 1905 1,117,513,071 1906 1,226,562,446 1907 1,434,421,425 1908 1,194341,792 These figures indicate that we are selling a great deal more than we are buying from foreign countries and the natural inference would be that we receive the bal- ance due us from this trade in gold. This is far from iPage 1843 of Monthly Summary of Commerce and Finance of the U. S., April, 1909. Total Excess of Exports. Exports. $1,231,482^30 $615,432,676 1,227,023,302 529,874,813 1,394,483,082 544,541,898 1,487,764,991 664,592,826 1,381,719,401 478,398,453 1,420,141,679 394,422,442 1,460,827,271 469,739,900 1,518,561,666 401,048,595 1,743,864,500 501302,054 1,880,851,078 446,429,653 1,860,773346 666,431,554 132 MONEY AND BANKING being the case. In the year 1898 our excess of exports was $666,000,000, while our imports of gold were $76,- 000,000. In the year 1905 our excess of imports was $400,000,000 while we actually exported $390,000,000 worth of gold. The figures for the export and import of gold for ten years 1898-1908 are given below. This ten year average of imports is considerably higher than previous decades. MOVEMENT OF GOLD TO AND FROM THE UNITED STATES.* Twelve months Total Total Excess of Excess of ending Imports. Exports. Imports. Exports. June 30. 1901 $ 66,051,187 $53,185.177 $12,866,010 $ 1902 52,021,254 48,568,950 4,452,304 1903 44,982,027 47,090,595 ,108,568 1904 99,055,368 81,459,986 17,595,382 1905 53,648,961 92,594,024 38,945,063 1906 96,221,730 38,573,591 57,648,139 1907 114,510,249 51,399,176 63,111,073 1908 148,337,321 72,432,924 75,904,397 164. Invisible items of foreign trade. Even though we do not get paid for our excess of exports in gold, nevertheless we are paid for them in some form or other. The figures of imports and exports include only the goods which pass through the Custom House. There are many kinds of transactions requiring pay- ments of money which are never reported at the Cus- tom House at all and yet their effect upon the trade balance is the same as merchandise. In the last decade the capital of the world has become more and more mobile as the facilities for loaning and investing in foreign countries reached a higher perfection through the banks and stock exchanges. England has always owned a very large amount of American stocks and bonds representing investments in our industries. It is i Monthly Journal, April, 1909, p. 1849. DOMESTIC AND FOREIGN EXCHANGE 133 said that the larger part of the capital used to construct our railroads before 1885 belonged to England. American securities are so extensively dealt in on the London exchange that the closing quotations on the London prices for them at the end of the day, which come, due to the difference in time, at the opening of our own exchanges in this country, have an important effect upon quotations here. 165. Movements of capital. In recent years the well- known thrift of the French people has induced our financiers to make unusual efforts to establish a market for certain American securities in Paris. The Pennsyl- vania Railroad Company sold a very large issue of bonds in that country and at the present writing Mor- gan and Company are eagerly seeking the privilege of listing the securities of the United States Steel Corpo- ration on the Paris Bourse. The United States is just coming to be a market for foreign securities. The only foreign security which is at present quoted on our exchange is the Japanese war bonds. Portions of bond issues of South American states, such as Peru and Chili, are occasionally allotted to American bankers to be disposed of in this country. The movement of these securities to and fro is the most potent cause of fluctuation in the foreign exchange market. Stocks are probably the first thing in the country to feel the effect of the tendency to higher prices, caused by an increased amount of money or credit. A very small rise in the quotations of securities is sufficient to cause considerable selling of them in this market, which has a tendency to create a demand for foreign exchange to pay for them, hence a rise in the price of exchange until exports of gold are induced. This explains why an issue of paper money can drive 134 MONEY AND BANKING an equal amount of gold out of the country so quickly, even before the prices of commodities have felt the change. The more highly developed the financial in- stitutions of the world the more sensitive will every country become to price-changing influences. 166. Interest and dividend payments to foreign stock- holders. Another item of trade which affects the balance without appearing in the Custom House figures is the interest and dividend payments made to the holders of American securities. These payments are made in foreign exchange and create a demand for it, hence they have a tendency to lift the price of foreign exchange away from the gold import point. 167. Freight. Most of the merchandise which is moved to or from the United States is carried in foreign ships. Since 1846 the Americans have found them- selves at a disadvantage compared with England and Germany in the carrying trade of the world and the result is that we must pay freight charges to foreign companies. These payments are made in foreign ex- change and help to create a demand to offset the exces- sive supply of bills on the market. 168. Tourists. There is still another item which does not appear in the official figures. Since European travel has become so popular there has arisen a large demand for letters of credit on the part of tourists. The effect of these letters of credit is to create a de- mand for bills. These four items, namely, securities owned abroad, interest and dividend payments to the holders thereof, freight charges to foreign ship owners, and tourists' ex- penses in Europe in excess of European travel in America represent the equivalent of the excess of DOMESTIC AND FOREIGN EXCHANGE 135 goods we export over those we receive from foreign countries. 169. Foreign exchange market. Below are repro- ductions of a daily article on the foreign exchange mar- ket from the Wall Street Journal: [February 24, 1909.] The foreign exchange market opened strong, with demand sterling 4.8760@4.8765, up ten points from Saturday's close. There was a good inquiry for remittance, attributed to foreign selling of stocks here, and on account of the London settlement. The market remained strong for the first hour's trading, in which demand sterling went to 4.8765@4.8770, but it became evident then that there was not sufficient buying power and the market thereafter sold off. The opening strength was largely influenced by the weak opening of the stock market and Lon- don's sales of stocks here were evidently overestimated. There was some buying of sterling cables for the settlement. In the afternoon bidding was greatly withdrawn and the mar- ket showed further ease, closing with demand sterling 4.8745 @ 4.8750, off fifteen points from the opening and off five points on the day. [May 3, 1909.] The foreign exchange market opened steady, with demand sterling 4.8740@4.8745, unchanged from Friday's close. The large short interest which is said to exist in exchange was further in evidence to-day. The covering movement that started in on Thursday was continued with vigor during the short day's session demand sterling advanced fifteen points. It appears that a considerable part of the present movement is due to the manipulation of one institution, which is thought to be "rigging" the market. The market closed strong with demand sterling 4.8755 @ 4.8760, up fifteen points on the day. 136 MONEY AND BANKING [Compiled by Redmond & Co.] Cables. Demand. 60-days. Sterling open 4 8760a4 8T65 4 8740a4 8745 4 8620a4 fajj: do closed 4 8770a4 8775 4 8755a4 8760 4 8635a4 8G1^- 170. Explanation of articles. Our purpose in re- printing these articles is to acquaint the student with the meaning of the daily money articles. "The foreign exchange market opened up ten points from Saturday's close." A point in foreign exchange is 1/100 of one cent. The "London settlement" refers to the English prac- tice of settling stock exchange transactions fortnightly. That is to say, if a customer gives an order to a banker to buy or sell he is not required to deliver or receive the securities until the next settling date. Because a great many speculators desire to close up their com- mitments before the settlement date there is likely to be considerable foreign trading just before settlement time. If the foreigners have been buying our securities for temporary speculation they are likely to close up the trade by selling. If they have been selling short they are likely to purchase securities just before the settle- ment. "The opening strength was largely influenced by the weak opening of the call market and London sales of stock here were evidently overestimated." The sales of American stocks by London traders would naturally give rise to a demand for exchange with which to settle. Lower prices in the New York market would induce foreign selling and thus strengthen the foreign exchange market. "There was some buying of sterling cables for the settlement." 171. Cables. A cable means the transference of credits by means of cable messages. Dealers in se- DOMESTIC AND FOREIGN EXCHANGE 137 curities who find that they have a balance against them just before settlement time in London have not sufficient time to buy other forms of sterling exchange and send them by mail. In order to meet their obligations in London they are obliged to provide funds in the market at once. "A large short interest which is said to exist in ex- change was further in evidence to-day." Foreign exchange is bought and sold speculatively in much the same way as stocks. If the dealer believes that the price is going down in the near future because of the prospects of an unusual supply of bills or because of an unusually light demand he may "sell short." That is he will contract to provide exchange at a given price at a future time. A short interest existing in sterling exchange will have the same effect upon prices of exchange as the same condition existing in stocks. A person who has sold short must ultimately buy the thing he has agreed to deliver and this buying or "cov- ering" by shorts is likely to sustain prices even in the face of adverse conditions. "The covering movement that started in Thursday was continued with vigor." For some reason on this particular date the shorts concluded that prices were going higher and made all haste to purchase in order to make deliveries before the quotations went higher yet. "It appears that a considerable part of the present movement is due to the manipulation of one institution which is thought to be 'rigging' the market." Here again we find another similarity between the market for foreign exchange and the stock market. Exchange is manipulated by artificially interfering with the bidding and offering. The manipulator who de- 138 MONEY AND BANKING sires to buy or sell either depresses or raises the market quotations by purchases and sales, the object being to inspire similar buying or selling on the part of people who see prices going up or down and wish to partici- pate in the advance or decline, as the case may be. The manipulator is able to advance prices by pur- chases but if he is unable to sell out before the price has declined to its previous level he makes nothing by the transaction. The manipulator always expects that his selling will have a less effect on prices than the buy- ing. Otherwise he gains nothing in the transaction. 172. Varieties of foreign exchange. There are four different varieties of sterling exchange quoted above. Cables we have already described as transfers of credit which take place within an hour or two. Dealers who have sold time drafts on London without having deposited credits there sometimes postpone the forwarding of funds until the drafts have reached maturity. They do this hoping perhaps that the market will decline before the maturity date and thus enable them to purchase exchange at a greater profit. Having waited so long without purchasing demand sterling they are obliged to go into the market for cables at the last moment. It will be noticed that the price of cables is twenty points above the price of demand sterling. This difference represents the price of cable messages and also the interest for six or seven days. The dealer who sells a demand draft knows that the funds cannot be called for in London until the draft has reached that city by mail, which at the very best must require at least six days. In the meantime his London account is draw- ing interest. 173. Demand sterling. Demand sterling repre- sents a draft which is payable on presentation and de- DOMESTIC AND FOREIGN EXCHANGE 139 mand. It will be noted that there is a difference of five points between the quotations at opening and clos- ing. This difference is accounted for by the difference in quality of the drafts in the matter of security. Drafts drawn by the best known and most reliable in- stitutions command a slightly higher price than those issued by weaker firms. Bank drafts command higher price than commercial drafts accompanied by bills of lading and other documents. The price of the ninety day drafts is nearly 2 cents per pound sterling less than for demand drafts. This difference is accounted for by the fact that the purchaser of the draft must wait ninety days before he can demand payment. The 2 cents represents the interest for the ninety days. A point must be noted here that is of great import- ance in understanding the use of finance bills. The rate of interest which is to be subtracted from the quotation for demand sterling in order to get the equivalent for ninety days drafts is reckoned at the English current rate of interest, even if the quotations are given out in New York. The reason for this is that the purchasers of the bills may send them at once to London and redis- count them there at current rates of interest and if they choose to realize on the funds may sell demand sterling at the market price, even before they forward the ninety day bills. 174. English banking customs. There exists in England a class of bankers called bill brokers whose function it is to discount time drafts for persons who desire to realize funds immediately and who are willing to pay a consideration to avoid waiting until the ma- turity of drafts. So universal is the custom in England of drawing drafts for accounts payable that the rate of discount is more important than the rate of loaning 140 MONEY AND BANKING funds. Most English business men have no direct re- lations with banks but deal through these bill brokers in much the same way that in legal matters English people deal directly with a solicitor who represents a barrister, who is the one who appears in court and actually handles the case. The rate at which the long bills can be discounted in London depends very closely upon the official rate at the Bank of England. Very few of the bill brokers expect to hold the bills until maturity, but they expect to rediscount them at one of the large banks ; their profit lies in the difference between the discount which they get from the customer and that they have to pay the bank. The large stock banks of London are under normal circumstances will- ing to discount bills at about y 2 per cent less than the Bank of England. Therefore the official bank rate is nearly always higher than the actual rate. The official rate of the Bank of England has such an important effect upon credit conditions in this country that it is worth while to understand the mechanism by which the relation is kept so close. 175. Finance bills. Interest rates in the two coun- tries are equalized by means of finance bills. A finance bill is a draft drawn by a banker in this country upon a foreign bank for the purpose of realizing funds here for the time being and with the intention of meeting the draft at maturity by the purchase of demand ster- ling or cables. It is simply a method by which a banker borrows money in a cheap market and loans it in a dear one. A concrete case will make the subject clear. Suppose the actual rate of discount in London is 5 per cent and that the rate in this country is 6 per cent. If a banker is able to borrow funds in England and re- loan them in this country he will be able to make a profit DOMESTIC AND FOREIGN EXCHANGE 141 of 1 per cent per annum, less the expense of doing busi- ness. A banker desiring to engage in this transaction is not obliged to actually borrow the funds in England and ship the gold to this country. He can accomplish the same purpose with less expense and loss of time by drawing a ninety day draft against a London bank and selling it in the foreign exchange market and loaning the proceeds at the prevailing rate. The price he will realize for the ninety day draft will be the price of de- mand drafts less a discount equivalent to the London rate, as we have explained above in connection with the quotations on ninety day drafts. It is not necessary that the banker have a deposit credit abroad; under the conditions mentioned it would be very unprofitable for him to have a deposit when he might loan funds to such advantage in his own country. This lack of deposit credit does not deter him from drawing drafts upon the London bank if he can make some arrangements with the bank for accepting the draft so presented in order to give it negotiability with the bill brokers. At the expiration of the ninety days, however, he is obliged to have the funds in the London bank to meet the draft. These funds he provides by purchasing demand sterling a week or so before matur- ity in order to give the draft plenty of time to reach England before the draft is presented; or, if he has waited too long, he must buy a cable. 176. Profit on finance bills. The amount of his profit depends entirely upon the difference between the pro- ceeds realized from the sale of the ninety day draft (which are near the face of the draft, as the discount rate in England is low) , plus the interest he has gained by loaning the proceeds, and the price which he must pay for the means of covering the draft at maturity, MONEY AND BANKING plus the commission for acceptance payable to the English Bank, and the British Government tax on bills. The banker who issues finance bills is forced to be- come a speculator in sterling exchange because his profit depends upon the price at which he can buy demand ster- ling or cables eighty to ninety days after the date of issue of the finance bills. If he wishes to make sure of a profit and shift the risk to others who are more specu- latively inclined or who are better able to forecast the conditions of the supply and demand in the foreign ex- change market in the future he may make a contract at the time of issuing the finance bills for demand sterling eighty days after at a certain fixed price. The issuing of finance bills has the same effect upon the market value of foreign exchange as bills rising out of commer- cial transactions. If they are issued in large amounts at any one time they depress the market, but when the time of maturity of these bills approaches, the purchases of demand sterling to cover stimulate the market artifi- cially. If the condition of the market is such that gold im- ports are imminent the issue and sale of finance bills is likely to reduce the price of bills just enough to bring about the import of gold. In this case the final result is exactly the same as borrowing money abroad and shipping it to this country for loaning purposes. In spite of this very effective method of equalizing interest rates between different countries there are times when the discrepancy between the rates is very great. This is accounted for by the fact that unusual condi- tions exist in one country or the other. The defects in our currency system, of which much is to be said later, are responsible for great variations in the interest rate in New York. It has been said by financiers of authority DOMESTIC AND FOREIGN EXCHANGE 143 that New York can never hope to become the financial center of the world or compete with London in that respect as long as it is possible for the rate on call loans to exceed 100 per cent, or so long as it is possible for a condition to arise where a premium is paid for cur- rency. The profits from the issue of finance bills and from other international financial transactions are so small when reckoned in per cent that the variations of our money market destroy the delicate adjustment by making such operations too speculative and risky. The great advantage which London possesses over every other financial center is stability. Bankers can always depend upon being able to realize funds upon satisfactory collateral in London and take no risk of having their transactions absolutely blocked by a sud- den money panic. 177. Foreign department of a bank. In recent years there has been a great increase in the foreign business of banks and many foreign departments have been es- tablished. This has been due to the rapid extension of our foreign commerce and the large number of Amer- icans traveling abroad, giving rise to a demand for banking facilities to expedite the forwarding of funds and the collection of drafts. Competition between the banks has raised the price paid for commercial drafts drawn by exporters, at the same time it has lowered the price of drafts and banker's checks sold to importers. The advantages to a bank arising from the mainte- nance of foreign department are, according to Mar- graff: 1 1. The foreign department affords facilities to the general clientele of the bank to transact all its banking business with the bank, thereby avoiding the possibility 1 International Exchange: p. 14, 144 MONEY AND BANKING of losing a profitable account that is open to successful solicitation by a competitor. 2. Serves as a valuable auxiliary through the medium of advertisements and personal invitation to attract de- positors. 3. Commands prominence of the name of the bank among New York bankers, by whom its foreign ex- change is purchased, and among bankers throughout the entire world, with whom accounts are kept, and by whom drafts against its letters of credit are negotiated. 4. Practically converts the bank into an international banking institution, thereby vastly increasing its field of operation, by placing it in close touch with the long- established monetary centers of the world. 5. Affords the bank an opportunity of placing loans, at remunerative rates of interest, in European money markets when favorable conditions prevail, by the pur- chase of bills of exchange as an investment. 6. Affords the bank an opportunity of borrowing funds by means of finance bills in any monetary center of the world. The foreign department of a bank usually transacts the following business : 1. Sells letters of credit to travelers and commer- cial houses. 2. Sells drafts to persons desiring to send money abroad. 3. Buys drafts drawn by exporters on foreign con- signees. In addition to these transactions, the possession of a foreign department gives the large international banker a chance to borrow money abroad to loan at a higher rate of interest at home by means of finance bills, or to invest funds in sterling bills of exchange and thus DOMESTIC AND FOREIGN EXCHANGE 145 realize a higher rate of interest than he could get by loaning at home, or to engage in profitable arbitrage transactions. 178. Traveler's letters of credit. So many Ameri- cans travel abroad in these days that there is a large demand for letters of credit. It is so much more con- venient for people to obtain these letters from banks with whom they have an account that if they are com- pelled to get them from other banks they are likely to transfer their accounts to those banks. Letters of credit may be issued in three ways: 1. The purchaser buys the letter outright and pays cash for it at once. The banker sells it to him at the selling price of demand exchange for that day plus 1 per cent commission. Thus a letter for 1,000 with demand sterling selling at $4,8550, would cost $4855 plus $48.55 or $4903.55. 2. If the applicant is a depositor enjoying high credit, the bank is willing to issue to him a letter with- out payment until the customer has drawn money upon the letter and the drafts have been received by the sell- ing bank. 3. If the applicant is not a depositor or one having sufficient credit, the bank will issue a letter upon the deposit of collateral security to secure the amount. Under the last two methods, the customers are not debited with the amounts until the drafts which they have signed to draw out the money abroad have been returned to the bank. These drafts are charged at the current selling rate of sterling exchange plus 1 per cent commission plus interest on the amount for thirty days while the draft is coming from England and while the remittance to cover same is going. A bank can place itself in position to sell letters of VII 10 146 MONEY AND BANKING credit by making arrangements with a London banker who has a large number of correspondents over the world to cash drafts drawn by the holders of letters. A specimen copy of the letter with the signatures of the manager of the department is sent to every correspond- ent of the London banker. When a person presents a letter of credit obtained from a Philadelphia bank addressed to the London City and Midland Bank and its correspondents to the Deutsche Bank in Berlin, for instance, they will com- pare the letter with the specimen on file, then they will write out a draft on the London City and Midland Bank which they will ask the person presenting to sign. If the person has asked for <10, they will give him for the draft the amount in marks which they are paying for sterling drafts on that day. If the price of sterl- ing drafts is M 20.43 per <, the person is entitled to M 204.30 for the 10 draft which he signed and which was endorsed on the letter of credit. The reason why banks are always so willing to cash letters of credit is because of the great demand for sterling exchange everywhere. When the bank has bought a draft for .10, it sends it to London for credit and can immediately sell a draft for 10 against this credit. The London City and Midland, when it receives the draft from the Deutsche Bank, credits it to their ac- count and charges it against the Philadelphia bank. The Philadelphia bank must provide funds in London by buying sterling exchange at home. 179. Commercial letters of credit. These are used by importers to purchase goods abroad. By means of them merchandise can be purchased in any part of the globe on a cash basis, although actual payment of the DOMESTIC AND FOREIGN EXCHANGE 147 cost of the goods imported will not be demanded of the importers, by the banker furnishing the credit, until maturity of respective drafts drawn by the exporters. Advance orders may be given by importers with expor- ters for the manufacture of goods, according to the specifications and requirements of the importers, without prepayment of the value of the goods ordered, or a cash deposit, the commercial letter of credit being sufficient security in the hands of the exporters. The exporters are benefited because they receive cash for all merchandise ordered under the letter of credit on the date of the shipment ; that is to say, drafts cover- ing the cost of merchandise, even if issued for a spec- ified time after sight can be converted into cash by dis- counting such drafts with their local bankers. The buyer of the letter of credit signs an agreement to reim- burse the bank for the drafts drawn under the letter at the current rate of exchange and to pay a commission of 1 per cent on drafts at sixty days 5 sight. The fact that the drafts are drawn at sixty days obviates the necessity of charging interest, for the London bank does not pay the drafts until sixty days after the goods have been shipped and the bank notified that the draft has been made. When the foreigner has the goods ready for shipment he draws the draft and discounts it with the local banker, the letter of credit making it secure and worth more than an ordinary commercial draft. The dis- counting bank either holds it until maturity or sends it to London for discount. Before it is due the American bank provides funds in London to cover it. 180. Buying foreign exchange for investment. Suppose the rate of interest at home is very low at the same time it is high abroad. The international 148 MONEY AND BANKING banker finds that he could make profit by loaning in the better market. He can do this very easily by purchas- ing "long" bills and holding them himself instead of sending them abroad for discount. This he could easily do by detaching the first of exchange (foreign bills are always made out in triplicate) and instead of indors- ing it for discount, would write across the face: "For acceptance only." The correspondent bank receiving same would secure acceptance and hold it. At the end of the period for which the bill ran, or at any time before, if the holder found that he needed the funds, the holder could take the second of ex- change, endorse it for collection and send it. The first containing the acceptance and the second containing the endorsement would together constitute a complete bill. The correspondent would collect (or discount them if they were not yet due) and place the proceeds to the credit of the sending bank. Suppose demand sterling were selling at $4.85, the Bank of England rate was 6 per cent and the average bank rate in this country was 4 per cent. In this case the price of bills would be: * Open discount rate in England 5y 2 %. 90 days' interest at 5y 2 on $4.85 = .0666 British Bill Stamps ' =.0020 Commission 1-40% =.0012 .0698 Therefore the price of ninety-day bills would be $4.85 .07=$4.78. Suppose the banker purchased 10,000 of ninety-day bills at $4.78; the cost would be $47,800. At the end of the ninety days he would be able to sell 10,000 of demand sterling, say at $4.85 (if the price had not fluc- 1 Margraff, " International Exchange," p. 133, DOMESTIC AND FOREIGN EXCHANGE 149 tuated), or a total of $48,500. His profit would be 48,500 $47,800 or $700. If he had loaned the $47,- 800 at 3 per cent, he could have gained in interest only $358.50. The net profit on the exchange would there- fore be $341.50. 181. German and French exchange. The mone- tary unit of Germany is the mark which contains one hundred pfennings. Measured in gold, it is equiva- lent to $.238309 in United States money. The quota- tions for exchange in marks, however, are quoted, not as the price of one mark, but as the price of four marks. For example, demand sterling was recently quoted at $.94 7-16 less 1-32, meaning that drafts on German banks were sold at $.94 7-16 less 1-32 for every four marks. "Less 1-32" means that 1-32 per cent of $.94 7-16 must be deducted from $.94 7-16 to get the true quotation. Expressed decimally the quotation would be .94 .0043 less .0003 or $.9440. In foreign exchanges the expression "per mille" is often used. One-half per mile (written 1-2 0-00) % per thousand or 1-20 per cent. It is a more convenient term that fractional percentages. The French monetary unit is the franc, divided into one hundred centimes. Measured in gold, it is equiv- alent to $.19295 in our money. The quotations for French exchange are given exactly opposite the Eng- lish or German that is, they quote the number of francs which one dollar will purchase. A recent quota- tion for demand exchange on Paris was 5.16 7-8 less 1-32. This means that 5.16 7-8 less 1-32 per cent francs will be sold for $1. It will be noted that the larger the figures, the lower the quotations and vice versa: 5.15 is a higher quotation than 5.16. The quotations vary 1-8 per cent or in intervals of 5-8 150 MONEY AND BANKING centime (because 5-8 centime is approximately 1-8 per cent of 5.15 francs, the basis of computation) . The in- tervals begin with 5.15 and go down thus: 5.15 5-8, 5.16 1-4, 5.16 7-8, 5.17 1-2, 5.18 1-8, 5.18 3-4, etc. The reason for this is the fact that formerly 1-8 per cent was close enough for the brokers and was a convenient figure in arbitrage transactions. Recently prices are quoted closer and the quotations are raised and lowered by de- ducting or adding 1-16 per cent, 1-32 per cent or 1-64 per cent. In order to deal with such awkward quotations it is necessary to convert them into decimals, for it is im- possible to find, for instance, 5 per cent on 5.16 7-8 less 1-32. To convert 5.16 7-8 less 1-32 into a decimal, we would first find the decimal equivalent of .007-8 = .00875; then we would find 1-32 per cent of 5.16 7-8 = .00156 + 5.16 + .00875 = 5.16875. To this we must add .00156 = 5.17031. It is added because "less 1-32 per cent" means a lower quotation; since the higher the figures are the lower the actual quotation must be, the reason for adding the decimal instead of subtract- ing it is clear. To convert a quotation expressed decimally to the reg- ular fractional form is more difficult. Let us take, for example, 5.1925. The next nearest quotation fractionally is 5.19 3-8 (see list above) or 5.19375, which is too large by .00125. .00125 is equivalent approximately to 1-32 per cent of 5.19, so we would complete the quotation by reducing the 5.19375 by 1-32 per cent, making it 5.19 3-8 plus 1-32, plus representing a lowering of the actual quota- tion. To find the value of a 90 day bill on Paris for 525 francs if demand exchange were at 5.16 7-8 less DOMESTIC AND FOREIGN EXCHANGE 151 1-32 (5.17031 as above) we would calculate the discount and expenses : * Francs. Commission 1-40% or y t % (% = PER MILLE) 13 French Bill Stamp 1-20% or 1 20-00 36 Discount 90 days at 2%% 3.60 Francs 3.990 Price of demand exchange 517.031 Price of 90-day exchange 521.021 Quotation per $1.00 worth of exchange 5.21 3.99 francs are added to the price of demand because 90 day exchange is worth less than demand and the lower the quotation, the greater the number of francs given for $1. 182. Arbitrage. The arbitrage transaction consists in buying or selling exchange on a certain center indi- rectly through a third city. For example, a banker wishing to increase his London balance would buy Ber- lin exchange and instruct his German correspondent to use the proceeds of the bill in purchasing sterling in Berlin, thus increasing his London balance by the tri- angular operation. Suppose a banker had an opportunity to sell a draft on Paris but had no funds there. It would be very easy for him to sell the draft, purchase with the pro- ceeds sterling exchange, remit it to London with in- structions to purchase Paris exchange in London with the proceeds and forward for credit to the Paris corre- spondent to cover the draft sold at first. Suppose the quotations for the day were as follows: Sterling exchange in New York $ 4.84 Paris exchange in New York ^.l? 1 /^ Francs in London 25.25 per i Margraff, " International Exchange," p. 142. 152 MONEY AND BANKING If he sold a draft for 25,250 francs, he would receive therefrom $4,879.23 (25,250 divided by 5.175). To cover this draft in Paris by French exchange purchased in London, it would be necessary for him to buy sterling exchange at $4.84. If 25.25 francs in London sold for < he would be required to buy .1,000 in order to get 25,250 francs. This would cost him in New York at $4.84, $4,840. His profit would be: Proceeds $4,879.23 Cost 4,840 $ 39.93 His London banker would probably charge him 1-40 per cent for doing the business, which would cut down his profit by $1.21, leaving it net at about $38.00. The quotations in New York for continental ex- change are influenced largely by the price of sterling exchange, both in New York and in Berlin or Paris. If from any cause the price of continental exchange in New York should tend to fall to a point where there would be a profit in the arbitrage transaction, the de- mand for it on the part of the bankers who wish to make a profit from arbitraging would immediately force up the price again. Therefore, there is a certain relation existing between all the quotations of foreign exchange. When there is neither profit nor loss from arbitraging, they are said to be at par. For instance, if demand sterling in New York were at $4.8665, the unit par., and in Berlin at 20.43, also the unit par, the commercial par of marks in New York could be found by dividing 4,8664 by 20.43, equals .2383, the value of one mark exchange in New York; multiply it by four (.2383x4=.9582) and we have the commercial par of exchange for mark exchange which is also the mint par. % CHAPTER X PRODUCTION OF THE PRECIOUS METALS 183. World's stock of gold. The total amount of gold estimated to have been produced in the world within historic times is $10,948,899,000. The amount of gold at present in use throughout the world as money is $5,685,700,000; thus leaving over $5,000,000,000 to be accounted for. Of this amount it is calculated that two and a half billions have been consumed in the arts, and fifty millions have been lost through the abrasion of coins; and that $1,300,000,000 has been exported to the Asiatic countries where it has been hoarded and passed out of monetary use. This leaves unac- counted for about $1,800,000,000, which probably rep- resents the gold that has been lost in transporting it across the sea, or has been hidden away in the earth, or is at present in hoards of which no record is kept. 184. History of the precious metals. According to the figures of the production of silver throughout his- toric times it is estimated that there has been produced over $12,000,000,000, which is accounted for as follows: Consumed in the arts, $1,750,000,000; devoted to mone- tary uses, $3,213,000,000 ; exported to India and China, $1,990,000,000. This leaves unaccounted for the sum of five billions. In ancient times there was considerable production of the precious metals, mostly from the mines of southern Europe. These sources were worked by slave labor al- most exclusively, and the productions found their way 153 154 MONEY AND BANKING into great hoards which served no valuable purpose other than to provide a visible evidence of the wealth and power of the owner. Only a small part of the existing stock of precious metals was used as a circulating me- dium, and of course at that time its use as a basis of credit was entirely unknown. Gold and silver were regarded as an end, not as a means; as treasure, not money. They were distributed, not by trade, but by war. It was the hand of the conqueror that stripped them from palaces and temples. If they were taken from the store of monarchs, it was not to freight the caravans of commerce, but to fill the chariots and mule carts, to load the sumpter horses or the camel trains of a victorious army. 1 After the fall of the Roman Empire the mines fell into the hands of the barbarians in their southern migra- tions and ceased to be worked. From that time on until the discovery of America the quantity of precious metals in Europe decreased rather than increased. Large quantities were used in decorating the churches. There was probably even less used for monetary pur- poses than the limited amount which had been so used in the ancient times. 185. The Feudal Period. Under the feudal system society was organized on a basis on which was required very little exchange of products, and most of what exchange existed was done on a barter basis. Taxes and payments to the lord of the manor were made in produce. The royal court was maintained not from money taxes collected, but from the produce of the crown lands which the king received as the lord of the manor. Wars were conducted without the use of money; the soldiers were equipped from their own re- i F. A. Walker, " Money," p. 108. PRODUCTION OF PRECIOUS METALS 155 sources and were sustained from the forage of the country traversed in campaigns. 186. Discovery of America. One of the most impor- tant effects of the discovery of America on European economic conditions arose from the quantities of silver which began to flow in an increasing stream from the Spanish colonies to Spain and from thence to be dis- bursed throughout Europe. The eager quest of the early explorers for the precious metals can be better understood when we know that the value of silver was many times its value to-day, and that the precious metals were about the only property which could be profitably transported during these times when transportation was so difficult and expensive. When Columbus and the explorers who followed him set out on their quest for undiscovered countries, it was largely with the hope of finding gold and silver. Gold was found at the outset in Hispaniola, the first island acquired by Columbus for Spain, but even with the forced labor of the natives it was obtained in. only limited quantities. The quest for gold, at first disap- pointed, was more amply rewarded after the conquest of Mexico by Cortez, about 1520, and of Peru by Pizzaro, about 1532. The treasures which had been accumulated by many years of mining by the simple but partly civilized peoples of these coun- tries were poured into Europe and were the subject of most fab- ulous estimates as to their amounts. Thus, the ransom of the Inca of Peru extorted by Pizzaro a sum equal to about $4,- 000,000 gold of our money, and an additional sum in silver was a large amount to be distributed among a small body of adventurers, but did not add greatly to the monetary resources of the world. It was the discovery of rich silver deposits of the mountain of Potosi, in Peru, about 1545, which revealed the New World as an important producer of the precious metals and especially of silver. Up to this date (14931545) the pro- duction of gold preponderated in the proportion of about $220,- 156 MONEY AND BANKING 000,000 to $144,0001,000 in silver; but from that discovery, fol- lowed by many others, began what Leroy-Beaulieu designates as "the first age of silver." It was an age which lasted for nearly three centuries, terminating about 1840, and which brought into the commercial world nearly $6,000,000,000' of silver against less than half as much gold. 1 187. Effect of silver from America. The effect of the American silver upon the economic conditions of Europe was revolutionary. Payments from the tenants to the landlords for the use of the soil had been made either in produce or in labor, a system which reduced the tenant to a condition not far removed from that of the slave. Commerce was so limited that every com- munity had to be practically self-supporting, and its consumption was limited to the articles which could be produced in the immediate vicinity. The lack of com- merce made it possible for famine to exist in one county while great plenty existed in the neighboring county. The transmission from payment in kind to money payment, which soon profoundly altered the relations between the lords and tenants, making the latter much more independent, was not so much due to the greater abundance of money as it was to the effect produced by the new silver on prices of all commodities. The Span- iards to whom this new silver first came, appeared in the markets of Europe as purchasers of goods, thus creating a steady demand for export. The rise of prices and the steady market gave a stimulus to indus- try. Originally money had been used chiefly as a store of value and had been hoarded up as a protection against misfortune. This was justified from the con- ditions of the time which made it difficult to accumulate any other form of property. The land was not bought i C. A. Conant, " The Principles of Money and Banking," p. 86. PRODUCTION OF PRECIOUS METALS 157 and sold as to-day, but was considered permanent in the possession of families who held it under various forms of limited title from the king or lord. There was very little opportunity to acquire produc- tive capital. What little invested capital there was in the form of flour mills, etc., was held by the lords under the same conditions as the land practically. Money was therefore about the only form of property in which savings could be invested. There was no incentive to circulate money except when misfortune forced the possessor to release it for the necessities of life, or when it was extorted by force. 