The Online Library of Liberty

A project of Liberty Fund, Inc.

• Foreword to the Revised Edition.
• Modern Economic Problems
• Part I: Money and Prices
• Chapter 1: Nature of Economic Problems
• Chapter 2: Origin and Nature of Money
• Chapter 3: Commodity Money and the Quantity Theory
• Chapter 4: Fiduciary Money, Metal and Paper
• Chapter 5: Price Levels and the Gold Standard
• Chapter 6: Rising Prices and the Standard
• Part II: Banking and Insurance
• Chapter 7: The Functions of Banks
• Chapter 8: Banking In the United States Before 1914
• Chapter 9: The Federal Reserve Act
• Chapter 10: Crises and Industrial Depressions
• Chapter 11: Institutions For Saving and Investment
• Chapter 12: Principles of Insurance
• Chapter 13: Scientific Life Insurance
• Part III: Tariff and Taxation
• Chapter 14: American Tariff History
• Chapter 15: International Trade
• Chapter 16: The Policy of a Protective Tariff
• Chapter 17: Objects and Principles of Taxation
• Chapter 18: Property and Corporation Taxes
• Chapter 19: Personal Taxes
• Part IV: Wages and Labor
• Chapter 20: Methods of Industrial Remuneration
• Chapter 21: Organized Labor
• Chapter 22: Public Regulation of Hours and Wages
• Chapter 23: Other Protective Labor and Social Legislation
• Chapter 24: Social Insurance
• Chapter 25: Population and Immigration
• Part V: Public Policy Toward Private Industry
• Chapter 26: Agricultural and Rural Population
• Chapter 27: Problems of Agricultural Economics
• Chapter 28: The Transportation Problem
• Chapter 29: Railroad Regulation
• Chapter 30: The Problem of Industrial Monopoly
• Chapter 31: Public Policy In Respect to Monopoly
• Part VI: Private Property Versus Socialism
• Chapter 32: The Present Economic System
• Chapter 33: Public Ownership
• Chapter 34: Methods of Distribution
• Chapter 35: Socialism, Present and Future

PART II

BANKING AND INSURANCE

CHAPTER 7

THE FUNCTIONS OF BANKS

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

In the United States there were on June 30, 1920, more than 30,000 banks reported. These may be classified first according to the source from which they derive their charters or authority to do a banking business as: national, state, and private. The last are unchartered and act under the general state laws governing private contracts; in general they are unsupervised.1 Banks may be classified also, according to the two main types of business they perform, as banks for savings and commercial banks. Most banks do mainly a general commercial business; some are distinctly banks for savings; but in truth this dividing line can be less and less sharply drawn between banks as units; rather the distinction must be made between the savings function and the commercial discount function, which are more and more being performed by one and the same bank. The statistical data collected in the United States distinguish only imperfectly between these two. The trust company usually unites these two functions in large degree. This matter will be better understood in connection with the analysis of the functions that banks perform, now to be given.2

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

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

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

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

(d) Acting as trustee and business manager for passive investors, and especially as executor and administrator of estates or as guardian of a minor heir. This function was taken up rapidly after about 1890 by trust companies3 organized under state laws, and after 1918 (as a result of an act of Congress) by many national banks.

(e) Receiving time deposits at a low rate of interest to lend or invest in securities at a higher rate of interest. Such time deposits are not subject to withdrawal by customer’s check, excepting after notice to the bank (if required). Receiving time deposits is the essential function of savings banks (as distinct from commercial banks) and will be more fully discussed in a later chapter.

(f) Selling its credit, that is, giving its promise to pay at some other place, or at some other time, in return for a payment that yields a profit.

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

§ 4. Demand deposits. Demand deposits are those payable on demand, the demand in practice being by means of personal checks requesting the bank to pay to (or on the order of) a specified person, or to pay to bearer. A customer’s bank account consisting of demand deposits is called a checking account. Since the turn of the century it has become increasingly the practice to pay a low rate of interest (about 2 per cent) on current balances, oftener to large depositors. Banks attract demand deposits mainly by the convenience and economy which they offer to their customers in the guarding of funds from theft and fire and in saving the time, trouble, and expense of carrying money for making payments. A deposit in a bank is to the depositor for most purposes “just as good” as money in the pocket and for many purposes is even better. Thus the banks have become the custodians of a large proportion of the money (or funds) needed for current use by individuals and business corporations. Large amounts of deposits (though only a small proportion of the total) are brought to the banks in the form of bags and rolls of money, or as funds consisting of credit papers, such as checks and drafts, calling for the payment of money. But most deposits are created in another manner now to be described.

§ 5. Discount and deposit. The process of discount and deposit is the purchase of the promissory note of a customer,4 the price being a credit in the form of a demand deposit on the books of the bank. This—the central and most characteristic banking operation—has something of mystery in it at first view. In simple deposit, described in the last section, the bank becomes the debtor and the depositor becomes the creditor of the bank. But in discount and deposit the depositor brings no money, and the credit paper that he gives is his own promise to pay, whereby he becomes the bank’s debtor. For example, when a bank discounts a $1000 note for three months and credits its customer with the proceeds, its deposits are at that moment increased (let us say) $985. Notice that hereby the bank does not add a cent to the cash in its vaults while it has added to its liabilities payable on demand. As an offsetting asset it holds the note of its customer receivable at some future time. Most of the loans and discounts of commercial banks serve thus to create deposits, and the two items (loans and deposits) rise and fall in about the same ratio. In 1920 in all reporting banks (exclusive of the twelve Federal Reserve banks) individual deposits were $38,000,000,000 and loans were $31,000,000,000.

§ 6. Nature of banking reserves. Banks would have nothing to gain by receiving deposits or by issuing notes if they were obliged to keep in the vaults actual money to the amount of their deposits and outstanding notes (unless they were paid by depositors for taking care of deposits). It was found necessary in practice for banks to keep on hand money amounting to only a fraction of all their outstanding obligations in order to be able to pay promptly all due demands under ordinary business conditions. The sum thus kept on hand is called the reserve or the reserves of the bank, and this is frequently expressed as a percentage of reserves against deposits or against note issues, respectively, or of both together. Frequently, as in the United States, a minimum percentage of reserves is fixed by law.5

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

The explanation of the adequacy of a mere fractional reserve is found in the nature of the individual monetary demand6 and in the effective way in which a checking account serves as a substitute for actual money.7 Every customer, if he would avoid overdrawing his account, must at most times keep a goodly balance to his credit that he does not immediately need. Many individuals and corporations must at times keep very large balances. The times of maximum monetary need of the customers of a bank never exactly coincide, and many payments are made among the customers of a single bank, requiring only bookkeeping transfers. A fractional reserve is therefore ordinarily fully adequate, although with any less than 100 per cent reserve any bank would be insolvent if all of its demand obligations were presented at the same instant. Such an extreme condition is made impossible by business custom and public opinion, especially among the larger customers of banks; but the panic of small depositors and the urgent need of larger ones often bring about a dangerous situation, in which banks with abundant assets find their reserves nearly or quite exhausted. To prevent the breakdown of the separate banks and of the whole banking system at such times, by providing ways of replenishing the reserves, is a large part of the “banking problem.”

§ 7. Time deposits. Time deposits are funds to the credit of customers which, by agreement, are to be left for some specified minimum time or on condition that the bank may require notice in advance of the depositor’s intention to withdraw them. The notice that may be required is usually from thirty to ninety days; but only in times of general financial crises or of runs on particular banks is this requirement enforced. A sufficient deterrent to irregular withdrawal of funds is usually found in the loss of interest if deposits are withdrawn at other than stated times. The bank’s right to require notice makes prudent the investment of a much larger proportion of its deposits and for a longer time; it reduces the proportion of deposits needed for reserves, and yet reduces the danger of a “run” upon the bank in time of financial distress. These are reasons why banks can and usually do pay interest on time deposits (at from 2 to 4 per cent), as until more recently they rarely did on demand deposits. From the standpoint of the depositor a time deposit is, by its very nature, an investment and not a demand credit available for current monetary uses. Only that portion of a person’s capital that for some more or less considerable period is not likely to be needed for other purposes ought to be put into time deposits. A bank, however, is generally a much safer place in which to keep a fund of purchasing power for the future than is the strongest private treasure-box. Receiving time deposits is the one essential function of savings banks, but this function is increasingly performed by other banks.8 In some cases time deposits are cared for by a separate department and kept separate from the general business of a commercial bank.

§ 8. Bills of exchange, domestic. Foreign and domestic exchange is the sale of orders for the payment of specified sums of money at distant points. But for this, payments at distant points would ordinarily have to be made by sending the money in some way. It must often occur, for example, that hundreds of payments, aggregating millions of dollars, must be made by persons in and near Chicago to those in and near New York, while, at the same time, equally large sums are due from New York to Chicago. The wasteful process of shipping these sums back and forth is avoided by the cancellation of indebtedness between the two localities. It has been the practice for each small bank to keep a part of its funds in correspondent banks in one or more of the larger cities on which it draws bills of exchange for its customers and to which in turn it remits for collection drafts and checks which it has received. Before 1914 such deposits might, up to a certain percentage, be counted as part of the depositing bank’s legal reserves. From time to time, as balances of accounts increase on the one side or the other, shipments of actual money become necessary; but these are only a small fraction of the total amount of the bills of exchange mutually cancelled. Similarly, the settlement of accounts between any two localities can be made by the shipment of comparatively small sums of money. Under the Federal Reserve Act the reserve banks have in various ways assumed the functions of the correspondent banks, aiming to bring about parity of checks issued in any part of the country.

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

§ 9. Issues of notes. The issue of bank-notes as a mode of lending a bank’s credit calls for consideration here. Yet it must be observed at once that comparatively few banks in the world have now the legal right to issue their own notes. The function of bank-note issue has come to be looked upon as so closely connected with that of the coinage and regulation of the standard money that it has been increasingly limited in each country to a central national bank, or group of banks, which is in many respects practically an organ of the government. To such banks the right of note issue is granted as a monopoly in return for specified payments and services. In normal times the issues of bank-notes are regulated by the banks themselves; but in times such as those following the outbreak of the World War the bank-note issues become essentially political money (irredeemable) issued by command, and to meet the urgent financial needs, of the sovereign state.

No two countries have quite the same kind and system of bank-notes. Typical bank money (or “credit currency”) consists of notes issued by banks on the credit of their general assets, without special regulation by law. Many of the bank-notes issued by the banks chartered by either the federal or the state governments before the Civil War were of this kind; but after 1837 the notes of the Second Bank of the United States, which had been prudently controlled, were retired. The experience with many (not all) of the state bank-notes issues thereafter, until the Civil War, was less fortunate. As it was to the interest of the banks to keep in circulation as many notes as possible, many banks yielded to the temptation to abuse the power of note issue. The period is known as that of “wild-cat” banking. In 1866 a federal tax of 10 per cent on state bank-notes made their issue unprofitable.

Since the passage of the Federal Reserve Act we have temporarily two kinds of bank-notes, the old bond-secured notes, in use since 1863 (very different from the typical form),9 and the new kind of Federal Reserve notes very nearly typical in character but issued only by the Federal Reserve banks, not by individual banks.

