of credit by the banks at such times when they still had large amounts of cash in their vaults increased the need and eagerness of the public to draw from the bank all the cash they could, and often precipitated the insolvency of the banks. Clearly some means were needed to enable the loaning power of the individual banks to be increased at such times, so that no customer with good commercial paper need fear to be refused a loan, even tho the rate of interest might have to be somewhat higher for a few days or weeks than the normal rate.
Our bond-secured bank notes lacked almost entirely the quality of elasticity needed to meet these changing business needs.[6] Their value being dependent primarily upon the amount and price of United States bonds, they might be most numerous just when least needed as a part of our circulating medium.
Sec. 7. #Periodical local congestion of funds#. In times of general confidence each bank finds it profitable, and is tempted, to extend its credit to the extreme limit permitted by the law governing the proportion of reserves to deposits. Of the 15 per cent reserves required in most banks, three-fifths (9 per cent) might be kept in banks in reserve cities, and of the 25 per cent in reserve city banks, 12-1/2 per cent might be kept in central reserve cities, where it counted as part of the depositing banks’ legal reserves, was a fund upon which domestic exchanges could be drawn, and usually earned a small rate of interest (usually 2 per cent). Very large reserves were kept in New York city where they could be loaned “on call,” and the largest use for call loans was in stock-exchange speculation. Thus every period of prosperity encouraged an unhealthy distribution of reserves, gave an unhealthy stimulus to rising prices, and “promoted dangerous speculation.”
Sec. 8. #Unequal territorial distribution of banking facilities.# Another aspect of this concentration of surplus money and available funds in the larger cities was the comparatively ample provision of banking facilities in the cities and in the manufacturing sections, and imperfect provision in the agricultural districts. The whole financial system seemed designed to induce the poorer country districts to lend funds at low rates of interest to be used speculatively in cities, instead of enabling the richer districts, the cities, to lend to the rural districts for productive enterprise. The rates of bank discount in different sections of our country have long been most unequal–lowest in the largest cities, and highest in the rural South and West–whereas in all parts of Canada, with a different system of banking, the rates have long been much more approximately uniform.
Indeed, our national banking development has been predominantly urban and commercial to the neglect of rural and agricultural interests. National banks were (until 1913) forbidden to make loans on real estate, and this greatly “restricted their power to serve farmers and other borrowers in rural communities.” There was “no effective agency to meet the ordinary or unusual demands for credit or currency necessary for moving crops or for other legitimate purposes.” The lack of uniform standards of regulation, examination, and publication of reports in the different sections prevented the free extension of credit where most needed. Finally, the methods and agencies for making domestic exchange of funds were, compared with other countries, imperfect and uneconomical even in normal times and could not “prevent disastrous disruption of all such exchanges in times of serious trouble.”
Sec. 9. #Lack of provision for foreign financial operations.# Not without its influence on public opinion was the consideration that we had “no American banking institutions in foreign countries.” Many bankers and business men felt, as did the commission, that the time had come when the organization of such banks was “necessary for the development of our foreign trade.” Foreign banks in South America and the Orient, handling American trade, were believed to favor their own countrymen rather than the interests of American merchants. In contrast with the European nations with their centralized control of banking, we had “no instrumentality that” could “deal effectively with the broad questions which, from an international standpoint, affect the credit and status of the United States as one of the great financial powers of the world. In times of threatened trouble or of actual panic these questions, which involve the course of foreign exchange and the international movements of gold, are even more important to us from a national than from an international standpoint.”
Sec. 10. #The “Aldrich plan.”# The National Monetary Commission submitted with its report a plan which was known by the name of the commission’s chairman, Senator Aldrich. This plan was embodied in a bill for a National Reserve Association, a bank for banks which bore some likeness to the great central banks of Europe. In the many details of the plan an effort has been made to remedy every one of the difficulties above described and to supply all the needs indicated. The plan was favored pretty generally by bankers, but called forth many adverse opinions. In the year of a presidential election, however, Congress took no action in the matter. All parties were pledged to some kind of banking reform, but particular proposals were not discussed in the campaign.
[Footnote 1: Whichever was the smaller. In 1900 this was changed so that notes could be issued to the full amount of the denomination of the bonds.]
[Footnote 2: In recent years this has been one half of 1 per cent when 2 per cent bonds, and 1 per cent when bonds bearing a higher interest, were deposited.]
[Footnote 3: In reserve cities 25 per cent and in other cities 15 per cent. The details of the regulations in the old law (given in part below, sec. 7) were ll altered by the legislation of 1913.]
[Footnote 4: The expressions within quotation marks in the following sections are taken from this report.]
[Footnote 5: See further on this in sec. 7 on periodical congestion of funds.]
[Footnote 6: See above, sec. 3.]
Chapter 9
THE FEDERAL RESERVE ACT
Sec. 1. General banking organization. Sec. 2. The Federal Reserve Board. Sec. 3. Federal reserve banks. Sec. 4. Federal reserve notes. Sec. 5. Reserves against Federal reserve notes. Sec. 6. Reserves against Federal reserve bank deposits. Sec. 7. Reserves in member banks. Sec. 8. Rediscount by Federal reserve banks. Sec. 9. Changes in national banks. Sec. 10. Operation of the Act.
Sec. 1. #General banking organization#. President Wilson and the newly elected Congress with its Democratic majority made banking reform one of the main objects on the program for the special session beginning March 5, 1913. The result was the Glass-Owen bill, which became law as the Federal Reserve Act December 23 of that year. The bill was actively discussed within and without the halls of Congress, and many of its features were attacked by bankers individually and acting through the bankers’ associations, at various stages of its progress. As a result it underwent numerous amendments in details, and tho it remained in most essentials as it was first proposed, it was at last accepted even by its critics as on the whole a beneficent act of legislation. Indeed, its strongest critics had been the friends of the Aldrich plan, and the Federal Reserve Act embodies, in a greater degree than its authors were ready to admit, the main features of the Aldrich plan. In one important respect, however, it is different; it provides for more decentralization of control and of reserves than did the Aldrich plan. It created not one central banking reserve, but, in the end, twelve regional, or district, banks each to keep the reserves of its district. The Jacksonian tradition of opposition to a central bank[1] in part helps to explain this; in part the contemporary congressional investigation and discussion of the so-called “money-trust” and the consequent desire to decrease the importance of “Wall Street” and of New York city banking power.
On the accompanying map are given the outlines of the districts as constituted and altered down to 1916.[2]
[Illustration: FEDERAL RESERVE BANK DISTRICTS]
Sec. 2. #The Federal Reserve Board#. At the head of the banking system stands the Federal Reserve Board of seven members, five of them appointed by the President and Senate of the United States for this purpose, and two serving _ex-officio_–the Secretary of the Treasury and the Comptroller of the Currency. One of the five shall be designated by the President as Governor and one as Vice-Governor of the Board, but the Secretary of the Treasury is _ex-officio_ chairman. The term of the appointive members is ten years and the salary is $12,000 a year.
The powers of the board are numerous and important. The board is made the head of a real _system_ of banking, the twelve parts of which can, in times of emergency, and at the board’s discretion, be compelled to combine their reserves by means of lending to each other (rediscounting), to the very limit of their resources, at rates fixed by the board. By this means the reserves of the several district banks may be “piped together” and thus be practically made into one central bank under governmental control, altho centralization was in outward form avoided by the bill. Alongside of the Reserve Board, is placed a Federal Advisory Council, consisting of one member from the board of directors of each of the twelve district banks. This council has only the power to confer with, make representations and recommendations to, and call for information from, the Federal Reserve Board.
Sec. 3. #Federal reserve banks#. The twelve Federal reserve banks which opened for business November 16, 1914, are of a type of institution new in our financial history. They are “banks for banks” belonging to the system in their respective districts. Every national bank must, and any state bank or trust company may,[3] subscribe for stock to the amount of 6 per cent of its capital and surplus, and thus become a “member bank.” The capital of each Federal reserve bank was to be at least $4,000,000; in fact only two of those organized (Atlanta and Minneapolis) had at their opening less than $5,000,000 capital; the largest (New York) had $21,000,000, and the average was $9,000,000. The member banks are to receive dividends of 6 per cent, cumulative, on this stock, and net earnings above that amount are to be paid to the Government as a franchise tax.[4]
Each reserve bank has nine directors, consisting of three classes of three men each. Classes A and B are elected by the member banks by a system of group and preferential voting designed to prevent the large banks from outvoting the smaller ones. Directors of class A are chosen by the banks to represent them, and are expected to be bankers; those of class B, tho chosen by the banks and tho they may be stockholders, shall not be officers of any bank, and shall at the time of their election be actively engaged within the district in commerce, agriculture, or some other industrial pursuit. Directors in class C are appointed by the Federal Reserve Board, one of them being designated as chairman of the board of directors and as Federal reserve agent. They represent the public particularly, and may not be stockholders of any bank.
Any Federal reserve bank may:
a. Receive deposits from member banks and from the United States.
b. Discount upon the indorsement of any of its member banks negotiable papers, with maturity not more than ninety days, that have arisen out of actual business transactions, but not drawn for the purpose of trading in stock and other investment securities.
c. Purchase in the open market anywhere various kinds of negotiable paper.
d. Deal anywhere in gold coin and bullion.
e. Buy and sell anywhere bills, notes, revenue bonds, and warrants of the states and subdivisions in the continental United States.
f. Fix the rate of discount it shall charge on each class of paper (subject to review by the Federal Reserve Board).
g. Establish accounts with other Federal reserve banks and with banks in foreign countries or establish foreign branches.
h. Apply to the Federal Reserve Board for Federal reserve notes to be issued in the manner below indicated.
Sec. 4. #Federal reserve notes#. In 1914 there were outstanding about $750,000,000 of what we may now call the old-style bank notes (bond-secured). These were by the new act not forcibly retired at once; but, as the law is shaped, they probably will be retired at the rate of about $25,000,000 a year, and will all disappear from circulation in thirty years.[5]
Whenever the banks having old-style bank notes outstanding desire to retire any of their circulating notes, the Federal reserve banks are required[6] to purchase the bonds in due quota (not to exceed $25,000,000 in any one year). On the deposit of these bonds with the Treasurer of the United States, the Federal reserve banks may receive other circulating notes (essentially of the old style) called Federal reserve bank notes, or may receive 3 per cent bonds not bearing the circulating privilege.
