XXIII. CREDIT
Analysis and description are much more important than definition. Definition at the beginning of a study is frequently a fetter, rather than an aid to thought. This is especially true in a field where phenomena overlap and interlace, and where the "pure principle," "essence" or "Wesen" of the thing defined never presents itself, but is only to be reached by violent abstraction. To pick out one element--as "futurity"[503]--as marking off credit from other things would be an illustration of this. Or to take the notion of promise, or contract obligation, in connection with futurity, is likewise to limit the field unduly, on the one hand, and to include things which do not belong there on the other. Thus, a contract whereby A is to build a house for B by the end of a year, receiving at that time, or in instalments as the work proceeds, a sum of money, is not a credit transaction. We have, however, promise, futurity, and a future payment of money all called for in the contract. On the other hand, if A sends B a telegraphic order for money, which B receives three minutes after the money is entrusted by A to the telegraph company, we have a credit transaction, with no element of futurity in it. Certainly there is less of futurity there than in the case where a laborer, working all day, is paid only at night for work done in the morning. Futurity enters into the values of all goods which are not destined for immediate consumption--capital values of long-time goods are discounted present worths of future values. Contracts, promises, and beliefs in promises run through the whole range of economic life,--the domestic servant, paid weekly, illustrates all three. Yet only a special class of these economic activities are commonly counted as credit transactions. Credit is really a part of the system of economic value relations not easily marked off in economic nature from the rest. Its clearest differentiae are juridical rather than economic. It will be the purpose of the present chapter, in part, to blur, rather than to make precise, the line between credit and non-credit in economic phenomena, and to assimilate the laws of credit to the general laws of value.
This will involve, however, a careful analysis and precisioning of certain phenomena commonly counted as credit phenomena. Buying and selling on the one hand; borrowing and lending on the other: the distinction seems clear. It is in law. But what is it in economic nature? When a merchant discounts his own note at the bank, it is borrowing. When he discounts the note of another, his debtor, it is selling. If he writes before his endorsement of the note, "without recourse," (unusual at a bank, but common enough with real estate mortgage-notes) he has made a perfect sale, and is entirely out of the transaction. Is it, however, in economic nature a different transaction from the original one in which he got the note from a borrower? Legally bonds are credit instruments, and stocks are not. Stocks represent ownership. But practically, as an economic matter, both represent the alienation of control, on faith, to a small group of men, and practically, too, the difference between preferred stocks and bonds is often very slight. Whatever the legal rights of a bondholder, under the terms of his contract, the legal fact itself often is, under the growing practice of receiverships, that he cannot exercise his right to foreclose without such difficulty that it doesn't pay to do it. Very frequently indeed the junior bondholder will come out of a reorganization as simply a preferred stockholder--which is what he practically was all the time. He couldn't vote as a bondholder, but his voting rights as a stockholder commonly mean little! As a bondholder, if he held enough bonds, he might even have more influence on the affairs of the corporation than as a stockholder. The market is moved by other forces than the legal distinctions in corporate contracts! And market facts are not necessarily correctly told by the accountant's categories either. I shall trouble myself little, in what follows, with the juridical and accountancy problems of credit, save in so far as these bear directly on the more pertinent economic aspects of the matter. I am interested in the question of credit as a part of the problem of value and prices--and particularly from the standpoint of the problem of the value of money.
What difference is made in values and prices by lending and borrowing? What kinds of lending and borrowing are there? What shall we say of bank-notes, of bank-deposits, of bills of exchange? What difference is made by the money market? Behind the legal forms and the technical methods, what are the psychological forces at work? How are these psychological forces modified by the technical forms and methods? What are the economic differences between long and short time loans? How shall we draw the distinction between the "money-rates" and the long time interest rate on "capital?" Why can some things serve as collateral in the money market when others cannot? What sorts of credit are appropriate to commerce, to manufacturing, to agriculture? Is credit capital? Is an increase in credit an increase in values? The last two of these questions imply that we have a definition of credit. Perhaps the answers to some of the other questions may have given us such a definition. But analysis and description will precede definition.
The etymology of "credit" has sometimes been taken as the clue to the meaning of the word for economics, and the idea of confidence, or belief, has been made the heart of the matter. A man has good credit when others have confidence in his integrity, etc. Men lend to others when they can trust them to repay. Doubtless something of this sort was responsible for the original choice of the word. But when loans are made on good mortgage security, or on collateral security, the personality of the borrower may count for little or nothing. Confidence there is, but not confidence in the intentions of the borrower. The confidence is in the "goodness" (i. e., the value and marketability) of the collateral. The same questions are raised by the lender here which he would raise if he were going to buy the thing, instead of lending with it as security. None the less, I think that in the etymology of the word we have an important clue. We must generalize the notion, however, beyond the limits of confidence in personal intentions. It involves confidence in the general economic situation, in the future of business, in the permanence of values, in the certainty of future incomes, etc. Thus viewed, the element of confidence, though important in highest degree, is not peculiar to the phenomena which we call credit phenomena in economics. It appears wherever there are values which depend on future events. One does not need much confidence in buying potatoes or apples or meat--though in the case of meat quite a lot of confidence may be involved--and misplaced! But whenever the future is involved, whenever capital values of any kind are involved--lands, stocks, bonds, houses, horses, manufacturing equipment, etc.--the element of belief, confidence, hopeful attitude toward the future, is quite as much present as in the case of a loan. Nor is the element of personal confidence less present, often, in these things than in the case of a loan. Very often the value of a horse may depend in considerable degree on the integrity of the man who offers it for sale; the value of a piece of land may be much enhanced if a trustworthy owner makes certain statements as to the yields he has got from it; the values of stocks (really credit instruments, from the angle of economic analysis) may depend very much on the personality of the organizers and managers of a corporation. Personal prestiges may count for much more in these cases than in the case of a collateral loan.
Further, in connection with the element of belief, or confidence. Borrowing is expensive, and men do not borrow for amusement. That borrowing and lending may increase, it is not enough that lenders have confidence in the ability of borrowers to repay. Borrowers must also have confidence in the future of their businesses, in their ability to make enough out of the loan to pay the expense involved, and have a surplus left over. I abstract here from consumption loans. They play a very minor role.[504] The analysis in an earlier chapter, based on Kinley's figures, showing that retail trade is less than one-eleventh of the total pecuniary transactions in 1909, and that the percentage of credit instruments used in retail trade is much lower than in other transactions, will justify us, when quantitative questions are involved, in abstracting from consumption loans. Since such loans will be chiefly employed in retail buying, and since we know that most retail buying does not result from loans for consumption purposes, we may conclude that modern credit is overwhelmingly of a different sort. Most of it arises from business activities of one kind or another, and rests on expectation of profit and loss.[505] Such loans are not made when borrowers, as well as lenders, have not confidence in the transactions they mean to put through.
So far the thing has run in terms of individual calculation of profit and loss. But even the most sagacious business men do not play a lone hand. No one is uninfluenced by the expectations and feelings of others. In general, business confidence is in large degree a matter of social psychology, resting on suggestion, contagion, etc., as well as on cool calculation of profit and loss. Even where men are able in considerable degree to free themselves from the prevailing optimism or pessimism, they must take it into account. The man who extends his business when nobody is in the mood to buy, when no one will make contracts with him, runs a very fair chance of bankruptcy, even though there be, in the technical facts of industry, no reason for the prevailing pessimism. A man with large resources, which are not fully employed, seeing that the prevailing "bad business" is "largely psychological" may, indeed, take advantage of the fact, get his labor and raw materials cheaply, and produce some staple in advance of his market. If he can afford to hold his surplus, he may make large profits by so doing. But usually business men will not, in such a situation, have the surplus resources to enable them to put through such an undertaking, and hence, even though they may recognize that the rest of the business world is irrational, they must, perforce, conform to its irrationality, and their sober estimate of the prospects of a given undertaking may be just as much adverse as if they shared the feeling of gloom which all about them feel. They meet it from the banker from whom they wish to borrow. Even if able to borrow, they meet it from the dealers to whom they are accustomed to sell their products. The prevailing gloom is as much a fact with which they must reckon as is the price of their raw materials, or the technical qualities of those raw materials.
Further, business confidence is not a matter in which each man counts one! There are centers of prestige, men and institutions whose attitude toward the future counts heavily indeed in determining the attitudes of others. These prestiges may arise from various causes. Recognized wisdom and probity may give a man great prestige in economic matters. There are financial writers and students of the market, not necessarily men of great wealth, whose opinions are exceedingly influential in making business confidence. The wisdom without the probity is not enough. Some men, known to be sagacious students of the market, have been known to succeed in their plans by telling the truth, with the result that everybody else did the wrong thing! They made business confidence, but not the sort that was complimentary to them. Other men have prestige, influence in making business confidence, by virtue of possession of large wealth. They are, first, in position to lend largely. Their decisions count directly for more than the decisions of thousands of other men. The very fact that they have confidence in the future, apart from anything else, means a tremendous increase in effective business confidence--which we are here concerned with. The optimism of a man who can neither buy nor sell nor borrow nor lend, because he himself has no economic resources, and no prestige, is like the desire of a penniless beggar for an economic good--its effect on the market is not great! But further, the fact that a rich man is lending makes possible activities which would not otherwise be possible, and so justifies confidence on the part of those who wish to deal with those to whom he lends. Such a man may, on the other hand, borrow. His borrowing, for business activity, justifies confidence on the part of those who would deal with him. Quite apart, therefore, from any influence on the opinions of others growing out of respect for his judgment, or less rational reaction to him, he can do much to make or unmake business confidence. But commonly, also, such a man is a center of prestige, as well as a controller of economic power by virtue of his wealth. Men look to him for their cue. If he has confidence enough in the future to risk his great wealth, surely smaller men with smaller interests need not be afraid. Vitally important centres for the making and controlling of business confidence are the banks. Having intimate knowledge of the affairs of many business men, of business men in many different lines, they are in a position to judge wisely of business prospects. Having great power to make or refuse loans, they can encourage or chill the enthusiasm which business men may independently develop. The whispered word of a banker may well count for more than the half-page advertisement of a promoter. But the banker is not all powerful. His influence is much greater, often, in restraining than in evoking business confidence. Bankers may during long periods be quite unable to increase their loans, though they tempt borrowing by easy rates.
Business confidence is a fact of social psychology. It is an organic phenomenon, with radiant points of control. It is a matter of inter-mental activity, rather than a thing in which each man makes an independent choice.
But this is to say nothing of credit phenomena that is not true of all value phenomena. All economic values are social values. The values of wheat or sugar or bicycles are social values. There are centers of power and prestige, growing out of the distribution of wealth, or various other social factors, which have a dominating influence on economic values, as a rule. Credit phenomena are merely part and parcel of the general system of economic motivation and control.
In Social Value (pp. 102-103) I have denied the doctrine of Meinong and Tarde that explicit belief, existential judgments, are essential to the existence of values, taking value in the generic sense, which includes aesthetic value, religious and patriotic value, legal, moral, and other values. I have pointed out that we do, at times, value ideal objects, the creatures of our imaginations. The dead sweetheart, or the Beatrice that never was (or that never was what she was imagined to be) may have tremendous value. Not merely things hoped for, but things hopelessly gone, as "The Lost Cause" to the Southerner, may be objects of value so high that other things, known to be real, may sink into insignificance beside them. Even in these cases, however, there must be a "reality-feeling" an unconscious presumption or assumption that the object valued is real. Indeed, belief, as distinguished from mere ideation, is an emotional "tang," an essentially emotional, rather than intellectual, fact. If it be present, the ideation and explicit judgment may be dispensed with.
It is, however, characteristic of economic values, particularly of the values of instrumental goods and of the goods with which business men make profits, that the tendency to raise the question of reality, to require explicit judgment, is strong. The successful business man is necessarily the man who does this, who does not too highly value the creatures of his imagination, when he imagines a vain thing. One need not, perhaps, seriously raise the question as to the reality of the loaf of bread he buys. Explicit judgment there would be superfluous. But very serious questionings come in whenever lands or houses or securities or bills of exchange come in. One needs to know what the facts are, and to make judgments based upon them. Hence, for all values of capital goods and income-bearers, for the values which pass in wholesale and speculative trading in general, the matter of belief is vitally important. Here, again, then, we have nothing in the psychological principles underlying credit phenomena to mark them off from the general field of value phenomena.
The general laws of value, then, apply in the case of credit phenomena. We find nothing unique in essence in them. The juridical relations, also, in so far as they have economic significance, shade into one another. To buy a bond from a bondholder is purchase and sale. To pay a borrower money for his personal note is lending. But from the standpoint of the theory of value and prices this distinction may be ignored. We may extend the idea of buying, selling, and price to cover all contracts where values are balanced against values, and expressed in terms of each other. Future money has its price in present money, just as much as present wheat has its price in present money. Really it is not future money against present money. It is a case of rights, which involve the payment of money in the future, sold for money, and priced in money. In general, it is rights, rather than things, which pass in economic exchange. Physical delivery does not constitute selling. Delivering a load of wheat to a railroad does not constitute sale of the wheat to the railroad; selling a farm does not involve any physical moving of the farm. Rights, in personam or in rem, are objects of economic value, and the exchange of these rights makes up the bulk, if not the whole, of economic exchange. (Exchange may be limited to the transfers of juristic rights, without value being so limited. I have discussed the relations of value and exchange in the chapter on "Value," above.) Property rights are commonly conceived of as the proper objects of buying and sale. Contracts involving the future services of free men stand legally on a different footing from contracts regarding physical goods. But economic analysis is not greatly concerned with these distinctions, except in so far as they affect the values of the things exchanged, and so the terms of the exchanges. I do not believe that the legal distinctions can be made to run on all fours with any significant economic distinctions, and shall not undertake to make them do so. In the phenomena we have simply cases of buying and selling (in a generalized sense of those terms) of rights, at prices (by a very slight extension of the term, price, to which the market is well accustomed). The terms of these exchanges, the prices, are governed by values, social economic values, in no wise different from the values which govern the prices in exchanges which we do not class as credit transactions. I say that credit phenomena are exchanges of rights. This is true of all exchanges. We do not exchange rights for money. We exchange rights to other things for rights to money. The mere physical transfer, even of money, does not give rights to the money. I may merely be giving you the money for safe keeping, or for use for my purposes. While the law makes the rights to money that has left the hands of its owner less lasting, as against innocent third parties, than in the case of other objects, and while the right to money is always, or almost always, met by returning other money of equal amount, even in the case of money it is a right, and not a mere physical transfer, that is significant.