A bank, by the issue of notes, puts into circulation as money its own promises to pay. The customer, in borrowing money or in withdrawing deposits or cashing checks and drafts from other banks, is paid with the bank’s notes instead of with standard money. These notes may be returned to the issuing bank, either to be redeemed in specie or to be paid in some other form of credit, such as deposits or exchange. The limit of the issue of such notes is the need of the community for that form of money, and if they are promptly redeemed in standard money on demand, they never can exceed that amount. A holder of a note (in the absence of special regulations) has the same claim on the bank that a depositor has.

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

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

At the other extreme of view have been those who consider bank-notes to be essentially of the nature of political money. If they are so, it is argued, the power of issue should not be exercised by any but the sovereign state. In this view it is overlooked that bank-notes, unlike inconvertable paper money, depend for their value on the credit of the bank, not on their legal-tender quality and on political power.10 They must be redeemed on penalty of insolvency; government notes need not be, and yet will circulate at par if properly limited. Adequate provisions for the prompt return and redemption of bank-notes makes them “elastic” in their adaption to monetary needs, which fluctuate with changes in commerce and industry from season to season and even from day to day.

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

§ 11. Banking credit as a medium of trade. The credit which, in various ways, banks sell11 serves, in most cases, the purposes of money to their customers. On the contrary, this is not usually true of time deposits, for the motive of the depositor in such cases is usually to invest his funds for a time rather than to keep them available as money. However, there are many cases in which persons save for some moderately distant use—such as the purchase of furniture, of a piano, of a house. The safety and convenience of time deposits, combined with the reward of a small rate of interest, cause great sums, in the aggregate, to be deposited as temporary savings, which otherwise would be hoarded in the form of money and thus withdrawn from circulation. In such cases the time deposit may serve both as an investment and as a monetary fund for future use. This is a great economy in the use of money, for experience shows that in the savings banks of America the average reserves of actual money kept against deposits are only about 1½ per cent. In countries where banks are little known, the amount of actual money hoarded is therefore vastly greater than it is in the United States, where there are $6,500,000,000 of individual deposits in regular savings banks, besides large sums in time deposits in commercial banks.

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

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

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

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

§ 13. Earnings of banks. The earnings of banks are drawn from different sources, according to the size of the community and the nature of the banks. While in the villages and smaller cities the commercial banks perform a number of functions, in the larger cities they usually specialize in a far greater degree. The trust companies, however, with their greater versatility have been increasing in number. The earnings of banks are derived from discounts, interest on their own capital, charges for exchange and collection, dividends, interest and rents on investments, and profit from their bank-notes. The capital with which a bank starts in business13 could be lent with less trouble and more cheaply without starting a bank, but used as a banking capital it can be lent in part while still serving to attract deposits, which are the main source of the income of banks to-day. In the past it has been customary for many banks, especially “country banks,” to charge for remittances and for the collection of checks from other banks; but under the Federal Reserve system great progress has been made toward parity of exchange, or parity of checks, everywhere in the United States. While many small banks have strenuously opposed this because it cuts off a considerable source of revenue, they gain in other ways by performing this service freely for their customers. Banks make few investments in real estate or other physical property; it is, in fact, their duty to keep out of ordinary enterprises; but they are forced sometimes to take for unpaid debts things that have been held as security. Profits on bank-notes have at times been the main, almost the sole, motive for starting banks; but that is not the case to-day, when the right of issue is so strictly limited.

References.

• Agger, E. E., Organized banking. P. 385. New York. Holt. 1918.
• Cleveland, F. A., Funds and their uses. N. Y. Appleton. 1902.
• Conant, C. A., History of modern banks of issue. 5th ed. N. Y. Putnam. 1915.
• Dunbar, C. F., Theory and history of banking. New ed. N. Y. Putnam. 1917.
• Fiske, A. K., The modern bank. N. Y. Appleton. 1903.
• Holdsworth, J. T., Money and banking. N. Y. Appleton. 1914.
• Phillips, C. A., ed., Readings in money and banking. N. Y. Macmillan, 1916. Chs. IX, X.
• Same, A study of the principles and factors underlying advances made by banks to borrowers. P. 374. New York. Macmillan. 1920.
• Pratt, S. S., The work of Wall Street. P. 447. An account of the functions, methods, and history of the New York money and stock markets. New York. Appleton. 1921.
• Scott, W. A., Money and banking. N. Y. Holt. 1916.
• White, Horace, Money and banking illustrated by American History Bost. Ginn. 1914. Bk. III. Chs. I-III.

CHAPTER 8

BANKING IN THE UNITED STATES BEFORE 1914

§ 1. The First and Second Banks of the United States. The form of our present banking system has been affected by various economic and political events, a knowledge of which is helpful to an understanding of the present banking system in our country.

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

In 1816, however, after only a moderate discussion, the Second Bank of the United States was chartered for a period of twenty years. This, also, in its purely banking aspects, seems to have been distinctly successful, conducting numerous branches in various parts of the country, maintaining at all times the parity of its notes, facilitating domestic exchange throughout the country, and enjoying unquestioned credit and solvency. However, this bank became, even in a greater degree than did the First Bank, the creature of political rivalries. In the period of rising democratic sentiment typified and led by Andrew Jackson, the bank came to be looked upon as the embodiment, or the stronghold, of plutocratic interests. Jackson’s suspicions and hostility to a central bank were magnified by the untactful conduct of the head of the bank, and Congress permitted its charter to expire by limitation in 1836, near the close of Jackson’s administration. In the light of history the change of policy must be pronounced unfortunate, the more so because it committed the then leading political party to opposition against a better organization of banking on a national scale. The action was directly that of Jackson, but the fixing of the blame is not an entirely simple thing.

§ 2. Banking from 1836 to 1863. The federal government, which up to that time had deposited its funds in the central bank and its branches, and in local state banks, established the “independent treasury” in 1840. This was abolished in 1841, but reëstablished in 1846, and continuously maintained until January, 1921, when the Federal Reserve Board took over all nine of the offices and sub-treasury branches. By this plan the government kept its money of all kinds in various depositories (or sub-treasuries) in charge of public officials. While from 1792 to 1836 almost continuously a central banking system was in operation, other banks, organized under state charters, were steadily increasing in number. They received deposits, issued bank-notes under state laws, and cared for local commercial needs. The abolition of the central national bank in 1836 left to the various state-chartered banks for twenty-seven years all the banking functions of the country. A few of the states became stockholders in central state banks, or even undertook to conduct a banking business, with unsatisfactory results. The banks of some states (notably those of New England and New York), conducted as private enterprises under careful regulation and held to strict standards by public sentiment, for the most part maintained a high credit; but many banks, under lax laws and regulations, were guilty of great abuses of credit and of downright dishonest practices. The evils were more especially apparent in connection with excessive issues of bank-notes.

§ 3. National Banking Associations, 1863-1913. No further step was taken in federal legislation until 1863, when, in the midst of the Civil War, local “national banking associations” were chartered. The purpose was in part to provide banks under national charters for banking purposes (both of deposit and of issue), and in part it was to make a wider market for United States bonds at a time when government credit was at low ebb. The plan adopted followed the experience of New York state (from 1829 on) with a system of bond-secured banknotes. Congress provided that every bank taking out a national charter must purchase bonds of the United States and deposit them with the Treasurer of the United States, in return for which it would receive banknotes to the amount of 90 per cent of the denomination or of the market value of the bonds, 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.) Notes of failed banks or of banks that go out of business are redeemed from the guaranty fund held at Washington and from the proceeds of the sale of the bonds. Bank-notes issued on this plan, being secured by the bonds and a redemption fund, rest ultimately on the credit of the government, not on the credit of the bank. They are not promptly sent back for redemption to the banks issuing them, as should be done if they were typical bank-notes. They may circulate thousands of miles away from the bank that issued them, and for years after the bank has gone out of business. They are perfectly safe for the holder, but are not an “elastic currency,” increasing or diminishing with the needs of business. The changes in their amount depend upon the chance of the banks to make more or less in this way than by any other use of their capital, and this in turn depends largely on the price of bonds and on the rate of interest they bear. From 1864 to 1870 fortunes were made from this source, but thereafter banks could make little more from note issues than they could by investing the same amount in other ways. Many banks for a long period did not avail themselves in the least of their privilege of issue. The notes were subject to a tax.1

A national bank (as the law now stands) may be organized, with $25,000 capital in towns not exceeding three thousand population, with $50,000 in towns not exceeding six thousand, with $100,000 in cities not exceeding fifty thousand, and with $200,000 in large cities. Three cities, New York, Chicago, and St. Louis, have long been designated as central reserve cities, and some forty-seven other cities as reserve cities, in which the reserves of banks have always been required to bear a considerably larger proportion to their deposits than in other cities.2 Other banks might, until 1914, count as part of their legal reserves their deposits in reserve city banks, up to a certain proportion. The national banks in the larger cities thus became the great capital reservoirs of cash for the whole country.

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

§ 4. Defects of our banking organization before 1913. Taken altogether, the national banks in the United States between 1863 and 1913 represented great banking power and very efficient service for the community in times of normal business, as with few exceptions did also the state banks. But in several respects it long ago became apparent that our banks were operating less satisfactorily than those of several other countries. American banking organization had failed to keep pace with the increasing magnitude and difficulty of its task. Especially at the recurring periods of financial stress, such as those of 1873, 1893, 1903, and 1907, our banking machinery showed itself to be wofully unequal to the strain put upon it. Financial panics were more acute here than in any other land, and this fact clearly was traceable in large part to defects in the banking situation. In academic teaching and in public conferences of bankers, business men, publicists, and students, the subject was continually discussed after 1890. At length Congress in 1908 created a “National Monetary Commission” to inquire into and report what changes were necessary and desirable in the monetary system of the United States or in the laws relative to banking and currency. After the most extended inquiry and discussion that the subject had ever received, the commission submitted its report in January, 1912. The defects to be remedied, as enumerated in the report3 may be reduced to the following five headings: (a) Lack of system. (b) Inelasticity of credit. (c) Periodic local congestion of funds. (d) Unequal territorial distribution of banking facilities. (e) Lack of provision for foreign banking.

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

There was no provision whatever for the concentration of bank revenues so that each bank would be supported by the strength of the other banks if a movement began to withdraw deposits in unusual amounts. Each bank then was compelled for self-protection to call for any sums it had deposited with other banks,4 and to keep for its own use all the reserves it might have in excess of its own immediate needs. This threw a great strain upon the banks in the reserve cities, which in normal times had become the depositories of a good part of the reserves of the banks in other places. Thus developed a spirit of panic, like the fright of theater-goers crowding toward the door at the cry of fire.

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

§ 6. Inelasticity of credit. Our banks, considered both separately and collectively, were unable to increase their lending powers quickly and easily to respond to business needs. The need of greater elasticity of credit was felt in the more or less regular seasonal variations within the year, and in the more irregular variations in cycles of years from periods of prosperity to those of panic and depression in business. The inelasticity was necessitated by illogical federal and state laws restricting absolutely the further extension of credit when the reserves fell below the percentage of deposits (15 or 25 per cent) fixed by law. Reserves thus could not legally be used to meet demands for cash payments at the very time when most needed. This feature has been likened to the rule of the prudent liveryman who always refused to allow the last horse to leave his stable so that he would never be without a horse when a customer called for one. The refusal 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 lending 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 though 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.5 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.

§ 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 that were required in the so-called “country” banks, three fifths (9 per cent) might be kept in banks in reserve cities; and of the 25 per cent in reserve city banks, 12½ per cent might be kept in central reserve cities. There it counted as part of the depositing banks’ legal reserves, was a fund upon which domestic exchanges could be drawn, and earned a small rate of interest (usually 2 per cent) paid by banks in reserve and central reserve cities to their “country” correspondents. By this process of pyramiding, reserves in very large part came to be kept in New York city, where they could be lent “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.”