The new kind of notes provided by the act are called Federal reserve notes. They are not secured by the deposit of government bonds, but they are secured beyond all question in other ways. First, they are obligations of the United States receivable for all taxes, customs, and other public dues, and are redeemable in gold on demand at the Treasury of the United States. Secondly they are receivable by all member banks in the twelve districts and by all Federal reserve banks, and redeemable by the latter in gold or lawful money (which includes greenbacks and gold and silver certificates). Thirdly, their credit and prompt redemption is insured by certain elastic rules as to reserves in gold which must be kept for the redemption of outstanding notes. Fourthly, they are secured by collateral, consisting of notes and bills accepted for rediscount from member banks, which must be deposited by a Federal reserve bank with the Federal reserve agent of its district, dollar for dollar for every note it receives. Fifthly, the notes become “a first and paramount lien on all the assets of the bank.” This is what gives the notes their character of asset currency. It is evident that the notes unite in a manner without example the characteristic of asset bank notes with the characteristics of political paper money.[7]
No notes, it will be observed, are issued by or on request of the member banks, but only on request of a Federal reserve bank. After the notes have been issued, the bank may reduce its liability any day by depositing lawful money with the Federal reserve agent who is right there in the bank. The Federal reserve banks and the United States Treasury must promptly return to the banks through which they were issued all notes as fast as they are received, and “no Federal reserve bank shall pay out notes issued through another on penalty of a tax of ten per centum.” The regulations do not apply to the member banks, but their effect must be to keep notes from circulating long in any district except that for which they were issued.
Sec. 5. #Reserves against Federal reserve notes.# The rule applying in normal times to reserves against note issues is that each bank must provide a reserve in gold equal to 40 per cent “against the Federal reserve notes in actual circulation, and not offset by gold or lawful money deposited with the Federal reserve agent.” At least 5 per cent is to be on deposit in the Treasury of the United States. The proportion of reserves to the liability for note issues by any bank, however, may be allowed to fall below 40 per cent, on condition that the Federal Reserve Board shall establish a graduated tax of not more than 1 per cent per annum (it evidently might be made less if the board chose) upon such deficiency, until the reserves fall to 32-1/2 per cent and thereafter a graduated tax of not less than 1-1/2 per cent on each additional 2-1/2 per cent deficiency or fraction thereof.[8]
This tax must be paid by the reserve bank, but it must add an amount equal to the tax to the rates of interest and discount charged to member banks. The effect of these rules is to give a power of note issue in time of emergency without compelling the reserve banks to lock up their reserves held against notes. Suppose for example that the circulating notes were in normal times $1,000,000,000 and the reserves, therefore, were $400,000,000 and the rate of discount 5 per cent. Then the circulation might be doubled with the same reserves, the proportion thus falling to 20 per cent of outstanding notes, and the rate of discount to customers rising to 13.5 per cent (5 plus 8.5). Or, to take a most extreme supposition, suppose that the withdrawal of gold had been so great as to reduce the reserves against notes to $50,000,000; yet outstanding notes might be doubled (becoming $2,000,000,000,) the proportion falling to 2.5 per cent, the rate of discount rising to 24 (5 plus 19).
Sec. 6. #Reserves against Federal reserve bank deposits.# Every Federal reserve bank shall, under normal conditions, maintain reserves in lawful money of not less than 35 per cent against its deposits. But the Federal Reserve Board may suspend any reserve requirement in the Act for a period not exceeding 30 days and from time to time renew the suspension for periods not exceeding 15 days; but in that case it must establish a graduated tax upon the amounts by which the reserve requirements may be permitted to fall below the levels specified as to note issues. Altho the amount of the tax on the deficiency of reserves against deposits is not indicated in the act (as it is in respect to excess note issues) it is plainly the thought that the Board, to which discretion is left, will follow somewhat the same rule in both cases. The great discretionary power as to reserve requirements thus lodged in the hands of the Board makes possible at times of emergency the use of the reserves both of the reserve banks and of the member banks, down to the last dollar, if need be, without violation of law. This gives practically unlimited opportunity to expand credit both by the issue of bank notes and by discount and deposit in periods of financial crises.
Sec. 7. #Reserves in member banks.# A fundamental change is made in the rules as to the reserves against deposits that must be maintained by the member banks. A new distinction is made between time and demand deposits. Time deposits are defined as those payable after thirty days or subject to not less than thirty days’ notice; and demand deposits as those payable within thirty days. In every case the reserve requirement against time deposits is only 5 per cent. This gives encouragement to banks to maintain savings departments.
The requirements as to reserves against demand deposits are not uniform, being the lowest for banks in smaller cities (the great majority), larger for banks in the reserve cities, and largest for banks in the three central reserve cities (New York, Chicago, St. Louis). The act substitutes the new Federal reserve banks for the banks in reserve and central reserve cities as the depositories of funds that may[9] be counted as a part of the reserves of member banks. The new rule requires that one-third must be in the bank’s own possession, a fraction slightly over a third must be in the Federal reserve bank, and the remainder may be kept in either place. This may be tabulated as follows:
_Not in In reserve In central reserve cities cities reserve cities_
Total reserves, per cent 12 15 18 Must be in its own vaults 4/12 5/15 6/18 May be either place 3/12 4/15 5/18 Must be in a Federal reserve bank 5/12 6/15 7/18
These requirements as to total reserves are, as compared with requirements of national banks under the old law, a reduction respectively of 20 per cent, 40 per cent, and 28 per cent. The total decrease in the amount of reserves required for all three classes of national banks was about $400,000,000 on the amount of deposits held in September, 1914.
Sec. 8. #Rediscounts by Federal reserve banks.# More important than any other single feature of the act is, however, that by which each Federal reserve bank is to rediscount notes, drafts, and bills of exchange arising out of actual commercial transactions, when indorsed and presented by any of its member banks. This, quite apart from the note issues, gives a power to the banks collectively, under the general supervision and control of the board, to expand credits indefinitely at any time for real business purposes. Any business man able to offer any commercial paper of sound quality should now be able to borrow on it at some rate of discount, even in the most stringent times. And, in turn, every member bank will now be able at such times to rediscount such paper and thus secure credit toward its reserve requirement on the books of its Federal reserve bank. Suppose, for example, that a member bank (in a central reserve city) saw its reserve in the Federal bank fall below 7 per cent of its deposits. It could by rediscounting $7000 worth of notes increase by $38,888 the amount to which it might legally extend credit to its customers (i.e., $7000 is 18 per cent of that sum). The deposits of the Federal reserve bank would then be increased $7000, against which it must have a reserve of 35 per cent, or $2450. If the reserves of any Federal reserve bank fall too low, it can in turn rediscount its paper with the other Federal reserve banks.[10] If the time comes when no one of the twelve banks can longer maintain a 35 per cent reserve, the board may reduce or suspend the requirement, levying a tax graduated according to the deficiency. The provision here for elasticity of credit combined with union and solidarity of all the central banking reserves of the country to meet unusual demands in emergencies, exceeds any needs which can be expected to arise.
Sec. 9. #Changes in national banks.# There is here created a national system of reserves, but it will be observed that membership in the new system of the Federal reserve banks is not limited to national banks, but is open on equal terms to banks organized under state laws. While in most respects the general banking law remains as it was, certain changes are of importance. The percentage of reserves henceforth required of all member banks (as above indicated) is a substantial reduction of the former requirement for national banks. In some other respects the powers of national banks are enlarged. One with a capital and surplus of $1,000,000 may with the approval of the Board establish foreign branches, and one not situated in a central reserve city may loan on farm lands for a term not longer than five years, but not to exceed one third of its time deposits or 25 per cent of its capital and surplus. National banks may now be granted permission by the board to act as trustee, executor, administrator, or registrar of stocks and bonds, thus having the rights that have proved in many cases to be of advantage to trust companies organized under state laws.
Sec. 10. #Operation of the Act#. It was fortunate that this act was nearly ready to be put into operation when, August 1, 1914, the great European war broke out. The able appointees to the Federal Reserve Board commanded the confidence of the bankers and of the public. The knowledge that the reserve banks would early begin operations was reassuring during the grave financial stress of the next three months, and the opening of the district banks in November, 1914, at once made possible the release for commercial uses of cash reserves and credits to meet the needs of reviving business.[11] Only an extended experience can show how this enormous new banking organization will operate as a whole and in its details.
Because of the very wide discretionary powers given to the board in the administration of the act much depends on the character and ability of the members of the board as well as on a sound public opinion that will keep this great power from use in partisan and selfish ways. No doubt amendments of the act will appear necessary, but there can be no question that the Federal Reserve Act has inaugurated a new epoch in the banking and financial history of our country.[12]
[Footnote 1: See ch. 8, sec. 1.]
[Footnote 2: The law provided that an organization committee should designate not less than eight nor more than twelve cities as Federal reserve cities and should divide the continental United States, excluding Alaska, into districts each containing one such city. Twelve districts were designated. Wherever, therefore, the act speaks of “not less than eight nor more than twelve,” or of “as many as there are Federal reserve districts,” we may, for convenience, speak of twelve.]
[Footnote 3: On agreeing to comply with reserve and capital requirements of national banks and to submit to Federal examination.]
[Footnote 4: Except that until the surplus of any reserve bank amounts to 40 per cent of its paid-in capital stock, one half of its net earnings shall be paid into a surplus fund.]
[Footnote 5: These notes are all secured by the deposit of bonds of the United States, a large share of them bearing interest at the very low rate of 2 per cent. Two per cent is less than the market rate for government loans, for 3 per cent bonds without this privilege sell above par. Therefore these 2 per cent bonds were held almost exclusively by banks, and would have lost a good share of their value had the note-deposit privilege been withdrawn.]
[Footnote 6: Through the Federal Reserve Board or they may do it voluntarily, sec. 4.]
[Footnote 7: The Act does not explicitly say by whom the notes are issued: it says that they are “to be issued at the discretion of the Federal Reserve Board”; that “the said notes shall be obligations of the United States.” Further on the notes are spoken of as “issued to” a Federal reserve bank, and again as “issued through” a Federal reserve bank, but not _by_ it. But the phrase occurs (sec. 16) “its [i.e., the Federal reserve bank’s] Federal reserve notes.” The notes thus are technically issued by the United States, but not as ordinary political (fiat) money, for they are not given a forced circulation by the Government in paying its indebtedness. But the banks “shall pay such rate of interest on” the amounts of notes outstanding as may be established by the Federal Reserve Board (i.e., to the Government of the United States). Practically the notes (as respects choice of time of issue, amounts, profits from them, commercial assets to secure them and to redeem them) are asset currency issued by the several Federal reserve banks.]
[Footnote 8: This may be shown in the following table:
When reserves against notes are the tax rate upon the total are– deficiency shall be–
Below 40.0 to 32.5 per cent 1.0 per cent ” 35.5 to 30.0 ” ” 2.5 ” “
” 30.0 to 27.5 ” ” 4.0 ” ” ” 27.5 to 25.0 ” ” 5.5 ” “
” 25.0 to 22.5 ” ” 7.0 ” ” ” 22.5 to 20.0 ” ” 8.5 ” “
” 20.0 to 17.5 ” ” 10.0 ” ” ” 17.5 to 15.0 ” ” 11.5 ” “
” 15.0 to 12.5 ” ” 13.0 ” ” ” 12.5 to 10.0 ” ” 14.5 ” “
” 10.0 to 7.5 ” ” 16.0 ” ” ” 7.5 to 5.0 ” ” 17.5 ” “
” 5.0 to 2.5 ” ” 19.0 ” ” ” 2.5 to 0.0 ” ” 20.5 ” “
]
[Footnote 9: The complete application of the new rule is deferred for a period of three years from the passage of the act.]