Our problem regarding credit is, then, much simplified. We have simply to pick out certain economic exchanges to which the name of credit transactions has been applied,--a various and heterogeneous set of exchanges, in many ways--and study them, to find their peculiarities. These peculiarities will not make them exceptions to the general laws of value. They will make them merely special cases. To find essential principles marking off credit transactions, at large, from non-credit transactions is an exceedingly difficult thing. There are more differences among credit transactions themselves, than there are between the genus, credit transactions, and the class of things not called by that name.
Thus, monthly payments of rent, of wages, of college professors' salaries, are not commonly called credit transactions. The monthly payment of grocery bills, or of telephone bills, involves credit. Where is a real difference to be found? On the other hand, between book credit between grocer and patron on the one hand, and a bank-note or deposit credit on the other, the difference is large, in many practically important ways. Between a call loan and a ten year agricultural mortgage-note, the differences are even greater.
One may be disposed to find the differences between credit transactions and non-credit transactions in the fact that the former stipulate a definite sum of money, due at definite times. This would partly differentiate a bond, say, from a stock. The bond not merely calls for stipulated yearly payments, but also calls for a definite payment at the end. This would, however, exclude British Consols from the list of credit instruments! British Consols differ from safe preferred stocks in legal, rather than in economic, ways. Legally they are alike in that no terminal payment is called for. Practically they are alike in that annual regular sums may be expected. It may at least be said of credit transactions that stipulated money payments, either at a different time or a different place, are called for. This would include the telegraphic transfers of funds, and would exclude the case where A, a farmer, does a day's work for B, a neighbor, for the promise of a day's work in return at a later season. The latter transaction involves many of the elements that definitions of credit have included, but I think that we may at least limit our conception of credit transactions to transactions within a money economy, where money, as a measure of values, functions in the calculations. Shall we, however, limit credit transactions to cases where a stipulated amount of money is named in the contract, for a stipulated time?
Shall we exclude contracts where the payment of money is made contingent on anything? By contingency here I mean legal contingency. This test would exclude the highest grade preferred stock. It would include the shakiest bonds that contained, in the terms of the contract, no contingency. But where, then, would one place such an instrument as the Seaboard Airline Adjustment 5% Bonds, which may default in a given year half of the interest, if it is not earned,[506] and which yet call for the payment of the principal at a stipulated time?
What shall we say of "borrowing and carrying" transactions on the stock exchange? Is not the loan of stocks a real credit transaction? Ordinarily, when stocks are put up as collateral, one thinks of the money as being lent, and the stock merely as a pledge. But in the case of borrowing stocks by a bear to deliver next day, the transaction is definitely thought of as a loan of stock. It is sometimes paid for, the bear paying the bull a premium, instead of receiving interest on the money he has turned over to the bull as a "pledge." The more usual thing, is, of course, for the bull to pay the bear interest. But in a contract like this, there are many contingencies. As the stock rises in value, the bear must lend more money to the bull; if the stock falls, the bull must return part of the money to the bear. Both times and amounts are here contingent, even though in the end the amounts lent and repaid balance. Call loans, of course, do not call for payment at a stipulated time, and the same is true of bank-deposits and bank-notes, and of many other forms of credit. Interest on deposits in mutual savings banks is contingent, legally, as to amount. Are insurance policies credit instruments? What of endowment policies?
It is easy to draw legal distinctions in all these cases, but to show that definite and uniform economic consequences flow from these legal distinctions is quite impossible. Rather, it is easily possible to show that uniform or certain economic consequences do not, in general, flow from them.
I shall refrain from the effort to give a general, fundamental definition of credit. I shall rather discuss certain of the more important types of what have been called credit, with a view to seeing what bearing they have on the problems with which this book is concerned; the value of money, and prices. The general class of transactions to which the name, credit transactions, has been applied may be roughly designated as transactions in which the consideration on one side, at least, is the assumption of a debt, running in terms of money (though not necessarily to be paid in actual money), payable either at a future time or at another place. Objections can be found to this definition. It does not meet the fundamental test of a definition that, for the purpose in hand, it should seize upon the essential and unique characteristic of the things marked off. I am not sure that it meets the tests of inclusiveness and exclusiveness even for those transactions which we call credit transactions. Thus, if A and B go to the bank together, and A there buys B's horse, standing in front of the bank, giving B in return a check, which B immediately cashes in the same room where the check is drawn, the idea of different time or different place is not realized in any but a technical sense. A, in drawing the check is, of course, assuming a debt. The check, if repudiated by the bank, becomes a note, which A must pay. A, moreover, is paying B, not with money, but with the transfer of a claim on the bank, and the fact that his check, if unpaid, becomes a note is not the main fact about the check. Understanding our definition of credit to cover this case also, however, and attaching no fundamental importance to the definition save as a means of marking off a class of more or less related phenomena which we mean to discuss, the definition will serve.
Thus defined, we have in credit a concept susceptible to quantitative treatment. Debts, in terms of money, can be summed up, and we may have the concept of the "volume of credit" as the sum of such debts at a given time, or through a given period of time, or as an average through a period of time. We may distinguish credit transactions from credit, defining credit as the volume of debts, and credit transactions as transactions in which the debts are passed in exchange. This would be to broaden the notion of credit transactions beyond the usual conception, since it would include transactions in which A sells ("without recourse") B's note to C. It would also include cases where bonds are sold. It would exclude cases where stocks are sold, since they are not legally debts. Some would prefer to limit the notion of credit transaction to transactions in which there remains some contingent responsibility on the part of the one who uses the credit instrument, but this would be to deny the name, credit transaction, to cases where bank-notes or government paper are used in payments, as well as to deny it to the case where bonds are sold. It is not important, for my purposes, to draw a sharp line about the concept, credit transaction, however. And about the concept credit itself I have drawn a line resting on a legal, rather than an economic, distinction.
Within the field of credit, thus defined, we may single out for especial consideration certain forms of demand or short time credit, particularly bills of exchange, bank-notes and bank-deposits, and merchants' book-credit. We shall also have something to say regarding long-time credit, including bonds, and mortgage-notes that have no general market.
All these debts in terms of money, to which, in the aggregate, we have given the name, volume of credit, have grown out of exchanges. Exchange is here used in a wide sense, and is not confined to the case where goods or services are bought and sold. It is an exchange, if a man gives his note to a banker in return for a deposit credit. But, on the assumption that exchanges are made only when gains are to be realized, it follows that all debts, and so all credit, have been created in view of anticipated gains (or to avert anticipated losses). In a society where everything is in equilibrium, a "static state," where there are no "transitions" to be effected, where there is no occasion for speculation, and where exchanges of lands, etc., are negligible, the volume of all exchanges, including those where debts are passed in exchange, would be small. The occasion for the creation of the debts which make up the volume of credit would not be nearly so numerous as under dynamic conditions. The volume of credit, in other words, is largely a function of dynamic conditions, even though credit would exist in a static condition of economic life. The bulk of credit, as the bulk of exchanging, grows out of dynamic conditions, transitional changes, and the like.
This will be clearer when we raise the question as to why debts are created, as to what function debts perform in economic life. Why should a man borrow? Let us suppose that a farmer has 600 acres of land. He wishes to sell 100 acres, and use the proceeds in buying equipment for his farm. But he finds it difficult to sell the 100 acres. There is no ready market. He can sell it immediately only at a great sacrifice. By waiting, and looking industriously for a customer, or by engaging a real estate dealer to do so, he could finally find a buyer, but the thing is slow and uncertain, and he wishes to get the equipment at once. He borrows, therefore, giving his farm as security, or a part of the farm as security. He exchanges a claim on the future income of the farm for present money, and with this he can buy the equipment he needs. The net result has been that the credit transaction has transformed his unmarketable quantum of value into a marketable form of value. He has been able, by an indirect step, to do what he could not do directly--to trade a part of the farm (which in its economic essence is a prospect of future income) for the equipment. In this illustration, credit has functioned as a means of increasing the marketability or saleability of non-pecuniary forms of wealth. Credit is primarily a device for effecting exchanges that could not otherwise be effected, or for effecting exchanges more easily than they could otherwise be effected. This means that credit transactions are a part of the productive process, and that they increase values. It is the function of credit to universalize the characteristic of money, high saleability. It is the function of credit to "coin," so to speak, rights to goods on shelves, lands, etc., etc., into liquid rights, bearing the dollar mark, which are much more highly saleable than the rights in their original form were, and which often become as saleable as money itself, functioning perfectly as money.
Credit thus tends to universalize that characteristic which Menger[507] considers the unique characteristic of money. By means of credit transactions, a man borrows up to 50% of the value of the farm, makes his farm in effect, 50% saleable or fluid. The man who owns livestock may not be able, on a given day, to market them without loss, but he can use their value in the market, up, say, to 75%, by a loan. The man who owns a hundred shares of United States Steel may not be able, at a given time, to market them to his satisfaction--though in the case of articles and stocks dealt in the speculative markets saleability is very high indeed, and in the case of United States Steel, in particular, the "spread" between "buying price" and "selling price" is very narrow--but he can borrow, with the stock as security, up to 80% of its value. On a bond of the United States government, he may borrow up to 100%.[508] The process of creating credit is a process of transforming rights from unsaleable to saleable form. Often this means the subdivision of rights, preferential rights to a portion of the value of a piece of wealth being more saleable, because of greater certainty, than the total right to the whole. Another reason why partial rights may be more saleable is that the value represented by each partial right is smaller. It is easier to market things worth a thousand dollars than things worth fifty thousand, as a rule. In any case, a chief economic function of credit is,--the chief function for our purposes--to make fluid and saleable articles of wealth other than money; to universalize the quality of saleability.
This justifies us in our contention made before that all corporate securities, whether stocks or bonds,[509] are, in economic nature, alike. Driven to a legal concept for a definition of credit, we were obliged to exclude stocks from our rough definition. But corporate organization does precisely what the various other transactions that we have called credit transactions do. Lands and buildings and machinery, or the roadbed and rolling stock of a railroad, are highly specialized, often unfit for use in any form other than that in which they now appear. As concrete instruments of production, they would be highly unsaleable. In their totality, as a going concern, they are highly unsaleable, because in the aggregate so very valuable. Grouped together, however, but still subdivided, the objects of many thousands of partial rights, represented by stocks and bonds, they become saleable in high degree.
As objects other than money gain in saleability, they tend to gain in value, also. This is not necessarily true, always. If wealth is already in the best place, at the proper time, and in the proper hands, no point is involved in further exchanges. Additional saleability--or an increase in the qualities that make for saleability--could make no difference. But when objects could be employed to greater advantage if in different hands, if, in other words, there is occasion for exchange, then whatever adds to the saleability of a good adds to its value. What would otherwise have gone into the trouble and expense of marketing now is saved. In general, items of wealth tend to gain in value as they gain in saleability--though not in any definite proportion.
Further, as objects of value other than money gain in saleability, money tends to lose its differential advantage in this respect, and so tends to lose that part of its value which comes from the money-uses. If all things, including gold, were equally saleable, there would be no raison d'etre for money, and gold would have only the value that comes from its commodity functions. In so far as credit-arrangements give to partial rights to wealth the capacity to serve as a medium of exchange or for other money purposes--and this is true to a high degree of bank-credit--this tends to cut under the sources of value of money. Credit thus, from two angles, tends to raise prices; it raises the values of goods; and it tends to lower the value of money. The limits on this, however, are reached when gold ceases entirely to function as money, and when all items of value are perfectly saleable. Then credit has done its perfect work for prices, and can do no more. No incentive remains for further borrowing, if all items of value that need to be exchanged are perfectly saleable.
These theses will meet objection, particularly from those who are accustomed to quantity theory reasoning, and who look upon the volume of credit as something independent of the volume of trade. On the logic of the quantity theory there is no reason why prices might not mount indefinitely, if only credit could increase indefinitely. The causes controlling the volume of credit are, on this view, quite independent of the volume of trade. I have given this line of thought sufficient criticism, perhaps, in Part II, but shall find occasion to recur to it at a later point in this chapter. However, writers not bound by quantity theory ideas, may still find reason to question these theses, and it is necessary that I should take account of various complications, and make what may well be called substantial qualifications and modifications, before the theses are acceptable.
