Readings in Money and Banking Part 77

[246] E. M. Patterson, _The Theories Advanced in Explanation of Economic Crises_. _Annals of American Academy of Political and Social Science_, Vol. 59, May, 1915, pp. 140, 141, 147.

[247] E. W. Kemmerer, _Seasonal Variations in the Relative Demand for Currency and Capital in the United States_, p. 232. Publications of the National Monetary Commission, Senate Doc.u.ment No. 588, 61st Congress, 2d Session.

[248] Walter Bagehot, _Lombard Street_, pp. 46-56. Charles Scribner's Sons. New York. 1892. (First Edition, 1873.)

CHAPTER x.x.x

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

CONFLICTING OPINIONS

[249]For fifty years the United States has lived rather happily under the National Bank Act, born in the strife of the Civil War and developed in the period of the nation's greatest expansion and growth. This act has, by its record, earned for itself a place as a great piece of constructive legislation; and the recognition of this fact is responsible for the preservation of our national banking system almost intact under the Federal Reserve Act. The National Bank Act removed the ills of wild-cat banking, which so afflicted the country prior to the Civil War; gave us an absolutely safe form of money which, although not legal tender, is taken without question by everyone; and has made possible an enormous expansion in the banking resources and facilities of the country. In spite of the denunciation and abuse which have been heaped upon it, the act has been reasonably satisfactory in operation.

Anyone who reviews the figures of the material growth and prosperity of the nation and the rise of its financial power will be forced to the conclusion that no act that was fundamentally unsound could have been an integral part of the achievement of such a notable record.

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

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

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

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

INFLEXIBILITY OF LEDGER BALANCES

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

RIGID RESERVE REQUIREMENTS

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

NEED OF BANKERS' BANK

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

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

Just as an individual bank economizes and mobilizes and makes flexible in amount the funds of individual members of a community, so a bankers'

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

THE PARCELLATION OF RESERVES

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

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

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

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

While theoretically an inst.i.tution so const.i.tuted would be strongest and most efficient, none such exists, and no one would advocate such a system. Omniscience and omnipotence would be required for its wise administration.

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

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

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

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

REDEPOSITED OR OVERLAPPING RESERVES

[254]If we are to understand the radical change which will be worked by the Federal Reserve Act in the reserve situation in this country it is necessary to examine at some length the system heretofore prevailing.

Under the National Bank Act these banks were divided into three groups or cla.s.ses, referred to as the country banks, the reserve city banks and the central reserve city banks.

There are three central reserve cities: New York, Chicago, and St.

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

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

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

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

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

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

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

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

_Cash in vaults._ _Due from banks._

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

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

~Dangers of the System.~--So conclusive are the lessons to be learned from the experience of the last half century with the system of redeposited reserves, that there is a practical unanimity among bankers and financial experts that the reserves of our banks, with the exception of the money actually held in the vaults, are, in the words of William Ingle, vice-president of the Merchants and Mechanics National Bank of Baltimore, "A great deal of a delusion and a snare." In every panic, the country banks and the reserve city banks have found that it has been impossible for them to secure the return of the portion of these reserves which has been redeposited in New York, Chicago, and St. Louis.

At a time of great stress, when the banks have been subjected to a drain, they have been suddenly bereft of the support which, in theory, should have been forthcoming from their reserve agents, and have been forced to depend upon the 6 per cent. or 12-1/2 per cent. reserve, which was contained in their own vaults. What is even worse, the outbreak of a panic in New York City, where every panic of the last half century has started, was the signal for the suspension of cash payments by every bank in the country, within a few hours.... Thus a local panic, in many cases occurring when business conditions were exceedingly prosperous and healthy, has completely disorganized the exchanges of the country and brought business to a standstill.