[Footnote 10: See on “piping” provision, sec. 2, above.]
[Footnote 11: See sec. 7 above.]
[Footnote 12: Several other features of the law well merit description. Among these features are measures for developing bankers’ acceptances, open market operations, the gold clearing system of the Federal Reserve Board, and the clearing of checks and parring of exchange.]
CHAPTER 10
CRISES AND INDUSTRIAL DEPRESSIONS
Sec. 1. Mischance, special and general, in business. Sec. 2. Definitions. Sec. 3. A feature of a money economy. Sec. 4. European crises. Sec. 5. American crises. Sec. 6. A business cycle. Sec. 7. General features of a crisis. Sec. 8. “Glut” theories of crises. Sec. 9. Monetary theories of crises. Sec. 10. Capitalization theory of crises. Sec. 11. The use of credit. Sec. 12. Interest rates in a crisis. Sec. 13. Dynamic conditions and price readjustments. Sec. 14. Tariff changes and business uncertainty. Sec. 15. Rhythmic changes in weather and in crops. Sec. 16. Remedies for crises.
Sec. 1. #Mischance, special and general, in business.# Every separate business enterprise is subject to chances which suddenly decrease its profits and the prosperity of its owners; such are fire, flood, illness of its owners, unfavorable changes in prices of materials or of the products.[1] The interests of many other persons in the neighborhood may be so bound up with an enterprise that its losses may mean unemployment, lower wages to workingmen, and bankruptcy to local merchants and to banks. Sometimes misfortune and disaster affect whole communities. The lack of cotton while the Civil War was in progress compelled the factories of Manchester to close in 1864, and the earthquake and fire in San Francisco in 1906 left a quarter of a million people homeless.
But a change of business conditions is constantly occurring that is of wider extent, that is of less accidental and of more rhythmic nature, and that appears to be the effect of slowly working and more general causes. The enterprise of a modern community, as a whole, “general business,” moves along, in a wavelike manner, going through a somewhat regular series of changes that is called a business cycle. We are now to study the nature of these cycles.
Sec. 2. #Definitions.# Crisis means, generally, a decisive moment or turning point. The word crisis suggests a brief period, a moment, something that is sudden, severe, and soon over. In medical usage it is the period when the disease must take a turn for better or for worse. As used in economics, the term, however, implies a sudden change of business conditions for the worse, a collapse of prosperity. What precedes has not the appearance of disease, but rather that of exuberant health. Crises in economics may be distinguished as industrial, speculative, and financial, according as one or another influence seems to be more potent, but all are essentially financial. The change that occurs always is connected in some way with the use of money and credit.
A financial _crisis_ is the culmination of a period of rising prices, and a sudden fall which shatters the credit of some banks, brokers, merchants, and manufacturers. Every crisis is marked by much confusion and loss and by hasty efforts of individuals and institutions to meet their pressing obligations. Sometimes this process of liquidation goes on quietly and in other cases it becomes a wild scramble, each one trying to save himself, in which case it is a financial _panic_. An _industrial depression_ is the period of hard times that usually follows a financial crisis.
Sec. 3. #A feature of a money economy.# Financial crises, by their very nature, are confined to communities in which the money economy prevails and where there is a developed state of industry. The periods of industrial hardship in the Middle Ages were connected usually not with the collapse of prices, but with political oppression, famine, wars, pestilence, and scourges of nature. Throughout the lands money was little used and there was no development of credit and of credit prices. The money economy began, as has been noted, in the cities. As the use of money spread, as larger commercial enterprises were undertaken, as borrowing and the payment of interest became common, there began to appear in city trading circles, on a small scale, the phenomena of the modern crisis.[2]
Sec. 4. #European crises.# In Europe financial crises date from 1763 and have occurred at more or less regular intervals since. The common statement that the cycle of a crisis is run in a period of ten years, finds only partial support in history. The chief crises of the eighteenth century occurred in 1763, 1783, 1793, these dates marking the close of wars of some magnitude. The crises were not widespread or general, but were more marked in England, which was at that time farther developed industrially and in its money economy than other countries. Likewise, in the nineteenth century, the crises were of unequal force in various countries, usually being severer in England. They may be dated 1803, 1825, 1838, 1847, 1857, 1864-66, 1875, 1890, 1900, 1907, and 1914. These were attributed to various causes; that of 1825 to over-trading abroad; that of 1847 to railroad-building; while that of 1866 followed the severe disturbance of trade in 1864 caused by the interruption of the cotton trade and commerce by the Civil War in America. While in many parts of England the crisis of 1864 was unusually severe, in other countries it was of little moment. Germany, after several years of great speculative prosperity, had a most severe crisis in 1875; while France, although prostrated by the war of 1870-71, losing a large amount of wealth, and paying a thousand millions of dollars to Germany as a war indemnity, escaped a commercial crisis almost entirely at that time.
Sec. 5. #American crises.# Since the beginning of the nineteenth century, the financial connections of the United States with London, the leading loan market of Europe, have been such that every crisis in either England or America has extended its effects to the other country. But the disturbances are so modified by the particular conditions (of crops, politics, and speculation) that the phenomena never correspond exactly in time of occurrence, in duration, or in intensity. The first notable crisis in America occurred about 1817 in the very violent readjustment of trade after the resumption of commerce with Europe in 1816.[3] In 1837-39 came in quick succession two crises, not quite distinct from each other, the second similar to the relapse of a fever patient. The conditions were rapid westward expansion, over-speculation in lands, reckless state internal improvements, great issues of state bank notes, and the financial measures of Andrew Jackson, which included the dissolution of the Second Bank of the United States in 1836.[4] The crisis of 1857 followed a period of great prosperity marked by rising gold production and prices and a great increase in foreign trade. The crisis of 1873, possibly the severest in our history, followed great speculation, especially in the direction of railroad building on an unexampled scale after the war. The blow, when it fell, was intensified by the relative contraction of currency then in progress, leading to the return to a specie basis and lower prices.[5] The crisis of 1884, a comparatively slight one, occasioned (rather than caused) by the discussion of the money question, was followed by some years of noticeable depression. The years 1889 to 1892 witnessed prosperity, only slightly interrupted in 1890, that culminated in a crisis in May, 1893 (likewise generally explained as due to the unsettled state of our monetary system), followed by a period of great depression lasting until 1897. A rapid growth of business was checked but little in 1900 when a crisis occurred in Europe, especially severe in Germany. In November, 1902, began in America what has been called “the rich man’s panic” of 1903 in which for a year many securities were sold by holders because European creditors were recalling their loans. American business, however, slackened but little, altho building operations were somewhat checked. General prices, which had been moving upward since 1897, remained almost unchanged in 1903 and 1904, and then continued going upward until 1907. In the period from September to November of that year occurred a severe crisis both in Europe and in America. The industrial depression following this was marked in 1908, slowly growing less. The crisis at the outbreak of the war in August, 1914, was quite exceptional, being due to the sudden demand of Europe upon New York for funds. Within a couple of months it was over and soon prices were again rising as the result of large exports of merchandise followed by gold imports.
Sec. 6. #A business cycle#. Let us now sketch in broad outline a business cycle, bearing in mind that this series of changes does not repeat itself with unvarying regularity, but that it is fairly typical in the modern business world. The period leading up to a crisis is one of relative prosperity; then occurs a crisis in which prices fall, at first rapidly, and afterward for a while going slowly lower. When prices are at the lowest point many factories are closed, and much labor is unemployed. Let us start at that point. Conditions are worse in some industries than in others. General economy and great caution prevail; few new enterprises are undertaken. For those persons having available funds this is a good time to buy, and property begins to change hands. Then hoarded money begins to come out of its hiding places. Money and credit flow in from other countries, particularly if business conditions are better abroad than here, for when prices are lower than they have been, relative to those of other countries, a country is a good place in which to buy. At the same time that the money in circulation thus increases, there is a general return of confidence that increases credit. Not only are there more dollars, but each does more work. Then old enterprises are resumed and new ones are undertaken. The purchase of materials in larger quantities causes a rapid rise in the prices of many raw materials and of all kinds of industrial equipment. The less efficient laborers and others that have been out of work, begin to find employment, and then, more tardily, wages begin to rise. As a result, the costs of many products begin to rise rapidly. The only classes not sharing in this improvement are the receivers of fixed incomes. As prices rise, the purchasing power of their incomes correspondingly falls.
At length prices begin to go up less rapidly, and the question arises in many minds whether the movement can continue, and if not, when it will cease. Men wish to hold on for the last profits, and are willing to risk something to gain them. When prices rise not only as compared with former domestic prices, but as compared with current foreign prices, foreign imports are stimulated and exports fall. This calls for a new equilibrium of money and requires at length large and continued exportation of specie. This checks prices, and, reducing the specie reserves of the banks, compels them to be more cautious. At the same time the increase of costs in many industries begins to reduce profits. The fall in the value of many stocks and securities held by the banks forces many brokers and speculators to convert their resources into ready money. This is the moment of danger; weak enterprises find their foundations crumbling, and there are many failures.[6] The falling prices, the shattered credit, and the financial losses force many factories to close, and many workmen are thrown out of employment. This moment of widespread loss is the crisis, It is followed by another period of low prices and of small output, and therefore of profits small or negative in many industries. Business must again enter upon a period of retrenchment, for it has completed another cycle.
Sec. 7. #General features of a crisis.# Altho irregular in time of occurrence and unlike in their immediate occasions, financial crises show certain general features. They are a part of the larger movement here outlined as the business cycle. Some have thought this cycle to be normally a period of ten years, divided into one year of crisis, three years of depression, three years of recovery, and three years of unusual prosperity. This succession of events occurs pretty regularly, though not in the regular intervals of time. Crises are more severe in countries with more extensive use of money and credit, but still more severe where the credit system is more loosely administered and less efficiently cooerdinated. They are harder in the United States and England than in Germany, harder in Germany than in France, harder in western Europe than in eastern Europe, harder in Christendom than in heathendom. They are less severe in rural districts, where prosperity depends more on crop conditions, and business has in it less of financial speculation. Their effects are least felt in the staple industries, for when hard times come people economize on the less essential things. The glove-factory, the silk-factory, the golf-club-factory are more likely to close than the flour-mill. In a crisis wages and salaries are less affected than are profits, but wageworkers suffer in the loss of employment. Those money lenders who have eliminated chance as far as possible and have taken a low rate of interest lose little; the risk-takers who draw their incomes from dividends on stock or from bonds of a less stable kind, often lose much.
