New York State College of Agriculture At Cornell University Ithaca, N. Y. Library Cornell University Library HG2481.W36 Essays on banking reform in the United S 3 1924 013 900 638 Cornell University Library The original of tiiis bool< is in tine Cornell University Library. There are no known copyright restrictions in the United States on the use of the text. http://www.archive.org/details/cu31924013900638 PROCEEDINGS OF THE ACADEMY OF POLITICAL SCIENCE IN THE CITY OF NEW YORK Volume IV JULY, igi4 [Number 4 ESSAYS ON BANKING REFORM IN THE UNITED STATES PAUL M. WARBURG PUBLISHED QUARTERLY BY THE ACADEMY OF POLITICAL SCIENCE. Columbia University n6TH Street and Broadway, New York SnUrtdat ie€»nil*Uut matUr Wcv. *t, tgio, at Ikt fott effiei at Ifna Yerk, If. Y. mtdtr the Act ofCongrm, July ib, i8 POLITICAL SclIHCB PROCEEDINGS OF THE ACADE My QF POL ITICAL SCIENCE Tier Proceedings are issued ty the Academy as a record of its activities and as a means of giving detailed treatment to special subjects of importance. Each volutije consists of four numbers, published in January, April, July and October. The January and July numbers give in full the papers read at the meetings of the Academy, together with the discussions and the addresses at the dinner meetings. The numbers thus far issued are as follows : Vol. I, No, I. The Economic Position of Women October:, 1910. Pp. 190 No. 2. The Reform of the Currency January, 1911. Pp. 300 No. 3. The Year Book of the Acaddray April, 191 1. Pp. 27 No. 4. The Reform of the Criminal Law and Procedure July, 191 1. Pp. Z08 Vol. II, No. I. Capital and Labor Unified October, 191 1. Pp. 50 No. 2. Business and the Public Welfare January, 1912. Pp. 185 No. 3. National Housing Association April, 1912. Pp. 236 No. 4. Organization for Social Work July, 1912. pp. 236 Vol. lit. No. I. The Year Book of the Academy October, 1912. Pp. 48 No. 2. Efficient Government January, 1913. Pp. 194 No. 3. The Bryce Meeting April, 1913. Pp. 16 No. 4. The Caged Man July, 1913. Pp. 136 Vol. IV, No. I. Banking and Currency in the United States October, 1913. Pp.239 No. 2. Good, Roads and Convict Labor January, 1914. Pp. 96 No. 3. Yearbook of the Academy April, 1914. Pp. 52 No. 4. Essays on Banking Reform in the United States July, 1914. Pp. 228 Separate copies of numbers i, 2 and 4 of volume I, numbers 2 and 4 of volume II, numbers 2 and 4 of volume III, and ^numbers i , 2 and 4 of volume IV may be obtained in paper covers at ^1.50 each. A limited number of copies are also available in cloth binding at ;?2.oo each. Communications in reference to the Proceedings should be addressed to Henry Raymond Mussey, Editor of the Proceedings of the Academy of Political Science, Kent Hall, Columbia University. Subscriptions should be forwarded and all business communications addressed to the Secretary of the Academy of Political Science, Kent Hall, Columbia University; Members of the Academy receive the Proceedings without further payment. PROCEEDINGS OF THE ACADEMY OF POLITICAL SCIENCE IN THE CITY OF NEW YORK Volume IV] JULY, 1914 [Number 4 ESSAYS ON BANKING REFORM IN THE UNITED STATES BY PAUL M. WARBURG The Academy of Political Science- Columbia University, Nev* York ' 1914 copyrioht by The Academy of Political Science C-? /-.'■' tJ' 7 CONTENTS FASE Editor's Note i Introduction 3 Edwin R. A. Seligman Defects and Needs of our Banking System ... 7 A Plan for a Modified Central Bank . . . .23 American and European Banking Methods and Bank Legislation Compared ...... 30 A Central Bank System and the United States of America . . . . . . . -57 A United Reserve Bank of the United States . . -75 Principles that Must Underlie Monetary Reform in the United States . . . . . . .116 The Discount System in Europe . . . . .129 Circulating Credits and Bank Acceptances . . -159 The Owen-Glass Bill as submitted to the Democratic Caucus , . . . . . . . .173 The Owen-Glass Bill : Should there be Four or Eight Fed- eral Reserve Banks? ....... 204 The Owen-Glass Bill : Gold or Lawful Money, Note Issue, and Government Bonds ...... 220 EDITOR'S NOTE THE essays collected in this volume originally appeared as follows: Defects and Needs of our Banking System, in the New York Times Annual Financial Review, January 6, 1907 ; A Plan for a Modified Central Bank, privately printed, November 12, 1907 ; American and European Banking Methods and Bank Legislation Compared, an address delivered at Co- lumbia University and printed in The Currency Problem and the Present Financial Situation : Columbia University Press, 1908 ; A Central Bank System and the United States of America, an address delivered before the American Economic Association on December 30, 1908, and published in American Economic Association Quarterly , 3d series, vol. x, no. i ; A United Re- serve Bank of the United States, an address delivered before the Finance Forum of the Young Men's Christian Association of New York, March 23, 1910, and published in the Proceedings of the Academy of Political Science, vol. I, no. 2 ; Principles that must Underlie Monetary Reform in the United States, an ad- dress delivered before the Academy of Political Science, No- vember 12, 1910, and published in the Proceedings, vol. I, no. 2 ; The Discount System in Europe, prepared for the National Monetary Commission, and published as Senate doc. no. 402, 6ist Cong., 2d sess., 1910; C'rculating Credits and Bank Acceptances, an address delivered before the convention of the American Bankers' Association, November, 191 1, and printed in the Commercial and Financial Chronicle, December 2, 191 1 ; The Owen-Glass Bill as Submitted to the Democratic Caucus, in the North American Review, October, 191 3; Should there be Four or Eight Federal Reserve Banks? privately printed, December 5, 19 13. The thanks of the editor are extended to the New York Times, the Columbia University Press, the American Economic (385) 2 EDITOR'S NOTE Association, the William B. Dana Company, and the North American Review Publishing Company, owners of the copy- right of the first, third, fourth, eighth and ninth essays respect- ively, for their courteous permission to reprint the same. (386) INTRODUCTION THE essays which are here collected and published in book form not only are valuable in themselves but form a landmark in the history of American contributions to the banking problem. It is in a general way known to the public that Mr. Warburg was in some way connected with the passage of the Federal Reserve Act, and his appointment to his present responsible position on the Federal Reserve Board was acclaimed on all sides with a rare degree of approval and con- gratulation ; but I fancy that it is known only to a very few ex- actly how great is the indebtedness of the United States to Mr. Warburg. For it may be stated without fear of contradiction that in its fundamental features the Federal Reserve Act is the work of Mr. Warburg more than of any other man in the country. Up to a very few years ago, virtually all the efforts of the banking reformers in this country were directed to securing what was called elasticity of the currency, through the abolition of the bond reserve for bank-note circulation. Neither the re- port of the Indianapolis Monetary Conference nor the schemes of the committee of the New York Chamber of Commerce a decade later attempted to do anything more than that ; and no single plan seemed to approve itself to the country. The two new ideas which were injected into the discussion by Mr. War- burg were, first, the shifting of the emphasis from the currency problem to the reserve problem, and second, the advocacy of the principle of rediscounting a new kind of commercial paper. The first point is fully explained in the essay on the United Reserve Bank of the United States. Mr. Warburg recalled to our mind what had been forgotten by most of us, that the real pith of modern banking is the question of the reserve, and that the essential weakness of the American system was the extreme decentralization of resources, resulting in the time of stress or trouble in every individual bank attempting to secure its own (387) 4 INTRODUCTION [Vol. IV solvency in disregard either of the welfare of other banks or of the needs of the business community. In essay after essay Mr. Warburg hammered on this one idea until he got it firmly fixed in the opinion, first of the experts and then of the general pub- lic. Without some method of combining the scattered resources of the individual banks it was clear that no essential progress could be made. The second point was equally new to the American public, although, like the first, it was a familiar achievement of modern banking reform abroad. Mr. Warburg pointed out that the ab- sence of proper two-name commercial paper and the non-exist- ence of any central bank or banks at which such paper could be instantly rediscounted for cash, compelled the banks either to invest their money in illiquid securities or to loan the funds on the stock exchange, thus producing the remarkable varia- tions in the money rate and bringing about the periodical stringency in the money market. After his lucid exposition of what might be accomplished by a rediscounting and thus intro- ducing into the United States the so-called discount policy of European countries, it was gradually realized that this was the second essential feature of banking reform. Mr. Warburg also called attention to the advantages of a new currency not based upon the deposit of government bonds, but he made it clear that this reform, which was the sole objective of all previous schemes, was of only minor importance and that it would follow as a necessary consequence from the adoption of the two fundamental points mentioned above. These two principles form the real backbone of the new Federal Reserve Law. When the Aldrich commission was appointed it was not long before Senator Aldrich — to his credit be it said — was won over by Mr. Warburg to the adoption of these two fundamental features. The Aldrich bill differed in some important particu- lars from the present law. It went further in the direction of centralization and it involved less control by the government of banking operations. The new act is in some details superior to the Aldrich bill ; in others infeiior. The concession in the shape of the twelve regional reserve banks that had to be made for political reasons is, in the opinion of Mr. Warburg as well (388) No. 4] INTRODUCTION 5 as of the writer of this introduction, a mistake; for it will prob- ably, to some extent at least, weaken the good results which would otherwise have followed. On the other hand, the exist- ence of the Federal Reserve Board creates, in everything but in name, a real central bank; and it depends largely upon the wisdom with which the board exercises its great powers as to whether we shall be able to secure most of the advantages of a central bank without any of its dangers. In many minor respects also the Federal Reserve Act differs from the Aldrich bill ; but in the two fundamentals of combined reserves and of a discount policy, the Federal Reserve Act has frankly accepted the principles of the Aldrich bill ; and these principles, as has been stated, were the creation of Mr. Warburg and of Mr. Warburg alone. It is this fact which gives especial interest to the present col- lection of essays which are printed just as they were originally published and which show the gradual development, in unim- portant points, of Mr. Warburg's thought. In weighing the merits of these essays it must not be forgotten that Mr. Warburg had a practical object in view. In formulating his plans and in advancing slightly varying suggestions from time to time, it was incumbent on him continually to remember that the education of the country must be gradual, and that a large part of the task was to break down prejudices and remove suspicions. His plans therefore contain all sorts of elaborate suggestions designed to guard the public against fancied dangers and to persuade the country that the general scheme was at all prac- ticable. It was the hope of Mr. Warburg that with the lapse of time it may be possible to eliminate from the law not a few clauses which were inserted, largely at his suggestion, for educa- tional purposes. As it was my privilege to say to President Wilson when origi- nally urging the appointment of Mr. Warburg on the Federal Reserve Board, at a time when the political prejudice against New York bankers ran very high, England also, three-quarters of a century ago, had a practical banker who was virtually respon- sible for the ideas contained in Peel's bank act of 1840. Mr. Samuel Jones Lloyd was honored as a consequence by the (389) 6 INTRODUCTION British government and was made Lord Overstone. The United States was equally fortunate in having with it a Lord Overstone. And while it is not the custom for America to confer peerages upon its distinguished citizens, it is fortunately beginning to become the practise to induce them to accept positions of great public responsibility in which they can at once serve the com- munity and honor themselves. It is my especial pleasure to be able to write these few words of introduction, because it was in my study that Mr. Warburg first conceived the idea of presenting his views to the public. When he began to chat familiarly on the subject he at once im- pressed his listeners by the importance and novelty of his views. His modesty and his shrinking from public controversy were so pronounced that it was only with the greatest difficulty that he was persuaded to put his ideas on paper. But having once set out on the task, there was no stopping, and from year to year essay upon essay flowed from his facile pen, giving more pre- cision and point to his fundamental principles, until he was recognized as the real leader in the new movement. The Federal Reserve Act will be associated in history with the name of Paul M. Warburg, and the Academy of Political Science deem it a rare privilege to be able to present to the public this volume of his collected essays. Edwin R. A. Seligman. Lake Placid, New York, August, 1914. (390) DEFECTS AND NEEDS OF OUR BANKING SYSTEM THE question of the reform of the currency system is uppermost in the minds of all, not only in our own country, but in Europe as well; for Europe also is vitally interested in the problem. So much has been said and written on this subject that it is almost a presumption to seek to add any new thoughts. There is, however, one point which has not as yet been sufficiently emphasized, but which appears to lie at the very root of the problem. This is the question of our commercial paper. It is a strange fact that, while in the development of all other commercial phenomena the United States has been fore- most, the country should have progressed to so slight an ex- tent in the form of its commercial paper. The United States is in fact at about the same point that had been reached by Europe at the time of the Medicis, and by Asia, in all likeli- hood, at the time of Hammurabi. Most of the paper taken by the American banks still consists of simple promissory notes, which rest only on the credit of the merchant who makes the notes, and which are kept until maturity by the bank or cor- poration that discounts them. If rediscounted at all, they are generally passed on without indorsement, and the possibility of selling any note depends on the chance of finding another bank which may be willing to give the credit. The conse- quence is that, while in Europe the liquid assets of the banks consist chiefly of bills receivable, long and short, which thus constitute their quickest assets, the American bank capital in- vested in commercial notes is virtually immobilized. In Europe — as for instance in England, France, or Ger- many — there are scores of banks and private banking firms which give their three-months' acceptance for the commercial requirements of trade, or which make it their specific business to indorse commercial bills. A commercial borrower in these countries who does not get a cash advance will do one of two (391) 8 BANKING REFORM IN UNITED STATES [Vol. IV things. He will either sell to his bank or his broker his own three-months' bill drawn on a banking firm willing to give him this credit, or he will sell the bills drawn by him on his cus- tomer (in payment for goods sold to them), which bills will be subsequently passed on with the indorsement of the banker. This banker's acceptance, or this indorsed paper, can be readily negotiated by the buyer at any time whenever there is a profit to be derived, or whenever the holder desires to realize on the bill. The holder will always be able to dispose of it, either through private discounting or, in case of need, by selling, as the case may be, to the Bank of England, the Banque de France, or the German Reichsbank. In any event, the firm or corporation which buys this paper can secure its equivalent at any time. The quality of the bills, assured by the estab- lished credit of the acceptor or by the various indorsements on the bill, is such as practically to eliminate the question of credit, and the conditions of the sale will depend only on the rate of interest. The value of the existence of thousands of millions of such standard paper, as it is found in all the important European financial centres, can scarcely be sufficiently emphasized. Just as the check system is a method of clearing bank cash credits, thus helping largely to prevent unnecessary absorption of the currency, so modern commercial paper, through the additional safety which is secured by the banker's indorsement, acts in like manner as a clearing of credits on time not only within the community, but, what is just as important, among the var- ious nations as well. If money tightens in Europe, let us say in Germany, France and England will immediately invest in German bills. They could not buy the paper of individual German merchants, whom they do not know, but they do and must know the value of the acceptance or indorsements of the German banks which offer and indorse or accept this paper. By a well organized system of such bills of exchange the credit of the whole nation — that is, of the farmer, merchant, and manufacturer — is joined to that of the banker and becomes available as a means of exchange both within and without the country. (392) No. 4] DEFECTS AND NEEDS OF OUR SYSTEM 9 Under present conditions in the United States, on the other hand, instead of sending an army, we send each soldier to fight alone. With us the borrower receives money from the bank and his note becomes an illiquid asset in the bank's portfolio. If the bank desires to raise money, it must use its own credit, instead of adding its own credit to that of the borrower, thus making the dead note a live instrument of exchange. The only modern bills in our country are the so-called " foreign exchange " bills, drawn on European banks and bankers, which are indorsed and which always have a ready market. But what an anomalous position ! Instead of having the credit of the entire country available in the shape of millions upon millions of modern paper which Europe might and would buy, we must rely on the willingness and the ability of a few banks and bankers to use their own credit by drawing their own long bills on Europe. This is a costly and most unsci- entific mode of procedure, which is in no way adequate to the necessities of the situation. For there is, as a matter of course, a limit to the amount which the American banker can draw and which the European banker will and can accept. Recent events have shown the inefficiency of this system. In spite of unwise provocation the government banks of Europe would not and could not have made a stand against us (as they have done during these past few months by raising their rates of discount and by discriminating against our so-called finance paper) had we been able to send our legitimate com- mercial paper instead of forcing the banks and bankers to draw their own bills. These bills, it is true, indirectly help commerce, for a bank which requires money in order to ac- commodate its merchant customers will call its stock-exchange loans, while bills drawn against stock-exchange collateral will in turn provide the money that has thus been called. But such bills must inevitably bear a financial character, and will not be regarded so favorably as commercial paper would be. Moreover, since the drawers and, to an even greater extent, the European acceptors, are comparatively few, the European banks must at times feel that they are getting too large an amount of paper drawn on and indorsed by the same (393) lO BANKING REFORM IN UNITED STATES [Vol. IV firms. As these bills, drawn, as the case may be, in pounds, francs, or marks, sell normally at the same rate of private dis- count as all the other long bills in the country, the European banks find no particular inducement to purchase them. When, therefore, there is an excessive amount of these American bills offered, the consequence is discrimination, and, what is worse — owing to the financial aspect of the bills — a feeling of uneasiness and distrust. If instead of this unfortunate method of financing we could offer American paper drawn in dollars, showing its commercial origin and indorsed by and drawn on American banks or banking firms, we should vastly multiply the avenues leading into the portfolios of the European banks, and our bills would be well spread instead of going into a few channels which can so easily be closed. We should create a new and most power- ful medium of international exchange — a new defense against gold shipments. This is no visionary theory. In view of the fact that a great many millions of even Russian bills are con- stantly held by French, English, and German banks, institu- tions and capitalists, there is no reason whatsoever to doubt that these same avenues could be readily opened to American paper. In order thus to make our paper part and parcel of the means of the world's international exchange, it needs, how- ever, as a preliminary condition, to become the foundation on which our own financial edifice is erected. It must always have a ready home market, where it can be rediscounted at any moment. This is insured in nearly every country of the world claiming a modern financial organization, by the existence of some kind of a central bank, ready at all times to rediscount the legitimate paper of the general banks. Not only England, France, and Germany have adopted such a system, but all the minor European states as well — and even reactionary Russia — have gradually accepted it. In fact, Japan without such an organization could not have weathered the storm through which she has recently passed, and could not have achieved the commercial success which she now enjoys. Our methods are just the reverse of the European system. (394) No. 4] DEFECTS AND NEEDS OF OUR SYSTEM 1 1 With us call money does not go into the bill market. Every American bank, since it cannot count on reselling the notes which it buys, must necessarily limit the amount which it can properly invest in American paper, and as a consequence almost all the call money is invested in demand loans on the stock exchange. The result of this is that the overflow of money of the entire country, from the Atlantic to the Pacific, is thrown into the stock exchange, making stock-exchange money easy and stimulating speculation when trade is relax- ing, while on the other hand, as soon as demand for money for commerce and industry increases, the funds to provide for the needs of the whole country are called from the stock ex- change, causing a disturbance there. Our whole elasticity is built up on the bond and stock market. Banks can issue notes on government bonds, and call money is kept in stock-exchange loans. In Europe the situa- tion is reversed ; banks issue notes primarily against their pur- chases of bills of exchange, and the reserves of the country are kept primarily in bills of exchange. In Europe banks and bankers invest against their deposits chiefly in bills of exchange, short and long, and only to a comparatively small extent in fortnightly or monthly settle- ment money on the stock exchange or in call loans on stock- exchange collateral. If call money becomes easier, it is in the first instance the rate for short and long bills that goes down, and since this rate is practically the same all over the country, a withdrawal or an influx of money, instead of being felt primarily by the stock exchange, is borne equally by thousands of millions, the grand total of all money invested in such bills being a great many times larger than the comparatively small amount employed in stock- exchange loans. It is like throw- ing a pebble into a pond ; the ripples will slowly spread in con- centric circles, until in the end they are scarcely perceptible. With us it is like casting a stone into a small basin ; the entire surface is suddenly and violently agitated for a short time. To explain briefly the workings of a European central bank, to show how little political power need attach to it and how little it interferes and need interfere with the business of the (395) 12 BANKING REFORM IN UNITED STATES [Vol. IV general banks (except to act as a general brake on the market, if it over-extends, and to provide for the needs of the country, as long as they are legitimate) it may be well to say a few words about the German Reichsbank, admittedly the most per- fect organization of its kind. The capital stock of the German Reichsbank is owned partly by the government and partly by the public. The Reichsbank has a central board in Berlin, consisting of the foremost men in financial and commercial circles. The presi- dent of the bank is a. salaried officer, a trained banker (no politician) who retains his position irrespective of the party in power, like the president of any private bank who remains in office as long as he does his work well. The Reichsbank has its branches in every important town similar to our central reserve and reserve cities. Each branch has its own board of directors, consisting of ten or twenty men, representing the best financial and commercial men in the locality, while each branch has its own salaried president, responsible to the board. The chief duty of the bank, leaving all other details not bear- ing upon our subject aside, is to buy at the published bank rate legitimate paper, which must bear the acceptance or in- dorsement of at least two well-known banks or bankers. This bars the Reichsbank from doing a general commercial busi- ness, and converts it practically into a bank for the other banks. Moreover, the published rate of the Reichsbank is, as a rule, from ^ of l% to i% higher than the private discount rate at which the other banks buy paper. Since, however, the central bank has branches in every town, the banks use it chiefly in the normal course of events for the collection of bills throughout the entire country as they fall due. The bank has its established rules for such collections, deducting at its pub- lished rate from five to ten days' interest, according to the dis- tance of the towns on which the bills are drawn, but not charg- ing any commission. According to this system, for instance, a Hamburg bank, owning a bill on Munich, would sell the bill to the Reichsbank. five days before it falls due, simply rediscounting the last five days at the bank rate. A Munich bank having a bill on (396) No. 4] DEFECTS AND NEEDS OF OUR SYSTEM 1 3 a Hamburg bank would do the same, both getting the money immediately, while the Reichsbank, as the general clearing house, would simply transfer on its books the credits of the one branch to those of the other. Through a system of this kind it is possible to avoid the constant remittance of cash and the locking up of money by the banks. The advantages that a system of this kind would bring to the United States are obvious. When money tightens in Germany the banks rediscount through the Reichsbank their short bills which have a little more than five days to run, and as the private discount rate throughout the country rises, the bills that the banks redis- count will gradually be longer and longer. While this process is in progress, the private discount rate and the bank rate will be approaching each other. If rates are comparatively low, the general tendency of the Reichsbank will be to advance its rate, so as not to be forced to put out too large an amount of notes issued in payment for the bills. For, as is well known, the bank is compelled to pay a tax when its note circulation exceeds a certain limit. After a normal amount of its notes is out, the Reichsbank will, therefore, tend to keep its rate well above that of the ordinary banks until the rate of interest re- ceived in discounting paper is high enough to indemnify the Reichsbank for the payment of the tax. As a consequence the Reichsbank, as a rule, keeps its rate high enough to leave to the ordinary banks the general busi- ness and the fixing of the rates at which this business is con- ducted. By raising or lowering its rate, however, the Reichs- bank indicates the general trend and exerts a moral and prac- tical influence on the tendency of the banks to extend or to re- strict business. If money is low in Germany and high in other countries, with a natural consequence that German capital would leave the country, and gold as a result be exported, the Reichsbank will work for a higher rate of interest as a precau- tionary measure, and the general banks will, as a rule, follow the Reichsbank's lead. In the opposite case, however, when money is becoming very scarce in Germany, there is no fear at any time of a money (397) 14 BANKING REFORM IN UNITED STATES [Vol. IV squeeze, as the Reichsbank, on paying the tax, can issue a vir- tually unlimited amount of notes as long as safe and legiti- mate paper is offered for discount. In times of very high money the Reichsbank will at a certain point cease to keep its own rate above the private discount rate of the banks, and at such times the ordinary banks will often rediscount with the Reichsbank not only the short bills, but even the long ones. Thus the duties of the Reichsbank are, on the one hand, to counteract the influence of too abundant a money supply, and on the other hand, to furnish at legitimate rates all the money that the country legitimately may require. It should be added here that the Reichsbank also makes loans on collateral. There is, however, a fixed rate for this, namely, i% above the bank rate. This is, cis a rule, a much higher rate than that at which the general banks will furnish the money, and in addition there exist very strict regulations as to the kind of securities on which the Reichsbank is per- mitted to advance money and as to the percentage of the market value of the securities which it may loan. Since these rules are much more rigid than those of the general banks, nobody would under normal circumstances apply to the Reichsbank for a loan on collateral. When money becomes scarce, however, the banks or the bankers can always count on the Reichsbank to fcdl back upon, and in case of a crisis this is readily done. The ability of the Reichsbank to advance against securities is, however, of minor importance as compared with the fact that the existence of such an institution forms the foundation on which is erected the whole system of financing the business interests of the empire on bills ; for this results in an elastic system, expanding and contracting, according to the require- ments of trade and industry. Reason, as well as the experience of all other nations, tells us that we in the United States should attempt to reorganize our present system of issuing and handling commercial bills, in order to create the basis necessary for a modern system of currency and finance. Not only, however, should we endeavor to make such bills the medium of equalizing the daily demand (398) No. 4] DEFECTS AND NEEDS OF OUR SYSTEM j 5 for and supply of money, but we should also by all means try to break with the other system, which makes call loans on stock-exchange collateral serve for this purpose. Let us next consider another point of some importance. The principal stock exchanges in Europe have their dealings for fortnightly or monthly settlements, while on the New York stock exchange all transaction are for daily cash settlements. The advantages of the European system are obvious ; it avoids unnecessary duplication of work and unnecessary outlay of money, and it assures a greater stability. In Europe the " positions " are " carried " from one settle- ment to the next; that is to say, the broker borrows or lends the money from the end or the middle of the month to the next settlement day at a rate of interest agreed upon in ad- vance. Unlike his unfortunate New York brother, he need not find his money from day to day, and he need not fear that money rates will jump from 4% to 100%, or that, even at such rates, he may not be able to secure the money at all. In Europe the amount employed on the stock exchange is a fairly constant one. The daily plus and minus of the demand for or the supply of money is adjusted in the bill market, and if more money is required on settlement days and the rate of settlement money rises, the normal consequence is that more money will go from the bill market to the stock exchange, and be employed there until the next settlement. This process takes place year in and year out practically without any ser- ious disturbances ; fluctuations and exorbitant money rates such as we have so frequently witnessed in this country are not only unheard of, but absolutely inconceivable in Europe. From settlement to settlement in Europe the broker and the customer are safe ; the stock-exchange loans remain unchanged. If such a system of settlements should be established on the New York stock exchange — for which case it would be ad- visable, in order not to stimulate gambling, to provide in some way for putting up margins to protect the contracts — several objects would be achieved. In the first place, individuals would be in a position to secure money for a reasonable time and at reasonable rates, and panicky fluctuations, so frequent (399) 1 6 BANKING REFORM IN UNITED STATES [Vol. IV at present, would become rare. Secondly, the regulation of the daily supply and demand of money would be forced from the stock exchange into the bill market. It should be added here that our present system of cash dealings on the stock exchange is forced upon us as the result of the unreasonable usury law of the state of New York, which, although making it unlawful to take more than 6% on time loans, is in reality the direct cause of an almost confisca- tory rate being charged from day to day for weeks at a time. That the usury law should provide a maximum rate for pawn shops or for small individual loans is defensible, but for large business transactions most of the European laws do not limit the rate. Even in those countries which still retain some form of usury laws, in order to constitute usury it must be proved that the party taking the money was in dire stress and that the party loaning the money designedly took advantage of the debtor's helpless position to exact an exorbitant rate. If the hight of the rate is to be the deciding factor in judging whether usury has been exacted, the law ought to state the maximum amount permissible in excess of the ruling interest rate of the country (like, e. g., the bank rate abroad). But for the large transactions of a country one fixed maxi- mum rate cannot be laid down by law. It is preposterous to extend such a principle to the business of large solvent houses, and to prevent them from making a legally binding contract for time money at more than 6% in the face of the fact that such a loan at 7% or even 8% might be of the greatest benefit to them, while the impossibility of securing money except on call at ridiculous rates might cause the most severe loss of money and of business. Conditions like the present show the absurdity of such a system ; when money in Europe is worth more than 6% on time — as happens to be the case just at pres- ent — the consequences can only be that under present circum- stances some people will loan at more than 6% on time, and take the risk of such illegal action. As there are, however, comparatively few, the call rate must rise to such an abnormal hight as is necessary to keep money from going abroad or to attract a new supply to our country. But as this exorbitant (400) No. 4] DEFECTS AND NEEDS OF OUR SYSTEM ij rate for call loans may break from day to day, in considera- tion of the resulting risk of exchange connected with the trans- action, one might say that the rate for short money, in order to attract foreign capital, will rise about io% to 2o7o, where the rate for time money would have to rise only i%. With no modern paper to offer, with the usury law limit- ing the legal time rate to 6%, and with an unwritten law, ob- served by many banks, not to charge their regular customers more than 6%, even on call loans, our only primitive means of protecting the country are either an immense rate for call loans in the open market or a violent break in the price of our securi- ties, as a rule the consequence of such shortage of money. This break must bring our securities .down to a level where Europe will buy, and ultimately results in a relief of our money market by reason of remittances from abroad for such purchases. Such are the consequences of the perpetuation oi an absurd system which has been abandoned everywhere else. Banks and bankers may by manipulation sometimes exaggerate the disgraceful conditions which exist in our money market, but the direct cause is our present system, which makes these occurrences, as it has been endeavored to make clear, abso- lutely inevitable. Our immense national resources have enabled us to live and prosper in spite of our present system, but so long as it is not thoroughly reformed it will prevent us from ever becom- ing the financial centre of the world. As it is, our wealth makes us an important but dangerous factor in the world's financial community, with immense resources indeed, but with- out a central organization of our own, using and sometimes abusing the financial organization of Europe in order to atone for our own shortcomings; unable effectively to put on the brakes ourselves, we compel the government banks of Europe to take measures for the regulation of our own household. In closing, a few words may be said about the propositions now before the country with reference to currency reform. At the outset we were between Scylla and Charybdis; on the one hand the tendency to give unlimited power to the Secre- tary of the Treasury — a political officer, possibly untrained in (401) 1 8 BANKING REFORM IN UNITED STATES [Vol. IV the banking business and one who, although probably in most cases unselfish and wise, may also be selfish and unwise; and on the other hand the movement of the bankers' association to take all power from the treasury, forcing it to put out its money at a fixed rate and practically vesting its power in the national banks. The one tendency appears to be as bad as the other; it is dangerous to give so much power to one individual who is not in business, but it is equally dangerous to give so much power to men who are all in business. The bills re- cently introduced in Congress show a material improvement on these first attempts. The one bill, known as the Elkins bill, which empowers the Secretary of the Treasury to deposit with the national banks against collateral all moneys received — including custom-house revenues — leaving the rate of interest, however, to be fixed in his discretion, deserves unqualified indorsement. It leaves a vast discretionary power with the Secretary, but this is a nec- essary evil as long as we have no central bank. To make the treasury an automatic institution and practically to transfer its powers to the national banks would be worse ; for it is im- possible to see how any concerted action could be taken by these banks to protect the country (as a central government bank would do by increasing the rate of interest or by supply- ing money at moderate rates) if such a course proved to be contrary to their interest. They are, after all, money-making concerns — not public institutions — keenly competing against one another, and they cannot be forced to cooperate in any way that may injure their own business. There must be some power capable of taking an unselfish and larger point of view, for otherwise the country would be without any financial pro- tection whatsoever. This function must be left for the time being to the treasury, which, by increasing or decreasing the rate at which it deposits the government funds in the banks, can put on the brake to a certain extent and thus protect the country and its gold. It is to be feared that any scheme which attempts to estab- lish a concentration of control of note issue by the national banks and to create a joint guarantee of such notes will fail (402) No. 4] DEFECTS AND NEEDS OF OUR SYSTEM 19 of adoption or will not work, in the long run, for the reason that each individual bank will be unwilling to submit to con- trol or interference, and that the conservative banks will sooner or later feel that they are shouldering the burden for the less careful sister institution, which, if it fails, would in- flict losses, to be borne by the joint guarantee fund contributed by all the banks. The second bill which has been introduced meanwhile is the bill of the House committee on banking and currency, which urges that authorization be given to any national bank to issue unsecured notes to the extent of 25% of its capital, on paying a tax of 3%, and an additional I2j^% on paying a tax of 5%. This bill is undoubtedly an improvement on the pro- position of the bankers' association, as through the higher tax there is more probability that the notes would be redeemed from time to time, since it would pay the banks to keep even the lower-taxed notes in circulation only as long as money is worth at least 4j4%. The rising scale, however, previously recommended by the chamber of commerce appears to be the safer plan, as with the almost stationary rate of 6% for com- mercial paper, some of the country banks might otherwise be tempted to keep the lower-taxed notes outstanding nearly all the time. This, instead of elastic circulation, would mean in- creased circulation, which is not needed. But the chief ob- jection to this bill and all similar recommendations is that it is a wrong principle to allow any bank giving unsecured com- mercial credits to issue unsecured notes. Besides, if a bank is allowed to issue, as a net result, about 28% (37% less the 25% reserve) of its capital in unsecured notes, does it not simply mean that the bank, on paying a certain tax, may in- fringe upon its reserve to this extent ? Should we not through such a measure place our national banks on a less conservative basis than they were heretofore, when they were not allowed to issue unsecured notes? Undoubtedly our system would gain in elasticity, and the guarantee fund might grow to take care of the notes of many a bank that might fail, perhaps just in consequence of the greater latitude offered to it by the pres- ent bills, but the principle remains bad all the same. (403) 20 BANKING REFORM IN UNITED STATES [Vol. IV I strongly believe that banks issuing unsecured notes which are to pass as the people's money should be restricted to buy- ing paper that is endorsed by other banks or banking firms, and that they should be restricted also as to the kinds of loans to be made by them; in short, they should not be allowed to take the same risks as every general bank or banking firm. To meet, however, the needs of the hour it might be advis- able to authorize the banks to issue notes, on paying a tax as proposed by this bill, but to secure these notes by a deposit of paper bearing at least three bona-fide signatures, of which at least two would have to be those of banks or bankers. This course would commend itself for several reasons. 1. It is more conservative and would make the banks and the notes safer. 2. It would force the banks to apply the money to be re- ceived from additional circulation to the purchase of commer- cial bills ; it would prevent the money from being used directly for stock-exchange loans, as it could be under the present bill. 3. It would further the creation of modern paper, since, if such a law were enacted, modern paper which could be de- posited would be taken in preference by the banks. 4. Certain committees would have to be appointed in every reserve and central reserve city in order to scrutinize the bills deposited as security by the banks. These committees might be the predecessors of iuture local committees of a central or- ganization. 5. We should lay the foundation to modernize our financial structure, a foundation that would carry in itself the elements of a central system built up on the trade, commerce and in- dustry of the country, an end which at present is far out of our reach. The scope of the issue of secured notes can be safely en- larged from time to time, especially since a guarantee fund of secured notes would grow rapidly with comparatively few losses, while the bill of the House committee would be limited in its scope, and would be only a makeshift, endangering the safety and soundness of our currency. Whether a cential bank will be eventually owned by the (404) No. 4] DEFECTS AND NEEDS OF OUR SYSTEM 2 1 national banks is impossible to foretell, nor can it be predicted whether the business of accepting and rediscounting will be- come the domain of the trust companies and the general banks, or whether new discount companies, like those in England, will be started for this purpose. It is, however, not beyond the bounds of imagination that a wholesome line of demarca- tion between the business of national banks and that of other financial institutions might gradually be reestablished through such a development. Such paper could eventually be ad- mitted also as collateral against the deposits of treasury money. That a central bank is the ideal solution of the difficulty and that it must finally come — though, perhaps, we may not live to see it — is my firm belief. None of the reasons ad- vanced against it are tenable. It has been argued that a central bank would be dangerous, as, in fact, it was in the past, because it might become the tool of politicians, and it has been frequently stated that " we do not want politics in business." But the powers which the Secretary of the Treasury, a political officer, must exercise now are much vaster than those that any single officer of a central bank would ever enjoy, and these officers could be appointed in such a way — for instance in part by the govern- ment, by the national banks, by the courts, by the chambers of commerce — that the constitution of the board would be taken entirely out of politics. Are we not unduly depreciating our- selves by saying that we should not be able to find a set of business men of sufficiently high standing to form the central and local boards of such a central bank, and that we could not secure salaried officers competent to fill the post of managers of the central bank and of the branch offices ? I think that we are greatly mistaken if we believe our coun- try so entirely different from all others that we should be obliged to continue to do the opposite of what is done by them, while the system of all other important nations has proved to be excellent, and ours has proved to be defective. We have reached a point in our financial development where it is absolutely necessary that something be done to remedy the evils from which we are suffering, and it would be a thou- (40s) 22 BANKING REFORM IN UNITED STATES sand pities if our legislative bodies did not meet the situation. Let us, however, be careful clearly to recognize the cause of the evil before we act, so that we may not be found repairing the roof while the foundation is rotten. Meanwhile there remains important work to be done by the banking community itself, without any aid from Washington. At present our bankers look with scorn on rediscounting and accepting American bills. They should recognize the fact that these two branches of business are not only most legiti- mate, but most necessary for the nation's development. (406) A PLAN FOR A MODIFIED CENTRAL BANK THE appalling panic which we have experienced during the last few weeks will do more, I suppose, to bring home to the public the absolute necessity of a change in our present banking and currency system than all the efforts that have hitherto been made to warn the nation of the imminent danger. It is to be expected that Congress will take some action on this question at its next session, but it is sin- cerely to be hoped that it will not follow the line of least re- sistance by adopting some paltry palliative, but that the ques- tion will be approached in a bold and broad spirit. As I tried to prove in a previous paper on " Defects and Needs of Our Banking System," which The New York Times published in its Financial Supplement in January last, nothing short of a modern central bank will effect a final solution of the problem, but, as was also indicated in that paper, we are still so far removed from the fundamental conditions which would have to be created in order successfully to establish a central bank on the European basis that the attempt to take so far-reaching a step would involve material and harmful delay. There are grave objections, however, to the scheme, advo- cated by so many, of creating an emergency currency by per- mitting each national bank independently to issue unsecured notes up to a certain percentage of its share capital, subject to a tax sufficiently heavy to insure the prompt withdrawal of these notes -when times again become normal. If issued indi- vidually by each national bank, without a joint guarantee by all the national banks, such notes would add a new element of danger in times of panic. Let us imagine what would have happened during the last few weeks when one of the national banks became somewhat involved, if notes of this kind had been outstanding. It stands to reason that the panic which caused a run of the depositors (407) 24 BANKING REFORM IN UNITED STATES [Vol. IV would have been carried into the ranks of the noteholders, and it might easily have intensified the distress by creating a general lack of confidence and wholesale discrimination against national bank notes, thus aggravating the general hysteria and increasing the withdrawal and hoarding of legal- tender currency as well as gold. It is, moreover, not at all improbable that the emergency notes of this bank and those of a majority of the other banks would have been in circula- tion before the real pinch came, as a great many people thought that the culminating point had been reached when, as a matter of fact, the crisis was only beginning. Further, it is bad practise to allow a bank to issue unsecured notes, which are to pass as current money, against invest- ments in single-name commercial paper or against loans of all kinds, as, for instance, in this case, on inflated copper and bank stocks. No European central bank would be allowed to proceed in this way. There are strict regulations as to the loans which these note-issuing banks are permitted to make; and as to their purchases of commercial paper additional guar- antees (generally' three good signatures) are required. It is very doubtful whether the stronger national banks would consent to a joint guarantee by all the national banks for the entire amount of unsecured notes issued by the national banks. This could be done safely only if they could exercise a material control over their sister banks. As a way out of the difficulty, the following plan is sug- gested — a plan which does not purport to cover the situation fully, but embodies a general sketch of what might possibly be tried. The scheme adopts some of the good features of the European system, while it seeks to avoid those parts of the European machinery which could not well be adapted to our present conditions. It is proposed to create at Washington a bank, to be called hereafter the Government Bank, endowed with a capital of from $50,000,000 to $100,000,000, possibly paid up only in part, the share capital to be owned, if feasible, half by the gov- ernment and half by the national banks, and the management to be in the hands of a salaried president or presidents, who (408) No. 4] A PLAN FOR A MODIFIED CENTRAL BANK 25 are to be appointed for an indefinite period by the board of directors. The board of directors is to consist of delegates of the various clearing houses of the central reserve and reserve cities ; the Secretary of the Treasury and the controller of the currency are to be members ex officio, and some additional directors are to be appointed by the stockholders, by the Su- preme Court, and by the chambers of commerce of, let us say. New York, Boston, Philadelphia, and Chicago. This is only a rough outline, susceptible of easy modifica- tion, intended merely to show how it is possible to create a board which would be independent of politics, which would comprise men of business knowledge and experience, and which, by its composition, would afford a reasonable guarantee that it would not be swayed by selfish motives in its actions. The Government Bank would receive the treasury's moneys, and the deposits of these moneys with the national banks would in turn be made by this bank. The Government Bank would have the right to issue legal-tender notes, not to exceed a certain multiple of its capital and its holdings of gold or of gold notes. The bank would, in the main, be limited to trans- actions with the clearing houses of the various cities of the United States and with the clearing-house members. The Government Bank would be allowed to deposit moneys with the clearing-house institutions and national banks in the country against collateral, taking United States government securities at 90% of their market value, municipal securities at 80% of their market value, and railroad bonds at 60% of their market value. (The percentages above given are again only illustrative of the way in which government moneys, through the medium of the government bank, could safely be put out against good securities on a plan similar to the Euro- pean mode of handling government moneys.) The bank would establish a general rate of interest for such deposits, such rate to be modified from time to time, very much as is done under like circumstances by the European government banks. The bank would be allowed to advance money against (409) 26 BANKING REFORM IN UNITED STATES [Vol. IV clearing-house certificates of the banks of the central reserve and reserve cities of the United States. It would further be allowed to buy paper running for a period not to exceed three months, made out in dollars or in sterling, francs, or marks, such paper to be strictly commer- cial paper and to bear at least three signatures, of which one must be that of a well-known bank, trust company, or banker. The privilege of buying such foreign paper is proposed in order to enable the government bank to accumulate a reserve of long bills having a gold basis, as is done by the European government banks. Such bills would be used to meet and to counteract, as far as possible, demands for gold which might be made upon us from time to time by other countries. The authority for the government bank to buy three months' dollar paper, also bearing at least three signatures, including a bank's or banker's indorsement or acceptance, is added for the purpose of encouraging the creation of such paper, the lack of which is largely the cause of the immobilization of the re- sources of our banks. It would probably suggest itself that a limit be set to notes issued tax-free by the Government Bank, and that a penalty be paid for notes issued in excess of this limit. The general scheme as roughly outlined above has this ad- vantage, that the control of the clearing houses over the indi- vidual banks would be strengthened, while it would, on the contrary, be weakened through the general emergency-cur- rency plan. The clearing house would, as a matter of course, examine the collateral against which a national bank proposed to take out currency from the Government Bank by means of the clearing-house certificate. The clearing house would thus be able, to a certain degree, to prevent the moneys so received from Washington from being used for any but strictly legiti- mate purposes. The clearing-house committee would have the right, but not the duty, to issue such certificates, and it could, through this power, hold a check on those institutions which it might re- gard as not sufificiently conservative. Moreover, the clearing- house committee would pass on the question in general whether (410) No. 4] A PLAN FOR A MODIFIED CENTRAL BANK 27 or not it would be well for the community to issue additional currency. The idea that the issuing of clearing-house certificates in itself implies the existence of a crisis would soon disappear, and before long the general public would be as little excited by it as is the German public when the limit of the amount of notes which may be issued without paying a tax has been reached. The issue of clearing-house certificates would mean, in general, that it is time to go slow, but it would not neces- sarily imply the imminence of a panic. The scheme as proposed above would have the further ad- vantage that clearing-house certificates, which now merely allow the banks to draw on their reserves, without increasing the currency, would serve in future as a means of providing additional currency, and while clearing-house certificates now materially increase the difliculty of settling the debits and credits between the various cities, they would, if used in the way proposed above, facilitate the intercourse between the cities. The Government Bank would act as the clearing house for the clearing houses. It is not beyond the bounds of imagination that local boards for branches of the Government Bank in the various cities could be established, taking the clearing-house committee or some members thereof as a nucleus around which some other independent members might be added. It is also possible that these agencies would receive moneys in one city in order to pay them out in the other, as is done by the Reichsbank of Germany. It is precisely in times of panic, when so much cur- rency is absorbed by unnecessary shipments from one place to another, that it would be a blessing to have a safe mechanism to act as a daily clearing house between the cities. There are, of course, many sides to this question which need further discussion and elaboration in detail. I have tried, however, to confine myself to the presentation of the rough outlines only of a plan which seeks to avoid all those aspects of a central bank which render it objectionable to many. In the bank contemplated the composition of its board is a guarantee that we shall not have " politics in business," and (41--) 28 BANKING REFORM IN UNITED STATES [Vol. IV the limitation of its scope of business eliminates all danger of selfish or speculative use of its moneys. At the same time we should be laying a broad foundation on which it may be pos- sible gradually to build a modern financial structure. This scheme will perhaps meet with opposition from the numerous small country banks which are not members of a clearing house, and which, of course, would prefer that each bank should have the right to issue emergency notes independ- ently for its own account. It is to be hoped that selfish consid- erations will not prevail in the solution of the problem, which is one of the most serious the country has faced for many years. Moreover, it should not be difficult gradually to work out some device, by means of which each clearing house would be enabled to take care of the banks of the surrounding cities. Above all, even if the scheme embrace for the present only the clearing houses in larger cities, there can be no doubt that it would prevent any recurrence of the present situation, which practically means a temporary suspension of payment all over the country. We need some centralized power to protect us against others and to protect us from ourselves, some power able to provide for the legitimate needs of the country and able at the same time to apply the brakes when the car is moving too fast Whatever causes may have precipitated the present crisis, it is certain that they never could have brought about the exist- ing outrageous conditions, which fill us with horror and shame, if we had had a modern banking and currency system. With our present methods our " elasticity " depends princi- pally on stock- exchange loans, while the most legitimate busi- ness, the purchase of commercial paper, causes a dangerous locking up of capital in single-name promissory notes, which under normal conditions cannot be resold. My previous paper fully explained that this is exactly the opposite of the European and of any modern system and that by modernizing the form of our commercial paper and by creating a central bank we should aim to transform our com- mercial paper from a non-liquid asset into the quickest asset of our banks. This change, however, is so far-reaching that (412) No. 4] A PLAN FOR A MODIFIED CENTRAL BANK 29 it would take years of educational work to carry it out, while relief should come at once. In creating a central bank with limited powers and in mak- ing clearing-house certificates the regular means of rediscount- ing and of taking out additional currency in times of scarcity of money — not a means to be used only as a last resort in a severe crisis — we should adequately meet the situation. To the single-name paper we should add the guarantee of the joint clearing-house institutions before making it the basis of our current notes, which, with the additional weight of the issuing Government Bank, would form a safe means of elastic circulation, based on the legitimate demands of trade and in- dustry. Incidentally, we should gradually extend the influence of the clearing houses and the Government Bank, not only o\er the finances of the whole country in general, but also over indi- vidual concerns, against the reckless financial management of which these bodies might feel called upon to discriminate. Instead of giving vast