Book Nine - The Rise of Bank Money

Book Nine. THE RISE OF BANK MONEY BY the nineteenth century there had begun to appear out of the confusion of European monetary history, like timid faces in a storm, certain practices upon which might be fixed some hope for a more ordered regime of money. Unfortunately, these embryos of principle never gestated; the trend taken by monetary developments of the past hundred years has been such as to destroy all the accumulated wisdom of the thousand years preceding, and to set loose new monsters of destruction for a dazed and harassed world to combat. We shall attempt in this chapter to set forth briefly the main advances in monetary science and to indicate how they have been nullified. /. The Retreat from Achievement ONE of the most hopeful of the achievements of the seventeenth and eighteenth centuries was the formal abandonment by government of its prerogative to control the minting of money. In perfect theory, and under ideal conditions, it is the state alone, as the agency of society, which can exercise that plenary and permeant control of the money mechanism which is necessary for its highest functioning in the economic order. Nevertheless, so abused had been this sovereign prerogative that as a practical measure its surrender had the most salutary results. The surrender of the coinage privilege was first accomplished, as we have observed, in England by the Act of 1666 (Act of Free Coinage of 18 Car. II, c. 5) which opened the mint to coinage by individuals.

Under a regime of free coinage, the state exercises no more than its police power. In coinage for private account the state merely converts the raw metal presented by individuals into pieces of uniform size, and impresses its insignia on the pieces 166 THE RISE OF BANK MONEY 167 as certification of their weight and fineness. The state's function is no more and no less than that which it performs in inspecting the scales of green-grocers and setting official standards of weights and measures. The principle of free coinage has proved its practical worth as a deterrent to debasement and depreciation. Where coinage is on private account there is no profit to the state in tampering with the standard, and there is no opportunity for such practice by the individual. The circulation of coins of similar appearance and denomination but of uncertain standard, the arbitrary and unpredictable modifications in the standard by autocratic government, the temptations to profit which were constantly dangled before despotic rulers—these were evils which had perplexed and harassed society and hindered the natural growth of economy since the days when coined money first appeared. By a stroke they were swept away. At the same time, the institution of free coinage, by giving stability and character to one of the chief instruments of organized economy, made possible a more vigorous and healthy commercial life and gave prestige and increased substance to the government adopting it.

The importance of free coinage has been generally overlooked. Indeed, the temptations offered by the central bank mechanism, the necessities of war, and public pressure for abundance of money, all aided by a "managedmoney" school of economists, have succeeded in suppressing free coinage everywhere and for many years coinage altogether. The monopoly of the state has become an iron hand, under which the value of money has become a matter not of the standard but of the fiat of the state. The development and denouement of this process we shall examine further on. Under the Gold Standard Act of Great Britain, of 1925, the right to present metal to the English mints for coinage has been withdrawn from individuals, and restricted to the Bank of England. The French monetary reforms of 1928 accomplished the same effect by permitting the Bank of France to redeem its notes either in coin or in gold bars, and elsewhere in Europe the coinage was restricted to the state. In the United States, by the Gold Reserve Act of 1934, not only was free coinage suspended, 168 MONEY AND MAN but the monopoly of gold was vested in the Treasury and citizens were forbidden to acquire, hold, or trade in the metal except at the pleasure of the Secretary. The value of the dollar domestically became one of official fiat, while its international value was maintained by freely buying and selling gold at $35 an ounce, a price fixed by Presidential proclamation of January 31, 1934.

Another advance toward a more intelligent control of money was the single metal standard. During the centuries of disastrous attempts to give to metals a currency at a fixed relationship to each other, the money system had been the prey of the bullionist, the arbitragist and the speculator, who made their profit by taking advantage of the fluctuating market of the two metals, circumventing the fiat of the state, and draining the country of its undervalued metal in order to sell it at a profit elsewhere. The establishment of the single metal standard at once destroyed the opportunity for these speculative profits and to that extent removed the money mechanism as an object of commerce, and allowed the economy of the country to concern itself in greater safety and assurance with its primary purpose of the production of physical wealth for the satisfaction of human needs, rather than in the specious pursuit of money profit.

The actually great advantage of the single standard has likewise been generally lost. This is partly because of the strength of bimetallic tradition, partly because it involved the demonetization of a historic metal, partly because gold, though the more precious metal, is less capable of sustaining a universal monetary standard—less capable because its greater scarcity and value renders its coinage into hand to hand currency impracticable and hence unfamiliar to the commonalty. There are good arguments for silver as a universal standard. It is more abundant—mine production being five times that of gold (252 million ounces in 1970, compared with 46 million ounces of gold). It is cheap enough to be coined in small denominations—though the price would probably rise if it were remonetized. However, silver is becoming so important industrially that current production and more is all consumed, for THE RISE OF BANK MONEY 169 such uses as photography, brazing, and the electronics industries. Such heavy demand, unless balanced by increased production, might cause complications in maintaining an adequate money supply. On the other hand, nearly half of the gold mined since the discovery of America exists today in central bank vaults, and industrial consumption takes less than half of current output.

The chief reason that the advantage of the single standard has never been fully recognized is that—theory to the contrary— nowhere in the world has a monetary system rested upon a onemetal basis. Since the rise of central banking, which was almost coincident with the establishment of the theoretical single (gold) standard, the money system has remained dual. Instead of money consisting of gold, or gold and silver and copper, as previously, it has consisted of gold and paper. Theoretically, the paper is representative of gold, but actually it is representative of something less than either silver or copper—that is, debt, the debts of industry and the debts of government. Upon this fact— the diversity of items which make up the paper, and hence the money system—has been built a new system of money speculation, arbitrage operations and financial manipulation which throws into the shade all the antisocial practices that grew up in monetary practice during the seven hundred years following the commercial renascence.

Perhaps the real solution to the problem of the single standard would be the adoption of a theoretical measure of value—some form of the "commodity dollar" that is advocated by proponents of managed currency. The actual standard used may not be so important as is generally believed, but it is necessary that the standard be fully understood by those using it. Our present money system, in which gold constitutes merely a portion, and an insignificant portion, of the security behind the paper money outstanding, is a hermaphrodite. It is neither gold nor commercial paper, but a deceptive combination of both. To the engineers of the system, its composition is fully understod, but the public long believed that its money was gold, and implicitly relied upon that fact, while the money traders recognized it for what it was, and made their profit by playing upon these dif170 MONEY AND MAN ferences, now draining one country of its gold, now another, and in the process forcing the central bank authorities into recurrent chills and sweats over the fear that the public would discover the imposture that was being played upon them.

The third advance in practice was the use of paper money representative of actual coin or metal warehoused in banks under authority of the state. This practice, in its simplest and purest form, appeared in the history of the Bank of Venice, the Bank of Amsterdam, and the Bank of Hamburg. The use of paper billets, or receipts, of the bank, in preference to good yellow or white metal, arose, as we have seen, because of the confusion of the coinage and the variety of pieces with which the merchant had to deal. The bank became an assayer, sorting out the good coins, weighing and testing them, and giving the client a warehouse receipt entitling him to their equivalent in good money of the realm. The superscription of the bank upon a piece of paper became a better certificate of valid money than the seal of the state upon the coin, and because it was not, like coin, subject to wear and abrasion, it became a more acceptable medium of payment than the actual metal.