188. Increased circulation of money. The rise of prices accompanied as it was by the growth of commerce and by the commutation of money for labor dues had the effect of putting money into circulation. As the opportunities increased for the investment of funds in some form of productive property, the tendency to hold money grew less and less especially as the increase in the value of goods and the decline in the value of money made the latter very unprofitable and a losing invest- ment. It is doubtful whether the new silver which flowed into Europe, when measured in terms of value, increased the amount of money. An ounce of silver was worth so much less that the increased quantity had little more power to perform money work than the smaller quan- tity had before. The effect was produced by the change of prices and by the consequent increase in the circulating power of the stock of silver already existing in Europe. 189. Discovery of gold in California. The quantity of gold and silver in the world was subjected to an- other great change in the middle of the nineteenth cen- 158 MONEY AND BANKING tury. On January 28, 1848, a workman named Mar- shall, while erecting a sawmill on the American fork of the Sacramento River, discovered gold in the mill race and within three years from that time California had not only become a part of the United States, when it had previously belonged to Mexico, but had also been admitted as a State under the Compromise of 1850. Gold had been discovered in Australia in 1823, but min- ing had been discouraged by the Government. Under the stimulus of the California gold discoveries, the Government changed its attitude and the rush of gold seekers to Australia in the early 50's was almost as great as that to California. As a result of these discoveries the annual average production of gold increased from about $16,000,000 before 1850 to nearly $130,000,000 between 1850 and 1870. The effect upon prices may be seen in the price tables of that period. 190. Effect of California gold. Owing to the fact that the monetary circulation in this country during that period consisted almost entirely of bank notes based on the specie reserve, the effect of the new gold was not so pronounced as it would have been had the circulation consisted entirely of specie. The gold which was not required for circulation in California and which was not exported was used to strengthen the bank reserves and to provide for the increased circulation required by ex- panding industries. The tendency of the sudden ad- dition of so large a quantity of gold to the world's supply would have been to raise prices very sharply, had it not been diverted by these considerations. After 1870 the annual production of gold declined steadily for twenty years and had more serious economic effects than the increase in the previous twenty years had had. The declining prices which it occasioned gave PRODUCTION OF PRECIOUS METALS 159 rise to the silver question which agitated the world for more than ten years. 191. South African gold. The discovery of gold in South Africa in 1889 and in the Klondike region a few years later brought another period of increased gold production and a rise in prices. These later discoveries, combined with the invention of new processes for the extraction of gold, have given the science of money an entirely new turn within the last ten years. 192. Production of gold. The following table shows the production of gold and silver from 1492 to 1906: 1 Gold. Silver. Total. Annual Average. Total. Annual Average. 1500-1800 $2,371,000,000 1801-1850 798,000,000 1851-1870 2,596,000,000 1871-1890 2,211,000,000 1891-1900 2,101,000,000 1901 262,000,000 1902 295,000,000 1903 325,000,000 1904 358,000,000 1905 379,000,000 1906 400,242,100 1907 410,436,000 B 7,900,000 $4,863,000,000 $ 16,210,000 15,960,000 1,359,000,000 27,180,000 129,800,000 879,000,000 43,900,000 110,500,000 2,218,000,000 110,900,000 210,100,000 2,089,000,000 208,900,000 223,000,000 215,000,000 220,000,000 226,000,000 203,429,400 193. Origin of gold. The specific gravity of gold is very high and is exceeded by very few metals, most of which are exceedingly scarce and valuable. The theory is that when the earth was thrown off from the sun it was in a gaseous state. The gradual cooling of the mass and the dispersion of heat permitted the forma- tion of liquids and finally of solids. The first solids to be formed were the metals of the highest specific gravity which naturally sank to the center of the earth through the gaseous and liquid medium by the force of gravity. As the cooling process continued and the i Report of Director of the Mint. 160 MONEY AND BANKING earth took solid form, there were tremendous upheavals of the surface. The enormous heat at the center formed gases which in escaping threw up to the surface molten matter containing gold in combination with other elements. This accounts for the presence of gold in mountainous localities where the upheavals have been severe and gives rise to the theory that at the center of the earth gold exists in large quantities. 194. Sources of gold. Until within recent years practically all the gold produced was taken from gravel deposits. The free gold had been washed out of the rock by erosion, had been carried down in the streams and because of its great weight had sunk to the bottom of the stream not far from the place of its origin. These small particles of free gold were separated from the mass of sand and gravel by the simple process of "panning." The mass was mixed with water and gradually shaken until the sand had been washed away, leaving only the heavier materials behind. The fine particles of gold were separated from the gravel by means of quick silver, for which it has a very great affinity. The gold was then separated from the quick silver by filtering the latter through heavy skins. 195. Improvements on placer mining. This simple process has been developed by the use of machinery into hydraulic mining and "sluicing." A powerful head of water is obtained by diverting a stream of water from the mountains by conduits. This head of water produces a jet which is directed against the banks of gold bearing earth, tears them down and washes them into the sluices. In these sluices are built artificial ob- structions which are called riffles and which catch the particles of gold as they sink to the bottom. The gold PRODUCTION OF PRECIOUS METALS 161 is recovered by means of quick silver the same as in panning. 196. Dredging. Another modern method is that of dredging. Huge dredgers follow the beds of streams, scraping up in huge shovels the gold bearing earth, washing it out inside the dredge and passing out the earth and water behind as the dredge moves on. This wholesale machine method of placer mining has re- duced the cost of producing gold under this process from $5.00 to $8.00 per ton of material handled to 1% to 8 cents. 197. Quartz mining. Other processes of mining have been so developed that at the present time the largest portion of the gold produced is taken from the quartz. Gold occurs in the rock either in the form of free milling gold which requires simply to be separated from the rock by a mechanical process or it occurs in chemical combination with other elements which requires special treatment to be recovered. The quan- tity of gold which can be produced by the placer process is limited because the beds of streams can be exhausted very soon. The opportunities for extracting the gold from rock formation has made the future pro- duction of gold very much more certain and reliable. In extracting gold from quartz it is first crushed with powerful machinery. The question of power to run the ore crushing machines has been a very serious one be- cause the mines have usually been in inaccessible places remote from coal deposits. The question has been solved in recent years by the development of electrical transmission so that the energy in the mountain streams can be converted into electricity and transmitted hun- dreds of miles by wire to the mines. If the ores are VII 11 162 MONEY AND BANKING refractory, containing sulphur and other troublesome elements, they must first be roasted to expel these ele- ments in the form of gas. After roasting chlorine is added, which combines with the gold, forming chloride of gold. Water is then added to the mass and the chloride of gold leached out. The pure gold is pre- cipitated from the chloride by means of sulphate of iron. Cyanide of potassium is another medium used in extracting gold. The gold is precipitated from the solution either by zinc shavings or by electrolysis. In the latter process gold is deposited on aluminum plates from which it can be easily removed. These processes described have made it possible to treat ores of a very low grade; in fact it has been pos- sible to work over profitably the "tailings" from old placer mines. 198. The Comstock Lode. The "Comstock Lode," one of the most famous of the silver mines, was also a large producer of gold. Although discovered in 1858 by a Virginian miner named Finney, the lode took its name from a high-handed and reckless adventurer named Henry Comstock. It was gold which was first taken out, and before mining for silver was systematized a serious battle for control of the country had to be fought with the Indians at Pyramid Lake. Then moved across the scene Adolph Sutro, with his finally successful plan for a tunnel to carry off the waters; William Sharon, agent of the Bank of California and railway promoter; John Mackay, J. G. Fair, James Flood, and William 0'Brien, as purchasers of the Vir- ginia Consolidated and discoverers of the "Big Bonanza" ; after 1877 came the falling off in the product and the gradual decline of the mine. Up to 1880 the total product of the Comstock mines was computed at $174,000,000 in silver and $132,000,000 in gold. The highest yield was $38,000,000 in 1876. In 1880 the product had fallen to $5,100,000 and in 1881 to $1,000,000. PRODUCTION OF PRECIOUS METALS 163 The Comstock Lode was typical of the highly speculative char- acter of mining enterprises. Of 103 mining enterprises started up to 1880, only six proved profitable. They yielded a product of $115,900,000 for an expenditure of $18,300,000. The other ninety-seven mines, even in this rich district, showed a loss of $43,400,000. While cost of production must in the long run influence the volume of the precious metals taken from the mines, the speculative character of mining has made this in- fluence difficult to trace and slow in its operation. It is prob- able that the total stock of gold and silver taken from the earth has been extracted at a cost in labor several times the value of the metal obtained. Where a few have obtained rich prizes, many more have suffered disappointment and ruin. It is necessary not merely to obtain the metals, but to obtain them in propor- tions which compensate for the labor expended. They must, as Hauser expresses it, fall within the "limit of exploitability." A summary of the economic results in the Californian mines, made by Dr. Reyer, after the study of actual conditions, puts the case thus : "Even though the dividends in particular cases are large, they by no means cover the deficit of all the unprofitable under- takings. In fact, the production of gold here, as in Australia, has always yielded a net loss. This may be explained as fol- lows: A few dozen mines produce the great mass of gold. They make large profits and determine the price. Their success attracts capital without end to similar undertakings; these are given up after awhile, and the money is returned to other really productive branches of industry. But the temptation from the fortunate gold producers continues, and causes new capital con- stantly to rush to its destruction the same phenomenon that is seen in games of chance. A few win a great deal; hundreds lose all they have. The business, on the whole, is a losing one." l i C. A. Conant, " The Principles of Money and Banking," pp. 92-3. CHAPTER XI BIMETALLISM 199. Bimetallism defined. Bimetallism is a mone- tary system under which a government permits any- body to bring gold or silver to the mints and have it coined into money, which shall be legal tender for all purposes. By thus permitting the coinage of metals without restriction the relation between the values of coins and bullion is automatically regulated. A demand for money will tend to increase its value compared to bullion, or as it appears to the public, the price of bul- lion falls slightly. Even a very small decline would be sufficient to induce somebody to convert bullion into coins through the mint and thus re-establish the equilib- rium. Prior to 1816 countries were on a bimetallic basis, admitting to their mints both metals at a fixed ratio. In this country the first coinage laws established a double standard; the dollar was to be composed of either 371.25 grains of silver or 24.75 grains of pure gold, the ratio as to weight being fifteen to one. 200. Difficulties of bimetallism. In our study of the standards in a previous chapter we have seen how the difference in mint ratios between the different Governments created a condition which has made it im- possible to keep gold and silver coins in circulation con- currently. In fact there has been no time since the founding of our Government when it could have been said that we were actually upon a double standard. The truth is that at first we were upon a silver standard ; 164 BIMETALLISM 165 then from 1834 to 1862 we were upon a gold stand- ard; then from 1862 to the resumption of specie pay- ments in 1879 we were upon a paper money standard; from 1873 to 1879 we were nominally upon a single gold standard and after the latter date actually upon a gold standard. In 1816 England adopted a single gold standard and was the first country to do so. The other countries of Europe and the United States continued nominally upon an alternating standard until the 70's. Before the beginning of the nineteenth century bi- metallism in Europe was practicable because at that time trade had not been developed to a point where the different ratios in the different countries produced any appreciable flow of metals. It is not until values and prices respond readily to conditions of supply and de- mand and until there is sufficient commercial intercourse between localities to equalize values that difficulties con- cerning the standard arise. Prior to the nineteenth cen- tury there were so many interferences with the natural play of supply and demand that the values were mostly conventional rather than competitive. 201. Advantages of bimetallism. Notwithstanding that practically all of the nations of the earth except- ing England were on a bimetallic basis before 1870, the system could not be called international bimetallism be- cause of the different ratios of the various countries. Those authorities who advocate bimetallism do so on the ground that it assures a more stable standard than either metal if used exclusively. It is argued that if the pro- duction of either metal should diminish compared with the other its natural rise of value would prevent its being taken to the mint for coinage; the monetary de- mand of the country would therefore fall upon the 166 MONEY AND BANKING other metal according to Gresham's Law which is. a statement of the tendency of cheaper money to drive out the dearer. The increased demand for the more abundant metal transferred to it from the scarcer metal would tend to restore the equilibrium between the two. For instance, if under the conditions just mentioned it had been gold that had grown scarcer and more valuable, under bimetallism the money demand would have been transferred to silver until its bullion value again was restored to an equality with gold. If there had been a single gold standard under the same cir- cumstances the increased value of gold would have re- sulted in an appreciating standard and a consequent fall in prices. Under the double standard there could be no rise of general prices until the quantity of both gold and silver had altered sufficiently to produce this result. 202. International bimetallism. The argument of the advocate of bimetallism is theoretically sound if the system is adopted by all countries at the same ratio. If only a few countries have a bimetallic standard, the changes in the quantity of the production of either metal, instead of throwing increased demand upon the other metal, would tend to cause an export of the scarcer and an import of the more abundant metal so that the system would not only fail to prevent fluctuations of prices, but would bring about conditions which might lead to a grave crisis. 203. Disadvantages to commerce of different stand- ard. There are a great many advantages in favor of one common par of exchange between all countries hav- ing extensive commercial relations. The difficulties encountered when the standard of the trading countries is different is apparent in the silver standard countries BIMETALLISM 167 to-day. Importers of goods from silver countries are forced to become speculators in silver. If they force the dealer with whom they contract for goods to quote prices in gold they simply shift the speculative risk to his shoulders. It is axiomatic that wherever there is risk and uncertainty in making contracts and doing bus- iness the volume of business will diminish and the ex- pense of doing it increase. More serious than the complications in importing and exporting merchandise is the hindrance which different money standards place in the way of the international movement of capital. Countries on a silver basis when they wish to place a loan in the world's money centers are obliged to promise payment in gold; since the in- come upon which they depend to pay interest and prin- cipal comes to them in silver, they are likely to face grave problems at any time, should the values of gold and silver standards change. Every decline in the price of silver in the world's markets means to the silver standard countries an appreciation of gold and greater difficulty in payment of debts. Private enterprises are restricted in the same way. If to the uncertainty of investment in the new country there is added the uncertainty of the value of profits earned on capital sent to those countries, the invest- ments offered to attract foreign capital must be more than other countries need to offer. The silver standard countries are laboring under a handicap in competition with gold standard countries. 204. Early attempts at inflation. After 1870 there was continuous decrease in the annual amount of gold produced in the world, the result of which was to check the rise of prices and to cause them to decline. In the United States the decline of prices was accentuated bjr 168 MONEY AND BANKING the contraction of the paper currency of the Civil War Period. This decline of prices was very unwelcome to a large class of persons who attributed it to a scarcity of money. They sought to improve this condition by advocating an issue of additional amounts of paper money. The agitation took shape in the formation of the greenback party in the 70's which was strong enough to force through Congress a bill providing that the retirement of the greenbacks should be suspended and that new issues should be put out. This infla- tionists' bill was vetoed by President Grant, but the re- tirement of the greenbacks which had gone on steadily for ten years was brought to an end and the quantity in circulation fixed at the amount at which it now stands, namely $346,000,000. This attempt to raise prices by artificial interference with the money system of the country was unsuccessful in increasing the paper money of the country, but it was the parent of a movement which sought to accomplish the same purpose with silver instead of paper as the means. But before we discuss the silver question as such, it is proper to study the conditions which led up to it. Simultaneously with the decrease in the production of gold and the increase in the production of silver the influence of England, which was on a single gold stand- ard, was no doubt the cause which induced the bimetal- lic countries to demonetize silver at this time. 205. Demonetization of silver. The term "demoneti- zation of silver" signifies the suspension of the free coinage of that metal. When the mints refuse to coin silver bullion into money, the value of that metal is no longer sustained by the demand for it as money. Henceforth its value is determined the same as that BIMETALLISM 169 of any other commodity inasmuch as that peculiar de- mand which before distinguished it from other com- modities is now withdrawn. Demonetization does not mean that the metal is no longer to be used as money, for silver is still used in all countries which have de- monetized it. The silver coins in a gold standard country belong to the class of credit money instead of standard money. Their value has no relation to the quantity of metal in them, any more than the paper dol- lar is affected by the rise and fall in the value of paper stock of which it is composed. In making and issuing these coins the Government purchases the metal in the open market and while this demand will have an effect upon the value of that metal, yet it is perfectly arti- ficial and arbitrary. 206. The Latin Union. Prior to 1874 France was the most important bimetallic country in the world. After 1864 France was in league with several smaller countries of Europe; France, Italy, Greece, Belgium and Switzerland. This league was the Latin Union, which was so important an element in the silver discus- sions of the 90's. France furnished these countries with coins of gold and silver so that for monetary purposes the Union might be considered as one country. The Latin Union, together with the German Empire created a demand for silver which maintained its value for some years in the face of increased production. In 1871 the German Empire was founded and the monetary system of various countries composing the empire was entirely reconstructed. The free coinage of silver was suspended and supplies of gold were ac- cumulated to maintain the value of all the credit money of the Empire. France, which had acted as an equalizer of the values 170 MONEY AND BANKING of gold and silver in Europe up to this time, in 1874 suspended the free coinage of silver in response to the tendency of the times. The bimetallist claims that the close correspondence of the market ratio with the French coinage ratio was not fortuitous, but was due to the fact that the money demand for the two metals was kept in equilibrium by the "bimetallic law of France. Even after the great influx of gold from California and Aus- tralia in the fifties, the market ratios between the two metals fluctuated very little. In the year 1800 the earth was producing fifty ounces of silver to every ounce of gold; between 1852 and 1858 it produced only five ounces of silver for every ounce of gold. Despite this great change in the production- ratio, the value ratio of the two metals was only slightly affected. The increased supply of gold after 1850 undoubtedly tended to lessen its value, and for ten years the French mint was busily coining the yellow metal; large quantities of silver were exported to India and the East. Between 1850 and 1865 there happened in France exactly what the theory of bimetallism would lead us to expect, namely, an increased coinage of the cheaper money metal, gold, and a lesser use of the other. However, France did not lose all of her silver even under this great strain ; and the two metals of the world retained during this period a value ratio remarkably close to the ratio established by the law of France. The monometallist meets this argument from French expe- rience in various ways. He first makes an absolute denial of the contention that the so-called "mint demand" has any effect whatever on the value of the metal. No mint, he says, can add the slightest value to any metal; a mint merely puts a stamp upon the coin to signify the quantity of metal it contains, but if a coin is hammered on an anvil its value is not lessened. This is true, but it does not prove that the value of a metal is not due partly to the fact that the mint is open to its coinage. Free coinage makes the value of the metal uncoined practically the BIMETALLISM 171 same as when coined, and so tends to cause an increased demand for it, thereby increasing its value. A mint does not add value to the metal, but the demand for it, growing out of the fact that it can be freely minted into money, does give it a value which it otherwise would not possess. 1 207. Demonetization of silver by the United States. Because the United States was on a paper money basis at the time when the European governments were chang- ing to the silver standard, the effect was not immediately felt. In 1873 Congress codified the coinage laws of the country and accomplished the momentous change from a double standard to a single standard without exciting any comment. It is even claimed that the change was effected by the accident of leaving out unintentionally the name of the silver dollar from the list of coins. The Act of 1873 declares that the gold dollar of 25.8 grains standard "shall be the unit of value." After enumerating the various gold coins that may be minted, it provides for the free coinage of silver "trade dollars," to contain 420 grains standard silver, and for the coinage by the Government of subsidiary silver coins, all these to be legal tender only for amounts not exceeding $5.00. The old silver dollars of 412.5 grains standard is not mentioned; its coinage, therefore, was prohibited by the follow- ing: "That no coins, either of gold, silver or minor coinage, shall hereafter be issued from the mint other than those of the denominations, standards and weights herein set forth." 2 When the redemption of Government paper at par was resumed in 1879 it might have been preferable to take silver to the mint for coinage, but it was found that the privilege had been withdrawn, and the owner of silver was forced to sell the metal in the open 1 Johnson, " Money and Currency," pp. 225-6. 2 Id., p. 242, note 1. 172 MONEY AND BANKING market the same as any other commodity. At the time these changes were taking place with reference to the standard the price of silver bullion was $1.298, at which figure the quantity of silver in the dollar was worth slightly more than the gold equivalent. The curtail- ment of the demands of European countries for silver as money combined with the increased production, and the quantities thrown on the market by France and Germany in exchange for gold caused a decline in the price of silver to set in, which continued steadily year after year until in 1902 it stood at 52.7 cents per ounce, less than half its value thirty years before. 208. The silver purchase acts. The fall in the price of silver stimulated the silver mining interests in this country to activity. They were successful in 1878 in getting passed through Congress the Bland- Allison Act, which required the Secretary of the Treasury to purchase each month in the open market two million ounces of silver which should be coined into silver dol- lars. In this way the interests sought to substitute an artificial demand for silver which would have been nat- ural if free coinage had not been suspended five years before. The effect of these purchases was not sufficient to counteract the tendency of the constantly increasing supply and in 1890 the Sherman Act passed, which required the Secretary of the Treasury to purchase each month four and a half million ounces of silver instead of two million and authorized the issue of treasury notes of 1890 to pay for the silver. The effect of this act was to inflate the currency by the addition of both silver and paper credit money practically an accomplishment of what the greenback party had failed to do in 1875. 209. Sherman Act one of the causes of the panic BIMETALLISM 173 of 1893. There is a very general agreement among authorities that the Sherman Act of 1890 was one of the most important causes of the panic of 1893. The act came at a time when speculation had already forced prices to an artificial level and led to great over-expan- sion of credit. The silver purchase law accelerated this tendency, while at the same time it undermined the foundations of credit. Gold exports began and con- tinued until 1896. The earlier exports of gold came from the vaults of the banks. Soon the banks became unwilling to permit their gold reserves to be diminished in this way and the gold was secured by exporters from the Government treasury. In the Resumption Act of 1879 the Government had pledged itself to redeem the greenbacks in gold whenever presented. Accordingly it was a very simple matter for exporters desiring gold to take greenbacks to the treasury and demand gold for them. This demand grew steadily and finally became so large as to waken the apprehension of the Adminis- tration. When President Cleveland was inaugurated for the second time in 1892 he found himself face to face with an extremely serious problem. The unwise acts in favor of silver were rapidly putting the Government in a position where it could not keep its promises or main- tain the foundations of credit, already overburdened at this time. The Sherman Act of 1890 had been put through Congress by a log-rolling scheme by which the pro- moters of the McKinley Tariff Bill secured votes by promising to vote for the Silver Bill. This alliance of the Republican party leaders with the silver interests proved in later years to be very embarrassing and re- quired the greatest ingenuity to explain away. 174 MONEY AND BANKING The crisis which arrived in 1893 was the legitimate effect of the monetary and tariff vagaries of the pre- ceding years. There is no doubt that the crisis would have arrived but it is likely that it would have been much less severe and that the period of depression following ! it would have been much shorter, had the legislation of the preceding years been more scientific. The distress and suffering caused by the crisis and depression created great discontent among the people and stimulated a search for the causes, so that the blame might be properly placed. 210. Silver would not circulate. It is incredible that the panic of 1893 should have been attributed to lack of sufficient currency in the country, when the real difficulty was redundancy of certain kinds of currency. The coinage of the new silver dollars under the silver purchasing acts of 1878 and 1890 had piled up in the treasury amounts of currency with which the officers did not know how to deal. The coins were so bulky and in- convenient that the people refused to take them in any large quantity. Whenever they were paid out they very soon returned to the treasury in payments made to the Government. So long as the Government had a surplus of revenue sufficient to meet all expenditures including the enforced purchase of silver bullion, there was no immediate cause for apprehension. The prosperity and good crops of the years 1879-80 created a demand for additional circulation in the western states and the silver dollars found an outlet there. The movement was accelerated by an offer on the part of the Treasury to buy silver certificates in the west and south in ex- change for gold deposited in the sub-treasury in New York. Whenever the rate of exchange was in favor of the west and BIMETALLISM 175 south, the person desiring to make remittance could save express charges by accepting the Government's offer. In this way the surplus silver in the Treasury was worked off for the time being. 1 A minor commercial crisis occurred in 1884, the effect of which was to cause a decline in the public revenues. In addition to this shrinkage the percentage of the receipts paid in gold diminished from 75 per cent to 36 per cent of the whole; the silver receipts rose from 17 per cent to 36 per cent; and the balance of 28 per cent was received in greenbacks. 211. Attitude of banks toward silver. The banks at this time had begun to discriminate against the silver certificates. The clearing houses had made a rule that they were not to be received in settlement of balances. However, after Congress had passed a law forbidding national banks to become members of clearing houses which did not receive the silver certificates, the rule was rescinded, but the banks voluntarily agreed among themselves not to make payments in silver certificates. The sub-treasury of New York was a member of the clearing house and at this time in order to prevent the payment of its balances in certificates the New York banks voluntarily turned into the treasury $6,000,000. 212. Silver certificates. To Secretary Manning be- longs the credit for having postponed for several years the worst effects of the bad financial legislation. Up to 1885 the greenbacks had been issued in denomina- tions below $5. After that date the Secretary or- dered that none should be issued under $5. In the next year he procured from Congress the authority to issue silver certificates in denominations of $1, $2 and $5. This device solved the problem of keeping silver in White, " Money and Banking," p. 172. 176 MONEY AND BANKING circulation by proxy, but it did not cure the funda- mental trouble, the serious consequences of which cul- minated eight years later. The secretary was helped out of his dilemma by a favorable condition at this time. Sharp advances in price of Government bonds had reduced the profit in the issue of national bank notes and a considerable con- traction in their volume occurred. The vacancy in the circulation left by the retirement of a number of the national bank notes was filled by the silver certificates and they were restrained from returning to the treasury for redemption or in payment of Government dues. When the silver coinage act was passed in 1878, its opponents predicted that sooner or later it would cause a financial panic. They said that, since the metallic value of the silver dollars was not equal to the face value, they were simply a new kind of fiat money, and that, whenever they should become redundant, they would act like any other fiat money like the greenbacks at the beginning of the war, for example. There would then be a change in the standard of value, if the coinage were continued. This was a true prophecy, but the fulfillment was delayed by the shrinkage in the national bank circulation and by the retire- ment of small greenbacks, which created a vacuum for the new silver to fill. But this was a silent operation. The public could not understand it, and so, as the years rolled on and no harm came from the coining of silver dollars, the predictions of panic fell under popular ridicule. 1 213. Currency situation in 1890. In 1890 there was outstanding in circulation three varieties of money de- pending for their value upon the credit backing of the Government. The silver dollars, the treasury notes and the greenbacks all rested upon the Government's pledge to redeem them upon demand in gold. At this i White, " Money and Banking," p. 175. BIMETALLISM 177 time the law required no particular gold reserve, but custom had established the amount of $100,000,000. Even if the gold were maintained at a minimum figure the constant increase in the volume of credit money due to the silver purchases lessened the reserve percentage. This might not have led to serious consequences of it- self, but after 1890 other natural and inevitable effects of the redundant issue of credit money began to be per- ceived. Gold exports began and continued until the gold reserve had been so depleted as to cause grave alarm for the maintenance of government credit. The great danger of a sudden demand for one kind of money over another comes from the cumulative effect. When there was danger of gold becoming scarce, every- body began to desire it before other forms of money, and thus accelerated the withdrawal of gold from the treasury after the banks had begun to refuse to make payments in that metal. 214. The treasury gold reserve. As doubt increased as to whether the Government would be able to redeem the credit money on demand in gold, the banks began to convert their reserves into gold as rapidly as possible. Gold exports were resumed in 1892. In November of that year the gold in the Treasury had fallen from $185,000,000 (in August, 1890) to $124,000,000 and was still declining. Secre- tary Foster was much depressed. When he came to New York to speak at a dinner of the Chamber of Commerce, he said, among other things, that the Government intended to maintain gold payments, even if it became necessary to sell government bonds for the purpose. This was an admission on his part that gold payments could not be continued without resorting to extraor- dinary means. Probably Mr. Foster made this speech in order to test public sentiment and to find out whether he would be sustained in issuing government bonds in time of peace. There VJI-13 178 MONEY AND BANKING had been no increase of the bonded debt since the close of the Civil War, and some persons in high place denied that there was any legal authority to issue new bonds. Apparently Mr. Foster was satisfied by the applause with which his announced purposes was received by his hearers and by the press, for shortly after- wards he issued an order to the Bureau of Engraving and Print- ing to prepare new bonds. This order was dated February 20, 1893, and Mr. Foster was to go out of office on the 4th of March. Naturally, he preferred to put upon his successor the onus of issuing the bonds if he could. So he came to New York and persuaded the banks to give him a few millions of gold in exchange for legal tender notes, enough to carry him along till the 4th of March. This enabled him to glide out of office leav- ing the $100,000,000 redemption fund intact, but with only $982,410 gold in excess of that sum and with the penumbra of a deficit in full view. 1 215. Repeal of the Sherman r Act. Upon Secretary Carlisle fell the burden which the Republican adminis- tration had managed to avoid. President Cleveland announced that the redemption of Government credit money in gold would be continued under all circum- stances. And early in the summer he called a special session of Congress which repealed the silver purchasing clause of the Sherman Act of 1890. Just at this time the mints of India were closed to the free coinage of silver, which caused the price of that metal to fall from $.82 to $.67 per ounce within three days. These events inaugurated the panic of 1893. The repeal of the Sherman Act came too late to save the situation. The gold reserve continued to decline until it had reached $67,000,000 in January of the fol- lowing year. The difficulty was aggravated by the i White, " Money and Banking," p. 176. BIMETALLISM 179 sharp decline in government revenues which the shrink- age of imports and consequently the duties collected thereon brought about. Congress at this time was Republican. President Cleveland used his utmost endeavor to get legislation authorizing him to replenish and maintain the gold re- serve by means of bonds issued. The partisanship of the Republican party in this crisis was greater than its patriotism. It seemed to be willing to permit the coun- try to suffer and its credit to be ruined if only the prestige of the Democratic party could be injured, not- withstanding the fact that the cause of the crisis could be traced to legislation passed by the Republicans them- selves. That party relied upon the ignorance of the public and upon their power to inculcate the belief that the Democratic party was responsible for the panic. The opprobrium which the President was compelled to endure in the next two or three years proved that the Republicans had been successful in their calculations. 216. Authority to issue bonds. Failing to get the consent of Congress to the issue of bonds the President was obliged to fall back upon the Resumption Act of 1875 which provided power to sell bonds for the pur- pose of redeeming the greenbacks. The purpose of this law was to give the Secretary the means by which the greenbacks could be redeemed and there was grave doubt as to the propriety of using it for the present purpose. President Cleveland was strong enough, however, to put the needs of the country above legal technicalities and a bond issue was authorized. 217. Successive issues of bonds. By means of this bond issue the gold reserve was brought up above the $100,000,000 limit, but the same causes which had be- 180 MONEY AND BANKING fore depleted it were still operative and it was again reduced by withdrawals to $52,000,000 within six months. Another bond issue of $50,000,000 in November, 1894, failed to help the situation. Faith in the ability of the United States to maintain its credit grew weaker and weaker. The withdrawals of gold for export, however, had a limit, but at this time evidence appeared showing that much gold was being hoarded. This was an ominous sign, for if this hoarding went on with cumulative ef- fect there was no limit to the demands which might be made upon the treasury. 218. The Belmont-Morgan Syndicate. At this crisis President Cleveland took an action which for the time being, made him more unpopular than any President who had preceded him. Perceiving clearly that bonds sold in this country simply created an endless chain, the final result of which was to increase the bonded indebtedness of the Government without permanently relieving the situation, he appealed to the syndicate of New York bankers. The arrangement made with Belmont-Morgan was that they should provide the treasuiy with gold to the amount of $65,117,500, half of which at least should be brought from Europe and that the syndicate should do all in its power to protect the gold reserve in the treasury. It may seem strange that the syndicate of bankers had more power to produce a certain result than the Government of the United States in time of peace. The Government at this time, however, was in a con- dition similar to that of a strong man who has indulged in a debauch which has paralyzed all his powers. The BIMETALLISM 181 Government had abused its credit by the issue of prom- ises to pay gold until it was in immediate danger of collapse. The gold which the syndicate agreed to furnish to the treasury was paid for with 4 per cent thirty-year bonds at 104.49, the rate of yield of which would figure 3% per cent per annum. The syndicate made a proposition to the Government that if the bonds were made payable in gold they would accept them at a price equivalent to 3 per cent instead of 3% per cent yield. The saving to the Government on this proposition would have amounted to over $16,000,000 during the life of the bonds, but the narrow mindedness of Congress and their petty satisfaction in embarrassing the President caused them to reject the proposition. The syndicate stopped the exports of gold by offering to sell ex- change at a price which would make it unprofitable to ship gold out of the country. By keeping the maxi- mum price of sterling exchange below the export point they protected the gold in this country and importa- tions of gold from their European correspondents soon brought up the reserve above the one hundred mil- lion dollar mark. There were not wanting people at this time to charge that the financiers had brought about the crisis and the shortage of gold for the sake of their own profit. It was forgotten that the losses which members of the syndicate as well as all the financial interests of the country suffered by the panic of 1893 were hundreds of times greater than the profit they derived from this transaction. It was forgotten that when the syndicate made this agreement they were taking the greatest risk in being able to carry it out. And if there had not been 182 MONEY AND BANKING an improvement in conditions, their losses in attempt- ing to keep sterling exchange below the export point, might have exceeded greatly the profits. The episode which began with the silver purchased and ended with the syndicate agreement ought to teach a lesson for all time that the Government is not all- powerful and that its credit may be endangered the same as that of a private individual or corporation. To show how little the lesson had really been appre- ciated it is sufficient to recall that one of the strong arguments of the free silver party within a year or two was that the Government is big enough to absorb all the silver in the world without feeling it. 219. Silver question. It must be remembered that during the trying times of President Cleveland's sec- ond administration the Republican party sympathized with the Silver party and were under obligations to them for assistance in passing the McKinley tariff bill, which at that time was more important to the interests represented by the Republican party than the money question. The panic of 1893 and the depression fol- lowing, so far from teaching the public a wholesome lesson in the elements of finance, gave the inflationists an opportunity to press their demand for more cur- rency. The average man in 1894 could not be brought to believe that the business depression was caused by a redundancy rather than a scarcity of money. From his point of view money was very scarce and hard to get. He could not see that it was a contraction of credit and the lack of confidence in future values that had laid a heavy hand on all business enterprises. He readily fell in with the doctrine that more money made higher prices and that higher prices would bring prosperity. BIMETALLISM 188 If a proposition had been made to change the bushel from thirty-two quarts to thirty quarts in order to increase the supply of potatoes in the country its ab- surdity would have been readily perceived. The same proposition with reference to the dollar was readily accepted. There can be no doubt that the decline of prices had been caused by the decrease in the production of gold relatively to the increased volume of business in the world after 1870 and also to the increased demand placed upon the gold in existence by the demonetization of silver. The devotees of international bimetalism were quite right in believing that concerted action by the governments of the world in restoring silver to its status as standard money would lighten the demand upon gold and cause a general rise of prices. The futility of expecting any such action, however, was apparent after the failure of the International Mone- tary Congress of 1878. 