and vaguely defined powers, properly belonging to a central bank, to one or two political officers — possibly without business training — and instead of putting the burden and responsibility on them alone, we should define the power and responsibility clearly and should associate with our political officers in bearing it a large body of our best- trained business men. This would mean a democratic, a con-> servative, and a modern way of self-government. (41:) AMERICAN AND EUROPEAN BANKING METHODS AND BANK LEGISLATION COMPARED I A COMPARISON of European and American banking methods and legislation is so broad a subject that it cannot be fully dealt with in a single address. It will, therefore, be necessary to limit ourselves to the broad outlines of the subject. We shall endeavor to state the general basis of the banking business in Europe and to compare it with our own, and where European methods differ from each other in detail, we shall single out for the purpose of compar- ison that system which is generally acknowledged to be the most efficient. Furthermore, in speaking of Europe, we shall understand the term to mean primarily the three prominent financial powers, — England, France, and Germany. Let us begin by establishing the line on which modern bank- ing has developed. From the primitive method of bartering goods for goods, exchange gradually develops to the accept- ance of an acknowledged standard or measure, be it the ac- cepted value of an ox, a slave, a woman, a measure of grain, or a certain weight of metal. Those means of exchange which prove the most durable and, at the same time, are the handiest because, being the most precious, they absorb the least space, are finally evolved as the best measures of value. Thus gold and silver of officially certified weight and fineness have de- veloped as the coin and currency of nations. The next evo- lution is that, instead of accepting and carrying about clumsy masses of metal coins, the owner is satisfied to accept a cer- tificate of ownership of metal — the note. Here we see the first appearance of credit. Credit means, literally, faith; it is faith in the bank or government issuing the paper repre- senting the bullion. We reach a state of modern banking, (414) BANKING METHODS COMPARED 31 however, only when to this credit, which still means payment for each transaction in coin or coin certificate, are finally added other bank credits, which become part and parcel of the bank- ing system. This means that instead of paying by money only, the vast majority of the payments are effected through transfer of credits; it means payment by check. I need not dwell at length on this question of deposits and checks, as it has been fully dealt with in some of the preceding addresses. The check, however, is only one, although a very important one, of the factors that constitute a modern banking sys- tem; many other currency-saving devices which prevent the use and absorption of cash have to be added to render the system a perfect one. We must add a modern system of bills of exchange (by which we mean two- or three-months paper drawn on banks or bankers or indorsed by them) well regu- lated by clear and simple laws. As the check acts as a means of transfer of cash credits from one owner to another, so the transfer of the acceptance of a bank is the transfer of credits on time; it is like the transfer of banks' interest-bearing cer- tificates of deposit on time. We shall have to deed fully with this important question a little later. As parts of a modern banking system we must further add well-organized stock and produce exchanges and clear and simple laws regulating the administration of corporations, and the issue, the transfer, and ownership of securities. All these refinements of our business intercourse, if I may so call them, have the object and effect of minimizing the physical transfers of property, and of reducing to a minimum the dangers of such transfers by establishing well defined and generally accepted laws and regulations governing such transactions, by avoiding unnec- essary payments (through clearings), by liquidating whatever balances remain to be settled with the smallest possible use of currency, and by concentrating into large centers all offers for purchase or sale, so that on a common meeting ground of buyers and sellers the exchange of properties can be effected with the least expense, the least risk, and the least delay. To transform the unsalable individual part ownership or individual indebtedness into stocks and bonds having a wide (415) 32 BANKING REFORM IN UNITED STATES [Vol. IV market, and to standardize merchandise, is an important step in the development of this time-, risk-, and currency-saving device, without which modern banking is inconceivable. We have to add one more factor and a most important one. The partial replacement of money by instruments of credit must needs bring about, as a logical consequence, the neces- sity of reserves of money to meet these credit tokens, to re- deem which cash may of right be demanded. How large these reserves must be depends largely on the strength of the confidence — the credit — upon which the general structure is erected, and on the degree of perfection with which these re- serves may be made available. An ideal banking system is that which provides for the legitimate needs of a country at moderate rates with the maxi- mum use of credit and the minimum use of cash, which checks illegitimate or dangerous expansion or speculation, and which avoids or minimizes as far as possible all violent convulsions. We need not emphasize the fact that the European system comes very near accomplishing this ideal, while our system has proved palpably inefficient. Recent events have again brought it home to us that the richest and soundest country of the world went into a disgraceful state of temporary insol- vency, while European nations, poor by nature and loaded down with much heavier burdens than we, have weathered similar storms without any such pan^c and wholesale destruc- tion of property values. Let us consider, then, wherein our system differs from theirs, and let us see which component parts are missing in our machinery. II If we may anticipate our conclusions, we may say that our methods are completely opposed to those of European coun- tries. The European system aims at centralization, ours at decen- tralization. Europe believes in and has established a system of central banks, issuing an elastic currency which follows the requirements of commerce and trade and is based, more or less, on bills of exchange ; while the United States has so far (416) No. 4] BANKING METHODS COMPARED 33 refused to reestablish a central bank and persists in maintain- ing a system of inelastic currency issued by 6,500 banks. The European system is built on modern bills of exchange, which form the quickest assets; while in the United States, the re- discounting of paper by banks being practically unknown, the chief quick assets relied upon by the banks are call loans on stock-exchange collateral. Europe has a system of general banks with large capitals and branch banks all over the coun- try ; we prohibit a similar branch-bank system, and prefer a network of 20,000 small independent banks and trust com- panies. Europe believes in a system of monthly or half- monthly liquidations for stock-exchange transactions, while the United States maintains daily settlements. Europe has succeeded in working out for each country clear, generally ob- served, and uniform laws, regulating all commercial and finan- cial questions ; while in the United States not only do the laws differ in the various commonwealths, but the underlying prin- ciples are not so clearly and so definitely laid down as abroad, and every now and then the basis of the business structure is violently shaken by some new interpretation or legislation, or temporarily upset and endangered by sweeping injunc- tions. In order fully to understand the European system, it will be necessary to explain at the outset the importance of the bill of exchange in Europe in the financial intercourse among individuals as well as among nations. In the United States our commercial paper is the old promissory note, it is a bill; in Europe commercial paper is a hill of exchange. I think that I cannot more forcibly express the difference between the two. In the United States this promissory note is an invest- ment, in Europe it is a means of exchange. If, in the United States, this promissory note has entered the bank, it usually remains there until it falls due; if a New York bank, under normal conditions, should try to rediscount such paper, it would create suspicion and distrust. This means that every dollar invested by a bank in American commercial paper, that is, every dollar invested to satisfy the most legitimate require- ments of business, leads, without fail, to a locking up of cash (417) 34 BANKING REFOHM IN UNITED STATES [Vol. IV in unsalable assets. We have been shown bricks of the time of Hammurabi, the Babylonian monarch, evidencing the sale of a crop and similar transactions, and I am inclined to believe that it was as easy to transfer the ownership of these bricks from one person to another as it is to-day for an American bank to realize upon its discounted paper, if indeed it was not easier. Let us now observe the absolutely reverse method of the European countries. In Europe there are scores of banks and private banking firms that give their two- or three-months' ac- ceptances for the commercial requirements of trade, or that make it their specific business to indorse commercial bills. A commercial borrower in those countries who does not get a cash advance will do one of two things : he will either sell to his bank or his broker his own three-months' bill, drawn on a banking firm willing to give him this credit; or he will sell the bill drawn by him on his customer in payment for goods sold to him, which bill may be subsequently passed on with the indorsement of the banker. Through the addition of the established credit of the acceptor, or by the various indorse- ments on the bills, the quality of the bill becomes such as practically to eliminate the question of credit and risk, and the conditions of the sale will depend only on the rate of in- terest. From being a scarcely salable promissory note, the ownership of which entails a more or less pronounced com- mercial risk, the paper has been transformed, if I may call it so, into a standard investment, the equivalent of which in cash can be easily secured at any time. This prime constituent of the European banking machinery is entirely missing with us. Its existence is, however, most important. Without such paper, the government banks of Europe could not accomplish their work; and vice versa, the role which this paper generally plays in Europe's financial household is dependent on the existence of central banks. The two cannot be separated. It is one of the main duties and privileges of the govern- ment banks to buy legitimate commercial paper, with bank- ers' acceptances or bankers' indorsements. As the govern- (418) No. 4] BANKING METHODS COMPARED 35 ment banks buy this paper, the circulation of the notes which they issue in payment increases, and on the other hand, as they collect this paper upon maturity and reduce their dis- counts, their outstanding circulation decreases. This means that they expand or contract according to the requirements of trade. However, this is not a merely automatic process. For as those intrusted with the management of the government bank see the necessity of exercising a restraining influence, they raise the rate at which the bank discounts, and in this they are generally followed by the other banks of the country. In the same way, if the government bank finds it advisable for any reason to discriminate against the paper or the securi- ties of certain groups or individuals, general discrimination by the other banks will usually follow. It might be well to add that the European government banks are not limited to- the purchase of paper, but that they also have the privilege of making advances within certain limits upon securities up to a fixed percentage of the market value, according to stated pub- lished schedules. The rate, however, at which such advances may be made, as well as the government bank's discount rate, is uniform for everybody and is, as a rule, so much higher than that of the general banks, and the restrictions as to the character of the securities on which the government bank may advance are so much more rigid, that in normal times the bulk of the business is done by the general banks. Only when the demand for money increases does the rate of the general banks begin to approach that of the government bank; but in that case the government bank will, as a rule, raise its rate, so as again to increase the margin over that of the general banks. The government banks consider themselves, more or less, as constituting the national reserve, ready to take an active part in the nation's business only in times of emergency. A dis- tinction is, however, carefully to be drawn between the ab- normal crisis and what we may call the normal emergency which arises regularly in consequence of certain economic de- velopments, like crop movements or particular requirements for special industries at fixed periods, and which, as experi- ence has shown, subside after a time as regularly as they (419) 36 BANKING REFORM IN UNITED STATES [Vol. IV occur. When these normal emergencies arise, the banks do not unduly raise their rate, but for the time being meet all the requirements at a given rate, and allow their circulation to increase, while the reserves go down. When the government banks anticipate, however, that more than a normal emergency will have to be dealt with, they continue to raise the rates in order to protect their reserves and to force liquidation, and in order to deter all branches of industry and trade from en- tering upon far-reaching new engagements. The notes which the government banks are allowed to issue are limited by the amount of gold and bullion which must be held to cover them in full, or, as in Germany, up to at least 33%. It would, however, lead too far astray to go into the details of these special regulations which govern the issue of notes in the different countries. It will suffice here to out- line the general rule. Each government bank has a very de- cided interest in keeping its gold holdings as large as possible, and in preventing the gold from leaving the country. If an augmented demand for money and credit accommodation in- creases the amount of notes outstanding, the government bank, by raising its rate, purposes not only to encourage a general contraction of business, and to force the general banks of the country to contract, but also to attract foreign money into the country. If England has a private discount rate of, say, 6%, that is, if first-class commercial paper accepted or indorsed by banks can be bought on an interest basis of 6%, and if at the same time, there is in France a discount rate of 4%, it stands to reason that the big French banks and the French public will invest in English bills, and that French money will go to England. The same holds good, of course, as to Ger- man, Austrian, Russian, or Scandinavian bills. It is, for in- stance, well known that at present, while rates in Germany are high and in France comparatively low, hundreds of mil- lions of German paper are held by the French banks. The French banks would not buy the individual note of an English, German, Russian, or Scandinavian merchant whom they do not know; but they do know, and must know, the value of the acceptance or the indorsement of the foreign (420) No. 4] BANKING METHODS COMPARED 37 banks, which offer and indorse or accept this paper. They would not buy this paper, unless they knew that it could be rediscounted at any time through the existence of a central bank in the home country. None the less, however, the bulk of the business transacted by a central bank is only a fraction of the total business of the country, and is, in normal times, limited almost entirely to the purchase and collection of short bills. The mere existence of the central bank, however, en- ables the general banks to discount freely; and as everybody thus discounts freely, there is the widest possible market for discounts even without any active purchases by the central bank. While we cannot attempt to give any full description of the working of central banks, it may be well to add that some, like the Banque de France and the Reichsbank, have hundreds of branch offices, spread all over the country, which, in Ger- many in particular, have developed an admirable system of collection and of transferring moneys from one place to an- other. It may also be interesting to note that, contrary to a widespread idea, the central banks of Europe are, as a rule, not owned by the governments. As a matter of fact, neither the English, French, nor German government owns any stock in the central bank of its country. The Bank of England is run entirely as a private corporation, the stockholders elect- ing the board of directors, who rotate in holding the presi- dency. In France the government appoints the governor and some of the directors {regents). In Germany the government appoints the president and a supervisory board of five mem- bers, while the stockholders elect the board of directors. The German government receives three-quarters of the profits after the stockholders have received a dividend of 3^%. Thus the central banks are independent of direct government interference, or there is a joint control by government and stockholders. But the government is the largest depositor of the bank, and is thus obviously, both for its own credit and for the welfare of the nation, vitally interested in maintaining its credit at the highest possible point. The consequence of a broad bill market is that, whereas (421) 38 BANKING REFORM IN UNITED STATES [Vol. IV our banks keep against their defSosits primarily call loans on stock-exchange collateral, a European bank or banker will keep against his demand obligations a large amount of bank- ing paper, which he can sell at any time at the discount rate, without causing any such commotion as is created with us when call money is rapidly withdrawn from the stock ex- change. Call-money rates and their daily fluctuations do not directly affect European stock exchanges. Europe has developed a system of monthly or half-monthly settlements on its stock exchanges, which means that from one settlement to another, the amount of cash required by the stock exchange remains stationary. If, at the settlement, it develops that commitments on the stock exchange have increased, and that a larger amount of money is needed for stock-exchange loans under normal circumstances, so much more money will be withdrawn from the bill market and go into the stock exchange. If less money is wanted by the stock exchange, so much more will go into the bill market. We cannot dilate fully on the interesting question of the comparative merits of daily versus monthly stock-exchange settlements. It may, however, be said that if it is a saving not to settle each transaction by individually de- livering and paying for each purchase and sale, but to pay and deliver only the balance of the whole day's transactions by one clearing (without which it would be impossible to deal in a million shares a day), then the saving would be still further increased if the clearings covered not only one day, but a whole week or a whole month. It might, however, be asked: Why not then clear only once a year? The answer is that, until the transaction is actually paid for, there is a risk that with wide fluctuations one of the contracting parties may not be able to pay the difference between the price on the day on which the business was concluded and on the day when it would be finally settled. That is the reason why settlements in England do not exceed two weeks, and why in New York they should probably not exceed one week, for which period some method of clearing the differences daily or of securing them by collateral might easily be devised. (422) No. 4] BANKING METHODS COMPARED 39 The present American system of daily settlements, how- ever, combined with the lack of a central bank and of modern paper, brings about the shocking conditions from which we are suffering. It is a fact that in Europe, where settlements exist, such wild fluctuations as prevail with us are unknown, except in our own securities. Our much-maligned stock exchange is the scapegoat of the nation ; if trade contracts, the surplus money from the Atlantic to the Pacific is thrown on the stock exchange, creating easy money and encouraging speculation in securities just at a time when speculation ought to be slow. If industry and trade thrive, and are in need of money, call loans are withdrawn from the stock exchange, and, the more money is required by commerce and industry, the more the stock exchange will be depleted. The usual consequence is our annual money panic, and a resulting violent collapse of prices of securities. This obnoxious system of cash dealings is forced ujDon us as the result of our unreasonable usury law, which, although making it unlawful to take more than 6% on time loans, is in reality the direct cause of an almost confiscatory rate being charged from day to day for weeks at a time. We shall dwell upon this law later. The fact remains that with a legal limit of 6% for time money, and with the desire of the banks not to charge merchants a higher rate, and with the lack of any mod- ern paper which we could offer to other nations, there remain practically only two means of relieving the stringency and of attracting foreign money. These are the utilization of for- eign credit, through long bills drawn by our banks or bankers on Europe (and these could hardly be used during the last crisis in consequence of England's drastic measures) and in- credibly high rates for call money, that bring about wholesale realizations and attract foreign buyers at our bankruptcy prices. Banks have been blamed for the high rates and for having had so much money on the stock exchange. They are abso- lutely helpless with regard to both. How could a bank with- stand a run, if it had all its money in unsalable commercial paper, and how is a bank to meet the demands made upon it (423) 40 BANKING REFORM IN UNITED STATES [Vol. IV Otherwise than by drawing upon its quick assets, viz., its call loans? It is our system that is wrong from top to bottom; it is this and not the individual that is to be blamed in this respect. The aggregate amount invested in trade and commerce must vary. Its grand total should be many times the amount invested in stock-exchange loans, which represent the securi- ties carried for speculative investors. Our way of doing busi- ness may be illustrated by two adjoining reservoirs, a small one and a very large one. The small one represents the stock exchange and contains the call loans; the large one represents the general business of the country, as expressed by commerce and industry. In Europe they regulate the small reservoir by pumping water into it from the large one, or by withdrawing water from the small reservoir into the large one. In this way, the outflow and inflow in the large reservoir are scarcely per- ceptible, and there is no difficulty in regulating the small one. With us, we do the reverse. If there is a shortage of water in the large reservoir, we begin to draw on the small one and, in order to increase the water in the large reservoir by an inch, we empty the small one altogether or, in order to decrease the amount of water in the large reservoir by an inch, we fill the small one to the overflowing point. Moreover, Europe can tap a third reservoir, the additional currency issued by a cen- tral bank, with which to regulate the large reservoir if it fluc- tuates more than a few inches, while with us no such final reserve exists. As a consequence, fluctuations of several feet appear to be inevitable and regular occurrences with us. It may be added that not for many years has the European reser- voir shown such variations as this year, and we must sadly admit that Europe's abnormal rates were due largely to our own unbalanced conditions. Unable to regulate our own household and to use our own gold, we have accustomed our- selves to use and to abuse Europe, which suff'ers intensely from our lack of a proper system. (424) No. 4] BANKING METHODS COMPARED 41 III Let us now add a few words about European and American banks in general. We have in the United States national banks, state banks, and trust companies, practically without any proper line of demarcation ; they are all, more or less, doing a similar busi- ness, except that the national banks have the privilege and duty of providing currency against government bonds. In Europe we find the privilege of note issue restricted to the government banks, which are hemmed in by such regulations as to keep them out of speculative business or general com- mercial transactions. Whenever a note-issuing bank desires to enter upon general business, it has to abandon the privilege of issuing notes. Outside of the note-issuing banks the only European banks that are regulated by law as to their investments and their way of doing business are the savings banks. For all other banks there is no government supervision, there are no laws as to their reserves against deposits, and no restrictions as to indorsing or establishing branch banks. On the contrary, ac- cepting, discounting, and indorsing paper form the essence of Europe's banking, which is built up on a system of old, es- tablished, very important general banks with large capital and with a network of branch offices and agencies all over the country, and in the centers with many branch offices in a single town. On the whole, this system of making large re- sponsible banks and their branches the custodians of the peo- ple's money is preferable to our system of allowing a few, often irresponsible, men to get together, hire some ground- floor corner, fit it up in marble and bronze, and call it a bank, with a capital of $100,000, and often less, and a corresponding surplus paid in, not earned. Small banks constitute a danger, particularly so if they accumulate deposits which are 'out of proportion to their own resources. There is an old French and Italian banking rule that deposits ought not to exceed four or five times the amount of capital and surplus. This rule is certainly a wise one for a country with so imperfect a banking organization as the United States. (425) 42 BANKING REFORM IN UNITED STATES [Vol. IV While Germany and France may claim the best government bank organizations, there has been too much concentration in the business of the general banks of these two countries. The German and French banks have accomplished a wonderful piece of work, but their system of " taking it all," being banks of deposit, discounters, acceptors, indorsers, brokers, and un- derwriters at the same time, is not free from danger. Not that there is risk of their getting involved, but there is too much elimination of independent firms, which constitute a. val- uable backbone, especially in times of need. In Germany, where this process has been most marked, there is a strong movement on foot to undo the harm that has been done. The English system has, in this respect, so far proved the best, for the reason that, while they have large deposit banks with branch offices all over the country, they have kept these deposit and check banks comparatively free from commission, investment, underwriting, and kindred operations. In Eng- land the investment and the commission business remain mainly with the broker, while the contracting of large loans and the formation of syndicates is generally left to private firms, or if it is a question of South American, Oriented or colonial loans, to the banks which confine themselves to busi- ness with these countries. Again, there are foreign exchange houses and firms conducting exclusively an accepting and in- dorsing business ; and finally, there are the big discount com- panies. One might say that every branch of these various enterprises is taken care of in an able and efficient manner in England ; business is done at fair rates and at the same time substantial profits are earned. In Europe the general banks are not required to hold gold reserves. Gold reserves are kept exclusively by the note-issu- ing central banks, which have outstanding demand obliga- tions payable in gold. We ought carefully to draw the line between a working re- serve and a gold reserve. A general bank has no need of a gold reserve. But every general bank or financial institution ought to have a large working reserve against its demand ob- ligations. Such working reserve, however, need not consist (426) No. 4] BANKING METHODS COMPARED 43 of legal-tender notes, but of such assets as can be quickly turned into cash credits; be it call loans, bank paper, British consols, or whatever can readily be made available in times of stress. In addition, the European banks generally have very large on-demand deposits, especially with the central bank of the country, and, of course, a substantial amount of actual cash, as it is required for the daily needs of the business. But why should state banks or trust companies or national banks, if they happen not to issue notes, carry gold reserves? For their own protection they need strong working reserves, but, if it were not for our lack of a central bank and for the shortcomings of our treasury system, why must they lock up legal-tender notes to such an extent? In Europe the gold reserve and the emergency reserve of the country are kept and managed by the central bank. We have already shown how the government bank acts in pro- tecting the country and in providing for its needs. Let us clearly understand that without the bank rate, that is, without the ability to regulate the rate of interest in times when the government bank's cooperation is needed its efficiency would be nil. A system of modern banking paper is absolutely nec- essary to establish this power of the bank, and furthermore, a credit so firmly established that the higher rate of interest will act as an inducement to invest and not as a breeder of distrust and an incentive to realize. A further requirement is a sys- tem of large and conservative banks that will cooperate, and that, as a matter of fact, cannot afford to abstain from falling in line with the general tendency initiated by the central bank. With such a system, a panic like the one from which we are just emerging should be impossible. For no matter whence money is withdrawn, it would turn up in another bank. It is inconceivable that conditions would nowadays arise in either England, Germany, or France where people would lose entire confidence in all banks, government banks and savings banks, so that actual hoarding and locking away of money would occur. Our worst hoarders, the banks and trust companies, would, under a European system, have no reason to lock up actual money, since they would be fully protected by accumu- (427) 44 BANKING REFORM IN UNITED STATES [Vol. IV lating a balance with the central bank. The unheard-of fact that during a scarcity of currency the banks, instead of dis- bursing their cash, begin to accumulate and actually to hoard currency, would be an impossibility. There are two different kinds of panics or crises with which a nation may have to deal. One is a domestic drain, created by strong domestic demands, degenerating into a panic by some catastrojjhe engendering the fear that the supply of money will reach an end. Such panics must be met by paying out freely and boldly. Bagehot says : A panic, in a word, is a species of neuralgia; and according to the rules of science, you must not starve it. The holders of the cash reserve must be ready, not only to keep it for their own liabilities, . but to advance it most freely for the liabilities of others. In wild periods of alarm one failure makes many, and the best way to pre- vent the derivative failures is to arrest the primary failure which causes them. And further on he says : It is not unreasonable that our ultimate treasure in particular cases should be lent; on the contrary, we keep that treasure for the very reason that in particular cases it should be lent. Another kind of panic may arise through a drain from with- out. Such drain must be met in modern countries by increas- ing the rate of interest until the tide has turned, until the creditor finds it more profitable to leave the money where it brings attractive interest than to withdraw it. Both kinds of panics have been successfully met, or have been entirely averted, in Europe by central banks and by a firmly estab- lished credit. Germany, for instance, without such a system, would now be in the midst of a panic ; but she has safely avoided it, in spite of her being by nature a poor country, while we, nature's spoilt children, need only be wise to be rich and safe. ' As it is, neither can we protect ourselves by a discount rate, there being no discount system, no central bank, and no legal rate beyond 6% ; nor can we meet an internal panic because, (428) No. 4j BANKING METHODS COMPARED 45 irrespective of other shortcomings of our system, it forces each bank to look out for itself and to try to draw away the cash from the others, in order to increase the amount in its own vaults, thus aggravating the panic. While the only way to meet a panic should be to pay freely, any bold action is para- lyzed by the frightful thought that there is no way of creating additional currency, and by the knowledge that, if the drain continues, there are no means of preventing wholesale indi- vidual failures unless general suspension of cash payments is adopted. .While one thousand millions of dollars were lying idle in our banks and trust companies as so-called reserves, that is, as the final resort in case of need, this money, by vir- tue of the law, could scarcely be touched ! What, then, is the use of such reserves, if they are not available in such times, and if, even in contravention of the law, they could not be used by one bank without fear of being ruined unless all banks agreed to use them freely? And as it is impossible, even without such a law, to make all banks act in the same bold way, it follows that I'eserves should be concentrated, as they are in Europe, and that while the banks may be asked to cooperate, they must be governed in this respect by one cen- tral organ. The question of treasury and government-bond secured bank notes has been so fully and so ably dealt with by Mr. Hepburn in a preceding address, that I can limit myself to the hearty indorsement of what he said in this respect. The net result of our system is that immense amounts of gold and currency are wastefully locked up, and that, in spite of our immense gold treasure, which is four times as large as that of England, and notwithstanding our enormous per capita circulation of thirty-five dollars, we suffer almost annually from acute scarcity of money. If we only had the means energetically to contract our cur- rency, and to use our gold in a scientific and a practical way, we should have gold and currency enough to meet any panic. As it is, the amount of notes outstanding is about stationary in times of activity or stagnation alike, while as a consequence the rates for money vary between zero and 200%. In Europe (429) 46 BANKING REFORM IN UNITED STATES [Vol. IV it is the reverse; rates are fairly stationary and the amount of notes outstanding contracts and expands. With a cash bal- ance of $260,000,000 during the recent crisis, our govern- ment had to incur new indebtedness to enable and to induce the banks to issue additional currency. Within three months the circulation increased through this artificial process by eighty million dollars, but the government had to lose about $1,000,000 of the people's money to reach this result. On the other hand, the German Reichsbank issued in one week, at the end of last December, M. 320,000,000 and the government received a 5% tax on this issue, which is borne by those who received the money. These notes returned to the Reichsbank within less than three weeks. Our present system of maintaining and selling government bonds on a basis so high that only national banks can buy them results in constant inflation of our currency by about 75% of the amount of new government securities issued from time to time. Inflation with practically no contraction ! It would be cheaper and more straightforward if the govern- ment, instead of issuing interest-bearing government bonds, would issue new greenbacks. It amounts to the same thing, and the government would in addition not lose the interest. Furthermore, our one-man-power system of the treasury is contrary to European ideas; it is harmful to the country and unfair toward the incumbent of the office. While our genera- tion has been particularly fortunate in seeing this office occu- pied by honest and able men only, the danger remains, never- theless, that this vast power may one day be vested in less de- sirable men. Besides, the laws governing the functions and powers of the Secretary of the Treasury are old-fashioned, in parts too loose and in parts too extreme, and not clearly de- fined, so that even under the same President we find a radi- cal change from one method to another, according to the indi- vidual interpretation by the incumbent of the office. This lack of continuity is injurious. Europe does not give such vast and arbitrary powers to one single political official, holding office for a comparatively short time only, and often without proper business training. On the contrary, the powers, (430) No. 4] BANKING METHODS COMPARED 47 clearly defined and properly restricted, are vested in a per- manent non-partisan body of business men of the highest standard, thus constituting a system which insures clear legal conditions, safety and continuity. IV A similar difference exists between the United States and Europe as to general legislation governing banking transac- tions and corporations. In dealing with these questions it is not my intention to accuse anybody or to excuse anybody ; the only object of this investigation is to explain certain funda- mental shortcomings of our system. Modern banking is built upon gold — and confidence. The question of how to estimate working reserves, business risks and profits, as well as the general valuation of securities, all these are indissolubly interwoven with the other question of how firmly established is the confidence on which the whole structure rests and how far this confidence is liable to be shaken in normal and in troublous times. The basis of confidence is an immutable belief in the con- tinuity of political and social conditions, which are held to be safe and sacred. There must be faith in the continuity of the form of government, in the continuity of the legal status, and in the fair observance of law by government and governed alike. There cannot, however, be confidence in the continuity of the laws until they rest on a broad, equitable basis, and are fairly uniform over the entire country. There is nothing so harmful and so dangerous as the existence of two laws, the one a written law, unenforced and often impossible of enforce- ment, the other a customary law, which stands unchallenged for generations and which the written law cannot override, often because the latter, enacted in haste or hate, is incom- patible with reasonable business usages and necessity. Just and uniform laws, universally observed and equably enforced, imply wholesome government regulation. Loose or extreme laws that cannot be observed and that, therefore, are not generally enforced, but that may be suddenly and spasmodically enforced according to the whim of the people (431) 48 BANKING REFORM IN UNITED bTATES LVol. IV or of the party in power (yesterday a dead letter and to-mor- row a firebrand), imply anarchy or autocracy. In financial matters Europe has advanced far in attaining the former con- dition; we have made little progress in emerging from the latter state. To cite only a few instances : If the full taxes on capital, at present about i.68%, were exacted and paid, no capitalist could remain in New York. If banks did not over-certify, our financial centers would have to stop business. If it had not been possible to pay rates far exceeding 6% for time loans, it would not have been possible a few weeks ago to draw so much gold from Europe, where money rates were above 6%, and the catastrophe would have been still worse than it was. But, fit venture to ask, why is it necessary to force people to evade the laws in order to carry on business? Among the important laws that have a distinct bearing on the banking situation, and that are in great need of revision, I should specify the following: In the first place is to be put the usury legislation of our separate states and especially of New York. The usury laws in Europe, where they exist at all, apply only where the bor- rower is in dire distress when seeking and accepting a loan, and where the individual or corporate lender knowingly profits from his helpless situation when exacting usurious rates. Usury can be judged only in the light of the surrounding cir- cumstances; and usury laws in Europe generally apply only to individuals. Our law, which prevents solvent firms of bankers, merchants, manufacturers, or brokers from contract- ing for money on time at more than 6%, implies not only un- dignified tutelage, but unsound business judgment. The re- cent crisis has shown that it was not taking advantage of peo- ple in need to give them money on time at over 6% ; on the contrary, it would have been a blessing, and in many cases their salvation, if they had been able to receive the money at even a much higher rate. This unsound and completely inde- fensible usury law is, however, the reason why we must have (432) No. 4] BANKING METHODS COMPARED 49 daily settlements, and in this and other ways it indirectly leads to frequent convulsions of our money rates. Secondly, the lack of a modern system for discounting com- mercial paper in the United States is due to the want of uni- formity and precision in the laws governing bills of exchange and bankruptcy. This uncertainty as to procedure forces us to prefer the well-defined promissory note — however unsal- able — to the business of accepting and indorsing commercial paper at the low commissions customary in Europe. Further- more, since our commercial business is chiefly financed by the national banks, it is a foolish regulation that prevents their indorsing or accepting such paper to any extent, in order that they may carry out the purely secondary object of issuing bank notes. Another diff'erence between Europe and America that af- fects the banking business is the regulation of the issue of se- curities. Stock watering, that is, capitalization of earning power and of goodwill, is permitted in England and France, while it is not allowed in Germany. While, personally, I prefer the German system, it is a mistaken idea to think that the capitali- zation of earning power necessarily means taking advantage of somebody. If the German sells at 200% an industrial stock paying 10% dividends, it amounts to the same as if the Eng- lishman had sold at par twice the amount of shares, on which a 5% dividend is paid. But whether we adopt the one system or the other, it is of the first importance that the public should be fully informed as to the real value of the stock which it ac- quires, and that the law should be clear and definite in its terms, and equal rather than erratic in its enforcement. In Germany the law makes all public offerings of securities and applications for listing on the stock exchange dependent on the publication of a full prospectus. This document must contain all facts of importance concerning the security offered and must be submitted to, and approved by, a state commis- sioner. Anybody withholding information, or furnishing wrong and misleading information, is criminally liable. At the same time, the law requires that balance sheets be pub- (433) 50 BANKING REFORM IN UNITED STATES [Vol. IV lished regularly, and where the issue deals with a new flota- tion the prospectus must state clearly the value and the price of the properties transferred to the corporation at the time of its incorporation, and in certain cases also the names of those from whom they were bought. We come finally to one of the most important of the subsi- diary points affecting our banking system, namely, the rela- tion of the directors to the corporation. In most of the Euro- pean countries, particularly in Germany and France and, to a certain extent, in England, this relation departs radically from our custom. The French and German corporation is man- aged by a board of directors and salaried managers. The latter are not members of the board, as is the managing presi- dent with us. The board of directors in Europe supervise the managers, who have to report to the board about their acts and proposed acts, in order to secure their sanction. The rule is that both the managing officers, whose fixed salaries are comparatively small, and the board of directors share in the profits of the company. The stockholders ordinarily receive the first 4%, while of the surplus over 4%, a certain propor- tion goes to the managing officers and their staff and to the board of directors. As the corporation grows, the percentage going to the directors and the managers is frequently modified to whatever the shareholders consider a fair compensation. The net profit of the forty-five important German banks for 1906 was M. 231,000,000. The aggregate capital of these banks was M. 2,198,000,000 with a surplus of M. 542,000,000, making their total resources M. 2,740,000,000. Of this net profit about M. 200,000,000 were paid out ; about one-seventh, viz., M. 28,000,000, was paid to the managers and staff and to the directors, while the remaining six-sevenths, being M. 171,000,000, were paid to the stockholders, being an aver- age dividend of 8.07%. The underlying idea is a very different one from our own. The European maintains that, in order to hold any one liable in case he does not perform his duty, one ought to pay him if he does. In Germany, for instance, if a director does not act with what would be deemed ordinary business prudence, and (434) No. 4] BANKING METHODS COMPARED 5 j if he neglects his duties, so that the company suffers loss, he is made personally liable. In the very rare ca^es of bad bank failures which Germany has witnessed, like that of the Leip- ziger Bank, — which, however, owing to Germany's admirable system, passed by without any panic — the directors, among whom were men of many millions, lost all they possessed. While the law is thus very rigid, it does, on the other hand, not require the director to be anything more than honest, or to do anything more than use the utmost possible care. But the board members in a bank, who receive quite a large in- come through their share of the profits, realize that they must in turn devote a good part of their time and energies to the interests of the bank. All corporations, like the big shipping lines, the industrial concerns, and the insurance companies, are run on exactly the same system. As a result, the so-called dummy director, so familiar to us, does not exist, because every director is materially concerned in seeing to it that the interests of the company are fully safeguarded at all times, and that no one director or manager receives any profits that might be determined to the corporation ; while at the same time this system makes the directors disinclined to consent to over-capitalization. With us, on the other hand, the laws and usages regulating the relations of director to stockholder need much moderniz- ing. We do not pay our directors, for ten dollars or so per meeting cannot be considered a remuneration. Under the old system is was considered good style to be on the board of a bank, as it was to be on philanthropic, religious, or educa- tional boards ; membership was, in fact, largely a social func- tion. Or, on the other hand, some individuals were willing to join a board without any compensation, because it was their own business that they were managing; e. g., their own rail- road, for which they had to supply the wherewithal them- selves, and the territory of which they had to open by taking up farming or mining or by starting other industries. In such cases they sometimes made money and sometimes suffered heavy losses; but on the whole, it was this system of directors as chief stockholders and ever active prospectors, assuming (435) 52 BANKING REFORM IN UNITED STATES [Vol. IV large risks themselves, that developed the country and made it what it is to-day. In the course of time, however, as the corporations grew in size and number, directorship ceased to be a social function, and the corporations ceased to be the property of a few. They became the property of a large community of stockholders, and the directors, from being majority stockholders, slowly be- came trustees. With the evolution of the modern conception of trusteeship has come the present tendency to endeavor to tie the director hand and foot and to hold him liable if anything goes wrong with the corporation. But let me ask, what right has one shareholder substantially to say to the other: "Go on the board, work for me, worry for me, give your time and spend your energy; I shall not pay you for it, but I shall hold you strictly accountable if anything happens to my company. If you chance to have a business of your own, and if you find any time left for it, be very careful not to do any business with my company. Leave that privilege to me. Because you work for me, you lose that privilege; and because I do not work for you — I retain it." That is virtually the present attitude of the American stockholder and to a certain degree the legal status of the director. Let us do as the Europeans do, let us remun- erate our directors in proportion to the dividends they earn for us, and then we shall not only have the full right to hold them liable and to ask them to give up certain privileges, but we shall at the same time have greater certainty that every di- rector will be careful to do his best. Banking, like almost all other commercial transactions, is in reality an insurance business. For each risk, we ask and receive a premium commensurate with the hazard of the trans- action. In a city built on volcanic ground the insurance premium is high. Bankers' profits in America are higher than in Europe; but they must be high so long as, for lack of modern banking methods and of uniform and well-established laws, we live financially on volcanic ground. We have just passed through a pretty lively earthquake, and the losses which wiped out the profits of years show conclusively that the (436) No. 4] BANKING METHODS COMPARED 53 premiums earned were not too large in proportion to the risk. Do not let us blame the insurance company, but let us be doubly careful to build only in steel and stone and let us build on solid ground. For, luckily, in this instance it is within our power to transform that volcanic ground into a solid foun- dation. We are apt to think that our problems are peculiar to us and that we must find our own way of solving them. If we had only realized that American and European history is being written with the same ink, that man is man, with similar virtues and similar vices, on both sides of the Atlantic, we might have learned much from experience, and might have been able to avoid much amateurish and harmful legislation. Germany also had many sovereign states which ultimately formed a union. In each of these states there was a different legal system, — German law, Roman law. Code Napoleon and all kinds of local laws. Yet Germany organized a commission, which worked for twenty-five years and which finally com- pleted a code of laws to govern the entire country. A uniform commercial code had, in fact, been created far earlier, and Germany has now for many years been enjoying the advan- tages of uniformity. With us, also, there are surely many questions, social as well as commercial, on which the Etist and the West, the North and the South, can agree, and on which uniformity of state legislation can be secured — if for no other reason than to avoid the much-disliked federal regulation. In Germany, Sweden, and Switzerland — the last of the countries to adopt a central bank — we find that obstinate oppo- sition was long directed against the creation of such a central institution, chiefly by the then existing numerous banks of issue, which feared lest their business might suffer. In each country in turn the very banks that were forced to abandon the right of issue in order to become banks of discount and de- posit acknowledge to-day that they have derived nothing but profit from the change, and that the central bank has con- ferred unalloyed benefit on the entire country. (437) 54 BANKING REFORM IN UNITED STATES [Vol. IV V While our investigation has disclosed the nature of the ideal, it has, at the same time, also made it evident that we are still far removed from this ideal; so far, in fact, that any at- tempt to reach it immediately would be futile. We can, in- deed, advance only step by step, but I am convinced that we shall never attain the summit of our ambitions or reach a com- pletely satisfactory condition until we have worked our way to a central bank and to the adoption of clear and equitable stat- utes. We cannot secure uniform laws promptly, but we can begin by modifying some of the laws mentioned above, which are incompatible with common sense, and by creating truly re- sponsible boards of directors like those in Europe. We cannot have an effective modern central bank, because there are no modern American bills of exchange, and we can- not create a sufficient amount of modern paper without a cen- tral bank. We cannot have stock-exchange settlements with- out the abolition of the usury law; but even after its abolition we must have a bill market before we can do away with daily settlements and call loans, based on these daily transactions. Nevertheless, every one of these changes will have to be ef- fected some day, and it is all-important that each successive step in currency and banking reform be made with this end in view. From this standpoint it is evident why neither the Aldrich bill nor the Fowler bill can be deemed to be a step in the right direction. Every measure is bad ( i ) which accentuates decentralization of note issue and of reserve; (2) which uses exclusively bonds as a basis for additional circulation; (3) which gives to commercial banks power to issue additional notes against their general assets without restricting them in turn in the scope of their general business, and without creat- ing some additional independent control, indorsement, or guaranty; (4) which gives arbitrary powers exclusively to political officers, often untrained in business, and usually hold- ing office only for a short period. A central clearing house, with power to issue against clear- (438) No. 4] BANKING METHODS COMPARED 5 5 ing-house certificates notes to be guaranteed by the United States, would, in my judgment, form the best solution for the time being. The creation of a central clearing house with a capital of its own and with a limited dividend, the surplus revenue going to the United States, would leave present con- ditions undisturbed, and, while offering immediate relief, would at the same time form a sound basis for future develop- ments. The plan would possess the following advantages : — 1. The clearing house would have its own gold reserve. 2. It would centralize the additional note issue and would therefore do better service in permitting legitimate expansion as well as in forcing effective contraction, which, with sixty- five hundred independent note issuers, is well-nigh impos- sible. While additional notes issued by a bank mean an increase of deposits, which may perhaps be called any day or which, on the other hand, may remain forever, an advance by the cen- tral clearing house would be made to the banks for a given period, after which the money must be returned. It would, therefore, be safer for the banks, and would at the same time insure contraction after a certain time, as in Europe. 3. The central clearing house would be able to accommo- date commerce and industry in times of need by accepting commercial assets, provided that they are recognized as legiti- mate and safe by the indorsement of the local clearing houses. 4. It would leave our national banks without any further independent note-issuing power, and would in this respect be beneficial ; for additional note-issuing power should logically carry with it further restrictions as to their privilege of doing a commercial business, whereas their privileges in this respect should rather be increased. 5. Through the share in the profits reserved for the gov- ernment, the latter would receive some return on the funds which it would deposit with the banks through the central clearing house, whereas at present the government does not receive any such return. 6. It would form a medium through which gold loans (439) 56 BANKING REFORM IN UNITED STATES might be contracted with European government banks in a way similar to that by which transactions have been concluded between the Bank of England and the Banque de France. 7. If there were formed to supervise the management of the central clearing house a central board administered by sal- aried managers, as in Europe, and comprising business men, largely selected from the clearing-house committees, as well as political officials, it would eliminate the arbitrary powers which the Secretary of the Treasury is now called upon to ex- ercise, and it would create a continuity of policy, which is most essential for the development of the country. 