The actual and theoretical advantages of paper money over actual metal in circulation have already been touched upon. The superiority of paper for making large payments, or payments in distant places, is unquestionable. It is true economy in the use of the precious metals in that it saves them from abrasion and loss. It removes a source of profit by "sweating," filing, shaving, clipping, and other practices of the bullionist where coined money is the principal medium of exchange. By means of representative paper, a piece of metal can be infinitely subdivided, so that the question of scarcity of a metal for circulation is not important. Except for small change, where metal coins are more convenient, paper money is, in fact, an ideal money for the use of a perfectly intelligent people. The reason for the failure of paper money to function properly is the inability of human nature, as at present constituted, to withstand its temptations. Paper money was subjected THE RISE OF BANK MONEY 171 by governments to abuses of the most distressing character, until the power of the state to issue it was restricted by an outraged society. The power passed for a generation to the commercial banking system, where it was similarly abused; the result was a new brood of Loki's offspring—panics, concentration of wealth, poverty in the midst of plenty, political revolution, and economic stagnation.

In the twentieth century, sovereignties began to reassert their monopoly of money, and under the pretext of assuring full employment through the manipulation of the interest rate, have used their power for the spread of statism, the socialization of activity, the annihilation of private property, and the extinction of individual liberty. //. Beginnings of Paper Money in England WE have already traced the first great experiment in the use of paper money in Europe, when it appeared in France at the beginning of the eighteenth century as a cloud no bigger than a man's hand. It is now necessary to observe its spread—in its extension in the money systems of Europe and America—until it filled the economic sky and covered the world with its dark and ominous shadow. In England, the first paper money enjoying a legal tender status by the authority of the state was the exchequer order of Charles II, which we have noted in an earlier chapter. The exchequer order did not prove popular as a medium of exchange. In 1696 it was supplanted by the exchequer bill, an invention mothered by the necessities of William Ill's wars.

The order differed from the bill in that it was convertible on demand into cash. An elaborate scheme was set up to provide for the convertibility of the bills, and funds were provided for this purpose by making the bills a charge upon the proceeds of certain state revenues. The bill was always fully covered, and the amount outstanding at any one time was strictly limited. It was good money, but it remained, in effect, a form of investment, 172 MONEY AND MAN a shortterm government loan, which it is today. In 1707, the Bank of England, which had been called into being thirteen years earlier and which was struggling to keep its head above water, was entrusted with the guarantee and redemption of the bills; and from then on they gradually passed out of use as currency. There was more profit to the bank in fostering the use of its own notes, and paper money issued by government was effectively superseded by the banker's bill or note. From the middle of the eighteenth century to 1844, when the note issue function was centralized in the Bank of England, the privately issued bank note became the only form of hand to hand paper money in England.

Bank notes, including those of the Bank of England, were, however, private paper, accepted only by custom, unrecognized by the state, and devoid of any quality of legal tender. The right to issue such paper was conferred by act of Parliament or by charter on lines that were not uniform. In certain parts of the country a monopoly was granted to the Bank of England, in other parts paper issues were authorized with or without regulation. It was not until the Act of 3-4 William IV in 1833 that a limited legal tender quality was given by Parliament to the Bank of England note. The bank note had been a logical development of the goldsmith's note, which had become popular during the political disturbances incident to the Puritan Revolution. English merchants had been in the custom of depositing their cash in the London Tower, until Charles I seized £120,000 of the treasure in 1640, and repaid it only after long delay and much protest.

As a result merchants and nobles began to leave their coin and valuables with the goldsmiths, receiving in exchange the goldsmith's receipts or notes. Because it represented the actual deposit of money, it came to be freely received in private transactions as money. Though the goldsmith's note was never legal tender, it served to accustom the commercial community with the use of paper equivalents of money. As gold and silver are fungible, it was not necessary to retain THE RISE OF BANK MONEY 173 the actual coin or plate deposited if an equivalent of value could always be returned upon demand. It was only a step to the discovery by the more unprincipled goldsmiths that funds of clients might be lent out so long as the goldsmith retained on hand sufficient amounts to meet anticipated calls for the return of deposits. The practice of the goldsmiths, of using deposited funds to their own interest and profit, was essentially unsound, if not actually dishonest and fraudulent. A warehouseman, taking goods deposited with him and devoting them to his own profit, either by use or by loan to another, is guilty of a tort, a conversion of goods for which he is liable in civil, if not in criminal, law. By a casuistry which is now elevated into an economic principle, but which has no defenders outside the realm of banking, a warehouseman who deals in money is subject to a diviner law: the banker is free to use for his private interest and profit the money left in trust.

The practice of the goldsmiths was in harmony with the financial ethics of the times, but it is to be noted that with the warehouseman the only deviation from the code was the practice of the factors in pledging the property of their principals left with them on consignment for the purpose of sale. The factors frequently had been compelled by the financial needs of their overseas clients to advance them money before the sale of the goods consigned to them had been consummated; to meet the drafts they began, in turn, to pledge the goods for advances from their own bankers. This pledging of property left in trust or on consignment was nothing more than a conversion, but during the sixteenth century it had become so common that the custom was finally legalized by parliamentary enactment. Such hypothecations were permitted, however, only in the case of goods whose owner had received advances from the factor, and only to the extent of such advances.

Today, it is a well defined principle, sanctified by experience and enshrined in the statutory and common law, that a warehouseman shall not engage in trade and, that, while receiving 174 MONEY AND MAN goods in safekeeping, he shall neither store nor own goods of his own of the same character which he stores. Yet at such a distance from this well-established principle is that followed by the banker that he may not only deal in his own capital, but may also lend out the funds entrusted him by his depositors. He may go even further. He may create fictitious deposits on his books, which shall rank equally and ratably with actual deposits in any division of assets in case of liquidation.* The goldsmiths had lent freely to Charles II and he had spent the money in the support of a profligate court, set up in imitation of Versailles. The result was a royal default. On January 2, 1672, Charles II issued a proclamation repudiating his debts, and sequestrating to his own use some £1,328,526 lent by the goldsmiths. As this money was the property of some 10,000 depositors the loss spread ruin and suffering throughout London, f In spite of this early experience in the viciousness of the goldsmith system, it evidently met a commercial need of the day, for it continued to expand. After the rise of jointstock companies toward the end of the century, the goldsmiths' business passed into the hands of the chartered banks. Under the regime of corporate banking the same practices were followed, extended and even sanctioned by the terms of the charter or by act of Parliament.

There seems to have been no conception on the part of government of the unsoundness and impropriety of this system of private money, and no awareness of the threat to the safety and well-being of the state through the exercise of such tremendous and ungoverned power of note issue. Thus, the Bank of Australasia, chartered March 28, 1835, was privileged by its * It is true that Roman jurisprudence recognized the right of the banker to use deposited funds to his own profit, but English concepts are an outgrowth of common law, to which Roman law made, at most, a negligible contribution. f These effects of Charles' default are disputed by R. D. Richards, 'The 'Stop of the Exchequer,' " Economic History, Vol. II (1930), No. 5,pp.45-62.

THE RISE OF BANK MONEY 175 charter to issue circulating notes of one pound denomination and upward to an amount of three times the paid-in capital plus the total of deposits. The charter of the Colonial Bank, issued in the following year, limited note issues merely by a provision restricting the discounts of the bank's own paper to one-third of the total discounts of the bank. "As the most decisive proof of the indifference of the state to these mere private paper tokens," says Shaw, "no attempt was made to safeguard the public against the dangers of unregulated paper. Disaster after disaster had to come upon the country before the British government realized the necessity of insisting upon some form of cover as a guarantee of the financial soundness of the private issue of paper. And when at last the necessity was realized, there was the greatest diversity in the means which were adopted in order to cope with the danger."1 ///. Revival of a Principle THE Bank of England, which is the parent of modern banks of issue, and around which the English banking and money system is built, was created not with the object of bringing the money mechanism under more intelligent control, but to provide means outside the onerous sources of taxes and public loans for the financial requirements of an impecunious government.

