America’s Money Machine

THE FEDERAL RESERVE SYSTEM had been designed, as we have noted, to serve the domestic currency needs of this country. At the time, the people of the United States regarded themselves an insular power and aloof from the main currents of international—or at least European—politics.1 World War I ended all that. Despite popular rejection at the polls of President Wilson’s policy of European involvement, including membership in the League of Nations, the circumstances of trade and finance combined with the ferment of a nascent megalomania to persuade the American public that their government was the bellwether among the nations and that it had world responsibilities to meet. It was not exactly the sense of “the white man’s burden”—the cliché that had succeeded in almost exhausting British national vitality within the course of three hundred years, as it had exhausted the Roman and that of other peoples of history; but it was dangerously close to it.

Thus it came about that although the U. S. continued to remain aloof politically from European affairs for another two decades, it became more and more implicated economically. The instrument of this involvement was the Federal Reserve System.

For this reason we must now turn to some of the events abroad during the years we have just covered. World War I had left Europe more exhausted than the U. S. How much of this exhaustion was the dislocations and confusions caused by war-time inflation, and how much was due to the physical destruction by bombs and gunfire are interesting questions that have never been answered; we may only note the almost miraculous recovery that occurred in Germany after currency stability was restored in 1924 (and again in 1949).

In Great Britain, however, where cities and soil escaped relatively unmarred by bombs and shell fire, a perilous weakness had fallen upon the livelihood system that was not disclosed immediately, and which in fact has hardly yet been cured. The nature of this malaise was revealed when the government attempted to restore the gold monetary system.

We may look for a moment at what had happened to the British pound sterling. The outbreak of war in 1914 had affected business in Great Britain very much as it had here; that is, after a momentary panic forcing the Exchange to close, trade revived, and gold began to return to the banks. Meantime, by what was expected to be a temporary measure to meet demands for cash, the Bank of England was authorized2 to increase the fiduciary (that is, unsecured) note circulation by the issue of legal tender £1 and 10s. currency notes. The practical effect of this measure was to abolish the historic gold currency system for a fiat money system. Unlike the German and French systems, adopted in the Federal Reserve System, that allowed currency to be issued against commercial paper, since 1844 the British system allowed currency to be issued only against gold, except for a statutorily limited fiduciary issue. Peel’s Act had originally fixed this maximum at £14 million; from time to time the limit had been raised by Parliament, but the principle of an arbitrary and fixed maximum had never been abandoned before 1914. By the Currency and Bank Notes Act of 1914, all limits were removed.

Subsequently, instead of commercial bills in its portfolio, the Bank acquired Ways and Means Advances,3 Treasury bills, and even long-term government bonds—an intersting but unfortunate parallel with Federal Reserve practice in these same years.

Feavearyear points out that there was no definite legal abandonment of the gold standard while the war was in progress, but the increase in bank credit, and eventually of the note issue also, meant that the effectiveness of the link with gold was destroyed slowly and insidiously. By 1916 a premium on gold began to appear, and an act was passed forbidding the melting down or defacing of gold coin. While the war lasted there was no specific prohibition on the export of gold. This was a facade maintained only by assistance of the United States. When this country entered the war it began extending large credits to its allies4 by which they were able to maintain the stability of their foreign exchange. The dollar-sterling rate was pegged at $4.76 7/16, or slightly less than par, until March, 1919, after which the pound began to drop steadily, falling to a low of $3,195 in February, 1920.

After U. S. financial assistance ceased, the British currency was not the only currency to sink under the weight of excessive war-time issues. The French franc dropped in the international exchange to around a third of its pre-war value, and the German mark, which at the time that Paul Warburg was preaching the benefits of the German system of commercial acceptances and flexible note issue was even stronger than the pound sterling, had depreciated by the end of 1923 to a rate of 42 billion for one cent.

