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Modern Economic Problems by Frank Albert Fetter

Part 2 out of 9

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others in turn will take it in the same way.[2]

Sec. 2. #Present monetary system of the United States.# Here is given a
summary of the main features marking the present monetary system of
the United States (in 1915).

Not all this variety is essential to an efficient monetary system and
several of the kinds survive as the result of historical accidents
(political and legislative). But all are now kept in accord with the
value of the gold coin which, it will be observed, is the only kind
the amount of which is not artificially limited. Silver dollars are
no longer coined, subsidiary silver and minor coins are issued only
in exchange for other money, as are gold and silver certificates in
exchange for gold or for silver, which they merely represent while in

Sec. 3. #Saturation point of fractional money.# Fiduciary money is that
on which regularly the issuer makes a seigniorage charge.[3] Let us
consider now the effect of seigniorage on the value of money.

Fractional coins are those of smaller denominations than the standard
unit of money, as shillings and pence in England, and half dollars,
quarter dollars, dimes, nickels, and cents in America. Money to serve
well a variety of uses must be of different denominations, and "small
change" is necessary to make small purchases and for exact settlement
in larger payments that are not multiples of the standard unit. The
amount required (or most convenient to use) in each denomination
of fractional coins is thus a more or less certain portion of each
person's monetary demand, shaped by experience and fixed by habit. For
example, within certain elastic limits of convenience quarters may be
used for halves, and dimes for nickels (and _vice versa_); but each
person has a point of preference. The total demand for each kind of
change is the sum of the individual demands. This point where the
amount of coins of any denomination (in relation to the whole monetary
system) is most convenient may be called the saturation point of that
kind of small change, up to which point the people prefer a share
of their money in that form, and beyond which they will, if free
to choose, exchange that kind for other denominations (smaller or
larger). Each kind of money, as the cent, nickel, dime, has its own
peculiar demand and its saturation point.


Metals | Weight, grains | Fineness |Ratio to gold
1. Gold coins | 25.8 | .90 | 100
2. Silver dollar | 412.5 | .90 | 15.988 to 1
3. Silver, subsidiary | 385.8 | .90 | 14.953 to 1
4. Nickel (5 cents) | 77.0 | .25 | ...........
5. Copper (1 cent) | 48.0 | .95 | ...........
Metal |Limit of issue | Legal tender for|Receivable for
| | private debts |public dues
1. Gold coins | Unlimited. | Unlimited. |For all
2. Silver dollar |Ceased in 1905 | Unlimited. |For all
3. Silver, | Needs of the | $10 |$10
subsidiary | people | |
4. Nickel (5 cts.) | Do. | 25 cts. |25 cts.
5. Copper (1 ct.) | Do. | 25 cts. |25 cts.
| \ |
_Paper_ | | |
6. Gold certificates|Unlimited in ex-| No |For all
|change for gold | |
7. Silver |In exchange for | No |For all
certificates | silver $ | |
8. US notes | No new issues. |Unlimited. |Except customs
9. Treasury notes | No new issues. |Unlimited |For all
of 1890 | | |
10. National bank |Capital of banks|No |Except customs
notes. | | |
11. Federal reserve |Per cent. of |At banks of |For all
notes. | gold reserves |reserve system |
Metal |Exchangeable at |Redeemable at |In circulation
|treasury for | treasury in |Oct 1, 1915
1. Gold coins |Gold certificates| |616,000,000
|U.S., Treas., or | |
|Fed, res. notes | |
2. Silver dollar |Silver | |65,000,000
|certificates | |
3. Silver, |Minor coins |Lawful money[a]|
subsidiary | |in sums or mul-|162,000,000
| |tiples of $20 |
4. Nickel | | Do. \
> 62,000,000[d]
5. Copper | | Do. /

Paper | | |
6. Gold certificates| Subsidiary and |Gold coin |1,172,000,000
| minor coins | |[e]
7. Silver | Silver and |Silver dollars | 482,000,000[f]
certificates | minor coins | |
8. US notes | Subsidiary and |Gold | 337,000,000
| minor coins | |
9. Treasury notes of| Silver and |Gold | 2,200,000
1890 | minor coins | |
10. National bank |Subsidiary silver|Lawful money[b]|761,000,000
notes |and minor coins | |
11. Federal reserve | Gold[c] |Gold[c] |133,000,000
notes | | |

[Footnote a: "Lawful money" includes gold coin, silver dollars, U.S.
notes, and Treasury notes.]

[Footnote b: Redeemable also in lawful money at bank of issue.]

[Footnote c: Redeemable also at Federal reserve banks in gold.]

[Footnote d: Not usually included in the estimates of total money
in circulation.]

[Footnote e: Represented dollar for dollar by gold kept in the U.S.

[Footnote f: Represented dollar for dollar by silver kept in the U.S.

[Footnote g: Besides, there were about $312,000,000 in the U.S.
Treasury not offset by outstanding paper. The total money stock (in
circulation and in the Treasury, eliminating certificates representing
gold and silver), was about $4,233,000,000, of which 70 per cent was
metal (largely represented in circulation by paper certificates) and
30 per cent was paper. Of the 70 per cent 50 was gold, 18 was silver,
and 2 was copper and nickel.]

Sec. 4. #Light-weight fractional coins.# The standard metal is usually
too valuable to be suitable for coins of the smaller denominations.
Therefore, when gold is the standard, copper, nickel, and silver
remain in restricted use. But when coins of these metals are issued
at weights corresponding with their bullion value, difficulties arise.
Not only are they too heavy for convenience, but with every slight
rise in their bullion value as compared with that of the standard
metal, they become worth more as bullion than as coin and begin to
disappear from circulation. This happened often throughout the Middle
Ages and until the nineteenth century. The attempt was generally made
to coin gold and silver at a ratio of weight corresponding exactly
to their market values at a given moment and, every time the market
conditions varied, the best full-weight coins of one of the two metals
were taken out of circulation. [4]The country thus suffered for lack
either of the larger gold coins or of fractional coins. At length, to
remedy this difficulty, fractional silver coins, often called
"token coins," were issued, in limited numbers, of less than full
proportionate weight and bullion value.

This plan, having been partially tried, was generally adopted by the
United States in 1853 at a time when the silver dollar of 371.25 fine
grains was legally rated at the same value as the gold dollars of
23.22 grains, and was freely coined. The fractional coins were made
a little over 6 per cent lighter per dollar than the dollar coin; two
half-dollars or four quarters or ten dimes contained 93.52 cents worth
of silver. Since then silver bullion has become worth much less in
terms of gold, and for years past the bullion value of the silver in
a dollar of silver small change has been between 40 and 60 cents. Why
then has the fractional coinage a monetary value equal to the standard
money, dollar for dollar?

The answer is, because it is artificially limited in quantity, so that
it does not pass the point of saturation in the field of its use. Its
value rests on its monetary use; it is fiduciary money, not commodity
money. It is limited simply by letting "the needs of the people"
determine its amount. This is done by issuing it only in exchange for
other money of the larger denominations, and by redeeming it in other
money on demand. Fractional coins are issued on the request of banks
in exchange for standard money. One needing "change" gets it at the
bank; when the bank finds its supply falling short it gets more from
the government mints. As business increased in 1898, the demand for
nickels, dimes, and quarters became unprecedented, and the mints
worked night and day to supply them. If these coins were made in
great quantities and forced into circulation by the government through
paying them out to creditors and officials, their quantity would
become excessive and they would fall in value (be at a discount)
compared with standard money. But as this is not done, and as,
moreover, they are redeemed on demand at the treasury (and practically
at every bank and post office) in other money, any slight tendency
to depreciation in any locality is at once corrected. As it is, the
government makes a seigniorage profit on the fiduciary coinage, as
shown in the following table. [5] The fractional coinage is maintained
at a parity with the standard money in accordance with the monopoly
principle, expressed in the limitation of the amount.


Earnings (charges for refining, assaying, manufacture
for other countries, etc.)......................... $392,000
Bullion recovered, by-products, old materials, etc... 143,000
Profits on seigniorage, subsidiary silver............ 3,013,000
Profits on seigniorage minor coinage and recoinage... 2,387,000
Total receipts.......................................$5,935,000

All kinds............................................$1,138,000
Net revenues from mint service.....................$4,797,000

Sec. 5. #Worn coins and Gresham's law.# Coins may be light-weight as the
result of another cause--namely, the abrasion (wearing off) of the
coins in circulation. Nearly always when this has occurred the worn
coins have still been accepted as money,[6] and ordinarily without any
depreciation. That is to say, they have a value as money greater than
the value of the bullion that is in them. Everybody takes them without
hesitation as readily as if they were full weight. If, however, at
this point, new full-weight coins are put into circulation, these at
once disappear while the old ones remain in circulation--a fact that
has always been somewhat mystifying.

In explanation of the phenomenon was formulated "Gresham's law" of
the circulation side by side of coins of different bullion value: bad
money drives out good money. Sir Thomas Gresham (whose name has but
recently been given to this so-called law), explained the principle
to Queen Elizabeth when counseling her regarding the recoinage of the
debased money of the realm as was done in 1560. He showed that when
old, worn coins were in circulation and the mint began putting out
full-weight coins, the old lighter ones remained as money, while the
new ones, being heavier, were picked out by jewelers and by those
needing to send money abroad.

Gresham's law has a paradoxical wording and is frequently
misunderstood. "Bad" money means not counterfeit money, but merely
money that has not as great a bullion value compared with its money
value as some other kind of money then in circulation. But not every
piece of such money will drive out every piece of good money. The law
applies only under certain conditions, and within certain limitations.
The "good" will be driven out only if the total amount of money in
circulation is in excess of what would be needed if all were of full
weight and of best quality. Paradoxically speaking, if there is not
too much of the bad money, it is just as good as the good money. But
even if good money is driven out, it may not leave the country. It
may be hoarded, or be picked out by banks and savings-institutions to
retain as their reserves, or be melted for use in the arts. Gresham's
"law" becomes thus a practical precept. As applied to the plan of
recoinage it is: Withdraw the worn coins as rapidly (in equal numbers)
as you put new coins into circulation.

The continued circulation of "bad" money along side of "good" money
(light-weight along side of full-weight coins), so long as the total
number of coins is not in excess of the money demand for full-weight
coins, is explained thus on just the same principle as is the
circulation at parity of a light-weight fractional coinage, in the
preceding section.

Sec. 6. #A general seigniorage charge on standard money.# The fiduciary
coinage problem presents itself under a some-what different guise in
case a seigniorage charge is made on all coinage, even of that metal
used as the standard unit. In this case coinage is free but not
gratuitous. In this case no bullion is brought to the mint unless the
coined pieces the owners receive have a value equal to the bullion
value plus the seigniorage charge. The power to impose a seigniorage
charge is a monopoly power. Artificial limitation is present.
Evidently, the number of coins that can be issued without depreciation
is limited to that number which would circulate if they were made
full weight without a seigniorage charge.[7] This number of pieces of
full-weight metal is the saturation point of the money demand of the
country. If more than that could in any way be put into circulation it
would become worth less as money than as bullion, and would be melted
or exported.