Such has been the motivating force leading to the establishment of all the great banks of issue of modern times. Such had been the purpose in founding the first Bank of North America, which financed the Revolution in this country; such had been the purpose in forming the first and the second Bank of the United States, and in operating the present national banking system of this country. Such had been the lure which induced the Regency to grant the charter for the Banque Generate to John Law. Banking became, in the eyes of the nineteenth century, the magic wand, the Midas-touch, with which to turn the solid substance of capital into the glistening and fluid thing of money. The idea of using banking as a means to a more intelli176 MONEY AND MAN gent control of the money mechanism did not appear until later, and for 150 years banking in England was a precarious business, a reed bent by every wind of political or commercial disturbance.

The story of the Bank of England is no different from the story of others. In the case of the Bank of England, the necessities that called it into existence had been the War of the Palatinate, embarked upon against France after the deposition of James II, his flight to the court of Louis XIV and the accession of William of Orange to the English throne. The high-handed policies of the Stuart kings toward their obligations, and the unsettled state of England as a result of the Bloodless Revolution, had made investors wary of entrusting their funds to the government. To finance the war with France the government accepted a proposal of a bank presented by William Paterson, a Scots promoter, whose antecedents apparently did not bear too close scrutiny. It was this same Paterson whose notorious Darien scheme had ruined half of Scotland. His proposal was that, in return for an advance of £1,000,000 to the government, the government should accord to him and his associates £65,000 a year as interest and the costs of management, and, in addition, authority to issue bills which should be legal tender. The proposal to give the bills a legal tender was unacceptable to the government, and the whole idea was repugnant to many of the Lords. The pressing need of money, however, finally overcame the prejudices of the upper body of Parliament, and a charter was granted authorizing the bank to issue notes (without legal tender quality, however), to deal in bullion and commercial bills, and to make advances upon merchandise. It enjoyed, in addition, the privilege of limited liability for its shareholders, the advantage of holding the government deposits, and the power of lending money in excess of deposits by reason of the circulating notes it was allowed to issue against government debt. These privileges gave the bank an immense advantage over the goldsmiths.

THE RISE OF BANK MONEY 177 The bank had hardly been in existence two years when it was forced to suspend payments. Created as a financial tool of the Whigs, it had to support the government without any regard to the economic or financial soundness of its operations, or its obligations to the commercial community which trusted in its paper. The suspension of specie payments, which lasted from July 13, 1695, to the autumn of 1697, was followed by a depreciation of the bank notes, which fell to a discount of 17 per cent. This was hardly unnatural, since the account submitted to the House of Commons on December 4, 1696, showed notes outstanding to be £764,196, supported by cash of only £35,664. Specie payments were resumed in 1698, but in 1720, after the collapse of the South Sea Bubble, in which the bank was not entirely a passive observer or agent, a run occurred which was met only by making payments in light six-pences and shillings, by engaging men to fill up the line, draw money and redeposit it at another window, and by the fortunate intervention of the festival of Michaelmas, during which the bank remained closed while public alarm subsided.1 A similar crisis occurred in 1745 following the success of the Pretender in Scotland, and was met by the same tactics.

The next collapse of the Bank of England occurred in 1797. Thirty years of fairly successful operation of the bank had produced a flood of noteissuing institutions in imitation, and by 1793 there were nearly four hundred noteissuing banks in business. The wars with France and the struggle with the American colonists, combined with a currency chaos produced by an immense, various, and unregulated note issue, led to a general collapse of credit in 1793, and one-third of all the English banks of issue suspended payment. The Bank of England followed suit by suspending payments in 1797. The suspension of 1797 continued throughout the period of the Napoleonic wars. In 1816, partial resumption was attempted, and then postponed. Final resumption of specie payments did not occur until 1821, when the bank commenced to redeem its own issue at discount. During this period, 1797 to 1821, practically every bank of issue in Europe had suspended specie payments.

178 MONEY AND MAN <«§ $»> It was not until 1844, when Sir Robert Peel's Bank Act was passed, that the first real attack was made against lax banking and unsound paper money. The country had gone through a severe crisis in 1825, which had arisen from a frenzy of speculation and foreign lending, particularly to the newly formed states of South America. Stock companies had been formed with objects as indefinite and impracticable as in the time of the South Sea Bubble—one, for instance, for the purpose of draining the Red Sea to recover gold lost by the Egyptians when pursuing the Israelites. Some £150,000,000 of British money, it is estimated, was sunk in government loans and corporate investments in Mexico and South America alone. This speculation, it was generally believed, had grown out of the excessive extension of country banks, without any legal regulation, and by the unwarranted expansion of loans both by these banks and by the Bank of England. The reserves of the Bank of England had been gradually whittled down from £13,800,000 in March, 1824, to £3,012,150 in November, 1825, and the country banks had been brought up short by the failure of Sir Peter Cole and Company. Collapse followed, sixty-three banks were forced to suspend, and the consequences were so severe, says Walter Bagehot, that they were remembered after nearly fifty years.

The debacle of 1825 had forced attention upon the necessity of reform, and in 1833 restrictions were placed upon the issue of notes by country banks, and the Bank of England was given a wider monopoly of the note-issue power. It was not, however, until a second crisis occurred, that of 1839, that thoroughgoing reform was undertaken, and the banking and note system of England was given the foundations upon which, with some modifications, it rested until 1945, when it was taken over by the government. Sir Robert Peel, who sponsored the Act of 1844, was dominated by the purpose of making the notes of the Bank of England as "good as gold." The declared purpose of the act was "to cause our mixed circulation of coin and bank notes to expand and contract, as it would have expanded and contracted under similar circumstances had it consisted exclusively of coin." In THE RISE OF BANK MONEY 179 other words, the paper circulation of England was to be made to represent as nearly as possible warehouse receipts for actual metallic money.

With this object the note-issue department of the Bank of England was separated from the banking department, so that the gold held against the note issue would be clearly set forth, and not confounded with the reserves held against deposits. The act, however, allowed a maximum amount of £14,000,000 uncovered notes, that is, notes not supported by gold, but provided that they should be backed by government bonds. For this purpose £14,000,000 government securities were transferred from the banking to the note-issue department. The limit of £14,000,000 for the uncovered circulation was determined upon by having regard to the minimum amount of notes that could be counted to remain always in circulation. It was found that the net circulation in December, 1839, during the worst of the run, had not fallen below £14,732,000, and it was argued that at least £2,000,000 must be kept in the banking reserve of the bank. It was considered safe, therefore, to fix the uncovered circulation at £14,000,000; and it was left to the play of the foreign exchanges to control fluctuations above that amount.

The country banks were still permitted to retain the noteissuing powers conferred by their charters, but a great many of these banks had become insolvent, and it was expected that the privilege would be gradually withdrawn as the charters expired, with eventual concentration of all the note-issue function in the Bank of England. In order to take up the vacuum caused by such note retirements the act provided that the Bank of England might increase its fiduciary issue against securities by an amount equivalent to twothirds the amount of such other notes retired. "The Act of 1844," says Conant, "proposed substantially to destroy the bank note as an instrument of credit and make it a mere certificate of coin, leaving to other forms of commercial paper the functions which the bank note had in part performed."2 Sir Robert Peel's Act is criticized by modern economists on 180 MONEY AND MAN the ground that it fixed upon England a rigid, inelastic money system. The theory upon which Peel worked is in sharp contrast to that which later found widespread acceptance, that note issue should expand and contract with the needs of trade, and still further from the currently prevailing view that the money supply should conform to the requirement of full employment on a steady price level, or from the view advocated by the so-called Chicago school, that the money supply should increase at a mathematically determined pace. Peel's concept of the function of central banking was that the notes of a central bank should be always convertible, and that this convertibility can be assured only by making them fully representative of money. In a word, he went on the theory that the capstone of an arch should not be made of rubber.