8. Finally, it would show that this country is able to pro- duce a body of men as honest, as trustworthy, and as efficient as those into whose hands Europe has confided the care of its central banks. As the confidence in this body grows, as the banks come to feel its beneficent influence, the powers of this clearing house may gradually be increased, and thus from the joint indorsement by the clearing houses we may gradu- ally gain our way to the indorsement and acceptance by indi- vidual banks, so that we may finally be able to develop a cen- tral organ which, safeguarded from political and from finan- cial domination and rigidly restricted as to its scope of busi- ness, will place us financially in a sound and healthy condition and will cause us in this domain, as in others, to be respected as a modern and completely civilized nation. (440) A CENTRAL BANK SYSTEM AND THE UNITED STATES OF AMERICA IN dealing with the problem of a " Central Bank of the United States," one should properly discuss first the ad- vantages and disadvantages of the central bank system in general, and then the particular problem of a central bank of the United States. For the purpose of this discussion, however, I may take it as a matter of common agreement, that in the present state of our civilization, wherever circumstances permit of its establish- ment, the central bank system is the most suitable and efficient. When the millennium comes, when the reign of eternal peace is ushered in, and When competing armies and navies no longer exist, we may see a system which will centralize all the gold of all countries into one big international reserve, or a system which can be operated without the use of any gold at all, as some theorists, like Prof. Knapp, of Strassburg, foresee. I, for one, do not believe that either we or our great-grandchildren shall have to discuss these possibilities as more than theo- retical questions. While we all hope that the arbitration movement will con- tinue to grow and that wars may in the future become less and less frequent, the possibility of struggles among nations al- ways remains. Hence nations will never consent entirely to abolish their armies and navies, and just as little as they will give up their reserves of powder and guns, will they agree to give up their reserve of gold. This is important; for while, within the confines of our own political boundaries, our pres- ent money system acts as a national clearing house — credit- ing to each of us the net result of his work, and accomplishing this practically without the actual use of gold, by means of bank accounts or of checks to bearer, viz., bank notes, — still ulterior payments between nations, whenever all other means (441) 58 BANKING REFORM IN UNITED STATES [Vol. IV of settling a debit balance with a creditor nation have been exhausted, must be made in gold. To meet the immense volume of demand obligations, which are, by their terms, payable in gold, there exists in actual gold under a modern banking system an amount equal to but a small fraction of the total amount of gold debts. This sys- tem is therefore safe only if the credit of the banks is so strong as to inspire a confident reliance that even if actual gold in large quantity is at one and the same time demanded from one or from several banks, the metal will not be needlessly and wastefully hoarded, the public and the banks themselves being confident that money so withdrawn will be redeposited, so long as there remain some institutions the credit of which can- not be shaken. Furthermore, the system must be so consti- tuted that in case of a demand for gold each solvent bank will pay out the metal freely and boldly, recognizing this as the sole method of stopping an internal drain, and of preventing it from degenerating into a panic. In addition, the system must provide for a means of successfully combating the export of gold, and of encouraging its import, when necessary, through the medium of the discount rate. This again pre- supposes the existence of a large volume of safe commercial paper endorsed by, or bearing the acceptance of, well-estab- lished banks or bankers, paper which is salable at any time and which, by the customs of the country, is freely purchased or resold by financial firms and institutions, as their daily needs develop. Finally, the laws governing and safeguard- ing the creation and collection of such paper must be so clear and uniform and the collection of such paper in every part of the country must be so easy, as to make an investment in such paper not only the safest, but also the quickest asset of a bank. These conditions actually prevail in countries enjoying a pow- erful and well-organized central bank. There is a very old English phrase saying, " John Bull can stand anything, but he cannot stand 2%." Since this phrase originated, centuries ago, John Bull has seen lower rates, but none the less it remains true to-day. It means that money seeks to draw a fair return of interest, and it illustrates, fur- (442) No. 4] A CENTRAL BANKING SYSTEM 59 thermore, why a period of too easy money invariably brings in its train a period of expansion and overspeculation. With both phases the central bank is intimately connected. As the meteorologist draws his chart showing the points of high and low pressure, and from these deduces the probabilities of wind and weather, so a map could be drawn showing how money, among financially well-organized nations, flows with absolute certainty from the point of low interest rates to the point where a higher return can safely be secured. And just as low pres- sure is not the only factor determining atmospheric transfor- mations, but as temperature and humidity are important ele- ments as well, so in the movement of money also there are im- portant local questions to be taken into account. Such are the rates of exchange which, as the case may be, either add to the interest rate to be earned in another country, or else decrease the return to be received. There is furthermore the question of the degree of confidence enjoyed by each country. As the insurance premium is commensurate with the risk of each transaction, so money exacts a larger return from invest- ment in countries which are considered financially less secure or in which, owing to a smaller or more irregular market, the investment cannot be so quickly resold. The total amount which the investor is willing to place in each particular coun- try will depend upon these considerations. An investigation of European conditions will show that money moves freely, according to this principle, between the larger and well-regulated European financial centres. In the face of political antagonisms money will flow to that centre where the highest interest return can be received, provided that confidence in that particular country is so strong that the higher rate does not act as a deterrent but as an inducement. Thus French gold began to flow into England when the Eng- lish bank rate went up to 7% at the end of last year. French capital at the attractive interest rate was invested in English bills to such a degree that the balance between the two nations turned in favor of England, and had to be settled by ship- ments of gold. In a similar way hundreds of millions of for- eign capital move into Germany when rates become remuner- (443) 6o BANKING REFORM IN UNITED STATES [Vol. IV ative there, and leave that country again when the difference in rates, the margin, as the banker calls it, disappears. We cannot too strongly grasp this idea of the power of the bank rate to protect and to attract gold. Without such power the central bank system is useless; for it would collapse when the first drain occurs. How is it possible, it is often asked, for England to do this enormous business which comes to it as the world's clearing house, with so small an amount of gold? The answer gener- ally given is that it is possible only through England's power to command the gold — thus implying the idea of immense bal- ances due to England, which are called in when needed. While this at certain times may be correct, it does not state the most important cause, namely, England's credit, the great confidence commanded by the English banks and by their paper and the knowledge that that paper can always be resold without any difficulty whatsoever, and that, if required, it can be collected in actual gold. England's credit and her ability to adjust her rates of interest render her system possible and effective. Between the indebtedness of one nation to another and the actual settlement of that debt in gold there lies as a buffer the borrowing power of the banking communities of the respective countries. Nations financially well-organized will find that for a moderate inducement money will flow to them freely for the purchase of securities, or for the purpose of short-time investment. This buffer is strong in England, as it is weak in the United States. We have no modern and readily salable paper which in critical times we can offer to foreign markets, and while the European banks work with fluctuations within fractions of l%, our primitive methods eften mean that before the tide can be turned we must suffer fluctuations of interest rates of ioo% and a fall in the value of securities to bankruptcy prices. Just as important as the protective power of the central bank is its preventive power. When money becomes too abundant there is always danger that it may leave the country, and also that speculation may be unduly stimulated. It is during such a period of general exuberance and expansion (444) No. 4] A CENTRAL BANKING SYSTEM 6l that the central bank, if wisely managed, will draw in its funds and prepare for the coming storm ; to accomplish this it will seek to stiffen money rates, and, by sounding its note of warning, it will often avert the coming crisis or modify it into that normal form of natural reaction which inevitably follows any period of great prosperity and expansion. On the other hand, a perfect central bank system will pro- tect the country not only from too easy money, but also from too high rates during those periods when money is in active demand, as for instance, in our country, during the crop sea- son. During such times a perfect central bank system will, without unduly increasing the rate, provide freely for legiti- mate demands. It will be prepared to let its reserve decrease materially, knowing by experience that the notes issued in ex- cess of its normal circulation will quickly return after the par- ticular business of a given season has been done. Thus we see that the end of December annually brings with it a large in- crease in the note circulation of the German Reichsbank, which notes, however, quickly return for redemption during the first two weeks in January. From the banker's point of view, the chief features and ad- vantages of a central bank system are the following : ( 1 ) The protection and replenishment of the country's gold holdings. (2) The creation of an elastic currency which tends to pre- vent too low money rates in times of abundance, as well as too high rates in times of money scarcity. (3) The establishment of a broad market for commercial bills. This market at bottom owes its existence and its im- portance to the central bank's readiness to discount such bills at any time, thus making the commercial bill the best quick asset of a bank. (4) The fact that it acts as a bed-rock foundation for confi- dence in times of stress, because it centralizes the reserves of the country, thus rendering possible their free and effective use. ( 5 ) The fact that it creates a central institution able to deal (445) 62 BANKING REFORM IN UNITED STATES [Vol. IV with other nations, in case exceptional measures become ad- visable, and with which other nations, even in times of the worst panic, can negotiate to furnish or obtain large loans of gold, as has frequently been the case as between France and England. The shortest and most striking way to illustrate the short- comings of our system will probably be to review our experi- ence of last year. We had, like Europe, gone through a period of rapid expansion, probably over-expansion, and a natural reaction was bound to come to us, as to Europe, and it did come to both. Expansion was probably more acute in Germany than with us. Why then did Germany, much weaker than we, weather the storm without a panic, while we went into a most disgraceful state of utter helplessness and tempor- ary bankruptcy ? We may leave aside the ephemeral question as to which " straw " is was that " broke the camel's back." After a long period of prosperity, there will almost always develop some point of weakness where the break will first occur, and, as a rule, that break and the ensuing strain will bring down other parts of the structure affected by dry rot. Some " bubbles " were pricked in Germany also, and some ugly failures oc- curred there, but they did not create any panic. Distrust did not spread in Germany, because the general system, being what it is, keeps unshaken the belief that against good assets good money will always be available, and so " hoarding " re- mains an unthinkable phenomenon. Furthermore, there was unimpaired confidence that so long as the Reichsbank was in general touch with the situation, though some things might be rotten, they would remain the exceptions, and that it would be impossible for all or even any large proportion of the finan- cial institutions to be unsound. We shall not deal with the question whether with us bad judgment and mismanagement had been so extreme that the resultant outbreak of distrust was, as a natural consequence, bound to be as violent as it proved to be, or whether artificial fanning of the flame by agitation, sensation, and exaggeration (446) No. 4] A CENTRAL BANKING SYSTEM 63 played any part in the unfortunate development, or whether such a complete collapse of credit would under any circum- stances have been possible had the legal foundation on which the whole industrial and financial structure rested been firmly and equitably constructed and had it been less subject to vio- lent upheavals. Whatever causes may have combined in the United States to bring about the crisis of 1907, it cannot be doubted that it would never have reached such appalling dimensions had it not been for the lack of elasticity in our currency, the utter uselessness of our reserve, our inability to apply the brakes while we were going too fast, the absence of any means to negotiate for measures of relief with other countries through a channel recognized by them as official, and finally the lack of modern American bills of exchange, which, while serving as the means of settling the daily balances of the nation, would have been assets on which the banks might have realized in Europe and in the United States, by rediscounting among themselves or at a central bank. When the panic came, no outflow of gold had taken place, and no natural shortage of currency prevailed. Our existing per capita currency was very large, much in excess of that of most other nations, and there were hundreds of millions of currency in the banks and trust companies. But when, owing to an epidemic of distrust, people began to withdraw cash, it became strikingly apparent that our system was only a fair weather system, liable to absolute collapse in adverse times. Where, as with us, there are no means of issuing additional currency against the best commercial assets, where the enor- mous reserves of cash, accumulated in the banks, cannot be used because each manager fears a run on his own bank if his reserves go below the 25% limit, it is inevitable that each bank must attempt to draw upon the reserves of every other bank, and that each will hesitate to pay out cash at a time when the panic-stricken public should be fortified in its confidence that its money is safe and that cash is coming out freely every- where. Under such conditions the drain by the public must increase instead of being stayed, and it is inevitable that the (447) 64 BANKING REFORM IN UNITED STATES [Vol. IV worst and most aggressive hoarder will come to be the bank or trust company, which, realizing that its 25% cash reserve is quite useless, will, as an act of self-protection, and because no other way exists, use every means of " building up " a reserve, by preying on its neighbors, at the very moment when reserves should by all means be decreased. From such a system there can result only one consequence : a tremendous rise in interest rates and a tremendous fall in the price of securities ; and if even these brutal effects do not attract foreign capital and do not convert the home depositor and hoarder into investors, a general suspension — politely called clearing-house certificates — must follow in order to pre- vent wholesale individual suspensions. Our system, in fact, did not permit us even to suspend scientifically. When New York began to issue clearing-house certificates and all the rest of the country had, as a natural consequence, to follow, the struggle for gold and currency became even more acute among the various cities, and a shameful gold premium which lasted for several months drained Europe's gold chests and brought needless harm and anxiety to our friends on the other side of the Atlantic. Some years ago a stranger arrived late at night in a Ger- man town, and when he was about to leave the station, he saw that there was only one cab left. He hailed the driver, who, however, refused to move, and the policeman explained that as the law prescribed that one cab should always be in waiting at thfe station the cab could really not be allowed to leave! Ridiculous as this story may appear, it is quite applicable to our law which prescribes that the 25% reserve must always be kept intact. It cannot be too strongly emphasized that our most urgent needs in addition to the creation of an elastic currency are concentration of reserves and the possibility of concerted action in lieu of our present system of decentralization. Let us now consider what circumstances there are to prevent us from establishing a central bank similar to those found in the European systems. The chief difficulties are the existence of our bond-secured currency, the decentralization of our note- (448) No. 4] A CENTRAL BANKING SYSTEM 65 issuing power and of our reserves, the lack of modern com- mercial paper on which to base an elastic currency, the exist- ence of our obsolete usury laws, and finally the deep-rooted prejudice against anything bearing the name of a central bank, the fear alike of politics in business and of business in politics. It is unnecessary to make a long argument against bond- secured currency. Only weak nations or a people in times of stress, generally during a war, have issued bond-secured cur- rency, and every healthy nation as soon as it was again strong enough, has always abolished this obnoxious system of infla- tion. As long as we have this bond-secured currency, we can- not succeed in getting an elastic one. Bond-secured currency always expands, it hardly ever contracts. Our recent legis- lation, enacted last summer, was wisely created as a temporary measure only, since a far-reaching reform could not be suc- cessfully achieved in a hurry and without thorough research. The new law is an important step in advance, inasmuch as for the first time commercial paper is admitted as a basis for the issue of notes. But unfortunately the issue of notes against commercial paper is made dependent upon the previous issue of bond-secured currency to the extent of no less than 40% of the note-issuing power of a bank. This, and other condi- tions imposed upon such note issue, make the new currency an emergency currency, but not a healthy and normally elastic currency. With elasticity we generally connect the idea of the rubber band. If we take an old and frayed rubber band, which has been stretched to its utmost capacity by holding together a large bundle of papers, we cannot make the old rubber elastic by tying to it a new piece of elastic band. Where this has been done we have indeed made room for more papers and when this new room is filled, some little elasticity will develop, but if the papers should then decrease below their previous maximum size, the rubber band will stay as it is — it will not contract. In order to have eflFective elasticity, the band must still fit tight when the bundle has been reduced to its smallest size. This means that in order to make the old band elastic we must shorten it considerably before we affix the new elastic (449) 66 BANKING REFORM IN UNITED STATES [Vol. IV addition. In other words, we must first of all redeem our bond-secured currency so that our note issue may hereafter be able to contract in times of abundance and so that roughly from the lowest point upwards the note issue shall remain in healthy touch with the demand for currency. In redeeming the bond-secured currency, two points will have to be borne in mind : the one is that it must be done with- out injuring the banks that now own these bonds, or it will never be done — and besides, to do it otherwise would be unfair; and the other is that we must be able to provide new currency when we withdraw the old, so that no scarcity will be arti- ficially created. If I were asked to suggest how this could be done, I should propose an inverse conversion of the bonds, i. e., I should ad- vocate the conversion of the present government bonds into bonds bearing a rate of interest higher by so much that after the privilege of issuing notes against them shall have been withdrawn, the bonds will sell just as high as, and possibly a little higher than they now sell with this privilege. This can be done gradually and in various ways; it would indeed mean an increase in the yearly interest charge to be borne by the United States, but it would put our bonds on a natural basis, like the English consols or French rentes, so that the Amer- ican people could afford to own their own government bonds. In fact, this money, by securing a healthy financial system, and by protecting us from a repetition of past convulsions, would come back to us a thousandfold, and would constitute the best expenditure that our government could make. In creating the new currency, we could probably follow the lines of the recent legislation, and provide for the organiza- tion of currency associations throughout the country. These associations, which should be open also for state banks and possibly also for trust companies, and which should be modi- fied in many other respects, would discount the legitimate com- mercial paper handed in by their members and pass it on with their indorsement to the central issue department at Washington, which in turn would issue its notes against such guaranteed paper. Of course, such paper with such guarantee (450) No. 4] A CENTRAL BANKING SYSTEM Qy should be taken at par, and not at 75%, as at present provided, and it should be taken at a uniform rate, to be published from time to time by the central issue department. The currency associations would receive from the institution handing in the paper a certain remuneration for every endorsement or guar- antee executed by them. (Whether the profit, after paying for the running expenses and after having accumulated a large reserve fund, should in years to come be paid out to the members of the associations, in proportion to their pro rata of the guaranty, is a detail to be worked out later. ) A most im- portant consequence of such a development would be that we should break with our present dangerous system by which the banks are filled with single-name paper which they cannot re- sell, and which, under our present conception of banking, they could not attempt to sell without ruining their credit. The laws would, of course, have to be so amended that banks could indorse and accept freely as in Europe, and it will in time fol- low as a natural development that discount companies will be created, as in England, and that when money is in active de- mand in the South and offered freely in the East, the southern banks, instead of rediscounting with their association, will be able to rediscount frankly and openly in New York or in Bos- ton or in Europe. If, as it is to be hoped, the currency asso- ciations and the discount companies will, at the proper mo- ment, begin to establish two different rates for guaranteeing paper, a higher one for single-name paper, and a lower one for paper bearing in addition to the commercial signature the acceptance of a bank or banking firm, we shall give an added stimulus to the modernization of our paper. When our banks once feel that they can rely on being able to rediscount their legitimate paper, they will be able to purchase the same freely without, as now, running the risk of dangerously locking up their capital through such investment. I have repeatedly dealt with this question and with the dis- astrous effects of our usury laws, and have tried to show that our system is in this respect directly opposed to the European system, and that our almost annual convulsions will perforce continue unless we make our commercial paper the quickest (451) 68 BANKING REFORM IN UNITED STATES [Vol. IV asset and the basis of our banking, instead of using the stock- exchange call loan for this purpose. As for the organization of such a Central Issue Department, I have also dealt with this question on previous occasions,^ and I must not go fully into the details of that problem here. Suf- fice it to say that the board of trustees or directors should be composed of delegates from the various currency associations, of the Secretary of the Treasury, the comptroller of the cur- rency, some members of the Senate and of the House, to whom some members of the commercial classes might be added by election of the stockholders. This body of men should elect two governors, salaried officers of highest standing and train- ing, who would be retained in office as long as they are ef- fective and honest, irrespective of the political party that may for the time being be at the helm. The powers of the Central Department of Issue should be strictly limited, and should be as follows : To discount paper, running not to exceed three months, for the various currency associations ; to make advances against certain bonds (government bonds, savings-bank bonds, etc.') at uniform, published rates and up to certain percentages of their market value to be designated from time to time. (Whether such advances are to be made only through the currency association or also direct, is a detail which can be left open for the time being) . To buy and sell foreign bills running not to exceed three months and bearing at least three bona fide signatures. To deal in bullion and to contract for loans of bullion. To act as the depository of the treasury's money without giving collateral. And finally, to receive deposits from the currency associa- tions. The Central Issue Department may issue notes which must be covered by gold or commercial paper; no less than one- third of the notes issued to be at all times covered by gold or legal tender. '^ Cf. Defects and Needs of Our Banking System, and American and Euro- pean Banking Methods and Bank Legislation Compared, supra, pp. ^ and 30. (452) No. 4] A CENTRAL BANKING SYSTEM 69 A Central Department of Issue so constituted would be be- yond any possibility of abuse for political or other purposes. The constitution of the board and the limitations of its power preclude any such possibility, however remote. As the Central Department of Issue must command the highest possible confidence and as it is necessary to provide a strong gold purchasing power from the start, it is suggested that the department be endowed with a large stock capital of, let us say, $100,000,000. In order, however, to prevent any possibility of having the department administered with a view of earning large dividends for the stockholders, it is proposed to limit the dividends to a certain percentage, and after hav- ing accumulated certain reserves, to turn over the balance to the United States government. Whether or not, in considera- tion of such profit to be received, the United States should guarantee the notes, may be left for future consideration. The bugbear that somebody might buy the control of such an institution may safely be dismissed. A man or a group of men purchasing all the stock would not derive the slightest profit from it, except the limited return on the investment. They could not appoint the board, and even if they could do so, they would not profit by it, as the department is restricted to a limited number of safe transactions. The Central Department of Issue should have the right to ask from time to time that the banks, through the associations, deposit with it a certain proportion of their cash reserves, and the law would have to be amended so as to allow the banks to count as cash their deposits with tlie Central Department of Issue. The object of such an amendment is obvious, as the gold in the hands of the Central Issue Department can do thrice the amount of good that it can do with the individual bank, which, after the organization of a Central Issue Depart- ment, need not fear the withdrawal of cash so long as by redis- counting its sound and legitimate paper it can secure currency. As for greenbacks and silver certificates, I believe that we could well afford to leave them untouched for the time being and possibly use the surplus to be derived from the profits of the Central Issue Department for the purpose of gradually re- (453) ■JO BANKING REFORM IN UNITED STATES [Vol. IV tiring the greenbacks. With the bond-secured currency re- deemed and replaced by an elastic currency, it is conservative to hope that with the large exporting power of this country, we shall be sufficiently equipped to protect our gold, and that the greenbacks and silver certificates will represent no more than the pocket money of our large population. However, this scheme with all its details, as far as they can be outlined in this brief address, does not pretend to be the only solution of the problem; it is a suggestion, subject to many modifica- tions. I have great hesitation in outlining it at all, for while the Monetary Commission is so seriously at work, accumu- lating material for thought and study, I should have preferred not to express any views at this time. However, as this most important question cannot be solved by the politician alone, nor by men of science alone, nor by the business man alone, I feel that we, each of us, must do our little share, when called upon, and I therefore accepted your invitation, though fully realizing my own shortcomings for such an undertaking. The advantage of the scheme as outlined is, that instead of trying new experiments, it proceeds on lines which have been successfully followed in the most important financial centers. Conditions are too different with us to permit of an exact copy of any of the European systems; but the proposed plan would tend toward the gradual evolution here of conditions that, as we develop, would render the Central Issue Department more and more efficient and simple in operation. Some schemes which have heretofore been advanced pro- pose to leave the note-issuing power with the national banks, and to regulate their reserves and rates by a central board or similar institutions. I for one, do not believe in such plans. Their shortcoming is, that in order to be efficient they must interfere too much with the liberty of conducting business. For such a central board would eventually have to dictate the rates at which the banks would be allowed to take money or to lend money, and a general guarantee of deposits is only one of the logical consequences of such a scheme. As a matter of fact, under that scheme there would be one central board managing all the banks — an entirely new departure and much (454) No. 4] A CENTRAL BANKING SYSTEM 71 more drastic than any central bank. If under that scheme such central interference were made less effective than above outlined, our present defects, viz., the weakness of scattered reserves, and the danger of the decentralization of the note- issuing power into more than 6,500 banks, would remain as obnoxious as before. Other schemes have been suggested, which propose to regu- late the whole question automatically by a tax; but automatic measures cannot possibly meet in the most efficient way alii the different eventualities that may arise. A drain from within must be met in a very different way from a drain from with- out, and a drain from both within and without will again have to be treated in a diiferent way. How, then, can we hope to attempt to create one measure which by a tax will automati- cally meet all these varying requirements? Besides, these measures provide for inflation without creating new reserves or effective means to attract and retain the gold. Most of these measures will remain passive measures; they have scarcely any preventive or protective power at all. Some people believe that we should imitate the Canadian system. Without going into the question whether a system that has proved a success for six million people would also be well adapted for a population of eighty-five or ninety millions, (and without discussing the point whether this system, like many others, could survive in the absence of the close rela- tionship with the well-organized English banking commu- nity) , we shall follow out only this one thought : The Canadian system is based on the small number of some 30 banks with branches in every hamlet. The minimum capital of a bank admissible by law is $500,000, but the majority of the banks have a much larger capital, some up to $14,000,000. Of our 6,650 national banks, 5,367 have a capital of less than $100,- 000. Are all of these to go into liquidation? And would not a concentration of the whole banking power into the hands of a few gigantic institutions with branch banks bring about the very conditions which popular sentiment abhors, and which the government is striving to avoid? The central bank system — and also the modified system of (455) 72 BANKING REFORM IN UNITED STATES [Vol. IV a Central Issue Department — stands for sounder principles in this resp2ct : it centralizes reserves and brings about the possi- bility of concerted action in the face of danger. By creating safe conditions, it makes the small bank independent and the danger of an overpowering individual control, instead of being aggravated, is for this reason immensely lessened by a Cen- tral Issue Department. Thus the Central Issue Department would protect the small bank and not menace it as is gener- ally believed. The Central Issue Department is sound also in this, that each transaction which it brings about, directly or indirectly, is a plain business transaction. If a bank desires its paper guaranteed by the currency association the bank pays the com- mensurate commission for such indorsement, and the guar- antors earn the commission. If the currency association finds the security insufficient, it will refuse the business. Each transaction is an individual one, carefully scrutinized, and there is no unbusinesslike wholesale guaranty. Nor is there any real interference; each bank deals with the currency association of its own free volition, and through it with the Central Issue Department. The Central Issue De- partment can post the rates at which it is willing to do business with others, but it cannot force anybody to do business at these rates, nor directly interfere with anybody's conduct of busi- ness. It is its indirect influence which is strong, and which is of the most beneficial effect. Furthermore, it is a sound principle that the financial affairs of a nation should be guided not by an automaton but by will- power and brains behind the machinery, though strong re- strictions must give the assurance that this will-power cannot go beyond certain safe lines. Such a system will be a vast im- provement upon our present treasury organization, which is constructed on the one hand in order not to do what a central bank of issue ought to do and which, on the other hand, as a consequence of our defective system, has gradually vested in the Secretary of the Treasury more autocratic and dictatorial powers than any central bank manager could ever exercise. Finally, banks are money-making concerns. Money mak- (456) No. 4] A CENTRAL BANKING SYSTEM 73 ing and money issuing are two entirely distinct functions. It is precisely in order to abate eagerness in making money that the issuing of money at times must be rendered more difficult. Moreover, the note-issuing bank must be put beyond the dan- ger of material losses and beyond the possibility of being drawn into individual transactions, for otherwise its credit will not be unassailable as it absolutely must be, even in times of the worst panic. The ordinary bank, on the other hand, has the duty of taking commercial risks and of carrying on in- dividual transactions. That is why with us, as in every mod- ern country, general banking and the issuing of notes must be kept separate. I have avoided calling the institution of the future a cen- tral bank, because, as proposed here, it is not a central bank. If, instead of the independent currency association, this Cen- tral Issue Department were endowed with active branch offices dependent upon the head office, such a name would be cor- rect. No doubt a central bank with active branch offices would be the more efficient, so far as concerns the controlling of the country's gold, its money rates and its financial safety. But with our present political and financial conditions, it would probably be impossible, and in many respect unsafe, to vest such vast powers and duties in one body. Though the sys- tem suggested by me may be a little less effective and more cumbersome, we must, for the beginning, at least, interpolate the currency association, or some similar institution, to stand as guarantor and examiner between the Central Issue Depart- ment on the one side and the local bank and its customer on the other. As our banking paper becomes modern, and as safe standards for the same develop, as we outgrow those financial and political dangers which are stronger in a country in its period of rapid growth than under conditions of more ad- vanced and slower development, we may gradually — and it is to be hoped, soon — simplify the system. But it is safe to leave this further development to the future, provided that we now find the right principle for the establishment of a sound basis. In constructing such a basis, it is better to err on the conser- vative side than to attempt too big a stride at the beginning. (457) 74 BANKING REFORM IN UNITED STATES While we may disagree as to the extent to which a central bank system may be applied in the beginning, there cannot be the slightest doubt that the principle of that system must be adopted. It is most surprising that so ineffective and obsolete a cur- rency system as that of the United States should have been so long maintained by so eminently practical a nation. The ex- planation is that the wonderful resources of the country, its marvelous prosperity and natural everlasting credit balance against other nations appeared to legitimize and justify our system. The currency reformer has always been met with the argument that while theories might be good for poor little Europe, practise proved that the American system was sound enough for the United States. We had to live through last year's horrible crisis to learn that we had been prospering in spite of our system, not in consequence of it, and that, unless we effect a thorough reform, the future is bound to bring us similar disasters and similar disgrace as the past. It is our duty to keep the memory of the crisis of 1907 fresh in our minds, for unless we grasp not only the danger but the certainty of its reappearance, we shall not realize the blessings and the absolute necessity of a central bank system in the United States. (4S8) A UNITED RESERVE BANK OF THE UNITED STATES THE summary of a recent investigation undertaken by the Banking Law Journal discloses the fact that out of 5,613 answers given by national and state bankers to the question : " Do you favor a central bank if not controlled by ' Wall Street ' or any monopolistic interest? " 59j4% were affirmative, 7% were undecided, and 33^% were negative. Almost all the negative answers, as far as published, are based upon the argument that a central bank, if established, could not permanently be kept out of political or " Wall Street " control. Between the opponents and the champions of a cen- tral bank plan there is complete unanimity of opinion that such a system should be tried in our country only if the dan- gers of " Wall Street " or political control can be absolutely averted. The main question at issue is this : Is it possible to evolve a plan which, while containing these elements of safety, will at the same time be completely practicable? It is our belief that no progress can be made by meeting the sweeping assertions of those opposed to a central bank plan by equally sweeping replies, but that advance is possible only by outlining a tangible plan for such a bank. This, on the one hand, will give to those not yet familiar with the actual work- ing of such an institution an opportunity for study, and on the other hand it will force the critics of such a plan, it is hoped, to offer specific and well-defined objections which may lead to some definite results. It should be stated at the outset that the plan here submitted does not suggest a central bank such as exists in various Euro- pean countries. It is a scheme based upon conditions peculiar to our country and our form of government. It recognizes the vast territorial area of the United States, the diversity and dissimilarity of interests, and even the traditional, sectional (459) -jQ BANKING REFORM IN UNITED STATES [Vol.. IV and partizan prejudices of the people. In consequence of this, many features which are contained in European plans and which figured, to some extent, in the operations of the First and Second Banks of the United States have been omitted, while certain features foreign to European organizations have been incorporated. All the underlying principles of safe and intelligent modern banking, however, — principles which must be adopted if we are to obtain a banking system adequate to our present and prospective needs — have been observed and are embraced in the plan. This essay, while advocating the central bank idea, submits a much modified system, which we should like to designate the " United Reserve Bank of the United States." The plan does not pretend to be final or com- plete in all its details; its purpose is to indicate the funda- mental principles upon which the solution of the problem de- pends and to point out one method of solution. The strongest arguments made against the plan of a central bank in the United States are those advocated by Mr. Victor Morawetz and by Professor O. M. W. Sprague. We have made free to answer these two critics in the second and third parts of this essay, and in endeavoring to refute their argu- ments have attempted at the same time to meet the principal objections of other critics whose writings have come to our notice. I Let us assume that a United Reserve Bank of the United States be established in Washington with a capital of $ioo,- 000,000 fully paid. Let us assume the United States divided into twenty zones of operation, similar to the currency-asso- ciation districts now proposed by the Aldrich-Vreeland meas- ure, each zone of operation to contain a voluntary association of banks grouped around a financial and commercial center, in accordance with a plan to be worked out in detail. To form the operating associations, which we shall call banking asso- ciations, the banks within each zone should have the privilege of appointing from their own number a board of directors, who in turn may appoint a president or managing director of (460) No. 4] A UNITED RESERVE BANK jj the association. Certain mistakes which crept into the Aldrich- Vreeland bill must be avoided. The measure should be drafted so as to permit a bank to withdraw from the associa- tion at will ; to restrict the obligations of each bank to certain transactions, in each case carefully examined and approved by the associations; and also to enable the associations, with the approval of the Secretary of the Treasury, to group themselves into subdivisions. One might simplify the formation of these associations by making them stock companies, each bank within a zone of operations having the privilege of subscribing its pro rata share, according to its capital and surplus. In order that the board of directors of the United Reserve Bank in Washington may be thoroughly representative of the various interests and districts of the country, that it may be non-political, non-partisan, and non-sectional, a certain num- ber of the directors, say three-fifths, should be appointed by the banking associations ; a further number, perhaps one-fifth, should be elected by the stockholders; while the Secretary of the Treasury, the comptroller of the currency, the treasurer of the United States and others to be nominated by them, should fill out the remainder of the board. It might be ad- visable to provide that no director, excepting the ex officio members, should serve more than a certain number of years in succession. In order that commercial interests be adequately repre- sented, provision might be made that the members appointed by the stockholders should not be bank or trust-company presidents, and that these members should be elected prefer- ably from the class of merchants and manufacturers. One would then have a mixed board, of whom three-fifths would be bankers, appointed by the banking associations, while one- fifth would be chosen from the commercial classes by vote of the stockholders, and one-fifth would be ex officio government members and the additional members appointed by them. This board should have the right to elect one or two gov- ernors of the United Reserve Bank, who would be salaried officers appointed, like other bank presidents, for an indefinite time, irrespective of political considerations, and remaining in office as long as they render satisfactory service. (461) 78 BANKING REFORM IN UNITED STATES [Vol. IV The share capital of the United Reserve Bank could be di- vided among the banks of the country under a fair plan of apportionment, or the stock could be sold to the public. The dividends on the stock should be limited to, let us say, 4%. Any profit in excess of this should go to the government. A provision that no one stockholder be allowed to have more than a certain number of votes should be inserted. The United Reserve Bank should be authorized to perform the following functions : ( 1 ) To accept deposits from the government of the United States and from members of the banking associations only. No interest should be paid on such deposits, but they might be counted as cash by the banks and trust companies making them. (2) To buy from members of the banking associations, at a discount rate to be published from time to time, commercial paper having not more than twenty-eight days to run, and issued at least thirty days before the date of rediscounting. The aggregate amount which it might buy from each member should be restricted to a certain proportion of the unimpaired capital and surplus of such member, and the aggregate amount issued by one issuer of commercial paper to a member of the banking association and rediscounted with the United Reserve Bank, should also be limited to a certain proportion of such unimpaired capital and surplus. (3) To buy from member banks, at a discount rate to be published from time to time, commercial paper having more than twenty-eight days to run, but in any case less than ninety days. The aggregate amount to be rediscounted by the United Reserve Bank from each member and the aggregate amount admissible from individual makers of notes should be re- stricted as under (2). Such paper, however, could be dis- counted by the United Reserve Bank only with the indorse- ment or guaranty of the banking association to which the mem- ber belonged.^ '' In consideration of such guaranty or indorsement, the banking association would receive from the member handing in paper for rediscount a certain re- muneration, let us say Yi, or y2 oi \°fo ra. the interest rate. The banking asso- (462) No. 4] A UNITED RESERVE BANK 79 (4) To buy, at a discount rate to be published from time to time, paper having no more than ninety days to run, drawn by a commercial firm on, and accepted by, a bank, trust com- pany or banker, and indorsed by a bank, trust company or banker. One of these signatures should be that of a member of the banking association. Limits as to amounts of accept- ances admissible from time to time for discount with the United Reserve Bank should be fixed by the central board. ^ (5) To buy bills on England, France, Germany (and such other countries as may be decided upon), such bills to have a meiximum maturity of ninety days, to bear one commercial signature, to be drawn on and accepted by a well-known for- eign banking house and indorsed by a member of a banking association or a banker in good standing. The United Re- serve Bank should have power to resell all bills that it might buy and to do all things necessary for their collection. (6) To deal in bullion, and to contract for advances of bul- lion, giving security therefor and paying interest on such ad- vances. ( 7 ) To buy and sell bonds and treasury notes of the United States. (8) To issue circulating notes, payable on demand in gold; such notes to be secured by bills, bought by the bank under provisions (2) to (S), and by gold to the amount of at least 33/^% of the aggregate amount of outstanding notes. (9) To establish branches in places where there are head ofiices of banking associations. Such branches under the di- rection of the central board of the United Reserve Bank, might do the same business as the head office. Each branch would have a local board, chosen by the board of managers of the local banking association, to which board might be added some members of the commercial classes appointed by the head ciations would, of course, like the clearing houses when clearing-house certifi- cates are issued, have the right to reject any paper which they did not deem it safe or proper to guarantee or indorse. ^ It might be advisable to provide that in case of emergency the central board, with the approval of the Secretary of the Treasury and the President of the United States, might increase the limits fixed under (2), (3) and (4). (463) 80 BANKING REFORM IN UNITED STATES [Vol. IV office in Washington. This local board would supervise the business of the branch bank, and elect its salaried president, subject to the approval of the central board in Washington. (lo) To request banks or trust companies desirous of mak- ing use of the services of the United Reserve Bank, to keep with its branches a cash balance commensurate with the amount of business done by them. The United Reserve Bank should have the right to transfer sums of money from the account of one member to that of another upon request. (ii) To join the clearing-house association of the various cities where the bank and its branches are located. Let us now consider the plan, as above outlined, from the following points of view : First, would it be safe ? Second, would it be effective? Third, would the vested interests of the banks have reason to oppose or favor it, and can the general prejudice existing against any such plan be overcome? The chief criticism that has been raised against a central bank is that it is subject to the danger of control either by politics or by Wall Street finance. Would this danger exist under our plan? Could anybody acquire control? Nobody could do so if a provision were made that the stock should be divided among the i8,ooo banks of the United States.'^ But even without such provision there would be no danger on this score. A man or a group of men acquiring the whole capital stock of the United Reserve Bank would, after all, acquire the right to appoint only a few members of the board, who would be in a hopeless minority against the combined members of the banking associations of the whole country and those represent- ing the government. But furthermore it is evident, with the restrictions placed upon the United Reserve Bank as to the transactions in which it might engage, and with the restrictions as to the earning power of the stock, that the control of the United Reserve Bank by one individual or a group would not offer any attraction. 1 The author is fully aware that there are only about 6,500 national banks now, but it is to be expected that under any new plan all national banks would become state banks or all state banks national banks. It would, however, lead too far to go into this question here. (464) No. 4] A UNITED RESERVE BANK 8 1 As an investment it would not pay, because any earnings in excess of 4% would go to the government, and as for secur- ing help for speculative ventures or aggrandizement of power, this aim could not be achieved by the control of a bank re- stricted in its dealings to the purchase of short paper from member banks, and of three-months paper which could be ac- quired only from the banking associations. Taking into con- sideration all these safeguards, namely, the method of appoint- ing the board, the restriction of income on the stock, and the limitation of transactions permitted, it is absolutely safe to say that under such a system any fear of undue financial or political control may be dismissed once for all. Secondly, would the plan be effective? It is easy to devise a plan that would be ultra-safe, and not very hard to create one that would be effective, but to combine safety and effective- ness is difficult. Let us first determine what is the main object of a central bank, and then investigate whether the plan above outlined would fulfill this purpose. A central bank acts as a central reserve of a nation. Its first duty is to see that a proper proportion is maintained be- tween actual cash reserve and all demand obligations of the nation which are payable in cash at the option of the payee, but of which the majority are habitually paid by exchange of credits. Its duty in this respect is two-fold: on the one hand, to protect and to strengthen the country's holdings of gold, and on the other hand to establish and maintain a perfect system of credit, enabling the general banks to transform cash credits into actual cash with such absolute ease and certainty that the use of the cash credit, instead of the actual cash, will not cease, no matter what may happen. In other words, there must not remain the faintest possibility of hoarding during a crisis, or the system will fail. In order to assure this, cash credit must not only be as good as cash, it must be better than cash ! The carrying of cash entails a risk of actual loss as well as a loss of interest ; a cash credit is free from this first-named evil and, in addition, investments which can be quickly turned into cash credits bear interest. The general tendency of civil- ized people in a well-organized country must therefore be to (465) 82 BAJS/KING MBFORM IN UNITED STATES [Vol.. IV free themselves as rapidly as possible from cash and to trans- form it into the safer and more economical cash credit or into assets which can be quickly transformed into cash credits. Every idle token of money must, therefore, under a modern system return without delay into the central reservoir, where it must be unreservedly available for every legitimate demand for cash. There must never arise any doubt that a legitimate demand for cash will be met promptly and that legitimate quick assets can be turned into cash credits. If quick assets can be promptly and reliably turned into cash credits, and if cash credits can be turned into cash at will, then it is certain that all such credits never will be turned into cash at the same time, because nobody has any use for so much cash and therefore he will not ask for it, as long as he is sure that he can get it.^ This is the only basis on which our mod- ern system of immense demand gold obligations, built up on a comparatively small amount of cash, is safe. Let us use an illustration for this fundamental point : '^ If after a prolonged drought a thunderstorm threatens, what would be the consequence if the wise mayor of an Oriental town should attempt to meet the danger of fire by distributing the available water, one pailful to each house owner? When the lightning strikes, the unfortunate householder will in vain fight the fire with his one pailful of water, while the other citizens will all frantically hold on to their own little supply, their only defense in the face of danger. The fire will spread and resistance will be impossible. If, however, instead of use- lessly dividing the water, it had remained concentrated in one reservoir with an adequate system of pipes to direct it where it was wanted for effective use, the town would have been safe. Ridiculous as these conditions may appear, the parallel with our own financial organization is evident. Our reserves of 1 This applies only to the internal drain. We shall deal later with the demand for gold that might arise from without. ^ This illustration is taken from the writer's pamphlet, The Discount System in Europe, published by the National Monetary Commission, which appears at p. 129, infra. (466) No. 4] A UNITED RESERVE BANK 83 cash are entirely disconnected ; they are insufficient for even a single institution in times of serious stress, and instead of being a protection they are a dangerous weakness, because the con- sciousness of insufficient protection causes one bank to try to draw on the reserves of others, and the very moment these mutual attacks begin, panic inevitably follows. Our true conditions are, as a matter of fact, even more pre- posterous than those in the Oriental town, by reason of our law prescribing that a certain proportion of the deposits must be kept in cash, — a law which must be observed if a bank wants to preserve its credit. Not only is the water uselessly distributed into 18,000 pails, but we are permitted to use the water only in small quantities in proportion as the house burns down. If the structure consists of four floors, we are practi- cally forced to keep one-fourth of the contents of our pail for each floor. We must not try to extinguish the fire by using the water freely in the beginning; that would not be fair to the other floors. Let the fire spread and give each part of the house, as it burns, its equal and insufficient proportion of water. As long as the owners of houses threatened with fire know that the central water supply is well in hand, with one central power, available wherever danger may arise, everybody feels safe and is not frightened by the thought that if all the houses should burn at the same time there would not be enough water to go around. Though there may not be enough water for the last house that might burn down, even the owner of that last house would not ask that some water be kept back for him, because he realizes that unless the fire be stopped before it reaches him, his own little supply of water will not help him. If, however, a central system does not exist, everybody will hoard water, trying to steal it from his neighbor or from the community by tapping some source in order to create a supply of his own. He will lessen thereby the full supply that ought to be led into the central reservoir, without protecting himself adequately in time of danger. The main function and object of a central bank is to make every dollar which lies idle return to the central money reser- voir to make it available to the fullest extent, wherever and (467) 84 BANKING REFORM IN UNITED STATES [Vol. IV whenever it can do good legitimately, and to provide a system of mains, by which it can be conveyed quickly to any point of danger. Note issue is not a fundamental, but only a side question, and it is very important to grasp this fully. If the British gov- ernment should issue a government loan and use the proceeds to pay into the Bank of England in gold £18,400,000, thereby paying off its present indebtedness to the bank and providing a gold cover for the uncovered portion of the note issue of the bank, the latter could pay off every one of its sterling notes in gold. If this were done, the only change would be a change in pocketbooks, to enable people to carry gold instead of notes. The central bank system of England would go on absolutely undisturbed. With or without the note-issuing power, the Bank of England would remain the central reservoir of gold. It would continue to protect England's gold holdings and to maintain the proper proportion between the country's demand obligations and actual cash. It would continue to guarantee the prompt transformation of cash credit into cash smd of quick assets into cash credits. This is possible only through the discount system. The banks know that they can, in case of need, rediscount their legitimate bills with the central bank. The central bank, on the other hand, having a large investment in bills of short ma- turity, can, by increasing its discount rate, withdraw from new investments and thereby strengthen its reserve. Incident- ally, by increasing the interest rate of the country, it attracts foreign money, wards off gold exports, and by throwing part of the burden on the general banks brings about a general con- traction of business. Money flows where it can draw good interest in safety. Where credit is firmly established and financial organization sound, money flows easily from one city or country to another, for a difference in interest of a fraction of one per cent. It is humiliating to realize how large a margin in interest rates we must offer to attract money, as compared with our European competitors. This question and the working of the discount system, of which the central bank system is a part, have been (468) No. 4] A UNITED RESERVE BANK 85 dealt with fully in my previous paper, so that I need not dwell on them here. Elastic note issue, that is, the power of a central bank to issue notes not fully covered by bullion, is an auxiliary meas- ure. The central bank system becomes more pliable and safer by this addition because, the lines being less rigid, the fear of reaching the end of the tether is not so great; and, further- more, since the result to be reached is not exclusively depend- ent upon the discount rate, the latter need not be changed so often and so drastically as with an inelastic system. To return to our metaphor: note issue represents an auxil- iary reservoir. Where it does not exist, the men in charge of the central reservoir have to advance the price for water so as to discourage extravagant use whenever the available supply falls below a safe margin. Unsecured note issues enable the managers to use this auxiliary supply, which renders it pos- sible often to provide for the needs without increasing the price for the water, where the increased demand is normal and only temporary. To decide when to supply water freely, when to warn the consumer to save, and when to limit the supply without ever refusing to comply with legitimate demands, is the duty of the central bank. No automaton — no tax or fixed regulation — can perform it, but the best judgment of the best experts must indicate the policy to be pursued from time to time. In addi- tion, it must be the exclusive care and responsibility of one in- stitution, chartered and constructed for the single purpose of maintaining the proper proportion between demand and supply. With us the general banks, which are the consumers and represent the consumers, are at the same time the regulators. Where everybody regulates himself, there is anarchy and chaos in times of stress. Money making and the maintenance of a safe proportion between cash and cash obligations are at times distinctly opposed functions, and the performance of these functions should lie in entirely separated bodies. The general banks must remain money-making concerns, adminis- tered with the full responsibility of being able to meet all pos- (469) 86 BANKING REFORM IN UNITED STATES [Vol. IV sible cash demands by available cash credit. To guarantee that every cash credit can be met, if desired, by actual cash payment, and to avoid the possibility of such general demand for cash — this is the function of the central bank. Let us consider whether these aims of a central bank can be safely and effectively reached under the system above outlined. The great difficulty in the United States is the complete lack of modern bills of exchange, freely indorsed by the banks and passed on from hand to hand, as in Europe. With us there still prevails the old single-name promissory note, which, under our present system, is practically unsalable once it has entered the bank, and which therefore immobilizes our bank holdings. To permit the banks to rediscount these promissory notes with a central bank would be the easiest way, but the criticism may be justly raised, that in doing so we should open the door to abuse. Hence the inclusion, in a scheme previously out- lined by me, of the banking associations, which, having to guarantee the paper before it enters the United Reserve Bank, would carefully examine and sift it. The interjection of the banking association would make the paper safe beyond perad- venture and, if nothing else could be found or agreed upon, this system might well be adopted for the present. The criticism, however, has been raised against this method, that it would be fairly clumsy and that in normal times the banks would try to do without it. Therefore it would remain only an emergency system, out of touch with the market in normal times. To meet this difficulty, it is proposed in this plan to empower the United Reserve Bank to take directly from members, without the guaranty of the banking associa- tions, bills with not more than twenty-eight days to run. This thought developed from the following observation : Upon examining the report of the Reichsbank one finds that on December 31, 1908, it held in German bills M. 1,032,000,- 000; of which 44% were payable within 15 days, 17.4% within 16 to 30 days, 24.8% within 31 to 60 days, and 13.9% within 61 to 90 days. This brings out the surprising fact that the maturity of 61.4% of all the bills held by the German Reichs- (470) No. 4] A UNITED RESERVE BANK 87 bank was of i to 30 days. The average duration of all bills held by the Reichsbank is thirty-four days. A similar propor- tion could be shown by the Banque de France, where the aver- age duration of all bills held is even less, namely, twenty-four days. How is this to be explained? It