Sec. 8. #”Glut” theories of crises#. Many explanations of the causes of financial crises have been offered.[7] Nearly all of these belong to the general group of “glut” theories, of which genus there are two species, under-consumption and over-production theories. These are, in truth, but two aspects of the same idea.[8] The one view is that too many goods are produced, the other that too few are consumed. The over-production theorist seeing that in a crisis warehouses are filled with goods that cannot be disposed of for what they cost (or at best, not so as to give a profit), and that factories are shut down and men are out of employment for lack of demand, declares that productive power has grown too great. The under-consumption theorist, seeing the same facts, says that the trouble is lack of purchasing power. He observes that there are some people who would like to buy more of some of these things, but that such people lack income with which to buy. Usually he asserts that this is because production grows faster than wages, wages being fixed, as he believes, by the minimum of subsistence–a theory akin to the iron law of wages. In both over-production and under-consumption theories, the inequality of demand and supply is looked upon as a general one. There is supposed to be not merely an unequal and mistaken distribution of production, but a general excess of productive power.
The wide vogue held by these views would justify a fuller discussion and disproof of them here, did space permit. It must suffice to indicate merely that they have the same taint of illogicalness as the “fallacy of waste,” and the “fallacy of luxury.”[9] They overlook the fact that an income, either of money or of other goods, coming even to the wealthiest, will be used in some way. It may be used either for immediate consumption or for further indirect use in durable form. Through miscalculation there may be, at a given moment, too many consumption goods of a particular kind, but the durable applications can find no limit until the inconceivable day when the material world is no longer capable of improvement. At the time of a crisis, there is unquestionably a bad apportionment of productive agents, and a still worse adjustment of their valuations, but these facts should not be taken as proving that there is an excess of all kinds of economic goods.
Sec. 9. #Monetary theories of crises.# Another group of theories explains the crises as being due to money, either too much or too little. The unregulated issue of bank notes has been assigned as the cause of crises, especially under the circumstances accompanying such crises as those of 1837 and 1857 in America, when bank note issues greatly contributed to the unsound expansion of credit. The issue of government paper money years before, leading to inflation and speculation, was by many believed to be the cause of the crisis of 1873. The reverse view is taken by the advocates of a cheap and plentiful money. They say that these crises were caused, not by the expansion, but by the contraction of the money stock; for example, not by the inflation of prices through the issue of greenbacks in 1862 to 1865, but by the contraction of the currency from 1866 to 1873.
There is only a fragment of truth in these various views. It is always lack of “money” at the moment of the crisis that causes any particular failure, and in that sense it is always lack of “money” that causes a crisis. The question is, whether in any reasonable sense it can be said that it was lack of a circulating medium before the crisis that brought it on. There is no support for this view, except in the rare case when the money standard is undergoing a rapid change, as in the United States from 1866 to 1873, and the statement then needs much modification and explanation. The monetary theories of crises are a bit nearer to the truth than are those of the over-production type, for the crisis is always connected with prices and credit. But it is clear that these rhythmic price changes occurring in the business cycle are not due to the same causes as are the general movements of the price level, due to an increasing or decreasing output of gold or again to a paper money inflation. Statistics show that while a general price level is slowly changing like a tidal movement, the effect of the rhythmic business cycle appears now in hastening, now in retarding, the changes in the price level.
Sec. 10. #Capitalization theory of crises#. Here we verge upon a different type of explanation of the financial crisis–one of a psychological nature. The quantity of money, we have seen, affects prices more or less according as credit is more or less used in connection with it. Money plus confidence has a larger power of sustaining prices, than money without, or with less, confidence. And throughout the business cycle the amount of confidence, expressed in such ways as the readiness to grant credits and in the easy extension of the time of collection, is constantly changing. Over-confidence at one time is suddenly followed by widespread lack of confidence. This has led some to say that lack of confidence is the cause of crises. This is a truism, but it does not explain what is the real cause of this lack of confidence, which, when the crisis comes, is not mere unreasoning fear that needs only to ignore the danger to banish it. Might it not just as truly, if not more truly, be said that the cause is _over-confidence_ in the period preceding the crisis?
The essential characteristic of a crisis is the forcible and sudden movement of readjustment in the mistaken capitalization of productive agents. Capitalization runs through all industry. The value of everything that lasts for more than a moment is built in part upon incomes that are not actual, but expectative, whose amount, therefore, is a matter of guesswork, or “speculation.”[10] Many unknown factors enter into the estimate of future incomes. The universal tendency to rhythm in motion (material or psychic) manifests itself in an overestimate or underestimate of incomes and of every other factor in value. This is emphasized by a psychological factor called sometimes the “hypnotism of the crowd,” and sometimes, the “mob mind.” Most men follow a leader in investment as in other things. The spirit of speculation grows till often it becomes almost a frenzy, and people rush toward this or that investment, throwing capitalization in some industries far out of equilibrium with that in others.
The cause of crises immediately back of the maladjusted capitalization thus is seen to be a psychological factor; it is the rhythmic miscalculation of incomes and of capital value, occurring to some degree throughout industry, but particularly in certain lines. This subjective cause in men is given an opportunity for action only when certain favoring objective conditions are present.
Sec. 11. #The use of credit.# Most noteworthy of these objective conditions is the general use of credit. The credit system greatly enhances the rhythm of price. If the value of a thing that is fully paid for falls, the owner alone loses; but if the value of a thing only partly paid for falls so much that the owner is forced to default in his payment, the loss may be transmitted along the line of credit to every one in a long series of transactions. A credit system, highly developed, is a house of cards at a time of financial stress. Demand liabilities are at such a time the greatest danger, so that the banks, ordinarily the pillars of financial strength, become at such a time the points of greatest weakness in the financial situation. If many of the customers were not restrained by their sense of personal obligation to the banks, by the strong pressure which the banks can bring to bear upon them, or by the force of public opinion among business men, from withdrawing the balances to their credit in a time of crisis, all commercial banks would become insolvent at once in a crisis by the very nature of their business; for all their ordinary deposits are nominally payable on demand.
Sec. 12. #Interest rates in a crisis.# In normal times there is always outstanding a great mass of short-time, commercial loans.[11] The motive of the borrower, in most cases has been to hire more labor and to buy more materials for use in his business. Ordinarily these loans can and are renewed without difficulty or are replaced by others, based on the security of new business transactions in unbroken succession. Now at the time of a crisis a general contraction of credit occurs, and all borrowers with maturing obligations are faced with bankruptcy. The effort of the business man at such a time is not to make a positive profit, but to save what he can from the threatened wreck. The demand for short-time loans, therefore, in such times of stress, fluctuates rapidly, and exceedingly high interest rates prevail in these loan markets for a few days or a few weeks, rates which have only a remote relationship with the usual capitalization of most agents.
The distress of the business man is magnified by the fact that it is just at such times that both the equipment he has bought and the products he has made become temporarily almost unsaleable at prices as high as he paid for them when he bought them with the borrowed money. He may know that prices will soon be higher, but he cannot wait. Various courses are open to him in this emergency; he may borrow the money at a very high rate of interest, holding the goods for better prices; or he may sell the goods under the unfavorable conditions; or he may sell other capital such as stocks and bonds. The end sought is the same–to get ready money; and the methods are not essentially unlike–the exchange of greater future values for smaller present values. The sacrifice sale thus reveals the merchant’s high estimate of present goods in the form of money. The purchaser of some kinds of property in times of depression is securing them at a lower capitalization than they will later have. The rise in value may be foreseen as well by seller as by buyer, but the low capitalization reflects the high interest rate temporarily obtaining. A.T. Stewart, once the most famous New York merchant, is said to have laid the foundation of his fortune when, being out of debt himself, he bought up the bankrupt stocks of his competitors in a great financial panic. The high interest at such times is but the reflection of the high premium on present purchasing power.
The worst of the evils of crises are confined to the markets where the greatest numbers of short-time loans are made. Most of the long-time loans do not fall due in such seasons of stress, and the great mass of slowly exchanging wealth alters little and slowly in price. Such loans as fall due can generally be renewed for long periods at rates little higher than usual, the market for long-time and short-time loans being in large measure independent of each other. But they are not quite independent, and some lenders take whatever sums they can collect on maturing long-time obligations and loan them on short terms at high rates of interest, or buy goods, whole enterprises, bonds, and stocks, at the unusually low prices temporarily prevailing. The effect of this is to raise somewhat the interest rate on long-time paper to accord with the new conditions.
Sec. 13. #Dynamic conditions and price readjustments.# Another condition favorable to the rhythmic movement of capitalization is a dynamic economic society. The past century has opened up new fields for investment on an unexampled scale. Investment has advanced both intensively and extensively in a series of great waves. New machinery and processes have given undreamt of opportunities for enterprise in the older countries, and the physical frontier of investment has moved outward with the march of millions of immigrants to people the fertile wilderness. Such factors disturb the equilibrium of prices both in time and space, give a powerful impulse toward higher values in the older lands, and stimulate the hopes of all investors. When the balance between the capitalizations of various industries and between the incomes of the various periods proves to be false, the inevitable readjustment causes suffering and loss to many, but particularly in the inflated industries. But, because of the mutual relations of men in business, few even of those who have kept freest from speculation can quite escape the evils.
Among the dynamic conditions in industry are changes in the general price level whether due to changes in the production of the standard money commodity (relative to population) or to changing methods of doing business. If the price level is falling (i.e., the standard unit is appreciating), the burden of the great mass of outstanding debts is growing heavier upon the debtors.[12] Sooner or later some of them break down under its weight. At such times many attempt to shift their capital from active investments such as stocks, to passive investments such as bonds. When the price level is rising, the opposite conditions prevail. But such adjustments proceed uncertainly and unevenly in different industries, with much speculation in shifting from one type of business to another, and with much accompanying miscalculation.
Sec. 14. #Tariff changes and business uncertainty.# Another variable influence in American business has been the tariff. Every tariff revision, whether the rates go upward or downward, shifts somewhat the relative opportunities and profitableness of different industries. Some of these call for far-reaching readjustments of investments and of productive forces. Some persons gain and some lose by every such change. It is observed that a reduction of tariff rates seems to have a more disturbing effect upon business than does an increase. This probably is because the industries favored by protective tariffs in America are those most fully within the circle affected by crises; whereas most of the consumers adversely affected by a rise of tariff rates are outside the commercial circles where short-time credit is common and where the rapid readjustment of investment leads to a financial crisis. It never has been convincingly shown, however, that there is any large measure of correspondence in time (not to say causal relation) between tariff revisions and crises.[13]
Sec. 15. #Rhythmic changes in weather and in crops#. A psychological movement, once started, accumulates force and momentum up to a certain point where a reaction begins. This rhythmic movement as it appears in the capitalization of enterprises is favored and magnified, we have seen, by the wide use of credit and by the constantly changing technical and physical conditions of industry. These call for constant revaluations of the sources of incomes, thus destroying customary and habitual valuations. But why should the cycle begin or end at one point of time rather than at another; and what determines the length of the cycle? Some of the new dynamic forces such as inventions and growth of population are distributed pretty regularly along the line, so that their influences are nearly equalized. But occasionally some large impulse may serve to start a swing and if this impulse is somewhat regularly repeated, it may serve to keep up the rhythmic motion. True, the lack of coincidence in the impact of various influences which occur accidentally, such as political changes, wars, and the rapid opening of new routes of transportation, would serve to hasten or to retard, perhaps for a time quite to alter, what would otherwise be the rhythm of the cycle. That there is nevertheless, a noticeable degree of regularity in the recurrence of crises may be due to the presence of one dominating factor.