220. Origin of the Free Silver movement. The purchasers of silver bullion who had a selfish interest in attempting to raise the price of silver found a pow- erful alliance with the western farmers. This class of men had gone into the country west of the Mississippi and had taken up as much land as they could under the easy terms of the Homestead act. As a rule these men were lacking in capital to begin farming opera- tions. They were compelled to borrow funds at exor- bitant rates of interest by mortgaging their real estate. Under the high prices of wheat, which at that time was the one crop which the farmer was sure of being able to turn into cash, he figured that he would easily meet the interest on the mortgage and lay aside each year enough to pay off the mortgage at maturity. As wheat 184 MONEY AND BANKING declined in price from $2 per bushel to $.50 while the amounts payable on the mortgage remained the same as before, the burden of meeting these payments be- came greater and greater until foreclosure and bank- ruptcy seemed inevitable. Under such depressing con- ditions the farmers were ready to accept the most plausible explanation presented by the silver interests. The only possible remedy seemed to be a rise of prices, especially in wheat. 221. Arguments for free silver. There does not seem to be any way to deny that an increase in the quantity of standard money would raise prices, but the proposi- tion to swell the volume of standard money by diluting it with silver under the world-wide conditions prevail- ing at that time would probably have brought conditions to the country as a whole which were much worse than they were enduring, although probably the mortgage- burdened farmer as a rule would have been helped tem- porarily. The farmer was also invited to consider how difficult the pay- ment of the national debt was becoming. At the end of the Civil War it amounted to $2,800,000,000 and might then have been paid with 1,400,000,000 bushels of wheat, which was worth at that time $2.00 a bushel. This national debt was mainly in the form of bonds which the Government had sold for greenbacks worth only fifty cents on the dollar in gold. Owing to the con- spiracy among the "gold bugs" of the east, Congress had en- forced the payment of these bonds in gold, so that the Govern- ment was paying back to its creditors twice as much as it had received. But this was not all, for that same conspiracy had increased the value of gold itself. The real wealth of the country lies in such commodities as wheat. The gold payments already made on account of the national debt had been sufficient to buy, at the BIMETALLISM 185 prices prevailing when the payments were made, 4,000,000,000 bushels of wheat, an amount nearly three times as great as the original debt when figured in wheat. Nevertheless the debt had not been paid, for there remained still due $1,500,000,000, which represented at the then low price of wheat, 3,000,000,000 bushels, or over twice as much as was owed in the beginning. It is not strange that this reasoning, which made the debt in goods grow in spite of the fact that it had been twice paid, should have a powerful influence upon the agricultural population. Wheat was not the only agricultural product that had fallen in price. The price of almost everything that the farmer could raise for the market had been cut in two. The advocates of silver held that its free coinage would cause a tendency of prices upward, and that this would atone for the injustice worked by the fall of prices after 1873. It was only fair, they argued, that the debtor who had been robbed should now get back some of his due. 1 222. Argument to the workingman. While the low price of wheat and other food stuffs had placed the farmer in such a predicament it might seem that there was a corresponding benefit to all consumers, especially the laboring class, the largest percentage of whose in- come must be spent for food. The advantage to this class, however, had been negatived by the crisis of 1893 which threw so many out of employment. They could not be brought to consider that cheap food was a great advantage when their incomes were so precarious. Even the statisticians proved that the relative rate of wages in proportion to the cost of living had increased greatly since 1873 it was not sufficient to offset the lack of employment during the business depression. To this class it appeared also that the difficulty lay in the scarcity of money; free silver meant more money in i Johnson, " Money and Currency," pp. 244-5. 186 MONEY AND BANKING circulation and that was obviously the remedy for the distress. 223. Arguments of advocates of gold. While many of the arguments of the free silver leaders were un- scientific and calculated to appeal to popular prejudices and ignorance, many of the arguments of their oppo- nents were no better. The advocates of gold made some strange deductions from the argument that with the free coinage of silver the country would be placed upon a silver standard along with Mexico and China. They tried to frighten the workingman by stating that his wages would be paid in "50-cent dollars." They prophesied a deluge of silver from all quarters of the world without perceiving that the latter event would be absolutely inconsistent with 50-cent dollars. There would be no inducement for the importation of silver from abroad unless its value was raised in this country. If Congress passed a law authorizing the coinage of 50 cents worth of silver into legal tender which would perform the same money work as $1 worth of gold, it is not difficult to see that there would at once arise a great demand for silver. Nobody would pay out gold in the payment of debts or for commodities so long as it could be exchanged anywhere in the world for a quantity of silver that would do more money work. Gold would absolutely retire from circulation in this country until the demand for silver would have brought the value of the latter metal to a par with gold at a ratio of 16 to 1. 224. The 50-cent dollar. The persons who threat- ened the country with the bogey of the 50-cent dollar forgot the influence which an enormous demand would have on the value of silver. As rapidly as the gold was withdrawn from other countries, in those countries BIMETALLISM 187 prices would rise. The only nations which had large quanties of silver were India, Mexico and China. The silver in the gold-standard countries was to a large extent needed there for subsidiary coinage. The effect of withdrawing any considerable quantity of silver from silver-standard countries would be to reduce the money supply there, causing an appreciation in the value of silver as compared with commodities and putting those countries in a far worse position in con- sequence of the appreciating standard, than the United States had been. The silver prices of commodities in those countries would have fallen so low that large exports would have been inevitable. After the confusion incident to the alteration of the standards had passed and the new equi- librium established, it is doubtful whether the United States would have received any large proportion of the world's supply of silver. The United States would certainly have found itself on the single silver-standard basis until the price of silver had reached par with gold 16 to 1, and perhaps for a considerable time thereafter. People would have learned to appreciate gold to such an extent that it is not likely the habit formed during this interval could be easily broken. 225. Probable results of free silver. It is quite likely that the victory of the free silver party would have resulted in a very sharp rise of prices; then as the value of silver rose toward a parity with gold, a de- cline from the new high level would probably have begun, so that the gradually appreciating level of prices which had been hoped for by the silver leaders would not have occurred. There would probably have been a gradual rise of prices in all gold-standard countries corresponding to the gradual decline in silver-using 188 MONEY AND BANKING countries. The greatest beneficiaries of free silver would therefore have been those countries which had been charged with causing the whole trouble. So when two countries are using different metals as money a fall in the value of one causes the country using it to increase its exports by an amount sufficient to pay for the additional quantity of metal needed in its money supply. If the value of one rises, the exports of the country using the other metal as money will apparently be stimulated but will not in the long run be increased in quantity. The free coinage of silver could have given the United States no advantage in the markets of the world unless silver had continued to depreciate, in which case the United States would simply have increased its exports by an amount sufficient to pay for the additional silver which it needed as money. It is doubtful if such an increase of exports could be called advantageous, for we should have been giving to the world larger and larger quantities of wheat, cotton, etc., in ex- change for a cheapening metal. There was no certainty, how- ever, that even this doubtful advantage would have been gained, for silver, if we coined it freely, would have been quite as likely to rise in value as to fall. 1 If free coinage of silver had become a fact the debtor class would have gained enormously at the expense of the creditors; the western farmer would have been able to pay off his mortgages easily. So far the silver lead- ers were probably correct in their predictions. To off- set this advantage, however, the country would probably have experienced a period of monetary chaos extending over a period of some years. During this time there would have been a great reluctance on the part of busi- ness men to enter into contracts involving the future payment of money. The banking business, foreign exchange and the whole mechanism of credit would have i Johnson, " Money and Currency," p. 259. BIMETALLISM 189 been thrown out of adjustment, so that in spite of the stimulating effect of the higher prices it is likely that general business would have diminished in volume below the low level reached in 1896. The sudden rise of prices would have stimulated speculation to a most unwarranted degree and the credit which would have been created in these transactions would have been of the most ephemeral and dangerous character. 226. The real debtor class. The advantage which free silver would have brought to the debtor class in general must not be exaggerated. Popular sympathy is always with the debtor, who is pictured as a poor man at the mercy of a wealthy one. The holder of the mort- gage against the struggling western farmer was al- ways conceived to be a corpulent and greedy capitalist. An accurate conception of the debtor and creditor classes would practically reverse this popular idea. The greatest debtors in the country are the banks, who owe millions of dollars to their depositors ; also the great corporations which have enormous bond issues on which they must pay interest. While the farmer was strug- gling with his little mortgage, the great railroad and other corporations of the country were having exactly a similar experience with their mortgages. As a gen- eral rule the great financiers are more likely to be debt- ors than creditors, for their very wealth comes from the profitable use of funds borrowed of other people. On the other hand the creditors of the country are the great mass of people who have deposits in banks or shares in building and loan associations or policies in life insurance companies. They are the great universi- ties and other endowed institutions of the country. In short they are the people who possess properties which 190 MONEY AND BANKING they are not able to use in business themselves and in- trust to others to use for them. 227. Solution of the silver question. The end of the free-silver agitation did not come because of the admis- sion that either side had been in error, nor did it come because the defeated party accepted the result without protest. Like the tariff the silver question would prob- ably have been a perennial one if it had not been that the whole problem was eliminated by nature herself. Even when the agitation was at its height the natural remedy for the scarcity of the standard metal had be- gun to work. The tendency to lower prices for com- modities had extended to the materials and labor used in gold mining with the result that the margin of profit between the cost and the proceeds had widened until the industry became very attractive. Moreover the processes for obtaining the gold from low-grade ores at a fraction of the former cost, described in the chapter on the production of gold, were beginning to have their inevitable effect and within half a dozen years the change was so abrupt that instead of apprehension be- cause of the threatened scarcity of gold, the authorities began to be alarmed lest the excessive production of gold might lead to disastrous economic consequences. At the same time, however, the production of silver was increasing at an equal pace, due largely to the fact that it is an important by-product of copper production, which had experienced an extraordinary boom follow- ing the development of electrical machinery. For this reason the increased production of gold did not solve the monetary problem for countries on a silver-standard basis. Without adopting the gold standard, several of these countries have been able to eliminate the difficul- ties inherent in a standard different from that of the BIMETALLISM 191 principal trading countries of the world. This happy result was reached without political agitation by a com- mission of expert economists from all the important countries of Europe, and including Jeremiah W. Jenks, Charles A. Conant and H. H. Hanna, Americans well known for their connection with the monetary discus- sions. The system which they worked out is called the "gold exchange standard" and has been applied to sev- eral countries on the silver basis. 228. Gold exchange standard in Mexico. Mexico adopted the system in 1905 and the standard unit of money in that country is the Mexican dollar or peso, which contains silver to the amount of about 50 cents in gold. Without interfering with its function as a standard of value the right of free coinage was with- drawn from silver. By regulating the amount of silver coined and by the sale of foreign exchange at a fixed rate so as to prevent the export of gold or the appear- ance of a premium on gold for export the Government is able to maintain a fixed ratio between the silver peso and gold. The country is protected against a sudden decline in the price of silver because of the control exer- cised by the Government over the coinage of silver pesos. A fall in the bullion value of the peso does not lower the value of the coin as money because the de- mand for them for monetary uses maintains their value irrespective of the worth of the bullion. The Mexican dollar is a very popular medium of ex- change in the silver-using countries, and an extraor- dinary number of them has been distributed throughout the world. In order to prevent their return to Mexico in large quantities in the event of a fall in their bullion value, which might cause them to be rejected in trade, the Government has placed a customs duty upon them, 192 MONEY AND BANKING which can be so adjusted as to prevent their influx into the country sufficiently to depress the value of the peso below the present level. In the event of a rise of the price of silver above 64 cents per ounce, at which price the peso is equivalent to 50 cents in United States money, the coins will be worth more as bullion than they are money and will be ex- ported from the country to be sold in the silver market. The resultant contraction of the currency will raise the value of the peso as a coin to a par with its value as bullion. To provide for this contingency there is a condition in the system for the free coinage of gold pesos which would supply Mexico with gold coins in the place of the disappearing silver pesos. The subsidiary coins would still remain in circulation, however, being underweight as compared with the standard coin. A rise of the price of silver, therefore, would place Mex- ico at once upon a gold standard basis. Under the present plan with the price of silver below 50 cents per peso Mexico has a basis of silver credit money redeemable in gold, because the Government guarantees to sell foreign exchange calling for gold in England and other countries in exchange for the money of the country. This amounts intrinsically to redemp- tion in gold. PART II: BANKING CHAPTER XII NATURE OF CREDIT 229. Origin and kinds of credits. A credit is a de- ferred or postponed payment of money. It always represents a promise, express or implied, to pay a certain number of dollars at some time, definite or indefinite. Inasmuch as it is a promise to pay money, certain forms of it circulate in lieu of money, the ease and extent of this circulation depending directly upon the integrity and ability to pay of the maker of the credit, and the date and conditions of payment. Credits come into existence always as the result of an exchange, either the exchange of credit for goods, credit for money, or credit for credit. If A purchases goods from B, he may tender in payment either gold, his personal check, bank notes, United States notes or his own promise to pay in sixty days. If the payment is made in gold, no credit operation is involved. If made by check or in bank notes, it represents merely a transfer of credit already created by the bank. If made in United States notes it is likewise a transfer of credit, this time of Government credit. If payment is made by his own promissory note, however, a new credit, payable at a definite time, is created. Credit is of two kinds non-circulating and circulat- ing. Non-circulating credit accomplishes one ex- change while circulating credit accomplishes many. In vn-13 194 MONEY AND BANKING the case above if A pays with a promissory note, an exchange has been made by means of the credit thus created. At the end of sixty days, however, the credit must be liquidated, by means of cash, if it has not been cancelled by an exchange of property in the opposite direction. The credit which served as a medium of ex- change in the first transaction must itself be exchanged for cash at maturity, and the whole transaction amounts in the end to an exchange of goods for cash extending over a period of sixty days. 230. Use of credit in industry. Under our capital- istic system of industry every enterprise requires cap- ital. The entrepreneur must have buildings, land, ma- chinery a great variety of capital goods which make up the plant and equipment of the business and he must have the services of employes and raw materials. He must prepare for the various expenses of the busi- ness wages, taxes, etc. If he is not a capitalist him- self and cannot induce capitalists to share with him the risks and profits of his business, he must borrow this property from others. All these obligations are credits and must sometime be liquidated by the payment of cash. The form which these credits will take will be deter- mined largely by the nature of the business, the sagacity of the entrepreneur himself and the condition of the credit market. We have seen that credits vary in re- spect to time and conditions of payment. Most entre- preneurs are capitalists to a certain extent, their demand for credit arising from the fact that they expect to enlarge their business by supplementing their capital. Let us suppose that a manufacturer owns outright his lands, factory and machinery, and in addition has a working capital sufficient to meet his payrolls and ex- NATURE OF CREDIT 195 penses for some time to come. He has also a stock of finished product on hand, the market for which is sea- sonal and which amounts to only one-half the product which he expects to market, or perhaps has contracted to deliver when the season comes. Obviously he must have more raw material, and if he cannot purchase it on credit, he will go to his banker, make a complete state- ment of his condition, and if it is satisfactory, give to the bank his promissory note maturing at a date when he will have marketed his product. In return for this he will receive a credit on the bank's books, which will enable him to purchase the desired material. 231. Function of commercial banking. This is the great function of commercial banking, to enable manu- facturers and merchants to enlarge their business by extending to them for short periods the use of credit by which they can carry goods from the time of pur- chase to that of sale. The readiness with which credit will be granted depends upon the reputation of the manufacturer or merchant for selling his product, the amount of credit asked for and upon the nature of the business. In dull times not every commodity will sell, yet upon the proceeds of the sale depends the redemp- tion of the credit. Therefore those who deal in articles which are always reasonably sure to sell, such as food products, clothing and in general the necessities of life, are the most certain to obtain credit and in the largest amounts relative to their capital investment. Reputa- tion for selling, however, is a great factor, and credit is often extended on this account even to those whose product is, generally speaking, not apt to be quickly convertible. It may be, however, that the entrepreneur after reach- ing the limit of his own resources, will prefer to add 196 MONEY AND BANKING permanently to his working capital instead of increasing and decreasing it as his business demands. It may be that the nature of his business is such that he finds it difficult to obtain credit in dull times. Even in pros- perous times he may feel that a general contraction of credits is due, and that he may be unable to market his product to meet his obligations. If such is the case, he may add to his working capital by borrowing for a long period, placing a mortgage upon his real property. 232. Mortgages and bonds. A mortgage is a secured credit, that is, secured by the pledge of specific prop- erty. The most common form in which this kind of credit is used, is that of bonds. A bond is a portion or fraction of a mortgage. When mortgages are so large in amount that in their entirety they cannot find a mar- ket with any one individual or institution, they are divided into parts, called bonds, for distribution. This credit must be redeemed, of course, at its maturity just like the short-time credit, but the maturity is usually far enough distant to give the entrepreneur an opportunity of meeting it out of his accumulated profits. Moreover if the property which secures it has not depreciated in the meantime, it can often be renewed at maturity. This form of credit is ordinarily used when the pro- ceeds of the loan are to be used for some fixed or per- manent investment. Thus it is the form commonly used by railroads, public service corporations, large industrial corporations owning valuable real property, and the like. The interest on the bonds is paid out of the sav- ings of the corporation, and when they mature the principal is paid by the sale of new securities. 233. Example of timber industry. There are cer- tain industries, however, in which both these methods of obtaining credit are used. A good example is the lum- NATURE OF CREDIT 197 ber industry. We have seen that the merchant and manufacturer of quickly convertible products will ordi- narily borrow commercially and that railroads and sim- ilar corporations will borrow on long-time obligations because the money so obtained is to be used in permanent investment, and the obligations cannot be redeemed ex- cept by refunding. The lumberman is of course a manufacturer but his product is not always quickly con- vertible. When a panic comes, people must still have food and clothing but they can get along without build- ing new houses. Therefore lumber is one of the first commodities to feel the depression through a falling off in demand. A complete lumbering industry will own a saw mill, a supply of timber sufficient to last for a number of years, and a quantity of manufactured lumber piled in the yards awaiting sale. In this country lumbermen have always been large borrowers. The price of lum- ber, and the value of timber land have advanced steadily with the decrease of the available supply. Lumbermen have been quick to take advantage of this condition, and have always been eager to borrow to add to their timber holdings. When the northern lumbermen began to go south in the eighties they found that timber land was cheap and that it could be bought on credit, hence they invested their capital in equities. That is, they made a first payment in cash, agreeing to pay an additional amount every year or as the timber was cut. Obvi- ously they must manufacture and market lumber in order to meet their obligations. As soon as the product was ready for sale it was a "bankable asset" because in boom times lumber finds a ready market. Conse- quently lumbermen became large commercial borrow- ers, the amount of their short-time credit outstanding 198 MONEY AND BANKING often exceeding the value of the manufactured stock on hand. 234. Advantages of timber bonds. Since the year 1900, however, many dealers in lumber have taken ad- vantage of the increase in value of their timber lands to retire their outstanding notes and the obligations they incurred in the original purchase of this land, by issuing bonds secured by all their real property. These bonds are usually serial, a certain amount of them maturing every year as the timber is cut. The advantage of this method of borrowing is obvious. Only a fraction of their indebtedness must be met each year, and they know beforehand just what that amount will be and can pre- pare for it. When they borrow on short-time notes and a panic occurs, they may find it very difficult either to sell their product or to renew their notes. Almost their entire indebtedness is likely to become due within six months, and if conditions do not improve, there is grave danger of bankruptcy. It is probable that this condition was largely responsible for the big slump in the price of Southern pine following the panic of 1907. There was such a great amount of short time lumber credits outstanding, that the competition between sellers became acute and prices declined very sharply. The lumbermen whose obligations were in the form of bonds, however, did not enter this competition, so did not sacri- fice either their manufactured product or their timber. 235. Interest rates on bonds. The form which this borrowing will take, however, is further influenced by the condition of the credit market, as evidenced by the prevailing rate of interest. The rate of interest paid upon the various kinds of long-time obligations is fairly well fixed, although it varies somewhat with the demand or supply of such investments. Thus railroad bonds NATURE OF CREDIT 199 bear from 3% per cent to 4% per cent interest; public service corporation bonds from 4^ per cent to 5% per cent and industrial and real estate mortgage bonds from 5 per cent to 6 per cent. These rates are fixed by the regard in which the bonds are held by investors in re- spect to security of principal and convertibility into cash. The rate at which the commercial borrower must dis- count his note, however, varies within much greater limits. It may be as low as 3 per cent when the demand for credit is small and the banks are eager to loan. This condition is known as "easy money." When busi- ness improves and demand for credit increases, the rate advances until in time of panic it may be as high as 10 or 12 per cent. The average is from 4 to 5 per cent. 236. Long-time borrowing. Naturally the entre- preneur wishes to borrow money at the lowest possible rate. During periods of easy money he is loath to re- tire his short-time indebtedness on which he may be paying 4 per cent by the issue of bonds which will cost him 6 per cent. As money becomes tight, however, he becomes anxious to make this change, but often the time has passed when the market will absorb his bonds. Thus, in an endeavor to obtain the lowest rate at all times, there is danger of his rinding himself in a tight money market with all his obligations in short-time form. The advantage of long-time borrowing in cer- tain lines of industry is so obvious, however, that sagaci- ous business men will often sell high-rate bonds when the commercial rate is much lower, knowing that in the long run their interest account will average lower, and that in case of panic their situation will be much more secure. 237. Credit economizes the use of gold. Credit is like fire a good servant, but a bad master. So long 200 MONEY AND BANKING as it is controlled and prevented from sudden contract- tion it serves to economize the use of gold, doing the work of exchanging goods more conveniently than gold itself. We have seen that prices depend upon the amount of the media of exchange. The use of credit, therefore, permits business to expand and trading to be accelerated without a reduction of prices, but on the other hand its use destroys the check which otherwise would prevent prices from rising to an artificial height thus bringing on a panic. A discussion of the effect of credit on prices, however, belongs to a later chapter. 238. Liquidation of credit. We have seen that all private credits must in the end be liquidated by means of cash. During a time of prosperity when prices are rising and fortunes are being made simply by buying at a low price and selling at a higher, many people pur- chase property on credit, usually giving the property as security for the credit. The profits of industry are increasing, hence business men are straining every nerve to increase their business. To do this they must obtain credit. Furthermore at such times bankers be- come accustomed to seeing goods sold and credits liquidated, and they loan more freely. Their portfolios are full of time credits, maturing in the future, acquired in exchange for demand credits due whenever called for. At such a time suppose a political or financial dis- turbance shakes public confidence in the ability of debtors especially banks to meet their obligations; a demand for the pament of such credits as are due is sure to follow. Since the obligations of a bank are always due and payable, they are apt to suffer a "run." When this occurs they must themselves request payment of all credits that are due them and make practically no re- NATURE OF CREDIT 201 newals. Other banks follow suit. This forces the merchant and manufacturer as their notes become due to sell their goods at a sacrifice, and before we know it we are in the midst of a financial panic. 239. Commercial paper houses and the credit situa- tion. The danger of this condition has been somewhat augmented by the custom of large borrowers discount- ing their notes through commercial paper houses. While this is more necessary on account of the process of consolidation which has gone on in industry in the last decade, it nevertheless injects into the situation a further element of danger. Formerly the merchant borrowed from his own bank direct, or if his business was large, from two or three banks in his own city. He knew the bankers personally, and kept an account at each bank. They were anxious to serve him, and would do so if possible, even in case of a panic. Hence his chances of renewing his maturing notes at such times were good. With consolidation, however, and the growth of large industries came the necessity of increased credit. Many industries are now so large that the banks of one city cannot possibly finance their borrowing. Hence the necessity of a notebroker or commercial paper house, whose function is to distribute the notes of various concerns throughout the banks of the entire country. No doubt it is a necessary developement of the era of consolidation but it destroys the personal element of banking. The banker in Kansas has no per- sonal interest in the success or failure of the New York merchant whose note he holds, beyond the payment of that particular note, and in times of panic he is quick to request valuable payment. The ability to borrow at a large number of banks is an asset during prosperous 202 MONEY AND BANKING times; but if over-exercised, it can become almost in a moment a most importunate liability. 240. Use of credit as a medium of exchange. The most important function of credit is its power to circu- late as a medium of exchange. Obviously, if exchange can be consummated in large volume by means of credit, the necessity of huge national investment in the precious metal is obviated. The whole system rests upon the assumption that not everyone is going to present de- mand credits for redemption at the same time. Ex- cept in extreme instances, the assumption is a good one, and credit has become the chief medium of exchange of this country. In order to circulate in lieu of money, credit must be payable on demand. Furthermore, the issuer must be one in whose integrity and ability to pay, the public has entire confidence. Naturally, then, the credit which circulates the most freely is Government credit. Second to this is bank credit, and as this is the medium in which a large proportion of our exchange is made, it is well to consider it separately. 241. Bank credit. Bank credit has two forms, notes and deposits. The true bank note is the simple promise of the bank to pay legal tender on demand; the de- posit is precisely the same except in form. These credits are created as the result of an exchange, either of money for credit, or credit for credit. If the cus- tomer brings money to the bank he receives for it either notes or a deposit account, depending upon which will best suit his needs. If he comes to the bank as a bor- rower, he exchanges his own time credit for the bank's demand credit and again takes it in either form he de- sires. It is the credits thus created which perform so NATURE OP CREDIT 203 great a proportion of our money work. The notes themselves passing from hand to hand, and the checks drawn against the deposits consummate probably 90 per cent of our exchanges. The issue of credits intended for circulation by pri- vate persons, corporations and banks has been attended by so much abuse in the past that governments have come to regard it as a quasi-public function which must be regulated strictly. Accordingly in this country the banks have lost the power to issue true bank notes, and can only issue notes secured by a deposit of government bonds with the United States Treasury. Our bank notes therefore are really Government bonds converted into currency. Each note is simply a fragment of a bond stripped of its interest and payable on demand. 242. Deposit credit. The other form of circulating credit, or credit currency, consists of checks and drafts drawn against deposit credits. The currency is not the check or draft but the deposit credit itself; the docu- ment is simply a temporary form which the deposit takes for circulation. The drawing and paying of checks do not expand or contract the deposit currency but merely measure its rate of circulation. This form of credit has been found to be much better suited to the needs of thickly settled communities than the bank note currency, whereas in new regions with poor banking facilities, notes are still the favorite medium. This is because of the fact that in new regions, transactions are smaller; whereas in the cities transactions are large and it would be most burden- some to carry about large amounts of bank notes with which to settle obligations. It is only in this country, however, that the deposit currency has reached its full- 204 MONEY AND BANKING est development and it is noteworthy that even here it did not begin to do so until restrictions were placed by the Government upon the issue of bank notes. Up to 1855 the note issues of the banks exceeded their deposits. In that year deposits forged ahead somewhat, but it was not until the national bank act of 1865 that they were given thier real impetus. Since that time the deposits have increased out of all pro- portion to the increase of the capital invested in bank- ing, while the notes have materially fallen off in amount. 243. Elasticity of deposit credit. The reason for this condition is to be found, of course, in the increase of population and the consequent growth of the bank- ing habit; but even more important than these factors in its growth has been its innate ability to provide a medium of exchange which expands and contracts with the business needs of the country. There are certain times of the year when exchanges increase greatly in volume; this condition being particularly true of single communities where industries are not greatly varied. Moreover, as business becomes brisk or slack, there are changes in the volume from year to year. This necessitates a constant change in the amount of the medium of exchange. Unless it is a period of general speculation and credits rest upon an unstable basis, this change in the demand for medium will be met auto- matically by an increase or decrease of checks and drafts drawn against the deposit currency. We shall see later on that this is the only currency in use in this country that had this attribute of elasticity. It is ob- vious that the issue of bank notes which must be first secured by deposit of Government bonds with the Treasury is exceedingly inelastic. NATURE OF CREDIT 205 Having come into existence as the result of an ex- change transaction, these circulating credits serve as a medium of exchange in a number of transactions before they are extinguished. They are usually liquidated by cancellation of one against the other rather than by pay- ment of money; so that the exchanges which they have made have not merely postponed the actual transfer of money as in the case of the non-circulating credits. The fact that they serve the purpose of money and are usually settled by cancellation misleads people into supposing that they obviate the need for money. That such is not the case they learn sometimes to their sor- row when there comes a general demand for the redemp- tion of credits according to their tenor. The volume of credits contracts whenever there is liquidation or whenever they become depreciated in value. As long as the debtor continues to meet the matured obligation in money their value is maintained but whenever he refuses to do this value begins to de- cline concurrently with the chances of future payment. A credit depreciated to half its par value has lost half its power to do money work and is contracted half as much as if it had been liquidated. Inasmuch as credit can serve the purposes of money even better than money itself, nobody would ever de- mand money unless they thought it was more valuable than the credit, that is, unless, in their opinion the value of the credit had depreciated. Such a depreciation could take place only when confidence in the ability of the debtor to pay was impaired. The only exception to this are cases where gold is required for use in the arts and for foreign payments. The run on the Gov- ernment in 1893-4 for gold for the redemption of greenbacks was caused by the demand for gold to be 206 MONEY AND BANKING exported in settlement of the international balance which had gone against us. This legitimate and regular demand for gold soon led to another demand which arose because people began to fear that the Gov- ernment might not be able to meet its obligations. To maintain the value of outstanding credits it is necessary for the issuer to sustain the confidence of the public in his ability to pay on demand. This can be done only by keeping within easy reach, money enough to satisfy all but the most extraordinary demands. It is not enough that he have property which is ordinarily convertible into means of payment, for when the de- mand for liquidation comes it is likely to fall on every- one at once and no one will care to part with money. Safely for the issuer of demand credits, therefore, lies only in keeping at all times a reserve of money suffi- cient to maintain confidence in his ability to pay. This reserve is the basis of outstanding credits. 244. Gold the basis for all credit. The basis for bank credit is reserve money. All of this reserve money except gold coin is based more or less on the credit of the government. It is kept at par with gold because the government stands ready to redeem it dol- lar for dollar upon demand. In order to meet possible demands for redemption the government is required to keep a gold reserve of $150,000,000. The principle behind this law is the same as that behind the reserve section of the National Bank Act. The credit money of the government is based upon gold. The bank credit of the country is based upon government credit money, plus gold. The ordinary time and mercantile credit of the nation is based upon bank credit, govern- ment credit, money and gold. The following diagram illustrates the idea: NATURE OF CREDIT 207 Mercantile and Time Credit. Government Credit Money. Gold. 245. Reserve. The essential feature of the bank is its power to keep outstanding a mass of non-interest bearing demand credits, either in the form of notes or deposits, which it has issued in exchange for interest bearing time credits. To keep these demand credits out, the bank must have the confidence of the public. This it acquires by its capital and reserve. The re- serve represents to the depositor his protection, should he choose to request immediate redemption of his credit ; the capital and surplus, represents his ultimate pro- tection. The national bank act requires that national banks in central reserve cities (New York, Chicago and St. Louis) shall keep a cash reserve of 25 percent of their outstanding demand credits. This reserve consists of gold, and Government credit. The general reserve cities, of which there are forty-nine, must keep 25 per cent reserve with the privilege of depositing half of it in central reserve cities. All other national banks must keep a 15 per cent reserve with the privilege of deposit- ing 3-5 of it in reserve city banks. 