America’s Money Machine

AFTER THE PASSING of the Panic of 1907 the demand for business credit and for circulating money abated. For six years, as we have noted, until the outbreak of war in Europe in August, 1914, not a single dollar of emergency currency was issued. On the contrary, the press complained of the plethora of money and credit. Public interest turned to other events—the election of William Howard Taft to the Presidency and the retirement of the controversial Roosevelt to the hunting wilds of Africa, and to other topics—that of the tariff, and the agitation for an income tax, and the mounting European tension.

Meantime, the issues in the money debate began to clarify—if their underlying meaning remained foggy. Oklahoma, admitted to statehood in 1907 as the 46th State, had adopted a constitution with a number of novelties, including the initiative and referendum, and some laws that caused reactions from laughter to consternation in the older sections of the country. Among them was one prohibiting the common drinking cup; another required hotel keepers to use bed sheets nine feet long—the “nine foot bed sheet law”; and another authorized a system of bank deposit guaranty.

Under the Bank Guaranty Act, passed in February, 1908, state banks were required, and national banks permitted, to contribute one per cent of their deposits to a fund to meet the claims of depositors of defaulting banks. Despite a ruling of the U. S. Atrtorney General that national banks could not lawfully participate in the program, the idea attracted the attention of politicians: William Jennings Bryan, the perennial Democratic Party candidate for president, enthusiastically endorsed it, and the Democratic Party adopted a plank in its platform favoring a national bank guaranty system.

Unfortunately, in September, 1909, long after banking had returned to normal throughout the country generally, the Columbia Bank and Trust Co. of Oklahoma City failed with deposit liabilities of $2.9 million and cash and liquid items of less than $1.2 million. The guaranty fund then had less than $260,000 of assets and despite special assessments of another $250,000 the fund was soon exhausted. Many of the member banks, to avoid further assessments, transferred from state to national charters.

Although a few other Western states followed the Oklahoma example and although the constitutionality of the system was sustained by the Supreme Court, the idea lost popularity and faded from interest until revived by the Great Crash of 1933.

Among the Eastern financial community, and in Congress, discussion turned upon the use of gold and the nature of the reserve. It was about this time that the phrase “economizing gold” began to appear as the latest novelty of economic sophistry. The New York Times editorialized on the subject with naïve solemnity. The occasion was an address by Secretary of the Treasury Sherman in which he had admiringly pointed to the nearly $1 1/2 billion of gold in the Treasury, in addition to the $200 million in national bank vaults, and had emphasized that the Treasury’s holdings alone exceeded those of the three richest powers of Europe.

“Mr. Sherman seems to think that it is a good thing to waste abundance of resources” commented the Times. “The nations whose supply of gold is so scanty support a commerce larger in the aggregate than the commerce of the United States. . . . By making one gold dollar do the work of four in the United States they save the burden upon industry of supplying three unnecessary dollars.”1

Despite its captivation by the idea of “economizing” gold, the Times correctly saw the evils in a system of bond secured money, as one of monetizing the public debt, and stated the fundamental objection as admirably as it has ever been stated:

Meantime, the National Monetary Commission, authorized by the Aldrich-Vreeland bill, with a broad grant of investigative power and unlimited funds, had begun its studies under the chairmanship of the industrious and able Aldrich.

Aldrich, however, as chairman of the Senate Finance Committee, was heavily involved in the controversial tariff legislation that later became law as the Payne-Aldrich Tariff Act. It was not until the following year, 1909, that he was able to give personal direction to the activities of the Monetary Commission.

Undoubtedly, the most influential intellect in shaping the course of public opinion was that of Paul M. Warburg, a Jewish newcomer to the United States, member of the distinguished banking house of Kuhn, Loeb & Co. and formerly a member of an equally distinguished German banking house. Paul Warburg came to the United States in 1902, when he was thirty-four years of age and successfully established as a banker. In November, 1907, he published a pamphlet, “A Plan for a Modified Central Bank,” that attracted wide attention and that strongly influenced the direction of discussion, and impelled the course of the National Monetary Commission investigation toward German experience.

The trouble with the U. S. monetary system, Warburg explained, was that it was inflexible. Circulating money was limited mainly to gold and silver coins, and certificates of deposit therefor, or to the remnants of the Civil War greenbacks (United States notes) and to national bank notes. The greenbacks were no longer being issued, and national bank notes had to be secured by U. S. government bonds. Because of the frugality of the government, surpluses rather than deficits were the rule, and the amount of bonds which could be used as backing for currency was steadily diminishing. The debt, that had stood in excess of $2 billion following the Civil War, had been reduced to a little over $1 billion by 1900, and to less than $900,000,000 at the time of the Panic.