The actual results of Peel's legislation will be examined in a later chapter, while, meantime, we turn to developments of the paper money device in America. IV. Groping Toward Control in America MONETARY history in the United States during the first seventyfive years of its federal existence is the story of feeble and sporadic attempts to deal with the new engine of paper money. Despite an awareness of the dangers in paper money and the prohibitions against its use written into the Constitution, prohibitions that were systematically ignored, the actual management of monetary policy was marked by ignorance and political subservience. The federal government and the states each took their hand at dabbling with it, crossing each other and defeating their common objectives in the process, leaving it in the end the shuttlecock for the play of speculators, manipulators and financial parasites.

One thing stands out clearly in a survey of the period, perhaps more clearly in this country than in the case of England: the gradual merging of money and banking, and the confounding of the problems of credit with those of the media of exchange.

THE RISE OF BANK MONEY 181 With the dawn of the nineteenth century, the study of money is no longer the study of coinage, of the ratio between the metals, of the coinage prerogative, or of the question of metallic supplies. The problem enlarges, as it has been gradually enlarging since the reestablishment of interest as a formal institution of economy, until it becomes a study of commerce-debt relationships and the institutions which exercise authority over the body of commercial debt. Our story, therefore, must from now on concern itself largely with the money mechanism as it is affected and moulded by banking and credit. During the colonial days, the shortage of circulating media had been supplied, as we have observed, by the use of barter implements: wampum, beaver, tobacco and rice, and later by the use of colonial paper money. Paper money, representing warehoused tobacco or rice had been introduced in the southern colonies with some success, and in Massachusetts, the Land and Manufacturers Bank had, in 1740, begun to issue notes redeemable in goods. These forms of money, which possessed the one advantage of representing a quantity of tangible wealth, gave way to note issues backed by nothing more than the credit of the colonies, which was a very nebulous substance. During the Revolutionary War the Continental Congress had issued notes in such quantities that their value became characterized by a phrase that is still current in our speech as a synonym for worthlessness.

From the situation produced by the inability of the colonial governments or the Continental Congress to control money, the commercial community turned for relief to bank notes. Despite the successes of the Revolutionary army on the field, the problem of financing the war had become more and more pressing, and after the fall of Charleston in 1780, it became imperative to find new methods of raising money. As in England in 1694, a bank was proposed, and the Bank of Pennsylvania was called into existence. The Bank of Pennsylvania was created with a capital subscription of £400 in coin and £103,360 in depreciated Conti182 MONEY AND MAN nental currency, and its notes were nothing more than interestbearing obligations payable at a future time. It lasted for a year, when its functions were taken over by the more stably organized Bank of North America, the creation of Robert Morris. This bank did much to restore order to the chaos of federation finances and continued in business for sixty-five years.

The framers of the Constitution had inserted a provision forbidding the states to coin money; emit bills of credit (that is, circulating notes), or "make anything but gold and silver coin a tender in payment of debts" (Art. I, Sec. 10). The federal government was an instrument of delegated powers, that is, it enjoyed no powers not specifically conferred by the Constitution, all others being reserved to the states, except as limited, as in the case of money. It is noteworthy in connection with our present survey, that while the Constitution authorized the Congress "to coin money, regulate the value thereof, and of foreign coin" (Art. I, Sec. 8), nothing is said about emitting bills of credit, or declaring instruments of credit as legal tender. Despite these explicit limitations, state after state continued to charter banks with the right of note issue, and even as quasilegal tender. Even so strict a federalist as Alexander Hamilton, leading proponent of centralized authority and first Secretary of the Treasury, thought it proper for the federal government to create bank credit as a money mechanism. His fiscal plan for strengthening the federal government included a bank, the first Bank of the United States, which was chartered in 1791. Fortunately, it was managed with conservatism, a conservatism uncharacteristic of the times, and indeed Hamilton's effort to provide the country with a sound banking and money system antedated that of Sir Robert Peel by fifty years.

The Bank of the United States was organized with a capital of $10,000,000, of which one-fifth was subscribed by the government by way of loan, and note issues were limited by a provision restricting all the liabilities of the bank, except deposit liabilities, to an amount not exceeding the capital of the bank. Despite any specific Constitutional authority, but in reliance upon "implied"

THE RISE OF BANK MONEY 183 powers—a doctrine sanctified by the early decisions of the Supreme Court under its first chief justice John Marshall—the notes were declared legal tender for government dues so long as they were redeemable in coin. The bank did not enjoy a monopoly of the note issue, as the various states still chartered banks with this privilege, but its large capital and preeminent status were calculated to give it a commanding position in the banking system. The bank followed a conservative policy so far as note issue was concerned. Its statement for January 24, 1811, showed $5,009,567 in coin against $5,037,125 circulating notes outstanding and $5,900,423 in individual deposits. Government deposits in the amount of $1,929,999 were offset by United States 6 per cent stock in the amount of $2,750,000. Hamilton's concept of a strong centralized banking system, controlled by the federal government, was not due for realization. In 1811, the charter of the bank expired and Congress refused a renewal, largely on political and constitutional grounds.

A second Bank of the United States was founded in 1816, but it became an object of political opportunism, and in 1836 it ceased to function as a state institution. Meantime, despite the provisions of the Constitution, state banks were springing up like mushrooms, all issuing circulating notes and obtaining their acceptability as money despite their invalidity as legal tender, and in such number that, before long, conservative financiers began to grow alarmed. Oliver Wolcott, who succeeded Hamilton as Secretary of the Treasury, wrote in 1795: "These institutions have all been mismanaged. I look upon them with terror. They are at present the curse, and I fear they will prove the ruin, of the government. Immense operations depend on a trifling capital, fluctuating between the coffers of the different banks." John Adams, just elected to the presidency, also wrote of the growing evil of unregulated paper money. Because of the supposed immense advantage to agriculture, he said, the Massachusetts legislature was authhorizing a number of new banks, but credit could not be solid when a man was 184 MONEY AND MAN likely to be repaid for a loan in bank bills that were constantly depreciating.

But these were voices in the wilderness. Bank expansion continued at a heedless, unregulated pace. Little money was required to be paid on subscriptions, as the profits from the note issue were enough to take care of all. Says Hoggson, "The allowed emission of bank bills was so large that the question of profits depended simply upon whether the new bank could get its bills accepted first by borrowers, and then by the public in the surrounding district. In fact, the further from home the bank bills were distributed the better, as there was less chance of their returning at an inopportune time."1 Panics and financial collapses followed as a matter of course, leading to various proposals of how to sustain confidence in the system. The main devices were four, each according to a particular theory of how to multiply loaves and fishes, or how to make candy wool. They were: note issues upon general assets; issues protected by a general safety fund; issues based upon public securities; and issues based upon the faith and credit of the states.2 It was in the New England states, and particularly in Massachusetts, that the theory developed of regulating note issue in relation to the general assets of the bank. No limitations were imposed upon note issues in the colonial enactments of Massachusetts, but an act of 1792 prohibited notes below $5 denomination, and noteissuing banks were directed to limit the amount of notes, together with "money loaned by them by a credit on their books or otherwise," to "twice the amount of their capital stock in gold and silver, actually deposited in the banks and held to answer the demands against the same." A general law passed in 1799 prohibited banking by unincorporated companies, or the issue, except by the Nantucket Bank, of notes of smaller than $5 denomination. In 1805 the restriction was modified so as to permit the issue of bills of $1, $2, and $3 denomination to the amount of 5 per cent of paid-up capital. In 1809 the limit was raised to 15 per cent, reduced to 10 per cent in 1812, and THE RISE OF BANK MONEY 185 again increased in 1818 to 25 per cent, remaining at this figure down until state bank notes were finally extinguished by the passage of the National Bank Act amendment in 1864.3 The Massachusetts method of control was put to the test in 1814 when, incident to the war with England, and the extinction of the Bank of the United States, there occurred a widespread collapse of banking. The New England banks succeeded in maintaining payments in coin, and after the passage of the crisis, banking capital flocked to Massachusetts, and the organization of banks proceeded with alarming rapidity. At the end of 1836, seventy-eight new banks had been added to the sixty-two older banks. In spite of the enactment of 1829 limiting note circulation of banks to 125 per cent of capital, and total obligations, exclusive of deposits, to twice the capital, the crisis of 1837 was like a scythe over this crop, and thirty-two Massachusetts banks wound up between 1837 and 1844.