246. Effect of reserve requirements. The amount of reserve which should be kept by a bank depends upon the nature of its outstanding demand credits. If they are due to other banks they are more likely to be called for than if they are in the hands of large numbers of 208 MONEY AND BANKING people scattered over the country. The amount of re- serve necessary cannot be determined by any fixed rule. The purpose of the reserve requirements of the national bank act is to put a check on undue expansion of de- mand credit by the banks, and forbids them making further loans as long as their reserve is below the legal requirements. In prosperous times this operates very well, but times of crisis and stringency; are prolonged by it. At such times each bank strives to hold as large a reserve as possible, refusing to make new loans or to renew old ones, and withdrawing its deposits from the city banks. The effect of this is to intensify the stringency. The proper policy would be to loan freely so that solvent firms may not be compelled to suspend because they cannot get ready funds with which to meet their current obligations. The Bank of England pur- sues this policy and permits its reserves to fall to a very low point, but it selects automatically the most urgent cases for relief by raising the rate of discount. In the recent panic, the Secretary of the Treasury and J. P. Morgan followed the correct banking principle when they put on the market large sums of money to be loaned. 247. Danger of use of credit in panics. It is during panics that an elastic medium of exchange is most needed, and unfortunately the deposit currency, ordin- arily elastic, not only refuses to stretch at such times, but contracts instead. Just as soon as there is a gen- eral demand for redemption of private credits even the banks are compelled to redeem their credits in legal tender, whether their ability to pay is thought to be impaired or not. To do this they must pay out their reserve money. This in turn cripples their ability to NATURE OF CREDIT 209 loan and further depletes the deposit currency. Most of the so-called currency bills which have been in- troduced in Congress have attempted to remedy the evil by authorizing banks to issue note credits in pay- ment of the deposit credits. In this way note credits could be used instead of reserve money for circulation, and unless the credit of the bank has suffered, reserve money will not be drawn out. Under our present law the issue of notes is impracticable at such times be- cause it necessitates the purchase of United States bonds, which would further deplete the amount of the reserve. In spite of these grave dangers which attend the use of credit as a medium of exchange, its use is a necessity of the era of modern industry; and as the public is gradually aroused to a study of the problems, its de- fects will disappear in the wake of competent legis- lation. 248. Importance of credit. Credit is the life blood of the economic system, its amount and condition de- termining whether business be healthy and vigorous, or unhealthy and stagnant. It determines whether the population shall be busy and prosperous or unemployed and poverty stricken. Insomuch then as the science of banking and money is so intimately concerned with the very fundamentals of life, the procurement of food, shelter and clothing, with health and with the whole standard of living, it assumes an importance equal to any other. If all the distress which followed the panic of 1907 the failure of business men, the reduction of incomes among all classes, the loss of employment and wages by thousands of workmen, bringing poverty into innumerable homes if all this tremendous calamity was unnecessary and remediable, then the subject is one VII U 210 MONEY AND BANKING of the greatest human interest, well worthy of the at- tention of trained investigators and master minds. We have progressed far enough in our study to realize that the sole cause of some of our panics is the misuse of the credit medium and that it is a leading factor in all of them. Abnormal and sudden contrac- tions and expansions of credit disturb the economic equilibrium by causing fluctuations of prices, manipu- lating profits, and destroying the spirit of enterprise among those who control the industrial activity of the nation. CHAPTER XIII EFFECT OF CREDIT ON PRICES 249. Increasing need of more efficient money. We have already seen that the use of credit affects the gen- eral level of prices by increasing the efficiency of money. Were it not for credit the price level must always be fixed by the rates between the amount of goods to be exchanged and the amount of money in circulation, pro- vided of course that the rate of circulation remain con- stant. As population increases, more goods are produced and more exchanging must be done, hence prices are certain to decline unless the value of money is increased or rendered more efficient. Declining prices lessen profits, the incentive to enterprise is deadened, the factors of production become idle and depression is chronic. A developing country, therefore, to be healthy economically must have a constantly increasing quantity of medium of exchange. This need has been met by credit, chiefly in the form of bank credit. In the preceding chapters the several kinds of credit have been discussed and it may be well to consider briefly the effects of each. 250. Effect of non-circulating credit. The use of non-circulating credit (promissory notes) has very little effect on prices through any economy of the use of money which it brings about per se. Such credits must be settled at maturity in money. Hence the use of money is postponed rather than obviated. It must be remembered, however, that the use of non-circulating 212 MONEY AND BANKING credit, while it facilitates production and thus increases the amount of transactions, at the same time greatly in- creases the medium by its creation of circulating credit. The manner in which non-circulating credits are con- verted by the banks into circulating credits had already been described. Business men issue promissory notes, discount them at the bank and receive in exchange bank credit either in the form of notes or deposit accounts. It is this deposit currency which has in this country removed a greater part of the burden of exchanging goods from the shoulders of money itself. Probably 75 per cent of our exchanges are performed by the use of checks and drafts drawn against these deposits. Money must be held by the banks against their credits as a reserve to maintain confidence in their redemption, but the amount needed is only from 15 to 25 per cent of the outstanding credits. These checks and drafts, while they are merely promises to pay money and theoretic- ally must be redeemed in money are so cancelled one against the other that little actual money is used. 251. Cancellation of credit. For example, let us take an isolated community in which there are two banks, the deposits of each being $100,000, and the money reserves $25,000. A, B and C are local business men ; A and B have deposit accounts with one bank and C with the other. If A gives his check to B in pay- ment for goods, the check will be deposited by B and his account will be credited with the amount of the check, while's A's account will be charged. Thus goods have been exchanged solely by credit. If A gives his check to C, it will be deposited in C's bank, and theoretic- ally C's bank may expect A's bank to pay the check in money. It is probable, however, that each bank will hold checks drawn on the other, in which event only EFFECT OF CREDIT ON PRICES the difference in total amounts, of balance will be set- tled in money. In this manner the checks are cancelled one against the other without any use of money. It is obvious that in large communities where it is customary to make settlements by check, that this cancellation be- comes very important. How very important this cus- tom has become will be seen when the functions of the clearing house are discussed. 252. How lessened demand for money causes rise in prices. Thus money is used by the banks only as a reserve against actual withdrawals of money and for the settlement of balances. The efficiency of the dollar is by this system multiplied several times, hence the de- mand for money is lessened, and prices tend to rise. The use of this form of credit has, moreover, a further, though not so important, influence upon prices. In poorly settled communities where banking facilities are meagre the merchant and the farmer must keep on hand in their cash drawers or pockets sufficient money to accomplish their purchases. It is inconvenient to make payments by check; in fact, if they did so, the check would probably be followed by the delivery of actual money. There is no way in which checks can be cancelled against each other. With the establishment of banks and the growth of the checking habit, how- ever, the necessity for carrying about large amounts of actual money is overcome. The demand for money is thereby lessened, and prices again tend to rise. 253. Effect of national bank notes. In the chapter on the nature of credit the difference between the true bank note and the national bank note was described. Inasmuch as the national bank notes are secured by Government bonds, which are merely long time Gov- ernment credits, they circulate freely as money itself. MONEY AND BANKING Their effect on prices, therefore, corresponds to the effect of other forms of Government credit, and will be discussed under that heading. 254. Bank notes and checks differentiated. It has been already stated that the difference between the de- posit and the true bank note is one of form. It remains, however, to describe the difference in form before the effect of true bank notes upon prices can be considered. The chief difference is that the bank note is payable to bearer, whereas checks and drafts the forms in which the deposit currency circulates are usually drawn in favor of a definite payee. Before the check is valuable it must be endorsed by the payee, whereas the note cir- culates without endorsement. Furthermore the value of a check depends upon the size of the deposit account possessed by the maker of the check. Thus checks do not circulate as freely as notes because both personal and bank credit are involved. They usually return to the bank promptly for redemption, whereas notes may remain outstanding for considerable periods. Because notes are meant for wider circulation than checks, they have been generally endowed with certain preferences over deposits that enable them to meet more readily the demand for hand to hand money. These banks may be compelled to keep a larger and specific reserve for their redemption, or perhaps a guarantee fund with the Government; or as in this country the notes may be a first lien on all the assets of the bank and be secured by the pledge of Government bonds. That there is danger in endowing their security with too in- flexible provisions, so that once issued they become a part of the actual money supply and are never pre- sented for redemption, will be seen when our own bank note system is decribed in a subsequent chapter. HI The true bank note, that is, one which is not secured, by the pledge of specific assets or a deposit of bonds but by the general credit of the bank, may have a very im- portant effect on prices. For example let us suppose that the holder of deposit credits needs money for hand to hand transactions. Perhaps he is going away where he is not known and where his check would not be hon- ored. If note issue were greatly restricted, the bank must honor his credit by the payment of actual reserve money. Under a system of free note issue on the other hand, no money would be needed; the bank would issue the note which would be generally acceptible and would remain outstanding only as long as there was demand for it as a medium of exchange. Once in the possession of another bank it would be presented for redemption because money is more valuable to bank than credit. The use of the bank note tends to raise prices by lessening the demand for money. Its chief benefit, however, arises from the fact that it so often prevents prices from falling sharply when any extraordinary de- mand for hand to hand money (such as we are apt to have at certain times of the year and are sure to have in panics) causes a depletion of bank reserves and a con- traction of credit. 255. Effect of government credit money. The use of Government credit money and, in the country, of national bank notes, has practically the same effect on prices as a similar increase of actual money. When faith in the redemption is entire, and when it is made legal tender and is therefore available for bank reserves, an increase in Government credit money tends to raise prices just as would an increase in gold itself. A con- siderable issue of new Government credit in a single country will in fact increase prices all over the world. 216 MONEY AND BANKING Its first effect is a rise of prices in the issuing country. This means that imports will increase, and exports di- minish. Finally gold must be exported in settlement of the international balance, and thus gold will tend to raise prices in the other countries. 256. Credit and speculation. The use of credits, particularly bank credit has a further effect on prices in that it fosters speculation. Speculation is that sort of buying and selling which does not help to move goods along the channels of industry and commerce from the producer to the consumer. The object of speculation is gain from the adventitious fluctuation of price and not from the natural increment in value of goods arising from increased utility as they approach consumption. Legitimate speculation tends to equalize supply over long periods and adapt it to the demand, thus decreas- ing fluctuations of price and distributing its effects in the least harmful way. Illegitimate speculation increases fluctuations of price, either through trading in ignorance of conditions of supply and demand or by manipulating the market and causing temporary changes which are not justified by supply and demand. It makes prices abnormal, usually abnormally high at first, followed by a period when they are abnormally low. Bucket shopping and mere gambling on price fluc- tuations are not referred to here; though reprehensible in themselves and injurious to public morals, they are innocent of any effect on prices. It is only when prop- erty is actually bought and sold, when the demand and supply are altered, that changes in price result. 257. How speculation may be both cause and effect of a rise in prices. To buy property, one must have means of payment. Speculation requires that the speculator EFFECT OF CREDIT ON PRICES 217 must not only have means of payment but that he must be able to hold property out of the market for a time. In speculation then, capital instead of being invested in productive enterprises and adding to the supply of goods, is locked up in goods hoping to profit not by productive increases but merely by a rise of price. Pro- ductive profits arise from an increase in the amount or utility of goods; speculative profits from artificial scarcity of goods. Speculation is both the cause and effect of price fluctuations; a natural increase of price will start, often, a speculative boom which soon makes prices abnormally high. Credit is the instrument of speculation. It furnishes the medium of exchange which releases prices tempor- arily from their dependence on money, and permits them to soar. It enables persons with small capital to purchase and hold property. If credit were unknown and every exchange of property required money, spec- ulation would still exist on a small scale; none but cap- italists, however, could engage in it and the money which was diverted to the speculative buying of one commodity would be withdrawn from other uses, and the prices of others things must fall. A general spec- ulative movement, therefore, would be impossible. So far we have spoken of the effect of the various forms of credit only as compared to a system in which credit is not used. This was equivalent to considering merely the effect of an increase or expansion of credit. It remains therefore to examine the effect of prices of a contraction of credit. 258. Defect of our currency system. Unfortun- ately this is the great defect of our credit system. Un- like expansion, which is gradual and always takes place in answer to a demand for money, contraction of credit 218 MONEY AND BANKING is likely to be very sudden. Moreover, it is likely to occur after a long period of expanding credit and ris- ing prices ; therefore the contraction and consequent fall of prices will be the more acute. We have seen that credit depends on confidence that the debtor will be able and willing to meet his obliga- tions. If anything occurs to destroy this confidence, there will be a general demand for payment. More- over, it does not always take some great political up- heaval to cause this disturbance, particularly if credits are greatly expanded and prices high. Any decided fall in prices in any great industry, due perhaps to con- ditions entirely peculiar to that industry, may cause a general slump of the stock market. This shrinkage in values causes doubt to be cast on the ability of debtors to pay, and such credits as are due are presented for payment. To meet these obligations, debtors must sell their goods and property. Since no one cares to pur- chase, prices decline sharply, to be followed by still greater distrust, lower values, further selling and so on, with cumulative effect. This process continues until a large portion of the credits have been liquidated. This condition is not attributable to credit itself, but to our particular system. The great desideratum of a credit currency is elasticity the power to expand when it is stretched and, what is more important, to contract of itself when the pull is removed. The amount of readily acceptable medium of exchange should, how- ever, expand quickly and without restrictions when a general demand for liquidation appears. Hence if the banks could issue notes freely in times of panic, a vast amount of credits might be liquidated without resort to a depletion of bank reserves. The effect of liquida- tion on prices, therefore, would not be so cumulative. EFFECT OF CREDIT ON PRICES 219 It should not remain outstanding longer than there is an actual demand for it as a medium. When times are prosperous and profits increasing with rise in prices, stocks lend themselves readily to speculation and for that reason are apt to be abnormally high. All the money in existence, however, cannot be said to be in circulation, and hence is not offered for goods at any one time. Besides the limitations on the num- ber of exchanges which the average dollar can make within a given time, it frequently happens that dollars are hoarded for longer or shorter periods ; until they are again put into circulation they might just as well be non-existent so far as their effect on prices is concerned. Moreover, the amount of the credit medium of exchange which is offered for goods constantly varies. GOVERNMENT CREDIT CURRENCY 259. Classification of government credit currency. A large amount of the money supply of the United States consists of Government credit. Under this head must be classed the greenbacks, the treasury notes, gold and silver certificates, silver dollars, and all subsidiary coins. These are all forms of credit money, because they derive their value as media of exchange from the Government's ability and readiness to redeem them in gold on demand. It is obvious, however, that they do not all depend equally upon the Government's general credit. Silver dollars and the subsidiary coins possess a certain value in themselves because of the metal they contain. Gold and silver certificates are mere warehouse receipts for an equivalent amount of metal held in the treasury, and depend only upon the safe keeping of that metal. The greenbacks and treasury notes only are true credit money. Credit money should not be confused with fiat money. We have already noted that the gold dollar derives its value both from the metal it contains and from the de- mand for it as a medium of exchange. Under our sys- tem of free coinage the supply is regulated auto- matically. In economic speech, the gold dollar is known as commodity money. 260. Fiat money defined. Fiat money, on the other hand, is any money the supply of which is regulated 220 GOVERNMENT CREDIT CURRENCY 221 artificially and the demand for which is the result of its service as a medium of exchange. It may be com- posed of valuable metal, or it may not; in any event it is not its contents or convertibility, but its exchange utility that fixes its value. Credit money is a promise to pay either fiat or com- modity money. If it is a direct promise to pay, it is said to be redeemable, at least as long as the promise is kept ; if the redemption is suspended or if it does not depend upon a direct promise to pay, but upon its cus- tomary redemption by the Government, it is said to be irredeemable. The difference between irredeemable credit and fiat money is that the good faith of the Gov- ernment is pledged to the redemption of the former in spite of a period of suspension and its value will always be influenced by the prospect of its actual redemption. 261. Factors determining the value of credit money. Since commodity money derives its value both from the value of the metal it contains and from the need for it as a medium of exchange, credit money based on gold, whether nominally redeemable or not, depends for its value first, upon the prospect of the redemption and second, upon the supply of credit money relative to the exchanging that is to be done. In an earlier chapter we saw how the greenbacks fluctuated in value relatively to gold during the Civil War as their redemption seemed immediate or remote. This was not the sole reason, however, for their fluctu- ation. Within narrower limits the relative value of greenbacks to gold and of goods to greenbacks fell with each additional issue of notes. This can hardly be attributed to a belief that the new issue made redemp- tion more uncertain ; if the Government could redeem at all, it would make little difference whether there were MONEY AND BANKING 50 or 100,000,000 more notes. It can more reasonably be attributed merely to an increase of the money sup- ply, which in itself was sufficient to raise prices. It is impossible to reach any definite conclusion as to how much of the fluctuation was caused by each of these in- fluences, but it is clear that they were both at work. In fact, when after 1868 the Government suspended entirely the retirement of the greenbacks, they con- tinued to circulate and even rose rapidly in value. Dur- ing the year that followed they were practically fiat money, drawing their value solely from the demand for them as a medium of exchange. In 1869, however, Congress passed what is known as the Public Credit Act, pledging their redemption in coin, so that they re- sumed their character of credit money. 262. Risk in free use of credit money. The theory behind the issue of credit money is that it economizes the use of gold and prevents price fluctuations. Its most ardent advocates claim that it can become the sole medium of exchange in a nation where confidence in the government and its ability to redeem in gold is maintained. This confidence can be sustained by a re- serve of gold upon which the country will draw only for the purpose of paying for imports. Furthermore its supply can be regulated and adapted to the varying needs of industry; at least such is the claim. That it is a dangerous device, however, the history of almost every nation shows. 263. Regulation of credit money. That credit money economizes the use of gold is evident; hence so far as it can be issued without ill effects, it must be a benefit to a nation. The great danger is in its regula- tion. The effect of any issue of credit money on prices and on the money supply has already been mentioned. GOVERNMENT CREDIT CURRENCY Prices rise because there is more circulating medium; this increases imports which are always quick to take advantage of a rise in price; gold flows out of the coun- try to pay for the imports. Prices then fall somewhat in the issuing country because of the loss of gold, and rise abroad; in the end, world prices are readjusted on a higher level. This will take place whenever there is an issue of credit money, whether it is redeemable or irredeemable. As long as the issue is not excessive, that is, as long as the amount of credit money issued does not approach the amount of gold formerly in circulation, its effect is not dangerous. When the issue of either becomes ex- cessive, so that all the gold flows out in payment for im- ports or is hoarded in expectation of such a condition, the credit money becomes the standard of prices and the sole medium of exchange. At such times it makes little difference whether the credit money is nominally redeemable or not. Even if it is redeemable and the government keeps a gold re- serve for the purpose, it will soon be depleted because all credit money issued in excess of the monetary de- mand will promptly be presented at the treasury for redemption. When this reserve has been paid out, credit money of either kind becomes irredeemable in fact. The only difference between the two forms seems to be that irredeemable credit will drive the gold out somewhat faster. When the government's promise to pay is express, and a reserve is kept, public confi- dence in the redemption will last longer, so that hoard- ing will not start as soon. In other words, a greater amount of redeemable than of irredeemable credit can be issued with safety. The moment that credit money fails to circulate at MONEY AND BANKING par with gold, the credit money is said to be depreciated currency. This will take place long before all the gold has been driven out of circulation. The standard of prices will be a double one ; goods will be priced so much for gold, and a greater amount for the credit money. 264. Devices to maintain value of credit money. It has been the history of credit money that efforts are usually made to keep the credit circulating at par with gold by making it legal tender. This means that it must be accepted in payment of all debts. While this feature increases its efficiency as money, and theoretic- ally makes it a more perfect substitute for gold, it is difficult to understand how it prevents its depreciation. We have seen that the value of credit money depends first upon the prospect of its redemption and second upon its supply relative to the money work which is to be done. The legal tender stamp does not increase the prospect of redemption of redeemable credit, because for that the government's faith is already definitely pledged. It is only when credit money is irredeemable that making it legal tender to prevent depreciation is bene- ficial. In this case, the government is not already def- initely pledged to redeem the credit, hence anything attached to it which is an evidence of the government's good faith increases public confidence in its redemption. The promise to accept it in payment of debts to itself is obviously an evidence of its purpose to redeem. 265. Argument for government credit money. It must be admitted in support of those theorists who ad- vocate the use of government credit as the "ideal money" that it has been tried usually under the most inauspicious circumstances, its issue generally having been resorted to only to finance wars or to maintain GOVERNMENT CREDIT CURRENCY 225 prosperity which has already grown unhealthy. If it could be issued with the sole aim of steadying prices under conditions which would necessitate its redemption when the need for it disappeared, it might become a very effective instrument in the hands of a competent government. Its issue on this theory is impracticable, however, be- cause automatic redemption is impossible. When con- fidence in the government is general, all forms of credit issued by it find their way into the channels of trade, causing a rise of prices. As long as confidence is main- tained, they will continue to be a part of the money sup- ply because there is no motive for their redemption. 266. Difficulties of adjusting supply. Moreover, it would be unsafe to give to Congress or to any associa- tion of bankers the power to expand and contract the money supply artificially. Congress is not always well informed of the business needs of the country; and bankers must always have personal and selfish interests. The effect of a sudden contraction of the money supply as seen in panics is well known. Moreover, the power to regulate the money supply would include the power to inflate or depress the price level. We are forced to the conclusion, therefore, that this credit has been well named "ideal money" by the theorists; "ideal" because it presupposes a state of technical knowledge on the part of legislative bodies and absence of self-interest which we may expect with the millennium. Irredeemable credit money may circulate at par with gold if the issue is not excessive and if there is general confidence in the government. In this case the govern- ment has not promised to redeem the money, but it does so in practice, receiving it itself at par with gold. This is not fiat money because it derives its value not entirely VII 15 226 MONEY AND BANKING from its exchange utility but from the government's actual redemption. The silver dollar is a good ex- ample. Unfortunately, however, government credit money has seldom been issued in response to a demand for money as a medium of exchange. It has been issued largely in response to the fiscal needs of governments, that is, to meet extraordinary increases in current ex- penditures. 267. Prejudices against government credit money before 1861. This has been especially true of the United States. The Constitution gave Congress the power "to borrow money on the credit of the United States"; also "to coin money and regulate the value thereof." In the Constitutional Convention a proposi- tion to enable Congress "to emit bills of credit was de- feated, it being the sense of the Convention that paper money was dangerous." The history of the Govern- ment shows that the dislike of paper money, no doubt a survival of the days of the Revolutionary bills of credit, must have continued until 1861. On only three occasions prior to this time had treasury notes been is- sued, namely, during the War of 1812, the panic of 1867 and the Mexican War of 1847. Moreover, the aggregate of these issues amounted to only $110,000,- 000, and in every case the notes were interest-bearing, and never attained general circulation. 268. Financing the Civil War. The opening of the Civil War brought extraordinary conditions. Money must be raised at once for conducting the war, and in large sums. Should the Government "borrow money on the credit of the United States," or should it create money by issuing its notes and endowing them with the legal tender feature? The former it was empowered GOVERNMENT CREDIT CURRENCY 227 to do by the Constitution and could have done by the sale of bonds. Government bonds are a form of gov- ernment credit, but they are not credit money, as they are not payable on demand. The market for bonds was not good, however, and Congress chose the latter method as less expensive, though the constitutionality was very doubtful. It may be objected that "the power to borrow money" included the right to issue notes. In regard to this point, the distinctions between cap- ital and money must be kept in mind. From the busi- ness man's standpoint what the Government really needed was working capital. No business man would think of issuing demand obligations in exchange for capital goods, particularly when there was no prospect of an immediate increase of revenue with which to meet the obligations. The business man's obligations is- sued under such circumstances would be long-time cred- its in the form of bonds. Furthermore, there was no necessity for an increase in the money supply. Prices were sufficiently high. What the Government wanted was not money but purchasing power and this it could have borrowed without increasing the supply of money itself. 269. Disadvantage of government debt. Govern- ment credit always represents a government debt. In this country we have become so accustomed to having a government debt that its elements of weakness are sel- dom analyzed. Our prosperity orators point with pride to the fact that the United States is the only nation in the world which can sell bonds that pay only 2 per cent interest. This is applauded as an evidence of pros- perity, without analysis, with no thought that the very presence of a debt on the books of anyone, even of a nation, must always be a weakness. In what respect 228 MONEY AND BANKING should a government's financial activities differ from those of a well-regulated business? Do not the same principles underlie them both? The business man will not borrow until he has already devised a time and method of payment. As we have already noted, the form in which he will borrow depends upon the disposition he wishes to make of the credit. If he expects to add to his fixed capital, he will borrow by issuing long-time credits, expecting either to pay them out of his profits or to renew them at maturity. If he merely wants the use of funds for a short time, he will issue short-time or demand credits. These he will expect to meet out of the proceeds of his sales. 270. Government debt. When a government bor- rows it does so for current expenditures. These may be for permanent improvement, such as federal build- ings, harbors, canals, which will benefit the public gen- erally and the cost of which should be spread over the period of their usefulness rather than be met out of the revenue of a single year at the time of expenditure. A favorite expression is "to let posterity have its share of the burden." The government bonded debt in 1870 amounted to $2,331,169,956; in 1902 it had been re- duced to $925,011,639. The income of a government is generally spoken of as revenue and is derived entirely from various methods of taxation. If we wish to carry out the analogy be- tween the government and the business man, we may say that the differences between the revenue and ex- penditures in any one year are profit, and that it is with this profit that the bonds are retired. The issue of bonds, therefore, when the proceeds are not squan- dered, rests on a firm business basis. GOVERNMENT CREDIT CURRENCY 229 The issue of credit money, however, presents diff er- ent problems. When the business man issues demand credits he purchases something salable with the pro- ceeds, and expects to be in a position to retire the credit at any time. The government on the other hand merely spends the money, usually to meet some extraordinary expenses, and then has nothing to show for it. If it is a war that has been financed, as in the case of our green- backs, it had a perfect right to borrow for the purpose just as it would have to make permanent improvements because, on the same theory, posterity should help bear an expense from which it will benefit. If it does that, however, a provision for redemption on demand must be made by the establishment of a sufficient gold re- serve; but to rest on a business basis, more is necessary. Posterity should not bear the burden by keeping the re- serve always intact but by actually retiring the demand credits. Redemption in gold on demand is not suffi- cient. These credits should be canceled just as the bonds have been canceled. 271. Demand debts a weakness. A debt is always a weakness, but especially so when payable on demand. It may be well to examine the claim made by the advo- cates of the issue of greenbacks that their issue would result in a saving to the government. The argument that turned the tide of battle in Congress was that in- terest-bearing bonds could be sold only at a considerable discount, whereas the non-interest-bearing notes could be issued at par; in other words, a large saving was to be effected in the interest account. In an earlier chapter the preference of business men, who deal in goods which are not always marketable, for long over short time debts was pointed out. Further- 230 MONEY AND BANKING more, it was shown that they will often pay a higher rate of interest on long time loans simply to make their business more secure. A good example of the preference has been shown by the issue of $30,000,000 in bonds by Armour & Company of Chicago. These bonds bear 4% per cent interest and were issued when the commercial rate was less than 4 per cent in spite of the fact that Armour & Company always had a ready market for their short time credits owing to their reputation and the quick convertibility of their product. The government does not deal in goods at all. Its only method of meeting obligations is by doing so out of its excess of revenue over expenditures or by re- funding them. The first must always be a slow process. In its ability to refund only does the government have an advantage over the business man; and even this ability may be crippled at critical times, so that in re- funding a loss greater by far than the interest orig- inally would result. It is obvious, therefore, that the proper business policy would be to avoid the issue of demand credits, in spite of the original saving of in- terest. 272. Provisions for retiring debt. In any event, however, whether a debt so incurred is in the form of bonds or notes, provision for its cancellation should be made. The smaller the debt, the greater the nation's borrowing power; and there is no telling when this bor- rowing power may be needed. It is not a correct busi- ness policy to allow a debt incurred during one period of stress to remain outstanding to reduce the govern- ment's credit when another period of stress appears. It should be paid off in prosperous years, so that when an- other calamity comes the slate will be clean and the gov- ernment's credit unimpaired. 273. Productive industries classified. The economic life of a community consists in the production and con- sumption of goods. The production of goods becomes more difficult and complicated as the wants of men grow and a great number of auxiliary institutions be- come necessary. Banking is one of these institutions, developed to assist in the production of goods. The institutions which carry on the process of pro- duction may be classified in three groups. 1. Those whose purpose it is to extract raw materials from the earth and to adapt these raw materials to human wants therefore, the activities of agriculture, mining, manufacturing, etc. 2. Those whose purpose it is to transport materials and finished goods to the place where they can be most ad- vantageously used. 3. Those whose purpose it is to assist in transferring the ownership of materials and finished goods so that they may come into the possession of those persons who can use them most advantageously therefore, the ac- tivities of retail and wholesale merchandising, broker- age, coining and issuing money, banking, etc. This third group of economic activities is not absolutely] necessary to the economic process but is a consequence of the private ownership of materials and the means of production ; under a thorough socialistic regime these institutions would be superfluous. 231 232 MONEY AND BANKING 274. Recapitulation of fundamental principles. Under our present system of private ownership of wealth and the division of labor in production, frequent transfers of ownership are required. Exchange is an absolute prerequisite to any but the most primitive form of production. Only an insignificant portion of the goods produced are consumed by the producer ; they were made to be exchanged for other goods. In the process of manufacture most goods change hands many times before reaching the consumer. These elementary economic facts are recapitulated for the purpose of emphasizing the importance of ex- change in our economic life. Under an economic sys- tem of private property there could be no civilization without the means of exchanging one form of property for another. The exchange of one goods for another, however, involves considerable difficulty. In any exchange there must be two parties, each desiring the article which the other wishes to part with, at the same time and place. These conditions must coincide in order to make an ex- change possible. These obstacles in the way of barter led early to the use of money, which was a commodity enjoying so universal a demand that everybody was willing to accept it in exchange for his goods. In order that production shall be most successfully carried on that is, that goods of the highest quality shall be produced in the largest quantity, it is necessary that each person shall be set to do the thing at which he is the most skillful and that he shall be able to make use of the proper tools and materials. It is necessary that the capital resources and the labor force of the country should be brought together and organized in the most efficient way. The number of persons who ECONOMIC FUNCTION OF THE BANK 233 are capable of becoming organizers of industry entre- preneurs is limited, and these are not usually the own- ers of capital. If the community is to utilize the expert abilities of these capable but propertyless entrepreneurs, a method must be provided by which they may come into possession of capital without being required to give an equivalent value immediately. So we have the insti- tution of credit, which is the third step in the develop- ment of exchange barter, money, and credit. 275. Credit. A credit is a deferred payment. In exchange for valuable property, one of the parties to the transaction gives his promise to pay a certain sum of money in the future, or, in other words, he gives his creditor the right to receive a certain sum at a future time. The value of this right depends of course upon the certainty of payment at the future time. This de- pends further upon the character and ability of the debtor and upon the aid afforded by the law in enforcing payment. A credit, therefore, is a contract to pay money, and is usually evidenced by a written instrument for the further protection of the creditor and for the purpose of making the contract negotiable. The fact that credits in the form of negotiable instruments are transferable add enormously to their utility as media of exchange. 