UNIVERSITY 
 
 OF CALIFORNIA 
 
 LOS ANGELES 
 
 SCHOOL OF LAW 
 LIBRARY 

 
 BOBERT M. PEASE 
 
 ATTORNEY AT L&W 
 
 8O8 QUINBY BUILDING 
 
 TRinity 2O87 
 LOS ANGELES, CALIF.
 
 MATERIALS FOR THE STUDY 
 OF BUSINESS
 
 Materials for the Study of Business 
 
 Readings in Industrial Society. By Leon C. Marshall. xxiv+ 1,082 
 pages, royal 8vo, cloth. 
 
 Financial Organization of Society. By H. G. Moulton. xxii+790 
 pages, crown 8vo, cloth. 
 
 Principles of Accounting. By Albert C. Hodge and J. O. McKinsey. 
 xiv-{-390 pages, 8vo, cloth. 
 
 Law and Business. By William H. Spencer. 
 
 Vol. I. Introduction to Business Law. xviii+612 pages, 
 
 8vo, cloth. 
 Vol. II. Law and the Market. Law and Finance. xviii+ 
 
 670 pages, 8vo, cloth. 
 
 Business Administration. By Leon C. Marshall, xxiv+920 pages, 
 8vo, cloth. 
 
 IN PRESS 
 
 Law and Business. By William H. Spencer. 
 
 Vol. III. Law and Labor. Law and Risk-Bearing. Law 
 and the Form of the Business Unit. 
 
 IN PREPARATION 
 
 Business Communication. The Worker in OUT Economic 
 
 Risks and Risk-Bearing. *?"*&' 
 
 1 he Manager s Administration 
 Managerial Accounting. of Labor. 
 
 Bank Management. The Social Control of Business 
 
 Commercial Cost-Accounting. 
 
 Government and Business. 
 
 The Manager s Administration -ri DL ; c- t 
 
 , _ I he Physical Environment of 
 
 of Finance. Business. 
 
 The Place of the Market in Our Traffic and Transportation. 
 
 Economic Society. The Psychology of Business Pro- 
 
 The Manager's Administration cedure. 
 
 of the Market. Readings in Business Education. 
 
 THE UNIVERSITY OF CHICAGO PRESS 
 
 CHICAGO, ILLINOIS
 
 THE FINANCIAL ORGANIZATION 
 OF SOCIETY
 
 THE UNIVERSITY OF CHICAGO PRESS 
 CHICAGO, ILLINOIS 
 
 THE BAKER & TAYLOR COMPANY 
 
 NEW YORK 
 
 THE CAMBRIDGE UNIVERSITY PRESS 
 
 LONDON 
 
 THE MARUZEN-KABUSHIKI-KAISHA 
 
 TOKYO, OSAKA, KTOTO, FUKUOKA, 8ENDAI 
 
 THE MISSION BOOK COMPANY 
 
 SHANGHAI
 
 BY 
 
 HAROLD G. MOULTON 
 
 it. 
 
 ASSOCIATE PROFESSOR OF POLITICAL ECONOMY 
 UNIVERSITY OF CHICAGO 
 
 THE UNIVERSITY OF CHICAGO PRESS 
 CHICAGO, ILLINOIS
 
 \9Z\ 
 
 COPYRIGHT 1921 BY 
 THE UNIVERSITY OP CHICAGO 
 
 All Rights Reserved 
 
 Published January 1921 
 
 Second Impression April 1921 
 
 Third Impression July 1921 
 
 Fourth Impression October 1921 
 
 Fifth Impression February 1922 
 
 Composed and Printed By 
 
 The University of Chicago Pre 
 
 Chicago. Illinois. U.S.A.
 
 EDITOR'S PREFACE 
 
 <k 
 
 Collegiate training for business administration is now so 
 widely attempted that the time has arrived when experiments 
 should be conducted looking toward the organization of the 
 business curriculum into a coherent whole. Training in 
 scattered "business subjects" was defensible enough in the 
 earlier days of collegiate business training, but such a method 
 cannot be permanent. It must yield to a more comprehensive 
 organization. 
 
 There can be no doubt that many experiments will be con- 
 ducted looking toward this goal; they are, indeed, already 
 under way. This series, "Materials for the Study of Business," 
 marks one stage in such an experiment in the School of Com- 
 merce and Administration of the University of Chicago. 
 
 It is appropriate that the hypotheses on which this experi- 
 ment is being conducted be set forth. In general terms the 
 reasoning back of the experiment runs as follows: The business 
 executive administers his business under conditions imposed 
 by his environment, both physical and social. The student 
 should accordingly have an understanding of the physical 
 environment. This justifies attention to the earth sciences. 
 He should also have an understanding of the social environment 
 and must accordingly give attention to civics, law, economics, 
 social psychology, and other branches of the social sciences. 
 His knowledge of environment should not be too abstract in 
 character. It should be given practical content, and should 
 be closely related to his knowledge of the internal problems of 
 management. This may be accomplished through a range of 
 courses dealing with business administration wherein the student 
 may become acquainted with such matters as the measuring 
 aids of control, the communicating aids of control, organization 
 policies and methods; the manager's relation to production, to 
 labor, to finance, to technology, to risk-bearing, to the market,
 
 Vlll 
 
 EDITOR'S PREFACE 
 
 BASIC ELEMENTS OF THE BUSINESS CURRICULUM 
 
 Of problems of adjustment to 
 physical environment 
 
 a) The earth sciences 
 
 b) The manager's relation- 
 ship to these 
 
 Of problems of technology 
 a) Physics through mechan- 
 ics, basic, and other 
 sciences as appropriate 
 b} The manager's adminis- 
 tration of production 
 Of problems of finance 
 
 a) The financial organization 
 
 of society 
 
 6) The manager's adminis- 
 tration of finance 
 Of problems connected with the 
 market 
 
 a) Market functions and 
 market structure 
 
 b) The manager's adminis- 
 tration of marketing (in- 
 cluding purchasing ana 
 traffic) 
 
 Of problems of risk and risk- 
 bearing 
 
 a) The risk aspects of mod- 
 ern industrial society 
 b} The manager's adminis- 
 tration of risk-bearing 
 Of problems of personnel 
 
 a) The position of the worker 
 in modern industrial so- 
 ciety 
 
 b) The manager's adminis- 
 tration of personnel 
 
 Of problems of adjustment to 
 social environment 
 
 a) The historical background 
 
 b) The socio-economic insti- 
 tutional life 
 
 c) Business law and govern- 
 ment 
 
 CONTROL 
 
 1. Communicating aids of con- 
 
 trol, for example 
 
 a) English 
 
 b) Foreign language 
 
 2. Measuring aids of control, 
 
 for example 
 
 a) Mathematics 
 
 b) Statistics and accounting 
 
 3. Standards and practices of 
 
 control 
 
 a) Psychology 
 
 b) Organization policies and 
 methods
 
 EDITOR'S PREFACE IX 
 
 to social control, etc. Business is, after all, a pecuniarily 
 organized scheme of gratifying human wants, and, properly 
 understood, falls little short of being as broad, as inclusive, as 
 life itself in its motives, aspirations, and social obligations. It 
 falls little short of being as broad as all science in its technique. 
 Training for the task of the business administrator must have 
 breadth and depth comparable with those of the task. 
 
 Stating the matter in another way, the modern business 
 administrator is essentially a solver of business problems 
 problems of business policy, of organization, and of operation. 
 These problems, great in number and broad in scope, divide 
 themselves into certain type groups, and in each type group 
 there are certain classes of obstacles to be overcome, as well as 
 certain aids, or materials of solution. 
 
 If these problems are arranged (i) to show the significance 
 of the organizing and administrative, or control, activities of 
 the modern responsible manager, and (2) to indicate appropriate 
 fields of training, the diagram on the opposite page (which 
 disregards much over-lapping and interacting) results. It 
 sets forth the present hypothesis of the School of Commerce 
 and Administration concerning the basic elements of the 
 business curriculum covering both secondary school and col- 
 legiate work. 
 
 The present volume in the series is designed to give the 
 student an understanding of the financial institutions which 
 the manager utilizes and which largely condition his financial 
 policies. It presents one phase of his social environment. 
 
 L. C. MARSHALL
 
 AUTHOR'S PREFACE 
 
 Increasing interest in the systematic study of financial 
 problems is everywhere manifest since the war. Not only are 
 the classes in finance in our colleges, universities, and schools of 
 commerce literally flooded with students; the high schools are 
 also seeking to incorporate the subject in their rapidly developing 
 commercial curricula; Y.M.C.A. and institute study courses in 
 finance are being formed throughout the country; and, more 
 significant still, many business houses, recognizing the depend- 
 ence of successful business management upon a thorough knowl- 
 edge of financial principles, are now organizing special courses 
 for their employees and officials. Even the business manager 
 who has already "arrived" is reading and studying financial 
 literature as never before. The present volume is designed to 
 serve as the basis of a general survey course in finance and to 
 enable the general reader to obtain a clear understanding of 
 the nature of the modern financial system, and of the economic 
 functions performed by each of the numerous financial institu- 
 tions investment banks, stock exchanges, commercial banks, 
 trust companies, savings institutions, commercial paper houses, 
 discount companies, Federal Reserve and Federal Farm Loan 
 institutions, etc. which together comprise this system. 
 
 Perhaps the most striking feature of the modern economic 
 organization is the dependence of practically all business 
 enterprise upon borrowed funds that is, upon credit. As 
 the charts on pages 134, 136, and 650 indicate, the funds used 
 by business concerns whether organized on an individual, 
 a partnership, or a corporate basis must largely be borrowed 
 from the rank and file of individuals, who purchase securities 
 or make deposits in savings or commercial banking institutions. 
 Now the modern financial structure has evolved to meet the 
 needs of this credit system the origin and development of all 
 the financial institutions of the present time being largely
 
 Xll 
 
 AUTHOR'S PREFACE 
 
 (Survey Course) 
 
 Financial Organization 
 
 of Society 
 
 attributable to the necessity of raising fixed and working 
 capital for the uses of modern capitalistic enterprise. 
 
 The teacher will wish to know precisely where a course 
 organized on the basis of this volume would fit into the economics 
 or school of commerce curriculum, and wherein it differs from 
 the traditional course in money and banking. The answer to 
 the first question may best be given by means of a diagram: 
 
 (Advanced Specialized Courses) 
 
 Money, Prices and the Cost 
 
 of Living 
 
 Advanced Banking Theory 
 International Financial Prob- 
 lems 
 
 Business Cycles 
 Commercial Bank Manage- 
 ment 
 
 Investment Bank Manage- 
 ment 
 
 Business Finance 
 Investment and Speculation 
 Law of Bills and Notes 
 Banking Law 
 
 The survey course in Financial Organization is designed as a 
 one quarter, or semester, course, and is a prerequisite to each 
 of the advanced specialized courses in the field. Following this 
 series of advanced or graduate courses would come research 
 or seminar courses in each of the various special fields of inquiry. 
 The primary purpose of a survey course in financial organi- 
 zation as a prerequisite to more advanced study is of course to 
 give the student a view of the entire financial system before 
 undertaking a highly critical study of any single part of it; 
 each financial institution can obviously be fully understood 
 and critically appraised only when it is envisaged as a part of a 
 larger financial structure. All teachers will doubtless concur 
 with this doctrine and all, I fancy, will agree that for one 
 reason or another it has seldom been practiced, largely because 
 of historical accident. All of our so-called "applied" economics
 
 AUTHOR'S PREFACE xiii 
 
 courses have been developed, one at a time, either to meet the 
 need for an elaboration of the theoretical material outlined in 
 the general introductory course in economics, or the demand 
 for more practical instruction as a training for business. Accord- 
 ingly, we have witnessed in the financial field the development 
 of a whole series of specialized courses: money; banking 
 (or money and banking) meaning by banking, as a rule, only 
 commercial banking; investments; corporation finance; specu- 
 lation; foreign exchange; bank management, etc. It was 
 inevitable that there should be much duplication of material in 
 these specialized courses; and at the same time the want of a 
 common background of training on the part of the students 
 in any one course necessarily militated against a highly critical 
 analysis. The present treatise constitutes an attempt to bring 
 together within a single volume, and in a single course, the 
 material that is necessary as a background to advanced study 
 in any of the special fields of financial inquiry suggested in 
 the outline of courses above. It is believed that much economy 
 of teaching effort may thus be achieved and that at the same time 
 the advanced courses may be lifted to a substantially higher 
 plane than obtains in most institutions at present. The 
 treatise therefore differs from the traditional volume in money 
 and banking, in that it is more inclusive in scope. 
 
 The attempt to organize a general survey course in the 
 field of finance has, however, not only resulted in combining 
 in a single volume certain material that is common to all 
 financial courses; it has also, inevitably, led to a substantial 
 shift in emphasis and in the point of view from which the 
 material is presented. As is indicated above, and as is more 
 clearly revealed in the charts to which reference has been made, 
 the numerous financial institutions which make up the modern 
 financial system are united in a common task of furnishing 
 fixed and working capital for business enterprises, the various 
 types of institutions being very closely interrelated as parts of a 
 general financial structure. I may frankly say that I did not 
 fully appreciate this fact until I undertook to describe the 
 practical operations of each of the numerous types of financial
 
 xiv AUTHOR'S PREFACE 
 
 institutions that exist today, and to point out the economic 
 significance of each. The very attempt to explain the economic 
 function of each financial institution inevitably carried one into 
 a discussion of its relation to other financial institutions, and 
 thus to a consideration of the relation of the financial system in 
 general to the economic system in general. A more complete 
 statement of the relationship here suggested, as well as an 
 explanation of the use of the term Financial Organization of 
 Society, will be found in the introductory chapter. 
 
 Another reason for making the introductory course in 
 finance a general survey rather than a discussion merely of 
 money and of commercial banking is found in the fact that 
 almost every financial institution hi the United States now 
 conducts under a single roof and under the direction of a single 
 management, nearly every variety of financial operation. As is 
 indicated in the chapter on "Financial Integration," the 
 department-store financial institution has become the prevailing 
 type. In consequence, it is difficult to justify a survey course 
 designed to acquaint the student with the principles of finance, 
 which selects for discussion only a single function performed 
 by any banking organization such as commercial banking to 
 the exclusion of all the others. This is particularly the case 
 if the needs of the business student be held in mind. The 
 modern business has its setting in the midst of a financial 
 system upon which it is at all times dependent in many ways; 
 and the business man needs to know not merely the relation 
 of his business to the commercial banking department of, 
 say, the First National Bank of New York, but to all of the 
 other departments of that bank as well. Moreover, because 
 of the close interrelations that exist between the departments 
 of an integrated financial institution, the student of banking 
 organization and theory will gain a very inadequate view of 
 modern finance if he studies the commercial banking department 
 as though it were an isolated institution. 
 
 In colleges where but a single course can be devoted to 
 the study of finance, it would seem that a course which pre- 
 sents a general view of the system as a whole, would prove both
 
 AUTHOR'S PREFACE XV 
 
 of more practical and of more cultural value to the student 
 than one which considers merely certain special features of 
 the financial system. 
 
 The author anticipates no little criticism for having failed to 
 include in a volume on finance a thorough discussion of so 
 important and vital a subject as the relation of money and 
 credit to prices. A word of explanation is therefore hi point. 
 In chapter ii there is presented a very brief statement of the 
 relation of money and prices. The emphasis is, however, not 
 placed upon the causes of price changes; it is merely pointed 
 out that the values of goods are expressed in terms of money 
 and that these money prices fluctuate widely and more or less 
 continuously. Now the reason for not entering into a dis- 
 cussion of the causes of price changes at that place is merely 
 that the price question cannot be intelligently discussed until 
 an analysis of the commercial banking system has been made; 
 and by the time the analysis of the commercial banking system, 
 including its relation to other financial institutions and to the 
 general business organization as conditioned by the phenomena 
 of the business cycle, was completed, limitations of space did 
 not well permit an adequate discussion of this most vital aspect 
 of the modern financial system. The controversial issues with 
 reference to the relation of money to prices are therefore 
 necessarily left for consideration in advanced courses. It is 
 believed that enough data bearing on the price question are 
 presented in the treatise for the purposes in hand. If, in the 
 view of any teacher, such is not the case, the text material 
 may be readily supplemented by lectures and by collateral 
 reading. 
 
 In the preparation of the volume I am indebted to Mr. 
 Walter Buckingham Smith, of the Department of Political 
 Economy of the University of Chicago, for assistance in con- 
 struction of the various charts; and to Messrs. Hardy, Keister, 
 Marshall, Meech, Thompson, Smith, and Viner, of the same 
 department, for many helpful criticisms, as well as for assistance 
 in reading the manuscript. I am also indebted to Professor 
 E. G. Nourse, of Iowa State College, for criticisms of the
 
 xvi AUTHOR'S PREFACE 
 
 chapter on Agricultural Credit. But most of all I think I am 
 indebted to the generations of suffering students who have 
 patiently submitted to experimentation as the volume has 
 slowly evolved through mimeograph, preprint, and preliminary 
 editions to its present form. 
 
 H. G. M. 
 
 CHICAGO, ILLINOIS 
 
 December 25, 1920
 
 TABLE OF CONTENTS 
 
 PAGE 
 
 CHAPTER I. INTRODUCTION 
 
 CHAPTER II. THE NATURE AND FUNCTIONS OF A PECUNIARY 
 UNIT 
 
 I. Definition and Origin of the Pecuniary Unit ... 4 
 II. The Pecuniary Unit and Business Administration . 6 
 
 III. The Pecuniary Unit and the Apportionment of Family 
 Expenditures n 
 
 IV. The Pecuniary Unit and Economic Organization . 13 
 
 CHAPTER III. THE STANDARD FOR DEFERRED PAYMENTS 
 
 I. Why Gold Is Used as the Standard 19 
 
 II. Relation of Money and Prices 21 
 
 III. Economic Consequences of Price Changes ... 23 
 
 IV. Price Changes and Social Maladjustments ... 30 
 
 CHAPTER IV. OTHER FUNCTIONS AND SERVICES OF MONEY 
 
 I. Money as a Medium of Exchange 41 
 
 II. Money as a Store of Value 42 
 
 III. The Use of Money in Production 43 
 
 IV. The Role of Money in War Finance 45 
 
 V. The Role of Money in Peace Finance 48 
 
 CHAPTER V. THE PECUNIARY SYSTEM AND ECONOMIC AND 
 SOCIAL STANDARDS 
 
 I. Monetary Evaluation and Social Ideals .... 54 
 
 II. The Confusion of Money with Wealth .... 56 
 
 III. The Quantity of Money Required by a Nation . . 60 
 
 CHAPTER VI. THE REGULATION OF METALLIC CURRENCY 
 
 I. The Necessity of Government Coinage .... 65 
 
 II. Economic and Social Effects of a Bad Coinage System 67 
 
 III. Coinage Rules and Regulations of the United States . 69 
 
 IV. Gresham's Law and Bimetallism 73 
 
 V. Why Gold Became the Single Standard .... 79 
 
 VI. Production of Gold and Silver in the World Since the 
 Discovery of America 82 
 
 xvii
 
 xviii CONTENTS 
 
 PAGE 
 
 VII. Commercial Ratio of Gold and Silver Since 1687 . 83 
 
 VIII. The Regulation of Subsidiary Metallic Currency . 84 
 
 DC. Legal Tender Provisions for Metallic Currency . . 85 
 
 CHAPTER VII. THE REGULATION OF GOVERNMENT PAPER 
 CURRENCY 
 
 I. Irredeemable Paper or Fiat Currency 92 
 
 II. Arguments for and against Fiat Paper Currency . 96 
 
 III. Methods of Regulating Paper Currency .... 98 
 
 IV. Forms of Government Paper Currency in the 
 United States 100 
 
 V. Redemption of United States Paper Currency . . 102 
 VI. Legal Tender Provisions of United States Paper 
 
 Currency 102 
 
 VII. Estimated General Stock of Money in the United 
 
 States, February i, 1920 103 
 
 CHAPTER VIII. THE FOREIGN EXCHANGES 
 
 I. The Nature of the Problem 107 
 
 II. The Exchange Mechanism 109 
 
 III. The Maintenance of Equilibrium 114 
 
 IV. Domestic Exchanges . . .115 
 
 V. Foreign Exchange during the War 116 
 
 VI. The Post-War Depreciation of the European Ex- 
 changes 117 
 
 CHAPTER LX. THE NATURE AND FUNCTIONS OF CREDIT 
 
 I. The Nature of Credit 121 
 
 n. The Various Kinds of Credit 122 
 
 in. Investment, Commercial, and Consumptive Credit . 124 
 
 IV. The Basis of Credit 125 
 
 V. The Significance of Credit 127 
 
 CHAPTER X. THE MODERN FINANCIAL STRUCTURE 
 
 I. Institutions Utilized in Financing Non-Corporate 
 
 Enterprise 134 
 
 II. Institutions Utilized in Financing Corporate Enter- 
 prise 136 
 
 CHAPTER XI. THE CORPORATION AS A DEVICE FOR RAISING 
 CAPITAL 
 
 I. Advantages of the Corporation in Raising Capital . 140 
 II. Stages of Corporate Development 143
 
 CONTENTS xix 
 
 PAGE 
 
 CHAPTER XII. CREDIT INSTRUMENTS 
 
 I. Investment Credit Instruments 151 
 
 II. Commercial Credit Instruments 162 
 
 III. The Use of Credit Instruments in Transferring Wealth 170 
 
 CHAPTER XIII. THE MARKETING OF LOW-GRADE SECURITIES 
 
 I. The Promotion of Fraudulent and Worthless Securities 186 
 II. The Sale of Highly Speculative Securities . . .191 
 
 III. Blue Sky Legislation 197 
 
 IV. Suggested Control over the Formation of Corporations 205 
 
 CHAPTER XIV. THE MARKETING OF HIGH-GRADE SECURITIES 
 
 I. History of Investment Banking 212 
 
 II. Modern Investment Banking Development . . . 214 
 
 III. Functions of Investment Banking Institutions . .217 
 
 IV. Investigation and Analysis 218 
 
 V. The Underwriting Function 228 
 
 VI. The Distribution Function 234 
 
 VII. Sundry Services of Investment Bankers .... 240 
 VIII. Capital Requirements and Profits of Investment 
 
 Banks 243 
 
 IX. The Regulation of Investment Banking .... 245 
 X. Investment Banks and the General Economic Organi- 
 zation 247 
 
 CHAPTER XV. FOREIGN INVESTMENT TRUSTS 
 
 I. British Investment Trusts 257 
 
 II. The Shift in America's Financial Position . . . 260 
 
 III. American Investment Trusts 263 
 
 IV. Future of American Foreign Investments .... 269 
 
 CHAPTER XVI. THE STOCK EXCHANGE AND CAPITAL RAISING 
 
 I. History of Stock Exchanges 279 
 
 II. The Organization of Exchanges 281 
 
 III. The Brokerage Business 285 
 
 IV. Economic Functions of the Stock Exchange .... . 293 
 
 CHAPTER XVII. TRUST COMPANIES AND THE MODERN FINAN- 
 CIAL SYSTEM 
 
 I. The Scope of Trust Company Operations . . . 302 
 
 II. Services Rendered to Individuals 304 
 
 III. Services Performed for Estates 305
 
 XX CONTENTS 
 
 PACK 
 
 IV. Trust Companies and Corporation Finance . . . 306 
 
 V. The Trust Company as Custodian of Securities . .316 
 
 VI. The Regulation of Trust Companies 322 
 
 CHAPTER XVIII. THE FUNCTIONS OF SAVINGS INSTITUTIONS 
 
 I. Stock Savings Banks 327 
 
 II. Mutual Savings Banks 332 
 
 III. Savings Departments in Commercial Banks . . . 334 
 
 IV. Postal Savings Banks 335 
 
 V. The Management of Savings Institutions .... 339 
 
 VI. The Profits of Savings Banks . 343 
 
 VII. Insurance Companies as Savings Institutions . . 344 
 VIII. The Economic Significance of Savings Institutions . 348 
 
 CHAPTER XIX. THE PRACTICAL OPERATIONS OF THE COM- 
 MERCIAL BANK 
 
 I. Classification of Commercial Banks 358 
 
 II. Incidental Services of Commercial Banks . . . .361 
 HI. Analysis of Commercial Banking Operations . . . 363 
 IV. Analysis of Commercial Bank Loans 374 
 
 CHAPTER XX. COMMERCIAL BANKING AND THE FINANCING OF 
 FOREIGN TRADE 
 
 I. Financing Import Trade 410 
 
 n. Financing Export Trade 418 
 
 III. The Edge Law and the Financing of Foreign Trade 422 
 
 IV. Conclusion 423 
 
 CHAPTER XXI. COMMERCIAL PAPER HOUSES AND DISCOUNT 
 COMPANIES 
 
 A. Commercial Paper Houses 427 
 
 I. Practical Operations 428 
 
 n. The Economic Significance of Commercial Paper 
 
 Houses 435 
 
 B. Discount Companies 437 
 
 I. Purchasing Accounts Receivable 438 
 
 II. The Financing of Automobile Distribution . . . 443 
 
 CHAPTER XXII. THE COMMERCIAL BANKING SYSTEM 
 
 I. Clearing-House Associations . 457 
 
 II. Relations between Banks in Different Cities . . . 470 
 III. Loans, Deposits, and Reserves 475
 
 CONTENTS xxi 
 
 PACT 
 
 IV. Commercial Banking and the Supply of Liquid 
 
 Capital or Currency 483 
 
 V. Commercial Banking and the General Economic 
 Organization 486 
 
 CHAPTER XXIII. COMMERCIAL BANKING AND THE EBB AND 
 FLOW OF BUSINESS 
 
 I. Seasonal Variations in the Demand for Funds . . 495 
 
 II. Cyclical Variations in the Demand for Funds . . 505 
 
 III. Commercial Banking and Business Cycles . . . 519 
 
 CHAPTER XXIV. GOVERNMENT REGULATION OF BANKING 
 
 I. Summary of American Banking History .... 547 
 
 II. Principles of Governmental Regulation .... 550 
 
 III. The Regulation of State Banking 559 
 
 IV. The Regulation of Bank Notes 562 
 
 CHAPTER XXV. THE FEDERAL RESERVE SYSTEM 
 
 I. The History of Banking Reform 566 
 
 II. Administrative Framework of the System . . . 574 
 
 III. Provision of an Elastic Bank-Note Currency . . . 577 
 
 IV. The Control of Credit 589 
 
 V. The Creation of a "Discount Market" . . . . 600 
 
 VI. Clearings and Collections 608 
 
 VII. Relation of the Treasury to the Federal Reserve 
 
 System 614 
 
 VIII. Federal Reserve Bank Statements 616 
 
 CHAPTER XXVI. THE WAR AND THE FEDERAL RESERVE 
 SYSTEM 
 
 I. fiect of War Finance upon Bank Reserves . . .627 
 n. The Movement of Reserves after the War . . .632 
 III. The Attempt to Control Credit and Business Expan- 
 sion 634 
 
 CHAPTER XXVII. RAISING CAPITAL FOR AGRICULTURE 
 
 A. Working Capital 653 
 
 I. Trade Credit 654 
 
 II. Commercial Bank Loans for Agriculture . . . 656 
 III. The Work of the Cattle Loan Company . . .659 
 
 B. Fixed Capital 665 
 
 I. The Nature and Extent of the Farm Mortgage 
 Business 665
 
 Xxil CONTENTS 
 
 PAGE 
 
 II. Institutions Utilized in Marketing Farm Mortgages 667 
 
 III. The Federal Farm Loan System 672 
 
 IV. Significant Results of the Federal Farm Loan 
 System 686 
 
 V. Criticisms of the Federal Farm Loan System . . 688 
 
 CHAPTER XXVIII. CONSUMPTIVE CREDIT INSTITUTIONS 
 
 I. The Business of Pawnbroking 699 
 
 II. The Loan Sharks 703 
 
 III. The Morris Plan Bank 708 
 
 IV. Co-operative Credit Unions ....... 708 
 
 V. Building and Loan Associations 714 
 
 CHAPTER XXIX. FINANCIAL INTEGRATION 
 
 I. Causes of the Growth of Financial Integration . .725 
 
 n. Possible Dangers of Department-Store Banking . . 732 
 
 EQ. The Unification of the Banking System .... 733 
 
 CHAPTER XXX. THE FINANCIAL SYSTEM AND THE GENERAL 
 ECONOMIC ORGANIZATION 
 
 I. Merits and Defects of the Pecuniary Mechanism . 743 
 II. The Role of Finance in Modern Economic Organiza- 
 tion 748 
 
 III. The Dominant Position of the Financier . . . .750 
 
 IV. International Aspects of Financial Organization . .754 
 
 V. The Concentration of Financial Power . . . .756 
 VI. Financial Power and the Control of Undeveloped 
 
 Regions 772
 
 LIST OF ILLUSTRATIONS 
 
 PAGE 
 
 CHART: LEVEL OF PRICES FROM 1840 TO 1920 .... 31 
 CHART: I. INSTITUTIONS UTILIZED IN FINANCING NON- 
 CORPORATE ENTERPRISE 134 
 
 CHART: II. INSTITUTIONS UTILIZED IN FINANCING CORPORATE 
 
 ENTERPRISE 136 
 
 CHART: THE INVESTMENT BANKING STRUCTURE . . . .218 
 
 CHART: DETERMINATION OF BOND VALUES 222 
 
 CHART: THE GOLD HOLDINGS OF THE LEADING NATIONS . .271 
 CHART: GROWTH AND IMPORTANCE OF COMMERCIAL BANKS AND 
 
 TRUST COMPANIES 359-360 
 
 CHART: MONEY RATES IN NEW YORK CITY . . . . . 393 
 CHART: PRINCIPAL ITEMS IN NATIONAL BANK STATEMENTS 479 
 CHART: RESERVES AND RATIOS OF RESERVES TO DEPOSITS OF 
 
 NEW YORK CITY CLEARING-HOUSE BANKS, 1890-1908 498 
 CHART: SEASONAL VARIATIONS OF VARIOUS KINDS OF MONEY 
 
 AND OF DEPOSITS IN THE UNITED STATES, 1890-1908 . 499 
 CHART: WORLD MOVEMENT OF PRICES, 1914-1920 . . . 626 
 CHART: INSTITUTIONS UTILIZED IN AGRICULTURAL BORROWING 650 
 
 MAP: FEDERAL RESERVE DISTRICTS 573 
 
 MAP: THE FEDERAL FARM LOAN DISTRICTS 676 
 
 FIRST MORTGAGE BOND 158-59 
 
 SHARE OF CUMULATIVE PREFERRED STOCK 160-61 
 
 PROMISSORY NOTE '. . 163 
 
 TRADE ACCEPTANCE 165 
 
 BANK ACCEPTANCE 166 
 
 BANKERS' BILL OF EXCHANGE ON LONDON 167 
 
 CASHIER'S CHECK 167 
 
 PERSONAL BANK CHECK 167 
 
 BORROWER'S STATEMENT CORPORATION 381 
 
 COLLATERAL NOTE AND AGREEMENT 387 
 
 BILL OF LADING 398 
 
 WAREHOUSE RECEIPT 400 
 
 TRUST RECEIPT 415 
 
 LETTER OF CREDIT AGREEMENT 416 
 
 IMPORT LETTER OF CREDIT 417 
 
 CHATTEL MORTGAGE 445 
 
 CONDITIONAL SALE AGREEMENT 447 
 
 LEASE AGREEMENT 45 2 
 
 rriii
 
 CHAPTER I 
 
 INTRODUCTION 
 
 The term "financial organization of society" is intended to 
 indicate the dependency of modern industrial society upon finan- 
 cial institutions. It is hardly too much to say that the entire 
 process of wealth production and distribution is organized on the 
 basis of a monetary unit of calculation, called in the United 
 States the "dollar," and worked out through the use of financial 
 instruments and agencies. The assembling of land, labor, and 
 capital, and their organization into a productive business, is 
 accomplished through the use of money and credit; the market- 
 ing of the products of such industry is carried out through 
 financial means; and the division of the rewards of the enter- 
 prise in the form of rent, wages, interest, and profits is effected 
 in financial terms and by financial instruments. 
 
 In a broader way, the distribution of our social energy 
 among the various forms of productive activities in the world 
 of industry is determined by financial considerations which 
 manifest themselves through the mechanism of prices and 
 profits. And the flow of labor and capital over the earth, from 
 country to country and from region to region, is largely guided 
 and controlled by considerations which find their expression in 
 financial terms. 
 
 Stated in specific terms, the financial organization of society 
 involves a study of the part that money, in its various roles, 
 plays in the organization of industrial activities; of the regu- 
 lation of the monetary unit and of the various forms of sub- 
 sidiary currency; and of the relationship of the pecuniary 
 system to the pressing problems of social well-being. Since 
 modern industry is largely conducted on the basis of borrowed 
 funds, the entire credit mechanism is involved. This treatise 
 therefore includes an analysis of the process of raising funds
 
 2 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 for fixed capital, i.e., plant and equipment, and for working, 
 or operating, capital, through the use of investment and com- 
 mercial credit instruments in the form of stock and bonds, and 
 bills of exchange and promissory notes, respectively, and the 
 problems associated therewith. The corporation, as the pre- 
 vailing form of business organization, is considered in its aspect 
 as a financial institution, designed to facilitate the raising of 
 capital; and much of the discussion is devoted to an analysis 
 of the services rendered by the numerous types of financial 
 institutions that have been developed in connection with the 
 marketing of corporate securities underwriting syndicates, 
 distributing bond houses, savings banks, insurance companies, 
 commercial banks, brokerage concerns, the stock exchange, etc. 
 The treatise also naturally includes a study of the financing of 
 agricultural business and the market mechanism that this 
 has required; as also private borrowing for non-business pur- 
 poses and the organization of co-operative loan associations. 
 
 Of predominant importance in the entire financial mechan- 
 ism is the commercial banking system. This is discussed in 
 relation to the furnishing of funds for fixed capital, both by the 
 outright purchase of securities and by advances of funds to 
 investment bankers and to stock exchange "margin" operators, 
 as well as in relation to the furnishing of working capital to pro- 
 ducing, manufacturing, and mercantile establishments. The 
 regulation of commercial banking, the weaknesses that developed 
 in practice under the national banking system, particularly in 
 connection with the ebb and flow of business activities at differ- 
 ent seasons of the year and at different periods of the business 
 cycle, are set forth as a background for a study of the Federal 
 Reserve System and the machinery that has been devised 
 thereunder for the more efficient adjustment of finance to the 
 varying requirements of business. 
 
 If the reader will turn to the charts on pages 134, 136 and 
 650, he will be afforded a general view of the various financial 
 institutions which enable the business operators of the modern 
 industrial system to raise the funds required for the conduct of 
 partnership, corporate, and agricultural industry, respectively.
 
 INTRODUCTION 3 
 
 A study of the financial organization of society should 
 clearly reveal the economic functions performed by the various 
 types of financial agencies that have been developed. And it 
 should inquire whether these agencies on the whole promote 
 an efficient and well-balanced national life. It should disclose 
 such weaknesses as have developed from time to time in the 
 financial mechanism and indicate how and to what extent these 
 have been eliminated through private and government regula- 
 tion. It should also be the purpose to ascertain what defects 
 in the financial organization of society still persist and, where 
 possible, to point the way to their elimination. 
 
 It is apparent that, thus conceived, a study of the financial 
 organization of society is of very broad scope. The many types 
 of financial institutions and instrumentalities which function in 
 the modern industrial system are, moreover, not to be regarded 
 merely as isolated economic agencies. They constitute an 
 intricate financial structure that is closely interwoven with the 
 entire economic organization by means of which the wants of 
 the world are supplied.
 
 CHAPTER H 
 
 The complex social and industrial system of the present day 
 is commonly said to be organized on the basis of a pecuniary 
 unit of calculation called, according to the country, the dollar, 
 pound sterling, franc, mark, ruble, etc. In this chapter it 
 is our purpose to consider the precise nature of the monetary 
 unit and to disclose the various ways in which it is of service 
 to society. It will help to avert misunderstanding on the part 
 of the reader if it is stated at the outset that the function of a 
 pecuniary unit of calculation is quite different from that of a 
 medium of exchange, discussion of which is reserved for the 
 fourth chapter. 
 
 I. DEFINITION AND ORIGIN OF THE 
 PECUNIARY UNIT 
 
 The significance of the monetary unit may best be appre- 
 ciated if it is thought of as a certain definite weight and fineness 
 of metal. For instance, the unit in the United States (the gold 
 dollar) is composed of 25 .8 grains of metal, of which nine-tenths 
 is gold and one- tenth copper alloy. How this particular amount 
 of metal came to be chosen as the unit need not be considered 
 here. It is sufficient for our present purposes to know that Con- 
 gress is not much more likely to change the weight and fineness 
 of the dollar than to change other units of measurement, such as 
 the pound, foot, gallon, etc. It may also be noted in passing 
 that this monetary unit does not necessarily circulate in the 
 form of currency; indeed, it need not be coined at all. The 
 American gold dollar, for example, is not coined because it 
 would be too small for convenience in the channels of circulation. 
 
 The pecuniary unit is a sort of language device. To under- 
 stand the functions of this pecuniary, or calculating, unit, it will
 
 NATURE AND FUNCTIONS OF A PECUNIARY UNIT 5 
 
 be well to regard it as a sort of language device, a final step, as 
 it were, in the development of means of communicating ideas. 
 Because of restricted vocabulary primitive man found great 
 difficulty in exchanging ideas with his fellows, with a result that 
 both intellectual and material progress were seriously retarded. 
 Trading operations were early impeded, moreover, not only 
 because of inadequate word symbols for the communication of 
 ideas, but also because of the lack of numerical, symbols for 
 reckoning quantities. It was necessary for a system of notation 
 to be developed before trading could be conducted on any con- 
 siderable scale; for it is apparent that without a means of 
 quantitative measurement of the goods to be purchased or sold, 
 the risk involved in trading operations would be so great as to 
 prevent all except the simplest transactions. 
 
 But the development of a system of notation was not suffi- 
 cient of itself to lay the basis for extensive trading operations. 
 A still further step in the development of the language of 
 trade and business was necessary, namely, that of expressing 
 a variety of quantitative units in terms of some qualitative, or 
 value, unit. It is very difficult to trade yards of cloth for tons of 
 coal, or bushels of wheat for skins of animals, without some 
 means of reckoning the relative values of physical quantities of 
 unlike goods. 
 
 It is probable that the use of money as a pecuniary unit, in 
 terms of which the values of unlike quantities are measured, 
 developed earlier than its use as a medium of exchange. The 
 word "pecuniary" comes from the Latin word for money, 
 pecunia, and it is generally allowed that pecunia is derived from 
 pecus, meaning cattle. Now cattle were probably not used as 
 media of exchange; one would suppose, rather, that since their 
 approximate value was a matter of common knowledge during 
 the pastoral stage of economic development, cattle served merely 
 as a means of measuring values. 1 Among barbaric tribes 
 
 1 "But now Zeus, son of Kronos, took from Glaucus his wits, in that he 
 made exchange with Diomedes, Tydeus' son, of golden armor for bronze, 
 the price of fivescore oxen for the price of nine." Iliad, Book vi, 118, 
 Lang, Leaf and Meyers' translation.
 
 6 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 wealth has often been expressed in terms of shells, precious 
 stones, skins, or whatever commodity was most widely known. 
 Wherever they were found in sufficient quantity the precious 
 metals, gold and silver, naturally came to be used for the same 
 purpose. But gold and silver, shells, etc., unlike cattle, were 
 also serviceable as media for effecting actual exchanges of goods. 
 It would seem that the use of money as a medium of exchange 
 was necessarily of later development than its use as a common 
 denominator of values; for it is difficult to conceive of an 
 exchange of goods for money where there had not already been a 
 pre-existing evaluation of the goods hi terms of a pecuniary unit. 
 In any event, the development of a pecuniary unit gave the 
 necessary commensurability to pounds, quarts, and bushels 
 and to wheat, cattle, and cloth and was thus one of the most 
 significant developments in history. It was the final vital 
 step hi the evolution of means of communicating ideas. It made 
 language and numbers intelligible for the purposes of business. 
 
 H. THE PECUNIARY UNIT AND BUSINESS 
 ADMINISTRATION 
 
 We have been saying that without a unit for measuring 
 values exchange operations are very difficult and involve large 
 risks. We shall now see that a pecuniary unit is of the greatest 
 importance from the standpoint of efficient production. Let us 
 take a simple case and endeavor to ascertain the difficulties 
 that would arise in the conduct of a business in the absence of a 
 pecuniary unit such as the dollar. 
 
 Mr. X is a manufacturer. He finds that he has 10,000 yards 
 of finished cloth on hand, 12,000 pounds of raw cotton in his 
 warehouse, and 5,000 yards of cloth in process of manufacture. 
 He has supplies in his shop, consisting of so many gallons of oil, 
 rolls of packing, etc. He has a building that is 100 feet long 
 and 60 feet wide, with two stories, each 14 feet high. The 
 building is made of reinforced concrete material. His power 
 and heating plant is five years of age, with five years of wear 
 remaining. He owns two delivery wagons and four horses, all 
 somewhat the worse for wear and tear. He manufactures
 
 NATURE AND FUNCTIONS OF A PECUNIARY UNIT 7 
 
 50,000 yards of cloth per year, of which 30,000 yards are of grade 
 A, 10,000 yards of grade B, and 10,000 yards of grade C. With- 
 out a means of measuring all these units in terms of a common 
 denominator of value, it is apparent that it would be impossible 
 for Mr. X to ascertain from his books whether his business is 
 successful or unsuccessful. It is also obvious that the chances of 
 failure would be very great. 
 
 The choice of a business is determined by analysis of pecuniary 
 accounts. Let us now inquire how Mr. X came to choose this 
 particular line of business. Having capital at his disposal, he 
 naturally would wish to employ it in that line of industry which 
 would yield him the largest income. Let us assume that at the 
 period when Mr. X must decide where to invest, the typical 
 establishment is receiving a return of 5 per cent on the capital 
 invested in line A; 10 per cent in line B; 15 per cent in line C; 
 and 20 per cent in line D. If other things were equal, Mr. X 
 would as a matter of course choose line D. But other things 
 are not usually exactly equal. There may be more risk involved 
 in line D, and hence a greater chance of failure in the event of 
 untoward developments. It may well be, however, that the 
 risks in line D are not proportionately greater in line A and 
 line B. The demand for the produce of line A may have been 
 declining, or perhaps D is at present enjoying an extraordinary 
 demand. In either event, a larger margin of profit can for the 
 time be secured in line D than in line A. Since Mr. X is looking 
 for employment of his funds in the most profitable branch of 
 industry, he will therefore be likely to choose line D, providing 
 of course there are no personal reasons which might prevent his 
 success in that line. 
 
 The question now arises, how can the business man ascertain 
 the rate of profits in different industries ? In brief, by a study 
 of the general market conditions in the different industries and of 
 the financial returns actually received by existing plants in the 
 various lines of industry. The quotations of securities on the 
 stock exchange serve, as we shall later see, as a fairly reliable 
 index to the relative profits of different industries. In case, 
 however, one is thinking of venturing as a pioneer into a new
 
 8 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 line of industry, he can of course rely only upon a study of 
 general market conditions. But in any case the estimated 
 relative costs of production in this and other lines will serve as 
 an important index to the probabilities of success. 
 
 It should be noted at this point that the decision of the 
 business man is more or less controlled by financiers who advance 
 the funds required to finance the industry. The typical business 
 is nowadays organized on a corporate basis, and the fixed 
 capital is largely raised by the sale of bonds and stock through 
 the intermediation of investment bankers, whose support is 
 necessary to the success of the enterprise. Investors also study, 
 with the aid of pecuniary accounts, the prospective value of the 
 securities, and since investors hold the purse strings, they 
 have the power to veto the judgment of both the financiers and 
 the corporate managers. 1 
 
 After the fixed capital has been raised and the plant con- 
 structed and equipped, it is usually necessary to borrow some of 
 the working capital required to operate the business. Financial 
 aid must now be sought from commercial banks; and the com- 
 mercial banker thus in turn passes judgment on the feasibility 
 of the enterprise. And once more the financial standing of 
 the business, as shown by accounts that are expressed in 
 pecuniary terms, affords the criterion for reliable judgment. 
 
 Managerial decisions are rendered on the basis of pecuniary 
 data. In connection with the construction of the plant, there 
 are numerous decisions which must be rendered. In the build- 
 ing of the manufacturing establishment there is, for instance, a 
 question of the types of materials to be used in the construction. 
 Shall it be of wood, of steel, or of concrete ? The cost of each, 
 the varying rates of fire insurance with the respective types of 
 materials, the relative durability for the purposes in hand of the 
 different materials, all must be taken into consideration. And 
 in every case the decision revolves around the question of 
 costs, computed in terms of dollars. 
 
 Similarly in equipping the establishment, there is the choice 
 between machine A and machine B. Machine A costs $1,000, 
 
 1 See chaps, xiii and xiv below.
 
 NATURE AND FUNCTIONS OF A PECUNIARY UNIT 9 
 
 machine B costs $1,200. Machine A, however, would turn 
 out only three-quarters as much product as machine B. On the 
 other hand, machine A would require $50 more per year for 
 maintenance; while machine B would last five years longer. 
 The problem of deciding which type of machine to use under 
 these conditions is not a simple one at best. But it is much 
 simpler by virtue of the dollars and cents computation that is 
 possible than it would be in the absence of any such guide. 
 
 Let us suppose that the decision is for the purchase of 
 machine B. Two years later a new machine is put upon the 
 market, which can perform the same work at one-half the 
 cost per unit of product. Machine B has, however, ten years of 
 wear remaining in it. Should it be discarded now as obsolete, 
 or should it be used until worn out ? There is here involved a 
 delicate balancing of costs; and a decision necessarily carries 
 with it a certain element of risk. But again it is clear that the 
 pecuniary basis of reckoning greatly lessens the chances of 
 error and thereby increases the probability of business success. 
 
 This factory employs a large number of laborers. The 
 management finds that there is a possibility of a considerable 
 substitution of machinery for labor. The question arises, 
 When is it wise to substitute machinery for labor, or vice versa, 
 as the case may be? The decision is made, as in the other 
 cases, on the basis of pecuniary calculations. 
 
 Or it may be that the question is not one of machinery 
 versus labor, but one of methods. Shall a new system of office 
 management be installed? Shall trained technical men be 
 employed to work out new processes in the various parts of the 
 industry ? The business man attempts to compare the costs of 
 such technological aids with the returns from the improvements 
 that accrue. There is again some risk of loss involved, but by 
 and large the cost computation points the certain way to 
 improvements in methods and efficiency. 
 
 Instances of this sort might be multiplied indefinitely. 
 In fact, virtually every decision that is made by the business 
 manager today involves a careful consideration of costs and 
 returns; practically all of modern business is organized on the
 
 io THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 basis of pecuniary computations. The enormous size of the 
 business unit nowadays, together with the complex relationships 
 that obtain between the business man and those from whom he 
 buys his materials, on the one hand, and, on the other, those 
 to whom he sells, requires not merely the keeping of records of 
 transactions that are entered into; it necessitates the develop- 
 ment of elaborate financial accounting systems from which 
 cost and profit data may be obtained. It should be repeated 
 here that without the monetary unit accounting records would 
 be lifeless; while with the dollar unit the business man may use 
 his accounts both as an indication of past business achievement 
 and as a guide to future courses of action. 
 
 In the preceding paragraphs we have been considering the 
 relation of the monetary unit to the problems that arise in 
 connection with the administration of any given business. Let 
 us now assume that, owing to the stress of competition or to a 
 declining demand for the products of a given industry, the 
 manager decides that he should leave this industry and go into 
 something else. 
 
 The manager is now confronted with the task of making the 
 transfer with a minimum of loss. It should be borne in mind 
 that since the industry as a whole is in a declining state, the 
 establishment cannot readily be sold to someone else. He must 
 either (a) convert an establishment that manufactures com- 
 modity X into an establishment that manufactures commodity 
 Y, or (ft) completely dismantle the existing establishment and 
 erect an entirely new plant, adapted to the production of 
 commodity Y. In case he is forced to choose the latter alterna- 
 tive the problem arises, should the plant be dismantled at once 
 and, the large amount of fixed capital hi the form of building 
 and equipment be scrapped at a heavy loss, or should it con- 
 tinue to be used in this line of production until worn out ? In 
 the latter event the yearly profits would be set aside with a 
 view to the subsequent erection of a plant for the manufacture 
 of commodity Y. With this problem before him, the business 
 man must compare the losses involved in scrapping his present 
 fixed capital with the added profits that might be gained from
 
 NATURE AND FUNCTIONS OF A PECUNIARY UNIT 1 1 
 
 an earlier development of the plant for the manufacture of 
 commodity Y. Relative costs expressed in terms of the dollar 
 unit again serve as the guide to action; although, as before, such 
 guidance does not enable the decision to be rendered with 
 absolute precision. 
 
 In case the plant is of such a nature that it does not require 
 complete dismantling, if it is one which can be rehabilitated for 
 the purpose, the process of shifting industrial production is 
 somewhat simpler, though it still involves questions of technical 
 engineering, construction, and administration. As before, how- 
 ever, the decision concerning the best method of making the 
 necessary changes and the rapidity with which they should be 
 accomplished rest on cost computations expressed in terms 
 of money. 
 