The crisis of 1837 brought greater state control into the banking system: the institution of bank examiners, and greater liability of stockholders for the redemption of notes. But even these were not enough. A new crop of banks arose, followed by a new speculative mania, which culminated in the crisis of 1857. In 1862, just before the establishment of the national banking system, the 183 banks in operation in Massachusetts had created a credit structure of $73,685,000 in notes and deposit liabilities supported by only $9,595,000 in cash, a ratio of 13 per cent.4 The continued issues of bank notes that circulated as money, but without legal tender quality, was supportable only by confidence that the notes would be redeemed on demand in gold or silver coin. To strengthen confidence the system of bank guaranty by a safety fund was first initiated in New York in 1829. By legislative act of that year banks were required to deposit annually with the treasurer of the state a sum equal to one-half of one per cent of their capital stock until the deposits should amount to 3 per cent, the sum so accumulated to be held to pay off liabilities of failed institutions. The panic of 1837 put the fund to its test, and it was kept intact only by allowing canal tolls to be paid in notes of defunct banks. Bank failures in the three years following proved how ineffective was deposit guaranty in 186 MONEY AND MAN the face of general banking overextension. The fund was exhausted, and the solvent banks had to be assessed to maintain the guaranty. Redemption of notes was finally suspended, temporarily, and in 1842 the act was modified by making the guaranty cover only notes, instead of all the liabilities. In 1857 the whole attempt at guaranty was abandoned.

Conant thought the safety fund system failed because it was to cover all liabilities instead of simply the liability for note issues, but this is a view, like so much taught in formal economics, that proceeds on logic rather than on understanding of human nature. The real reason for the failure, like the reason for the failure of all such schemes, is that bad apples will rot good apples, but good apples will not make bad apples sound. The safety fund system made the soundly operated institutions responsible for the mistakes and malfeasance of the recklessly operated, over the operations of which neither they nor the state exercised any control or responsibility. So long as the opportunities for profit exist, with few or no questions asked as to how the institutions are managed, the speculative element is willing to pay assessments on the same basis that a racketeer buys protection from the police—by recouping itself through extending operations. Many of the shyster element—and banking attracted many of this kind—evaded the law by issuing notes in excess of the maximum limits, or by obtaining through political influence charters which gave them special privileges. The conservatively managed institutions, lending upon the safer risks, upon which naturally the margins of profit were smaller, found the assessments burdensome, and were compelled to embark upon the more speculative business in order to carry the charges.

The third form of control arose out of the campaign for "free banking," as it was called—that is, total liberty for individuals or associations to engage in banking merely on compliance with statutory requirements, and without the necessity of acquiring a charter by legislative act. The Free Banking Act of New York, passed April 18,1838, authorized individuals or associations to THE RISE OF BANK MONEY 187 issue notes against a reserve in coin of 12.5 per cent and the deposit with the state comptroller of an equivalent amount of federal and state securities approved by the comptroller. The financial interest was prompt to take advantage of the free banking law, and by the end of 1839 seventy-six persons or associations were issuing notes, and applications from fiftyseven more were on file. Before the first of January, 1841, eight of these institutions had gone out of business, and eighteen more followed in the course of the year. Modifications of the system, however, improved the operations of the free banking system somewhat, and it was successful enough to attract attention in Canada in 1850. Later, it became the pattern for the national banking system established in 1863.

Various states modeled their banking legislation after that of Massachusetts or New York. In Maine, for instance, banks were allowed to issue notes up to 50 per cent of capital, and up to the full amount of capital provided the excess were covered by a reserve in specie, that is, in coin, equivalent to one-third the amount of notes issued. Vermont patterned its legislation of 1831 after the New York safety fund act. But if the safety fund system proved salutary in the East, where more conservative traditions were beginning to gain strength, in the newer states of the West, the system only proved the opportunity for further abuse. Hardly had a safety fund been enacted in Michigan, in 1836, when it was forgotten in a frenzy of paper inflation that in the following years swept over the West like a prairie wind. The panic of the following year became the occasion for lowering, rather than raising banking standards, and an act was passed permitting banks to begin business in a condition of suspension of specie payments. Thirty per cent of the capital was required to be paid up in coin, but this provision was evaded by borrowing the money for a few days when the bank commissioners made their tours of inspection. A bank could be organized by any twelve persons able to put up $50,000 consisting of $15,000 cash and the balance in bonds and mortgages that could meet 188 MONEY AND MAN the approval of the auditor general. After the resumption of specie payments, it became the practice to organize banks in the most inaccessible places in order to make it difficult to present the notes for redemption, and eastern speculators developed a profitable business of taking out Michigan charters and distributing the notes in other states where the standing of the bank could not be known. Fraudulent overissues were frequent and in many cases not even recorded.

Before long a million dollars in worthless bank notes were in circulation, a bewildering variety of issues each circulating at its own rate of discount with a confusion that required corps of bookkeepers to keep the accounts of a firm straight. Merchants kept couriers by whom they hurried off to the banks the notes they were compelled to take, in order to exchange them—if possible—for something which had more value. Misery and bankruptcy spread over the state, with the inevitable harvest of stay laws and laws fixing the value at which the property of debtors should be taken. The climax came in 1844 when, nearly all the "free banks" being in the hands of receivers, the state supreme court held that the general banking law had been passed in violation of the constitution and hence that even the receiverships had no legal existence! The experience of Michigan was repeated elsewhere in the West. Banking laws basing note issues upon securities were adopted by Illinois in 1851, Indiana in 1852, Wisconsin in 1853, and other states soon afterward. The restrictions which had been developed in New York were ignored, and so rampant was the note-issue mania that the notes came to be called by the appropriate name of "red dog" and "wild cat" currency.The inflation that resulted presented patterns that were repeated in the decade 1920-1929, which we shall have occasion to examine later. The rising crop of banks created a fictitious demand and a rising market for securities (to be used as capital stock) and a consequent stimulus to the creation of public debt by the issue of securities. This was followed by more bank notes being issued against the securities, demand increasing and the market rising, more securities issues, more bank notes, and so on in an endless THE RISE OF BANK MONEY 189 chain of debt creation and the inflation of paper wealth. The process was finally brought to a stop by the panic of 1857.