First, objection will be offered to the doctrine that all credit is merely rights to wealth, that credit rests on wealth. It will be urged that many loans are made without collateral, or mortgage security, that the "personal credit" of the borrower is the only security, and the only basis of the loan. This objection is not serious. There are, doubtless, loans which are disguised benevolences, where the lender gets nothing good in return for his loan. I abstract from such cases. Quantitatively they are not important, and qualitatively they are not really commercial transactions. In general, when a good merchant borrows at the bank on his personal note, the bank knows very well what goods he has in stock, what prospects he has for marketing them, what other debts he has, what his "net worth" is. And the bank knows that it has legal claims, even though not preferred claims, on his wealth. When a young business man borrows capital from a neighbor, giving no security because he has no marketable wealth which would serve as security, he is, none the less, exchanging a valuable right for the loan. He is giving the lender a right to a preferential share in his future income. The lender has considered the young man's abilities as sources of income, in conjunction with the capital lent. Incidentally, the lender retains rights, preferential rights as against the young man himself, in the quantum of value he has turned over to him. If a young man borrows the resources with which he buys a farm, the lender takes a mortgage on the farm itself. Transactions of this sort frequently have in them the element of benevolence, and the considerations are not always strictly commercial. In the case of a young man of unusual ability, however, who insures his life for the benefit of the lender, such transactions may be perfectly good commercial transactions, value balancing value in the exchange. The thing traded is commonly present money (or its equivalent) for rights to future money income.
Public loans present no exception to our rule. They represent the transfer of present wealth for the future income which the government, by virtue of its public domain, or, more commonly, its taxing power, may expect to receive. With a strong government, this future income may be a very substantial part of the total income of the people. Public loans may often be for commercial purposes, as when municipalities borrow to build or extend municipal enterprises. In cases of this sort, the market frequently will consider the prospects of commercial success of the enterprises in fixing the value of the municipal bonds. Where the proceeds of the loan are for non-commercial purposes, as war, the question of the future income of the government will still, ordinarily, be a dominant factor in determining the value of the securities. Often, however, there is the direct action of patriotic fervor, etc., enhancing the values of government securities. We have seen this in the case of government money. It is no part of our theory to maintain that men's calculations are always rational, or that the whole of the value of a long-time income-bearer rests on the anticipated income. But this is no peculiarity of credit phenomena. The same thing is true of lands, for example. Capital values often get independent in part of their "presuppositions," as we have seen in the chapter, supra, on "Economic Value." War security issues often represent the effort of the government--as at the present time--to bring into the present every possible bit of future values, as a means of increasing their power in a desperate struggle. The high prices of goods in such a situation represent the concentration of future values into the present, an increase in the motivating power which stimulates the people to unwonted exertions. In war time, moreover, many ideal values,--those whose fate is dependent on the outcome of the war--enter into and increase the values of those goods which are needed for carrying on the war. This leads to larger sacrifices of future income than would ordinarily be tolerated. It is not so much a case of present goods rising because of extra credit, as of extra credit because present goods are more valuable.
A second objection would be raised that in many cases, the values pledged by the borrower could not exist if the lender did not make the loan. This would be particularly the case with credit granted for the starting of a new or novel enterprise, which as yet exists only in idea. The established merchant, with goods on his shelves, or with a bill of lading for goods which he has sold, has a very tangible, concrete basis for a loan, whose value is independent of the decision of any given banker. If my doctrine is to be taken as holding that all credit rests on concrete physical goods, very many exceptions indeed could be found. But this is not my doctrine. It is that credit rests on valuable rights. These rights may be rights to existing concrete goods; they may be rights to future incomes. In any case, it is the values, rather than the physical quantities, that are significant. Witness cotton before and after the outbreak of the World War. Ultimately, in general,[510] economic values come from the "primary values" or "first order" values of consumption goods and services. These values are reflected back, by the imputation processes, to the various "factors of production" which have made the existence of the goods and services possible, in accordance with well-known laws which need not be here elaborated. But the category of "factors of production" is far from exhausted when we have named land, labor, and produced instruments of production! Some writers have rejected the notion of "factors of production" largely or altogether, and prefer such a term as "agents of acquisition."[511] I certainly have no intention to give to the term, factor of production, any ethical connotation. Even though a factor of production be, like land or labor, a sine qua non of production, it does not follow that the owner of that factor gets his proper, or ethically just share, under the laws of economic imputation. Many of the "factors of production," in the sense of factor which derives a value from the economic laws of imputation, may well be parasitic from the angle of ultimate social welfare. The only test is as to whether, under existing social arrangements, a portion of the income of a given establishment would cease to exist if that factor should disappear, or be reduced. From the angle of this test, monopoly power, trade-marks, established trade connections, the big idea of an entrepreneur, a dynamic personality, capacity for winning other men's confidence and good will, and sometimes that brutal selfishness which makes other men shrink from conflict, or the reputation of being a dangerous and vindictive man, may be equally "factors of production" with land, labor, and produced instruments of production. In Part IV of this book, "The Reconciliation of Statics and Dynamics," we have discussed the "intangible capital items" of this class, and have indicated that many of them perform really important and necessary social functions. Others are doubtless pernicious. Production involves leadership, organization, the making and maintaining of "interstitial connections," as well as the technology of muscle and machine. But credit is based on values, rather than on concrete goods as such, and if these "intangibles" have value, they may have credits based upon them.[512]
That some of these values exist only by virtue of the fact that credit is granted is no marked peculiarity. The granting of credit is an exchange of the rights of the creditor for rights to the future income of the borrower. If the exchange were not made, in certain cases, the borrower would have no future income to which he could give rights. The entrepreneur with a big idea cannot actualize that big idea unless he can bring it into conjunction with land, labor, capital, and a market for the products. The exchange of rights to the value of the products for the banker's deposit-currency, or the private lender's money is merely one of many necessary exchanges required to bring about the combination which will create the products. If there were no possibility of marketing the products, he would be equally helpless, and his idea be equally valueless. The general range of values, under our present system of division of labor, private property, private enterprise, etc., depend on the possibility of exchange. Men produce for the market, rather than for their own consumption, or for the consumption of a communist society. Without exchange, many values would persist, but most values would at least be diminished. Exchange is part of the productive process. The only peculiarity in the case under discussion is that the man getting credit for the exploitation of a big new idea commonly has a very limited market--is dependent on the decision of one bank or lender, or at most of one out of a few possibilities. The narrower the market, the more dependent are the values of things that must be exchanged upon the decisions of a few men. Wheat is free, virtually, from individual caprices, though even there a big operator may organize a pool and temporarily affect the value very greatly. But the immediate power of a few men on values is increasingly great as we get closer to those things which are unique, which are capable of only specialized employment, and which call for the cooeperation of elaborate and expensive systems. And, of course, the influence of individual caprice, or individual decisions, on all values grows greater as wealth and power are concentrated. Economic social value is an institutional value, specially weighted and controlled by individuals, classes and institutions.[513]
Joseph Schumpeter, in his Theorie der wirtschaftlichen Entwicklung, has made much of the role of the banker in economic evolution. He sees in the banker a creator of "Kaufkraft," by means of which an entrepreneur, a dynamic man who has a new idea which he wishes to actualize, is able to wrest from the unwilling "static economic subjects" their land, labor and instrumental goods for the purpose of putting his new plan through. This new Kaufkraft is the true Kapital which the new enterprise requires. Capital, thus defined, is not an accumulation of goods, is not embodied in goods. It is an agent, a power, which the banker creates. It makes dynamic change possible. Schumpeter is particularly anxious, in clearing the way for his new theory of interest, to get rid of all the notions of saving, accumulations of stocks of goods, etc., which have commonly been made prominent in the discussion of capital and interest. We need not here discuss his theory of interest.[514] He maintains that the new dynamic credit, credit granted by a banker for a really new enterprise, as yet not concretely in existence, represents something new in the world, anomolous from the angle of static values, and static credit. Indeed, he regards credit as unessential for the static analysis, and banishes it from the "Wesen" of his static state. But this new credit is different from such credit as there may be in the static state, because, he holds, the new credit does not rest on goods, and has no Deckung. Schumpeter himself calls these doctrines "heresies." They become less dangerous, however, when we learn that by "saving" Schumpeter means mere trenching upon accustomed expenditure, so that the entrepreneur who saves part of unusual profits is really not saving at all, and when one discovers that his contention that there need be no accumulation of goods prior to the starting of a new enterprise means merely that there need be no special accumulation of goods ad hoc. Of course if saving means trenching upon accustomed expenditure, it is banished by hypothesis from the static state, but there may still be plenty of capital (in the ordinary sense of accumulated produced means of production) for Schumpeter's entrepreneur to get hold of by means of his new Kapital. His contentions that the new credit does not rest on goods, that it has no Deckung, and that we have a new thing in the world since in dynamic credit we have a case of temporal discrepancy between the making of obligations and the ability to pay them, calls for further analysis.
It is true that there is a time during which the new credit has no basis in concrete goods. Very speedily, however, the new credit is exchanged for concrete goods, and the enterprise is started. Further, the banker commonly insists on a margin at the start. Further, the claims of the borrower on the banker are themselves, prior to their expenditure for the things needed in the enterprise, assets to which the banker may look as a basis for his confidence in the goodness of the entrepreneur's promise to pay him. There is never a moment when the new credit does not rest on values. The loan by the banker to the borrower is, essentially, like the case of the purchase of any bearer of future incomes, say a machine, or a factory. The machine is, after all, in economic nature, merely a "promise" of future goods and future values, as an Austrian economist should be quick to recognize, and machines are almost as frequently poor performers as borrowers--indeed, most commonly, the borrower's inability to repay comes from the failure in the value of the goods which his physical equipment produces. The raison d'etre of the new credit is the new values which have come into existence: the new plan of the entrepreneur, validated by the banker, attains a value equal to the present worth of the extra products which it promises. I repeat that it is values which are significant as the basis of loans, that values are not all embodied in physical goods, and that value is essentially a psychological thing.
The banker's validation of the plan may be an essential factor in its value. Belief is often an essential factor in values. The new value, and the new credit, have a large element of belief in them. The value of the new plan rests proximately in the belief of the banker, manifested by his granting of credit. But the value of the bank-credit rests ultimately in the prestige of the banker, which is a fact of social psychology, resting in a massing of belief on the part of the public in him, in the validity of his bank-notes and deposit-currency, coupled with support from legal and other institutions. But this is to anticipate the discussion of the nature of bank-credit. The point involved is sufficiently illustrated by the case where a man who is not a banker lends his money to an entrepreneur of a new undertaking. Here again the enterprise is impossible without the loan. Here the loan is made on the basis of an anticipated income. Here again the anticipated income is made possible only by the loan; one of the values that enters into the exchange exists only because the exchange is possible. None the less, the credit rests on value. It is a right to an anticipated income. The man who has made the loan has his security in the value which he has lent, plus the present worth of the extra income which the new idea is expected to create.
Now a great practical difference is made in the course of economic life by the decisions of lenders to lend to men who plan new things, instead of to men who plan old things. It makes an enormous difference whether or not new plans appeal to the imaginations of those who control the economic resources of society. It makes a great difference whether static values (the capital values of incomes to be created in familiar ways) or dynamic values (capital values of incomes to be created in novel ways) win out in the competition for loans from those who have loans to make. But as values, the two are of the same psychological stuff and substance: futurity and belief are essential elements in both of them.
Stable belief, and strong belief, are easier to evoke in the case of the established and the familiar. New ways of creating wealth must promise larger returns, and make more dramatic appeals to the imagination, than old ways. Schumpeter indicates that it is the essential function of the banker to give preference to the new ways, that the mass of men are "static" in their attitude, and that, for some reason which he does not clearly indicate, the banker is not. This has not been our American experience, on the whole. The contrast which Schumpeter makes between the timid, static masses, and the few highly important dynamic entrepreneurs, holds very much less true in America than in Continental Europe. There it is doubtless true that new industrial enterprises have had their main encouragement from bankers. Here, such enterprises have appealed largely to the mass of men, to the investing and speculative public. Our commercial banks have lent largely upon stock exchange collateral, which means that, indirectly, bank-loans have gone to finance industry. The extent of this is enormous, as will later appear. However, the banks, as banks, have not been large buyers of stocks. They have guarded themselves by requiring "margins" from those to whom they have lent on such collateral. Seasoned bonds have been bought in great volume by our commercial banks, but few stocks. Even the underwriters and investment bankers have been primarily intermediaries, expecting to pass on to private buyers the securities they hold temporarily. My point here is, merely, that there is nothing in the distinction between static and dynamic credit, when by that is meant the distinction between credit for new enterprises and credit for old enterprises, to mark off a peculiar or essential province for bank-credit. The need for bank-credit does arise out of dynamic conditions, primarily, but it is not the need for credit to start dynamic changes, even though bank-credit may do, and does do, that. The chief reason for bank-credit is to enable economic society to readjust itself quickly and readily to dynamic changes, by putting through without friction the necessary exchanges that such readjustment requires, and by holding in liquid form a fund of rights which can meet the emergencies and unexpected occurrences which dynamic conditions involve. To this we now turn.
Bank-credit is the debt of responsible institutions, payable on demand in money. It may take the form of notes, or of the right to draw checks. Long evolution has begot a system of legal relationships, and of banking technique which makes these promises easily performed. The same process of development has led to social reactions toward banks and bankers which give them enormous prestige. Legal regulation, in the case of many banks, requiring adequate capital, and, in this country, requiring minimum cash reserves, have added to that prestige. The promise of the bank is commonly so liquid and saleable that the banks are not called upon to fulfill it by the actual payment of money--the promise alone is an object of value which is perfectly saleable, which runs in terms of money, and which functions as a perfect substitute for money in almost every use except for very small retail transactions. Even there, it is very much used.