 III. THE PECUNIARY UNIT AND THE APPORTION- 
 MENT OF FAMILY EXPENDITURES 
 
 Not only does the pecuniary unit lie at the basis of business 
 organization; it is also the basis for an intelligent apportion- 
 ment of income. When family incomes, which in a pecuniary 
 society are initially received in the form of money rather than 
 in the form of goods, are carefully considered, a formal budget is 
 prepared by means of which the income is apportioned in such 
 a way as to bring the largest satisfaction of family wants. 
 
 Let us assume, first, a family income of $150 per month, 
 an income sufficient to buy only the ordinary necessities of life. 
 This $150 must provide for food, clothing, shelter, light, heat, 
 and miscellaneous expenses. Since this income should be so 
 apportioned among these various needs that the family will enjoy 
 the largest measure of comfort, the expenditure in each direction 
 must be considered in comparison with the expenditures in every 
 other direction. Will $50 for rent and $100 for the remaining 
 necessities give as large a measure of satisfaction as $25 for 
 rent and $125 for the remaining items ? Should $75 be spent for 
 food and $20 for clothing, or should it be $85 for food and $10 
 for clothing? The arrangement of a family budget in this 
 fashion is difficult enough at best and precision in measurement
 
 12 
 
 is of course not to be expected. The dollar unit, however, 
 provides a rough measuring stick by means of which a larger 
 satisfaction may be derived from a given income than would 
 otherwise be possible. 
 
 With an income of $1,000 a month the problem of family 
 expenditures is in some ways less difficult, because the adequacy 
 of the income to meet the bare necessities of life is no longer in 
 question. From another standpoint, however, it is more diffi- 
 cult, because a wider range of expenditures for luxuries is now 
 possible. After necessities are provided for, how shall the 
 remainder be spent ? Shall it be for a new chair, a picture, or 
 other household decoration ? Shall it be for more extravagant 
 clothes, for a pleasure trip, or for a new automobile? The 
 family would no doubt prefer to enjoy all these luxuries rather 
 than to choose between them ; but if the income is not adequate 
 to provide for all of them, the question of selection inevitably 
 presents itself. The cost of the automobile must then be com- 
 pared with the cost of a pleasure trip, and, in fact, with all the 
 additional things that might be purchased if the automobile 
 were foregone. The dollar unit comes to stand for a certain 
 amount of "generalized purchasing power" and the task of 
 making a wise apportionment of the family income is thus 
 greatly simplified. 
 
 The monetary unit is a guide to savings requirements. Every 
 family also has the problem of making provision for the pro- 
 verbial rainy day, for old age, and for dependents. By reckoning 
 in terms of dollars, one may compute with a fair degree of accu- 
 racy how large a fund of savings is necessary to provide, upon 
 retirement, an income sufficient to insure himself and depend- 
 ents from want. Let us assume that in a given case this is 
 $3,000 a year. To make sure of a perpetual income of $3,000 
 a year it is therefore necessary to accumulate, assuming the 
 interest rate to be 5 per cent, a fund of $60,000. In order to 
 provide this fund of $60,000, one must save each year such 
 proportion of his income as will eventuate in a given period 
 of time into a fund of $60,000. There are of course many 
 exigencies that may arise to prevent one's working this out with
 
 NATURE AND FUNCTIONS OF A PECUNIARY UNIT 13 
 
 precision. The monetary unit, however, serves at least as a 
 valuable guide to one's requirements. Indeed, insurance tables 
 worked out on the basis of the dollar unit serve as a very reliable 
 guide to the saving that is necessary in given cases to make ade- 
 quate provision for old age or other contingency. 1 
 
 IV. THE PECUNIARY UNIT AND ECONOMIC 
 ORGANIZATION 
 
 Thus far we have been considering the pecuniary unit in its 
 relation to the making of business and personal decisions. We 
 may now look for some of the broader economic and social 
 consequences of the decisions that are made on the basis of 
 pecuniary computations. We have already seen that without 
 an accurate means of computing values extensive trading 
 operations would be impossible. The development of the 
 pecuniary unit in the various commercial nations has given 
 rise to an international denominator of values, by means of which 
 foreign transactions are greatly facilitated. A merchant who 
 wishes to sell goods in a foreign country may ascertain the 
 profits from such sales by simply translating dollars into pounds 
 sterling, francs, or marks, as the case may be. The actual 
 settlement of these international financial obligations, however, 
 has required the development of a rather complex financial 
 mechanism known as the foreign exchanges (see chapter viii). 
 
 It should be noted here that with narrowly restricted 
 trading operations little division of labor was possible and 
 small-scale inefficient production therefore necessarily pre- 
 vailed. A large volume of output is absolutely dependent upon 
 wide markets national and international; hence division of 
 labor and large-scale efficient production had to wait, among 
 other things, upon the development of the pecuniary unit and 
 the extensive trading operations which it made possible. 
 
 Similarly, territorial specialization, whereby each portion of 
 the earth is devoted to the production of those commodities 
 for which it is best adapted, depends upon wide markets 
 
 1 See, however, the effect on these calculations of unforeseen changes 
 in the price level, p. 35.
 
 Jr 4 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 national and international. In the absence of an extensive 
 commerce each region must produce most, if not all, of the 
 commodities required for its use. 
 
 Territorial specialization is expedited by pecuniary calculation. 
 The pecuniary unit serves as a ready means of indicating the 
 relative productive advantages of different regions and thus 
 directs and hastens the spread of population to the regions where 
 a given expenditure of effort will produce the maximum return. 
 There are, of course, barriers which prevent complete geo- 
 graphical specialization, such as costs of transportation and 
 trade regulations. Within a given country, however, these 
 barriers are nowadays usually negligible, and domestic terri- 
 torial specialization is therefore comparatively unhampered. 
 The result is a great augmentation on the volume of wealth 
 produced. 
 
 Analogous to the spread of population has been the flow 
 of capital from the older to the newer portions of the world. 
 Investors seek to place their funds where returns netted will be 
 highest. The pecuniary unit makes possible a fairly accurate 
 directing of capital to the portions of the world where it will 
 be most productive. Sooner or later every nation reaches a 
 stage in its industrial development when larger returns are to 
 be obtained from investments abroad than from investments 
 at home. Without the pecuniary unit and the mechanism of 
 the securities markets, 1 knowledge as to when this stage has 
 been reached would be uncertain; hence the flow of capital to 
 regions of greater productiveness would be more tardy. Within 
 any given country the flow of capital from one section to another 
 is of course guided in a similar manner. 
 
 Pecuniary accounting facilitates the satisfaction of human 
 wants. The directing of labor and capital into the various lines 
 of industry, guided, as we have seen, by the pecuniary unit 
 of calculation, has likewise important social results. The 
 reason why any given line of industry becomes more profitable 
 than others is that the demands for the products of such industry 
 are not as adequately met by existing production as is the case 
 
 1 See chap. xvi.
 
 NATURE AND FUNCTIONS OF A PECUNIARY UNIT 15 
 
 in other lines. The pecuniary unit of calculation, which hastens 
 the diversion of labor and capital from other lines into this line 
 where the demand is greatest, thereby serves to satisfy human 
 wants more quickly and more adequately than would otherwise 
 be the case. This is only another way of saying that it provides 
 for a larger satisfaction of human wants with the same expendi- 
 ture of energy than would otherwise be possible. 
 
 Similarly, if any given line of industry is waning, owing to 
 a decrease hi the power of its product to satisfy human wants, 
 the losses expressed hi dollars and cents on a balance sheet 
 force labor and capital out of that line of industry much more 
 quickly than would otherwise be the case. Hence misdirected 
 labor and capital remain misdirected for a shorter tune, with 
 the result that the losses incident to such misdirection are 
 minimized. 
 
 Again, in the internal organization of any business, pecuniary 
 calculations cause improvements in machinery, labor organi- 
 zation, and administrative methods to be made more quickly 
 than would be the case in the absence of an accurate index of 
 profits. There is a continual process of elimination, by means of 
 which antiquated industrial organization is rapidly supplanted, 
 the changes being superinduced by a fear of pecuniary loss on the 
 one hand, and by the incentive to pecuniary profit on the other. 
 Every such improvement means an elimination of productive 
 waste. It means a larger output with a given expenditure of 
 human energy; it means that society more easily wrests from 
 nature the means of subsistence and comfort. 
 
 QUESTIONS FOR DISCUSSION 
 
 1. Note the titles of the second, third, and fourth chapters. Note 
 especially that chapter ii does not relate to. the medium of 
 exchange. Define the term "pecuniary unit." 
 
 2. The text indicates three stages in the development of the language 
 of business. What are they ? 
 
 3. Would it be possible for a business man to keep accounts with- 
 out a system of notation ? without a pecuniary unit of calcu- 
 lation ?
 
 [6 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 4. It has been suggested that the standardization of grades of 
 commodities marks another stage in the development of the 
 language of business: it defines quality as well as quantity. Do 
 you agree ? 
 
 5. "The more highly developed our specialized exchange society 
 becomes, the more essential accurate financial accounting 
 becomes." Do you agree ? 
 
 6. "The larger the scale on which business is conducted, the more 
 necessary is the keeping of financial accounts. The crossroads 
 merchant has no need of keeping accounts." Do you agree ? 
 
 7. "Without accounting systems based on the pecuniary unit it 
 would have been impossible to develop large-scale industry." 
 If so, why ? 
 
 8. " Modern business organization is largely controlled and directed 
 by means of information obtained from financial records. By 
 accounts the business manager ascertains whether the business as 
 a whole is profitable; whether each particular part is profitable; 
 and whether particular methods or devices pay. He also formu- 
 lates future business policy on the basis of knowledge obtained 
 from his financial accounts." Do all business men do this ? Are 
 those who do not likely to survive in competition with those who 
 do ? Will everyone who does not do this fail ? 
 
 9. Do you know of any types of business that are not conducted on 
 a profit-making basis? If so, are such businesses conducted 
 without reference to financial accounts? 
 
 10. "The business man endeavors to reduce the inevitable risks of 
 industry as much as possible." Show how financial accounting 
 helps him to do this. 
 
 11. What are some of the social consequences of: (a) reduced risks in 
 business? (6) the accurate appraisal of the profitableness of 
 the business as a whole? (c) the accurate appraisal of the 
 profitableness of particular divisions of the business ? 
 
 12. "Not only does the business man control the internal affairs of 
 his business by means of financial accounts; but his external 
 relations with other businesses, with banks, and with the govern- 
 ment are also governed by financial accounts." ' Do you know 
 of any case where this is not true ? 
 
 13. Indicate the service performed by the pecuniary unk of calcula- 
 tion in directing the flow of labor and capital (a) from region to 
 region, (6) from industry to industry.
 
 NATURE AND FUNCTIONS OF A PECUNIARY UNIT 17 
 
 14. Do you or does your family keep a budget? If not, on what 
 basis is the income apportioned? Do you think the largest 
 possible amount of satisfaction is obtained from the use of such 
 income ? 
 
 15. Is it necessary for charitable and endowed institutions, clubs, 
 societies, etc., to make a budget ? Is it necessary for govern- 
 ments to make budgets? 
 
 1 6. The commissioner of internal revenue recently siiid that 2,000 
 certified public accountants were necessary for the successful 
 collection of the federal taxes for 1919. Why? 
 
 17. Can you think of any form of public control over industry that 
 can be effectively administered without the use of financial 
 accounts ? 
 
 1 8. What profession or occupation are you going to follow as a life- 
 work ? To what extent are financial considerations involved in 
 your decision ? 
 
 19. Do the decisions that are rendered on the basis of pecuniary 
 calculations always tend to promote social welfare? Illustrate. 
 
 20. The "profits' guide" is not a satisfactory guide to what is good 
 for society. Granting the truth of this statement, what can 
 you suggest as a better guide ? 
 
 2r. Under a socialistic organization of society what would be the 
 means of arriving at business and social decisions ? 
 
 REFERENCES FOR FURTHER READING 
 
 Holdsworth, John Thorn: Money and Banking, pp. 14-16. 
 Laughlin, J. Laurence: Principles of Money, chap. i. 
 Moulton, Harold G.: Money and Banking, Part I, Selections 
 Mos. 26-31, pp. 31-44- 
 
 Phillips, Chester A. : Readings in Money and Banking, chaps, i, ii. 
 Scott, William A.: Money and Banking, pp. 2-6.
 
 CHAPTER HI 
 
 THE STANDARD FOR DEFERRED 
 PAYMENTS 
 
 It was the purpose of chapter ii to show the relation of the 
 pecuniary unit to financial accounting, and thereby to the 
 organization of both business and household economics. It is 
 of note that the discussion related mainly to the rendering of 
 decisions at a given moment; it was not concerned with trans- 
 actions where the time element was a factor. The present 
 chapter will consider the function of the pecuniary unit in con- 
 nection with credit operations or deferred payments. 
 
 Wherever an individual or corporation sells goods on time, 
 that is, on agreement that they are to be paid for at some date 
 in the future, it is highly important that both buyer and seller 
 be protected, so far as possible, from the risks that inhere in the 
 mere lapse of tune. Because of the interdependency of eco- 
 nomic institutions and their great sensitiveness to shock, 
 economic changes of serious import may occur during relatively 
 short periods. As one means of minimizing the effects of such 
 changes, society has come to use the pecuniary unit, gold, as 
 the standard in which deferred obligations are paid. 
 
 The standard of deferred payments is of importance not 
 merely in the purchase and sale of actual commodities. It is 
 quite as important in connection with the lending of funds. 
 Business is largely conducted in the modern industrial world by 
 means of borrowed capital, represented by credit instruments 
 in the form of stocks, bonds, notes, and bills of exchange. All 
 these financial borrowing operations involve risks of loss inci- 
 dent to economic changes during the Me of the loans; and it 
 is accordingly necessary that the standard for deferred pay- 
 ments be a commodity which possesses a high degree of value 
 stability. 
 
 18
 
 STANDARD FOR DEFERRED PAYMENTS 19 
 
 I. WHY GOLD IS USED AS THE STANDARD 
 
 Aside from its important qualities of durability, homo- 
 geneity, divisibility, and cognizib'ility, gold is especially superior 
 to other commodities as a standard for deferred payments for the 
 reason that it fluctuates less widely than does the value of 
 wheat, iron, and other commodities which might be used for 
 the purpose. 1 The. reasons for this relative stability of value 
 may be readily indicated. 
 
 Gold, as a commodity, is subject to the forces of supply and 
 demand just as is any other commodity. The supply of gold 
 is influenced directly by the conditions of production at the 
 mines. The discovery of a "bonanza" mine tends to depress 
 the value of gold as a standard, by greatly increasing its supply; 
 and the exhaustion of a rich vein of ore conversely tends to 
 raise the value of gold by preventing an increase in supply. 
 
 Changes in the cost of producing gold, however, have not in 
 the past had very much effect upon the quantity produced, 
 owing to the speculative character of gold mining. It has been 
 stated that the cost of producing gold has probably on the 
 whole exceeded its value, that the losses sustained by the many 
 who have searched in vain have outweighed the gains made by 
 the fortunate few. But in recent years, with the rapid dis- 
 appearance of placer mining and the development of machine 
 production of gold, the cost of production has come to be very 
 carefully considered. There are marginal mines where it barely 
 pays to take out the gold, just as there are marginal farms and 
 marginal factories. The increased cost of producing gold during 
 the war, for instance, resulted in the closing of many mines 
 where production had formerly been profitable. 
 
 Gold differs from most other commodities in that the supply 
 at any given time is not merely the output of a previous year's 
 mining operations; it is a stock that has been accumulated 
 through centuries of production. Gold is a highly durable 
 commodity, and as a result the world's supply becomes larger 
 
 I The reasons why gold rather than silver came to be used as thtt 
 standard are considered in chap, vi below.
 
 20 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 each year, even though the annual production may be rapidly 
 decreasing. The greater part of all the gold mined in modern 
 times is still in existence and performing service quite as though 
 it were fresh from the mines of the Klondike. The result of 
 this accumulated world's supply is to render any yearly change 
 in output less and less effective in influencing the value. Pour- 
 ing a cup of water into a large tank has but a slight effect upon 
 the level of the water in the tank. Similarly, the discharging 
 of a $100,000,000 increased annual output of gold into a total 
 world's supply of twelve or fourteen billions can have but little 
 effect upon the value of the entire mass. A great increase in 
 gold production continued over many years would, however, 
 obviously have a substantial effect upon the value of the mass. 
 
 The demand for gold is twofold: (a) for use as a commodity 
 in the manufacturing and industrial arts; and (b) for employ- 
 ment as a medium of exchange and as the basis of monetary 
 systems. The demand for gold as a commodity is, of course, 
 subject to the same general conditions as the demand for any 
 other commodity. It has utility in the satisfaction of human 
 desires, and this utility is affected by degree of scarcity, change 
 of custom, possibility of substituting other commodities, etc., 
 in the same way that the utility of other commodities is affected. 
 For monetary uses, however, the demand for money, where free 
 coinage exists, is sometimes said to be unlimited; since all 
 the gold produced may be taken to the mints and converted into 
 dollars or sovereigns, it would seem that there is a limitless 
 demand. This view, however, overlooks the matter of intensity 
 of demand. It is true that monetary systems will absorb the 
 entire quantity of gold offered. But if the supply of the metal 
 is greatly increased, the purchasing power of gold may never- 
 theless be lessened. Nearly any quantity of wheat would be 
 demanded, at some price, but a doubling of the total supply 
 would substantially lessen the exchange value of each bushel. 
 It is the same with gold. 
 
 An increase in the monetary demand for gold would be 
 caused by the giving up of silver as a standard metal in leading 
 countries; by an increased use of gold as a medium of exchange;
 
 STANDARD FOR DEFERRED PAYMENTS 21 
 
 by an increase in the quantity of gold required as reserve for 
 substitute forms of money; by an expansion of commerce and 
 trade; or by a less effective use of gold through poor organization 
 of credit. A decrease in the monetary demand for gold would 
 result from opposite causes. 
 
 In the foregoing discussion of the value of gold we have been 
 saying, not that gold is absolutely stable in value, but merely 
 that it is more nearly stable than any other commodity that 
 might be chosen. As a matter of fact, gold is subject to wide 
 variations in value and hence leaves much to be desired as 
 a standard for deferred payments. Great fluctuations in the 
 production of gold may cause considerable variations in value, 
 despite the factor of durability. And the use of credit instru- 
 ments may serve greatly to reduce the demand for gold in the 
 channels of circulation. The relation of credit instruments to 
 the value of gold is one of the most complex problems in eco- 
 nomics. It cannot be taken up at this place, for it can be under- 
 stood only in the light of a thorough analysis of banking 
 operations. 
 
 H. RELATION OF MONEY AND PRICES 
 
 We have thus far been speaking of the value of gold and of 
 its relative stability for the purposes of deferred payments. To 
 appreciate fully the significance of the standard of deferred 
 payments, however, it is necessary to understand the relation 
 of money to prices. 
 
 As already stated, the quantity of money that has been 
 chosen in the United States as the standard, or dollar, is 25.8 
 grains of metal, nine-tenths gold and one-tenth copper alloy. 
 To express the value of another commodity in terms of money, 
 therefore, we always compare a certain quantity of it, as a 
 pound, bushel, or yard, with 25.8 grains of standard gold. 
 If a bushel exchanges for a dollar, we say the price is one dollar 
 a bushel, while if it requires two bushels to equal a dollar in 
 value, then we say the price is fifty cents a bushel. The 
 value of each particular commodity expressed in dollars gives 
 US the price of that commodity.
 
 22 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 The price level is an average of individual prices. It rises 
 or falls as the value relation of gold and commodities in general 
 changes; that is to say, as the value of gold falls, the level of 
 prices rises, and vice versa. 
 
 Variations in the price level are shown by means of an index 
 number. "An index number of any given article at any given 
 date is the percentage which the price of that article at that 
 date is of the price of the same article at a date or period which 
 has been selected as base or standard." There are numerous 
 index numbers in use; and the base or standard chosen varies. 
 For example, the index number of the London Economist takes 
 as its base the average price of the commodities included for the 
 years 1845 to 1850. The index number of the Aldrich (U.S.) 
 Senate Report takes average prices for the year 1860 as a base; 
 while the most recent American index number, that used to show 
 the history of prices during the Great War, is computed on the 
 basis of average actual prices in the twelve months preceding 
 the outbreak of the war, July, 1913, to June, 1914, inclusive. 
 
 The method of computing index numbers may be illus- 
 trated as follows. The average price of each commodity for the 
 year 1913 is considered as 100. Then every month the prices 
 of the various commodities are turned into relatives on that 
 scale. Thus if wheat sold in 1913 at $i a bushel and in May, 
 1918, at $2.26 a bushel, the relative price of wheat is then 226. 
 If, on the other hand, the price of any commodity should drop 
 from 50 cents to 40 cents the relative price would be 80. To 
 ascertain the change that has occurred from month to month 
 hi the general level of prices it is only necessary to strike an 
 average of these relative prices. 
 
 It is obvious that if the index number is to be truly repre- 
 sentative of general changes in prices, a large number of com- 
 modities must be used. The index number used in the history 
 of prices during the Great War is based upon 1,371 commodities. 
 The commodities chosen are moreover weighted in accordance 
 with their relative importance, the reason assigned for this being 
 that "great staples like bituminous coal, yellow pine lumber, 
 beef, and cement exercise much more influence upon the final
 
 STANDARD FOR DEFERRED PAYMENTS 23 
 
 results than articles like horsehair, hickory, cinnamon, and 
 bone buttons. " In order to make the price level reflect the 
 greater importance of such commodities, they are weighted by 
 multiplying the monthly price of each commodity by the quan- 
 tity produced in and imported into the United States in 1917. 
 
 The index number of relative prices will thus reveal a 
 change in the relative value of the standard of deferred pay- 
 ments and of goods hi general. It is not to be inferred, however, 
 that a change in the level of prices is necessarily due to causes 
 directly touching the value of the standard rather than to 
 causes affecting the value of the goods which are being com- 
 pared with the standard. The index number merely reveals 
 the change in relationship; the cause of the change is another 
 question, 
 
 It may be said, however, that the level of prices is often 
 changed by forces operating directly upon the standard of de- 
 ferred payments. This is particularly true in cases where the 
 standard is not a commodity which has utility for other than 
 monetary purposes. Some striking cases of this are given in 
 Section III below. This is not the place, however, to enter 
 upon a discussion of the complex causes of price movements. 
 The present purpose is merely to reveal some of the social and 
 economic results of price fluctuations. But it may be stated in 
 passing, that the general theory of the causes of price fluctu- 
 ations is among the most baffling and complicated in the whole 
 realm of political economy. 
 
 m. ECONOMIC CONSEQUENCES OF PRICE 
 CHANGES 
 
 Price fluctuations, if extensive or long continued, are always 
 disruptive in their effects upon the general economic organiza- 
 tion. Rapid price changes render more difficult the pecuniary 
 calculations of business men, thereby greatly increasing the 
 risks of industry and acting as a serious deterrent to business 
 enterprise. The accumulation of capital is discouraged, lend- 
 ing or credit operations are deterred, speculation is induced, 
 and international financial relations are deranged.
 
 24 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 
 
 The recital of some typical experiences with unstable 
 monetary standards will best serve to indicate the disastrous 
 effects upon the economic system. 1 Finlay tells us in his History 
 of Greece that the depreciation in the value of the circulating 
 medium during the fifty years between the reign of Caracalla 
 and the death of Galienus annihilated a great part of the trading 
 capital in the Roman Empire, and rendered it impossible to 
 carry on commercial transactions not only with foreign countries 
 but even with distant provinces. Every payment was liable 
 to be greatly diminished in real value, even when it was nomi- 
 nally the same. This state of things at last induced capitalists 
 to hoard their coins of pure gold and silver for better days; 
 and as these better days did not occur, all memory of many 
 hoards was lost, and the buried treasures, consisting of select 
 coins, have often remained concealed until the present time. 
 Thus the frauds of the Roman emperors have filled the cabinets 
 of collectors and the national museums of modern Europe 
 with well-preserved coins. 
 
 The laws which regulate the distribution, the accumulation, and 
 the destruction of wealth, the demand for labor, and the gains of 
 industry attest that the depreciation of currency was one of the most 
 powerful causes of the impoverishment and depopulation of the 
 Roman Empire in the third century, and there can be no doubt that 
 Greece suffered severely from its operation. 
 
 A second illustration may be taken from the experience of 
 France during the period of the French Revolution. Paper 
 currency had been issued in great quantities in the hope of pro- 
 viding the liquid capital necessary for economic recovery 
 from the ravages of war. Since these paper "assignats" were 
 legal tender, they became the standard of deferred payments. 
 Issued in vast quantities and irredeemable in specie, they 
 fluctuated widely in value and eventually became utterly 
 worthless. In a brillant monograph 2 Andrew D. White portrays 
 the results hi the following language: 
 
 What the bigotry of Louis XIV, and the shiftlessness of Louis XV, 
 could not do in nearly a century was accomplished by this tampering 
 
 1 For other illustrations see chaps, vi and vij belo^y, 
 Paper Money Inflation in France^
 
 25 
 
 with the currency in a few months. Everything that tariffs and 
 custom-houses could do was done. Still the great manufactories of 
 Normandy were closed; those of the rest of the kingdom speedily 
 followed, and vast numbers of workmen in all parts of the country 
 
 were thrown out of employment In the spring of 1791 no 
 
 one knew whether a piece of paper money, representing 100 francs, 
 would, a month later, have a purchasing power of 100 francs or 90 
 francs, or 80 or 60. The result was that capitalists declined to 
 embark their means in business. Enterprise received a mortal blow. 
 Demand for labor was still further diminished. The business of 
 France dwindled into a mere living from hand to mouth. This 
 state of things, too, while it bore heavily against the interests of the 
 moneyed classes, was still more ruinous to those in more moderate, 
 and most of all to those in straitened, circumstances. With the 
 masses of the people the purchase of every article of supply became 
 a speculation a speculation in which the professional speculator 
 had an immense advantage over the buyer. Says the most brilliant 
 apologist for French Revolutionary statesmanship, "Commerce was 
 dead; betting took its place." 
 
 The use of inconvertible greenback currency disorganized trad- 
 ing methods, A more recent experience with a rapidly fluctuat- 
 ing standard of deferred payments is that of our own Civil War. 
 As a means of financing the war, the government issued $400,- 
 000,000 of United States notes, popularly known as greenbacks. 
 These notes were not redeemable in specie upon demand; they 
 were merely promises of the government to pay at some future 
 time, date uncertain. Indeed, their ultimate redemption in 
 specie was dependent upon the outcome of the war and upon 
 future political and economic considerations. In any event, it 
 was certain that not until the war should be over would it be 
 possible for the government to accumulate the necessary specie 
 reserve with which to redeem and retire them. 
 
 Since the value of these greenbacks depended upon the 
 intention and the ability of the government ultimately to redeem 
 them in specie, their value fluctuated with the probabilities of an 
 early or remote successful ending of the war. At one time the 
 value of a dollar greenback was less than forty cents in gold; 
 and throughout the war, as well as for fourteen years thereafter
 
 26 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 (they were not convertible into gold until January i, 1879), they 
 were at a substantial discount. The chart on page 31 indicates 
 the fluctuations that occurred. 
 
 Since the greenbacks were legal tender in the settlement of 
 obligations, everybody preferred to use them in making pay- 
 ments instead of the more expensive money, gold and silver. 
 Their rapid fluctuation in value, however, made them a very 
 unsatisfactory standard, one result of which was to cause wide- 
 spread disorganization in mercantile trade and ultimately to 
 modify profoundly the method of conducting mercantile busi- 
 ness in this country. 
 
 Before the Civil War it was customary for the jobbing and 
 wholesale establishments of eastern cities to sell goods to 
 retailers in the West on long-term credits, usually a year's time. 
 The country merchant came to New York once a year and laid 
 in supplies sufficient for a twelve months' business, to be paid 
 for at the end of the year. But when payments began to be 
 made in greenbacks, the fluctuations in value from January to 
 December proved so great that business men were deterred 
 from extending credit for so long a period. "The internal 
 credit system of the country broke down," says Horace Greeley, 
 "and rural traders, no longer able to replenish their stocks on 
 credit, bought little or nothing." On September 9, 1865, the 
 Commercial and Financial Chronicle stated that most jobbing 
 sales were on short time, from sixty days to four months; but 
 if settled within thirty days from date a discount of i per 
 cent a month was allowed, including interest for the first thirty 
 days. Most buyers took advantage of these terms. It will 
 be noted that the sellers of the goods were thus willing to knock 
 off 12 per cent a year in order to be relieved of the risks caused 
 by a fluctuating standard. It is of interest that the practice thus 
 begun continued even after greenbacks had come to a parity with 
 gold hi 1879. In fact, it has persisted down to the present time, 
 with the result that we now have in some respects a very 
 different type of commercial organization than exists else- 
 where. 1 
 
 1 See p. 169.
 
 STANDARD FOR DEFERRED PAYMENTS 27 
 
 The depreciation of the greenbacks also greatly increased 
 the hazards of foreign trade. A very interesting practice of 
 protecting one's self against variations in prices, while waiting 
 for payments, developed that of selling gold short on the gold 
 exchange, an institution which was organized as soon as the 
 greenbacks became the pecuniary standard and gold a com- 
 modity quoted in terms of greenbacks. 
 
 The free silver agitation deranged international finance. The 
 results of an unsettled or unstable standard of deferred pay- 
 ments upon business organization find no better illustration 
 than in an American experience of the early nineties. The 
 single gold standard had been decreed by the Act of 1873, 
 afterward known as the "crime of '73," which omitted the silver 
 dollar from the list of coins that could be struck at the mint. 
 Powerful interests, however, supported the restoration of the 
 bimetallic standard; with the result that the Bland-Allison 
 Act of 1878 partially restored the coinage of silver, while the 
 Sherman Act of 1890 still further increased the amount of 
 silver that must annually be converted into currency. 
 
 This latter act provided that silver, purchased by the govern- 
 ment, could be paid for by means of an issue of legal tender 
 Treasury notes, redeemable in either gold or silver at the dis- 
 cretion of the Secretary of the Treasury. At the time, the 
 bullion in a silver dollar was worth only a little over fifty cents, 
 and silver coins were kept at a parity with gold by virtue of the 
 government's willingness to accept silver as the equivalent of 
 gold hi the payment of taxes, etc. Under these circumstances, if 
 the Treasurer had refused to redeem these Treasury notes in 
 gold the result would have been to destroy the parity value of 
 silver and gold; since the Treasury notes would have been 
 redeemable only in silver, the country would in effect have been 
 thrown upon a depreciated silver basis. Deferred obligations 
 would then have been payable in dollars that were worth only 
 about half as much as the dollars in which they had been con- 
 tracted. The Secretary of the Treasury wisely took the stand 
 that he would never refuse to redeem them in gold, so long as
 
 *8 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 there were available funds in the Treasury. In order to main- 
 tain gold payments, however, it proved necessary for the 
 government to replenish the Treasury in 1894 and 1895 by a 
 series of bond issues. 
 
 While suspension of gold redemption was thus avoided, the 
 imminent possibility for several years of precipitating the 
 country upon a depreciated silver basis, together with a power- 
 ful agitation for a complete restoration of the bimetallic standard 
 of fold and silver which would have meant a cheaper stan- 
 dard nevertheless worked havoc with American finance and 
 industry. In the first place, it destroyed the confidence of 
 foreign investors in American securities. If the interest on the 
 principal of these investments were to be paid in silver, the 
 purchasing power of which was only about half that of gold, 
 the value of European investments would thus be cut in two. 
 During the latter part of 1892, the year 1893, and the early part 
 of 1894, it is estimated that about $300,000,000 of European 
 securities were returned to the United States by their foreign 
 owners because of the uncertainty of the standard in this 
 country; and at the same time the annual increase of new Euro- 
 pean investments was largely curtailed. This necessitated 
 large exports of gold; and this in turn greatly embarrassed the 
 Treasury in its efforts to maintain the convertibility of all forms 
 of currency into gold, because the banks could obtain the gold 
 required for export only by presenting Treasury notes (and 
 greenbacks) to the Treasury for redemption. While there were 
 at work during this period other factors which had an important 
 bearing on the general financial situation, the uncertainty of the 
 standard of deferred payments, on the basis of which all time 
 obligations are undertaken, was a primary source of difficulty. 
 
 Domestic finance was also disorganized. Moreover, it was 
 not alone foreign investments that were thrown out of adjust- 
 ment. Domestic financiers who had debts which called for 
 payment in gold at maturity found themselves in a quandary. 
 If they accepted the Treasury notes (and this they must do 
 because they were legal tender) in ordinary business operations, 
 they safely hold and use these notes until debts matured
 
 STANDARD FOR DEFERRED PAYMENTS 29 
 
 and then exchange them at the Treasury for the gold required to 
 fulfil their gold obligations ? The answer depended on whether 
 the Treasurer should continue to redeem the notes in gold as 
 well as in silver coins. The uncertainty of the situation caused 
 many business men to present notes for redemption as fast as 
 they were received, instead of waiting until the gold was actually 
 needed. For so long as the Treasury continued to pay in gold, 
 the gold withdrawn could be hoarded, thereby making certain 
 the meeting of gold obligations when they should mature. But 
 this constant draining of the Treasury of its gold supply only 
 served to render more precarious the ability of the Treasury to 
 maintain the gold standard ; and this in turn served to intensify 
 the general uncertainty. 
 
 If existing contracts were rendered unsatisfactory and 
 precarious by virtue of this uncertainty over the future of the 
 standard, it is easy to see that individuals would hesitate to 
 incur additional long-time obligations. The investment and 
 loan market was, in fact, demoralized. 
 
 Rising prices now handicap Germany's export trade: 1 
 The tremendous revolution of prices which has shocked our 
 economic body during recent months has rendered it nearly impos- 
 sible for industry to make exact calculations and to stick to them 
 for a definite period. Efforts are made to set up fixed price lists; 
 but this is done in vain so long as wild fluctuations take place in 
 the raw material markets and so long as new wage demands are 
 advanced by labor almost daily, demands which appear to be justified 
 because of the rapidly rising cost of living. 
 
 In order to rely somewhat on fundamental prices the majority 
 of industrial concerns have adopted the system of an additional 
 price imposed upon a standard basis. But this system is practically 
 useless today, as these additional prices are higher than the funda- 
 mental prices. The additional charges must be increased constantly, 
 and these price changes are fraught with serious consequences, 
 especially if the time of delivery must be postponed on account of 
 deficiency of coal, raw materials, or strikes. In accepting orders 
 these circumstances act in a most disagreeable way, as the settlement 
 
 1 From foreign correspondence of the New York Evening Post, March 20, 
 
 TQ2O.
 
 30 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 of prices must be made under such restrictions as to give them the 
 character of orders in blank. This is a particular drawback for 
 exporters who, in competition with foreign competitors, must appear 
 on the market with fixed prices. 
 
 The exp'orter who does not want to suffer losses is therefore 
 forced to alter his prices in the end, and the foreign customer who 
 is not entirely informed about the prevailing circumstances shows no 
 appreciation of the reasons for these fluctuations and is only too 
 willing to attribute them to ill-will or deliberate deceiving. The 
 consequences are an accumulation of complaints about unreliable 
 management of German business and a gradually growing distrust, 
 even of old firms of formerly worldwide reputation. 
 
 The price level changes more or less continuously. The fore- 
 going are rather extreme cases of price fluctuations and their 
 effects upon industry. The general level of prices, however, is 
 always changing more or less, owing to causes which need not be 
 considered here. From 1850 to 1865, for example, there was a 
 substantial increase in the level of prices; from 1865 to 1896 
 there was a great decrease in the price level; from 1896 to 1914 
 there was a marked rise; while from 1914 to 1918 the price level 
 advanced by practically 100 per cent. The Great War may or 
 may not be followed by a substantial recession in prices, as was 
 the case after the Civil War. The chart on the opposite page 
 shows the variations that have taken place in the price level 
 in the United States from 1840 to the present time. 
 
 IV. PRICE CHANGES AND SOCIAL 
 MAL- ADJUSTMENTS 
 
 In the foregoing illustrations we have considered the effects 
 of changes in the level of prices upon the risks of industry and 
 hence upon the stability of business enterprise. We shall now 
 see that price changes produce other maladjustments, which 
 are of almost as great importance. Social maladjustments 
 are caused: (i) between borrowers and lenders, or debtor and 
 creditor classes; and (2) in the real income of the salaried and 
 wage-earning classes. 
 
 Price changes disrupt the equities between debtors and creditors. 
 The effects of the depreciated paper of the Revolutionary
 
 0161 
 
 0x361 
 
 88 1
 
 32 
 
 War period upon the debtor and creditor classes have been 
 vividly described by a writer of the time, as follows: 1 
 
 The aged who had retired from the scenes of active business to 
 enjoy the fruits of their industry found their substance melting away 
 to a mere pittance, insufficient for their support. The widow who 
 lived comfortably on the bequests of a deceased husband experienced 
 a frustration of all his well-meant tenderness. The laws of the 
 country interposed, and compelled her to receive a shilling where a 
 pound was her due. The blooming virgin who had grown up with 
 an unquestionable title to a liberal patrimony was legally stripped of 
 everything but her personal charms and virtues. The hapless orphan, 
 instead of receiving from the hands of an executor a competency to 
 set out in business, was obliged to give a final discharge on the pay- 
 ment of 6d. in the pound. In many instances, the earnings of a long 
 life of care and diligence were, in the space of a few years, reduced to a 
 trifling sum. A few persons escaped these affecting calamities by 
 secretly transferring their bonds, or by flying from the presence or 
 neighborhood of their debtors. A hog or two would pay for a slave; 
 a few cattle for a comfortable house; and a good horse for an improved 
 plantation. A small part of the production of a farm would dis- 
 charge the long-outstanding accounts, due from its owner. The 
 dreams of the golden age were realized to the poor man and the 
 debtor, but unfortunately what these gained was just so much taken 
 from others. 
 
 Another illustration less extreme is found in the green- 
 back currency of our Civil War era. The general fall in prices 
 after the war, incident to the appreciation of greenbacks as 
 compared with gold, was bitterly opposed by the debtor classes; 
 but it was looked upon with composure, and even championed, 
 by the creditor classes. The reason for this was that a fall in 
 prices impaired the economic position of debtors and improved 
 the economic position of creditors. It should be understood 
 here that by debtors is meant not merely the ne'er-do-wells, 
 people who are poverty stricken, shiftless, and hopelessly in 
 arrears. The debtor class is composed most largely of indi- 
 viduals and corporations who have borrowed capital for use in 
 business enterprises of various sorts. For instance, the farms of 
 
 "David Ramsay, History of American Revolution (1789), pp. 134-35.
 
 STANDARD FOR DEFERRED PAYMENTS 33 
 
 the Middle West were largely purchased on borrowed funds. A 
 small accumulation was sufficient to make an initial payment, 
 and a mortgage was given for the balance. Out of the income 
 from the farm, the owner paid interest on his mortgage and 
 gradually reduced the principal, thus eventually acquiring 
 complete ownership. -s 
 
 The fall in the prices of farm products after the Civil War 
 made it very difficult to pay mortgages as they fell due, with 
 the result that a large percentage of them were extended again 
 and again. Since a falling price did not increase the number of 
 bushels grown per acre, the farmer found his actual income 
 reduced. Falling prices thus meant hard times, inability to 
 get ahead in the world. The result was a great popular resent- 
 ment against a contraction of the volume of currency, which 
 was deemed responsible for the fall in prices; 1 and for more than 
 a generation the money question overshadowed all other issues in 
 American politics. 2 
 
 The view of the debtors was well expressed in the following 
 statement made by Congressman Voorhees in 1891 : 3 . 
 
 It may be stated without the slightest fear of contradiction that 
 the attack upon silver money in this and other countries is based 
 upon no demerit or unsoundness on its part, but is simply a movement 
 for the contraction of the currency. This movement is made by 
 the moneyed classes who wish to increase the purchasing and interest- 
 gathering power of money in their own hands by making it scarce in 
 the hands of others; by people with large incomes growing out of 
 monopolies protected by unjust legislation; by those who enjoy 
 annuities, interest in public securities, fixed salaries under great cor- 
 porations and by the creditor classes in general, including all the 
 
 1 A similar opposition to a fall in prices after the Great War is mani- 
 fested by the agricultural interests. 
 
 2 It is not to be understood from this statement that the attitude of the 
 debtor class was alone responsible for the agitation for greenback currency 
 and a restoration of bimetallism during the period in question; for numerous 
 other interests were involved. For a good discussion of the entire problem 
 see R. F. Hoxie, "The Silver Debate of 1890," Journal of Political Economy, 
 I (1892-93), 545-73. 
 
 1 From "A Plea for Free Silver," North American Review, CLIII (1891), 
 529-30.
 
 34 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 enormous loan associations, who join in the movement of silver 
 destruction and financial contraction in order to enhance twofold 
 and more the value and power of the money they wring from the 
 hands of the laboring people. This will result in the practical 
 enslavement of those who are in debt and who toil for a living. 
 The policy of contraction is the policy of organized, unsparing, 
 pitiless avarice. 
 
 The viewpoint of the creditor class is found in the following 
 statement by Francis A. Walker, one of the most eminent 
 economists of his day, at the time president of the Massachusetts 
 Institute of Technology: 1 
 
 The inflationists, like the poor, we have always with us. Political 
 education, the growth of sound economic ideas, the establishment of 
 manufactures, trade, and banking will do much to diminish the 
 number of the members of this class; but humanity will have to pass 
 through many more stages of refinement and education before that 
 element will be entirely eliminated. The instinct of spoliation and 
 confiscation, the passion for making something out of nothing and 
 much out of little, the desire to pay debts in depreciated currency, 
 are too deeply implanted in poor, fallen human nature, to give way 
 altogether either to ethical instruction or to demonstrating that in the 
 long run honesty is the best policy. Thdre are tens of thousands of 
 people hi Massachusetts today who, if removed west of the Missis- 
 sippi, or only even beyond the Alleghenies, would be rampant infla- 
 tionists, but are here overawed by the dominant sentiment of the 
 community, or are silent because they see no chance to act with 
 effect in such a hopeless minority. 
 
 With the reverse movement of prices that began in 1896, 
 it soon became a horse of another color. The rise in the general 
 level of prices meant that it became increasingly easy for those 
 who had borrowed funds to meet interest payments and to 
 reduce the principal when the obligations matured. Farmers, 
 for instance, did not need to raise a larger number of bushels of 
 wheat in order to secure larger incomes when the price of wheat 
 was advancing. On the other hand, lenders who received this 
 interest and principal found that the dollars received in pay- 
 ment would not go so far as formerly in purchasing commodities. 
 
 1 From Journal of Political Economy, I (1892-03), 166.
 
 STANDARD FOR DEFERRED PAYMENTS 35 
 
 The real return on trie money invested was thus diminished; 
 while the shrinkage in value of the investment itself often 
 produced serious consequences. 
 
 When we speak of creditors in this connection, we have in 
 mind not merely large capitalists who have money invested. 
 The term includes all people who put money in savings banks, 
 take out insurance, and invest in bonds. Widows and orphans 
 on fixed incomes from investments find their annual purchasing 
 power steadily reduced. A larger amount of insurance is 
 required to afford the necessary protection to one's dependents, 
 and the volume of savings that must be set aside for old age 
 must be increased. 
 
 A rise in the general level of prices causes serious variations in 
 real salaries and wages. Only in case salaries were increased 
 proportionally to the increase hi the prices of those commodities 
 which enter into the consumption of the salaried man could a 
 fall hi his real income be avoided. But the truth is that salaries 
 almost never advance in step with an increase of prices. There 
 are numerous reasons for this. 
 
 First, there is a great deal of inertia to be overcome. Second, 
 salaried men are seldom organized and they can therefore bring 
 no concerted pressure to bear. Third, there are many cases 
 where the employer cannot raise salaries without serious financial 
 consequences. This is particularly true in the case of insti- 
 tutions whose income is largely derived from fixed investments, 
 themselves subject to adverse effects of rising prices. Fourth, 
 there is usually the hope, if not the expectation, that prices will 
 shortly recede again; and since salaries once raised are difficult 
 to lower, it is regarded as the part of wisdom to make no pre- 
 mature salary advances. 
 
 Wages show more of a tendency to rise with prices than do 
 salaries, although there has usually been a considerable lag in 
 wages, due in general to the same forces that operate to prevent 
 an increase hi salaries. But where laborers are strongly 
 organized, an early increase of wages is usually secured. And 
 since it is usually industrial concerns, which are making good 
 profits in a period of rising prices, that employ wage-earners,
 
 36 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 it is often easier to make the adjustments than is the case with 
 the salaried class, so many of whom are in the employ of insti- 
 tutions which are dependent upon fixed investments or upon 
 an increase in public taxes. 
 
 A factor of great importance in connection with the wage 
 situation in a period of advancing prices is that in trie early 
 stages of the price increase there is usually very active business, 
 and hence steady, as opposed to intermittent, employment. 
 Even though wage rates do not advance as rapidly as prices, the 
 aggregate annual wage may nevertheless for a time keep pace 
 with the cost of living. There is always an end to this com- 
 pensating advantage, however, for there is a limit to the number 
 of hours per day and the number of days per year that a laborer 
 can work. Eventually, the laborer always feels keenly the 
 effects of a general advance in prices. 
 
 Because of the difficulty in lowering wages and salaries that 
 have once been raised, employers prefer to give bonuses during 
 periods of rising prices, as a means of adjusting incomes. A 
 bonus does not become a permanent part of an employee's 
 income; it is in its very nature a temporary adjustment. Hence 
 if prices later recede, the bonus may be omitted without vigorous 
 opposition on the part of employees. Bonuses take many forms 
 and there is no general agreement as to the most satisfactory 
 type. One feature appears to be common, however, that of 
 giving a larger bonus to those in the lower ranges of salaries 
 and wages, on the principle that these classes are nearest the 
 minimum of subsistence and therefore stand in greatest need of 
 relief. 
 
 One of the most distressing results of rising prices is that it 
 becomes increasingly difficult for those who most need to make 
 adequate provision for the future to make such provision. Since 
 the annual purchasing power of one's income is decreased, 
 customary savings, to say nothing of compensatory savings with 
 which to offset the rise of prices, can be secured only by a reduc- 
 tion in the standard of living, something extremely difficult to 
 countenance. The general problem is complicated by the fact 
 that few people have any means of knowing in advance what the
 
 STANDARD FOR DEFERRED PAYMENTS 37 
 
 trend of prices is likely to be. Hence it is virtually impossible to 
 adjust one's savings to the changing needs of the situation. 
 Security against the vicissitudes of existence thus becomes more 
 uncertain; and the risks of life are substantially increased. 
 
 Since the real return from fixed investments is a diminish- 
 ing one during periods of rising prices, it is preferable at such 
 a time to invest in stocks rather than bonds. The reason for 
 this is that the income from stocks is not fixed and is likely to 
 increase as prices rise. Since the monetary value of the invest- 
 ment rises with the price level, the original investment does 
 not shrink as it does in the case of bonds. While men of affairs 
 may well take advantage of this factor, knowledge of it affords 
 small comfort to those who are most adversely affected by a 
 changing price level, namely, dependents with small knowledge 
 of business and of the character of specific shares of stock. The 
 risks involved in purchasing stocks, together with the inability, 
 in most cases, to distribute the risks adequately by a variety of 
 investments, generally necessitates those dependent upon an 
 income from investments to purchase bonds rather than stocks. 
 
 During a period of falling prices results opposite to those 
 portrayed above tend to work out. Salaries are usually not 
 reduced as prices fall, and the real income of the salaried man 
 therefore increases. While wages fall, they do not as a rule 
 decline as rapidly as prices; and the laboring class would 
 accordingly also find its standard of living improved were it not 
 for the fact that a period of falling prices is usually a period of 
 dull times, during which the employer endeavors to minimize his 
 losses by reducing the number of men on the pay-roll. It 
 is therefore commonly urged that labor always gets the short 
 end of things. 
 
 QUESTIONS FOR DISCUSSION 
 
 1. Why was the function of money as a standard of deferred pay- 
 ments of comparatively late development? Is it a result or 
 a cause of industrial progress ? 
 
 2. Does the same commodity usually serve both as a pecuniary unit 
 or common denominator of values, and as a standard of deferred 
 payments ? Is this necessarily the case ?
 
 38 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 3. What is the difference between value and price? 
 
 4. What is the value of the dollar unit ? 
 
 5. What is meant by the mint price of gold? What is the mint 
 price of standard gold? 
 
 6. What is meant by the level of prices ? How is it determined ? 
 
 7. To what various uses may an index number of relative prices be 
 put? 
 
 8. What factors govern the value of gold as a commodity ? 
 
 9. Have we ever reached the ideal in the matter of a standard for 
 deferred payments ? of a pecuniary unit ? 
 
 10. Why should a fluctuating standard of deferred payments have 
 deterred "saving" in Rome? Why should it have deterred 
 capitalistic enterprise in general? 
 