The fourth method of control, that of note issues against the faith and credit of the state, developed chiefly in the southern states. As it was tried, it was a tragic failure—"one of the most dismal chapters in American banking," comments Conant.5 Kentucky, in 1820, had created a state bank with the power of note issue, but within two years the notes were quoted at 62.5 cents on the dollar, and the whole state was soon embroiled in a legal controversy over the bank, a controversy that almost ended in revolution. Alabama created a state bank with the naive object of distributing its notes as evenly as possible throughout the state: to assure this, a directorate of between sixty and seventy persons was chosen annually by the state legislature; and various public funds were turned over and some $13,800,000 state bonds were issued to support the notes. A period rivaling that of the Mississippi Bubble followed. Political control of the bank and apparently unlimited supplies of money brought "good times" and cast a roseate flush over the state; so intoxicated with money did the state become that an act was passed (January 9, 1836) abolishing direct taxation and setting aside $100,000 of bank money to meet the state budget.

The inevitable end came with the panic of 1837. An investigation showed $6,000,000 of the bank's assets to be worthless. Confidence in paper money "supported by the faith and credit and wealth of the state"—to use the favorite phrase of champions of government paper money—suddenly collapsed, and with it the whole structure of business and credit in Alabama. The lesson of the experiment is indicated by the provision in the Constitution of 1867 that "the state shall not be a stockholder in any bank, nor shall the credit of the state ever be given or loaned to any banking company or association or corporation." Not deterred by the experience of Alabama, however, Mississippi, in 1838, established a state bank with a capital of $15,000,000 provided by a state bond issue. Management was 190 MONEY AND MAN of the worst, and the bank ran its course within four years. When the bank collapsed, the state repudiated its obligations on the bonds, bringing wails of angered anguish particularly from British bond buyers who had invested heavily in the issues. The results are described by Henry V. Poor: The $48,000,000 of the bank's loans were never paid; the $23,000,000 of notes and deposits were never redeemed. The whole system fell, a huge and shapeless wreck, leaving the people of the state very much as they came into the world. Their condition at the time beggars description. Society was broken up at its very foundations. Everybody was in debt, without any possible means of payment. Lands became worthless, for the reason that no one had any money to pay for them. The only personal property left was slaves, to save which, such numbers of people fled with them from the state that the common return upon legal processes against debtors was in the very abbreviated form 'G. T. T.'—gone to Texas—a state which in this way received a mighty accession of her population."6 Several other southern and western states went through similar experiences. The Territory of Florida incorporated the Union Bank of Florida on February 12, 1833, with a capital of $1,000,000, assisted by an issue of territorial bonds of which half were sold in Europe. The state government, after the admission of Florida to the Union, refused to recognize the privileges of the bank and the Secretary of State in 1858 reported that its circulating notes were not worth twenty cents on the dollar. A real estate bank was one of the features of the Arkansas system, towards which the subscribers were required to pay nothing in but merely to secure their subscriptions by mortgaging their real estate. Incorporated in 1838, its career was four short years. In 1842 the directors made an assignment, and the notes afterward passed for about 25 per cent of their face value in specie.

Illinois tried several experiments at issuing circulating notes "on the credit of the state," and the circulation of the State Bank of Illinois, incorporated in 1821, did not exceed $300,000, but even this moderate limit did not keep the notes from falling THE RISE OF BANK MONEY 191 within three years to twenty-five cents on the dollar. In 1825 the bank was ended by collecting all the notes in its possession and publicly burning them at Vandalia, in the public square. Another bank formed in 1835 collapsed in 1842, and the Constitution of 1848 provided that no state bank should thereafter be created nor should the state own any banking stock. A state bank in Tennessee, formed in 1820 stood up for twelve years, but failed in 1832. Louisiana incorporated the Union Bank of Louisiana in 1832 on lines similar to those of the Union Bank of Florida, and issued some $17,000,000 in bonds to provide the capital for it and two other institutions, all three of which succumbed in 1842.

Georgia, Vermont, Missouri, Delaware and the Carolinas all tried state ownership and management of banks, but the first two early abandoned the experiment, and the others ceased to be banks of issue upon the establishment of the national banking system. Throughout this period neither Congress nor the courts came face to face with the Constitutional prohibitions upon the issuance of paper money—or indeed what was money. The term "money" (derived from moneta) properly refers only to minted coins, while the term "currency" embraces whatever is generally circulated and accepted. Meantime, three usages had grown up to describe the different forms of circulation—lawful money, standard money, and legal tender. Lawful money, of distinctly American usage, originally meant only coined gold and silver. Since 1837, other forms of circulation have at times been treated as "lawful money," but the term has never been defined by statutes or courts. Legal tender implies what can be lawfully offered in payment of debts and dues, although in certain cases this quality may be limited to payment of government dues—and in the case of state authorized bank notes, only state dues. National bank notes (discussed infra) were never legal tender until 1933, while Federal Reserve notes, first authorized in 1913, were legal tender but never lawful money, and the Federal Reserve Act declared that the 192 MONEY AND MAN notes should be redeemed on demand "in lawful money." In 1933, all forms of federal circulation were declared legal tender, with disastrous confusion as to the actual legal qualities of money.7 In 1974, a suit was brought in the District Court of California by Mobley M. Milam, an attorney of San Diego, to require the Federal Reserve to redeem its notes in lawful money. To do so would create havoc in the monetary system, since Federal Reserve notes comprise (1974) some $66 billion of total circulation of some $75 billion, the balance being mostly fractional coin. The purpose of the suit was to face the courts with the Constitutional inconsistencies involved in the present monetary system; the suit was dismissed by the court, and also by the Circuit Court of Appeals, and subsequently by the Supreme Court.

The establishment of the national banking system in 1863— 1864 removed note issues of the state banking systems, and introduced a new regime in the control of private money. By the National Bank Act of 1863, as amended in 1864, the privilege of note issue was restricted to nationally chartered banks (by the process of taxing state note issues out of existence) and the notes themselves were required to be secured by the deposit with the Treasurer of the United States of an equivalent amount of United States Government securities. The act had been passed as a war measure, sponsored by the Secretary of the Treasury, Salmon P. Chase, to aid in financing the federal government, and had been a part of his policy of carrying on the war by means of loans rather than by taxes. Irredeemable fiat money (greenbacks) had been issued by the federal government to such an amount that they had fallen to a discount of 65 per cent in terms of gold, and it had become imperative, as in 1780, as in 1694, to bolster the credit of government by calling in the aid of the banking mechanism. The prime purpose in basing the bank note issue upon government credit was thus to strengthen the government by providing a market for federal securities rather than to strengthen society by means of sound money.

By placing paper money solely upon the back of federal THE RISE OF BANK MONEY 193 credit, however, the act achieved for the note issue a security and uniformity which it had not hitherto possessed, and to that extent was a long forward step. The successful outcome of the war redeemed the hopes of the sponsors of this form of note issue, and as the wealth and power of the country expanded, the value of the national bank notes rose, and was reestablished at par on the resumption of specie payments in 1879, with redemption of notes in coin. But if the substitution of federal credit for state and private credit behind the bank note issue was to introduce uniformity and a greater degree of security, it also introduced a new problem of major import in the control of the money mechanism. This problem, which is still so little understood, because it is so elusive and has so little appearance of actual money, is that of deposit credit. Before taking up this manifestation of the money mechanism, it is necessary once more to advert to the English experience with money following the passage of the Act of 1844.

V. Extension of Central Banking IT had taken Europe four hundred years to learn how to deal with the problem of bimetallism; perhaps two hundred years is not too long for man to learn how to deal with the problem of bank money. By the Act of 1844, which made the English note issue almost synonymous with gold, Sir Robert Peel thought he had achieved the sought-for solution. The principal finance ministers of Europe evidently thought so too, for the Bank of England became the model for European central banking. Events proved otherwise. Neither limits on the note issue, nor requirements as to cover, were sufficient to forestall panics and breakdowns in the money mechanism. Within three years after the passage of the act, that is, in 1847, the banking reserve of the bank had been reduced to such an extent as to threaten suspension of discounting. In order to support the banking function of the institution, the issue department was sacrificed. The gov194 MONEY AND MAN ernment intervened, authorizing the bank, in effect, to disregard the legal reserve restrictions upon the note issue. Fortunately, this recourse did not become a necessity.