276. Bank a dealer in credits. The business of a bank is to deal in credits ; it is a market for the purchase and sale of credits. It is an institution the function of which is to assist in the exchange of goods by facili- tating the use of credit as a medium of exchange. It is with credit as with any salable commodity the exist- ence of a market where it may be bought and sold increases its use because a demand for it is always assured. Banks are an economic benefit to the commu- MONEY AND BANKING nity to the extent that they promote the exchange of goods and services, to the end that the material resources (capital) and the labor force shall be most advanta- geously employed in the best possible organization and that the finished products shall find their way, with the minimum of delay and difficulty, to the best markets. Every exchange, excepting mere barter, involves the use of a medium of exchange. Money and credit are the two media of exchange. The term "money" is now used by economists to mean simply the standard of value which, in most countries to-day, is gold. Where the gold standard prevails, all other forms of currency token coins, government notes and bank notes are credit currency. The government usually undertakes to provide and regulate the metallic coinage of the coun- try, but leaves to the banks the task of providing and handling the credit currency. The United States goes further than most European countries in concerning itself with the credit currency of the country by issuing "greenbacks," and Treasury notes, and by guaranteeing the redemption of national bank notes. In England, as well as in most of the larger Euro- pean countries, to the banks is delegated the function of managing the credit currency; of course, under re- strictions more or less stringent. The point to be observed in this, and one which has been urged by sev- eral of our recent writers on money, notably Conant in his "Principles of Money and Banking," is that the handling of credit, even of credit currency, is properly a banking function rather than a governmental one. Credit as a medium of exchange varies in form all the way from a national bank note, which passes from hand to hand as freely as a gold coin, to a mere verbal promise to pay evidenced by a memorandum in a ledger ECONOMIC FUNCTION OF THE BANK 235 which, often as it has served in one exchange, is but rarely negotiated further. Arranged in the order of their negotiability (their serviceability as media of ex- change) between these two extremes, we have the cer- tified check, check, draft, bond, promissory note, etc. 277. Banks supply a medium of exchange. Banks perform the function of supplying a medium of ex- change in two ways: (1) by the issue of paper money, intended for general circulation, as the national bank notes, and (2) by granting, in exchange for a cash de- posit or an interest-bearing note, its own credit which can be used by the customer as means of payment by drawing a check against the bank. The function of providing a medium of exchange for a community is essentially a public one and is pecul- iarly liable to abuse if left without restriction in the hands of private parties. Before the Civil War this country suffered severely from badly regulated issues of bank money and, since the National Bank Act, the right to issue paper money has been limited to national banks under very strict regulations. 278. Banking is a quasi-public function. The right to furnish a medium of exchange by the system of checks and deposits still belongs to every bank, but in all cases it is regulated either by federal or state statutes. Min- imum cash reserves are required to be kept and in many other ways the public nature of the business is recog- nized. Besides the quasi-public function of providing a me- dium of exchange by the use of credit in one form or another, banks have another function closely allied to it and sometimes scarcely to be distinguished from it to supply temporary capital to industry in the form of short time loans. 236 MONEY AND BANKING In this age, scarce any industry can be carried on without capital. It is very rare also that the best pro- motors and managers of industry are the proprietors of the large amounts of capital necessary to carry on the business. On the other hand, a large portion of the country's capital is in the hands of those who have no ability to employ it successfully or it is scattered about among the people. To get this capital into the hands of the entrepreneurs who can employ it most profitably is a function largely assumed by banks. 279. The bank a distributor of capital. Capital is employed in industry in two ways. Some of it must be invested in the plant and machinery; this is fixed cap- ital. Another installment must be invested in materials, labor, incidental expenses of production, etc., the neces- sity for which arises out of the length of time required to manufacture and market the product. There is naturally great variation in the length of the period of production in the various industries. In some of them this circulating capital must be tied up for weeks, in others for years. The distinction between circulating and fixed capital is that the former after a period reappears in the form of a salable product from which is realized the value of capital invested and something more in such shape that it can be reinvested; in other words it is fluid, whereas fixed capital remains in the form in which it is invested and only becomes fluid as a replacement or depreciation fund is accumulated or the plant is sold. This distinction has great value in the science of banking, for as we shall see later, the credit which a bank loans has a very precarious existence and it may become necessary to withdraw it at any moment from the enterprise in which it is invested. The restrictions ECONOMIC FUNCTION OF THE BANK 237 which legislation has placed upon the manner of loans a bank may make are really based upon this principle. 280. Banking principle. A large proportion of the bank failures of the country is caused by a violation of this fundamental banking principle. The National Bank Act forbids banks to loan on real estate or mort- gages. The idea back of this is to prevent the locking up of funds in fixed capital. The failure of the three Walsh banks in Chicago in 1906 occurred because the funds of the banks had been used to build railroads which some day may be very profitable, but which for the present tie up capital where it cannot be easily turned into a means of payment. The reasons why bank funds should not be tied up in the form of fixed capital are : ( 1 ) The value of the investment may be unstable. (2) The value of the investment may depend on the completion of the whole plant, as in the case of the Walsh railroads. (3) The value of the investment may depend upon a monopoly or upon the ability of one man, so that if the peculiar advantage ceases to exist the property shrinks in value. New processes may make old plants entirely obsolete and destroy their value. 281. Double function of commercial banks. The function of a modern commercial bank is therefore two- fold: (1) To provide a means of payment and (2) to provide temporary capital for the use of industry. It will perhaps be well to show briefly how these func- tions were developed. One of the early banks, the Bank of Amsterdam (1609), was practically a warehouse for coin. Holland was the commercial center of Europe at that time, and the currency in circulation was a heterogeneous mass 238 MONEY AND BANKING of the coinage of all the neighboring and distant coun- tries, of uncertain value and frequently mutilated. Such a currency served the needs of commerce very badly, and the Bank of Amsterdam was organized to relieve the difficulty. It received deposits of this mis- cellaneous currency, calculated its value on the basis of a fixed standard and permitted the depositor to transfer his credit at the bank. The deposits were all kept in- tact in the bank, or at least were supposed to be. As a matter of fact, the sight of so much idle money seem- ingly doing no good to anybody in time proved too strong a temptation to the management and they from time to time permitted large sums to be used in financ- ing hazardous ventures, principally the colonial enter- prises of the Dutch East India Company. When these facts became notorious the depositors lost faith in the bank and it was compelled to suspend. This bank per- formed a banking function in that it provided a good medium of exchange, but it did not deal in credit in any other sense than a grain warehouse man who is sim- ply under obligations to return the deposit on demand. In the Bank of England (1694) we find the bank- ing functions considerably developed. In considera- tion of a loan to the government, which at that time was in sore need of funds, the subscribers were given the exclusive right to organize a bank which should have the privilege of issuing notes payable to the bearer and which were intended to circulate as currency. Here we have the essential element in banking an organization which is able in some way to create credit at small expense and which it may loan out to the public, deriving an income therefrom which leaves a net profit above expenses. In other words, the bank is able to ECONOMIC FUNCTION OF THE BANK 239 produce something cheaply and to rent it out at a cer- tain rate per cent. The following features were a part of the creation of the credit of the Bank of England: (1) A subscription of funds which should be loaned to the government at 8 per cent. (2) Notes must be printed, counterfeiting guarded against, an office for doing business and redeeming the notes must be maintained. (3) A demand for currency must exist so that the notes will remain outstanding. 282. Peculiar privilege of bankers. There are a great many persons and firms who can create credit, but the banker is the only one able to derive an income from loaning it out. The reason of this is that the bank- credit is in such form that it can be used as a means of payment and, therefore, will be received and held by the public so long as there is need for it to do the necessary work of exchange. Naturally a business in which the stock-in-trade can be produced at very little expense and can be loaned out at from 5 per cent to 25 per cent per annum is peculiarly attractive and liable to abuse. Until the pas- sage of the National Bank Act, the United States had to suffer many and heavy losses through the insufficient regulation of this important function. It took us all those years to learn that the function of supplying the currency of the country is a public one and should be delegated to private parties only under the most strin- gent regulations. Under our present laws the privilege of issuing bank- credit to be used as currency (the national bank notes) costs the bank nearly as much as the income derived from loaning the notes and, furthermore, a large part 240 MONEY AND BANKING of the country's need for credit currency is supplied by the government itself by issues of "greenbacks" and Treasury notes. By far the largest portion of the payments in business transactions are made by the use of credit in another form than currency, that is, by means of the check or draft. The service of the banks in providing currency is really insignificant when compared to their service in furnishing a method of payment by check. The essential element in the check system is the same as in the bank-note system, viz., bank credit. Instead of selling, or more properly, loaning its credit in the form of bank notes, at a certain rate per cent, the bank loans the right to draw checks against it, which checks can be used as a means of payment, but to a much more limited extent than bank notes and with a much more restricted circulation. The principle underlying both systems, however, is the same. The peculiar characteristic of a bank is the privilege of using its credit as a medium of exchange. This gives its credit a utility enjoyed by the credit of no other organization except the government. Because its credit has this utility it can be kept outstanding with- out the payment of interest. The principal business of the bank is to exchange its own credit, in the form of bank notes or a deposit credit on its books against which checks may be drawn, for the credit of someone else in the form of a promissory note bearing interest. Under ordinary circumstances neither the bank notes nor the deposit credits bear interest, consequently the bank gains by the transaction a gross profit equal to the interest on the promissory note. In order to make this profit it is necessary that the bank-credit should be kept out- standing and not be returned to the bank for payment. ECONOMIC FUNCTION OF THE BANK Credit is simply a deferred payment and this bank- credit represents a payment due at any time the posses- sor chooses to call for it; if it is in the form of a bank note he may present it for redemption in cash; if it is in the form of a deposit-credit he may draw a check and cash it at the bank. Now, if bank notes were re- deemed soon after their issue, or if deposit-credits were checked against and the checks cashed soon after the credit was granted, the bank would not be able to keep its credit, having no interest outstanding. It would gain the interest on the promissory notes purchased but, since it had to pay cash for them ultimately by redeem- ing the outstanding credit given for them, the whole transaction would be equivalent to loaning money at the current rate of interest, nothing more or less. In actual practice, however, the bank is not compelled to redeem its credit in cash immediately, but is able to keep it outstanding for some time. In case the bank puts out its credit in the shape of bank notes, the public need for currency keeps them circulating from hand to hand and serving the same purpose as money; as there is no need to exchange them for money the bank is not called upon to redeem them. However, this no longer applies to banking in the United States since the privi- lege of issuing bank notes freely has been taken away from the banks by the National Bank Act. Under the present system of banking in this country the banks can no longer put out their credit in the form of bank notes, except in the case of national bank notes where the restrictions upon their issue are so many that their character is quite changed; they no longer represent the credit of the issuing bank but the credit of the government in the shape of a United States bond. Having been deprived of this one method of keeping VII 16 MONEY AND BANKING their credit outstanding by the issue of bank notes, the banks have made use of another method, the check and deposit system, which serves the same purpose but which is more difficult to understand. 283. Banks do not create capital, Dunbar says in his little book, "The Theory and History of Banking": It is obvious that the bankers create no new capital by their lending and deposit holding, but it is equally plain that they direct the stream of capital to the enterprises and industries re- quiring such support, and that they quicken the succession of commercial and industrial operations. A given amount of cap- ital is thus made more effective, so that the result of the introduc- tion of banking in any community is the equivalent of a consid- erable increase of capital, although not implying any real increase in the first instance. Industry is impossible without two things: Capital and management. Very frequently the class of per- sons owning the capital are not capable of employing it in industry to the best advantage, and many persons of ability have no capital. It is the function of the bank to bring the two together for their mutual advantage and thus promote industry. It is important to get the distinction between capital and capital goods. Capital goods are those material things which are employed in the further production of goods, such as machinery, factory buildings, raw materials, and goods in the hands of merchants. Cap- ital is a certain sum of value so many dollars worth from which the person owning it expects to get an in- come. Capital goods wear out and disappear, but cap- ital survives in the form of replacement and sinking funds under normal conditions. ECONOMIC FUNCTION OF THE BANK 243 A factory may be turning out some form of capital goods machinery, for example and at the same time there may be entrepreneurs desiring to make use of that machinery in production but having no ready funds. The makers of the machinery cannot part with the machinery unless they get some form of medium of exchange with which to pay their bills for wages, materials, etc. The bank steps in at this point and enables the two parties to get together to the advantage of both themselves and the community. The machinery company either takes a note from the entrepreneur and gets it discounted at the bank, thus changing a non- circulating form of credit into a medium of exchange with which they can pay their bills, or they sell the ma- chinery on time and borrow from the bank enough to pay running expenses until the account shall have be- come due. Production requires a lapse of time and the owners of the capital employed must wait until the goods pro- duced are sold before they can get back their capital. The bank takes the burden of waiting from those who have to employ their capital more rapidly and places it on those who are content to wait so long as they get an income for it. 284. Source of capital and credit of bank. The sources of the capital and credit which is the stock in trade of the bank: (1) Capital stock subscribed by stockholders, and (2) deposits of cash. On the basis of the funds thus provided the bank is able to create a large amount of credit which, when loaned to entrepre- neurs, serves the purpose of actual capital because with it they can purchase the capital goods they require. Credit is a substitute for money in making exchanges MONEY AND BANKING and may be compared to airships which in the near future may render superfluous railroad tracks and right- of-way. 285. Operations of a bank. The operations of a bank are three : Discount or loaning, deposit, and issue. In discounting or loaning, the bank buys from the customer a non-circulating credit in the form of a prom- issory note and pays for it with cash or, what is much more frequently the case, with its own credit in the form of bank notes or a deposit credit, either of which are circulating and can be used as a medium of exchange. In dealing with the bank the customer may either sell (discount) notes of other people which he has taken in trade, or he may sell his own note with these trade notes as collateral security, or he may sell his own note with or without some collateral. We have now to consider what it is that the bank gives in exchange for the right to demand and receive money at a future time which is acquired by it under these circumstances. In the case of discount the proceeds of the discounted note (face value less inter- est) are placed to the credit of the customer, to be drawn out by him by means of checks to suit his convenience. The customer has given the bank the right to demand funds from him at a definite future time in exchange for the right to demand funds from the bank at any time. The item "individual deposits" in a bank statement does not imply that persons have deposited cash to that amount in the bank; some of it of course represents cash deposited, or checks, drafts, etc., deposited for col- lection which are equivalent to cash; but the greatest proportion represents credits which have been sold by ECONOMIC FUNCTION OF THE BANK 245 the bank in exchange for non-circulating forms of credit, i. e., promissory notes, commercial paper, etc. A bank note is a form of demand liability sold by the bank. It is simply the evidence of the debt of the bank the same as an entry in a bank book showing that whoever possesses it can claim from the bank a certain sum. The system of checks and deposit is a substitute for bank note issues and developed out of them. Eng- land and the United States are the only countries mak- ing extensive use of the system, the continental countries still clinging to the bank note. In the operations we have been considering the sub- ject matter involved is in every case either money or contracts for the payment thereof, viz., credit. No form of dealing in merchandise or real property comes properly within the field of banking. 286. Responsibility of the banker for proper distribu- tion of capital. Mr. Conant says in his "Principles of Money and Banking" : It is in distributing between depositors, borrowers, and his own vaults the money intrusted to him by depositors in such a man- ner that he shall be able to repay it according to his promise, that the most delicate and important function of the banker arises. It is in the execution of this function that the modern banker has become the arbiter of the direction of investment, the organization of industry, and even of the fate of nations. Sim- ple as the process is by which the banker transfers to others the stored purchasing power which he has gathered up in small de- posits from his customers who have acquired gold or the right to command gold, it is his selection among these borrowers which determines the course of the industrial progress of the nation. Hence it comes that the banker, in the financing of important enterprises, can within certain limits determine whether a given project shall succeed or fail. In every growing community 246 MONEY AND BANKING much of the real burden of deciding upon the course of its future development lies with the banker. It is for him to determine the relative marginal utility of one enterprise as compared with another and to grant his support to the enterprise which promise* the highest utility and therefore the most certain profits. Thu there rests upon the banker in a sense the vital function of tru- tee for the community in its dealings with itself. This trustee- ship is especially sacred if he deals with the money of others, as ia usually the case, and not purely with money of his own. The peculiar nature of a bank and the close relation existing between it and the economic welfare of the community is brought out clearly when a failure occurs. In the case of an enterprise of a more private character a manufacturing or mercantile concern a failure does not ordinarily bring such disastrous results as the failure of a bank, because the parties injured expected to take a risk and usually have means of protecting themselves. A bank failure, on the other hand, throws a direct loss on a great many people who have not calculated on any risk. Furthermore, there is an indirect loss of confidence in banks. This leads people to withdraw their deposits and go back to the more primitive and expensive methods of exchange, thus retarding the eco- nomic development of the country. Our prosperity is owing to a large extent to the devices which make exchange easier and cheaper, just as better railways and steamships increase our welfare by promoting that form of exchange. Banking de- vices, the use of checks against deposits, etc., are just as important as inventions which help to annihilate dis- tance. The banks have so important a role to play in the disposition of the circulating capital of the country that ECONOMIC FUNCTION OF THE BANK they can cause a very serious complication when, by departing from the true rule of banking and in hope of gaining large profits, they invest these circulating funds in enterprises of a speculative character and by; so doing convert circulating into fixed capital* 287. Analysis of credit. A bank loans its credit, as a general rule, rather than cash. We shall have to prove this statement, for the average banker will insist that he loans cash. Credit is the promise to pay money at a future time and arises out of an exchange in which property, serv- ices, or some valuable thing is exchanged against a promise to pay an equivalent value in the future. The transaction is not complete until the promise is dis- charged. A credit is created, therefore, by a transfer of value which is still incomplete, one of the parties as yet not having performed his part of the contract; in lieu of property, the second party gives the right to receive from him value at some future time. Having been once created, this credit this right to receive value is regarded as property and may be transferred as any other form of property is transferred. Whoever possesses the legal right to receive this value may de- mand it of the debtor when it is due. As a medium of exchange, credit is superior to stand- ard money in that it does not involve the transfer of intrinsically valuable commodities produced at great cost. The function of the bank is to promote the use of this inexpensive substitute for standard money credit. It does so by affording a market wherein credits can be bought and sold. A typical illustration of this im- 248 DEPOSIT CURRENCY 249 portant service to the business of the community is as follows : 288. How credit promotes industry. The process of producing from the raw material a cotton garment be- fore it reaches the consumer requires months of time and the participation of many separate industries. The raw cotton must be grown from the seed, ginned, baled, transported, carded, spun, woven into cloth, cut and sewed into the form of the garment, transported, and sold to the jobber, then to the wholesaler, to the retailer, and finally to the consumer. Practically every step involves an exchange in which a quid pro quo is necessary. For example, a cotton-mill owner cannot perform his part in the chain of production unless he can possess himself of the raw cotton and hold it long enough to make it into cloth. If he has no equivalent to exchange for the cotton, he is estopped from business. The owner of the raw cotton, perhaps, cannot wait sixty or ninety days for his pay and he cannot, therefore, accept the credit of the mill-owner in exchange unless he can sell that credit for cash. The credit of the mill- owner, in the form of a promissory note, is not a medium of exchange which the cotton dealer can use to pay his obligations. The bank, however, stands ready to buy that note and give for it something which can be used as a means of payment. The bank, a market for negotiable commercial paper, has made possible the ex- change of cotton, and the industry of the country has been aided. Because a market for credit exists, ex- changes can take place which would otherwise be im- possible. 289. Banks create credits. Besides furnishing a market for credits already in existence, banks engage in transactions in which credits are created by receiving 250 MONEY AND BANKING deposits and making loans. In exchange for cash de- posited, the depositor receives the promise of the bank to repay the sum on demand. This is evidenced by an entry in the pass book of the depositor. The bank redeems its promise, either partially or entirely, when- ever it accepts a check drawn upon it by the depositor. In loaning money, the bank may exchange cash for the promise to pay of the borrower, either on demand (a call-loan) or at some stated future time (a time- loan) . This, however, is not the usual transaction. Ordinarily, when the bank makes a loan it is to a regular customer who has an account. In this case the borrowing customer receives, in return for his promise to pay, a credit on his deposit account against which he may draw checks. In this transaction the bank ex- exchanges its own promise to pay money on demand for the promise of the borrower to pay a larger sum at some future time or, if it is a call-loan, on demand; the whole matter is simply an exchange of credits. It is because the borrower rarely takes cash from the bank but prefers to accept a deposit credit, that the loan and deposit items of the bank statement correspond so closely in amount. Most of the deposits of a bank are created in this way; the rest are created by the deposit of cash or cash items. The deposit item of a bank is not, therefore, a record of the sums of money brought into the bank by cus- tomers, although it includes such sums; it represents, rather, the demand liabilities of the bank (excepting its circulating notes outstanding) that is, the sums it may be called upon to pay at any time. Is it not clear, therefore, that what a bank loans is not cash but its own credit? It is a simple matter of fact that the borrower does not take money when he DEPOSIT CURRENCY 251 gets a loan but takes instead a credit on the books against which he can draw checks, that is, he accepts the promise of the bank to pay on demand, which is a deposit credit. The very fact that a deposit credit is payable on demand does not make it any the less a credit. 290. Bank credit preferable to cash. Why do per- sons borrow from the bank unless they need the money? Why are they willing to pay interest on funds which they leave in the bank? Why are they willing to take the credit of the bank instead of cash? Answers to these questions involve a study of the business habits of the business community. A business man borrows from a bank in order to get something with which to make payments; not usually immediate payments, but payments falling due from time to time within a month or more. The most con- venient method of making payments is by means of a check drawn against a deposit credit at the bank. The chances are, however, that it will be some time, perhaps several weeks, before the business man who made the loan at the bank will have given out checks for the whole amount of the loan and in the meantime he may be receiving funds which are deposited in the bank. Furthermore, before the loan falls due, he begins to accumulate a deposit so that when the loan matures he has simply to draw a check in favor of the bank in order to cancel the debt. The bank has had the use of the funds, for which the customer has been paying it in- terest, for some days after the loan was made and for some days before it is repaid. 291. Shifting of bank credit without liquidation. But there is still a further advantage to the bank. In the first place, the checks given out by the depositor are not presented at once for payment but may go to a MONEY AND BANKING distant city and pass through many hands before they find their way to the bank. During all this time, per- haps for a week or two, the bank has the use of the funds. Even when the check comes back to the bank, the bank does not ordinarily have to part with the funds represented by the check, although the drawer has ordered the bank to pay to the presenter the amount. If the check falls into the hands of a customer of the bank, he will take it to the bank and increase his de- posit account instead of asking for cash. As a rule the check will come into the possession of a person who is the customer of another bank and he will increase the deposits of that bank. This bank will present the check to the bank, which is liable for its payment, for payment through the clearing house. Yet even now the debtor bank need not part with the cash, for on the preceding day it has received on deposit from its own customers checks on the bank holding the check against it. They simply cancel off their mutual obligations, perhaps paying a small balance the one to the other. Still the money remains in the bank. In fact, the only time the bank is called upon to redeem its demand obligations is when a check is actually pre- sented at the teller's window for cash payment or when the balances at the clearing house are running against it. The bank statement in the following chapter shows that demand liabilities (deposits) of the banks are usu- ally four times as large as their cash on hand. Expe- rience has taught them that a cash reserve is amply sufficient to meet all demands for cash payments which are likely to appear. Three-fourths of their demand liabilities represent the bank's own credit which it is able to keep outstanding because the business community prefers to use checks rather than cash as a medium of DEPOSIT CURRENCY 253 exchange. This credit of the bank serves all the pur- poses of money and the bank can get interest for the use of it just the same as if it were cash. 292. Similarity of checks and bank notes. It is pre- cisely the same as if the bank loaned its credit in the shape of bank notes. Before the Civil War, when there was no restriction on the issuing power of banks, the borrower received from the bank its notes, that is, its promises to pay on demand ; to-day the borrower receives the promise of the bank to pay, but in the shape of a deposit credit which really amounts to exactly the same thing. Checks, based on these deposit credits, circulate as a medium of exchange, although in a more restricted way than the old bank notes. Nobody will deny that a bank note is simply the promissory note of the bank and that the bank loaned its credit when it gave bank notes to borrowers. Why should anybody deny that a modern bank loans its credit when it gives to the bor- rower a deposit credit? 293. Limits of earning power of the bank. The main source of the bank's profit is the interest received on loans and discounts, and it follows that the profit varies directly with the amount of loans made. What then is the limit to the amount of loans a bank can make? The National Bank Act sets no direct limit except that it forbids any national bank to loan to any individual or firm an amount greater than one-tenth of the bank's capital. Indirectly, it places a limit on loans by pro- viding that national banks shall keep a reserve which shall not fall below a certain percentage of the net de- posits. When a bank gives a loan it must either part with that amount of cash, thus reducing its reserve, or it must give a deposit credit, thus increasing its net deposits ; in either case it has increased the ratio between 254. MONEY AND BANKING reserve and net deposits, and the limit to which this ratio may be increased is one to four, which is the same as saying that the reserves must be 25 per cent of the deposits. 294. Difference between a cash and credit loan. When the bank loans actual cash instead of credit, it increases the ratio between reserve and deposits four times as much as when credit is loaned. For example: A bank with deposits of $1,000,000 and a reserve of $300,000 (the ratio between them being 1:3 1-3), loans $100,000. If the borrower takes the cash from the bank, the deposits remain as before but the reserve has fallen from $300,000 to $200,000, thus changing the ratio of reserve to deposits to 1 :5, which means that the reserve is only 20 per cent of the deposits, and this is below the legal minimum if the bank is a New York national bank. Suppose, on the other hand, that the borrower accepts a deposit credit instead of demanding cash. The deposits have increased to $1,100,000, while the reserve remains as before at $300,000, the ratio in this case rising to 1:3 2-3. When the borrower took cash, the ratio changed from 1:3 1-3 to 1:5; when the bor- rower took credit, the ratio changed from 1:3 1-3 to 1:3 2-3. In the first case, the reserve was depleted below the legal limit; in the second case, the bank could still loan another $100,000 before it reached the limit. There can be no question as to whether the bank would prefer to loan its cash or its credit. 295. Cash a precious commodity at times. It be- comes easier now to see the reason why cash is such a precious commodity in Wall Street; not because cash is a medium of exchange, for Wall Street uses very little of it in transacting its business, but because cash is the basis of credit which is the medium of exchange, DEPOSIT CURRENCY 255 Hence the rivalry among the banks to secure cash de- posits, for cash deposits mean larger reserves, larger reserves mean new credit created to three times that amount, new credit means larger loans and consequently increased dividends. Hence, also, the great disturbance caused by the withdrawal of a few millions of cash deposits, such as when withdrawn by the country banks to "move the crops." Withdrawals of cash mean de- pleted reserves, which condition creates a shrinkage of bank credit and a reduction of profit-making loans. More than that, the contraction of credit the me- dium of exchange in 99 per cent of the important transactions of the market has the same effect as the retirement of a large portion of the circulating medium. The effect of the movement of a few million dollars westward to move the crops would be an unimportant matter if it involved the contraction to that amount simply of the medium of exchange; under present con- ditions it involves a contraction of three times or more of the amount. Those great accumulators of cash, the country banks, the savings banks, trust companies, investment com- panies, and insurance companies, have in their power the control of the money market, for the cash at their disposal forms the basis of a vast structure of credit on which the business of the financial center of the country rests. The dangerous element in the situation arises from the instability of this foundation, for the withdrawal of cash from the reserves of the banks causes the collapse of the superstructure, credit. In view of these facts the rate of interest which the New York banks pay for cash deposits, 1% per cent or 2 per cent, is a small matter. For every dollar of cash deposited they are enabled to loan credit to three 256 MONEY AND BANKING times the amount at from 2 per cent to 6 per cent, thus making a gross profit of from 5 per cent to 15 per cent on the deposit. The word "deposit" is ambiguous and has a dual nature. When a banker asserts that he makes 5 per cent gross profit on his deposits, he uses the term as meaning demand liabilities outstanding (excepting, of course, circulating notes) . A deposit of cash in a bank, however, means something more than an increase of that amount of the demand liabilities of the bank; it means an increase of reserve to that amount, on the basis of which the bank is justified in increasing its demand lia- bilities by three times the amount deposited, and this it usually does if there is a market for the loans. On the receipt of a deposit of $1000 cash, the bank does not put $250 in the reserve and loan $750; it puts $1000 in the reserve (for the reserve is not a special fund, but represents practically all the cash on hand at any par- ticular time) and increases its loans and demand lia- bilities (deposits) $3000, if it is a national bank, or more if it is not. 296. Problem of the reserve of greatest importance. The problem of what constitutes a sufficient reserve is one that engages the mind of bankers at all times. The amount of credit which they can keep afloat and upon which their profits depend is determined by the size of the reserve which they can hold in their vaults. It is obvious that if a large proportion of the demand credits are presented at any one time that the bank cannot meet them. This happens only when some event occurs that shakes the confidence which the depositors have in the bank. If the bank cannot dispose of its assets by bor- rowing from the other banks, it must fail. In addition to this danger there are certain times of year, varying DEPOSIT CURRENCY 257 in different localities, when banks increase their reserves. It may be that more actual money is used in hand to hand transfers, or that the banks expect a demand for local loans that causes them to increase their reserves. When there is any general movement on the part of the country banks toward increasing their reserves, such as takes place every year when the crops start to move, the withdrawal of actual money from the reserve cities causes bank reserves there to fall in volume. Con- versely, when the demand for money in the interior subsides, the money flows back into the reserve city banks, and their reserves are thus increased. Hence a reserve which is sufficient at one time of year may not be at another; and reserves which are sufficient during a period when the granting of credit is on a normal basis may be lamentably insufficient when there is a general demand for liquidation. 297. Lack of cooperation causes banks to lose re- serves. Unfortunately, under our present system, there is very little cooperation between the banks of different cities when demand for liquidation becomes general. Each bank does everything in its power at such times to increase its reserve, and it must all be at the expense of some other bank. The writer knows personally of several banks which increased their reserve during the recent panic until they totaled 75 per cent of their deposits. 298. Methods of increasing reserves. At such times there are only two ways of increasing the total of the country's bank reserves until they begin to be increased automatically by the gradual liquidation of credit. The most common method is to negotiate for gold abroad. This is slow, however, and is apt to be expensive. The second method is by the deposit of Government funds VII 17 258 MONEY AND BANKING with the hanks. This was of great assistance during the panic of 1907, but it could be taken advantage of by the holders of certain securities which the Government offered to accept as collateral for the loan. Since that experience the law has been changed so that the list of acceptable securities has been greatly enlarged; and thre is no doubt but that the new arrangement would prove of value if the experience should be repeated. This presupposes, however, an available surplus of money in the United States Treasury, on the presence of which it is not safe to rely. 299. Secondary reserve. A great many banks, in ad- dition to their cash reserve, carry what is sometimes known as a secondary reserve. The cash reserve means money on hand and deposited in other banks. The secondary reserve consists of any securities which are readily marketable. Railroad and such municipal bonds as are listed on the New York Stock Exchange are the most popular, because they are bought and sold daily, and the banker may always ascertain their market value by recourse to the daily paper. There are certain issues which are very active on the exchange, hence they best serve the bankers' purpose. Because of this, many bank- ers fall into the error of thinking that any bond which is listed is readily marketable. There are a great many issues, however, which are listed but for which it may be far from easy to find a market. It may be that the issue is small and not widely known; or it may be that the bonds are closely held by a few interests. In either case the issue is not active, and the bonds will not always sell readily. The great fallacy of the theory of investment in listed bonds on the assumption that they are salable, however, is more fundamental. Even when a bank se- DEPOSIT CURRENCY 259 lects as a secondary reserve, bonds which are active, it does not follow that they can be sold when there is a general demand for liquidation. The same issue of bonds may be held by a thousand banks over the country on the same theory and it is needless to say that they cannot all convert them at the same time. If any of them sell, it will be at a great sacrifice in price, and with each sale the price declines still further. 300. Unreliability of bonds as reserves. It must not be supposed from this that investment in listed bonds is unwise. In practice they have many times proved to be a very valuable asset, but generally for a somewhat different reason. First, they are readily marketable except during panics, so that if a bank wishes to realize on its bonds for reasons peculiar to itself it may do so without great loss. Furthermore, in the panic of 1907 the city banks refused to redeem any credits in cash, so that even if bonds had been sold on the exchange, the sale would not have obtained for them any currency. This action, however, enabled them to make more loans than they otherwise could have made, and the bonds of their country correspondents were very acceptable col- lateral. When the country banks saw the market price of bonds falling off", they preferred borrowing with their bonds as collateral to selling, especially as neither alternative netted them any actual currency. 