 1 1 . Why did the fluctuating standard of paper currency at the time 
 of the French Revolution result in wild speculation ? 
 
 12. During the period of depreciated greenback currency in the 
 United States, do you think the wholesale merchant was justified 
 in requiring cash payments or very short-time credit terms ? 
 
 13. Was the system of cash discounts that was developed fair to the 
 buyer? to the seller? 
 
 14. Does a fluctuating standard interfere more with short- or with 
 long-term credit operations ? Why ? 
 
 15. Why should European investors have sold American securities 
 in the early nineties, when it was thought the United States 
 might resort to a silver standard ? 
 
 1 6. Would the conditions that existed in the early nineties have 
 deterred you from making long-time loans ? 
 
 17. "A debt for $1,000 that 1,000 bushels would have paid ten years 
 ago now requires the farmer to give up 2,000 bushels of wheat, in 
 exchange for these dollars, with which to pay the same debt. 
 The debts now in existence are principally old debts or renewed 
 or funded debts, or new debts contracted to pay old debts, or 
 debts which the people have been forced to contract by reason 
 of the continued decline of prices. The owners of products must 
 now give up twice as much property to pay the taxes as in 1873 " 
 (open letter to President Cleveland, April, 1894; distributed 
 among farmers in a pamphlet). Discuss. 
 
 1 8. To your way of thinking, was it the moral duty of the debtors to 
 stand by their contracts? Suppose prices had risen, would the 
 debtors have advocated a contraction of the currency ?
 
 STANDARD FOR DEFERRED PAYMENTS 39 
 
 19. "I object to the silver standard being adopted in lieu of the 
 existing standard, because it will defraud all creditors out of 
 one-half of the value of their debts. Every debt contracted since 
 January i, 1879, was contracted on the gold standard. The 
 debtor honestly owes the value of 23. 22 grains of gold for every 
 dollar promised, and the creditor is honestly entitled to receive it" 
 (open letter in 1896 to Texas Democrats by Hon. Roger Q. Mills). 
 Discuss. 
 
 20. Would not the men in the creditor class have had different views 
 if they had been debtors ? 
 
 21. Was the opposition to "cheap money" in New England due to 
 superior honesty and morality, or to self-interest ? 
 
 22. "If a free silver bill becomes a law, a veteran who now gets a 
 pension worth to him $4.00 per month would receive actually 
 $2.80, with the chance of its going down to an actual value of 
 $2 . 40. An old soldier who is a total physical wreck gets $72 . oo 
 a month. If a free silver bill passed, while he would nominally 
 get this sum, he would really get but $50. 40. This coinage ques- 
 tion should not be one of party politics. It rises above partisan- 
 ship. The honor of the country is at stake. Its good faith not 
 only to its living soldiers is brought into question, but if a so-called 
 free coinage bill becomes law, the widows and orphans of the 
 nation's dead will be robbed by the laws of the land they died to 
 save. The law would work a monstrous wrong, for from the 
 moment it goes upon the statute book it represents over 
 $45,000,000 per year taken from the ex-soldiers, their widows, 
 and their orphans" (Congressman Harter in a circular to all 
 the Grand Army posts, 1892). Do you agree? 
 
 23. Upon what classes of the community do the evils of a depreciating 
 standard fall most heavily ? 
 
 24. If the value of the dollar falls 8 per cent in a year, how much net 
 interest does a man receive who buys bonds yielding 5 per cent ? 
 
 25. What was the net return on a 4 per cent Liberty bond purchased 
 in 1917? Was the investor indirectly paying the costs of the 
 war ? (See chart on p. 31.) 
 
 26. Do investors usually take into account the shrinkage in the value 
 of the standard ? 
 
 27. If a man "discounts the future" at the rate of 5 per cent, would 
 he invest at all when the dollar is shrinking rapidly ? 
 
 28. Most educational and eleemosynary institutions receive a large 
 portion of their income from investments in bonds. In a period
 
 40 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 of rising prices is it easy for them to increase salaries and thus 
 offset the high cost of living ? Is it easy for them to raise tuition 
 sufficiently to offset at once the- shrinkage in the real return from 
 investments and to increase salaries ? What is the way out ? 
 
 29. An insurance company invests its premiums largely in bonds. 
 What is the result during periods of rising prices ? falling prices ? 
 
 30. Do you imagine insurance companies, savings banks, etc., 
 would shift investments to stocks during periods of rising prices ? 
 
 31. What is meant, precisely, by the high cost of living? Does it 
 mean hard times? for everybody? If prices were low, would 
 everybody be happy ? Were they in the early nineties ? 
 
 32. Is there any means by which the salaried and wage-earning 
 classes may escape the evils of rising prices ? 
 
 33. If prices should recede in this after-the-war period, what classes 
 will gain ? what ones lose ? 
 
 34. Indicate why a business man might dislike falling prices. 
 
 35. Why do farmers usually object to falling prices? 
 
 36. What is the attitude of labor toward falling prices ? 
 
 37. Do you think it possible that we might have an anti-deflation 
 movement at the present period if prices should decline ? 
 
 38. Which do you prefer, the high cost of living or the evil of fall- 
 ing prices ? 
 
 39. During the war did salaried people and those whose wages did 
 not increase as fast as prices pay indirect taxation ? Did such 
 taxation help win the war ? Is it a good form of taxation ? 
 
 REFERENCES FOR FURTHER READING 
 
 Johnson, Joseph French: Money and Currency, chap. ii. 
 Laughlin, J. Laurence: Principles of Money, chap. iii. 
 Moulton, Harold G.: Principles of Money and Banking, Part I, 
 Selection No. 7. 
 
 Scott, William A. : Money and Banking, chaps, iii and iv.
 
 CHAPTER IV 
 
 OTHER FUNCTIONS AND SERVICES 
 OF MONEY 
 
 I. MONEY AS A MEDIUM OF EXCHANGE 
 
 "Money is a medium of exchange." This is the definition 
 of money commonly found in the dictionaries; it is the essence 
 of the layman's thought on the subject; and it is the function 
 upon which most emphasis is usually laid by writers on monetary 
 theory. Treatises on money, indeed, commonly begin with a 
 statement of the inconvenience of barter, or direct exchange of 
 one commodity for another, and then proceed to show the 
 advantages of money as a medium for effecting exchanges. 
 
 The inconvenience of effecting exchanges by means of 
 barter is obviously very great. It is necessary for an indi- 
 vidual who wishes to trade a commodity not only to find some- 
 one who has the precise commodity which he desires; he must 
 also find someone who wishes the particular commodity that is 
 offered in exchange. And even when two individuals, each 
 having a commodity desired by the other, are brought together, 
 it is still often impossible to effect an exchange, because the com- 
 modities may be of substantially different value. It is of inter- 
 est to note that the unequal value of bartered commodities 
 has given rise to the familiar practice of paying something 
 "to boot." 
 
 Money as a medium of exchange eliminates the inherent 
 difficulties in barter. The seller disposes of his goods for 
 money, and with the money purchases, at such times and in such 
 quantities as he desires, the goods which he needs. 
 
 This function of money as a medium of exchange really 
 divides barter into three parts, as follows: 1 "(i) selling goods for 
 money, (2) keeping the money until other goods are needed, 
 
 1 F. M. Taylor, Some Chapters on Money, pp. 14, 16. 
 
 41
 
 42 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 and (3) using the money to buy other goods. It is further 
 evident that in these three phases, looked at from the stand- 
 point of the man who starts out with goods to sell, money 
 plays three different parts. In the first, its role is that of a 
 thing which can be obtained with any goods whatsoever. In 
 the second, its business is to keep store this power to obtain 
 other goods. In the third, its part is that of a thing which 
 can obtain any goods whatsoever." 
 
 Exchange makes possible large-scale production. The service 
 of money in this connection is not merely that it saves time in 
 effecting exchanges. Of infinitely greater significance is the 
 fact that it makes possible a specialized exchange society, and 
 hence large-scale production. Without a medium of exchange 
 business transactions would have to be of the very simplest 
 nature. Trading would have to be confined to local areas, and 
 production would have to be conducted on a small-scale basis. 
 In fact, without a medium of exchange the modern system of 
 specialized production and exchange, by means of which 
 industrial establishments are enabled to produce in tremen- 
 dous quantities at a low cost per unit, and to sell their products 
 throughout the civilized world, would be out of the question. 
 
 II. MONEY AS A STORE OF VALUE 
 
 Before the development of modern banking institutions 
 and the system of credit by means of which funds may be 
 safely invested in productive enterprises, wealth was usually 
 stored up for future use by means of hoarding the precious 
 metals. Gold and silver, comprising large value in small bulk, 
 and being of universal acceptability in exchange for commodities, 
 constituted the best means available for accumulating wealth for 
 old age; hence the hidden treasures of history and fable. While 
 under modern conditions money is characteristically held for a 
 brief interval, as noted above, it is not often stored in the sense 
 of being hoarded; it is invested instead through the machinery 
 provided by banking institutions.
 
 FUNCTIONS AND SERVICES OF MONEY 43 
 
 HI. THE USE OF MONEY IN PRODUCTION 
 
 When money is spoken of as a medium of exchange, one 
 usually has in mind the exchange of consumers' goods. For 
 convenience of exposition, economic treatises have commonly 
 been divided into four parts, devoted respectively to con- 
 sumption, production, exchange, and distribution. Money is 
 treated under exchange, and its chief function is usually regarded 
 as that of effecting the exchange of goods that have already 
 been produced and are in the market awaiting transfer to 
 the hands of those who are to consume them. 
 
 The common failure of writers on money to call attention 
 to the part that money plays in effecting the exchange, on the 
 one hand of personal and professional services, including labor, 
 and on the other of capital goods, raw materials, and partly 
 finished products in the processes of capitalistic production 
 is no doubt attributable to the fact that monetary theory was 
 first worked out at a time when the volume of personal and 
 professional services was negligible, when the producing 
 and manufacturing process was largely conducted on a non- 
 capitalistic basis, and when in the main it was only completed 
 consumers' goods that were exchanged through the use of 
 money. In emphasizing only the exchange of produced goods 
 modern writers on money have therefore merely followed 
 tradition. 
 
 But if one is to appreciate fully the significance of money 
 under a capitalistic industrial regime it is necessary to consider 
 the part that it plays in the productive as well as in the exchange 
 process. Exchange of consumers' goods is not to be excluded; 
 but the role of money in getting goods ready to be exchanged 
 as completed products is to be included. 
 
 Modern business is almost universally conducted through the 
 use of money. Under the conditions of modern capitalistic 
 industry money is utilized in connection with every stage of 
 the productive process. With money the manufacturer pur- 
 chases the materials needed for the construction of his plant; 
 with money he hires laborers to build the factory; with money
 
 44 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 he employs an administrative staff to manage the business; and 
 with money he purchases the materials and supplies, together 
 with the necessary labor force required to operate the business. 
 In a similar way the farmer, under modern conditions, uses 
 money in connection with every phase of his operations. So 
 also with the producers of raw material, whether in the form of 
 coal, ores, lumber, what not. While from one point of view the 
 wholesaler and retailer are engaged in distributing goods that 
 have already been produced, from another they are occupied 
 in carrying out certain essential parts of the productive process. 
 Transportation agencies also use money in connection with 
 every phase of their business operations. 
 
 In short, practically the entire productive process is nowa- 
 days organized and operated through the use of money. All 
 the capital used in modern business is expressed in terms of 
 money, and indeed it is initially in the form of currency. The 
 economist defines capital as concrete material goods used in 
 producing other goods; while the business man usually thinks 
 of capital as money, or funds, available for business purposes. 
 This is primarily due to the fact that subscriptions to shares of 
 stock or to bonds are received in the form of liquid funds, 
 and that with the "fixed capital" thus raised the business 
 man constructs and equips his plant. Similarly, "working 
 capital usually consists initially of funds in the till or in the 
 bank, derived either from the subscriptions of partners or share- 
 holders or from bank loans. With these liquid funds the busi- 
 ness man hires his labor and purchases the materials and 
 supplies required in the producing, manufacturing, or marketing 
 process. With "liquid funds," or money, the factors of pro- 
 duction are thus assembled and organized into a going concern. 
 
 It is therefore not surprising that the business man should 
 usually think of capital in monetary terms. Upon reflection 
 he will realize, of course, that money is only a handmaiden of 
 production, that the things with which wealth is really created 
 are concrete capital instruments in the form of machines, build- 
 ings, etc. On the other hand, while the economist is warranted 
 in laying emphasis upon the material instruments of production,
 
 FUNCTIONS AND SERVICES OF MONEY 45 
 
 he must recognize, if he is to appraise successfully the part that 
 money plays in a capitalistic society that without the use of 
 liquid funds or monetary instruments capital goods and labor 
 cannot be assembled and put to productive work. 1 
 
 IV. THE ROLE OF MONEY IN WAR 
 FINANCE 
 
 A consideration of the part that money plays in time of 
 war will serve as a convenient means of revealing its significance 
 in ways other than those that have already been discussed. 
 . Napoleon once said that three things are necessary if a war is to 
 be waged successfully: money, more money, and still more 
 money. How often during the recent Great War we were told 
 that money provided the sinews of battle, that cash and credit 
 would insure the victory. Let us consider precisely how money 
 is of service in time of war. 
 
 In a war between two nations only, with the rest of the 
 commercial world unaffected, money is of paramount impor- 
 tance. With money in hand, the government can purchase 
 the war supplies needed from neutral countries. Money thus 
 buys the real sinews with which wars are waged. Before the 
 entrance of the United States into the Great War, for example, 
 England and France purchased, with money, great quantities 
 of war supplies from the United States. And if these countries 
 could have increased their total supplies of money, they could 
 have continued to purchase materials from the neutral world, 
 to an extent limited only by the producing capacity of the 
 neutral nations. 
 
 But under the conditions that existed at the time the 
 United States entered the Great War, it was impossible for us to 
 use money to any great extent in buying goods from any other 
 nation, for the simple reason that almost the entire commercial 
 world was then at war. With his money, Uncle Sam could buy 
 
 1 From the viewpoint of productive requirements, the supply of money 
 is not always a matter of indifference. "Capital" in the form of funds is 
 sometimes " scarce " and sometimes " plentiful." The amount available may 
 have an important bearing upon productive activities. See chap, xxiii.
 
 46 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 war supplies only from himself. It may be noted that, in con- 
 sequence of the blockade, Germany had been in this condition 
 from almost the beginning of the war. 
 
 It was often said early in the struggle that as long as Ger- 
 many kept all of her money within the country, she would never 
 be lacking in funds with which to wage the war; and, similarly, 
 many people thought that as long as the United States had 
 great quantities of gold and other forms of currency, we should 
 surely be in a position to wage war effectively. What was 
 not usually appreciated was that money is only a means to an 
 end, and that the total quantity available is of less importance 
 than the way in which it is used by the nation. 
 
 There was much apparent mystery in the year 1917 as to 
 how our government could raise some twenty billions of dollars 
 when there was only $4,702,130,941 of currency in the country. 
 The answer is that when we, the people, turn funds into the 
 Treasury, the Secretary promptly buys the needed supplies 
 from us, the people. Funds are thus merely passed through the 
 Treasury Department in successive installments, giving purchas- 
 ing power while there, but passing, in the act of purchasing the 
 supplies required, back again into the channels of industry. 
 Twenty billions could thus be raised in a single year by 
 having, say, four hundred millions pass through the Treas- 
 ury Department once a week for fifty weeks. In fact, how- 
 ever, actual gold or actual money is not used to any very 
 great extent; credit instruments in the form of checks and 
 drafts are the means most generally employed in making 
 payments. 
 
 Industrial mobilization is accomplished by monetary means. 
 With money in hand, the government seeks to induce the 
 production of war supplies by means of ,an offer of high prices 
 to business men engaged in production. It is necessary to 
 offer high prices because it is necessary to effect a substantial 
 shifting of production if the vast quantities of war supplies 
 required are to be forthcoming. This shifting of industry 
 from ordinary lines to the production of war supplies gives rise 
 to many unusual risks. The price offered by the government
 
 FUNCTIONS AND SERVICES OF MONEY 47 
 
 must therefore be high enough to cover all costs incident to 
 the transition into the war business, the losses due to high costs 
 of operation while engaged in the manufacture of war supplies, 
 and finally the losses incident to the transition back to peace- 
 time industry after the war. The price and profit system, 
 expressed in terms of the pecuniary unit of calculation and made 
 effective by a diversion of a portion of the money supply of the 
 nation to the government, is thus the means by which the nation 
 secures the readjustment of industry necessary to the successful 
 prosecution of the war. 1 
 
 Private consumers compete against the government for pro- 
 ductive energy. The general public may either aid or deter the 
 government in this process, depending upon the way in which 
 people employ the monetary income at their disposal. If the 
 wages and profits of industry are freely used in the purchase of 
 goods for ordinary consumption, this spending results in a direct 
 competition with the government for the productive energy of 
 the nation. The competition of private buyers of ordinary com- 
 modities is usually effective against the government's competi- 
 tion without a proportionate bidding up of prices, for the reason 
 that business is adjusted to the production of commodities for 
 ordinary consumption, and hence the risks of industry are less 
 than is the case where shifting to war production is required. 
 It was because of this competition between private buyers and 
 the government for a limited supply of social energy that the 
 argument for "business as usual" was unsound; and it was 
 because of this that the governments of all the belligerent 
 nations urged the most rigid economy on the part of the general 
 public. 
 
 It will be seen from the foregoing that the chief function of 
 money in time of war is to facilitate the proper direction of 
 industrial energy, to shift production from less essential to 
 
 1 While this method of financial inducement was the chief means relied 
 upon early in the Great War, it was later largely supplanted by methods of 
 priority in the use of raw materials, transportation, etc., and in some 
 countries by actual conscription of industrial establishments for war pur- 
 poses. Taxation may also be made to play an important part in forcing 
 economic readjustments.
 
 48 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 more essential enterprises. This is not to say, however, that 
 the total quantity of money available in time of war is a matter 
 of entire indifference; for the necessary shifting of energy can, 
 as a practical matter, be secured more quickly if there is an 
 increase in the total quantity of monetary instruments. Dis- 
 cussion of this phase of the question must, however, here be 
 passed by, since it would involve a study of the problem of 
 reorganizing the entire economic system to meet the tyrannical 
 requirements of war. 
 
 V. THE ROLE OF MONEY IN PEACE FINANCE 
 
 A consideration of the way in which money is used in time 
 of war to effect a redistribution of social energy is a convenient 
 point of departure for a consideration of a similar service 
 performed by money in distributing productive energy in 
 ordinary times. As we have already seen, the work of society 
 is now largely organized through the use of money. The 
 greater part of this work is under the direction of private busi- 
 ness men in search of profits. Some of it, however and the 
 amount is constantly increasing is, in peace as well as in 
 war, under the control of government. Our government, for 
 instance, provides funds for education, charitable organiza- 
 tions, public health, highways and parks, national defense, and 
 a large amount of scientific and social investigation in connection 
 with such departments as agriculture, the interior, commerce, 
 labor, etc. It also conducts the postal service; while in most 
 countries of the world the great transportation systems have 
 long been under governmental direction. 
 
 Society secures the prosecution of governmental enterprises 
 by diverting funds, through taxation and bond issues, from 
 individuals, who would be spending them for ordinary con- 
 sumptive purposes, to the government, where they are available 
 for hiring the necessary labor supply and for purchasing the 
 required materials for the enterprises in question. Money is 
 the means by which the government is enabled to bid for a 
 diversion of our productive energy into these channels.
 
 FUNCTIONS AND SERVICES OF MONEY 49 
 
 The distribution of productive energy is effected by the use oj 
 money. In a similar way, money is the means by which the sup- 
 ply of social energy is distributed among the various forms of 
 private enterprise. We have already seen (chapter ii) that it 
 is the relative profits that are to be obtained in different lines 
 of industry that determine the distribution of social energy 
 among those lines. It only remains to note that a demand for 
 a particular line of goods sufficient to induce energy to enter 
 that line is made effective by the use of monetary expenditures 
 in the market; and that money is the means by which the 
 entrepreneur entering that line bids in the labor and com- 
 modity markets for the productive energy which he requires 
 in order to produce the goods in question. 
 
 Not only is money the instrumentality through which 
 energy is distributed among the different industries engaged in 
 the production of consumers' goods; it is also the means by 
 which the energy of society is apportioned between the produc- 
 tion of consumers' goods and the production of additional capital 
 goods. The creation of additional capital goods requires the 
 borrowing of liquid capital in the form of monetary instruments. 
 If society at any given time utilized all of its wages and profits 
 for the purchase of consumers' goods, no funds would be avail- 
 able for the uses of entrepreneurs who desire to create additional 
 capital goods. Saving of a portion of the annual income is 
 necessary if a sufficient volume of funds is to be available in 
 the hands of investment banking institutions for the uses of 
 capitalists who are seeking to develop new enterprises. 
 
 On the other hand, every industry which is engaged in 
 turning out consumption goods uses monetary instruments 
 (working capital) as the means of securing the necessary 
 social energy. There is thus a competition for the supply of 
 monetary instruments between those who are engaged in the 
 production of new capital goods and those who are engaged in the 
 creation of additional quantities of consumers' goods. This 
 competition for the available supplies of monetary instruments 
 and the consequent apportionment of social energy between the 
 creation of capital goods and the creation of consumers' goods
 
 SO THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 involves some of the most intricate and important problems in 
 the entire field of economic organization. Our present purpose, 
 however, is merely to point out the fact that money plays an 
 important role in the apportionment of our productive energy. 
 
 QUESTIONS FOR DISCUSSION 
 
 1. "With barter there must be a 'double coincidence" in order to 
 effect an exchange." Explain by a concrete illustration. 
 
 2. Mention as many cases as you can of the use of barter at the 
 present time. Is money not used as a basis of reckoning, even in 
 these cases ? 
 
 3. Precisely what is meant by the function of a medium of exchange? 
 
 4. Discuss the relation of a medium of exchange to: (a) industrial 
 specialization; (b) territorial specialization; (c) the size of the 
 business unit ; (d) the efficiency of production. 
 
 5. Do you think that money is more important as a medium of 
 exchange than (a) as a pecuniary unit of calculation; (b) as a 
 standard of deferred payments? 
 
 6. Is the use of money as a store of value really a monetary function ? 
 Is it a function separate and distinct from that of a medium of 
 exchange ? 
 
 7. When money is invested, is it not still serving as a store of value ? 
 
 8. Does the business man ordinarily think of money as a medium 
 of exchange ? What would he be likely to say the function of 
 money in business is ? 
 
 9. Is it only goods ready to be transferred to ultimate consumers 
 whose exchange is effected by the use of money ? 
 
 10. Do you regard the transfer of services under modern conditions 
 as relatively unimportant? Do you regard the payment of 
 money wages as an exchange function ? 
 
 u. The organization of a business requires the raising of a certain 
 amount of fixed capital. Immediately speaking, this fixed capital 
 is in the form of liquid funds or monetary instruments. Are not 
 these funds, however, merely used as a means of procuring goods 
 that have already been produced ? 
 
 12. Every business also requires "working" or "operating" capital. 
 Immediately speaking, this capital is in the form of liquid funds 
 or monetary instruments. Are these funds always used as a 
 means of procuring goods which have previously been produced ?
 
 FUNCTIONS AND SERVICES OF MONEY 51 
 
 13. Suppose, with the liquid capital possessed by a business, immi 
 grants are hired to come to the United States and are set to work 
 digging coal or ore out of the ground: Was this money used 
 merely in transferring goods ? Suppose men otherwise unem- 
 ployed are put to work producing raw materials or building a 
 factory: Does this involve merely a transfer of existing wealth ? 
 
 14. In time of war money is regarded as a prime requisite. Can it 
 be used in firing at the enemy? Can it be used to purchase 
 supplies in foreign countries ? 
 
 15. What is the precise function of money in connection with war 
 finance under conditions where goods cannot be secured from 
 abroad ? 
 
 16. Could industrial mobilization in fact be effected without the 
 use of money ? Could the motive force to industrial mobilization 
 be something besides monetary profits? If so, what? Would 
 money still be used under these conditions ? 
 
 17. Do you think it is true that private spenders compete directly 
 against the government in time of war ? What are the responsi- 
 bilities of private consumers under such circumstances ? 
 
 1 8. In ordinary times do different groups of individuals compete 
 against each other for the use of society's productive energy? 
 
 19. What determines the proportion of our social energy that is 
 devoted to the production of food and other necessities of life ? 
 Does this coincide with the principle, "Necessities for all before 
 luxuries for any " ? 
 
 20. "The greater the differences in relative incomes of different 
 classes, the larger tends to be the percentage of our social 
 energy which is diverted to the production of luxuries." Do 
 you agree ? 
 
 21. At the present time the masses of the people in Europe have very 
 low incomes. Certain classes which were favorably placed in 
 the industrial system during the war have large incomes. The 
 latter, by extravagant expenditure, are inducing the production 
 of luxuries and other dispensable commodities. The poverty of 
 the masses makes the production of additional quantities of 
 necessaries of life relatively unprofitable. Do you think the 
 profit-making system is working well under present conditions ? 
 
 22. In the cases under discussion money is serving a double function: 
 (a) as a basis for computing profits; (b) as the means by which 
 labor and capital are attracted into the more profitable lines of 
 business. Do you agree ?
 
 52 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 23. The number of enterprises that are being undertaken by govern- 
 ments national, state, and local has been constantly increas- 
 ing in recent years. Are there important social measures which 
 must be held in abeyance because they cannot be financed? 
 Why is it that they cannot be financed ? 
 
 24. Each year an adequate proportion of the social energy of society 
 should be devoted to the replenishment and extension of the 
 capital supply. How is this apportionment of our productive 
 energy, as between the creation of capital and consumptive 
 goods, effected under a pecuniary system? 
 
 25. Does spending compete against saving ? 
 
 26. Precisely what is meant by " saving " ? Has saving been effected, 
 in fact, as soon as money income has been placed in a bank or 
 invested in securities ? 
 
 27. What determines the percentage of the monetary income annually 
 received by society that is saved and that is spent for consumptive 
 goods? Is this apportionment necessarily worked out in the 
 interests of long-run, general welfare ? 
 
 REFERENCES FOR FURTHER READING 
 
 Holdsworth, John Thorn: Money and Banking, chap. i. 
 Johnson, Joseph French: Money and Currency, chap. L 
 Laughlin, J. Laurence: Principles of Money, pp. 15-22. 
 Moulton, Harold G. : Principles of Money and Banking, Part I, 
 Selections Nos. 4 and 5. 
 
 Scott, William A.: Money and Banking, pp. 6-13.
 
 CHAPTER V 
 
 THE PECUNIARY SYSTEM AND ECONOMIC 
 AND SOCIAL STANDARDS 
 
 From the very beginning of the capitalistic regime, under 
 which, as we have seen, practically all productive and trading 
 operations are carried on through the intermediation of currency 
 and find expression in monetary terms, there has been a general 
 misunderstanding of the social significance of money. Consti- 
 tuting a general fund of purchasing power a veritable key 
 to things desired money is by many people regarded as an 
 end in itself, the summum bonum of human endeavor; while 
 by many more it is deemed at least a very superior form of 
 wealth, a plentiful or scanty supply of which renders a nation 
 rich or poor, powerful or impotent. The confusion of money 
 with welfare has, moreover, been responsible for many ill- 
 judged movements for social reform. Indeed, so vital an 
 influence has money been hi the evolution of industrial society 
 that Alexander Delmar, who has doubtless given more study 
 to the origin and development of monetary systems than any 
 other writer, suggests that the history of money is the history 
 of civilization. 
 
 While this view is not accepted by most writers, all are 
 nevertheless agreed that money has played a r61e of enormous 
 importance hi the affairs of men. More articles and books have 
 been written and there has been more discussion on the subject 
 of money than on any other in the entire realm of political 
 economy. At the same time the various controversies have 
 developed more extreme enthusiasm and greater bitterness of 
 denunciation than those in any other field. In the somewhat 
 exaggerated phraseology of Mr. Bryan, "Brother has been 
 arrayed against brother, father against son. Warmest ties of 
 love, acquaintance and association have been disregarded; 
 
 S3
 
 54 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 old leaders have been cast aside .... and new leaders have 
 sprung up to give direction to the cause of truth." 
 
 I. MONETARY EVALUATION AND SOCIAL IDEALS 
 
 The extraordinary importance that has been attached to 
 money throughout the ages may be appreciaced by reference to 
 the following classical quotations. They also suggest the 
 influence of the pecuniary calculus upon ethical standards: 
 Horace: Make money, money, man; 
 
 Well, if so be, if not, which way you can. 
 
 Timocles: Money's the life and soul of mortal man. Who 
 
 has it not, nor has acquired it, 
 
 Is but a dead man, walking 'mongst the quick. 
 Milton: Money brings honor, friends, conquest, and realms. 
 
 Pope: There London's voice, 'Get money, money still, 
 
 And then let virtue follow if she will.' 
 Tennyson: But the jingling of the guinea helps the hurt that 
 
 honor feels. 
 Paul of Tarsus: For the love of money is the root of all evil. 
 
 The perversion of social ideals that has attended the develop- 
 ment of a pecuniary system is well expressed by Professor 
 Davenport in the following language: 
 
 More and more, and more and more exclusively, and over an ever- 
 widening field of human effort, human interests and desires and 
 ambitions fall under the common denominator of money. Doubtless 
 many of the best things in life do not get bought and sold. Some 
 of them are not exchangeable; and not all things that could be 
 transferred are men weak enough to sell or other men strong enough to 
 buy. Not every man has his money price. But most good things 
 do, in greater or less degree, submit to the money appraisal. Health 
 is easier for him who can take his ease and who has the wherewithal 
 to pay for good foods and medicines, to travel, to employ good nurs- 
 ing, and to command capable physicians and efficient surgeons. 
 And in their degree, also, love and pity and respect and place are 
 bought and sold upon the market. It takes a goodly number of 
 dollars to get a child safely born, and even more dollars to achieve for 
 one's self a respectable burial. Much money is power over many 
 things. Money is the standard of value in the sense that all values of 
 all exchangeable things are expressed in terms of it. And this holds,
 
 PECUNIARY SYSTEM AND ECONOMIC STANDARDS 55 
 
 not only of all commodities and services, but of all incomes and 
 of all capitals. The capital of a banking house, or a factory, or a 
 railroad company is not a congeries of tangible things, but a pecuniary 
 magnitude so many dollars. All economic comparisons are made 
 in money terms, not in terms of subsistence, or of beauty, or of artistic 
 merit, or of moral deserving. This same standard tends to become 
 also the test and measure of human achievement. Men engage in 
 business, not solely to earn a livelihood, but to win a fortune in a 
 pecuniary sense. To win by this money test is to certify one's 
 self tangibly and demonstrably as having scored in the most wide- 
 spread and absorbing of competitions. Is one a great artist what 
 do his pictures sell for? Or what is the income of this leading 
 advocate ? or of that famous singer ? How great are the author's 
 royalties ? The pecuniary standard tends to be carried over into non- 
 pecuniary fields. 
 
 It is almost past belief how far both in degree and in direction 
 money valuations pervade all our thinking. Cheapness is prone to 
 be synonymous with ugliness, richness with beauty, elegance with 
 expensiveness. No one can tell for himself where the really aesthetic 
 begins and the sheer pecuniary ends. In the field of morals, also, 
 the so-called cash-register conscience is an actual thing. And one 
 might go still further and note that almost all great political issues, 
 and almost all absorbing social problems, and almost all international 
 complications, rest upon a pecuniary basis. Our national problems 
 are tariff, labor unions, strikes, money, trusts, banking, currency, 
 railroads, conservation of resources, shipping, taxation. Success 
 in elections, in the selection of senators, in the making of laws, and 
 in the selection of judges is prone to be desired for financial ends 
 and to be decided by pecuniary means. Diplomatic comph' cations 
 hinge upon trade connections, the open door, fisheries and sealeries, 
 colonies for markets, and spheres of influence for trade. Navies 
 are trade guardians and trade auxiliaries. Eliminate from local 
 politics the influence of the public-service corporation, of the con- 
 tractor, and of the seekers for special pecuniary privileges, and what 
 is left of the municipal problem will be mostly the pecuniary nexus 
 of the slum with the ballot box, of the saloon with the police system, 
 and of saloon and slum and brothel with the city hall. 1 
 
 The system of pecuniary evaluation also tends to substantial 
 conservatism in the matter of social progress. All people who 
 1 From The Economics of Enterprise, pp. 22-24,
 
 56 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 are in possession of monetary incomes hesitate to see social insti- 
 tutions, upon the stability of which depends the certainty of their 
 incomes, disarranged by either political or industrial changes. 
 Vested interests which find their expression in pecuniary terms 
 stand as a bar sinister to social progress. Even labor has 
 generally been induced to resist change because change usually 
 involves, immediately speaking, a sacrifice of wages. Short- 
 run pecuniary needs usually bulk larger in the laboring man's 
 horizon than long-run gains, either to himself or to society as a 
 whole. 
 
 Nearly everywhere, indeed, the price system tends to 
 emphasize the short- rather than the long-run point of view. 
 Obsolete and inefficient methods or institutions persist long 
 after it is clear that welfare would be distinctly promoted were 
 they supplanted by others. Natural resources are ruthlessly 
 exploited during a few brief years, leaving to future generations 
 a depleted national heritage merely because it pays best to 
 mine, or lumber, or farm without thought of the distant morrow. 
 Human beings, also, are at times driven at an exhausting pace 
 and at others denied the opportunity of earning a livelihood, in 
 order that a maximum of monetary profits may result for 
 those who, in the evolution of industrial society, have come to 
 direct the machinery of modern production. 1 
 
 IL THE CONFUSION OF MONEY WITH WEALTH 
 
 The importance that individuals in a pecuniary society 
 necessarily attach to their monetary incomes lies at the basis of 
 the prevailing idea that the quantity of money possessed by a 
 nation is always of paramount importance. If the more money 
 an individual has the wealthier he is, why is it not also true that 
 the greater the quantity of money within a nation the richer is the 
 nation ? This belief that nations, like individuals, are well-off in 
 proportion to the amount of their wealth or income as expressed 
 in monetary terms lies at the basis of most of the monetary 
 
 1 For an exposition of this phase of the modern pecuniary system see 
 chap, xxiii.
 
 PECUNIARY SYSTEM AND ECONOMIC STANDARDS 57 
 
 controversies of the past, among which may be mentioned the 
 cheap money experiments of colonial days and the greenback 
 and free silver panaceas of our later history. Indeed, more or 
 less continuously throughout American history there has been 
 a persistent complaint that our economic ilk are largely attribut- 
 able to an insufficient quantity of money. 
 
 Professor Bullock tells us that a review of the currency 
 history of America reveals that "a strong movement in favor 
 of cheap currency has existed continuously in this country 
 from the earliest period of colonization; .... back of all 
 the strivings for an inexpensive medium of exchange, each 
 generation of our people has always heard the complaint that 
 our supply of money has been insufficient." And Adam Smith 
 wrote in 1776 that "no complaint is more common than that 
 of a scarcity of money." John Witherspoon, writing in Revo- 
 lutionary days, points out that if those persons who perpetually 
 cry for a larger volume of gold and silver read the Scriptures 
 "they may there learn that in Solomon's time, the silver was 
 plentiful as stones hi Jerusalem"; but that silver was so 
 plentiful that "it was nothing accounted of in the days of 
 Solomon." 
 
 The mercantilist philosophy rests on confused ideas about 
 money. The belief in the potency of much money is the princi- 
 pal basis of the policy known as mercantilism, a doctrine which 
 flourished most extensively in the seventeenth and eighteenth 
 centuries but still survives in the belief that an excess of exports 
 over imports and a consequent flow of gold into a country is at 
 all times and under all circumstances distinctly advantageous. 
 The doctrine of mercantilism, it is true, was linked up with ambi- 
 tious programs for national supremacy, to be attained through 
 the diversification of industry and particularly through the 
 development of manufacture; and it was apparently instigated 
 by manufacturing and producing interests with something to 
 gain personally as a result of mercantilist policy. But it 
 undoubtedly owed its popular support to the prevalent assump- 
 tion that an inflow of specie into a country is the paramount 
 requirement for national affluence.
 
 58 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 Examples of mercantilist doctrine at the present day are 
 legion; for the financial and business press of the country is 
 continually calling attention in times of large exports to the 
 enormous gains that are accruing to the nation. To give 
 but a single quotation, a well-known financial writer stated in 
 1916 that " the great balance of trade in our favor, amounting to 
 practically one billion dollars, is very gratifying to the American 
 people and to the American government." 1 
 
 The doctrine that we should "patronize home industry" affords 
 another illustration of the prevalent confusion. Closely akin to 
 the supposed advantages of a favorable balance of trade with 
 other nations is the contention that it is the duty of the people 
 of all communities to patronize home industry. The following 
 quotations indicate the assumed advantages of trading only 
 with local dealers: 
 
 A dollar spent in Auburn gives you another chance at it; but, if 
 it is spent out of town, it's "Good-bye, Mary." 
 
 Down with the parcels post. No more diabolical device was 
 ever perfected by the big cities for stripping the small towns and 
 country districts of all their surplus cash. Yet the rich mail-order 
 houses wax fat with the dollars that are the property of local mer- 
 chants. 
 
 The individual can get rich only by selling more than he buys. 
 Likewise a community can prosper only by selling to other com- 
 munities more than it buys from them. 
 
 The annual influx of students and other outsiders into our fruit 
 belt to engage in fruit-picking and packing is an abuse that should 
 be stopped at once. These people consume very little, saving their 
 money to take back to Ann Arbor, Madison, Champaign, and other 
 places from which they come. Thus, while making large sums off 
 us, they give little or nothing in support of our industries. 
 
 The county commissioners should be promptly impeached and 
 removed from office for their action last Monday. We understand 
 that the contract for the building of the new courthouse was let to 
 
 1 The fallacy in this reasoning is revealed in chaps, viii and xv dealing 
 respectively with the mechanism of foreign exchange and the problems of 
 post-war readjustments occasioned by the unprecedented redistribution of 
 the gold supply of the world that occurred during the Great War.
 
 PECUNIARY SYSTEM AND ECONOMIC STANDARDS 59 
 
 the Knoxville firm only because their bid was $1,800 under that of 
 our fellow-citizen, James R. Robertson. Robertson, as we are all 
 aware, is an expert at this line of work, and was well equipped to 
 do a handsome job. The only excuse which the commissioners give 
 is the $1,800. But against this must be set down the $32,000 which 
 will be paid to the Knoxville gang. Think of it! Sending $32,000 
 out of town to save a paltry $i ,800. 
 
 The system of pecuniary evaluations often serves to obscure 
 fundamental economic conditions. An excellent example of the 
 way in which the system of evaluating wealth in terms of money 
 tends to obscure actual economic conditions and lead to errone- 
 ous conclusions is found in the events of the past six years. The 
 great rise in prices that occurred in the United States during 
 the years from 1914 to 1919, accompanied as it was by a great 
 increase in the quantity of circulating medium, has resulted in 
 much confusion of thought on such matters as national- pros- 
 perity, the distribution of this world's goods, profiteering, etc. 
 We have finally come to learn that the increase in monetary 
 wages does not benefit laborers so long as the prices of com- 
 modities which they must buy are proportionally, or more 
 than proportionally, higher; but it took some time for people 
 to appreciate fully that an increased monetary wage does not 
 necessarily carry with it an increased standard of living. 
 
 Most people in the United States do not even yet understand 
 that the figures which are everywhere quoted showing the 
 great increase in national wealth are largely illusory. This 
 increased wealth is measured hi terms of a depreciated pecuniary 
 unit. With prices twice as high hi 1920 as they were in 1914, 
 the number of dollars' worth of wealth in the country hi 1920 
 may be double that in 1914 without there being any increase 
 whatever in the wealth of the nation, as measured by actual 
 goods and services. 
 
 The increase in bank deposits is repeatedly pointed to as an 
 evidence of the great increase in the nation's wealth, but the 
 truth is that the doubled price level now requires business men 
 to use twice the volume of funds in order to conduct the same 
 volume of productive and trading operations as in 1914. The 
 increased deposits are thus merely a reflection of a changed
 
 60 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 price level. Incidentally, the United States, which has suffered 
 less from the ravages of war than any of the other great nations, 
 has not shown as rapid an increase of deposits as have the 
 European countries; for the greater the rise in the level of 
 prices, the greater is the increase hi the volume of deposits. 
 
 It is also frequently observed that the war has given rise to 
 a great increase in the number of millionaires from seven 
 thousand to thirty thousand and it is widely believed that this 
 was a direct result of profiteering. Some of it, no doubt, is 
 attributable to large profits derived from the production of war 
 materials. But, speaking generally, every man whose prop- 
 erty was valued before the war at five hundred thousand 
 dollars would, merely by virtue of the inflation of prices that 
 has occurred, now find such property worth a million dollars. 
 His real wealth, however, would obviously not have increased 
 at all. 
 
 The increase in net earnings of corporations and in dividends 
 paid to stockholders is everywhere pointed to as evidence of 
 an increase of wealth. Failing to realize that these increased 
 net earnings, in many instances, at least, no more than com- 
 pensate for the changes in the price level, the capitalist class 
 deludes itself with the belief that earnings are unprecedentedly 
 large, while labor insists that profiteering is everywhere rampant, 
 and that there is no valid reason why wages should not be 
 greatly increased at the expense of profits. In other words, the 
 monetary basis of reckoning serves under these conditions to 
 conceal the real economic position of the various classes; and 
 the consequent misunderstanding is one of the chief factors in 
 the social unrest of the time. 
 
 III. THE QUANTITY OF MONEY REQUIRED 
 
 BY A NATION 
 
 We have no doubt been giving the impression in this chapter 
 that the quantity of money within a country is a matter of 
 entire indifference, that actual goods and services are alone 
 important. It is not strictly true, however, that the amount 
 of currency supply is of no consequence in a society that is
 
 PECUNIARY SYSTEM AND ECONOMIC STANDARDS 6 1 
 
 organized on a pecuniary basis. Indeed, under the conditions 
 that actually obtain an increasing volume of currency may 
 sometimes be a matter of real importance, while at other times 
 a decreasing supply would prove advantageous. How much 
 money, then, does a nation need ? To answer this question with 
 entire satisfaction is impossible at this juncture, but the general 
 principles involved may at least be suggested. 
 
 It is necessary in this connection to distinguish between 
 standard money and subsidiary forms of currency, which 
 serve as media of exchange. As for the quantity of gold that is 
 necessary, it may be pointed out, first, that a considerable 
 volume of gold is required for the settlement of international 
 trade balances, which between gold standard countries have 
 to be met in gold. The supply of gold should be large enough 
 to permit the payment of foreign obligations without causing 
 a serious impairment of the gold reserves that support a nation's 
 monetary system. Under normal circumstances there is little 
 difficulty in this connection; but there are times when an 
 outflow of gold reserves may imperil the entire financial and 
 business structure. 1 
 
 Second, since the standard money, gold, is the regulator of 
 all other forms of currency, including not only subsidiary coins 
 and the ordinary forms of paper money, but also deposit or 
 "check" currency created by the commercial banks, 2 the stock 
 must be large enough to insure the maintenance of all these 
 other forms of currency at a parity with gold. The proper 
 ratio of gold to the total quantity of currency redeemable in 
 gold varies widely, depending upon the fundamental conditions 
 of business, upon the length of time over which there has been 
 no depreciation of these forms of currency, and upon the 
 general attitude of the people with reference to the maintenance 
 of a sound monetary system. 
 
 The amount of subsidiary currency that is required also 
 varies. It should be adequate to meet the needs of retail 
 trade and other exchange operations requiring the use of small 
 
 1 See pp. 117 and 270-73. 
 
 1 See chapters on commercial banking, below.
 
 62 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 currency denominations, as denoted by the demand for "change" 
 at the banks; and tiie amount required for these purposes 
 depends upon both the price level and the volume of business 
 that is being transacted. The sharp rise in prices during the 
 war, for instance, enormously increased the demand for sub- 
 sidiary currency of all denominations. Seasons of great busi- 
 ness activity have a similar effect. 
 
 Writers customarily argue that the total quantity of media 
 of exchange, including standard money, subsidiary coins, paper 
 currency, and checks, should be gradually expanded in pro- 
 portion to the expansion in the volume of business. It is 
 believed that under these circumstances the price level would 
 remain unchanged, thus avoiding the serious maladjustments 
 incident to fluctuating prices. This is, however, very difficult, 
 if not impossible of attainment in practice; for the reason that 
 the supply of gold money is dependent upon the productivity 
 of the mines and the varying demands for gold in the arts; 
 while the amount of money required for exchange purposes is 
 dependent upon the rapidity of turnover, or the "velocity 
 of circulation" of given units of money, upon the effectiveness 
 with which the whole monetary and banking system is organ- 
 ized, as also upon the conditions of business activity. During 
 the dull seasons of the year money may be relatively "easy," 
 while in the months of great activity the scarcity of available 
 funds may prove a serious handicap to business. What is 
 needed is an elastic currency one that will expand to meet 
 unusual requirements. 1 Similarly, in years of great business 
 activity there is a very heavy demand for funds. Business 
 men, whether engaged in the production or in the marketing 
 of goods, require "liquid" capital with which to finance their 
 operations. If money is " tight " there is a limit to the expansion 
 of business that can occur. A consideration of the expansibility 
 required in our monetary system must, however, be postponed; 
 for it involves an analysis of the mechanism of commercial 
 banking.' 
 
 1 For a discussion of the problem of elastic currency see pp. 497-502. 
 
 2 See chapters on commercial banking, below.
 
 63 
 
 QUESTIONS FOR DISCUSSION 
 
 1. What do you understand is meant by the term "pecuniary 
 system"? 
 
 2. Has your experience been that most of the affairs of life are 
 measured either directly or indirectly in terms of money? 
 
 3. Is it not true that "money talks"? Does it speak as loudly 
 now as it did before the war ? 
 
 4. " It is not so much a question of how you got it, as have you got it." 
 What does "it" refer to? Do you agree with the sentiment? 
 
 5. "Not what a man has, but what he is." Which is more impor- 
 tant (a) practically speaking ? (b) ideally speaking ? 
 
 6. In view of the domination of the pecuniary system over the 
 activities and thoughts of men, does it seem to you probable that 
 the free play of private initiative in quest of pecuniary gain 
 tends to promote the general welfare: (a) always (b) on the 
 whole ? 
 
 7. "From the individual point of view, an increased quantity of 
 money is the equivalent of an increased quantity of wealth. 
 From the social point of view this is not necessarily the case." 
 Why or why not ? 
 
 8. If the pioneer settlers of America had possessed plenty of capital 
 and wealth, do you think they would have been desirous of 
 having more money? With greater wealth, would more or less 
 money have been required, in fact? 
 
 9. What did the pioneers wish to do with additional quantities of 
 money? Is it possible that there was a genuine scarcity of 
 funds for business purposes ? 
 
 to. Do you find any evidences of mercantilist doctrine in present-day 
 discussions on foreign trade ? 
 
 11. Precisely why is it that an inflow of gold into a country is con- 
 sidered advantageous ? 
 
 12. Are there ever any circumstances under which a large and con- 
 tinuous flow of specie into a country is advantageous ? disadvan- 
 tageous ? 
 
 13. What nations at the present time might be benefited by an inflow 
 of specie ? (See chapter xv.) 
 
 14. Do you agree with any of the arguments given in the text for 
 patronizing home industry ? 
 
 15. How would you measure the increase in the nation's wealth 
 between 1914 and 1920 ?
 
 64 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 16. In a period of rising prices, why do bank deposits always rapidly 
 increase ? Does this necessarily denote great prosperity ? 
 
 17. Does not the great increase in the number of millionaires since 
 1915 prove that there has been unconscionable profiteering? 
 
 1 8. Does the fact that wages have increased from, say, nine hundred 
 to eighteen hundred dollars a year since 1915 prove that there has 
 been unconscionable "wageering" ? 
 
 19. A retail merchant in 1914 receives a net income from his business 
 of $2,000. In 1918, with prices 100 per cent higher, he receives 
 $3,000 net income. Is he profiteering? How do you define 
 profiteering ? 
 
 20. Can you judge whether a retailer is profiteering by ascertaining 
 the profit margin on individual articles ? How can you tell what 
 is a legitimate margin of profit on any particular commodity? 
 Is the retailer's business one of joint costs ? What of it ? 
 
 21. If the net earnings of a corporation doubled in amount between 
 1914 and 1918 would you say that the corporation was profiteer- 
 ing? 
 
 22. It has been officially stated that the purpose of the government 
 investigations and of the "fair price committees" that have been 
 established is to reduce the cost of living. Therefore, if it is 
 found that in any cases prices are too low, they should not be 
 raised. Does this constitute the establishment of "fair" prices? 
 
 REFERENCES FOR FURTHER READING 
 
 Cooley, Charles H.: Social Process, chaps, xxvi-xxviii. 
 
 Davenport, H. J.: The Economics of Enterprise, pp. 21-23. 
 
 Hamilton, Walton H.: "The Price System and Social Policy," 
 Journal of Political Economy, January, 1918. 
 