Alternation of good and poor harvests has always seemed to be favorable to business prosperity. In America since about 1865, farm products have constituted the larger part of our exports, so that a succession of large harvests has usually acted to stimulate exports (one of the features of a period of prosperity), to give us a larger credit balance in international trade, and to reduce the rate of exchange. Large harvests of the staple agricultural crops in America have been known to be closely related to the amount of rainfall in the three most important growing months. Recently, it has been shown that the rainfall of the Ohio Valley occurs in cycles of about eight years, and in a larger cycle of thirty-three years. The cycle of yield per acre of the nine principal crops is shown to correspond closely with the cycle of pig iron production (one of the best single indices of growing business) dated one to two years later.[14] As the cycles of rainfall and of harvests are not coincident in different countries, it will require further study to adjust to these observations the fact of the world-wide extent of the great financial crises. But a better understanding of objective conditions of this kind will give fuller meaning to the psychological interpretation of crises.
Sec. 16. #Remedies for crises#. The financial crisis must be looked upon as an economic disease which brings many evils in its train. The need is not merely to mitigate the severity of the brief period of crisis, but also to smooth out the curve of the business cycle so as to reduce periodic unemployment, the lottery element in profits, and the number of unmerited failures in business. Several measures may aid toward this end. In the past the crisis has been more severe in America than in Europe because of certain well-recognized defects which now have been largely remedied in the Federal Reserve Act.[15] The provisions whereby any one may get credit on good commercial assets should make it impossible for a crisis to degenerate into a panic. This legislation has provided springs to reduce the jolt of the change from a higher to a lower level of prices.
Probably other improvements may be made in our banking laws. Competent students of the subject have urged that the payment of interest on deposits not subject to notice before withdrawal should be made unlawful, because demand deposits constitute the greatest danger at critical times. In principle this objection is sound, tho experience may show that this evil has been practically remedied by other features of the Federal Reserve Act. Moreover, bankers could, by pursuing a more conservative policy, discourage speculative methods of enterprise. The strong public disapproval of stock-market speculation on margins may some day be able to express itself effectively in ways that will not injure healthy business. Greater stability in our tariff policy would remove a constantly disturbing factor in prices, as would likewise the stabilizing of the standard of deferred payments. In the attempt to remedy the great evil of unemployment, public works of every kind might be planned and distributed in time so as to better equalize the demand for labor and materials. Finally, much better commercial statistics are needed, and for collecting them and reporting the outlook, government organization is required comparable in range and methods to the weather bureau.
It cannot be expected, however, that financial crises, in the sense of general readjustments of prices downward from time to time, ever can be completely abolished. There will always be changes in general industrial conditions calling for reevaluation of the existing sources of income; and in this process there will always be a tendency to rhythmic swing like that of a river, which carries the stream of prices now on this side of the valley, now on that. But this fluctuation of general prices surely can be so greatly moderated in magnitude and in evil results as to make the word “crisis” almost a misnomer. It is toward the attainment of this irreducible minimum of uncertainty and disaster in business that efforts should be directed.
[Footnote 1: On the way these affect private profits see Vol. I, pp. 340, 341 (and references there given in note), 348 ff. and 361 ff. There are thus good reasons for discussing crises in connection with profits, as well as with money and banking.]
[Footnote 2: See Vol. I, pp. 51, 154, 300-302.]
[Footnote 3: See below, ch. 15, sec. 5, on the tariff legislation at this time.]
[Footnote 4: See ch. 8, sec. 1.]
[Footnote 5: See ch. 6, sec 5.]
[Footnote 6: See diagram of business failures 1890-1914, in Vol. I p. 364.]
[Footnote 7: In the first annual report of the United States Commissioner of Labor is given a long catalog of theories that have been suggested, many of them quite fantastic.]
[Footnote 8: See Vol. I, ch. 38, on Abstinence and Production. Believers in the glut theory usually condemn efforts to encourage frugality among the masses, calling it the “fallacy of saving.”]
[Footnote 9: See Vol. I, ch. 37, secs, 6 and 9.]
[Footnote 10: See e.g., Vol. I, pp. 271. 335, 365 367.]
[Footnote 11: See Vol. I, p. 304.]
[Footnote 12: See above, ch. 6, on the standard of deferred payments.]
[Footnote 13: See note on tariff legislation and business crises, end of ch. 15.]
[Footnote 14: In both cases there is what is called in statistics a high degree of correlation (viz., .719 and .800), indicating that there is that percentage of probability that there is some causal relation between the two sets of figures.]
[Footnote 15: See above, ch. 9, secs. 5, 6, 8.]
CHAPTER 11
INSTITUTIONS FOR SAVING AND INVESTMENT
Sec. 1. The nature of saving. Sec. 2. Economic limit of saving. Sec. 3. Commercial bank deposits of an investment nature. Sec. 4. Investment banking. Sec. 5. Savings banks in the United States. Sec. 6. Typical mutual savings banks. Sec. 7. Postal savings plan. Sec. 8. Advantages of the postal savings plan. Sec. 9. Collection of savings and education in thrift. Sec. 10. Building and loan associations. Sec. 11. The main features. Sec. 12. The continuous plan. Sec. 13. The distribution of earnings. Sec. 14. Possible developments of savings institutions.
Sec. 1. #The nature of saving.# The motives actuating the different classes of lenders may, for our present purpose, be reduced to two: to postpone the consumption of income, and to obtain a net income from wealth (or investment). Saving always is relative to a particular period and is for more or less distant ends. The child saves its pennies to go to the circus next week, the working girl saves her dimes for a new hat next spring, the earnest high school pupil saves to go to college next year, and the provident man saves for his family’s future needs and for his own old age. But always, to constitute saving, there must be for the time a net result: the excess of income over consumptive outgo in that period. This is easily distinguishable from various forms of pseudo-saving of which many persons that are really spending all their incomes are very proud. Such forms are: planning to buy a particular thing and then deciding not to do so, but buying something else; finding the price less than was expected, and thereupon using this so-called saving for another purpose; spending less than some one else for a particular purpose, such as food, but off-setting this by larger outlay for another purpose, such as clothing; spending all one’s own income but less than some one else with a larger income. We may define saving as the conversion, into expenditure for consumptive use, of less than one’s net income within a given income period.
Saving goes on in a natural economy both by accumulation of indirect agents and by elaboration so as to improve their quality.[1] It goes on to-day by the replacement of perishable by durative agents, as in replacing a wooden house by one of stone or concrete, and by producing wealth without consuming it, as in increasing the number of cattle on one’s farm. But saving has come to be increasingly made in the form of money (or of monetary funds), and in this chapter we shall consider some of the ways in which this can now be done.
Sec. 2. #Economic limit of saving#. There is an economic limit to saving, as judged from the standpoint of each individual.[2] The ultimate purpose of every act of saving is the provision of future incomes, either as total sums to be used later or as new (net) incomes to be received at successive periods. The economic limit of saving in each case is dependent upon the person’s present needs in relation to present income and conditions, as compared with the prospect of his future needs in relation to his future income and conditions. Each free economic subject must form a judgment and make his choice as best he can and in the light of experience. There is no absolute and infallible standard of judgment that can be applied by outsiders to each case. Yet there is occasion to deplore the improvidence that is fostered and that prevails, especially among those receiving their incomes in the form of wage or salary. Considered with reference to the possible maximum of welfare of the individuals themselves, the apportionment of their incomes in time is frequently woful. It is uneconomic for families of small income to save through buying less food than is needed to keep them in health; but it is likewise uneconomic to spend the income, when work is plentiful and wages good, for expensive foods having little nutriment and then, for lack of savings, to go badly underfed when work is slack and wages are small. There is for each class of circumstances a golden mean of saving. The saving habit may develop to irrational excess and become miserliness, but this happens rarely compared with the many cases where men in the period of their largest earnings spend up to the limit on a gay life and make no provision for any of the mischances of life–business reverses, loss of employment, accidents, temporary sickness, permanent invalidity, or unprovided old age. Despite the development of late of new agencies and opportunities for saving there is need of doing more toward popular education in thrift.[3]
Sec. 3. #Commercial bank deposits of an investment nature.# If a commercial bank pays no interest on demand deposits there is no motive for the depositor to keep a balance larger than he needs as current purchasing power. When his bank account increases beyond that point, it becomes available for a more or less lasting investment to yield financial income. If the sum is small or if the owner is at all uncertain as to his plans or if he is not in a position to find another attractive form of investment, the offer by the bank of a small rate of interest on special time deposits (2 to 3 per cent is not an unusual rate in such cases) will suffice to cause him to leave such funds in the bank. Since about 1900 the practice has been greatly extended of paying interest even on “current balances” of regular checking accounts (demand deposits). If the new 5 per cent rule[4] as to reserves against time deposits operates to cause commercial banks generally to pay a rate ranging from 2-1/2 to 3-1/2 per cent on time deposits, their amount will doubtless increase greatly. But still, in the future as in the past, those depositors having funds that can be invested for considerable periods will seek a higher rate of interest than can be obtained from commercial banks.
In their loaning function the “commercial” banks (as the adjective indicates) serve mainly the special needs of the _commercial_ elements of the community–business men borrowing for short terms to carry out particular transactions. Loans made on short-time commercial paper (quick assets) are very suitable to the needs of a bank that has its liabilities largely in the form of demand deposits. Time deposits can be more safely loaned on the security of real estate and for longer periods.
Despite their limitations in this respect, the commercial banks must be recognized as of growing importance in the work of encouraging and collecting small savings, which in many cases are better invested in other ways. In 1916, the centenary of the beginning of savings banks in this country, a nation-wide propaganda was undertaken by the American Bankers’ Association for the encouragement of savings.
Sec. 4. #Investment banking#. Enormous amounts of securities issued by governments or by corporations (railroad or industrial) are now on the market and to be bought conveniently by private investors. Through special bond houses some bonds are to be had in denominations as small as $100 and $500. The regular brokers on the stock exchanges buy and sell, for a small commission, the regular bonds and investment stocks. Several large statistical and financial expert agencies[5] in return for an annual subscription, offer advice to investors regarding general market conditions and special securities.
For a large number of investors the personal examination and selection of sound securities is too difficult a task. To serve their needs many bonds and trust companies have of late developed special departments for investment banking. Through these agencies the banks are constantly placing as relatively permanent investments securities which they have bought or have aided “to float” or which they handle only as commission agents. In any case the real investment banker is bringing to his task special training and a high sense of his professional obligations, and is employing the services of statisticians, financial experts, and of practical engineers to determine exactly the fundamental conditions of each investment. Investment banking promises to increase steadily in amount and importance.