§ 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 manufacturng sections, and imperfect provision in the agricultural districts. The whole financial system seemed designed to induce the poorer country districts to lend temporarily available 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 Canada, with a different system of banking, the rates have long been much more approximately uniform in urban and agricultural districts.

Indeed, our national banking development has been predominately 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 in the more agricultural regions, “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.”

§ 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.”

§ 10. The “Aldrich plan.” The report of the National Monetary Commission represented most careful study of the whole subject, and embodied the efforts and aid of many of the best financial experts of this and other lands. The Commission in its work gave an admirable example of the right way to prepare for and undertake important economic legislation. Though it discovered nothing essential that was not known to the small group of expert economic students, it put all material into systematic and convincing form and served during several years to educate public opinion as to the needs and proper means of sound banking policy. The analysis of difficulties as outlined above has not merely a temporary but a lasting interest to the student of financial history, for it implies an ideal for the banking system of the nation.

The Commission submitted with its report a constructive 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 was 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.

References.

• National Monetary Commission, Report. 1912. In Sen. Doc. 243, 62d Cong., 2d Cess.
• Phillips, C. A., ed., Readings in money and banking. N. Y. Macmillan. 1916. Ch. XXX.
• United States Comptroller of the Currency, Annual reports.
• White, Horace, Money and banking illustrated by American History. Bost. Ginn. 1914. Bk. III, chs. IV, XV, XVII, XX, XXI, and appendices A and B.

CHAPTER 9

THE FEDERAL RESERVE ACT

§ 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, though 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 were 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 bank1 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 (Fig. 1) are given the outlines of the districts as constituted and altered down to 1921.2

§ 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 was fixed at ten years and the salary at $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 the Board’s control, although centralization was in outward form avoided by the bill. Alongside of the Reserve Board is placed a Federal Advisory Council, consisting of twelve members, one from each of the boards of directors 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.

§ 3. Federal Reserve banks. The twelve Federal Reserve banks, which opened for business November 16, 1914, are institutions of a type new in our financial history. They are “banks for banks,” that is, for the “member banks” in their respective districts. Every national bank must, and any state bank or trust company may (on agreeing to comply with reserve and capital requirements for national banks and to submit to federal examination), 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 receive dividends of 6 per cent, cumulative, on their paid-in shares of capital, and (beginning 1921, by amendment) all remaining net earnings are added to surplus until it amounts to 100 per cent of the subscribed capital; after that 10 per cent shall be added to surplus and the rest goes to the government as a franchise tax. By the end of 1920 the total surplus of the system exceeded the subscribed capital, and only two of the banks (Cleveland and Dallas) had less than 100 per cent surplus.

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, though chosen by the banks and though 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.

And Federal Reserve bank may:

a. Receive deposits from member banks and from the United States.

b. Discount upon the endorsement 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.

§ 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 not retired by the new act; but the law was shaped with the purpose of retiring them at the rate of about $25,000,000 a year, so that they would all disappear from circulation in thirty years.3 Whenever the banks having old-style bank-notes outstanding desire to retire any of their circulating notes, the Federal Reserve banks may be required by the Federal Reserve Board 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 other kind of notes provided by the act is called Federal Reserve notes. They are secured in several ways. First, they are obligations of the United States receivable for all taxes, customs, and other public dues. Secondly, they are receivable by all member banks in the twelve districts and by all Federal Reserve banks, and are redeemable by the latter in gold or in lawful money (which includes greenbacks, Treasury notes, gold certificates, and silver dollars). 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, eligible paper, such as notes and bills accepted rediscounted for member banks, or gold or gold certificates 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.” The notes unite the characteristics of asset bank-notes with those of political paper money.4

Notes, it will be observed, are issued only on request of a Federal Reserve bank, and not by or on request of the member banks. 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.” This regulation does not apply to the member banks, but its effect must be to keep notes from circulating long in any district except that for which they were issued.

§ 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 32½ per cent and thereafter a graduated tax of not less than 1½ per cent on each additional 2½ per cent, deficiency or fraction thereof.5

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 not less than 20 per cent of outstanding notes, and the rate of discout 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 still be doubled, becoming $2,000,000,000, the proportion of reserves falling to 2.5 per cent, the rate of discount rising to 24 (5 plus 19).

§ 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 thirty days and from time to time renew the suspension for periods not exceeding fifteen 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. Although the amount of the tax on the deficiency of reserves against deposits is not indicated in the act, it is plainly the thought that the Board will follow somewhat the same rule as in respect to excess note issues. 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.

§ 7. Reserves in member banks. Important changes were made in the rules as to the reserves against deposits that had been in force under the old national banking system. A new distinction was 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 now only 3 per cent (first 5 per cent, but later amended). This gives encouragement to banks to maintain savings departments and to make agricultural loans. The Federal Reserve banks take the place of the banks in reserve and central reserve cities as the depositories of funds that were6 counted as a part of the reserves of member banks. The legal minimum reserves for country banks (as fixed by amendment June, 1917) is 7 per cent; for banks in reserve cities 10 per cent; for banks in the three central reserve cities 13 per cent, all of which must be kept in the Federal Reserve bank, till-money not being counted as part of the reserve.7

These legal requirements as to proportion of reserves, as compared with those of national banks under the old law, are smaller by 53 per cent, 60 per cent, and 48 per cent, respectively (though practically less reduced because till-money is no longer counted). The large increase in lending power thus given to the member banks explains in part the large expansion of banking credit between 1915 and 1920, the encouragement of speculation in 1918-1920, and the large earnings of most member banks.8

§ 8. Rediscounts by Federal Reserve banks. More important than any other single feature of the act is that by which each Federal Reserve bank is to rediscount notes, drafts, and bills of exchange arising out of actual commercial transactions, when endorsed 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. This enables any business man who can offer commercial paper of sound quality to borrow on it at some rate of discount, even in the most stringent times. And, in turn, every member bank should 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 13 per cent of its demand deposits. It could by rediscounting $13,000 worth of notes increase by $100,000 the amount to which it might legally extend credit to its customers. The deposits of the Federal Reserve bank would then be increased $13,000, against which it must have a reserve of 35 per cent or $4550. If the reserves of any Federal Reserve bank fall too low, it can in turn rediscount its paper with the other Federal Reserve banks.9 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 that can be expected to arise.

§ 9. Changes in national banks. There was thus created a national system of reserves, but it will be observed that membership in the new system of the Federal Reserve banks was not limited to national banks, but was opened on equal terms to banks organized under state laws. While in most respects the general banking law remained as it was, certain changes of importance were made. The percentage of reserves 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 were 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 lend 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.

§ 10. Operation in the pre-war period. Nearly a year was spent preparing for the opening of the Federal Reserve banks. The organization committee, after holding meetings in many cities, divided the country into twelve districts. Officers and a staff of employees had to be selected for each of the twelve banks, part of the capital had to be paid in, bank buildings and equipment had to be secured, and many details arranged.

It was fortunate that the district banks were nearly ready to begin operations 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 system would early begin to function was reassuring in the grave financial stress of the next three months, and the opening of the district banks November 16, 1914, at once made possible the release for commercial uses of cash reserves and credits to meet the needs of reviving business.10

The history of the Federal Reserve system for the first seven years of its operation may be divided into four periods: (1) the pre-war period, from the opening of the banks till our entrance into the war on April 6, 1917; (2) The war-time period, till the armistice, November 11, 1918; (3) the post-war period of expansion to May 1920; the period of falling prices and contraction thereafter (not yet ended at this writing).

Two years and nearly five months elapsed from the opening of the banks until the United States entered the war. This period was filled with work of organization, redistricting, preparation of rules and regulations, development of plans for the clearing of checks between Federal Reserve banks and between member banks, and the admission of state banks (a few of which entered the system). Growth was steady but slow up to April, 1917. A general idea of the development of the system can be gained from a study of the charts showing some of the more important statistical data. Federal Reserve notes were issued to the amount of $306,000,000 and net deposits were $707,000,000, making $1,013,000,000 total liabilities against which reserves must be held; whereas the reserves held equaled 89 per cent of liabilities. For several months before our entrance into the war the system increased the reserve percentages, absorbing some of the gold that was flowing into the country and, consequently, reducing somewhat its “earning assets,” which fell to $168,000,000. Little use had as yet been made by member banks of the rediscount privilege, because, as the new legislation had reduced their own reserve requirements, they had “plenty of slack” lending power, which only gradually had begun to be taken up. Nevertheless, all of the Federal Reserve banks, before the end of 1916, had earnings in excess of expenses, and one after the other began to declare dividends and to increase their surpluses, to the surprise of many who had predicted that this would not be possible.

§ 11. Operation in the war period. With our entrance into the war the Federal Reserve system, and our banking institutions altogether, entered upon a growth that has been characterized by the Federal Reserve Board as “in many ways the most remarkable in the financial history of the world.” At the beginning of the period the volume of business at the Federal Reserve banks was too limited, while the available resources of member banks were too large to enable the Federal Reserve institutions to exert more than an incidental influence upon credit uses. The period of belligerency changed these conditions, and at its close the Federal Reserve banks stood as the holders of nearly the entire reserves of the country, the directors of the one unexhausted reservoir of banking credit in the world.11 The Federal Reserve system began at once to act as the fiscal agency of the government, and continued throughout the war period and the post-war period, including the fifth (or Victory) loan, to fill the central rôle in fiscal operations. During this period the net deposits of the system increased 2½-fold, the notes in circulation increased 7-fold, and earning assets increased 14-fold. Paper admissable under the rules for rediscount, especially that based on governmental securities, which were given preferential treatment and rates, increased greatly in amount. Member banks made use extensively of the rediscount privilege, and took the proceeds, either in notes or in credit, to their reserves, this being a source of large earnings for the Federal Reserve banks. The accompanying table shows the net earnings by years:

§ 12. Gold hoards and artificial interest rates. The wartime influence and activities of the Federal Reserve Board, and of those controlling the various district banks in general, merit high praise. They steadily urged the sound economic policy of industry, thrift, and self-denial on the part of the people. They fostered no illusions that the magic of banking credit or of paper money could take the place of real production of the goods needed, and of real abstaining from the goods not needed, for the prosecution of the war. Although the banks (district and member) found it necessary to take and hold for a time an increasing proportion of the successive loans (“war paper”), and the local banks to lend heavily at low rates of interest to customers on the security of war paper, great efforts were made to get the public to pay in full and to relieve the banks of this burden.

In two particulars the policy of the Board is more open to question. The Board showed a mercantilist bias in favor of an artificial heaping up of gold in this country, as shown in its fathering and defense of the gold embargo. It defended this on the ground, first, that it was desirable to conserve the available gold supply on the assumption that this would make the country stronger economically. But this could but have the effect, in the end, of artificially inflating our prices at home, of increasing the amount of Liberty bonds to be issued, and of causing the value of the American dollar to depreciate in the countries from which at the time we were buying in excess of our sales. The Board thus contradicted its own sounder doctrine that goods, not artificial inflation of credit and prices, was what was needed to win the war. The Board further attached undue importance to maintaining low interest rates artificially at a time when the natural trend of rates was upward. This could but encourage the increased use of credit by the public, and thus neutralized the Board’s own sound policy of keeping down the use of credit for purposes less urgent or of a speculative nature. Throughout the war period (and for a full year thereafter) our banking practice was in violation of the basic principle of central rediscount, “well established in the tradition of Europe, that the official rate of rediscount should be above the market rate.”