Assume that this full supply of money at a given moment is 100,000
pieces or dollars; then consider the effect of imposing a seigniorage
charge of ten per cent on further coinage. The government alone having
the right of coinage, the need of money would give the circulating
medium a monopoly value. The value of the money would rise. When
it had risen until the coin would buy any more than one-ninth more
bullion than was in it, the citizens would begin to take metal to the
mint. After the ten per cent charge was taken out they would receive a
coin which, the containing one-tenth less bullion, would be worth
very nearly the same as the metal taken to the mint. No considerable
depreciation could take place unless the volume of business fell off
so that less money was needed than before. In that case there would
be no outlet for the excess of coins until they fell to their bullion
value, i.e., till they lost the entire value of the seigniorage, the
monopoly element in them. Melting or exporting them before that point
was reached would cause to the owner the loss of whatever element of
seigniorage value they contained. We thus have arrived at the general
principle of seigniorage: when the number of coins issued is limited
to the saturation point, a seigniorage charge does not reduce their
money value; they are worth more as money than as bullion. And this
holds good of a large seigniorage charge as well as of a small one,
even up to the extreme limit of a charge of 100 per cent. In this last
case the government would retain the whole of the bullion brought to
it and would give in return a piece of money made of material (metal
or paper) with a negligible value.

Sec. 7. #Coinage on governmental account.# The fiduciary coinage problem
may be presented also when coinage is not free, and the times and
amount of coinage are determined by law or by legally authorized
officials. In this case the bullion must be obtained by purchase
in the open market (and paid for by some form of legal money, or by
bonds). Coinage is then said to be "on governmental account."

Now, assuming that the normal money-demand (the volume of business, or
sum of exchanges) remains unchanged, let us consider what will result
if the government begins to issue money in this way, when, as in the
preceding case, 100,000 units of full-weight money are in circulation.
This action might be taken most simply by recoining all the
full-weight pieces that came into the treasury, making them contain
1/10 less precious metal, and paying out 1111 pieces for every 1000
received. Every time this was done there would be an excess of 111
pieces above the normal money-demand, and 111 full-weight pieces would
be exported or melted (Gresham's law). The process (in strict theory)
may be repeated 90 times, at which point 90,000 full-weight coins have
been received, 100,000 light-weight coins have been issued to take
their place and 10,000 full-weight coins have gone out of circulation.
The total seigniorage charge would be 1-10 of 90,000, or 9000 units.
No depreciation has taken place, and the pieces, by reason of their
limitation, bear a money value in excess of the bullion that is in

Now the government, with the next 1000 pieces collected by taxation,
could buy enough bullion (in the open market) to make another 1111.
The excess of 111 pieces could not now be promptly removed by the
melting down or exporting of 111 coins, for all those remaining in
circulation have a bullion value 1/10 below their money value. As this
process is repeated the excess must continue to grow from 100,000 to
111,111, and the value of the money piece in terms of bullion continue
to fall from 10 to 9. At this point the 111,111 pieces would contain
just the same amount of bullion and have just the same value as the
100,000 pieces did before. Thereafter no further profit would accrue
to the government from issuing coins of that weight. To make a further
profit it must again reduce the amount of pure metal in the coin.

This process was often repeated in the Middle Ages. A ruler, either by
making a higher seigniorage charge or by coining on his own account,
debased the quality or reduced the weight of the money of his realm.
For a time the new coins, having the same monetary use, circulated at
par with the old coins. The ruler, pleased with this almost magical
power of getting a revenue with little trouble, continued to issue
coins until suddenly the heavier coins began to be exported or melted,
and the value of the other money fell, to the mystification alike of
the prince and of his people. The reason is now perfectly plain: the
number of coins was not kept within the proper limits and they went
down to their bullion value. The only way a further profit could be
made in this way was to debase the coin again. By successive steps the
coinage came to consist almost entirely of cheaper alloy.

Sec. 8. #The gold-exchange standard.# In a number of silver-using
countries and colonial dependencies near the end of the nineteenth
century, the fluctuations of the value of silver in terms of gold was
a constant source of difficulty in the payment of foreign obligations
to gold standard countries. Yet there were strong reasons in the
habits of the people and in the industrial conditions of the country
to forbid the adoption of gold and the disuse of silver as the actual
money in circulation. The method adopted, that of the gold-exchange
standard, involved these features.

(1) Closing the mints of the country to the free coinage of silver, as
was done most notably in India in 1893 and in Mexico in 1904.

(2) Adoption of a fixed ratio of exchange between the silver coins in
circulation and some gold coin which is made the standard of value in
all transactions (as the dollar or the pound sterling), the money in
circulation thus being all or nearly all of a fiduciary nature.

(3) Regulation and limitation of the amount of money in circulation so
that a fixed parity between it and gold may be maintained (a) by the
limited issue of coins only on governmental account, (b) by the sale,
at a fixed rate, of foreign exchange bills payable abroad in the
standard unit, the money paid for the bills being withheld from
circulation in a special reserve, (c) by the purchase of foreign bills
of exchange at a fixed rate, thus paying out and putting again into
circulation some of the fiduciary money in the special reserve.

These monetary changes furnish numerous illustrations and
demonstrations of the quantity theory of money as applied to the
entire circulating medium of a country.[8]

Sec.9. #Nature of governmental paper money.# The problem of seigniorage
presents itself in its most extreme form when money is made of paper.
Paper money is issued either by a government or by a bank. We will
consider governmental notes here, reserving until Chapter 7 the case
of bank notes.

The issue of paper money in some cases grew out of the practice of
debasing metal. However this may have been, governmental paper money
may be looked upon as money for which a seigniorage of one hundred per
cent is charged. The gain of seigniorage from paper money is greater
and is just as easily secured as that from coinage of metals.
Governmental paper money is called "political money," in contrast
with commodity money. However, all coins that contain an element of
seigniorage, or monopoly value, are to that degree "political money."
The typical paper money is irredeemable; that is, it cannot be turned
into bullion money on demand. It is simply put into circulation,
usually with the "legal-tender" quality. Money has the _legal-tender_
quality (as the term is used in the United States) when, according to
law, it must be accepted by citizens as a legal discharge for debts
due them, unless otherwise provided in the contract. The prime purpose
of making money legal tender is to reduce the danger of dispute as to
payments; but another purpose often has been to force people to use a
depreciated money whether they would or not. The purpose of the issue
of political money is usually to gain the profit of seigniorage for
the public treasury, and often it has been the desperate expedient
of nearly bankrupt governments. Governmental paper money differs
from bank notes in that its value does not necessarily depend on the
promise of redemption by the issuer. It differs from promissory notes
and bonds in that its value is not based on the interest it yields,
but mainly on its monetary uses. The issue of paper money may save the
government the payment of interest on an equal amount of bonds. The
promise to receive paper in payment for taxes or for public lands may
help to maintain its value by reducing its quantity, but nothing short
of its prompt redemption in standard coins makes it truly redeemable.

Sec. 10. #Irredeemable paper money.# The most notable examples of paper
money in the eighteenth century were the American colonial currencies,
the continental notes, and the French assignats. In all the American
colonies before the Revolution, notes or bills of credit were issued
which were in most cases legal tender. Parliament forbade the issues,
but to no effect. Without exception they were issued in large amounts
and without exception they depreciated. The continental notes were
issued by the Continental Congress in the first year of the war
(1775), and for the next five years. The object at first was to
anticipate taxes, and it was expected that the states would redeem and
destroy the notes, but this was not done. The notes passed at par for
a time, but depreciated rapidly as their number increased. It has been
estimated that the country had less than $10,000,000 of coin before
the war, and when, in 1780, over $200,000,000 of notes were in
circulation they were completely discredited: hence the phrase "not
worth a continental." Specie then quickly came back into use. A few
years later the leaders of the French Revolution, failing to learn the
lesson of the American experience, issued, on the security of land,
notes called assignats in such enormous quantities that they became
worth no more than the paper on which they were printed. The paper
money issued under the English bank restriction act of 1797-1820 is
especially notable because it gave rise to the controversy which did
much to develop the modern theory of the subject. Parliament forbade
the Bank of England to redeem its notes in coin because the government
wished to borrow the coin the bank held. The result was the issue of
a large amount of bank money not subject to the ordinary rule of
redemption on demand. It was virtually governmental paper money. The
notes depreciated and drove gold out of circulation, and it was not
until 1821 that specie payments were definitely resumed.

The United States, under the Constitution, did not try legal-tender
paper money till 1862 when paper notes (called greenbacks, because of
the color of ink with which the reverse side was printed) were first
issued, later increased to a total of about $450,000,000. Other
interest-bearing notes were issued with the legal-tender quality and
circulated as money to some extent. Greenbacks depreciated in terms
of gold, and gold rose in price in terms of greenbacks until, in June,
1864, it sold at 280 a hundred. Fourteen years elapsed after the war
before these notes rose to par, in terms of gold (in December, 1878),
and they became legally redeemable in gold January 1, 1879. This was
called "the resumption of specie payments."

Almost every nation has at some time issued political money. During
the Franco-Prussian War in 1870, France, through the medium of its
great state bank, made forced issues of notes of a political nature,
which only slightly depreciated. Many countries--Russia, Austria,
Portugal, Italy, and most of the South and Central American
republics--have had or still have depreciated paper currencies.

At once, at the outbreak of the great war in 1914, the governments of
the warring nations began to exercise a strict control over the issue
of paper money, sought to gather into the public treasury all the
specie, and to give paper (either governmental notes or bank
notes) practically a forced circulation, making it almost the sole
circulating medium. The values of the paper moneys have fallen in all
the countries, especially in Germany and Russia. In such cases the
money partakes somewhat of the characters both of bank notes and of
political money. Resorted to in desperate extremities, political
money has usually proved to be a costly experiment. A result usually
unintended is the derangement of business and of the existing
distribution of incomes. The rapid and unpredictable changes in prices
gives opportunity for speculative profits, but injure legitimate
business. This incidental effect on debts and industry offers the main
motive to some citizens for advocating the issue of paper money. It
is peculiarly liable to be the subject of political intrigue and of
popular misunderstanding. It is this danger, more than anything else,
which makes political money in general a poor kind of money.

Sec. 11. #Theories of political money.# There are two extreme views
regarding the nature of paper money, and a third which endeavors
to find the truth between these two. First is that of the
cost-of-production theorists, who declare that government is powerless
to influence value, or to impart value to paper by law. They deny that
there is any other basis for the value of money than the cost of the
material that is in it. Money made of paper, on a printing press, has
a cost almost negligibly small, and, therefore, they say it can have
no value. The facts that it does circulate and that it is treated as
if it had value are explained by the cost-of-production theorists as
follows: while the paper note is a mere promise to pay, with no value
in itself, it is accepted because of the hope of its redemption, just
as any private note. Depreciation, according to this view, is due
to loss of confidence; the rise toward par measures the hope of

Taking a very different view, the extreme fiat-theorists assert that
the government has unlimited power to maintain the value of paper
money by conferring upon it the legal-tender quality. The meaning of
_fiat_ is "let there be," and the fiat-money advocates believe that
the government has but to say, "Let there be money," to impart value
to a piece of paper. The typical fiat-money advocates in the United
States were the "Greenbackers," who wished to retain the greenbacks
issued in the Civil War and to increase the amount greatly. They saw
in paper money an unlimited source of income to the government.
They proposed the payment of the national debt, the support of the
government without taxes, and the loan of money without interest to
citizens. All might live in luxury if the extreme fiat-money theorists
could realize their dreams. The depreciation that has taken place
in nearly every case where government notes have been issued, the
fiat-theorists declare to be due to a mild enforcement of the law of
legal tender. To them the fact that paper money may circulate for
a time at par appears a reason why it always should. They do not
recognize that there is a saturation point in the use of money, and
that its use is still further limited by the fear of larger issues.