By the end of 1921, there was general talk of an international economic conference to solve the post-war problems of war-bred dislocations: it always seems easier to reform the world around a horseshoe table than in the market place and in the fields. Samuel Gompers, head of the American Federation of Labor, with world prestige in the labor movement, was among the first to broach the idea: it was advanced also by the General Commission on the Limitation of Armaments; speakers at a Foreign Policy Association luncheon dallied with it; Senator France introduced a joint resolution authorizing and directing the President to convene such a conference. But President Harding had been elected on a platform of repudiation of the League of Nations, and announced that Europe would have to take the initiative. Aristide Briand, Premier of France, seized the leadership and issued an invitation to a conference of British, American, Italian, Japanese, and Belgian government representatives to meet at the Hotel Crillon in Paris.

Immediately, a host of other countries begged to be invited. It was decided to open the doors to all, until the leaders of Soviet Russia indicated their willingness, even eagerness, to attend. Lenin was then introducing his New Economic Policy (NEP) which allowed a modicum of private enterprise. But he was fearful of going to Paris, and the locus was moved to Genoa. At the same time the list of questions to be taken up expanded like a catalog of human sins. The prospective presence of the Russians alarmed the French, particularly when the Soviet war minister and second-in-command, Leon Trotsky, announced from Moscow that the conference would accomplish a revision of the Versailles Treaty. When the Siberian Republic of Pir-Amur vented a protest against the participation of U. S. delegates, it seemed that Babel was ready to reassemble.

The conference eventually came to pass, convening early in April, 1922, along with seven hundred representatives of the press.

What the conference accomplished mainly was to prove that Europe was not yet ready for an international system, despite the League of Nations—or perhaps that the institutions of Europe were not yet refashioned to the needs of an international system. The issue of the conference soon began to turn upon European-Soviet relations, and to hang upon the demand of Belgium for integral restitution of foreign-owned private property in Russia. France supported the Belgian claim, Great Britain less warmly; meantime, the Germans on April 16 signed a separate treaty with the Russians at Rapallo, in which the principal objects of the Genoa conference were achieved, at least as between these parties, in their mutual renunciation of reparation claims and resumption of normal consular and diplomatic relations. The denouement threw the conference into confusion, and awakened fears of a German-Soviet entente that would threaten the peace of Europe. Under the cirumstances, no general economic arrangements were possible, and the conference quietly dissolved.

France now hardened its reparations demands on Germany, and in 1923, when delivery schedules were not met, sent troops into the Ruhr to enforce its claims. The results were as expected: a sullen resentment paralyzed activity and the German economy stagnated and collapsed. The final debacle was the German inflation which reduced the value of money to practically zero.

It was at this juncture that the United States quietly abandoned its post-war mood and policy of isolation and undertook again to intervene in European affairs. President Coolidge announced on December 15 his agreement to a commission to examine German finances and to propose a solution to the reparations impasse, and the appointment of Charles G. Dawes as the principal U. S. member. From this investigation came the Dawes Plan to stabilize the German currency and to revise downward the reparations payments. The Plan was to be financed initially by an international loan of which the principal amount ($110 million out of $200 million) would be subscribed in the U. S.5

In this fragile condition of the European economy, the British government, under the influence of Winston Churchill, then Chancellor of the Exchequer, concluded to restore the pound sterling to its former parity—as a necessity for British prestige and British international finance. U. S. cooperation would be needed, and this was forthcoming. The Federal Reserve System was the agency. In favor of the action was the relative strength of the pound in the international exchanges. Since 1921 it had held at no greater than 15 per cent discount from parity. It was reasoned by British monetary authorities that with some assistance from the U. S. the restoration could be managed. Not everyone was of this opinion, however; indeed, some able economists argued for a devaluation of the pound, and others frankly proposed the abandonment of a metallic standard altogether and the establishment of a managed currency.