§ 13. The post-war period. At the sudden termination of military operations, the Federal Reserve Board at once gave expression to wise warnings against the inflation and speculation that usually have occurred at such a time. It declared the immediate problem to be that of “preventing credit from expanding too far, and so far as practicable of reducing any excess that already exists.” It again counseled thrift and the acceptance of falling prices by the people, and limitation of credits by the banks. If this policy could have been made effective, the price index of armistice month (which was 206) might have been the peak, and prices might have moved slowly downward to lower levels. As it was, prices wavered, fell as low as 197 in February, 1919, rose again, then with a bound went up in July, 1919, to 219, and still upward to the peak of 272 in May, 1920, then to plunge steeply downward to 151 in May, 1921. Enormous evils of speculation and undeserved profits to some, unjust burdens of rising prices to many others, great waste of productive effort, and finally much unemployment and suffering in the period of crisis, would have been avoided if the price readjustment downward had progressed evenly from the date of the armistice.

To fix the blame precisely is not easy, or indeed possible; but a large part of it must be traced back to the policy of the United States Treasury in fixing the rate of interest on all its issues of loans artificially below the market rate. As a result the bonds had to be marketed more by appeals to patriotic motives, enforced by many measures of popular coercion to induce and compel the public to subscribe to the loans, and still further supported by preferentially low interest rates by member banks to enable customers to carry bonds on bank loans, and preferentially low rediscount rates on such paper presented for rediscount at the Federal Reserve banks. At one time the total of war paper held by all banks (including the Federal Reserve), exceeded $6,000,000,000, and the very preference given to it for rediscount was a premium to active business not to pay off the loans but rather to use funds for other purposes in a period of rapidly rising prices. The Treasury and the Federal Reserve banks, in this policy of artificially low interest rates, had “caught a Tartar,” and did not know how to let go without causing a slump in the price of Liberty bonds, which nevertheless was sure to occur. The 4¼ per cents (which composed the larger part of those outstanding) fell somewhat below par early in 1919, fell to 92 in December, 1919, as discount rates and rediscount rates were raised, and as low as 82 in May, 1920. Large quantities of the bonds appear to have been thrown upon the market by holders who had been carrying them on credit. The whole policy above discussed must be looked upon as a case of price-fixing by which the rate of interest on government loans was kept artificially lower through an unsound use of government control over banking policy. The results were speculation, inflation of prices, and eventual disillusionment and loss to investors and to large numbers of other citizens.

§ 14. Future of the Federal Reserve system. The Federal Reserve system rendered valuable service during the war, and was a stabilizing influence in the period of industrial depression that began midway in 1920. While there has been enormous shrinkage in prices, in valuations of goods in stock, in securities, and in “paper profits,” and inevitable loss to many investors and business men, the “retreat” has been more orderly than in previous financial crises, and at no time has the banking system as a whole been anywhere near danger of collapse, as in former crises. The Federal Reserve banks have become an indispensable part of our banking system. Probably valuable lessons have been learned from the wartime experience. It is probable that the use of the rediscount privilege will, in normal times, not be extended to the limit, as in 1919 and 1920, but will be kept in large part in reserve for emergencies. This would result in smaller earning assets and earnings for the Federal Reserve banks, and would make the recent figures in these respects appear abnormal, and not to be expected regularly. Altogether, as a piece of financial machinery, the Federal Reserve system has been a demonstrated success, and doubtless is capable of beneficial development. However, the possibility of political interference with banking policy is apparent, and might become a grave danger to the whole financial situation.

References.

• Federal Reserve Board, The Federal Reserve Bulletin. Monthly.
• Kemmerer, E. W., The A B C of the federal reserve system. Princeton. Pp. 192. Princeton University Press. 3d ed. 1919.
• Phillips, C. A., Readings in money and banking. Ch. XXXI. N. Y. Macmillan. 1916.
• White, Horace, Money and banking illustrated by American History. Bost. Ginn. 1914. Bk. III. Ch. XXII and appendices D and E.
• Willis, H. P., The Federal Reserve Act. A. E. Rev., 4: 1-24. 1914.

CHAPTER 10

CRISES AND INDUSTRIAL DEPRESSIONS

§ 1. Mischance, special and general, in business. Every separate business enterprise is subject to chances that 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.

§ 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 preceeds 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 that brief period in which the general rise of prices culminates and a general fall begins 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; when it becomes a wild scramble, each one trying to save himself, it is called a financial panic. An industrial depression is the period of hard times that usually follows a financial crisis. A business cycle is the period from one crisis to another within which occurs the complete series of price and business changes above and below the average.

§ 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

§ 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, thereafter, the crises were of unequal force in various European countries, usually being more severe in England, where they occurred in 1803, 1825, 1838, 1847, 1857, 1864-66, 1875, 1890, 1900, 1907, and 1914. These have been attributed to various causes: that of 1825 to over-trading abroad; that of 1847 to railroad-building; while that of 1864-66 was attributed to the severe disturbance of the cotton trade and of 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.

§ 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 corresspond 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, overspeculation 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 in America was checked but little in 1900, when a crisis was occurring 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 probably because European creditors were recalling their loans. Although building operations were somewhat checked, American business slackened but little. General prices, which had been moving upward since 1897, remained almost unchanged in 1903 and 1904, and then continued 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.

The rise in war prices, slightly checked at the beginning of 1919, reached its peak in America, as we have seen,6 in May, 1920, and within about a month of the same time in most of the leading countries. The average fall of wholesale prices in the next year (from 272 to 151) was the most rapid that has ever been experienced in America.

§ 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 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.7 The falling prices, the shattered credit, and the financial losses force many factories to close, and many workmen are thrown out of employment. This period of beginning collapse 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.

§ 7. General features of a crisis. Although 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 coordinated. As a rule they have been 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 is the flourmill. In a crisis wages and salaries are less quickly 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 staple kind often lose much.

§ 8. The use of credit. The general use of credit is, as we have observed, an essential condition to the occurrence of a financial crisis, so that, indeed, a crisis might be called a disease of the credit system. The use of credit 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 structure. If many of the customers were not restrained by their sense of personal obligation to the banks, by the strong pressure that 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.

§ 9. Interest rates in a crisis. In normal times there is always outstanding a great mass of short-time commercial loans.8 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 borrowers with maturing obligations would face bankruptcy if they could not renew their loans. 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 may prevail in these loan markets for a few days or a few weeks, rates that 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 at just such times that both the equipment he has bought and the products he has made become temporarily almost unsalable 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 long-term loans as fall due can generally be renewed 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 lend 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.

§ 10. Dynamic conditions and price readjustments. A condition favorable to large and rapid shifts in prices and credits 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 undreamed 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 prices and profits in 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. 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.

§ 11. 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 has been contended that a reduction of tariff rates has a more disturbing effect upon business than does an increase. If this is true it may be because the industries injured by a lowering of tariffs in America are those most fully within the circle of the credit system; 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.9

§ 12. Rhythmic changes in weather and in crops. The periodic though not quite regular recurrence of crises has suggested the thought that they may be causally related with some one dominating force such as is found in the conditions of nature. The English economist Jevons attempted toward the end of the nineteenth century to show statistically a relationship between financial crises and the variation in sun-spots. This idea has usually been treated as whimsical, but the continued efforts of physicists to discover a causal relation between sun-spots and the weather suggests that a real causal relation between the physical and the economic phenomena may yet be found. The alteration of seasons of poor with seasons of good harvests, “lean years with fat years,” follows a line strikingly suggestive of the curve of the business cycle. Some reasons for this relationship are apparent. For example, 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 shown 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, and that the cycle of yield per acre of the nine principal crops corresponds closely with the cycle of pig-iron production (one of the best single indices of growing business and of an upswing in the business cycle) dated from one to two years later. There is found what is called in statistics a high degree of correlation (.719 in the former and .800 in the latter case), indicating that there is that percentage of probability that there is some causal relation between the two sets of figures. 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 interpretation of the financial and the psychological features of crises.

§ 13. “Glut” theories of crises. Many explanations of the causes of financial crises have been offered.10 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.11 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. The Marxian socialist’s theory of crises is a more complex variety of this type, being connected with the “theory of surplus value,” in which the capitalist class is conceived of as gradually appropriating the surplus value produced by the workers until there is no longer enough purchasing power left in the workers’ hands to purchase the products of the capitalists’ factories.

These views have wide vogue, but they have the same taint of illogicalness as the “fallacy of waste” and the “fallacy of luxury.”12 Both in over-production and in 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. Such theories 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 direct 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 could find no limit until the material world became incapable of improvement; but that day is inconceivable. 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.

§ 14. Monetary theories of crises. Another group of theories of crises connects them with the supply of money, either too great or too small. The unregulated issue of bank-notes has been assigned as the cause of crises, especially such 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. If it may be said to be “lack of money” at the moment of a crisis that is the immediate cause of particular failures and losses, it is “money” only in the figurative sense of credit and immediately available purchasing power. 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 a 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.

§ 15. Capitalization theory of crises. Here, as repeatedly above, we verge upon a different type of explanation of the 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 true, but 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 guess-work, or “speculation.”13 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 until 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. This rhythmic movement as it appears in the capitalization of enterprises is favored and magnified 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. 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. But, the lack of coincidence in the impact of various influences which occur accidently, such as political changes, wars, and the rapid opening of new routes of transportation, serve to hasten or to retard, perhaps for a time quite to alter, what would otherwise be the rhythm of the cycle.

§ 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 recent 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.14 The provision whereby any one may get credit on good commercial assets should make it difficult if not impossible for a crisis to degenerate into a panic. It provides 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, though 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 re-evaluation 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.

References.

• Dewey, D. R., Financial history of the United States, 4th ed. N. Y. Longmans. 1912.
• Hamilton, W. H., Readings in current economic problems. Univ. of Chic. Press. 1914. 91-93, 93-95, 95-98.
• Hobson, J. A., Evolution of modern capitalism. Ch. 7. Lond. Walter Scott Pub Co. 1912.
• Jones, E. D., Economic crises. N. Y. Macmillan. 1900.
• Juglar, C., and Thom, C. W., A brief history of panics and their periodical recurrence in the United States. N. Y. Putnam. 1916.
• Marshall, L. P. and others, Materials, for the study of elementary economics, Pp. 391-396. Chicago Univ. Press. 1913.
• Mitchell, W. C., Business cycles Berkeley. Univ. of Cal. Press 1913.
• Moore, H. L., Economic cycles: their law and cause. N. Y. Macmillan. 1914.
• Nelson, S. A., The A B C of Wall Street. N. Y. S. A. Nelson. 1900.
• Phillips, C. A. (Ed.) Readings in money and banking. N. Y. Macmillan. 1916. Chs. XXVIII, XXIX.
• Sprague, O. M. W., The crisis of 1914 in the United States. A. E. Rev., 5: 499-533. 1915.
• United States Bureau of Labor, Annual report for 1886.

CHAPTER 11

INSTITUTIONS FOR SAVING AND INVESTMENT

§ 1. The nature of saving. The motives actuating different classes of lenders may, for our present purpose, be reduced to two: to postpone the expenditure 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 who 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 offsetting 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 enjoyable 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 bridge 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.