 Moulton, Harold G.: Principles of Money and Banking, Part I, 
 Selections Nos. 9-25.
 
 CHAPTER VI 
 
 THE REGULATION OF METALLIC 
 CURRENCY 
 
 In order that money may perform effectively its various 
 functions it has been necessary to develop a system of regu- 
 lation that would give precision to business transactions in- 
 volving the use of money. In this chapter we are to consider 
 the various problems that have arisen in connection with the 
 regulation of the different forms of metallic currency. 
 
 I. THE NECESSITY OF GOVERNMENT COINAGE 
 
 The first problem is that of coinage. If the pieces of metal 
 which serve as money were not of uniform certified weight, 
 it is evident that traders would be put to no end of irfconvenience 
 in weighing the currency tendered hi the settlement of obliga- 
 tions. Because of the high value of gold and other precious 
 metals a very slight variation hi weight would involve con- 
 siderable loss. 
 
 Quite as important as the question of uniform weight is 
 that of uniform fineness. Bullion containing gold and silver 
 varies widely in the amount of impurities contained therein; 
 and it is accordingly necessary that it be assayed before 
 coining. It is also easy to melt up gold and silver coins and 
 debase them by adding copper or other metal. In order to 
 permit exchanges to be made with certainty, it is, therefore, 
 imperative that the fineness as well as the weight of coins be 
 attested. 
 
 The objects to be attained by a good system of coinage are 
 stated by Jevons as follows: (i) to prevent counterfeiting; 
 
 (2) to prevent the fraudulent removal of metal trom the coin; 
 
 (3) to reduce the loss by legitimate wear and tear; (4) to make 
 
 6$
 
 66 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 the coin an artistic and historical monument of the state issuing 
 it and the people using it. 
 
 Coinage is now everywhere a government function though 
 it appears that in earlier times there were numerous private 
 mints. The reason for making the coinage of money a govern- 
 ment prerogative is readily apparent. Even if private coiners 
 could be relied upon always to put the same imount of pure 
 metal into a coin, the various private coiners might neverthe- 
 less issue dollars of different weights and fineness. One would 
 therefore always need to know whose dollar it was that he was 
 to receive in payment of obligations; and we should have as 
 many different prices as there were different pecuniary units. 
 A monopoly of coinage is obviously necessary to insure uni- 
 formity of the currency. A private monopoly in the coining 
 of money is clearly undesirable. 
 
 A defective coinage permits the operation of Gres ham's law. 
 Whenever legal tender coins of the same face value, but of 
 different weights or degrees of fineness, are in concurrent circula- 
 tion the light-weight or base coins tend to drive the full-weight 
 pure coins out of circulation. This fundamental monetary 
 law derives its name from Sir Thomas Gresham, a royal agent 
 of Queen Elizabeth, who first expressed in precise terms a 
 phenomenon that had long been observed. 
 
 The reason why the light-weight or base coins will drive 
 the full-weight and pure coins out of circulation wholly or in 
 part is not difficult to see. In making foreign payments 
 money is accepted only by weight; hence the full- weight and 
 pure coins are sent out of the country in payment of foreign 
 balances, while the base or light-weight coins are kept in the 
 domestic circulation. Full-weight and pure coins may also be 
 melted down and used as bullion. While the general public 
 does not discriminate between coins unless there is a con- 
 siderable variation in value, money changers, bullion dealers, 
 and bankers are quick to derive a profit from such varia- 
 tions. History is replete with instances where light-weight 
 and base coins have driven the "good coins" entirely out of 
 circulation,
 
 REGULATION OF METALLIC CURRENCY 67 
 
 H. ECONOMIC AND SOCIAL EFFECTS OF A 
 BAD COINAGE SYSTEM 
 
 Marked differences in the weight and fineness of coins, such 
 as frequently occurred before the coinage process was perfected, 
 usually lead to disastrous social consequences. For instance, 
 Macaulay tells us that: 1 
 
 The old, crude, hammered coins of Great Britain were of varying 
 weight, slightly irregular shape, and with unmilled edges. As a 
 
 result they were easily clipped and mutilated In the autumn 
 
 of 1695 it could hardly be said that the country possessed, for prac- 
 tical purposes, any measure of value. It was a mere chance whether 
 what was called a shilling was really tenpence, sixpence, or a groat. 
 The results of some experiments that were tried at that time deserve 
 to be mentioned. The officers of the exchequer weighed 57,200 
 of hammered money which had recently been paid in. The weight 
 ought to have been 220,000 ounces. It proved to be under 114,000 
 ounces. Three eminent London goldsmiths were invited to send 
 100 each in current silver to be tried by the balance. The 300 
 ought to have weighed almost 1,200 ounces. The actual weight 
 proved to be 624 ounces. The same test was applied in various 
 parts of the kingdom with practically everywhere similar results. 
 
 Interestingly enough, although the penalties against clipping 
 and mutilating the currency were most severe, it was almost 
 impossible to check the practice. Says Macaulay: 
 
 The severity of the punishment (clipping carried the penalty of 
 death) gave encouragement to the crime. For the practice of clipping 
 did not excite in the common, mind a detestation resembling that with 
 which men regard murder, arson, robbery, nay, even theft. The 
 injury done by the whole body of clippers to society as a whole was 
 indeed immense; but each particular act of clipping v/as a trifle. 
 To pass a half-crown after paring a pennyworth of silver from it 
 seemed a minute and almost imperceptible fault. Even while the 
 nation was crying out most loudly under the distress which the state 
 of the currency had produced, every individual who was capitally 
 punished for contributing to bring the currency into that state had 
 the general sympathy on his side. Constables were unwilling to 
 
 1 From History of England (1848), chap, xxj,
 
 68 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 arrest the offenders. Justices were unwilling to commit. Witnesses 
 were unwilling to tell the whole truth. Juries were unwilling to 
 pronounce the word guilty. There was a general conspiracy to 
 prevent the law from taking its course .... the offenders who were 
 convicted looked on themselves as murdered men, and were firm in 
 the belief that their sin, if sin it were, was as venial as that of a 
 schoolboy who goes nutting in the wood of a neighbor. 
 
 These examples clearly reveal the paramount necessity 
 of a uniform currency. Macaulay concludes that : 
 
 It may well be doubted whether all the misery which had been 
 inflicted on the English nation in a quarter of a century by bad kings, 
 bad ministers, bad Parliaments, and bad judges was equal to the 
 misery caused by bad crowns and bad shillings. Those events which 
 furnish the best themes for pathetic or indignant eloquence are not 
 always those which most affect the happiness of the great body of the 
 people. The misgovernment of Charles and James, gross as it had 
 been, had not prevented the common business of life from going 
 steadily and prosperously on. While the honor and independence 
 of the state were sold to a foreign power, while chartered rights were 
 invaded, while fundamental laws were violated, hundreds of thou- 
 sands of quiet, honest, and industrious families labored and traded, 
 ate their meals, and lay down to rest, in comfort and security. But 
 when the great instrument of exchange became thoroughly deranged, 
 all trade, all industry, were smitten as with a palsy. The evil was 
 felt daily and hourly in almost every place and by almost every class, 
 in the dairy and on the threshing-floor, by the anvil and by the loom, 
 on the billows of the ocean and in the depths of the mine. Nothing 
 could be purchased without a dispute. Over every counter there 
 .... was wrangling from morning to night. The workman and his 
 employer had a quarrel as regularly as the Saturday came around. 
 On a fau: day or a market day the clamors, the reproaches, the 
 curses, were incessant; and it was well if no booth was overturned 
 and no head broken. No merchant could contract to deliver goods 
 without making some stipulation about the quality of the coin in 
 which he was to be paid. Even men of business were often bewildered 
 by the confusion into which all pecuniary transactions were thrown. 
 The simple and the careless were pillaged without mercy by extor- 
 tioners whose demands grew even more rapidly than the money 
 shrank. The price of the necessaries of life, of shoes, of ale, of
 
 REGULATION OF METALLIC CURRENCY 69 
 
 oatmeal, rose fast. The laborer found that the bit of metal which, 
 when he received it, was called a shilling, would hardly, when he 
 wanted to purchase a pot of beer or a loaf of bread, go as far as a 
 sixpence. 
 
 HI. COINAGE RULES AND REGULATIONS OF 
 THE UNITED STATES 
 
 The following rules and regulations 1 govern the coinage 
 process at the present time in the United States: 
 
 a) Receipt of bullion. All bullion deposited or purchased at 
 any of the mints or assay offices of the United States shall be weighed 
 in the presence of the depositor or his agent, and the weight shall be 
 verified by the registrar of deposits. If the bullion deposited is 
 found to be of less value than $100, it may be legally refused. If, 
 upon report of the assayer, it is found to be unsuitable for the opera- 
 tions of the mint, it shall be refused. 
 
 b~) Assaying. As soon as the weight of a deposit has been ascer- 
 tained and recorded, the assayer takes at least two samples in suffi- 
 cient portion for assay and proceeds to test the quality of the metal. 
 The assayer shall insert in the report the fineness of the gold or silver 
 contained in the deposit. If the base is ascertained to be copper 
 suitable for standard metal, he shall so state in his report. He 
 shall also insert in his report the charges to which the deposit is 
 subject. 
 
 c) Mint charges. Section 3524, Revised Statutes of the United 
 States, provides that the charges for the various operations on bullion 
 deposited and for the preparation of bars shall be fixed from tune to 
 time by the Director of the Mint, with the concurrence of the Secre- 
 tary of the Treasury, so as to equal, but not exceed, in their judg- 
 ment, the actual average cost to each mint and assay office of the 
 material, labor, wastage, and use of machinery employed. The 
 following are the principal mint charges: 
 
 i. Melting charge. On deposit of bullion a charge of $i shall be 
 imposed for each i ,000 ounces of bullion or fraction thereof as shown 
 by weight after melting, except in the case of uncurrent United States 
 coin and mint-fine bars for which no charge is made. 
 
 1 Adapted from General Instructions and Regulations in Relation to 
 the Transaction of Business at the Mints and Assay Offices of the United 
 States.
 
 76 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 2. Parting and refining bullion. The charges for parting and 
 refining bullion vary with the amount of impurities and base metal. 
 Bullion containing 800 thousandths or more of base metal is not 
 accepted. At the other extreme no charge is made for bullion contain- 
 ing 992 thousandths of gold and upward. The charges on other bullion 
 vary from one-half cent per ounce to four cents per ounce, depending 
 upon the amount of base metals and copper alloy contained. For 
 instance, where bullion contains from 950 to 991! thousandths inclu- 
 sive of gold and not more than 30 thousandths base, the charge is 
 two cents per ounce. The depositor is given credit for the copper 
 contained in the bullion. There is no charge for parting and refining 
 foreign coins unless they are below standard fineness. 
 
 3. Toughening charge. Bullion containing one or more of the 
 following substances, viz., iron, lead, antimony, bismuth, tin, arsenic, 
 zinc, or sulphur, in amounts sufficient to make it impossible to obtain 
 a satisfactory assay, shall, at the discretion of the superintendent, 
 be subject to an additional charge equal to the cost to the government 
 for remelting and treatment by the deposit melter. 
 
 4. Copper alloy. Two cents per ounce for copper required, to 
 be determined by taking one-tenth of the standard weight of gold, 
 except where the base in the deposit is all good copper and the fine- 
 ness above standard, when the method of determining the number 
 of ounces of copper required shall be by taking the difference between 
 the standard weight and the gross weight of the deposit. 
 
 5. Assays of bullion and plated ware. Samples of gold and silver 
 bullion will be assayed at the mints and assay offices at a charge of 
 $2 per sample. In case of plate, or what is known as rolled or filled 
 plate, the charge shall be $4 for each assay; or the assay may be 
 refused, at the option of the assayer. 
 
 d) Advances or partial payments on deposits. In case of deposits, 
 the fineness of which may be readily determined approximately by 
 inspection, payments may, at the discretion of the superintendents of 
 the coinage mints and the assay office at New York, be made within 
 10 per cent of their value, or within 2 per cent when already closely 
 determined by assay and awaiting remelting or reassay for exact 
 determination: provided, no partial payment shall be made on a 
 deposit containing less than $5,000 in gold, or 5,000 ounces of silver. 
 
 e) Deposits of United States coin. United States gold coin of 
 legal weight shall not be received from depositors except in sums of 
 not less than $5,000 in exchange for gold bars.
 
 REGULATION OF METALLIC CURRENCY 7! 
 
 Mutilated or otherwise uncurrent United States gold coins, of any 
 denomination, will be received at any of the mints or assay offices 
 of the United States, and the value of the fine gold contained will be 
 paid to the depositor at the rate of $20.67 per ounce fine, or $18.60 
 per ounce standard (0.900 fine). 
 
 /) Mode of payments. Payments for deposits of gold bullion 
 at the coinage mints and at the assay office in New York will be made 
 in fine bars, coin, or by check, as may be desired by the depositor. 
 At the minor assay offices payments are made by check on an Assist- 
 ant Treasurer of the United States, or government depository bank 
 nearest at hand. 
 
 g) Mamtfacture of bars. Unparted, fine, and standard bars may 
 be manufactured at the coinage mints and the assay office at New 
 York, and unparted bars at all of the institutions. Fine bars may 
 be approved when they have a fineness of 0.992 and upward, and no 
 bar of gold or silver of less weight than 5 ounces shall be issued at 
 any of the mints or assay offices of the United States. 
 
 h) The "tolerance of the mint" and "trial of the pyx." The 
 weight of a new gold eagle, or double eagle, must not vary more 
 than half a grain from the standard weight fixed in the law. That 
 of the smaller gold coins must not vary more than a quarter of 
 a grain. This allowable variation is called the "tolerance of the 
 mint." 
 
 The testing of this weight is determined by a "trial of the pyx." 
 Five pieces out of every thousand coined are taken out by the superin- 
 tendent upon receipt from the coiner and tried separately by him. 
 If successful, these pieces are sealed and deposited in a pyx which is 
 kept under the joint care of the superintendent and the assayer 
 and secured so that neither can have access to its contents without 
 the presence of the other. 
 
 If the original trial by the superintendent proves unsatisfactory, 
 all the coins shall be weighed separately, and such as are not of legal 
 weight shall be defaced and delivered to the melter and refiner. 
 Four times a year the samples from the minor mints are sent to the 
 mint at Philadelphia. The entire quantity of samples is then sub- 
 jected to an annual "trial of the pyx" by a special Assay Commission, 
 composed of the judges of the district court of the eastern district 
 of Pennsylvania, the Comptroller of the Currency, the Assayer of 
 the assay office at New York, and such other persons as the President 
 may from time to time designate. If an error is found, the officers
 
 72 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 implicated in the error are thenceforward disqualified from holding 
 their respective offices. 
 
 The penalty imposed upon an officer of the mint for debasing, 
 embezzling, or in any way altering coins, or for tampering with the 
 scales or weights used at the mints, shall be a fine of not more than 
 ten thousand dollars and imprisonment for not more than ten years. 
 
 i) The standard troy pound. For the purpose of securing a due 
 conformity in weight of the coins of the United States to the provisions 
 of this title, the brass troy pound weight procured by the minister of 
 the United States at London, in the year eighteen hundred and 
 twenty-seven, for the use of the mint, and now in the custody of the 
 mint in Philadelphia, shall be the standard troy pound of the mint of 
 the United States, conformably to which the coinage thereof shall 
 be regulated. Duplicates of this standard troy pound shall be pro- 
 cured for the other mints and assay offices. Inspection and testing 
 of these shall be made annually by the Assay Commission along with 
 the testing of coins. 
 
 j) Abrasion. Where gold is used extensively as a circulating 
 medium there is a considerable loss from wear and tear, or abrasion. 
 The law in the United States permits an abrasion equal to one-half of 
 i per cent in twenty years, and proportionally for each year. For 
 instance, an eagle at the end of twenty years would be current if it 
 weighed only 256.71 grains instead of 258 (or 258.50 when allow- 
 ance is made for the tolerance of the mint). The annual abrasion 
 permissible is 0.0645 grains. Experiments have shown that this 
 limit of abrasion is high enough to avoid frequent recoinage in the 
 United States. 
 
 In case a gold coin is uncurrent on account of abrasion in the 
 United States, the loss falls on the last holder. This appears like an 
 injustice, since the loss is due to social wear. It has thus far been 
 held, however, that the impossibility of determining whether the light 
 weight is due to abrasion or sweating makes it necessary to charge the 
 loss entirely to the last holder. 
 
 k) Counterfeiting. "Whoever shall falsely make, forge, or 
 counterfeit, or cause or procure to be falsely made, forged, or counter- 
 feited, or shall willingly aid or assist in falsely making, forging, or 
 counterfeiting any coin or bars in resemblance or similitude of the 
 gold or silver coins or bars which have been, or hereafter may be, 
 corned or stamped at the mints and assay offices of the United States, 
 or in resemblance or similitude of any foreign gold or silver coin which
 
 REGULATION OF METALLIC CURRENCY 73 
 
 by law is, or hereafter may be, current in the United States, or are in 
 actual use and circulation as money within the United States; or 
 whoever shall pass, utter, publish, or sell, or attempt to pass, utter, 
 publish, or sell, or bring into the United States or any place subject 
 to the jurisdiction thereof, from any foreign place, knowing the same 
 to be false, forged, or counterfeit, with intent to defraud any body 
 politic or corporate, or any person or persons whomsoever, or shall 
 have in his possession any such false, forged, or counterfeited coin 
 or bars, knowing the same to be false, forged, or counterfeited, with 
 intent to defraud any body politic or corporate, or any person or per- 
 sons whomsoever, shall be fined not more than five thousand dollars 
 and imprisoned not more than ten years." For counterfeiting minor 
 coins the penalty is a fine of not more than one thousand dollars and 
 imprisonment for not more than three years. For debasing, defacing, 
 injuring, etc., any gold or silver coins with intent to defraud, the 
 penalty is not in excess of a fine of two thousand dollars and imprison- 
 ment for five years. 
 
 /) Mints and assay offices. To facilitate the conversion of 
 bullion into coin, mints have been established in the following cities: 
 Philadelphia, Denver, and San Francisco. Assay offices, where bullion 
 can be exchanged for currency, are located at New York, New Orleans, 
 Carson, Boise, Helena, Deadwood, Seattle, and Salt Lake City. 
 
 IV. GRESHAM'S LAW AND BIMETALLISM 
 
 We have seen that under a poor coinage system, with 
 counterfeiting, clipping, and sweating everyday occurrences, 
 the operation of Gresham's law tended to make it impossible 
 to keep the better coins in circulation! It remains to discuss 
 Gresham's law under other conditions in connection with a 
 bimetallic standard. 
 
 Bimetallism appears to have been adopted by all the leading 
 European countries at the beginning of the modern era, without 
 discussion as a mere matter of course. Since both gold and 
 silver were adapted to exchange purposes and since it was 
 everywhere assumed that a large volume of currency was an 
 unmitigated blessing, both metals appear to have been by 
 common consent adopted as the standard of value. It was not 
 until late in the eighteenth century that any agitation for the
 
 74 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 elimination of bimetallism developed, and, save in England, it 
 was not until the latter half of the nineteenth century that the 
 double standard was abolished. 
 
 The fundamental weakness of the bimetallic system lies in the 
 fact that it permits the operation ofGresham's law. With a bime- 
 tallic standard gold and silver 1 together constituted the pecuni- 
 ary unit of value. For example, under the bimetallic system 
 which existed in the United States for so many years, both gold 
 and silver were standard. With a coinage ratio of 16 to i, 25.8 
 grams of gold, nine-tenths fine were defined as a dollar; and 16 
 times that weight, or 412.5 grains, of silver, nine-tenths fine, 
 were also defined as a dollar. Under bimetallism, Gresham's 
 law must be stated in slightly different terms, as follows: When 
 two metals of the same nominal value, but of different bullion 
 value, are freely coinable at the mints and of unrestricted 
 legal tender power, the metal that is overvalued at the mint 
 tends to drive the other from circulation. The difficulty in 
 this connection may best be illustrated by reference to some 
 actual cases from our own bimetallic history. 
 
 Our first coinage law, passed in 1792, fixed the coinage ratio 
 of silver to gold at 15 of the former to i of the latter. At the 
 time, the relative value of gold and silver bullion in the commer- 
 cial markets was about 15 .3 to i. That is to say, it took 15.3 
 ounces of silver to equal one ounce of gold in the form of bullion; 
 but in the form of coins it took only 15 ounces of silver to 
 equal an ounce of gold. Accordingly, silver had a greater value 
 at the mint than it had hi the form of bullion. Since specie 
 must always be used in making international payments, gold 
 rather than silver was always sent whenever a foreign obligation 
 had to be settled. Gold was quite as good as silver for this 
 purpose; but, on the other hand, it did not pay to take gold 
 to the United States mint to be coined, because it had a greater 
 exchange power as bullion than it had as coin. Similarly, it did 
 not pay to ship silver out of the country in settlement of foreign 
 obligations, because silver brought a higher return as compared 
 with gold when it was taken to the mint and converted into coins. 
 
 1 Other commodities might, of course, have been used.
 
 REGULATION OF METALLIC CURRENCY 75 
 
 Accordingly, gold was driven out of circulation and silver became 
 the actual standard of value. 
 
 In 1834 Congress changed the coinage ratio from 15 to i to 
 1 6 to i. At the time the market ratio of silver to gold was 
 about 15.7 to i. With the new ratio it required 16 ounces 
 of silver to equal one ounce of gold in the form of coins, but 
 only 15.7 ounces of silver to equal an ounce of gold in the form 
 of bullion. Thus gold became relatively overvalued at the mint, 
 and accordingly gold was sent to the mint for coinage, whence 
 it shortly reappeared in the channels of circulation. Indeed, 
 even before the act was finally passed, a shipment of gold 
 was en route from England to the United States to take advan- 
 tage of its overvaluation at the United States mint. 
 
 These two illustrations will suffice to show the principle 
 involved. Given full legal tender power and unrestricted 
 coinage at the mint at a given ratio, one metal will drive the 
 other from circulation, wholly or in part, whenever the market 
 ratio varies from the mint ratio. Many more examples might be 
 cited from our own history ; and every country that has employed 
 the double standard has witnessed the same phenomenon. 
 
 The controversy over bimetallism waited upon the perfection of 
 coinage technique. The reason why the controversy over 
 bimetallism made so belated an appearance was -that until the 
 coinage process had been perfected, the cause for a disappear- 
 ance of metal from circulation appeared to lie in the disparity 
 in value between light-weight, debased coins, and full-weight, 
 pure coins. The problem appeared to be merely one of coinage 
 technique. But after the great improvement in the coinage 
 process, it was observed that the cheaper of two standard metals 
 still drove out the dearer one. Thus a disordered currency, due 
 to poor coinage, counterfeiting, clipping, etc., had long obscured 
 the operation of Gresham's law in connection with bimetallism. 
 When this phase of the problem of monetary regulation eventu- 
 ally became clear, a movement for the abolition of the double 
 standard gradually gained headway. 
 
 It required many generations to secure the adoption of a 
 single gold standard by all the leading commercial nations. The
 
 76 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 elimination of silver as a standard coin was opposed by silver 
 miners for obvious reasons. It was also opposed by many 
 people who confused money with wealth and accordingly be- 
 lieved that a reduction in the quantity of the circulating 
 medium would mean a net reduction in the nation's wealth. 
 The establishment of a single gold standard was also strenu- 
 ously opposed by the debtor class, who desired rising prices as 
 a means of lessening the burden of their indebtedness. 1 
 
 England was the first country to abandon bimetallism, the 
 single gold standard having been adopted in the year 1816. 
 Portugal was next in order, abolishing the free coinage of silver 
 in 1854. Three years later, the states composing the German 
 Zollverein and the empire of Austria entered into a monetary 
 treaty and adopted the single silver standard. Shortly after 
 the establishment of the German Empire hi 1871, Germany, 
 however, shifted to the single gold standard. 
 
 The states composing the Latin Monetary Union (France, 
 Belgium, Switzerland, and Italy), which had been formed in 
 1865 in an endeavor to secure a uniform international double 
 standard, one by one virtually 2 went over to the single gold 
 standard in the decade of the seventies. 
 
 In 1873 the Scandinavian Monetary Union was formed by 
 Norway, Sweeten, and Denmark, and a single gold standard 
 was adopted. In 1874 silver was entirely demonetized. 
 Holland limited the coinage of silver in 1873 and two years 
 later adopted a single gold standard. Spain began the restric- 
 tion of silver money in 1876, and completed the process in 1878. 
 In 1876 Russia suspended the coinage of silver for individuals, 
 except as required for trade with China. In 1899 Russia 
 adopted the single gold standard. Finland adopted the single 
 gold standard in 1877, and in 1878 Austria-Hungary abolished 
 the free coinage of silver. In 1893, after a protracted contro- 
 versy, the mints of India were closed to the free coinage of silver. 
 And in 1898 Japan definitely adopted the single gold standard. 
 
 1 Compare chap. Hi. pp. 30-35. 
 
 2 1 say virtually because silver was usually retained as a standard coin; 
 it was thus a "limping" standard that was adopted.
 
 REGULATION OF METALLIC CURRENCY 77 
 
 Practically all of the small states of the world have also 
 in recent years adopted either the single gold standard, or the 
 gold exchange standard, a variation of the principle of a single 
 gold standard. 
 
 In revising her coinage system in 1873 the United States 
 omitted the standard silver dollars from the list of coins that 
 might be struck at the mints, and thus became a single gold 
 standard country. This law was modified, however, under the 
 influence of the silver mining interests and of those who desired 
 a cheaper currency, and the coinage of silver was partially 
 restored by the Bland-Allison Act of 1878. Another law, 
 known as the Sherman Silver Purchase Act of 1890, still further 
 increased the quantity of silver that might be coined, although 
 it did not go so far as to restore the bimetallic system. The 
 question of the restoration of bimetallism was the great issue in 
 the presidential campaign of 1896. The Republican party, 
 standing for the single gold standard for the United States 
 until such time as the leading commercial nations of the world 
 should agree to adopt "international" bimetallism, was suc- 
 cessful at the polls by a narrow margin. The Democrats, under 
 the leadership of Mr. Bryan, stood for national bimetallism at 
 the ratio of 16 to i. Four years later, on March 14, 1900, 
 Congress enacted a law known as the gold standard law, 
 by which the United States definitely established gold as the 
 pecuniary unit. 
 
 The operation of Gresham's law was to be prevented by the 
 "compensatory action" of a double standard. Those who ad- 
 vocated the retention of the bimetallic standard looked to what 
 was known as the compensatory action to prevent a variation of 
 the market from the mint ratio, and thus to prevent the familiar 
 operation of Gresham's law. In brief, the argument is as 
 follows: 
 
 With the mint ratio at 16 to i, if silver should be worth in 
 the market, say, 16.1 to i, silver would be overvalued at the 
 mint and gold undervalued. Silver would accordingly be in 
 increased demand at the mint and gold in decreased demand, 
 with the result that the value of silver would be raised and the
 
 78 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 value of gold lowered, which would operate to restore the 
 ratio to 16 to i. And if perchance the market ratio should 
 become 15.9 to i, then gold would be overvalued at the mint 
 and silver undervalued, whereupon an increased demand foi 
 gold and a decreased demand for silver would bring the ratio 
 back to 1 6 to i. Since this compensatory action would work 
 immediately and automatically as soon as any variation between 
 market and mint ratio appeared, the readjustment would be 
 practically instantaneous, thus effectively preventing the opera- 
 tion of Gresham's law. Scientific writers on the subject saw 
 clearly enough that an international bimetallic system was 
 necessary to a successful operation of this compensatory action; 
 for if France, for instance, had a ratio of 15 to i, whereas the 
 United States had a ratio of 16 to i, it would pay bullion 
 dealers to ship silver from the United States to France, where a 
 higher coinage value existed. Many economists have con- 
 tended, however, that with international bimetallism the 
 compensatory action would at all times insure a practical 
 equalization of mint and market ratios. 
 
 During the protracted struggle over bimetallism, a num- 
 ber of international conferences were held with a view to 
 securing the adoption of an international bimetallic standard. 
 These conferences, however, came to naught. National 
 jealousy was manifested in connection with the unit to be 
 adopted whether mark, franc, pound, or dollar should be 
 chosen. In all these conferences, moreover, England was 
 apathetic because she had for a great many years possessed 
 a single gold standard and was on the whole well satisfied with 
 the results attained under it; indeed, there was good reason for 
 believing that England's commercial and financial supremacy 
 was in no small degree due to the stability and certainty of 
 her monetary system. 
 
 It remains to inquire whether, with international bimetallism, 
 the compensatory action would have prevented the operation 
 of Gresham's law and in the face of all contingencies have 
 maintained a parity of market and mint ratio. Reference 
 to the table on page 82, which gives the figures of relative
 
 REGULATION OF METALLIC CURRENCY 79 
 
 production of gold and silver over a long period of years, indi- 
 cates that the supplies of these metals are dependent upon 
 mining conditions. While in the years following 1849, for 
 example, there was no noteworthy change in the relative demand 
 for gold and silver, there was a tremendous increase in the 
 supply of gold because of the discovery of the rich gold fields 
 of California and Australia. The table on page 83 indi- 
 cates the resulting effect upon the commercial ratio of the two 
 metals. 
 
 If there were but minor variations in the supply of the two 
 metals, it is possible that the compensatory action would 
 operate to maintain the commercial ratio "of gold and silver 
 at a parity with the mint ratio. It is hardly probable, how- 
 ever, that the system would work under all circumstances. If 
 the gold mines should be completely exhausted and if at the 
 same time the output of silver should increase at a rate 
 hitherto undreamed of, it is doubtful, to say the least, if the 
 compensatory action could prevent a fall in the relative value 
 of silver. 
 
 V. WHY GOLD BECAME THE SINGLE 
 STANDARD 
 
 The reason why gold rather than silver has everywhere been 
 chosen as the single standard is usually said to be the "inherent 
 superiority of gold" for the purpose in hand. It will be of 
 interest to consider this statement in the light of the data pre- 
 sented in the tables on pages 82 and 83. 
 
 After the coinage law of 1834, which fixed the mint ratio 
 at 1 6 to i, silver was undervalued at the mint and hence it was 
 unprofitable to have it coined. The "crime of 1873" con ~ 
 sisted, as noted above, in eliminating the standard silver dollar 
 from among the list of coins that could be struck at the United 
 States mint. Had the silver dollar not been undervalued at the 
 mint owing not to any inherent inferiority of silver but merely 
 to the legislation which fixed the mint ratio at 16 to i when the 
 market ratio was about 15.7 to i it is altogether improbable 
 that it would have been demonetized. If, on the other hand,
 
 8o THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 rich silver mines, rather than gold mines, had been discovered 
 in 1849, and the commercial ratio had in consequence changed 
 to, say, 17 to i, it would have been unprofitable to coin 
 gold. Under these circumstances a revision of the coinage 
 laws might conceivably have resulted in the demonetization 
 of gold. 
 
 In any event, it was the great increase in the output of silver 
 after 1874, occasioned by the discovery of the Comstock lode, 
 that brought the silver issue to the front. In the absence of 
 this, or similar discoveries, the silver issue might never have 
 arisen; for so long as silver was worth more in the form of 
 bullion than as coin no one had any interest in presenting it at 
 the mint. 
 
 The controversy over bimetallism ended> as was noted 
 above, with the presidential campaign of 1896. Reference to 
 the statistics of production of gold after 1896 and to the price 
 movement (as depicted on p. 31) will serve to indicate one reason 
 why the bimetallic controversy has not been resumed. If the 
 cyanide process had not been developed (for it is the chief 
 cause of the great increase in gold production during the past 
 thirty years), if the Klondike and South African fields had not 
 been opened, and if prices had continued to fall after 1896 as 
 they did in the previous decade, it is not at all improbable 
 that bimetallism would have been a recurrent issue in American 
 politics. 
 
 The rise in the price of silver since igi$ may cause a renewed 
 agitation for bimetallism. With the great change in the com- 
 mercial ratios of gold and silver since the outbreak of the Great 
 War, the possibility of a restoration of bimetallism has again 
 received some attention. The great increase hi the value of 
 silver was due to three factors: first, a decline hi the production 
 of silver bullion, owing to labor shortage and unsettled condi- 
 tions in leading silver-producing regions; second, an enormous 
 increase in the demand for the metal by the silver-using countries 
 of the Orient, occasioned by favorable trade balances and the 
 rising price level, which necessitated an increased volume of 
 currency in active circulation; and third, the rising price level
 
 REGULATION OF METALLIC CURRENCY 81 
 
 in all occidental nations, which, as in the Orient, has required 
 a great increase in the volume of subsidiary silver currency. 
 
 The rise in the relative value of silver from 39.84 to i in 
 1915 to less than 16 to i in the fall of 1919 marks the most 
 rapid fluctuation on record in the commercial ratio of the two 
 metals. The return to 16 to i has created in some quarters a 
 sentimental agitation for the restoration of the silver dollar, 
 which appears to its devotees thus to have vindicated itself 
 despite all hostile legislation. Added to this sentimental argu- 
 ment is the practical one, that there is now an insufficiency of 
 "specie" to support the vast credit and paper-money circula- 
 tions that have arisen from the exigencies of war finance. An 
 increase of specie reserves may therefore possibly be sought by 
 way of the restoration of bimetallism and the stimulation of 
 the production of both gold and silver. 
 
 Indeed, in a speech before Congress on February 9, 1920, 
 Senator Thomas, of Colorado, urged the establishment of 
 international bimetallism at the ratio of 16 to i, stating that 
 "events have confounded the contentions of the advocates 
 of gold standard supremacy, justified the arguments of the 
 defenders of silver, and confirmed the wisdom of the theory of 
 bimetallism." He declared that the "whirligig of time" has 
 made applicable to gold the same arguments that were used 
 against silver in the nineties; gold rather than silver now 
 requires the steadying influence of an international agreement. 
 He pointed out that the volume of paper money in the world is 
 out of all proportion to the volume of specie, thus causing the 
 tremendous depreciation of the foreign exchanges; and con- 
 cluded that "we must stimulate international confidence in 
 modern currency systems, make the problem of deflation com- 
 paratively easy and re-establish the regime of a saner and more 
 dependable monetary medium." Since February, 1920, how- 
 ever, silver has declined from a maximum price of $1.38 to 
 less than $i .00 per ounce, owing mainly to a business depression 
 in the Orient, attended by falling prices and a collapse of 
 speculation in silver. Accordingly, a renewal of the bimetallic 
 agitation now appears much less probable.
 
 82 
 
 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 VI. PRODUCTION OF GOLD AND SILVER IN THE 
 WORLD SINCE THE DISCOVERY OF AMERICA 1 ' 
 
 
 GOLD 
 
 SILVER 
 
 
 ANNUAL AVERAGE FOR PERIOD 
 
 ANNUAL AVERAGE FOR PERIOD 
 
 PERIOD 
 
 
 Coining Value in 
 
 
 Coining Value in 
 
 
 Fine Ounces 
 
 Standard Silver 
 
 Fine Ounces 
 
 Standard Silver 
 
 
 
 Dollars 
 
 
 Dollars 
 
 1493-1520. . 
 
 186,470 
 
 $ 3.855,000 
 
 1,511,050 
 
 $ i,954,ooo 
 
 1521-1544.. 
 
 230,194 
 
 4,759,000 
 
 2,899,930 
 
 3,740,000 
 
 1545-1560. . 
 
 273,596 
 
 3,656,000 
 
 10,017,940 
 
 12,952,000 
 
 1561-1580. . 
 
 219,906 
 
 4,546,000 
 
 9,628,925 
 
 12,450,000 
 
 1581-1600. . 
 
 237,267 
 
 4,005,000 
 
 13,467,635 
 
 17413,000 
 
 1601-1620. . 
 
 273,918 
 
 5,662,000 
 
 13,596,235 
 
 17,579,000 
 
 1621-1640. . 
 
 266,845 
 
 5,516,000 
 
 12,654,240 
 
 16,361,000 
 
 1641-1660. . 
 
 281,995 
 
 5,828,000 
 
 11,776,545 
 
 15,226,000 
 
 1661-1680. . 
 
 297,709 
 
 6,154,000 
 
 10,834,550 
 
 14,008,000 
 
 1681-1700. . 
 
 346,095 
 
 7,154,000 
 
 10,992,085 
 
 14,212,000 
 
 1701-1720. . 
 
 412,163 
 
 8,520,000 
 
 11,432,540 
 
 14,781,000 
 
 1721-1740. . 
 
 613,422 
 
 12,581,000 
 
 13,863,080 
 
 17,924,000 
 
 1741-1760. . 
 
 791,211 
 
 16,356,000 
 
 17,140,612 
 
 22,162,000 
 
 1761-1780. . 
 
 665,666 
 
 13,761,000 
 
 20,985,591 
 
 27,133,000 
 
 1781-1800.. 
 
 571,948 
 
 11,823,000 
 
 28,261,779 
 
 36,540,000 
 
 1801-1810. . 
 
 571,563 
 
 11,815,000 
 
 28,746,922 
 
 37,168,000 
 
 1811-1820. . 
 
 367,957 
 
 7,606,000 
 
 17,385,755 
 
 22,479,000 
 
 1821-1830. . 
 
 457,044 
 
 9,448,000 
 
 14,807,004 
 
 19,144,000 
 
 1831-1840. . 
 
 652,291 
 
 13,484,000 
 
 19,175,867 
 
 24,793,000 
 
 1841-1850. . 
 
 1,760,502 
 
 36,393,000 
 
 25,090,842 
 
 32,440,000 
 
 1851-1855.. 
 
 6,410,324 
 
 132,513,000 
 
 28,488,597 
 
 36,824,000 
 
 1856-1860. . 
 
 6,485,262 
 
 134,083,000 
 
 29,095,428 
 
 37,618,000 
 
 1861-1865.. 
 
 5,949,582 
 
 122,989,000 
 
 35401,972 
 
 45,772,000 
 
 1866-1870. . 
 
 6,270,086 
 
 129,614,000 
 
 43,051,583 
 
 55,663,000 
 
 1871-1875.. 
 
 5,591,014 
 
 115,577,000 
 
 63,317,014 
 
 81,864,000 
 
 1876-1880. . 
 
 5,543,110 
 
 114,586,000 
 
 78,775,602 
 
 101,851,000 
 
 1881-1885.. 
 
 4,794,755 
 
 99,116,000 
 
 92,003,944 
 
 118,955,000 
 
 1886-1890. . 
 
 5,461,282 
 
 112,895,000 
 
 108,911,431 
 
 140,815,000 
 
 1891-1895.. 
 
 7,882,565 
 
 162,946,000 
 
 I57,58i,33i 
 
 203,742,000 
 
 1896-1900. . 
 
 12,446,939 
 
 2 57,3 01 , 100 
 
 165,693,304 
 
 214,229,700 
 
 1901-1905.. 
 
 15,606,730 
 
 322,619,800 
 
 167,995,408 
 
 217,206,200 
 
 1906 
 
 10,4.71,080 
 
 4O2, i ;o'?.ooo 
 
 165,054,497 
 
 213,403,800 
 
 IQO7 
 
 y,^/ , v *-" 
 I0.077.26O 
 
 ^ u o, 
 412,966,600 
 
 184,206,984 
 
 238,166,600 
 
 1908 
 
 *y,y / / )*v 
 21,422,244 
 
 442,836,900 
 
 203,131,404 
 
 262,634,500 
 
 IQOQ. . 
 
 21. 06^, III 
 
 454,059,100 
 
 212,149,023 
 
 274,293,700 
 
 
 17 J, 
 22,O22,l8O 
 
 455,239,100 
 
 221,715,673 
 
 286,662,700 
 
 1911 
 
 22,348,313 
 
 461,980,500 
 
 226,192,923 
 
 292,451,500 
 
 1912 
 
 22,549,335 
 
 466,136,100 
 
 224,310,654 
 
 290,017,800 
 
 ion . 
 
 22. 240, ^06 
 
 410.0^0,OOO 
 
 223,907,843 
 
 289,497,000 
 
 IQI4. . 
 
 m ~ j^Hyjoy^ 
 21,24.0,4.16 
 
 ^O y,yJV,y 
 43Q,O78.26O 
 
 168,452,942 
 
 217,797,743 
 
 IQIC. . 
 
 *> T^*,T^ v 
 
 22,674, 168 
 
 ^J79 / 1 
 
 468,724,918 
 
 184,204,745 
 
 238,163,710 
 
 1016. . 
 
 t 1 ^9tJ 
 21,070,788 
 
 T^ , / ^97 
 4<;4,I76. 1OO 
 
 168,843,000 
 
 218,302,060 
 
 IQI7. . 
 
 97 1 ^9 i v% ^ 
 2O,280,q46 
 
 TJT) * / V 9 J*"* 
 4I9,422,IOO 
 
 174,187,800 
 
 225,212,509 
 
 1918 
 
 ,7,0^" 
 18,427,232 
 
 380,924,700 
 
 197,394,900 
 
 255,217,648 
 
 Total.. 
 
 841,599,968 
 
 $17,397,417,278 
 
 12,222,260,479 
 
 $15,802,518,570 
 
 From Annual Report of Director of the Mint, 1918.
 
 REGULATION OF METALLIC CURRENCY 
 
 VII. COMMERCIAL RATIO OF GOLD AND SILVER 
 SINCE 1687' 
 
 Year 
 
 Ratio 
 
 Year 
 
 Ratio 
 
 Year 
 
 Ratio 
 
 1687 
 
 14 Q4 
 
 1824 
 
 15 82 
 
 1872 
 
 IS 63 
 
 1690 
 
 I? O2 
 
 1825 
 
 IS 7O 
 
 l873 
 
 IS O2 
 
 i6os ...:.. 
 
 1C. O2 
 
 1826 
 
 IS ?6 
 
 l874 
 
 16 17 
 
 i 700. . 
 
 14. 8l 
 
 1827. . 
 
 IS 74 
 
 l87S 
 
 16 so 
 
 1 70S. . 
 
 IS. II 
 
 1828 
 
 IS 78 
 
 1876 
 
 17 88 
 
 1710. . 
 
 IS. 22 
 
 1820 . 
 
 IS 78 
 
 1877. 
 
 17 22 
 
 1712 . . 
 
 iS.^I 
 
 1830 
 
 IS 82 
 
 1878 ... . 
 
 17 04 
 
 I7IS. . 
 
 I?. IT 
 
 1831 
 
 IS 72 
 
 1870 
 
 18 40 
 
 I72O. . , 
 
 1C O4 
 
 1832 
 
 IS 73 
 
 1880 .... 
 
 18 05 
 
 I72S. . 
 
 I?. II 
 
 1877. . 
 
 IS O3 
 
 1881 
 
 18 16 
 
 I73O. . , 
 
 I4.8l 
 
 1824. . 
 
 IS 73 
 
 1882 
 
 18 19 
 
 I73S. . 
 
 I 8 ? .41 
 
 i83S 
 
 15 80 
 
 1883 
 
 18 64 
 
 I74O. . 
 
 14.04 
 
 1836 
 
 IS 72 
 
 1884 . . . 
 
 18 S7 
 
 1741: . . 
 
 I4.o8 
 
 1837. 
 
 IS 83 
 
 1885 
 
 IO 41 
 
 1 7 SO. . 
 
 14. ^ 
 
 1838 
 
 is 8s 
 
 1886 
 
 2O 78 
 
 I7;e. . 
 
 14 68 
 
 1830 . 
 
 15 62 
 
 1887 
 
 21 17 
 
 1760 
 
 14. 14 
 
 1840 
 
 15 62 
 
 1888 
 
 21 GO 
 
 176"?. . 
 
 14.83 
 
 1841 
 
 IS 7O 
 
 1889 
 
 22 IO 
 
 1770 
 
 14.62 
 
 1842 
 
 IS 87 
 
 1890 
 
 IO 76 
 
 I77S. . 
 
 14. 72 
 
 1843 . 
 
 IS O3 
 
 1891 
 
 2O 92 
 
 1780 
 
 14. 72 
 
 l844. . 
 
 is 8s 
 
 1892 
 
 27 72 
 
 178?.. 
 
 14.02 
 
 1841;. 
 
 IS O2 
 
 1803 
 
 26 4O 
 
 I 7OO . . , 
 
 1C. Q4 
 
 1846 
 
 IS QO 
 
 iSoj. 
 
 32 S6 
 
 I7QC. , 
 
 ic. cc 
 
 1847. 
 
 15 80 
 
 i8os 
 
 31 60 
 
 1800 
 
 is:68 
 
 1848. 
 
 is 8s 
 
 1896 
 
 30 66 
 
 1801 
 
 ic. 4.6 
 
 1840. . 
 
 IS 78 
 
 1807 
 
 74 2O 
 
 1802 
 
 I?. 26 
 
 1850 
 
 IS 7O 
 
 1898 
 
 7S O7 
 
 1803.. 
 
 ic 4.1 
 
 1851 
 
 IS 46 
 
 1800 
 
 74 76 
 
 1804 
 
 jc. 41 
 
 1852 
 
 IS SO 
 
 1900 
 
 77 77 
 
 i8os. . 
 
 1C. 70 
 
 i8s3 
 
 IS 33 
 
 1901 
 
 34 68 
 
 IOO6. . 
 
 jc. 72 
 
 i8s4 
 
 IS 33 
 
 1902 
 
 7O I S 
 
 1807 
 
 ic .4-2 
 
 i8ss 
 
 IS 38 
 
 IOO7 
 
 38 10 
 
 1808 
 
 16.08 
 
 1856 
 
 IS 38 
 
 IQO4 
 
 7S 7O 
 
 1809 
 
 ic .06 
 
 i8s7. . 
 
 IS 27 
 
 IOOS 
 
 77 8? 
 
 1810 
 
 jc. 77 
 
 i8s8 
 
 IS 38 
 
 1906 
 
 7O S4 
 
 1811 
 
 ic. S3 
 
 l8sQ 
 
 I S IO 
 
 IOO7 
 
 71 24 
 
 1812 
 
 16. II 
 
 1860 
 
 IS 2Q 
 
 1908 
 
 & 64 
 
 181-?. . 
 
 16. 2? 
 
 1861 
 
 IS SO 
 
 IOOO 
 
 7O 74 
 
 1814 
 
 ie. 04 
 
 1862 
 
 IS 3S 
 
 I9IO 
 
 38 22 
 
 181?. . 
 
 IS. 26 
 
 1863 
 
 IS 37 
 
 I9II 
 
 ^8 ?! 
 
 1816 
 
 is. 28 
 
 1864. . 
 
 IS 38 
 
 IQI2 
 
 77 62 
 
 1817 
 
 IS. II 
 
 1865 
 
 IS \\ 
 
 IOI7 
 
 7A IO 
 
 1818 
 
 IS.3S 
 
 1866 
 
 IS 43 
 
 IOI4 
 
 77 77 
 
 1810.. 
 
 1C . 77 
 
 1867.. 
 
 IS S7 
 
 IOI S 
 
 7O 84 
 
 1820 
 
 IS. 62 
 
 1868 
 
 IS SO 
 
 1916 
 
 7O II 
 
 1821 
 
 IS. OS 
 
 1860. . 
 
 15 60 
 
 IQI7 
 
 27 OO 
 
 1822 
 
 is. 8 
 
 1870. . 
 
 IS S7 
 
 I9l8 
 
 21 OO 
 
 1823 
 
 IS. 84 
 
 1871. . 
 
 IS 7O 
 
 IQIQ 
 
 17 OO* 
 
 
 
 
 
 
 
 * Estimated. Late in 1919 the ratio became less than 16 to i. It has since risen to 
 about 84 to i. 
 
 1 From Annual Report of Director of the Mint, 1919, p. 155.
 
 84 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 VHI. THE REGULATION OF SUBSIDIARY METALLIC 
 CURRENCY 
 
 The subsidiary metallic currency of the United States con- 
 sists of the silver dollar, half-dollar, quarter, dime, nickel, and 
 one-cent piece. All of these coins now have a face value greater 
 than their value in the form of bullion. Such corns are called 
 token coins. They are maintained at par with gold, the stand- 
 ard metal, by a process of redemption, direct in the case of cents, 
 nickels, dimes, quarters, and half-dollars, indirect in the case 
 of silver dollars. The following are the redemption provisions 
 of the United States currency laws: 
 
 Fractional silver coins half-dollars, quarters, and dimes 
 and minor coins nickels and cents may be presented, in 
 sums or multiples of twenty dollars, to the Treasurer of the 
 United States or to an Assistant Treasurer for redemption or 
 exchange into lawful money. Being redeemable in gold, they 
 are as good as gold. 
 
 Fractional silver coins were originally of proportional weight 
 with the silver dollar; but since 1853 they have contained 
 about 7 per cent less silver. The nominal value of two half- 
 dollars, four quarters, and ten dimes, respectively, is obviously 
 equal to one gold dollar. The value of the bullion content 
 varies with the fluctuations in the price of silver bullion. 
 
 The nickel, or five-cent piece, is a combination of copper and 
 nickel three-fourths copper and one-fourth nickel. The cent 
 is composed of 95 per cent copper and 5 per cent tin and zinc. 
 