301. Aldrich-Vreeland act. Most important of all in making bonds a valuable asset in a panic is the Aldrich- Vreeland act, passed by Congress in 1908, which recog- nizes the security of certain bonds by making them acceptable as collateral to secure deposits of money from the Government. Prior to the passage of this act, Gov- ernment bonds only could be used to secure Government deposits, and Government bonds are an expensive asset. CHAPTER XVII BANK STATEMENT RESOURCES 302. Combined statement. In passing from the the- oretical to the practical discussion of banking, it is well for the student to become familiar with the bank state- ment. It is a summing up of all the transactions of the bank a condensed record of all the books of account and every transaction, no matter how small, produces a change in the statement. An understanding, therefore, of all the items of the bank statement will provide a good introduction to the actual practice of the business. The statement reproduced in section 303 on page 261 is the combined statement of all the national banks in the country. The federal law provides that each national bank shall make a report to the comptroller of the cur- rency at least five times each year. The dates for mak- ing the reports are not fixed but are announced by the comptroller at intervals. It is a peculiarity of the bank- ing business that it may have a complete report of its financial condition at the end of each day. In a mercan- tile or manufacturing establishment it is possible to have such a statement only after an inventory of the stock on hand is taken. The assets of a bank are of such a nature that the perpetual inventory can be kept. It was thought best to take the report of all the national banks rather than a statement of any single bank; the items are exactly the same and the relation between the different amounts is more typical of the average bank than any single statement could be. 260 BANK STATEMENT RESOURCES 303. Proof of the deposit currency theory. Further- more, the figures showing the relation between loans, deposits and reserves, are the best proof that can be offered as to the validity of the deposit-currency theory presented in the preceding chapter. It will be observed that the total volume of loans and discounts in the 6544 national banks in 1907 was but little over four and a half billion of dollars. The individual deposits, or the amount due to depositors of all sorts except banks, was a little less than four and a half billion dollars. The amount of reserve, including the specie and legal tender notes and 5 per cent redemption fund, amounted to something over one billion dollars, or 20.8 per cent of the deposit liability. Since the total amount of money of all descriptions in this country is only a h'ttle more than three billion dollars, and since the deposits in the state banks and trust companies, combined with the figures given, will make a total of over twelve billion dollars, it requires no argument to show that the item "deposits" does not represent cash deposited but rather credit extended by the bank. There is not enough actual cash in the whole world to pay the depositors of the banks of the United States if they should suddenly desire to exercise their legal right and all at once call for payment of their deposits. COMBINED REPORTS REQUIRED BY THE COMPTROLLER OF THE CURRENCY FROM THE NATIONAL BANKS.i BANK STATEMENT. 6,544 BANKS AUG. 22, 1907. RESOURCES: 1. Loans and discounts on which officers and directors are liable, either as payers or indorsers. Loans and discounts on which officers and directors are not liable as payers or indorsers $4,678,583,968.99 2. Overdrafts, secured, $ , unsecured, $ 30,443,119.51 3. U. S. Bonds to secure circulation, par value 557,277,950.00 4. U. S. Bonds to secure U. S. deposits, par value 95,628,650.00 i Report of Comptroller of Currency, 1907, p. 9. 262 MONEY AND BANKING 5. Other bonds to secure U. S. deposits 68,198,039.03 6. U. S. bonds on hand 7,390,840.00 7. Premium on bonds for circulation; premium on other U. S. bonds 14,554,194.17 8. Bonds, securities, etc., including premium on same 700,352,456.58 9. Banking house; furniture and fixtures 160,845,896.15 10. Other real estate owned 20,241,913.97 11. Due from National Banks (not approved reserve agents) 334,571,435.56 12. Due from State and private banks and bankers, trust companies and savings banks 123,020,454.14 13. Due from approved reserve agents 614,496,352.27 \4. Checks and other cash items 26,905,246.13 15. Exchanges for the clearing house 190,602,163.58 16. Bills of other national banks 31,240,127.00 17. Fractional paper currency, nickels and cents 2,314,530.17 18. Lawful money reserve in bank, specie, legal tender notes. 701,623,532.52 19. Redemption fund with the U. S. Treasurer 27,305,679.43 20. Due from the U. S. Treasurer 4,731,853.60 $8,390,328,402.80 LIABILITIES: 21. Capital stock paid in $ 896,451,314.00 22. Surplus fund 548,303,602.00 23. Undivided profits, including amounts set aside for spe- cial purposes. Less current expenses and taxes paid 186,554,1*1.85 24. Circulating notes secured by U. S. bonds. Less amount on hand in Treasury for redemption or in transit. . . 551,949,461.50 25. State bank circulation outstanding 30,419.50 26. Due to National Banks (not approved reserve agents) . . 823,680,087.29 27. Due to state and private banks and bankers 395,745,494.77 28. Due to trust companies and savings banks 337,927,872.50 29. Due to approved reserve agents 38,139,918.96 30. Dividends unpaid 1,583,606.56 31. Individual deposits subject to checks. 32. Demand certificates of deposit. 33. Time certificates of deposit. 4,319,035,402.62 34. Certified checks. 35. Cashier's check outstanding. 36. U. S. deposits ." 143,282,393.15 37. Deposits of U. S. disbursing officers 17,755,770.92 38. Bonds borrowed 59,994,634.56 39. Notes and bills rediscounted 14,415,550.30 40. Bills payable 44,760,529.68 41. Reserved for taxes 4,358,763.69 42. Other liabilities 6,859,429.01 $8,390,328,402.80 304. Double-entry system. The first thing to be noted about the statement on this page is that the two columns of resources and liabilities exactly balance each other to the cent. The reason of this is to be found in the system of double-entry bookkeeping by which every transaction is recorded twice, so that it is impossible to BANK STATEMENT RESOURCES 263 alter the credit or resource side without at the same time changing the liability or debit side. Under this system the bank is considered as having no property of its own, but that all its resources above its liabilities belong to the stockholders, and these resources are classified as part of the liabilities under the items capital stock, sur- plus funds, dividends, profits, and dividends unpaid. These items are liabilities of the bank only in the event of liquidation. The fact that the resources and liabilities of the bank are equal has no bearing whatever on its solvency. The last statement given out before a bank fails invariably shows the resources to be equal to the liabilities. The discrepancy must be looked for in some of the items: either the resources have been put in at valuations above their real worth, or some item of liability has been omitted or reduced. It is almost always discovered in the event of a failure that loans and discounts contain items which are far less than the figures set down. Under resources are put down all the items of property owned by the bank and all sums due to be paid to it in the future. Under liabilities are placed all the debts owing by the bank and all items representing the equity of the stockholders in the property of the bank. In other words, the liability side of the statement simply indicates to whom the resources belong in case the bus- iness of the bank were to be settled up instantly. 305. Alterations in value of resources. The items on the resource side may increase or diminish without any transactions having taken place and therefore without any changes having been made in the liability side. Some of the loans may prove to be bad and non-col- lectible, or some of the real estate or bonds may increase in market value; profits may be made or losses may be 264 MONEY AND BANKING incurred. It is impossible constantly to adjust the values given in the statement to correspond to the real conditions. In some banks the adjustment is made periodically; in others only when it is discovered that the alteration of value is permanent; and in still others it is never made. 306. Concealed assets. It frequently happens that where the items of property have enhanced in value the figures on the statement are allowed to remain absurdly low, creating what is called "concealed assets." It is considered by a great many bankers an evidence of conservatism to continue to list at a low figure, property worth much more than its book value. There can be no objection to this practice so long as everybody under- stands the real condition and knows that the statement is a fictitious one. The objection to the practice comes from the fact that even the stockholders do not realize the full value of their stock and may be induced to part with it at a price which they would not consider at all if they knew the equity represented by it. We will now take up each item separately with such explanations as are necessary to describe the transac- tions by which it is created. 307. Loans and discounts. This item of assets is in the form of promissory notes of individuals or corpora- tions. The discount represents notes which have been purchased or discounted by the bank at a certain price below their face value at maturity. The difference be- tween the value at maturity and the price paid is called discount, and is at once credited to the profit account, appearing under "liabilities" in the item "undivided profits." "Loans," technically speaking, represents the sum paid out equal to the face of the note ; at maturity the bank will receive that amount plus the interest. The BANK STATEMENT RESOURCES 265 difference between loans and discounts, therefore, is that in the case of loans the hank does not realize its profit until the note is due; in the case of discounts the hank takes its profit when the transaction is made. Discounting has always been considered the peculiar business of a bank. In Pennsylvania the trust com- panies are not empowered to discount, but they have the right to loan money and to purchase notes and other obligations. The prohibition of discount does not pre- vent the trust companies from doing a general banking business; instead of discounting they simply purchase the notes outright or loan the funds on the security of the notes, taking the interest at maturity. On the back of the bank report are printed certain schedules which must be filled out in order to show more in detail the meaning of the various items. The law provides that "all debts due to an association, on which interest is past due, and unpaid, for the period of six months, unless the same are well secured, and in process of collection, shall be considered bad debts within the meaning of this section." All such notes must be listed in the schedule, together with all notes which are overdue and all notes repre- senting liability of directors as borrowers. While there is no law limiting the right of the bank to loan to its directors on the same terms as to any other person, it is recognized that the privilege is likely to be abused and hence the banks are asked to make a separate statement of such loans. 308. Overdrafts. Where banking is not conducted on the strictest business principles the depositors are likely to overdraw their accounts. Under certain local conditions of business overdrafts are unavoidable. But the good banker can usually arrange with the depositor 266 MONEY AND BANKING to give a note to the bank for the amount and thus con- vert the overdraft into a loan or discount. If a certain maximum temporary credit is wanted to draw against, a demand note should be given to the bank, the amount passed to the customer's credit, and when settlement is made the customer should be charged with the interest on the amount checked out. 309. United States bonds to secure circulation. This item represents bonds owned by the bank but deposited in Washington. The law requires the bank to deposit or to own United States bonds up to 25 per cent of its capital whether circulation is taken out on them or not. The value of the bonds is given at par and not at market value. 310. United States bonds to secure United States deposits. The law provides that the funds of the United States not required by the Treasury may be deposited in national banks if United States bonds, or under cer- tain circumstances other bonds approved by the secre- tary of the treasury, are deposited in Washington as collateral. The secretary may use his discretion as to whether other than Government bonds shall be accepted at all and what bonds may be accepted as collateral security. 311. United States bonds on hand. Sometimes the banks hold Government bonds in their own vaults with- out using them to secure circulation. It is not likely that any bank would hold Government bonds as an in- vestment, and it is likely that this item represents bonds which it is expected will be sold to customers of the bank or will be required later for securing circulation. 312. Premiums on United States bonds. This item represents the difference between the par value and BANK STATEMENT RESOURCES 267 market value of the United States bonds owned by the bank. 313. Bonds, securities, etc. This item embraces be- sides bonds, also stocks, chattel-mortgages, judg- ments, claims, etc., owned by the bank. The securities which are deposited by borrowers as collateral security for loans do not appear in the statement because they are not the property of the bank until default has been made on the note. Under the law national banks are not allowed to own corporation stocks unless it is neces- sary to take them in the collection of a debt. This item, therefore, represents practically the bonds owned by the banks. It has increased greatly within the past few years, because many of the banks are dealers in bonds and hold them pending their sale to customers, and fur- thermore because the ready market which is at hand un- der normal conditions for the bonds causes the bank to regard them as a form of secondary reserve which can almost immediately be converted into money in case of emergency. 314. Banking house furniture and fixtures. The comptroller has been rather strict in interpreting the law with reference to the holdings of real estate by banks. The large office buildings which have been erected to house the banks as well as to accommodate hundreds of tenants have been erected by separate com- panies, usually composed of the same stockholders as the bank. 315. Other real estate holdings. This item includes not only real estate but all mortgages and assets rep- resenting real estate. The law is very strict in limiting the power of the bank to hold real estate, as indicated in the following provision: 268 MONEY AND BANKING A national banking association may purchase, hold, and convey real estate for the following purposes, and for no others : First. Such as shall be necessary for its immediate accommoda- tion in the transaction of its business. Second. Such as shall be mortgaged to it in good faith by way of security for debts previously contracted. Third. Such as shall be conveyed to it in satisfaction of debts previously contracted in the course of its dealings. Fourth. Such as it shall purchase at sales under judgments, decrees, or mortgages held by the association, or shall purchase to secure debts due to it. But no such association shall hold the possession of any real estate under mortgage, or the title and possession of any real estate purchased to secure any debts due to it, for a longer period than five years. The object of this provision is to prevent the banks from investing their resources in forms which are not readily convertible into current funds. In former years, before there was so much property other than real estate which could be used as security for loans, the banks were almost forced to take mortgages or nothing at all. In times of stringency when depositors were de- manding cash, the banks were frequently embarrassed and forced into insolvency because they could not con- vert real estate, which under such circumstances is always very unsalable except at a tremendous sacrifice, into funds which would satisfy their depositors. 316. Due from national banks. This represents de- posits in other national banks which may not be counted as part of the reserve. 317. Due from approved reserve agents. Under the law the country national banks may deposit in the re- serve cities, three-fifths of the 15 per cent of their de- BANK STATEMENT RESOURCES 269 posits required as reserve. In the reserve cities national banks may deposit one-half of the 25 per cent required in central reserve cities. 318. Checks and other cash items exchanges for the clearing house. Under these headings are included everything which may be immediately convertible into cash. In cities where there is a clearing house the checks on the clearing house banks are listed separately. In the statement we see that the exchanges for the clearing house are over seven times as great as the checks and other cash items. This shows the propor- tion of checks, etc., which can be collected inexpensively and also the proportion which must be collected by mail. 319. Bills of other national banks. The national banks are not allowed to count other national bank notes as part of their reserve. It is therefore to their interest to have as few of them on hand as possible. To ac- complish this they pay them out before any other form of currency, or send them to Washington to replenish the 5 per cent redemption fund or to make other pay- ments to the Treasury. Under the different items representing specie it will be noted that the gold and silver certificates are in- cluded. 320. Legal tender notes. This represents the green- backs held by the banks and also the Treasury notes of 1890, which are now very rare. 321. Redemption fund. Every national bank is re- quired to keep on deposit with the Treasury of the United States a fund equal to 5 per cent of its outstand- ing circulation. This requirement is no hardship at all to the bank because it can count this amount as part of 270 MONEY AND BANKING its reserve. It makes no difference whether the money is in its own vaults or in the vaults of the Treasury at Washington. 322. Due from the United States Treasury. This item includes any amounts due from the Treasury other than the 5 per cent fund, such as notes of other national banks, or forms of currency, or bonds forwarded to it for redemption. CHAPTER XVIII BANK STATEMENT LIABILITIES 323. Capital stock paid in. The capital stock of a bank represents the funds paid in by the stockholders. The National Bank Act provides that no bank shall begin to do business until 50 per cent of the capital has been paid in cash, and the balance must be paid in installments of at least 10 per cent per month. The capital is the margin paid up by the stockholders to protect the creditors in case of any shrinkage in the resources. The law requires no stated percentage of capital proportionate to the size of the bank, but aims to prevent under-capitalization by the following section: Sec. 5138 as amended by act of March 14, 1900). No as- sociation shall be organized with a less capital than $100,000, except that banks with a capital of not less than $50,000 may, with the sanction of the Secretary of the Treasury be organized in any place the population of which does not exceed three thou- sand inhabitants. No association shall be organized in a citj the population of which exceeds fifty thousand persons with a capital of less than $200,000.* By this requirement of a certain maximum capital for banks in towns of more than a certain population the act prohibits the establishment of banks with insuf- ficient capital in cities where the loans and deposits are likely to be large. Until 1900 the minimum capital for i National Bank Act, p. 7. 271 272 MONEY AND BANKING a national bank was $50,000 ; since that time it has been $25,000 to encourage the establishment of national banks in small towns where hitherto the amount of busi- ness was too small to justify the organization of a bank with larger capitalization. Sec. 5139. The capital stock of each association shall be di- vided into shares of $100 each, and be deemed personal prop- erty, and transferable on the books of the association in such manner as may be prescribed in the by-laws or articles of asso- ciation. Every person becoming a shareholder by such transfer shall, in proportion to his shares, succeed to all the rights and lia- bilities of the prior holder of such shares. 1 324. Double liability of stockholders. The shares of stock in a bank differ from stock in other corporations in the double liability feature. The principle of limited liability is an almost universal feature of corporation laws in this country and the stockholders cannot be made liable for further payments for the stock if it has been fully paid. The idea of limited liability is of course to make it possible for persons who are unwilling to take unlimited risk in becoming partners in an enterprise to become stockholders with a maximum risk of losing only what they have paid in. In the case of banks, however, it has become a fixed custom not only in the national bank act but also in most of the state statutes to place a double liability on the shareholders for the better protection of depositors; the reason being that the depositors are creditors of an entirely different sort from the creditors of other corporations. Sec. 5151. The shareholders of every national banking asso- ciation shall be held individually responsible equally and ratably, and not for one another, for all contracts, debts, and engage- i National Bank Act. BANK STATEMENT LIABILITIES 273 ments of such association to the extent of the amount of their stock therein, at the par value thereof, in addition to the amount invested in such shares, except that shareholders of any banking association now existing under state laws having not less than $5,000,000 of capital actually paid in and a surplus of 20 per centum on hand, both to be determined by the Comptroller of the Currency, shall be liable only to the amount invested in their shares ; and such surplus of 20 per centum shall be kept un- diminished, and be in addition to the surplus provided for in this title; and if at any time there is a deficiency in such surplus of 20 per centum such association shall not pay any dividends to its shareholders until the deficiency is made good; and in case of such deficiency the Comptroller of the Currency may compel the association to close its business and wind up its affairs under the provisions of chapter four of this title. 1 The whole purpose of requiring a certain capital sum to be contributed by the shareholders can be defeated by the subsequent withdrawal of its funds as loans to shareholders. It has frequently happened that banks have been started with capital borrowed by the incor- porators, which borrowings have been repaid just as soon as the bank was in position to make loans to the shareholders. In the statement it will be noticed that the capital stock of all the national banks amounts to a little less than one billion dollars, or a little more than one-fifth of the deposits. This means that there must be a shrinkage of 20 per cent in the assets of the banks be- fore the depositors are in any danger. 325. Surplus fund. This item signifies that a cer- tain portion of the resources in addition to the capital paid in belongs to the stockholders. The surplus is created either by cash paid in at the organization of i National Bank Act. VII 18 274 MONEY AND BANKING the bank in addition to the capital paid, for which no stock is issued, or it represents profits which have accumulated and which have not been paid out in divi- dends. The idea of the surplus fund is to provide an item in the liabilities which can be used to represent changes in the equity of the stockholders in the reserves without altering the capital stock. If the bank should suffer a loss of resources in any manner beyond the amount of undivided profits, the capital of the bank would be impaired if it were not for the surplus. A surplus is required by law under the following section: Sec. 5199. The directors of any association may semi-ammally declare a dividend of so much of the net profits of the associa- tion as they shall judge expedient ; but each association shall, be- fore the declaration of a dividend, carry one-tenth part of its net profits of the preceding half year to its surplus fund until the same shall amount to 20 per centum of its capital stock. 1 A liberal surplus enhances the credit of the bank and for that reason new banks frequently start with a surplus of 50 or 100 per cent of the capital subscribed. This proves an advantage in several ways. The banks are required to purchase fewer bonds than they would if the whole investment had been put into the capital. In states where the shares of the bank are taxed on their par value it reduces the personal property tax of the holders thereof. On the other hand the smaller amount of capitaliza- tion reduces the power of the bank to issue circulating notes and until the recent amendment to the law for- bidding the banks to loan more than 10 per cent of their i National Bank Act, p 28. BANK STATEMENT LIABILITIES 275 capital and surplus the banks were restricted to 10 per cent of their capital alone. The fact that the shares of stock represent the equity of the holders not only in the capital but also in the surplus gives the par value of bank stock much less meaning than the "book value." The book value of the bank stock represents the $100 par value plus the proportionate share of the surplus. 326. Undivided profits. Unlike the majority of manufacturing businesses the profits of a bank are car- ried to the profit and loss account as they accrue each day. From the gross profits must be deducted all the expenses of doing the business. At the end of the fiscal year the directors meet and declare dividends from this item, the effect of which is to transfer a part of it to the account of dividends unpaid and the balance to the surplus. Sometimes the dividends when payable are placed directly to the accounts of the shareholders when they happen to be depositors as well. 327. National bank notes outstanding. This item represents the amount of notes for which the bank is still liable. All the notes which the comptroller has forwarded to the bank are charged against it until he has received the notes back again or in their place has received lawful money for their redemption. If the bank has any of these notes on hand they will be de- ducted from this account. It will be noted that the amount of national bank notes outstanding almost equals the amount of United States bonds deposited in the Treasury to secure circu- lation. At the particular time this report was made the banks were putting out as much circulation as pos- sible on their bond deposits on account of the very high rate of interest at which they could loan the funds. 276 MONEY AND BANKING The amount of bonds to secure circulation is consid- erably over one-half the capital stock of the combined banks, showing that the banks are disposed to hold more bonds than they are required to under the law. 328. State bank notes outstanding. This small item, which amounts to only $30,000, is a vestige of the Civil War period. Many of the state banks of that time were converted into national banks. The circulation which they had outstanding at that time could not be called in and $30,000 of it has never been presented for redemp- tion. The items due other national banks, state banks, trust companies, and approved reserve agents represent the deposits made by other banks. 329. Individual deposits. This item represents the amount due to individuals and corporations. The amount signifies the obligations of the bank which may be demanded at any time during banking hours. This obligation is created either by the deposit of money or cash items which appear in the opposite column under these headings, or by the loans which the bank has granted to customers, and corresponds to the item "Loans and Discounts" on the resource side. The pe- culiar nature of this item was explained in the preceding chapter. On the books of the bank the individual deposits appear under several accounts. By far the largest amount is recorded in the individual ledgers and is sub- ject to check. For some of the deposits the banks have issued certificates of deposit either payable on demand or at a certain date. These deposits are not subject to check and are usually payable only upon the return of the certificate which is negotiable. These deposits closely resemble savings deposits except that they rep* BANK STATEMENT LIABILITIES 277 resent a deposit made at one time instead of in install- ments. The certificate of the bank is sometimes given by the bank instead of a note, where funds have been borrowed. 330. United States deposits and deposits of United States disbursing officers. The Government deposits secured by bonds are divided into two classes. The first is more permanent in character and consists of funds owned by the Government in excess of the disburse- ments required. The second class signifies deposits which have been made by officers of the Government temporarily but which will soon be required to make payments to Government creditors. 331. Bonds borrowed. There is no requirement in the National Bank Act that the bonds deposited by the banks to secure circulation or deposits shall be owned outright by the bank. Some banks find it profitable to borrow from investors or other financial institutions the bonds required for the purposes mentioned. So long as the borrowing bank is solvent and the interest on the bonds is paid regularly to the real owners, the latter suffer no disadvantage whatever from having the bonds out of their possession. 332. Notes and bills rediscounted. This item, so in- significant in amount, suggests the great difference between American and European banking. In this country it is considered a confession of financial weak- ness if a bank seeks to rediscount any of the paper held by it. In Europe, on the contrary, a large pro- portion of the paper purchased or discounted by the bank is acquired with the expectation of rediscounting it. This is a great advantage because it places any bank in a position of being able to loan to any amount, knowing that it can always replace the funds by redis- 278 MONEY AND BANKING counting the notes. In the United States, however, when any bank has reached the limit of its loaning power, it is obliged to refuse accommodation to its cus- tomers, no matter how pressing their need or how dis- tressing the consequences of denying them the funds. The practice of rediscounting practically amounts to making available for the whole community the credit of the local bank in the larger money markets. The failure of American bankers to adopt the practice of rediscounting with all its advantages both to themselves and the community, particularly to the community, is much more inexplicable because the disadvantages of the system appear to be insignificant compared to its ad- vantages. 333. Bills payable. This item, which is more than three times as large as the preceding one, signifies that the banks have borrowed outright the sum represented instead of selling some of their resources. 334. Certified check. This is an ordinary check drawn by a depositor which has been certified by the cashier or other appropriate officer and which has not yet been presented for payment. When the bank certi- fies a check the amount is taken from the account of the depositor and placed in the certified check account. By this act it becomes a direct obligation of the bank the same as a promissory note. If the bank should fail before it is presented for payment the holder would have no recourse upon the original drawer of the check. The fact that the holder chose to have it certified instead of demanding payment at the bank throws the risk of non-payment upon him. If the maker of the check himself had it certified his liability for payment is the same as in the case of an ordinary check. 335. Cashier's checks outstanding. This item repre- BANK STATEMENT LIABILITIES 279 sents the checks which the cashier has signed on behalf of the bank against deposits in other banks or checks upon the bank itself. New York exchange is the name given to cashier's checks which are payable at New York banks and which are sold by banks throughout the country to persons wishing to make remittances. CHAPTER XIX ORGANIZATION AND BUSINESS OF THE BANK 336. National banks. Five different kinds of insti- tutions in this country are included in the general term bank: National banks, state banks, trust companies, private banks, and savings banks. National banks are corporations which are char- tered by the Federal Government to assist the United States Treasury in providing the paper currency of the country. The strict limitations imposed upon these banks by law, especially the law which prohibits them from loaning on real estate security, is offset by the credit which their national charter and supervision by the examiners gives them in the community. 337. State banks. State banks are chartered by the several states. The legal restrictions thrown around them vary widely but in general the state statutes are modeled after the National Bank Act. The differences between national banks and state banks so far as the functions they perform are concerned, are so unimpor- tant that it is not worth while to discuss them separately ; therefore what follows will refer primarily to national banks. Since the Civil War state banks have been al- lowed to issue paper currency only upon payment of a 10 per cent per annum tax, which is so high as to be abso- lutely prohibitive and in consequence the state banks issue no paper currency. 338. Private banks. Private banks are partnerships in which each of the partners is liable for all the debts 280 ORGANIZATION AND BUSINESS 281 of the firm to the extent of his private fortune. The only private banks of any considerable size are those dealing in foreign exchange, in bonds, or in real estate. An important function of private bankers is the pro- motion of new corporations and underwriting for new issues of securities. The firm of J. P. Morgan and Company is typical of this class. 339. Underwriting. When a new issue of securities is to be brought out an arrangement is usually made with professional financiers who understand how to make a market for them. As the officers of the cor- poration issuing them are usually not qualified to mar- ket a very large issue a specialist in that line is in demand. The underwriter agrees to sell the entire issue at a certain fixed price ; sometimes he gets a commission but more often he relies for his profit on selling the securities above the agreed price. If an issue is larger than his own firm can handle he may organize a syndi- cate, with himself as syndicate manager. He then invites other capitalists or firms to subscribe to the syndi- cate. If the market conditions are good the whole issue can be disposed of without calling upon the subscribers to furnish any funds. It is usual in the case of the subscribers that they know nothing about the whole transaction from the time of their agreement to provide a certain sum if necessary until they receive a check representing their share of the profits. If the issue should fail to find a market it may be necessary to call upon the subscribers to make up the loss, or at least to give them the privilege of taking up their share of the unsold securities at the syndicate price. The very large proportion of "undigested securities" which so troubled the financial world in 1903 and caused the rich man's panic of that year, were securities which under- writing syndicates had failed to sell to the public and had to carry themselves on margin at their bankers. 340. Trust companies. A trust company was origi- nally not a bank at all but a company incorporated to execute trusts in the legal sense. The large powers granted to these corporations were, sometimes "inad- vertently," found to include the powers necessary to do a banking business without many of the limitations of state banks. In the last twenty years there has been an enormous growth of this type of institution, and it has become a very serious competitor of both national and state banks. 341. Banking department. The trust company has two distinct departments, the bank department and the trust department, with two sets of officers. The bank- ing department is conducted almost the same as a com- mercial bank, although the conditions and laws in the different localities have forced it to take on a different form to suit the circumstances. In New York City, for example, the trust companies have specialized largely in the collateral loan business. Until recently the trust companies in New York City were not required to keep any reserve. Instead of placing money in their own vaults, therefore, they either deposited in national banks, receiving thereon a small rate of interest, or loaned it for stock exchange purposes at call loan rates. These loans could be converted into cash at such short notice under ordinary circumstances that the trust companies felt it unnecessary to keep any other reserve. When the volume of this business reached enormous proportions the national and state banks felt that they were forced to have on hand ready money sufficient to provide for any sudden demands, not only at their own counters but at the counters of ORGANIZATION AND BUSINESS 283 aD the trust companies as well. They feared that in time of general panic the small percentage of cash rela- tive to the demand deposits of both banks and trust companies would precipitate a disaster. At this time the trust companies were members of the clearing house and in order to force the trust companies to keep re- serves they passed a rule requiring all members to keep in cash 25 per cent of their deposits. The trust com- panies were unwilling to comply with this provision and withdrew from the clearing house, nor have they ever returned to it, preferring to make their collections on city checks in the more cumbersome manner. Recently the state of New York has passed a law requiring the trust companies to keep a reserve of 15 per cent. 342. Deposits of trust companies. In a great many localities the trust company has developed an entirely new field hitherto neglected by the banks. By adver- tising and other means they have attracted large num- bers of personal accounts of people who had never before thought of having a bank account. These de- positors are given the privilege of drawing an unlimited number of checks against their account and are usually paid interest on their daily balances of 2 per cent. While these personal accounts do not average very large, still they are so numerous that the total is con- siderable. However, most of them are fairly inactive, and the number of checks required to be handled is not excessive. With the improved methods of bookkeep- ing and the use of adding machines, etc., the trust com- panies have found that it is profitable to cater to this class of customers. 343. Trust department. The trust department of the trust company has no banking function whatever, and the great number of trust companies do not pretend 284 MONEY AND BANKING to do this sort of business at all. The importance of this business, however, in modern finance warrants a brief description. 344. Individual trusts. A trust department of any size will be divided into two parts, an individual and a corporate trust department, each in charge of a trust officer. The function of the individual trust depart- ment is to act as trustee for the property of individuals, as guardian for minors and incompetents, as conservator of estates, as executor of wills and administrator of the estates of intestates. A great deal of this business comes to the trust company by appointment of the courts. The duties of the trust company require it to manage large amounts of property in the form of real estate and securities. Hence it is necessary for them to have a real estate and bond department. The bond department of many trust companies has grown beyond the requirements of trusteeship into a regular bond house for the general purchase and sale of securities. 345. Corporate trusts. The corporate department acts as trustee under corporate mortgages and trust deeds. When a corporation wishes to issue bonds under a single mortgage it is impossible for each one of the shareholders to have a separate mortgage. The trust company holds the mortgage subject to the terms pre- scribed in the bond, and in case of default of principal or interest on the bond it proceeds against the corpora- tion in the interests of all the bond holders. It also acts as fiscal agent for corporations, taking charge of the payments of coupons when they are due and receiv- ing and holding sinking funds to provide for the retire- ment of the obligations at maturity. When an issue of bonds is subject to redemption the trust company may take charge of the drawing of the numbers and ORGANIZATION AND BUSINESS 285 the payment of the call bonds. The trust company may act as registrar for corporations, authenticating the issues of stocks and bonds in order to prevent an over-issue. It frequently acts as transfer agent for corporations if it is located in a central city. In the case of failures a trust company sometimes acts as re- ceiver under the direction of the court. All these func- tions are of modern development but so necessary have they become that it would be almost impossible to dis- pense with them. 346. Savings banks. A savings bank is really not a bank at all, if the word is restricted in its use to institu- tions which provide a medium of exchange. A savings bank is more closely related to the investment company. Its purpose is simply to receive funds in small amounts for investment in securities or real estate. The deposits are not subject to check and the bank may even require thirty days' notice before making payment. Conse- quently the savings bank is under no necessity for keep- ing a reserve. On the other hand, the savings bank has no credit which it can loan and receive an income upon. The business of the savings bank is simplicity itself. It simply gathers together small sums which of themselves are too small for investment and pur- chases with them interest-yielding securities or mort- gages. They usually pay interest of 3 per cent or more to depositors, while the income from the investments is usually below 5 per cent. In some states, like Massa- chusetts and New York, where the laws restrict very closely the securities in which the savings may be in- vested, thus forcing the savings bank to buy only first class securities, the margin is frequently less than 1 per cent. The expenses of the business, however, are so small that even a 1 per cent margin is profitable.. 286 MONEY AND BANKING 347. The organization of a bank. The usual method of organizing a bank is first to get a subscription of the necessary capital. Recently companies have been formed for the purpose of opening new banks in com- munities where the recent growth of business has justi- fied their establishment. These companies, when they have found a locality which promises to develop suffi- cient business to be profitable, provide the capital and the oificers. When the bank is once started and the people of the community interested as depositors and patrons, then the organizing company sells the stock to local capitalists and employs the capital in establishing new banks elsewhere. 348. Evolution of the bank. In communities of slower growth, however, the bank is usually an evolu- tion. First the local merchant or wealthy farmer with idle capital makes loans to his neighbors and friends. As the original capital grows the merchant or farmer may find that the loaning business with all its details is becoming more important than his regular occupation. People have learned to trust these men in their regular lines of business and intrust to them for safe keeping their savings or valuables. They are also asked to take charge of estates and are consulted with reference to investments, etc. In the course of time these men find it necessary to have separate offices arranged for the convenient transaction of this financial business and per- haps to have assistance in their bookkeeping. This may gradually develop into the private bank, or the size of the business may make it advisable to take other men into the business. 349. Stockholders. In an incorporated bank the stockholders are the ultimate authority. Their power, however, is all delegated to a number of directors. Once ORGANIZATION AND BUSINESS 287 a year the shareholders of the bank have the right to choose directors, after which they are entirely powerless, except in cases of fraud on the part of the directors, until time for a new election arrives. 