§ 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

It has been estimated that the net annual investment fund of the United States is on the average about fifteen per cent of net incomes. The annual savings in the years just preceding 1914 were probably three billion dollars, and in 1919, an especially prosperous year, about ten billion dollars. Of course, as the amounts are expressed in terms of dollars, changes in the totals must be interpreted in connection with the changing price levels.

§ 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 or 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 3 per cent rule4 as to reserves against time deposits operates to cause commercial banks generally to pay a rate ranging from 2½ to 3½ per cent on time deposits, their amount will greatly increase. 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 lending 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 lent 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.

In 1920 the national banks alone had more than 9,000,000 deposit accounts (nearly one half of all their accounts) on which interest was allowed. Like information is not available regarding state banks (and trust companies) doing a commercial business, but probably the number is as great, if not greater. If so, there is one interest-bearing banking account, outside of regular savings banks, on the average, for every family in the United States. Evidently, in many families there are two or more such accounts.

§ 4. Investment banking and bond houses. 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. 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. For many investors the personal examination and selection of sound securities is too difficult a task. Several large statistical and financial agencies.5 in return for an annual subscription, offer advice to investors regarding general market conditions and special securities. Many banks 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.

§ 5. Savings banks in the United States. For the increasing number of wage-earners, salaried employees, and persons following professions, investment as active capitalists has been steadily growing more difficult.6 Their savings must usually take the form of passive investments. The opportunities for lending money in small amounts without great risk are few, 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 directors are self-perpetuating and the members receive only fees for attending meetings. In their legal aspects 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 1920 was 620, all but 24 of which are located in the Northeastern and Eastern states. (The 24 are all in the four states of Ohio, Indiana, Wisconsin, and Minnesota). These banks are not increasing in number, though their depositors and resources are. They have nearly 10,000,000 depositors, deposits to the amount of more than $5,000,000,000, an average of $550 per depositor, or of nearly $200 per capita of the population of the geographical divisions in which they are located. Though but one third of all institutions with the name of “savings banks” are on the mutual plan, these are the most important, the typical “savings banks” in the United States, and hold about four fifths of all the deposits in “savings banks” (as distinct from the savings departments of commercial banks).

Savings banks seek to keep invested as large a part as possible of their assets, keeping in ready cash only enough to meet a possible temporary excess of withdrawals over deposits. The mutual savings banks average about $.006 of actual cash (and “checks and cash items”) in their tills for every dollar of deposits, but in addition they have for every dollar of deposits $.04 due on demand from state and national (commercial) banks (in the aggregate a large sum, much of which bears a low rate of interest). About one half of their resources are invested in long-time loans, mostly to small borrowers and on the security of real estate, and most of the remainder is in bonds and other securities of the safer kinds. The average rate of interest they have paid to depositors since 1914 has been nearly 4 per cent; the rate is not fixed in advance by contract, but is declared at regular periods (usually three months), as in the case of a dividend of a corporation.

The name “savings bank” is applied also to institutions known as “stock savings banks,” organized for profit like other banks.7 These are not in most cases sharply marked off from commercial banks with savings departments. The number reported in 1920 was 1087, their deposits being more than $1,300,000,000; almost one third are in Iowa, and almost two thirds in California, the remainder (only 3 per cent) being in nine other states. The capital stock of these banks is about 9 per cent of their deposits. Since the change in reserve requirement for time deposits under the Federal Reserve Act, the contrast between savings banks and commercial banks has become less significant and that between time and demand deposits (and banking departments) more significant.

§ 6. Security for thrift. It is essential to sound policy that savings banks have the right to require depositors to give notice of intention to withdraw deposits. The period of such notice varies from a minimum of ten days (almost invariably now the minimum is thirty 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 that is impossible for all, and thus to endanger the interests of all. The Federal Reserve Act, by making it possible for loans to be had at any time (through member banks) on good security, reduced the danger of runs on savings banks.

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 mistaken judgment or dishonesty on the part of the bank officials. The average losses to deposits in savings banks have been about one-fifth of 1 per cent of total deposits. It is highly desirable that a plan of insurance of deposits should be worked out which would make savings deposits absolutely safe. This measure is even more important than that repeatedly proposed by the Comptroller of the Currency to insure or guarantee all deposits of $5000 or less in national banks, the effect of which would be to bring from hiding-places many millions of dollars of hoarded money, largely prevent in the future runs on banks, and, more than anything else that could be done, unify and solidify the entire banking system. It would doubtless also greatly stimulate the saving habit among the people and increase the use made of the savings banks.

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 by the savings banks. Viewed in this way, the great social importance of the savings function appears, and the importance of developing the savings institutions.

§ 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 deposits began to flow in at the average rate of more than a million dollars a month, and then more rapidly until the war period. The maximum balance to the credit of depositors was attained in March, 1919, when it was $177,000,000, from which point the withdrawals have pretty regularly exceeded the new deposits each month. This may be explained by the rise of the general interest rate, the opportunities for good investments of small sums in Liberty Bonds, and heavy withdrawals by immigrants for remittance to Europe.

The funds of the postal savings system 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 2½ per cent on the amount of the deposits. The ½ 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, in exchange for certificates of postal savings, of bonds bearing interest at the rate of 2½ per cent. Postal savings bonds are exempt from all kinds of taxes, federal and local.

§ 8. Advantages and limitations of postal savings. As compared with ordinary 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 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 hearing 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 offers less favorable conditions than do ordinary banks, and its usefulness was deliberately restricted by provisions in the law, as has been clearly pointed out and deplored by competent critics. The post-office will not receive deposits of less than one dollar, whereas regular savings banks usually accept for deposit as small an amount as ten cents. It pays only 2 per cent interest (only half as much as the regular savings banks now pay) and only for a full year instead of quarterly. Only simple interest is paid, not interest compounded automatically, as in the case of banks. These and other features of the law so greatly restrict the usefulness and appeal of the system that its failure to grow is not surprising. With wise and proper changes it should be possible to refund a large part of the national debt in securities issued in small denominations through the postal savings system.

§ 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.

Before the Great War began, public schools in Germany were equipped with automatic machines vending savings stamps in as small denominations as ten pfennigs (2½ cents) when a coin was dropped into a slot. This method could be used 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 schoolhouse, 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 nickel or 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.

§ 10. Building and loan associations. Building and loan association is the name applied to a coöperative organization having as its purpose the collecting regularly from members of small sums which are loaned to some members for the purpose of building or paying for homes.8 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 (though 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 (in 1920) was 4,300,000, which is about one third of that of savings banks depositors, and the amount of their assets ($2,100,000,000) is nearly one third that of the reported savings banks. But they are growing more rapidly, and their relative influence in educating and encouraging to thrift is doubtless much greater than these figures indicate. There are nearly eight thousand of them, more than three times as many as 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 houses that are fully paid for, and that continue to yield their usances and rents 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 more than half a billion dollars, which is twice as much as the annual increase in the deposits of the reported savings banks.

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 just, but it is an exception to the rule of the illogical general property tax.9

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 had more of the nature of ordinary profit-making enterprises. They should not be confused with the local associations.

§ 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 lent 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. 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 encumbrance, 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.

The receipts of the association are of several kinds.

(a) Interest is received from borrowing 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.

(b) Premiums may be charged, either in the form of a higher rate of interest bid by the applicant for a loan, or in the form of additional weekly dues. Dozens of premium plans are in effect or have been tried, but the practice of charging premiums has decreased so that the total premiums now constitute 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 these 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 lend at the beginning of its career, and a surplus of unlendable 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.

§ 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 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. These safeguards make impossible anything like a “run” on a bank or a forced liquidation of the association.

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 will be discharged. These privileges are possible because of the method of distributing profits, which will now be described.

§ 13. The distribution of profits. At least twenty-five plans, with hundreds of variations in details, have been in operation for the distribution of profits. The essential features are, however, these. Periodically, usually 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, increasing its “book value,” and paid in cash to holders of paid-up stock. The dues frequently are 25 cents a week per share, in other cases $1 per month. Take, for example, the latter case, when the maturing value of a share is $200. If all of the capital paid in is lent out continuously at 6 per cent, the profits will be equal to about 6 per cent compound interest, and the shares will mature in about 11½ years (the average experience has been 138 months). A non-borrower will then be paid $200, of which $138 has been paid as dues over the period and $62 is the accumulated profit of each share. A borrower of $3000 (on this plan) must take at least fifteen shares, and would pay $30 each month, $15 as dues and $15 as interest. If he keeps up his regular payments, he will at the maturity of his shares have a capital just sufficient to pay off the whole debt. In most cases a prudent tenant can become the owner of a house 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 that are included in contractual rents.10

§ 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 coöperation 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 bonds can be bought and sold at any time; and banks ought, as they increasingly do, 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 that 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 large amounts of Liberty bonds now are especially suitable for the small investor.

The general plan and principles of local building and loan associations was extended in 1916 to groups of rural co-operators in the joint-stock land banks, enabling them to make loans to their members11 ; and it might well be extended 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.

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 coördinate 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.

References.

• Chamberlain, Laurence, Principles of bond investment. 4th ed., N. Y. Holt. 1911.
• The work of the bond house. 1913.
• Devine, H. C., Peoples coöperative bank for workers in towns, and small holders, allotment cultivators, and others in country districts. N. Y. Cassell. 1908.
• Dexter, Seymour, A treatise on coöperative savings and loan associations. N. Y. Appleton. 1894.
• Hamilton, J. H., Savings and savings institutions. N. Y. Macmillan. 1902.
• Kemmerer, E. W., Postal savings. P. 176. Princeton. Princeton University Press. 1917. (A historical and critical study of the postal savings system of the U. S.)
• Kniffin, W. H., The savings bank and its practical work. N. Y. Bankers Pub. 1912.
• Phillips, C. A., Readings in money and banking. N. Y. Macmillan. 1916. Ch. XVI.
• Wolf, H. W., A coöperative bank handbook. Lond. King. 1909. Coöperative banking. Lond. King. 1907.
• People’s banks. 3d ed. N. Y. Longmans. 1910.

CHAPTER 12

PRINCIPLES OF INSURANCE

§ 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 may be favorable as well as unfavorable. Extra-hazardous enterprises must in general afford a higher average of profit in order to induce men to engage in them. It is folly to take a risk without ascertaining its degree as 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.

§ 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 that 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, as 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, although 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 that the loser must forgo. As a result the loser is often seriously injured by the loss of his income, and driven to despair, while 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.

§ 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 thoroughly; 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.

§ 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 a guaranty of partial or complete 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; the price paid by the insured in fulfilment 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 (as 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. The Jeffries-Johnson and the Dempsey-Carpentier prize-fights were insured against rain. Frequently racehorses, the fingers of pianists, the lives of ball-players, and the throats of singers are now insured. Summer hotels in England regularly insure for large sums against more than so many days of rain per season. Insurance is capable of further development in a variety of directions.

§ 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 the characteristics that 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 the insured runs, but to neutralize or offset an already existing chance. The insurance bet is what is called a “hedge.”

§ 6. Insurance as mutual protection. The difference between gambling and insurance 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 to all members of the group. 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.

§ 7. Conditions of sound insurance. To be economically sound, insurance must have to do with real productive agents, and with a group of occurrences that, as a whole, are approximately ascertainable in advance—however irregularly they may fall upon individuals. The insured must be numerous enough, and the objects insured so distributed in space and in time, that the “law of large numbers,” or of statistical averages, applies. This means that in any one year the cost will not vary greatly from the average; otherwise the security is weakened.