 Both fractional silver coins and the minor coins are struck 
 only as the needs of trade, as evidenced by the demand for 
 "change" at the banks, require. The government purchases 
 the bullion required in the market; and the profit called 
 seignorage which arises fsom coming dollars whose face 
 value is greater than that of the bullion content, goes to the 
 government. 
 
 The silver dollar is still designated a standard coin of the 
 United States, although since 1873 its coinage has been limited, 
 and since 1900 it has been to all intents and purposes definitely
 
 REGULATION OF METALLIC CURRENCY 8$ 
 
 in the position of a subsidiary coin. Since 1904 no silver dollars 
 have been coined. But because of the historical importance 
 of silver and the persistency of long-established custom, the 
 silver dollar is still called a standard coin, and is not directly 
 redeemable in gold. A system of indirect redemption has been 
 established, however, which has thus far proved quite as 
 effective as would specific redemption in gold. In all payments 
 due to itself, the Treasury will accept silver on an equality with 
 gold, and in all treasury disbursements gold is paid out whenever 
 that metal is desired. In no case does the Treasury force silver 
 upon an unwilling person. Moreover, it is provided by the 
 Currency Act of 1900 that silver shall be maintained at a parity 
 with gold, and that it shall be the duty of the Secretary of the 
 Treasury to maintain such parity. In case the foregoing 
 method of indirect redemption did not prove efficacious the 
 Secretary would therefore be obliged to resort to direct means, 
 and redeem silver dollars in gold. 
 
 IX. LEGAL TENDER PROVISIONS FOR METALLIC 
 CURRENCY 
 
 The purpose of legal tender is to legalize the settlement of 
 obligations. If business is to be conducted both with dispatch 
 and certainty and if endless disputes are to be avoided over the 
 kind and quality of the thing which is tendered in payment of 
 debts, there must be some lawful means of payment. Money 
 has therefore been given the quality of legal tender. It is to 
 be noted, however, that the tender of money in payment of an 
 obligation may be refused by the person to whom the money is 
 proffered, without an automatic cancellation of the debt. The 
 law holds that the tender must be made continuous. The 
 payment of interest on the obligation, however, automatically 
 ceases with the tender of lawful money and certain legal advan- 
 tages are lost to the creditor. 
 
 Gold coin is legal tender at its nominal or face value for all 
 debts, public and private, when not below the standard weight 
 and limit of tolerance prescribed by law; and when below
 
 86 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 such standard weight and limit of tolerance it is legal tender in 
 proportion to its weight. 
 
 Silver dollars are legal tender at their nominal or face value 
 in payment of all debts, public and private, without regard 
 to the amount, except where otherwise expressly stipulated in 
 the contract. 
 
 Fractional silver is legal tender for amounts not exceeding 
 ten dollars in .any one payment. 
 
 The minor coins of nickel and copper are legal tender to the 
 extent of twenty-five cents. 
 
 QUESTIONS FOR DISCUSSION 
 
 I. COINAGE 
 
 1. Which would be more difficult to detect, impure or underweight 
 pieces of uncoined metal ? Which would be easier to adjust to 
 the satisfaction of traders ? 
 
 2. In weighing gold, how much difference would it make if the scales 
 weighed an ounce light ? 
 
 3. What are the objections to a private monopoly of coinage? 
 
 4. Which of the various objects sought in a good coinage system is 
 the most difficult of attainment ? 
 
 5. Enumerate the specific conditions necessary to the operation 
 of Gresham's law. 
 
 6. If you had the opportunity of paying a debt to a friend in full- 
 weight or light-weight coins, which would you use? which in 
 paying a debt to a foreigner ? 
 
 7. If a bullion dealer wished to melt up coins, would he use new or 
 abraded coins ? 
 
 8. Mr. A takes 1,000 ounces of gold bullion to the mint: (a) it is 
 assayed, parted, and refined; (6) standardized by the adding of 
 copper; (c) manufactured into coin. Who assumes these various 
 charges ? 
 
 9. What is meant by free coinage ? by gratuitous coinage ? 
 
 10. Do we have both free and gratuitous coinage of gold in the 
 United States ?
 
 REGULATION OF METALLIC CURRENCY 87 
 
 11. Mr. A takes to the United States mint 20,000 ounces of gold 
 . 950 fine. The impurities are removed and the gold is standard- 
 ized and coined. How much will A receive from the mint ? 
 
 12. If in the preceding problem the .050 is copper, how many 
 standard dollars would A receive? 
 
 13. Mr. B takes 10,000 ounces of British gold coins, which are eleven- 
 twelfths fine, to the United States mint. How many American 
 dollars would he receive? 
 
 14. What is meant by the "tolerance of the mint"? Why is this 
 permitted ? 
 
 15. What is the purpose of the "trial of the pyx"? of the Assay 
 Commission ? 
 
 1 6. What is meant by "minimum circulating weight" ? 
 
 17. Who should suffer the loss when a coin is found to be legally 
 uncurrent on account of abrasion ? Why ? 
 
 1 8. What sort of coins in the United States is most likely to be 
 counterfeited ? 
 
 19. What devices and methods are used to prevent counterfeiting? 
 
 20. What bearing have the following upon the possible variations in 
 value of coined and uncoined gold: (a) tolerance of the mint; 
 (6) minimum currency; (c) brassage; (d) gratuitous coinage; 
 (e) free coinage ? 
 
 21. Do you think that Macaulay overemphasizes the social evik of a 
 bad currency ? 
 
 H. BIMETALLISM 
 
 22. How do you account for the fact that bimetallism was every- 
 where an accepted principle in the sixteenth and seventeenth 
 centuries ? 
 
 23. If the coinage or mint ratio is 16 to i and the market ratio 15 . 5 to 
 i, show what would happen under the operation of Gresham's 
 law. 
 
 24. Between 1792 and 1834 the mint ratio in the United States was 
 15 to i. Consult the table of commercial ratios of gold and 
 silver and indicate what must have occurred. 
 
 25. In 1834 the mint ratio was changed to 16 to i. What must have 
 occurred then, in view of the market ratio ?
 
 88 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 26. Suppose the "crime of '73" had been committed in, say, 1860: 
 when would it have been discovered? Suppose the Currency 
 Act of 1873 had been passed a year later: could the silver dollar 
 then have been omitted, without controversy, from the list of 
 coins that could be minted ? 
 
 27. Three causes may be assigned for the growth of an agitation for 
 monometallism: (a) the decline of mercantilism; (6) the im- 
 provement of coinage technique and the consequent revelation 
 of the evils of bimetallism in connection with international opera- 
 tions; (c) the increase in the quantity of precious metals and 
 hence in the supply of currency. Which do you think has been 
 most important ? (Consult the tables on pp. 82 and 83 in con- 
 nection with the principal dates of the bimetallic controversy.) 
 
 28. Study the table showing the commercial ratios of gold and silver 
 and see if you can find a reason for the demonetization of silver 
 rather than gold. Do you attribute it to the inherent inferiority 
 of silver ? 
 
 29. "Gold has been proved to be the most satisfactory metal for 
 monetary uses." Does this apply to its use as a medium of 
 exchange, as a pecuniary unit of calculation, or as a standard for 
 deferred payments ? 
 
 30. Do the statistics of production of gold show, as a matter of 
 fact, that gold is more likely to prove of stable value than 
 silver ? 
 
 31. If the annual gold production had declined after 1896, rather 
 than increased, might our subsequent monetary history have 
 been different ? If so, how ? 
 
 32. How do you account for the great rise in the value of silver since 
 1914? 
 
 33. The standard silver dollar contains 371 .25 grains of pure silver. 
 The mint price is $i . 29 per ounce. Look up the latest quotation 
 of the price of silver bullion in the financial pages of the daily 
 press or in the financial journals and compute the present bullion 
 value of a silver dollar. 
 
 34. What would happen to our monetary system if silver bullion 
 should become worth $i . 30 an ounce ? $i . 40 an ounce ? 
 
 35. Would a restoration of bimetallism necessarily increase the 
 total quantity of specie in
 
 REGULATION OF METALLIC CURRENCY 89 
 
 m. THE REGULATION OF FRACTIONAL SILVER CURRENCY 
 
 36. After 1850 fractional silver coins disappeared from circulation. 
 Why did they not disappear earlier ? (Consult tables on pp. 82 
 and 83.) 
 
 37. An act of 1853 reduced the weight of fractional silver coins 
 by about 7 per cent. What would be the result of such a 
 reduction ? (Consult the table of commercial ratios.) 
 
 38. When fractional silver coins were thus reduced in weight, what 
 steps would have to be taken to prevent them from driving gold 
 out of circulation ? 
 
 39. Is there any good reason at the present time for making frac- 
 tional silver pieces of less proportional weight than the silver 
 dollar? At what price per ounce for silver bullion would it 
 pay to melt up fractional silver coins? 
 
 40. How is the parity of the fractional silver pieces maintained ? 
 
 41. What is meant by legal tender? Is it necessary that money be 
 legal tender in order to pass current ? 
 
 42. X owes Y ten dollars, and the debt is due. They are riding 
 together on a railroad train. Seeing a bandit entering the car, X 
 says to Y, "Here is the ten dollars I owe you." What would 
 you say if you were Y ? 
 
 43. Would contracts like the following be binding in the United 
 States: (a) "I promise to pay for value received, one thousand 
 dollars in lawful money, except in silver"? (b) "I promise to 
 pay for value received, one thousand dollars in lawful money, 
 except in gold"? (c) "I promise to pay for value received, one 
 thousand silver dollars"? (d) "I promise to pay for value 
 received two thousand fifty-cent pieces"? (e) "I promise to 
 pay for value received, one thousand bushels of wheat"? 
 
 44. Why limit the legal tender power of the silver dollar ? Why give 
 any legal tender power to fractional silver coins ? 
 
 REFERENCES FOR FURTHER READING 
 
 Holdsworth, John Thorn: Money and Banking, chap. iii. 
 Jevons, W. S. : Money and the Mechanism of Exchange, chaps. v ; 
 vi, and vii. 
 
 Laughlin, J. Laurence: Principles of Money, chaps, *i and xij.
 
 go THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 ^ Moulton, Harold G.: Principles of Money and Banking, chaps, 
 if, iv, and vi. 
 
 Phillips, Chester A.: Readings in Money and Banking, chaps, vi 
 and vii. 
 
 Scott, William A.: Money and Banking, chap. ii. 
 
 White, Horace: Money and Banking, Book I, chaps, ii-vi.
 
 CHAPTER VII 
 
 THE REGULATION OF GOVERNMENT PAPER 
 CURRENCY 
 
 Paper money is of so many different kinds, and the princi- 
 ples of regulation involved are so numerous and diverse that 
 a clean-cut treatment of the subject is difficult. A broad dis- 
 tinction may be made, however, between government and 
 bank paper money. The former is issued by the state for the 
 purpose of meeting current obligations when the Treasury is 
 empty, or to provide an inexpensive and convenient medium of 
 exchange by substituting in the channels of circulation paper 
 bills for metallic money; the latter is issued by privately 
 managed institutions which are seeking private profit from 
 the making of loans. The principles of regulation underlying 
 these two forms of paper currency are fundamentally different, 
 and they cannot be satisfactorily treated together. Since the 
 regulation of bank paper is tied up with the whole theory of 
 credit and banking, treatment of it is reserved for subsequent 
 discussion. 1 
 
 Government paper is of three main types: (i) mere repre- 
 sentative paper; (2) convertible fiduciary paper; and (3) incon- 
 vertible or fiat currency. Representative money is backed 
 dollar for dollar by specie, and the paper certificates which 
 circulate are merely claim checks to an equivalent in coin. Such 
 paper gives rise to no problems of regulation. Convertible 
 fiduciary paper is exchangeable for specie, but is not covered by 
 a coin reserve of 100 per cent. Unlike representative paper, 
 it involves an element of trust or credit and affords a means 
 of expanding the quantity of money beyond what is possible 
 with the use of specie alone. Numerous devices have been 
 developed, as we shall see, by means of which redeemability may 
 
 1 See chapters on commercial banking below.
 
 92 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 be insured without a full specie reserve, and there has been a 
 long-continued discussion as to the most effective means for the 
 purpose, resulting in the development of a fairly definite body 
 of principles. Similarly, there has been a prolonged controversy 
 over the advantages and the practicability of inconvertible paper 
 currency, or what may be called the "fiat" or paper standard 
 of value. This controversy has disclosed some of the most inter- 
 esting fallacies in the whole realm of political economy, and 
 the experiences of mankind with irredeemable paper money have 
 been among the most costly lessons that society has ever had to 
 learn. The lesson has, morever, even yet not been thoroughly 
 learned. 
 
 I. IRREDEEMABLE PAPER OR FIAT CURRENCY 
 
 The history of inconvertible or fiat paper currency is prac- 
 tically contemporaneous with that of the controversy over 
 bimetallism; indeed the underlying cause of the advocacy of 
 fiat paper money is virtually identical with that underlying 
 the popular agitation for the retention of bimetallism, namely, 
 the desire for a plentiful supply of cheap currency. 
 
 There have been numerous instances in this and other 
 countries of the use of irredeemable paper money. While there 
 have always been many who have believed that irredeemable 
 paper is the ideal money at all times, the actual issue of such 
 currency has usually been the result of pressing financial needs 
 on the part of governments; and the issuers have usually sought 
 to justify their acts as emergency measures, particularly as a 
 means of meeting the financial exigencies of war. In our own 
 history, in addition to the early Colonial and Revolutionary 
 experiences, both the South and the North during the Civil 
 War issued large quantities of paper with which to meet the 
 immediate requirements of government ; and in the recent Euro- 
 pean struggle, paper money, issued through the medium of 
 central banks controlled by the various governments, played 
 an important role in meeting the enormous financial require- 
 ments of the nations involved,
 
 REGULATION OF PAPER CURRENCY 93 
 
 The striking feature of the history of paper money is that 
 once an issue is started it becomes well-nigh impossible to 
 prevent an almost indefinite increase. Let the first step be ever 
 so hesitant, when once it has been taken other issues are almost 
 certain to follow in rapid succession until the entire monetary 
 system is deranged and the stability of the pecuniary unit in 
 which prices are expressed is completely undermined. The 
 effects of an issue of irredeemable paper currency have always 
 been disastrous in the end, resulting not only in a general 
 disrupting of financial and business activities but also in 
 unsettling the customary ethical concepts which lie at the 
 very basis of modern commercial life. Some cf these effects 
 were noted above in the chapter on "The Standard for Deferred 
 Payments." 
 
 The Confederate States had a disastrous experience with fiat 
 currency. In view of the grave monetary crisis that confronts 
 the continental countries of Europe as an aftermath of the 
 Great War, it will be of interest to recall the experience of our 
 own Confederate States during the Civil War. The following 
 is the story of one who apparently "enjoyed" a first-hand 
 experience. 1 
 
 The history of the South during the Civil War furnishes one of 
 the best illustrations on record of the disastrous consequences of 
 relying mainly upon the issue of irredeemable paper currency as a 
 means of financing war. There were some slight tax levies, it is true, 
 and some borrowing through the use of bonds, but paper money was 
 looked to from the first as the chief fiscal resource of the government. 
 There was only one difficulty incident to the process of printing 
 treasury notes enough to meet all the expenses of the government, 
 namely, the impossibility of having the notes signed in the Treasury 
 Department as fast as they were needed. There happened, however, 
 to be several thousand young ladies in Richmond willing to accept 
 light and remunerative employment in their homes, and as it was 
 really a matter of small moment whose name the notes bore, they were 
 given out in sheets to these young ladies, who signed and returned 
 them for a consideration. I shall not undertake to guess how many 
 Confederate treasury notes were issued. Indeed, I am credibly 
 
 1 G. C. Eggleston, A Rebel's Recollections, pp. 78-105.
 
 94 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 informed by a gentleman who was high in office in the Treasury 
 Department, that even the secretary himself did not certainly know. 
 The acts of Congress authorizing issues of currency were the hastily 
 formulated thought of a not very wise body of men, and my informant 
 tells me that they were frequently susceptible of widely different 
 construction by different officials. However that may be, it was 
 clearly out of the power of the government ever to redeem the notes, 
 and whatever may have been the state of affairs within the Treasury, 
 nobody outside its precincts ever cared to muddle his head in an 
 attempt to get at exact figures. 
 
 We knew only that money was astonishingly abundant. Provi- 
 sions fell short sometimes, and the supply of clothing was not always 
 as large as we should have liked, but nobody found it difficult to get 
 money enough. It was to be had almost for the asking. 
 
 Money was so easily got, and its value was so^utterly uncertain, 
 that we were never able to determine what was a fair price for any- 
 thing. We fell into the habit of paying whatever was asked, knowing 
 that tomorrow we should have to pay more. Speculation became the 
 easiest and surest thing imaginable. The speculator saw nc i-.ks of 
 loss. Every article of merchandise rose in value every day, and to 
 buy anything this week and sell it next was to make an enormous 
 profit quite as a matter of course. 
 
 Naturally enough, speculation soon fell into very bad repute, and 
 the epithet "speculator" came to be considered the most opprobrious 
 in the whole vocabulary of invective. The feeling was universal that 
 the speculators were fattening upon the necessities of the country 
 and the sufferings of the people. Nearly all mercantile business was 
 regarded with suspicion, and much of it fell into the hands of people 
 with no reputations to lose, a fact which certainly did not tend to 
 relieve the community in the matter of high prices. 
 
 The prices which obtained were almost fabulous, and singularly 
 enough there seemed to be no sort of ratio between the values of 
 different articles. I bought coffee at forty dollars and tea at thirty 
 dollars a pound on the same day. My dinner at a hotel cost me 
 twenty dollars, while five dollars gained me a seat in the dress circle 
 of the theater. I paid one dollar the next morning for a copy of the 
 Examiner, but I might have got the Whig, Dispatch, Enquirer, or 
 Sentinel for half that sum. For some wretched tallow candles I paid 
 ten dollars a pound. The utter absence of proportion between these 
 several prices is apparent, and I know of no way of explaining it 
 except upon the theory that the unstable character of the money
 
 REGULATION OF PAPER CURRENCY 95 
 
 had superinduced a reckless disregard of all value on the part of both 
 buyers and sellers. A facetious friend used to say prices were so high 
 that nobody could see them, and that they "got mixed for want of 
 supervision." He held, however, that the difference between the old 
 and the new order of things was a trifling one. "Before the war," 
 he said, "I went to market with the money in my pocket, and brought 
 back my purchases in a basket; now I take the money in the basket, 
 and bring the things home in my pocket." 
 
 In the winter of 1863-64 Congress became aware of the fact that 
 prices were higher than they should be under a sound currency. If 
 Congress suspected this at any earlier date, there is nothing in the 
 proceedings of that body to indicate it. Now, however, the news- 
 papers were calling attention to an uncommonly ugly phase of the 
 matter, and reminding Congress that what the government bought 
 with a currency depreciated to less than i per cent of its face, the 
 government must some day pay for hi gold at par. The lawgivers 
 took the alarm and sat themselves down to devise a remedy for the 
 evil condition of affairs. With that infantile simplicity which char- 
 acterized nearly all the doings and quite all the financial legislation 
 of the Richmond Congress, it was decided that the very best way to 
 enhance the value of the currency was to depreciate it still further 
 by a declaratory statute, and then to issue a good deal more of it. 
 The act set a day, after which the currency already in circulation 
 should be worth only two- thirds of its face, at which rate it was made 
 convertible into notes of the new issue, which some, at least, of the 
 members of Congress were innocent enough to believe would be 
 worth very nearly their par value. This measure was intended, of 
 course, to compel the funding of the currency, and it had that effect 
 to some extent, without doubt. Much of the old currency remained 
 in circulation, however, even after the new notes were issued. For a 
 time people calculated the discount, in passing and receiving the old 
 paper, but as the new notes showed an undiminished tendency to still 
 further depreciation, there were people, not a few, who spared them- 
 selves the trouble of making the distinction. 
 
 The financial condition got steadily worse to the end of the war. 
 I believe the highest price, relatively, I ever saw paid, was for a pair 
 of boots. A cavalry officer, entering the little country store, found 
 there one pair of boots which fitted him. He inquired the price. 
 "Two hundred dollars," said the merchant. A five hundred dollar 
 bill was offered, but the merchant having no smaller bills, could not 
 change it. "Never mind," said the cavalier, "I'll take the boots
 
 96 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 anyhow. Keep the change; I never let a little matter of three 
 hundred dollars stand in the way of a trade." 
 
 Will the reader believe that with gold at a hundred and twenty- 
 five for one, or 12,400 per cent premium; when every day made the 
 hopelessness of the struggle more apparent; when our last man was in 
 the field; when the resources of the country were visibly at an end, 
 there were financial theorists who honestly believed that by a mere 
 trick of legislation the currency could be brought back to par? I 
 heard some of these people explain their plan during a two days' stay 
 hi Richmond. Gold, they said, is an inconvenient currency always, 
 and nobody wants it, except as a basis. The government has some 
 gold several millions, in fact and if Congress will only be bold 
 enough to declare the treasury notes redeemable at par in coin, we 
 shall have no further difficulty with our finances. So long as notes 
 are redeemable in gold at the option of the holder,, nobody wants 
 them redeemed. Let the government say to the people, We will 
 redeem the currency whenever you wish, and nobody except a few 
 timid and unpatriotic people will care to change their convenient for 
 an inconvenient money. The gold which the government holds will 
 suffice to satisfy these timid ones, and there will be an end of high 
 prices and depreciated currency. The government can then issue as 
 much more currency as circumstances may make necessary, and strong 
 in our confidence in ourselves we shall be the richest people on earth: 
 we shall have created the untold wealth which our currency represents. 
 
 When the full story of the present paper currencies of 
 Central and Eastern Europe shall be told, we shall doubtless 
 find that it presents a striking parallel to this Confederate 
 monetary history. Indeed, the evidence already available 
 indicates price increases quite as phenomenal. With the end 
 of the Civil War and the collapse of the Confederate govern- 
 ment, the Confederate currency became automatically worth- 
 less. The final outcome of the present European inflation 
 will not be disclosed for many years. 
 
 H. ARGUMENTS FOR AND AGAINST FIAT 
 PAPER CURRENCY 
 
 The following quotations, taken from various addresses 
 and "programs," will serve to reveal the nature of the prevalent 
 arguments in favor of irredeemable paper currency.
 
 REGULATION OF PAPER CURRENCY 97 
 
 1. We (speaking for the Farmers' Alliance in the nineties) believe 
 in the people making their own money; we believe in the government, 
 which is simply the agent of the people, issuing their money directly 
 to them without going around Robin Hood's barn to find them 
 (that 'is, without the intermediation of banks). 
 
 2. If the people had twice as much currency in their pockets as 
 now, their prosperity would be greatly increased. 
 
 3. I am in favor of more currency. We haven't enough currency 
 per capita to do the business of the country. (Written in 1894.) 
 
 4. I propose that the government, only, shall issue money for the 
 public use. In order to do this, I would have it issue immediately 
 500,000,000 new treasury notes of the denomination of one dollar 
 each. So much of this amount as was necessary the government 
 should loan to the people; 10 per cent of each loan to be paid back 
 each year; Q per cent to be applied to the extinction of the principal; 
 i per cent covering the interest. In that way it would be possible 
 to redeem every mortgaged farm in the land within fifteen years. 
 
 5. Banks should not be allowed to issue notes. These should be 
 printed and put out by the government. The tariff should be reduced 
 till there is a deficit in the Treasury, and then greenbacks should be 
 printed and issued to pay all claimants. These should not be redeem- 
 able in metal money. Each bill should bear the legend, "One dollar, 
 receivable for all dues and debts." This would make it receivable 
 for all taxes and import duties and a legal tender. This would keep 
 it perpetually at par. 
 
 The argument against irredeemable paper currency was 
 trenchently stated as long ago as the American Revolution 
 by John Witherspoon, in the following words: 
 
 The irredeemable paper money such as was issued by the Conti- 
 nental Congress and the various state legislatures during the Revolu- 
 tion, that is, paper bills stating that the person holding them is entitled 
 to receive a certain sum specified in them, is not, properly speaking, 
 money at all. It is barely a sign without being a pledge or standard 
 of value, and therefore is essentially defective as a medium of uni- 
 versal commerce. To arm such bills with the authority of the state, 
 and make them a legal tender in all payments, is an absurdity so 
 great that it is not easy to speak with propriety upon it. It has been 
 found, by the experience of ages, that money must have a standard 
 value, and if any prince or state debase the metal below the standard, 
 it is utterly impossible to make it succeed. How can it be possible
 
 o8 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 to make that succeed which has no value at all ? In all such instances 
 there may be great injuries done to particular persons by wiping off 
 debts; but to give such money general currency is wholly impossible. 
 The measure carries absurdity on its very face. Why will you make 
 a law to oblige men to take money when it is offered them ? Are there 
 any who refuse it when it is good ? If it is necessary to force them, 
 does this not demonstrate that it is not good ? We have seen, indeed, 
 this system produce a most ludicrous inversion of the nature of 
 things. For two or three years we constantly saw and were informed 
 of creditors running away from their debtors and the debtors pursuing 
 them in triumph, and paying them without mercy. 1 
 
 Paper currency would not depreciate if the supply were controlled. 
 Many economists insist that, if properly controlled, irredeemable 
 paper will not depreciate in value. For example, Ricardo says: 
 
 By limiting the quantity of money it can be raised to any conceiv- 
 able value. It is on this principle that paper money circulates; the 
 whole charge for paper money may be considered as seignorage. 
 Though it has no intrinsic value, yet by limiting its quantity, its 
 value in exchange is as great as an equal denomination of com or of 
 bullion in that coin. There is no point more important in issuing 
 paper money than to be fully impressed with the effects which follow 
 from the principle of limitation of quantity. It is not necessary 
 that paper money should be payable in specie to secure its value; it 
 is only necessary that its quantity should be regulated according to 
 the value of the metal which is declared to be the standard. 
 
 Experience, however, shows that neither a state nor a bank ever 
 has had the unrestricted power of issuing paper money, without 
 abusing that power; in all states, therefore, the issue of paper money 
 ought to be under some check and control; and none seems so proper 
 for that purpose as that of subjecting the issuers of paper money to 
 the obligation of paying their notes, either in gold coin or in bullion. 2 
 
 III. METHODS OF REGULATING PAPER CURRENCY 
 
 The following methods have been used in regulating the 
 issues of government paper currency : 
 
 i. Full specie reserve method. By this method the issuing 
 government retains in its coffers metallic money equal in amount 
 
 1 Adapted from Works, IV, 222-23. " Principles of Political Economy.
 
 REGULATION OF PAPER CURRENCY 99 
 
 to the paper issued. The paper is thus a true representative 
 currency, serving merely in lieu of so much specie. 
 
 2. Percentage specie reserve method. With this method a 
 specie reserve equal to a certain fixed percentage of the 
 paper must be held by the issuing government. The amount 
 of paper may be changed with changes hi the amount of 
 reserve. 
 
 3. Minimum specie reserve method. A certain fixed 
 minimum quantity of specie is held as reserve, and the paper 
 outstanding against this may or may not be increased or 
 decreased. 
 
 4. The uncovered issue method. A certain fixed amount of 
 paper may be issued, secured by bonds, etc., and beyond this 
 amount any quantity may be issued if backed by a full specie 
 reserve. 
 
 5. The elastic uncovered issue method. This method differs 
 from the above only in that the uncovered issue may be extended 
 in tune of emergency. 
 
 6. Property reserve method. Land or other real estate, or 
 personalty such as bonds, stocks, etc., may be used as security 
 for government paper currency. 
 
 7. Revenue payments method. A free issue of paper money 
 which relies on its acceptability for taxes in lieu of coin to keep 
 up its value. 
 
 8. The deferred convertibility method. Notes may be issued 
 promising to pay metallic money at some future date, either 
 definitely fixed, or dependent upon political or other contingent 
 events. 
 
 9. Fiat method. The government may give freely issued 
 paper full legal-tender power and command its acceptance in 
 payment of all obligations. It is irredeemable. 
 
 10. Limited issue method. A fiat issue may be definitely 
 restricted in amount in order that an active demand may pre- 
 vent depreciation. 
 
 11. F or ce-of -habit method. An issue once redeemable may 
 circulate by force of custom after the government has been 
 absolved from the obligation of redemption.
 
 100 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 Of these various methods of maintaining the value of paper 
 currency the first five are the ones now most commonly used 
 in the important commercial countries of the world. Of those 
 which do not involve a full specie reserve, the second, third, 
 and fourth are the most frequently employed at the present 
 time. The various methods used in the United States at the 
 present will be shown in the section which follows. It remains 
 to state that while this chapter is devoted only to government 
 paper currency, some of the methods of regulation here out- 
 lined are worked out through banking institutions. 
 
 IV. FORMS OF GOVERNMENT PAPER CURRENCY 
 IN THE UNITED STATES 
 
 The forms of government paper currency in the United 
 States at the present time and the main facts as to their 
 nature and history are as follows: 
 
 a) Gold certificates. Gold certificate? are mere claim checks 
 to like quantities of gold held in the Treasury. These certifi- 
 cates date back to the Civil War period. The inconvenience 
 of gold for everyday exchange transactions led to an authoriza- 
 tion by the Secretary of the Treasury to receive gold in sums 
 of not less than twenty dollars and to issue certificates in its 
 place. None may be issued in a denomination of less than 
 ten dollars; and at least one-fourth of the certificates shall 
 be in denominations of fifty dollars or less. They are designed 
 to meet the needs of our large monetary transactions. 
 
 b) Silver certificates. The use of silver certificates, which 
 are claim checks to silver deposited in the Treasury, was author- 
 ized by the Bland-Allison Act of 1878. Silver currency was 
 redundant and the purpose of authorizing the issue of certifi- 
 cates was to encourage the circulation of silver, in substitute 
 form. The Secretary of the Treasury is required to accept 
 any quantity of silver, in sums not less than ten dollars, and 
 to issue as substitutes therefor silver certificates in denomi- 
 nations of ten dollars and less. From 1890 until our entrance 
 into the Great War the volume of silver certificates remained
 
 REGULATION OF PAPER CURRENCY 101 
 
 practically unchanged except in so far as they were increased by 
 the process of retiring the Treasury notes of 1890 (see c), below). 
 The Pittman Act of 1918, however, has led to a substantial, 
 though' temporary, reduction in the volume of silver certificates. 
 This act, which grew out of the exigencies of war finance, was 
 designed to release American silver for export to the Orient in 
 payment of trade balances. It authorized the Secretary of 
 the Treasury to convert into silver dollars the bullion held 
 in reserve in the Treasury against outstanding silver certifi- 
 cates; and as these silver dollars were exported a proportional 
 volume of silver certificates was retired. The act provided for 
 the eventual replacing of the silver thus released by requiring 
 the Treasury ultimately to repurchase silver at a price of $i .00 
 an ounce, the total amount finally involved being 207,000,000 
 ounces. Under the terms of the loss the Treasurer is required 
 to purchase silver bullion (American product only) whenever 
 its price is $i .00 an ounce or less; but whenever the price of 
 bullion is above $1.00 an ounce none is purchased. The 
 process of repurchase may therefore extend over many years; 
 and it is possible that it will never be entirely consummated. 
 Some silver was, in fact, repurchased in the summer of 1920. 
 
 c) Treasury notes of 1890. These government notes were 
 issued as a means of purchasing silver bullion under the terms 
 of the Sherman Silver Purchase Act of 1890, repealed in 1893. 
 In 1893 there were $153,931,002 outstanding, but they are 
 now canceled as fast as received at the Treasury, and are 
 therefore gradually disappearing from circulation. There 
 were outstanding on February i, 1920, only $1,695,736. 
 When retired, their place is taken directly by silver dollars 
 coined from the bullion originally purchased with the notes. 
 Indirectly their place is filled in the channels of circulation 
 by a silver certificate issued as representative of the silver 
 dollar. 
 
 d) United States Notes. United States Notes, or greenbacks, 
 were first issued during the Civil War to meet the expenses of the 
 government. Since 1878 there have been outstanding $346,- 
 681,016. They are backed by a cash reserve of $150,000,000,
 
 102 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 held as a special funds in the Treasury. The amount of these 
 notes never increases or decreases, since the law provides that 
 any notes redeemed in cash at the Treasury shall be promptly 
 reissued. They have usually been issued in five- and ten-dollai 
 demoninations; but because of the dearth of small bills that 
 was occasioned by the great increase hi prices during the war, 
 and hence in the quantity of money required to carry on our 
 trade and business operations, they are now also issued hi one- 
 and two-dollar denominations. 
 
 V. REDEMPTION OF UNITED STATES 
 PAPER CURRENCY 
 
 The provisions governing the redemption ~in specie of the 
 various forms of government paper currency in the United 
 States at the present time are as follows: 
 
 United States Notes are redeemable in United States gold 
 coin in any amount by the Treasurer and all the assistant 
 treasurers of the United States. 
 
 Treasury notes of i8go are redeemable in United States 
 gold coin in any amount by the Treasurer and all the assistant 
 treasurers of the United States. 
 
 Gold certificates, being receipts for gold coin, are redeemable 
 in such coin by the Treasurer and all assistant treasurers of 
 the United States. 
 
 Silver certificates are receipts for standard silver dollars 
 deposited, and are redeemable in such dollars only. 
 
 VI. LEGAL TENDER PROVISIONS OF UNITED 
 STATES PAPER CURRENCY 
 
 The legal tender provisions applicable to the various forms 
 of United States paper currency at the present time reflect the 
 exigencies of our financial history. Some of the "exceptions" 
 which were important at one time or another are now of no 
 significance.
 
 REGULATION OF PAPER CURRENCY 
 
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 104 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 Treasury notes of 1890 are legal tender for all debts, public 
 and private, except where otherwise expressly stipulated in the 
 contract. They are thus on exactly the same basis as the 
 standard silver dollars. 
 
 United States Notes, or greenbacks are legal tender for all 
 debts, public and private, except duties on imports and interest 
 on the public debt. These exceptions were an outgrowth 
 of Civil War financial exigencies. Since the greenbacks were 
 depreciated in value, to have made them legal tender for inter- 
 est on government bonds would have made it impossible to sell 
 bonds except at a tremendous discount. And since the govern- 
 ment elected always to pay interest on government bonds in 
 specie, it was necessary to insist that the customs duties, the 
 principal source of revenue, should be paid in specie rather 
 than in depreciated greenbacks. Upon resumption of specie 
 payments on January i, 1879, the United States Notes, then 
 at a parity with gold, were, by Treasury order, made accept- 
 able in payment of duties on imports. The wording of the 
 original law, however, has not been changed. Since they are 
 now at a parity with gold, it is obvious that the restriction 
 on their use in the payment of interest on the public debt is 
 also a dead letter. 
 
 Gold and silver certificates were not given a specific grant of 
 power in the settlement of private debts until 1920. But, since 
 they were always receivable for public dues and were redeem- 
 able in gold and silver coin respectively, no one had any 
 occasion to refuse to accept them; indeed, few people ever 
 realized that they were not legal tender. The belated grant of 
 legal tender power is therefore only an act of supererogation. 
 
 QUESTIONS FOR DISCUSSION 
 
 1. What are the chief arguments for: (a) representative paper 
 currency ? (6) fiduciary convertible paper ? (c) fiat or irre- 
 deemable paper ? Do you think these arguments are sound ? 
 
 2. Over which kind of paper money do you think the greatest 
 controversy has been waged ?
 
 REGULATION OF PAPER CURRENCY 105 
 
 3! Is there a genuine saving of interest from the use of convertible 
 fiduciary paper ? 
 
 4. "An issue of paper currency by a government is a forced loan." 
 Explain. 
 
 5. When irredeemable paper is given legal tender power and the 
 paper is not at a parity with the standard metallic currency, will 
 prices be made in paper or in the standard metal? Why? 
 
 6. What would be the effect of an irredeemable paper stand- 
 ard upon: (a) time contracts? (6) business risks? (c) business 
 activity ? 
 
 7. Can paper money have any value if it is not redeemable, either 
 immediately or ultimately ? 
 
 8. Is there any means by which it can be inconvertible and yet be 
 prevented from depreciating ? 
 
 Q. "Value is dependent upon cost of production, and the cost of 
 producing paper money is virtually negligible; therefore the 
 value of paper money must be virtually negligible." Criticize. 
 
 10. "Paper money is all right in theory; but it will not work in 
 practice." Discuss; 
 
 11. "The lesson of America's fight against paper currency should 
 never be lost to the instructors of youth or the statesmen of this 
 country. The only way to make inflationism truly dangerous 
 is to be afraid of it. Once the calm, unfaltering eye of courageous 
 reason is fixed on the savage thing that would rend the nation, 
 it shrinks back o'ermastered to its lair." This was written in 
 1892. Do you agree ? 
 
 12. As a practical matter is it possible to avoid the use of irredeemable 
 currency in tune of war ? 
 
 13. Of the various methods employed for maintaining the value of 
 paper money without specie redemption, which do you regard 
 as most efficient ? 
 
 14. Of the various methods of maintaining the convertibility of paper 
 money, which do you think preferable ? 
 
 15. Which of these methods of regulating paper currency are now 
 used in the United States ? 
 
 16. Upon what does the value of the silver certificate depend: 
 (a) immediately? (6) ultimately? 
 
 17. Look up in the financial press the present price of silver bullion 
 and tell whether the Treasurer is now purchasing silver under 
 the terms of the Pittman act.
 
 io6 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 1 8. Upon what does the value of the gold certificate depend? 
 
 19. What percentage of trust or credit is there in the United States 
 Notes ? 
 
 20. How is it possible to redeem $346,681,016 of greenbacks when 
 the fund available for the purpose is only $150,000,000? 
 
 21. What other forms of our currency, besides the United States 
 Notes, are based in part on faith ? 
 
 22. Can you lay down any general rule as to the proportion the 
 standard money should bear to the entire monetary stock of a 
 country ? 
 
 REFERENCES FOR FURTHER READING 
 
 Holdsworth, John Thorn: Money and Banking, chap. iv. 
 Moulton, Harold G. : Principles of Money and Banking, chap. v. 
 Noyes, Alexander D.: Forty Years of American Finance. 
 Phillips, Chester A.: Readings in Money and Banking, chap. v. 
 White, Horace: Money and Banking, chaps, i-iv.
 
 CHAPTER VTII 
 
 THE FOREIGN EXCHANGES 
 
 In this chapter we axe to consider the financial mechanism 
 known as the foreign exchanges, by means of which the great 
 majority of international trading and financial obligations 
 are settled without requiring monetary payments. The 
 "exchanges" have always been a sealed mystery to the rank 
 and file of even well-informed people for the reason that an 
 understanding of the mechanism involved requires a certain 
 amount of simple technical information, which the "average 
 citizen " is never willing to acquire. Of late, however, because 
 of the great depreciation of foreign currencies that has resulted 
 from the financial and trade exigencies of the Great War and 
 the potential effects of this upon the American industrial 
 situation, the subject has attracted unusual attention, and 
 even the man in the street is now vaguely conscious that 
 foreign exchange is, somehow or other, a subject of no little 
 practical significance. 
 
 I. THE NATURE OF THE PROBLEM 
 
 Foreign exchange is concerned with the settlement of inter- 
 national financial obligations. Whenever an American travels 
 in Europe he requires funds with which to meet the expenses 
 incident to travel; whenever a merchant in the United States 
 buys goods from Europe, he needs a means of paying his 
 debt to the foreign seller; whenever a European wishes to 
 buy American securities, some means of payment must be 
 found; in a word, whenever any international transaction 
 takes place, a settlement must be made. The nature of 
 the problem may be most clearly revealed by a statement of 
 the principal sources of international obligations that have 
 normally existed between the United States and Great Britain. 
 
 107
 
 io8 
 
 a) Transactions tending to cause an outflow of funds from 
 the United States: 
 
 1. American imports of British goods 
 
 2. American premiums on British insurance 
 
 3. Interest payments on British investments 
 
 4. American bank loans to British banks 
 
 5. American payments of freight bills to British ship owners 
 
 6. Expenditures of American tourists abroad 
 
 b) Transactions tending to cause an inflow of funds to the 
 United States: 
 
 1. Exports of goods to Great Britain 
 
 2. Payment of British insurance policies to Americans 
 
 3. British investments in American securities 
 
 4. British bank loans to American banks 
 
 Now it is obvious that if every individual transaction involv- 
 ing payments by Americans abroad were settled in actual 
 money, and if every transaction involving payments by Great 
 Britain to the United States were met by a shipment of specie, 1 
 a very considerable portion of our monetary resources would be 
 constantly in transit between the two countries, for the volume 
 of international settlements effected in the course of each year 
 runs into hundreds of millions of dollars. Such shipments of 
 actual money would obviously be subject to the risks of ocean 
 transportation, and to substantial costs through loss of inter- 
 est on the money while in transit and in connection with the 
 packing and expressing of the currency. Clearly a mechan- 
 ism that would make possible a reciprocal cancellation of 
 the greater part of these obligations would be of very great 
 economic advantage. In brief, it is the function of the foreign 
 exchanges to cancel all except the net balance of indebtedness, 
 that is, the difference between the total of transactions involv- 
 ing an outward flow, and the total of transactions involving an 
 inward flow, of funds. This balance is met by currency ship- 
 ments. 
 
 1 Specie, alone, is acceptable in international monetary settlements 
 and it is accepted by weight and fineness only.
 
 THE FOREIGN EXCHANGES 109 
 
 II. THE EXCHANGE MECHANISM 
 
 The means by which international payments are effected 
 largely without the shipment of specie is by sending bills of 
 exchange abroad in lieu of actual cash. In order to make the 
 process clear, it will be necessary to understand, first, precisely 
 what is meant by the parity of exchange, "gold points," and 
 bills of exchange. 
 
 Exchange between United States and England is said to be at 
 par when a sterling bill is worth 4.866 in New York. What 
 does par or parity of exchange mean, and how is this quotation, 
 4.866, derived? Parity of exchange is nothing but a simple 
 statement of the relative value of American and British coins. 
 The gold in the British monetary unit, the pound sterling, 
 is worth 4.866 times as much as the gold in the American 
 monetary unit, the dollar. The par exchange rate thus depends 
 upon the varying gold content of the monetary units of the 
 different countries. 
 
 The par of exchange between the United States and France 
 is 5 . 18, the American dollar being 5 . 18 times as valuable as the 
 French unit, the franc. The franc is thus worth in terms of 
 our money a little over 19 cents. France, Belgium, Italy, 
 Switzerland, and Greece belong to the Latin Monetary Union, 
 with monetary units of equal weight and fineness, though of 
 different names; hence the par of exchange between the United 
 States and all of these countries is 5.18. Parity of exchange 
 with Germany is 23.8, the mark being worth 23.8 cents. It 
 is of note that in quoting French exchange it is customary to 
 state the number of francs in a dollar, while in comparing 
 American and British coins we speak of the number of dollars 
 that it takes to equal one pound sterling (4.866). The French 
 quotations are thus stated inversely. 
 
 The money of each of the various countries has its par- 
 ticular parity as compared with United States coins, and in 
 turn the pound sterling, franc, etc., each has its parity with the 
 coins of all the other countries. It is unnecessary for our 
 present purpose to enter into a detailed discussion of all these 
 quotations, for they all involve a common principle.
 
 110 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 The use of bills of exchange reduces currency shipments. 
 The function of bills of exchange may best be revealed by the 
 use of some concrete illustrations. Let us assume that Mr. A 
 in New York has sold 1,000 worth of goods to Mr. X in London, 
 and that at the same time Mr. B in New York has purchased 
 1,000 worth of goods from Mr. Y in London. It is apparent 
 that if it could be arranged so that B could pay A and X could 
 pay Y, it would be unnecessary to ship any currency in order 
 to settle these obligations. If A were to draw an order (or 
 bill of exchange) on X in London ordering X to pay Y 1,000 
 and then could sell the bill to B, he would receive his money 
 from B ; then if B sent this bill over to Y and Y presented it to 
 X, who paid it, both obligations would have been settled with- 
 out the use of any currency. 
 
 But in practice there are usually two difficulties which pre- 
 vent this simple solution of the problem. In the first place, A is 
 not usually acquainted with B, and X is not usually acquainted 
 with Y. Secondly, the amounts involved in the two transactions 
 are not usually identical. Accordingly, dealers in foreign ex- 
 change (banks and brokers) are required as financial intermedi- 
 aries. When A draws his bill of exchange for 1,000 of exchange 
 on the London buyer of his goods, he takes it to a foreign-exchange 
 banker, who pays him, when exchange is 'at par, $4,866. The 
 banker then sends the bill to a correspondent bank in London, 
 which presents the bill to X for payment. The payment is 
 next deposited with the London bank to the credit of the New 
 York bank. Now when B wants to buy a bill of exchange he 
 goes to the foreign exchange banker and the banker sells him a 
 draft drawn against this London bank account a draft for 
 1,000, or for whatever amount the buyer may desire. 1 B then 
 sends the draft to Y in London and Y presents it to the bank 
 against which it is drawn and receives his payment. The New 
 York banker thus acts as an intermediary between A and 
 B, serving in effect to bring them together, and serving also 
 to make "change," that is, to break up bills of exchange into 
 whatever denominations are required. 
 
 1 See p. 167 for a sample of one of these bills.
 
 THE FOREIGN EXCHANGES in 
 
 Sometimes these bills are drawn directly by the exporters 
 against foreign banks with whom the foreign importer has made 
 arrangements for the purpose. They are sometimes drawn 
 payable at "sight," that is, when presented, and sometimes 
 they run for thirty, sixty, or ninety days, etc. The drafts may 
 have attached to them documents in the form of bills of lading 
 and other shipping receipts, or they may be what are known as 
 "clean bills," unaccompanied by any documentary evidence. 
 There are many angles to the problem, giving rise to many 
 different types of bills involving different methods of payment; 
 but the foregoing simple illustration will suffice to reveal the 
 essential principles in all cases. 
 
 It remains to be noted that bills of exchange are not always 
 drawn by American banks or American exporters against 
 foreign banks, and sold to American importers who have 
 remittances to make. The process may be reversed the 
 method actually employed hi any given case being a matter of 
 agreement between the parties to the transaction. 1 
 
 The price of exchange is determined by the demand and supply 
 of bills. What now determines the price at which a bill of 
 exchange can be bought or sold in the New York market? 
 In the illustration above we assumed that exchange was at 
 par. In fact, it is sometimes above and sometimes below par. 
 The price of a bill of exchange is, like the price of wheat or 
 any other commodity, a reflection of the relative demand for, 
 and supply of, bills in the market at the moment. If at any 
 given tune 1,000,000 worth of sterling bills were offered for 
 sale in New York and 1,000,000 worth were demanded, the 
 price would be at par, that is, at 4 . 866. But if only 1,000,000 
 worth of bills were offered in the market for sale, and 1,200,000 
 worth were demanded, the price would be bid up above 4.866 
 by those who desired the bills as a means of meeting their 
 obligations abroad. On the contrary, if only 800,000 were 
 demanded, the sellers would have to make concessions in order 
 to dispose of their bills. 
 
 1 For a more detailed discussion see chap. rix.
 
 112 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 The maximum extent to which the price of exchange can 
 be bid up or forced down, as the case may be, is determined by 
 the costs involved in shipping the actual specie. I should be 
 willing to pay $4,866 for a bill of exchange with which to settle 
 a 1,000 obligation, because that would be cheaper than shipping 
 the currency. I should be willing to pay as high as $4,885. 
 under normal conditions, for such a bill; but I should not be 
 willing to pay more than that, because it would then be 
 cheaper for me to ship the actual specie instead. On the other 
 hand, I should be willing, if necessary, to sell a 1,000 bill of 
 exchange for $4,845; but not for less, since it would then be 
 cheaper for me to pay the expense of importing the actual cur- 
 rency. These points, 4.885 and 4.845, are known as gold- 
 exporting and -importing points. 
 
 The supply of and demand for bills of exchange in the 
 New York and London exchange market depend at any time 
 not merely upon the relative volume of exports and imports. 
 They depend upon all of the international operations outlined 
 above (p. 108). Whatever the occasion for remittances of 
 funds to Great Britain, bills of exchange are demanded in the 
 market, and whatever the occasion for payments to the United 
 States, bills of exchange are drawn and offered for sale. For 
 instance, if an individual is contemplating a trip abroad, he 
 places, say, $1,000 with his bank, with an express company, or 
 with one of the tourist concerns, and asks for letters of credit or 
 travelers' checks. It is then necessary for the bank where the 
 funds have been deposited to transmit means of payment to the 
 other side, and this it does by buying a bill of exchange which it 
 sends to a correspondent bank in Europe, where it is credited 
 to the account of the American bank and made available for the 
 payment of checks when properly signed by the authorized party. 
 
 Finance bills serve as a buffer against currency movements. 
 Finance bills, which are to be considered in connection with the 
 borrowing and lending of bank balances (see outline p. 108) 
 also play an important part in maintaining the balance of 
 payments and in minimizing shipments of specie. International 
 bankers have frequent occasion to increase or decrease their
 
 THE FOREIGN EXCHANGES 113 
 
 balances with correspondent banks abroad; and they buy 
 or sell finance, as distinguished from trade, bills of exchange 
 as a means of accomplishing the desired result. Among the 
 factors making it desirable for a New York bank to increase its 
 balance abroad would be higher interest rates in London than 
 in New York. 
 
