America’s Money Machine

The recommendations of the Commission are of interest in comparison with the legislation finally enacted. Like many political documents it straddled the main issues. Nevertheless, by admitting divergent viewpoints and giving them recognition it did propose basic changes in the organization and administration of the money system and in the quality of the money.

On the principal issue of whether currency should represent a monetization of public debt or private debt, the Commission boldly adopted the views so lucidly advocated by Paul Warburg: its proposals provided in effect that the substantial backing of the note issue should be commercial paper rather than bonds, whether private or public.

The strictly commercial character of this new backing for paper money was assured by the stipulation that such notes and bills have a maturity of not more than twenty-eight days, and that they must have been made at least thirty days prior to the date of discount. In exceptional cases, bills running up to four months would be accepted as collateral for note issue, if they were guaranteed by the endorsement of the local bank association in addition to that of the member bank.

At the same time, as a concession to advocates of a bond backed currency, the Commission’s proposals would authorize the issue of notes against the pledge and deposit of satisfactory securities up to 75 per cent of the value of such collateral. The character and quality of the “satisfactory securities” was left open—a provision that tacitly allowed the use of corporate bonds as note issue reserve. Notes could also be issued against U. S. government bonds and also against notes of one year maturity or less of states and even of foreign governments.

Ordinarily, circulating notes and demand liabilities of the proposed central issuing authority (the National Reserve Association) were to be secured by gold to the extent of one-half, but a technical provision would permit U. S. government bonds to be counted at par as reserve, and provision was made for a tax upon the note issue when the reserve fell below 50 per cent, with a minimum reserve in any case of 33 1/3 per cent. An additional limitation was that notes issued in excess of $900 million should be covered 100 per cent by gold or be subject to a graduated tax.

On the question of the locus of authority, whether control of the banking and monetary system should be centralized in one institution with autocratic powers, or dispersed throughout the banking system, the Commission again offered a compromise. Control over the quality of the note issue, that is, of the reserves supporting the notes, would be vested in a central authority called the National Reserve Association. This institution alone would have the power to issue notes through the rediscount process, and to assess the quality of the collateral offered. It would also have the right and the duty to examine into the condition of member banks—although, curiously, the draft bill gave no disciplinary authority to the Association beyond publishing the reports.

The quantity of the note issue was to be governed by the market demand for money. That is, as member banks needed cash to meet calls from depositors or to extend credit to customers, they would obtain the means from the National Reserve Association by rediscounting their commercial paper with the Association.1 As demand for credit diminished, and the discounted paper matured, the circulating notes would be retired. The procedure represented an essential democracy in the money system whereby the economy, working through the mass of individual transactions, would make its will manifest in regard to the money supply.

Such was the admirable theory. The structure, however, had a fault that did not become apparent until much later when the scheme was taken over essentially in the Federal Reserve System. This was the provision that would permit the National Reserve Association, of its own accord, to purchase acceptances2 from bankers or financial houses. This little provision, inserted for use in emergencies, became the seed of the “open market” operations of the Federal Reserve System, by which the central authority took upon itself to determine the amount and flow of liquid assets (money and credit) into the economy, and which eventually became a major instrument by which the central authorities sought to manage and control, not only the credit stream, but the direction and pulse of the entire productive activities of the country.

The administrative mechanism of the National Reserve Association need not detain us. The Commission proposed that the Association function through fifteen branch banks which would become regional money centers, and that the operating units of the systems be local associations of banks. Such associations could be formed by any ten banks serving contiguous territory. Such local associations would perform normal clearing house functions. Government of the National Reserve Association was to be through the member banks through a representative system moving upward through the local association to its corresponding branch to a board of directors, but the national interest was preserved by the requirement that the top executive, the governor of the National Reserve Association, be selected by the President of the U. S. from nominees presented by the board, and by the requirement that the Secretary of the Treasury and three other high officials serve ex officio on the board of forty-six directors. Provision was also made that the board membership reflect the principal economic interests of the country.

Finally, the Commission set forth the mechanism by which outstanding national bank notes should be retired and replaced by notes of the National Reserve Association—provisions that need not delay our story.