Sec. 5. #Savings banks in the United States.# For the increasing number of wage-earners, salaried employees, and persons following professions, investment as active capitalists is impossible.[6] Their savings must take the form of passive investments. But there are few good opportunities for lending money in small amounts, without great risk, and the requirement of skill, time, and labor to look after the loans and to collect the interest is prohibitive to a small lender. To provide a place where small sums could be kept with safety and so as to yield a moderate rate of income, the first modern savings bank in the United States was instituted in New York in 1816 after a plan already developed in England.
In form these banks are mutual, having no capital stock on which dividends are to be paid. The boards of trustees are self-perpetuating and receive only fees for attending meetings. In their legal aspect these banks have a philanthropic character. Their investments are limited by law to specified, conservative classes of securities and loans on real estate. The total increase from investments is, after paying the expenses of operation and setting aside a surplus, distributable to the depositors at regular periods. In the United States the number of such institutions reported in 1914 was 2100.[7] They have over 11,000,000 depositors, deposits to the amount of $5,000,000,000, an average deposit of $444 per depositor, or of $50 per capita of the whole population. These figures are very unequally distributed geographically, the divisions ranking as to total deposits in the following order: the Eastern Middle, New England, Middle Western, Pacific, Southern, and Western divisions. The first two of these groups of states have about 75 per cent of all the deposits, the Southern states hardly 2 per cent, and the Western (North Dakota to Oklahoma) only 1/4 of 1 per cent.
Sec. 6. #Typical mutual savings banks#. About one third of these banks are on the mutual plan, having no capital stock (most of them in the East) and these contain about four fifths of all the deposits. The stock savings banks have individual deposits of over a billion dollars, and have outstanding capital stock to the amount of about $90,000,000 (about 9 per cent of their deposits). These stock savings banks to a much greater extent than do the mutual banks transact also a commercial business.
The banks on the mutual plan are therefore the most important, the typical savings banks. The average rate of interest they paid to depositors in 1914 was 3.86 per cent. About one half of their resources are invested in loans, mostly to small borrowers on the security of real estate, and most of the remainder consists of bonds and other securities of the safer kinds.
Savings banks are subject to the supervision and inspection of the banking departments in the several states, a fact that exerts a salutary effect though not insuring absolutely against either mistaken judgment or dishonesty on the part of the bank officials.[8]
Savings banks seek to keep invested as large a part as possible of their assets, keeping only in ready cash enough to meet a possible temporary excess of withdrawals over deposits. In contrast with the policy of commercial banks with their demand deposits, the sound policy for savings banks is to reserve the right to require notice of intention to withdraw. The period of such notice varies from a minimum of ten days to a maximum of about sixty days. In ordinary circumstances it is not needful or usual for a bank to exercise this right, but it is a needful safeguard in times of commercial crises. This requirement of notice is greatly to the advantage of depositors collectively and thus of the community as a whole. It is not an undue limitation of the rights of the individual depositor. It is unfair for the individual, in a period of financial stress, to seek his own safety in a manner which is impossible for all, and thus to endanger the interests of all.[9]
The mutual savings banks in 1914 had (on the average) but six tenths of a cent of actual cash (and “checks and cash items”) in their tills for every dollar of deposits, but in addition they had for every dollar of deposits four cents due on demand from state and national (commercial) banks. In the aggregate these demand deposits amounted to the large sum of $172,000,000, a large part of which bore a low rate of interest.
The depositors in savings banks have a direct legal claim on the bank as a corporation. The bank’s only means of payment are its assets, consisting of claims upon the owners of such wealth as houses, factories, railroads, electric light plants, good roads, and school buildings. Thus virtually the depositors have by their savings made possible the building and equipping of these actual forms of wealth, and have an equitable claim upon the usance of them, which claim is met by the payment of interest and dividends to the savings banks. Viewed in this way the great social importance of the savings function appears, and the importance of developing the savings institutions.
Sec. 7. #Postal savings plan.# In many countries of the world the governments have not only authorized private, corporate, and trustee savings banks, but have provided public agencies where it is possible for the citizens to deposit small amounts. Thus municipal, and what are called communal, savings banks are operated by many European cities; but the most effective and widely used agencies for the purpose are the national post-offices. Postal savings banks, or postal savings systems as divisions of the postal service, are now found in all the larger countries of the world, and in many smaller ones. The United States of America was almost the last civilized country to establish such a system, which was authorized by act of Congress in 1910, and went into operation in a few designated cities in January, 1911. The number of offices at which it was in operation was rapidly increased, and the number in 1914 was about 10,000.
Any one ten years of age may become a depositor. Deposit must be made always in multiples of one dollar. Not more than $100 will be accepted for deposit in any one calendar month, and nothing after the total balance to the depositor’s credit is as much as $1000, exclusive of accumulated interest. However, amounts less than one dollar may be saved for deposit by purchasing a ten-cent postal savings card and affixing ten-cent postal savings stamps until the nine blank spaces are filled. Such a filled card will be accepted as a deposit of one dollar either in opening an account or in adding to an existing account.
Deposits are not entered in a depositor’s book, as is the usual practice of savings banks, but are evidenced by certificates issued in fixed denominations of $1, $2, $5, $10, $20, $50, and $100. These bear interest, from the first day of the month next following that in which the deposit is made, at the rate of 2 per cent per annum for a whole year (interest is not paid for any fraction of a year). Interest is not compounded, unless the depositor withdraws the interest and redeposits it, but simple interest continues to accrue annually on a certificate so long as it is outstanding, without limitation as to time.
By the end of the first year (1911) of operation the savings system held a balance to the credit of depositors of nearly $11,000,000; in the next year (1912) there was added to this about $17,000,000; in the next year (1913) about $12,000,000; and this average rate of one million dollars a month net addition to deposits has continued to the present (1916). These funds are deposited in banks belonging to the federal reserve system, which must deposit with the Treasurer of the United States designated kinds of bonds (national, state, and municipal) as security and pay interest at the rate of 2-1/2 per cent on the amount of the deposits. The one-half per cent difference between this rate and that paid to individuals goes far toward paying the expense of operating the system.
Provision is made for the issue of postal savings bonds in exchange for certificates issued in sums of $20 or multiples thereof up to $500. These bonds bear interest at the rate of 2-1/2 per cent payable in semi-annual instalments, January 1 and July 1. These bonds are not counted as a part of the $500 maximum of deposits allowed to one person, and there is no limit to the amount of bonds which may be acquired by one depositor. Postal savings bonds are exempt from all kinds of taxes, federal and local. These bonds are issued only on the surrender of postal savings deposits, but may be sold by the owner at any time. Three years after the law went into effect, there were $4,635,820 of postal savings bonds outstanding.
Sec. 8. #Advantages of the postal savings plan.# As compared with corporate savings banks the postal savings system has certain advantages.
(a) It protects the small depositors from the danger of dishonest private bankers who have preyed upon the immigrants in the larger cities. To foreigners, accustomed to the postal savings plan in their home countries, it is especially useful.
(b) It gives to every depositor the greatest safety possible, as “the faith of the United States is solemnly pledged” for the repayment of depositors.
(c) It brings a savings institution to many a small town and rural place formerly entirely lacking in facilities for small depositors. The benefit of this has not immediately appeared to be great, but may in time prove to be.
(d) It pays interest from the first of the month following the date of deposit whereas the usual practice of savings and commercial banks is to pay only from the beginning of the quarter year or half year.
(e) It provides for the exchange of deposits for bonds bearing a higher rate of interest–a unique feature greatly simplifying for the small saver the process of buying bonds for more lasting investment.
In some respects, however, the postal savings system falls short of the advantages of the regular savings banks. These usually accept for deposit as small an amount as ten cents; they pay interest either quarterly or semi-annually; they pay on the average (at present) almost double the rate of interest, and the interest is credited to the depositor’s account at stated intervals and automatically compounded. The postal savings system, as the law now stands, may be looked upon, therefore, as supplementing the regular savings banks rather than competing with them.
Sec. 9. #Collection of savings and education in thrift.# Small savings have been encouraged in many places by penny provident funds, dime savings banks, and school savings funds, which have been conducted at public schools, social settlements, and factories, by school officers and by charitable and educational societies acting through canvassers. These plans all call for much personal effort and cost, which must be provided by volunteer services and private gifts. These plans being undertaken mainly as a means of education in thrift and in the related moralities, their results are not to be measured merely by the magnitude of the sums collected. They are not rivals of the ordinary savings banks, but rather auxiliary methods of encouraging their use. The funds collected by these agencies are usually deposited in local savings banks, and depositors are encouraged to open individual accounts there, whenever they have considerable sums saved.
In Germany the public schools have been furnished with automatic stamp vending machines, from which savings stamps in as small denominations as ten pfennigs (2-1/2 cents) may be had by dropping a coin into a slot.[10] This method could be used very effectively in connection either with the postal savings system or with a local savings bank. It ought to be made easy to deposit funds at every school house, at every post-office, at every factory counter on pay day, and wherever people pass in numbers. Allurements to foolish expenditures meet old and young at every turn; to spend the dime is made all too easy, whereas to save it and deposit it in a safe place too often calls for wasteful and discouraging efforts from the person of small means.
Sec. 10. #Building and loan associations.# Building and loan association is the name applied to a cooeperative organization of persons with the purpose of collecting regularly from members small sums which are loaned to some members for the purpose of building or paying for homes.[11] The first association of this type was organized in Frankford, Pennsylvania, in 1831. It and others of its kind have made Philadelphia notable among all the larger cities as “the city of homes.” The number of such associations has almost steadily increased in the United States. Pennsylvania continues to rank first in respect to amount of total assets, with Ohio a close second, and New Jersey third (the ranking first in proportion to population). Associations of this type have been hardly second in importance in America to the savings banks as institutions for savings for persons of moderate means. The number of their members (nearly 3,000,000) is about one-fourth of that of savings bank depositors, and the amount of their assets (1-1/4 billion dollars) is about one-fourth that of the reported savings banks. But their relative influence in educating and encouraging to thrift is doubtless much greater than these figures indicate. There are more than three times as many of them as of reported savings banks, their management is much more democratic than is that of the banks, and many of their members attend and participate in the meetings and understand how they are conducted. Moreover, the savings made through these associations are constantly passing on into the houses that are fully paid for, and which continue to yield their incomes to their owners. Each year these associations collect from their members as dues and in repayment of loans (made to build houses) the sum of over half a billion dollars, which is twice as much as the annual increase in the deposits of the reported savings banks.[12]
Sec. 11. #The main features.# A building and loan association is organized by a group of persons in a neighborhood, uniting to form a corporation under the laws of the state, every member to subscribe for one or more shares. The officers elected all serve without pay excepting the secretary-treasurer, who receives a small fee for his services. All official meetings are open to all members. The shares vary in denomination from $25 to $200; the larger figure being common under the serial plan and $100 being usual under the continuous (or permanent) plan, described below. Whenever there is a sufficient sum it is loaned to one of the members for the purpose of building a house. The borrower must subscribe for shares to the par value of his loan.