 As a means of minimizing the volume of currency ship- 
 ments, international bankers also usually establish foreign 
 credits by borrowing when there is reason to believe that the 
 balance will soon turn the other way. If international obliga- 
 tions are considerably out of balance, however, it is impossible 
 for the bankers to stand in the breach for long; exchange soon 
 moves to the gold-exporting or -importing point, as the case 
 may be, and gold flows out or in to restore the equilibrium. 
 
 Roundabout operations minimize the flow of specie. Thus 
 far we have been illustrating the principles involved in foreign 
 exchange by reference to the trade and financial relations that 
 obtain between the United States and Great Britain. The 
 mechanism of the exchanges also makes it possible for a round- 
 about settling of balances involving three or more countries; 
 for instance, there has long been a triangular trade situation 
 involving the United States, Great Britain, and Brazil. The 
 United States imports from, more than she exports to, Brazil; 
 Great Britain has an unfavorable balance with the United 
 States; and Brazil's imports from, exceed her exports to, Great 
 Britain. Thus Great Britain owes the United States, the 
 United States owes Brazil, and Brazil owes Great Britain. 
 The exchanges make it possible for the United States to pay 
 for her imports from Brazil by bills of exchange drawn against 
 London bank accounts, such bills being acceptable because 
 they can be used in paying Brazilian obligations to Great 
 Britain. In a similar way, since Canada commonly has an 
 adverse balance with the United States, but a favorable balance 
 with England, it is usually advantageous all around for Canadian 
 importers from the United States to meet their obligations by 
 means of bills of exchange drawn against London banks by 
 Canadian exporters to Great Britain.
 
 H4 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 Foreign-exchange dealers or traders also assist in this process 
 of roundabout settlement by arbitrage transactions. The 
 skilful trader makes a careful study of the quotations in all 
 the foreign-exchange markets at any given time. By virtue of 
 temporary variations in rates on different countries he may 
 make a slight profit by buying exchange in one market and 
 selling simultaneously in another. These arbitrage transactions 
 often involve several markets, and they thus tend to stabilize 
 all the exchanges and hold them upon a common level, with 
 movements of currency a last-resort measure. 
 
 In any given year the United States, then, will have a net 
 outflow or net inflow of gold as a result of variations in the 
 relative demand for, and supply of, bills of exchange, arising 
 from trade and financial operations with all the world. Statis- 
 tics of international currency movements are usually presented 
 by the year; for example, in the year 1910 the United States 
 would show a net inflow of gold of, say, $100,000,000. It is im- 
 portant to note, however, that during certain months or weeks of 
 the year gold may be flowing out of a country and during other 
 months or weeks it may be flowing in, the direction of the flow 
 depending upon seasonal variations in the trade and financial 
 relations between different countries. In the United States 
 there is normally a surplus of foreign bills, with a consequent 
 depression of exchange rates to the gold-importing point 
 during the autumn and early winter, when American exports 
 of cotton and wheat are large. In the spring, when American 
 imports of British textiles and other manufactured goods are 
 heaviest, exchange rates are frequently bid up to the exporting 
 point. 
 
 m. THE MAINTENANCE OF EQUILIBRIUM 
 
 This mechanism of the exchanges, as we have seen, permits 
 an outflow of specie from the United States whenever the total 
 of foreign obligations that must be met is greater than is the 
 volume of remittances due us. Under normal circumstances an 
 outflow of gold from any country cannot continue long, 1 for it 
 
 1 Except from a gold-producing country.
 
 THE FOREIGN EXCHANGES US 
 
 is soon followed by financial and trade readjustments which will 
 shortly restore the balance. An outflow of gold from the 
 United States to England, for instance, would mean a lessened 
 volume of funds in New York, with a tendency for interest rates 
 to rise there. The inflow of funds to the London banks would 
 at the same time tend to lower interest rates, in London. 
 In consequence international bankers would find it profitable 
 to transmit, by means of bills of exchange, funds from London 
 to New York, thus serving to restore the equilibrium of the 
 exchanges and to prevent a further outflow of gold from New 
 York, if not to bring about a reverse movement. 
 
 It is the generally accepted economic theory that if an 
 outflow of gold from the United States to England should 
 continue for any considerable length of time it would eventually 
 cause a rise in prices in England and a fall in prices in the 
 United States; whereupon American producers would find 
 it more profitable to export than to sell in the domestic market, 
 while American importers would find it less profitable to import 
 commodities from a country with a high price level for sale in 
 a country with a low price level. The same factors would 
 obviously be operating on the British side, and English traders 
 would strive to reduce exports and increase imports. Accord- 
 ingly, the volume of exports would be somewhat increased 
 and the volume of imports somewhat lessened. There would 
 result a favorable balance of trade, and gold would flow back to 
 the United States, thus restoring the international equilibrium. 
 
 IV. DOMESTIC EXCHANGES 
 
 The foreign exchanges find their counterpart in domestic 
 exchange, that is, in the settlement of balances between the 
 different financial centers of any given country. The domestic- 
 exchange quotations are different, however, by virtue of the 
 fact that the same monetary unit exists in New York as in 
 Chicago, in Liverpool as in London. Par of exchange between 
 New York and Chicago is, therefore, $i; that is to say, the 
 dollar in Chicago is to the dollar in New York as i is to i.
 
 Il6 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 At any given time there are numerous obligations of various 
 types which require a remittance of funds, or "means of pay- 
 ment," from New York to Chicago, and vice versa. When 
 the balance due New York exceeds the balance due Chicago, 
 exchange on New York is at a premium, that is, above par. 
 Since the cest of moving specie from Chicago to New York 
 is about 50 cents per thousand dollars, one would pay as much 
 as, but not more than, $1,000.50 for a bill of exchange with 
 which to meet a thousand-dollar payment in New York. And 
 one would never have to sell a thousand-dollar bill of exchange 
 on New York for less than $999.50. 
 
 Between the different financial centers of the United States, 
 as between foreign countries, specie moves only as a last resort. 
 As in the case of international operations, the amount of specie 
 reflects the net balance of trade and financial obligations. 
 As with international operations, also, an important factor is 
 always the transmitting of bank balances from one center to 
 another through the purchase and sale of bills of exchange. 
 There are also triangular settlements, as between St. Louis, 
 New Orleans, and New York. 
 
 At certain seasons of the year, however, the balance against 
 Chicago is such that specie moves from Chicago to New York; 
 at other seasons funds move west. And when at the end of 
 the year the net figures are shown, Chicago and vicinity will 
 have had a net favorable", or unfavorable, balance with New 
 York and vicinity. But, as with international operations, 
 once more, there cannot be a continuous flow of funds from 
 Chicago to New York, or vice versa, because changes of interest 
 rates and ultimate changes of price levels bring in their train 
 readjustments which cause a reversal of trade, and thus lead 
 to the restoration of the balance. 
 
 V. FOREIGN EXCHANGE DURING THE WAR 
 
 At the outbreak of the European war the normal adjust- 
 ments of international trade and financial obligations were 
 very quickly disrupted. In the autumn of 1914 there was a
 
 THE FOREIGN EXCHANGES 117 
 
 great rush on the part of European holders of American securi- 
 ties to sell them back to us as a means of securing funds required 
 for war purposes. At the same time the usual fall movement 
 of our cotton and other products was checked both by a tempo- 
 rary decline in European demands and by the fear of German 
 raiders. Insurance rates also tremendously increased, so that the 
 gold-exporting point no longer remained at 4 . 885. So great was 
 the demand for sterling bills as compared with the supply that 
 sterling exchange rose at one time as high as $7.00, though 
 it soon declined to $5.00, a figure still substantially above the 
 previous maximum. 
 
 In the autumn of 1915, however, when Great Britain 
 began to buy great quantities of war supplies in the United 
 States the situation was sharply reversed: the supply of bills 
 of exchange outran the demand, and exchange quickly fell to 
 the gold-importing point. For a time Great Britain attempted 
 to maintain the normal method of correcting adverse exchanges 
 by allowing an export of gold, but this had to be checked before 
 long because of the disastrous consequences to the British 
 monetary system. 
 
 The balance of payments continued to run so heavily in 
 favor of the United States that sterling declined to 4.48, at 
 which point the British government intervened, checked further 
 depreciation, and restored the rate to about 4.76^, where it 
 remained "pegged" until March, 1919. This pegging of the 
 exchanges was accomplished chiefly through sales by the British 
 government of American securities which were taken over from 
 British owners, and by government loans from the United 
 States. 
 
 VI. THE POST-WAR DEPRECIATION OF THE 
 EUROPEAN EXCHANGES 
 
 With a view to effecting a gradual restoration of the 
 normal functioning of the international exchanges, the British 
 government, four months after the conclusion of the armistice, 
 abandoned control of exchange rates; and similar action was 
 shortly taken by France, Italy, and other countries. For
 
 Il8 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 reasons to be discussed elsewhere (see p. 270 below), European 
 embargoes on gold shipments were, however, still retained; 
 hence the normal corrective of depreciated exchanges remained 
 inoperative. The results of the international economic mal- 
 adjustments occasioned by the war were quickly shown in a 
 sharp fall in exchange rates on all these countries. 
 
 One reason for the decline may be easily seen by a brief 
 consideration of some of the changes that have occurred in the 
 financial and trade transactions enumerated on page 108 above. 
 As between the United States and England, for instance, 
 interest on British investments has largely ceased because of the 
 return of American securities. On the other hand, we have 
 lent huge sums to Great Britain, so that heavy interest pay- 
 ments were due us instead. British shipping has been reduced 
 by submarine destruction; but American shipbuilding has 
 increased, with the result that the American debt to Great 
 Britain on account of freight charges is now much less than 
 formerly. Tourist travel in England is for the present almost 
 negligible; and finally, the balance of trade is temporarily 
 tremendously in our favor, owing to the necessity for England to 
 import large quantities of raw materials, as well as food-stuffs, 
 until s*uch time as her own industries can be rehabilitated for 
 the purposes of peace. These same general factors hold in 
 exaggerated fashion as between the United States and the 
 Continental belligerents. 
 
 An idea of the magnitude of the changes that have occurred 
 may be gained from a consideration of the following figures: 
 Before the war we owed foreign nations about $6,500,000,000, 
 on which the annual interest charges amounted roughly to 
 $300,000,000. During the war we bought back nearly five 
 billions of these securities, and loaned to the Allies about 
 $10,000,000,000 on government account and about $2,000,000,- 
 ooo on private account, the interest charges on which amount 
 to about $600,000,000 annually. 1 
 
 1 Another important factor in the post-war depreciation of European 
 exchanges is the irredeemable paper currency of all of the belligerent coun- 
 tries. See pp. 270-73 below.
 
 THE FOREIGN EXCHANGES 1 19 
 
 For a discussion of the economic consequences of the de- 
 preciation of the exchanges wrought by the maladjustments 
 of the war, and the remedy that has been suggested, the reader 
 is referred to chapter xv below. 
 
 QUESTIONS FOR DISCUSSION 
 
 1. Enumerate as many sources of international obligations as 
 possible, in addition to those listed on page 108. 
 
 2. Why is it that specie alone is acceptable in settling the balance 
 of international obligations ? 
 
 3. Define parity of exchange; gold points; premium; discount. 
 
 4. What data would you require in order to ascertain the parity of 
 exchange between United States and Japanese money? 
 
 5. What is the service performed by the banks in connection with 
 settling trading obligations by means of bills of exchange? 
 
 6. Show by a concrete illustration how bankers may find it profitable 
 to draw finance bills when exchange is below par. What is the 
 effect of such purchases upon the volume of currency shipments ? 
 
 7. Describe the process by which each nation is required to settle 
 with actual currency only its net balance with all the rest of the 
 world. 
 
 8. What is meant by finance bills ? Do they affect exchange rates 
 in the same way as trade bills ? 
 
 9. What will determine whether the United States has an inflow or 
 outflow of gold in a given week or month ? 
 
 10. Describe the process by which the international financial equi- 
 librium is maintained. 
 
 11. In the light of the exchange mechanism is there any reason to 
 fear an inundation of American markets by cheap foreign goods ? 
 
 12. In the light of foreign-exchange analysis do you accept the 
 doctrine that an excess of exports gives a "favorable" balance of 
 trade ? 
 
 13. Under what circumstances would an inflow of gold into a country 
 be particularly advantageous ? Under what circumstances would 
 an outflow be disadvantageous? Give concrete illustrations, if 
 possible. 
 
 14. One of the leading bankers of this country stated in 1916 that the 
 United States had received a great inflow of gold and that means 
 must be devised to prevent its outflow in the future. Since this 
 banker was engaged in international financial operations, do you
 
 120 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 imagine the activities of his bank were, in fact, directed toward 
 impounding this gold supply for the permanent use of America ? 
 
 15. How does a nation which does not produce gold secure a gold 
 supply ? 
 
 16. What is the par of exchange between Berlin and Cologne? 
 Paris and Berne ? London and Montreal ? 
 
 17. Enumerate the chief sources of obligations as between New York 
 and Chicago. 
 
 18. What caused sterling exchange to rise to $7 shortly after the 
 outbreak of the European war ? Do you think it was necessary 
 for the European nations to suspend, as a war measure, the 
 normal operation of the exchanges? 
 
 19. Indicate the changes that occurred during the war in the inter- 
 national financial relations between the United States and France, 
 and show the effect of each upon French exchange. 
 
 20. By what means were the exchanges "pegged" by the European 
 governments ? 
 
 21. During the war we loaned in the neighborhood of $Q,OOO,OOO,OOO 
 to the Allies. Of what did such loans consist ? What was their 
 relation to exchange rates? 
 
 22. Why should this war-time control of the foreign exchanges have 
 been abandoned in March, 1919? What would have been 
 involved in a continuance of the policy of pegging the exchanges ? 
 
 23. Draw up in parallel columns a statement of the sources of inter- 
 national obligations that now obtain between the United States 
 and Great Britain, and compare them with the statement in the 
 text showing the situation before the war. 
 
 24. Look up in the financial pages of the press the present exchange 
 rates between the United States and the principal European 
 countries. 
 
 Escher, Franklin: Elements of Foreign Exchange, chaps, i, ii, iii, 
 and v. 
 
 Johnson, Joseph French: Money and Currency, chap. v. 
 
 Phillips, Chester A.: Readings in Money and Banking, chaps, 
 xvii and xviii. 
 
 Scott, William A.: Money and Banking, chap, viii, pp. 121-31. 
 
 Whitaker, Albert C.: Foreign Exchange, chap. v. 
 
 Withers, Hartley: Money Changing, chaps, ii, viii, and ix.
 
 CHAPTER IX 
 
 THE NATURE AND FUNCTIONS OF CREDIT 
 
 With this chapter we pass from a study of the nature and 
 functions of money to a consideration of the part that credit 
 plays in the general economic organization. The great impor- 
 tance of the institution which we loosely call "credit" finds 
 emphasis in such common expressions as: "modern industrial 
 society is a credit society"; "credit is the heart and core of 
 the industrial system"; and "credit is the life-blood of com- 
 merce and industry." What is the nature of this striking 
 phenomenon? In what does its great service consist; and 
 why, precisely, does it occupy so prominent a position in the 
 economic system of today ? It is the purpose of the present 
 chapter to consider the nature of credit operations, to study 
 the numerous types or classes of credit that exist today, and to 
 indicate in a general way the significance of the institution 
 of credit from the point of view of economic organization. It 
 will be the task of the remainder of the volume to disclose in 
 greater detail the economic functions of credit and to indicate 
 the services that are rendered by the numerous types of financial 
 instruments and institutions which have been developed in 
 order to facilitate credit operations. 
 
 I. THE NATURE OF CREDIT 
 
 In simple business parlance, credit involves merely getting 
 something now and paying for it later. It is synonymous with 
 borrowing, the essential element in credit operations always 
 being the postponement of payment for something that has 
 been received. It is important to bear in mind that the thing 
 loaned (on credit) may be either commodities or funds. Goods 
 sold on time involve credit; indeed, we usually say that such 
 goods are sold "on credit." Such goods may be paid for by 
 a return of goods in kind; though under modern conditions 
 
 121
 
 122 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 the obligation is usually settled by money payments. Money 
 loaned by a bank or other financial institution, or by one indi- 
 vidual to another, similarly involves a future payment, the 
 credit consisting in allowing the individual to have the use of 
 funds which he is to return at a later time. 
 
 Practically all credit operations are expressed in terms of the 
 pecuniary unit. It may also be observed that it is in connec- 
 tion with credit, or borrowing operations, that the standard 
 of deferred payments, discussed in chapter iii, finds its function 
 in industrial society. 
 
 While credit is thus closely associated with the monetary 
 system, it should not be confused with money, and the reader 
 should be especially careful to distinguish between credit and 
 credit instruments, which will be discussed in chapter xi. 
 Credit is a loaning operation involving, as already seen, a post- 
 poned payment; credit instruments, on the other hand, are 
 the written evidences of antecedent credit operations, that is, 
 of the agreement to pay at a future date. It is credit instru- 
 ments, not credit, as will be seen in an ensuing chapter, that 
 serve as important media of exchange. 
 
 H. THE VARIOUS KINDS OF CREDIT 
 
 From the point of view of the institutions or individuals 
 utilizing credit, the various types or kinds of credit operations 
 that exist in the modern world have been classified as follows: 
 public credit; capital credit; mercantile credit; individual 
 or personal credit; and banking credit. 
 
 By public credit is meant chiefly the borrowing operations 
 of governments, whether national, state, or local, through 
 the issue of securities. The government typically promises 
 to pay interest semiannually and to meet the principal at 
 some stated future date. The funds borrowed are commonly 
 devoted to public enterprises which involve large initial outlays 
 and the benefits of which are to be spread over a period of years. 
 National governments of course often borrow for war purposes.
 
 NATURE AND FUNCTIONS OF CREDIT 123 
 
 By capital credit, or industrial credit, to employ another 
 term, is meant the credit used by manufacturing and producing 
 corporations in procuring the necessary permanent capital 
 required for their operations. The corporation agrees to return 
 to the purchaser of its bonds at some future date the equivalent of 
 the funds borrowed, with interest. The purchaser of stocks also 
 hi a sense loans funds to the corporation with the understand- 
 ing that he is to receive dividends in the future (if earned) and 
 ultimately, if the business is liquidated, his share of the capital. 
 It is the usual practice to exclude from capital credit the invest- 
 ments that are made by individuals in a business largely their 
 own, such as a partnership. 
 
 Mercantile credit is the term applied to the borrowing 
 operations of jobbers, wholesalers, commission merchants, and 
 retailers in connection with the movement of goods from first 
 producer to ultimate consumer. Another term sometimes 
 used synonymously with mercantile credit is commercial credit. 
 The distinction between commercial and other forms of credit 
 is made clear in the section which follows. 
 
 Individual or personal credit obviously takes its name from 
 the fact that it is connected with individuals rather than with 
 public or private corporations. Individuals borrow money 
 from acquaintances and from financial institutions for a wide 
 variety of purposes; and, more important, they purchase con- 
 sumptive goods on time from retail stores. In cities the goods 
 thus borrowed are usually paid for at the end of each month, 
 except in cases where they are sold on the instalment plan. 
 But in the rural communities the settlements are made at 
 much longer intervals, usually at crop-selling times, when the 
 farmer's ship comes home. 1 
 
 Banking credit relates to the process by means of which 
 banking institutions are enabled to attract the funds of deposi- 
 tors and to make loans and create obligations payable on 
 demand, that are not backed by a dollar-for-dollar cash reserve. 
 This will be discussed fully in subsequent chapters. 
 
 1 This practice is becoming less common, however, as farming becomes 
 better organized.
 
 124 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 HI. INVESTMENT, COMMERCIAL, AND 
 CONSUMPTIVE CREDIT 
 
 Viewing credit apart from the borrowing operations of 
 particular institutions, such as governments, corporations, 
 individuals, etc., three distinct types of credit operations 
 may be distinguished, namely, investment, commercial, and 
 consumptive credit. This classification regards credit from the 
 point of view of the uses to which the funds borrowed are 
 devoted, and thus is concerned with the means by which the 
 obligations created are to be met at maturity. 
 
 Investment credit is that which is used in connection with the 
 development of business enterprises, such as railroads, factories, 
 workshops, stores, farms, mines, etc. The funds borrowed are 
 used mainly for the creation of "fixed" or durable forms of 
 capital goods; hence the term "fixed capital." In consequence 
 of the productivity of capital goods, the borrower plans to pay 
 the principal of the loan out of the accumulated earnings of the 
 business over a period of years. Under the circumstances, the 
 credit instruments employed usually call for payments several 
 years hence. 1 
 
 Commercial credit is that which is used in financing the 
 production, manufacture, and marketing of goods, in operating 
 an establishment as a going concern. In contrast with the 
 case of investment credit, the borrower is here usually in a 
 position to repay his loan in a very short period of time. A 
 concrete case will serve to illustrate the difference. Mr. X, a 
 wholesaler, borrows, let us say, $10,000 from the bank and 
 purchases a stock of goods with the money. In the course of 
 two months he sells these goods for $12,000, or at a gross profit 
 of 20 per cent, the goods purchased being the direct means of 
 liquidating the loan. Similarly, the manufacturer, Mr. Y. 
 borrows $20,000 with which to operate his plant and equip- 
 ment. In the course of three months, say, he has produced 
 and sold $25,000 worth of goods, thus being enabled to repay 
 his loan directly from the uses to which the borrowed funds 
 were put. 
 
 1 See pp.
 
 NATURE AND FUNCTIONS OF CREDIT 125 
 
 The borrower for investment purposes, on the other hand, 
 invests $10,000 in a factory. He does not contemplate selling 
 the factory within a few weeks or months; on the contrary, 
 he expects to use it for many years as the basis for his manu- 
 facturing enterprise. Ten years or more must usually elapse 
 before the accumulated profits will permit the repayment of 
 the principal of the loan. Investment credit furnishes capital 
 for the development and maintenance of industries. Commer- 
 cial credit provides funds for running or operating business 
 establishments engaged in the producing, manufacturing, and 
 marketing of goods. It is by means of the former that the 
 business manager assembles land, labor, and materials, and 
 constructs permanent and durable capital goods; it is by means 
 of the latter that the -business manager assembles labor, sup- 
 plies, and materials, and produces and markets the consumptive 
 goods required by society. 
 
 Consumptive credit refers to the granting of loans or the 
 selling of goods on time to individuals who use the money or 
 the goods received in satisfying consumptive wants. If the 
 obligations thus created are met at maturity, it will not be 
 because the funds or property borrowed were devoted to 
 productive uses; it will be because the borrower has other 
 sources of income. Such credit, therefore, usually involves 
 somewhat greater risk of non-payment at maturity, particularly 
 of prompt payment, than does either investment or commercial 
 credit. 1 
 
 IV. THE BASIS OF CREDIT 
 
 There has been a great deal of discussion, participated in 
 by both economists and practical credit men, concerning the 
 essential basis of a credit or borrowing operation. Some 
 writers on the subject have stoutly insisted that confidence is 
 the basis of all grants of credit; that if one did not have confi- 
 dence that the borrower would repay a loan he would neve? 
 think of making the loan, save on grounds of friendship or 
 philanthropy. Others have held that property, rather thar 
 
 1 For a consideration of consumptive credit see chap, xxviii.
 
 126 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 confidence, is the basis of all genuine credit transactions. And 
 still others insist that character is the essential factor; while 
 some recent writers have indulged a propensity for alliteration 
 by stating that the bases of credit are character, capital, and 
 capacity; or the man and the means; or reliability and 
 resources. 
 
 Without attempting to enter into a discussion of the reasons 
 for these different statements of the basis of credit, a tabular 
 exhibit of matters commonly investigated by competent credit 
 men will indicate that while confidence must exist before, a 
 loan will be granted, such confidence has its basis in a knowledge 
 of the borrower's financial standing and ability and of his 
 personal integrity. The things that are usually investigated 
 may be grouped in two general classes as follows: 
 
 PERTAINING TO THE MAN PERTAINING TO THE BUSINESS 
 
 a) Record for honest dealing a) Ratio of quick assets to cur- 
 
 b) Personal attributes rent liabilities 
 
 1. Gambling and drinking b) Amount of capital invested 
 tendencies and property owned 
 
 2. Political and other "out- c) Earnings of business 
 
 side " activities d) Character and rate of turn- 
 
 3. Style of living, including over of stock 
 wife's social ambitions e) Location of business 
 
 c) Ability f) Character of the business 
 
 1. Common sense and organization 
 shrewdness g) Insurance carried 
 
 2. Education and technical h) Nature and intensity of the 
 training competition 
 
 3 . Age and general experience 
 
 4. Success already attained 
 
 This list of factors is by no means inclusive; it is designed 
 merely to be suggestive of the character of the investigation that 
 must be made if credit is to be conservatively extended. It 
 will be noted, also, that the points raised in the parallel columns 
 are not entirely unrelated. A man of excellent business ability, 
 for instance, would be practically certain to have a proper
 
 NATURE AND FUNCTIONS OF CREDIT 127 
 
 ratio of quick assets to current liabilities, substantial earnings 
 etc.; and, on the other hand, if it were found that a business 
 was poorly equipped and managed, there would be a definite 
 reflection upon the manager's business capacity. Investigation, 
 both of the man and of the business, usually serves, however, 
 to furnish a more adequate basis for a sound judgment than 
 investigation of either one alone. 
 
 One may conclude from this brief analysis that before 
 deciding to extend credit one should have confidence, first, 
 in the ability of the borrower to pay as promised, and, second, 
 in his willingness and intention to pay. One is a matter of 
 property and business ability; the other a question of honesty 
 and business integrity. The basis of credit may be diagram- 
 ma tically presented as follows: 
 
 . Character of man 
 
 Credit Confidence 
 
 (Intention to pay) 
 Character of business 1 
 (Ability to pay) 
 
 V. THE SIGNIFICANCE OF CREDIT 
 
 While the economic significance of the credit system cannot 
 be adequately discussed in the present chapter, a few of the ways 
 in which credit is of assistance in the conduct of modern affairs 
 and some of its broader social aspects may, however, be sug- 
 gested. 
 
 Credit enables governments to obtain possession of funds 
 with which to meet pressing emergencies, when no other means 
 are available. It also enables individuals to surmount tempo- 
 rary difficulties or embarrassments. For example, it makes pos- 
 sible the purchase of goods for consumptive requirements pending 
 the receipt of income; it permits the purchase of a home before 
 the entire purchase money is in hand; and it makes possible the 
 acquisition of an education on borrowed funds. 
 
 Credit makes it possible for honest and capable men without 
 capital to secure the funds required for the conduct of modern 
 
 1 Collateral security is also often required. See pp. 386-90.
 
 128 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 industry. Similarly, it enables people with funds in excess of 
 their immediate needs to lend the surplus to capable men of 
 affairs who utilize them in productive activities. This process 
 of lending funds tends to shift "capital" from the hands of those 
 who have not the desire or the ability to make use of the funda 
 to those who are willing and able to assume the risks of capital- 
 istic enterprise. The result is a more effective utilization of 
 the national resources. 
 
 The ability to borrow makes it possible for the business 
 manager to adjust the volume of his capital to the varying 
 requirements of business. When the demand for his products 
 is very large at certain seasons and in certain years of extraordi- 
 nary business activity, he may enlarge the volume of output 
 by borrowing additional working capital and in dull seasons 
 and years he may reduce the volume of capital employed. This 
 expansion and contraction of loans, as we shall later see, finds 
 reflection in the condition of the commercial banking institutions 
 which constitute the foundations on which the credit structure 
 is reared. 1 
 
 With reference to the broader aspects and relations of the 
 credit system, it may be pointed out that its development 
 has depended upon the growth of three things: first, a sense of 
 business morality, or what may amount to the same thing, a 
 recognition of the fact that honesty is the best policy; second, 
 a relatively stable monetary standard for deferred payments; 
 and third, a legal system designed to safeguard the rights of 
 individuals and to enforce a prompt fulfilment of contracts. 
 The evolution of these three supports of the credit system 
 has been one of the most significant features of the trans- 
 formation from medieval to modern industrial society. All of 
 these developments have been very closely interrelated; more- 
 over, each has contributed to, and each has been accelerated 
 by, the growth of the credit system. 
 
 The institution of credit has made possible the growth of 
 large-scale business enterprise and, in turn, the specialized 
 industrial society of the present tune. For the moment industry 
 
 1 See chap, xxiii below.
 
 NATURE AND FUNCTIONS OF CREDIT 129 
 
 passed beyond the handicraft stage, each enterprise usually 
 required a volume of capital greater than could be furnished 
 by the proprietors. Accordingly borrowing became an indis- 
 pensable handmaiden of business. The growth of the capital- 
 istic (profit-making) system of industry has, moreover, been 
 marked by an ever-enlarging scale of business enterprise, insti- 
 tuted, under the competitive regime of the eighteenth and 
 nineteenth centuries, in the expectation of obtaining larger 
 profits through enlarged output, decreased costs of production, 
 and lowered selling prices. The various stages in the trans- 
 formation from the medieval household non-profit-making 
 economy to the twentieth-century capitalistic industrial system 
 are outlined in chapter xi below. It need merely be noted 
 here, therefore, that the steadily expanding scale of both 
 industrial and commercial undertakings is dependent upon 
 ever enlarging aggregations of capital, the assembling of which 
 has been made possible only by a great extension of the credit 
 system, whereby funds might be raised for a given enterprise 
 from a veritable multitude of individual investors. Small 
 accumulations of capital which could not be effectively utilized 
 by their owners are thus joined with other accumulations and 
 placed under the control and management of individuals who 
 are able to make the most effective use of capital resources. 
 
 Since nearly every business enterprise is nowadays in greater 
 or lesser degree dependent on the use of borrowed funds, it 
 is not difficult to understand why writers should stress the 
 importance of credit in the extravagant terms noted in the 
 introductory paragraph of this chapter. Credit is in truth a 
 pervasive, fundamental institution one that is indispensable 
 to the conduct of a capitalistic industrial system. 
 
 QUESTIONS FOR DISCUSSION 
 
 1. Give a definition of credit. 
 
 2. What is the difference between credit and credit instruments? 
 
 3. Do you know of any businesses that do not borrow at all? 
 
 4. Give concrete illustrations of borrowing operations that take 
 the form of the borrowing of actual goods. Are the operations 
 settled by a return of goods in kind ?
 
 130 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 5. Give concrete illustrations of borrowing operations that take the 
 form of the borrowing of money or "funds." 
 
 6. With what function of money is credit most closely associated ? 
 
 7. What are the bases for the two different classifications of credit 
 given in the chapter ? 
 
 8. Which classification do you regard as more significant? Why? 
 
 9. What is the essential distinction between commercial arid in- 
 vestment credit, that of the length of time for which the 
 credit is extended or the use to which the funds borrowed are 
 devoted ? 
 
 10. What is the explanation of the fact that investment credit usually 
 runs for long periods of time and commercial credit for short 
 periods? 
 
 n. Turn to the chart on page 136 and indicate where commercial 
 credit might be placed. 
 
 12. Where would "capital" or "industrial" credit appear on the 
 chart? Where would "mercantile" credit appear? 
 
 13. Would consumptive credit ordinarily be extended for a shorter or 
 longer period than commercial credit? Why? 
 
 14. Does consumptive credit appear upon the chart on page 136 ? 
 
 15. What is meant by the statement that the "basis of credit is 
 confidence " ? 
 
 16. As a business proposition, would you lend a man funds on the 
 strength of his moral character alone ? 
 
 17. As a business proposition, would you lend funds to a man on the 
 strength of his ability to pay alone ? 
 
 1 8. Which do you regard as more important in credit, the character of 
 the man or the character of the property security ? 
 
 19. " The law's delays and the law's circumventions permit property 
 to melt away, but the element of personal honesty and the 
 quality of efficiency do not change with time." If you agree 
 would you conclude that ability to pay is less important than 
 determination to pay ? 
 
 20. In the case of public credit, is there any property basis for credit ? 
 
 21. Is there ever any doubt of the intention and willingness of a 
 government to pay ? 
 
 22. Why do French borrowers have to pay in the neighborhood of 
 10 per cent on loans placed in the United States in the year 1920 ? 
 
 23. Is the basis of capital or industrial credit confidence in the 
 management or in the property of the corporation ?
 
 NATURE AND FUNCTIONS OF CREDIT 131 
 
 24. The railroads now have to pay relatively higher interest rates on 
 borrowed funds as compared with other industries than formerly. 
 To what is this relative decrease in credit standing attributable ? 
 
 25. When a retailer advertises: "Your credit is good; cash pay- 
 ments not required," on what is he basing his belief that his 
 customers will prove good ? 
 
 26. When a small-town retailer sells goods on credit, does he make 
 any investigation of the borrower ? 
 
 27. When Marshall Field & Company extend credit to a lawyer, 
 allowing him to pay his bills monthly, what is the basis of the 
 credit ? 
 
 28. What, in general, is the basis of consumptive credit? 
 
 29. Do you think it is true that large-scale business enterprise would 
 not be possible without the institution of credit ? 
 
 30. Could we have a specialized industrial society without credit ? 
 
 31. In what way would you say that the institution of credit lessens 
 the cost of producing goods ? 
 
 32. Draw up a statement showing how the institution of credit has 
 made it easier for society to satisfy its wants. 
 
 REFERENCES FOR FURTHER READING 
 
 Hagerty, James E.: Mercantile Credit, chaps, i, iii, and v. 
 
 Laughlin, J. Laurence: Principles of Money, pp. 71-88. 
 
 Meyer, Charles A.: Mercantile Credits and Collections, chaps, i 
 and viii. 
 
 Prendergast, William A. : Cr edit and Its Uses, chaps, i and ii. 
 
 Shaw Banking Series: Credits and Collections, chaps, iv-viii. 
 
 The Credit Monthly. Published by the National Association 
 of Credit Men.
 
 CHAPTER X 
 
 THE MODERN FINANCIAL STRUCTURE 
 
 The great growth of credit operations which followed the 
 development of large-scale business enterprise, particularly that 
 organized on the corporate basis, has been attended by the 
 development of an extensive and interdependent financial 
 structure, designed to facilitate the raising of the funds required 
 for capitalistic industry. The great number of financial instru- 
 ments, agencies, and institutions that are utilized in connection 
 with the borrowing operations of producing, manufacturing, 
 and mercantile businesses is indicated in the diagrams on the 
 accompanying pages. 1 The diagrams are designed merely to 
 enable the reader to visualize the financial mechanism as a 
 whole and to afford a general view of the financial structure 
 of society, with its complex interrelations, as a preliminary 
 to the detailed study of the numerous particular institutions 
 which will constitute the subject-matter of the succeeding 
 chapters. 
 
 The diagrams, however, require a few words of explanation 
 and qualification. In general, the purpose is to show the 
 financial institutions and agencies that are employed in the 
 assembling of the capital required by modern business enter- 
 prise. It is of note, first, that the financial structure involved in 
 the raising of fixed capital for individual firms and partnerships, 
 as shown on the first diagram, is relatively simple, since it is 
 largely contributed by the owner, or owners, of the business. 
 The greater complexity of the second diagram, moreover, is an 
 indication that the development of the very intricate and 
 extensive financial organization of the present day is largely 
 attributable to the enormous growth of the corporate form of 
 business organization. 
 
 1 For a diagram showing the financial structure that has been developed 
 in connection with agricultural borrowing, see p. 650. 
 
 13*
 
 MODERN FINANCIAL STRUCTURE 133 
 
 With reference to the corporation diagram, particularly, 
 the arrows pointing downward from fixed capital indicate the 
 movement of the securities that are issued by corporations 
 through the financial institutions that assist in marketing 
 them to the ultimate purchasers, who in the last analysis furnish 
 the funds to the corporation. In some cases the securities do 
 not find lodgment with individual investors but are purchased 
 by financial institutions, as is indicated by the arrows which 
 point to savings banks, insurance companies, etc. In these cases, 
 however, the funds are still furnished by individual savers, 
 namely, the shareholders, depositors, etc. These financial insti- 
 tutions thus serve as intermediaries in the process of rendering 
 individual savings available for the uses of corporate industry. 
 
 The stock market has been placed at one side of the diagram 
 in order to indicate that it is not a direct intermediary in the 
 marketing of securities. It is rather a great central market 
 place which is made use of by nearly all of the various types of 
 financial institutions in connection with their operations, as well 
 as by the ultimate investors in securities. All of these relations 
 will be made clear in the chapter on the stock exchanges. The 
 lines connecting the stock exchange with the different institu- 
 tions are designed to indicate in a general way the interrelations 
 that exist. 
 
 Finally, it will be seen that the commercial banks are 
 directly concerned with the raising of working capital, and 
 indirectly associated with investment banking instituti<fns hi 
 the raising of fixed capital. Note the transverse line connect- 
 ing commercial and investment banks. A line might also be 
 drawn from the commercial banks to the fixed capital side of the 
 corporation; for to a considerable extent they purchase securi- 
 ties directly and make loans to corporations for fixed capital 
 purposes (see chap, xxi and pp. 487-88). 
 
 To safeguard against misconception it is necessary to state 
 that the diagrams could not be made to reveal all the phases of 
 the modern financial structure without complicating them to 
 the point of obscurity. It will be well, therefore, to point 
 out here certain things which they do not indicate.
 
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 "8
 
 MODERN FINANCIAL STRUCTURE 135 
 
 First, although a line is drawn from the corporation direct 
 to the purchaser of securities, the corporation chart fails to 
 convey an adequate idea of the vast amount of capital that is 
 raised without the assistance of financial intermediaries. A 
 very great number of our corporations have raised their capi- 
 tal by direct subscription; indeed, I think it may safely be 
 said that a large percentage of our present-day corporations 
 secured their start by converting individual firms or partner- 
 ships into corporations and issuing shares of stock to the 
 owners. There are many "close" corporations those which 
 have never raised any funds from general subscription. 
 Among some of the more important of such corporations 
 are: most of the great New England cotton mills; several of 
 the larger chemical companies; the Du Pont Powder Com- 
 pany; many of the great department stores in all the large 
 cities of the country; the large corporations in the aluminum, 
 brass, zinc, asbestos, and sulphur industries; and the great 
 majority of financial institutions. Perhaps the most conspicu- 
 ous example of the close corporation in the United States 
 at the present tune is the Ford Motor Company. As a result 
 of recent acquisitions, Mr. Ford and his son are said to be 
 the sole proprietors of the largest privately owned business in 
 the country. 
 
 Second, the charts do not reveal the raising of capital by 
 the common process of creating a surplus through setting aside 
 a portion of the earnings for an expansion of the business. 
 A tremendous amount of capital is thus raised, especially by 
 corporations. It will be noted that this method merely involves 
 a decision of the directors of the corporation with reference to 
 the disposition of earnings. 
 
 Third, the charts reveal only those credit operations which 
 involve the borrowing of funds, as distinguished from actual 
 goods. Working capital in part takes the form of materials 
 bought on credit. A retailer, for instance, may do most of 
 his borrowing by buying goods from wholesalers on time. But 
 since the wholesalers, who sell these goods on credit to the 
 retailer, usually borrow from the commercial banks during the
 
 (33BJJ 35|re^| pHUaQ 
 
 3ONVHDX3 NDO1S
 
 MODERN FINANCIAL STRUCTURE 137 
 
 interval while awaiting payment, it all comes to much the 
 same thing in the end working capital is largely borrowed from 
 the commercial banks. 
 
 The corporation chart does indicate, however, that a portion 
 of the working capital is usually derived from the sale of securi- 
 ties. Indeed, if a business is to have a good credit standing 
 with its bank, it must, in fact, provide a considerable part 
 of its working capital by stock subscriptions. 
 
 Fourth, one might conclude from the corporation diagram 
 that savings banks are associated only with the problem of 
 raising fixed capital. As a matter of fact, many savings-bank 
 loans are also made for working capital purposes (see chap. xvii). 
 
 Fifth, the position of the trust company in the financial 
 structure of society is not adequately revealed. As the chart 
 stands, the trust company is related only to the raising of fixed 
 capital and is placed in a parallel position with savings banks 
 and insurance companies. In fact, as we shall later see (chap, 
 xviii below), the trust company performs so wide a variety of 
 functions that it is impossible in the present diagram to indi- 
 cate its relationship to the entire financial structure. The com- 
 mercial banking department of the trust company would go 
 with the commercial banks, the bond department with the bond 
 houses, the savings department with the savings banks, the 
 insurance department with the insurance companies. But, 
 in addition, the trust company performs a great variety of 
 services for the holders of corporate securities in connection with 
 the safekeeping of valuables, the holding of mortgages in trust, 
 the transfer of ownership of stocks and bonds, the financial 
 reorganization of companies, etc. 
 
 Finally, the diagrams tend to give a false impression of 
 specialization by financial institutions. The truth is that more 
 and more there is being conducted under one roof and by a 
 single administrative organization a great variety of financial 
 activities. Just as the trust company has many departments, 
 the commercial bank nowadays usually has associated with it 
 savings and bond departments, and, in the last two or three 
 years, trust departments as well. The designations given on
 
 138 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 the diagram must, therefore, be considered as representing types 
 of financial functions rather than (in every case) distinct and 
 specialized financial institutions. 1 
 
 The remaining chapters of the volume will be devoted to a 
 discussion of the services and functions that are performed by 
 the numerous parts of this financial organization, the problems 
 of regulation that have arisen in connection with the various 
 types of financial institutions, and the interrelations of this 
 intricate financial mechanism with the larger economic organi- 
 zation of which it forms so important a part. 
 
 1 See chap. xxix.
 
 CHAPTER XI 
 
 THE CORPORATION AS A DEVICE FOR 
 RAISING CAPITAL 
 
 At the head of the diagram showing the financial institutions 
 and agencies that function hi the raising of capital in the modern 
 industrial world (p. 136) is placed the corporation, the domi- 
 nant type of business organization at the present time. In 
 discussions of the corporation as a form of organization for the 
 conduct of business, its advantages over the partnership have 
 usually been listed as follows: (i) greater ease of raising capital; 
 (2) perpetual (or, at least, definite) existence; (3) centralization 
 of managerial responsibility and power. It is the purpose of 
 the present chapter to outline the significance of the corporation 
 as a capital-raising institution to account for its origin and 
 development in terms of capital requirements. 
 
 It is not too much to say that the outstanding advantage of 
 the corporation over the partnership is its greater effectiveness 
 hi assembling the capital required for large-scale enterprise. 
 Partnerships may be and some have been "given a perpetual 
 life. Partnerships may delegate the management to a single 
 individual or group of individuals and hold them responsible for 
 results, quite after the fashion of the corporate organization. 
 Indeed, some modern partnerships are thus organized; while 
 the "silent partner" is, of course, a common phenomenon. 
 But without shares of stock and bonds and without the prin- 
 ciple of limited liability the partnership could not possibly 
 effect the accumulation of the large quantities of capital required 
 by the great majority of modern businesses. Some modern 
 partnership associations, it is true, have the equivalent of 
 shares and some have been organized with a limited liability; 
 but these features constitute the very essence of the corporate 
 form of organization. To the extent that they have now been 
 
 139
 
 V 
 
 140 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 taken over by partnerships the latter may be said to have 
 " corporationized." 
 
 I. ADVANTAGES OF THE CORPORATION IN 
 RAISING CAPITAL 
 
 The corporation is for several reasons an effective agency 
 for the raising of capital. In the first place, the division of 
 the capital into small units in the form of shares of stock or 
 bonds makes it possible to attract funds from people of very 
 moderate means. To this end the par value of bonds and of 
 shares of stock is made small, often very small in the case of 
 shares. While the standard unit is $100, many companies are 
 organized that sell shares at $10, $5, $i, and even at 5 cents each 
 Investments are thus brought within the reach of every class. 
 
 Second, the division of the shares and bonds of corporations 
 into small denominations also makes it possible for individuals 
 to diversify their investments and thus reduce the risks of loss 
 to a rnirumum. Even so small a fund as $10,000 may be 
 invested in a hundred or more different companies. It is of 
 note that "baby bonds," of $100 denominations, and with 
 instalment-payment provisions, have become increasingly 
 popular in recent years. 
 
 Third, the division of corporate securities into bonds and 
 shares serves to attract the investments of people of different 
 temperaments and of different economic position. Bonds, 
 constituting a first claim upon earnings, make their appeal to 
 those who are by temperament conservative, or whose economic 
 position is such as to make safety of investment the prime 
 requisite. On the other hand, stock offers an opportunity of 
 higher returns and thus appeals to people who are willing to 
 take chances in the hope of large rewards, and to those whose 
 economic position is such that they can afford to assume larger 
 risks. 
 
 Similarly, the division of stock into preferred and common 
 shares is calculated to appeal to investors of different degrees 
 of conservatism. The preferred stock, while not so safe as 
 bonds, is still relatively safe in well-established companies,
 
 THE CORPORATION AND THE RAISING OF CAPITAL 141 
 
 and it yields a higher return than bonds. Common stock is 
 subject to still greater risks, but affords the possibility of very 
 large returns. Nowadays there is, moreover, a great variety 
 of subclasses of shares, notes, and bonds, all designed to facili- 
 tate the raising of funds through varied appeals. 1 
 
 Fourth, the easy transferability of bonds and shares, made 
 possible by the development of organized stock exchanges, 
 enables an individual to withdraw his investment in a corpora- 
 tion at almost a moment's notice. The significance of this for 
 our present purpose is that the ease with which one may get 
 out of a corporation has an important bearing on his willingness 
 to get in. Under present conditions one is not necessarily 
 committed to a given under taking once and for all; with 
 readily marketable securities the investor retains almost 
 instantaneous command over capital. 
 
 Fifth, the large aggregations of capital made possible by 
 virtue of these various advantages, together with the limited- 
 liability principle discussed below, give to the corporation 
 unusual competitive strength and stability, and this in its 
 turn renders securities the more attractive to the general 
 investing public. 
 
 Sixth, the corporation now universally embodies the prin- 
 ciple of limited liability, i.e., liability of each shareholder only 
 to the amount (usually) of his individual stock. This is 
 indispensable to the assembling of the vast amounts of capital 
 required by modern business establishments, for it would be 
 utterly impossible to induce an individual to purchase shares 
 of stock in a corporation of large size if his individual liability 
 to creditors was equal to the entire capital. Unlimited liability 
 will be assumed only where the number of owners is few, where 
 they are well known to each other, and where the amounts 
 involved are relatively small. 
 
 It should be noted that the principle of limited liability 
 applies only to stock, the bondholders being creditors of the 
 corporation. It is apparent, finally, therefore, that even with- 
 out the principle of limited liability the corporation would have 
 
 1 See pp. 155-56,
 
 H2 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 advantages over the ordinary partnership in the assembling 
 of capital, since the sale of bonds would in any event make it 
 possible to draw funds from a large number of investors. 
 
 The growth of large-scale enterprise was dependent upon 
 limited liability. Light will be thrown upon the' importance of 
 the principle of limited liability from the point of view of facili- 
 tating the raising of capital by a brief review of its history. For 
 a considerable period during English industrial history, joint- 
 stock companies did not enjoy the principle of limited liability. 
 Following a period of great speculation in the shares of unincor- 
 porated "companies," 1 in which many people were financially 
 ruined, the so-called Bubble Act of 1719 prohibited unincorpo- 
 rated companies from acting as corporate bodies or selling trans- 
 ferable stock. This prohibition interfered with the formation 
 of genuine trading companies and "greatly hindered the employ- 
 ment of accumulated capital." 2 The strict enforcement of the 
 act, however, was found to be impracticable and for many years 
 it was allowed to remain a dead letter, many new unincorporated 
 companies continuing to be formed. 
 
 The Bubble Act was repealed hi 1825 and the Crown was 
 empowered to grant charters of incorporation; but the indi- 
 vidual owners of the corporation were made personally liable 
 for the whole or any part of the debts of the corporation. 
 During the next thirty years men of investment and social 
 standing held aloof from concerns in which the smallest invest- 
 ment involved so great a risk. Of 4,049 companies registered 
 provisionally from 1844 to 1855, 3,084 were abandoned before 
 complete registration. The principle of limited liability was 
 so important, however, for the raising of the capital required 
 for the rapidly expanding size of industrial enterprises that 
 Parliament finally passed an act in 1856 permitting the forma- 
 tion of corporations "with limited or unlimited liability, with 
 all the benefits of incorporation." Banking and insurance 
 companies were, however, still excluded. The complete accept- 
 
 1 See p. 144. 
 
 ' S. E. Perry, "History of Companies' Legislation in England," Journal 
 of the Institute of Bankers, Vol. XXIX.
 
 THE CORPORATION AND THE RAISING OF CAPITAL 143 
 
 ance of the limited liability principle, together with the 
 adoption of a general incorporation law by the act of 1856, 
 paved the way for the great expansion in the size of business 
 enterprise that marked the second half of the nineteenth 
 century. 1 
 
 In the United States, however, it appears that the principle 
 was accepted from the very beginning. Davis informs us that 
 " limited liability was recognized as an attribute of an incorpo- 
 rated company almost invariably without specific mention; 
 indeed, it was a principal object desired through incorporation." 2 
 With scarcely an exception, early American corporations, in 
 fact, enjoyed the advantages incident to limited liability. 
 