The net effect of the currency laws in force and the fiscal tendencies in effect was that there was no “elasticity” in the money supply. Thus, as Warburg argued, in times of great seasonal movement of merchandise, as when the wheat was in harvest and the great American plains were yellow with the ripening grain, the merchants and millers were straitened for ready cash with which to buy and store this abundance of nature’s wealth. The consequence was that farmers, unable to find buyers with ready cash, dumped this grain for What it would bring. There Were great fluctuations in price, and the farmer and the basic producer took the loss. The solution to this dilemma, the German banker-economist pointed out, was a money supply that would fluctuate in accordance with the rise and fall of business demand. The question was, how to achieve this desirable result?

Warburg argued that the proposal to create an emergency currency was dangerous for the reason that if a bank were involved in difficulties, as happened in the case of the Trust Company of America and the Knickerbocker Trust Co., if it had notes outstanding, the run of the depositors would have been carried into the ranks of the note holders, to the disaster of the entire money system.

The solution, he urged, was that discovered abroad and most highly developed in Germany, of issuing money (circulating notes) against the security of good commercial paper (notes of hand) made in the course of trade and business. Such notes would meet the urgent demand for circulating money when crops were moving, and the amount would naturally contract as the obligations behind them were paid off.

As a provisional measure to meet the shortage created by panic Warburg proposed a modified central bank, to be called for convenience the Government Bank, endowed with a capital of from $50 to $100 million, possibly to be paid up only in part; the shares to be owned, if possible, half by the government, half by the national banks; the management to be by a president, named by the board of directors and enjoying indefinite—and unlimited—tenure. The Bank would act as depository for the Treasury, and would in turn redeposit Treasury funds in the member national banks. The Government Bank would be authorized to issue legal tender notes, not to exceed a certain multiple of its capital and gold reserves. These notes would find their way into the bloodstream of commerce through the process of exchanging them for commercial paper—short term promises to pay given by merchants and others and held by the member banks. To limit the privilege such notes would have to be guaranteed by endorsement of the member bank.

“Most of the paper taken by the American banks,” he explained, “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 corporation that discounts them. If discounted at all they are generally passed on without endorsement, and the possibility of selling any note depends on the chance of finding another bank which may be willing to give the credit. The consequence 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 invested in commercial notes is virtually immobilized.”

Warburg’s idea was that this commercial paper, if doubly or triply secured by the endorsement of banks, could be made an acceptable medium of payment and could circulate like money. Actually, the veritable documents themselves would not circulate but they would be deposited with a central institution which would issue its own promissory notes secured by its holdings of endorsed commercial paper. The promissory notes would be issued in standard denominations and in pieces of uniform size, and would be declared by law to be legal tender in payment of debts and taxes.

This is the essence of the idea that eventually became the foundation of the Federal Reserve System.

The theory now advanced differed from that of the assignats of the French Revolution and the rentenmark of the Great German Inflation in that the security of the proposed circulation was not land but the produce of the land in trade. In this respect it differed only in degree from the system proposed by John Law to the Regent of France, by which he would restore the credit of France, ruined by the excesses of Louis XIV, and which became the basis of the charter of the Banque Générale in 1716.

The conditioning view of Paul Warburg, which in turn was ultimately to govern the procedure and direction of the Federal Reserve System, was admirably stated in his article written after the Panic, in which he proposed his new currency system.

“We need some centralized power,” he wrote, “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 outrageous conditions, which fill us with horror and shame, if we had had a modern bank and currency system.”2

With a central bank such as he proposed, the “inelasticity” of the prevailing system would have been remedied. The prevailing system, as Warburg rightly pointed out, depended primarily upon stock exchange loans, while the most legitimate business, that of the purchase of commercial paper, caused a dangerous locking up of capital in single name promissory notes, which under normal conditions were unsalable. By creating a central bank, after the European pattern, such commercial paper would be converted from a non-liquid asset into the quickest asset of the banks.

What Warburg neglected to point out, however, was that such commercial paper, while gaining increased liquidity—that is, wider acceptability and marketability—was not thereby rendered more substantial as a base for money, particularly if the endorsing banks were careless of their credit and endorsed more notes than their own assets could possibly cover.

Warburg’s proposal was, undoubtedly, an improvement over the existing system which permitted the unlimited issue of circulating notes against government bonds, though as we will notice later, the system eventually adopted did not remove this evil.

Warburg’s ideas, cogently phrased as they were, were profoundly influential, perhaps because they seemed to offer such an easy solution to the problems besetting the country.3

Because of the influence exercised by the German system in the ultimate framing of the Federal Reserve System, a brief description of its features is appropriate.