Senator Aldrich, in presenting the Commission’s report, drew up a seventeen-point criticism of the existing monetary-banking system. He began by declaring that in examining the printed literature of banking, the Commission was struck by the meagre information available on any aspect of banking except the history of the note issue privilege. By contrast, as we have noted, the Commission’s report dealt almost entirely with banking operations to the neglect of the theory or the history of money.

The Commission’s attitude toward this subject is evident from the seventeen points. Point 1. states: “We have no provision for the concentration of the cash reserves of the banks and for their mobilization and use wherever needed in time of trouble.”

From this it is apparent that the Commission accepted assumptions which it should have been its prime duty to question and analyze. Probably no question is more germane to the theory of individual (that is, personal) sovereignty and of representative government exercising delegated powers, than that of where the reserves of a nation are to be kept. To deprive an individual of his liquid reserves and to concentrate them in the hands of a central bureaucracy is, of course, the ultimate negation of individual liberty and responsible citizenship, and the substitute therefor of autocratic and irresponsible government. We shall have more to say about this as we go along, but the cleavage in political and economic philosophy should be clear at the outset: human liberty is co-extensive with the right of property. The simplest and most usable and marketable form of property consists of a piece of intrinsic money—a coin of good metal. When, by whatever means, the individual is deprived of the possession of that piece of metal—that intrinsic substance of worth—whether by the subtle sophistries of “mobilization of reserves” or other phrase, we witness the first steps on the road to serfdom and submission to an all-powerful state.

The second item in the Commission’s summary states that “antiquated Federal and State laws restrict the use of bank reserves and prohibit the lending power of banks at times when, in the presence of unusual demands, reserves should be freely used and credit liberally extended to all deserving customers.”

In this statement the Commission neglected to consider the function of money. For when the proposition is stripped to its bones it means that regardless of the condition of business, the individual, or the economy, the individual should always be able to convert his property into money. (For the moment, of course, the proposition limits itself to notes of hand represented by property in the course of movement from hand to hand; but the theory is the same.) The logical meaning of this is that the quantity of money should always be potentially or actually co-extensive with property—at least with movable property in the course of trade. (Later it would mean all property when subsequently bonds and mortgages were made eligible for rediscount.)

Now, obviously, if money must be co-extensive with goods in trade, or potentially so, any notion of a stable value of money—or any value what-soever—must be abandoned. For the unique quality of money—that which gives it meaning above other forms of wealth—is this, that it is the most liquid of all forms of wealth, being generally infinitely divisible, readily transmitted, and universally acceptable. Now, if this liquidity be nullified by equating it to all other forms of property (at least property in course of trade) then its uniqueness as money ceases and its worth diminishes. In short, any idea of stability in the value of money must be surrendered.

At the same time, the theory upon which the notion of bank liquidity rests requires the negation of the theory of profits and rent. For the essence of profit is compensation for risk; but the commonest risk of enterprise is its illiquidity—that is, the inability to convert goods of trade into money. (The risk of loss from natural or other disaster is commonly covered by insurance.) Now if goods in trade (or even capital goods) can be converted into cash at any time—through the mechanism of note issue as proposed by the Commission—then enterprise is relatively without risk, and the incentive of and reason for profit disappears.

The remaining fifteen points need not detain us. They are, in one form or another, elaborations of the argument discussed above, that the defect of the banking system, which monetary legislation should attempt to remedy, was that it lacked the means to provide cash to all customers in time of need—that is, to discount their notes of hand, and provide them money in exchange for a claim on their goods.

Whether there should be, in monetary practice, allowance for emergencies and provision to relieve business in time of credit crisis, may be left for further consideration. We need only note here that the theory, apparently endorsed by the Commission, that it was the responsibility of a monetary system—or rather the managers of the monetary system—to provide practically unlimited liquidity to trade—is one that leads down the path of economic chaos if not annihilation.

Senator Aldrich’s presentation to the Senate (January 8, 1912) was followed by an address to the House, on February 6, by Congressman Edward B. Vreeland, joint chairman of the Commission. His report is an extensive, sometimes impassioned, argument for a paper money system secured by commercial power.

“Mr. Chairman,” he declared, “I stand here to say that, in the opinion of all intelligent men who have studied the question, both here and abroad, these money panics are entirely due to a defective banking and currency system. . . .

“I say it, Mr. Chairman, because when we turn to every other great nation on the face of the earth . . . we find that no one of them has had a money panic for more than fifty years.”