 II. STAGES OF CORPORATE DEVELOPMENT 
 
 A study of the changes that have occurred in the organiza- 
 tion of industry from the Middle Ages to the present time 
 indicates that the development of the corporation was in 
 truth very largely governed by capital requirements. While 
 the germ of the corporate idea is no doubt to be found in the 
 guild associations of the early Middle Ages, the first corporations 
 of significance, from the point of view of business enterprise, 
 were the great trading companies of the sixteenth and seven- 
 teenth centuries. These companies were organized for the 
 purpose of developing trade with foreign dominions and as 
 colonizing agencies. 3 
 
 The early corporation embodied numerous features; it 
 was a bundle of special rights and privileges, and has been 
 aptly called a collection of monopoly grants of power. While 
 there was no single reason for the use of the corporate organiza- 
 tion, large capital requirements were nevertheless in every 
 case the paramount factor. The shares of stock of small 
 
 1 Loc. dt. 
 
 3 Essays in Earlier History of American Corporations, IV, 317-29. 
 
 s The joint stock was also used in the sixteenth and seventeenth cen- 
 turies in mining companies, and in nearly every important monopoly. 
 Wm. E. Price, English Patents of Monopoly, p. 131.
 
 144 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 denomination made it possible to secure capital contributions 
 from a large number of individuals. 
 
 Moreover, unusual risks were involved, owing to the un- 
 certainties both "of ocean transportation and of trade, and this 
 was a serious deterrent to the advancement of large sums by 
 any one individual. The joint-stock company made it possible 
 for individuals to distribute their risks over a number of different 
 undertakings. 
 
 Investment opportunities were few before the corporate era. 
 These early corporations were necessary not only for the raising 
 of capital for overseas enterprises. They appear to have been 
 quite as serviceable in the accommodation of would-be investors. 
 Macaulay 1 writes: 
 
 During the interval between the Restoration and the Revolution 
 the riches of the nation had been rapidly increasing. Thousands 
 of busy men found every Christmas that, after the expenses of the 
 year's housekeeping had been defrayed out of the year's income, 
 a surplus remained; and how that surplus was to be employed was a 
 question of some difficulty. In our time, to invest such a surplus, at 
 something more than three per cent on the best security that has 
 ever been known in the world, is the work of a few minutes. But in 
 the seventeenth century, a lawyer, a physician, a retired merchant, 
 who had saved some thousands and who wished to place them safely 
 and profitably, was often greatly embarrassed. Three generations 
 earlier, a man who had accumulated wealth in a profession generally 
 purchased real property, or lent his savings on mortgage. But the 
 number of acres in the kingdom had remained the same; and the 
 value of these acres, though it had greatly increased, had by no 
 means increased so fast as the quantity of capital which was seeking 
 for employment. Many, too, wished to put their money where they 
 could find it at an hour's notice and looked about for some species of 
 property which could be more readily transferred than a house 
 or a field. A capitalist might lend on bottomry or on personal 
 security but, if he did so, he ran a great risk of losing interest and 
 principal. There were a few joint-stock companies, among which 
 the East India Company held the foremost place; but the demand 
 for the stock of such companies was far greater than the supply. 
 Indeed, the cry for a new East India Company was chiefly raised 
 
 1 Quoted in Bagehot, Lombard Street (1912), pp. 131 ff.
 
 THE CORPORATION AND THE RAISING OF CAPITAL 145 
 
 by persons who had found difficulty in placing their savings at inter- 
 est on good security. So great was that difficulty that the practice 
 of hoarding was common. We are told that the father of Pope, the 
 poet, who retired from business in the City about the time of the 
 Revolution, carried to a retreat in the country a strong box containing 
 near twenty thousand pounds, and took out from time to time what 
 was required for household expense; and it is highly probable that 
 this was not a solitary case. At present the quantity of coin which is 
 hoarded by private persons is so small that it would, if brought forth, 
 make no perceptible addition to the circulation. But in the earlier 
 part of the reign of William the Third, all the greatest writers on 
 currency were of opinion that a very considerable mass of gold and 
 silver was hidden in secret drawers and behind wainscots. 
 
 The natural effect of this state of things was that a crowd of pro- 
 jectors, ingenious and absurd, honest and knavish, employed them- 
 selves in devising new schemes for the employment of redundant 
 capital. It was about the year 1688 that the word stockjobber was 
 first heard in London. In the short space of four years a crowd of 
 companies, every one of which confidently held out to subscribers the 
 hope of immense gains, sprang into existence 'the Insurance Com- 
 pany, the Paper Company, the Lutestring Company, the Pearl 
 Fishery Company, the Glass Bottle Company, the Alum Company, 
 the Blythe Coal Company, the Swordblade Company. There was a 
 Copper Company, which proposed to explore the mines of England, 
 and held out a hope that they would prove not less valuable than those 
 of Potosi. There was a Diving Company, which undertook to bring 
 up precious effects from shipwrecked vessels, and which announced 
 that it had laid in a stock of wonderful machines resembling complete 
 suits of armour. In front of the helmet was a huge glass eye like 
 that of a Cyclops; and out of the crest went a pipe through which the 
 air was to be admitted. The whole process was exhibited on the 
 Thames. Fine gentlemen and fine ladies were invited to the show, 
 were hospitably regaled, and were delighted by seeing the divers in 
 their panoply descend into the river and return laden with old iron 
 and ship's tackle. There was a Greenland Fishing Company, which 
 could not fail to drive the Dutch whalers and herring busses out of the 
 Northern Ocean. There was a Tanning Company, which promised 
 to furnish leather superior to the best that was brought from Turkey 
 and Russia. There was a society which undertook the office of 
 giving gentlemen a liberal education on low terms, and which assumed
 
 146 
 
 the sounding name of the Royal Academies Company. In a pom- 
 pous advertisement it was announced that the directors of the Royal 
 Academies Company had engaged the best masters in every branch 
 of knowledge, and were about to issue twenty thousand tickets at 
 twenty shillings each. There was to be a lottery two thousand 
 prizes were to be drawn; and the fortunate holders of the prizes 
 were to be taught, at the charge of the company, Latin, Greek, 
 Hebrew, French, Spanish, conic sections, trigonometry, heraldry, 
 japanning, fortification, bookkeeping, and the art of playing the 
 theorbo. 
 
 The second stage in corporate development came during 
 the seventeenth and eighteenth centuries when the corporate 
 principle was extended to such enterprises as insurance, banking, 
 and inland navigation. The importance and the supposed 
 limitations of the joint-stock company during this period may 
 be glimpsed by reference to a well-known quotation from Adam 
 Smith: 
 
 The only trades which it seems possible for a joint-stock com- 
 pany to carry on successfully without an exclusive privilege are those 
 of which all the operations are capable of being reduced to what is 
 
 called routine Of this kind is, first, the banking trade; 
 
 secondly, the trade of insurance in fire and from sea risks and capture 
 in time of war; thirdly, the trade of making and maintaining a navi- 
 gable cut or canal; and fourthly, the similar trade of bringing water 
 for the supply of a great city. 
 
 He adds that in order to render the use of the joint-stock com- 
 pany feasible, two other circumstances should concur: "first, 
 that the undertaking is of greater and more general utility 
 than the greater part of the common trades; and secondly, 
 that it requires a greater capital than can easily be collected 
 into a private copartnership." It appears that the corporation 
 was not regarded as particularly well adapted to the efficient 
 conduct of most lines of business, but that it was a very useful 
 device in lines of activity where it was necessary to raise large 
 sums of capital. 
 
 The third stage in corporate history may be designated the 
 transportation period, beginning in England about 1780. 
 Adam Smith, who wrote in 1700, had foreseen the use of the
 
 THE CORPORATION AND THE RAISING OF CAPITAL 147 
 
 corporation in connection with canal building, although the 
 great era of canal transportation came after his time from 
 1780 to 1815. The corporation was almost universally used 
 as a means of assembling the large capital required for canal 
 construction. It is significant from the point of view of the 
 capital-raising function of corporations, to note that the canal 
 companies did not conduct transportation; the canal barges 
 were run by individual boatmen. The use of the corporation 
 was here dictated solely by capital-raising requirements. This 
 was also true of the turnpike companies. 
 
 With the development of railway transportation after 1830 
 the use of the corporation was greatly extended. While in the 
 case of the railroads the corporation was early used both as a 
 capital-raising and as an operating device, the capital-raising 
 feature was of primary importance. It was manifestly impos- 
 sible to raise the funds required by individual or partnership 
 means. As with the old trading companies, not only was the 
 volume of capital required very large, but the risks assumed 
 were likewise exceptional. 
 
 The fourth stage is that of the extension of the corporate 
 form of organization to producing, manufacturing, and mer- 
 cantile enterprises. Although the corporation was used to 
 some extent in ordinary business in both England and the 
 United States before 1800, it was not until after the develop- 
 ment of efficient and cheap transportation systems that it 
 became the dominant form of organization in manufacturing 
 and mercantile lines. During the earlier years of its history 
 the factory system did not require very large aggregations of 
 capital, for the simple reason that markets were narrowly 
 circumscribed, owing to the inadequacy and the great cost of 
 transportation, as also to the decentralization of wealth and 
 population. The volume of output that could be sold by any 
 single plant was thus definitely limited. Under these conditions 
 only a few thousands of dollars of capital was required for the 
 largest business establishment; individuals and partnerships 
 found no serious handicap in financing such enterprise. But 
 while the earlv factories did not recmire larere caoital. in view
 
 148 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 of market limitations, their development gave rise to an in- 
 sistent pressure for wider markets, in order to make possible 
 a larger and more profitable scale of industrial enterprise; 
 and this undoubtedly hastened the development of efficient 
 transportation. 
 
 The widening of markets that resulted from the development 
 of modern transportation facilities gave in turn a tremendous 
 impetus to the enlargement of the size of business undertakings. 
 Given cheap transportation to the markets of the world, there 
 was almost no limit to the profitable size of the business unit. 
 By 1845 railroad transportation had definitely proved itself, 
 both in England and in the United States; and before 1860 it 
 had succeeded in linking the great Middle West with all the 
 markets of the world. 
 
 The second half of the nineteenth century then witnessed 
 a gigantic effort on the part of industries to expand the scale 
 of their productive operations to a point where they could take 
 full advantage of the world-markets that were available to 
 them. Cheap transportation meant reduced costs for the lay- 
 ing down of goods hi distant markets. And the enlarged 
 output made possible by widened markets still further reduced 
 the cost per unit and made possible a competition over ever- 
 widening areas. This tremendous growth in the size of the 
 producing unit, and also in the size of the commercial and 
 distributing businesses concerned with the marketing process, 
 made the use of the corporation as a capital-raising device just 
 as indispensable here as it was in foreign trading, finance, 
 insurance, and transportation. Where during its earlier history 
 the factory required a capital of perhaps a few thousand dollars, 
 the large-scale business enterprises of the present necessitate 
 capital accumulations of hundred of thousands, millions, and 
 even hundreds of millions of dollars. 
 
 Thus did the changing structure of industrial society, 
 with its ever-increasing size of business undertaking and ever- 
 enlarging capital requirements, gradually extend the scope 
 of corporate industry, until today the corporation is the domi-
 
 THE CORPORATION AND THE RAISING OF CAPITAL 149 
 
 nant form of business organization. Without minimizing the 
 advantages of the corporation as an operating agency, it may 
 be repeated that intrinsically and historically the corpora- 
 tion is a capital-raising device. We shall see in the following 
 and in other chapters that this changing industrial structure, 
 with the development of the corporation, has called into 
 existence most of the financial institutions that function in the 
 economic system of today, and has profoundly modified the 
 problems of organization and control of all of them. 
 
 QUESTIONS FOR DISCUSSION 
 
 1. Is the corporation to be regarded primarily as an efficient form 
 of organization for the conduct of a business once established, 
 or primarily as an efficient instrument for raising capital ? Is it 
 either exclusively ? 
 
 2. What advantages do shares of stock and bonds afford as a means 
 of raising capital ? 
 
 3. Why should both bonds and stock have been developed? 
 
 4. What is the purpose of issuing different kinds of stock and 
 bonds ? 
 
 5. Without bonds and stock it would be impossible for an individual 
 of moderate means to diversify his investments. Why ? Indi- 
 cate the probable results of such a situation. 
 
 6. In what way, precisely, is the ready transferability of bonds and 
 shares an inducement to investment ? 
 
 7. What would people do with temporarily idle funds in the absence 
 of an opportunity to invest in readily marketable securities ? 
 
 8. Indicate how the perpetual existence of a corporation might 
 facilitate the raising of capital. 
 
 9. What is the significance of the limited liability principle from the 
 viewpoint of capital raising ? Has it any significance from any 
 other point of view ? 
 
 to. What opportunities for investment existed in England before 
 the extensive development of the joint-stock company ? 
 
 [i. Have we had speculative manias since the time of which Macaulay 
 wrote ? (See pp. 186-87 below.) Do plenty of opportunities for 
 conservative investment always deter people from indulging in 
 speculation ?
 
 150 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 12. During that period of English history when corporations were 
 not granted the limited liability principle, did they possess 
 any advantage over partnerships in the raising of capital ? Were 
 they subject to any comparative disadvantages ? 
 
 13. Why was it so difficult to enforce the Bubble Act in England ? 
 
 14. How do you account for the hostility to the principle of limited 
 liability that was manifest in England until the middle of the 
 nineteenth century ? 
 
 15. Suggest some of the probable industrial consequences of the 
 refusal to permit limited liability in England between 1825 and 
 1856. What were the outstanding industrial requirements of 
 this period ? 
 
 1 6. Do you know of any classes of corporations today whose liability 
 is not limited to the individual shareholders' contributions ? 
 
 17. Outline the different stages in corporate development and indi- 
 cate why each new stage developed. 
 
 18. Has Adam Smith's prophecy come true? What did he over- 
 look? 
 
 19. Are there any great divisions of economic activity that are not 
 at the present time characteristically organized on the corporate 
 basis ? If so, what ? Is this likely to be a permanent state of 
 affairs ?
 
 CHAPTER XII 
 
 CREDIT INSTRUMENTS 
 
 The borrowing or credit operations of modern society are 
 evidenced by written documents, drawn up in legal form, and 
 known as credit instruments. As has already been noted, the 
 term "credit" is often loosely employed in such a way as to 
 give the impression that credit is a form of currency. It is 
 not credit, however, that is used as a form of currency; it is 
 rather the instruments which are the written evidences of 
 antecedent credit operations that serve as media of exchange. 
 In the present chapter we shall consider the various types of 
 credit instruments which are employed in modern credit opera- 
 tions and discuss the development of certain legal principles 
 which have made possible the effective use of these instruments 
 in transferring the ownership of wealth. 
 
 As is indicated in the diagrams on pages 134 and 136, the 
 capital of modern businesses is usually divided into two classes, 
 fixed and working. The financial instruments that are used in 
 evidencing the loans made in the raising of fixed capital are 
 usually called investment credit instruments; while those 
 evidencing borrowed working capital are known as commercial 
 credit instruments. Let us consider the various types of 
 instruments that fall within each class. 
 
 I. INVESTMENT CREDIT INSTRUMENTS 
 
 The three principal types of investment credit instruments 
 are bonds, stock certificates, or shares, and short-term notes. 
 An explanation is perhaps necessary for designating a share of 
 stock as a credit instrument; for from a certain point of view a 
 shareholder is legally not a creditor of the corporation but a 
 joint owner in the enterprise. He receives income from his 
 shares only hi case the earnings are sufficient to permit or 
 warrant the payment of dividends. The bondholder, op the
 
 IS* THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 other hand, is legally a creditor of the corporation and is 
 entitled to interest on his investment, regardless of the volume 
 of earnings. 
 
 Although the stockholder is legally not a lender of funds to 
 the corporation, but a part owner in the enterprise, he is never- 
 theless for all practical purposes commonly an "outsider" 
 lending his funds in anticipation of a return. The rank and file 
 of investors in stocks are not in fact actively interested in the 
 management of the concern. Indeed, it is a rare thing for any 
 but a relatively small group of insiders to exercise their voting 
 prerogatives. The familiar expression, "Shall I invest in 
 stocks or bonds?" indicates clearly enough that in a majority 
 of instances the purchaser makes no differentiation between 
 stock and bonds, save as to relative certainty of income. 
 
 A mortgage security does not guarantee against loss. The 
 fact that a bond is usually secured by a mortgage on the property 
 does not insure that the bondholder cannot lose on his invest- 
 ment. In the event that earnings are not sufficient to pay 
 interest on bonds, the bondholder may foreclose under the 
 terms of the mortgage and take possession of the property; 
 but an enterprise whose earnings are insufficient to permit 
 the payment of interest on its bonds could not ordinarily be 
 sold at a price which would equal the amount of the bond- 
 holder's investment whatever may have been the evaluation 
 originally placed upon the property. Nor is there any assur- 
 ance that the bondholders can conduct such an enterprise 
 at a profit; indeed, there is a certainty that they cannot do so 
 when the mortgage is against only a portion of the corporation's 
 property. In the event that interest on bonds is not paid, it 
 is therefore usually wise to effect a financial reorganization, by 
 means of which the amount of outstanding bonds is reduced 
 by converting some of the bonds into stock. It is thus apparent 
 that in the last analysis the safety of both bonds and stock 
 depends upon the earning power of the corporation. It remains 
 true, however, that bonds are usually the more conservative 
 investment by virtue of their prior claim to earnings. 1 
 
 The fact that bonds have a maturity date is also often of practical 
 importance.
 
 CREDIT INSTRUMENTS I$3 
 
 There are various types of stocks. Shares of stock are 
 divided into two main classes, preferred and common. As the 
 term itself indicates, preferrecT stock has a prior claim on 
 dividends and usually in the event of liquidation on the assets 
 of the business. Because of the existence of common stock 
 as a participant hi the earnings of the corporation, it is obviously 
 necessary to limit the extent to which preferred shares may 
 receive dividends. Seven per cent is the usual limit. 
 
 Preferred stock may be either cumulative or non-cumulative, 
 participating or non-participating. With cumulative stock 
 the dividends which cannot be paid hi one year, because of low 
 earnings, accumulate from year to year as an obligation prior 
 to that on common stock. With participating preferred stock 
 the owner is entitled to share in the earnings above the 
 7 per cent limit; sometimes it is an equal participation hi all 
 earnings above 7 per cent on the common stock, and some- 
 times it is above 10 or above 15 per cent, depending upon 
 the specific terms governing the issue. The great number and 
 variety of corporations that exist have given rise to other 
 variations on these practices, a detailed study of which is quite 
 unnecessary for the present purpose. 
 
 Some modern preferred stocks are almost equal to bonds. In 
 recent years preferred stock has developed some additional 
 features which now place it more nearly on an equality with 
 bonds in the matter of certainty of income. Provisions such 
 as the following are common to what is called " modern preferred 
 stock." 
 
 1. No bonded debt exists nor can any be created without the 
 consent of 75 per cent of the preferred stockholders. No stock having 
 priority over, or on a parity with, this issue exists nor can be created 
 without the same consent. 
 
 2. A cumulative sinking fund of 5 per cent per annum of the 
 greatest amount of preferred stock at any time outstanding is 
 created for retiring the issue at not more than no. This increases 
 the equity in the property annually and assists in maintaining the 
 market price. 
 
 3. Net total assets must be maintained at 250 per cent and net 
 auick assets at 150 per cent of the preferred stock outstanding.
 
 154 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 4. No dividends can be paid on the common stock until a reserve 
 equal to two years' dividend and sinking fund requirements on the 
 preferred stock has been set up out of earnings, and none can be paid 
 which will impair this reserve. 
 
 With these provisions in force the preferred-stock owner 
 is in a position, from the standpoint of security, almost equal 
 to that of the bondholder. It remains true, however, that hi 
 case dividends are not paid, the individual shareholder has no 
 power to take possession of the management of the corporation, 
 as has a bondholder under the terms of the usual mortgage. 
 
 The common stock of the corporation merely represents 
 claims to such earnings as may be available after the payment 
 of dividends on preferred stock. Dividends on common stock 
 will accordingly vary widely in amount, depending on the 
 volume of the earnings. Since common stock is traditionally 
 speculative and uncertain as to dividends, the majority of 
 corporations do not hesitate to "pass" common-stock dividends 
 as a matter of financial conservatism, even though the earnings 
 might be frequently sufficient to pay a moderate-sized return. 
 
 Stock is now being issued without any par value. Stock, 
 both preferred and common, has usually been issued with a par 
 value, most commonly of $100, although often of $50, $25, $10, 
 $5, and $i; it has even been as low as 5 cents in the case of 
 highly speculative issues. During recent years, however, 
 numerous corporations have issued stock without any par 
 value. In the year 1919, for instance, twenty-seven stocks of 
 no par value were listed on the New York Stock Exchange. 
 When stock is issued without par value, a certain total number 
 of shares is offered for sale and each will bring in the market a 
 price that is determined by the estimated earning power of the 
 corporation. Dividends on such stock are paid, not as so many 
 per cent on $100 par value, but as so many dollars per share. 
 Stock without any par value is of advantage in that it is not 
 so likely to mislead the innocent investor, who somehow will 
 persist in believing that a stock whose par value is $100 will 
 ultimately be worth $100, even though its temporary market 
 price may be below that figure; hence he will pay for it more
 
 CREDIT INSTRUMENTS 155 
 
 than its real worth. From the viewpoint of the corporation 
 the issue of stock without par value is also a means whereby 
 opposition to overcapitalization may in a measure be circum- 
 vented. 
 
 Stockholders' "rights" are an interesting but little known 
 form of credit instrument. Stockholders' "rights" have arisen 
 out of the exigencies of corporate financing. For instance, 
 when the existing stock of a corporation is selling at, say, 105, 
 additional capital can easily be raised by offering for sale new 
 shares at par, or slightly above. But if additional shares are to 
 be offered for sale at a bargain, it is only equitable that the 
 existing stockholders should be given the first chance to sub- 
 scribe for the new issue, because the increased capitalization 
 may well affect the value of outstanding shares. Accordingly, 
 it is the usual practice to allow existing shareholders to subscribe 
 for the new issue in proportion to the amount of their holdings; 
 indeed, in many jurisdictions the stockholders have a legal 
 right to subscribe for new stock at par. 
 
 Such stockholders' privileges are known as "rights," 
 and they are issued to shareholders in the form of transferable 
 instruments. Upon the receipt of one of these instruments, 
 the shareholder may either avail himself of the opportunity 
 to purchase stock at par, or whatever the figure mentioned, 
 or he may sell his right to another. These rights are in fact 
 bought and sold on the stock exchanges in the same manner as 
 bonds and shares. The market value of a shareholder's right 
 is roughly equal to the estimated difference between the issue 
 price of the new stock of the corporation and its prospective 
 market price. 
 
 There are many dijferent types of bonds. The terminology 
 employed in describing the many different types of bonds that 
 are in use nowadays is quite baffling to the layman. For 
 instance, a certain bond is described as follows: a 5 per cent 
 railroad collateral trust, refunding, registered, coupon gold 
 bond. The whole matter may be greatly simplified by classify- 
 ing bonds from certain points of view as follows: (i) the 
 nature of the issuing corporation; (2) the purpose of the issue;
 
 l$6 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 (3) the conditions governing the payment of interest or princi- 
 pal; and (4) the character of the security. 
 
 The most important sub-classes 1 under each of these head- 
 ings are as follows: 
 
 
 
 1. The nature of the issuing corporation 
 
 a) Government bonds national, state, territorial, county, 
 city, township, school district, etc. 
 
 b) Corporation bonds transportation, public utility, indus- 
 trial, reclamation, real estate, timber, etc. 
 
 2. The purpose of the issue 
 
 a) Construction bonds c) Refunding bonds 
 
 b) Improvement bonds <f) Equipment bonds 
 
 3. The conditions governing the payment of interest or 
 principal. (Classification here is dependent upon the legal 
 provisions governing payment of principal and interest.) 
 
 a) Participating bonds e) Premium bonds 
 
 b) Profit-sharing bonds /) Serial bonds 
 
 c) Registered coupon bonds g) Callable bonds 
 
 <f) Gold bonds h} Convertible bonds 
 
 4. The character of the security 
 
 a) First mortgage c) Collateral trust 
 
 b) Second mortgage d) Debenture 
 
 In the case of a first-mortgage bond the bondholders have a 
 prior claim against income, and against property in case interest 
 on the bonds is not paid. The mortgage pledges the property 
 owned by the corporation as a security for the payment of 
 interest and principal. Since it is obviously impossible to give 
 each bondholder a share of the mortgage, the mortgage is piaced 
 in trust, and in the event of failure to pay interest the bond- 
 holders as a group may foreclose under the terms of the agree- 
 ment and take possession of the property. 
 
 As the name indicates, a second mortgage constitutes a 
 secondary claim against income and property. Anything left 
 
 1 Only the main subdivisions in each case are given. For a full classi- 
 fication the reader is referred to Lawrence Chamberlain, The Principles oj 
 Bond Investment (Henry Holt & Co.), chaps, viii to xi, inclusive. The 
 kind of individual securities that might be listed under the various sub- 
 classes are legion.
 
 CREDIT INSTRUMENTS 157 
 
 after payments have been made to the owners of the first 
 mortgage may be devoted to meeting the claims of the second- 
 mortgage holders. 
 
 A collateral trust bond is one which is secured, not by real 
 estate or other physical property owned by the corporation, 
 but by stock or bonds of other companies owned by the issuing 
 corporation. This type of security is mainly found in connec- 
 tion with railroad companies. The term "trust" indicates that 
 these collateral securities are placed hi trust with a trust company 
 or other trustee. In the event interest is not paid on such bonds, 
 the holder may seize the collateral which is held in trust. 
 
 A debenture bond proper has no mortgage security but 
 merely a claim against the income of the corporation a claim, 
 moreover, that is secondary to that of any outstanding mortgage 
 bonds. Its claim against net earnings, however, is prior to 
 that of preferred stock. 
 
 The short-term note is now frequently employed in raising 
 fixed capital. The designation "short term" is employed be- 
 cause the notes in question usually run from one to five years 
 rather than for long periods, as is the case with bonds. These 
 notes are usually secured only by the income of the company. 
 Accordingly it is customary for payments on the principal to 
 be made serially, that is, a certain percentage of the total debt 
 is paid back annually, thus gradually increasing the security 
 back of the loan. 
 
 Short-term notes are usually issued to meet temporary 
 emergencies. In periods of tight money and high interest 
 rates, or of general uncertainty over the industrial future, it 
 is difficult to sell long-time bonds on favorable terms; hence 
 it has been found expedient to sell short-term notes which can 
 be refunded into long-term bonds at a more propitious time. 
 Short-term notes are also used and increasingly so to provide 
 funds for new construction under conditions such that the debt 
 can be paid off out of earnings within a relatively short period 
 of time. Their claim on income is secondary to that of bonds. 
 
 The accompanying illustrations are examples of a standard 
 bond and a share of stock.
 
 
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 pon No. i. 
 City of New
 
 [FORM OF ASSIGNMENT ON THE BACK or THE UNITED STATES STEEL CORPORATION 
 PREFERRED STOCK CERTIFICATE] 
 
 For value Received 
 
 hereby sell, assign, and transfer unto 
 
 NOTICE: THE SIGNATURE TO THIS ASSIGNMENT MUST CORRESPOND WITH TH1 
 NAME AS WRITTEN UPON THE FACE OF THE CERTIFICATE, IN EVERY PARTICC 
 LAB, WITHOUT ALTERATION OR ENLARCEMENT, OR ANY CHANTCB WHATEVM 
 
 
 
 
 Shares 
 
 of the Capital Stock represented by the within Certificate 
 and do hereby irrevocably constitute and appoint 
 Attorney 
 
 Ho transfer the said stock on the 'Books of the within named 
 Corporation with full power of substitution in the premises. 
 
 DntpA 10 
 
 
 
 In Presence of 

 
 l62 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 H. COMMERCIAL CREDIT INSTRUMENTS 
 
 Commercial credit instruments promissory notes and bills 
 of exchange are the written evidences of the commercial bor- 
 rowing operations discussed in the preceding chapter. Because 
 of the nature of the uses to which funds borrowed for working- 
 capital purposes are devoted, these instruments run for short 
 periods of time only. Especial importance is attached to 
 them because of the prevalent use of certain forms of bills of 
 exchange as a substitute for money, a phenomenon made 
 possible, as we shall see, by the principle of negotiability. 
 
 Book accounts. Many credit operations are evidenced 
 merely by entries hi the account books of business men 
 "accounts receivable" in the books of the seller (or lender), and 
 "accounts payable" in the books of the buyer (or borrower). 
 While such informal credit extension is quite as significant as 
 any other, it does not concern us here for the reason that it does 
 not give rise to tangible legal instruments. 
 
 The promissory note. A promissory note is an unconditional 
 written promise by X, the maker, to pay at a definite future 
 date a sum of money to Y, the payee. It may or may not 
 designate the place at which payment is to be made. Promis- 
 sory notes may be issued by banking and other institutions and 
 governments as well as by individuals, and as a result of non- 
 commercial as well as of commercial obligations. An illustration 
 of a promissory note will be found on page 163 below. 
 
 The draft or bill of exchange. A bill of exchange, or draft, 
 is an unconditional written order signed by X (the drawer) 
 ordering Y (the drawee) to pay at a definite date a definite sum 
 of money to Z (the payee). The payee may be the same person 
 as the drawer. Before a time draft is good, the drawee must 
 indicate his willingness to honor it by signing his name below 
 the word "Accepted" written across the face of the bill. 
 
 Bills of exchange may be classified from several points of 
 view. In the first place, we have (i) foreign and (2) domestic, or 
 inland, bills. A foreign bill is legally defined as one, the drawer 
 and drawee of which live in different countries or different 
 states of the United States; while a domestic bill is one, both
 
 CREDIT INSTRUMENTS 163 
 
 parties to which live within the same state. This classification 
 is of importance from the legal point of view, but from the 
 standpoint of commercial and banking practice the distinction 
 is without significance. 
 
 We have thus far been using the terms "bill of exchange" 
 and " draft " indiscriminately. The two terms are, in fact, com- 
 monly used interchangeably; for instance, we speak of drafts 
 on' London and bills of exchange on London, and we say New 
 York exchange or drafts on New York. The term "draft," 
 however, is by many people employed when they mean a par- 
 ticular type of draft, such as a banker's draft or a draft drawn 
 
 PROMISSORY NOTE 
 
 f *-* x ~~ 
 
 after daft for value received the undersigned promise to pan to the order of 
 
 r "me NATIONAL CITY BANK OF CHICAGO 
 
 <~t^sr/-*^i^~i f -<*-r^, f>^ f^^/aj DOLLARS 
 
 at Its Banting House in Chicago Illinois, with interest AFTER MATURITY at the rate of seven per cent per 
 annum until paid and with costs of collection and a reasonable attorney fee if not paid at maturity. Presentment 
 and demand for payment, notice of non-payment, protest and notice of protest are each and all hereby waived by 
 the makers, endorsers and guarantors jointly and severally. Any indebtedness owing from said bank or legal 
 holder hereof to the undersigned or to any endorser or guarantor mag be appropriated and applied by sold bank 
 or legal holder on this note at any time either before or after maturity of this note and without demand upon or 
 notice to any one. 
 
 by one individual on another as a reminder that a debt is due 
 and payable. In order to give precision to our terminology 
 it will be well for us to use the term "draft" and this appears 
 to be a growing custom when speaking of domestic operations, 
 whether or not they cross state lines; and the term "bill of 
 exchange" when speaking of international credit instruments. 
 
 These instruments may also be classified according to 
 whether the parties to the order are bankers. A banker's draft 
 is an order drawn by one bank on another bank, although it is 
 not necessary that the party to whom it is payable be a bank. 
 A bill drawn by one individual against another would be called, 
 an individual draft. 
 
 Finally, bills may be classified in accordance with the nature 
 of the operation giving rise to the draft. Hence we have
 
 164 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 bankers' or finance bills, trade or commercial bills, and accom- 
 modation bills. Bankers' bills are used merely as a means of 
 making payments and transferring balances between banks. 
 A trade draft, or a "trade acceptance," to use the more common 
 term, is an order drawn by a seller of gqpds against the buyer 
 of the goods and accepted by the latter. Accommodation 
 drafts are drafts which do not arise out of any business trans- 
 action already concluded; and there may or may not be an 
 intention to purchase goods with the funds procured; it is a 
 " non-trade " draft. "Accommodation " is a term that has been 
 handed down from English commercial practice and is not fre- 
 quently employed in the United States at the present time. 
 
 The accompanying forms on pages 165, 166, and 167, are 
 specimens of the various types of drafts. 
 
 Checks, bank notes, and bank drafts are not really credit instru- 
 ments. Bills of exchange are also sometimes classified as demand 
 and time bills: a demand bill being one payable "at sight," 
 that is, immediately upon presentation, and a time bill one 
 payable at some definite date in the future. It is these demand 
 instruments, particularly bank notes, cashiers' checks, bank 
 drafts, and personal checks drawn against bank-deposit ac- 
 counts, that serve extensively as media of exchange. While 
 these demand notes and bills have commonly been called credit 
 instruments, they are strictly not credit instruments at all, for 
 they are not evidences of postponed payments, the essential 
 characteristic of credit operations. A few words of explanation 
 will serve to clarify matters. 
 
 A check is a credit instrument hi the sense that it must be 
 honored by the bank before it is the equivalent of cash, just as 
 credit is involved in a business operation when one receives 
 goods a second or so before he passes the money over to the 
 seller; there is a brief interval during which the seller is waiting 
 to be paid. But no one really regards such a business trans- 
 action as a credit operation, the essence of which is a postponed 
 or future payment. A cashier's check, a certified check, and 
 even an uncertified check hi the vast majority of instances are 
 in practice precisely as satisfactory means of payment as
 
 CREDIT INSTRUMENTS 
 
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 166 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 I
 
 CREDIT INSTRUMENTS 167 
 
 BANKER'S BILL OF EXCHANGE ON LONDON 
 
 Wjrfttfo FIRST OF EXCHANGE 
 
 CASfflER's CHECK 
 
 TlIEX\TIO^AI,(] 
 
 RWTO rm: OI<I>E n 
 
 / 
 
 - ' > !-'. '"!" 
 
 PERSONAL BANK CHECK 
 
 CHICAGO.ILL- 
 
 ThePirstNationalBankof Englewood2 109 
 
 .DO.LLARS 
 
 JUADIES PEPARTMEMT.
 
 l68 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 actual cash. Even though they are credit instruments in form 
 mere promises, direct or implied, to pay cash this distinc- 
 tion has little practical significance. For the same reason the 
 bank note, which is a promise by a bank to pay to the borrower 
 on demand a certain specified sum of money, is not a credit 
 instrument; it passes everywhere as an equivalent of money. 
 
 Checks, bank drafts, and bank notes are credit instruments 
 only in the sense that greenbacks and token coins are credit 
 currency. These sight instruments, like greenbacks and token 
 corns, are not backed by a gold reserve of 100 per cent; and 
 hence confidence in the ability of the banks and of the govern- 
 ment to redeem them upon demand is an essential to their 
 acceptance as media of exchange. 1 Under ordinary circum- 
 stances no one questions the convertibility of these instruments 
 into gold on demand, and accordingly they are for all practical 
 purposes equal to gold as a means of payment. Whenever a 
 doubt arises as to the possibility of conversion, as it has arisen 
 in the past, the difference between such instruments and 
 standard money is revealed. But this does not make them 
 credit instruments in the same sense that a promise to pay at 
 some future date is a credit instrument. 
 
 Notes and drafts serve identical purposes. It remains to 
 point out the similarity of the operations that give rise to promis- 
 sory notes and bills of exchange. Mr. Jones, a wholesaler, 
 sells goods on credit to Mr. Smith, a retailer. The transaction 
 may of course be evidenced merely by "open accounts" on the 
 books of Jones and Smith, respectively "accounts receivable" 
 from Smith in Jones's books, and "accounts payable" to Jones 
 in Smith's books. But, passing by this informal method of 
 evidencing the credit operation, the sale of goods by Jones 
 to Smith may give rise either to a promissory note or to a trade 
 draft, according to the commercial practice in vogue. In the 
 case of a promissory note, Mr. Smith takes the initiative and 
 writes the instrument evidencing his obligation to pay Jones. 
 
 1 An uncertified check and a bank draft differ slightly, however, from 
 certified and cashiers' checks and bank notes in that there must also be 
 confidence that the drawer has the requisite funds to his credit in the bank 
 on which the instrument is drawn.
 
 CREDIT INSTRUMENTS 169 
 
 In the case of the trade draft, Jones takes the initiative, writes 
 the order against Smith, and sends it to Smith, who honors the 
 draft by writing "accepted" on its face. The result is the 
 same in either case: Smith has signed a legal instrument 
 obligating himself to pay Jones. It is the custom nowadays, 
 as the illustration on page 165 shows, to have stated on the 
 face of the trade acceptance that the obligation to pay arose 
 out of a sale of goods by Jones to Smith. While this is not the 
 custom with the promissory note, there is no theoretical reason 
 why a trade note carrying such a statement on its face should 
 not be developed. 
 
 In case Jones wishes to borrow from a bank in anticipation 
 of the payment of the obligation by Smith, he may do so by hav- 
 ing a bank discount either Smith's note or Smith's acceptance. 
 From the standpoint of the bank, the security is identical hi 
 both cases. With the note the bank has Smith's promise to 
 pay at maturity and a secondary liability on the part of Jones, 
 as indorser. With the draft the bank again has Smith's promise 
 to pay, by virtue of his acceptance of the instrument, and it 
 has Jones's secondary liability, as maker of the draft. Which 
 form of instrument is employed at any time depends upon the 
 custom of manufacturers and merchants. In Europe the draft 
 is characteristically employed. In the United States both 
 drafts and notes were in common use before the Civil War; but 
 because of the risks of price changes during the period of green- 
 back currency (see p. 26 above) American commercial practice 
 was gradually transformed to the system of selling on "open" 
 or book account. Except in a few special lines credit instru- 
 ments came to be employed only in cases where the creditor's 
 standing was not first class, as when an account was not paid 
 at maturity and a note was given in "settlement." Since the 
 passage of the Federal Reserve banking law in 1913 an effort 
 has been made to restore the extensive use of credit instruments, 
 in the form of the trade acceptance. As yet, however, the effort 
 has not been as successful as was hoped; and the desirability 
 of making the change is still a debatable issue. 1 
 
 1 See pp. 384-85.
 
 170 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 III. THE USE OF CREDIT INSTRUMENTS IN 
 TRANSFERRING WEALTH 
 
 A share of stock is a written evidence of ownership that is, 
 partial ownership of a designated business. The possessor of 
 a share is in effect a joint owner of certain definite, tangible 
 wealth, although in the nature of the case he is debarred from 
 taking possession of such wealth without the consent of other 
 shareholders. The owner of a bond or promissory note or 
 accepted draft has a partial claim against definite, tangible 
 wealth that is owned by others. Under present conditions, 
 where industry is primarily organized on the corporate basis, 
 and where capital, both fixed and working, is largely borrowed, 
 these ownership shares and creditor claims represent a very 
 considerable proportion of the total wealth of the world. 
 
 A business, the capitalization of which runs into millions 
 of dollars, is seldom sold outright. Its shares and bonds con- 
 stantly change hands, however, and there is an ever-shifting 
 body of shareholders and creditors. Similarly, the evidences of 
 borrowed working capital in the form of promissory notes and 
 bills of exchange are continually being transferred through the 
 process of purchase and sale. Indeed, a large corporation 
 does not usually even know who its creditors are, either the 
 owners of its bonds or the holders of its notes and acceptances; 
 it merely knows that a certain total amount of claims against it 
 are "floating" somewhere in the investment and commercial 
 markets. 
 
 In the preceding chapter we have seen that the market- 
 ability of bonds and shares greatly facilitated the raising of 
 capital. A ready marketability is equally important with 
 short-term promissory notes and bills of exchange. The essen- 
 tial point is that if one were not able to extricate himself from 
 a financial relationship, if he could not regain command of his 
 funds at will, he would be less willing to make loans either for 
 fixed or working capital purposes. We shall find that, by virtue 
 of the development of certain legal principles, these credit 
 instruments have also come to be extensively used as a means' 
 of transferring the ownership of wealth.
 
 CREDIT INSTRUMENTS 171 
 
 Salability and transfer ability. Three legal principles have 
 been developed to facilitate the use of credit instruments in 
 transferring the ownership of wealth: namely, salability, 
 transferability, and negotiability. The various forms of credit 
 instruments bonds, shares, notes, drafts, checks, certificates 
 of deposit, etc. possess these attributes hi varying degrees, 
 and it appears that, consciously or unconsciously, each has been 
 given the particular attributes required by the nature of the use 
 to which it has been found convenient to devote it. 
 
 On the matter of salability a word of explanation will be 
 sufficient. By means of a sale an individual may transfer to 
 another all of his ownership rights in a piece of property. The 
 law of sales has been made applicable to all of these credit 
 instruments; and an owner of one of them may therefore 
 always transfer to another at least the same amount of owner- 
 ship of the instrument, and thus of the property which the 
 instrument represents, that he himself possesses. 
 
 While salability is an obvious prerequisite to the transfera- 
 bility of any of these instruments, it does not fully explain the 
 latter. For instance, a credit instrument, unlike tangible per- 
 sonal property, may be automatically transferred by the mere 
 process of indorsement, that is, by writing one's name on the 
 back of an instrument that is made payable to him or to his 
 order; or, in the case of an instrument made payable to bearer, 
 it may be transferable merely by delivery, that is, by passing 
 it on to another. Similarly, an instrument that has been 
 indorsed hi blank, that is, by the owner's writing his name on 
 the back of it without designating any specific payte, is also 
 transferable by mere delivery. The ease with which these 
 instruments may be transferred renders their use as a means 
 of exchanging the ownership of wealth much more general than 
 would otherwise be the case. 
 
 But transferability may involve more than this. For even 
 though he himself has no title at all, a possessor of an instru- 
 ment that is payable to bearer may transfer to another a valid 
 or unimpeachable title. A bearer instrument is thus for all 
 practical purposes equivalent to money. But this borders on
 
 If a THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 the principle of negotiability, to a consideration of which we 
 may now turn. 
 
 The principle of negotiability. A negotiable instrument 
 possesses the attribute of salability, and its title is transferable 
 from one person to another, either by indorsement or by delivery. 
 But it has other attributes as well. As usually defined, a 
 negotiable instrument differs from a simple contract, or "chose 
 in action," in that a "bona fide purchaser for value," innocent of 
 any irregularity as between the original parties to the contract, 
 obtains a title to the instrument that is free from all personal 
 defenses and equities of prior parties. A purchaser of a non- 
 negotiable instrument, however, takes the instrument subject to 
 all its original defenses and is apparently supposed to protect 
 himself by an investigation of the origin and history of the 
 instrument. While there are some exceptions to this principle, 
 while transferability with a better title is not an exclusive 
 attribute of a negotiable instrument, it nevertheless possesses 
 this attribute in a very high degree; and it is commonly said to 
 be its distinctive characteristic. 
 
 In order to possess the quality of negotiability, an instru- 
 ment must conform to certain requirements prescribed by the 
 custom of merchants now codified hi the law of negotiable 
 instruments. The instrument must be drawn up in a certain 
 prescribed form, it must be sold hi a specified manner, certain 
 precise steps must be followed in presenting it for payment, 
 and a definite procedure must be gone through hi giving notice 
 of its dishonor in case of non-payment. 1 These requirements 
 originally -related only to commercial credit instruments in the 
 form of promissory notes and bills of exchange, and the history of 
 the law of negotiability is associated with commercial, rather 
 than investment, credit instruments. 
 
 The law governing negotiable instruments had its inception 
 in the customs of the mercantile world; they were born of the 
 necessities and needs of merchants, as is indicated by the fact 
 that the law relating to such instruments is usually known 
 
 1 For details see pp. 175-78.
 
 CREDIT INSTRUMENTS 173 
 
 as "the law merchant." 1 The custom of making such notes 
 and bills of exchange payable to order or bearer arose in 
 England early hi the seventeenth century.* But until 1756, 
 when Lord Mansfield, "the father of the law merchant," 
 expressed and molded into the form of definite rules of law the 
 numerous customs that had grown up among merchants in 
 connection with these instruments, the law of bills and notes 
 was in a more or less chaotic condition. Mansfield made the 
 law merchant an integral part of the great body of the English 
 law, which was inherited by the American colonies, and in 
 due course by the American commonwealths. 
 
 During the first century of American legal history, differing 
 interpretations of the law merchant developed hi the various 
 states, with the result that commercial practice was seriously 
 handicapped. About 1890, however, a movement was initiated 
 to bring about a codification of the law merchant, with a view 
 to securing uniformity in the various jurisdictions. A negoti- 
 able instruments bill was finally drafted in 1896 by a "com- 
 mittee on commercial law," and this has since become a law 
 in nearly every state hi the Union, in a few instances, however, 
 with more or less important modifications. 
 
 The reason for developing the principle that an instrument 
 in the hands of an innocent third party should be free from 
 personal defenses and collateral claims existing between prior 
 parties was to facilitate the use of such an instrument as a 
 means of making payment. In the settlement of transactions 
 between merchants at the great fairs and market places in 
 early England there was plenty of occasion for irregularities. 
 For instance, the maker of an instrument might have entered 
 
 1 While originating in mercantile lines, these instruments are now used 
 quite as much by manufacturers as by merchants. 
 
 3 Promissory notes and bills of exchange appear to have been used by 
 various nations of antiquity. There are records of their use in Babylonia 
 and Syria, in Athens and in Rome. It appears, indeed, that by the time 
 of Justinian the fundamental principles of the bill of exchange and the 
 promissory note were pretty well developed. After the Dark Ages we find 
 them arising again with the trading operations of Italian cities; and by the 
 middle of the thirteenth century the bill of exchange had apparently 
 become a common document.
 
 174 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 into the transaction without consideration, 1 and if a third 
 party were asked to accept an instrument subject to such 
 defenses as an original maker might set up, he would usually 
 refuse because of the risks involved. Accordingly, it was neces- 
 sary to devise a means whereby the purchaser of such an instru- 
 ment would be protected from irregularities of which he could 
 have no cognizance without a careful investigation of the 
 origin and history of the instrument in question. 
 
 To be negotiable, an instrument must meet certain essential 
 conditions. In order to guard against misinterpretation, fraud, 
 etc., the law prescribes that an instrument to be negotiable 
 must be drawn up in a certain definite way. The conditions that 
 must be met to make an instrument negotiable are as follows: 
 
 1. // must be in writing. No oral contract could be negoti- 
 able. A written contract may be either in writing or in printing, 
 and the writing may be executed with any substance, as ink or 
 pencil. 
 
 2. // must be properly signed. It is usual that the signature 
 be made by writing in full the name of the signer; but a mark 
 or any other character intended to be the signature will suffice. 
 The signature is usually placed at the close of the instrument, 
 although if it is clear that it is meant for a signature it may be 
 placed on any part of the instrument. 
 
 3. // must be negotiable in form, that is, payable to order or 
 bearer. It must be clearly shown to be the intent of the party 
 making the instrument to execute a negotiable paper; and to 
 make this intent clear there must be some expressed words 
 showing such a purpose. 
 
 4. // must be payable in money only. The reason for this 
 requirement is to insure the amounts being certain and definite. 
 By the term "money" is meant the legal tender of the country. 
 
 5. The amount must be certain. The sum payable is con- 
 sidered fixed and certain if it is a definitely stated amount with 
 interest, or in stated instalments, or with exchange (the bank's 
 charges for collection), or with the cost of collection in case 
 payment is not made at maturity. 
 
 1 See pp. 177-78.
 
 CREDIT INSTRUMENTS 175 
 
 6. It must be payable to a designated payee. It is not neces- 
 sary to name the specific party, but it must be payable to a 
 person or persons who can be definitely ascertained at the time 
 of the payment. 
 
 7. 77 must be payable absolutely. If the instrument is so 
 drawn that any condition might arise that would render it of 
 no effect, it is not a negotiable paper. Consequently a promise 
 to pay a certain sum out of a designated fund is not negotiable ; 
 this is the case even though the fund exists at the time and 
 although the condition that would nullify the contract had not 
 in fact arisen. 
 
 8. It must be payable at a time that is certain. The date 
 of payment must be definitely stated; though it may be payable 
 on or before a certain definite date, or at a certain time after the 
 happening of some future event. The contingent event must 
 be certain to occur, however, or the promise will not be absolute. 
 
 Negotiability depends upon certain legal procedure: 1 
 
 i. Indorsement. The indorsement must be on the instru- 
 ment itself or on a paper attached to it. The indorsement 
 must relate to the entire instrument; a part cannot be trans- 
 ferred by indorsement, or a part to one party and the remainder 
 to another. 
 