The almost universally accepted opinion among economists rejects both
of these views, tho recognizing in each a certain limited aspect of
the truth. The cost-of-production view quite overlooks the features
in which paper money differs from ordinary credit paper. The value of
one's promises to pay depends on his reputation and his resources; the
resources constitute the basis of value. Bonds have value because they
yield interest and are payable at a definite time in standard money.
But paper money, lacking this basis for its value, has another basis
in its money use, in its power to buy goods.

The theory of paper money here outlined makes the value of paper money
a special case of monopoly value. As the power of any private monopoly
over price is relative, not absolute, so is that of the government
over the value of political money. The money use is the source
of value of the paper notes. It is this which gives the economic
condition for value in paper money and strictly limits the power of
the government--a fact overlooked by the fiat-theorists. Business
conditions remaining unchanged, the limit of possible issue without
depreciation is the number of units in circulation before the paper
money was issued, the saturation point of full-weight and full-value
coins. Whenever governments have failed to stop at that point,
paper money has depreciated. But under wise and honest control and
regulation political paper money might serve the monetary function
very effectively.

[Footnote 1: The problem of a legally authorized double standard,
bimetallism, is treated in the next chapter. An irredeemable paper
money may be, for a time, the standard money.]

[Footnote 2: The faith _(fides)_ is not always that the issuer of the
money (whether it be a bank or the government) will redeem the money
on demand at any future time; for fiduciary money may circulate while
irredeemable, that is, either carrying no promise of redemption in the
standard money or in fact not being redeemed. Yet undoubtedly actual
redemption on demand or a good prospect of future redemption is one
of the circumstances stimulating the faith and the readiness of each
person in turn to receive fiduciary money.]

[Footnote 3: In the broad sense as above defined, ch. 3, sec. 10.]

[Footnote 4: See next section on worn coins.]

[Footnote 5: Receipts and Expenditures of Mint Service in 1914:]

[Footnote 6: It makes no difference what may be deemed the cause of
their acceptance; whether it be habit, public opinion in business
circles, or the act of law making them a legal tender; the essential
thing is that they continue to be accepted as money.]

[Footnote 7: In this and following numerical examples no account is
taken of the possibility that the standard metal may depreciate in the
world market in terms of all other goods as a result of its diminished
use as money in one or more countries. This properly belongs in a
complete theoretical treatment of the subject.]

[Footnote 8: See "Modern Currency Reforms" (1916), by E.W. Kemmerer,
professor of Economics and Finance in Princeton University, for a
detailed treatment of this remarkable series of monetary changes,
probably unequaled in instructiveness to the student of monetary



Sec. 1. Relative positions of gold and silver; historical. Sec. 2. Gold
production, first half of nineteenth century. Sec. 3. Concept of the general
price level. Sec. 4. Index numbers. Sec. 5. Gold production and monetary
legislation, 1850 to 1879. Sec. 6. Definition of the standard of deferred
payments. Sec. 7. Increasing importance of the standard. Sec. 8. Fluctuating
standard and the interest-rate. Sec. 9. Notable changes in prices.
Sec. 10. Nature and object of bimetallism. Sec. 11. The movement for
national bimetallism in America. Sec. 12. Rising prices after 1896. Sec. 13.
Defectiveness of the gold standard. Sec. 14. Various ideal standards
suggested. Sec. 15. The tabular standard.

Sec. 1. #Relative positions of gold and silver: historical.# It is not
possible within the limits of our space to enter here into the details
of the world's monetary history. It must suffice for our purpose to
sketch briefly the period preceding the nineteenth century. Both
gold and silver were used as moneys in Europe in the Middle Ages, tho
silver was much the more common. The two metals continued to be used
side by side in Europe and in the new settlements in America, silver
for the smaller and gold for many of the larger transactions.
Both were made legalized forms of money (and standards of deferred
payments) in units of specified weights and fineness, the weights
bearing a certain ratio to each other. Thus it was possible for a
debtor to discharge his obligations with that one of the two metals
that at the moment was the cheaper at the legal ratio. Fluctuations in
the prices of gold in terms of silver were at times such as to cause a
large part of the full-weight coins of one or the other metal to leave
circulation (in accordance with Gresham's law). So from time to time
the ratio was slightly changed by law in the various countries to
permit the circulation or to bring back the kind of money that had
been undervalued in terms of the other. But it is a very remarkable
fact that from the time of Xenophon until the discovery of America
(a period of nearly 2000 years), the market ratio of silver to
gold bullion in Europe remained pretty close to 10 to 1, being only
temporarily altered by sudden and unusual occurrences. From 1492 to
1660 the ratio changed to 15 to 1, where it remained with remarkable
stability until about the year 1800. At the establishment of the mint
of the United States in 1792 that ratio was found to exist. Men
had come to look upon the ratio of 15 to 1 as the natural order,
determined (it was sometimes said) providentially by the deposit of
the two metals in due proportion in the earth's surface. But as we
now see it, this in part was mere chance and in part was due to the
equalizing effect of the wide use of both metals so that the one could
be easily substituted for the other in case of a divergence of the
market ratio from the legal ratio as money. From the year 1500 until
1800 the Western hemisphere was the main source of the precious
metals, the alluvial deposits were widely scattered, were gradually
discovered, were usually found in small quantities, and were
extracted in primitive ways. The existing stock of precious metals,
gold and silver, more than other products of mine and field, is at any
time the accumulation of many years' production, and is changed very
little, proportionally, by a large change of output in any year or
short period. It changes in volume as does a glacier fed by the snows
of many years, not as does a river, filled by a single rainfall. For
a short time after the discovery of America (from 1493 to about 1544)
the average coining value[1] of the world's production of gold,
nearly all found in America, was about 1-1/2 times as great as that of
silver; but thereafter for three centuries from about 1545, the annual
value of silver produced was between 1-1/2 to 4 times as great as that
of gold, averaging about twice as great. Silver was the money chiefly
in use in the ordinary transactions in all of the principal countries
of the world.

Sec. 2. #Gold production, first half of nineteenth century.# We have now
to note some great changes in the production of gold in the nineteenth
century, changes both absolute and relative to that of silver. The
market ratio of the two metals had been gradually changing before 1792
and continued to change. Gold was slowly becoming more valuable in
terms of silver and the legal ratio of 15 to 1 in the United States
(at which both metals were admitted free to the mint) proved to have
undervalued gold. Gold largely left circulation and silver and bank
notes formed the greater part of our circulating medium. Then, in
1834, soon after the production of gold had begun to increase somewhat
more rapidly than that of silver, the legal ratio of the United States
was changed to 16 to 1. This brought a good deal of gold back into
circulation and gradually drove out most of the silver (the heavier
coins disappearing first).

In the decade 1841-50 the average annual value of the gold production
had, for the first time since the early sixteenth century, exceeded
that of silver. Then, from 1848 to 1850, came the great gold
discoveries in California and in Australia. In 1851 the value of gold
produced was one and one-half times that of silver; in 1852 was three
times, and in 1853 four times as great; and then slowly declined, but
continued every year as late as 1870 to be over twice as great.
This caused the displacement of silver by gold and drove out a large
proportion of the silver coins of smaller denominations. This led to
the law of 1853, authorizing subsidiary coinage (on government account
only) of lighter weight.[2] Let us observe the effect on prices that
was brought about by the discoveries of 1848-49, and, first, we
must consider briefly the method of measuring and expressing general
changes in prices.

Sec. 3. #Concept of the general price level.# The price of any good
is some other good or group of goods given for it in trade.[3] The
standard unit of money coming to be the most convenient expression for
price (whether or not money be actually passed from hand to hand in
that particular trade), prices usually are monetary prices, and
more specifically are prices in gold, or in silver, or in whatever
constitutes the standard money unit. But the price of each good is
a definite, separate fact, which expresses the ratio at which that
commodity is sold. The price of any particular kind of goods may
fluctuate in either direction as compared with the prices of other
goods at the same time. For example, iron and many other goods
may rise while wheat and many other goods fall in price. There is,
therefore, no such thing as an actual _general_ change in the prices
of goods in terms of money, but it may be seen that the prices of
large classes of goods, often of nearly all goods, change upward or
downward at the same time and in the same general direction. We
thus have need to distinguish between changes in the valuations of
particular kinds of goods in terms of each other and general changes
in the valuation of a number of different goods in terms of the
monetary unit.

To get some idea of whether such a general trend occurs, the algebraic
sum of all the changes in the particular prices of a selected group
of goods may be taken, and for convenience this may be reduced to an
average price (by dividing the sum by the number of articles). Such
an average is called a general price and, when comparing it with
the general price of another time, we speak of changes up or down
in _general prices,_ or in the _general scale of prices,_ or in the
_price level._

When gold is the standard unit, its value is the converse of general
prices; as prices go up the value of gold goes down, and gold is said
to _depreciate_. As prices go down, the value of gold goes up and gold
is said to _appreciate_. Rising prices mean falling value of gold (and
at the same time falling purchasing power), and _vice versa._

[Illustration: FIG. 2. INDEX NUMBERS OF PRICES. The four series of
prices here shown begin at different periods; the American in 1840
(Aldrich report 1840-1889 and Bureau of Labor from 1890 on); the
English in 1846; the German in 1851; the French in 1857. We have
adjusted each of these series to a base of the average prices for
1890-1899, in accord with the basic period used by the American Bureau
of Labor.

The reader must be on his guard against misunderstanding the diagram.
It does not represent the heights of the prices of the different
countries compared with each other either at any one date or for the
entire period. For example, the heights of the lines at the year
1860, do not indicate that American prices were lowest and French the
highest at that date, or, indeed, tell anything whatever directly
on that point. The various series of prices are compared within
themselves, every year with the average of the prices for 1890-1899 in
each country, respectively. The only comparison allowable, therefore,
between the several lines, is that between the fluctuations, both as
to their times and as to their directions, both as to the larger tidal
movements and as to the lesser wave-like movements within the business
cycles. The Figure does indicate that both American and German prices
have risen somewhat as compared with the English and French prices,
since the period before 1860.

This figure should be studied in connection with Figure 1, in ch.
4, sec. 9, on gold production. The Figures indicate that the rapidly
growing monetary use of gold offset a large part of the effects of
increasing gold production between 1840-1860 and 1884-1914. Between
1884 and 1896 prices actually continued to fall after gold production
had begun to climb. Likewise the growing monetary use of gold
accentuated strongly the effects, between 1873 and 1883 of a
comparatively small decrease in gold production.]

Sec. 4. #Index numbers.# The process of calculating general prices and
changes in them has in it, inevitably, something of arbitrariness and
incompleteness. For not all prices can be included, but only those
of articles of somewhat standardized grades and those that are pretty
regularly sold in markets where prices are publicly quoted. Any list
of articles that can be selected is of unequal importance to different
persons and classes of persons, at different places, at different
times, and for different purposes. And yet the study of general prices
as shown by any broadly selected list reveals changes which in some
measure affect the interests of every member of the community.