The defeat of France by Prussia in the War of 1870 and the collection of a war indemnity of 5 billion francs in gold made possible the formation of the German Empire and with it the establishment of a new currency system and standard. The condition of the currency had been one of near-chaos. Six different systems were legally in force, and in addition an uncounted number and variety of coins were in circulation. Both gold and silver were legal standards. Currency reform began with the Acts of December 4, 1871, and July 9, 1873, which established the standard as the gold mark equivalent to 1/1395 of a pound weight of fine gold (5.531 English grains) and proclaimed the formal acceptance of the gold standard. The acts permitted coinage for individuals, or what is known as free coinage, subject only to the mint charges or brassage, and provided for the gradual retirement of the circulating notes outstanding. The note issue was gradually to be concentrated in the Reichsbank, a new institution that took over the charter of the Prussian state bank.

What was unique in the German system was the allowance of a note issue secured by “good commercial bills,” as the act described them, provided that the bank held in vault cash equal to one third of the notes issued. A limit was also placed upon the total amount of such notes that could be issued, and the bank would be taxed at the rate of 5 per cent per annum on the amount of notes issued in excess of this maximum. The theory of this was that in times of financial emergency, additional notes could be issued to prevent a monetary stringency, but because of the tax to which they would be subject, there would be every incentive to reduce the amount the moment the emergency had passed.

A limit of 385 million marks was prescribed for the total free, or nontaxable, notes that could be issued, of which 250 million marks were assigned to the Reichsbank and the balance allocated among the various banks whose charters still permitted them to issue notes.4

Not unexpectedly, the amount of the “contingent” issue was enlarged periodically, and by 1910 it had been increased to 618 million marks, most of which was by now concentrated under the note issue power of the Reichsbank.

Nevertheless, at the time of the Panic of 1907 German currency enjoyed a prestige rivalled only by English sterling, and was actually more strongly fortified with gold than the English pound.

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5September 28, 1908. From the gold miners’ viewpoint, a procedure that permits the banking or monetary authorities to create, with a stroke of the pen, three dollars each having a purchasing power equivalent to the dollar of gold extracted from the earth at cost of labor and equipment is nothing short of iniquitous.

6A Plan for a Modified Central Bank. Mr. Warburg did not live long enough to see his assurances confounded by the Crash of 1929, the Debacle of 1933, and the Break of 1962.

7The National Monetary Commission spent a great deal of time in examining the workings of European banking systems, particularly the German, to the exclusion of a study of monetary history, the question of coinage, or the standard, or the qualities and requisites of legal tender. Of the twenty-four volumes of reports produced by the Commission, five dealt exclusively with the German banking system.

8In addition, of course, the banks could issue circulating notes secured 100 per cent by coin. These would be in the nature of warehouse receipts for gold and silver. It is the “fiduciary” or “contingent” issues with which we are concerned here.

• 1*September 28, 1908. From the gold miners’ viewpoint, a procedure that permits the banking or monetary authorities to create, with a stroke of the pen, three dollars each having a purchasing power equivalent to the dollar of gold extracted from the earth at cost of labor and equipment is nothing short of iniquitous.
• 2*A Plan for a Modified Central Bank. Mr. Warburg did not live long enough to see his assurances confounded by the Crash of 1929, the Debacle of 1933, and the Break of 1962.
• 3*The National Monetary Commission spent a great deal of time in examining the workings of European banking systems, particularly the German, to the exclusion of a study of monetary history, the question of coinage, or the standard, or the qualities and requisites of legal tender. Of the twenty-four volumes of reports produced by the Commission, five dealt exclusively with the German banking system.
• 4*In addition, of course, the banks could issue circulating notes secured 100 per cent by coin. These would be in the nature of warehouse receipts for gold and silver. It is the “fiduciary” or “contingent” issues with which we are concerned here.
• 5“Mr. Sherman seems to think that it is a good thing to waste abundance of resources” commented the Times. “The nations whose supply of gold is so scanty support a commerce larger in the aggregate than the commerce of the United States. . . . By making one gold dollar do the work of four in the United States they save the burden upon industry of supplying three unnecessary dollars.”*
• 6“We need some centralized power,” he wrote, “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 outrageous conditions, which fill us with horror and shame, if we had had a modern bank and currency system.”*
• 7Warburg’s ideas, cogently phrased as they were, were profoundly influential, perhaps because they seemed to offer such an easy solution to the problems besetting the country.*
• 8A limit of 385 million marks was prescribed for the total free, or nontaxable, notes that could be issued, of which 250 million marks were assigned to the Reichsbank and the balance allocated among the various banks whose charters still permitted them to issue notes.*