The proponents of restoration were aided by prevalent speculation which anticipated the result, and began to bid the pound up, a process which, of course, also promoted their own ends. By the end of 1924 sterling was selling at $4.70 in terms of dollars, and to within 1 1/2 per cent of par early in 1925. This was decisive. On April 28, Winston Churchill announced a return to the gold standard, and authorized the Bank of England to deliver gold for export against the receipt of any form of legal tender money.

The return was formalized by the passage of the Gold Standard Act of 1925 (May 13), but it was not to the gold standard as historically known in England. While the Act declared that both Bank of England notes and the war-time Currency notes were legal tender, they were no longer convertible into gold coin. The ancient right of all persons to bring gold to the Mint and have it coined was abolished, and this privilege was restricted to the Bank of England. Holders of notes could, however, obtain gold on presentation of their notes, but only in quantities of 400 oz.—the weight of the standard gold bar. The utility of this provision was practically limited to foreign trade.

To support the pound against possibility of heavy unloading of sterling by speculators who now no longer had interest in it, the government arranged for a $300 million credit with the Federal Reserve Bank of New York. Fortunately, this credit was not required.

The significance of this arrangement lies in a related field—the growth of the gold exchange standard. The ability of the U. S. economy to support, almost unimpaired, the gold convertibility of the dollar throughout the war, led to the general acceptability abroad of dollar bank balances as the equivalent of gold. It now became customary—and indeed authorized in many instances by the respective banking and currency laws—for European central banks to treat as the equivalent of gold in their reserves any holdings of convertible bank balances abroad—particularly in London or New York.

The way the gold exchange standard corrupted the monetary systems of the world can be illustrated by an example drawn from actual happenings in the money markets during the years 1924-1929:

An Austrian corporation, for instance, obtains a long-term loan in New York, the net proceeds of which are $1 million, credited to the borrower as a deposit in a New York bank. The corporation, which needs schillings, sells these dollars to a Viennese bank. The latter in turn transfers the deposit credit to the Austrian national bank. Because this dollar deposit was then readily convertible into gold, the national bank could treat this deposit as part of its prime reserve. Thus, it was able to increase its notes in circulation or extend credit by about $3 million or about 21 million schillings, assuming a reserve ratio of 33 1/3 per cent (the legal requirement at the time). As these notes or deposits were in turn reserves for the commercial banks of Austria, commercial credit of three or four times this amount could be created.

The subsequent efflorescence of this system into the Eurodollar market, a phenomenon which continues to baffle understanding or control, will be treated later. Here we may note only the advantage of the gold exchange standard to the newer sovereignties that arose out of the ruins of Eastern Europe. American “money doctors”—the most famous of whom was Prof. E. W. Kemmerer of Princeton—were now being invited to assist impoverished governments to reform their monetary systems in accordance with the new dispensation. And so throughout the world, in primitive countries in remote regions of the globe, that hardly knew the meaning of stable government, among peoples to whom banks were practically unknown, the authorities were encouraged to establish the complex institutions of managed money and credit, and for the good silver coinage to which the people were accustomed, to substitute flimsy paper currency of doubtful value and continually depreciating worth.

The effect of the expansion of the gold exchange standard—defended by its advocates as “economizing the use of gold”—was a tremendous pyramiding of credit that was eventually to lead to a new debacle of international proportions, more destructive in some respects of the moral and physical fabric of society than war.

Here in short was the lever by which the modern Archimedes of credit was to upset the whole world in the fateful crash of 1929.

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6This, despite the fact that for a hundred years the United States had held a major trading position in the Pacific, and assumed to exercise a fiat in Latin America.

7By the Currency and Bank Notes Act, 1914, passed Aug. 6, 1914.

8Temporary borrowings authorized in the first instance by the House ofCommons Ways and Means Committee.

9Totalling $9,647419,494.84 by November 15, 1919.

10This, strictly, was not the first post-war resumption of international activity. In 1921 Harding had convened an international conference on naval disarmament, by which substantial reduction of the world’s principal navies was achieved, and about the same time the U. S., as its contribution to the economic rehabilitation of Europe, agreed to a major revision of the war loan repayments.