General prices are conveniently compared from one time to another
through the use of index numbers. An _index number_ of any article is
the per cent which its price at any certain date is of its price at
another date (or of the average for a series of prices) taken as a
base or standard. Thus if the average price of cotton in the base year
were 10 cents (taken as 100) and the price rose to 12 cents, the index
number would be 120. _A tabular index number_ is the per cent which
the price of a selected group of articles at any certain date is of
the price of the same group of articles at a date which has been taken
as the base.[4]

The principal index numbers of the leading countries are here shown.
The fact that from 1862 to 1879 inclusive prices in the United States
were expressed in an irredeemable paper standard makes comparisons for
that period misleading. A better idea is obtained by using as the base
for each of the several series, the average of prices in each country
for the years 1890 to 1899.

Sec. 5. #Gold production and monetary legislation, 1850 to 1879#. The
unprecedented increase in gold production between 1849 and 1853, and
the continuance of production in volume about four-fold as great as
that of the decade 1840-49 was reflected at once in a rise of prices.
This was a period of prosperity in business culminating in the
crisis of 1857 (felt more or less in all the leading countries). This
prosperity accelerated the effect of increasing quantities of the
standard money. Credit was stimulated and the rate of circulation and
the efficiency of money were increased. Prices rose to a temporary
maximum in 1857 and then fell as a great international financial
crisis occurred. The great new supplies of gold had been readily taken
("absorbed") into the monetary circulation of the world, to meet
the needs of rapidly growing commerce and industry. In the European
countries,[5] prices in terms of gold, tho fluctuating somewhat, kept
at about the same level from 1860 to 1870. The years 1871 and 1872
were very prosperous and showed rapidly rising prices which reached a
maximum in 1873, when a financial panic occurred.

In that very year, just as the gold production for the first time
since 1851 had fallen below $100,000,000, several notable changes in
monetary legislation were made which made gold more important in the
circulation of a number of countries.

In 1873 Germany made gold the standard throughout the new German
Empire (having prepared the way by legislation in 1871 which made
gold a legal tender alongside of silver), and provided that silver was
thenceforth to be used only in the subsidiary coinage. The same year
Belgium, and the next year the other countries of the Latin Union
(France, Switzerland, and Italy) took steps which resulted in
demonetizing silver; that is, in limiting its coinage to governmental
account, and in making gold their one standard money.

The United States at that time had neither gold nor silver regularly
in circulation (except in California), and there was a long-continued
discussion of "a return to specie payments," which meant the return
to a metallic standard, and the redemption of greenbacks on demand.
Meantime in 1873 a law was passed making the gold dollar "the unit of
value," and dropping out the standard silver dollar from the list of
coins authorized to be issued at the mint.[6] From 1873 until 1879,
prices (in greenbacks) were falling in this country very rapidly
because the country with the increase in population, wealth, and
business, was "growing up to" its unchanging currency supply. For a
like reason at the same time gold prices throughout the world were
falling. While this country was lowering its level of prices from an
inflated paper money to a gold commodity basis, the gold basis itself
was sinking to a lower level. The very demand of our treasury and
banks for gold caused the retention of our own gold product (which
between 1864 and 1876 had been nearly all exported) and required an
enormous net importation of gold between 1878 and 1888. This
reduced suddenly by one-half the amount available each year from our
production for the rest of the world.

Sec. 6. #Definition of the standard of deferred payments.# These various
changes in the purchasing power of the standard money had great
effects upon industrial conditions. Particularly had they shifted the
positions and claims of debtors and creditors, because of the enormous
importance of money as "the standard of deferred payments," Let us now
get a more definite understanding of that term.

As a medium of exchange, money comes to be the unit in which most
prices are expressed and compared; in other words, it becomes
the common denominator of prices.[7] This makes it also the most
convenient unit in which to express the amount of credit transactions
and of existing debts.[8] A credit transaction is a trade lengthened
in time; one party fulfils his part of the contract, the other party
promises to give an equivalent at a later date. The equivalent may be
in any kind of goods; for example, in barter one may part with a horse
on the promise of a cow to be received later; or a small horse on
the promise of a large one; or a flock of sheep on the promise of
its return at the end of the year with a part of the increase of the
flock. A simple standard in which to express the debt is the thing
borrowed, as horse, sheep, wheat, house. Again, the thing to which
the value of debts is referred may be a thing quite different from the
goods borrowed and, with the growth of the monetary economy and the
use of the interest contract, money comes more and more to be used as
the standard. At length the law declares that, in the absence of any
other agreement, the amount of a debt is to be payable in terms of the
unit of standard money, which thus is made legal tender as well as
the customary standard of deferred payments. A _standard of deferred
payments_ is the thing of value in which, by law or by contract, the
amount of a debt is expressed and payable.

Sec. 7. # Increasing importance of the standard.# Until the use of money
develops, the use of credit is difficult and limited; it becomes
easy when the value of all things is expressed in terms of a common
circulating medium. It therefore generally is true that the importance
of money as the standard of deferred payments increases with the
use of money as a medium of trade. The volume of outstanding debts
expressed in terms of money now very greatly exceeds the total value
of the circulating medium. Changes in the general level of prices
have, therefore, great effects upon all existing debts. The value of
all debts changes in the same proportion as does that of the standard
unit of money; when this rises or falls in value, it means increase
or reduction, in the same ratio, of the purchasing power of every
creditor. It is as if he had in his possession metal dollars equal
in amount to the face of the debt, and they had changed by so much
in purchasing power. The debtor's interests in such changes are, of
course, just the reverse of the creditor's interests.

Outstanding contract debts may be roughly divided into two classes:
short-time loans, running less than a year; and long-time loans,
running for a year or more.[9] Fluctuations are rarely rapid and great
enough to affect appreciably the debtors and creditors in the case
of short-time loans. The results are appreciable in the case of loans
running from one to five years, and may be very great in the case of
loans made for still longer periods, such as the bonded indebtedness
of nations, states, municipalities, and business corporations, and
as mortgages given by farmers on their land or by owners of city real
estate. A multitude of interests are thus affected by a change in the
value of money. When money rises in purchasing power, receivers of
fixed incomes are gainers. When it falls in purchasing power, they
lose. Receivers of fixed incomes from loans include not merely private
investors, but also many educational and charitable institutions which
dispense their incomes for public purposes. Wages and salaries of many
kinds go up and down less rapidly than do other prices, and thus
to some extent wage-earners are in the position of passive
capitalists[10] as regards changes in the monetary standard. In a
capitalistic age, therefore, almost every individual is affected in
some way by a change in the value of money.

Sec. 8. #Fluctuating standard and the interest-rate.# In connection with
the standard of deferred payments there is presented a problem of
the effect that fluctuations of the standard may have upon the
interest-rate.[11] As the general price-level falls or rises, the
monetary standard conversely appreciates or depreciates.[12] If these
changes are slight in amount and imperceptible in their direction
they may not affect considerably the motives of borrowers and lenders.
Therefore, the rate of interest this year in long-time loans would be
just that resulting in the expectation, on all hands, of a stationary
level of general prices. Suppose that rate to be 5 per cent on the
standard investment (such as real-estate loans and good bonds). Then
the lender of $1000 will receive each year a $50 income and at the end
of the investment period $1000 principal, each dollar of which will
purchase the same composite quantum of goods that a dollar would have
purchased at the time the loan was made. Likewise, the borrower would
pay interest and principal in a standard that reflected an unchanging
general level of prices. But, now, if the general level of prices
unexpectedly falls 1 per cent within the year, the creditor of a loan
maturing at the end of the year would receive (principal and interest)
$1050 which will purchase 1 per cent more goods per dollar than the
sum he loaned, or (approximately) $1060 worth of goods. Hence, he
has received, in quantum of goods, a yield of 6 per cent on his
investment. If this change continues for five years, the lender of a
five-year loan would receive each year $50 having a purchasing power
successively 1, 2, 3, 4, and 5 per cent greater than the same sum
had at the making of the loan; and at the end of the five years would
collect the principal, having a purchasing power 5 per cent greater.
The lender, on his part, would have to pay interest and repay the
principal in a money that is to be obtained only in exchange for a
larger sum of goods than that which could be bought with each dollar
that he borrowed. This means that, with individual exceptions,
creditors generally gain and debtors lose by falling prices.

But this is fully true only in respect to loans already made. For just
to the extent that such a movement of prices comes to be more or less
regularly in the same direction, both borrowers and lenders are able
to take it into account, and as experience shows, do take it into
account.[13] When prices fall men become more eager to sell wealth, to
lend the proceeds, and more reluctant to borrow for investment at the
prevailing rate of interest and at the prevailing prices. There is an
incentive to divest one's self of ownership (e.g., by selling stocks)
and to become a lender (e.g., by buying bonds). This whole situation
is reversed in a period of rising prices. The result is that the rate
of interest in any long continued period of falling prices (such as
from 1873 to 1896) has a trend downward and in a period of rising
prices (such as from 1897 to 1915) has a trend upward. This movement
of readjustment would not go on indefinitely, even if the same
trend of prices continued; for in the strict theory of the case the
adjustment would be complete when the interest rate had changed by
just the amount of the annual change in the level of prices. For
example, if 5 per cent is the static normal rate of interest, then
when prices are falling 1 per cent each year, the adjusted rate of
interest would be 4 per cent; and when prices were rising 1 per cent
each year, the adjusted rate of interest would be 6 per cent. Such
adjustments serve to some extent to neutralize the effects of changes
in the standard of deferred payments so far as concerns new loans made
in view of just such a change and in expectation of its continuance.
But no one can foresee exactly, and most persons take little account
of, such a change until it has continued for several years in the
same direction. The adjustment is therefore never very prompt or very
exact. In some years the general level of prices has risen more than
5 per cent, or more than enough to offset the entire interest received
by most lenders. A man with dollars to invest would have been as well
off if he had kept them buried during that period.[14]

Sec. 9. #Notable changes in prices#. In most cases the true effects of
monetary changes escape recognition. In a few cases, however, the
change has been so great as to cause an economic revolution. Such
was the change in prices following the discovery of America, which
occurred soon after the old feudal dues had come to be generally
expressed in terms of money instead of labor services. In modern
times, since the mass of debts has become greater than ever before,
such changes bring even graver economic consequence. The increase in
the output of gold in 1849-57,[15] caused what was the most rapid, if
not the greatest money inflation that had occurred since the sixteenth
century. The substitution of gold for silver by some countries at that
time, by making a great additional market for gold, helped to check
the fall in its value. Indeed, a considerable decline in the output
of gold after 1870 combined with its widening use to cause in 1873 the
beginning of a great fall of gold prices. The resulting increase
in the burden of outstanding debts was felt by all debtors, but
particularly by great numbers of the agricultural classes both in
Europe and in America. Their tribulations were aggravated by the fact
that at that time (especially from about 1873 to 1896) the prices
of their products were falling much more rapidly than were general
prices, as a result of the very rapid extension of the agricultural
land supply.[16] There was complaint, agitation, and demand for relief
on the part of many interests in France, Germany, England, and the
United States. As a result, the money question became in this country
a leading political issue and continued to be such between 1873 and

Sec. 10. #Nature and object of bimetallism.# First came "the greenback
movement," which, lasted until after 1880.[17] This then gave way to
an agitation for bimetallism. _Bimetallism_ is the plan of using two
metals as standard moneys. Bimetallism is legally authorized when both
metals are admitted to the mints for free coinage at an established
ratio of weight. Bimetallism may be legally authorized, but not
actually working, for, if the market-value long continues to vary
appreciably from the legal ratio, only one of the metals may in fact
be left in circulation. This situation is called _limping_ bimetallism
(or the halting double standard), tho this is a contradiction of
terms. National bimetallism is confined to a single country, as was
the case in the United States before the Civil War, or in France
before 1867. International bimetallism is that resulting from an
agreement among several nations to use two metals on the same terms.