The receipts of the association are of several kinds.
(a) Interest is received from members, usually at the rate of 6 per cent, and from banks at a lower rate on the small working cash balances kept on deposit. Usually the loans made are large enough to cover a large proportion of the cost of the house, but the land on which the house stands must be free from all incumbrance, and its value gives a margin of safety to the association. Then by the method of payment of dues the debt is, from the first month, steadily reduced and the security for the loan therefore grows constantly better.
(b) Premiums are collected in addition, sometimes in the form of a higher rate of interest, but the practice of charging premiums has been mostly abandoned and the total amount of premiums now constitutes less than 1 per cent of all payments from members.
(c) Fines for delinquency also are less commonly imposed now and constitute a small fraction of 1 per cent of total payments.
(d) Deductions are made on account of withdrawal before the maturity of the shares; under these circumstances it is usual to pay a portion but not all of the accumulated profits, sometimes a proportion increasing as the shares approach maturity.
Different plans have been and still are followed in respect to the method of issuing the shares. Under the _terminating plan_ all the shares begin and mature at the same time (for all members that continue to the end). Whereupon the association dissolves or starts anew. The chief difficulty in this plan is that the association has too few funds to loan at the beginning of its career, and a surplus of unloanable funds as it nears the maturity of the series. It is therefore necessary to encourage or to compel the withdrawal of non-borrowing members on the payment of estimated profits to date.
The better to remedy this difficulty the _serial plan_ was devised, by which new series of stock are issued at intervals–yearly, half-yearly, quarterly, and even oftener.
Sec. 12. #The continuous plan.# A further development is the continuous plan (usually called the _permanent_ or the Dayton plan), by which much greater flexibility is attained in the organization. Shares of stock may be subscribed for at any time, each man’s separate subscription of shares being treated as a separate series, and maturing each at its own time. There is thus, after an association has been for some time in operation, a continuous stream of new members (or new subscriptions) flowing into the association, and a continuous outflow of shareholders whose shares have matured. The maturing shares of borrowing members discharge their indebtedness to the association; the maturing shares of non-borrowing members are paid in money, or may (if the association has use for the funds) be left as an interest-bearing loan.
Additional funds are obtained when needed by issuing paid-up stock to non-borrowers. This is convenient at the beginning of an association and when the movement in building is more active than usual. But if an association has funds that cannot be loaned, outstanding paid-up stock may be called in. In practice a large part of the paid-up stock as well as of the running stock is subscribed for and held not by large capitalists but by persons of small means, especially “the more frugal element in the working classes.” Non-borrowing members desiring to withdraw may do so at any time under certain conditions; but to safeguard the association, the laws usually require that thirty days’ notice of intention to withdraw shall be given, that not more than one half of the funds received in any one month shall be paid on withdrawals, and that withdrawing shareholders shall be paid in the order of the notices of intention to withdraw.
The most intelligent and prudent workers were formerly deterred from subscribing by the fear that sickness, unemployment, or other mishap might make it impossible to keep up regular payments. Now, however, fines for late payment have been almost entirely done away with. On the other hand, extra payments may be made at any time by borrowing members, to hasten the date when their shares mature and their debt be discharged. These privileges are possible because of the method of distributing earnings which will now be described.
Sec. 13. #The distribution of earnings.# Every six months is ascertained the amount of the gross earnings which, under this plan, consist almost entirely of interest paid on loans. From this amount are deducted expenses (and in some states 5 per cent of the total is placed in a “loss fund” to meet possible losses) and the rest is divided in proportion to the amount standing to the credit of each member, being credited to the account of running stock and paid in cash to holders of paid-up stock.
The payment of dues is correspondingly simple. The dues at twenty-five cents a week amount to $13 a year per share of $100. This is the whole bill; there are no extras. The interest at 6 per cent (the usual rate) is $6, and the rest, $7, is credited upon the stock. Thus at the end of the first six months the member has $3.50 to his credit, and is entitled to his share of the net earnings on that amount. Thus his share of the earnings is steadily increased by compound interest, and if he keeps up his regular payments the shares mature in about sixteen years. This means in most cases that a prudent tenant can become the owner of a house in sixteen years while paying no more than the rent would be. As the active investor he becomes his own rent collector and uses the house with less need of repairs, thus dispensing with services and costs which are included in contractual rents.[13]
These associations are properly made subject to supervision and examination by state officials, in the manner of that exercised over banks. They have been favored by exempting the shares of members and the mortgages held by the associations from all state and municipal taxation. As the houses built or paid for are taxed, this is of course but just, but it is an exception to the rule of the illogical general property tax.[14]
Sec. 14. #Possible developments of savings institutions.# The social importance of increasing and improving the agencies of savings for the masses is being more fully recognized, but much more might be done in these directions. Some possible changes have been suggested above, and a few words more may be added.
Probably the greatest developments in the near future will be through the savings departments of commercial banks (favored by the reserve rules of the Federal Reserve Act) rather than by the increase in the number of special banks for savings. The initial expense and risk of starting a savings bank is considerable, and outside of cities of some size this is prohibitive. Whereas a savings department, with its funds and reserves separated, can be easily and cheaply operated in connection with a general bank. It is much to be desired, however, that a larger measure of popular cooeperation might be made possible to the depositors, both for its educational value and to reduce the real evil of the autocratic or the plutocratic centralization of the money power in the small communities.
Savings banks usually limit the amount of an account to $3000. It is desirable that depositors should be able easily to convert their savings-bank deposits over certain amounts into good bonds, bearing a higher rate of interest (after the method of the issue of postal savings bonds). There is need of a central market in each community where such bonds can be bought and sold at any time; and the savings banks might easily serve to buy and sell for their customers in this way in the larger bond market. This would be of benefit also to the states and municipalities which issue bonds for such purposes as schools, roads, and public utilities, by creating a more open and regular market to small investors than now is provided for such securities. This might somewhat reduce the rate of interest and there would be a gain divided between taxpayers and lenders.
The general plan and principles of local building and loan associations might well be extended to groups of rural cooeperators, enabling them to make loans to their members; and to groups of small investors, permitting them to hold real estate mortgages and bonds and stocks of corporations, free from taxation other than that paid on the wealth itself. Members of such organizations could get a higher income on their investments than a savings bank could pay, and with greater security than if each attempted to save and invest by himself.[15]
Savings institutions are necessarily also lending institutions. In this chapter they have been looked at mainly from the saver’s (the lender’s) standpoint, though their service to the borrower is of cooerdinate importance. In the case of building and loan associations this feature is most apparent. Later, the problem of the agricultural borrower will receive further consideration.
[Footnote 1: See Vol. I, chs. 9 and 10.]
[Footnote 2: See Vol. I, pp. 285-290 for the analysis of saving from the individual standpoint; and pp. 482-499 for its relation to general economic conditions.]
[Footnote 3: See Vol. I, p. 484.]
[Footnote 4: See above, ch. 9, sec. 7.]
[Footnote 5: E.g., Babson Statistical Organization, Brookmire Economic Service, Moody Manual Co., Moody Corporation Service.]
[Footnote 6: See Vol. I, p. 318.]
[Footnote 7: Report of the Comptroller of the Currency. Not all of these are mutual. Statistics, moreover, include in some cases (e.g., California) the savings deposits of commercial banks but not the number of such banks, and in other cases (Michigan) some banks that do chiefly a commercial business. The line of demarcation between savings banks and savings departments of commercial banks cannot be sharply drawn. The Comptroller of the Currency reported in 1914 in a different form the amount of savings deposits and of time certificates of deposits in _all_ kinds of banks as the enormous sum of $8,675,000,000.]
[Footnote 8: In the last twenty-three years, on the average, seven savings banks a year have failed, the annual excess of liabilities over assets being about $200,000, or about $30,000 for each failing bank. The total loss has been about 1/5 of 1 per cent of total deposits.]
[Footnote 9: The Federal Reserve Act, by making it possible for loans to be had at any time (through member banks) on good security, should reduce the danger of runs on savings banks.]
[Footnote 10: The author saw in operation a new machine of this kind which had been installed in a German public school as early as 1910.]
[Footnote 11: See Vol. I, pp. 290, 297-298, 484, and 486.]
[Footnote 12: The figures here given and the description of methods apply to the “local” building and loan associations. The success of this kind led to the organization of other associations which took the name “National” building and loan associations, to carry on a business in a larger field. The number of these has always been comparatively small, and their operation is less simple, democratic, and economical than the local associations. They have borne more of the nature of ordinary profit-making enterprises. They should not be confused with the local associations.]
[Footnote 13: On these economies, see Vol. I, p. 298.]
[Footnote 14: See ch. 17, sec. 4.]
[Footnote 15: Since this was written the Federal Rural Credits Act has been passed, embodying the main idea here described.]
CHAPTER 12
PRINCIPLES OF INSURANCE
Sec. 1. Chance, unavoidable and average. Sec. 2. Uneconomic character of gambling. Sec. 3. Borderland of gambling. Sec. 4. Insurance: definition and kinds. Sec. 5. Insurance viewed as a wager. Sec. 6. Insurance as mutual protection. Sec. 7. Conditions of sound insurance. Sec. 8. Purpose of life insurance. Sec. 9. Assessment plan. Sec. 10. The reserve plan. Sec. 11. The mortality table. Sec. 12. The single premium for any term. Sec. 13. Level annual premiums and reserves. Sec. 14. Different features of policies. Sec. 15. Insurance assets and investments as savings. Sec. 16. Excessive costs of insurance operation.
Sec. 1. #Chance, unavoidable and average.# Every action and every movement in life has in it some element of chance. There are what may be called natural chances, arising from the uncertainties of the seasons, or from rainfall, heat, hail, storm, flood, lightning, or land-slides. Such chances must be taken both by the small enterpriser and by the large. In earlier conditions of society natural chance dominated industry, and it still remains and must always remain important. There is the chance of unexpected political events, such as war, riot, and legislation on money, tariffs, credit, and business relations. These things are caused, it is true, by the action of men, but it is a collective action out of the control of the individual. There is the chance of human carelessness causing fire, explosions, and wrecks on misplaced switches. There is the chance of physical or mental collapse, as the sudden insanity or the sudden death of one performing responsible duties. There is the chance of sickness that often wrecks the plans and the fortunes of a whole family. There is the chance of economic alterations in methods of production and of transportation, in fashions and demand in this direction or for those materials.