The beneficiary must have an insurable interest in the property or person insured, that is, the beneficiary must actually suffer a loss by the occurrence insured against, and 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, or drives his automobile more carelessly than he otherwise would, 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.

§ 8. Farmers’ mutual insurance. Property insurance may be viewed as an aspect of enterpriser’s cost,2 but may also, as may any insurance, be considered a form of saving. The premium paid each year may be looked upon as a sum prudently saved and laid aside to repair or rebuild the house when later it burns. Let us suppose that the chance of any one house being destroyed by fire in any one year is 1 in 500; then, on the average, the owner of each house would in 499 of the years have no loss from fire and the other year would lose the whole house. If the loss could be mathematically distributed over 500 houses, each house would burn down 1/500 each year, never more nor less, and fire loss would be a regular cost of repair. If no provision is made for this, the actual income of each owner in his lucky years would be .2 per cent greater (estimated on the capitalization) than, on the average, is the net income of the whole group of owners. A prudent owner of one house, understanding this, could only in small measure protect himself against this loss by setting aside each year $2 for each $1000 of valuation, for any year his whole house might burn down, long before he had laid aside its valuation. If, however, one man owned 500 houses of equal value, so situated that no two of them could ever catch fire from the same cause, and if in fact fate so distributed the fires that just one house burned down each year, his loss would be actually distributed in time according to the mathematical probability. If 500 different owners of houses, alike but each located apart from all the others, band together, they become collectively like one owner of 500 houses as regards the chance of loss in any one year. Still better, if 10,000 owners unite, the distribution of losses will approach much more closely to the mathematical probability.

In fact, a very simple application of this idea has been made in the insurance of farm property. It was a not uncommon custom in agricultural communities in America for the neighbors to band together to help rebuild a house that had been destroyed by fire, or to take up a collection for the family that was in distress. Insurance affords a more regular, equitable, and effective way of accomplishing the same purpose, and likewise is a coöperative enterprise of neighborhood good-will. There are now about two thousand farmers’ mutual fire insurance companies in the United States,3 with $6,000,000,000 of insurance in force, insuring the property usually up to a maximum of two thirds of the estimated true value. Usually the organization of these companies is simple, their officers unpaid, the overhead expenses very small, and the operations of each company limited to a small area, a township or at most a county.

Premiums are usually not collected, or even determined, in advance; but, the losses having been determined at the end of the year, the amount is collected pro rata in proportion to the face of the policies in force. More often of late, to add to safety and to equalize variations in losses from year to year, a small reserve is laid aside, $3 per thousand dollars of insurance in force being deemed ample for this purpose. Otherwise this is pure assessment fire insurance, and is not only very inexpensive, but very generally safe and convenient. This coöperative plan is, however, less suitable in an urban neighborhood, because of the concentration of risks.

Mutual hail insurance companies provide on a similar plan indemnity for the destruction of growing crops. Forty-one such mutual companies were in existence in 1919, and in recent years have collected premiums ranging from $3,000,000 to more than $6,000,000 a year. The smaller measure of success of these, as compared with the mutual fire insurance companies, is largely due to the irregularity of the losses from year to year and their wide extent when they do occur. The risks are not distributed in a manner suitable for neighborhood insurance, and mutual companies that are not organized and managed in a neighborhood are less honestly and efficiently run. In the attempt to improve conditions, four states (the two Dakotas, Nebraska, and Montana) had hail insurance departments and collected premiums (in the year 1919) of more than $6,000,000, paying losses of three fourths of that amount, and setting aside a surplus. Mutual and state hail insurance premiums are virtually collected on the assessment plan, but it has been found best to collect a definite amount in advance, and, in case of unusual losses, to pro-rate among the losses the premiums collected. The plan of mutual property insurance is likewise being applied to live stock and other farm property.

§ 9. Joint-stock insurance of property. Much the largest part of insurance against fire and other causes of property losses is carried by joint-stock companies, or by so-called mutual companies. Though these companies have, like banks, more of a public character than have most businesses, and are subject to special legislation and supervision by state officials, they were organized and are conducted primarily for the profit of the owners. Even in many rural districts, especially where conditions are unfavorable to mutual companies, the joint-stock companies have large amounts of insurance in force, and in urban communities they all but completely obtain the business. The joint-stock fire insurance companies4 collect each year in the United States $700,000,000 in premiums on risks to the value of more than $72,000,000,000. The premium rate thus averages about 1 per cent. In 1917, a fairly representative year, substantially this group of companies returned to the insured, in payment of losses, only 48 per cent of the premiums received, used 34 per cent for expenses, and applied the remaining 18 per cent either to dividends or to surplus. The dividends were nearly 15 per cent of the capital stock (a considerable portion of which represented stock dividends in previous years) and the increase in assets 84 per cent of the capital of the preceding year. When it is considered that 20 per cent of all premiums received are paid in commissions, and that in the case of the higher officials the salaries and commissions run to very large amounts, it appears that the insurance business is exceedingly profitable to the fortunate few in control of these organizations. The starting of new companies is now attended with increasing risk and cost, so that the existing companies occupy, in some respects, a monopolistic position. Another large group of stock companies (about 200) engaged in casualty, surety, and miscellaneous insurance, very rapidly growing in magnitude and importance, now collecting more than one third of a billion dollars a year in premiums, returned (in 1919) to the policy-holders 41 per cent (“including all expenses in connection with payment of claims”) and expended 40 per cent on actual expenses of management.

§ 10. Purpose of life insurance. Of all forms of insurance at present, the most important in the extent of its financial operation and as an agency of thrift is life insurance. The total receipts (about $1,800,000,000 in 1919) of life insurance organizations (fraternal, ordinary, and industrial) are almost twice those of all other forms of insurance, and the total assets more than twice as great ($6,800,000,000 in a total of $9,100,000,000 in 1919).

Life insurance is to provide partial indemnity for survivors against the financial loss incurred by the death of the insured. Usually the insured is the bread-winner of the family and the beneficiary is a member of his family; but the number and variety of other cases in which life insurance is provided is now large. 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 officers or employees. “Babe” Ruth is said to be insured for $200,000 in favor of the owners of the ball club for which he wields his mighty bat; Mary Pickford, Charlie Chaplin, and Douglas Fairbanks are each insured for $1,000,000 in favor of the moving picture company, their “producer”; and one of the large motion-picture corporations insured the life of its managing head in 1921 for $5,000,000. This is said to be the largest life insurance policy ever written, and it was divided among six or more insurance companies.

Life insurance has been much used by persons mainly dependent on labor incomes,5 salaries, professional fees, and active business profits, rather than from funded incomes. In essence and largely in origin it is a coöperative method of providing for survivors, by all in a group contributing a sum to be given to the families of those dying. Naturally, the need is most urgent in families not having accumulated wealth. It has of late been extended rapidly, as “industrial insurance” to wage-earners, in policies never exceeding $1000, but averaging very much less, 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 high in proportion to the amount of insurance.

§ 11. Assessment life insurance. Life insurance plans may be distinguished, with reference to the time and method of collecting the premiums, as assessment and reserve insurance.

In the simplest form of assessment insurance the losses are paid by contributions taken after the losses occurred, each member paying an equal share without regard to age. In a slightly modified plan the assessments are made at the beginning of the year, based upon the expected mortality for the year. Life insurance of this plan is essentially like the mutual fire insurance already described, the percentage of risk for each policy, whether on persons or houses, being assumed to be equal to that of every other policy. The great variation in the chance of loss in the case of various forms of urban property makes simple mutual assessment fire insurance unsuitable in such cases, and even in the case of farm buildings it has been increasingly seen that differences in location, grouping, structural materials, nature of uses, condition of water supply, and other means for fighting fire, cause differences in risk which properly should be recognized. This can be done by classifying risks and insuring on a scale at lower or higher assessment rates. If some concession is not made to the better risks, some enterprising commercial companies will see a profit in giving them a lower rate. Mutual companies which ignore these differences feel the effects of “adverse selection” in that they are left with only the more hazardous property.

Now, in the case of life insurance the risk varies with great uniformity (considering the average mortality of large groups of men) according to the one factor of age. The cost of assessment life insurance, therefore, is closely related to the average age of the members composing the group of insured. 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 be increased. By the constant addition of young members this rise of cost may be retarded. But when these members grow older, a still larger addition of young members is required to keep down the average. But other young men are averse to entering the organization under these conditions; and the result is that the rate of assessment must be steadily increased. Finally failure results, or some form of “reorganization” that drives out the older members. The simple assessment plan carries with it the seeds of its own decay.

To meet these difficulties in part, various modifications of the flat-rate assessment plan are employed, such as classification by age, so that each member pays a flat rate according to age at entry; or large initiation fees at entry, which form a temporary “reserve” to offset increasing mortality in late years. Finally, the policies may be issued on the natural premium plan, by which the members of each age class pay exactly what the insurance costs for the year. Under this plan the company will remain solvent, but the annual cost to the insured rises so rapidly that many surviving members are forced to drop the insurance in later years.

Assessment insurance is sold by stock companies organized for profit, by fraternal orders, and by various types of mutual organizations. Many of the stock companies have had a dismal history of hardship to surviving members and of eventual failure. They are reforming or disappearing under the influence of hostile legislation resulting from a better popular knowledge of insurance principles. The fraternal orders have more than ten million policies in force and incomes totaling more than $180,000,000. They combine insurance with other objects of a benevolent and social character. With good management, a favorable death rate, and very low expenses, some of them have provided protection at very low rates for many years. Many in the past have failed, with disappointment and disaster to the older members. Still others are struggling with difficulties that presage dissolution. Most of them now have some, though inadequate, reserve accumulations, and some have so improved their methods that they begin to resemble reserve companies. The assessment companies average $1.37 reserves per $100 of insurance in force, and get 10 per cent of their total incomes from their funded investments. Even with the favorable conditions under which fraternal orders conduct their insurance business, they eventually must fail unless they adopt rates and policies based upon adequate reserves. Many thousands of present members are paying for insurance at rates that will not suffice to meet the future losses. The assessment plan fails to eliminate the one great risk, that of leaving the survivors without insurance in advancing years.

References.

• Gephart, W. F., Principles of insurance, vol. 2, Fire. N. Y. Macmillan. 1917.
• Same, Insurance and the state. N. Y. Macmillan. 1913.
• Huebner, S. S., Property insurance. N. Y. Appleton. 1913.
• Willet, A. H., Economic theory of risk and insurance. N. Y. Longmans. 1901.
• Winter, W. D., Marine insurance. Pp. 450. New York. McGraw-Hill. 1919.
• Zartman, L. W. (Ed.) Fire insurance. Yale Univ. Press. 1915.

CHAPTER 13

SCIENTIFIC LIFE INSURANCE

§ 1. Reserve life insurance. The plan of reserve insurance provides a remedy for the difficulties just indicated. The essential purpose of the reserve plan is to collect during the earlier years of the insurance policy, when the mortality is less, a sum larger than is needed to meet the current losses. This sum, the reserve, is kept invested and accumulating an income sufficient to offset the increase in losses as years advance. In reserve insurance, therefore, the premium never increases from year to year, although it may be so arranged as to diminish or to cease entirely some time within the term for which the insurance continues.