The theory of bimetallism is that the government can act on the value
of the two metals through the principle of substitution. The metal
tending to become dearer will not be coined, the other will be coined
in greater quantities. The degree of influence that can thus be
exerted on the value of the two metals depends on the size of the
reservoir of the metal that is rising in value. When it all leaves
circulation, the law on the statute book permitting it to be coined
becomes a mere phrase. In such a case there is bimetallism _de jure,_
but monometallism _de facto._ The greater the league of states the
greater is the likelihood that the plan will continue to work. The
only notable historical instance of international bimetallism is
that of the Latin Union, which united France, Belgium, Italy, and
Switzerland in an agreement remaining actually in force from 1866 to
1874. A strong movement developed between 1878 and 1892 in favor of
forming a great international bimetallic union of states.

One object of the movement was to put an end to the great fluctuations
in the rates of exchange of money between the silver-using and
gold-using countries, fluctuations which occasioned much uncertainty
and loss to individuals engaged in foreign trade. The rise in the
price of gold-exchange in the silver-using countries (notably India)
meant also an increase in their burden of taxation. These countries
collected their revenues in silver, but they had to pay their debts,
principal and interest, in gold. Another object of this movement was
to prevent the burden of individual debts from increasing by reason
of the rise in the value of the single standard, gold. It was, indeed,
hoped that by bringing silver much more into use, the value of gold
would be reduced, thus bringing relief to the debtor classes. Still
another object of the bimetallic movement was to aid the silver miners
and silver-producing districts by creating a larger market for silver.

Several international conferences were held which were taken part
in by some of the leading financiers of the world representing their
respective governments. The United States was foremost in advocating
the policy, France at first favored it, as did in large measure the
British Indian administration, tho England was in the main opposed.
The movement came to nothing.

Sec. 11. #The movement for national bimetallism in America#. When all
hope of international bimetallism failed, the efforts of many of its
advocates were turned to the plan of legalizing national bimetallism
in the United States at a ratio of 16 to 1. This was very different
from the market ratio. Gold had become before 1860, in fact, the
standard of our money system, and after 1873 it was the only metal
admitted to free coinage. Silver, little by little, had been losing
purchasing power in terms of gold, until from being worth, in 1873,
one-sixteenth as much, ounce for ounce, it became, in 1896, worth but
one-thirtieth as much as gold. The power of silver to purchase general
commodities fell much less than the change in its ratio to gold would
indicate, gold having risen in terms of most other goods as well as
of silver. Nevertheless, the proposal to open the mints to the free
coinage of silver at the ratio of 16 to 1 in the year 1896 threatened
a sudden and marked cheapening of money.[18] Probably gold would have
been entirely driven out as money and silver would have taken
its place as the standard. In any event "free silver" would have
accomplished the purpose of making the standard of deferred payments
cheaper. It was at first a debtors' movement, but to succeed it had
to enlist the support of other large classes of voters. And thus
it developed into the more sweeping theory that wages, welfare, and
prosperity were favored by a larger supply of money quite apart from
the effect it would have upon debts.

In its extreme form the free-silver plan was a fiat scheme, for some
of its supporters believed that by the mere passage of the law the two
metals could be made to bear to each other any ratio desired. But its
most intelligent advocates recognized that the force of the law was
limited by economic conditions. The victory of the gold standard in
the campaign of 1896 was, it would seem, due more to the well-founded
fear that a sudden change of the money standard would cause a panic
than to a popular understanding of the question.

The free-silver advocates got what they desired, a reversal of
the movement of general prices, through an occurrence for which no
political party could claim the credit. In 1883 the gold production of
the world was less than $100,000,000. From that date, with the opening
of newer gold-yielding territory in South Africa and in the Klondike,
the annual output of gold had been increasing rapidly and almost
steadily. The methods of extracting gold theretofore had still been in
large part of a primitive sort. But intricate machinery was taking the
place of crude tools, chemical processes had been introduced (notably,
the cyanide process), and the principal product began to come from
the regular and certain working of deep mines rather than from chance
surface discoveries. In many parts of the world were enormous deposits
of low-grade ores, before useless, that could be worked economically
by the new methods.

The general price level fluctuated, but on the whole tended downward
between 1884 and 1893 (the year of panic), and reached a minimum in
the year 1895 in Germany, 1896 in England, and 1897 in America. It
is noteworthy that the very year 1896, which marked the height of the
political agitation to abandon the gold standard for silver, saw the
gold production for the first time in all history surpass the two
hundred million dollar mark. The gold output had caught up with, and
began to surpass, the normal monetary demands of the world, meaning by
that phrase, the amount of gold needed to maintain a stationary level
of prices.

Sec. 12. #Rising prices after 1896#. The whole character of the monetary
problem then changed. A period of rising prices set in, which has
continued to the present time. By 1913 prices had risen just about 50
per cent above the low level of 1896. The rise has been, and still
is, at the average rate of nearly 3 per cent each year. This caused a
reversal of the former positions of advantage and disadvantage on the
part of debtor and creditor respectively. The purchasing power of a
3 per cent annual interest on notes and bonds has been offset by the
decrease in the purchasing power of the principal of the debt. The
burden of the average debt began relatively to decrease. A wide field
for enterpriser's profits was opened up by the rapid displacement of
prevailing prices in all quarters of the industrial world. The price
of manufacturer's products rose in advance of the rise of costs of
many raw materials and especially of the labor costs of manufacture.
The average enterpriser's gain was the average wage-worker's loss.
Wages (and salaries), as nearly always in the case of a change of
price levels, moved more slowly than did the prices of most of the
commodities which are bought with wages, thus causing great hardship
to large classes living on comparatively slowly moving incomes.[19]
Extremes meet, and these classes include both those living on
passive investments, and those dependent on their daily labor for a

Thus we escape the evils of a rising standard of deferred payments,
only to meet those of a falling standard. And as long as we have so
fluctuating a standard these difficulties must arise again and
again, continually repeated, causing unmerited gains and losses
to individuals. Let us conclude with a brief consideration of the
fundamental principles involved in this problem.

Sec. 13. #Defectiveness of the gold standard#. Money is, in general, for
both borrowers and lenders the most convenient standard of deferred
payments. But from the usage of speaking of all things in terms of
gold, arises the popular notion that the value of gold is always
the same, while the value of other things changes. In truth, a fixed
objective standard of value is not possible of attainment. Altho the
value of gold is stable as compared with most things, it rests on the
estimates made by men and is constantly changing with conditions. The
current new supplies of gold are comparatively regular. For centuries
at a time there was little change in the methods of mining gold and
there were no radical changes in its output. The nature of the use of
gold, likewise, is such as to made changes in the amount of it needed,
under ordinary conditions, more stable than is that of most other
goods. Moreover, the stock of gold in monetary uses is but slowly
worn out; it is, therefore, a large reservoir into which flows a
comparatively small stream of annual production; the existing stock
is twenty or thirty times the annual output. Yet the value of gold
expressed in other things is never quite stable, and sometimes
several influences combine to affect it greatly and suddenly. Recent
inventions, chemical and mechanical, moreover, have considerably
altered the conditions of production. While, therefore, it is the
best standard yet devised and put into actual practice, it is very
imperfect. A standard better than a single metal, more stable than a
single commodity, is desirable if it can be found.

Sec. 14. #Various ideal standards suggested.# It may, perhaps, be agreed
that the ideal standard of deferred payments is one that would insure
justice between borrower and lender. Yet different views may be and
have been taken as to what constitutes justice in this matter. The
suggestion is attractive that repayment should involve the return of
enjoyment equal to that which could be purchased with the sum at the
time of the loan. Such a standard is impossible of perfect realization
in any general way, for men's circumstances are constantly changing.
To insure even to the average man the same amount of enjoyment is only
roughly possible. The same goods do not afford the same enjoyment
when conditions, either subjective or objective, have changed. Another
suggestion is that the goods returned should represent the same
sacrifice as those loaned. Here again the difficulty is in the lack of
a standard applicable to all men. Whose sacrifice? That of the lender,
who may be rich, or that of the borrower, who may be poor? Some have
supposed that the condition of equal sacrifices was met by the labor
standard, according to which the sum returned should purchase the same
number of days of labor as when borrowed. But what kind of labor is to
be taken, that of the lender or that of the borrower or that of some
one else? Labor is of many different qualities, which can be exactly
compared only through their objective value in terms of some one

It must be recognized that any possible concrete standard of deferred
payments will sometimes work hardship in individual cases. The best
average results for justice and social welfare will be secured by
measuring debts in some standard that will change least often, and
least rapidly, in relation to the great majority of people of all
classes in the community.

Sec. 15. #The tabular standard.# Apart from the difficulties of its
practical operation, a standard better than a single metal and
more stable than a single commodity would be a _tabular standard_,
consisting of a number of leading commodities in fixed proportions,
such as is used in calculating index numbers expressing the general
scale of prices. Such a standard averages the fluctuations of
particular goods and would give a fair approximation in practice to
the ideals of equal sacrifice and equal enjoyment (on the average tho
not in individual cases). While some natural materials are growing
more scarce and call for more sacrifice, other products are by
industrial progress becoming more plentiful. This kind of standard has
been viewed with favor by many monetary authorities, and despite the
administrative difficulties ways may yet be found for putting it into

After determining the tabular standard, the actual regulation of the
quantity of money to make prices conform to the standard might be
accomplished in one of several ways. It might be done by letting the
value of the gold dollar fluctuate as it does now, while requiring
a greater or less number of dollars to be given in fulfilment of all
outstanding contracts. For example, if prices by the tabular standard
fell from 100 to 95 in the time between the origin of a debt of $100
and its payment, the debt would be discharged by paying $95; if prices
rose to $110, the debt would be discharged only by the payment of

By the plan of a "compensated gold dollar" the legal weight of the
gold coins would be increased or decreased from time to time to
conform with the tabular standard. Still a third method would be to
regulate the issue of standard paper money, contracting and expanding
its amount by issue and redemption, by deposit in and withdrawal from
depository banks, at regular intervals to bring prices into conformity
with the tabular standard. These are as yet but distant possibilities,
and for some time to come gold will continue to serve as the standard
money in the same manner as in the past.

[Footnote 1: The amount of silver is here expressed at its coining
value; this is not the commercial value, but rather the number of
silver dollars 371.25 fine grains weight that could be made out of
the silver produced. Silver and gold of equal coining value are,
therefore, as to weight always in the ratio of 16 to 1.]

[Footnote 2: See above, ch. 5, sec. 4.]