Some of these chances are more connected with money-lending, others with manufacturing, some with agriculture, others with commerce; but all are present in some degree in every industry. Some events are unique in nature and seem unlikely ever to occur again; others are of a kind occurring so irregularly that no reasonable prediction can be made as to the time and frequency of their occurrences. Still others occur frequently and to many different persons; but no individual can tell when and how they will occur to him. A general average of chances in different lines of business causes some to be called safe, others extra-hazardous. Chance has its favorable as well as its unfavorable aspects. Chances are averaged and added algebraically to the profit or loss in an industry, for an extra-hazardous enterprise must in general afford a higher average of profit in order to induce men to engage in it. It is folly to take a risk without ascertaining its degree so far as general experience enables one to choose. But inasmuch and in so far as the gains and losses fall unequally upon different individuals, income depends upon chance.
Sec. 2. #Uneconomic character of gambling.# This prevalence of chance sometimes tempts men to say that business is “a gamble.” But a distinction in principle must be made between gambling and legitimate risk-taking. The chances enumerated above are not sought, but avoided as far as possible; yet they must be borne by some one if productive enterprise is to continue, and the burden must somehow be distributed throughout the community. Gambling is, however, a kind of risk-taking which has a very different economic and moral quality. Gambling creates the hazard, making the gain or loss of income depend on an event that is not a necessary part of productive enterprise. Typical gambling is the transfer of wealth on the outcome of events absolutely unpredictable, so far as the two gamblers are concerned. Examples are the shaking of unloaded dice or the honest dealing of a pack of cards, and the betting on prices in so-called “bucket-shops” by persons having no connection with the market of real things, and seeking to get something for nothing as a result of mere chance.
Cheating is not a necessary mark of gambling, altho the cruder forms of dishonesty, such as the loading of dice or the collusion of horse-owners or of horse-jockeys to deceive the betting public, are so common that they seem often to be an essential feature. Gamblers recognize fair as opposed to unfair methods. Fair gambling is a kind of minor morality within the immoral field of gambling, like the honor found among thieves. The chance-taking in gambling has no useful purpose or result outside itself. Betting and gambling do not produce wealth, but merely shift the ownership of existing wealth. The gamblers constitute themselves a little fictitious economic circle, and they transfer gains and losses on the turn of events that have no practical objective result within their circle except to determine the direction of the transfer. Even when fairest, gambling must, in its average results, be uneconomic. In any economic trade each trader gains by getting goods that are, on the marginal principle, to him more valuable than the other kinds of goods he gives up.[1] But in gambling the winner gets all, the loser gets nothing. If two men of like incomes gamble the additional desires that the winner is able to gratify are (by the principle of decreasing gratification) less in amount than the desires which the loser must forego. As a result the loser is often depressed and seriously injured by the loss of his income, the winner makes reckless and extravagant use of his winnings. Easy come, easy go, is the rule of gamblers.
Moreover, gambling reduces the amount of wealth by relaxing the motives of economic activity, diverting energy from productive enterprise, tempting men into dishonesty to offset their losses, and leading them into speculation and embezzlement.
Sec. 3. #Borderland of gambling.# Ranging between the extremes of unavoidable risk-taking and of gambling are a number of cases of a mixed nature. In nearly all wagers, judgment in some degree influences the choice of sides. One man bets on a horse whose pedigree and performances he knows thoroly; another judges by the horse’s appearance as it comes upon the track. The professional bookmakers have the latest possible and most exact information on which to base their bids.
In the bets made on one’s own prowess, as on speed in running, the chance-taking is still on the uneconomic side of the borderland, certainly if the running is for the sake of the wager, not for pleasure or for a useful purpose. A premium won by a runner for speed in delivering a message of economic importance presents an essential contrast to the winnings in a wager.
Finally, the very borderland of difficulty is reached in the purchase and sale of goods in the market with a view of profiting by chance changes in price. The purchasing and holding of land, lumber, grain, cattle, and other tangible and useful things, that need to be stored, held for buyers, or taken to market, must be judged liberally. The quality of gambling depends somewhat on the motive as well as on the ability of the trader. The enterpriser dealing with real wealth, and fitted to take the risks both because of his resources and of his exceptional knowledge, needs the motive of gain in such cases, and in a sense can be said to earn socially what he gets. The motive of the uninformed must be a blind trust in luck, and a hope to gain from a rise in prices which they are quite unable to foresee or to explain.
Sec. 4. #Insurance: definition and kinds.# The large element of luck in industry due to unavoidable chances has something of the same evil character as gambling. It brings unearned prizes to some and to others unmerited losses. It must therefore be a benefit to the community, if this element of unavoidable chance cannot be reduced as a whole, at least to regularize it and make it exactly calculable for any individual. In this way each may be encouraged by the more certain prospect of receiving a reward proportionate to his efforts and abilities. This desirable condition has in many respects been accomplished by means of insurance.
_Insurance_ is the act of providing a guarantee of indemnity against a financial loss that will result if an event of a specified kind occurs. The person seeking some surety against the possible loss is the _insured_; the person contracting to indemnify against the loss is the _insurer_; the written contract of insurance is the _policy_; and the price paid by the insured in fulfillment of his part of the contract is the _premium_; the amount paid when a loss has been incurred is the _indemnity_; and the person to whom the indemnity is paid is the _beneficiary_ (who may or may not be the insured).
The insurance with which we are here concerned is that which gives financial indemnity. This is given for loss of expected net income, when by chance either receipts are less or costs are more than average. The two main classes as regards kinds of loss are property insurance and personal insurance. _Property insurance_ is that which indemnifies for loss of one’s possession in specified ways, such as by fire, by the elements at sea (marine), by hail, lightning, or cyclone, by death (of valuable animals), by robbery, and by breakage (of window glass). _Personal insurance_ is that which indemnifies the beneficiary for loss of income as the result of various happenings to persons, the chief being death, accident, sickness, invalidity, old age, and unemployment. The principle of insurance is being constantly extended to new subjects[2] and it is capable of further development in a variety of directions.
Sec. 5. #Insurance viewed as a wager.# Insurance, without question a highly useful thing, appears, paradoxically, to be in its outer form a bet. The large merchant with many vessels used in many kinds of business had in the days before marine insurance an advantage in distributing his losses over a number of voyages. Antonio, the wealthy merchant, is made thus to express his security:
“My ventures are not in one bottom trusted Nor to one place; nor is my whole estate Upon the fortune of the present year.
Therefore my merchandise makes me not sad.”
In its early form marine insurance was the attempt of smaller ship-owners to distribute their losses (as could the wealthy merchant) over a number of undertakings, lucky and unlucky. It became customary for a ship-owner to bet with a wealthy man that the ship would not return. If it did come back, the owner could afford to pay the bet; if it did not, he won his bet and thus recovered a part of his loss. Gradually there came about a specialization of risk-taking by the men most able to bear it. They could tell by experience about what was the degree of uncertainty, and could lay their wagers accordingly. When several insurers were in the same business, competition forced them to insure the vessel and cargo of the ordinary trader for something near the percentage of risk involved. The insurance thus tended to become a mutual protection to the ship-owners; what had to be paid in premiums to cover risk came to be counted as part of the cost of carrying on that business.
Every legitimate form of insurance exhibits substantially the same characteristics; it reduces loss at the margin where it is felt most keenly. The difference between insurance and gambling, thus, lies primarily in the purpose of insurance, which is not to increase artificially the risk that any individual runs, but to neutralize or offset an already existing chance. The insurance bet is what is called a “hedge.” The difference lies further in the collective method of insurance, which combines the chances scattered among a number of persons. Insurance does not increase the total of risks and of losses, but merely combines, averages, and distributes them equally among all the insured. This eliminates the chance element to the individual by converting it into a regular cost.
Sec. 6. #Insurance as mutual protection.# Modern insurance is conducted either by enterprisers for profit, or by mutual companies; but in any case in large measure the losses in insurance are mutually shared, as the premiums (plus interest earned) equal the total losses plus operating expenses and profit, if any is made. Each insured gets a contract of indemnity for the payment of a sum that will help cover the losses of others. Such an exchange is mutually beneficial. The premium comes from marginal income; the loss if it occurs would fall upon the parts of income having higher value to the insured. The less urgent needs of the present are sacrificed in order to protect the income that gratifies the more urgent needs of the future. In insurance each party gives a smaller value for a greater; each makes a gain. The greater security in business stimulates effort. This effect is quite the opposite of that of gambling.
Sec. 7. #Conditions of sound insurance.# To be economically sound, insurance must have to do with real productive agents, and with a group of occurrences which, as a whole, are approximately ascertainable in advance–however irregularly they may fall upon individuals. The beneficiary must have an _incurable interest_ in the property or person insured; that is, the beneficiary must actually suffer a loss by the occurrence insured against. Finally, the amount of the indemnity must not be greater than the loss incurred. Some of the greatest difficulties in insurance arise from the absence of these essential conditions. When there is no insurable interest or when the indemnity is greater than the loss that may be incurred, the beneficiary may and sometimes does find it to his interest to bring about the socially injurious event insured against. He artificially increases the loss against which insurance was taken. When the insured sets fire to his own buildings, he makes an illegitimate use of insurance. Constant efforts are made by insurance companies to guard against these “moral risks,” the least calculable of any. Merchants whose stocks have been mysteriously burned two or three times find difficulty in getting further insurance. Formerly insurance was not paid in case of death by suicide; but now usually no such limitation is contained in a policy after a period of one or more years. As men rarely plan suicide years in advance, death by one’s own hand some years after taking life insurance is regarded as coming under the ordinary rules of chance. Yet it is to be feared that this liberal policy serves as a temptation at times to crime and to self-destruction.
Sec. 8. #Purpose of life insurance.# Property insurance is mainly an aspect of enterpriser’s cost, whereas personal insurance is more closely connected with the object of saving.[3] We shall in the rest of this chapter limit the discussion to the one most important form of personal insurance, that called life insurance (sometimes called survivors’ insurance).
Life insurance is that form of insurance in which partial indemnity is provided for survivors against the financial loss incurred by the death of the insured. Usually the insured is the breadwinner of the family and the beneficiary is a member of his family, but in an increasing number of cases the beneficiary is the surviving business partner, a creditor, or a business corporation with an insurable interest in the life of one of its employees.
Life insurance has been much used by persons mainly dependent on labor incomes[4] rather than on incomes from capital, by those receiving salaries, professional fees, and by active business men. It has of late been extended rapidly, as “industrial insurance” to wage earners, in policies never exceeding $1000, but averaging very much less, and often being for no more than enough to pay funeral expenses. The premiums on such policies are usually collected weekly and by agents making personal visits. The cost to the insured is, therefore, necessarily very high in proportion to the amount of insurance.
Sec. 9. #Assessment plan.# Life insurance plans may be distinguished, with reference to the time and method of collecting the premiums, as assessment and reserve insurance.
In the simple form of assessment insurance originally the losses were paid by contributions taken after the losses occurred, each member paying an equal share without regard to age. In a slightly improved plan the assessments are made at the beginning of the year, based upon the expected mortality for the year. The sum just sufficient for this purpose (omitting expenses) is called the _natural premium_. The cost of such insurance is closely related to the average age of the members. The rates are very low in a new organization with a membership of young men; but each year the average age, and therefore the mortality of the membership, rises and the annual assessments must