Among the features of banking technique to which we must give especial attention are the following: (1) the banker has substantial resources of his own, his "capital," which constitutes the "margin" of protection which he offers to those who give him valuable things in return for his promises to pay money on demand; (2) the banker exchanges his promises to pay on demand, as far as possible, for those things which have a high degree of "liquidity," i. e., for those things which he can quickly dispose of for cash, or for the promises of other bankers which are the equivalent of cash. Farm mortgages are not good assets for a banker to hold in large amount. They are long-term obligations, with a very limited market, and they will not help him in emergencies to meet his obligations to pay on demand. Agricultural loans, and other mortgage loans are made in considerable volume by our State banks and trust companies. All classes of commercial banks make many non-liquid loans, as we shall later see. But all of them get as high a proportion of liquid loans as they can. Bills of exchange, running ten, thirty, sixty or ninety days, growing out of commercial transactions which automatically terminate themselves in the payment of cash or the promises of other bankers, constitute admirable assets. In return for these, the banker may give his promises freely. This is especially true where there is, in the banking practice, a wide "rediscount market," in which he can sell these bills before maturity if he wishes to get even more liquid assets. Promissory notes, for short periods, thirty, sixty, or ninety days, growing again out of commercial transactions, which, like those for which the bills of exchange were drawn, automatically bring in cash or the promises of other banks, are in many respects like the bills of exchange, even though the rediscount market for such notes has not been so highly developed as the market for bills of exchange in Europe. Whether such notes are as available for rediscount as bills of exchange is a question of technical banking which we need not here discuss in detail, though I venture the opinion that bills of exchange are superior decidedly for this purpose, especially "documentary" bills. The element of personal credit is commonly larger in the promissory note, and that limits the market. Banking organization, and particularly our new Federal Reserve System, may greatly reduce the disadvantages of the promissory note from this angle, but it seems not unlikely that the bill of exchange may be a factor of increasing importance in our internal banking arrangements. The general test, however, of what is available for a banker's assets depends on varying conditions, and is not to be answered by a simple formula. A bank in a rural region which loads up heavily with the safest local bonds is little better off than with farm mortgages. For neither is there a quick market in an emergency. A city bank, near the stock exchange, may very safely buy in large amounts highly saleable as a profitable substitute for part of its cash reserve. Even country banks may, and do, safely own such bonds. Short loans on stock and bond security, constitute the most important single type of bank-loan in the United States, as we shall later see. (3) The third feature of banking technique to which attention must be given is the reserve policy. The banker must keep some actual money on hand (how much we have in part considered in Part II, and shall again discuss).
I shall give attention to these points in what follows. The first point needs little discussion. Large "capital" for a bank gives prestige and security. Some capital is a sine qua non for a bank which expects its notes or deposit currency to have general acceptability.
It will be well to consider further the circumstances determining the form which a bank's assets shall take. Though commercial banks own enormous quantities of high grade bonds, it is rare for commercial banks in America to buy stocks of corporations.[515] They will often lend to owners of such stocks with the stocks as collateral, up to a high percentage of the value of the stocks, but they will rarely trade their demand obligations for the stocks directly. In general, a bank wishes to have its assets in the form of obligations of other people, expressed in terms of dollars, and having a definite term to run (or callable on demand).
One reason for this is a bookkeeping reason. "Par value" of stocks has little meaning any more. Market-prices of stocks, even the best stocks, are not absolutely fixed. They fluctuate, even though within narrow limits. This fact presents complications to the bookkeeper! Of course, the bank's buildings and fixtures, listed among its assets, fluctuate also, in value, and in the price that could be obtained on a given day, but the bookkeeper can abstract from that, since the bank has no intention of selling its buildings and fixtures. The notes and bills held in the bank's portfolios also in fact fluctuate in value, and in the price at which they might be sold on a given day, but they are expressed in terms of dollars, and the bookkeeper commonly has no need to look beyond the figures written on them. At irregular intervals, a small percentage of them may be marked off the books as "bad," but usually the minor fluctuations are abstracted from. The bank does not like to have assets whose published prices fluctuate. But this is, I suppose, not the main objection which banks have to stocks as assets since it does not prevent their buying bonds. I abstract from the legal restrictions that prevent many banks from buying stocks. The fundamental reason is to be found elsewhere. The point is to be found here: the transaction whereby property rights in roadbed, rolling stock, etc., were collected into property rights in a going, organic whole increased the saleability of all these rights; the further subdivision of these rights into many thousands of equal parts enormously increased the saleability of these rights, especially when coupled with listing in an organized market; the further transaction, by which a preferential claim upon these subdivisions of rights is embodied in a collateral note still further increases the saleability of the value of these rights. The whole of the value embodied in a share of stock has not the certainty and saleability which a banker wishes for his assets. It might not be possible to market the stock on a given day without loss. But a collateral note, embodying 80% of that value, with provision for additional collateral in case the margin is reduced, is highly liquid and the banker has no doubt that, with watchfulness, he can always realize the full face value of such a note. It becomes saleable enough for his purposes. The transaction by which this note is exchanged for the banker's demand obligation gives the drawer of the collateral note a perfectly saleable form of value with an almost universal market, which he can convert without loss into practically anything that money can buy. We have here a series, a scale, saleability of rights growing steadily greater, through a series of transformations and exchanges, till at last the virtually perfect saleability is reached. Again we are reminded of Menger's analysis[516] of the methods of primitive barter, whereby the man who possesses a good of low saleability, through successive exchanges, gradually gets goods of higher and higher saleability, until he finally reaches his goal. Bank-credit, this most highly saleable of all forms of rights except the rights to actual money in hand, and in general not inferior to money, cannot usually be had by direct offer to the bank of crude property rights. These must be refined and distilled, till a central core of highly saleable value emerges, and then they may enter the bank's assets in return for bank-credit. The best bonds likewise offer such a central core of highly saleable value.
A further point is to be noticed about this scale of saleabilities. At each stage of the exchanges of less saleable for more saleable rights, the holder of the less saleable rights must make concessions to the holder of the more saleable rights. And the degree of his concession is, in general, correlated with the lack of saleability of what he offers. Commonly this takes the form of giving up a right which has a higher yield for one which has a lower yield. Or, viewed more fundamentally, from the angle of the capitalization theory, income-bearers of low saleability are capitalized at a higher discount rate than income-bearers of higher saleability, with the same yield. Farm lands may be capitalized on a 10% basis. (There will be great differences between regions in this, depending in considerable measure, often, on the activity of farm sales. I would refer here to the facts mentioned in my chapter on "The Quantity Theory and International Gold Movements," contrasting Cass Co., Iowa, with Yazoo Co., Mississippi. Of course, the risks of agriculture count heavily, also, and the prestige of owning land as compared with other forms of property.) The farmer's mortgage note may bear 7%. A merchant who holds that note may use it as collateral, with a margin, backing his own note, and get accommodation for three months at 6%. The bank may rediscount the note of the merchant, giving it its own endorsement, on a 4-1/2% basis. The coal mine owned by a small company may yield 12%; sold to a large iron company, which combines mining and smelting and manufacturing, that mine may be represented by 7% stock; a collateral loan, for sixty days, based on 80% of the value of the stock may be had for 4%; the demand liability of the bank given in exchange for the collateral note will either yield nothing at all, or else yield a low per cent, one, one and a half, or 2%, on large checking accounts. If the collateral note be a call note, the rate will be lower, in general, than on a time note. I here refer to what was said in the chapter on the functions of money with reference to the relation of short loans, especially call loans, to the "bearer of options" function of money. Part of the yields of these loans is in the bearing of options. This function grows out of the uncertainties of a dynamic market. It would disappear if uncertainties, "friction," and dangers disappeared.
The importance of liquidity and saleability in the assets of a banker needs little discussion. It has been reiterated by virtually every writer on the subject. Its connection with the need for meeting demand obligations is obvious. The point that I would here emphasize is, however, that this, too, grows out of dynamic changes, uncertainties, etc. An economic life in "normal equilibrium," in static balance, with all things going smoothly, in anticipated ways, could dispense in large measure, or wholly, with such liquidity. Obligations which matured at the time that the holders of the obligations had maturing obligations, would serve their purpose perfectly. Again I would emphasize the fact that the theory of money and bank-credit is essentially a dynamic theory, and that the notion of "normal equilibrium" which underlies the quantity theory has no bearing whatever on these fundamental matters.
The market where fluid bank-credit is exchanged for less fluid rights has been given the name, "the money market." The prices fixed in this market are "money-rates," figured as percentages on the amounts of bank-credit exchanged for the less fluid rights. It is, of course, strictly speaking, not a money market. Money, as the term has been used in this book, has been taken to mean gold coin, subsidiary coin, government paper, and for the United States, bank-notes. In a country where much bank-credit is elastic bank-notes, it is better to distinguish money from bank-notes. The term, money, is not one easily defined in a logical manner. A good logical definition should seize on some essential characteristic of the object defined, should include all the objects of that class, and should exclude all others. We can meet the tests of inclusiveness and exclusiveness in a definition of money, but we can hardly meet the first test. The differences between gold money, for example, and gold bullion are less than the differences between gold money and government paper. The differences between bank-notes and bank-deposits are less than the differences between bank-notes and government paper, or bank-notes and gold. The term, money, covers a group of more or less miscellaneous things, concerning all of which few general laws are possible. Gold, or other standard money, in particular, may obey different laws from other forms of money. I have been careful, in the foregoing, to avoid the danger of letting the argument rest on any ambiguity in the meaning of the term, however, and for the present shall not attempt further definition. For the present, we shall use the term, "money market," in its familiar sense, as meaning that market in which bank-credit is exchanged for less fluid rights. An organized money market commonly appears only in larger cities. In smaller places, relationships between banks and customers are much more personal, and indeed, even in larger cities, regular business houses have particularly intimate relations with special banks. A fluid, impersonal market, to which men may repair without reference to anything but the marketability of the collateral they have to offer, is a distinctively metropolitan affair. Only large dealers commonly have relations with more than one or two banks. Larger houses in the big cities often do sell their "commercial paper" through brokers, and some of the big New York mercantile houses have had their paper scattered a good deal throughout the country. The lack of protection which houses which sought such credit faced during the Panic of 1907 tended to check the practice in some measure, but it has revived, and even increased.[517] In the matter of a wide market for commercial paper, however, an impersonal market, with great fluidity, we are well behind not only England, but also Continental Europe. The London acceptance house has especially contributed to an impersonal market. The American money market is par excellence a New York market, and the primary type of paper discounted in the American money market is stock exchange paper, and foreign bills of exchange. For commercial paper, however, there are innumerable more personal, more restricted, markets, and commercial paper constitutes a very considerable part of banking assets, though much less than is often supposed. But this we shall discuss in the next chapter.
XXIV. CREDIT--BANK ASSETS AND BANK RESERVES
In traditional discussions of banking, the impression is given that commercial paper is the normal and dominant type of banking assets.[518] To one accustomed to this view, the figures of the Comptroller of the Currency for banking investments in the United States for 22,491 banks of all kinds (State, national, private, and savings banks, and trust companies) in 1909,[519] will occasion dismay:
(000,000 omitted) Loans on real estate $ 2,505 Loans on other collateral security 3,975 Other loans and discounts 4,821 Overdrafts 69 United States bonds 792 State, county and municipal bonds 1,091 Railroad bonds and stocks 1,560 Bonds of other public service corporations 466 Other stocks, bonds, etc 703 Due from other banks and bankers 2,562 Real estate, furniture, etc 544 Checks and other cash items 437 Cash on hand 1,452 Other resources 111 -------- Total Resources $21,095
These figures, however, call for further analysis. They include figures from institutions which should not be counted with commercial banks. The percentage of real estate loans, especially, is too high to represent the workings of commercial banks, a very high percentage of real estate loans being held by stock and mutual savings banks. The other items, however, are not much changed by the inclusion of savings banks and private banks. It will be well to draw some conclusions from these aggregate figures for all classes of institutions, before taking up a more detailed analysis of State and national banks, and trust companies.
Where, among these items, does one find "commercial paper"? In the reports of the metropolitan papers, giving daily variations in interest rates, it is usual to find "commercial paper" listed as a separate category, cooerdinate with "sixty day paper," "ninety day paper," etc. Recent periodical discussion has gone elaborately into the question as to what should be called "commercial paper," from the standpoint of the policy of the Federal Reserve Banks. I think it safe to say that no two markets, at present, in the United States will use the term in precisely the same way, and that all would restrict the term to a small portion of the "other loans and discounts" listed above. The most general definition of "commercial paper" would be paper bought through note-brokers. Despite the decided increase in loans and discounts which our war prosperity has involved, there has been very frequent complaint of the scarcity of "commercial paper." I shall use the term, "commercial paper" in a much more liberal sense than the American money market does, and shall mean by it all loans of a really liquid character, made by banks to merchants and others to pay for the purchase of goods in anticipation of a resale within the term of the loan which will enable the loan to be repaid at maturity. From this should be excluded, however, loans made to speculators. With this liberal, and not very precise, definition of commercial paper, we raise again the question as to where it may be found in the items above given.