[Footnote 3: See Vol. I, p. 45 ff. See also above, ch. 4, sec. 8.]

[Footnote 4: Numerous tabular index numbers have been worked out for
different countries and periods. The main results of the more recent
ones have been brought together with critical comments, by Professor
Wesley C. Mitchell, in Bulletin 173 of the U.S. Bureau of Labor
Statistics, July, 1915, from which the figures here used are quoted.]

[Footnote 5: The price movements in the United States between 1860 and
1879 must be left out of consideration here, for the excessive issues
of greenbacks drove gold out of circulation and made greenbacks the
standard money, except in California and elsewhere on the Pacific
Coast where, by public opinion, gold was retained as the circulating

[Footnote 6: This change was what later was referred to in political
discussions as "the crime of '73." The dollar referred to was the
_standard_ silver dollar; at the same time the coinage of a _trade_
dollar was authorized (intended to be used only in foreign trade),
which, after 1876, was not legal tender in the United States.]

[Footnote 7: See Vol. I, p. 262.]

[Footnote 8: See Vol. I, p. 263, on credit transactions, and p. 302,
on the interest contract.]

[Footnote 9: See Vol. I, p. 304.]

[Footnote 10: See Vol. I, p. 319.]

[Footnote 11: This could not be treated in connection with the
interest-rate in Vol. I, Part IV, for the reason that even its
elementary treatment must presuppose the fuller study of the nature of
money and the study of changes in the level of prices, that has just
been given in this and the three preceding chapters. The theory of
interest in Vol. I, therefore, is a static theory in respect to the
standard of deferred payments, and requires adjustment to apply to a
condition of a changing price-level.]

[Footnote 12: See above, sec. 3.]

[Footnote 13: Mention was made in Vol. I of the prospect of profit
as affecting the motives of commercial borrowers; e.g., pp. 298, 335,
348, 495.]

[Footnote 14: The modern explanation of this phenomenon was worked out
in the period of falling prices before 1896 and hence was referred to
as the theory of "appreciation and interest" (meaning the relation of
the appreciating dollar to a falling rate of interest). More generally
the theory is that of the relation of a changing standard of deferred
payments and the rate of interest.]

[Footnote 15: See ch. 4, sec. 12, and above secs. 1, 2, 4, 5.]

[Footnote 16: See Vol. I, on agricultural leases, p. 159, wheat
prices, p. 436, and changes in the land supply, p. 442.]

[Footnote 17: See ch. 5, sec. 11.]

[Footnote 18: The advocacy of this proposal was called "the
free-silver movement" because it involved resuming the free coinage of
silver at the legal ratio of 16 to 1.]

[Footnote 19: This happened to coincide with a relative increase of
the price of food-products and of other necessities of daily life at
a greater rate than general prices. This aspect of the much discussed
rising cost of living must be carefully distinguished from that of
the change of the _general_ price level, and also from that of the
relatively slower change of wages. See Vol. I, pp. 437, 445-446 on
population and food supply.]

[Footnote 20: See on the labor theory of value, Vol. I, pp. 210,
228-229, 502.]





Sec. 1. Nature and classes of banks. Sec. 2. Functions of banks. Sec. 3. The
essential banking function. Sec. 4. Time deposits. Sec. 5. Demand deposits.
Sec. 6. Discount and deposit. Sec. 7. Nature of banking reserves. Sec. 8. Bills
of exchange, domestic. Sec. 9. Issue of notes. Sec. 10. Divergent views of
typical bank notes. Sec. 11. Banking credit as a medium of trade. Sec. 12.
Productive services of banks. Sec. 13. Income of banks.

Sec. 1. #Nature and classes of banks.# Banks perform a variety of useful
functions in every modern community. All these functions touch in some
way upon the use of money, and banking problems always are related to
money problems. It is our purpose now to understand the general nature
and work of banks in relation to the general business activity of the
community. A bank, as one first comes to know it, is a building (or
a room in some building) in which there is a fire- and burglar-proof
safe. In this room are men receiving and paying out money and acting
as bookkeepers. Gradually one comes to understand that the bank is
perhaps not the building but the business organization that is there
performing these transactions.

In the United States there were in 1913 about 26,000 banks
reported.[1] These may be classified first according to the source
from which they derive their charters or authority to do a banking
business as: national, state, and private. The last are unchartered
and act under the general state laws governing private contracts;
in general they are unsupervised.[2] Banks may be classified also
according to the two main types of business they perform, as banks
for savings and commercial banks. Most banks do mainly a general
commercial business; some are distinctly banks for savings; but in
truth this dividing line can be less and less sharply drawn between
banks as wholes; rather the distinction must be made between the
savings function and the commercial discount function, which are more
and more being performed by one and the same bank. The trust company
usually well exemplifies this union of functions. This will best be
explained in connection with the subject to which we now turn, the
analysis of the functions which banks perform.

Sec. 2. #Functions of banks.# Almost every bank performs various
functions useful to its customers, but some of which are not
essentially bound up with banking, and may be performed by
institutions that are not truly banks. Among these are:

(a) Maintaining a safe deposit vault, where space may be rented by an
individual to keep his valuable papers, jewels, etc. The customer
does not usually deliver to the bank possession of the valuables,
but himself retains the key to the box which the bank has no right
to open. In larger cities this work is often done by separate

(b) Acting as money-changer to buy and sell moneys of different
nations. This function is of less importance in America than elsewhere
because of the great size of our country and of the small portion
of our boundaries touching those of other nations using different
monetary units. Moreover, the function is in large part performed for
Americans by ticket agencies at the ports of embarkation and by the
steamship companies en route.

(c) Selling bonds and other investments to customers. In smaller
communities the customers of a bank turn to it as the best source
of information for safe investments of personal or trust funds. This
opens to it a new possibility of service. Large investments, however,
are usually made through the agency of more specialized investment

(d) Acting as trustee and business manager for passive investors, and
especially as executor and administrator of estates or as guardian of
a minor heir. This function has been taken up rapidly since about 1890
by the trust company[3] organized under state laws.

Sec. 3. #The essential banking function.# The one essential function of
a bank, however, is selling (lending) its credit to its customers in
some form which will conveniently serve the same function as money. A
bank is sometimes defined as a business whose income is derived from
lending its promises. The bank's credit is sold in the form of its
promises, the evidences of which are its receipts, depositors'
account books, drafts and checks on other banks, and bank notes. The
indispensable condition to the exercise of this function by a bank is
public confidence in its ability to fulfil its promise to pay whenever
it is due. This confidence is built upon the bank's paid-up capital;
its surplus and undivided profits: the further liability of the
stockholders to make good any losses up to an amount equal to the
capital stock each holds ("stockholder's double liability");
the financial prestige of the bank's officers, directors, and
stockholders; the bank's established reputation and "good will" in the
community after a period of successful operation; the character of
its loans and of the securities which it owns; and, finally, by the
reliance placed in the control and inspection by official examiners.
The bank may then sell its credit in any one or in all of the
following five ways: (1) by receiving time deposits; (2) by receiving
demand deposits; (3) by the method of discount and deposit; (4) by
selling exchange of funds to distant points; (5) by issuing bank

Sec. 4. #Time deposits.# Time deposits are funds to the credit of
customers which, by agreement, are to be left for some specified
minimum time or on condition that the bank may require notice in
advance of the depositor's intention to withdraw them. The notice that
may be required is usually thirty to ninety days; but only in times
of general financial crises or of runs on particular banks is this
requirement enforced. A sufficient deterrent to irregular withdrawal
of funds is usually found in the loss of interest if deposits are
withdrawn at other than stated times. The bank's right to require
notice makes prudent the investment of a much larger proportion of its
deposits and for a longer time; it reduces the proportion of deposits
needed for reserves, and yet reduces the danger of a "run" upon the
bank in time of financial distress. These are reasons why banks can
and usually do pay interest on time deposits (at from 2 to 4 per
cent), as until more recently they rarely did on demand deposits[4].
From the standpoint of the depositor a time deposit is, by its very
nature, an investment and not a demand credit available for current
monetary uses. Only that portion of a person's capital that for some
more or less considerable period is not likely to be needed for other
purposes ought to be put into time deposits. A bank, however, is
generally a much safer place in which to keep a fund of purchasing
power for the future than is the strongest private treasure box.
Receiving time deposits is the one essential function of savings
banks, but this function is increasingly performed by other banks[5].
Sometimes time deposits are cared for by a separate department and
kept separate from the general business of a commercial bank.

Sec. 5. #Demand deposits#. Demand deposits are those payable on demand,
the demand in practice being by means of personal checks requesting
the bank to pay to (or on the order of) a specified person, or to pay
to bearer. A customer's bank account consisting of demand deposits is
called a checking account. Since the turn of the century it has become
increasingly the practice to pay a low rate of interest (about 2 per
cent) on current balances, oftener to large depositors. Banks attract
demand deposits mainly by the convenience and economy which they offer
to their customers in the guarding of funds from theft and fire and
in saving the time, trouble, and expense of carrying money for making
payments. A deposit in a bank is to the depositor for most purposes
"just as good" as money in the pocket and for many purposes is
even better. Thus the banks have become the custodians of a large
proportion of the money (or funds) needed for current use by
individuals and business corporations.

Sec. 6. #Discount and deposit#. The process of discount and deposit is
the purchase of the promissory note of a customer,[6] the price being
a credit in the form of a demand deposit on the books of the bank.
This--the central and most characteristic banking operation--has
something of mystery in it at first view. The simplest idea of making
a deposit is that of bringing to a bank window bags and rolls of money
or other funds (credit papers such as checks and drafts, calling for
the payment of money). The bank in that case becomes the debtor and
the depositor becomes the creditor of the bank. But in discount and
deposit the depositor brings no money, and the credit paper that he
gives is his own promise to pay whereby he becomes the bank's debtor.
For example, when a bank discounts a thousand dollar note for three
months and credits its customer with the proceeds, its deposits are at
that moment increased (let us say) $985. Notice that hereby the bank
does not add a cent to the cash in its vaults while it has added to
its liabilities payable on demand. As an off-setting asset it holds
the note of its customer receivable at some future time.

Sec.7. #Nature of banking reserves#. Banks would have nothing to gain by
receiving deposits or by issuing notes if they were obliged to keep
in the vaults actual money to the amount of their deposits and
outstanding notes (unless they were paid by depositors for taking care
of deposits). Banks have found it necessary in practice to keep on
hand money amounting to only a fraction of all their outstanding
obligations in order to be able to pay promptly all due demands,
excepting in periods of general financial distress. The sum thus kept
on hand is called the _reserve_ or the _reserves_ of the bank, and
this is frequently expressed as a percentage of reserves against
deposits or against note issues, respectively. Frequently, as in the
United States, a minimum percentage of reserves is fixed by law.[7]

A bank's reserves consist, first, of the lawful money which it
actually holds in its vaults at any moment and secondly, of certain
other credit items in other banks or with the government, of such
a nature that a bank is permitted to count them as tho immediately

The explanation of the adequacy of a mere fractional reserve is
found in the nature of the individual monetary demand[8] and in the
effective way in which a checking account serves as a substitute for
actual money.[9] Every customer, if he would avoid overdrawing his
account, must at most times keep a goodly balance to his credit that
he does not immediately need. Many individuals and corporations must
at times keep very large balances. The times of maximum monetary need
of the customers of a bank never exactly coincide and many payments
are made among the customers of a single bank, requiring only
bookkeeping transfers. A fractional reserve is therefore ordinarily
fully adequate, altho with any less than a 100 per cent reserve
any bank would be insolvent if all of its demand obligations were
presented at the same instant. Such a contingency is made impossible
by business custom and public opinion especially among the larger
customers of banks, but the panic of small depositors often brings
about dangerous conditions.