means that if, when making up its daily balance sheet, a German or French bank finds that on balance it needs money, it will send to the Reichsbank or Banque de France for discount its bills falling due the next following days. These central banks have a complete schedule for each city where they have an office, stating the minimum number of days that will be deducted at the bank rate, without any further charge for collecting the bill. To illustrate this procedure : the Reichsbank in Berlin will charge on a bill be- yond M. 5)000 a minimum of four days for bills on Berlin, a minimum of five days on Hamburg, Bremen, Frankfort, and similar cities, a minimum of ten days for smaller bills on small and remote towns. This means that when the rate for call money and the bank rate are about even, a Berlin banker will send his bills on Hamburg to the Reichsbank for collection five days before the bills mature; if he collected them through his own correspondent in Hamburg, he would lose one day's in- terest at least, which would be consumed by the return trip of the money after the bill had been collected ; and the longer the distance, the larger the loss of interest. When money is very easy, it pays the banks to lose that day's interest, and col- lect the bill themselves, since, instead of submitting to a dis- count of five days at 4%, they might pay on call six days at 2% or 3% and still fare better. This illustrates how, by keep- ing its rate higher than the ruling interest rates, the central bank withdraws its funds from general business and accumu- lates reserves for times when stronger demands arise. The stronger this demand grows, the longer will be the bills which are being sent for discount to the bank, until they reach the permissible maximum of ninety days. A consideration of these facts brought up the question as to whether it would not be feasible and conservative to allow such institutions as may be admitted to dealings with the United (471) 88 BANKING REFORM IN UNITED STATES [Vol. IV Reserve Bank to rediscount with it directly, and without the intervention of the banking association, legitimate paper hav- ing no more than twenty-eight days to run. It would appear that this could safely be permitted. A bill which has only a few weeks to run embodies a much smaller risk than one hav- ing three months to run. General conditions and the standing of the bank offering the paper for discount, and of the maker of the note, can be judged with a fair degree of safety for a few weeks ahead. The United Reserve Bank would make it a rule not to buy thirty-day notes issued for the obvious purpose of being immediately rediscounted and renewed at maturity, but to acquire only paper originally issued as 2, 3 or 4 months' paper, in accordance with the usages of the trades in question. The bank examiners would be trained to ascertain infractions of the rule and, besides, the United Reserve Bank would notice them immediately when the new bill was offered for discount so promptly after the expiration of the old note. The shorter the maturities of bills, the stronger would be the United Re- serve Bank's position. While this plan would be of immense advantage to the banks inasmuch as it would enable them without difficulty to turn into cash at once about one-third of the bills which they have discounted, at the same time it would not encourage reck- less banking or speculation. No customer and no bank will dare to enter into extended commitments on the strength of an advance of twenty-eight days. What will happen after this lapse of time one does not know, and he must be prepared for possible retrenchment by the United Reserve Bank. Moreover, some rule would have to be established that the aggregate amount of such short bills sent in for discount by any bank should not exceed a certain percentage of its capital and surplus, and that the aggregate amount of paper sent in for discount issued by one individual or concern should not exceed a certain part of such surplus and capital. This method would appear to be entirely safe ; if deemed necessary, the twenty-eight-day limit might be reduced to twenty-one days. In the writer's opinion a twenty-eight-day limit is con- servative. (472) No. 4] A UNITED EESERVE BANK 89 We should then have one rate at which the branches of the United Reserve Bank in the banking association cities would take short bills directly from members, and one rate, possibly the same, at which they would take longer bills from members with the guaranty of the banking association. There remains to be established one more rate, the private discount rate, at which the United Reserve Bank would take sixty- or ninety-day bills, drawn by commercial firms on, and accepted by, a bank, trust company or private banker [as under {4)]. The private discount rate of the United Reserve Bank would be kept very low in the beginning, for the purpose of encouraging shippers at home and abroad to use the credit of American banks, where now they use foreign credit. Ship- ments of coffee from Brazil to New York and of cotton from Galveston to Boston are now usually financed by long drafts on Europe. Under this plan such banking transactions will be turned over to the United States. Bills will be drawn on Amercan banks and bankers, instead of on London, Paris or Berlin, and instead of being financed by others we may gradu- ally become the financers of others. Not only will this increase our trade, but most important of all, once we establish the modern banking bill in the United States, its use will grow and our banks will reap the tremendous advantage of being able to invest their deposit money in assets upon which they can quickly realize at home and abroad. As the use of this modern paper increases, so will the financial safety of the banks and the business community. These bills will be strictly commercial in character and it will be an easy matter to scrutinize the legitimacy of their origin. At least two well-known banks, trust companies, dis- count companies or bankers must accept or indorse them, and one of these names should be that of a member of a banking association. This is much more than any European central bank requires, and it should be entirely sufficient to provide against any political or financial danger in this respect. On the other hand, the powers given are far-reaching enough to bring about the most important change, viz., the creation of modern American bills of exchange. (473) 90 BANKING REFORM IN UNITED STATES [Vol. IV There remains to be considered one more field of activity for the United Reserve Bank; that is, its privilege of buying foreign bills having not more than ninety days to run. This power is necessary for obvious reasons. It would afford the United Reserve Bank an opportunity to employ its idle funds in times when the management should decide upon a policy of withdrawing funds from use in the United States, and it would enable the bank to accumulate an interest-bearing gold re- serve ; for foreign bills are available for the purpose of draw- ing gold from foreign countries, and they also serve as a means for warding off withdrawals of gold. We now have a fair outline of the normal functions of the United Reserve Bank. Though restricted in its dealings to the utmost limit of safety with respect to its scope of trans- actions and to its circle of clients, its effect will be most far- reaching. The cash reserves now scattered and useless will be concen- trated into an effective central reserve. The general banks will hold a sufficient amount of till money for their require- ments, but as a reserve they must hold a cash balance with the United Reserve Bank, commensurate as at present with the aggregate amount of their deposits. If cash is withdrawn from the general banks, they in turn will draw on the United! Reserve Bank for their needs and will replenish their balance by sending to it for discount short or long bills. As a result the dreaded cash withdrawal will lose its terrors for the banks. If a Chicago bank withdraws its balance from a New York bank, all the latter has to do is to notify the United Reserve Bank's branch in New York, by a transfer check, to transfer the amount in question from the account of the New York bank to that of the Chicago bank. Wherever branches of the United Reserve Bank are established, the wasteful remittances of cash between members will cease. The bank will act like a huge clearing house for the settlement of balances between various sections. Millions are now constantly in transit, mov- ing to and fro, crossing and recrossing one another in opposite directions. Hundreds of millions are kept in scattered bal- ances, which can be centralized under the new system. (474) No. 4] A UNITED RESERVE BANK 9 1 While banks now immobilize their assets by buying com- mercial paper which is legitimately issued, but which is prac- tically non-negotiable, and while they use for quick assets call loans on the stock exchange, that cannot be called in a panic or a time of stringency which falls short of panic, the new sys- tem makes commercial paper a quick asset which can be con- verted into a cash credit or into actual cash. Our present scandalous system, of attempting to regulate the money market of the entire country by first pouring money into the stock market, and then withdrawing it, creating inflation and exor- bitant security prices, followed in due course by stringency and unnecessary price depression, will give place to more or- derly movements, as our discount markets develop. This plan would be incomplete if it did not touch upon, with- out discussing in detail, the question of the government bonds and the notes issued against them by the national banks. It is certain that this question must be dealt with in a way entirely fair to the national banks. Otherwise they will oppose the plan. Having bought these bonds under the note-issuing privilege, they are entitled to due consideration if this privi- lege is to be withdrawn. It is most opportune that, whether we want a central bank or not, our miserable system of bond- secured note issue has at last come to a fatal impasse. One of the most beneficent influences of the construction of the Panama Canal is that it is opening our eyes to the impossibility of linking together the aggregate amount of the funded debts of a great nation and the aggregate amount of currency in the pockets of the people. There is no doubt that this foolish in- flation of our currency and of the price of our government securities must now stop. There is furthermore no doubt that elasticity means expansion and contraction and not expansion alone, as results from our present currency system. In order to secure an elastic currency and a safe basis for a United Reserve Bank, we must reduce our outstanding cur- rency somewhere, so as to substitute the new elastic note issue — an issue that will contract, so that it can expand with safety. One way would be an inverse conversion; that is, a gradual withdrawal of the existing note-issuing power with a simul- (475) 92 BANKING REFORM IN UNITED STATES [Vol. IV taneous conversion of our government bonds into obligations bearing a somewhat higher rate of interest, thereby safe- guarding the banks against a loss in the price of their bonds. This would bring the price of our bonds to a normal level, like those of England, France and Germany, whose people can afford to hold government securities. The higher interest rate to be paid by the government to the people would be the most wisely spent money in our entire budget. There are several other ways of dealing with this problem. Suffice it to say here, that to solve this part of the problem does not oiler insurmountable difficulties. It will be necessary only to inves- tigate which method is the best, and offers the least resistance. II Let us now turn our attention to the criticisms of those op- posed to a central bank system in the United States. Mr. Morawetz says ^ that the territorial expanse of the United States is too large for such a system, that the bank would be one of too " colossal magnitude " and that it would be necessary to place the central bank in a position to regulate and control financial conditions throughout the country. He furthermore claims that the central bank would either " have the power to discriminate," and therefore " the managers would be placed in the attitude of beneficent dispensers of bank credit and of prosperity " or, if properly restricted, the bank would be " a penny-in-the-slot machine for obtaining credit," the resources of which might be drawn upon too heavily by " banks engaged in speculative business or located in sections of the country where interest rates are high." The size of the country is an argument not against, but for, a central bank system. A small and unimportant country could live with a less perfect system, and could lean upon the other central bank countries in times of need. The immensity of our country, our resources and our transactions renders it '^ Victor Morawetz, The Banking and Currency Problem in the United States, The North American Review Publishing Co., N. V., 1909; and Address on the Banking and Currency Problem and the Central Bank Plan, delivered at the Finance Forum of the West Side Y. M. C. A., Nov. 24, igog. (476) No. 4] A UNITED RESERVE BANK 93 absolutely necessary for us to adopt the most efficient system in existence/ The greater the area, the more perfect the sys- tem must be in order to reach every remote point. The plan here outlined covers the whole country. Each section of the United States, as a matter of fact, will have a central reserve bank of its own, where directly — or indirectly through its correspondents — each bank in the United States will enjoy the advantages offered by the United Reserve Bank. While the general policy will be settled at the head office, in consultation with the presidents of the branch offices and the members of the central board, the actual business will be done by the branch offices, which will act as separate units for each sec- tion.^ There will be this most important difference, however, that, as far as reserves are concerned, they will be united and act as one. The surplus of one section will be available for other sections and the interests of all together will bring about the general policy of the United Reserve Bank. The effectiveness of this plan would not be interfered with by a provision that the discount rates of all the branches need not necessarily be the same. Thus it might be possible to meet undue expansion in one section of the country by increasing the rate of that branch without increasing the rate for other sections. As outlined here, the United Reserve Bank will not be a " penny-in-the-slot machine," any more than the European central banks, which discount and advance upon uniform con- ditions published from time to time. The United Reserve Bank would certainly have the right to refuse any paper that did not appear safe or legitimate. Furthermore, the power to increase or decrease its rate and its circulation would place it in a position amply to protect itself and the country. At the same time, the restrictions placed upon it absolutely preclude ' Our weight has become too heavy and threatens at times to break the Euro- pean machinery which we use to make up for the lack of elasticity in our own system. ' Even the banks at Washington, D. C, would deal with the United Reserve Bank only through a local branch office, like all the other banks in the country. (477) 94 BANKING REFORM IN UNITED STATES [Vol. IV any danger of its becoming " a beneficent dispenser of bank credit and prosperity." The fear that some section, where in- terest rates are high, might absorb all the available means of the United Reserve Bank, may be dismissed from considera- tion. The proportion to be fixed between capital-and-surplus and amount admissible for rediscount with the United Reserve Bank would prevent such abuse. Besides, as this facility of rediscount is a most valuable element in the strength of a bank and its real reserve, no conservatively managed institution would go to its full limit in normal times. An institution known to abuse its rediscounting privilege would quickly lose standing in the community. Mr. Morawetz's next criticsm is directed against the " con- trol of the bank." It is contended that there would be too much one-man control, or control by a group; that the bank might become involved in political strife or become the issue between contending political parties. The first two points we have already answered at length, and little remains to be added in this respect. The central office would merely indi- cate the policy; the branches, which practically are under the supervision of the local banking associations, would under- take certain well-defined, safe transactions, into which no ele- ment of politics could enter, any more than it enters into our clearing houses. No political patronage whatsoever would be connected with the United Reserve Bank. A conscientious and honest man, not even brilliant, would be required to fill the presidency, at the pleasure of a board which, as we have seen, would be made up of the best men the various banking com- munities could secure as delegates. There is no reason, despite our critics, why such a board should not work harmoniously and effectively, and whoever examines the plan from an un- biased point of view will see no danger of excessive power being vested in one man. Mr. Morawetz claims that great disaster would follow if the central reserve bank, once established, should be abolished again. Quite true; but should we hesitate to build a water reservoir, because we feel that it would be a calamity if one day it were to be removed? It is safe to say that if a system (478) No. 4] A UNITED RESERVE BANK 95 were established as safe as the one here outlined, it would de- velop as our country develops. Its requirements might change; but just as little as we can go back to the old mail coach after the railroad, just so little can we return to our present impos- sible system, once we have modernized it. If frauds or patron- age fill the post office or the custom house or the army and navy or the treasury, we should clean up but not abolish those departments. Though it is difficult to perceive how under our plan abuse could develop, in such a case we should clean the house, but we should not destroy it. Mr. Morawetz concludes his argument by saying that a central bank should not be tried because if it should fail, the cause of true reform would be postponed for a generation. In so doing, he reminds me of a man who should refuse to be born, for fear that he might die ! Now let us analyze Mr. Morawetz's plan.^ Under it, Mr. ^ [At the request of the editor, Mr. Warburg left this section as written in the spring of 1910, though Mr. Morawetz later modified his plan in some particulars. — Ed.] Mr. Morawetz's plan provides for so-called " note-issue associations,'' embracing practically all the national banks of the country. The banks will appoint a board of managers, who in conjunction with the Secre- tary of the Treasury will have authority to establish branches wherever they deem it advisable, the main office of the association being at Washington. The main function of the central office and the branches will be to regulate the issue and redemption of notes. Each national bank will be entitled to issue against its general assets an amount of notes equal to its capital stock. The board of managers, however, has the right to increase the amount of note issues of the banks to some fixed percentage of the capital stock of the banks, and this board also has the power to reducfe such increase as it may have au- thorized. Each bank having taken out notes will be required to keep on de- posit with the association, as redemption fund for their payment, a sum of lawful money equal to such percentage of the notes as may be prescribed from time to time by the board of managers and the Secretary of the Treasury. The required percentage of the redemption fund will be fixed from time to time by general order applying equally to all the banks, but the required percentage will never be less than 20%, of the outstanding notes. It is left open for further discussion in the plan whether each bank shall receive a special note issue and shall keep a separate redemption account, or whether it will be practicable to have one joint issue and one joint redemption account. The general idea of the plan is that when notes are issued, they shall be covered by a substantial amount of cash to be set aside in the redemption fund, let us say 40 to 70%. The board of managers will have the power, in times of stress, to allow a reduction of this reserve in the redemption fund, which, however, may not be lower than 20% and in times of easy money, the central (479) 96 BANKING REFORM IN UNITED STATES [Vol. IV Morawetz provides for a board of managers, to be elected by the banks. This board, in conjunction with the Secretary of the Treasury, will have the right and duty of dictating to every bank in the United States what percentage of cash it must hold against its outstanding notes. We grant that such a board could be so constituted as to be safe ; but every argument raised by Mr. Morawetz against the dangers of political or one-man control of the central bank board, can be applied with equal force to his board of man- agers. However, the power of this board of managers is more far-reaching and of broader scope and therefore more dan- gerous than that of the board of the United Reserve Bank. While the central bank is a passive institution, Mr. Morawetz's board of managers is an active institution. The central bank establishes rates at which it is willing to do business, but it does not force anybody to do business with it. If the bank rate should be 5%, banks in the South may find it to their ad- vantage during the cotton crop movement to rediscount with the United Reserve Bank, while banks in New England may for the time being dispense entirely with its services, and there- fore not be affected. If, however, the board of managers, under the Morawetz plan, issues its command that all banks must increase their reserve against notes from 30% to 40%, it is a direct interference with the business of every individual bank in the country, no matter if money is easy in Boston and tight in New Orleans. Expansion and contraction is ordered, whether it is needed or not, for every one at the same time. How about " expanse of territory " in this case? Is it possible to regulate all the varying demands of the varying sections of our immense country at the same time by one " You must!"? It is Mr. Morawetz's " You must!" against the United Reserve Bank's " You may I" This difference is most important. Furthermore, while the United Reserve Bank is enabled to board may decree that this redemption fund be increased up to ioo%, so as to withdraw the notes, finally, from circulation. The plan provides for the withdrawal of all national bank notes secured by government bonds. Some provision has been made to protect the bonds owned by the banks. (480) No. 4] A UNITED RESERVE BANK 97 perform its functions by the freest return of idle money into the central reservoir, thus avoiding its being needlessly held in separate reservoirs, Mr. Morawetz would force every one at the same time to withdraw more cash and to. lock it up as spec- ial collateral for new notes. This power to influence money rates, vested in a few men, would, from Mr. Morawetz's own point of view, form a grave danger. Leaving aside this phase of the question, the system is un- sound for these further reasons : ( 1 ) Our examination of modern systems has shown that note issue is only a side question. It is a poor plan, therefore, to try to solve the main problem by attacking an auxiliary part of it. It is just as unsatisfactory as the attempt to repair a broken-down dynamo by readjusting the storage battery at- tached to it only as an auxiliary emergency device. (2) Notes issued by banks must be considered as demand deposits, since for both, payment in cash may be demanded. It is an unfair and unscientific plan to secure one depositor by 50% or 60% of cash, while the other must be satisfied with 20%. (3) It is a faulty system that will change practically the whole outstanding currency carried in the pockets of the peo- ple into money which the banks may not hold when it is paid in to them. (4) It is an anomalous and unsound system that allows a bank to pay its creditors in notes which it may not carry as re- serve, or that forbids it to carry as reserve against a deposit, notes the very receipt of which may have created such deposit. (5) The Morawetz plan tries to solve the problem exclu- sively by issuing more or less currency. But it is cash credit, not currency, which is required most frequently. The two are not identical. (6) A bank is safe in granting time loans against time money which it may have taken ; the excessive granting of time loans (loans and discounts) against ceJI loans (deposits) is dangerous and often the cause of financial disturbances. A bank already overextended, makes its condition more dan- gerous by granting further accommodation through note issue. (481) 98 BANKING REFORM IN UNITED STATES [Vol. IV For increased note issue means an increase of demand obliga- tions, while rediscounting of paper with a United Reserve Bank means an outright sale of assets. That is, cash credit or cash becomes available without the creation of a new and dangerous demand obligation. (7) The vicious system of separated, disconnected and com- peting reserves remains the same. This is only an outline of the main arguments against Mr. Morawetz's plan. It would lead too far to follow up in detail every single point. What would the effect of this system be? There were in the United States in 1908, according to the report of the comp- troller of the currency : Nat'l Banks State Banks Trust Go's Sav. B'ks Number 6,853 11,220 852 1453 Cap. Stock $921,000,000 $502,000,000 $278,000,000 $36,000,000 Surplus 566,000,000 217,000,000 370,000,000 244,000,000 Cash 889,000,000 308,000,000 118,000,000 44,000,000 Deposits 4,374,000,000 2,937,000,000 1,866,000,000 3,479,000,000 Under the Morawetz plan, the 6,853 national banks, which are money-making concerns, competing against one another, with deposits of $4,374,000,000, would have to bear the bur- den of regulating not only their own conditions, but also those of the other institutions, having deposits of $8,282,000,000. But let us suppose the state banks all turned into national banks. We should then have 18,073 banks, with a capital of $1,423,000,000; surplus $783,000,000; cash $1,197,000,000; deposits $7,311,000,000. In order to bring the state banks up to the standard of the national banks, figuring only a 25% re- serve, a cash reserve of $1,462,000,000 would be required, being an addition to bank cash that must be withdrawn from circulation of $265,000,000. Every bank will have the right to take out these notes to at least the amount of its unimpaired capital, and the board of managers may authorize larger issues. Let us take the minimum, $1,423,000,000, and a reserve of only 40%. This would mean an additional withdrawal of cash of $568,000,000, or a total of $833,000,000. This means (482) No. 4] A UNITED RESERVE BANK 99 that two and three-fourths times the amount of cash held at present by all state banks, or about the total aggregate amount of cash now held by all the national banks, would have to be withdrawn from circulation and be replaced by bad notes — bad because they cannot be used by the banks as reserve money. Taking the above figures as a basis, it means that there would be in the hands of the public about $1,400,000,000 of national bank notes, while the circulation of such notes under our present system amounts to about $700,000,000. When there is a demand for more currency, and not for more credit, the plan may work for a while, though weaken- ing the currency ; but when there is currency enough in the pockets of the people, while demand for additional credit con- tinues, every note issued will return at once through the re- demption fund and must be paid in cash. Every bank will then try to accumulate legal-tender notes, to strengthen its power of granting credits, and will therefore at once present for redemption the national bank notes that it receives. Crises have frequently arisen because people believed that the top wave of demand for accommodation had passed, and all means had been spent in this expectation, when the main pressure had not yet begun. If during such critical times gold withdrawals from abroad should begin, it is difficult to see how under this plan reserves could be strengthened, for it is to be expected that in such case the reserves would already be at the lowest point. Then we should again witness the critical times when one bank, by refusing to renew its call loans and thus throwing the burden on the others, creates a credit balance for itself in the clearing house, thus strengthening its cash balance at the expense of the others. Retaliation would follow, and panic would be in sight in the future just as it has been in the past. The weakness of our present system in this respect would remain unchanged. This plan would leave the treasury money either wastefully piled up and withdrawn from circulation, or it would leave to the Secretary of the Treasury arbitrary power to dispense favors by depositing the funds wherever he may prefer. It would leave promissory notes as immovable in the future as in the (483) 100 BANKING REFORM IN UNITED STATES [Vol. IV past, with no hope of ever developing a modern system of bills of exchange. I have no hesitation in saying that it would be a most reckless experiment, on entirely new and untried lines, and it would in my opinion lead to certain disaster. Mr. Morawetz's plan contains two suggestions : one, as we have seen, being the regulation of reserves against note issue, and the other being the creation of sectional reserve banks. It is greatly to be regretted that Mr. Morawetz has emphasized the first scheme and touched only slightly upon the second. It is sincerely to be hoped that he will work out in detail this plan for sectional reserve banks, which he desires to be at all times in a position to furnish reserve money to the several banks in their sections by paying checks drawn against the deposit accounts of the banks or by rediscounting paper of- fered by them for that purpose. I am confident that Mr. Morawetz will soon reach the con- clusion that these sectional reserve banks must be endowed with all the powers and charged with all the duties given under our plan to the United Reserve Bank branches ; otherwise they will be nothing but safe-deposit vaults, which will have to hold for each bank the exact amount of cash received from it for safe keeping. They can not go a single step further without incur- ring the gravest danger unless they have some central bank to fall back upon, or unless they are themselves central banks, that is to say, disconnected central bank branches. Mr. Mora- wetz tries to cover the weakness of decentralized reserves by providing that the several sectional reserve banks be author- ized to make arrangements with one another in order to facili- tate exchanges between different sections of the country. But there must be more than this authority to make arrangements with one another with a view to facilitating these exchanges. These sectional reserve banks must in the end act as a unit. Otherwise we shall have a recurrence of our experiences at the end of 1907, when one reserve center closed itself against the others, when enforced credit was established within each finan- cial center, indeed,, but when New York, Chicago, Philadel- phia, Boston, Pittsburgh, and all the others, would not accept even the joint obligation of all the banks of their sister cities. (484) No. 4] A UNITED RESERVE BANK lOI Obligations between cities remained payable in cash, and dis- trust among these centers brought about the actual phase of the gold premium and the long period of general suspension of cash payments. Should a common foe attack Boston and New York, would Illinois keep her soldiers at home, or would she differentiate between Boston and New York ? The knowl- edge that all will stand together gives a feeling of confidence and safety. It is the same with our financial reserves : they must be held united under one direction, to be thrown where they are needed and to be withdrawn from places where they are superfluous. The joint credit of the nation must stand behind the reserves, insuring unlimited confidence that noth- ing will be able to shake. There must be one big reserve, one note-issuing power, one big bank, which will be neutral, administering impartially and economically the funds of the treasury of the United States, and issuing notes that are good enough not alone for the peo- ple, but also for the banks to be counted as cash. Instead of 20,000 institutions carrying an average of 8% cash against their deposits and notes, what we need is one big institution with a capital of $100,000,000, acting as reserve for all and maintaining a normal reserve for its notes and deposits alike of probably 80% instead of 8%. By following the central bank plan and adapting it to our conditions, we know with cer- tainty that we are following along lines which have been thor- oughly tested elsewhere and have led to success everywhere. Therefore, even with equal advantages otherwise, the central bank plan should prevail. In fairness to Mr. Morawetz it ought to be stated that he has never denied the superiority of the central bank system. In fact, he advocates its adoption wherever it can be done with safety, but he believes that our peculiar conditions render it impossible to evolve a plan which will be at once safe and ef- fective. Fear of a dangerous centralization of power has led him to prefer an attempt to control a scattered note-issuing power and has induced him to advocate separate sectional re- serve banks rather than em actual unification of reserves. The object of this essay has been to show that these half (485) 102 BANKING REFORM IN UNITED STATES [Vol. IV measures will not afford adequate relief and that they invite, and even to a larger degree, the very dangers which are sup- posed to be inherent in the central bank plan. On the other hand this essay has been designed to prove that it is possible to evolve, on the sound principle of a central bank, a plan which will not only be effective but at the same time meet the difficulties which Mr. Morawetz has so forcibly pointed out. Through his criticism he has helped us gradually to perfect the present scheme, and now that we have perhaps succeeded in meeting his objections, we trust that he will continue to help, not only by criticism, but by cooperation in further developing the scheme on lines which he himself has recognized as at least ideally the best. Ill Professor Sprague has published an article entitled " The Proposal for a Central Bank in the United States: A Critical View." ^ The conclusions which the author reaches in this essay are as follows : A central bank does not appear to be either required or well suited to relieve our financial difficulties. On account of the absence of branch banking it would not be able to handle the government funds in a satisfactory fashion, or to provide an elastic note issue. Branch banking is an essential preliminary, if we are to have a Central Bank of anything like the European type, and there are powerful objec- tions to such a change, the discussion of which does not fall within the scope of this essay. Neither from the historic nor from the practical point of view is this conclusion correct. Effective central bank systems existed in Europe before the branch-banking system was evolved. The Bank of England was organized in 1694, the Banque de France in 1800, the Bank of the Netherlands in 1814, and the Bank of Austria-Hungary in 1815. In all these countries the central banks performed their duties effectively during a period when banking concentration in the modern ^ Quarterly Journal of Economics, vol. xxiii, May, 1909. (486) No. 4] A UNITED RESERVE BANK 103 sense had not begun and when private banking firms were still transacting the main banking business. The phenomenal growth of the joint stock banks, the absorption of private firms, and the all-embracing development of the present branch- banking system are an evolution which has taken place in Europe almost entirely within the last thirty years, and which reached its present predominating importance only within the last twenty years. The evolution of branch banking is not in- cidental to a central bank system, nor is the central bank sys- tem the outgrowth of branch banking. Branch banking, in its present form, is incidental to the unlimited power of expan- sion and concentration which followed the evolution of the modern stock company, the corporation. From the practical viewpoint it is a mistake to think that branch banking is a preliminary step essential to a central bank system. The influence of the central bank is stronger with a system of small and disconnected banks than with enormous branch-banking organizations which, singly or combined, are so powerful that at times they are able to pursue a policy of their own in contravention of that of the central bank. While it is true that when these banks cooperate with the central bank, the latter may accomplish more immediate results, the fact re- mains that these larger institutions are able, at times, to eman- cipate themselves entirely from the influence of the central bank and that when in the end they are forced by circum- stances to fall back upon the reserves of the central institution, the sudden weight is such that the central bank finds it difficult to carry the burden. Enormous banking concentration has been watched by the managers of central banks with a feeling of concern rather than with a friendly attitude. The central banks look upon the independent and smaller institutions as their most loyal fol- lowers, and the central banks stand, as a matter of fact, as pro- tectors for the smaller institutions against the aggression and the overpowering influence of the larger ones. However, the jealousy between the large banks and the central banks, some- times prevailing in Europe, need not exist with us, since in Europe the central banks compete, to a certain degree, with the (487) 104 BANKING REFORM IN UNITED STATES [Vol. IV general banks; a' situation which would be avoided by us under the present plan. One might dissolve to-day all European branch banks into the many independent banks and banking firms which originally constituted these big concerns, and the central bank system would not suffer in efficiency from such a change. One might eliminate all the branches of the central bank, and the central bank system would still remain efficient though it would achieve its results in a somewhat slower, less direct and hence less economical manner. On the other hand, the elimination of the central bank system in England, France or Germany would force the smaller independent banks to sur- render at once to the big banks. Without the protection of the central bank they could not survive. The basis of the central bank is the centralization of reserves and what Professor Sprague calls " the fluidity of credit." Eliminate these two, and the central bank system must fail. Professor Sprague says in respect to this : The fluidity of credit is absent in this country, and will remain ab- sent while we wisely continue to prefer banks managed by persons with extensive local knowledge to branch banks subject to bureau- cratic managers, acting under general rules laid down at a distant head office. For this reason we cannot expect our money markets to be subject to the comparatively slight and distant influence exerted by a central bank. It would be necessary to concentrate bank re- serves to such an extent that every banker would feel that his safety depended upon the situation of the central bank. To begin with the last sentence of Professor Sprague's ob- servations, it has been shown in the previous chapters of this essay that the absolute concentration of banking reserves into one central reservoir is the very foundation on which a modern structure should rest, and there can be no doubt that every banker in the United States would be satisfied as to the abso- lute safety of reserves under such a system of centralized re- serves, for which, as a matter of fact, the credit of the entire United States would be pledged. Professor Sprague's suggestion that fluidity of credit is based upon branch banks cannot be admitted. What does (488) No. 4] A UNITED RESERVE BANK IO5 fluidity of credit mean ? The very expression points to a credit that is liquid ; it means the very thing to which I have so often and so insistently drawn attention, the question of rendering liquid the assets of a bank. Whether we had branch banks or not in the United States, the present system of issuing and handling American bills, which form non-liquid assets in the hands of the banks, would stand in the way of fluidity of credit. A central bank in the United States, even with a fully devel- oped branch-banking system, can not effectively perform its duties unless we find some way of making these immovable promissory notes movable instruments of credit. The object of this essay is to show how a central reserve bank system, as here proposed, could fill the present need in this respect, and pave the way for further development in the right direction. Professor Sprague's main arguments are based upon the mis- taken idea that a central bank in our country would need thou- sands of branches in order to deposit equably all over the coun- try its own and the government's moneys and in order to dis- tribute impartially its notes among the banks. To quote his argument in this particular : The manner of putting this vast sum (being the balances of the United States government) into general use would be equally without precedent. Without doubt there would be a general demand that the deposits be used with a general degree of approximation to popu- lation and the supposed needs of different parts of the country. At this point an insurmountable obstacle would be encountered. To lend directly to the business community would require an impossible number of branches. Lending at the relatively small number of branches which we have assumed might be established would not ac- complish the purpose. In order to distribute its funds widely, the central bank would be obliged to lend to at least as many banks as there are localities ; and, since the selection of a single bank would give rise to charges of favoritism, the bank would be certain to lend to all the banks. The central bank would be obliged to decide between the claims of 15,000 or more banks. This shows an entirely erroneous conception of the activities (489) I06 BANKING REFORM IN UNITED STATES [Vol. IV of a central bank in general and of our United Reserve Bank in particular. Under our plan, the central institution would neither deposit moneys nor distribute notes ; it would discount paper and collect discounted bills as they fall due. Deposit- ing moneys is an operation in which the initiative would rest with the central bank and in which the danger of favoritism might be lurking. For the operation of discounting bills at a published rate, the initiative rests with the general banks and, within certain limits, with all banks alike. The United Re- serve Bank does not reach the banks, but the banks reach the United Reserve Bank; and the organization as here proposed would enable each bank in the country, directly or indirectly, to reach the central institution. While as a matter of safety, economy and efficiency, a num- ber of branches as proposed in our plan would certainly be advisable and feasible, there is no need for thousands of branches to reach every single point where banks are in ex- istence. Professor Sprague evidently does not appreciate the spreading power of the discount rate. When promissory notes or " bills " become " bills of exchange," money for safe and legitimate purposes flows easily from one end of the country to the other, and the higher the development of the discount system, the more the spreading power of money will be felt and the safer our system will become. While our plan does not attempt to provide the highest degree of fluidity for the present, it will create conditions under which the spreading power of the discount rate will be felt at once, and that will insure efficiency for the United Reserve Bank and safety for the country. We cannot imagine that the prices for staples will ever vary greatly between New York and San Francisco in spite of their territorial separation. The maximum difference would prob- ably be the cost of transportation between the two cities. This is explained by the fact that we have established certain brands or standards as the basis of our dealings, which enable us to purchase and sell by letter or telegram without negotiating for individual bags or boxes which we sample and select. Without this method we should deal with necessities as we deal (490) No. 4] A UNITED RESERVE BANK 107 with luxuries, paying for each article a fancy price, which price may differ widely in the various parts of the country, though the quality be the same. In this respect the bills re- ceivable of an American bank are like a collection of curios, selected with care and pride by the president of each institu- tion, but difficult of sale unless another collector is found who happens to be interested in the same article, and who does not possess too many of the same kind already. Bills receivable in Europe are like so many bales of cotton, bushels of corn, or bags of coffee, standardized, homogeneous articles, which can be sold at once. The discount rate of the central bank, on the strength of which the general discount market develops, is a potent factor in bringing about the creation of standardized bills of exchange. This evolution in the United States also will follow the establishment of a United Reserve Bank, which from the beginning, even with our present conditions, will be able to provide a fluidity of credit sufficient to make the plan effective. When we conceive clearly the fundamental ideas underlying the working of a central reserve banking system, we see the lack of force in Professor Sprague's argument that " our diffi- culties would appear, as in the case of government deposits, as soon as the attempt was made to place the notes where they were really needed, — in agricultural sections of the country," in view of the difficulty which he foresees, that the banks gen- erally would be too eager to secure these notes and use them as reserves. Under our plan a balance with the United Reserve Bank is equivalent to cash in hand, and therefore there will not be an eagerness to secure any notes, except as they may be required for actual circulation. Professor Sprague appears inclined to think that a further danger inherent in a central bank scheme would lie in the di- rection of increased expansion. Under existing conditions, in his opinion, the risk of undue expansion could be averted and " normal seasonal variations in credit requirements could be readily met if our banks were less given to the habit of lending to the full extent of their resources in months when the course of business gives them an abundance of cash." His final (491) I08 BANKING REFORM IN UNITED STATES [Vol. IV recommendation is that the six largest New York national banks should hold reserves of 30% in times of financial quiet, and that they should use these reserves freely, without con- sidering the 25% limit, in times of financial disturbance. Inci- dentally the suggestion is made that reserve banks and central- reserve banks be not allowed to pay interest on bankers' bal- ances. These suggestions are coupled with a curious pane- gyric, praising the use of the clearing-house certificate, with a somewhat disguised recommendation of partial suspension of payments as a legitimate means of meeting extraordinary de- mands, and with an attack on the New York banks on account of the " ignorance of our bankers of the only method which experience in other countries has shown to be uniformly suc- cessful in allaying financial panics." The method here re- ferred to by Professor Sprague consists in meeting unre- servedly, by freely paying, any demand for cash made upon the banks. In this respect he makes the following statement : We already have far more centralization of banking power in New York than is generally realized. Before the crisis of 1907 the six largest New York national banks held net bankers' deposits of $305,- 000,000 out of a total of $410,000,000 of such deposits held by all the national banks of the city. It is somewhat disconcerting to find that these banks, which held a reserve of $140,000,000 in August, 1907, still held $110,000,000 in December, 1907. No stronger argument can be made in favor of a central bank than is contained in this statement. Once a panic begins under our present system of decentralized reserves, there is no other means of salvation for reserve and central-reserve banks than to stop payments. In their anxiety the country banks, which held $305,000,000 of balances in New York, would have withdrawn the entire $140,000,000 available in New York in August 1907, and while this process of diminishing reserves in New York was taking place, it stands to reason that the demand for cash within New York by the other depositors of the New York banks would have increased at the same dan- gerous rate. A system of decentralized reserves without any provision for transforming cash credits readily into cash must (492) No. 4] A UNITED RESERVE BANK I09 inevitably come to grief in a period of distrust, no matter whether the New York banks keep reserves of 30% or 25% in easy times. Professor Sprague does not appreciate the difficulty these six banks would have in realizing when conditions for legiti- mately decreasing the reserves actually prevail. These banks are primarily money-making concerns; if, during times of strong demand for accommodation, they should refuse to grant it and call-money rates should rise to extraordinary heights — as they inevitably must under our present system — these Wall Street banks would be accused at once, as they always have been in the past, of greed and manipulation. If they should meet the demands, yielding to such clamors, their reserves would soon diminish, and conditions would remain as hereto- fore. When the panic came, as come it inevitably would, it is more than probable that the reserves of the banks would al- ready be below 25%. Furthermore, if we carried out Professor Sprague's sugges- tion, that the central-reserve banks should not allow interest on deposits by other banks, the immense balances kept by coun- try banks in New York would cease, and th^e restrictive power which Professor Sprague wants to apply to these banks would thereby become void. These large amounts are not kept in New York for the sole purpose of acting as a safe reserve, but they are sent to New York to act as " on call " assets which at the same time earn interest. It is for this reason that Professor Sprague's remarks are not justified when he says: " The fail- ure to adopt proper methods seems to be due not so much to in- ability as to a failure to recognize the responsibility of their position by the New York banks which hold bankers' deposits." Country bankers demanding interest on their balances cannot expect to have them kept in cash. It is strange that a writer searching for remedies on the lines of the above suggestions should find fault with the central bank plan, for the reason that, as he believes, it would not be able to exert a restraining influence upon the expan- sion of credit, because it would have no means of carrying out a pre- (493) 1 lo BANKING REFORM IN UNITED STATES [Vol. IV cautionary policy. Is it not certain that, in the eager search for funds in times of active business, the other banks would resort to it for heavy loans? Doubtless a considerable measure of accommoda- tion would have been thus granted if we had possessed such a cen- tral bank in the years before the crisis of 1907, even though it had been managed with far more conservatism than we have any reason to be certain of securing at certain times. Every dollar thus bor- rowed would have been an addition to the extension of credit at a time when restraint was needed, not expansion. The central bank would have been creating a certain amount of credit expansion, which its later power of contraction could certainly not have exceeded, and probably could not have equaled, because the volume of credit cannot be largely diminished without serious disturbances. The power to issue notes by a bank of this kind would be a positive evil unless it were strictly reserved for use only upon occasions of actual emergency. It is evident that a central bank managed with the single object of watching expansion and contraction, and of maintain- ing the safe proportion between cash and cash obligations, a bank which cannot be swayed in its policy by any prospect of gain, and a bank the management of which is not subject to the immediate pressure brought to bear by the customer in need of accommodation, will be in a vastly better position to form a clear opinion concerning the large point of view of the country's financial conditions than a local money-making bank. The central bank would not be subject to the same temptations nor to the same attacks, in case it should deem it necessary, in order to force general contraction, to insist on higher discount rates; but, incidentally, its very existence would prevent the exorbitant rates which from time to time are inevitable under our present system. Professor Sprague's argument that " the central bank would bring about exclusively further expansion of credit," would be sound only if we did not provide for contraction at the same time and from the very beginning. A substitution of notes of the United Reserve Bank for either the bond-secured currency or the greenbacks presupposes from the outset that into our present ever-expanding currency we should inject a large (494) No. 4] A UNITED RESERVE BANK III amount of currency which will contract and which must re- turn to the United Reserve Bank the moment that this insti- tution, in easy times, decided to collect its short bills without renewing its investment in them. No European system provides, as our plan would do — as a logical development of existing conditions — that banks should maintain so substantial a proportion of their deposits as a cash balance with the central bank. This in itself is a regulator; and even if, on the other hand, owing to our present conditions, the United Reserve Bank did not have the same power as that enjoyed by the European central banks, thanks to the import- ance of the European discount markets, the combination of balances to be kept and transactions to be made with the United Reserve Bank in order to maintain these balances would give it a certain restrictive and regulative power, the possibility of which Professor Sprague denies. From the practical viewpoint there can be no doubt what- ever that the basis for a healthy control by a central bank must exist in a country where regular seasonal requirements cause, with almost absolute regularity, acute increased de- mands for money and accommodation. A country of this kind will require at given periods certain additional accommoda- tion to avoid stringencies as now experienced by us from time to time, and will stand without disturbance the withdrawal of the additional funds after the seasonal demand has subsided. Because our present currency system is expansive only, and lacks the power of contraction, we experience the difficulty of meeting unusual demands whenever they arise. Why should we assume, on the one hand, that the best men to be found, when placed at the head of such an institution, would be un- able to cope with the problem, and at the same time be ready to place the burden on the shoulders of the managers of the six largest Wall Street banks, — the very men whom Professor Sprague accuses of having proved entirely unable to meet the needs of the hour in 1907? The same argument holds good with respect to the treasury funds. While denying, on the one hand, the ability of the central bank management to deal with the large funds of the (495) 1 1 2 BANKING REFORM IN UNITED STATES [Vol. IV treasury in the guarded and safe way in whicli a United Re- serve Bank disposes of such fUnds, Professor Sprague is evi- dently willing to let the Secretary of the Treasury continue as heretofore to dispense his favors as well as he can. As to the wisdom of allowing the United Reserve Bank to issue " unsecured notes," the writer believes that under the plan here outlined it is not probable that for many years to come unsecured notes will be issued to any considerable amount, if at all. But it appeared advisable to endow the United Reserve Bank with this privilege, so as to imbue the country with the fullest confidence that cash will always be forthcoming. This confidence will be the very means of ren- dering unnecessary a large issue of unsecured notes. It is impossible to reply to every single point enumerated by Professor Sprague. I have therefore singled out these funda- mental arguments that needed refutation. But, in closing, let us touch upon one more point raised by Professor Sprague. It is evident that one of the functions of the United Reserve Bank would be to accumulate, in easy times, large amounts of foreign bills of exchange to hold as a gold reserve against emergencies. Professor Sprague believes that this would create anxiety in Europe. An accumulation of foreign bills of exchange would, indeed, give fair warning to the Euro- pean central government banks that in case of a stringency arising with us they must be prepared to meet a sudden de- mand from the United States. But the foreign government banks "would vastly prefer this danger, which amounts to noth- ing more or less than the perfectly legitimate collection of debts incurred by their own countries, rather than be subject to the violent attacks to which all Europe is now exposed when a panic is raging with us. There can be no doubt that the unwelcome presentation of a bill payable to the United States, but instrumental in avoiding a panic in the United States, would be much more satisfactory to Europe than a gen- eral suspension of payment with all the consequent terrors at home and abroad. It is a rather amusing coincidence that in this controversy the roles have apparently been exchanged. One would expect (496) No. 4] A UNITED RESERVE BANK II3 that the professor's and lawyer's point of view would be that nothing can be sound in practise which is unsound in theory, while the banker's attitude might be expected to express itself rather in an attempt at patching up existing conditions by practical measures without much concern about the theory. The banker's view in this case is summed up l5y asserting un- equivocally that no monetary reform will be' sound ''■'^d fif - fective which neglects the theory of centralized reserveB-ynd* fluidity of credit.