The premium must always be fixed in advance. The calculations for determining the premiums on different kinds of insurance policies are many and complex, but all conform to a few general principles. The three factors assumed are an average mortality table, a rate of interest (or yield on investments), and an expense rate in proportion to the premiums on outstanding insurance. Insurance on the reserve plan is often called scientific insurance because, upon the basis of these assumptions resulting from experience, it makes exact mathematical calculations of the premiums and reserves needed for insurance of any particular kind in respect to age of insured, number of payments, method of paying the beneficiary, and any other conditions. The premium thus fixed is, however, only a maximum, and usually is reduced as the result of conditions more favorable than those assumed.

§ 2. The mortality table. When large numbers of men are taken as a group, a certain proportion of those at each age may be expected to die. A mortality table starts with a group of persons, as 100,000, at a given age, as 10 years, and shows the number who die and the number who survive at each year of age until all are dead. The tables generally used in the United States are the “Actuaries” which assumes the limit of life to be 100 years, and the American Experience Table of Mortality, constructed by Sheppard Homans in 1868, which assumes the limit of life to be 96. Some figures from the latter table, at specified years, are given below:

The actual deaths in any group of insured are not exactly the number in the mortality tables. But this is not an essential difficulty as long as the deaths are fewer than the figures of the tables, at least in the earlier years of the policy. Any excess of premiums thus collected but increases the safety of the insurance or reduces the need of later payments. In fact, the mortality in all well conducted companies in the United States is below the figures of these tables, partly because the tables were conservatively calculated, partly because of the favorable influence of medical selection, especially among the recently insured, and partly because of the improvement in longevity since the tables were constructed.

The premiums given as illustrations in the following discussions are “net premiums,” or natural premiums, estimated as just sufficient to meet the actual payments required by the contracts in the policies. To provide for the expenses of management, an addition is made to the net premium, called the “loading.” The entire premium is called the “gross premium.” The loading, a large part of which goes for agents’ commissions and the costs of management, is a very considerable addition to the net premiums, adding in the case of the standard companies nearly 25 per cent to the premiums for an endowment policy, nearly 30 per cent on a limited payment, and more than 40 per cent on a straight life. A part of this, however, may be refunded to the insured in the form of “dividends.”

§ 3. The single premium for any term. It is apparent that the natural assessment premium (ignoring the factor of interest) for $1000 of insurance is expressed by the death rate for that year, e. g., at age 10 the payment of $7.49 by each of the 100,000 living at the beginning of the year will provide the $749,000 needed to pay the losses. If premiums are collected at the beginning of the year and losses are paid at the end of the year, and if interest can be earned meantime at the rate of 3½ per cent, the premium in advance for a one-year term policy is the natural premium discounted, e. g., $8.64 is the present worth of $8.95, which is the natural premium at age 35 due a year later, interest being 3½ per cent. In these calculations there is no allowance for expenses, the necessary “loading.”

In the same manner may be determined the natural assessment premium for each year of insurance. It is a simple matter to determine the amount of a single premium, at any age, that is adequate to pay for insurance covering any selected number of years (term insurance) up to the entire period of each insured person’s life (full life). It is necessary only to apply the formula of present worth and that of compound interest on investments.1 Thus the losses of any future year, according to the table of mortality, discounted by the rate of yield on investments, are the present worth of insuring the entire group for that year. The single premium for each of the insured for any term of years is the sum of the present worth of insurance for all the years of the term, divided by the number living at the beginning of the period.2

The payment in advance of the single premium for any definite term provides a reserve fund sufficient, on the assumptions made, to carry all the insurance without further payments. Each year there is added to the fund the income earned on investments, and there is subtracted the amount of the losses for the year, until the death of the last member of the insured group. If the deaths in the earlier years are fewer than were expected in the mortality table, this will be offset eventually by more deaths at the advanced years; but in the meantime a reserve larger than was expected is yielding income, thus providing a larger sum than is needed to pay all the policies at maturity. This surplus might be distributed as so-called “dividends” from time to time to those surviving, or be added pro-rata, at intervals, to the amount of the policies as accumulated dividends.

§ 4. Level annual term premiums and reserves. It is a matter of no very abstruse mathematics (in principle) to find the equivalent of this single premium in any one of many other forms of premium payment. The processes are but variations of present worth and compound interest calculations. Such calculations, however, lead into many complexities of practical detail difficult to explain in brief compass, and are the special task of the actuary (the mathematical expert dealing with such problems in the insurance business). The most useful actuarial equivalent of the single premium is the level annual premium for any period (term or life). Almost all policies now written have the level annual premium as a feature. The amount of the level annual premiums at first is greater than the losses: this causes for a time the steady accumulation of a reserve that yields income. Then, as the losses grow, they overtake and finally surpass the amount of the annual premiums. Therefore, the total reserve for any group of insured, within the definite term for which insured, increases year by year to a maximum and then declines until it reaches zero with the payment of the last claim. The individual reserve for each policy not yet matured increases steadily the longer it is in force, whatever be the term. The total reserve is essential to the solvency of the company and the payment of all the policies as they fall due.

The companies that issue policies on the level premium plan or reserve plan are known as “old line” companies, or as “legal reserve” companies, because the state laws require every company of this type to maintain the reserves calculated on the basis of a certain rate of yield. The growth of the legal reserve companies in recent times constitutes one of the financial marvels of the age. They had in 1919 more than 58,000,000 policies in force, for a total of nearly $36,000,000,000 of indemnity (insurance in force); their total income was nearly $1,600,000,000 (about one fortieth being from investments, the remainder from premiums), and their total assets $6,700,000,000. These figures grow so rapidly that any statistics are soon out of date. The upward curve may be seen in the following data:

Reserve insurance is carried on by both mutual and stock companies; of late some large stock companies, such as the Equitable and the Prudential, have been transformed into mutual companies. The mutual company legally belongs to the policyholders, though its control is actually in the hands of a self-perpetuating group of trustees and officers, more or less supervised by state officials. The gross premiums in reserve insurance are, for the purpose of safety, fixed at a figure larger than the expected cost of the insurance, and normally the earnings from interest are higher, the mortality is lower, and expenses are less than those on which the calculation of rates is based. From the excess of income resulting, the company sets aside a surplus and then divides the rest among the policyholders. These returns, virtually but the refund of excess premiums, are called “dividends” (a somewhat misleading term, not to be confused with dividends on corporate stock). The policies that receive dividends are called “participating” and are said to participate in the earnings. Formerly the majority of policies paid “deferred” dividends after five, ten, or twenty years, according to various tontine and semi-tontine plans, the survivors to these periods receiving their dividends plus those of the other policyholders who had died or had withdrawn from the company. This form of policy was objectionable in that it involved a lottery element, the survivors winning the “dividends” that should have been paid to the deceased; it was made illegal in New York and other states, and in most cases dividends are now paid annually. The stock company, organized for profit, frequently charges lower premiums for “non-participating” policies, and then retains such profits as may result from keeping expenses below receipts.

§ 5. Term policies and straight life. A person purchasing life insurance, taking out a policy, finds himself facing a choice among a confusing variety of policy forms. Apart, however, from some comparatively minor features such as those just described, as to distribution of dividends, the various forms of policies result from combining in various ways three features. The first of these is the term within which the level premium is calculated. This may be one year, or any number of years, most frequently five or some multiple. Whatever be the term, the rate of premium is calculated with respect to the expected mortality at the ages included, and at the renewal of the insurance for a new term the premium rate “steps up” to that required to meet the expected losses at the higher ages. Evidently, the shorter the term for which a policy is written, the lower the rate of premium, for the early years, because the smaller the reserve needed to keep down payments in the later years of the term. For example, on a twenty-year term policy taken at age 35 the natural premium would be $10.80 a year. Break this term up into two terms of ten years each, and the annual premium for the first ten year would be $9.36; but when the policy is renewed for the second term of ten years (at age 45) the rate would be nearly $15.00. The policy known as “straight life” or “level life” is simply term insurance for the term limit (or highest age) of the mortality table (in the American Experience table that is 96). The net premium for straight life at age 35 is $19.91, and this permits (at the rate of earnings assumed) the accumulation of a reserve of $310.75 at the end of twenty years, whereas the reserve on the twenty-year term ending then is zero. The income of this reserve, added to the annual premium, is enough to meet the expected losses in the later years as they gradually rise. (These amounts are on the assumption of the American mortality and 3½ per cent interest.)

§ 6. Limited premium payments. A second feature in which policies differ is in regard to the number of premium payments to be made according to the calculation. If the number of payments is any less than the number of years of the term the policy is one of “limited payment.” The most limited payment is the single premium already described, which may be used in connection with any term from one year to life. The single premium is simply the reserve required to meet the cost of the insurance, without further payments, to the end of the term. The net single premium, or reserve, for a straight life policy, at age 96 is $1000, the face of the policy. The most common limited payment policy is the twenty-payment life. The annual premium for this at age 35 is $27.40, which is more than twice as much each year as the premium on a twenty-year term ($10.80) although it provides no more indemnity. But whereas the reserve on the term policy at age 55 is zero, the reserve on the twenty-payment life is $566.15, this being just the amount of a single-payment life policy if taken at age 55.

By just as much as the experience of any company (or separate group of insured) is more favorable than the figures assumed as to rate of yield on investment, mortality, or expenses, there will be excess premiums to refund (“dividends”), which may be used by the insured to reduce his annual premiums or to purchase additional insurance or to add to the reserve. In the more successful companies an ordinary life policy eventually accumulates a reserve sufficient to carry the policy to the limit of age without further payments, and thus becomes in fact a limited payment policy.

§ 7. The endowment feature. A third feature in respect to which life insurance policies differ is as to the extent to which they include the feature of saving with that of insurance. We have seen that, just to the extent that any reserve whatever is accumulated to keep the premium level, to prevent its “stepping up” as the mortality rate advances with age, there is an act of saving distinct from the payment of a premium for insurance in that year. This is brought out clearly in the case of many insurance policies which provide for a “surrender value” annually equal to the accumulated reserve. So, in our example, the reserve of the straight life policy was $310.75, and that of the twenty-payment life was $566.15. If the insured survives he may, according to the terms of many policies draw for his own benefit these amounts, the “surrender value.” This privilege in many cases unfortunately defeats the purpose of insurance for the families, and tempts men to use the proceeds of their policies for enjoyment or for investment in business.

A further step is taken in the savings process in endowment policies. In these the level premium for a definite term is made high enough to accumulate a reserve more than sufficient for a single-payment life policy beginning at the end of the limited payment period. The premium on endowment policies is so calculated that the reserve equals the face of the policy at the end of the payment period. For example, on a twenty-year endowment the net annual premium is $38.35, the terminal reserve is $1000, which is the surrender value. Many persons are attracted to endowment insurance by the oft expressed thought that “You don’t have to die to beat it.” But this is a mistake. The endowment policy is merely a convenient but somewhat costly plan of saving, hitched on to an insurance policy, with which “actuarially” it has no essential connection. In “scientific” insurance the insured pays its full actuarial cost for each feature of the policy that he buys: so much for the insurance, so much additional for the accumulation of the endowment. The premium for endowment insurance is much higher than that for term life insurance alone during the same period. If insurance is the thing one needs, one is purchasing only a fraction as much for the same annual outlay.