Sec. 8. #Bills of exchange, domestic.# Foreign and domestic exchange
is the sale of orders for the payment of specified sums of money
at distant points. But for this, payments at distant points would
ordinarily have to be made by sending the money in some way. It must
often occur, for example, that hundreds of payments, aggregating
millions of dollars, must be made by persons in and near Chicago to
those in and near New York, while, at the same time, equally large
sums are due from New York to Chicago. The wasteful process of
shipping these sums back and forth is avoided by the cancellation of
indebtedness between the two localities. It has been the practice for
each small bank to keep a part of its legal reserves in correspondent
banks in one or more of the larger cities on which it draws bills
of exchange for its customers and to which in turn it remits for
collection drafts and checks which it has received. From time to
time, as balances of accounts increase on the one side or the other,
shipments of actual money become necessary, but these are only a small
fraction of the total amount of the bills of exchange. Similarly, the
settlement of accounts between any two localities can be made by
the shipment of comparatively small sums of money. Under the Federal
Reserve Act the reserve banks are in various ways assuming the
functions of the correspondent banks.

The wider use and acceptance of individual checks at long distances
from the banks upon which they are drawn limit by so much the
proportion of special bills of exchange drawn by the banks themselves.
Domestic exchange involves just the same principles as foreign
exchange of funds, except that in the latter, usually, two different
units of standard money are used. In connection with the discussion of
foreign trade below, foreign exchanges will be explained and further
light will be thrown upon the adjustment of the money supplies and
levels of prices of the various sections of a single country as well
as between different countries.

Sec. 9. #Issue of notes#. The issue of bank notes as a mode of lending a
bank's credit calls for consideration here. Yet it must be observed
at once that comparatively few banks in the world have now the legal
right to issue their own notes. In some cases the right has been
granted as a monopoly to certain banks in return for specified
payments and services. But in general the function of bank note
issue has come to be treated as so closely connected with that of
the coinage and regulation of the standard money that it has been
increasingly limited in each country to a central national bank,
or group of banks, which is in many respects practically if not
technically an organ of the government. This public nature of bank
note issues has been strikingly evident in Russia, England, France,
Germany, and other countries since the outbreak of the war in 1914.

No two countries have quite the same system and kind of bank notes.
It is well to consider first, therefore, the qualities of typical bank
money. This consists of notes issued by banks on the credit of their
general assets, without special regulation by law. With such a form of
note we have had until 1914 no experience in the United States since
1866, at which time a federal tax of 10 per cent on state bank notes
made their issue unprofitable. Since the passage of the Federal
Reserve Act we have temporarily two kinds of national-bank notes, the
old bond-secured notes, in use since 1863 (very different from the
typical form),[10] and the new kind of Federal reserve notes very
nearly typical in character but issued only by the Federal reserve
banks, not by individual banks.

A bank, by the issue of notes, puts into circulation as money its own
promises to pay. The customer, in borrowing money or in withdrawing
deposits or cashing checks and drafts from other banks, is paid with
the bank's notes instead of with standard money. These notes may be
returned to the issuing bank either to be redeemed in specie or to be
paid in some other form of credit, such as deposits or exchange. The
limit of the issue of such notes is the need of the community for that
form of money, and if they are promptly redeemed in standard money on
demand, they never can exceed that amount. A holder of a note (in the
absence of special regulations) has the same claim on the bank that
a depositor has. As it is to the interest of the bank to keep in
circulation as many notes as possible, there is a temptation to abuse
the power of note issue, to which many banks in America yielded in the
period of so-called "wild-cat" banking before the Civil War.

Sec. 10. #Divergent views of typical bank notes#. Some persons seeing in
bank notes but a form of ordinary commercial credit (like a promissory
note or an individual's check) have contended that their issue should
be entirely unlimited and unregulated except by the ordinary law of
contract which makes the bank liable to redeem the notes on demand.
Such bank notes would not be legal tender, and every one would be free
to take or refuse them as he pleased. Each bank would thus put into
circulation as many notes as it could, and as they would constantly
be returned for redemption when not needed as money their volume would
expand and contract with the needs of business.

It may be conceded that there is much truth in this view, but not the
whole truth. For, in reality, when bank notes are in common use, every
one is compelled to take the money that is current. This offers a
constant temptation to the reckless and unscrupulous promotion of
banking enterprises, as has been repeatedly shown (notably in America
in the days of "wild-cat" banking before 1860). The average citizen
cannot know the credit of distant banks, and thus has not the same
power of judging wisely in taking bank notes that he has even in
making deposits in the bank of his own neighborhood. Between bank
notes and ordinary promissory notes there are other differences. Bank
notes pass without endorsement and thus depend on the credit of the
bank alone, not, like checks, on the credit of the person, from whom
received. Unlike ordinary promissory notes, they yield no interest
to the holder. They go into circulation and remain in circulation for
considerable time by virtue of their monetary character in the hands
of the holders. Thus they approach political money in their nature,
and the banks are near to exercising the sovereign right of the issue
of money.

At the other extreme of view have been those who consider bank notes
to be essentially of the nature of political money. If they are so, it
is argued, the power of issue should not be exercised by any but the
sovereign state. In this view it is overlooked that bank notes, unlike
inconvertible paper money, depend for their value on the credit of the
bank, not on their legal-tender quality and on political power.[11]
They must be redeemed on penalty of insolvency; government notes need
not be, and yet will circulate at par if properly limited. Adequate
provision for the prompt return and redemption of bank notes makes
them "elastic" in their adaptation to monetary needs, which fluctuate
with changes in commerce and industry from season to season and even
from day to day.

The predominant opinion to-day is that in their economic nature bank
notes share to some extent the character both of private promissory
notes and of political paper money. They stand midway between the two.
Everywhere it has come to be held that the issue of paper money of any
kind is in its nature a public monopoly, and yet everywhere the
bank note policy has come to be that of permitting the issue only to
certain institutions, under strict public legislation and regulation,
and of requiring in return for this privilege some substantial
services or payments to the government.

Sec. 11. #Banking credit as a medium of trade.# The credit which, in five
ways, banks sell (see above, section 3) serves, in most cases, the
purposes of money to their customers. This is least true of time
deposits, for the motive of the depositor in such cases is usually to
_invest_ his funds for a time rather than to keep them available as
money. However, there are many cases in which persons save for some
moderately distant use--such as the purchase of furniture, of a piano,
of a house. The safety and convenience of time deposits, combined
with the reward of a small rate of interest, cause great sums, in the
aggregate, to be deposited as _temporary_ savings, which otherwise
would be hoarded in the form of money and thus withdrawn from
circulation. In all such cases the time deposit is serving both as
an investment and as a monetary fund for future use. This is a great
economy in the use of money, for experience shows that in the savings
banks of America the average reserves of actual money kept against
deposits are only about 1-1/2 per cent. In countries where banks are
little known, the amount of actual money hoarded is therefore vastly
greater than it is in the United States where there are $5,000,000,000
of individual deposits in _regular_ savings banks, besides large sums
in time deposits in commercial banks.

Demand deposits, while not money, clearly perform the function of a
reserve of purchasing power for depositors and reduce by so much the
amount of money each must keep at hand to meet his current needs of
purchasing power. If the depositor's credit balance bears no interest,
he has no motive to keep a balance greater than he would require
of actual money, and he has the motive to spend it or invest it in
income-bearing capital whenever his balance (plus his cash in hand)
exceeds his monetary needs.[12] Thus demand deposits are often spoken
of (somewhat inaccurately) as "deposit currency," being funds at
the command of depositors which are as disposable and as active and
current for the monetary function as so much actual money would be.
It is estimated that the rate of turnover of deposits in the United
States is about 50 times a year. We may view the demand deposits
subject to check as either a substitute for money or as a means by
which the rapidity of circulation and the monetary efficiency of
actual money held in bank reserves is multiplied many fold.[13]

The method of payment by bank drafts in domestic exchange reduces the
need for, or increases the efficiency of, money in just the same way
as does the use of checks. By the mutual credit of banks in different
parts of the country, very large payments may be made in both
directions with the movement of only the comparatively small amount
of physical money needed to pay the balance after the cancellation of
drafts, bills of exchange, and checks.

The use of bank notes reduces the amount needed of other kinds
of money more directly, tho not more effectively, than do deposit
accounts. Bank notes _are_ money, and so long as their amount is
limited by prompt redemption they circulate _instead of_ so much of
other kinds of money. Redemption is possible by the use of a reserve
of standard (or of legal tender) money very much smaller than the
amount of notes outstanding.

Sec. 12. #Productive services of banks.# There have always been some
erroneous ideas regarding the magic power of banks to multiply the
power of money. But there should be no more of mystery about
banking credit than about the nature of money itself. Banks are the
labor-saving machinery of finance. They gather loanable funds, reduce
hoarding, make money move more rapidly, and create a central market
between borrowers and lenders for the sale of credit. While not
creating more physical wealth directly, they add to the efficiency
of wealth; they simplify and quicken the movement of nearly all
commercial transactions. Banks perform incidentally a further service
in developing better business methods in the community. They enforce
promptness and exactitude in business dealings. In supplying credit to
enterprises, banks are constantly passing judgment on the collateral
security presented to them and on the soundness of the enterprises
that are seeking support. This gives to bankers great economic power,
capable at times of misuse in political and social affairs, especially
where a group of selfish men come to exercise a practical monopoly of
business credit in any community.

Sec. 13. #Income of banks.# The income of banks is drawn from different
sources, according to the size of the community and the nature of the
banks. While in the villages and smaller cities the commercial banks
perform a number of functions, in the larger cities they usually
specialize in a far greater degree. The trust companies, however, with
their greater versatility, are increasing in number. The income
of banks is derived from discounts, interest on their own capital,
charges for exchange and collection, dividends, interest and rents on
investments, and profit from their bank notes. The capital with which
a bank starts in business[14] could be loaned with less trouble and
more cheaply without starting a bank, but used as a banking capital it
can be loaned in part while still serving to attract deposits, which
are the main source of the income of banks to-day. Charging smaller
customers for exchange is a source of income to some banks, but in
many cases this service is freely performed for regular customers and
becomes a considerable expense. Banks make few investments in real
estate or other physical property; it is, in fact, their duty to keep
out of ordinary enterprises, but they are forced sometimes to take for
unpaid debts things that have been held as security. Profits on
bank notes have at times been the main, almost the sole, motive for
starting banks; but that is not the case to-day when the right of
issue is so strictly limited.