^ IV Some critics have raised the objection that a bank as t^fc. outlined would not earn its dividends. There' cannot be any doubt that the United Reserve Bank will without difficulty earn a return on its capital in excess of 4% per annum. But we should bear in mind that this question of earning power is of very minor importance. If we want a bank which is not to be run for profit, but for the general weal ; if we want to cede to the United States any profit in excess of 4% net; and if, at the same time, we want the stockholders to be satisfied with a 4% investment, we should be fully justified in proposing that the United States guarantee a return of 4% to the stockhold- ers. Or, to express it in a happier way, it might be suggested that in consideration of the profits to be turned over to the United States by the United Reserve Bank and in considera- tion of the savings to be made by the United States in trans- ferring the various disbursing and collecting functions from the treasury to the United Reserve Bank, the government of the United States should contribute to the running expenses of the United Reserve Bank such lump sum as will enable it to pay to its stockholders a dividend of 4% per annum. It is safe to expect that, once established, the United Reserve Bank 1 Just as this essay is going to press, Professor Sprague has begun the pub- lication of a new series of contributions in the Quarterly Journal of Economics, vol. xxiv, no. 2. He has here somewhat modified his recommendations, but before dealing with them, it will be necessary to await the appearance of the further chapters which are announced. What has been said of Mr. Morawetz, at the end of page loi, however, applies equally to Professor Sprague. (497) X 14 BANKING REFORM IN UNITED STATES [Vol. IV will become a permanent source of revenue to the government, and that important savings in its present budget will be ef- fected. One more word in closing. The thought is general, with people who have not studied the question, that a central bank is a step towards monopoly. The reverse is the truth. Wher- ever a central bank exists, it is the backbone of the independent institutions in their fight against the overpowering influence of the large stock banks, as they exist in England, France and Germany. It should be clearly understood that the United Reserve Bank, by creating safe conditions, would make the small banks independent, where they now have to rely, and are dependent for help, on the good-will of their big sisters or the often doubtful ability of the Secretary of the Treasury. A central reserve bank properly organized is not an oligarchic but a democratic institution ; it would mean safety for all, hardship for none. There is no good reason why the existing banks should op- pose it. Wherever a central bank has been established the vested interests at first tried to prevent its creation. They saw only the danger of a change in business conditions which, though bad in general, had been profitable to them. They recognized only later that by the change they were enabled to transact their business in safety and that therefore they could do a much larger business. There is not one of these countries, in which opposition ran high against a central bank, where to-day a move to do away with the central bank system would meet with the slightest support. Neither the socialist nor the capitalist would dispense with it; it has become one of the fundamental parts of the economic life of modern nations, like the telegraph or the railroad. Would it be repugnant to the so-called American spirit? Is it an un-American institution ? Our opinion is that it is a slur and a slander upon the American people to say that they are morally or politically so utterly unfit that they cannot afford to adopt a system for which Russia, Japan, the Balkan States, and some of our South American sister republics have proved adequately prepared and which even China is seriously think- (498) No. 4] A UNITED RESERVE BANK \ \ 5 ing of establishing in the near future. We believe that the people will wake up to the humiliation of present conditions and that they will demand in no uncertain voice a thorough modernization of our system. We are inclined to think that ignorance about what a central bank would really mean has been more responsible for the popular antagonism to such a system than has the ghost of Andrew Jackson. Good Amer- ican citizens, who lived two generations nearer than we do to the dissolution of the last Bank of the United States, and were more familiar with its history than are the people of to-day, did not consider it an un-American institution. In this respect Abraham Lincoln's first political speech, which he delivered at New Salem in 1832, may be of interest. He said : " Friends and Fellow -Citizens: " I am plain Abe Lincoln. I have consented to become a candi- date for the legislature. My political principles are like the old woman's dance — short and sweet. I believe in a United States Bank ; I believe in a protective tariff ; I believe in a system of internal im- provements, and I am against human slavery. If on that platform you can give me your suffrages, I shall be much obliged. If not, no harm done, and I remain respectfully yours, " Abe Lincoln." It is seventy-seven years ago that this simple man from the woods, with his never-failing instinct, laid down this remark- able program, of which only one single part, " a United States Bank," remains to be carried out. Let us hope that it will be the pride of our generation to have achieved this step in the onward march of the United States. (499) PRINCIPLES THAT MUST UNDERLIE MONETARY REFORM IN THE UNITED STATES PANICS are acute infections of the body economic by the germ distrust. Varying causes may bring about a crisis, which always precedes a panic, but the degeneration of a crisis into a panic is invariably an epidemic of distrust. Every modern financial system is built on confidence, on credit. Our whole financial structure has become a system of clearings of credit, a system of substituting the token of confi- dence for the payment in actual cash. Against the immense amount of demand obligations payable by rights in cash at the option of the payee there is only a comparatively small amount of actual gold. The very moment that a general hesitation sets in to accept this clearing by credit, the very moment that a simultaneous request begins, calling for actual cash in payment of all demand cash obliga- tions, a general collapse becomes inevitable. A modern system must be so constructed that a demand for cash caused by dis- trust shall be absolutely impossible, or the system is not safe, and the mere knowledge of its being unsafe will precipitate a panic whenever an acute crisis arises. If a small fire starts in an old-fashioned wooden theater a catastrophe is unavoidable. The mere fact that everybody knows that he is in a fire trap and that the combustion will spread rapidly, brings about a panic with all its horrors of un- necessary loss of life and property. In a modern fireproof building the fire will be quickly extinguished: there will be less food for the flames, there will be a possibility of fighting them, and the feeling of safety will allow everyone to save himself without trampling his neighbor to death or blocking those who also want to escape. It is a critical situation, a crisis, which, thanks to modern construction and wise precau- tion, does not degenerate into a panic. (500) MONETAR Y REFORM 1 1 7 Why has our building proved a fire trap and why is Europe's structure safe? Why does Europe's system guarantee the avoidance of panics and why does ours inevitably insure their recurrence from time to time? It is from this point of view that all the material published by the National Monetary Com- mission ought to be studied and it is from this point of view that the final question of monetary reform must be approached. Let us then lay down as the first priciple which must guide all our further investigations, that no system which is by uni- versal acknowledgment theoretically defective will ever stand the strain of an acute crisis without that crisis degenerating into a panic. It is of no avail to patch up a theoretically wrong system and to strengthen it by some practical measures which give a false assurance of safety. When the storm comes, fear and doubt will begin to creep in through the loophole which logic, then wide awake, will drill, and once well-founded distrust begins, the system loses its basis, which is confidence, and must collapse. Not every measure that is right in theory is good in practise; but what is wrong in theory can never be right in practise. Let us lay down then the second fundamental principle, that a financial system which scatters and decentralizes reserves, making them unavailable and insufiicient in case of need, is fundamentally wrong and defective. In a modern system, constructed on credit, cash must be centralized as far as possible into one big reservoir, from which everyone legitimately entitled to it may withdraw it at will and into which it must automatically return whenever it is not actually used. In order to achieve this there must be two guarantees : one, that the central reservoir is safe and strong enough to supply all the cash that may be required from it, so that nobody will hesitate to let it become practically the sole trustee of all cash ; and the second, that every bank depositing its cash or allowing it to stream into the central reservoir will be sure to have the means at its command with which to acquire the cash that it may legitimately have to demand. In order that cash should always return into the central Csoi) 1 18 BANKING REFORM IN UNITED STATES [Vol. IV reservoir, cash must become less valuable than the interest- bearing right to command cash, which is embodied in a legiti- mate bill of exchange. To keep large supplies of explosives under our roof is a source of danger; the safer a community the less is the necessity for us to be provided with ammunition. It is the same with large cash holdings. Individuals, corporations and banks alike in a modern house- hold must try to reduce the holdings of cash to a minimum, be- cause cash holding entails the risk of loss and robbery and because a hundred dollars carried in the pocket for a year, or needlessly hoarded, means a loss of four dollars. Instead of accumulating cash, the desire must prevail to dispose of it as quickly as possible and to turn it into cash credits or interest- bearing quick assets. This leads to a clear division of the functions of the central reservoir and of the general banks. It is the function and duty of the general banks to act as the custodians of the people's money and deposits and to employ the same in conformity with the principle that a bank must not give any other credit than it receives, which means that against all demand deposits it must be able to provide at all times payment by cash credit. It is the function and duty of the central organ : first, to watch that the right proportion be maintained between all demand cash obligations of the country and the actual cash at its disposal; second, to guarantee that every legitimate cash credit can be transformed at will into actual cash ; and third, to establish so firm a confidence in its ability to perform these duties that cash will never be withdrawn to be hoarded, but will always return promptly into the central reservoir, leaving in the hands of the banks and the public only the amounts absorbed by actual cir- culation or taken for gold exports by creditor nations. From these different functions of the central banks and the general banks, there follow as a logical consequence the differ- ent elements necessarily inherent in their reserves. The central bank, having cash obligations, must have the strongest pos- sible reserve of cash and quick assets payable within a short time. The general banks, having obligations payable only in cash credit, need have reserves only in cash credit and in quick assets, convertible at all times into cash credit. (502) No. 4] - MONETAR Y REFORM 1 1 9 The channel that connects these two systems and enables them both to perform their functions in safety is the central bank's discount rate. The discount rate enables the general banks to build up a cash credit with the central bank, by redis- counting with it legitimate paper, and to draw actual cash against this cash credit, if necessary. It thus renders the main- tenance of a large holding of actual cash unnecessary for the banks. An increase in the discount rate enables the central bank, on the other hand, to protect itself by collecting a larger proportion of its maturing bills discounted, decreasing at the same time the amount of new purchases of paper, and inci- dentally attracting foreign money or warding off gold exports. While cash payments continue without hesitation, the increased rate brings about a general contraction which will result in a safe ratio between the actual cash holdings of the nation and the grand total of its cash obligations. The less actual cash is required in the process of paying debts and settling balances, the more developed is the system. This applies not only to the transactions within each city, but much more so to the settlements and payments between cities. Whenever a central bank opens a branch in a city, it means that from that day a bank of that community can deposit with that branch a given sum of money, and request that the amount be transferred to tlie credit of any other bank having an ac- count with the head office, or any other branch of the central bank. This means that a great clearing system will come into existence all over the country, and that cash remittances for account of the general banks will cease to exist between places where there are central bank branches. We have repeatedly dealt at length with the folly of a sys- tem which makes the commercial paper purchased by a bank immovable assets, locking up the capital of the purchaser, and which forces the banks to consider as their only quick assets cash in their vaults which they must not use, and call loans on the stock exchange which during a panic they cannot turn into cash. We may then stop here for a moment and establish four gen- eral principles, as I would like to term them, which follow from our discussion up to this point: (503) 120 BANKING REFORM IN UNITED STATES [Vol. IV I. Cash reserves must be centralized into one strong organi- zation where they will be available when needed, and where they will command such confidence that they will not be with- drawn except for actual circulation or gold exports. II. In order to secure the free return of cash into the central reservoir, there must be some means of exchange between the central reservoir and the banks, so that banks may rely on their ability to build up with the central reservoir a credit balance against which they may draw cash if necessary. This medium of exchange must be commercial paper; (under safeguards to be discussed later on). III. Fluidity of credit must be our final aim. A sound financial system must mobilize its commercial paper and make it a quick asset instead of a lock-up. Mobilized commercial paper, instead of bonds and loans on stock-exchange collateral, must finally become the most important basis of our financial structure. The larger reservoir must regulate the smaller one; not vice versa, as with us. Discounts in the main liqui- date themselves within a comparatively short period, and by the natural process of consumption. Bonds, which are invest- ments of long maturity, are not self-liquidating, but they and stock-exchange loans, which represent undigested securities, must be finally absorbed by the process of investment of the savings of the nation. This is at best a slow process, in which only comparatively few persons participate subsequently to the initial process of general consumption by all. Therefore no nation enjoying a modern financial system bases it prim- arily on bonds and stock-exchange loans. IV. Clearings must not stop within the limits of a single city. Remittances of cash at cross purposes between cities are even more wasteful than within a city, for the loss of interest is so much heavier and the danger of cash withdrawals from one city to another is so much greater in critical times. The central reservoir must act as an inter-city clearing house, as it does in Europe. Here we have the four main general principles, to which, a little later, we shall have to add two more, concerning note issue. These four principles are so self-evident and so abso- (504) No. 4] MONETARY REFORM 1 2 1 lutely essential that once we recognize them clearly the work to be done by us in reforming our monetary system ceases to be bewildering and complicated. Our compass is set and the only question that remains is whether we can avoid the cliffs that endanger our course. To effect a centralization of re- serves and a safe system of inter-city clearing ought not to frighten us as a problem offering insurmountable difficulties. To the general principles governing every financial system we now add some principles which ought to be observed with reference to our peculiar conditions. These principles I should like to term the local principles. They are as follows : 1. The central reservoir must not be operated for profit. If it takes the form of a bank, as probably it must, the stock divi- dends must be limited to what would correspond to a fair in- vestment basis. This moderate return might be guaranteed by the government, which in turn would receive the surplus earn- ings. 2. The central reservoir would have to be restricted in its operations. It should deal only with banks, bankers, and trust companies. Its main function should be to buy foreign ex- change, which it should accumulate in times of ease as a gold reserve, and it should purchase commercial paper from banks and trust companies only. The difficulty here is that we have as yet no standard dis- count paper such as exists in England, France and Germany, and that therefore, in order to avoid abuse, some system must be invented which will act as an effective control and which will supply an additional and safe guarantee. How this can be accomplished I have outlined in detail in an article entitled " A United Reserve Bank of the United States," which was published by the Academy for the Merchants' Association of New York some six months ago and which forms a part of the present volume.^ It would lead too far to go into details con- cerning the suggestions made in that essay. They are subject to modifications and were published only for the purpose of showing that it is possible without doubt to devise some scheme 1 Cf. p. 75, supra. (50s) 122 BANKING REFORM IN UNITED STATES |:Vol. IV which, while strict enough to prevent any abuse, can still be made broad enough to allow of practical and effective oper- ation. 3. The management of the central reservoir must be abso- lutely free from the dangers of control by politics and by private interests, singly or combined. This can be achieved without doubt by a combination of measures like the follow- ing: the stockholders would appoint only a minority of the directors; a small number of additional directors would be furnished ex officio by some political officers, but the majority could be appointed by groups of banks all over the country under a system, for instance, like that proposed in the above- named plan. These directors should elect and appoint the managing governor of the central organ, who would be chosen and engaged like any other bank president, without any politi- cal consideration, but with due regard to ability and character alone. But safety would have to lie not only in this mode of elec- tion, but also and mainly in the limitation of the profits and in the restriction of the operations of the central organ. A stock offering a maximum return of 4% combined with the restriction that the central reservoir may not do anything else but buy certain clearly circumscribed paper under the strictest guarantees and injunctions, cannot possibly involve any dan- ger from monopolistic or political domination. 4. The treasury should cease to deal directly with the banks. The central reservoir should be the recipient of the govern- ment's surplus funds and should attend to the government's disbursements. The influence in business of the treasury, a purely political body, must cease. 5. Cash balances with the central reservoir or its branches must be considered and counted by the banks as cash in their own vaults. The central organ must have power to request the banks to keep with it cash balances proportionate to the amount of their deposits.^ Thus every bank will be made to contribute to the work of the central reservoir, of maintEiining ' " Banks " always means national banks, state banks and trust companies. (S06) No. 4] MONETARY REFORM 1 2 3 a safe proportion between all cash obligations of the nation and its actual cash, a work which, with the lack of a fully de- veloped discount system, would otherwise remain much less effective. It is fortunate that existing circumstances allow such a measure — which is more far-reaching than similar ar- rangements in Europe — without adding any new burden to the banks which are in the habit of keeping these large cash reserves. The immense advantage to be gained, without any sacrifice made by the banks, will be that the vast sums of cash accumulated in the central reservoir will be freely forthcom- ing when needed, and will insure safety, instead of being helplessly and hopelessly stored up by the individual banks. 6. The central organ must be in a position to contract for temporary loans of gold with other governments or foreign central banks, and to receive or give collateral therefor. This clause is self-explanatory. The power that this meas- ure would confer would go a long way toward allaying fear, and thereby strengthen and benefit the system, even if the privilege were never made use of. We have thus far left entirely out of consideration the ques- tion of note issue. We have done this because the problem loses so much of its complexity and presents itself so much more clearly if the question of notes, which is only a side issue, is temporarily disregarded; and secondly, it is just because we wanted to show how comparatively unimportant this question of note issue really is, that we have endeavored to present the structure in its fundamental lines complete in itself without embodying note issue from the beginning. To try to remedy the shortcomings of our present system by reorganizing only the note issue, as many reformers have done, is to attempt to repair a broken-down carriage by hitch- ing to it a fresh horse. Effective centralization of reserves and the creation of fluidity of credit are the main questions. Elastic note issue is a side question, though a very important one.'^ ^ A full argument concerning this point is embodied in the author's article, " A United Reserve Bank of the United States," to which reference is made. The writer apologizes for some unavoidable restatements contained in the pres- ent essay. (507) 1 24 BANKING REFORM IN UNITED STATES [Vol. IV V. We may now enumerate our fifth general principle, which is this : Inasmuch as note issue, partly secured by gold, is only an auxiliary activity of the central reservoir, the note- issuing power ought to be centralized as far as possible in the central reservoir. For not only does this uncovered note issue give additional safety to the central reservoir, but there is in- herent in it a certain regulative power which is lost and en- dangered by an excessive decentralized and scattered addi- tional note issue. The point is plain : If notes issued by other banks must be paid by them in cash, these other banks would again become accumulators of cash and thus interfere with the free return flow of cash into the central reservoir. This would be a fundamental danger. If, on the other hand, they could rely on the central reservoir to redeem their notes in cash, they could work at cross purposes with the central reservoir, an- tagonize its restrictive policy, weaken its position, and still throw on it the entire burden of final cash redemption. Bank notes are deposits on demand in bearer form, passing as cash. If we desire to authorize the issue of bank notes partly secured by bills purchased and only partly secured by gold — as there cannot be any doubt we should — the duty to make sure that this proportion remain within safe limits and that the notes always be met by actual cash must be left to the same organ that guarantees the prompt transformation of every cash token into actual cash. VI. Furthermore, the function of making money and of is- suing money are at times distinctly opposed, and the perform- ance of these functions should lie in entirely separate bodies. In developing these principles I am not unmindful of the fact that in Europe also there are countries where note issue is not entirely centralized. Changes in a monetary system have to be perfected with extreme care and patience, and every- where it has been necessary to live through periods of com- promise before finally reaching the coveted goal. In Ger- many, where there were thirty-two banks of issue, there are now only five, including the Reichsbank, which now, as a matter of fact, has become the all-important regulator. The other banks have been brought into a state of coordination (508) No. 4] MONETARY REFORM 1 2 S where they have to cooperate in following the Reichsbank's lead. We, too, shall have to be prepared for a period of compro- mise concerning note issue. We have before us a complex problem, inasmuch as there are at present in circulation too many inelastic and unsecured, or poorly-secured notes, like the national bank notes, the greenbacks, and the silver notes. To convert at once any and all of them into the notes of the central organ would be too large an undertaking at this time. However, we may safely leave in circulation about half the amount now outstanding, to serve as the pocket money of the people, and begin by substituting the new elastic notes of the central organ for the other half. For elasticity means not only expansion, but also contraction. We must instil into our pres- ent system a sufficient amount of elastic notes — elastic because, being issued against bills purchased, they are withdrawn from circulation when the money paid for this paper at maturity is not reinvested in the purchase of other bills. If the bank can- not contract its notes in time of ease, it cannot expand as far as it should in times of stress. The principle ought therefore to be established that an ample portion of our present unse- cured notes ought to be withdrawn and replaced by the notes of the central organ. This, again, is not an impossible task. We have outlined in our previous plan how it could be accomplished by withdraw- ing the national bank notes and leaving the greenbacks and silver notes in circulation. We could well imagine another plan,^ which is advocated also by Prof. Sprague of Harvard, in connection with sugges- tions now made by him for a modified form of a central bank. This plan would probably be more popular, though in my opinion not quite so sound. It is a scheme which would for the time being leave the national bank notes and silver cer- tificates undisturbed and provide for the redemption of the greenbacks. The government would deposit with the central organ the $150,000,000 gold held against the 356 millions of ^ Quarterly Journal of Economics, Feb., Aug. and Nov., 1910. (S09) 126 BANKING REFORM IN UNITED STATES [Vol. IV greenbacks now outstanding. The central organ would as- sume these greenbacks and we should suggest that it receive in turn the privilege of calling on the government in times of stress to pay for the remaining 200 millions, which the gov- ernment would have the privilege of doing either by issuing to the central organ some short treasury bonds or by paying in cash. This would enable the bank in case of extreme de- mands to place the treasury bonds at home or abroad and break the pressure on its gold holdings. The surplus earnings of the central organ should be applied under this plan as a gradual redemption fund of the outstanding government bonds held by the national banks, and if, later on, it should be found necessary, the redemption of the government bonds in the hands of the banks might be accelerated by other means. 7. No matter what may happen, not one additional, govern- ment bond must be issued, carrying with it the privilege of further note issue by the national banks. While the national banks, which acquired these bonds in the past, are entitled to full and fair protection as to their present holdings, this reck- less inflation of our currency system, which even to-day is a serious obstacle to monetary reform, must not be allowed to increase and thereby further weaken our miserable system. 8. Automatic taxes governing scattered note issue cannot bring about a safe and practical regulation. Conditions vary ; a drain from within has to be met in a different way from a drain coming from without. Demands originating in healthy periodical economic developments must be treated in a differ- ent way from demands caused by over-expansion and over- speculation. In a large country covering the most varying geographical, social, and economic conditions, one ironclad tax, applied without possible discrimination to all alike at the same time, will do harm in one corner while it does good in another. The system must provide for the use of brains and for a wise power of discrimination, though the regulative power must be so strictly circumscribed that there can be no other motive but the general good in deciding upon the questions as they arise. The elimination of any possibility of gain, the restriction of (510) No. 4] MONETARY REFORM 1 27 the functions of the central organ and the composition of its board will guarantee this. One word in closing. With a structure as defective as ours, we cannot expect to develop at once an absolutely perfect new system. Monetary reform must try to perfect changes without violently upsetting existing conditions. The principles laid down here, and the details contained in my previous plan fully allow for this. The changes proposed leave the business of the banks and even their methods almost untouched. In order to do this, the so-called local principles must adapt them- selves to conditions. However, there must not be the slight- est compromise in two respects : The changes must err rather on the side of safety than on the side of immediate perfection and the fullest efficiency ; and furthermore, they must contain nothing that is in contravention of those general principles which can be neglected only by endangering the whole struc- ture. Centralization of reserves, effective concentration of note issue, and fluidity of credit, strongly safeguarded, though thereby somewhat clumsy in the beginning, are the rules that must and can be observed. They are the only means of safely killing the germ distrust, or, to change the metaphor, of avert- ing the ignominious struggle for life in a fire-trap. Unless we follow these lines we shall again see the sorry day when banks will trample each other to death in the mad attempt at saving themselves, till general suspension will put an end to this disgraceful scramble, marking in turn only the beginning of untold misery for the nation. Slowly but surely it is becoming evident to the nation — and if the work- of the Monetary Commission had accomplished nothing more, it would have done a great deal — that central banks are not oligarchic but democratic institutions, that cen- tral banks by creating safe conditions render the small banks independent of the dominion of the large institutions, and that in Europe the central banks are the backbone of the inde- pendent banks in their fight against the ever-growing branch- banking system. A system of-centralized reserves and decentralized banking (Sii) 128 BANKING REFORM IN UNITED STATES power is clearly the one that this country requires, and it is my conviction that it will gladly accept it when once that sys- tem is clearly presehted to it in definite form. I have here avoided the name central bank, and have used the name central reservoir, just as in my previous articles I have termed the institution a central reserve bank or a united reserve bank. This has not been done from cowardice, for the purpose of avoiding a name against which popular prejudice ran high. It has been done for the reason that, first of all, the name expresses what is to me the most important feature of the problem, namely, the centralization of reserves. The second reason is that we should not have, and what we suggest is not, a central bank. Wherever central banks exist, their powers are infinitely wider; they are real banks privileged to do al- most a complete general banking business. The central organ, on the other hand, as here suggested, though securing to us the principal advantages of the central bank system, is nothing but a central reservoir, precluded from doing a general bank- ing business and invested only with such functions as it abso- lutely needs for its own protection and for the protection of the nation. It has been a great privilege to be allowed to read this paper under the auspices of this academy and the commercial bodies uniting with it in this national conference and under the eyes of the members of the Monetary Commission. We wish the latter godspeed. May success be with them and may they take up this momentous work without any further delay. These years have been well employed in locating the evil and in clearly diagnosing the case. But now is the time to per- form the operation, before the patient gets another relapse. Let us hope that this question, which is non-partisan — for as far as we remember we did not find that Republican faces looked any different from Democratic ones during the panic — will be solved on non-partisan lines and that new national- ism will bury the hatchet before the vastly more important question of new national-bankism. (512) THE DISCOUNT SYSTEM IN EUROPE IF banks were to keep, in cash, all the money deposited with them, business would come to a standstill and a crisis would ensue. If banks were to lend to those who apply for loans all the money on deposit with them, a general panic and collapse would follow a short period of overstimulation. Between these two extremes lies the middle course, the finding of which is the problem, and its practise the art of banking. No mathematical rule can state the correct proportion be- tween reserves and demand obligations. The proper solution of this question depends in each country on its varying political and economic conditions and on its financial system. This general principle, however, may be safely laid down : with the present system of immense deposits payable on demand, and, by right, payable in gold, at the option of the payee, only that structure is safe and efficient which provides for effective con- centration of cash reserves and their freest use in case of need, and enables the banks, when necessary, to turn into cash a maximum of their assets with a minimum of disturbance to general conditions. In this respect recent events have made it clear that our sj-stem is an unqualified failure. It is now gen- erally acknowledged, even by those who were formerly most unwilling to concede it, that the end of 1907 witnessed one of the most impressive victories of the central bank system. More specifically, it was a victory of the " discount system " over the system of cash advances, because the central bank is only a component part, though a most vital one, of the dis- count system. A close analysis of the discount system, on which Europe's entire financial structure rests, may therefore be timely and interesting. (S13) I30 BANKING REFORM IN UNITED STATES [Vol. IV What is the essence and the object of " discounts " ? The original transaction from which discounts finally de- velop is an advance; it is either an advance in cash, or an advance in kind, i. e., the postponed payment for goods re- ceived. As evidence of this advance, and as an instrument on which to sue in case of default, the promissory note was created. So long as this note retains this primitive form and function it is of comparatively little value to the financial sys- tem of a nation. It represents nothing but a handy way of expressing an individual contract between two parties, em- bodying the acknowledgment of having received a temporary advance and the promise to pay it back. Similarly, primitive part ownership in a business meant an individual contract, entailing a definite locking up of cash, in- asmuch as such a contract could not be sold except after pro- longed negotiation and search for a new partner. But gradual evolution led to the creation of the corporation, and the un- salable part ownership was transformed into bonds or stocks, for which important and well-regulated markets insured a ready sale. A modern financial household is inconceivable without the adoption of such system of mobilizing permanent investments of this character. We are so accustomed to this phase of economic development that we find it difficult to conceive how comparatively recent an achievement this device is Only a few, however, realize that we have stopped halfway. Although we in America have mobilized our permanent in- vestments, our promissory notes, or temporary investments, still retain their primitive form, while Europe has not only mobilized its permanent investments, but has in addition mobilized its temporary investments by changing the promis- sory note, or " bill," into a " bill of exchange " and by creat- ing large discount markets where these " bills " can be " ex- changed " freely at any time. "Discounts" represent — or, like our promissory notes, ought always to represent — temporary indebtedness which is (514) No. 4] THE DISCOUNT SYSTEM IN EUROPE 131 to be paid off by the liquidation of the business transaction for the carrying out of which the loan was incurred. A bill may be drawn for cotton while it is being harvested, or while it is in transit for Europe, or while it is being manufactured into yarn, or while the merchant that purchased the finished article continues to owe the manufacturer therefor, or possibly even while the finished article is being shipped back to the same country from which the raw product originally came. To bridge each of these periods a long bill might properly be drawn by the various parties who, each in turn, handle the goods on their way from their original state to their place of final distribution. The length of the bill will depend on the underlying transaction ; in England, France and Germany it varies, as a rule, between two and four months, the vast majority of such paper being issued for three months. With us the promissory note is, generally, one-name paper, while in Europe single-name paper is looked upon with dis- trust and is scarcely purchased at all by the banks. The European banker believes in having several signatures on the bill that he buys, thus securing more than one guaranty- Furthermore, additional signatures are evidence of the legiti- mate character of the paper and show that the money was. taken for a temporary transaction, not for permanent invest- ment. However, there are certain stages during the process; of manufacture when the producer is not yet able to sell the bill on his prospective customer; or there may be good reasons why a business man will prefer not to divulge the name of his customers. For such and similar cases the European banks or bankers either allow overdrafts (cash advances) or else they permit the customer to draw on them a sixty- or ninety-day bill (whichever may fit the case) which, when accepted by the banks or bankers drawn upon, the customer can then sell at the ruling discount, rate wherever and whenever he desires to do so. Through the acceptance or indorsement of the merchant's note by the bank or banker the promissory note — from being a dead instrument and a nonliquid asset — ^becomes a liquid asset, part and parcel of the system of tokens of exchange which serve as a substitute for money or as auxiliary currency. (515) 132 BANKING REFORM IN UNITED STATES [Vol. IV The old promissory note is nothing but the evidence of a commercial credit, the granting of which entails a material business risk and must remain an individual transaction to be concluded only by the few who happen to be well acquainted with the issuer of the note and are willing to take the hazard of granting that particular credit. Through the addition of the banker's signature the question of the maker's credit is eliminated and the note, instead of being a mere evidence of an advance, is transformed into a standard investment, the purchase and sale of which will be governed only by the question of interest. This investment commands the broad- est possible market. Acceptances are given by European banks and bankers mainly for three kinds of drafts: the documentary bill, the commercial credit bill, and the finance bill. The documentary bill is probably the most important of these three. If an American merchant buys coffee in San Paolo, he will generally pay for it by opening for the shipper a documentary credit in Europe; that is to say, the American purchaser makes an arrangement with the European banker, by which the latter agrees to accept, let us say, a three-months' bill drawn on him with shipping documents attached, cover- ing a certain shipment of coffee, the amount to be drawn being the equivalent of the amount due by the American purchaser to the South American shipper. The shipper will have no difficulty in selling to a bank in San Paolo his bill drawn on a first-class European banking house, and thus will promptly secure the money due him for the goods sold. The local bank in San Paolo will buy the bill without hesitation (if the shipper is not of the very best standing, the bank will demand that the letter of credit against which the bill is drawn be produced) because it knows that it need only send this foreign bill to England, Germany, or France, as the case may be, where, owing to the extensive discount market in these countries, it can immediately rediscount the bill, thus securing repayment in cash for the amount invested. Indeed, if the Brazilian bank prefers to do so, it can at the moment of shipment, by cabling to Europe, fix the discount rate at which the bills will be discounted upon their arrival in Europe. (Si6) No. 4] THE DISCOUNT SYSTEM IN EUROPE 133 When the bill reaches Europe, the drawee puts his accept- ance on it, and having thus obligated himself to pay the bill when due, the documents are in most cases released and sent to the American purchaser of the goods, who opened the credit with the European bank. Of course, the American purchaser pays a commission to the European banker for the service rendered. The compensation depends on the stand- ing of the purchaser and in part on the question of whether or not the documents are to be released upon acceptance (the American purchaser obligating himself to put the bank in funds before the bill falls due), or whether or not the docu- ments are to be given up by the accepting bank only against cash payment by the purchaser. It may be said that the average compensation for such acceptance credit is between J^ of 1% and ^ of 1% for three months, according to the conditions of the case. The majority of all shipments of merchandise, particularly those of raw material, are every- where " financed " in this way by documentary bills on Europe. It is interesting to note right here that no matter how good may be the credit of the American purchaser or of any American bank, whose acceptance the purchaser may oiler to the shipper in China, South America, or Europe, no shipper in such countries will, as a general rule, take the acceptance of an American bank or banker, because the American bill has no ready market, while the European bill is of very easy sale. It is impossible to estimate how large a sum America pays every year to Europe by way of commissions for accepting such documentary bills, and the other bills with which we shall now deal, but the figui-es run into many millions. This an- nual tribute to Europe resulting from our primitive financial system is not merely waste of money, but reflects upon the dignity of a nation of the political and economic importance of the United States. Next in importance to the documentary bill is the two- or three-months' bill drawn on a bank or banker as a commercial credit granted by the acceptor to the customer. This trans- action is a comparatively simple one. It means that the European banker permits his customer, whether residing in (S17) 134 BANKING REFORM IN UNITED STATES [Vol. IV the banker's own country or abroad, to draw on him at two or three months' sight, with the understanding that the cus- tomer will put the accepting banker in funds before the bill falls due, so that the drawee will not be called upon to advance any cash. He merely gives his signature to an acceptance, which the customer sells under discount, employing in his business the cash thus realized. The privilege of renewing the bill at maturity is often agreed upon at the outset, and the use to which the customer may safely and legitimately put the money realized from such a credit will in part depend on this feature of the arrangement between banker and customer. Large business firms will, as a rule, have such accommo- dation at their disposal in several countries and they will draw against their credits on such countries as have the lowest discount rate for the time being. They may use all foreign credits at the same time when the interest rate at home is higher than the rates ruling abroad, and, conversely, they may at times cover all their foreign credits and use only the financial accommodation offered at home if for the time being the home rate is lower than the rates abroad. The vast majority of these commercial credit bills are drawn without collateral, but there are many instances where the drawer of the bill gives security to the acceptor by the pledge of his own bills receivable or of claims against his cus- tomers or of merchandise or similar collateral. The total volume of bills representing commercial credits given by one country to any other is relatively unimportant as compared to the amount of documentary bills issued, but large numbers of such bills are drawn by the home customer on the home banker, especially in France and Germany. In England, banks and bankers generally avoid accepting long bills for home customers, whom they prefer to accommo- date by cash advances, but they accept very largely for out- of-town customers. The joint stock banks in England make it a rule to accept only against collateral, while important private banking firms and banks, which often make accepting their exclusive business, grant uncovered credits to a very large extent. In France and Germany no line of demarca- (518) No. 4] THE DISCOUNT SYSTEM IN EUROPE 135 tion of this kind exists; banks, large and small, and private bankers as well, accept with or without collateral, according to their own best judgment. The aggregate amount that a firm in any of these countries will accept must, of course, bear a certain relation to its own resources. But this proportion differs according to the character of the general business done by such firm. A bank doing an extensive general banking business will accept to the extent of a part of its capital only, while banks or bankers devoting themselves exclusively to the business of accepting will accept an aggregate amount representing many times their own capital. Since the rate for a three-months' CEish advance is very much higher than the discount rate for three-months' bills, it is nearly always more advantageous for the customer to draw on the banker and to pay the commission for acceptance and, in addition, the European stamp tax, rather than to pay the rate of interest charged for a three-months' cash advance. This heavy difference between the discount rate and the rate for cash advances most eloquently illustrates the different valuation applied by the European banker to an investment of easy sale — ^the discount — as compared to one that locks up cash for even the comparatively short time of three months in a nonliquid asset. Finally we must mention the so-called finance bill. Some finance bills are drawn and accepted within the same country, while some are issued in one country and drawn on another. The first class is drawn by home brokers on banks or bankers against stock-exchange collateral, which, for the time being, it is cheaper to carry by an acceptance credit than by a cash advance. But there is generally some discrimina- tion against finance bills, as the idea prevails in the banking community that discounts ought to be based on temporary commercial or industrial transactions and not on undigested securities. The central banks in general absolutely refuse to buy such finance paper, and, as the prejudice against local finance paper is even stronger than that against foreign-born finance paper, the amount of such paper issued within the boundaries of each nation is comparatively small. (519) 136 ]B AN KING REFORM IN UNITED STATES [Vol. IV The foreign finance bill is drawn by a bank or banking firm in one country on a bank or banking firm in the other country, either with or without collateral. It is drawn in order to profit by the difference between the interest rate in the country where the bill is issued and the discount rate in the country on which the bill is drawn. A great many of these bills are drawn on France, where the interest rate is generally lowest, and on England, which, as a rule, has indeed a somewhat higher rate of interest than France, but which, on the other hand, is a more liberal acceptor, and finally on Germany. At certain periods the largest amount of such bills probably originates in the United States, being drawn chiefly on independent European banks or bankers against stock-ex- change collateral. Very substantial sums, however, are drawn without collateral by American firms on their own branches in Europe. These so-called " house bills," which were very popular in the past, have during recent years met with a good deal of antagonism on the part of the European discounters, and in consequence are not used so freely as they were in years gone by. The most regular customer in drawing finance bills 'is Russia, whose bankers, owing to the comparatively high rate of interest generally ruling in that country, almost constantly use whatever acceptance credits foreign bankers are willing to place at their disposal, the collateral generally being Russian commercial paper. II There are, then, two primary kinds of bills in use in Europe — the one drawn by the producer, manufacturer, or trader on his respective purchaser and accepted by the latter, and the other the bill drawn on and accepted by a bank or a banker. Let us now consider how these bills are discounted in Europe. While methods differ in the various European coun- tries, the result in all cases is the same, and, as we are chiefly interested in results, it will be preferable not to cloud the question by going into too much detail respecting the various usages, but rather to state the main principles. (520) No. 4] THE DISCOUNT SYSTEM IN EUROPE 137 Stated very generally, and fully bearing in mind that there are exceptions to the rule, it may be said that the bulk of the bills drawn on mercantile firms go to the banks or bankers direct from their customers, and it may also be said that these bills do not circulate very freely in the open market, while the bills accepted by banks and bankers are freely sold and cir- culate freely in the open market. There are three kinds of purchasers of discounts in all im- portant financial centers. One is the central bank of each country ; the second is the banking community at large, which means banks, bankers, and brokers, who form the regular in- vestors ; the third is the irregular investor within and without the country. The relationship between the central bank and the dis- count market is a most important one. While in normal times only a small proportion of the business is done by the central bank, the existence of this bank is all-important to the whole financial structure, because even if a bank makes it a rule not to rediscount with the central bank and in its general business keeps independent of this institution, the fact remains that in case of need it can nevertheless rediscount with the central bank every legitimate bill, both bankers' or mercantile ac- ceptance, so that every legitimate bill represents a quick asset, on the realization of which every bank or banker can always rely. Consequently no investor, bank, banker, private capi- talist, or financial institution will ever hesitate to buy good bills. Furthermore, there will not be in critical times any rush to sell good bills, as everybody in these countries knows that there is no better and safer investment, because for no other investment is there an equally reliable market. It is this confident reliance that creates the enormous discount market in modern financial economies and that renders it possible for untold millions of discounts to change hands daily, sometimes without any change whatever of rate or else with fluctuations of only ^/le or ^ of 1% per annum. The literal meaning of " credit " is confidence. Our whole structure is based on credit, or confidence, and not on cash. Unless this confidence is absolute — and it can not be absolute under an admittedly defective system — ^the whole edifice is unsafe. (521) 138 BANKING REFORM IN UNITED STATES [Vol. IV Another factor which helps to strengthen this confidence and to render the system perfect is the existence of strict and uniform laws concerning the issuance, the indorsement, and the collection of such paper, and particularly regulating the right to " protest " and promptly to sue the maker, the in- dorser, and the acceptor. Finally, it is necessary for the development of a vast dis- count market that there be established a system of the freest exchange of money all over the country, rendering possible an easy collection of bills everywhere. The central bank system of the various countries has been fully dealt with in separate articles, and we may therefore confine ourselves to stating only the general outlines of this system as far as it relates to the discount market. It is one of the main duties and privileges of the govern- ment banks to buy legitimate paper, with bankers' acceptances or bankers' indorsements. As the government banks from time to time buy this paper, the volume of their circulating notes, which they issue in payment, increases, while, on the other hand, when they collect this paper at its maturity and thus reduce their holdings of discounts their outstanding cir- culation decreases. This means that they expand or contract according to the requirements of trade, because discounts represent progressive stages in the process of commerce and industry. However, this is not a merely automatic process, for when those entrusted with the management of the central bank see the necessity of exercising a restraining influence on the business community, they raise the rate at which the bank will discount, and in this they are generally followed by the other banks of the country. The government bank's discount rate, which is uniform for everybody, is, as a rule, so much higher than that of the general banks, and the restrictions as to the character of the paper which the government bank can take directly are so much more rigid than the requirements of the commercial banks, that in normal times the bulk of the business is done by the general banks and bankers. Only when the demand for money increases, does the rate of the general banks begin to approach that of the government bank, (522) No. 4] THE DISCOUNT SYSTEM IN EUROPE 139 but when this happens the government bank, as a rule, raises its rate, so as to maintain its margin over that of the general banks/ The government banks consider themselves more or less as custodians of the national reserve, ready to take an active part in the nation's business only in times of emergency. The distinction should, however, be carefully observed between the abnormal crisis and what we may call the normal emergency, arising periodically in consequence of certain economic changes, like crop movements or the particular requirements for special industries at fixed periods, which, as experience shows, subside as regularly as they occur. When these nor- mal emergencies arise, the central banks do not ordinarily raise their rate, but, for a time, meet all the requirements at the usual, or at a very slightly increased, rate and allow their circulation to increase with the result that the reserves go down. When the government banks anticipate, however, that more than a normal emergency will have to be dealt with, they successively raise the rate in order to protect the reserve and to force liquidation, and in order to deter all branches of industry from entering upon far-reaching obligations. Each government bank has a very decided interest in keep- ing its gold holdings as large as possible and in preventing the gold from leaving the country. If an augmented demand for money and credit accommodation increases the amount of notes outstanding, the government bank, by raising its rate, purposes not only to encourage a general contraction of busi- ness and to force the general banks of the country to con- tract, but also to attract foreign money into the country by the inducement of the higher interest return. Most of the central banks in normal times accumulate large amounts of foreign bank paper. This is done for a two-fold purpose: First, in order to withdraw funds from the home market at a time of ease, thus creating a reserve; second, for the purpose of warding off withdrawals of gold by use of the 1 Some of the government banks at times establish a private discount rate, lower than the official bank rate. We shall, however, not enlarge upon this point in order not to complicate the question unduly. (523) I40 BANKING REFORM IN UNITED STATES [Vol. IV foreign bills when foreign exchange rates approach the gold exporting point. The relationship of the central bank and of the general banks to the discount market differs somewhat in the various countries. In France and Germany, where the big banks have taken up, more or less, all branches of the banking busi- ness, the intercourse between customer and bank on the one hand, and bank and central bank on the other, is a pretty direct one. While a large business is still done by brokers and con- sequently in the open market, a majority of the transactions is carried on directly between customer and bank and bank and central bank. In England the various branches of business have, so far, been kept more strictly separated. The investment business in England is largely done through brokers. There are large check banks doing exclusively a deposit account business; there are certain firms devoting themselves almost exclusively to the flotation of loans, either international or domestic; cer- tain other firms doing exclusively a business of acceptance (for documentary or covered or uncovered credits, as explained above) ; still other firms doing almost exclusively foreign ex- change business, while certain large companies and private firms devote themselves entirely to the discount business ; and finally there are the bill brokers, doing an intermediary busi- ness between the customer, the banks, and the discount companies. The enormous amount of bills held by the discount com- panies and bill brokers in England is to a very large extent carried by them through loans on call from the banks. The banks regulate the average plus and minus of daily demands over daily maturities, to a large degree, by calling or increas- ing these call loans or else by buying or selling discounts. If, on balance, money is called from the discount companies or bill brokers, short bills will go to the Bank of England. In France and Germany, where the big banks have less hesitation in rediscounting freely with the central bank, the organization of discount companies and bill brokers is eliminated, and in order to settle the daily balances short bills are sent to the central bank directly by them. (524) No. 4] THE DISCOUNT SYSTEM IN EUROPE 141 It may safely be said that in normal times the big banks in Europe do not rediscount their long paper with the central bank. For in such times maturing paper and money on call take care of the daily demands made upon them, and if the demand reaches larger dimensions they send their short ma- turities for discount and collection to the central bank. It is a sign of somewhat abnormal conditions and a signal for banks and central banks to exercise caution, if the bills dis- counted by the general banks with the central bank gradually change from short maturities to bills having a long time to run. It is of interest to know that the average life of all bills taken by the German Reichsbank in 1907 was thirty-two days, and of those taken by the Banque de France twenty-six days. The Reichsbank's investment in discounts was 13.8% of the total of all discounts in circulation in Germany during that period; the Banque de France held 12.5% of the total French circulation of discounts. Similar statistics concerning the holdings of the Bank of England are not available.^ Not only do banks and bankers invest in discounts, but financial institutions, industrial corporations, private firms, and individuals do likewise. Instead of keeping all their idle money on deposit, they invest a certain proportion in paper drawn on banks and indorsed by banks or discount companies, thereby giving stability to the whole financial structure. This is in striking contrast with conditions as they exist in this country, where unemployed money is to far too large a degree deposited with banks and trust companies, with the result that this idle money, which must earn interest, is finally piled up in the large money centers, especially in New York, and is there lent out on the stock exchange in the shape of call loans, forming an element of danger for the whole structure. Moreover, the discount system plays a most important role as an equalizer between nations. Money flows where it can earn the best return, provided it can there be invested with 1 On December 31, 1908, the Reichsbank held in German bills 1,032,000,000 marks; of these 44% were payable within fifteen days, 17.4% within sixteen to thirty days, 24.8% within thirty-one to sixty days and 13.9% within sixty- one to ninety days. (525) 142 BANKING REFORM IN UNITED STATES [Vol. IV safety and with a confident expectation that the investment can easily be resold and the proceeds of the sale easily collected. If England has a private discount rate of, let us say, 4%, and if, at the same time, there is in France a discount rate of 2%, it stands to reason that the big French banks and the French public will invest in English bills, and that French money will go to England. The same holds good, of course, as to German, Austrian, Russian, or Scandinavian bills. The French banks would not buy the individual note of an English, German, Austrian, Russian, or Scandinavian merchant whom they do not know, but they do know and can value the ac- ceptance or the indorsement of the foreign banks that offer and indorse or accept this paper. They would, however, not buy this paper, unless they knew that it could be rediscounted at any time in the home country. Between the indebtedness of one nation to another and the actual settlement of that debt in gold, there lies, as a buffer, the borrowing power of the banking communities of the re- spective countries. This buffer with us has proved lamentably weak, because of our lack of a discount system. Because of this lack our bills are practically unsalable. It is not cus- tomary with us for a bank or a banker to indorse and to offer for sale the promissory note which he has purchased, nor is it customary for our banks and bankers to accept bills drawn on them, and so the United States has no American paper to offer which Europe could buy. Therefore when the neces- sity develops of temporarily attracting foreign money into the United States, there is nothing to fill the gap except our securities at bankruptcy prices and our " finance bills " drawn by our banks and bankers. That is to say, the American banker, instead of adding his own credit to that of the American merchant or manu- facturer and thus using the merchant's signature to legitimize his own demand for accomodation, locks up the unfortunate promissory note and secures for himself an entirely new credit on his own resources, quite independent of the original trans- action, instead of simply infusing life into this dead note. (526) No. 4] THE DISCOUNT SYSTEM IN EUROPE 143 But our bankers' bills inevitably bear a financial character, and therefore will not be regarded so favorably as would be commercial paper; moreover, since the drawers and, to an even greater extent, the European acceptors are comparatively few, European bankers must at times limit their purchases for fear that they are getting too large an amount of paper drawn, accepted, and indorsed by the same firms. Moreover, as these bills, drawn, as the case may be, in pounds sterling, francs, or marks, normally sell at the same rate of private discount as all the other long bills in the coun- try, the European finds no particular inducement to purchase them. When, therefore, there is an excessive amount of these American bills offered, the consequence is discrimination and, what is worse, a feeling of uneasiness and distrust. If, instead of this unfortunate method of financing, we could offer American paper drawn in dollars, showing its commercial origin, and indorsed by American banks or banking firms, we could vastly multiply the avenues leading into the vaults of the European banks, and our bills would be well distributed instead of going into a few channels which can so easily be closed, and which, as the past has shown, were very energeti- cally and disastrously closed just at the time of our greatest need.