Virtually all of it, I think, must be found in the item, "other loans and discounts"--an item which, in all, is slightly less than 23% of total banking assets.[520] But not all of this "other loans and discounts" is commercial paper. Very much indeed represents loans of a non-liquid character, regularly renewed, which manufacturers and others have put, not into moveable goods, but into fixed forms of capital-goods, as machinery, and even buildings. One case in New York, which the writer is informed by a business man well acquainted with both banking and business in many sections of the country is typical of many cases, is as follows: a New York bank is at present lending to a small manufacturer of automobile supplies about $30,000. Of this, about $10,000 is liquid, periodically covered by "bills receivable," and if the bills receivable should fail, in the period in question, to cover the $10,000, the bank would insist on a reduction of the loan. The remaining $20,000, however, is not liquid. It was spent for non-moveable equipment; the bank expects to renew the notes for this loan periodically, and is well aware that it could not force collection without bringing the business to a close--or else forcing the factory to get accommodation elsewhere. The $10,000 that is liquid is by no means all spent for goods, but is spent, in part, for wages. None of the $10,000 is spent for goods which are to be resold without being transformed by manufacture. None of the $30,000, therefore, is, in the strict sense, "commercial paper." It is manufacturer's paper. Part of it is virtually as liquid as commercial paper; two-thirds of it is not liquid.
A very large part indeed of bank-loans are of this character. A large part of the loans made to farmers are in no sense liquid: when the loan is made, for, say, six months,[521] it is perfectly understood by both bank and borrower that a renewal will be asked for and granted. It is impossible to say what fraction of this $4,821,000,000 of "other loans and discounts" is really liquid commercial paper, or liquid paper of any kind, in the sense that it can be automatically paid off at maturity. I venture the statement with entire confidence, however, that the proportion of liquid paper is not one-half of the amount. I should question if more than one-fourth of it is truly liquid, in the sense in which that term is commonly used: meaning that the loan is made to put through a transaction which will be completed during the term of the loan, and permit the loan automatically to be paid off. I do not mean by this merely that the banks could not reduce this item by one-fourth suddenly. Even in a market made up wholly of highly liquid paper, an arbitrary refusal to renew one-fourth of the loans, with the effort to reduce loans and discounts by one-fourth, would occasion great embarrassment and even disaster. The test of liquidity here applied relates to the items separately, on the assumption that other things are not radically changed. Even in this sense, however, viewing each loan transaction separately, it may well be questioned if the banks in the United States could find among their "other loans and discounts" items exceeding a fourth of the total (in value) which they could refuse to renew, at least in large part, without disappointing reasonable expectations, and embarrassing good business men.[522]
Of this paper, not truly liquid, no doubt a good deal is advanced to wholesale and retail merchants, and is, in this sense, commercial paper. The terms, "liquid paper" and "commercial paper" by no means run on all fours! As will later appear, the bulk of liquid banking assets are not commercial paper at all. And only that part of a bank's loans to a merchant may be called "liquid" which can be paid off by the merchant without disappointing his reasonable expectations,--causing him to seek other banking connections.
There is, however, another item in which we may find some commercial paper, and this is the item, "loans on other collateral security." This has commonly been supposed to be virtually all stock exchange loans. Thus, Conant[523] cites the growth in this item in New York as evidence of the growth of loans on stocks and bonds. For New York, loans on stocks and bonds do make up the great bulk of this item. Even in New York, however, there are other factors in it, absolutely, even though not relatively, important, and in the country outside, the other elements are not at all negligible, even though for the outside country the part secured by stocks and bonds is the major part, and even though the growth of this item in our total banking assets is, in general, fairly indicative of the growth of loans secured by stocks and bonds. Figures for the other items are not available for State banks, trust companies or savings and private banks. They are not till very recently available for national banks. In 1915,[524] however, the Comptroller separates the item, "loans on other collateral security," for national banks, into two parts, (1) loans "secured by stocks and bonds" ($1,750,597,273), and (2) loans "secured by other personal securities, including merchandise, warehouse receipts, etc." ($882,749,812). Is there any commercial paper in this last, not inconsiderable, item?
Let us locate the item, in the effort to find out. The percentage runs highest in Chicago, where this class of collateral loan exceeds the loans on stocks and bonds. The inference is strongly suggested, therefore, that much of it, there, at least, represents advances to live-stock, grain and produce traders and speculators on the Board of Trade, at the stock yards, etc. The inference is strengthened by the fact that St. Louis, where there is a good deal of grain and commodity speculation, shows more than twice as much of this kind of paper as does Boston, where this kind of speculation is unimportant--despite the fact that Boston's aggregate collateral loans of all kinds greatly exceed such loans in St. Louis. In New York, where there is a great deal of coffee and cotton speculation, and some other commodity speculation, the amount of this paper, though relatively small, is absolutely greater than in any other city. No doubt, in New York, which is the country's centre for foreign commerce, a fair amount of the paper secured by "other personal securities, including merchandise, warehouse receipts, etc.," is really commercial paper, representing advances to importers and exporters--though the difficulties of giving this kind of security where goods are in transit would prevent most of our foreign trade being financed in this manner. The total of this kind of paper in New York--all these figures are for national banks alone--was only 113 millions on June 23, 1915.[525] It may be doubted if very much of this paper, in the great cities, represents goods in transit. With the caution that the view here expressed is based on inference, and not on actual knowledge of what the large city banks are doing, the writer concludes that probably the bulk of this paper, in large cities, represents loans to speculators rather than to merchants. It is liquid, but it is not commercial paper.
What of such paper in the country districts? Nearly one-half--$436,000,000 out of $882,000,000--of these national bank-loans on "other personal security, including merchandise, warehouse receipts, etc.," are in the country, outside the Reserve and Central Reserve Cities. Much of it is in the South. Much of it in the grain and live-stock producing regions. What do such loans mean?[526] Much of it is loans to farmers and planters. In the South, much of it is on crop liens. The loans on cotton warehouse receipts, at least in the country parts of the South, are not as great as is commonly supposed. In the North and West, there are a great mass of farmers' chattel mortgage loans, including loans on horses, grain in cribs, hogs, sheep, cattle, mules, etc. The use of this type of paper for financing the breeding and feeding of live-stock, particularly hogs, cattle and sheep, is very extensive. Virtually all loans to farmers and feeders for these purposes are secured by such chattel mortgages. It seems improbable that a great deal of this paper could represent ordinary commerce. Neither wholesalers nor retailers can easily handle merchandise on which chattel mortgages have been given. The usual method of granting credit to them is to advance loans on one and two name paper, unsecured. Not many loans to retailers and wholesalers will fall in the category under discussion.
To what extent are the loans of this type to farmers liquid? Well, the crop lien loans in the South have a natural term, and, though commonly longer loans than bankers have in mind when speaking of liquid paper, are liquid in the sense that they are automatically paid off at maturity. Loans on work-animals need not have a natural term. Loans on animals being fed for the market have such a natural term, and are truly liquid. Loans, however, on breeding animals are not thus liquid, such loans are commonly regularly renewed at maturity, and the banks do not count on them in emergencies. It is the opinion of Dr. J. E. Pope that fully two-thirds of the aggregate loans on live-stock chattel mortgage security are to breeders rather than to feeders, and hence are not liquid. Of course, none of these loans are commercial paper.
I conclude, therefore, that the thesis with which we started that the overwhelming bulk of commercial paper is to be found in the item, "other loans and discounts" is correct. I see no reason to suppose that an analysis of the loans of State banks and trust companies would show a different conclusion. We lack the figures for breaking up the collateral loans of State banks and trust companies into the two classes, "secured by stocks and bonds" and "secured by other personal securities, including warehouse receipts, merchandise, etc." We have merely the gross figures for collateral loans. As the State banks are in large degree country banks, it is probable that the percentage of commodity collateral as compared with stock exchange collateral for State banks would be larger than for national banks. However, the total of collateral loans for State banks is relatively small--559 millions, for 1909, as against "other loans and discounts" for State banks in that year of 1,112 millions, and as against a total of collateral loans of all banks reporting in that year of 3,975 millions. On the other hand, the collateral loans of the trust companies are very large: 1,222 millions for 1909, as against "other loans and discounts" for the trust companies in the same year of 460 millions. As the trust companies are chiefly city institutions, and as the concentration of trust company loans and capital in New York City is relatively very great, it would seem pretty clear that taking both State banks and trust companies into account would substantially lessen the percentage of loans "secured by other personal security, including merchandise, warehouse receipts, etc.," to total collateral loans. As the amount of commercial paper in this class of loans for national banks is probably small, it may be expected to be still smaller in the aggregate of collateral loans.
The following figures, for State and national banks, and trust companies, only, will, in the light of the foregoing, give us basis for some further conclusions regarding the character of banking assets in the United States. As before, the year 1909 is chosen:
(000,000 omitted)[527]
_State _National _Trust _Aggre- Resources Banks_ Banks_ Companies_ gate_
Real estate loans 414 57 377 848 Collateral loans 559 1,939 1,222 3,720 All other loans 1,112 2,966 460 4,538 U. S. bonds 5 740 3 748 State, county and municipal bonds 65 156 155 376 Railway stocks and bonds 75 351 362 788 Bonds of other public service corporations 50 148 168 366 Other bonds, stocks, etc 95 208 769 1,072 Total of items here listed 2,375 6,565 3,516 12,456 ----- ----- ----- ------ Total Resources 3,338 9,368 4,068 16,774
This table makes clear that the figures for real estate loans given in the table for all banks, a few pages preceding, were much too high. It leaves the relations among the other items, however, not greatly changed. "All other loans" increase from slightly less than 23% of total assets to 27%. If we concede that one-half of the "all other loans" represents liquid "commercial paper"--a very liberal estimate, as we have previously concluded--we get about 13-1/2% of the assets of these institutions in the form of "commercial paper," an increase over the 11-1/2% to be assigned on the basis of the other table. The figure is the roughest sort of approximation. I attach little importance to the exact percentage, and the argument which follows is not dependent on any exact figure here. The proportion of collateral loans to total resources is changed also, and even more: collateral loans are 18% of total bank resources when all kinds of banks are included, and are over 22% of total bank resources when only State and national banks and trust companies are counted. If the foregoing is correct within very wide limits of error as to the amount of commercial paper, collateral loans very substantially exceed commercial paper. If all the "all other loans" should be counted as commercial paper, collateral loans are still not far behind them--22% as against 27-1/2%.
What is the significance of this? We have seen that for national banks, the great bulk (over 66%) of the collateral loans were secured by stocks and bonds in June, 1915. We saw reasons for supposing that a higher percentage of stock exchange collateral would be found when State banks and trust companies are included. Suppose we assume that 75% of the collateral loans of all three classes of institutions here in question are based on stock exchange collateral.[528] This would mean 16-1/2% of the total resources of these institutions in stock exchange loans--still well above the 13-1/2% we have assigned to "commercial paper." In any case, it is at least justifiable to contend that loans on stock exchange collateral are as great in volume as commercial loans. I think that they very substantially exceed them. But further, we have another large percentage of bank resources invested in stock exchange securities outright--chiefly in bonds. The aggregate for those investments in the institutions under consideration is 3,250 millions. This is something over 19% of the total assets of these institutions. Combining this with the loans on stock exchange collateral, we get nearly 36% of bank and trust company assets invested, directly or indirectly, in stock exchange securities, as against an assumed 13-1/2% in commercial paper. Conceding that all the "all other loans" are commercial loans, the stock exchange assets still exceed them in the ratio of 36 to 27-1/2.
In our second table, we have listed items which aggregate only 12,456 millions of the total resources for these institutions of 16,774 millions. The items listed, however, represent virtually all the credit extended by banks to industry, commerce, agriculture, the stock market, other speculation, and the State. The excluded items of main importance are: Due from other banks and bankers, 2,302 millions; checks and other cash items, 432 millions; and cash on hand, 1,411 millions--the three items aggregating 4,146 millions, which virtually closes the gap. These three items are of immense importance as making for liquidity in banking assets, and as making possible extensions of credit to the business world, but it is not proper to count them when an estimate of the extent of bank-credits is in question. Our second table contains, for the three classes of institutions, all the items properly counted there, except overdrafts (small in amount) and one other big item which does not get into bank statements at all, namely, overcertifications and "morning loans." Of this last item, more later. We may, then, recalculate our percentages on the basis of the credit extended by the three classes of institutions, instead of on the basis of total resources. On this basis, the percentages are:
Real estate loans, 7.4%;
Collateral loans, 30%, of which we assign to stock exchange collateral, 22-1/2%, and to other collateral, 7-1/2%;
All other loans, 36.4%, of which we assign to "Commercial paper" 18.2%;
Total stocks and bonds, 26%.
Adding the percentages for stock exchange collateral loans and for stocks and bonds owned, we get 48-1/2% of all extensions of bank-credit for these three classes of institutions in the form of credits extended to the security market. If everything else except the real estate loans should be counted as "commercial loans" the stock exchange credit would still exceed the commercial credit. If my estimate of 18.2% of bank-credit based on commercial paper is high enough,[529] the banks and trust companies have extended over two and a half times as much credit, at a given time, to the security market as they have to commerce. This on the face of the record. But there is, as above indicated, a further item which does not get into the record, namely, overcertifications and "morning loans." Every day in the great speculative centres, and very especially in Wall Street, enormous advances are made to brokers, which are canceled during the day, but which, during their short life, are a real addition to bank-credit. To attempt to estimate this with any accuracy is hopeless, but the total on any ordinary day is enormous, and most of it is extended in connection with stock market transactions.
A final comparison,[530] which will conclude this perhaps too wearisome analysis of these figures, will consider the loans alone, neglecting the securities owned:
Of total loans:
Real estate loans, 9.3%;
Collateral loans, 40.8%, of which we assign to stock exchange collateral, 30.6%, and to other collateral, 10.2%;
All other loans, 49.6%, of which we assign to "Commercial paper," 24.8%.