350. Directors. It is upon the directors that the whole responsibility of the bank falls. The National Bank Act makes certain requirements of directors which are set forth in the following sections : Sec. 5145. The affairs of each association shall be managed by not less than five directors, who shall be elected by the share- holders at a meeting to be held at any time before the association is authorized by the Comptroller of the Currency to commence the business of banking, and afterward at meetings to be held on such day in January of each year as is specified therefor in the articles of association. The directors shall hold office for one year, and until their successors are elected and have qualified. Sec. 5146. Every director must, during his whole term of serv- ice, be a citizen of the United States, and at least three-fourths of the directors must have resided in the state, territory or district in which the association is located for at least one year immediately preceding their election, and must be residents therein during their continuance in office. Every director must own, in his own right, at least ten shares of the capital stock of the association of which he is a director, unless the capital of the bank shall not exceed $25,000, in which case he must own in his own right at least five shares of such capital stock. Any director who ceases to be the owner of the required number of shares of the stock, or who becomes in any other manner dis- qualified, shall thereby vacate his place. Sec. 5147. Each director, when appointed or elected, shall take an oath that he will, so far as the duty devolves on him, diligently and honestly administer the affairs of such association, and will not knowingly violate, or willingly permit to be vio- lated, any of the provisions of this title, and that he is the owner in good faith, and in his own right, of the number of shares of 288 MONEY AND BANKING stock required by this title, subscribed by him, or standing in his name on the books of this association, and that the same is not hypothecated or in any way pledged as security for any loan or debt. Such oath, subscribed by the director making it, and certified by the officer before whom it is taken, shall be immedi- ately transmitted to the Comptroller of the Currency, and shall be filed and preserved in his office. Sec. 5239. And in cases of such violation every director who participated in or assented to the same shall be held liable in his personal and individual capacity for all damages which the association, its shareholders, or any other person shall have sus- tained in consequence of such violation. Sec. 5239. If the directors of any national banking associa- tion shall knowingly violate, or knowingly permit any of the officers, agents, or servants of the association to violate, any of the provisions of this title, all the rights, privileges, and franchises of the association shall be thereby forfeited. Such violation shall, however, be determined and adjudged by a proper circuit, district, or territorial court of the United States, in a suit brought for that purpose by the Comptroller of the Cur- rency, in his own name, before the association shall be declared dissolved. In recent years the responsibility of the directors of banks has become an important question. With the increase in the size and the complexity of the business of a bank it has become more difficult to get business men to serve on the directory who are willing to con- sent to contribute enough of their time to get fully and thoroughly familiar with the business of the bank. It has never been customary to pay salaries to directors and the small fee of $5 to $20 per meeting is not suffi- cient to justify busy men in giving up much of their time. 351. Considerations governing choice of directors. The credit of the bank and its attractiveness to depos- ORGANIZATION AND BUSINESS 289 itors depend in no small measure upon the reputation of the men on the board of directors, and hence it has become the custom to select men for that position whose names are likely to prove a business asset, not only among the business men of their particular line but with the general public. In most cases these men are not familiar even with the rudiments of banking and in many cases rarely attend the meetings of the board. Under these circumstances it has been comparatively easy for dishonest officials to use the funds of the bank in their own private interests and this has often resulted in the ruin of the bank. In an address before the Penn- sylvania Bankers' Association in Philadelphia in 1906, Mr. William B. Ridgely, at that time Comptroller of the Currency, made the following radical statement: Except from very rare and exceptional causes, such as sudden panics or runs due to false rumors, there is never any reason- able excuse for the failure of bank or trust company. It is almost always the result of inexcusable folly and incompetence or dishonesty and fraud, and often due to all these combined. When a bank does fail, it is the fault of the board of directors. Many others may be to blame, perhaps more than the directors, but the final responsibility of bank management rests upon the directors and they are to blame. In many cases the federal courts have declared that a director's duty is not discharged by merely electing officers of good reputation, ability and integrity to man- age a bank and then leaving its business in their hands. The board of directors, the courts have held, is bound to maintain a supervision of the affairs of its associa- tion, and to have a general knowledge of the character of its business and the manner in which it is conducted, and to know at least upon what security its larger lines of credit are given. VII 19 290 MONEY AND BANKING 352. Briggs v. Spaulding. The United States Su- preme Court decision most in point is the case of Briggs v. Spaulding, which was a suit brought by the receiver of the First National Bank of Buffalo against the de- fendants as directors for failure to perform faithfully and diligently the duties of their offices. It was alleged that they had failed to call and hold meetings, to appoint any committee of examination, to require bonds, or to make personal examination into the conduct and man- agement of the affairs of the bank, but that instead they allowed the executive officers to manage it without super- vision. In rendering its decision the court said : Without reviewing the various decisions on the subject, we hold that directors must exercise ordinary care and prudence in the administration of the affairs of the bank, and that this in- cludes something more than officiating as figureheads. They are entitled under the law to commit the banking business, as de- fined, to their duly authorized officers, but this does not absolve them from the duty of reasonable supervision, nor ought they to be permitted to be shielded from liability because of want of knowledge of wrongdoing, if that ignorance is the result of gross inattention. 1 The law requires more of directors than a reasonable care in selecting the officers of the bank. Although there has been great difficulty in charging the directors with civil liability for ignorance in cases where banks have failed, yet the federal courts have laid down cer- tain principles with which every director should be familiar. Referring to the case of Briggs v. Spauld- ing, the court in another case said: In my opinion it does not meet the requirements of this state- ment of the law that directors may confide the management of l Priggs v. Spaulding, 141 U. S. 132. ORGANIZATION AND BUSINESS 291 the operations of the bank to a trusted official, and then repose upon their confidence in his right conduct without making ex- aminations themselves, or relying upon his answers to general questions put to him with regard to the status of the affairs of the bank. The idea is not to be tolerated that they serve as merely gilded ornaments of the institution, to enhance its at- tractiveness, or that their reputations should be used as a lure to customers. . . . It is inconsistent with the purposes and policy of the Banking Act that its vital interests should be com- mitted to one man, without oversight and control. 2 353. Ignorance no excuse. Directors may not ex- cuse themselves from liability on the plea of igno- rance. Although it is a physical impossibility for directors to have personal knowledge of the condition of the books and funds of a very large bank, yet it is possible and even imperative for them to employ public accountants to make audits of the affairs of the bank independent of the federal or state examinations. 354. Supplementary examinations necessary. The fact that the National Bank Act requires a frequent ex- amination of the bank by regularly appointed examiners is not sufficient. These examinations are necessarily incomplete because of the limitations placed upon the examiner. Under the older methods of doing the bank- ing business no loan was granted until the directors had specifically authorized it. Applications for loans were recorded in an offering book which was placed before the board at every meeting, and no loans were granted until the formal consent was given. This method is too slow and cumbersome in these days and it is doubtful whether any number of directors would have sufficient credit information to intelligently authorize every loan. However, it is not too much to demand of a board of 2 Gibbons v. Anderson, 80 Fed. Rep. 345. 292 MONEY AND BANKING directors that they be familiar with every loan which may become dangerous to the bank. Experience has shown that large losses have occurred only where the directors have allowed the law to be violated by loaning more than 10 per cent of the capital to one person or corporation. Furthermore, every loan made to a direc- tor or officer of the bank should be carefully considered in the board meetings. If every director were familiar with these two types of loans and exercised his best judgment in passing upon them there would be few losses from these sources. Moreover, it would be impos- sible to deceive the directors regarding such loans be- cause an independent auditor instructed to report specially upon this point could not fail to discover any irregularities. 355. Opinion of Comptroller Ridgely. On this point Mr. Ridgely speaks as follows: Above all, the directors of a bank should most closely scru- tinize the loans to officers and other directors, and see that they are kept down to not only legal but safe amounts. Far the most frequent cause of bank troubles, in fact, the almost invariable cause of bank failures, is the granting of credits far beyond the legal and prudent limits to the officers or to one concern or group of allied, concerns, generally owned and managed by the officers or directors of the bank, or in which they have directly or indirectly, some large pecuniary interest. When a bank is in anything approaching this condition, it is in grave danger, for its entire safety depends on the success of outside enterprises, and the man who should protect the bank has, perhaps, a greater interest in protecting the other con- cern. It is probably the most common, serious dereliction of duty on the part of directors to allow such a condition as this to gradually obtain in a bank. It may sometimes be done honestly as the result of bad judgment only, but in my experience it is the most frequent cause of dishonesty and fraud among bank ORGANIZATION AND BUSINESS 293 officers. I do not remember a case where a bank officer had the moral courage to let loans of this kind carry down his bank without resorting to crimes of some kind to conceal or postpone the catastrophe, in hopes that some fortunate circumstance might intervene to save him and conceal his fraud. The function of the board of directors is to assume the responsibility for the safety of the bank and to deter- mine the general policies which shall be pursued. With the active conduct of the business it has nothing to do. This function is delegated to the officers, the chief of whom is the president. 356. The president. The president is always the pre- siding officer of the board of directors. It devolves upon him to see that the directions of the board are carried out. In some cases, especially where there is a dummy board of directors, the president exercises the whole power. In other cases he simply carries out the will of the board in the administrative details without having even the authority to grant a loan. Usually the powers and duties of the president lie somewhere be- tween these two extremes. The board as a rule deter- mines the maximum limits to which credit may be extended to particular firms, and leaves the president wide discretion in granting credits between these limits. In large banks there are vice-presidents who share with the president the duty of negotiating with borrowers. 357. The cashier. The cashier of the bank is its chief executive officer, upon whom falls the duty of operating the bank. He has direct charge of all the employes and must of course be familiar with the details of every department. He usually acts as secretary of the board of directors. It is his duty to prepare the reports and statements. He is the officer empowered to sign docu- 294 MONEY AND BANKING ments on behalf of the bank. His signature must always appear upon the circulating notes issued or the checks and drafts drawn by the bank upon its corre- spondents. In most banks which have not yet developed a special credit department the cashier is the chief credit officer. While the president or vice-president usually retains the authority to grant loans, he usually depends upon the cashier for information as to the credit responsibility of the applicant. In those banks where the list of bor- rowers has become extended and where the advantage of a credit bureau is recognized, the cashier frequently has an assistant who has specialized in this field and who understands how to accumulate and systematize informa- tion affecting the financial status of the patrons of the bank. The credit department of a bank probably offers more opportunity for an employe to acquaint himself with the science of banking in general than any other depart- ment. The business of a bank is of such a routine char- acter that the employes have very little opportunity to learn the business from the inside, or to display initiative, or to perform duties requiring discretion. Unlike most businesses there is no line of positions which require successively more and more business sagacity on the part of the occupant. The gulf between the highest em- ploye and the officer is a wide one and very difficult to cross ; in most large city banks it is practically impossible to cross, and the officers are usually recruited from small institutions where the employe has had an opportunity to learn all departments of the bank. 358. Paying teller. The highest employe of the bank is the paying teller. He has charge of all the out- going funds of the bank. The transactions which ORGANIZATION AND BUSINESS 295 require the paying out of cash are: (1) Cashing of checks presented at the bank; (2) payment of debit bal- ances to the clearing house; (3) shipment of currency to correspondent banks. It is the duty of the paying teller to see that all the cash of the bank is properly accounted for. It is necessary that he be familiar with the signatures of all the depositors so that he may make no payments without having proper vouchers to show for them. Banks are under legal responsibility to de- positors to pay out no funds on their account except to the proper payees or their order. Even if the signa- ture on the check is genuine, still the person demanding payment may not have proper title to the check or he may have altered it. It is, therefore, the duty of the teller to safeguard the bank by requiring proper en- dorsement before the check is paid, so that in case the depositor attempts to repudiate the check the bank can call upon the payee for reimbursement. 359. Receiving teller. The employe second in im- portance is the receiving teller. Unless there is a note clerk in the bank it is the duty of the receiving teller to take in and account for all the funds which come into the bank. His chief duty is to receive cash, checks, drafts, and other items, and to give credit to depositors for the same. His principal duty is to assure himself that every item for which credit is given is collectible. Funds come into the bank from (1) depositors, (2) credit balances at the clearing house, (3) payments on maturing paper held by the bank either as an asset or for collection, and (4) currency shipped by correspond- ent banks or by the Treasury of the United States. 360. Note teller. Where the business of a bank is extensive enough to require it, there is a note teller whose function it is to make all the collections. Matur- 296 MONEY AND BANKING ing notes payable at the bank are in his charge. He receives all cash remittances from out-of-town customers. He has direct charge of all the collections of drafts, etc., in the city, except the checks on clearing house banks, which are usually attended to by the clearing house clerk. 361. Discount clerk. The discount clerk has charge of all the loans and discounts of the bank after they have been negotiated by the officers. It is his duty to keep the documents so systematically that there will be proper presentation made of them when they mature. When due the interest is calculated and the note turned over to the note teller for collection. He has charge of all the collateral held to secure loans unless the bus- iness is so large as to require a collateral loan clerk. In banks having close relations with stock brokers the latter position may be a very responsible one. The collaterals held to secure loans to stock brokers are constantly being withdrawn, substituted and replaced. Furthermore, in times of active speculation, the values of the collaterals are shifting so rapidly that the collateral loan clerk has great responsibility in seeing that the margin of security demanded by the bank is maintained and the call for additional collateral is properly sent out, so that the borrower can have no grounds of complaint if the bank finds it necessary to sell the collateral to protect itself in a panicky market. 362. Bookkeeping department. The transactions of all the tellers and other clerks are finally referred to the bookkeeping department. There is always a general ledger of the bank containing the accounts summarized in the bank statement. It is the duty of the general bookkeeper to make up a daily statement showing the condition of the bank and all statements required by the ORGANIZATION AND BUSINESS 291 comptroller of the currency. The bulk of the book- keeping work falls upon the individual ledger keepers, whose duty it is to charge to the depositors' accounts every check drawn by the latter and to credit their ac- counts with all the deposits reported by the receiving teller. The bookkeeper must keep the paying teller informed as to the balances of depositors. In many banks there is a separate department for handling correspondence and the collection of out-of- town items. It has become the custom of late years for remittances to be made in checks on local banks rather than in New York exchange or money orders as for- merly. In some cities the banks are so anxious to secure the deposit accounts of large firms that they make no charge for the collection of local checks, although this may require correspondence with a multitude of banks in all parts of the United States. 363. Laws relating to collections. Every deposit in a bank other than cash must be collected. If the item is a check on the bank itself or a matured note payable at the bank, it is paid as soon as the bank gives credit to the depositor. But if the items are payable by another party the bank is usually considered, in the absence of a special agreement and when the items are endorsed in blank or in full, to be the bailee of the depositor. The deposit is in fact a special deposit until the proceeds of the collection are lodged in the bank and credited to the depositor, whereupon the relation between bank and depositor changes to that of debtor and creditor. As bailee, the bank has all the rights to the paper held and may sue upon it. In the event of its non-col- lection the bank may rescind the credit already given the depositor, thus proving that the bank had not purchased the paper and taken title. 298 MONEY AND BANKING Insolvency of a bank revokes its power to collect and it must hold uncollected paper as a special deposit of the owner. If it receives proceeds of a collection and mingles them with the general funds of the bank it is guilty of fraud. A collecting bank should accept nothing but money in payment but it has been held innocent of negligence when it had taken a certified or even an uncertified check which it presented to the drawee bank without delay and the taking of which caused no loss to the owner of the collection item by reason of release of endorsers, etc. Upon non-payment of the check taken in payment of the collection item the bank should recover the item if possible the same day and protest it. Payment by worthless check is no payment and the bank could pro- test the item even if the payor refused to give it up. If a collection item is endorsed "For collection and remittance," the proceeds become a part of the general funds of the bank as soon as a draft is remitted, and if the draft proves worthless the owner of the collection cannot claim the funds as a special trust deposit. If the bank has collected a check bearing a forged endorsement, the proceeds belong to the rightful owner and may be collected by him although the bank has turned over the proceeds to the person depositing the item. A New York bank received a "tramp" collection (one remitted by a stranger with whom it had no account), collected it, deducted its collection fee, and remitted. Later it turned out that the check had been lost in the mail after being endorsed in full; the thief forged the endorsement and sold it to an innocent party who sent it to the New York bank for collecting. The true owner ORGANIZATION AND BUSINESS 299 recovered from the bank, which was unable to locate the person to whom it had paid the proceeds. But a drawee bank cannot collect the proceeds of a raised check from a collecting bank if they have been paid over by it to the owner of the item. 364. Liability of collecting bank. When a bank un- dertakes to collect, it makes itself liable for all losses caused by its negligence, but it is not responsible for the negligence of a notary selected by it with ordinary care because the notary is a public officer. The law varies in the different states as to the liability of a collecting bank for banks to whom it sends the item in course of collection. In the federal courts, and in Pennsylvania, New York, New Jersey, Ohio, Indiana, Michigan, Montana, and Minnesota, it is held that a collecting bank is bailee and liable for the agents it se- lects to make the collection. In the other states, the bank is held to be the agent and renders itself liable for sub-agents appointed by it only to the extent of using due care in selecting them; beyond this the sub-agents are responsible to the owner and may be sued by him. It is held to be negligence for a collecting bank to remit the item directly to the drawee bank, since that bank may have an adverse interest. Banks do not succeed in avoiding responsibility by printing in the pass books notices that they will not be liable for the acts of banks to whom they send items. Such contracts have been held to be void by the courts on the same principle that railroads cannot avoid lia- bility for accidents to persons riding on passes even though the pass bears on its face such a disclaimer. If a note is payable at a bank and funds are kept to pay it, the bank is the agent of the maker and if the 300 MONEY AND BANKING bank fails before the holder of the note gets possession of the funds, the maker is liable to have to pay the note again. If a bank collects a check and the drawee bank dis- covers that it has paid by mistake, there being no funds, the collecting bank is safe in returning the payment and receiving back the check. The endorsers are not released even though the maker of the check is insolvent. The cashier of a bank received a note for collection. The maker appeared and said he had made arrange- ments for its renewal. The cashier, however, insisted on cash payment, which was made. Next morning he received instructions to return the note. He sent the proceeds instead. He would not have been justified in repaying the sum to the maker, receiving back the note and forwarding it. 365. Collection of out-of-town checks. The collec- tion of out-of-town items is perhaps one of the heaviest expenses of a bank. It has been calculated that the cost of collecting an item averages about eighteen cents divided as follows: Exchange .045 cents, postage and clerical labor .048, interest on money during the period of collection .085. Small banks shift the expense on- to the larger banks by keeping accounts with them and depositing all collection items. Large city banks re- quire such depositors to keep balances which they calcu- late are large enough to yield a profit over and above the expense of making the collections. The economics which would result obviously from a system of collecting country checks in some such manner as city checks are now collected through the clearing houses, has led to many schemes being proposed but none has as yet been adopted. It was proposed in Boston that one bank do all the ORGANIZATION AND BUSINESS 301 collecting for the city, thus avoiding a large amount of duplication of work and holding the country banks to stricter terms than competing city banks could do individuals. This was the Suffolk bank system applied to check collections. The scheme failed because none of the banks were willing to give any one bank the ad- vantage which such a position would bring, nor to give any one bank the opportunity to learn so much about its affairs as the collection of its items would give it. To avoid these difficulties it was proposed to charter a new national bank for the purpose, but the law forbids national banks to hold stock in other banks. Schemes for dividing the country up into districts with a clearing house for each district are impracticable because settlements could not be made on the same day and it would be necessary for each member to keep funds on deposit in the clearing city to pay balances against them. Furthermore, the pro rata expense would be considerable whereas now the country banks pay nothing for getting their collections made while they get fees for collecting items on other banks in their vicinity or even on themselves. 366. English method of country collections. Each bank in London receives during the day a large number of checks upon country bankers. Upon these checks the name of the London agent is printed. Every clear- ing banker in London is the agent for one or more country banks. So when the country clerks of each bank get such checks from the cashiers, correspondence department and other sources, they proceed to arrange them for clearing as they do town checks, sorting them and putting them in packages according to the London agencies at which they are payable. No credit is given in the clearing house for these country checks on the day 302 MONEY AND BANKING on which they are delivered. The amounts are simply settled by the delivering clerks and the receiving clerks, and then the items are taken to the respective banks, whence they are sent by mail the same evening to the country banks by whom they are payable. If these checks, reaching their destination, are found to be all right, they are credited to the account of the London agent who is advised; but if any of them are not all right, either from insufficient funds or irregular endorse- ment, or any other cause, such irregular checks are re- turned direct to the banker whose crossing they bear. All country checks not returned or advised by the morn- ing of the third day are assumed to be paid, and credit is accordingly given for them in the clearing of that day and the amount is settled for, along with those advised paid, in the final balance. All country checks held by London bankers, returned unpaid, must be re- turned into the hands of the clerk representing the deliv- ering bank by 12 :30 on the third day, and they are simply deducted from the total of the country checks on the day of settlement. CHAPTER XX DEPOSITS AND DEPOSITORS 367. General deposits. Deposits are of two kinds, general and special. General deposits are always money or the right to receive money. They create between the bank and the customer the relation of debtor and creditor. The relation is peculiar in that the bank not only contracts to pay the debt on demand (unless the deposit is a time deposit) but also agrees to pay to the order of the depositor any sums within the total amount of the deposit, and if it fails to do so it may be sued in damages by the depositor. The bank may satisfy the depositor by the payment of legal tender, no matter by what form of money the debt was created or how much the legal tender may have depreciated. The legal tender acts during the Civil War period were more im- portant to banks than any other class in the community, these acts permitting the banks to pay their depositors depreciated paper money, even though the depositor had deposited gold. At that time it was the custom among the banks to open special gold accounts all the payments on which should be made in gold. 368. Special deposits. A special deposit may consist of anything of value left with the bank for safe keeping. The relation between the bank and the depositor in such a case is that of bailee and bailor. The title to the deposit does not pass to the bank as in the case of a general deposit, but rests in the depositor. The bank is held to use only ordinary care in protecting it and if it is stolen 303 304 MONEY AND BANKING without negligence on the part of the bank, the owner must bear the loss. The banker must return to the de- positor the identical thing deposited. If the bank ac- cepts a consideration for keeping the deposit, it is held by law to exercise greater care. 369. Safety deposit vaults. Because the banker was the only business man in the smaller places, possessing a safe, it was formerly the custom for him to receive the valuables of customers for safe keeping. Nowadays the banks derive a profit from the function which was formerly a source of great annoyance to them, and they have established safety deposit vaults the boxes of which are rented by the year. These vaults are not only profit- able on account of the rentals they earn but also because they act as a feeder to the bank. Many people who will not trust the bank with their money will rent a box. This brings them into touch with the officials of the bank, and as a rule whatever suspicion they had grad- ually disappears, so that ultimately they become regular depositors either in the savings or commercial depart- ment, especially if the bank pays interest on deposits. 370. Inducements to depositors. We learned in the preceding chapter that a cash deposit enables the bank to earn credit from three to six times its amount. It is quite possible for a bank to make 15 to 20 per cent on the deposits left with it. Hence there is great competi- tion among banks for deposit accounts which are likely to be fairly permanent. In return for the use of the general deposit which is so profitable, banks have been led by competition among themselves to offer many valuable services to the depositor. Among these are the following : (a) Checks. It pays the checks of the depositor, taking the risk of their being genuine and that the money DEPOSITS AND DEPOSITORS 305 is paid to the person designated by the depositor or his order. This service is of great value to the depositor as it saves him the inconvenience and the expense of making cash payments. (b) Collections. The bank collects the checks and all other items of credit for the depositor, often at con- siderable expense. It offers the depositor a cheap and easy way to collect accounts due by drawing sight drafts on his debtor and collecting them through his bank. Since the growth of the custom of sending local checks in making small payments to city houses, such for example as the one dollar subscription to magazines, the associated banks in several of the larger cities have been compelled to establish a uniform fee for collecting out-of-town checks, the rate usually being 10 per cent, with a minimum charge of 10 cents per check. (c) Safety. The bank relieves the depositor of the risk of caring for his money. (d) Loans. The bank usually feels under obliga- tion to loan to a depositor on more advantageous terms and usually on less rigid requirements than to non-depositors. It can do so because it is more or less acquainted with the affairs of the depositor and can accept personal credit when other parties would require collateral security. The greatest advantage, however, comes in times of panic when funds are needed most and when all the banks are refusing to loan to others than their depositors. (e) Interest on balances. Sometimes the banks pay interest on the daily balances. This practice was an innovation of the trust companies and was due to the fact that the deposits in the banking department of the earlier trust companies were practically time de- posits. When the character of the deposits gradually VII 20 306 MONEY AND BANKING changed the custom still prevailed, much to the vexation of the national banks. (f) Increases credit. The banking connection fre- quently increases the credit of the business man. A good banking reference is frequently of great advantage in business, and the banks must be constantly on their guard against persons who use their connection with the bank to gain unmerited credit. 371. Difficulties in establishing a new bank. It is very difficult to establish a new bank in a community already supplied. If the old banks are not willing to accommodate their customers freely, and if they charge for making collections or refuse to loan except on oner- ous terms as to rate and security, a new institution may attract many depositors by superior inducements, par- ticularly by paying interest on deposits. Too many concessions, on the other hand, may cause the new bank to lose credit for soundness; it may be inclined to take great risks in loaning in order to recover the amounts paid out as interest to depositors and in the expensive services performed for them. There usually is no diffi- culty in finding borrowers for the funds of the new bank; in every community there are always business men of unsound methods who have been refused credit by the old banks and who welcome the appearance of a new bank, hoping to establish relations with it. They try to place the bank under obligations by opening de- posit accounts. 372. Value of a banking connection. Many well es- tablished banks are enabled to hold their depositors with- out paying interest on deposits against the competition of the trust companies because they offer the depositor something of more value to him than the interest, DEPOSITS AND DEPOSITORS 307 namely, credit in time of need. When a panic comes and even strong business concerns are in danger of bankruptcy through temporary need of funds, the op- portunity of the bank to render service is very great. A small loan at the proper time may count for more than interest on deposits for many years. Depositors remain loyal to old conservative banks, knowing that the banks will probably have a chance, sometime, to render reciprocal service. However, as business con- cerns grow richer and less dependent upon bank credit for existence this inducement will lose its force. 373. Kiteing checks and drafts. The practice of "kiteing" is a source of great annoyance to banks. It is practiced by depositors who wish to gain the use of funds for a short time without payment of interest. It is possible to accomplish this because of the custom of banks of giving credit immediately upon deposit for checks and drafts, even though they are drawn on dis- tant cities. Kiteing requires the collusion of two parties located some distance apart. It can be most easily done between branches of the same concern. 374. Method of "kiteing." To illustrate the practice let us assume that a depositor in New York draws a sight draft or deposits a check received from a con- federate in San Francisco. The bank will permit the New York depositor to check against the credit even though the bank will not realize the proceeds of the check or draft within one or two weeks. It will require at least a week for the check or draft to reach San Fran- cisco and be presented to the confederate for payment. Anticipating the arrival of the bill against him the con- federate will provide credit at his bank by depositing there a draft or check on a third confederate, perhaps 308 MONEY AND BANKING in New Orleans. Thus two or three persons may have the use of considerable sums of money for some time without payment of interest or principal. 375. Title to deposited checks, etc. The title to paper deposited in a bank often becomes an important ques- tion. It is a rule of law that if the items deposited in a bank are for collection and not for credit on the reg- ular account, the title does not pass to the bank but remains in the depositor until the proceeds have arrived at the bank. In this case the bank is simply the agent of the owner, and the proceeds of the collection are trust funds which, if they can be traced, must be re- turned to the owner in spite of insolvency of the parties holding them. If the paper is endorsed "for collection" there is no doubt as to the ownership, but when it is endorsed in full or in blank the ownership depends en- tirely upon the agreement between the depositor and the bank. If no agreement has been made the law holds that the deposit is for credit and that the bank acquires title. If the bank should fail the depositor must take his chances with the other depositors, but if the agree- ment has been that the items deposited are for collec- tion, or if they have been endorsed plainly "for col- lection," the depositor is a preferred creditor and is paid before all other depositors. .Unless the item is endorsed "for collection" or they have notice otherwise, innocent third parties who con- sider the item the property of the bank and seize it to pay any debts of the bank then having it, cannot hold to the rule longer. The law on this point was clearly laid down in the case of Doppelt v. National bank of the Republic. 1 376. Case of disputed ownership to deposited check. i No. 1, National Bank Cases. DEPOSITS AND DEPOSITORS 309 Doppelt deposited with his bank a check endorsed in blank for collection. The bank endorsed the check "For collection to the credit of Bank," (inserting its own name) , and sent it to the National Bank of the Republic. Doppelt's bank failed the next day owing a considerable amount to the National Bank of the Republic. The latter seized the proceeds of the check after it had been collected in order to satisfy the debt due it. Doppelt sued the National Bank of the Republic for the funds, claiming that his own bank had acquired no title to the check. Regardless of the agreement between him- self and his bank, Doppelt could not recover because the National Bank of the Republic had no notice, nor could it have learned from the endorsement of Doppelt's bank, that it was not the owner of the check. The law per- mitted the National Bank of the Republic to regard the check as being the property of Doppelt's bank. 377. Accepting deposits when insolvent is criminal. The receipt of deposits by an insolvent bank is clearly a fraud and the officers who take deposits are guilty of criminal offense, punishable by imprisonment. In convicting an officer of a bank of this charge it is neces- sary to prove that he knew the bank to be insolvent when he received the deposit. The insolvency of a bank is a very difficult matter to determine sometimes, because it depends upon the value of the loans and discounts in its assets. While the officers may know that some of the loans are not first class and may not be paid promptly yet they may believe them to be good ultimately. 378. Drawer released from responsibility after rea- sonable time. The drawer of a check is always liable for the ultimate payment in case the bank should fail before it is cashed. However, in order to protect the drawer of checks, the law requires that a check must be 310 MONEY AND BANKING presented to the bank for payment within a reasonable time, otherwise the holder of the check must assume the risk of the failure of the bank. 379. Local banks. In the case of a local bank the courts have held that a reasonable time means until the close of the business day following the delivery of the check. If the payee should endorse it to another party on the second day and the endorsee should hold it still an- other day before presenting it, the bank failing in the meantime, the original drawer would be released and the payee be compelled to reimburse the holder or endorsee, because the latter had presented it for payment within a reasonable time after receiving it. In the case of checks drawn on banks outside the city in which the drawer resides, the check must be forwarded on its way before the close of the next business day in order to hold the drawer responsible. 380. Holder of a check can not sue bank. In nearly every state a bank on which a check is drawn is under no legal obligation to the holder to pay or accept it, whether the maker's funds are sufficient for this .purpose or not. Of course if the bank has accepted the check by certification, then the holder has a claim against the bank. If a bank should decline without a valid reason to pay a check drawn on a sufficient fund belonging to its depositor the institution would be liable for whatever injury the depositor sustained. For example, should a bank decline to pay a check supposing that the maker's deposit was insufficient when in truth it was ample, the institution would be liable for the consequences of thus dishonoring his order, even though its conduct was founded on the mistaken calculation of a bookkeeper. 381. Revocation. The depositor has the privilege of stopping payment on a check, and the bank will be DEPOSITS AND DEPOSITORS liable for the amount if it pays the check in spite of the stop order. The death of a depositor works a revocation of all F the checks not yet paid just as soon as the bank receives notice of his death. 382. Insufficient funds. If the credit account of the depositor is insufficient to pay the full amount of the check, the bank has no right to pay a part of the sum with the funds on hand. On one occasion when a bank refused to pay a check where the funds to the credit of the depositor were insufficient, the holder of the check, fearing that if there was delay he might not receive any- thing on account of the embarrassment of the drawer, deposited to the account of the drawer a sum sufficient to cover the amount of the check. Thereupon the bank had no right to refuse payment. 383. Forgeries. The bank is presumed to know the signatures of its depositors and it cannot pay a forged check and charge the account of the depositor with the amount of the check. The principal exception to this rule is in the case of a check so negligently drawn that an alteration is easily made. The bank that pays a forged check cannot recover the money from the inno- cent payee. This seems a hard rule as both are innocent, but as greater vigilance on the part of the bank might have discovered the forgery it must be held responsible. 384. Post-dating. Sometimes checks are post-dated, that is, bear a later date than the one on which they are written. The object of this is to obtain delay in mak- ing payment, the drawer simply desiring time in which to have the money in the bank's possession on the date specified. The bank that pays an altered post-dated check before its due date cannot check the amount against the drawer. In no case can a check paid before 312 MONEY AND BANKING the time specified be charged to the drawer's account. 385. Set-off. The relation between the bank and depositor is that of debtor and creditor ; therefore either party has the right to set off his debt to the other with any claim he may have against him or it. For instance, if A has a deposit of $100 in a bank, the bank is his debtor for that sum ; but if the bank holds an unsecured and matured note against A for $50 the debt of the bank to A is only $50 the difference between the credits and debits. 