^ What an anomalous and inefficient system which, instead of using the credit of the whole nation — producer's, manufac- turer's, and merchant's credit joined to that of the financial institutions — demands that a few banks and banking firms >■ Our own system being absolutely inelastic, we have become accustomed to use as a substitute the power of our banking community to borrow in Europe. We thus use Europe as an auxiliary financial machine ; but we forget that our weight has become so great as to threaten the safety of the European ma- chinery when we are compelled to use it to its utmost capacity in order to pro- vide for our needs. Europe, in sheer self-defense, refuses under those cir- cumstances to let us borrow, and by the simple means of refusing our finance bills renders useless our reserve of elasticity. Thus, instead of securing addi- tional means of assistance at the most critical moment, we find ourselves sud- denly forced to dispense with a most important part of our machinery, upoi» which we were wont to rely in normal times. This is what happened during the panic of 1907, and history will repeat itself, unless we adapt our system to our growth. (527) 144 BANKING REFORM IN UNITED STATES [Vcl. IV should furnish single-handed the accommodation for a nation of ninety millions of people! Ill We shall now consider the discount system in its position as the basis of the whole financial structure, and contrast this system with our own. The European financial system is constructed upon discounts as its foundation; the American system is constructed upon bonds and stocks as its foundation. Bank notes in Europe are issued mainly against bullion and discounts ; in the United States mainly against bullion and bonds. The quick assets held by European banks against their deposits consist of discounts or call loans, largely secured by discounts. The quick assets of American banks — promissory notes being unsalable and cash reserves being unavailable — are primarily call loans on stock and bond collateral. In Europe the daily plus and minus of money requirements are adjusted by the use of the discount market — that is to say, in a final analysis, by purchase or sale of bills. (Calling in or putting out money on call where the loans are secured by bills amounts, in effect, to a sale or a purchase of bills.) In a last analysis this means that in Europe attempts to liquidate are primarily appeals to the whole nation to liquidate its tem- porary commercial investments, the brunt of such liquidation being borne by the entire community, and the pressure being constantly subdivided, every member of the community thus contributing his share. As a majority of discounts represent goods in process of production or on the way to consumption, liquidation with them expresses itself primarily by a falling off in new pro- duction, while the consumer, on the other hand, can not stop consuming and must therefore continue to pay. The brunt is thus borne by the whole nation and adjustment follows without violent convulsions. In sharp contrast with such a system the attempts to liquidate in the United States are directed primarily at the contractors of stock-exchange loans. This means that a comparatively (528) No. 4] THE DISCOUNT SYSTEM IN EUROPE 145 limited number of debtors are called upon to sell their securi- ties. This they can do only by finding new investors, who, as a rule, are at such times comparatively rare, because when acute pressure arises it generally originates in the inability of the investor to purchase because of lack of funds or in his unwillingness by reason of his distrust of the financial situa- tion. The concomitant of this is that those forced to sell securities at such times must offer them at sufficiently reduced prices to bring about an entire change in the attitude of the investor. The difficulty here is that violent reductions of prices in themselves cause distrust, and low prices caused by distrust not only frighten away purchasers but, in addition, unsettle the owners of securities and thus cause them to join the ranks of the sellers. An acute convulsion, therefore, must inevitably follow before the tide can be turned. In order to bring about relief from strained financial con- ditions the depositor tnustbe transformed into the investor and foreign money must be attracted into the country. To accom- plish either the discount system is the most efficient. The insurance premium for each transaction is commen- surate with the risk of the same. It is for this reason that an even moderately attractive interest rate for discounts in mod- ern countries will attract the foreign capitalist and the home depositor, as both know that an investment in discounts can be realized on at any moment without material sacrifice, and this is at the same time the explanation of the fact that, with our defective and explosive financial system, we must offer tremendous interest rates or our securities at bankruptcy prices in order to attract foreign money or turn the home depositor into an investor in critical times. Everybody knows that un- der our system convulsions must follow acute strains and must precede a cure, and therefore the average investor waits for the debacle before purchasing. And this attitude in itself accentuates the range of fluctuations, which, under the Euro- pean system, is far less wide. Of course, general liquidation in Europe includes a liquida- tion of securities, just as liquidation in the United States also includes liquidation of commercial paper as it matures. But (529) 146 BANKING REFORM IN UNITED STATES [Vol. IV the difference is that in Europe bills will be the main factor and securities will play a much more subordinate part, while with us just the reverse is true. A few words ought to be said here about the diastrous ef- fect of our obsolete usury laws. There does not exist any law fixing the maximum rate of discount in any of the important European states. During the development of the central bank system attempts have at times been made to keep money rates low by compelling the central bank not to charge more at any time than a given rate. History shows, however, that such attempts have invariably ended in failure, and the fact is now generally accepted that the fixing of a maximum rate kills the efficiency of a modern financial system. Such a system requires elasticity and the theoretical possibility of adapting itself unreservedly to all conditions that may arise. The mere fact that the system pro- vides for such means of free defense so strengthens the whole structure that where no such restrictions exist exorbitant rates are, as a matter of fact, the exception ; while in a country like ours, where such restrictions prevail, abnormal conditions be- come a regular occurrence. High call rates do not tempt either home or foreign in- vestors, the latter particularly being barred from freely profit- ing by a high call rate by the fact that rates of exchange for remittances from one country to the other vary constantly, so that, unless the margin of interest can be secured for a fairly long time, at least a month, the profit in interest is not large enough to compensate for the risk of a possible loss in the rate of exchange. It is obvious that, when European discount rates are higher than 6%, we must be able legally to make time loans at rates exceeding 6%, if we are to protect ourselves. Discount is time money on call, and in a modern community time money — not the call rate — is the decisive factor in the constant flow of money from one country to the other. Our usury law prevents the free development of rates for time money and incidentally prohibits the establishment of as wide a time-money market as exists in Europe. Since legally (530) No. 4] THE DISCOUNT SYSTEM IN EUROPE 147 and officially our time-money rates can not exceed 6%, the call rate, which is a fairly unimportant factor in Europe, must become the deciding factor with us. It is a most extraordin- ary (almost an amusing) fact that these call rates, fluctuating from a fraction of 1% up to the confiscatory rate of 100% and sometimes even more per day, and bringing ruin to the weak, should be the direct consequence of a law aimed at protecting the very people whom it destroys. Usury laws in Europe, where they exist at all, apply only where the borrower is in dire distress when seeking and ac- cepting a loan, and where the lender knowingly profits by the borrower's helpless situation when exacting usurious rates. Usury can be judged only in the light of the surrounding cir- cumstances ; and usury laws in Europe generally apply only to individuals. Our law, which prevents solvent firms of bankers, merchants, manufacturers, or brokers from contract- ing for money on time at more than 6%, implies not only un- dignified tutelage, but unsound business judgment. The re- cent crisis has shown that charging people in need more than 6% is not necessarily taking advantage of them. On the con- trary, it would have been a blessing to them, and in many cases their salvation, had they been able to borrow money even at a much higher rate. This unsound and completely indefensible usury law is, however, the reason why we must have daily settlements on the stock exchange, and why our system must in this respect also be strictly opposed to the systems of Europe. In England, France, and Germany there exist monthly or half-monthly settlements of stock-exchange transactions, and as stock-exchange loans run from one settlement to the next, the amount of money employed on the stock exchange between settlements remains stationary. If, at the settlement, it de- velops that commitments on the stock exchange have increased and that a larger amount of money is needed there, so much additional money will under normal circumstances be with- drawn from the bill market and go into the stock exchange. If less money is wanted on the stock exchange, so much more will go into the bill market. (531) 148 BANKING REFORM IN UNITED STATES [Vol. IV Without entering upon a discussion of the question of cash stock-exchange dealings versus stock-exchange dealings per settlement (for which, be it said in passing, a suitable method of weekly stock-exchange settlements can probably be devised for this country, combined with provisions for proper margin- ing in order to prevent over stimulation or gambling), we are, for the purposes of this article, interested only in the effect of this method of cash dealings on the whole financial system. An exclusive system of cash dealings brings about the preponderance of the call loan on stock-exchange collateral. But for the existence of the seducing call loan, which is one of the gravest dangers and curses of our system, we should have been forced to develop our bill market as a regulator of our daily money requirements. In that case, instead of see- ing the idle money of the whole nation poured into stock-ex- change loans when trade is inactive — thus unduly stimulating speculation when it should be discouraged — and again with- drawing money from the stock exchanges in order to provide for the business of the whole nation when trade becomes active — thus bringing about anxiety and convulsions on the stock exchange in the face of prosperity — we should have a system based on bills; that is to say, based on the broad foundations consisting of the commerce and trade of the whole nation, and we should then enjoy an almost uniform rate of interest all over the country, gently rising and falling within moderate bounds, instead of the violent fluctuations and unbearable con- ditions to which we are now subjected. The aggregate amount invested by a nation in trade and commerce should be and is many times the amount invested in stock-exchange loans, which latter represent undigested securities and securities carried for speculative investors. Our way of doing business may be illustrated by two adjoining reservoirs, one small and one very large. The small one represents the stock exchange and contains the call loans; the large one represents the general business of the country, as ex- presed by commerce and industry. In Europe the small reservoir is regulated by pumping water into it from the large one or by withdrawing water from it into the large one. In (532) No. 4] THE DISCOUNT SYSTEM IN EUROPE 149 this way the outflow and inflow of the large reservoir are scarcely perceptible, and yet there is no difficulty in regulating the small one. With us, the reverse is done. If there is a shortage of water in the large reservoir we draw on the small one and, in order to increase the water in the large reservoir by perhaps an inch, we empty the small one altogether, or else in order to decrease the amount of water in the large reservoir by an inch, we fill the small one to overflowing. Moreover, the discount system transforms into one large body of water a network of separate reservoirs, insufficiently connected with each other and each filled or emptied accord- ing to local supply or demand. The channel by which they are united is the discount rate, which would apply to bankers' paper alike in San Francisco and New York or in New Orleans and Seattle. It is a mistake to think that the size of a country will render such a system ineffective; for whether water is being withdrawn on one side of the basin and simul- taneously added at the other far distant end, the surface of the water will be fairly level on both sides. In order to keep the hight of the water within definite limits there is a strong main which brings additional water and a wide outlet to take care of the overflow ; this is the function of the central bank. Where there are several faucets and outlets — that is, branch offices of the central bank — ^the effect may indeed be secured more rapidly and fluctuations in the hight of the water will be somewhat smaller ; but the equalizing power of the discount rate will remain the same. The benefit of fairly normal in- terest rates is bound to be reaped under such a system; it is only a question of the degree to which it is possible or desir- able to secure this result. Finally, we must dwell for a moment on the effect of the discount system on the highly important questions of reserves and of elastic note issue. The central bank system and the discount system can not be separated; they are absolutely interdependent. The dis- count system can not exist without a central bank to which it may resort in case of need and, on the other hand, the central bank can not exist without an efficient bank rate — that is, with- (S33) I50 BANKING REFORM IN UNITED STATES [Vol. IV out the means of protecting itself and the nation through its power to influence upward or downward the general interest rates of the country. History has shown that without such power the central bank system fails. The central bank must not be so intimately and so directly connected with the nation's general business that it can by its change of policy directly afi'ect individual concerns. Between the central bank and the public there should be, as a buffer, the general banking community of the country, which should use its own credit and its own resources to modify the effect of changes in the bank rate, where the public can not so quickly adjust itself to changed conditions. But the central bank must be able to influence the banking community sufifi- ciently to enable it to regulate the general tendency of the money rates of the country. To achieve this is one of the functions of the discount system. With such a system, and only with such a system, can the most important further de- velopment safely be reached, viz., that of dividing the banking reserves of the nation into two kinds of reserves, the cash reserves and what we may call the working reserves. Working reserves are represented by quick assets easily convertible into cash credits available to meet the demand obligations of a bank. Under a central bank and discount system these are the main reserves kept by the general banks. Cash reserves are kept almost exclusively by the central bank, there available to permit the general banks tO' convert cash credits into actual cash whenever needed. This system is based on confident and immutable reliance by the banks on the fact that against good and legitimate bills a cash credit is always obtainable at the central bank, and that no one will therefore needlessly withdraw or hoard cash. Capital invested in discounts, though considered as good as cash, yet draws interest, while capital invested in actual cash, besides entailing material risk in the safe-keeping of the same, means a loss of interest. There is therefore no danger that cash withdrawn from one institution by reason of distrust of its solvency will be hoarded instead of being deposited in some other institution and thus finally reverting to the central bank without material delay. (534) No. 4] THE DISCOUNT SYSTEM IN EUROPE 151 Overstimulation of business, or other economic reasons, may- bring about an increased demand for cash at home or an out- flow of gold abroad. Such withdrawals of cash the bank will, as we have already seen, meet in various ways. But actual hoarding must be a thing inconceivable in a modern country organized to settle its enormous daily business with a com- paratively small amount of actual cash. To maintain the right proportion between the demand cash obligations of a nation and its holdings of actual cash is a task requiring the minuest study and the most constant care. In Europe this is the function of the central bank, which con- centrates its attention and energies almost exclusively on this duty, and which should therefore be kept free from too inti- mate and direct contact with the general business of the country. The general banks, on the other hand, organized to be money-making concerns and devoting their energies, as they do, to taking care of the requirements of the general public, can not be expected individually to watch this problem of the cash reserves of the nation. Moreover, such a duty can not possibly be performed by 21,000 competing institutions, which can protect themselves only by attacking one another. There must be one central reserve to which all unemployed cash will inevitably return, and to which everybody can apply, or an acute demand for cash will unavoidably bring forth hesitation to pay in cash, as happened with us during the last crisis. Hesitation in paying cash only increases the drain, which each bank can meet only by drawing on the reserves of the other banks, and if to these unbearable conditions there is added a foolish law (unavoidable under a decentralized system) which, by making it obligatory to keep 25% of the deposits in cash, renders the cash reserves absolutely useless, there can be only one consequence, viz., runs by the public, runs by the banks, hoarding by the banks and by the public sdike, and finally a general suspension. If after a prolonged drought a thunderstorm threatens, what would be the consequence if the wise mayor of a town should attempt to meet the danger of fire by distributing the avail- (535) 152 BANKING REFORM IN UNITED STATES [Vol. IV able water, giving each house owner one pailful? When the lightning strikes, the unfortunate householder will in vain fight the fire with his one pailful of water, while the other citizens will all frantically hold on to their own little supply, their only defense in the face of danger. The fire will spread and resistance will be impossible. If, however, instead of uselessly dividing the water, it had remained concentrated in one reservoir with an effective system of pipes to direct it where it was wanted for short, energetic, and efficient use, the town would have been safe. We have parallel conditions in our currency system, but, ridiculous as these may appear, our true condition is even more preposterous. For not only is the water uselessly distributed into 21,000 pails, but we are permitted to use the water only in small portions at a time, in proportion as the house burns down. If the structure consist of four floors, we must keep one-fourth of the contents of our pail for each floor. We must not try to extinguish the fire by freely using the water in the beginning. That would not be fair to the other floors. Let the fire spread and give each part of the house, as it burns, its equal and insufficient proportion of water. Pereat fnundus, fiat justitia! But, to continue the metaphor, the central bank and dis- count system provides not only for a centralization of reserves and for concerted action in accumulating and in using the same, but it also furnishes the means of reaching and of creating a new supply of water. Most of the central bank systems provide that a certain amount of bank notes may be issued against discounted bills. It would lead beyond the province of this article to state in detail to what extent each country requires bank notes to be covered by cash and to what proportion they may be issued against discounted paper. The principle, however, is ob- served in all countries enjoying a central bank system, that, as all bank notes represent demand obligations payable in cash, the amount of notes not secured by cash must at all times bear a certain safe proportion to the amount of cash held by the central bank. (536) No. 4] THE DISCOUNT SYSTEM IN EUROPE 153 In calculating the amount of cash required we must add to these unsecured notes the other demand obligations of the central bank, viz., deposits against which cash or bank notes may at any time be demanded, and which must, therefore, be treated as unsecured notes. As the Bank of England keeps a large part of its deposits invested in discounts, and not in actual cash, the same principle applies to it as to the German Reichsbank and the Banque de France, notwithstanding the fact that the Bank of England cannot issue any unsecured notes, while the other institutions named may issue a certain amount of unsecured notes. While the English system lacks the pliability of the German and French methods, and there- fore requires more frequent and more energetic adjustment by changes in the bank rate, the main principles are the same in all three countries. The bulk of the demand obligations of central banks, notes and deposits alike, so far as they are not covered by bullion, must be covered by discounts — that is, by promises to pay in bullion within a short time. They must be covered not by permanent but by temporary investments, so arranged that a very large amount thereof falls due every day and can thus be used to offset the cash demands made upon the bank. We have already mentioned that the holdings of the central bank consist largely of short maturities. The central bank meets the situation by collecting these as they fall due, keeping down the bank's new purchases by an increase in its rate designed to attract new purcahsers of the long paper coming into the market, and at the same time to bring about a curtailment of business. Finally, it increases its circulation and temporarily reduces its reserves. This means sound elasticity, based on discounts, and safely restricted by the proportion maintained between holdings of cash and of discounts. Elasticity does not mean expansion, but expansion and con- traction. Contraction, we are inclined to say, is even more important than expansion. Ability on the part of the central bank in normal times to decrease its holdings of discounts and to increase its reserves, without any material disturbance, is (537) 154 BANKING REFORM IN UNITED STATES [Vol. IV most essential to the system, because without such preparatory work the bank could not safely render assistance when called upon in active or anxious times. But the additional benefit of contraction is that it prevent inflation, with all its dangerous consequences. This system is elastic not only in its structure; it is elastic also in its operation. This is a most important fact; for each situation must be dealt with on its own merits according to the circumstances of the particular case. Thus, certain periodic and normal demands for cash, as well as a domestic drain caused by distrust, must be met by paying out freely. A foreign drain, on the other hand, must gener- ally be met by an energetic increase of rate, while a drain both domestic and foreign must be treated by varying combin- ations of both methods. The discount and central bank system enables the nation to meet these situations by concerted but varying action adjusted to meet each individual case. Is it credible that in a modern country like ours men should pro- fess to believe that all these emergencies can be met by auto- matic, iron-clad rules, fixing a definite percentage of reserves and an adjusted scale of taxes, applied without possible dis- crimination to constantly varying and contrasting conditions, and the whole problem being complicated by the disconnected action of 2 1 ,000 competing banks ? Notes issued against discounts mean elasticity based on the changing demands of commerce emd trade of the nation, while notes based on government bonds mean constant expansion without contraction, inflation based on the requirements of the government without connection of any kind with the tem- porary needs of the toiling nation. Requirements of the gov- ernment should be met by direct or indirect taxation or by the sale of government bonds to the people. But to use govern- ment bonds or other permanent investments as a basis for note issue is unscientific and dangerous. If the Panama Canal costs $500,000,000 we shall have $500,000,000 additional currency, whether the nation needs it or not. But what sane reason can be found to make the currency of the nation dependent on whether or not we build (538) No. 4] THE DISCOUNT SYSTEM IN EUROPE 155 a canal? And why should we have more currency if we de- cide to build a sea-level canal rather than a lock canal? If we were not so well protected by our immense exporting power, we should suffer even .-worse and more frequent catas- trophes through our system of issuing notes without main- taining a safe proportion between gold-secured and uncovered notes and through our device of a circulation not based on temporary investments and therefore incapable of contraction. There can not be any doubt that a continuance of such a system must prove disastrous. The economic law that bad money al- ways drives out good money can not be safely disregarded, and it is only a question of time when its effect will show itself. The Aldrich-Vreeland Bill, while only a temporary meas- ure, is an important step in advance, inasmuch as for the first time it admits commercial paper as a basis for note issue; but this measure, even if enacted as a permanent law, can not bring final relief, as the note issues not only remain decentral- ized, but, so far as based on discounts, are grafted on prior note issues based on bonds. This means that having been forced to stretch a rubber band for so long a time and to such an extent that it has become inelastic, we expect to restore elasticity to this old and frayed band by tying to it a small elastic piece. But by so doing we shall only have lengthened the band, which can never contract within the length which has become inelastic. If we compare the net results of the discount system with those of the bond-secured system, we find that in Europe rates of interest fluctuate within comparatively small limits, while the outstanding circulation constantly contracts and expands within wide ranges. With us it is the reverse. The outstand- ing circulation, once it is issued, remains fairly stationary, ■while the rates of interest fluctuate violently from i to 200%. The discount system enables the country to concentrate its reserves and to use them freely when needed ; it brings about a clear distinction between the working reserves of the general banks and the actual cash reserves needed to protect the cir- culation of the country. With us such a line of demarcation can not be drawn and our reserves become hopelessly decen- tralized and prove absolutely unavailable in times of stress. (539) 156 BANKING REFORM IN UNITED STATES [Vol. IV The discount system recognizes the fact that issuing money and making money are two entirely distinct functions, which are at times antagonistic to each other. It is the duty of the money-issuing bank to restrain the money-making bank when the latter wants to go too far or too fast. Therefore note issuing and general banking are separated in Europe, the power to issue notes being more or less centralized. With us, on the contrary, general banking power and note-issuing power are lodged in the same banks, and the note-issuing power is not centralized. In Europe an effective discount rate protects the country from foreign and domestic drains alike, while no such pro- tection exists with us. The discount system mobilizes the resources of the banks. It turns the bank's most legitimate investment, its commercial paper, into its quickest asset, and by so doing creates a new means of exchange, available both at home and abroad. Under our system investments in commercial paper are tantamount to a locking up of funds, which remain fixed assets till they mature. The discount system establishes a broad market for commercial paper and this market forms the basis of the note issues, and at the same time provides for an easy adjustment of the demand and supply of money, the burden being borne by the whole nation. Under our system notes are issued against bonds, and the daily adjustment of the demand and supply of money spends itself primarily in an increase or a decrease of call loans on stock-exchange collateral. Contraction and liquidation mean an onslaught on the security market with resultant dis- turbances. It is a result of the foolish attempt to regulate the big reservoir by means of the small one. There is an old banking rule that no bank may grant credit on other terms than those on which it receives credit. The truth of this adage is obvious and the extent to which this principle is carried out is the test of safe or unsafe banking. Safe employment of the millions upon millions deposited with the banks is one of their foremost duties. The European system has adapted itself to this problem. Our system makes (540) No. 4] THE DISCOUNT SYSTEM IN EUROPE 157 really safe banking an impossibility. An American banker invests his deposits in unsalable commercial paper and by so doing invests a call obligation in a time loan, which is bad and unsafe banking. As he is, however, practically compelled to do business in this way, he must, on the other hand, keep a large amount of assets on call in order to meet the first onrush of his depositors. In spite of the fact proved by our last panic, that, through the faultiness of our system, these call loans can not always be depended on when called and are therefore not so available as cash, it is, nevertheless, the only conservative way in which an American banker can invest a large proportion of his deposit money — unless he buys foreign exchange and thus places his money abroad. Banks have been criticized for placing so much money in stock-exchange loans and the stock exchange has been criticised for absorb- ing so much money. Neither of them deserves blame. It is our system that has made the stock exchange the clearing house for the money of the whole nation and that has im- mobilized our commercial paper. It is our system that ren- ders the banker helpless, leaving him to choose between the Scylla of locking up his capital and the Charybdis of adding to the accumulation of call loans on the stock exchange, thus placing further weight on this colossus on glass feet. The discount system, by creating sound conditions, makes the small bank independent and safe. Under present condi- tions the small bank with us is dependent in critical times on the assistance of the large institutions and on the arbitrary will of the Secretary of the Treasury, limited as this is by his (very uncertain) ability to help. The central bank, the back- bone of the discount system, has everywhere proved a check to plutocratic monopoly. We can not close this short essay on the discount system without a few words about its historical development. We are apt to believe, on this side of the ocean, that the European central bank and discount system have existed for centuries, that this system is the natural development of condi- tions as they exist in those countries, and that it was achieved without those radical changes in existing systems which with us would be necessary in order to modernize our system. (541) 158 BANKING REFORM IN UNITED STATES [Vol. IV This is a mistake. As will be seen by the history of the various government banks, published by the Monetary Com- mission, conditions in almost all the countries now enjoying a centralized note issue were in former days similar to those which now prevail with us. Aside from the Bank of England and the Banque de France, it is safe to say that all the im- portant central banks have been created within the last forty years. The discount system has been developed to its present importance only within the last sixty years. The immense accumulation of wealth during the last half century, the phenomenal growth of capitalization and of daily transactions, brought about the fullest development of every time- and money-saving device, such as checks, stocks and bonds, clear- ing houses, stock exchanges, and produce exchanges. The mobilization of the promissory note and its development as the fundamental and most essential part of the whole finan- cial structure is probably the most important phenomenon in modern financial evolution. Without it the far-reaching use of credit tokens as substitutes for cash is neither complete nor safe. It is inconceivable that the United States, a nation that leads the way in industrial progress and that more than any other nation weeds out old machinery and replaces it by the newest appliances, should be either unable or unwilling to modernize thoroughly its financial system and to discard old- fashioned financial machinery, which other peoples have long since thrown upon the scrap heap. We are not invited at this juncture to suggest a solution for the problem involved in modernizing the American currency and banking system, but are asked only to report the facts. We may however, state the case in this negative way : The question can not be solved by simply copying one of the European methods ; for our prospective system will have to be adapted to our own peculiar conditions. But, irrespective of the shape it may finally assume, any system we adopt will prove ineffective and disastrous, unless it be constructed on bills instead of on bonds, and unless it provides for a concentration of cash re- serves and of the power to issue bank notes. (.';42) CIRCULATING CREDITS AND BANK ACCEPTANCES IN studying and teaching ancient history we lay great stress upon the names of kings and dates of battles while we unduly neglect the more important problem of how the people lived and what were their thoughts and ambitions. It is in considering this phase of history that we perceive most clearly the development of man and the progress of intellec- tual development, a process as yet by no means completed. In dwelling upon such thoughts one cannot help recognizing as one of the most striking differences between primitive man and ourselves, that in the daily routine our ancestors took very little for granted, that everything they used and every mani- pulation they performed, they understood and did from begin- ning to end. In short, they were dependent entirely upon themselves. On the other hand, there is hardly anything in our daily routine that we use, or do, or even understand, from beginning to end. The activities of one day, even with the least developed of our fellow creatures, are indissolubly inter- woven with those of millions of fellow beings whose products we eat or wear or use, and the most surprising feature of this evolution is that we have become quite unconscious of it. Riding in the subway in the morning while reading our papers, do we think of the men that broke the coal, built the power-house, car and track, and that operate them at the very hour, do we think of the thousand manipulations and inven- tions that produced our newspaper, and of the hands that wrote, printed, and distributed it? Do we, while we are read- ing, think at all that we are riding at the rate of sixty miles an hour? Does the tenant of an office on the thirtieth floor think of the thousands of devices that had to be invented and applied to make the sky-scraper safe and practicable? Does he stop to consider what would happen to him if the house were not fireproof, or if he could not rely on the elevators or telephone ? (5^3) l6o BANKING REFORM IN UNITED STATES [Vol. IV We have become accustomed to rely so completely on the perfection of all these appliances and the normal functioning of the thousands of hands that cooperate in serving us during the day, that unless there be a sudden stop of a wheel, we use them without further thought. To this class of appliances that it takes millions to compose and ages to develop, and that we use without thinking, belongs the thing so important to us all, the thing commonly called " money." In a modern system we can no longer separate actual money from the many appliances that take its place in our daily routine ; they are linked together and have all become essential parts of one big machine. The modern banking system has been likened to a huge sky- scraper based on a comparatively small foundation of gold, and the many superimposed stories are represented by the immense number of all obligations payable in gold which, ordinarily, are settled by clearings of credits. The most evi- dent and direct forms of circulating credits which have taken the place of actual gold are the bank note — ^forming a class by itself, — ^bank deposits, and checks. These are the main ten- ants of the towering structure. But they in turn have sublet a great many floors to all the other appliances for clearing in- debtedness, all of which in the final analysis are being reduced to payments by exchange of bank credits. Time will not per- mit of dealing fully with the inter-relation and the functions of all these tenants of the building; we shall only casually mention the most important phases. A modern system aims at establishing standard values for which a broad market can be created, so that assets can be quickly turned into bank credits. This is one of the most fundamental principles of modern banking, of equal import- ance for depositor and banker. Our most important staples are no longer dealt in in individual lots, which must be per- sonally examined before the bargain can be struck, but they have been standardized, and special exchanges have been or- ganized in order to reduce merchandises into bank credits in the quickest way and to offset all purchases and sales so as to reduce to the minimum the actual use of money. (544) No. 4] CIRCULATING CREDITS 16I We have achieved the same perfection in dealing with stocks and bonds. While the original part ownership in a business could be transferred only by protracted negotiation and by finding a new purchaser who, after full examination, would take the place of the old owner, evolution has brought about the corporation, issuing stocks and bonds in easily transfer- able shape, so that these forms of investments and indebted- ness also have been mobilized. They, too, have been de- veloped into securities for which large special markets and organizations have been created, enabling the owner to trans- form his holdings with the greatest possible dispatch into bank deposits. In this respect stocks and bonds have become circu- lating credits ; they are the means of transferring part owner- ship in, or the indebtedness of, a corporation from one owner to another in quick succession. But while the bank note and the check are clearers of credits on demand, stock and bond transactions are clearers of credits on time, or even for an in- definite period. They are only indirect and secondary. The most important of the sub-tenants is the commercial paper. In a modern system the promissory note, running for a limited number of months, and representing some kind of a commercial transaction, has been mobilized by adding to it, by indorsement on the back, or by acceptance on the face, the banker's guarantee. Thus the old-fashioned " bill " — exist- ing already in the form of bricks in the age of Hammurabi — is being transformed into a " bill of exchange." Thus an im- movable investment is turned into a quick asset. The im- portance of this evolution is two-fold, because it is just as fundamental for the safety of the individual bank as it is for that of the whole credit banking system. The main assets of a deposit institution ought not to be stocks and bonds, nor loans on stocks and bonds, but commercial paper. But a bank, the deposits of which may be withdrawn on demand at any time, must have assets which can be reduced to bank credits within the quickest possible time and with the smallest possible loss, if any. If a banking system, like ours, is built up on promissory notes which have no free market, the consequence must needs (545) 1 62 BANKING REFORM IN UNITED STATES [Vol. IV be that when deposits are withdrawn heavily, or when there is a strong commercial demand for money, stock-exchange loans must be called and holdings of securities must be sacri- ficed, these being the only available liquid assets. This means great economic waste and often calamity, for it is an absolutely perverse system that expects a normal investment demand, in times, especially, when money is scarce, to be able to supply a sufficient sum to satisfy all the immense com- mercial demands of the entire nation. Moreover it follows that prices of securities have to be so far reduced that at bar- gain, or sometimes panic prices, an abnormal demand for securities at home or abroad will be stimulated. This method is not only wasteful, but, as the past has shown us, it is most dangerous. A modern system must provide the means which banks can rely upon to enable them to market their bills re- ceivable, which represent the trade and commerce of the nation. In a modern system this can be done without appalling losses, there being no question of sacrifice of capital in selling se- curities, but only a question of difference in rate of interest in selling paper. Moreover, it can be done without creating a panic; since gradual liquidation of commercial paper means a reduction of the volume of all commerce and trade, which is adjusted by cooperation of every toiler and consumer. It is thus spread over a hundred million of people, instead of falling back on the holders of stock-exchange loans and in- vestors, few in number by comparison. While our system has remained entirely archaic and primitive in this respect, Europe enjoys the full advantages of a highy developed dis- count system, which averts panics there with as much certainty as we may expect their occurrence with us. Commercial paper and bank acceptances form the main assets of European banks. These bills have the widest possible mar- ket, where millions are exchanged daily with margins of */ie or J^ of 1% in the interest rate, without the necessity of scrutinizing the paper when the bargain is struck. Bills of exchange have been standardized, everybody in all parts of the globe knows what names of the many thousands that ap- pear as indorsers and acceptors are considered as " good (S46) No. 4] CIRCULATING CREDITS 1 63 delivery," and everybody knows against which names there is discrimination. The daily differences are normally regulated in the case of European banks by means of larger sales of bills receivable or by larger investment in these bills. The mobilization of the promissory note, the system which enables Europe to transform bills into bank credits as quickly as staples or securities, is the explanation of Europe's success where we have failed. To insure safety for such a discount system, however, to render it possible and effective, a central reservoir for cdl the cash of the nation is necessary, as, inversely, for the safety and efficiency of the central reservoir a system of exchanging bills is a prerequisite. If a system constructed upon credit is to be safe, the first condition is that cash must be less valuable or attractive than the bank credit. Holding of cash entails the risk of loss or robbery; it is a source of danger, like ammunition which we keep under our roof. Moreover, to keep cash unemployed means a loss of interest. Depositor and bank alike must therefore try to turn cash holdings into interest-bearing bank credits with the great- est dispatch and to the largest degree that may be possible and permissible. This alone will allow cash at all times to return freely and rapidly into a central reservoir, as provided by modem financial systems; this alone will allow the central organization to respond freely to any demand for cash, be- cause the latter cannot fail to return through some other channel, unless it be taken for export. But in order to secure the free flow of cash into a central reservoir it is a prerequisite that there must be absolute con- fidence ( I ) that there is enough cash to meet all emergencies, (2) that it will be freely forthcoming when demanded, and ( 3 ) last and most important of all, that the banks will be able, in case of need, to build up with such central organization a cash credit upon the strength of which they can withdraw cash, if such be required from them. It follows, then, that, under a modern system, there are two entirely different duties to be performed by the general banking institutions and the (547) 1 64 BANKING REFORM IN UNITED STATES [Vol. IV central organ. The former must see -to it that they can com- mand cash credits to meet their demand obligations, but it is the duty of the central reservoir to see to it that these cash credits be always transformed into actual cash when required. The means, however, by which banks transform their as- sets into cash credits with the central organization are the re- discount of bills purchased, local or foreign. Commercial paper, transformed into bills of exchange easily marketable at all times, forms the means of connection between the central organ and the banks; it constitutes the elevator system of the skyscraper, which alone renders the evergrowing tower safe and habitable. This division of functions and this means of connection be- tween the central institution and the individual banks cannot be too clearly understood. In Europe the general banks have no cash reserves, they have credit reserves. The duty to transform credit into cash resting on the central organ, it alone is concerned in the holding of adequate gold reserves and in watching that a certain and safe proportion be preserved between the aggre- gate demand obligations of the nation and its holding of gold. The existence of such a strong supervisory organ and its ability to maintain the nation's credit creates that safety for the cir- culating credits of the nation which renders the whole system possible. For it is the confidence in these circulating credits which creates the broad market for money, always flowing where it can earn interest in safety, and it is in turn this free flow of money, attracted or driven away by a higher or lower rate of interest, which protects the central organ. By increasing or decreasing its rate of interest, thus taking a larger or smaller part in the nation's investments in commer- cial paper, by accumulating or selling holdings of foreign bills of exchange, the central organ exercises a regulative influence which keeps it strong enough to protect each bank individ- ually in case of need, thereby safeguarding the whole nation. Safety, from the point of view of banking investments, consists of two elements : the one, the intrinsic value ; the other, its market. A consideration of these two factors produces (548) No. 4] CIRCULATING CREDITS 1 65 the stipulation of the interest return that the investment must produce. International money may flow to England and buy three months' British bank acceptances at 2^/16%, while for three months' English time money it would possibly demand 3j4% ; the difference between the two rates showing the difference in value between a quick asset and an investment for a definite period. But, even a comparative rate of 4 and 5% could not cause international money to be invested largely in American commercial paper; since not only is it an unsalable, unliquid investment, but it has not been standardized. It is individual and provincial in its character, while the American banks which, knowing the maker of the note, might render it liquid and salable abroad, must not, under present conditions, freely indorse or accept it. Moreover, as long as there is lacking with us a central organ that would guarantee its market in case of need and secure at all hazards the transformation of cash credit into cash, foreign money will remain cautious and the interest inducement must remain comparatively exorbitant. Contemporaneous financial history furnishes us constantly with illustration showing the superiority of the European sys- tem. We have not only lived through the disgraceful collapse of our own machinery, but, quite recently again, we have seen the advantages of European financial methods. During the recent Morocco crisis a war scare developed in France and actual hoarding of gold began; the withdrawals from the deposit banks were at a given moment alarming. But there followed no panic. The Banque de France issued notes freely, the French banks collected their holdings of foreign paper and the general confidence in the Banque de France's power to cope with the situation overcame the fright without the calamities that would have ensued with us. When France, for reasons just explained and as a means of political pressure, withdrew from Germany more than two hundred million marks that had been invested there, when English and Russian money was called back, when runs began upon some savings banks, Germany had to face a very severe strain. But what happened? The German (549) 1 66 BANKING REFORM IN UNITED STATES [Vol. IV Reichsbank rapidly increased its credit facilities by about $150,000,000; moreover, it had accumulated in times of ease vast sums of foreign bills, and when rates of exchange moved up to a point warranting gold exports, it began to sell these foreign holdings. At the same time a comparatively slight increase in its rate took place which brought new money, mainly American, to Germany's assistance. This inflow of foreign money was increased by the sale abroad of German treasury notes. What would have become of Germany without the Reichs- bank? Without the confident reliance that the Reichsbank would be able to meet the situation and without its ability to apply all these various means of defense, general suspension would have been inevitable. It is the elasticity of such a system that renders it safe, and it is the implicit confidence that it inspires, that made our bankers send their money, without hesitation, in spite of a critical situation, in order to secure for a few months a beggarly J4 to J4% interest per annum more than they could have obtained at home. We had no war scare, the country was full of gold in 1907, but rates of 50 to 100% could not bring money, because our system — or rather our lack of system — had killed our own confidence in our own credit. We have no credit system, but a discredit system. The advantage of a big central organ, not run for profit like the general banks, but administered solely for the protection and safety of the nation, is plainly shown by Ger- many's recent history. The complete withdrawal of money from " gainful occu- pation," turning it into idle cash to serve as means of legiti- mate assistance in times of need (a real and effective reserve in that respect, not a nominal one like our ineffective idle funds, which are termed reserves by a misnomer) and the quiet accumulation of foreign bills — less profitable than the German bill carrying a higher rate of interest — could be brought about and brought into effect only by such an institu- tion. It is the inefficiency and the discredit of our system which (SSo) No. 4] CIRCULATING CREDITS 1 67 severely handicaps us also in our foreign trade; for a foreign purchaser will rather buy merchandise to be paid for in ster- ling than in dollars and for the shipping of goods purchased abroad, be it South America or Asia, the American merchant has to provide European bank acceptances, because the accept- ance of the American banker, no matter how good his credit, has no market. We pay an annual tribute of millions to Europe for the financing of our trade, which is not only a wilful national waste, but also a blemish on our financial standing. A wonderful change will take place in all these respects if the bill now in preparation by the Monetary Commission, be pcissed on the lines suggested by Senator Aldrich. With- out creating a central bank — for all the far-reaching bank- ing powers have been eliminated which are characteristic of European central banks — and without fundamentally dis- turbing existing banking methods, merely by a simple device of federating the now scattered reserves into one general reservoir to be jointly administered for the protection of all, our system will be changed from a provincial, old-ftishioned, wasteful and dangerous one into a national, modern, economic and safe structure. Our system — at present a tottering, top-heavy sky-scraper without a solid foundation — the tenants, instead of uniting in constructing a safe substructure, have solely concentrated their efforts on strengthening and fortifying each his own flat — a towering fire-trap, provided with an old-fashioned staircase as the only means of communication for all its disconnected tenants — with one stroke becomes modern and safe. Or, as I said on previous occasions, the 20,000 to 30,000 scattered pails of water, representing our disconnected bank reserves, will be united into one large reservoir, with a system of pipes leading to every house, bringing safety to all by cooperation. While the solution is simple in principle, it had to be com- plicated in form ; for it had to satisfy even the most suspicious mind that control and abuse of power by individuals, singly or combined, political or financial, would be absolutely im- possible, and it had to take into consideration that a modern (551) 1 68 BANKING REFORM IN UNITED STATES [Vol. IV discount system cannot be created by a stroke of the pen and that, therefore, a new device had to be invented to bring about a safe and effective mobilization of the present form of Ameri- can commercial paper. Both will be achieved under Mr. Aldrich's plan. It is true that we shall have to create a ma- chinery more cumbersome in operation and not quite so far- reaching in effect as the European system, but a careful con- sideration of all the details convinces the student that a sim- pler way would not be a safe one. The plan, carried out on its present lines, will by process of federation bring about a centralization of reserves with a guarantee of decentralization of banking facilities. It will strengthen the independence of the smaller banks, and while restricting the National Reserve Association to the smallest possible field of operations, it will give to this association power enough to protect the nation in the future. It will bring about the mobilization of our commercial paper and, in encouraging bank acceptances, it will help us to finance our own trade, and to establish in doing so the first basis for the development of an American discount market, a step of the greatest importance for the future of our country. The Na- tional Reserve Association will be able to accumulate foreign exchange, and thus to act as a protector of the nation in times of need. It is also to be hoped that some way may be found to enable it from the beginning to meet emergencies by being in a position to sell short treasury bills of the United States. The National Reserve Association, if enacted into law, will take the monetary system of the United States out of Wall Street. Instead of a rigid system, the slight elasticity of which is now based on stocks and bonds, we shall enjoy an elastic system based primarily on commercial paper, bank accept- ances, and foreign bills. I have almost concluded my address without dealing with the bank notes which, as circulating credits — the subject matter alloted to me — ought to have been treated prominently. In beginning to study the subject of monetary reform one is apt to think that the question of note issue is the primary one. After some years of struggling with this problem, one learns (552) No. 4] CIRCULATING CREDITS 1 69 to understand that the question of effective reserves and liquid credits is the main question, and that note issue is only a secondary phase and of lesser importance. If any bank, rediscounting with the Bank of England, Reichsbank, or National Reserve Association, may take gold against its credit balance, there is, from the National Reserve Association's point of view, no difference between this balance and a bank note against the presentation of which gold may be demanded. Bank notes are deposits in bearer form. The liability for bank notes and deposits is the same. For each deposit can be turned into bank notes, and each bank note into a deposit, and inversely, and for the same reason, it is immaterial whether a general bank owns a bank note or a credit balance with the Bank of England, the Reichsbank, the Banque de France, or the National Reserve Association.