The development of bank loans on stock exchange collateral is a remarkable feature of the three or four decades preceding 1909. The following figures, of national bank loans in New York City,[531] illustrate the tendency:
(000,000 omitted)
_Loans on _Advances on Date Commercial Paper_[532] Securities_
1886 146 107 1890 151 145 1892 160 183 1894 168 192 1896 151 162 1898 181 260 1900 185 384 1902 210 396 1903 239 391 1904 268 538
The tendency is not peculiar to America, however. The following table gives a classification of the loans and discounts of all the great European banks[533] in selected years from 1875 to 1903:
(Figures in francs, 000,000 omitted)
_Note _Commercial _Advances on Date Circulation_ Loans_ Securities_ 1875 9,699 4,027 828 1880 10,482 3,384 1,112 1885 11,662 4,050 1,231 1890 13,194 5,192 1,549 1895 15,896 5,328 3,669 1899 14,992 8,352 4,037 1900 15,906 8,514 4,171 1902 16,215 6,939 4,178 1903 16,539 6,147 4,129
We conclude, therefore, that the great bulk of banking credit in the United States, even of "commercial banks," is not commercial credit. Much of it, in the smaller places, especially, represents in fact, whatever the form, long time advances to agriculture and industry. Most of it, in the great cities, and to a large extent in even the smaller places, represents advances to the permanent financing of corporate industry. Excluding real estate loans, more than half of bank-credit represents either ownership of bonds (with some stocks) or else advances on stocks and bonds. Another important part of bank-credit, which I shall not even attempt to measure, is employed in financing commodity speculation.
It is worth while to compare our figures concerning bank loans with Kinley's figures, which we have previously considered, for deposits made on March 16 of 1909, the year we have chosen for the bank loans figures. It is important to remember that "deposits," as used by Kinley in this investigation, does not mean what the term means in a bank balance sheet. Kinley's figures relate to the actual items deposited on the day in question, and not to the net balance after deposits and withdrawals have been compared when the bank has closed for the day. A large deposit in the balance sheet sense might show no "deposits" in Kinley's sense, in a given day; while enormous "deposits" in Kinley's sense might be so offset by incoming checks that virtually nothing is left on the balance sheet at the end of the day, for a given depositor. Kinley's figures thus give us a means of getting at the degree of activity of different classes of deposits in the balance sheet sense, and so, indirectly, of different classes of loans.
Loans and deposits (in the balance sheet sense) are, as we know, closely correlated. This is true for banks in the aggregate, and for banks individually at a moment of time. It is not generally true of a given individual deposit account at a moment of time, but through a period of time, for business deposits, it tends to be true that the items deposited offset the amounts borrowed.[534] If the items deposited are numerous, if the depositor has an "active" deposit account, receiving a large flow of banking funds, as compared with his net deposit balances, we may infer that his loans are also active, that he pays off loans frequently, that his paper, in the assets of the bank, is "liquid."
I need not give the details of Kinley's figures again, as they have been elaborately analyzed in connection with the estimate of the "volume of trade."[535] The figures show that retail and wholesale deposits between them make up about 25% of the total deposits. This would serve to show that "commercial paper," which we have allowed to be about 24.8 of total loans, is slightly more active (and hence "liquid") than the average of loans.[536] It will also suggest, however, that our figure for "commercial paper," truly liquid, is too high, since we should expect this kind of paper to be more active than the average--unless, indeed, stock exchange collateral loans are so exceedingly active as to make a tremendously high average. I refrain from trying to get a definite answer on this point, since there are many indeterminate elements: among others, uncertainty as to the extent to which wholesale deposits and retail deposits include all commercial deposits, and uncertainty as to the extent to which they exclude manufacturer's deposits. The great bulk of Kinley's deposits, however, fall into the "all other" class, and the great bulk of the "all other deposits" are located in the great financial and speculative centres, particularly New York. We have concluded that they represent chiefly (a) transactions in securities; (b) other speculation; (c) loan and other financial transactions, particularly the shifting of call loans on stock exchange collateral. It is, then, the deposits of those connected with the great financial and speculative markets, particularly the stock market, whose deposits are most active, and whose loans are most liquid. Stock market collateral loans thus constitute the most perfectly satisfactory sort of bank loan, from the standpoint of liquidity. Though such loans do not make up the bulk of bank loans (we have concluded that they constitute 30.6% of the loans of State and national banks and trust companies in 1909), they do account for the bulk of banking activity, and supply the greatest part of the liquidity of total bank loans.
When we consider further the item of securities (chiefly bonds) in banking assets, we find another highly important source of liquidity. The sales of bonds in the great banking centres are enormous. The figures of bond sales on the exchanges do not begin to tell the story. One big bank in New York in 1911 sold more than half as many bonds as were sold in that year on the floor of the Stock Exchange.[537] It has been frequently stated that ten bonds, of those listed on the Exchange are sold over the counter for one on the floor. This is truer of Boston than New York. The "outside market" for unlisted bonds is a very important matter. Dealings among banks in these items and in foreign exchange are exceedingly important. This is especially true of the business of the great private bankers, as Morgan, Kuhn-Loeb and others. Much of this does not appear in Kinley's figures, since neither the deposits of the great private banks in other banks, nor the deposits made in the private banks themselves (so far as New York City is concerned) figure in his totals.[538] Had they been included, the percentage of the "all other deposits" would have grown, and we should have had still more impressive evidence of the fact that modern banking in the United States is largely bound up with the security market, and that modern bank-credit gets its liquidity chiefly from that source.
The story is even more impressively told by the figures for bank clearings, which include the transactions between banks, and the transactions of the private bankers. In New York, in 1909, total clearings for the year were 104 billions, as against 62 billions for the whole country outside New York.[539] That bank clearings are closely correlated with stock exchange transactions, has been demonstrated fully by N. J. Silberling, who has shown the following correlations: New York Stock Exchange share sales with New York clearings, r = .718; total clearings for the country with New York share sales, r = .607; total clearings for the country with railway gross receipts (as representative of ordinary trade), r = .356.[540] The active deposits and the liquid loans are chiefly connected with activities in finance and speculation.
Now two important practical conclusions are suggested by this analysis. The first is that the complaint of many farmers, merchants, politicians, and even scientific writers that too much money and bank-credit are at the disposal of Wall Street and other speculators rests on a misunderstanding of causal relations. Wall Street does not, by using a large amount of bank-credit, take just that much away from ordinary business. Rather, it increases the amount available for ordinary business! Wall Street, and the other financial and speculative centres, supply the liquidity for bank assets, and so make possible loans on non-liquid paper. Banks do not need to have all their assets liquid. If they did, American banks would have long since gone under! The foregoing discussion of loans to farmers, and manufacturers and even merchants should have made that clear. But banks do need a substantial margin of liquidity, to protect the rest. They get it from stock exchange collateral loans, and from ownership of listed and easily marketable bonds, primarily. They get part of it from true commercial paper. Thus, the director of a country bank in Iowa told the writer that banks in his section--where banks owned in large measure by farmers, and dealing largely with farmers, are very numerous and important--make a regular practice of buying, through brokers, a considerable amount of notes of outside merchants. They do this to protect themselves. Their other loans, to farmers, while good, are slow. If pressed themselves, they cannot press their depositors. These notes bought through note-brokers, however, are impersonal. They can refuse to renew them. They can sell them again. They thus buttress the rest of their assets. They can thus lend more, rather than less, to local customers. They can safely get along with much smaller cash reserves. Similarly with the practice of country banks of sending a large part of their cash to Wall Street banks to be lent on call, for which the country banks get, say, 2% from the Wall Street banks. Their country customers would pay 6% or more for that money in some cases, but the banks dare not tie up more of their assets in non-liquid local paper. They lend more, rather than less, at home, because they send part away. Wall Street is not "draining our commerce of its life blood"![541] Wall Street is rather preventing that life blood from coagulating!
A second important practical conclusion relates to the provision in the Federal Reserve Act which forbids Federal Reserve Banks to rediscount stock exchange paper. This provision was intended to keep funds from being diverted from commerce to stock speculation, and doubtless met the approval of many very good students of the subject. If the foregoing be true, however, that provision is a mistake. It is a mistake, first, because it will lessen, rather than increase, the power of the Reserve Banks to provide relief to commerce through aiding in making bank assets liquid via the stock market. It will limit the liquid assets of the Federal Reserve Banks in too great a degree to gold. It is a mistake, in the second place, because it prevents the Reserve Banks, particularly in New York and Boston, from making satisfactory profits--which is one important purpose of a bank! Even more important, however, is the third objection: it prevents, in large degree, the Federal Reserve Banks from being effective weapons against the "Money Trust." How far we have a "Money Trust" need not be here argued. The Pujo Committee, relying in considerable degree on admissions of prominent financiers that "concentration had gone far enough," and on the inability of Mr. Baker to find more than one issue of securities of over $10,000,000 within ten years, without the cooeperation or participation of one of the members of a small group, concluded that we have a "Money Trust" in the sense that there is "an established and well-defined identity and community of interests between a few leaders of finance ... which has resulted in a vast and growing concentration of control of money and credit in the hands of a comparatively few men."[542] How far this conclusion is justified is, of course, a matter that would require elaborate discussion. There seems to be evidence that there is, since the death of the elder Morgan, a decided loosening of ties. One feels the need, moreover, of discounting very considerably many of the conclusions of the Pujo Committee. The present writer feels that the case has been made, however, that there has been, and probably continues, a much greater concentration of such control than is desirable. Whether or not there is at present such a "Money Trust," it seems pretty clear that temporary, if not permanent, alignments, may give effective monopoly control when the issue of very big blocks of securities is involved. For present purposes, however, it is enough to note that if there is, or should come to be, a "Money Trust," it is a trust concerned with financing industry, through handling security issues, and not a trust in the granting of ordinary commercial credit.[543] If, therefore, the Federal Reserve Banks are to compete with it, and break its monopoly, they must do it by entering the market with funds for the financing of corporate industry. Power to rediscount commercial paper seems a feeble and hardly relevant weapon against a combination concerned with purchasing securities, and making collateral loans! No doubt, this power is worth something. If an independent investment banker wishes to compete with a "Money Trust" in financing a new enterprise, he can go to his commercial banker, and offer collateral security for a loan; if the commercial banker wishes to aid him, but is short of lending power, he may, if he has plenty of commercial paper available for rediscount, rediscount it with the Federal Reserve Bank, and so get the additional funds. But a New York bank, or trust company, with the bulk of its assets in stock exchange investments, may well not have enough commercial paper eligible for rediscount, and the Federal Reserve Bank could help very much more effectively if it could take collateral loans directly. A fourth, and even more important objection to the restriction on stock exchange collateral loans for Federal Reserve Banks relates to the power of these banks to aid in a crisis. Crises first hit the stock market. Financial panics are most acute there. The need for immediate and drastic relief is greatest there. If stock exchange loans lose their liquidity, what of the rest of bank loans? Power to lend on stock exchange collateral, in the hands of the Federal Reserve Banks, may well prove, in crises, an essential, if we wish to make our system definitely "panic proof."[544]
And now for a vital theoretical conclusion from this lengthy analysis of bank loans. For the quantity theory, and the "equation of exchange," all exchanges stand on a par. If one exchange takes place, that lessens the money and credit available for another exchange. The more exchanges there are, the less money and credit there are per exchange, and the lower prices must be, as a consequence. Nothing could be more false. Exchanges are not on a par.[545] Some classes of exchanges increase, rather than decrease the funds available for handling others. The activity of the speculative markets, making loans fluid, enormously increases the lending power of the banks for all purposes. Exchanges of securities, especially, instead of lowering prices, make it easier for prices to rise.[546] The years of extraordinary stock sales have always been "bull" years. There have been big "bear" days,[547] but never big bear years, in the record of New York Stock Exchange share sales. The selling and reselling of speculative goods of securities, and of notes and bills are especially important as making it easier for banks to expand loans. To list all manner of items, as Professor Fisher does,[548] "real estate, commodities, stocks, bonds, mortgages, private notes, time bills of exchange, rented real estate, rented commodities, hired workers," and count them all as "actual sales," all part of the "goods"[549] which make up the "volume of trade," is to put the theory utterly beyond the pale. Seasonal calls on an inelastic money supply for actual cash to move crops and pay agricultural wages may make a real difference in the value of money; scarcity of money of the right denominations for retail trade may give an agio to such money,[550] but the money and credit used by speculators, bill brokers, dealers in foreign exchange, investment bankers, etc., increases, rather than decreases, the funds available for ordinary industry and commerce.
I have made clear the distinction between the direct and indirect financing of industry by banks. Great banks in Continental Europe often buy the stocks of new corporations, hold them permanently, put bank officers on the boards of directors, and supervise closely the operations of the companies. In America, while officers of commercial[551] banks often are members of boards of directors of the companies which borrow heavily from the banks, the practice is to make short-time loans to such companies (in form, if not in fact), and to lend on their securities, rather than to buy them. Our banks own securities in enormous amount, but they are chiefly seasoned bonds, rather than stocks of new or even well-proved, enterprises.