[Footnote 1: These are classified as follows:

_Number_ --_Per Cent_--
_National charter_: 28.56
National banks 7,404 28.56
_State charter_: 67.52
State banks 14,011 54.05
Loan and trust companies 1,515 5.84
Savings banks 1,978 7.63
_Private_: 3.92
Private banks 1,016 3.92
------ ------ ------
25,924 100.00 100.00

[Footnote 2: Opinion favors prohibiting the use of the word bank
to any except regularly incorporated organizations, or at least
subjecting private banks to the same supervision as the chartered

[Footnote 3: Not to be confused with a trust in the sense of a
monopolistic enterprise, with which it has no connection except by
mere verbal accident, through the word trust.]

[Footnote 4: See next sec.]

[Footnote 5: The Federal Reserve Act of 1913 has given encouragement
to this practice by reducing to 5 per cent the reserve required to be
kept against time deposits. See ch. 9, sec. 7.]

[Footnote 6: Usually with deduction of interest in advance; a process
called discount. See Vol. 1, pp. 275, 302.]

[Footnote 7: The legal requirements as to minimum reserves vary
greatly from no specific per cent to 40 or more in different
countries, for different classes of banks, and for different purposes.
Some examples of legal reserve requirements in the United States occur
in the two following chapters.]

[Footnote 8: See above, ch. 4, sec. 5.]

[Footnote 9: See below, sec. 10.]

[Footnote 10: Including, now, some Federal Reserve bank notes secured
by United States bonds.]

[Footnote 11: In some cases, as during the bank restriction in
England, 1797-1821, bank notes become inconvertible--practically
political money.]

[Footnote 12: Payment of interest on credit balances reduces the
motive to withdraw for investment elsewhere any such excess, and
mingles in the depositor's thought monetary and investment motives.]

[Footnote 13: In the United States in 1914 there were individual
deposits reported in banks other than savings banks to the amount of
about $13,400,000,000

In national banks .................................. $6,000,000,000

In state banks ..................................... 3,250,000,000

In loan and trust companies .......................... 4,000,000,000

In private banks ..................................... 150,000,000

Nearly all these were doubtless demand deposits (what proportion were
time deposits we have no data for determining), and were available as
immediate purchasing power for the depositors. The total money (other
than bank notes) in the commercial banks of the country was hardly 11
per cent of this amount. In that year the total amount of money of all
kinds in circulation (and in banks) in the United States (outside the
Treasury), including gold and silver and certificates represented
by bullion in the treasury, United States notes of all kinds, and
national bank notes, was about one fourth of the amount of these
individual deposits in commercial banks. This may suggest the enormous
influence that banking has in determining the average efficiency of
the circulating medium of the country.]

[Footnote 14: See above, sec. 3.]



Sec. 1. The First and Second Banks of the United States. Sec. 2. Banking
from 1836 to 1863. Sec. 3. National Banking Associations, 1863-1913.
Sec. 4. Defects of our banking organization before 1913. Sec. 5. Lack of
system. Sec. 6. Inelasticity of credit. Sec. 7. Periodical local congestion of
funds. Sec. 8. Unequal territorial distribution of banking facilities.
Sec. 9. Lack of provision for foreign financial operations. Sec. 10. The
"Aldrich plan."

Sec. 1. #The First and Second banks of the United States.#

A knowledge of the history of banking is helpful to an understanding
of the present banking system in our country. The form of our present
banking system has been affected by various economic and political
events which will be sketched here in broad outline to give a
background for our present study.

Alexander Hamilton, the great first Secretary of the Treasury in
Washington's cabinet, advocated the charter of a central national
bank as one portion of his larger plan of national financiering. His
purpose was realized in the chartering, in 1791, of the First Bank of
the United States, for a period of twenty years. The capital for this
institution was in small part subscribed by the government, but mostly
by private capitalists. The management of the bank was left almost
entirely in private hands. The central bank established branches
in many parts of the country, issued bank notes which circulated
everywhere without depreciation, acted as the governmental depository
of funds and as governmental agency in various ways. It seems to
have been successful and useful as a banking institution until
the expiration of its charter in 1811, but it was touched by the
contemporary controversies over state rights and was from the first
opposed by those who feared the growth of a strong central government.
This opposition prevented the extension of its charter.

In 1816, however, after only a moderate discussion, the Second Bank
of the United States was chartered for a period of twenty years. This
also, in its purely banking aspects, seems to have been distinctly
successful, conducting numerous branches in various parts of
the country, maintaining at all times the parity of its notes,
facilitating domestic exchange throughout the country, and enjoying
unquestioned credit and solvency. However, this bank became, even in
a greater degree than did the First Bank, the creature of political
rivalries. In the period of rising democratic sentiment typified
and led by Andrew Jackson, the bank came to be looked upon as the
embodiment, or the stronghold, of plutocratic interests, and Congress
permitted its charter to expire by limitation in 1836, near the close
of Jackson's administration.

Sec. 2. #Banking from 1836 to 1863#. The Federal Government, which up to
that time had deposited its funds in the central bank and its branches
and in local state banks, established the "independent treasury," in
1840 (abolished in 1841 and re-established in 1846). By this plan the
government kept its money of all kinds in various depositories (or
sub-treasuries) in charge of public officials. While from 1792 to 1836
almost continuously a central banking system was in operation, other
banks, organized under state charters, were steadily increasing in
number. They received deposits, issued bank notes under state laws,
and cared for local commercial needs. The abolition of the central
national bank in 1836 left to the various state banks for twenty seven
years all the banking functions of the country. The banks of some
states (notably those of New England and New York), under careful
regulation and held to strict standards by public sentiment, for the
most part maintained a high credit; but many banks, under lax laws and
regulations, were guilty of great abuses of credit and of downright
dishonest practices. The evils were more especially evident in
connection with excessive issues of bank notes.

Sec. 3. #National Banking Associations, 1863-1913#. The next step in
federal legislation was taken in 1863 in the midst of the Civil War by
chartering local "national banking associations." The purpose was in
part to provide banks under national charters for banking purposes
(both of deposit and of issue), and in part it was to make a wider
market for United States bonds at a time when government credit was
at low ebb. The plan adopted followed the experience of New York state
(1829 on) with a system of bond-secured bank notes. Congress provided
that every bank taking out a national charter must purchase bonds of
the United States and deposit them with the treasurer of the United
States, in return for which it would receive bank notes to the amount
of 90 per cent of the denomination or of the market value of the
bonds.[1] Bank notes issued on this plan, being secured by the bonds,
rest ultimately on the credit of the government, not on the credit of
the bank. They are not promptly sent back for redemption to the banks
issuing them, as should be done if they were typical bank notes. They
may circulate thousands of miles away from the bank that issued them,
and for years after the bank has gone out of business. They are not
an "elastic currency," increasing or diminishing with the needs of
business. The changes in their amount depend upon the chance of the
banks to make more or less in this way than by any other use of their
capital, and this in turn depends largely on the price of bonds and on
the rate of interest they bear. From 1864 to 1870, fortunes were made
from this source, but thereafter banks could make little more from
note issues than they could by investing the same amount in other
ways. Many banks for a long period did not avail themselves in the
least of their privilege of issue. The notes were subject to a tax.[2]

A national bank (as the law now stands) may be organized, with $25,000
capital in towns not exceeding three thousand population, with $50,000
in towns not exceeding six thousand, with $100,000 in cities not
exceeding fifty thousand, and with $200,000 in large cities. Three
cities, New York, Chicago, and St. Louis, have long been designated as
central reserve cities, and some 47 other cities as reserve cities,
in which the reserves of banks were required to bear a considerably
larger proportion to their deposits than in other cities.[3] Other
banks might count as part of their legal reserves their deposits in
reserve city banks, up to a certain proportion. The national banks in
the larger cities thus became the great capital reservoirs of cash for
the whole country.

National banks have been subject to stricter inspection than have been
the banks in most of the states, a fact which has strengthened public
confidence in their stability. Except in this and the other respects
above mentioned, a national charter offered few, if any, attractions
to small banks, a majority of which have found it more advantageous to
operate under state charters because of less stringent regulations as
to amount of capital, reserves, and supervision.

Sec. 4. #Defects of our banking organization before 1913#. Taken
altogether, the banks in the United States since 1868 have represented
great banking power and very efficient service for the community in
times of normal business. But in several respects it long ago became
evident that our banks were operating less satisfactorily than those
of several other countries. American banking organization had failed
to keep pace with the increasing magnitude and difficulty of its
task. Especially at the recurring periods of financial stress, such as
occurred in 1893, 1903, and 1907, our banking machinery showed itself
to be wofully unequal to the strain put upon it. Financial panics
were more acute here than in any other land, and the evil clearly
was traceable in large part to defects in the banking situation. In
academic teaching and in public conferences of bankers, business men,
publicists, and students, the subject was continually discussed
after 1890. At length Congress in 1908 created a "National Monetary
Commission" to inquire into and report what changes were necessary and
desirable in the monetary system of the United States or in the laws
relative to banking and currency. After the most extended inquiry
and discussion that the subject had ever received, the commission
submitted its report in January, 1912. The defects to be remedied,
as enumerated in the report,[4] may be reduced to the following five
headings: (a) Lack of system, (b) Inelasticity of credit, (c) Periodic
local congestion of funds. (d) Unequal territorial distribution of
banking facilities. (e) Lack of provision for foreign banking.

Sec. 5. #Lack of system#. Only in a loose sense could the banks of the
United States be said (before 1914) to constitute a system at all.
Both national and state laws dealt with individual banks only. It was
not legal for a bank to establish branches in another city as is done
in most countries. The several national banks in one city were legally
quite separate. It was only by voluntary agreement that in some of
the larger cities they came together into clearing-house associations.
They made possible some measure of cooeperation which, small as it
was, proved at times of stress to be of much service within a limited
sphere for the local communities. But even with the aid of these
organizations the banks were unable in times of emergency to avoid the
suspension of cash payments.

There was no provision whatever for the concentration of bank revenues
so that each bank would be supported by the strength of the other
banks, if a movement began to withdraw deposits in unusual amounts.
Each bank then was compelled for self-protection to call for any sums
it had deposited with other banks,[5] and to keep for its own use all
the reserves it might have in excess of its own immediate needs. This
threw a great strain upon the banks in the reserve cities, which
in normal times had become the depositories of a good part of the
reserves of the banks in other places. Thus developed a spirit of
panic, like the fright of theater-goers crowding toward the door at
the cry of fire.

The maintenance of the government's independent treasury contributed
to the difficulties by causing the irregular withdrawal of money from
circulation and thus depleting bank reserves in periods of excessive
government revenues and by returning these funds into circulation only
in periods of deficient revenues. Efforts to modify this system by
a partial distribution of the public moneys among national banks had
resulted, it was charged, in discrimination and favoritism in the
treatment of different banks and of different sections of the country.

Sec. 6. #Inelasticity of credit#. Our banks, considered both separately
and collectively, were unable to increase their loaning powers
quickly and easily to respond to business needs. The need of greater
elasticity of credit was felt in the more or less regular seasonal
variations within the year, and in the more irregular variations
in cycles of years from periods of prosperity to those of panic and
depression in business. The inelasticity was necessitated by illogical
federal and state laws restricting absolutely the further extension of
credit when the reserves fell below the percentage of deposits (15 or
25 per cent) fixed by law. Reserves thus could not legally be used to
meet demands for cash payments at the very time when most needed.
This feature has been likened to the rule of the liveryman who always
refused to allow the last horse to leave his stable so that he would
never be without a horse when a customer called for one. The refusal

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