The great mistake of the Act of 1844 was the mistake that has been made in the commercial banking legislation of this country. The doctrine upon which the act had been built was that bank notes are a form of currency entirely distinct from other commercial paper and forms of credit. The law was framed to arrest commercial expansion by limiting the power of note issue; it failed absolutely in this object because such operations can be carried on, and usually are carried on, by other means than banknotes. The problem was thus not one of the control of actual money, but the control of the entire money mechanism, and the control of the system which has in its power the creation of money. By 1844 the money mechanism had passed beyond the control of government and into that of the banking system. The crisis of 1847 early demonstrated the futility of note-issue control without a concomitant control of credit. The actual situation that developed, as John Stuart Mill wrote,1 was that the bank, safe so far as its circulation was concerned, had actually overextended itself on the banking side, and that, faced with a panic, it was caught without banking reserves and had to contract its credit, with acute results on the commercial and banking community which relied upon the central institution for aid. Conant explains what happened, as follows: "It was the theory of the supporters of the act that the currency would fluctuate in exact accordance with the fluctuations of a metallic currency by the self-acting provision for the issue of notes only in exchange for gold and the issue of gold in exchange for notes. Both sides in the discussion of the bill, when it was pending in Parliament, seem to have made the incredible blunder of overlooking the fact that gold could be obtained (through the banking department) by the presentation of checks. This was exactly what happened in 1847. The bank saw its bullion decreasing on the one hand and its banking reserve THE RISE OF BANK MONEY 195 decreasing on the other hand, while gold and notes poured out of the banking department in the discharge of its obligations.

The banking reserve was chiefly in notes which had been obtained by the surrender to the issue department of such gold as was received on deposit, but the payment of these notes to customers either swelled the note circulation or reduced the gold in the bank by just the amount of the payment."2 Ten years later, in 1857, another crisis occurred, due to excessive and unwise lending as a result of over-optimism regarding foreign trade prospects. The bank found itself in the same position as in 1847, and similar measures were taken. On this occasion the bank was forced to use the authority to increase its fiduciary issue beyond the limit imposed by the Bank Charter Act, although the excess issue at no time reached £1,000,000, and the infringement of the act lasted only eighteen days. Again in 1866, the growth of banking without sufficient attention to liquidity, and the use of bank credit to support a speculative craze in which within a few years nearly three hundred companies, with a total nominal capital of £504,000,000, had been organized, prepared the way for a crash which was finally precipitated by the failure of the famous house of Overend, Gurney and Co. The Act of 1844 was once more suspended.

The financial storms of 1873-1879 and 1882-1884 were outridden by the Bank of England, largely as a result of more conservative management and the happy circumstance of an increasing world gold production for which the Bank of England, as a result of its world importance and discount policy, became the chief depository. Elsewhere in Europe and America these periods of depression were occasioned or accompanied by widespread bank failures and breakdowns in the money mechanism. In 1890, the Bank of England once again faced crisis, again the result of widespread and excessive speculation in foreign securities, particularly American and Argentine. This time it 196 MONEY AND MAN was the failure of Baring Brothers that precipitated the crash. The bank was saved, as it had been in 1839, by a loan of £ 10,000,000 from France, the proceeds of which were imported in gold. Yet in spite of these periods of strain and near breakdown, such was the general prestige of English institutions and the power of the Bank of England—a prestige and power derived from the English steel and coal industry and an overseas commerce that constantly refilled the depleted coffers of the bank— that the bank became the accepted model in Europe, as English tailoring the model for male attire. Central banking, as it expanded throughout Europe, was ostensibly patterned after English practices, especially in regard to concentrating the banking reserves in one institution. The one redeeming feature of the bank, the principle of making the notes practically synonymous with gold, which Sir Robert Peel had laid down as a basic principle, was, however, generally disregarded.

Thus, the Reichsbank, which was established in 1875, was entrusted with the note issue of the German Empire, and in order to enable it to unify the currency it was empowered to absorb the issues of the local banks just as the Bank of England had been authorized to do by Peel's act. A fixed limit was set to the circulation. Notes issued within this limit required a cover of only one-third; beyond this limit notes could be issued but only against a full cover. The "cover," however, could consist not only of gold bullion, foreign gold coin, or other money having currency in Germany, but also of imperial treasury bonds. This concept of "cover" of course vitiated the whole idea of a gold backed currency. Moreover, the "contingent" note issue, i.e., that portion required to be covered only one-third, which had been set in 1875 at 250,000,000 marks was subsequently raised to 550,000,000 marks and in 1910 had reached 750,000,000 marks. This bank disappeared in the World War I inflation, and the later Bundesbank was under no restrictions as to note issue reserves except public policy and convenience.

THE RISE OF BANK MONEY 197 In France, the note issue was concentrated in 1848 in the Banque de France, in imitation of Peel's act, but the control was regulated by legislation, with limits nominally fixed by legislation but conveniently enlarged from time to time, from 350 million francs to 12 billion francs by the outbreak of World War I. In 1928 the franc was devalued to one fifth its former value, and a new law, a la the Federal Reserve act, required gold equivalent to 35 per cent of total note and deposit liabilities. This did not prevent further devaluations in the franc in 1936, in 1937, and again in 1938. The following year the gold reserve requirement was suspended and has not been restored (1974). Further devaluations followed, in 1940, in 1945, in 1948, and in 1958, when the gold value was reduced to .0018 grams of fine gold to the franc. The existing franc was now abandoned for a new franc equivalent to 100 of the old, thereby establishing a new franc nominally containing .18 grams fine gold, but no francs were coined and the content was again reduced on August 10,1969, to. 16 grams fine gold.3 The experience of other countries of Europe paralleled that of France. In Italy notes are issued by the Bank of Italy, under a reserve requirement of 40 per cent in gold or foreign exchange, suspended however since 1935. Only two European countries currently maintain a gold reserve requirement for the note issue —The Netherlands and Switzerland. For The Netherlands the requirement, since 1956, has been 50 per cent, but this may be in gold or foreign exchange. In Switzerland, the requirement, in effect since 1905, is 40 per cent in gold. In neither case, however, are the notes presently (1976) redeemable in gold.

The tendency everywhere has been to eliminate gold reserve requirements, either at minimum amounts or at fixed minimum ratios, and to leave the question in the hands of the monetary authorities. In the United States this was accomplished by legislation in 1965, removing the gold reserve against deposits, and in 1968, against notes. The result has been, since the reform of currencies following World War II, the appearance of stability but the actual continuance of inflation and the deepening erosion of monetary values.