^ Some of our leading financial papers appear not to have grasped this point fully. Because national banks are not al- lowed to count their own notes as reserves, it is argued that the notes of the National Reserve Association also should not be counted as reserves. But the difference is obvious. The National Reserve Association could not count its own notes as cash ; returning notes will not be treated as an asset, but will be charged off, reducing liabilities. In order to avoid confusion, our present national bank notes must be con- sidered collectively in this connection. From that point of view national banks must treat their own notes, like checks on other banks, as clearing values ; as assets but not as cash. The notes of the National Reserve Association are liabilities of an independent institution endowed with a huge capital and or- ganized for the sole purpose of providing for the payment in gold of all its liabilities, including its notes. If the balance with such a National Reserve Association is to be counted as 1 Mr. Aldrich has very wisely, and I believe for the first time in banking history, made the liability a subject of measure and taxation — ^not alone the note issue as in France and Germany. To my mind the law would be even more perfect if the clauses taxing the note issue were left out entirely. In France and Germany, where an effective check system does not yet exist, note issue is the barometer of expansion, while with us and in England deposits play the more important part. (553) I70 BANKING REFORM IN UNITED STATES [Vol. IV cash, as it should be, the note certainly must be counted as cash, too. When one of our leading financial weeklies advanced the argument that such notes should not be counted as reserves because they are not so counted in Europe, it went far afield. For as we have seen, in none of the leading European countries is there any law requiring general banks to keep cash reserves nor do these banks generally keep more cash than they actually need for their daily business. Neither could it strengthen the general system if they accumulated gold reserves. Quite the contrary, it would interfere with the free flow of gold into the central reserve where, becoming the basis of an elastic system, it can do vastly more for the efficiency and safety of the whole system than if locked away in a single bcink. Since we possessed no central organ for the consolidation of our reserves, we had to have laws requiring each bank to ac- cumulate reserves of its own. This archaic and unfortunate method can, however, now be turned to good account. For this direct cooperation in strengthening the reserves of the National Reserve Association — which cooperation, in this form and to this degree, does not exist in Europe — is all the more necessary since, through the lack of a highly organized dis- count system and through the restrictions placed upon the scope of its operations, the National Reserve Association would otherwise not command the strength and the confidence en- joyed by European central banks. In other words, with us the elevator service being less perfect — in the beginning at least, — the foundation must be so much broader. The fear that notes counted as reserves would attenuate the basis on which our banking system rests, would apply with equal force to balances kept with the National Reserve As- sociation which, under the new plan, may be counted as re- serves. This possibility of attenuation is the very element of elasticity. It is the function of the National Reserve Association to see to it that all its liabilities — ^balances and note alike — are fully protected by an ample supply of gold and by a credit so strong that nothing can shake it. But a system without the (SS4) No. 4] CIRCULATING CREDITS 17I power to expand, no matter how large its gold holding, re- mains vulnerable. Elasticity wisely safeguarded — as in this plan — is the basis of confidence and therefore of safety. Not infrequently one hears the question : If it be true that the National Reserve Association will democratize our system and to a large extent turn the banks' call money into the bill market, taking it away from Wall Street, why should the latter favor the new law? The answer is plain : This overflow of money, which in times of ease floods New York, and which, when needed, is with- drawn with such vehemence that it causes violent convulsions, is a constant source of danger to that city. While our present system makes New York the undoubted money center and gives to its banks a position of pre-eminence and predomin- ance, this power is possessed only at the expense of a respon- sibility, which, with our present system, in times of stress brings mortification and humiliation. Wall Street, at present, is a ruler on a keg of dynamite. And, like many an absolute ruler in receqt years, it finds it more conducive to safety and contentment to forego some of its prerogatives — thrust upon New York not by its own will, but as a result of our present laws and conditions — and to turn an oligarchy into a con- stitutional democratic federation. But that is not all. We are a nation still in its formative period, full of ideals and ambitious imagination. It is not the hunt for the almighty dollar that prompts men, possessed of millions, to keep on toiling and struggling with nature and with their fellow creatures. It is the youthful and bound- less energy craving for constructive success, the joy of creat- ing and the conscious and unconscious desire of taking a hand in the triumphal development of this great country. Our ambitions are great, and it hurts our pride that, while we have become powerful, and are leaders in many respects, we are an object of contempt and of ridicule when it comes to the ques- tion of our monetary system. We cannot become a center of international finance on a par with European countries, until we reorganize. If New York has to make some sacrifice in order to achieve this aim, she is willing to do her share, just (555) 172 BANKING REFORM IN UNITED STATES as every part of the country will have to contribute. What- ever little advantage may be lost in the beginning will be more than counterbalanced by the safety and continuity of our financial life. The United States enjoying a modem financial system will attain that place among the nations which should be hers by destiny, and she will weather in safety and dignity the storms, from within and without, that may be in store for her. A modern financial system will enable the banks fully and safely to finance the future growth of this country and, vice versa, a healthy growth of the country is bound to bring prosperity to the banks. The sky-scraper placed on a solid foundation will safely carry many additional stories, and the tenants will be at once secure and prosperous. (556) THE OWEN-GLASS BILL AS SUBMITTED TO THE DEMOCRATIC CAUCUS Some Criticisms and Suggestions NOW that we have before us the Owen-Glass Bill in the definite form in which it has been submitted to the Democratic caucus, it may be interesting dispassion- ately to analyze it and to establish wherein it differs from and wherein it agrees in the main points with the bill of the Monetary Commission. It is a source of great satisfaction to note that, as the Republican party had to outgrow and to abandon its old doc- trine of " currency issued by national banks against govern- ment bonds," so the Democratic party had to relinquish its old heresies of the i6-to-i silver standard and the guarantee of deposits. Both parties are now agreed that reform must provide for " a currency " — to use President Wilson's own words — " not rigid as now, but readily, elastically responsive to sound credit, the expanding and contracting credits of every- day transactions, and the normal ebb and flow of personal and corporate dealings." There is a further and even more important progress. Both parties have now recognized that it is not the " currency " which is the exclusive or even the chief factor that needs re- form, but that, indissolubly interwoven with this question is the problem of rendering available and efficient the now im- mobilized reserves of the country, and of mobilizing and mod- ernizing the now illiquid American bills of exchange by creat- ing a " discount market " and " bank acceptances." Both parties are thus in agreement as to the ends to be striven for; more than that, they are agreed even as to the technical means by which they must be attained. Accordingly, both plans pro- vide for concentration of reserves, for the creation of an or- (S57) 174 BANKING REFORM IN UNITED STATES [Vol. IV ganization for the purpose of rediscounting commercial bills, for the substitution of an elastic note for the present national bank currency, and for a conversion of the 2% government bonds into 3% bonds. The country is to be congratulated upon seeing these theories and principles clearly established ; it remains the nation's duty conscientiously to watch that the aims now professed by both parties be carried into effect in the best possible way, and that they be not lost through ignorance, prejudice, or consider- ations of party policy. Where there is agreement as to the fundamentals, it should not be impossible to reach an accord as to the means, provided they be honestly sought for. There were five main criticisms of the Monetary Commis- sion's plan, and it is chiefly on these points that the Owen- Glass plan differs from its predecessor. Mr. Aldrich's critics claim : 1. That there is too much concentration of power and that this power is placed almost entirely in the hands of the banks or their representatives. 2. That a uniform discount rate for the whole country would not be practicable. 3. That the size of the balances to be kept by the subscrib- ing banks with the National Reserve Association is not defined. 4. That the National Reserve Association, after taking over all the 2 % government bonds, is not sufficiently protected, be- cause, although it would assume the responsibility for the en- tire national bank note issue, it would be prevented from sell- ing the United States 3% bonds in case of emergency (except $50,000,000 per annum and that only after five years). 5. Finally, it is claimed that currency should be issued only by the government of the United States and not by a semi- official body.^ As to point I, the writer partly agrees with these critics; as to 2, 3, and 4, he entirely agrees; as to point 5, however, he totally disagrees with them. 1 This article does not aspire to be a comprehensive criticism of the Owen- Glass bill in all its details, but has for its purpose the discussion only of these main points. (558) No. 4] THE OWEN-GLASS BILL I 75 Let us analyze each point consecutively : The Monetary Commission's plan proceeded on the theory of the Bank of England, which leaves the management en- tirely in the hands of business men without giving the gov- ernment any part in the management or control. The strong argument in favor of this theory is that central banking, like any other banking, is based on " sound credit," that the judging of credits is a matter of business which should be left in the hands of business men, and that the government should be kept out of business. The Aldrich plan, therefore, provided for only a moderate amount of government control; but on the other hand it restricted the powers of the central board and the scope of the branch boards to such a degree, and it proposed so democratic a system of electing directors, that its author hoped to satisfy the nation that the concen- trated reserves of the United States and the note issue would be safe in the hands of this National Reserve Association. The Owen- Glass bill proceeds, in this respect, more on the lines of the Banque de France and the German Reichsbank, the presidents and the boards of which are to a certain extent appointed by the government. The writer is inclined to think that the latter form is the one better adapted to modern nations. These central banks, while legally private corpor- ations, are semi-governmental organs inasmuch as they are permitted to issue the notes of the nation — particularly where there are elastic note issues, as in almost all countries except England, — and inasmuch as they are the custodians of prac- tically the entire metallic reserves of the country and the keepers of the government funds. Moreover, in questions of national policy, the government must rely on the willing and loyal cooperation of these central organs. Much is there- fore to be said for the theory of centralizing reserves and note issue in the hands of a semi-official private corporation under a mixed administration of business men and government ap- pointees, the managing officers being appointed by the gov- ernment. In strengthening the government control, the Owen- Glass bill therefore moved in the right direction ; but it went too far and fell into the other, and even more dangerous, extreme. (SS9) 176 BANKING REFORM IN UNITED STATES [Vol. IV In France and Germany the central banks are entirely free from any sectional or political color. An officer is appointed on the strength of his qualifications, generally after a long training and gradually rising in rank; a director is elected on account of his standing in the business world ; all irrespective of their political faith, and they will remain in office accord- ing to their merits and independent of whether the liberal or conservative party be in power. In our country, with every untrained amateur a candidate for any office, where friendship or help in a presidential cam- paign, financial or political, has always given a claim for political preferment, where the bid for votes and public favor is ever present in the politician's mind, where class prejudice and antagonism between East and West and North and South run high, in a country so different from these European states, a direct government management, that is to say a political management, would prove fatal. Moreover, in Europe the banks are not required to furnish the capital of the central banks, nor are they obliged to keep balances of such size as will be necessary with us, where the banks and the govern- ment will be the only depositors of the Federal Reserve Banks. The banks, therefore, should be satisfied that the administra- tion will be carried on without bias and upon sound business principles. There can be no doubt but that, as drawn at present, with two cabinet officers members of the Federal Re- serve Board, and with the vast powers vested in the latter, the Owen-Glass Bill would bring about direct government man- agement. The Owen- Glass Bill provides for the creation of twelve Federal Reserve Banks as against the one National Reserve Association, with fifteen branches, as proposed in the Aldrich Bill. The National Reserve Association is theoretically the simpler, sounder, and, in effect, the more efficient structure. The freest possible return of idle cash into one large reservoir is best assured by a single organ, and its larger strength and uniform policy render feasible the creation of a real discount market and the performance of other functions, such as ac- cumulation or disposition of foreign bills, and gold transac- tions, which are necessary for the safety of the structure. (S60) No. 4] THE OWEN-GLASS BILL 1 77 Moreover, as we shall see later, a single organ of vast strength is in a position to solve in a more effectual way the question of government bonds and note issue. Messrs. Owen and Glass were moved to adopt the Federal Reserve Bank system, not only because Senator Aldrich had adopted the other, but because the absolute centralization frightened a great many who are afraid that in some way or other " Wall Street " might secure the key to this great chest. Although, in the writer's opinion, this apprehension was unwarranted, still this fear existed and had to be taken into account. More- over, it was thought impossible to have one discount rate govern the whole country; and justly so. In dividing the country into separate districts, each having its own Federal Reserve Bank and its own rates, it was hoped to counteract the danger of centralization of power and to render each district independent of the others. It seems that the framers of the law were in the beginning impressed with the idea of creating from twenty-five to thirty such centers, or even a larger number. The longer they dealt with this question, however, the clearer it became to them that the number had to be reduced and, furthermore, that some way had to be found to coordinate these separate entities, or rather to subordinate them under the domination of one central power. It is clear that, if a large number of separate Federal Re- serve Banks should be created without any such superimposed organ, instead of having a free back flow of idle cash into one center, we should have competitive hoarding of gold at each central point. This would destroy the basic principle of the plan, which is that the reserves of one part of the country, where there would not be any seasonal demand, should be available for another, where crops might just be moving. Without a central organ the result would have been that these independent and weak Federal Reserve Banks would have had to depend on the strongest among them for assistance. In other words. New York would have become the center dictat- ing the country's financial policy, instead of having it formu- lated and carried out by a body of men from all parts of the country, as under the Aldrich plan. (561) 178 BANKING REFORM IN UNITED STATES [Vol. IV It became apparent then : first, that the number had to be reduced in order to make the units larger, and thereby more independent; and, second, that it was necessary to coordinate these units under a central board. Thus the number was re- duced to fifteen, and later on to twelve, and the Federal Re- serve Board was created. While these moves were in the right direction, they did not go far enough, for the proposi- tion as it now stands is not as yet a practicable one. Let us see how it would work. As an illustration we shall assume that a Federal Reserve Bank is established with the minimum capital permitted under the law, of $5,000,000 paid in, that is, a nominal capital of $10,000,000. This would presuppose a paid-in capital of the banks constituting this Federal Reserve Bank of $50,000,000. Let us assume that the deposits of these banks would amount to five or six times their capital, that is, $250,000,000 to $300,000,000. Of these, 5% would have to be paid in as balances with the Federal Reserve Banks, that is $12,500,000 to $15,000,000. Of these it should normally have no less than 66^% in reserve, equal to $8,000,000 to $10,000,000, leaving about 10% of the capital of the constituent banks, or $4,500,000 to $5,000,000 as available in normal times, and an additional 10% for special demands; after which the limit of a gold re- serve of 33%% would have been reached. This illustration presupposes that the banks, having paid in 10% of their capital, would want to reimburse themselves by rediscounting an equal amount with the Federal Reserve Bank, which means that the capital of the latter would be normally invested. But assuming that the capital would be uninvested, the total amount available for the accommodation of the constituent banks would even then be only 30% of their capital. This permits of several conclusions. It shows, first, that while the Aldrich plan left entirely optional with the banks the size of the balances to be kept with the National Reserve Association, permitting them to count both balance and lawful money in their vaults as reserve, the Owen-Glass Bill, while correctly stipulating a minimum balance of 5% of the deposits, errs in setting at the same time a minimum limit also for the (562) No. 4] THE OWEN-GLASS BILL I 79 amount of actual cash to be kept in the vaults of the banks. From the point of view of strengthening the Federal Reserve Banks, and thereby the banks themselves, the balances with the Federal Reserve Banks, that is their cash holdings, ought to be increased as far as possible. The banks ought to hold only as large or as small an amount of actual cash as they actually need for their daily business, and all unnecessary cash should be deposited with the Federal Reserve Banks. Allow- ing for an ample supply of till money, but leaving the deter- mination as to its size to the free judgment of the banks, it is safe to estimate that the aggregate gold holdings of the joint Federal Reserve Banks could be increased by some $200,000,000. The joint loaning power would thereby be strengthened by twice that amount. In estimating this in- crease it has been assumed that an amount equal to at least 2/^ or 3% of the aggregate deposits could be safely counted upon. In our illustration this would mean that about $7,500,000 would be added to the funds of the Federal Reserve Bank, of which $2,500,000 normally, and a maximum of $5,000,000, would become available for the contributing banks ; which would increase the total to 40% of their aggre- gate capital. The very object of the law should be to reduce to the smallest possible sum the amount of cash hoarded in the banks and to increase to the largest possible size the con- centrated reserves in the Federal Reserve Banks. But it would be a mistake to attempt at this time to do more than to free and to consolidate the cash reserves, now wastefully impounded in the banks. It would be inadvisable to add to these vast sums substantial portions of the cash balances now kept with reserve agents as part of the legal reserves. These balances are now actively employed by the reserve and central reserve banks; if withdrawn from these banks and replaced by actual cash in vaults, or by balances with the Federal Re- serve Banks, the accommodation heretofore granted to the community by the reserve and central reserve banks will have to be provided by the Federal Reserve Banks; that is to say, the regular business done by the banks will have been taken away from them, and the Federal Reserve Banks, which (563) l8o BANKING REFORM IN UNITED STATES [Vol. IV properly should act primarily as reserve institutions, provid- ing the elasticity for extraordinary demands, vi^ill have been forced into the normal business, from which they should try to keep away. Unless it be clearly understood by legislators and banks that the Federal Reserve Banks must not be used in normal times to finance the country to any substantial degree, the latter will fail to serve their purpose, because their funds will not be available when the real " pinch " comes. The balances with reserve agents should therefore be left undisturbed to a certain extent, or if we are to break with the old system of counting one bank's balance with another as a cash reserve, on the ground that such balance really is not cash, then we must concede that our system, as it stands to- day, implies a reserve of only 6% for country banks, of 1 2^% for reserve city banks, and of 25% for central reserve city banks. It is with these actual cash reserves that the nation's banking business has been done, and, if properly or- ganized, we can safely assume that they would be sufficient. No other nation requires cash accumulations or balances with central banks of such size. If the new law eliminates these bank balances as reserves, it ought to provide for a corresponding reduction of the re- serve requirements; not to the full measure of these bank balances, because a certain degree of liquidity was assured by the old system, but to a large extent. It would appear entirely practicable to reduce the reserve requirements of the country banks froni 15% (of which 6% were in vaults and 9% with reserve agents) to, let us say, 10% ; of the reserve city banks from 25% (of which 12^/3% were in vaults and I2j4% with reserve agents) to 17%; and of the central reserve city banks from 25% to 20%.^ The law should then provide that of these reserves a balance of no less than 50% would have to be kept with the Federal Reserve Banks. This would mean a minimum of 5% for country banks, of ^ Provided there are only a few central reserve cities ; if there were more than four or six there would not be any justification in requiring them to keep reserves so much larger than the other cities. (564) No. 4] THE OWEN-GLASS BILL 181 8)^% for reserve city banks, and of 10% for central reserve city banks. The writer has, however, no doubt that the balances would in fact be much larger, because there would not be any reason for the banks keeping more cash at home than they actually need for their daily business. On the other hand, the size of the balances generally kept by a bank with the Federal Reserve Bank — and thereby for the benefit of the entire community — would have some bearing on the consider- ation which, in case of need, may be claimed from the board of the Federal Reserve Bank. But whether this suggestion be adopted or not, there can be no doubt whatsoever that noth- ing can be gained by impounding an unduly large amount of cash in the vaults of the individual banks, or by unduly locking up their now free funds. If properly consolidated and organized, the present cash reserves ought to prove suffi- cient ; if linked together in an unsound and inefficient manner, the inclusion of the bank balances will not avail. If, after a few years of active operation, it should become necessary to increase the balances, the law can be easily amended to that effect. But it is most important to avoid all unnecessary con- vulsions at the beginning. As the law is now framed our illustration has shown that probably eight out of the twelve Federal Reserve Banks, thrown back on their own power alone, would not be able to provide the necessary facilities during seasonal or abnormal demands. The smaller the circle for each Federal Reserve Bank, the more acute would be its embarrassment, because the demands of its constituent banks will be simultaneous, the dominating industries of the region not being sufficiently varied. The larger the circle of each Federal Reserve Bank, the stronger must be its own intrinsic power. But even with larger units than are provided by the Owen- Glass Bill, the law would not achieve its purpose unless it ultimately brought about a market for bills and bank accept- ances and a free and natural interplay of reserves between the various centers. The business normally done by central banks must be only a fraction of the aggregate discounting done by the general banks, banking firms, corporations, large and (56S) 1 82 BANKING REFORM IN UNITED STATES [Vol. IV small, and in particular by foreign banks and governments. When the cotton crop is to be moved, not only the southern Federal Reserve Bank or banks must provide their limited share, but the local banks in those parts of the country where money is not in so strong demand during that season should be ready to buy southern bills. In doing so they would rely on their own ability to rediscount in turn their own short maturities with their Federal Reserve Bank or depend upon the broad market for discounts, in which they could, in case of necessity, resell these bills with their own indorsement. Can such a market, which is an absolute prerequisite for the safety of the entire structure, be developed with a system of twelve Federal Reserve Banks as now proposed? The an- swer is a most unqualified " No." The bcisis of a discount market is confidence; confidence in its large absorbing power and in its reasonable rates. By " reasonable " I mean to imply rates that can be foreseen by " reasoning," by summing up all the natural influences — and the extraordinary ones too — that may contribute to shape money rates in a rising or falling direction. Both these ele- ments would be lacking under the Owen-Glass plan. With twelve discount rates (even though a good many might be generally the same), with twelve competing centers, with twelve conceivably different discount policies, a large dis- count market cannot develop. A market develops where pur- chasers and sellers meet. Locally the majority of the small finance centers will be purchasers; but, as between the vari- ous centers, they will on balance almost invariably be sellers. No open discount market will therefore develop in such smaller centers. It could, however, develop in the large centers like New York, Chicago, St. Louis, Boston and Philadelphia, if it were not for the arbitrary powers vested in the Federal Re- serve Board. If, at these large centers, the banks could rely on a natural development of the discount rates, they would not hesitate to invest freely in bills instead of keeping their working reserves (not the legal ones) in "on-call money" ; but what means have they to cast any reasonable prognostication as to the course (566) No. 4] THE OWEN-GLASS BILL 1 83 of such rates? The New York Federal Reserve Bank's posi- tion may be very strong and the Federal Reserve Banks at Boston and Chicago may be in an equally good condition. Eastern banks might therefore be quite willing to buy south- ern paper at 5 J^ % while the official bank rate of the Federal Reserve Bank at New York presumably might be at 5% and that at New Orleans at 6%. But here comes the Federal Reserve Board and issues its edict that the Federal Reserve Bank of New York rediscount $10,000,000 each from the Federal Reserve Banks at New Orleans, Seattle, Kansas City, or, perhaps, Denver, Salt Lake City, Minneapolis, or Duluth. To what extent these requirements will be made and on whom they will be made, whether on New York, Chicago, or Boston, no banker will be able to foretell, nor will anybody know to what points the money may be directed. In the face of such conditions the call-money market will remain the standby of the banks ; for they will not incur the risk of investing in dis- counts while the discount rate, instead of developing accord- ing to the natural free flow of credit and money, jumps accord- ing to the whim of a largely political body. With an election coming — and an election is always coming in the United States — how strong a probability is there that a demand from Seattle or Dallas (be they over-extended or not) for money from the East will be refused? How strong a probability is there, in the face of some political agitation, that a depleted New York would receive money, even were it its own, from the South or the Far West? And even if the majority of the men constituting the Federal Reserve Board were entirely free from political considerations (which they cannot possibly be because some are political officers and owe it to their party not to disregard the political aspect of the case), what train- ing, what ability would they command to pass upon these business and banking questions so as to enable them actively to run the banking business of the entire country? For not only is the discount rate of each Federal Reserve Bank " sub- ject to review" by the Federal Reserve Board; not only has this board the power of throwing the reserves from one part of the country to any other part that it pleases ; but the board (S67) 1 84 BANKING REFORM IN UNITED STATES [Vol. IV will fix at its own discretion the rate at which " federal re- serve notes " will be " advanced " to the Federal Reserve Banks. To this latter question we shall have to revert later. While it is true that, by the addition of the Federal Ad- visory Council, a very commendable improvement has been made, because through it the Federal Board will have an op- portunity of at least learning facts concerning general condi- tions which otherwise it could not possibly know (though it remains entirely optional with the Federal Board to act on these facts, or rather upon local or political pressure) ; while it is true, furthermore, that the arbitrary powers 'of the Federal Board have been somewhat " toned down," none the less the proper working of the entire system will depend upon the wisdom with which the Federal Board exercises its func- tions, in particular that of " permitting or, in time of emer- gency, requiring Federal Reserve Banks to rediscount " paper of other Federal Reserve Banks. It has been argued with great insistence that the Federal Board should not be clothed with the power of " requiring Federal Reserve Banks" to rediscount for each other; but it is the weakness of the entire plan that without such power lodged in some group of men the whole structure would fall to the ground. With twelve Federal Reserve Banks the permission to rediscount for each other is a theoretical option of which they would hardly ever avail themselves. If the Federal Reserve Bank of New Orleans should happen to have a bank rate of 6%, against rates of 5% in the majority of the other zones, and if the Federal Reserve Bank of New Orleans became crowded, facing the necessity of increasing its rate to 7 or 8%, what would happen? Would New England or Penn- sylvania or Chicago or New York of their own accord apply for permission to grant a loan ? If money should be plentiful in these regions, the boards of these Federal Reserve Banks would argue that their individual constituent banks should take as much paper from the New Orleans banks as they thought safe and good business, but they would not for a moment consider it wise or incumbent upon themselves to weaken the reserve power of their own Federal Reserve Bank (S68) No. 4] THE OWEN -GLASS BILL 1 85 for the benefit of the New Orleans Federal Reserve Bank, shouldering thereby a burden which would otherwise fall on the remaining ten Federal Reserve Banks. In order to avoid the semblance of a central bank, the structure has been torn into twelve separate entities; but as the majority of these units are unable to stand alone, and as safety lies in union only, there must be some arbitrary power to take the place of the links that are missing in the structure. The further de- centralization has gone, where centralization is the end to be sought, the vaster and the more arbitrary those powers must be. With twelve units, for the deliberation and cooperation of which with one another the law does not contain any pro- vision — excepting the Advisory Council, which may advise the Federal Board but may not act — the initiative and executive power for any joint or individual action between these Federal Reserve Banks must rest solely with the Federal Board. This is most unfortunate, because for these seven outsiders, who constitute the Federal Reserve Board — outsiders because, living in Washington, they all stand outside of active business and they cannot possibly ever be in direct touch with the same — it is a problem beyond any man's power to decide wisely which of these twelve Federal Reserve Banks is to receive a rediscount and which of the remaining eleven, and in what proportions, shall grant the same.^ There will, therefore, be no natural flow of reserve money, nor any free flow of money, into these disconnected discount centers. Important open discount markets will not develop; because neither Europe nor the large American banks will '^ The law provides " that the interest charge to the accommodated hank (we take this to mean the accommodated Federal Reserve Bank) shall be of not less than one nor greater than three per centum above the higher of the rates prevailing in the districts immediately affected." This must be a mistake. If New Orleans's " Bank Rate " is 7%, its Federal Reserve Bank can take dis- counts only at the uniform rate of 7% ; why then should it sell its assets at 8% or 10% in order to accommodate at 7% some banks, conceivably those that have expanded too much? If the Federal Reserve Bank of New Orleans can borrow only at 8%, its bank rate should be not only at least 8%, but rather higher in order to keep down the expanding banks of the region and in order to draw money into the dry district from other banks of the United States o» Europe. (S69) 1 86 BANKING REFORM IN UNITED STATES [Vol. IV trust a system of this kind, which does not insure a sufficient mobility for commercial paper. Consequently the banks will not be enabled to dispense with their present habit of keeping a substantial proportion of their assets in loans " on call." For the sake of creating some provincial centers, which will be centers only in name, and which, standing alone, will not be able to provide the needed relief, the efficiency of the whole system will have been sacrificed. But while a system of twelve Federal Reserve Banks will prove a failure, it will be well-nigh an impossibility to re- duce the number later on. It is difficult to withdraw privi- leges once granted, even though their elimination would be of general benefit. On the other hand, it would not be hard, at any time, to increase the number, if this should prove advis- able later on. Meanwhile, under a system of a small number of Federal Reserve Banks, discount markets would have de- veloped, and the nation would have an opportunity of judg- ing itself whether or not those were true prophets who pre- dicted that the " discount market " would remove the con- centration of money on the stock exchange, and whether or not the fear of a " tyranny of credit " will survive under the new system. There are further phases of this problem that we must consider : The Owen- Glass Bill contains elaborate provisions for the development of bank acceptances and for dealing in foreign exchange. Both provisions are most appropriate, for with- out creating an effective machinery covering these two items the law would not achieve its aims. If we want to finance our own foreign trade, if we want to establish a standard banking paper with a large market at home and abroad, great pains must be taken to develop these bank acceptances (not only those of subscribing banks, but also of our private firms; for the banks alone could not pro- vide all the necessary facilities.) The accepting bank receiv- ing a commission of between J4 and ^% for giving its three months' acceptance, the discount rate for bank acceptances will have to be about i to i J4 % lower than the rate for single- (570) No. 4] THE OWEN-GLASS BILL 1 87 name promissory notes. Though it would be better business for the Federal Reserve Banks to buy 45 -day paper at, let us say, S3^%, they will have to make it a point to have a private discount rate for bank acceptances of, let us say, 4%. This private discount rate must meet the English, French, and German rates in the world's market, and, unless the Federal Reserve Banks make special efforts to make the American rate reasonably low, no American bank acceptance will take the place of the European ones, no matter how many foreign banks may be established under the American flag. Which of the twelve Federal Reserve Banks is to carry this burden? They all will want to earn their 5%, for which the margin does not appear to be very large as the bill is drawn at present, and they all will strive to make the surplus earnings beyond 5% as large as possible, since they are to receive 40% of such excess. There are several reasons, how- ever, why the 5% dividend is not so amply assured as it was under the Aldrich plan : ( i ) Under the latter plan, the treas- ury money was deposited free of interest, while under the Owen- Glass Bill interest is to be allowed to the treasury. (2) Under the Aldrich plan the profit on over $700,000,000 national bank notes, which were to be assumed by the Na- tional Reserve Association, and the profit on any further note issue, was to go to the National Reserve Association. Under the Owen-Glass Bill the Federal Reserve Banks will have to pay interest on the notes to the government, so that it may not be sure that any profit will be derived by them from this source. While the National Reserve Association's profit was limited to 5%, the balance going to the government, the mar- gin was so large that all transactions which were to be done, for the public welfare, with small profit or even at a loss, could be carried out without encroaching on the 5% dividend. It is a fair question whether, in view of these conditions and con- sidering the vast powers of the Federal Reserve Board to in- terfere with the profits of the Federal Reserve Banks, the Government should not guarantee a minimum return to the stockholding banks — let us say 4% as maximum and minimum, — and permit the banks to dispose of their stockholdings at (571) 1 88 BANKING REFORM IN UNITED STATES [Vol. IV their pleasure, selling the stocks to them above par, and using the premium for the establishment of a surplus fund.^ If we review our considerations at this point, we find that the result of the division of the country into twelve Federal Reserve Banks, under the Owen- Glass plan, would be the de- struction of a reliable and strong discount market, the weak- ening of the reserve power of the country, the undoing of the hope of developing on a broad basis the American bank ac- ceptance, and the sacrificing of a strong and efficient foreign exchange and gold policy. On the other hand, while all these advantages of a frank centralization have been lost, the Owen- Glass plan cannot avoid the same degree of centralization, which, however, it brings about by conferring autocratic powers upon a small group of men. And because the techni- cal decentralization into twelve units has gone too far, the individual powers, which are to take the place of the well- knit links of a single organization, must necessarily be too far-reaching. They become a danger to the whole structure and, at the same time, to those who are to be the responsible officers of the Federal Reserve Board. The remedy is a simple one. If the framers of the Owen- Glass Bill, continuing in the same direction in which they have moved up to the present, will further reduce the number of the reserve centers, the very serious objections to the present law may easily be eliminated. In the writer's opinion a system of four Federal Reserve Banks, with centers at New York, Chicago, St. Louis and San Francisco, with a Federal Reserve Board at Washington, would under the circumstances form the best possible solution. 1 The plan of permitting the Federal Reserve Banks to participate in any profit secured in excess of 5% does not appear to be sound. It would act as a stimulus toward activity and money making, where the main duty of these Federal Reserve Banks must be conservatism, and a strong tendency to remain in reserve without any consideration of sacrifice of profits. It would be better to allow the stockholders a return of ^Yz or 6%, under a liberal system that would permit them to earn this dividend even with the greatest conservatism, than to permit them a share in the excess profits under a narrow system that would rather force them to do business in order to be quite sure of even their 5% dividend. (572) No. 4] THE OWEN-GLASS BILL 1 89 If it be objected that by such a division New York, which would "include New England, would become too strong, a system of six Federal Reserve Banks would still be prac- ticable, though less safe and efficient. Any larger number the writer strongly believes to be pernicious. It may be well to bear in mind that with any further increase in number of the Federal Reserve Banks, New York's weight could not be much reduced, and the larger the number of the Federal Reserve Banks, the more acute will become the disproportion of New York's power as compared with that of the other centers. Let us contemplate now how a system of four or six Federal Reserve Banks will meet the various difficulties that we have discussed. For simplicity's sake we shall discuss a system of four Federal Reserve Banks, but if six should be decided upon, the argument, though weakened, will still remain the same. A system of four Federal Reserve Banks would offer to the people a guarantee that New York could not in any way have any direct influence upon the management of the banks in the other parts of the country. (The New York Federal Reserve Bank would embrace New England, New York, New Jersey, Pennsylvania, Delaware, Maryland.) The country would be as safe in this respect as it would be under a sys- tem of twelve Reserve Banks. On the other hand, what have we gained? The accumulations of reserve money would be so strong in each of the four centers that a sectional seasonal demand could be readily taken care of; all the more because with four large units, four powerful administrations with a distinct and strong policy, important discount markets will develop. We should then have a real concentration of re- serves and a real mobilization of credit. As to bank accept- ances, foreign exchange, government bonds and note issue, these four Reserve Banks could agree upon a joint handling of these (perhaps for a joint account to be based upon the capital of each Federal Reserve Bank.) Four large concerns will be able to agree upon a disinterested policy; twelve local Federal Banks, with unequal powers, and naturally more sel- (573) igo BANKING REFORM IN UNITED STATES [Vol. IV fish interests, never will. The idea prevails among some critics, that twelve centers will take better and fairer care of the country than four. This idea is unfounded. The re- verse is the case. The question of the branches of the National Reserve Association and of the Federal Reserve Banks has, in the writer's opinion, never been sufficiently considered in detail. If a free system of transfers from one part of the country to the other is to be established, if balances with Federal Reserve Banks are quickly and easily to be created and used for the purpose of clearing, then all important cities must have branches and all minor cities must at least be within easy reach of a branch. It will be impossible to establish an eflfective system of transfers of balances with twelve zones, within the boundaries of each of which the easy transfer would remain confined. There are between sixty and seventy cities now that are entitled to branches, or where branches are necessary to cover certain sections. Let us take cities like Cincinnati, Cleveland, Toledo, Columbus, Indianapolis, Detroit, Milwaukee, Minneapolis, St. Paul and Duluth. They all would be entitled to branches, and they all could be be branches of Chicago. If we were to pick out one of these and make it a Federal Reserve Bank, the others, almost equal in importance or possibly superior, would fare poorly by becoming tributary to, and dependent on, an organization weaker than Chicago. But this must happen with twelve centers. Moreover, it is hard to imagine that a federal re- serve city should not become a central reserve city. To create twelve central reserve cities would defeat the very idea of central reserve cities — we need not enlarge upon that thought — but with twelve federal reserve cities we could hardly escape that necessity. By adding San Francisco to the list of the existing three central reserve cities the question might be solved without difficulty with a system of four centers.^ ^ With four Federal Reserve Banks one could imagine that each Federal Reserve Bank city would become a central reserve city ; each city where there was a branch (and only those) would become a reserve city. If the accumulation of reserve money with reserve agents is to cease, the main motive (574) No. 4] ■ THE OWEN-GLASS BILL, 191 If six centers must be created, we must suppose that New Orleans and some other city, presumably Boston, would have to be added. (But, again, the South, grouped around New Orleans, will be less efficiently provided for than by group- ing a larger Southeast around St. Louis. Even New Orleans itself would fare better as an important branch than as a comparatively weak Federal Reserve Bank.) In other words ' — to use again our old metaphor, often employed in the last six years, — in order to procure fire protection for the entire community we must provide faucets in as many places as we possibly can («'. e., the branches), but we must concentrate the water so that we may have enough for any emergency. If we cannot concentrate all the water into one central re- servoir, let us at least see to it that there shall be only a few and large ones. Small reservoirs will quickly run dry, there- by creating consternation, and any other small reservoir, that may be drawn upon, will quickly show the eifect, again causing anxiety and, as a consequence, an increased demand. Large reservoirs can stand a drain without an alarming drop of the gage and, if interconnected, they can assist one another with- out much sacrifice and without creating any convulsion or alarm. Twelve interconnected reservoirs would be a compli- cated system, inefficient in its results and to be handled only in the most arbitrary and haphazard way. To insist on a large number of Federal Reserve Banks be- cause, it is argued, reserves ought to be kept where they origin- ate, is a selfish and narrow doctrine. For some charitable minds it may be a comfortable feeling of safety to see their neighbor's house burn down and to shut off from him their own water supply. But when their own house happens to be on fire they may find some fault with such a system. More- in the determination of central reserve and reserve cities will have been elimi- nated. On the other hand, the position occupied by a city in the organization of the Federal Reserve Banks will become a very important factor, and inas- much as there will be a certain concentration of business wherever there is a branch or a head office, it may be logical to require banks in these centers to contribute in a more substantial degree to the reserves of the nation than the other banks which in the future would constitute the " country banks." (S75) 192 BANKING REFORM IN UNITED STATES [Vol. IV over, with the key in the" hands of a board appointed by the President, they should be able to overcome this provincial point of view. As to the organization of the four Federal Reserve Banks and the Federal Reserve Board, it would not be difficult, while preserving machinery similar to that now proposed in the Owen- Glass Bill, to begin by organizing the branch boards, which would be responsible to, and under the control of, the boards of the Federal Reserve Banks. The latter would be constituted from members of the branches, and some members would be appointed by the Federal Reserve Board. Each branch would have a manager to be appointed by the board of the Federal Reserve Bank. Each Federal Reserve Bank would have a governor to be appointed by the President, from lists to be submitted to him by the board of the Federal Reserve Banks, which lists the President might return, asking for a new set of names. These governors would be first-class, expert men, who should receive large salaries in order to render them independent and in order to make the position an attractive one for men of the largest caliber. The Federal Reserve Board should consist of these four governors, three additional members to be appointed by the President, and to these should be added the governor-general to be appointed by the President in consultation with a committee consisting of delegates from the Federal Reserve Banks. It should not be difficult upon a basis of this kind to agree upon a constitu- tion of the Federal Board satisfactory both to Congress and to the business community. The Secretary of the Treasury and the comptroller of the currency ought to be members of a board of supervision. With units so large and a Federal Reserve Board thus con- stituted the powers of the latter may remain almost unchanged ; but it is submitted that it may not be necessary to destroy the independent character of each Federal Reserve Bank by mak- ing it obligatory for them to rediscount for each other at the request of the Federal Board. If there be only four Federal Reserve Banks, the heads of which are members of the Federal Reserve Board, at which they would meet one another, they (576) No. 4] THE OWEN-GLASS BILL 1 93 might be relied upon to stand by one another voluntarily — in particular if they have to deal jointly with government bonds, bank acceptances, foreign exchange, and note issue — and the law may be easily amended in case they should not. In the writer's opinion cabinet members should not be mem- bers of the active board. It would be safer both for these officers and for the country if men whom duty toward their party compels not to neglect the political aspect of each case should be kept away from this post. Moreover, secretaries resign, or, in the course of events, they change, whereas it is most important that the members of the Federal Reserve Board should gradually become experts like the members of the Interstate Commerce Commission. There are no cabinet members on this latter commission, nor are there any on the Supreme Court, with both of which the Federal Reserve Board has been compared. Inasmuch as the Democratic party ap- pears to have set its mind on exclusive government control, the writer's proposition, as above outlined, bears fully in mind this prerequisite even though he may consider it extreme. The plan as here proposed would not allow a single member on the Federal Board not appointed by the President ; but none the less it would gain the confidence of the business com- munity and overcome its objections, because the four gov- ernors of the Federal Reserve Banks, who would be thor- oughly familiar with actual banking and business conditions in their respective zones, would have an opportunity and duty to confer frequently with one another, and would have an important voice in the shaping of the policies of the Federal Reserve Board. The remaining three members would be free from any political pressure. The Democratic party's principles would have been fully respected, and yet grave dangers and defects would be avoided. But, no matter what conclusion may be reached in this respect, and what form the Federal Board may take, the dangers and iniquities of government management would be materially reduced by the establishment of only four Fed- eral Reserve Banks. The more the Federal Board is called upon to deal only with composite bodies — that is, a number '(^77) 194 BANKING REFORM IN UNITED STATES [Vol. IV of varied elements massed together — the more it is protected from political pressure. The local demand would address itself to the Federal Reserve Banks; the Federal Reserve Board at Washington would deal only with questions of policy, applying to groups that would be so large that the divergent interests of the various component parts would in themselves eliminate any provincial color, helping the Federal Board to deal with its problems without fear or favor, in an absolutely statesmanlike, unbiased way. A structure of this kind would have the advantage, as against the Monetary Commission plan, that, while there would be among the four reserve banks one policy of expan- sion or of contraction, they could each adapt their rate to their own conditions, as against the uniform discount rate for all the country proposed in the Monetary Commission plan. The Federal Board might even have power to permit a Federal Reserve Bank to establish a higher rate for a single branch, when it appeared necessary to curtail a particular over- expanding branch or community, without wanting to affect by a higher rate the entire zone of the Federal Reserve Bank. A structure of four (or six) Federal Reserve Banks would offer the greatest advantage in dealing with the government 2% bonds and the note issue. With both of these features the Owen-Glass Bill deals in a most unsatisfactory way. In the first place, our currency is already redundant and we should begin with the existing maximum as the minimum, because national bank currency, based on government bonds, does not materially contract. We should provide for a pos- sible increase of $500,000,000, though this limit has now been removed by law, but for a decrease of only $35,000,000 for the first year. The entire national bank currency ought to be converted into elastic currency from the beginning. What do we gain by spreading this conversion of bonds and notes over twenty years ? There is every argument for a prompt conversion. The present proposition is unsatisfactory for both the gov- ernment and the banks. If we consider that within the last twenty years English, French, and German government bonds (578) No. 4] THE OWEN-GLASS BILL 1 95 have gone down about 20%, anybody would be a bold man who would dare to foretell at what price United States gov- ernment 3% bonds will sell within the next twenty years. If the United States should embark upon any national enter- prise entailing a material issue of bonds, the price certainly would go down. Should United States 3% bonds sell below par, the national banks would, of course, not convert. The national bank note issue, in that case, would remain outstand- ing for twenty years, when the United States would have to sell a 3j^% or possibly a 4% issue to take the place of the old 2% bonds. The present proposition, then, gives the option to the national banks to convert in case the 3% United States bonds sell above par, while, if they sell below, the United States will have to take the loss. This is a poor proposition for the government; on the other hand, it is the minimum that, in fairness, could be oflfered to the national banks. The Aldrich plan proceeded on correct lines in converting the 2% bonds all at once and in assuming the entire national bank note issue. It went astray when it provided that these bonds were to be kept from the market for five years and were to be sold only at the rate of $50,000,000 per year after that period. This meant that the National Reserve Associa- tion, having assumed over $700,000,000 on-demand obliga- tions, would have had its hands tied if it had been called upon to protect these liabilities — an unsound position. The problem is not an easy one. If we imagine that after twenty years the national banks would have disposed of all their bonds to the public, we must expect that, on the other hand, at the period there will be required at least the same amount of circulation as we have to-day (and more according to the increase in population.) That means that federal re- serve currency will have been permanently substituted for na- tional bank currency, let us say to the extent of $700,000,000 to $800,000,000. But currency cannot be issued without some- thing having been given in return for it, which means again that, inasmuch as the Federal Reserve Banks would not own any government bonds against these outstanding notes, they must have other assets to that extent — that is, mainly, com- (579) 196 BANKING REFORM IN UNITED STATES [Vol. IV mercial paper. It follows that, in addition to their own capi- tal and part of their deposits, the Federal Reserve Banks would have permanently invested about $800,000,000 in com- mercial paper, and to this we should then have to add the extraordinary and seasonal demands for which $500,000,000 were estimated to be issued, a total of about $1,300,000,000 to $1,500,000,000. This would not be a healthy condition, for normally the Federal Reserve Banks should not be so deep in business, they should become such heavy investors in com- mercial paper only in times of active demand. It would therefore be desirable to find a way of investing several hun- dreds of millions of dollars otherwise than in commercial paper, provided that these assets were safe and quickly salable. It is from this point of view that the following suggestion is made. Let the four Federal Reserve Banks jointly assume the national bank note issue and let them take over jointly, in proportion to their respective capitals, the 2% government bonds. Let the government convert half of the amount so taken over into 3% 20-year bonds, the other half into one- year 3% treasury notes of the United States. As long as their charters last the Federal Reserve Banks would jointly bind themselves, whenever these one-year notes matured, to buy at par the same amount of new one-year 3% treasury notes. The advantage of this plan is obvious. For the United States it is indifferent whether they issue a twenty- year bond or a one-year bond the renewal of which at par has been guaranteed for twenty years. But the position of the Federal Reserve Banks would be immensely strengthened thereby. For, in case the Federal Reserve Banks found themselves in a situation where they wanted to strengthen their position or create a balance in foreign countries, they could at once sell these short treasury notes, if not on a 3% basis, let us say even on a 6% basis. In serious times the loss in- curred would not weigh heavily, because money at home would then be in strong demand and bring more than that rate. By such a sale the price for the long-term government bonds would not be affected in anxious times, when these could be No. 4] THE OWEN-GLASS BILL igj forced on the market only at great sacrifice and at the risk of tearing down the price of all other securities. On the other hand, these United States one-year treasury notes — which might be issued so as to mature half in January and half in July — would be a quick asset, a most suitable investment for the Federal Reserve Banks. With $350,000,000 of such an investment it might be quite safe to preserve the holding of the remaining $350,000,000 in twenty-years bonds. If it should be found that the available liquid means of the Federal Reserve Banks should be permanently increased, it can safely be left in the hands of the Federal Board to dispose of them gradually in favorable times and in quantities that the market will readily absorb. While the government, in following this suggestion, would continue to run the risk of having to renew the 3% bonds at their maturity on possibily a 3^^ or 4% basis, it would on the other hand preserve its chance of securing the advantage of a sale of the 3% bonds above par, in case the investment market should take a favorable turn. It would not grant a one-sided option. Furthermore, the profit on the circulation would from the beginning be received by the Federal Reserve Banks — that is to say by the government — and the earnings of these Federal Reserve Banks would show an ample margin over and above 5%, the importance of which we have already emphasized. This presupposes that sound counsel will prevail, and that, in the face of the emphatic protest coming from all parts of the country, the framers of the Owen-Glass Bill will ultimately abandon their intention of letting the government issue the new notes. One need not be a prophet in order to be able to foretell that this heresy will have the same fate as the i6-to-i silver standard and the gurantee-of-deposits plan, and that after a few years people will wonder how they could ever have considered seriously so absolutely unsound a theory. Though, as against its original form. Section 17 of the bill has been materially improved, it still remains a puzzle to the writer how, in practise and in theory, it will work out in any satisfactory way. Is there to be a uniform rate for the (581) 198 BANKING REFORM IN UNITED STATES [Vol. IV "advances" of these Federal Reserve notes? Or will the government undertake to discriminate between various parts of the country? Is this rate to be different from the bank rate in the Federal Reserve districts? Neither the constituent banks nor the Federal Reserve Banks, when granting accommodations, can know whether the ultimate customers will use this book credit for the payment of book debits (that is, by check), or whether it will be employed to discharge debts that cannot be paid by checks, and whether, consequently, notes will be required. Notes that have been issued to-day may again be turned into book credits to-morrow. They are interchangeable, and, from the Federal Reserve Bank's point of view, they ought to be treated alike, both as deposit liabilities. To cut these functions in two, to attempt to let the book credit and the note — twin brothers — ^be bom by two different mothers, is a most anoma- lous proceeding. But, we must ask, how would it be possible at cdl for the Federal Reserve Banks to act boldly and com- prehensively with their problems, if they cannot rely on being able to provide circulation as long as they are within the limits of the law concerning their cash reserves and collateral ? While it is inconceivable that the Federal Board should ever refuse to grant an advance to a Federal Reserve Bank in sound condition, still this arbitrary power given to the board would be a menace and an unnecessary source of weakness to the whole structure. Moreover, is it at all reasonable that a Federal Reserve Bank should not be in a position to figure what its investments in discounts will return? To illustrate: If a Federal Reserve Bank buys from the Sixth National Bank $100,000 of 60-day paper at 6%, and the latter draws a check against this rediscount, the Federal Reserve Bank nets 6%. If the Sixth National Bank, or its customer, should draw $100,000 in notes, and if the Federal Board should charge 6% for " advances," the Federal Reserve Bank would not re- ceive any return at all from the investment. Why punish the Federal Reserve Bank, and indirectly the people, for issuing a legitimate amount of circulation? If the Federal Reserve Bank's earnings above the 5% dividend are well as- (582) No, 4] THE OWEN-GLASS BILL 199 sured, the amount charged for the advances will be put from one pocket of the United States government into the other.