Observing with perspicacity that while “elasticity of cash is important,” “elasticity of credit is of vastly greater importance,” Vreeland pointed out that 95 per cent of business transactions were done with instruments other than currency. “The banking part of our problem is vastly more important than the currency part of it.”

Proceeding from these premises he argued against the minimum re-serve requirements of American banking practice. “Go to England, Austria, France, Germany—any great country abroad,” he exhorted—“Not one of them by law requires a bank to keep a dollar of reserve on hand.”

To illustrate his meaning he cited the practice of the French Crédit Lyonnais, at the time the greatest bank in the world, with over $300 million of deposits and upwards of $80 million capital funds. He reported that he asked the governor how much cash he kept in the vault against these deposits. The governor called his bookkeeper, who announced that it amounted to about 5½ per cent of the demand liabilities. In surprise, the Congressman asked if they did not have runs upon banks in France, and did the people never become excited? The governor conceded that the French did indeed become excited. “With the most excitable people on earth,” asked Vreeland, “how do you feel safe in carrying this small reserve of 5½ per cent?” The explanation which the Congressman reported from the governor was that the bank could take to the Bank of France up to $150 millions of paper bearing three solvent names and obtain notes “as good as gold.” “If I could not do that,” added the governor, “I could not sleep nights.”

Vreeland summarized his conclusions in two points.

First, the note issue should be centralized in one institution, with the issue to rest upon gold and commercial paper, not less than one-half of the reserve to consist of gold.

Second, the mobilization of part of the cash reserves of the banking system in one institution, this institution to carry large reserves, and to have the right to expand its note issue and credit liability based upon gold and commercial paper.

Congressman Vreeland, had he been gifted with prophetic foresight, might have curbed his enthusiasm for European monetary and banking systems by the knowledge that in the course of the following half century the German mark would twice disappear in a bottomless gulf of inflation, carrying with it the commercial structure of Germany and reducing trade to a barter basis in which—during the second experience—a cigarette would obtain more value in trade than a bundle of paper money. Had he lived through the following decades, he would have seen the practical disappearance of the French franc as he knew it, and a repeated devaluation of the English pound. He would also have discovered that the flexible currency system which was subsequently adopted for the U. S., following the main recommendations of the Committee, of a commercial paper security for the note issue, would not save this country from what history has set down as the most devastating panic and depression in modern annals, nor would it save the currency from a major devaluation of 40 per cent.

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3Another form of commercial paper, being a “draft,” that is, an order upon one person to pay to a certain other person such and such sum of money, which the drawee has agreed to honor by “accepting” by writing his name, or “endorsement,” upon the face of the draft preceded by the word “Accepted.”

4Rediscounting technically is the sale of a promissory note at a discount representing the amount of interest, with the guarantee of the offering bank—indicated by “endorsing” the note—to pay off the note at maturity if the maker defaults.

• 1*Another form of commercial paper, being a “draft,” that is, an order upon one person to pay to a certain other person such and such sum of money, which the drawee has agreed to honor by “accepting” by writing his name, or “endorsement,” upon the face of the draft preceded by the word “Accepted.”
• 2*Rediscounting technically is the sale of a promissory note at a discount representing the amount of interest, with the guarantee of the offering bank—indicated by “endorsing” the note—to pay off the note at maturity if the maker defaults.
• 3The quantity of the note issue was to be governed by the market demand for money. That is, as member banks needed cash to meet calls from depositors or to extend credit to customers, they would obtain the means from the National Reserve Association by rediscounting their commercial paper with the Association.* As demand for credit diminished, and the discounted paper matured, the circulating notes would be retired. The procedure represented an essential democracy in the money system whereby the economy, working through the mass of individual transactions, would make its will manifest in regard to the money supply.
• 4Such was the admirable theory. The structure, however, had a fault that did not become apparent until much later when the scheme was taken over essentially in the Federal Reserve System. This was the provision that would permit the National Reserve Association, of its own accord, to purchase acceptances* from bankers or financial houses. This little provision, inserted for use in emergencies, became the seed of the “open market” operations of the Federal Reserve System, by which the central authority took upon itself to determine the amount and flow of liquid assets (money and credit) into the economy, and which eventually became a major instrument by which the central authorities sought to manage and control, not only the credit stream, but the direction and pulse of the entire productive activities of the country.