386. When a depositor fails, his note not being se- cured. This point is of considerable consequence when one or another of the parties have become insolvent. If the depositor fails owing the bank on an unsecured note, whether matured or umnatured, the bank can seize the deposit to satisfy the note unless somebody has a prior lien upon it, for instance, an attachment; or in Illinois, South Carolina, Kentucky, Nebraska, or Texas when a check operates as an assignment of so much of the deposit, a check holder, after he presented the check, would have a claim superior to that of the bank. Since insolvency caused all unmatured obligations of the in- solvent person to become at once due and payable, the bank could apply a deposit on such a note. If the note has security the bank must first satisfy the note from the security. 387. Advantage to depositor. If the bank should fail the depositor may set off his note to the bank with his deposit. The receiver cannot, of course, enforce collection on the note until it matures but the depositor has his claim against the bank whenever the note is presented to him. The receiver cannot avoid this set- off by selling the note to an innocent third party, for the fact that the note was purchased from a receiver would DEPOSITS AND DEPOSITORS 313 be notice of irregularity. If a note after maturity was negotiated by one bank to another and the first bank failed holding a deposit of the maker of the note, the maker could use his deposit to off-set the note, because the second bank was not a bona fide holder and took the note subject to all equities between the maker and the first bank. 388. Set-off makes failures appear worse. Since a large portion of the loans of a bank are made to de- positors, whenever a bank fails a considerable part of the assets are canceled by an equal amount of liabilities in the shape of deposits. Depositors who are also bor- rowers are really in the position of preferred creditors for their deposits and they gain at the expense of de- positors who are not also borrowers. Therefore, in a bank failure where a 50 per cent dividend is paid to de- positors, the failure is not so bad as this figure indicates, for a large number of depositors may also have been bor- rowers and have lost little or nothing. 389. Illustration. A bank with $1,000,000 loans and $1,000,000 deposit liabilities fails. If half the loans are offset by deposits there remain $500,000 of loans with which to pay $500,000 deposits. Suppose the loans realize 50 per cent of their face value when liquidated, there would then be $250,000 to be distributed to depos- itors, or a 50 per cent dividend. If the depositors who were also borrowers had not been allowed to offset their obligations with their deposits, the assets collected would have been $750,000, which would have been distributed among all the depositors having claims of $1,000,000; that is, each depositor would have received a 75 per cent dividend. This explains why failures are not as bad as the percentage of dividends indicates. 390. Form of note. Some banks use a form of note 314. MONEY AND BANKING similar to the following in which the borrower specifically agrees to permit the bank to transfer to itself in case of his insolvency any deposit credit or other form of indebtedness : $ EVAHSTON, ILL., 19.. after date promise to pay to the order of STATE BANK OF EVANSTON, DOLLARS With interest at per cent, per annum after at the office of said Bank. Value received. In case of the insolvency of the undersigned any indebtedness due from the legal holder hereof to the undersigned may be appropriated and applied hereon at any time, as well before as after the maturity hereof. No... CHAPTER XXI LOANS OF THE BANK 391. Two qualities necessary to the making of a banker. The successful banker who has the entire re- sponsibility of his bank upon his own shoulders must pos- sess two qualifications almost opposite in character. Under former conditions conservatism was the distin- guishing quality of a good banker but with keen compe- tition in the business he must add to conservatism in granting loans, aggressiveness in securing deposits. In a large bank the two functions can be specialized in dif- ferent men. The point of view of the official who makes the loans should be, first, to avoid losses and, second, to make money; in these good judgment is more to be de- sired than enterprise. Mr. William Law, vice-president of the Central Na- tional Bank of Philadelphia, in an unpublished address, has made a fourfold classification of bank borrowers. 392. Investment loans. First, investment borrowers parties who borrow to invest the funds of the bank in certain securities or property which they wish to carry with a view of reselling at a profit, or of holding until funds can be accumulated to pay for the purchase, or of enabling the holder to gain certain control or influ- ence, or of otherwise accomplishing some object external to the transaction. Such are the loans ordinarily granted brokers, investment bankers, and market opera- tors. These loans can be readily realized upon in pro- portion to the convertibility or salability of the collateral ; 315 316 MONEY AND BANKING that is to say, under normal conditions such a borrower will pay his loan at one bank by selling the securities pledged there or by borrowing from another bank. 893. Conditions under which they are good banking loans. Loans of this character, if they are obligations of active and capable men, and especially if payable on demand and secured by well-distributed and properly margined collaterals possessing a broad market, are an excellent investment for a portion of the funds of a bank. However, when money is redundant such loans at times yield a lower rate of interest return than the rate paid by banks in reserve and central reserve cities upon the daily balances of their out-of-town correspond- ents. In recent years the rates upon such loans have ranged from 1% to 2 per cent for several consecutive months. In times of great financial stringency reali- zation upon such loans is often exceedingly difficult. The bank having loans secured by a large line of certain securities may hesitate to force their sale, fearing to break the market and thus reduce the market value of similar securities on other loans or injure the market price of securities belonging to their friends and business associates; but we are compelled to recognize the fact that under our system of a bond-secured, non-elastic currency, with its well-known central reserve city and reserve city features, call-loans upon stock exchange collateral afford a reasonably safe and exceedingly con- venient method of utilizing that portion of the loanable funds of an active bank in a financial center which is not employed in caring for the requirements of its borrow- ing dealers. 394. Industrial loans. Second, automatic or seasonal borrowers. By these terms it is intended to describe the operations of manufacturers, merchants, farmers, dro- LOANS OF THE BANK 317 vers, and other like borrowers who require temporary accommodation during a period of production, transpor- tation, distribution, or collection. To illustrate: A converter of cotton goods must pay the commission mer- chant or manufacturer for his raw material, for instance, gray goods, within ten days after purchase. The proc- ess of bleaching, dyeing, and finishing may consume sixty days; the process of distribution among and col- lection from the dry goods wholesalers who purchase the finished product will require at least sixty days more. Funds loaned a borrower of this description should be automatically returned with the completion of the trans- action. Or a company operating grain elevators in Minneapolis ships wheat in carload lots to a Philadel- phia grain exporter, asking its local bank to discount the bill of lading draft created by the transaction. The completion of this purchase by the sale of the sterling grain bill automatically returns to the bank the money borrowed. From the standpoint of a commercial banker loans of this character constitute the ideal bank credit. Banks are to be envied when a large part of their funds are utilized by local dealers engaged in producing, marketing, and distributing the great staples that the people consume, as food, clothing, heat, and light. A bank so located will continue its usual business whether or not there is a panic on Wall Street, whether or not the financial leaders are hurrying to Washington, whether or not there are eager buyers for life's light luxuries. A favorite form of loans of this sort are the re-dis- counts of other banks, especially if the borrowing banks are located in sections where seasonal borrowing is the usual rule and are, therefore, themselves seasonal or temporary borrowers. The risk involved is small and 318 MONEY AND BANKING proceeds of re-discounts are apt to remain on credit with the lending bank in much larger proportion than are the proceeds of ordinary loans. A bank usually borrows to increase its reserves; a firm usually borrows to pay out the proceeds. The above mentioned two classes are considered most desirable loans ; the two following less desirable. 395. Capital loans. Third, capital borrowers. This phrase is intended to describe the borrowing of perma- nent capital for a business to be repaid from earnings or profits as they accumulate, and the natural results are continuous loans and over-trading. For instance: The president of a manufacturing corporation, in con- structing a new plant, finds that its cost exceeds the capital subscribed by the stockholders. He borrows the necessary money by issuing notes which are discounted by a friendly bank. This loan can be extinguished only by borrowing elsewhere, by continuous operation at a profit, or by the sale of the plant. 396. Capital should come from stock and bond issues. The weakness of this position would quickly be made manifest should manufacturing operations cease. All capably managed banks discourage such loans in any substantial measure unless conditions are unusually fa- vorable for continued high earnings which can be ap- plied to reducing steadily such a loan within a reasonable time. Capital for requirements of this character should be provided by additional subscriptions of stockholders or by sales of bond issues. That is to say, the funds should be held in the form of permanent or long term borrowing at the option of the borrower through bonds secured by mortgage. This idea is concisely expressed by the advertisement of a prominent Chicago bank : "Conservative banking % LOANS OF THE BANK 319 consists in caring for many interests, while capitalizing none." The statement of a strongly organized manu- facturing corporation or firm indicates quickly convert- ible assets abundantly sufficient to protect all quick liabilities. Of course, from the standpoint of the man- ufacturer engaged in a highly profitable line of work, the temptation is alluring to endure for a period the sacrifices, buffetings, and annoyances of carrying what is termed a plant debt, knowing that he will thereby be enabled to maintain permanently a low capitalization and thus render the task of dividend earning lighter for all time to come when the plant debt shall once have been extinguished out of earnings. 397. Mortgage loans. Fourth, long time or perma- nent borrowers on mortgage. To this class belong the holders of improved and productive central real estate in the larger cities. Though these loans command low rates by reason of the stable value of the security, na- tional banks are prohibited from taking them directly, except to secure a debt previously existing, and are criticised severely for taking them indirectly. These loans are generally placed with corporations controlling trust or permanent funds, such as life and fire insurance companies, savings banks, and trust companies. The degree to which these loans are encouraged by our laws and the ease with which money can be borrowed in round amounts upon improved central real estate in our larger cities, possibly affect the advance in real estate values as directly as the increase in population and wealth. Building and loan associations afford the most effective plan for handling small real estate loans. In this classi- fication may be included, for some reasons, the bonds constituting preferred liens upon high class railroad and traction properties. But their ready convertibility 320 MONEY AND BANKING renders them also acceptable as a bank investment, and they are favored by the national banking system in that the rule regarding excess loans is not applied to them. 398. Loans reported to the comptroller. The fol- lowing classification is used by the Comptroller of the Currency in the reports required of national banks. Comparison is made with the statement of ten years previous : 1897. 1903. 1907. Class. Amount in Per Amount in Per Amount in Per Dollars. Cent. Dollars. Cent. Dollars. Cent. On demand, paper with , one or more individual or firm names. 103,837,578 5.1 374,689,245 8.7 428,221,535 9.2 On demand, secured by stocks, bonds and other per- sonal securities . . 326,447,852 15.9 828,016,734 19.3 882,878,479 17.8 On time, paper with two or more individual or firm names. 896,099,397 43.7 1,502,034,898 35.0 1,648,751,438 35.2 On time, single name paper (one person or firm) with- out other security . . . 317,520,501 15.5 776,125,101 18.0 899,494,658 19.2 On time, secured by stocks, bonds, and other per- sonal securi- ties, or on mortgages or other real estate security . . . 407,104,110 19.8 818,117,338 19.0 869,237,859 18.6 Total 2,051,009,438 4,298,893^16 4,678,583,969 LOANS OF THE BANK 321 399. Demand loans have increased. The first class represents the demand loans of all the national banks. It will be noted that these unsecured demand loans have increased over 4 per cent in ten years. The second class are demand loans secured by stocks and bonds as collateral. There is an increase propor- tionately in this form of loans between 1897 and 1906. The year 1906 was one of great speculation in the stock markets, and the increase in this item represents the growth of speculation on the margins. About one- third of these loans are reported by the New York banks alone. In 1897 these loans fell off proportionately to others, probably on account of the liquidation of the stock markets which had taken place during the summer, the margin traders having been sold out and their stocks going into the hands of holders who could purchase them outright. 400. Double-name paper. The next item represents trade paper discounted at the banks. The decrease of 8 per cent in ten years indicates the changing nature of bank loans. The commercial paper placed through commercial paper houses, which are described later, is single-name paper. It is now the custom of the largest houses not to take notes from their customers but to borrow on their own credit. This tendency is more ap- parent in the cities than in the country as a whole. Throughout the country there has been an absolute in- crease in two-name paper of nearly 100 per cent, while the increase in this class of loans held by New York banks has been not more than 30 per cent. 401. Single-name and brokers' paper. The amount of single-name paper held by the banks has almost dou- bled in ten years, indicating the growth of the com- mercial paper houses and the decline of discounting. VII 21 322 MONEY AND BANKING The last classification represents time loans on mort- gages or other security. Since the law prohibits the national banks from loaning on mortgages the collateral back of these loans is probably to a large extent personal securities and warehouse receipts. Below are reproduced two forms of notes in use gen- erally by banks : JUDGMENT NOTE $ EVANSTON, ILL 189 after date, for value received promise to pay to the order of the STATE BANK OF EVANSTON, DOLLARS, at the STATE BANK OF EVANSTON, with interest at the rate of per cent per annum from until paid. W And to secure the payment of said amount hereby en fe O * < w H < g authorize irrevocably any attorney of any Court of record to ap- pear for in such Court, in term time or vacation, at any time hereafter, and confess a judgment without process in favor of the holder of this note, for such amount as may appear to be unpaid thereon, together with costs and dollars attor- ney's fees, and to waive and release all errors which may intervene in any such proceedings, and consent to immediate execution upon such judgment; hereby ratifying and confirming all that said attorney may do by virtue hereof. No Due. COLLATERAL NOTE $ EVANSTON, ILL., ON DEMAND, after date promise to pay to the order of the STATE BANK OF EVANSTON, at its office, DOLLARS, for value received, with interest at the rate of per cent per annum, after date, having deposited with said Bank as collateral security for the payment of this and any other liability or liabilities of the under- signed to said Bank heretofore or hereafter contracted, the following prop- erty, viz.: the market value of which is now $ // the Bank or its assigns LOANS OF THE BANK 323 shall find that said collateral security is of less value than above stated, or any of said security shall decline in value, or the liability of the under- signed to said Banks or its assigns shall be at any time increased, said Bank or its assigns may call for additional security satisfactory to the holder hereof, and failure to furnish the same shall make this note at once due and payable. The undersigned hereby gives said Bank, its attorney or its assigns, full power to sell said collateral or any part thereof, without notice or demand, at public or private sale, in case said collateral shall be found of less value than above stated, or in case any of said collateral shall decline in value, or in case additional security, satisfactory to the holder hereof, shall not be furnished upon call as above provided, or in case this note or any other liability of the undersigned to said Bank shall not be paid at ma- turity, and if such sale shall be public or at Broker's Board, the holder hereof may purchase at such sale. In case of such sale the proceeds, after payment of the costs and expenses connected with said collateral, and the sale and delivery thereof, may be applied upon any liability of the under- signed to the holder hereof, whether due or not, and the surplus, if any, shall be paid to the undersigned, his or their assigns; but if the proceeds of such sale shall not pay in full the liabilities of the undersigned to the holder hereof, the balance of such liabilities shall become at once due and pay- able and bear interest at the rate of seven per cent per annum from the time of such sale. In case of any exchange, or addition to the collateral above named, the provisions hereof shall extend to such new or additional collateral. In case of the insolvency of the undersigned, any indebtedness due from the legal holder hereof to the undersigned may be appropriated and applied hereon at any time, as well before as after maturity hereof. No Due 402. Judgment note. In the judgment note the signer authorizes the bank through its attorney to ap- pear in any court and get judgment in the amount of the note without the trouble and expense of proving the existence of the debt or giving the signer the right to defend himself against the judgment. This form of note enables the bank to become a judgment creditor in case the signer is threatened with insolvency and thus to place itself in a preferred position in collecting the debt. 403. Collateral note. The collateral note is the ordi- nary note required of borrowers who pledge collateral to secure the debt. It will be noted that the collateral deposited secures not only this debt but any other debt that the signer owes to the bank. The bank has the right at any time to demand additional collateral, and failure to deposit such collateral makes the note due at 324 MONEY AND BANKING once. The bank does not have to wait until the matur- ity of the note to proceed against the debtor. Further- more, if additional collateral is not forthcoming the bank has the right to sell the collateral at public or private sale and is even permitted to buy it in itself if it cares to do so. If the sale of the collateral should fail to cover the indebtedness the balance is still an obli- gation against the debtor. If the signer should become insolvent the bank is a preferred creditor and may seize the collateral. These provisions, which seem so drastic, are necessary in order that the bank may protect itself in times of falling values. The banks making collateral loans usu- ally depend almost entirely upon the collateral and very little upon the general credit of the borrower. There have been numerous cases, however, to show that a bank is not always safe in relying upon the value of the collateral. Forged securities have been used to secure loans, the forgers depending upon the carelessness of the bank in not scrutinizing the securities as carefully as if they were purchasing them. 404. Risk in collateral loans. A few years ago a new stock of the Railway Equipment Company appeared on the curb market in New York. Being in the hands of the promoters of the company the stock was easily bid up to a very high price by means of "wash sales"- that is, the promoters buying and selling the stock among themselves. After the public had become accus- tomed to seeing the quotations of the stock in the daily newspapers the promoters went to other cities and opened deposit accounts with the banks. Having estab- lished their credit they persuaded the banks to accept this stock as collateral with a liberal margin. When the con- federates had borrowed as much as they could the banks LOANS OF THE BANK 325 were one day surprised and chagrined to find that the price of the stock on the curb market had fallen to almost nothing and that the collateral, which was the only security for the loan, was almost worthless. The great bulk of collateral loans in Wall Street are call or demand loans. When the lender, usually a bank or trust company, calls the loan the borrower must pay it or his collateral is sold to satisfy the debt. The rates for call money depend upon demand and supply. The greatest market for it is the New York Stock Exchange where it is offered by brokers just like a stock. When it is plentiful, call rates range from 1 to 3 per cent, and money is easy ; from 6 to 8 per cent is firm, and when it soars beyond that rate money is stringent. In times of panic the rate has gone past 100 per cent. 405 Usury laws. Any rate of interest higher than that fixed by law is usurious. How then can New York bankers and money brokers charge 40 or 80 per cent for call money? Before explaining how this is possible let us see just what is meant by the legal and maximum rates of inter- est as fixed by statute in most states. There is a very wide misconception of what is meant by the legal rate. Contrary to the usual impression it is not always the highest rate that can be charged for borrowed money. Instead, it is, for example, the rate that the court would impose if a judgment to collect an account "with inter- est" were entered. If the legal rate in the state where the judgment was entered happened to be 6 per cent, the defendant would have to pay 6 per cent. The max- imum legal rate is the highest rate that can be charged for money, and any rate above the maximum is usury. In some states, as for example in New York and Pennsylvania, the legal and maximum rates are the same 326 MONEY AND BANKING 6 per cent; in Alabama both rates are 8 per cent; in Illinois the legal rate is 5 per cent and the maximum rate 7 per cent; in Kansas 6 per cent and 10 per cent respectively ; in Indiana 6 per cent is the legal rate and 8 per cent the maximum rate. 406. Call loans exempted. Although the maximum rate in New York State is 6 per cent, the Wall Street bankers can charge any rate of interest for call loans by reason of a section of the state banking law which says : "Upon advances of money repayable on demand to an amount not less than five thousand dollars made upon warehouse receipts, bills of lading, certificates of stock or deposit, bonds and other negotiable instruments pledged as collateral security for such repayment, and any bank or individual banker may receive or contract to receive and collect as compensation for making such advance any sum to be agreed upon in writing by the parties to such transactions." Thus the banker can charge any rate for call money for sums of $5,000 and more that the borrower is willing to pay. With a time loan a loan made for a specified period, as ninety days the rate cannot be higher than the maximum rate. Most people believe that a call loan is for one or two days only. Some call loans run forty days or even more. The interest on it changes with the fluctuations in call money rates; the interest on a time loan remains the same during the life of the loan. 407. Loans on open book accounts. Some bankers loan funds to business men on the security of open book accounts of their customers or on installment contracts. This business is strongly discountenanced by the more conservative banks, they classing bankers who engage in it with pawnbrokers. Bankers who do this business claim that it is exactly the same as the old business of LOANS OF THE BANK 327 discounting trade paper. They argue that as trade paper is now no longer given by customers to the same extent as formerly, the merchants have none of it to dis- count at their banks and therefore it is permissible for them to borrow on the funds due them from customers, although these are not in the form of notes. Conserva- tive bankers on the other hand say that under present conditions of banking competition any business man can borrow on his general credit all the bank funds he is entitled to and that those merchants who can get funds only by hypothecating and assigning their book accounts are undeserving of any bank credit at all. 408. Providing temporary capital. The financial manager of a business is concerned principally with bridging over the interval between the purchase of ma- terials, etc., and the realization of the value of the out- put of the industry. The value of all the materials and stock represents capital which must be contributed by someone. If materials can be bought on credit, the seller is the one who has provided that capital for a short time, though he may shift this burden on to a bank by discounting a note taken in payment for the materials. The buyer of the materials may thus partially escape the burden of providing temporary capital. On the other hand his own customers the purchasers of his finished product may put upon him the necessity of furnishing capital to them by demanding terms of from thirty days to six months. In most cases the business man will find he is able to shift less of a burden upon concerns from whom he buys than that he is compelled to bear on behalf of his own customers. When collec- tions are slow this extra burden is correspondingly in- creased. The task of the financial manager, therefore, is to 328 MONEY AND BANKING get through the assistance of banks the use of capital not needed by its owners. Banks act as agents between the owners and the users of capital. They are always ready to furnish capital to any one, provided the bor- rower can give satisfactory security for repayment. The security off ered to a bank may be either the gen- eral credit of the firm, based upon its reputation for prompt payment; the possession of property above its liabilities ; or the maintenance of a certain deposit balance at the bank. In case these are not sufficient, capital may be granted on collateral some form of property hy- pothecated to the bank. CHAPTER XXII LOANS AGAINST COLLATERAL '409. Collateral for bank loans. The form of collat- eral most easily handled is no doubt stocks and bonds extensively dealt in on the Stock Exchange and which are marketable on a moment's notice. Real estate and other forms of permanently invested capital are bad collateral for a bank because of the difficulty of realizing upon them quickly. The third great class of property which may be used for collateral is merchandise and ma- terials representing the investment of that form of cap- ital which it is the legitimate function of banks to provide. If the calculations of the owner are not amiss, this property will be prepared for the market and sold within the near future, so that it embodies the best qual- ity in a collateral security in that it will be liquidated naturally and thus provide funds with which to repay the debt. 410. Merchandise as collateral. The difficulties met with in the use of this most natural form of collateral for bank loans have considerably hindered its employ- ment as such. Merchandise and materials cannot be delivered to the bank as in the case of stocks and bonds. If they are left in the possession of the borrower they may disappear, or substitution may be made, or they may deteriorate through neglect. These risks can be avoided only by placing the goods in the possession of a third party, who acts as trustee for all concerned and 329 330 MONEY AND BANKING who is required by law to conform to certain rules which make fraud and loss impossible. 411. Advantages of good warehousing laws. It is to the interest of both the banks and the borrowers that the warehousing system should be so regulated that loans can be negotiated on warehoused merchandise as easily and safely as possible. In a great number of cases of financial difficulty on the part of merchants or manufacturers, the source of the trouble lies in the investment of too much capital in merchandise or ma- terials which cannot be sold quickly without loss because of adverse market conditions. The goods have value but time is required to realize upon it. Bankruptcy may be imminent unless the banks consent to provide the temporary capital to carry the merchandise, and their doing so may depend upon the risk involved in loaning upon the security of the merchandise. The value of a warehousing system, regulated by law, is measured by its service in eliminating the risk attend- ant upon loans on merchandise. 412. Loans on merchandise a legitimate function of banks. The character of bank loans has changed greatly in recent years. There has been a marked de- cline in the amount of trade paper offered for discount and competition among banks has compelled them to develop new fields. The collateral loan is one of these, but few banks have been willing to accept anything except stocks and bonds as collateral loaning on merchandise is still regarded in many quarters as a species of pawnbroking and is classed with loaning on book accounts. Never- theless loans on merchandise conform more strictly to banking principles, and they promote the industrial property of the community more than any other class LOANS AGAINST COLLATERAL 331 of loans in that they give substantial aid to legitimate commerce in marketable goods, which is the basis of all business. Anything which removes obstruction from the free passage of goods through all the processes from raw material until they reach the consumer rep- resents an economic gain. All other business, of what- ever kind, is merely auxiliary to this fundamental productive activity. There is no doubt that the imme- diate future will see a gradual elimination of the uncer- tainties and risks incident to loans on merchandise and a development of this branch of banking. 413. Statement of a bank president. On this subject President Nash, of the Corn Exchange Bank of New York, at its fiftieth anniversary banquet, spoke as fol- lows: The bank has, however, made two important contributions to American banking. President Dunham, being familiar with the grain business, introduced, immediately on taking office, the un- usual practice among banks of assisting merchants to carry large stocks of grain and merchandise in this port, by making loans on that class of collateral when represented by the ware- house receipts or bills of lading. It subjected us at the start to the stigma of being a pawnbroker's shop, and this stigma was freely applied. But eventually the principle of advances on merchandise was adopted by other banks, until now it is well- nigh universal. It has always been a distinctive part of our business. Mr. Dunham used to say that wheat and cotton, wool and pork, lard and coffee were as good as gold, and he was ready to give gold to the man who was willing to pledge these commodities as security for its payment. He, however, con- fined his operations to the great staples named, because the quality and the price were less subject to wide variations, and was chary of general merchandise, where the differences are much more marked, and to a non-dealer somewhat deceptive. This preference for the staples has not prevented us from going 332 MONEY AND BANKING into less desirable lines of business, where the solidity of the borrower has outweighed the disadvantages of his collateral, and varied and sometimes amusing lists of merchandise have been re- ported to our directors for their approval. 414. Law of warehouse receipts. The great limita- tion to the use of merchandise as collateral is not so much in stability of values of the commodities as it is the diffi- culty of maintaining intact and secure the collateral itself. The development of warehousing and the use of the warehouse receipt under such legal regulation as to guard against fraud is gradually diminishing the risk of merchandise loans. 415. Uniform law. A valuable contribution to this end has been the drafting of an "Act to make uniform the law of warehouse receipts" by the Commission on [Uniform State Laws in 1906. The success of the Com- mission in getting its uniform law of negotiable instru- ments adopted in twenty-eight states and by the federal (government makes it more than likely that this new act will soon become a law in all the states. As in the law of negotiable instruments, the warehouse receipt law aims to codify existing laws as far as possible. Whenever anything new is proposed, it will invariably be found a step in the direction of promoting the busi- ness of loaning on merchandise. The passage of such a law in states which have not already a similar one is of the most vital interest to merchants and manufac- turers as well as bankers. It will hasten the time when loans will be made as readily on warehouse receipts for stored goods as they are now made on stocks and bonds. The advantage of the warehouse receipt is that it enables the goods described in it to be sold or pledged for a loan of money by the mere delivery of the ware- LOANS AGAINST COLLATERAL 333 house receipt, thus avoiding the inconvenience of an actual removal or delivery of the property itself. In other words, the warehouse receipt is a symbol for the property described, and the delivery of the receipt is in law a delivery of the possession of the property. 416. Risk involved in loans on warehouse receipts. The danger of accepting a warehouse receipt as collat- eral may arise from an insufficient or false description of the property; the unfaithfulness of the warehouse- man, who may misappropriate the property committed to his keeping; negligence in caring for it; or from carelessness in allowing receipts to circulate when the property behind them may not exist or may be subject to liens. In all these cases the holder of the receipt might lose his claim to the property and would be forced to rely upon the personal responsibility of the ware- houseman for reimbursement of his loss. 417. Under the present law. Under the present law in most states the warehouseman is responsible as bailee for the safekeeping of the goods. He is bound to use ordinary diligence or such care as prudent persons usu- ally take of their property. He is not liable for losses caused by fire, flood, insurrection, or public enemies. If he is guilty of no neglect he is not responsible for goods stolen even by his own employes. Persons depositing merchandise with a warehouse- man are obliged to trust to his fidelity and diligence in taking due care of their property, and persons dealing in warehouse receipts are in the same position, and must also trust to the accuracy of the warehouseman in de- scribing in the receipt the property intrusted to him. If the warehouseman misappropriates the property, or fails to take due care of it ; if he falsely or insufficiently 334 MONEY AND BANKING describes it in the receipt, the holder of the receipt may lose his claim to the property and may have only an action for damages against the warehouseman. 418. Issue of receipts safeguarded. The proposed act throws definite restrictions around the issuing of receipts, and makes the warehouseman criminally liable in many cases. It provides that all liens on the goods must be set forth in the receipt, including the rate of storage charges. The warehouseman may not insert any clause absolving himself from his legal liability for due care. Duplicate and non-negotiable receipts must be plainly marked as such. The warehouseman shall be obliged to deliver the goods on the receipt if the demand is accompanied by an offer to satisfy the ware- houseman's lien, a surrender of the receipt, and an acknowledgment of delivery. The warehouseman shall be justified in delivering the goods to any one tendering the receipt properly endorsed. If a thief presented a negotiable receipt properly endorsed the warehouseman would be protected if he delivered the goods innocently. 419. Protection to holders of receipts. If the ware- houseman shall fail to take up and cancel a negotiable receipt when goods are delivered, he shall be liable for failure to deliver the goods to any one who purchases for value in good faith such receipt, whether such pur- chaser acquired title to the receipt before or after the delivery of the goods by this warehouseman. A warehouseman shall be liable to the holder of a receipt for damages caused by the non-existence of the goods or by the failure of the goods to correspond to the description thereof in the receipt at the time of its issue. If, however, the goods are described in a receipt merely by a statement that they are said to be goods of a certain kind, or that packages containing the goods LOANS AGAINST COLLATERAL 335 are said to contain goods of a certain kind, or by words of like import, such statements, if true, shall not make liable the warehouseman issuing the receipt, although the goods are not of the kind which the marks or labels upon them indicate, or of the kind they were said to be by the depositor. This makes the warehouseman liable for what he asserts only. 420. Garnishment not allowed. Goods delivered to a warehouseman who issues a negotiable receipt there- for cannot thereafter, while in possession of the ware- houseman, be attached by garnishment or otherwise, or be levied upon under an execution, unless the receipt be first surrendered to the warehouseman or its negotiation enjoined. In most states the present laws disallow any garnishment; it was thought best in this act not to take so extreme a position but to cover the essential practical point by making it a condition of the validity of such seizure that the negotiation of the receipt be enjoined or the document impounded. A person to whom a negotiable receipt has been nego- tiated acquires, according to the act, such title to the goods as the person negotiating it had, and also the direct obligation of the warehouseman to hold possession of the goods for him according to the terms of the receipt as fully as if the warehouseman had contracted directly with him. 421. Penalty for illegal use of receipts. It shall be a criminal offense for a warehouseman to issue a receipt for goods not actually received, or to issue a receipt knowing that it contains a false statement, or to issue duplicate receipts not so marked, or to issue a receipt for goods of which he himself is the owner without stat- ing that fact, or to deliver goods without canceling the receipt. Any person who deposits goods to which 336 MONEY AND BANKING he has no title, or upon which there is a lien or mort- gage, and takes a negotiable receipt therefor with intent to deceive without disclosing want of title, shall be guilty of a crime. Loans may be made on receipts under such a law with little risk or inconvenience to the lender. If the goods are insured his chances of loss are practically limited to deterioration in the quality or value of the goods. Sea- sonable goods in cold storage, such as fruit, butter, eggs, poultry, etc., must be sold at certain seasons, lest they shrink in value by having to compete in the market with fresh goods at cheaper prices. 422. Transfer of title to lender. Many banks prefer not to accept receipts for warehoused goods as collateral at all but require the transfer on the books of the ware- house to themselves, taking a non-negotiable receipt therefor. CHAPTER XXIII CREDIT DEPARTMENT OF A BANK 423. Credit department of a bank. It is only within recent years that credit departments have appeared in the banks. Formerly the cashier was supposed to keep personally all the credit information. However, it has been found preferable by the banks to employ a compe- tent credit man, whose sole business is to accumulate information on credits. In some of the larger city banks and especially in the offices of a commercial paper house, there are highly organized systematic credit bu- reaus, which have on file every bit of information regard- ing the credit standing of their customers. 424. Sources of credit information. The chief source of information on credits is of course the statements of the customers themselves. Until within the last few years it was not the custom of the banks to demand writ- ten statements from customers and there are still business men who resent the request of banks for statements. As a rule, however, the borrowers have found it to their advantage to make a full statement of their affairs to their banker, knowing that failure to make such a state- ment will prejudice their credit. A standard form of customers* statement in use by banks is reproduced below for the purpose of showing the items of information which the banks believe to be important in the granting of loans. In some doubtful cases the banks may require the statement to be certified by a professional accountant. vii-22 337 338 MONEY AND BANKING Form A. STANDARD FORM OF STATEMENT FOR FIRMS AS ADOPTED BY NEW YORK STATE BANKERS ASSOCIATION. FROM ADDRESS TO For the purpose of procuring credit from time to time with you for our nego- tiable paper or otherwise, we furnish the following as a true and accurate state- ment of our financial condition on 190.., which you are to consider as continuing to be full and accurate until we give you written notice of change. ASSETS. Cash on hand Cash in the following banks ffame of bank Notes Receivable of custo- mers (not transferred) Accounts Receivable of custo- mers (not transferred) Notes and Accounts Receiva- ble of partners (not trans- ferred) Merchandise finished (how valued ) Merchandise unfinished (how valued ) Merchandise raw material (how valued ) Land owned by firm, used for this business Buildings ow_ned by firm, used for this business Machinery owned by firm, used for this business TOTAL LIABILITIES. Notes Payable given for mer chandise Notes Payable negotiated to own banks Notes Payable otherwise dis posed of Accounts Payable Deposits of Money with Us as follows By * By * By $ By sundry persona $. Mortgage Debt . . Chattel Mortgages Total Liabilities Net Worth TOTAL CONTINGENT LIABILITY: Notes Receivable of customers Discounted or Sold and not included in assets enu- merated above Other contingent liability We Have Not Pledged or Assigned any of the above Accounts Receiva- ble ; our Assigned Accounts Receivable amount to Other assets used as collateral INSURANCE: on merchandise $ buildings $ machin- ery $ Total Insurance BUSINESS and RESULTS: Annual Sales for the year ended 190. .or from 190. .to 190. . Gross Profits on Sales Expense of Conducting Business Net Profit Other Income, including investments Combined Profit WITHDRAWALS by PARTNERS (not included in expense of conduct- ing business) from 190. .to 190. . BAD DEBTS for the period from 190. .to 190. . SPECIAL CAPITAL: contributed by until 190. .