^ If there should be any doubt as to this 5% dividend, would it not stand to reason that the Federal Reserve Bank, if it had ample cash reserves, would rather pay out its lawful money than pay for the costly " advance " of Federal Re- serve notes? This is, of course, the very last thing the gov- ernment ought to encourage, but we can hardly see how this consequence can be escaped under the law as drawn at present. But these " advances," when carefully analyzed, are noth- ing but a myth. Sooner or later, but within twenty years, under the Owen-Glass Bill, there will be outstanding $700,000,000 of federal reserve notes (which will have re- placed the national bank notes), and in addition such notes as may have to be issued to take care of extraordinary de- mands, together, let us say, between $1,000,000,000 and $1,200,000,000. Against these notes " which will be the obli- gation of the United States," the United States will have no assets of their own whatsoever. The treasury balances, of about $100,000,000, are to serve for certain specified obliga- tions of the government, and are neither available nor suffi- cient for the purpose of securing these federal reserve notes. The government relies absolutely on the Federal Reserve Banks to pay these notes when presented. It has no money to advance to these Federal Reserve Banks and it has no money to pay the federal reserve notes when presented. As long as the note is in circulation, the government kindly grants the " advance;" as soon as the note is presented for payment, the Federal Reserve Banks have to cash it. In other words, if we thread our way through this bewildering maze, it is not the government that gives the advance, but the public which holds the notes that grants the credit. In other words, it is 1 As a question of revenue to the Government a tax on note issue is super- fluous when the excess earnings go to the Government. If the tax is created for the purpose of acting as a sentimental check on over-expansion — unnec- essary, because an effective one is being applied by the bank rates — ^it ought to be based on " liabilities " (comprising deposits and notes issued) and gold cover. But, in a country in which the deposit-and-check system is so highly developed, it would be impracticable to apply the brake on the note issue alone. (583) 200 BANKING REFORM IN UNITED STATES [Vol. IV not the United States upon whom rests the primaiy obligation, but the Federal Reserve Banks. The United States are the guarantors of the notes, which the treasury would be called upon to pay only after the Federal Reserve Banks are in default. Why then not put it into a clear form? Why not let the Federal Board at Washington issue these notes — under the supervision of the treasury — for the joint account and as the primary and joint obligation of the Federal Banks, the United States, in consideration of the profits to be received and against collateral, as proposed in the Owen-Glass Bill, guaranteeing the notes? It is this the writer makes bold earnestly to recommend. The status of both the Govern- ment and the Federal Banks would thereby become clear.^ Under the Owen-Glass Bill the Federal Reserve Banks set aside a gold reserve for notes which they have not issued and which do not appear as their liability. The United States Government, on the other hand, is to issue up to $1,200,000,000 of notes, and against these no gold cover would appear on their statement; but as a cover they would show only the indebtedness of the Federal Reserve Banks. There is not sufficient differentiation between contingent and direct liabilities and contingent and direct assets. The Federal Re- serve Banks are asked to assume practically the direct obli- gation for a contingent liability, and the United States figure a contingent asset as a direct asset. The writer proposes to put direct assets and obligations into the same balance sheet, and the contingent assets into the same balance sheet with the contingent obligations. This is not a question of bookkeeping only; it has a most vital bearing upon the question of direct responsibility or contingent responsibility in the management of the Federal Reserve Banks. If the United States issued the notes as their primary obligation, if the Federal Reserve Board fixed any interest rates for these advances, the government would 1 The guarantee by the United States is not a necessity ; the notes would be good enough without the same ; but as a matter of expediency it would appear wise to follow this course. (584) No. 4] THE OWEN-GLASS BILL 20I establish a direct connection and direct responsibility which, as we have shown, it is most important to avoid. If the method suggested by the writer be followed, any political pressure addressed to Congress or to the executive for a lower- ing or raising of rates, a freer or less free supply of facilities, in any particular part of the country, would be promptly turned off by the statement that while the government under- takes the responsibility for supervision, for installing an effi- cient and honest management, it could not have any direct influence upon the business of the Federal Reserve Board or the Federal Reserve Banks. It is the world's acknowledged theory and practise to keep the obligations of the central banks distinct from those of the government. It would lead too far to present a full argument showing the advantages of the semi-official central bank over a direct government organ. It may suffice here to refer to the gold loans granted in critical times by the Banque de France to the Bank of England, a transaction that in 1907 we should have been only too glad to bring about for the United States, but could not achieve because there were no modern American bills and no central organization. A semi- official organ can bring about a transaction of such kind, which would be hardly compatible with the dignity and the duties of a government. This is another reason for keeping the government in a " contingent position," but not in the first line of battle. History has shown that the Banque de France survived when the government of France went to pieces ; it remained unchanged whether France became an empire, a commune, or a republic. History has shown that by keeping the central banks and the governments separate entities, they become mutual supports. The government is a customer of a cen- tral bank; at times its largest depositor, at times its heavi- est borrower. The government's credit strengthens the cen- tral bank, the central bank strengthens the credit and power of the government. Where government credit and bank credit have been mixed up, the consequence has been to weaken both. Are the United States, under the presidency of a man (S85) 202 BANKING REFORM IN UNITED STATES [Vol. IV of science, going to throw this universal experience to the wind ? ^ The friends of the present administration, and any good citizen, for that matter, cannot too earnestly warn it not to insist on any extreme measure that would antagonize wide circles of business men and the very element through the agency of which alone the benefits of the law can accrue to the people of the United States. While technical parts of the measure will have to be amended as the country develops, it will prove the greatest curse for the nation if the funda- mental structure should not become a permanent one. Ex- treme party policy now applied will bring extreme revision whenever the Democratic party should happen again to be- come the minority party; and the Federal Reserve Bank, in- stead of being a rock standing unmoved and unshaken by the waves of party strife, will become its very plaything, a fate to be avoided at all hazards. We cannot set business free by tying it in turn to the chariot of every conquering party. Wise moderation alone will insure the safety and the contin- uity which are the basis of prosperity. It is sincerely hoped that amendments on lines here sub- mitted will be adopted. As the bill stands to-day it is vastly inferior to the plan ultimately submitted by the Monetary Commission. In its present form the Owen-Glass Bill is fraught with serious dangers, and it would not be able to bring about those remedies and benefits that the country is entitled to expect. The suggestions made in this article take into full account the political requirements of the problem. A reduction of the number of Federal Reserve Banks from twelve to four would not violate any principle. The demand for government control would be carefully complied with, and the notes would remain " obligations of the United States," with the difference only that they would express what in essence they are under the law, and that interest charges for " advances " would be eliminated. In dealing with the 2% government bonds as here proposed, no principle 1 We cannot dwell here upon the harm and danger that would follow the watering of the United States gold currency, which would militate against our securities and our " discount market." (586) No. 4] THE OWEN-GLASS BILL 203 would be involved at all, but the practical importance of this change for the safety of the entire structure cannot be overesti- mated. Amended on these lines, the writer feels confident that the law, though not ideal, will redound to the benefit of the nation and be a credit to the party under the auspices of which it was created. The writer deems it wise not to burden this article with a discussion of a number of questions of a more technical nature, preferring at this time to center attention on the main points at issue. He hopes that it may not be consid- ered a presumption on his part, if, just returned from Europe, after an absence of several months, and out of touch with the general discussion now taking place upon the subject, he ven- tures to make these suggestions. But the active interest which he has taken in developing the ideas on the main lines of which legislation is now proposed may, he trust, justify his effort to point out some pitfalls which may prove fatal and which can easily be avoided. (587) THE OWEN-GLASS BILL: SHOULD THERE BE FOUR OR EIGHT FEDERAL RESERVE BANKS? THE amendments to the Owen- Glass Bill submitted by the two Senate committees show most satisfactory progress in many respects, and we may congratulate ourselves that complete agreements have been reached" upon many fundamental questions. On two main points, however, the two committees still earnestly disagree ; these are the num- ber of the Federal Reserve Banks, and the control of their management. It is fortunate that in this part of the con- troversy each side is right and each side is wrong. For this situation carries in itself the possibility of a wise compromise. Senator Hitchcock and his friends are to be congratulated on the sound stand they have taken in the question of the re- duction of the Federal Reserve Banks to a maximum number of four. There is absolute unanimity among all students of the question that the establishment of a discount system, bring- ing about fluidity of credit and reserves, can best be secured by one central bank. The writer has gone to particular pains to gather the expressions of views of the most prominent men in Europe, among whom are the presidents of a num- ber of European central banks, leading financiers and heads of the largest financial institutions of Europe. They all agree that one central bank would be the best means of developing a discount system. While a majority insist that this is the only way, a few concede that there is a possibility of develop- ing a discount system with several central banks. But all agree that in that case there must be as few as possible and that they must be tied together in an efi'ective way by a busi- ness management free from political influence. They also state that if Europe is to be counted upon as an investor in our future American discounts, it will be a prerequisite that there be a free market for such discounts at home. It is clear (5«8) THE OWEN-GLASS BILL 205 that unless the European investor can count on his ability to resell such discounts in case he should desire to do so, he would have to consider the purchase of American discounts as an un- desirable lock-up of money. If Europe should hesitate to take our American paper freely, our discount system will lose 75% of its beneficial power. That a discount market would develop with a system of eight Federal Reserve Banks, is out of the question. I do not wish to tire the reader by repeating the arguments which I have already advanced in a previous article,^ but I venture to append quotations from some of the letters of these European authorities.^ I am giving only ab- stracts from these letters, omitting the strong arguments they contain for a central bank and against a note issue by the gov- ernment, these two points having passed beyond the phase of further deliberation in the present controversy. These men, some of whom are at the head of institutions of the same character as those that we are about to create here, state in unmistakable terms the grave dangers that would arise from a political influence in the management of such banks, and it is on this question that Senator Hitchcock and his friends go astray, while the views expressed in this respect by Senator Owen and his colleagues cannot be too emphatically endorsed. We need not enlarge upon the consequences that would follow a government management of the branches. It might debase and corrupt our entire political life, if the fate of the manage- ment of the Federal Reserve Banks and their branches should become the plaything of politics. No matter how we safe- guard the government management in the beginning, a nation that flirts with the recall of judges may at any time break down safeguards that we may now impose and all the offices, from that of director down to that of hall porter, may become the spoils of the conquering party. One need not emphasize what consequences this might entail for our political and busi- ness life. 1 Cf. p. 173, supra. 2 The quotations appearing as an appendix in the original pamphlet are here omitted. — Ed. (S89) 2o6 BANKING REFORM IN UNITED STATES [Vol. IV In dealing with the question of whether there should be four or eight Federal Reserve Banks, we have to concede that in certain respects both sides are right. From the point of view of securing a strong system and of safeguarding a possibility of developing effective discount markets, there should be only four. From the point of view represented by the Owen wing, that an intimate touch ought to be established between the management of each Federal Reserve Bank and the district which it represents, and that each district should be certain of receiving the fullest con- sideration it is entitled to, a system of eight Federal Reserve Banks would appear desirable. Furthermore, it is true that, if we pipe-lined all branches up to four points, a great many of these branches would be located far away from the points of concentration, that the machinery would, therefore, not respond quickly enough and that the sympathetic touch might be lost. The object to be achieved then is to secure the con- centration into four units, strong and independent enough to stand on their own feet and to develop fluidity of reserves and a discount market of their own, without at the same time losing by such concentration the necessary touch with the constituent communities. The writer has repeatedly expressed his belief that in pre- paring this law insufficient attention has been given to the question of the branches. It is at the branch office that the actual business will be done. Any favoritism or any unfair discrimination will express itself at the branches, where bills are handed in for discount. Sound judgment and business knowledge must be shown here, where alone the character of the bill can be scrutinized and understood. It is therefore most important that the board of these branches be wisely constituted, and the law, to the mind of the writer, errs, when in this most important point it simply leaves discretionary power with the Federal Reserve Board and the Federal Re- serve Banks. In the writer's opinion the law should not begin by prescribing the election of the Federal Reserve Bank's board, but it should begin by providing for the election of a board of each branch. Let the organization committee or (590) No. 4] THE OWEN-GLASS BILL 20/ the Secretary of the Treasury designate those 70 or 80 cities where branches are to be established, and provide that the member banks allotted to each branch elect their board on lines similar to those provided by the Owen-Glass Bill for the election of the board of the Federal Reserve Banks. The writer would then suggest that Class "A" be elected by the member banks and that the representatives of these member banks on the board be permitted to be directors or even officers of member banks. They should have a slight majority in the board, while Classes " B " and " C " should be appointed by the government. Directors of Classes " B " and " C " would be elected from classes other than bankers; Classes "A" and " B " would constitute the discount committee, Class " C " would become the committee on supervision. The chairman of this committee on supervision would act as chairman of the board. We should in this way constitute a local board which would be representative of all classes, which would command the local knowledge necessary to deal with the local paper, and in which the government would secure a vote and absolute supervision. The plan that I have in mind would then provide for the establishment of eight regional Federal Reserve Banks, each, let us assume, with about eight branches. But each regional reserve city, for its own local business, would have to be treated exactly like a branch, and therefore we should have, including the regional reserve city, up to nine organizations, or, let us say, nine branches in each region, being a total of about seventy-two points at which offices would be created. It is not necessary to start with the full number of these branches in each case, nor need it be limited to eight. How- ever, I am inclined to think that there will not be much less than 72 when the whole organization has been mapped out and there will be many more as the country develops.^ 1 While the suggestions here made appear to be radical they can be em- bodied into the law with comparatively few changes not disturbing the general lines of the bill. They follow the structure of the Banque de France and the Reichsbank, where there are local boards at the main branches. As the sys- tem develops, agencies or sub-agencies are established as feeders of the (sqi) 2o8 BANKING REFORM IN UNITED STATES [Vol. IV Let US now assume that the law is amplified, so that a number of these branch banks (let us say up to nine), would, in forming one regional reserve bank, elect a board consisting of one member to be designated by each branch bank.^ We should then have eight regional reserve banks, let us say at New Orleans, St. Louis, Chicago, Cincinnati, New York, Boston, San Francisco, and at some other far-western point, e. g., Denver. I should now propose that in each case two regional reserve organizations be linked together into one district, so that New Orleans and St. Louis would form one District Federal Re- serve Bank, with its head offices in St. Louis. The Chicago and Cincinnati District Federal Reserve Bank would have its seat at Chicago. Boston and New York would together form a District Federal Reserve Bank at New York, and the Denver and San Francisco Federal Reserve Bank would probably have its seat at Denver.^ The boards of these District Federal Reserve Banks would be constituted of four members each, to be designated by each regional reserve bank, and to these would be added the gov- ernor and two deputy governors to be appointed by the President of the United States. They would be chosen from lists to be submitted to the President by the eight members of branches, or the number of the latter is being increased. The Banque de France has now one head office, 128 branches with local boards and 71 aux- iliary offices and 312 agencies, together 383, which are attached to the branches. The German Reichsbank has now one main bank at Berlin and 20 main branches with separate boards, in addition 76 branches and about 400 side branches. '^ If there should be less than five branches, each branch might designate two members. ^ If it were thought wise to have three regional reserve banks to cover the Pacific Coast, it could be done under this plan without interfering with its general structure. There might be three regional reserve banks, viz., one at San Francisco, one at Seattle, and one at Denver or Salt Lake City. The three would have one stock capital, and each would designate one-third of the members to the district board, which would have its seat at the most centrally situated point, — probably Denver or Salt Lake City. Similarly if at a later time it should be found that Pennsylvania and Maryland should be divorced from New York, the New York district might be divided into three regions instead of two. (592) No. 4] THE OWEN-GLASS BILL 209 the board of the District Federal Reserve Bank; the President having the right to reject these lists entirely, asking for new names. If, after three lists had been submitted, the Presi- dent and the District Federal Reserve Bank could not agree, the President would choose from one list to be submitted by the Federal Reserve Board. The governor would be in charge of the District Federal Reserve Bank, the two deputy governors would be placed in charge of the regional federal reserve banks. The stock to which all the banks of the various branches subscribe would be that of the District Federal Re- serve Bank. If we review at this point the advantages that would be gained by a plan of this kind, it will become apparent : First: The unit of each district is large enough to in- clude varied forms of industrial, agricultural and commercial interests, so that the district will be able in itself to comply more readily with the demands that may spring up from time to time. Second : For transfers and collections, the boundary line within which these will move freely has been enlarged. Third : The local character of the branch boards which will deal with each individual case has been preserved, but the character of the board of the District Federal Reserve Bank, which will have to deal exclusively with larger problems of policy, from a higher point of view, without consideration of individual wishes, has been delocalized; it has lost its provin- cial character, all districts being represented. Fourth : The four districts so created will be large enough to command confidence, and large enough to enable the devel- opment of discount markets. At the same time, the equality between all branches and between all regional banks has been preserved. For its local transactions the central point, i. e., New Orleans, would have a board, constituted exactly like that of a branch, e. g., Dallas. For its dealings with its branch banks, the regional of New Orleans would be in exactly the same position as that of St. Louis, and the District Federal Reserve Bank of St. Louis would be constituted from as many members of the New Orleans organization as that of St. Louis. (593) 2IO BANKING REFORM IN UNITED STATES [Vol. IV Full consideration has therefore been given to the apprehen- sion that, by concentration, the sympathetic touch, to be pre- served for each region, might be weakened, and that the cen- tral points might gain at the expense of the minor points. An organization of the kind here proposed would remove the reason for any such fear, the parity among all eight cities hav- ing been strictly safeguarded. Fifth : If the plan be carried out that a portion or all of the stock of the Federal Reserve Bank is to be owned by the public, it stands to reason that the latter would much rather buy the stock of a larger organization than that of a smaller one, because the smaller ones are apt to feel to a stronger de- gree any losses that might be incurred. Moreover, the market for the purchase and sale of these stocks would be a more re- liable one, if there were only four different kinds of stock, than if there were eight or ten. Sixth : If at any time it should be found desirable to sub- divide the districts into a larger number of regions, there would not be any difficulty in doing so under this plan, while the difficulty of reshaping the districts would be increased if stock had been sold of too many organizations. It might be well to explain at this point what would be the functions of each of these three boards. The underlying principle of an organization as here proposed would be that each branch should be credited with the amount of the capital stock subscribed by its member banks and the aggregate amount of its deposits. On the other hand, each branch would be debited with the aggregate amount of its investment in commercial paper as well as its proportion of United States government bonds taken over and the circulation taken out by the regional federal reserve banks. Each branch once a week would give its status to the regional bank, which would consolidate all statements of the branches into one, showing the position of the regional bank. Each regional bank would then send the consolidated status and that of the individual branches to the District Federal Reserve Bank, and the latter would consolidate the statements of the regional banks into one, and send the same, with such additional in- (594) No. 4] THE OWEN-GLASS BILL 211 formation as might be required, to the Federal Reserve Board, which would publish regularly the consolidated and individual statements of the four District Federal Reserve Banks. The regional board would apportion the funds among the branches, permitting, in its discretion, one branch, as a matter of bookkeeping, to draw on the funds of the others, or rather, to go deeper into its own reserves, judging by the consoli- dated status of all its branches the measure up to which each branch may be accommodated. In such deliberation it would be guided, of course, by the fact of whether or not such demands made by any branch were based upon season- able and sound requirements. The District Reserve Board would, in turn, apportion in a similar way the funds be- tween the two regionals, taking into full account the status of each regional and of its branches. It need hardly be re- peated that fairness of dealing would be assured by having each regional board consist of members from each branch and by having the district board constituted by an equal num- ber from both regionals. The discussion just begun on the Senate floor has already shown the absolute necessity of dealing more explicitly with this question of branches. Atlanta desires to be made a fed- eral reserve city, because she objects to being forced to re- discount at New Orleans. If this claim should be granted there would be a great many cities, equal or more important in size and banking power, which would justly insist on the same privilege. The consequence would be, that a large number of small and weak reserve districts would be created, a system which would be doomed beyond doubt. The plan as proposed by the writer would easily solve this problem in one of two ways : One method would be to subdivide the dis- trict into more than two regions, which could be done without weakening the power and basis of operation of the district. The other way would be to have Atlanta satisfied as a branch. If Atlanta understood that for her local business she would have a local, independent board, just the same as New Orleans, if she understood that the bills rediscounted at Atlanta will (595) 2 12 BANKING REFORM IN UNITED STATES [Vol. IV normally remain until maturity in the hands of the Atlanta branch, if she understood that in the regional board she has the same vote as New Orleans, and that for the running of the business of the regional it is as immaterial whether the board be located at Houston, Dallas, Atlanta, or New Orleans, as it will be immaterial whether the district board is located at St. Louis or New Orleans, she should and would be quite satisfied to become a branch.^ The actual business would be done by the branches, and the administrative organizations at the regional and district points would have the same neutral composition wherever they happened to be located. As the bill is drawn at present, it is quite unclear how these branches are to be constituted and what powers they are to have. If they were to be only agencies, run by managers, who would discount bills subject to the approval of the Federal Reserve Bank and who would have to forward these bills to these head points, Atlanta's objection would be fully justified. Moreover, such a slow and cumbersome system would prevent the development of a free discount system which should make the sale of discounts as quick and as responsive as the calling of a demand stock-exchange loan. It is to be assumed, how- ever, that the framers of the Owen-Glass Bill have in mind some system of this kind. If they have not, if they intend to give local boards to each branch, it would be advisable to state this clearly and to let the member banks of the district of the branch have a voice in selecting some of the directors whom they know and trust. This would be better than to have the entire local branch board appointed by the Federal ^ A Federal Reserve Bank including all the national banks of both Atlanta and Savannah would have a capital (on the basis of 6% of capital and sur- plus) of about $600,000 and deposits of $600,000 to $I,300;000. The Fed- eral Reserve Bank, on a very liberal calculation, would then have resources ot its own of less than $2,000,000. In normal times it might grant accommoda- tions of $700,000, in strenuous times it might grant another $600,000. How long would it be till the Federal Reserve Bank of Atlanta would have given all the accommodation it could provide and would have to put its rates so high that any additional requirements would be satisfied from other quarters? Would not Atlanta fare better and be more secure if she were part of a larger organization? The Atlanta rate would remain more stable and, as a matter of fact, Atlanta would be in a more dignified position. (596) No. 4] THE OWEN-GLASS BILL 213 Reserve Bank's board, on which there would probably be one single member only representing the district of the branch. Furthermore, as the Owen-Glass Bill is drawn at present, the anomaly would arise that any Federal Reserve Bank board would probably not have more than one single member who would be competent to pass on the local discounts of that federal reserve city. To illustrate : The Federal 'Reserve Bank board of New York would probably be constituted of members from New York, Philadelphia, Pittsburgh, Baltimore, Washington, D. C, Buffalo, Rochester, and possibly Boston. This composite board, on which there would not be more than one New York member, would have to pass on all the New York paper to be discounted by the New York Federal Re- serve Bank. This is, of course, a dangerous and impossible situation. There should be in New York a local committee or board, as there should be in Philadelphia, and the com- posite board should deal only with questions of general policy, direction and supervision. If the Federal Reserve Bank board or the Federal Reserve Board at Washington, or both together, should have the power to appoint all local boards or to pass exclusively on all purchases of discounts, there would be too much concentration of power in a small group of men, — the very thing that this legislation is planned to avoid. It is not from a desire to be critical, but from a wish to be helpful, that these defects have been pointed out at such length. The writer is convinced that unless this question of branches be considered with more care a satisfactory system will not be created. There will be either a scattering of reserves or there will be a well-grounded apprehension of too much concentration of power. Whether there be 4 Federal Reserve Banks with each about 16 branches, or 4 District Reserve Banks with 2 (or more) regionals, each with 8 branches, is of smaller importance. The writer strongly believes that the latter system is the better, because it will create clearer statistics and, for the governor in charge, a problem easier to handle. This question of eight or four Federal Reserve Banks will be (557) 2 14 BANKING REFORM IN UNITED STATES [Vol. IV easily understood if we translate it into military language. Should we be able effectively to maneuver eight armies, if we entirely disconnected them, not permitting them to communi- cate with one another or to come to one another's assistance, except by way of reporting to headquarters at Washington? Should we not have a better chance of success if above the generals in charge of each two of these armies we placed one leader, who had authority to detach reserves from one army and throw them to the assistance of the other, or throw both armies into one and divide them again, without costly and dangerous delay and long explanations which might be only half understood at headquarters? Would not the two armies feel safer and more certain of success? Would they not in fact be stronger than each standing alone? Again, would not the two army corps be better organized by having each an able general and one leader above them, than if the one leader were to manage alone the sixteen armies constituting the two army corps? If the system is to succeed, the units by combination must be large enough to stand alone. If any one of them is so weak that it will frequently have to appeal to others, it will interfere with the others' safety and efficiency. Because, no matter how well the others might keep their own house in order, they could not foretell what their own available re- sources might be the next day. Moreover, if these units, though large, are to show a clear picture, which must be fully understood in all its details, if the local and the Washington managements are to be success- ful, then men and figures must be grouped. The figures must be clarified and simplified and they must crystallize in the brain of the man in charge at each point. The four govern- ors heading the four district Federal Reserve Banks must rely for their information on the two deputy governors in charge of the regionals, as these in turn would depend on the managers of the branch banks. It is not only the larger financial strength that is an absolute prerequisite for an ef- fective system; it is just as important to reduce the problem to so simple and clear a form, assembling men and material, (598) No. 4] THE OWEN-GLASS BILL 2IS that the Federal Reserve Board can intelligently and success- fully deal with it. It has been claimed that the Federal Reserve Board is not an administrative body, but merely a supervisory board. Nothing could be farther from the truth. If this system is to be crowned with success, the Federal Reserve Board must be an administrative board, and the larger the number of Federal Reserve Banks the more far reaching would become the power and administrative duty of the Federal Reserve Board. An effective discount policy, an effective gold and foreign exchange policy and an effective method of dealing with the one-year treasury notes and 3% government bonds can be se- cured only by a strong and intelligent Federal Reserve Board. On the other hand, intelligence in all these very intricate ques- tions can be displayed by the Federal Reserve Board only if it is in intimate touch with the conditions that exist, not at each point in this country alone, but also in each country of the entire globe. It is impossible for the seven or nine men, sitting in Washington in happy seclusion and far away from the business centers, to deal with these questions wisely, un- less intimate touch with those centers be established where all these threads converge. It is true that in crystallizing the problems of the country up to four points the difficulties of the Federal Reserve Board will be materially reduced. Instead of dealing with eight parts and instead of having the duty of equalizing reserves by helping one out of eight — and simultaneously of singling out one or more out of seven on whom to draw, — the problem would be reduced to judging one case out of four and distributing the burden among the other three. It is even more important that this question of distribu- tion (which with eight centers might easily become a ques- tion of retribution), come before the board only rarely if at all. As to the problem of dealing with bank acceptances, for- eign exchange, government bonds and gold, it is much easier to bring about an understanding between four members from large units that have lost their provincial character, than be- tween eight units, where each would have in mind only the advantage of his own little comer. (599) 2i6 BANKING REFORM IN UNITED STATES [Vol. IV While the problem has thus been simplified, and while it is conceivable that of the seven or nine members of the Federal Reserve Board, four might be delegated each to take particular charge of one of the four districts, the governor general and the other members of the Federal Reserve Board would still receive their information by an indirect and ineffective method. It would be infinitely better and would immeasurably strengthen the Federal Reserve Board, if the four governors of the four districts (who would have been appointed by the President) should actually become members of the Federal Reserve Board. These four governors would contribute and impart in a direct way to the other members of the Federal Reserve Board the actual business knowledge necessary to assure a wise management. At the same time a sorely needed oppor- tunity would be given to these four heads of the four dis- trict banks to meet one another and to discuss with one another conditions as they existed in each district. This would enable them to form a clear judgment, not only of the conditions gov- erning their district, but also of those of the other districts, and thus help them to decide upon a wise policy to be pursued by the Federal Reserve Board, not only for the entire country, but also for each district. In this respect the bill as drawn at present is entirely defective, because it does not provide at all for an exchange of views between the heads of the various Federal Reserve Banks. They run along disconnected from one another, where they should understand and help one an- other. The advisory board as planned will not fill the gap. The men on that board cannot possibly have the knowledge, nor speak with the authority of the heads in actual charge, whose main duty it would be to understand and to explain the con- ditions of their particular district. Moreover, if these four heads, who are responsible for the weal and woe of their dis- trict, should have a vote on those questions that so deeply touch their own fate, there would be more confidence in every part of the system that conclusions, no matter whom they might hurt, had been reached with full knowledge, for the best of the country, and without fear or favor. (6co) No. 4] THE OWEN-GLASS BILL 21 7 I should suggest that the Federal Reserve Board be cut into two parts, the one the discount committee, to consist of these four heads together with the governor general and two deputy governors general, to be appointed by the President; the other the committee of supervision, to consist of the Sec- retary of the Treasury and such other members as may be designated by the President. The discount committee would deal with all questions of routine and of business ; the board of supervision would be in charge of the supervision of the entire system. Both together would form the Federal Reserve Board, which would pass upon all questions of rules and regu- lations. The discount committee should be able to act only with the consent of the governor general or the acting deputy governor general, and in case of disagreement, the question would have to be brought before the full board, where the Secretary of the Treasury would preside and would have the casting vote in case of a tie. The object of dividing the board in this way will be apparent without much ex- planation : It takes the government official out of the em- barrassing position of normally passing upon questions of busi- ness, for which the governor general, appointed by the Presi- dent, would be mainly responsible, but it gives him supreme power in case of a tie. Furthermore, it gives him super- visory power — which should be primarily the government's function — over the entire system. The plan as here proposed appears to the writer as a compromise which might be acceptable to both sides to the controversy. It preserves the larger number of the regional reserve banks and branches which insure local independence and local sympathetic understanding, but at the same time it combines eight disconnected and weak units into four larger and stronger ones, which will be necessary for the develop- ment of any effective discount system. As far as governmental influence is concerned, the gov- ernment secures supervision from top to bottom. It secures a management appointed by the government at the top and down to the middle, where the functions of the regional and district Federal Reserve Bank boards will be those of ap- (6oi) 2l8 BANKING REFORM IN UNITED STATES [Vol. IV portioning funds and of advising and deciding upon the rates at which accommodation should be granted. It leaves the majority at the branches in the hands of business men with a strong share in the management of men appointed by the gov- ernment, with a strict supervision not only by the government, but also by the regional banks. While the highest authorities of Europe, whose system, after all, we are copying, are practically a unit in stating that a per- fect discount system can be established only through one single bank, I most confidently believe that — ^considering all the requirements of our case — we are safe and wise in starting with four units, provided they be properly organized and man- aged. But nothing will change my profound conviction that a system of eight Federal Reserve Banks, as now proposed, will end in failure. An effective discount rate is the link between the lever and the brake. Without an effective dis- count rate no European central bank would be able to stand. With eight independent districts (and even with six), no dis- count market can possibly develop. The safety of the system will be lacking, the member banks' funds will remain largely, as before, in the New York stock exchange. It seems scarcely justifiable to legislate the national banks into a position where they either would have to abandon their national bank charter and suffer a material loss on their government 2% bonds, or where, as the only alternative, they would have to throw in their lot with a system that, if carefully administered, could bring only very little relief and which, if managed without such extreme conservatism, would be bound to collapse. If the system be amended on lines as here proposed, objections against such constraint will largely be dispelled, and it might be expected that even a majority of the state banks and trust companies would join. A management of great ability might, by its sagacity and impartiality in equalizing reserves, gradually diminish to a certain extent the only too natural apprehension and distrust of the banks. It might, in spite of the law — ^by encouraging meetings of the heads of the Federal Reserve Banks among themselves and with the Federal Reserve Board at Washing- (602) No. 4] THE OWEN-GLASS BILL 219 ton, — bring about, to a certain degree at least, the much needed cooperation. But, as planned at present, the heads of the eight or ten Federal Reserve Banks would be so busy at home and half of them so far away, that frequent trips to Washington would be impossible. The plan of having district Federal Reserve Banks would cure this defect, because the trips would be cut in two and the absence from duty would thereby be reduced to a minimum. The San Francisco manager would once or twice a month go to Denver, where he would meet the head of the Denver and Seattle regional banks. The governor of the Pacific district, living at Denver, would once or twice a month go to Washington. Moreover, as the Denver governor's duties do not entail any large amount of detail routine work, he would have and should have the necessary time for extended conferences at Washington. But any wise management, no matter how hard it tried by ad- ministrative measures to overcome the defects of the present bill, would be forced to remain close to the shore. The rates would have to be kept high and changes would have to be made frequently in order to keep the district from getting overcrowded or from upsetting the stability of the other dis- tricts. The men in charge, both at Washington and at the Federal Reserve Bank points, would work under a fatal handi- cap, which it would be cruel and reckless to inflict upon the nation. It will take a few hours only to amend the bill on lines as here proposed; it will take weeks, and possibly months, of acrimonious debate if a proper basis for a compromise on these two questions cannot be found. (603) THE OWEN-GLASS BILL: GOLD OR LAWFUL MONEY, NOTE ISSUE, GOVERNMENT BONDS AND SIMILAR QUESTIONS THERE has been a rather lively discussion in the papers and in Washington upon the question whether federal reserve notes should be paid by the Federal Reserve Banks in "gold" only or in "gold or lawful money;" and furthermore, whether federal reserve notes should be counted as reserves by member banks. Let us first see what is lawful money. The answer is : gold dollars, silver dollars (not silver certificates), gold certi- ficates and greenbacks. Any greenback presented at the treas- ury in Washington must be paid in gold. Moreover, as the United States have solemnly undertaken to keep all the various United States currencies at par, even silver certificates pre- sented at Washington would, upon request, be exchanged into gold. The amended Owen-Glass Bill provides that federal re- serve notes are to be payable in gold at the United States Treasury and that the notes are to be the obligation of the United States. While it is correct that the United States must not be permitted to pay " one obligation by another," while the United States therefore must pay their notes in gold only, there is no reason why the Federal Reserve Banks should not redeem any obligation redeemable at their counters by paying in lawful money. If the Federal Reserve Banks were forced by law not to count lawful money as reserve and if they were forbidden to redeem federal reserve notes in law- ful money, it would mean that by legislative enactment they were obliged to discredit the sacred pledge of the United States. It would damage the credit of the United States and quite naturally lead to a discrimination between the two kinds of notes which the United States have promised to pay in gold, a most illogical and unwarranted proceeding. (604) THE OWEN-GLASS BILL 221 A similar argument must be applied in dealing with the federal reserve notes as reserves of member banks. Reserves of national or state banks or trust companies have been created for the purposes of providing that these institutions should have available in currency at all times a certain proportion of their deposits, so as to enable them to pay off immediately upon demand substantial amounts of their demand obligations. All debts are by law payable in lawful money and the Owen- Glass Bill provides specifically that federal reserve notes be accepted in payment of all taxes and public dues except cus- toms. Is it conceivable that a note which is the obligation of the United States payable at the treasury in gold and which is receivable for all taxes and public dues as above, shall not be considered as legal tender for any other purpose except the payment of taxes? Would Congress enact a law by which a bank or a private firm might refuse to accept in fulfilment of a contractual obligation a note issued by the United States payable in gold? As long as this note is to be the obligation of the United States let us at least be logical and bold about it and give to this currency the full recognition and privileges to which it is entitled. If a national bank could not pay out federal reserve notes to any other bank or depositor, how could we expect the member banks to give up their gold certificates and take federal reserve notes instead? The strength of the future system will depend, however, upon the amount of gold that the Federal Reserve Banks are able to assemble in their vaults by substituting the new notes for the old United States currency now in circulation. But if national banks are to be permitted to pay their depositors in federal reserve notes, why should such notes not be considered reserve money? Moreover, if a balance with the Federal Reserve Bank is to be counted as cash by a national bank, how is it possible that a note should not be so counted? Notes could be turned into balances and balances into notes. How is it possible to discriminate between the two ? At the close of business each national bank might send over to the Federal Reserve Bank or branch its federal reserve notes and have them credited to (605) 224 BANKING REFORM IN UNITED STATES [Vol. IV Sufficient consideration does not appear to have been given to the fact that when once the banks have thrown their re- serves together with the Federal Reserve Banks — no matter whether the circulating notes are still being issued by the national banks individually — any obligation to redeem them in gold, in case of contraction or foreign demand, will fall upon the Federal Reserve Banks and incidentally on the United States, which for the redemption of its federal reserve notes must rely on the strength and solvency of the Federal Reserve Banks. The Federal Reserve Banks, from the point of view of gold cover, will have to consider as their own obligations the national bank currency, whether or not they assume this from the start. It would therefore be the wisest and safest plan to assume the national bank circulation as rapidly as possible, so that, as long as the responsibility rests with the Federal Reserve Banks, they will at least at the same time become the owners of the assets securing this circulation and so that they may receive the benefit of the profits of this circulation, without which, it is to be feared, they will not have a sufficient earning power. However, the taking over of all government bonds at once would alienate the country banks, which do not want to forego their note-issuing privilege so rapidly, and it would frighten a great many individuals, who are unable to perceive that the difference is only one of form. Moreover the formal status of the Federal Reserve Banks would be greatly weakened with respect to the gold cover to be provided against notes issued to them by the Federal Reserve Board against these purchases of 2% government bonds. Let us assume as the first year's balance sheet the following statement, in millions: Assets Liabilities Discounts $150 Capital paid in $50 Cash 450 Deposits from Banks 400 3% Gov't Bonds 350 Treasury 150 3% One-Year Treas. Notes.. 350 Notes 700 $1,300 $1,300 (608) No. 4] THE OWEN-GLASS BILL 225 This would mean a gold cover for notes of 64%, and for lia- bilities of 35%, which latter percentage would leave little room for a liberal increase of the note issue with which to supply the commercial requirements of the nation. If, how- ever, we assume that within the next five years it would be possible to substitute $500,000,000 new federal reserve notes for lawful money in circulation the balance sheet would look as follows: Discounts $150 Capital $50 Cash 950 Deposits 400 3% Gov't Bonds 350 Treasury 150 3% One- Year Treas. Notes . . 350 Notes 1,200 $1,800 $1,800 This would show a gold cover for notes of almost 80% and for liabilities of about 50% and would leave a high margin of safety for the accommodation of the member banks and for the status of the Federal Reserve Banks. The further this sub- stitution of Federal Reserve Bank notes for lawful money circulation proceeded the stronger would become the Federal Reserve Banks and with that the position of the United States. It follows, then : First, there must be only one kind of notes, which must be eagerly accepted by the people and the mem- ber banks. The federal reserve treasury note must therefore have all legal-tender qualities, except payment for customs, and must be counted as reserve money by the member banks. Otherwise the free substitution of new notes for old will be interfered with. Second, as rapidly as this substitution pro- ceeds, the Federal Reserve Banks, with the approval of the Federal Reserve Board and the Secretary of the Treasury, ought to be permitted to increase the purchase and conversion of the 2% government bonds. How quickly this process can be carried on, nobody is in a position to foretell today. It would therefore be a mistake to attempt now to lay down a hard and fast program for the future. The law should be so framed as to give ample lati- tude in this respect to the men to be placed in charge, who should be able to meet conditions as they arise. (609) 226 BANKING REFORM IN UNITED STATES [Vol. IV I should suggest that the law be amended so as to provide that the Federal Reserve Board purchase from the member banks no less than 5% annually of the aggregate face value of the 2% United States government bonds outstanding as a basis for national bank circulation at the time of the passing of the law, but that the national banks be required to turn over annually up to io% of said aggregate amount, in case the Federal Reserve Board, with the approval of the Secretary of the Treasury, should decide to purchase up to that quota. It should furthermore provide that additional amounts may be purchased in the open market, in case the Federal Reserve Board, with the approval of the Secretary of the Treasury, should think this advisable. If this method be applied, the national bank circulation could be eliminated within ten years, provided the status of the Federal Reserve Banks permitted. As the acquisition of the 2% bonds proceeded, the Federal Reserve Banks would convert the same half and half into United States government 3% twenty-year bonds, and one- year United States treasury notes, to be renewed annually as provided in the bill. The Federal Reserve Board, with the approval of the Secretary of the Treasury, should have full power to dispose of the twenty-year 3% government bonds. They might find it desirable to retain the bulk of these bonds. If, however, for the permanent strengthening of the status of the Federal Reserve Banks, it should be advisable to dispose of a portion of the bonds, the management can be trusted to do so in the best manner, adapting itself to the conditions as they exist from time to time. No legislative body can fore- see now what these conditions will be. The one-year notds would normally be held in the treasury of the Federal Reserve Banks and form there a most valuable means of combating emergency situations as they might arise. They should be the free property of the Federal Reserve Banks, and the Federal Reserve Board should have full power to deal with them. It should be the object of this law to secure under strict governmental supervision the best possible board and the most efificient management, and to lay down the broad rules upon which the future institution is to be run. But no warning can (610) No. 4] THE OWEN-GLASS BILL 227 be too emphatic not to attempt to legislate too strictly con- cerning questions of administration. I believe it is a fair statement that there is not a single member in either house of Congress who would feel qualified to undertake the manage- ment of this future institution. How then can they be ex- pected to prescribe in the law details of administration whose effect cannot now be foreseen ? This refers not only to the question of government bonds, but to the question of discounting. The general principle ought to be that — as in the majority of the European central banks — normally no paper should be bought having more than ninety days to run. Inasmuch as the law as drawn at present contains an emergency clause which would enable the board to purchase all kinds of obligations of the banks in case of need, it appears quite unnecessary to provide, as proposed in the Hitchcock amendment, that bills having a maturity up to 1 80 days and not to exceed $200,000 might be bought from each member bank. This clause looks petty and small, and would not warrant the breaking down of an important prin- ciple. In a similar way the Hitchcock amendment goes astray when it fixes a minimum amount that any bank at any time may require the Federal Reserve Banks to rediscount for it, and when it determines now the increase in rates for any ad- ditional rediscounts the member bank might require. The Federal Reserve Banks' management must be trusted to be fair and reasonable ; it would be unwise to place it in a position where it could be dictated to or where it would have to be acting against its better judgment. Instead of laying down iron-clad laws, it might be better to insert a broader clause which would permit the Federal Reserve Board from time to time to establish rules, permitting or requiring the Federal Reserve Banks to charge a higher rate than the regular bank rate published, when member banks ask for rediscounts in excess of certain limits to be fixed by the Federal Reserve Board. This would give the Federal Reserve Banks and the Federal Reserve Board a means of protecting themselves, in case they found it necessary, but it would not bind their hands unnecessarily as long as a healthy supply of legitimate bills was ofTered for rediscount. (611) 228 BANKING REFORM IN UNITED STATES [Vol. IV In closing, the question of the ownership of stock of the Federal Reserve Banks might be touched upon. This ought to be dealt with from a similar point of view. It might prove a good basis for a compromise if the member banks, who are to be required to subscribe for the stock, were to be per- mitted, after three years and with the approval of the Federal Reserve Board and the Secretary of the Treasury, to sell all or a certain portion of their stock holdings, provided, how- ever, that each bank remained responsible to its Federal Re- serve Bank for the liability following the stock certificate. If this plan were adopted the public would not now be asked to subscribe for a stock which during the first few years might conceivably not earn its full dividend. The banks, on the ■other hand, would not be required indefinitely to tie up their own resources, which part of the scheme appears to be most objectionable to them. It is not the desire of the writer to go further into a dis- cussion in detail of the various sections of the law, but rather to confine himself to the above remarks, concerning a few of the main points. However, he ventures to hope that his argu- ments may have convinced the reader that the amendments as proposed by the two Senate committees cannot, by any means, lay claim to being considered as final and definite con- clusions. Further careful deliberation will be necessary if the law is to become as perfect as the nation may justly expect. Much as speedy legislation must be desired by everybody, the problem appears to demand further open-minded discussion by calm and intelligent brains. Rather than to drive it rough- shod to a quick conclusion, as a party measure upon which the final word has already been spoken, it would seem that the shorter and, in the long run, the better way would be for both sides to give and take and to agree upon the middle course, for safety lies between the cliffs. (6iz) PROCEEDINGS OF THE ACADEMY OF POLITICAL SCIENCE IN THE CITY OF NEW YORK Volume IV 1913-1914 EDITED BY HENRY RAYMOND MUSSEY The Academy of Political Science Columbia University, New York 1914 covyright by The Academy of Political Science CONTENTS PAGE I. BANKING AND CURRENCY IN THE UNITED STATES Owen, Robert L. The Federal Reserve Bank Bill . , i Glass, Carter The Opposition to the Federal Reserve Bank Bill . 12 Bulkley, Robert J. The Federal Reserve Act : A Reply to Criticisms 20 Aldrich, Nelson W. Banking Reform in the United States 31 Willis, H. Parker The Federal Reserve Banks 92 Hepburn, A. Barton Criticisms of the Proposed Federal Reserve Bank Plan . . . . . . loi Sprague, 0. M. W. The Organization of the Federal Reserve Banks . 106 Reynolds, Arthur Centralization of Banking and Mobilization of Reserves ... . 118 Noyes, Alexander D. Membership and Control of the Proposed Federal Reserve Bank System. 127 Seligman, Edwin R. A. The Economists and the Owen-Glass Bill . . 133 Discussion . 137 TV. jfohatmsen, George B. Morley, Mr. Vincent, A. D. Noyes Vanderlip, Frank A. The Rediscount Functions of the Regional Banks . 140 Discussion . . ■ . • 149 John A. Perrin, Prank A. Vanderlip, 0. M. W. Sprague, W. C. Ford, Mr. Stein Johnson, Joseph French The Note-Issue Provisions of the Owen-Glass Bill . 150 Kemmerer, E. W. The Bank-Note Issue of the Proposed Federal Re- serve Banks. . . 160 Howe, Edward L. The Country Banks and the Owen-Glass BiU . . . 169 Bush, Irving T. The Business Man and the Note-Issue Provisions of the Federal Reserve Act . 174 Andrew, A. Piatt Criticisms of the Note-Issue Provisions of the Owen-Glass Bill . . . . . . 177 Discussion • . • ... 182 Edward D. Page, L. Sternberg, Mr. Vincent Van Deusen, M. W. The Clearing of Checks at Par . . ... 184 Kent, Fred I. The Geographical Basis of Domestic Exchange Re- lations . 187 Talbert, Joseph T. Clearing-House and Domestic Exchange Functions of the Federal Reserve Banks . . ... 192 Gardin, John E. Foreign Exchange Problems and the Protection of our Gold Supply 213 Neilson, Jason A. Acceptance and Foreign Branch Powers under the Proposed Federal Reserve Act 217 Discussion • • ■ 223 John Perrin, W. C. Ford, Joseph T. Talbert, A Member, J. H Mitchell, John E. Gardin, Mr. Stern, 0. M. W. Sprague, F. B. Whitney iv CONTENTS PAGE II. GOOD ROADS AND CONVICT LABOR Davis, Charles Henry Foreword 241 Wilmot, Sidney Employment of Convict Labor for Highway Con- struction in the North 246 Whitin, E. Stagg Prison Industries of the State of Wisconsin. . . . 309 III. YEARBOOK OF THE ACADEMY Constitution and By-Laws 33S Officers of the Academy . . 339 List of Members 340-384 IV. ESSAYS QN BANKING REFORM IN THE UNITED STATES By Paul M. Warburg Editor's Note 385 Introduction 387 Edwin R. A. Seligman Defects and Needs of our Banking System 391 A Plan for a Modified Central Bank 407 American and European Banking Methods and Bank Legislation Compared. . 414 A Central Bank System and the United States of America 441 A United Reserve Bank of the United States 459 Principles that Must Underlie Monetary Reform in the United States. . . 500 The Discount System in Europe 513 Circulating Credits and Bank Acceptances 543 The Owen-Glass Bill as Submitted to the Democratic Caucus 557 The Owen-Glass Bill : Should there be Four or Eight Federal Reserve Banks . 588 The Owen-Glass Bill: Gold or Lawful Money, Note Issue, and Government Bonds 604 THE POLITICAL SCIENCE QUARTERLY The Quarterly, published for the Academy, is under the edi- torial control of the Faculty of Political Science of Colunibia University, and is devoted to the historical, statistical and com- parative study of politics, economics and public law. 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