It is commonly supposed, too, that collateral loans are chiefly or almost wholly made to speculators, who buy securities in the expectation of holding them only till investors take them off their hands, and that investors buy them, not with bank-credit derived from loans, but with money or bank-credit which they accumulate by saving out of current income. It is particularly true of the higher grade securities, which savings banks and insurance companies can buy, that this is the case. The bank-credit thus serves for temporary, rather than for permanent financing, to the extent that this is true. I think, however, that the extent to which bank-credit serves for permanently financing industry is underrated. A good many investors have learned that the short-time money-rates are, on the long time average, lower than the yield on long-time securities.[552] They have learned, too, that high-yield securities--securities high in yield as compared with the long-time average of money-rates--can be obtained which can safely be carried on margins of thirty, forty and fifty points, without danger that even such catastrophes as the slump in security prices at the outbreak of the War will wipe the margins out. The old distinction between investors and speculators, the former those who buy for the yield, and the latter those who buy for an anticipated rise in capital value, no longer corresponds to the distinction between those who buy outright and those who buy on a margin. The investor, buying a 6 or 7% preferred stock, carrying it on a forty point margin, with money from his bank or broker at 4 or 5%, is making 6 or 7% on his own forty dollars, and is making the difference between 6 or 7% and 4 or 5% on the sixty dollars lent him by his banker or broker. He substantially increases his yield thereby, and his risks, if he chooses his stocks carefully, and scatters them among a number of issues, are not great. For the banker or broker, such a loan is perfectly satisfactory. The margin of security is wider than that demanded on more speculative securities. Such a borrower will receive consideration when more speculative loans are being called, or not renewed. The investor of this type is, in effect, engaging in a form of banking business. He is lending to the corporation funds which he has borrowed from others; he has put up his own capital for the same purpose that the bank uses its capital--to supply a margin of safety to those who have taken his short-term promises to pay. Like the bank, too, he converts rights to payments at a later date into rights to payment at an earlier date. He is one of the links in the chain whereby the wealth of low saleability employed in industry becomes distilled and refined till it enters the money market. His profits come in the difference in the yield as between more saleable and less saleable forms of rights.
The extent of this practice cannot be stated, so far as any data to which the present writer has access are concerned. The writer has met the practice in a good many cases. One brokerage house, with whose operations the writer has considerable acquaintance, makes a practice of advising its more conservative customers to do this. A good many brokerage houses sell investment securities on the "instalment plan," which often means, in practice, that the initial margin put up by the investor is his only payment, and that the security is gradually paid for by letting the yield increase the margin. During the extremely easy money of the present War period, occasional reference has been made in the financial papers to the practice of buying even the highest grade bonds on this basis--the yield of the bonds being very substantially higher than the money-rates, giving a comfortable profit to those who hold the bonds on a margin.
That the practice is not wider spread is due primarily, probably, to the temperamental qualities required. The investor, proper, is commonly a very conservative person, who has an unreasoning distrust of speculation, and to whom the word, "margin," necessarily suggests speculation. That buying a stock on a margin is the same sort of thing as buying the equity in a mortgaged farm, does not occur to him. On the other hand, the man who knows the market well enough to be willing to deal on margins, frequently is not content with the slow process of accumulation which comes from annual yields, and prefers to take larger chances in speculation on capital values. But there is an intermediate class, who buy investment securities, with narrow range of fluctuation in capital values, for the sake of the yield, and who buy them on margins, margins ample to enable them to sleep at night, and to neglect the daily market reports. I think that there are indications that this class is growing larger, and more important. Doubtless much more important than individual "bankers" of this sort, however, is the enormous number of houses dealing in securities, "wholesalers" and "retailers," who find profit on their "wares" even while on their "shelves," through the differential between the yield and the charge made by commercial banks on collateral loans. A very large percentage of collateral loans is made to institutions of this type. As this practice becomes more important, the result must be to widen the money market, to increase the proportion of banking capital that goes permanently into financing industry, and to reduce the difference in yield between short-time paper and long-time securities--in other words, to bring the "money-rates" closer and closer to the long-time interest rates.
This would have seemed very strange and weird to Adam Smith. It means, in effect, that the bulk of our banking credit is, directly or indirectly, financing our industry rather than our commerce. Adam Smith thought that a bank could safely lend to its customers only so much as they would otherwise keep by them in the form of money. Perhaps this notion, as growing out of some speculations regarding the general theory of money, should not be taken as the statement of Smith's practical attitude on the matter, but that practical attitude, as clearly expressed in the paragraph[553] following, is that a bank can afford to lend only for mercantile operations that are carried through in a very moderate time, that the bank can afford to supply only the minor part of the circulating capital, and no part of the fixed capital, of a merchant, or manufacturer, no part of his forge and smelting house, etc. Such loans lack the liquidity which the bank must insist upon. Only those persons who have withdrawn from active business, and are content with the income upon their capital, can afford to lend for such purposes. The theory is sound, on the basis of the facts as Smith knew them. But modern corporate organization and modern stock markets have changed all that. Anything that is highly saleable can come into the money market, and the modern corporation organization of business, coupled with organized stock exchanges and a large and active body of speculators, has made the forge and the smelting house as saleable as the finished product.
This is not to accept Schumpeter's doctrine,[554] so far as the United States are concerned, that it is primarily the bankers, the manufacturers of bank-credit, who make the decisions that turn industry from old to new lines. They do not, on the whole. In Continental Europe, particularly Germany, they do to a much greater extent. Criticism has been made of our American commercial bankers, as contrasted with German bankers, that the former are parasites, who insist on sure things, and refuse to take chances with other business men in the development of industry. To the present writer, our banking system seems to be rather a more developed system than that of Germany, in that the "division of labor" has gone further with us, and risk-bearing and the manufacturing of bank-credit have been more sharply differentiated. We have bankers enough who are "risk-bearers." But they are, on the whole, "private bankers," "investment bankers," and the like, who do not manufacture a great deal of deposit credit, but rather borrow heavily from the commercial banks, which are the great manufacturers of bank-credit. Under our system, the decisions which divert industry from old to new lines are more democratically made, by speculators and investors under the leadership of private bankers, and sometimes without that leadership. These constitute the important intermediary which transforms stock exchange securities into the basis of bank-loans. The commercial banker buys, in general, not the stocks, but the note of the private banker, broker, speculator, or investor, with the stocks as collateral. If investment bankers, speculators and investors decide to support old ways of doing things, the banks lend on the securities of the old kinds of businesses; if investment bankers, speculators and investors turn to new things, the commercial banks follow suit. Commercial banks can and do discourage certain types of enterprises by refusing loans with their securities as collateral, or by requiring very heavy margins with such loans, but even these may be developed, and are with us on a large scale developed, on banking credit, advanced by the speculators and private bankers who borrowed it from the commercial banks with other securities as collateral. The commercial banks of the United States may to a very considerable degree check dynamic tendencies, but in general, they do not lead and direct them. Bank-credit, directed by others than commercial bankers, does, however, enormously facilitate both the starting of new enterprises and social readjustment to them.
How far can the total wealth of the country, agricultural as well as industrial, be brought into the circle of the money market? The full answer to the question would go far beyond the limits of this book. If agriculture can be brought under the control of large corporations, there is little reason for supposing that it, too, might not come in. There are some peculiarities of agriculture, special dangers of drought and flood, dangers of over-production and low prices, wide seasonal fluctuations in conditions, which make it hard to standardize in any case. But mining and even the manufacturing of such things as primary steel products have wide variations in prosperity too. So long, however, as agriculture remains a matter of families on a homestead--and for social and political reasons, we may hope that this will always be the case--it is difficult to bring it in. Bonds of agricultural associations or of agricultural banks have had limited sale on the bourses of Europe. The present writer, for example, found it impossible to find in four great libraries in New York and Boston any quotation of the bonds of the Bayerische Landwirtschaftsbank. Apparently, in general, such securities have not high saleability. While this remains true, agriculture may expect to remain under a handicap of higher interest rates than industry and commerce.
If, however, all forms of wealth could be made equally saleable, we should find interest rates rising for those loans and securities which now have the highest saleability. They would lose the peculiarity which now enables them to perform a service as bearer of options. Money-rates and long-time rates of interest would tend to come together. Long-time rates on formerly unsaleable loans would fall, and rates on highly saleable loans would rise. The present low rates in the "money market" grow out of differential advantages.
We turn now to the third important aspect of the technique of banking, namely, the matter of cash reserves. First I would point out that this is merely a part of the more general problem of liquid assets. The difference between cash and liquid paper is a matter of degree. There is large possibility of substitution of the one for the other, as it becomes more profitable to use one or the other. When money-rates are low, it may well be worth while to carry large reserves; when money-rates are higher, the gains to be made by substituting paper for cash in the bank's assets are much greater. I have pointed out the use which great European banks, notably the Austro-Hungarian Bank, make of foreign bills of exchange as "reserve," selling bills when money is "easy," and the yield on bills is small, buying bills when money is "tight," and the yield on bills is large.[555] The great Joint Stock Banks of England, the chief sources of bank-credit in the great banking country of the world, also make use chiefly of deposits with the Bank of England as their "reserves." Some cash they keep, but it is "till money," rather than reserve. They carry, also, "secondary reserves" in highly liquid paper, stock exchange loans and commercial bills. The differences are differences in degree. The Bank of England does keep a large reserve in cash (including notes of the Issue Department and gold bullion) but it denies that it has any definite ratio in mind,[556] and it protects its reserves, when they are low, not by ceasing to loan, but by raising its discount-rate. The whole thing is highly flexible.
This is, in general, true throughout the world,[557] where banking is highly developed. A country which has expanding business, based on rising values of goods and rising capital values of anticipated incomes, which in turn grow out of increasing business confidence, etc., and out of the development of new enterprises which make readjustment necessary, expands its bank-credit to meet the situation. Expanding bank-credits in time grow so large that bankers feel larger cash reserves to be desirable. Their reserves may be also, in some measure, drawn upon by the growing retail trade and wage-payments, which call for more money in circulation. They meet the situation by raising money-rates. This tends to prevent the exportation of gold, and tends to encourage the importation of gold, which finds its way into bank reserves. Banks may even borrow directly from banks in other countries, to get the gold they need, or to prevent the exportation of the gold they have. The higher money-rates, also, tend to check marginal borrowing--the borrowing by those who see only very small profits to be made by the use of the bank-credit they borrow. If the rising values of goods, however, and the profits to be made by effecting exchanges, speculative and other, are large, the volume of bank-credit will, none the less, grow. If the tide of rising business confidence is strong, the banks will be disposed to accept securities and rights as collateral which they would distrust at other times. A very big difference indeed may appear between bank reserves in active times and bank reserves in dull times. The banks need less reserves in proportion to deposits in active times, because the very activity itself increases the liquidity, the saleability, of their paper assets, and so makes actual cash less necessary. Even in this country, the practice of counting deposits in other banks as reserve is well developed. This is not only true of country banks, or banks outside the reserve cities. It has been, in considerable degree, the practice of the big trust companies in New York City. It is the practice of private bankers connected with the stock exchanges, and the practice of brokers, who are, for many purposes, bankers, especially those who allow their customers to check on their accounts. Such houses may carry no cash at all. One, with whose workings the writer is somewhat familiar, makes the rule--"We pay by check and receive only checks." None the less, this house allows its customers to check upon it, and checks drawn on it perform all the functions of checks drawn on banks which keep a cash reserve. Of course, our new Federal Reserve system is built, in part, on the principle of collecting reserves in central reservoirs, and our banks will doubtless increase the practice of counting deposits with other banks as reserve.[558] They will feel the need for less reserves, also, with a wider rediscount market.
Within a given country, I think that we may safely generalize the doctrine that the causal relation between reserves and deposits is exactly the reverse of that asserted by the quantity theory, within very wide limits indeed. That is to say, increasing reserves are a result, and not a cause, of increasing loans and deposits. We shall further hold that the relation between them instead of being definite, is highly flexible. This is not to assert that reserves may not increase without a prior increase in loans and deposits. That has happened in the United States during the present War. It does mean, however, that increasing loans and deposits will pull gold into a country, and that increasing reserves do not force increasing deposits and loans.[559] If a country's business is growing, if that business is soundly based, so that expectations are being met, obligations being paid out of the income which arrives, on schedule time, to meet anticipations, there need be no effective check to the amount of gold that will come into the country to serve as reserves, within limits that are rarely reached. It is miscalculation, maladjustment of costs and prices in particular enterprises, failure of "interstitial adjustments," especially failure of particular crucial links in the business chain, as the businesses engaged in producing iron and steel, to respond to the needs of other expanding businesses, that check movements of expansion in business, not inadequacies of bank reserves.[560] As long as only wise plans are made, as long as they meet no mishaps, as long as the carrying out of the new plans does not itself so change the facts on which the calculations of business men have been based as to cut under anticipated profits, so long may business, within a given country, expand without danger from inadequate reserves. Of course, if the whole world is simultaneously expanding, the competition for gold in the international money markets may be so severe that all may be hampered.