• 1*This, despite the fact that for a hundred years the United States had held a major trading position in the Pacific, and assumed to exercise a fiat in Latin America.
• 2*By the Currency and Bank Notes Act, 1914, passed Aug. 6, 1914.
• 3*Temporary borrowings authorized in the first instance by the House ofCommons Ways and Means Committee.
• 4†Totalling $9,647419,494.84 by November 15, 1919.
• 5*This, strictly, was not the first post-war resumption of international activity. In 1921 Harding had convened an international conference on naval disarmament, by which substantial reduction of the world’s principal navies was achieved, and about the same time the U. S., as its contribution to the economic rehabilitation of Europe, agreed to a major revision of the war loan repayments.
• 6THE FEDERAL RESERVE SYSTEM had been designed, as we have noted, to serve the domestic currency needs of this country. At the time, the people of the United States regarded themselves an insular power and aloof from the main currents of international—or at least European—politics.* World War I ended all that. Despite popular rejection at the polls of President Wilson’s policy of European involvement, including membership in the League of Nations, the circumstances of trade and finance combined with the ferment of a nascent megalomania to persuade the American public that their government was the bellwether among the nations and that it had world responsibilities to meet. It was not exactly the sense of “the white man’s burden”—the cliché that had succeeded in almost exhausting British national vitality within the course of three hundred years, as it had exhausted the Roman and that of other peoples of history; but it was dangerously close to it.
• 7We may look for a moment at what had happened to the British pound sterling. The outbreak of war in 1914 had affected business in Great Britain very much as it had here; that is, after a momentary panic forcing the Exchange to close, trade revived, and gold began to return to the banks. Meantime, by what was expected to be a temporary measure to meet demands for cash, the Bank of England was authorized* to increase the fiduciary (that is, unsecured) note circulation by the issue of legal tender £1 and 10s. currency notes. The practical effect of this measure was to abolish the historic gold currency system for a fiat money system. Unlike the German and French systems, adopted in the Federal Reserve System, that allowed currency to be issued against commercial paper, since 1844 the British system allowed currency to be issued only against gold, except for a statutorily limited fiduciary issue. Peel’s Act had originally fixed this maximum at £14 million; from time to time the limit had been raised by Parliament, but the principle of an arbitrary and fixed maximum had never been abandoned before 1914. By the Currency and Bank Notes Act of 1914, all limits were removed.
• 8Subsequently, instead of commercial bills in its portfolio, the Bank acquired Ways and Means Advances,* Treasury bills, and even long-term government bonds—an intersting but unfortunate parallel with Federal Reserve practice in these same years.
• 9Feavearyear points out that there was no definite legal abandonment of the gold standard while the war was in progress, but the increase in bank credit, and eventually of the note issue also, meant that the effectiveness of the link with gold was destroyed slowly and insidiously. By 1916 a premium on gold began to appear, and an act was passed forbidding the melting down or defacing of gold coin. While the war lasted there was no specific prohibition on the export of gold. This was a facade maintained only by assistance of the United States. When this country entered the war it began extending large credits to its allies† by which they were able to maintain the stability of their foreign exchange. The dollar-sterling rate was pegged at $4.76 7/16, or slightly less than par, until March, 1919, after which the pound began to drop steadily, falling to a low of $3,195 in February, 1920.
• 10It was at this juncture that the United States quietly abandoned its post-war mood and policy of isolation and undertook again to intervene in European affairs. President Coolidge announced on December 15 his agreement to a commission to examine German finances and to propose a solution to the reparations impasse, and the appointment of Charles G. Dawes as the principal U. S. member. From this investigation came the Dawes Plan to stabilize the German currency and to revise downward the reparations payments. The Plan was to be financed initially by an international loan of which the principal amount ($110 million out of $200 million) would be subscribed in the U. S.*