198 MONEY AND MAN VI. Seed of the New Inflation THE theory behind the founding of the first great banks of modern times—the Venetian Banco della Piazza del Rialto, the Bank of Amsterdam, and the Bank of Hamburg—had been that their function should be one of strict deposit. The continental banks, with the exception indeed of the Bank of St. George, accepted from the merchants coins of all countries of repute and held them as reserve against the bills issued by the bank. The notes of these earlier banks were, as J. E. Thorold Rogers points out, "of the nature of dock warrants, entitling the holder to claim not only the sum which they expressed, but, theoretically at least, the very coins which were deposited against them."1 We have noted how scrupulously this principle was regarded at Hamburg, and at Amsterdam, at least as late as 1672. Elsewhere, as the banks were made to serve the financial requirements of their governments by means of loans of the deposits entrusted to them, this principle was gradually lost sight of, if it was ever recognized. In England, as a result of the practices developed by the goldsmiths, an opposite concept grew up. The Bank of England was founded on a totally different idea from that upon which the continental banks were established. "It purported to give in its bills the equivalent of what it had received,"

says Thorold Rogers, "but it never pretended to take the deposit for any other purpose than that of trading with it."2 Thus, the conception of responsibility to depositors for the safekeeping of deposited money as the prime and paramount duty of banks never appeared in English theory. While the idea that the deposit and discount function may have something to do with the money mechanism received some consideration in the debates on the bank reform of 1844, Andreades correctly points out, in his history of the Bank of England, that the currency doctrine developed left out of sight the operation of other instruments of credit under the control of the banker, such as bills of exchange, private promissory notes, checks, bonds, stocks, etc., which do in fact perform, though sluggishly, the functions of a circulating medium, and are equally effecTHE RISE OF BANK MONEY 199 tive, in their way, as bank notes, on prices and the movements of commodities.3 We have already examined the breakdown of the money system in 1844 as a result of the failure of the Bank of England to protect its banking reserves, but from that day to this neither the Bank of England nor the English jointstocks banks have been under any reserve requirements for banking liabilities.

In this country, banking has been frankly regarded as a system for the creation of private money rather than for the safeguarding of money already created. Miller says, in the opening of his work Banking Theories in the United States Before 1860: "The colonists saw in a bank little more than the source of a form of currency. They complained frequently of a scarcity of circulating medium, and urged the issue of paper money to supply the want. With the exception of some reference to the service rendered by banks as safe depositories for the precious metals and other valuables, virtually the whole discussion of banks turned upon the matter of securing an adequate currency."4 When the first banks were organized it was taken for granted that their chief function would be the issue of a circulating medium for the communities in which they were located, and that their real value would arise from this service. Confusion of note-issue functions with banking were widespread. In spite of the clarity with which Alexander Hamilton explained the nature of deposit credit in his report on the Bank of the United States in 1800, there was such confusion in the public mind that the Professor of Political Economy at the University of Pennsylvania could write, as late as 1838, that "the furnishing of a paper circulation was the essential feature of the banking system."5 In 1833, the New York State Bank Commissioner declared: "The legitimate use of banks is not for the purpose of loaning capital, but for the purpose of furnishing a currency to be used instead of specie."6 Daniel Webster declared, in 1839, "What is that, then, without which any institution is not a bank, and with which it is a bank? It is a power to issue promissory notes with a view to their circulation."7 200 MONEY AND MAN The general banking law of 1838 of New York, which substituted for the safety fund the requirement that banks keep a reserve of 12.5 per cent in specie against notes in circulation made no mention of reserves against deposits, and apparently the subject did not even appear in the debates. And we have already noted, in the comments of the great monetary authority of the nineteenth century, Charles Conant, written as late as 1896, his error in presuming that the mistake of the New York safety fund was in making the guarantee cover deposits as well as notes.

"It is remarkable that the similarity of notes and deposits as parallel forms of bank credit was so long unrecognized in New York," says Miss Myers, "for the banks in that city seem always to have had a larger proportion of deposit currency than of circulating notes. The Bank of New York in 1791, when it was still the only bank in the city, reported nearly 50 per cent more deposits than notes outstanding."8 In 1839 the ratio of notes to deposits of New York City banks was 41.7 per cent, in 1849, 27.1 per cent, and in 1859, 9.3 per cent. The reverse was true for the country banks of New York, where the ratio of notes to deposits was as high as 319 per cent in 1839, but by 1859, notes of country banks had dropped to only 78.3 per cent of deposits. <«§ §»> Although banking theory, as it developed in this country, never embraced the idea that the banker's responsibility in regard to deposited funds was primarily an obligation toward those depositing these funds, and a duty for keeping these funds secure, there was some recognition of the importance of deposits as an aspect of the money mechanism. Hamilton perceived the dual nature of deposits in his Report on a National Bank in 1790. After explaining that banks can put a far greater sum into circulation than they have on hand in gold and silver, he pointed out that every loan which a bank makes is, in its first shape, a book credit, and in many cases is merely transferred to different creditors, circulating as such and performing the office of money until someone, into whose possession it has come, decides to use THE RISE OF BANK MONEY 201 it in cancellation of his debt to the bank, or to call for its conversion into coin or notes.9 Gallatin wrote in 1831: "The credits in account current or 'deposits' of our banks are also, in their origin and effect, perfectly assimilated to bank notes. Any person depositing money in the bank, or having any demand whatever upon it, may at his option be paid in notes, or have the amount entered to his credit on the books of the bank.

The bank notes and the deposits rest precisely on the same basis. .... We can in no respect whatever perceive the slightest difference between the two."10 In England, Professor Miller points out, the principle does not seem to have received any consideration until 1829, when James Pennington insisted that deposits be given a coordinate importance with notes as part of the currency.11 His theories were ignored, as we have seen, in the reformation of the banking system by the Act of 1844. In this country, toward the fifties, the banking community itself began to recognize the importance of deposits as an instrument of money, and along with this awakening to the dangerous power in their hands, began to show some attention to the needs of stricter reserve standards. New York banks, which were beginning to exercise their hegemony over American finance, began about this time to carry more substantial reserves against deposits than was customary for the country as a whole.

It was not until the creation of the national banking system in 1863 and 1864, however, that banks were compelled by law to carry minimum cash reserves against deposits. The National Bank Act required banks in the larger cities (reserve city banks) to keep in their vaults at all times a reserve in lawful money equivalent to 25 per cent of aggregate note and deposit liabilities. Banks outside these reserve cities were required to maintain similar reserves of at least 15 per cent, but they were permitted to include as reserves, up to three-fifths of the requirements, their deposits in reserve city banks. In 1874, the requirement for vault reserves against notes was repealed, vault cash being held there202 MONEY AND MAN after solely as a reserve against deposits, while notes were protected by the government bonds and a 5 per cent redemption fund held by the Treasurer of the United States at Washington for the account of the bank and for the redemption of the notes.

No legal requirements for reserves against deposits in state banks existed, however, until 1892. The state of New York in that year enacted that banks in cities of more than 800,000 population (which included only New York City) must keep a vault reserve of 15 per cent of aggregate deposits, and banks in other cities, a reserve of 10 per cent. Banks might include as reserves, up to one-half the requirements, their deposits in banks or trust companies of capital of $200,000 or more approved by the state superintendent of banks. <«§ §»> The significance of this unconcern toward deposits, or the tremendous inflationary possibilities that lay in the manipulation of the deposit mechanism, becomes apparent when the tenor of the times is remarked. The Midas complex, the desire to turn everything into money, to get a higher and higher money equivalent for the production of farm and factory, to make money cheaper and easier to acquire, either by loan or exchange, had become in the second half of the nineteenth century the dominant theme in the symphony of American civilization. After the Civil War era, which marked the final defeat of agrarian economy and the submergence of American life into mercantilism and industrialism, the manna of cheap money became the universal cry, and as with the Israelites, the easier the manna was acquired, the louder became the complaint, the less willing the people to struggle for it. The deposit mechanism, in the hands of unregulated commercial banking, became the means of satisfying the demands of the commercial community for easier credit and cheaper money, while at the same time providing a harvest in profits to the banking interests that catered to the public demand.

It shall be our task, in the pages that follow, to trace the gradual expansion of the deposit mechanism until it became, in the twentieth century, the agency for the unprecedented monetary inflation of the modern age.