It will be observed that only the survivors to the end of the term get the endowment, and those dying earlier receive no more than if they carried the cheapest term insurance. This gives to the endowment policy a strong “tontine” or lottery character, the survivors profiting at the cost of those who die within the term. This often deceives the uninformed applicant for insurance into the belief that, despite the costs of management, an endowment policy yields a much higher return than other conservative investments at compound interest. The excess of the net endowment premium over the net term premium in our example is annually $26.65, which, compounded at 4 per cent, would be about $825 at the end of the period; but this is sufficient to give the survivors $1000 each, or approximately 6 per cent compound interest. The survivors are lucky not only in living but in getting a monetary prize (paid for by those who have died) for their success. All those who have died, however, would have been better off if they had taken out some cheaper form of policy (term, or straight life, or limited premium) and had deposited in the savings bank each year the difference in the premiums.

§ 8. The choice of a policy. The choice of a policy by an applicant for insurance presents much difficulty in view of the manifold differences in the details of the various contracts, the contingent nature of so many features on which the ultimate cost will depend, and further because of the various circumstances of the insuring individuals, making different policies suitable to their different needs. Moreover, the advice of the agent is too often of little assistance, when it is given in view of the amount of his commission, and with the desire to make an immediate sale, rather than with regard to the true interest of the insured. The first condition of a wise choice is to get into a sound company, of which there are now many, for mere size does not necessarily indicate either superior soundness or superior economy in a reserve company. The various policies written by any honestly conducted reserve company are all actuarily equivalent on the basis of the assumptions made, and all provide reserves adequate to meet their outstanding contracts. There are certain questions on which the applicant must be clear and which he alone can answer.

(1) What is it he most needs—is it the protection of insurance, or is it an opportunity to deposit savings regularly? The insurance method differs from the method of depositing savings by its contingent nature, the resulting income of any individual being possibly much greater than the amounts actually saved (e.g., when the insured dies or is injured soon after taking insurance), and possibly less or nothing at all.

(2) What is the period within which insurance is most needed?

(3) How much can he devote to insurance or to saving respectively, and how will this amount probably change in the course of years, increasing or decreasing? The premium in personal insurance (life, accident, sickness, invalidity, old-age pensions) is in almost all cases paid out of some current income. The premium paid is just so much subtracted from the amount available for present direct use and applied to the purchase of future incomes for one’s self or family.

(4) What would be the most suitable mode and distribution of indemnity payments? The payment usually takes the form of a lump sum payment at death or at the maturity of the endowment. In recent times there has been a growing use of original forms of payment which give to the beneficiary annual or monthly instalments for a definite number of years or for life.

In the light of the foregoing discussion, it is apparent that the more immediate and greater the need of insurance, and the more limited the present income of the insured, the briefer the term for which insurance should be taken for the greater the amount of indemnity that can be bought with a given outlay. A young man in his twenties or thirties, with a limited salary or with his capital invested in business, needs particularly to protect his wife and his children until they are of age. The difficulty with term policies, especially for shorter terms, is the stepping up of premiums, which later makes the cost prohibitive. However, life insurance is essentially needed by one having dependents (wife, young children, sisters, parents, etc.), and is far less often important to the older man than it is to the man between twenty and fifty years of age. A good golden mean for many men is a twenty-payment life policy, its surrender value at age fifty-five being an endowment for nearly two thirds the face of the policy. The best general purpose policy for the active business man who can use and invest his funds safely and well is the “straight life.” A very desirable kind of insurance (as yet little developed) for salaried men is that terminating at some chosen retirement age, (say sixty-five years) combined with an old-age pension for life thereafter.

§ 9. Insurance assets and investments as savings. Of all savings institutions insurance probably is destined to be the most important. It is probable that abstinence will more and more express itself not in accumulating large capital sums to provide for one’s old age or for survivors, but in providing insurance for dependent survivors, and invalidity and old-age pensions for the insured and others, payable as terminable annuities. In any case, the results to be expected in the changing forms and magnitude of private fortunes are certain to be great. The assets of life insurance companies in the United States have already attained the enormous sum of nearly $7,000,000,000, a sum equal to the reported savings bank deposits. In the last thirty years life insurance assets have more than doubled in each decade, and are now increasing by more than a quarter of a billion dollars annually. These great funds, which in equity nearly all belong to the policyholders, form already approximately one thirtieth of all the private capital of the country. They are invested in many ways, in real estate, in loans secured by mortgages on real estate, in bonds, municipal, railroad, and industrial. This is one of the ways in which the equitable ownership of the wealth of the nation is being practically and effectively socialized. The problem of wise legislation for these organizations, of their competent and honest management, and of their relation to the social, business, and political life of the nation, is certain to be of ever increasing importance. We are hardly more than emerging from the experimental stage of insurance, hardly more than at the beginning of its development.

§ 10. Future of insurance. It is striking evidence of the importance of the marginal principle that insurance should still be desired by men when the cost is so high and so large a part of the total premiums is absorbed in expenses.3 Insurance of all kinds grows apace, but its use would be wider and its benefits greater if the “tare and tret” of doing the business could be reduced. It seems a reasonable hope, now that the experimental stages are passed, that this may be done. It is true that some portion of the expenses of insurance companies give to the insured valuable services, such as inspection of houses for fire prevention, medical examination, and home nursing to reduce illness and conserve life and these services might be further extended. In the case of all kinds of insurance as yet a large expense for agents has been necessary to educate men to see the value of insurance and to purchase it, as well as for many other competitive expenses. It has been found that much of this expense can be saved by insurance in groups (for all employees in an establishment), by compulsory insurance (as of all workingmen), and by central state administration serving to regularize and unify the organizations. An important problem to be solved in the future is to find methods of insurance equal to or exceeding in their efficiency those now in use, but at much more moderate cost. It is not improbable that universal coöperative state insurance, both of life and property, will be worked out. This important question will be further considered in connection with “social insurance” as a measure to benefit the working classes.

References.

• Dawson, M. M., The business of life insurance. New York. A. S. Barnes & Co. 1905.
• Gephart, W. F., Principles of insurance, vol. I, Life. New York. Macmillan. 1917.
• Huebner, S. S., Life insurance. N. Y. Appleton. 1915.
• Zartman, L. W., (Ed.), Life insurance. Ed. Yale Univ. Press. 1915.

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

[2 ]Banks in the United States, 1920.

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

[4 ]Usually with deduction of interest in advance; a process called discount. See Vol. I, pp. 275, 302.

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

[6 ]See ch. 4, § 5.

[7 ]See below, § 11.

[8 ]The Federal Reserve Act of 1913 has given encouragement to this practice by reducing to 3 per cent the reserve required to be kept against time deposits. See ch. 9, § 7.

[9 ]Including, now, two varieties: the “national bank-notes,” issued, as before, through local banks, and some “Federal Reserve bank-notes,” which are national bank-notes that have been taken over by the Federal Reserve banks.

[10 ]In some cases, as during the bank restriction in England, 1797-1821, and after 1914 in all the European countries, bank-notes become inconvertable—practically political money.

[11 ]See above, § 3.

[12 ]In the United States in 1920 individual deposits in banks could be classified as follows:

Of the total $14,000,000,000 were in national and $23,700,000,000 were in other banks. All the demand deposits were subject to check, excepting $1,300,000,000 of demand certificates. Of the time deposits $7,500,000,000 were in savings accounts, $2,600,000,000 in time certificates, and $10,100,000,000 not classified, of which a large part was “time deposits on open account,” for the withdrawal of which ordinarily no notice is required. It appears, therefore, that at least $25,000,000,000 of deposits are almost as good as cash in hand for the depositors’ current needs. This was more than four times the $6,000,000,000 of cash in circulation and in banks at the same time, and was twenty-five times the $1,000,000,000 cash in these same banks (the Federal Reserve banks not included) at that time. These figures indicate the great influence that banking has in increasing the average efficiency of the circulating medium of the country. (Figures from Annual Report of the Secretary of the Treasury, 1920, pp. 1188, 1430, 1431).

[13 ]See above, § 3.

[1 ]In recent years that 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.

[2 ]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, § 7) were all altered by the legislation of 1913, effective late in 1914.

[3 ]The expressions within quotation marks in the following sections are taken from this report.

[4 ]See further on this in § 7 on periodical congestion of funds.

[5 ]See above, § 3.

[1 ]See ch. 8, § 1.

[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 designed. Whenever, 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 now say twelve. See map, Figure 1, ch. 9.

[3 ]These notes were all secured by the deposit of bonds of the United States, a large share of them bearing interest at the artificially low rate of 2 per cent. Two per cent. was less than the market rate for government loans, for 3 per cent bonds without this privilege sold 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.

[4 ]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.

[5 ]This may be shown in the following table:

[6 ]The complete application of the new rule was deferred for a period of three years from the passage of the act.

[7 ]By amendment, September, 1918, banks in outlying districts of central reserve cities, or of reserve cities, may, by affirmative vote of five members of the Federal Reserve Board, be permitted to hold reserves less than the usual 13 and 10 per cent, respectively.

[8 ]The original act reduced the legal minimum of reserves required of each of the three classes of banks to 12, 15, and 18 respectively, and laid down an over-ingenious rule for the proportion that must be left in the member bank’s own vaults and in the Federal Reserve Bank, respectively, or that might be in either place.

[9 ]See on “piping” provision, § 2, above.

[10 ]See § 7 above.

[11 ]Paraphrased from editorial statement in the “Federal Reserve Bulletin,” Dec. 1, 1918, p. 1164.

[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.

[2 ]See Vol. I, pp. 51, 154, 300-302.

[3 ]See ch. 14, § 6, on the tariff legislation at this time.

[4 ]See ch. 8, § 1.

[5 ]See ch. 5, § 8.

[6 ]See ch. 6, § 9; ch. 9, § 13.

[7 ]See diagram of business failures, 1890-1914, in Vol. I, p. 364.

[8 ]See Vol. I, p. 304.

[9 ]See on tariff legislation and business crises, ch. 16, § 13.

[10 ]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.

[11 ]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.”

[12 ]See Vol. I, ch. 37, § 6 and § 9.

[13 ]See, e. g., Vol. I, pp. 271, 335, 365-367.

[14 ]See above, ch. 9, §§ 5, 6, 8.

[1 ]See Vol. I, chs. 9 and 10.

[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.

[3 ]See Vol. I, p. 484.

[4 ]See ch. 9, § 7.

[5 ]E. g., Babson Statistical Organization, Brookmire Economic Service, Harvard University, Committee on Economic Research, Moody Manual Co., Moody Corporation Service.

[6 ]See Vol. I, p. 318.

[7 ]Stock and mutual savings banks are both found in only two states. New Jersey has 26 mutual and one stock, New Hampshire 45 mutual and 11 stock savings banks. The other stock savings banks are in the District of Columbia, one southern and seven western states.

[8 ]See Vol. I, pp. 290, 297-298, 484, and 486.

[9 ]See ch. 18, § 4.

[10 ]On these economies, see Vol. I, p. 298.

[11 ]See ch. 27, below.

[1 ]See Vol. I, ch. 5, § 7.

[2 ]See Vol. I, pp. 365 and 374.

[3 ]These figures were collected by V. N. Valgren, investigator in agricultural insurance for the United States Department of Agriculture. They do not include a large number of similar companies that carry risks other than farm property to an extent greater than 35 per cent.

[4 ]National Board tables for 1917, published in the “Insurance Year Book,” 1918, p. 448. The Spectator Company. Mostly fire insurance, but including marine, automobile, and other business, see also, p. 540.

[5 ]See Vol. I, labor incomes, in Index.

[1 ]See Vol. I, p. 279.

[2 ]Let P be the present worth of all the policies for a group of the same age, p the present worth of one policy, X the total insured at the beginning of the period, f the total losses for any year. Then

[3 ]See ch. 12 § 6.