That reserves will increase, as expanding credit, due to increasing business or rising prices, requires increased reserves, can hardly be disputed, I think, if we look at a country of small size, or (what is the same thing from the angle of economic analysis, so far as the present problem is concerned) if we take a particular part of a country. Seasonal movements of cash for reserves in this country have been obviously determined by the movements of credit, rather than the reverse. Expanding business at crop moving seasons, requiring advances of credit by country banks, and an unusual drain on the cash resources of the country banks, has regularly meant that the country banks draw cash from the New York banks. When the need for such cash in the country banks passes, when they can no longer employ it to advantage at home, they send it back to New York. New York, to meet the emergency caused by the withdrawal of cash, draws to a considerable extent on Europe for gold. It is not as easy for New York to get gold quickly from Europe as it is for France to get gold in an emergency from England. More time is required. Inelasticity, too, in the forms of currency most needed for small transactions, has made very real difficulties for us. But that, within the country, the sections whose business and credit were expanding take cash reserves from those sections where credit is less urgently demanded, needs no debating. This is seasonal. But the same thing is true in the long run. As business and bank-credit have expanded, year by year, in Oklahoma, Oklahoma's cash reserves have grown. Bank-credit in a country cannot go on indefinitely mounting, if bankers are making unsound loans, if the values on which the loans rest are based on vain imaginings, if anticipated profits are not realized. But if a country have rich resources and intelligent entrepreneurs, with sagacious bankers who can discriminate between sound and unsound business, it may, within very wide limits indeed, expand its bank-credit without check from inadequate reserves, as its business expands, and as prices, particularly prices of lands and securities, rise.[561]
If the country in question be a very large country, however,--large in the sense that its business and volume of bank-credit are very large, and particularly in the sense that bankers' assets are of such character that a large volume of reserves is desirable--restraints on the process of expansion may come. Reserves will come in, but the resistance in stiffer money-rates will be felt. Bankers in other countries will compete with the bankers in the country in question for reserves. Rising money-rates will put an end to many marginal exchanges. They will lessen the saleability of many rights which might otherwise be available as banking collateral. The extension of bank-credit will feel a drag. There is large flexibility here. But, in a long run period of many years, the volume of gold in the world will impose a maximum limit upon the possibility of expansion of bank-credit in the world as a whole. This limit is doubtless never reached. Within the limit, the variations in the volume of the world's credit are primarily determined by the other concrete factors we have been discussing. Proportionality between the world's gold and the world's volume of credit does not at all obtain. Under certain conditions, much higher proportions of reserves to bank-credit will be found in a given country than at other times, and the same will be true in the world at large.
I would refer again to the discussion by J. M. Keynes, quoted in Part II.[562] Reserves have absorbed enormous quantities of gold, easily obtained as a consequence of abundant gold production, in the past fifteen years. Proportions of gold reserves to bank-credit have grown. In the preceding period, when gold production went on less rapidly than business development, percentages of reserves were lower. Most bankers feel better with large reserves. When they can get gold, they prefer gold to other substitutes. When they cannot easily get gold, they use other substitutes, of the various kinds of paper, particularly, which have been described. Gold differs from other things, in bankers' assets, in degree, rather than in kind. Instead, therefore, of the law of the proportionality of reserves to volume of bank-credit, I venture the generalization[563] that, as gold production increases rapidly, the tendency is for the proportion of gold reserves to volume of bank-credit to rise; with diminished gold production, the tendency is for the proportion of reserves to fall, assuming that the factors other than volume of gold production which make for expansion of business maintain themselves.
Increasing volume of gold tends to increase the volume of trade. But there are other causes for the increase or decrease of trade as well. These causes, working in harmony with rapidly expanding volume of gold, lead to a very rapid growth of trade.[564] Working in the face of a drag from less rapidly growing gold supply, they strain the possibilities of bank-credit expansion. Various substitutes for gold in bank reserves are employed. Substitutes in the form of other forms of credit are employed. Barter is resorted to increasingly. Methods of employing other things than gold in the retail trade of a country are resorted to. "Gold-exchange" standards are devised. Countries "wait their turns " to come on the gold standard. Cooeperation, not only within countries, but among countries, seeks to economize the scanty stock of the precious metal. Very large slack is thus revealed. But the expansion of business is checked, the volume of business confidence is reduced, the values of future incomes in enterprises is lowered, production is checked, and prices are reduced, (a) because the value of money rises; and (b) because the values of goods and income-bearers is reduced. The exchange side of production is hampered. Substitutes for gold, through increased activities of bankers and other agents of exchange, are costly. Greater tolls on values are taken by those who handle the mechanism of exchange. It does make a difference whether or not the world's gold is abundant! But the difference is not made solely, or even mainly, in the price-level.[565]
The reserve function of money is essentially a dynamic function. The reserve function is merely a phase of the bearer of options function.[566] It is the practice of quantity theorists to speak of "normal" ratios between reserves and deposits (or reserves and demand liabilities), and to speak of the "static" laws governing this relation. This in true of Kemmerer, of Fisher, of A. P. Andrew, and, in general, of contemporary quantity theorists. Kemmerer very explicitly puts it as a matter of static theory, "If we divide the money of the country into two parts; one, that used directly in daily cash transactions, and the other, that kept in banks as reserves, it may be said that, under perfectly static conditions [italics mine], the proportion of the total represented by each of these parts would be constant. Each banker would find from experience what proportion of reserve to liabilities it was advisable for him to maintain, and would order his business, as far as possible, so that his reserve would neither exceed nor fall below that most desirable proportion."[567] Kemmerer quotes the following passage from A. P. Andrew: "In the long run, as apart from cyclic oscillations, the quantity of bank-credit is governed by the quantity of money."[568] Fisher's view we have considered at length in Part II. It is essentially the same. He is working with the statics of the problem of money and credit. These different writers differ greatly in the extent to which they would insist on the validity of their static tendency in real life. Professor Fisher, as we have seen, is exceedingly uncompromising, holding tenaciously to his principle as subject only to slight modification during transition periods. Professor Kemmerer, in the chapter from which the quotation just given is taken, gives an important realistic analysis of dynamic conditions and makes liberal concessions to the view that the ratio is no constant in real life.[569] Professor Taussig, whose view was summarized at length in chapter IX, finds, in real life, so many exceptions to the doctrine of proportionality of reserves and deposits that he virtually abandons that doctrine. What I wish to insist on here, however, is that there are no static laws possible in this connection. The reserve function is a dynamic function. The theory of reserves must rest in an analysis of friction, of transitions, of dynamic uncertainty and dynamic change. It is a part of the general theory of liquidity of bank assets, of saleability of rights, and the like. If one can find a "normal" amount of dynamic change, a "normal" amount of uncertainty, a norm for the coming of technical inventions, a normal prospect of war, a normal rate of gold production, a normal rate of growth for population, a normal amount of Jew-baiting in Russia, with a norm for migration, and if one can hold these norms, and a multitude of similar norms, in fixed relation to one another, one might have justification for speaking of a "normal ratio" of bank reserves to bank demand liabilities!
Apart from dynamic changes, from frictional elements which create uncertainties, in general, apart from uncertainty and irregularity and lack of "normality," there would be no occasion for bank reserves at all! To the extent that static conditions are realized, bank cash reserves may be, and are, dispensed with. It is well known that England gets along with surprisingly little gold. The total stock in the country has been smaller than the gold reserve of the Banque de France, and much of the gold in England was in use among the people, since small paper money (before the War) was not in use in England. The gold reserve of the Bank of England has been usually only a fraction of that of the Banque de France. Some years since, the distribution of gold as between England and the United States, was, roughly, England six hundred million dollars, the United States, one billion, six hundred million. A larger proportion of gold was in reserves in the United States than in England. Yet England was doing the banking business of the world, while we had trouble in doing our own! The Bank of England carries virtually the only reserve in the country. The Joint Stock Banks, with demand liabilities vastly in excess of the demand liabilities of the Bank of England, carry only "till money" in cash or Bank of England notes, and for the rest, carry as their "reserve" their deposit credits with the Bank. A great deal of criticism, from Bagehot down (to go no further back) has been directed at the "inadequacy" of English banking reserves, and many dire predictions have been made as to the dangers that impended unless the reserves were increased. We shall probably hear less of this after the War! The Bank of England still stands! It has never failed to pay out gold over its counters, even though it has, with the aid of the government, doubtless restricted and controlled foreign shipments of gold. But it has met the unprecedented emergency better than any other bank in Europe, and to-day (Sept. 1916) is in exceedingly good shape. Sterling exchange at New York seems "pegged" at the "lower gold point," and apprehensions regarding the stability of the English financial system seem definitely allayed. It is aside from our present purpose to discuss war time conditions. I am rather interested in analyzing the features of the English money market which have made it possible, in the period preceding the War, for English bankers to get on with so little gold. As will appear, it is because English business and financial affairs have been more nearly "static," have come nearer to realizing the assumptions of static economic theory, than is true of any other country on earth.
The very fact, for one thing, that England is the great international banker has meant a scattering of risks. Acute panics do not come in all countries on the same date. Bad business in one country may be offset by good business in another; drains of gold to one country may be met with gold flowing in from others. The same considerations which tend to stabilize the railroad business, as compared with, say, cotton-growing, apply to the international banker as compared with the banks of a single country or section. But further, the London market has developed cooeperating agencies for smoothing out friction and eliminating uncertainties to a degree unknown anywhere else. An anonymous writer in The Americas for April, 1916,[570] has given an exceedingly interesting account of this organization of the London market,--the product of the development of generations. Let us enumerate some of the points: There is nowhere in the world so much expert judgment in the grading and evaluating of hundreds of commodities from all parts of the world. There is, coupled with this, a worldwide reputation for the experts of absolute integrity, so that producers in remote countries regularly ship ("consign") to London cargoes without definite arrangements, knowing that there are in London organized facilities by which the commodities are warehoused, expertly and fairly judged, and either sold at once or else made the basis of a collateral loan against which they can draw immediately. The institutions which make this possible are (a) the system of warehousing, with its certificates or warrants which give absolute title to the goods, and which are easily negotiable; (b) the organized arrangements in connection with the warehouses by which commodities are received and either graded as they are, or separated and mixed with others to form standard blends readily marketable--this with rigid integrity and expertness which the whole world trusts; (c) a speculative community which has unlimited banking credit, ready to buy at a concession in price virtually any commodity--honey in the comb, sealing wax, pianos, farm machinery, what not; (d) the organized markets or periodical auctions which speculation and final purchase together support; (e) the banks, which, relying on the standardization of the commodities and the readiness of the speculative community, can without hesitation lend the money on which the distant shipper is relying to conduct his business.
What comes to London is fluid. Everything comes to London! The multiplicity of items dealt in gives stability to that business which deals with all--the banking business. The London Stock Exchange is no provincial affair, easily demoralized by an adverse rate decision! Securities of every country on earth are listed there, and speculated in. It must be a world catastrophe which really demoralizes the London stock market!
It will doubtless seem strange to many to say that New York cannot displace London as the centre of world finance, that the dollar cannot displace the pound sterling in financing international trade, because New Yorkers do not speculate enough! They do speculate enormously, but not in many things. A restricted list of stock exchange securities--almost wholly American; cotton--in which New York is the world centre; coffee, in which New York has the largest volume of speculative futures, though yielding precedence, ordinarily, to Havre, Hamburg and Santos[571] in spot transactions. There is extensive sugar speculation at the New York Coffee Exchange, which has, indeed, recently changed its name to indicate the fact. There is a produce exchange in New York, but it is a very small affair as compared with the Chicago Board of Trade, and its operations and scope are infinitesimal when compared with the produce speculation in London. Of course, there is a vast deal of unorganized speculation in many things in New York, as in business everywhere, particularly in America. But, while the pecuniary magnitudes of organized speculation in New York are very great, the range of items dealt in is restricted. New York banks cannot possibly get such a variety of collateral, based on standardized and readily marketable goods and securities, as can London. New York, consequently, cannot finance international trade, save as an auxiliary to London--and New York banks must have vastly more gold in their vaults than London bankers need! As goods and securities become more marketable, gold--whose services are needed because of its superior marketability--becomes less necessary.
The whole story of London's organization would be a long one. London financial institutions have a degree of expertness, growing out of specialization, in large part, which makes all manner of paper fluid in the London money market which would lack fluidity in New York. The Acceptance Houses are a sort of international Bradstreet and Dun. They know intimately the standing and business of houses all over the world. They do not give out their information, but they do put their stamp on the paper of business houses, thus standardizing it, lending, not money, but "pure credit," while the other banks, relieved of the necessity of investigating the paper, can buy it as a miller might buy No. 1 wheat. There is the extraordinary extension of insurance, so that virtually any kind of risk may be shifted to those well able to bear it. All this makes for liquidity, for "static" conditions in the money market, and dispenses with the need for gold.
As we approach static conditions, we need less and less gold reserve behind bank demand liabilities. The static law of bank reserves is that none are needed! I think we have here the real reason why writers who have sought to give us the law for a "normal" ratio have given us such vague phrases as "shown by experience to be necessary," and the like. When irregularity of income and outgo in a bank's business, non-liquid assets, business cycles, uncertainties, legislative changes affecting business, crop failures, changes in demand, new inventions, wars, are abstracted from, no reason can be given why a banker should keep any reserve at all! But these things are dynamic things. And it is characteristic of irregularities that they are irregular. To get a "normal" ratio out of them is not easy.
On the static assumptions, an "ideal credit economy" is perfectly possible. If everything that needs to be marketed is perfectly marketable, if the stream of business flows regularly and without friction in the same channels, if all contingencies are foreseen and dated in advance, a bank needs no cash reserve. All payments can be made by bank-credit. Banks bookkeeping becomes merely a refinement of barter, with money remaining as a measure of values, a unit for reckoning, but not being used as a medium of exchange, or as a bearer of options, or in reserves. The measure of values function is the great static function of money.
To the extent that static assumptions are not realized, we need money in bank reserves. This extent is a thing that varies from time to time, and from place to place. It is not the same for a given place from time to time, nor is it the same at all places at a given time. It is not the same for the whole world from time to time.
Since friction, preventing the free marketing of goods and securities and services, exists, since there are dynamic changes which require readjustments through exchanges, we need the work of the banker and he needs cash. But there are other things than money which make for the "statification" of the market. The speculator does it. And the other agencies of the sort represented in the London market do it. They are substitutes for gold. Gold has no monopoly. The services performed by gold can be performed in many other ways, and by many other agencies. There is enormous flexibility in the matter.