 The obligation of an indorser to a transferee, like that of a 
 drawer of a bill, is that the indorser will pay the instrument, 
 provided the maker does not, and also provided it is duly 
 presented for payment and upon refusal is duly protested and 
 notice of protest given the indorser. In domestic bills and 
 notes the protest may be omitted and instead notice of non- 
 payment may be given the indorser. It should be noted that the 
 contract of the maker of a note or the acceptor of a bill is 
 absolute; each is liable in any event. But the contract of the 
 indorser and of the drawer of a bill is conditional upon the 
 failure of the maker or acceptor to pay upon proper protest and 
 notice to him. 
 
 If the indorser of a note wishes to avoid any personal 
 liability, he may indorse "without recourse" and sign his 
 
 1 For this material I am indebted to Gano, Commercial Law.
 
 1 70 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 name. He thus expressly stipulates that he will not be liable 
 if the maker does not pay. There is an implied warrant, 
 however, that the signatures of the maker and all prior indorsers 
 are genuine, that is, that they are not forgeries. The intent 
 and purpose of such indorsement is merely to pass title to the 
 instrument. 
 
 2. Presentment and demand. To fix the liability of the 
 drawer or indorser it is necessary to present the instrument to 
 the drawee and demand payment. Presentment consists in 
 exhibiting the instrument to the payer or handing it to him, 
 while demand is a request to either accept or pay it as the case 
 may be. If the paper is payable at a bank, the mere fact that 
 at the time of maturity the paper is at the bank at which it is 
 payable is sufficient presentment and demand, provided the 
 drawer has knowledge of the fact. Presentment must be made 
 on the day on which the instrument falls due, unless some 
 "inevitable accident" or other legal obstacle prevents such pre- 
 sentment. The fact that both the holder and indorser know 
 that the note will not be paid when due and that the maker 
 is dead and the estate insolvent does not relieve the holder 
 from his obligation to make presentment and give notice of 
 dishonor. 
 
 3. Notice of dishonor. After the payment has been refused 
 and the instrument dishonored, notice of such dishonor must 
 be given to the drawer of a bill of exchange and to each indorser. 
 Any drawer or indorser to whom such notice is not given is 
 discharged. If the parties reside in the same place, the notice 
 must be given the following day. If they reside in different 
 places and notice is sent by mail, it must be deposited in the 
 post-office so as to go the day following the dishonor; if given 
 otherwise than through the mail, it must be done in time to bf 
 received as soon as the mailed notice would have been. The 
 notice may be given by the holder or his agent or by any 
 party who may have to pay the debt and who is entitled to be 
 reimbursed. 
 
 When there are several indorsers, the last indorser can look 
 to the previous one, or, in fact, to anyone who has indorsed
 
 CREDIT INSTRUMENTS 177 
 
 before him, as well as to the maker or acceptor. The notice of 
 dishonor may be either oral or written, and can be either 
 delivered personally or sent through the mail. 
 
 4. Waiver. Notice may be waived, in which case the 
 obligations will be assumed without the formal notification. 
 The indorser may also add "protest waived," the effect being to 
 waive presentment and notice of dishonor as well. 
 
 5. Protest. Protest is a formal declaration in writing and 
 under seal, of an officer called a notary public, certifying to the 
 demand and dishonor. Protest of foreign bills of exchange 
 is necessary, but it is not required in the case of notes, checks, 
 and inland bills, although it, is often employed in giving notice 
 of their dishonor. The notary makes the presentment and 
 demand, and upon refusal to honor it issues a certificate, stating 
 that presentment and demand have been made and judgment 
 refused, and further that notice has been sent to the maker and 
 all indorsers of the note. 
 
 There are certain absolute defenses. It has been stated above 
 that a negotiable instrument in the hands of an innocent pur- 
 chaser for value is not subject to the defenses that might be 
 interposed to it between original parties the purpose being to 
 make such instruments serviceable as media of exchange. 
 But while the law was desirous of doing everything possible 
 to facilitate commercial operations, it was necessary to protect 
 the original maker of the instrument against abuse. Certain 
 absolute defenses have, therefore, been recognized by the 
 courts. The following are some of the absolute defenses: 
 
 1. Non-delivery. If either the maker or acceptor of an 
 instrument, or the agent of either, passes the instrument to a 
 third party; or if it gets into the hands of a bona fide holder 
 through negligence, the instrument is considered as having 
 been delivered. But if the holder has been deprived of its 
 possession by fraud or theft, he cannot be compelled to pay the 
 amount named to anyone. In the view of the law such an 
 instrument was not delivered and no contract exists. 
 
 2. Fraud in making the instrument. If in the making of the 
 instrument there was fraud of a nature that would vitiate an
 
 178 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 ordinary contract, the law holds that no contract exists; and 
 the maker or acceptor of such an instrument cannot, therefore, 
 be held responsible for payment to innocent third parties. 
 
 3. Alteration or forgery. Where there has been a material 
 alteration, or forgery, the law holds that the minds of the 
 parties have not met and there is thus no contract. An altera- 
 tion of the terms of a negotiable instrument, either by a party 
 to the instrument or one in lawful possession of it, destroys its 
 validity. It is obvious that if the law made an individual 
 responsible for the payment of an instrument on which his 
 name had been forged, it would not only work a gross injustice 
 upon the individual hi question but would be a distinct encour- 
 agement to the practice of forgery. 
 
 4. Want of capacity to contract. The contract represented 
 by the instrument is not genuine if the parties to the contract 
 do not have the capacity to contract, as in the case of an infant 
 or a person who has been adjudged insane. 
 
 These absolute defenses which may be set up by the original 
 maker of an instrument do not apply, however, to individuals 
 who have indorsed the instrument as it passed through their 
 hands. Every person who negotiates such an instrument 
 warrants that it is genuine, that he has good title to it, and 
 that all prior parties have capacity to contract. The indorser, 
 therefore, unless the indorsement is without recourse, assumes 
 liability for the payment of the instrument. 
 
 The law of negotiable instruments is extraordinarily com- 
 plex and the exceptions to and qualifications of the general prin- 
 ciples that have been categorically stated above are legion. 
 In this very brief discussion of the transferability and negotia- 
 bility of credit instruments, the purpose has been merely to 
 indicate the evident purpose and intent of the law to render 
 these instruments more serviceable in meeting the needs of 
 commerce and industry. 
 
 It remains to note the extent to which the various forms of 
 instruments possess the different attributes under consideration. 
 All of them are salable; some of them are transferable without 
 change of ownership rights; others show unproved title in the
 
 CREDIT INSTRUMENTS * 179 
 
 hands of an innocent third party; some of them are transfer- 
 able by indorsement only; others by delivery merely. In each 
 case it appears that the law has been seeking, consciously or 
 unconsciously, to facilitate the use of the instrument in the 
 particular ways desired. 
 
 The foregoing discussion of the law of negotiable instru- 
 ments related to commercial credit instruments in the form of 
 promissory notes and bills of exchange. Very little has been 
 written, indeed, upon the transferability and negotiability of 
 investment credit instruments, owing to the fact that the law 
 and procedure governing negotiable instruments arose in the 
 mercantile or commercial credit field. But with the develop- 
 ment of corporate industry, we find in fact that in greater or 
 lesser degree these principles have been applied as well to 
 investment credit instruments. 
 
 We find that some among the commercial credit instru- 
 ments are used extensively as substitutes for money, while 
 others are not. As we have seen above, the origin of the 
 principle of negotiability and transfer by indorsement is as- 
 cribed to the desire to facilitate the use of notes and bills of 
 exchange as media of exchange. In early times it is probable, 
 moreover, that promissory notes and bills of exchange fre- 
 quently changed hands numerous times, thus performing an 
 important exchange function. Nowadays, however, it is only 
 checks, bank notes, and bank drafts that serve extensively as 
 media of exchange. 1 These instruments in fact serve as a 
 means of effecting, in the United States, over 95 per cent of all 
 our wholesale exchanges and in the neighborhood of 80 per cent 
 of all exchanges, including retail operations. 
 
 The reason that a bill of exchange drawn by A against B 
 is seldom used by A as a means of paying a debt owed by A to 
 C is, first, that two such obligations may not mature on identical 
 dates, and, second, that they are not usually of equal amounts. 
 If B's debt to A for $1,000 is due March i, and A's debt to C 
 for $1,200 is due March 5, B's accepted draft is obviously not 
 
 1 It is to be noted that this list includes only demand instruments. It 
 will be recalled that they are not, strictly, credit instruments.
 
 l8o THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 a convenient instrument with which to pay C. The method 
 nearly always employed nowadays is for A to deposit funds 
 received from B in a bank and draw his check against his 
 account in favor of C or ask the banker for a cashier's check 
 or a draft on another bank made payable to C. 
 
 The transferable qualities of a bond vary. One drawn to 
 order is on a par with the ordinary bill of exchange or promis- 
 sory note drawn to order; it is transferable to the same extent 
 and in the same manner, and the liability of the parties to it is 
 fixed in the same way. A bond payable to bearer, that is, a 
 non-registered bond, passes title by delivery just as does a bearer 
 commercial instrument. A registered bond, however, is not 
 transferable by indorsement, nor is it negotiable. Bond coupons 
 are usually bearer-instruments, and are transferable by delivery, 
 with all the legal consequences that follow from the transfer 
 of any negotiable bearer-instrument. 
 
 Shares of stock are ordinarily transferable either by an 
 order indorsement or by an indorsement hi blank. The indorse- 
 ment operates as a power of attorney to remove the name of the 
 former owner and place the name of the new owner on the 
 certificate. A mere possessor of a share of stock (or of a 
 registered bond) has, however, no title at all, even though it is 
 indorsed hi blank; and he cannot pass title to a bona fide 
 transferee. A certificate of stock is therefore not negotiable in 
 the ordinary sense; there are no formal requisites; and there 
 are no questions concerning the fixing of liabilities of the parties 
 to the instrument, etc. Shares of stock are, however, readily 
 transferable. 1 
 
 QUESTIONS FOR DISCUSSION 
 
 I. INVESTMENT CREDIT INSTRUMENTS 
 
 i. What is the outstanding difference between a share of stock and 
 a bond: (a) from the point of view of law? (6) from the point 
 of view of investment? 
 
 1 Bills of lading and warehouse receipts also possess in substantial degree 
 the qualities of transferability and negotiability. While not credit instru- 
 ments, bills of lading and warehouse receipts are evidences of ownership of 
 wealth. For illustrations of these instruments see pp. 98, 400.
 
 CREDIT INSTRUMENTS l8l 
 
 2. Does a shareholder loan funds to a corporation? Is there any 
 justification for calling a share of stock a credit instrument ? 
 
 3. Is a bond always secured by a mortgage and the right to take 
 possession of certain definite property under foreclosure pro- 
 ceedings ? 
 
 4. Does a corporation always have outstanding bonds with prior 
 claims to stock against gross earnings? 
 
 5. In the case of failure of a corporation to pay interest and divi- 
 dends, whose loss is likely to be greater, that of the bondholders 
 or of the shareholders ? 
 
 6. What is meant by preferred stock? cumulative preferred? pre- 
 ferred participating? Which would you rather own, preferred 
 or common stock? Why? Would your answer always be the 
 same ? Upon what factors might it depend ? 
 
 7. What is meant by par value ? market value ? face value ? book 
 value ? 
 
 8. How could the market value of a share of stock be $450 when 
 its par value is only $100? How could its market value be 
 only $8 ? 
 
 9. What is meant by issuing stock without par value? Explain 
 how dividends could be ascertained under such circumstances. 
 Explain how an investor would know how much such stock 
 was worth. 
 
 10. What are the advantages of issuing stock without par value? 
 n. What is the nature and purpose of stockholders' rights? 
 
 12. Which of the different points of view from which bonds are 
 classified do you regard as most significant ? 
 
 13. How do you account for the development of so many different 
 types of security for bond issues ? 
 
 14. What is the meaning of each term under the heading on page 156. 
 "Conditions Governing the Payment of Interest or Principal"? 
 
 15. What are the reasons for issuing short-term notes ? 
 
 1 6. Why are short-term notes usually arranged in serial form ? What 
 is the security back of short-term notes ? 
 
 17. A corporation has outstanding $3,000,000 of 5 per cent bonds, 
 $1,000,000 preferred stock at 7 per cent, and $1,000,000 of com- 
 mon stock. If the net earnings (after interest has been paid) 
 are $150,000, what dividends could be paid on common stock? 
 If the following year the net income (before paying interest) 
 should be cut in two, what dividends could be paid ? If upon
 
 182 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 reorganization $1,000,000 of bonds were exchanged for preferred 
 stock, what would be the state of affairs: (a) assuming net 
 income to "be $150,000? (6) $75,000? 
 
 H. COMMERCIAL CREDIT INSTRUMENTS 
 
 18. What is the distinction between commercial and investment 
 credit instruments ? 
 
 19. What are the two principal types of commercial credit instru- 
 ments ? 
 
 20. For what different purposes may promissory notes be drawn? 
 
 2 1 . What is a joint note ? a joint and several note ? 
 
 22. Define a bill of exchange. 
 
 23. From what different points of view may bills of exchange be 
 classified ? 
 
 24. Where did ihe terms "foreign" and "domestic" bills originate? 
 2 5 . What is meant by this : " first of exchange, second being unpaid " ? 
 
 What is the purpose of duplicate bills ? 
 
 26. How does a certified check differ from an ordinary check ? 
 27.. How does a cashier's check differ from a personal check? 
 
 28. How does a personal check differ from a bank acceptance ? 
 
 29. How does a bank draft differ from an individual draft ? 
 
 30. What would you call an order drawn by a bank against an 
 individual ? 
 
 31. What is meant by "accepting a draft," and what is the party 
 who accepts it called ? 
 
 32. A may draw a draft against B for a debt of $1,000, or B may 
 write a promissory note for $1,000 in favor of A. What will 
 determine which instrument will be used ? 
 
 33. Suppose A discounts the promissory note or sells the accepted 
 draft to a bank: to whom would the bank look for payment in 
 each case, (a) primarily, (b) secondarily? 
 
 34. -Do you think that it is incorrect, strictly speaking, to call a 
 check a credit instrument ? 
 
 35. Draw up a classification of the various forms of instruments, 
 showing which are really credit instruments and which are not. 
 
 m. THE USE OF CREDIT INSTRUMENTS IN TRANSFERRING WEALTH 
 
 36. State the different legal principles that serve to make these 
 various instruments serviceable as a means of transferring wealth. 
 
 37. What devices have made these instruments readily transferable?
 
 CREDIT INSTRUMENTS 183 
 
 38. What peculiar advantages in the matter of transferability has a 
 negotiable instrument ? 
 
 39. A negotiable instrument is handled in accordance with certain 
 "customs of the merchants." Enumerate them. Is it only 
 merchants who use notes and bills of exchange at the present 
 time? 
 
 40. What was the reason for the development of the principle of 
 negotiability ? 
 
 41. Can you account for the extension of the principle of negotia- 
 bility to bonds on the same grounds ? 
 
 42. Why is it that only bank drafts and checks are used extensively 
 as media of exchange ? 
 
 43. How do you account for the fact that some of these instruments 
 are fully negotiable, others partly negotiable, others only readily 
 transferable ? Does it seem to you probable that the law con- 
 sciously sought to facilitate the use of each of these instruments 
 in the way to which it was best adapted. 
 
 44. Give a case in which the title would be good in the hands of a 
 bona fide holder for value, but not enforceable between the 
 original parties. 
 
 45. What is the purpose of "indorsement without recourse"? Is 
 such an indorsement of any value from the standpoint of security ? 
 
 46. What is an indorsement in blank ? 
 
 47. A note with four indorsements is dishonored. To whom may the 
 holder look for reimbursement ? 
 
 48. What is meant by a "no protest" note? What is the effect? 
 
 49. How would you indorse a note to be sent through the mail ? 
 
 50. How do you indorse checks payable to yourself ? 
 
 51. Is the following a negotiable instrument? 
 
 CHICAGO, ILL., May 17, 1904 
 Due John Jones, one thousand dollars. ' Value received. 
 
 JOHN SMITH 
 
 52. An instrument is written in lead pencil in the following form: 
 
 CHICAGO, ILLINOIS 
 
 I, John Jones, promise to pay John Smith, or order, fifty dollars, value 
 received. 
 
 Mention several particulars in which this note is not in the usual 
 form. Is it negotiable ?
 
 184 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 53. Is the following negotiable ? 
 
 ST. Louis, Mo., June i, 1915 
 
 Three months after date, for value received, I promise to pay John Doe, 
 or order, one hundred dollars, or ninety-five dollars if payable two 
 months after date. 
 
 RICHARD ROE 
 
 54. Is the following a negotiable instrument ? 
 
 NEW YORK, N.Y., June i, 1915 
 
 For value received, I promise to pay to George Rogers, or order, one 
 hundred dollars when he marries. 
 
 WILLIAM STONE 
 
 Would the foregoing be negotiable if it read "when he shall be 
 twenty-one years of age " ? 
 
 55. A check on a Chicago bank is given by A to B in Chicago on 
 January 25. It is not presented for payment on January 26, 
 and on January 27 the bank fails. Whose is the loss? 
 
 56. A check on a Chicago bank is given to A hi New York on May 15. 
 It reaches the Chicago bank on May 20, but the bank had closed 
 its doors May 18. Whose is the loss? What principle should 
 govern the decision in this and in the preceding case ? 
 
 57. What is meant by absolute defenses ? 
 
 58. What is the purpose of such defenses ? 
 
 59. Draw up in proper form a negotiable instrument. 
 
 REFERENCES FOR FURTHER READING 
 
 Gano, D. Curtis: Commercial Law, pp. 116-53. 
 Hagerty, James E.: Mercantile Credit, chap. ii. 
 Moore, Underbill: Commercial Paper. 
 Prendergast, Wm. A.: Credit and Its Uses, chaps, iii-vii. 
 The Credit Monthly. Published by the National Association of 
 Credit Men.
 
 CHAPTER 
 
 THE MARKETING OF LOW-GRADE 
 SECURITIES 
 
 In this chapter we are to consider the financial machinery 
 that has been developed for the marketing of low-grade, or 
 speculative, securities and the problems of regulation which 
 are associated therewith. The financial machinery employed 
 in the distribution of low-grade securities is indicated at the 
 extreme left of the diagram on page 136. The investment 
 banking institutions, shown nearer the center of the chart, 
 are associated with the marketing of high-grade, or non- 
 speculative, securities. These will be considered in the follow- 
 ing chapter. 
 
 It is impossible to give a very precise definition of low-grade 
 securities, for there is no hard-and-fast line of demarcation from 
 high-grade issues. But in general the term refers to securities 
 of such a nature that the risk of loss to the investor is acknowl- 
 edged to be relatively large. There would seem to be at least 
 four distinct types of securities that may be regarded as involv- 
 ing large risks: (i) those that are fraudulent; (2) those issued 
 by corporations in new and hence untested lines of industry; 
 (3) those issued by new and hence untried companies in staple 
 lines of industry; and (4) those issued by companies engaged 
 in lines that are essentially speculative in their nature that 
 normally involve a high degree of risk. Another classification of 
 low-grade issues is found in the securities designated " Class D " 
 under the Illinois Securities Law, a digest of which is presented 
 on pages 198-203 below. 
 
 It should be added that low-grade securities virtually 
 always take the form of shares of stock. Borrowing by means of 
 bond issues is essentially a later stage in the process of raising 
 capital, for the simple reason that the property basis required 
 as security for bonds usually implies a "going concern," 
 
 185
 
 186 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 the capital for which has already been raised by stock sub- 
 scriptions; and in any event the bondholder is more amply 
 protected, and hence the risks assumed are less. 
 
 The sale of securities of new corporations, except in the case 
 of relatively small concerns, the stock of which is entirely 
 subscribed by a small group of investors, usually involves what 
 is known as "promotion" of the sale of securities. If capital 
 is to be raised for a new corporation it is obviously necessary 
 that the securities be brought to the attention of possible 
 investors, just as it is necessary to commend manufactured 
 commodities, through advertising, to the good graces of 
 potential purchasers. The marketing of low-grade securities, 
 however, has been subject to such grave abuses that many 
 have urged that "stock promotion" be forbidden by law. 
 
 The problem of controlling the issue and sale of low-grade 
 securities is twofold in its nature: first, to prevent the marketing 
 of fraudulent and practically worthless shares; second, to make 
 it possible for the potential investor to secure adequate informa- 
 tion upon which to base a reasonably intelligent judgment 
 of the value of honest, but highly speculative securities. 
 
 I. THE PROMOTION OF FRAUDULENT AND 
 WORTHLESS SECURITIES 
 
 Hundreds of millions of dollars are annually taken from 
 ignorant investors by the sale of utterly worthless securities. 
 The mail frauds alone that have been discovered and stopped 
 by the federal government in a single year have reached a total 
 of $129,000,000. There is, of course, no way of estimating 
 the volume of undetected fraud; and there are numerous 
 cases lying within the twilight zone between fraud and legiti- 
 macy for which the laws afford no redress. 
 
 The post-war period, particularly, has been marked by the 
 issue of enormous volumes of highly speculative securities. 
 Literally thousands of companies have been organized for the 
 sale of securities in enterprises of every sort. The movement 
 has been accelerated by virtue of the increased earnings obtained
 
 MARKETING OF LOW-GRADE SECURITIES 187 
 
 by many people during the war, and by the habit of investing 
 that was engendered by the Liberty Loan campaigns. Indeed, 
 the possession of Liberty Bonds has been made the basis of 
 extensive stock-selling campaigns, thousands of individuals 
 having been induced to exchange their bonds for securities 
 promising fabulous returns. Despite all the efforts at sup- 
 pression that have been made by state, municipal, and federal 
 governments, hundreds of millions of dollars have been taken 
 from the pockets of the people by fraudulent investment 
 schemes. 
 
 The promoter of a new issue of securities has various means 
 at his disposal for reaching the investing public. As the diagram 
 on page 136 indicates, one of these means is newspaper adver- 
 tising, a method that has been followed very extensively in 
 recent years. It is particularly efficacious in boom periods when 
 the general public is both prosperous and credulous. The 
 nature of the appeal that may be made is indicated in the sample 
 advertisements on pages 192-97 below. A second method is the 
 sending of circulars through the mails to a list of selected names. 
 This method is perhaps the cheapest of any. Its effectiveness 
 largely depends upon the care and judgment with which the 
 list of names has been chosen. Another method involves the 
 employment of salesmen who interview potential investors 
 and attempt to convince them of the exceptional nature of the 
 opportunity offered. While more costly than newspaper or 
 circular advertising, this method possesses the advantage that 
 goes with personal contact. The plausible salesman, who 
 can look a hesitating and stammering investor hi the eye and 
 pat him on the shoulder at the psychological moment, is hi a 
 much more strategic position to silence doubts than is the 
 cold page of a newspaper or circular letter. It is not to 
 be considered that the foregoing methods are necessarily 
 mutually exclusive. All, indeed, may be resorted to simul- 
 taneously. 
 
 The nature of a great deal of the "promotion" that is being 
 engaged in every year may be surmised from the following adver- 
 tisement recently appearing in a New York newspaper, which
 
 1 88 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 sets forth the necessary qualifications for a writer of promotion 
 literature: 
 
 Wanted: Well-educated young man to write literature and 
 circulars for stock broker. No knowledge of securities necessary. 
 Must have good imagination and flow of language and write in a 
 convincing style. 
 
 There are well-known "earmarks 1 ' of a swindle. As a result 
 of an analysis of a large number of promotions that proved to 
 be swindles, the following earmarks of a stock-offering of 
 doubtful or fraudulent character have been compiled. It 
 should be stated, however, that honest promotion schemes 
 sometimes possess some of these "earmarks": 
 
 1. The argument that the investor should buy immediately 
 because the price of stock will be advanced within a short time. 
 It is obvious that the arbitrary advancing of the price by a 
 promoter does not increase the true value of the security. 
 
 2. The argument that the investor should send a remittance 
 by return mail, or, better still, by wire because there are only 
 a few shares left for distribution. ' Such golden opportunity, 
 however, usually knocks a second time. 
 
 3. The argument that the association of prominent men with 
 a company is a guarantee of the merit of the stock as an invest- 
 ment. It is assumed hi this connection that the typical investor 
 will not know that most successful business men have lost a 
 great deal of money in stock purchases. 
 
 4. The argument that other companies engaged in the same 
 or a similar line of business have made millions from an original 
 investment of little or nothing. 
 
 5. The argument that the company desires to place its stock 
 in the hands of very small investors, so that control may not 
 become vested in a coterie of capitalists. A similar argument is 
 that the company desires to permit only a limited number 
 of persons in each state or hi each city to buy the stock. Demo- 
 cratic organization and control as a means of preventing the 
 capitalistic octopus from reaping the rewards of the wonderful 
 idea to which the company has the exclusive right is regarded as 
 a very effective selling device. Companies of this sort always
 
 MARKETING OF LOW-GRADE SECURITIES 189 
 
 delight in the opportunity to enrich people who find themselves 
 in moderate circumstances. 
 
 6. The argument that the company has orders and con- 
 tracts already in sight, or under consideration, or about to be 
 under consideration, which will insure large earnings on the 
 stock issued. It will be apparent, however, that even when a 
 company has such contracts actually in force, the point to 
 remember is that money may be lost as well as made on an 
 agreement to do a certain thing at an agreed price. 
 
 7. The argument that the company has assets largely in 
 excess of its stock issue. Mention is seldom made of offsetting 
 liabilities. 
 
 Among the physical earmarks of swindling promotion 
 literature, the following have been listed: 
 
 1. A picture of the president of the corporation. He is 
 usually a clean-cut aggressive type of individual, distinctively 
 American in appearance. 
 
 2. A picture of a factory or of an oil field or of a mine 
 shaft, in some part of which is displayed a sign showing that 
 the photograph is genuine. 
 
 3. The adoption of a name that is similar to that of a 
 well-known firm or corporation. 
 
 4. Absence of reputable financial or banking support. 
 
 5. Testimonials of character by unknown persons with 
 imposing business titles. 
 
 6. The listing of high-grade securities in circulars promoting 
 worthless enterprises. 
 
 7. Sales on the instalment plan. The instalment plan is to 
 be distinguished, however, from the partial-payment plan used 
 by many reputable brokers for well-seasoned listed stocks. 
 Instalment sales do not usually permit the investor to require 
 a return of the money invested, even in case of fraud. On a 
 partial-payment contract with a reputable broker, however, 
 the investor may order the sale of his stock at the market price 
 and the immediate remittance of his balance. 
 
 The career of a promoter is vivid. There have been 
 innumerable cases of downright fraudulent promoters who have
 
 1QO THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 carried on their operations for many years. The following 
 biography of a promoter is typical: 1 
 
 Death stepped in yesterday and cut short the kaleidoscopic 
 financial career of George Underbill, past master in the art of extract- 
 ing the mites from the pockets of the middle class in exchange for 
 brilliantly colored stock certificates. 
 
 Underbill's most recent stock-selling venture was the Spring 
 Nut Lock Company, said to be capitalized for $4,000,000, the stock 
 of which was peddled in small lots, chiefly by appeals sent through 
 the mails and advertising hi magazines circulating in the small towns 
 and rural communities. 
 
 Another venture of recent date was the organization of a syndi- 
 cate to promote what was called the Ford machine gun. 
 
 He embarked in the promotion business in 1904, when he 
 attempted to float the Tennessee Development Company. This 
 concern, which was one of his own creations, was capitalized at 
 $500,000, and Underbill endeavored to exchange stock certificates 
 for gold by extensive advertising. 
 
 He painted rosy pictures of the money-making possibilities of 
 this stock, playing up the idea of a "triple profit." The plan was to 
 buy Tennessee lands from which the timber would be cut, making 
 one profit ; then sheep were to be turned loose to graze upon the land, 
 thus making a second profit; and finally, coal could be mined from 
 beneath it, thus reaping a third profit. 
 
 But Underbill waxed even more eloquent in his advertising 
 literature, holding out as further inducements to possible investors, 
 in addition to the triple profit, an added "probable oil find" and 
 "other products from the land, such as fruit, and farm produce, 
 the bottling and sale of mineral water, the sale of pipe clay, the 
 raising and sale of poultry, hogs, cattle, mules and horses, the breeding 
 of Angora goats for fanciers, etc." 
 
 He intimated that as much as 60 per cent in annual profits might 
 be realized from this venture, but according to persons who investi- 
 gated the proposition the whole scheme revolved around a hundred- 
 acre farm hi Tennessee, owned by Underbill's father. 
 
 In March, 1901, he was president and treasurer of the George 
 Underbill Company, advertising agents, which was forced intc 
 bankruptcy. Liabilities of the company agreggated $39,396, and 
 creditors received practically nothing. 
 
 1 From the Chicago Tribune, April 5, 1918.
 
 MARKETING OF LOW-GRADE SECURITIES 101 
 
 In 1906 Underbill launched into the promotion business again, 
 and became fiscal agent for the Hoosac Tunnel Mining Company. 
 He sold $200,000 worth of stock during that year, but the company 
 proved a failure. 
 
 During the same year he sold stock in the Trinity Mining Com- 
 pany. Some of it was sold as low as 35 cents a share. Later he 
 sold stock in the Copper Gold Mines Leasing Company and was 
 also active in a concern known as the Continental Securities 
 Company. 
 
 In 1915 Underbill sold stock in the Eagle Macomber Motor 
 Company of Sandusky, Ohio. On May 13, 1915, he was arrested by 
 the federal authorities on orders from Cleveland, Ohio, where he 
 had been indicted on a charge of using the mails to defraud. This 
 was in connection with the sale of 2,000 shares of stock in the Buick 
 Oil Company to a woman in Youngstown, Ohio. 
 
 II. THE SALE OF HIGHLY SPECULATIVE 
 SECURITIES 
 
 A large amount of capital is annually raised by corporations 
 in lines of business that are highly speculative, such as oil and 
 mining. Such enterprises, of course, afford a fertile field for 
 the operations of the sharper; but even where they are not 
 fraudulent they are nevertheless often based upon such slender 
 possibilities of success that the losses to innocent investors 
 are quite as serious as in the cases of outright fraud. Perhaps 
 the most notable recent cases of this type are found in the oil 
 fields of Kansas, Texas, and California. The discovery of oil 
 in various parts of the country has laid the basis for the wildest 
 sort of speculation in land adjacent to the oil fields. For 
 instance, the development of the Southern Kansas Pool resulted 
 in the organization of a veritable horde of companies, each with 
 prospectus and maps showing the wonderful profits to be secured 
 from oil development hi adjoining counties. Nor is such 
 promotion, when once well started, to be confined merely to 
 oil. Hundreds of salesmen travel over the farming sections of 
 the state, "offering shares in everything from oil prospects to 
 motor trucks and from car couples to adding machines." 
 Under the Blue Sky Law of Kansas there had been authorized
 
 IQ2 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 up to July 18, 1919, 238 stock-selling companies. Of these, 
 142 were oil companies and almost every county in the state 
 was represented. Besides these companies there were scores 
 of others disposing of units in oil leases, a device that has been 
 developed as a means of circumventing the regulations imposed 
 by the Securities Act. 
 
 The following is part of a circular letter used hi advertising 
 a Texas oil project: 
 
 WHAT WILL YOUR ANSWER BE ? 
 
 When the fortunes made by the investors in the oil fields of 
 North Central Texas have been written into history; when the 
 CHILDREN and the GRANDCHILDREN of these investors have been 
 made prosperous and independent and are enjoying the advantages 
 of higher education and world travel which wealth alone can give 
 
 WHAT WILL BE YOUR EXCUSE TO YOUR CHILDREN? 
 
 that they do not also have the advantages which a small 
 investment in the world's greatest and probably the last Frontier of 
 over-night Fortunes in gushing oil wells, would have made possible ? 
 
 When your children, or your grandchildren ask why you, too, did 
 not share in the profits of this, the world's greatest oil boom 
 
 WHAT WILL YOUR ANSWER BE? 
 
 Can you tell them that you did not have the nerve ? 
 
 Can you tell them that you did not have the opportunity ? 
 
 That might be true if we had not sent you the facts concerning 
 the greatest oil field the world has ever known it might be true if 
 newspapers and magazines from Maine to California, from the Satur- 
 day Evening Post, the Golden Rule, Truth, and other well-known, 
 reliable publications on down to the little local newspapers, had not 
 carried page after page of news of this oil boom that you surely have 
 had a chance to read, giving indisputable evidence that some of the 
 nation's greatest and quickest small fortunes have been and are 
 being made right now in Texas oil fields. 
 
 Can you tell your children or your children's children that you 
 were a Doubting Thomas that you stood back and waited while 
 men and women from all over the world with more nerve and 
 courage than yourself bought up all of the available chances to make 
 fortunes ?
 
 MARKETING OF LOW-GRADE SECURITIES 193 
 
 Can you explain to them that you didn't have sufficient ready 
 cash to take advantage of this big Texas oil boom ? You might use 
 this reason with success but our monthly payment plan makes it 
 possible for even the smallest wage earner to get a share of the 
 profits in this great oil boom where $100 has so often made a smaP 
 fortune of $10,000 to $100,000. 
 
 Can you tell your children or your grandchildren that you doubted 
 the sincerity of the Trust Company which brought to your 
 notice the chance to share in the profits of the great Texas oil 
 boom? 
 
 This might have furnished you an excuse if we had not sent you 
 the best evidence on earth evidence written by men and women who 
 live in all parts of the country who have told, in personal letters, of 
 the satisfaction and profits gained by dealing with us and following 
 our recommendations. 
 
 The limited number of shares in the Pre-organization Syndicate 
 of the Ranger-Texas Oil Company which you have now a chance to 
 acquire, are, without doubt, the most desirable shares we have ever 
 offered in our entire history, and here is exactly the reason that we 
 say so: 
 
 In the first place, this Syndicate privilege is being extended to 
 only a limited and carefully selected few whom we regard as leaders 
 in their community, and you are one of these. By making you a large 
 and quick profit we will not only get your future patronage, but that 
 of your friends as well. 
 
 You can only get the limit to which any one person is entitled, 
 which is 200 shares. The present selling price is $12.00 per share, 
 but we cannot guarantee this quotation unless you place your order 
 by wire, following it with the enclosed application. 
 
 This application also gives you an option, until July 3oth, on 
 double the number of shares that you subscribe for at this time, at 
 only $16.00 a share. We have every reason to believe that these 
 shares will be selling for at least $25.00 and possibly $30.00 before 
 July ist; therefore you have a chance to clean up a nice sum of 
 money on your option, without investing a cent. 
 
 WHAT WILL YOUR ANSWER BE ? Have you the nerve and the 
 courage to trust your own judgment this very minute rather than 
 face your children and your children's children with excuses, and get 
 a telegram off to us reserving the number of shares you want? If 
 you have, it may prove to be the turning point in your life.
 
 IQ4 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 The following is a portion of a full-page advertisement, with 
 photograph, of an investment opportunity in the automobile 
 industry. So far as the author knows the company is a bona 
 fide one honestly conducted: 
 
 CHICAGO'S MIRACLE MAN 
 
 How he has broken all records of Industrial 
 
 Achievement 
 
 by piling up Assets of $2,000,000.00 
 in One Year from $100,000.00 
 
 1074% Increase 1049% Increase 2000% Increase 
 
 in Sales and Production in Factory Floor Space in Assets 
 
 In putting Chicago on the map in one short year as a quantity 
 producer of automobiles, Mr. H. J. Hinman, Chicago's Miracle Man, 
 has written the most brilliant and romantic chapter in Motordom's 
 wondrous history. The plain facts concerning Hinman's Herculean 
 Accomplishments read like a financial fairy tale a story too good to 
 be true. Yet the proof exists in his Company's big, modern factory 
 buildings out at 8ist Street and Arrow Avenue, throbbing with the 
 high-pressure activity of hundreds of workmen rushing production to 
 the limit. 
 
 It exists in the huge circus tents used to provide extra manu- 
 facturing space, and in the great volume of orders on hand, with cash 
 deposits paid in advance, sufficient to run the factory almost a year. 
 
 But, most surprising of all, it exists in the Company's large cash 
 reserve fund and in its Balance Sheet, showing net profits which for 
 a Company so young seem little short of miraculous. 
 
 Hinman has built up the Waltham Motor Car Corporation in one 
 year from a humble beginning in a small rented frame building to a 
 Great Thriving Industrial Giant with 108,800 square feet of modern 
 factory space. Even with this record-breaking increase in manu- 
 facturing facilities, the Company is compelled to use 2 huge circus 
 tents to increase working space. 
 
 He has increased the factory output in one year from 724 cars to 
 the production of 7,776 cars which will be attained during 1917. 
 
 He has created a demand for Waltham Sixes that from the very 
 beginning has kept the factory "snowed under" with orders not- 
 withstanding the greatest ratio of production increase ever dared 
 by any company in one year
 
 MARKETING OF LOW-GRADE SECURITIES 195 
 
 
 
 He has multiplied the assets of approximately $100,000.00 one 
 year ago to the Company's more than $2,000,000.00 of today. 
 
 He has done all these things practically from a standing start, 
 while at the same time he was financing his Company and perfecting 
 a car which is today the acknowledged world's champion at its price, 
 and holder of records for speed, endurance, and economy. 
 
 He has caused more than 13,000 live American citizens to buy 
 stock in his Company (more stockholders than the three greatest 
 automobile companies in the world combined), thus providing him 
 not only with ample working capital, but at the same time com- 
 prising, with their families, a great, enthusiastic army of 65,000 
 vitally interested "boosters," all singing the praises of the beautiful 
 Waltham Six. 
 
 The Waltham Company is not in need of funds. It has been 
 generously supplied by its stockholders with ample capital to cover 
 all its current manufacturing requirements. 
 
 Hinman, with the rare foresight and business prudence which has 
 characterized his course throughout, has always rigidly adhered to 
 the policy he established for his Company at the beginning, of keeping 
 on hand a large cash reserve fund. The Company has thus not only 
 been safeguarded against possible business emergencies, but has 
 been able at all times to save substantial sums as a result of dis- 
 counting its bills. 
 
 The Waltham Corporation has been maintained, and is today, on 
 a sound and stable financial basis, and in the highest credit standing 
 throughout the automobile industry. 
 
 He has lured from several of the biggest dividend payers in the 
 automobile industry their most noted department heads, and formed 
 for the Waltham Corporation the greatest and most capable corps of 
 motor car executives ever brought together in one company. All 
 these men are stockholders and vitally interested in Waltham success. 
 
 One well-known automobile stock, thirteen years ago considered 
 little better than a scrap of paper, is today valued on its merits as a 
 dividend-payer at more than $250,000 for a par value share of $100. 
 
 Another automobile company's 1907 assets of $33,000 were lifted 
 by its guiding genius in ten years to its many millions of today, and 
 paid so many big dividends that the average business man can scarcely 
 believe the facts. 
 
 If Hinman does only half as well as these other men who have 
 blazed the way, Waltham stock will prove to be a phenomenal money- 
 maker, and Waltham stockholders will receive so many big dividends
 
 196 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 4 
 
 they will be looked upon with envy by those who have not been 
 fortunate enough to buy Waltham stock. 
 
 In pursuance of the plan that has helped make the Waltham Cor- 
 poration the sensation of the motor world, he continues, as heretofore, 
 to exclude the capitalists and large investors from his company by 
 declining to sell more than $5,000 worth of stock to any one individual; 
 but is now offering to the average investor, to the great American 
 public, the opportunity to join his army of Waltham "Boosters" and 
 share with him the enormous profits and dividends toward which 
 his Company is so rapidly moving. 
 
 His company, already strongly financed for all operating pur- 
 poses, today making money upon its operations and showing a grati- 
 fying profit upon its operations, can use additional capital only to 
 erect the big new factory buildings planned to take 'care of the 
 company's fast-growing business. 
 
 Almost i ,600 inquiries and applications for Waltham Sixes have 
 been received from automobile dealers in all parts of the civilized 
 world who have not only suffered from an automobile famine the past 
 three years, on account of the war destroying Europe's motor industry, 
 but will, for a generation, be unable to get cars from any part of the 
 world except the United States. 
 
 A few Waltham Sixes have been exported to various countries, but 
 the company cannot further deprive its American dealers, and the 
 insistent foreign demand must wait until new buildings and equipment 
 can be provided to take care of it. 
 
 The good fortune, which will be eagerly embraced by a few 
 "quick deciders," to get a few shares of the limited allotment yet to 
 be sold, will so quickly pass that those who procrastinate will have 
 left only a vain regret at a lost opportunity, while their wiser brothers 
 are being started on the road to wealth from a small investment. 
 
 On or before midnight of June 5, 1917, Waltham stock will 
 advance from $14.00 to $17.50 per share. Soon afterward, when 
 the small allotment for sale at $17.50 to erect additional factory 
 buildings has been sold, the price will advance to $20.00 per 
 share, until funds have been supplied for purchasing the necessary 
 machinery, tools, and equipment. 
 
 After that, there will be no more Waltham stock for sale at 
 any price. 
 
 Many who will delay are bound to be disappointed. The 
 present rapid rate of stock sales will, in a very few days, close out 
 the small amount remaining unsold.
 
 MARKETING OF LOW-GRADE SECURITIES IQ7 
 
 Will you get your share before it is too late? 
 
 If you are in position to invest from $500 to $5,000, act quickly 
 as you will probably never have such another big money-making 
 opportunity as long as you live. 
 
 To avoid disappointment, fill out the coupon and mail to us at 
 once. We will then hold some stock for you until you can visit our 
 busy factories, meet the company's officers and department heads 
 and judge for yourself whether you agree with the Waltham Corpo- 
 ration's thousands of stockholders that this is the biggest money- 
 making opportunity you ever had, or ever will have. 
 
 Mail this Coupon. It may start you on the Road to Wealth. 
 
 WALTHAM MOTOR CAR CORPORATION, 
 355.-56 Deering Bldg., 
 Chicago, 111. 
 
 Date 
 
 GENTLEMEN : 
 
 Kindly send me full information in regard to the Officers, Directors, 
 and Department Heads of your Company, its financial condition, and 
 why Waltham Motor Stock is considered a safe and unusually profit- 
 able investment. 
 
 Name 
 
 Street No 
 
 City.. H. 
 
 III. BLUE SKY LEGISLATION 
 
 In an endeavor to protect investors from fraudulent pro- 
 motion schemes and to insure that individuals desiring to 
 purchase securities of a speculative nature shall be provided 
 with adequate information on which to base an intelligent 
 judgment, about forty of our states have in recent years enacted 
 what are known as "blue sky laws." These laws have been 
 directed toward the supervision of dealers in securities through 
 the installation of systems of inspection and through the exerciee' 
 of a modicum of discretionary executive control in the granting 
 of licenses to dealers. 
 
 On the whole, these laws do not appear to have proved 
 very effective. In the first place, they have in most cases
 
 igS THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 attacked the problem from its most complex and difficult end- 
 that of regulation after the securities have reached the hands 
 of the dealers. In the second place, the wide variations in the 
 laws of different states have afforded many loopholes for the 
 sale of fraudulent securities. Stock issued by a corporation 
 in one state may be sold in another state, even though similar 
 issues of corporations organized under the laws of such state 
 could not be sold within its boundaries. For instance, the law 
 of California requires that before offering its securities for sale 
 a company must submit Us proposition to a state commission 
 for approval. While this prevents the issue and sale of unsatis- 
 factory securities by California corporations, it does not prevent 
 companies organized in other states from selling their securities 
 in California. So long as California newspapers will print the 
 stock-selling advertisements of companies organized in other 
 states, opportunity for disposing of fraudulent and highly 
 speculative securities to the people of California remains practi- 
 cally without restriction. 
 
 The Illinois Blue Sky Law is an advanced type. The new 
 Illinois Securities Law, effective June n, 1919, has gone further 
 in the way of regulation of the issue and sale of investment 
 securities than that of any other state. It is to some extent 
 modeled after the English investment securities legislation 
 passed many years ago. The law is directed not only to the 
 activities of dealers; it also supervises the issue of the securities. 
 For the purpose of the Act, the securities are divided into four 
 classes, designed to indicate the degree of speculation involved 
 The classification is as follows: 
 
 A. Securities, the inherent qualities of which insure their sale and 
 disposition without fraud. Within this group are included: 
 
 1. Securities issued by a government or governmental agency 
 
 2. Securities issued by any national or state bank or trust com- 
 pany, building or loan association, or insurance company of 
 this state 
 
 ,3. Securities issued by any corporation operating any public- 
 utility, in any state where the issues of such utilities are 
 regulated bv law.
 
 MARKETING OF LOW-GRADE SECURITIES 199 
 
 4. Securities dealt in on the New York, Chicago, Boston, Balti- 
 more, Philadelphia, Pittsburgh, or Detroit stock exchanges 
 
 5. Securities whose prices have been quoted from time to time for 
 at least a year in tabulated market reports published as news 
 items, and not as advertising, in a daily newspaper of general 
 circulation, published in this or in an adjoining state, including 
 Michigan 
 
 6. Securities issued by any corporation organized for non- 
 profit-making purposes 
 
 B. Securities, where the inherent qualities are such or the nature of 
 one or both parties to the sale thereof such that their sale and 
 disposition without fraud is assured. This comprises the follow- 
 ing types of securities: 
 
 1. Those sold by the owner for the owner's account exclusively, 
 when not in the course of continued and repeated transactions 
 of a similar nature 
 
 2. Increased capital stock of a corporation, distributed directly 
 among its stockholders, without the payment of any com- 
 mission or expense to agents, brokers, etc. 
 
 3. Those sold by or to any bank, trust company, or insurance 
 company or association, organized under the laws of Illinois 
 or of the United States, or under the supervision of the depart- 
 ment of trade and commerce or the auditor of public accounts 
 of Illinois; or by or to any building or loan association of 
 the state; or any public sinking fund, trustees, or to any 
 corporation or any dealer or broker in securities 
 
 4. Sold or offered for sale at any judicial, executors, or adminis- 
 trators' sale or any bankruptcy or public sale or auction held 
 at any advertised time or place 
 
 C. Securities based on an established income. This class includes 
 the securities issued by any business which has been in con- 
 tinuous operation not less than two years and which has shown 
 net profits, exclusive of all prior charges, as follows: 
 
 1. One and one-half times the annual interest charges upon all 
 outstanding interest bearing obligations 
 
 2. In the case of preferred stock, not less than one and one-half 
 times the annual dividend 
 
 3. In the case of common stock, not less than three per cent per 
 annum 
 
 D. All securities not falling within classes A, B, and C
 
 200 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 The main provisions of the law may be summarized as 
 follows: 
 
 I. Provisions governing the offer of securities for sale 
 
 Securities in Classes A and B are exempt from the provisions 
 of the blue sky law. 
 
 Securities in Class C may be sold only after filing a sworn 
 statement in the office of the secretary of state describing the 
 securities to be sold, stating the law under which and the time 
 when the corporation or business was organized, giving a balance 
 sheet of assets and liabilities, an income or profit and loss state- 
 ment, and an analysis of the surplus account, together with the 
 names and addresses of its principal officers, directors, 01 
 trustees, and other pertinent facts, data, and information, 
 establishing the character of such securities. 1 
 
 Before any Class D securities may be offered for sale, thero 
 must be filed in the office of the secretary of state documents 
 and statements as follows: 
 
 1. A description and the amount of the securities intended to bo 
 offered for sale 
 
 2. If the issuer is a corporation, a certified copy of the charter or 
 articles of incorporation and by-laws 
 
 3. If the issuer is a firm, trust, partnership, or unincorporated 
 association, a copy of the articles of partnership, association, 
 or trust agreement 
 
 4. The names, addresses, and prior occupations during a period 
 of not less than ten (10) years prior to filing such statement 
 (giving details as to time, place, and address of employer 
 and reasons for discontinuance of employment) of the 
 officers, directors, or trustees of the issuer, if it be a corpora- 
 tion, or of the persons composing the issuer, if the issuer be 
 a non-incorporated association 
 
 5. A description of the nature of the industry engaged in or 
 intended to be engaged in and the approximate time when 
 such industry was or will be established 
 
 'These provisions allowed the secretary considerable administrative 
 latitude, and at first he demanded very elaborate and detailed statements, 
 inventories, and accounts for qualifications. A great deal of unnecessary 
 annoyance and expense resulted, and therefore on November 8, 1919, 
 a new ruling was passed which greatly simplified the requirements by per- 
 mitting the filing of sworn summaries instead of detailed schedules. Since 
 then public hostility to the law has been greatly diminished.
 
 MARKETING OF LOW-GRADE SECURITIES 3OI 
 
 6. An inventory showing the assets of the issuer 
 
 7. An appraisement of the assets of the issuer 
 
 8. A statement in detail of the gross income of the issuer and 
 the source or sources thereof and of its operating and other 
 expenses for a period of twelve (12) months prior to the 
 date of filing such statement, or for the period of the existence 
 of the issuer if less than two years prior to the date of 
 filing 
 
 9. A copy of the most recent balance sheet of the issuer, showing 
 the financial condition of the issuer at a date not more than 
 thirty (30) days prior to the date of filing, and giving an 
 analysis of surplus account from inception of such issuers 
 
 to. A copy of the mortgage, trust deed, indenture, or writing 
 securing the securities, whereunder the same are issued, 
 if any such instrument there be 
 
 1 1 . A copy of the form of the securities intended to be offered 
 
 12. A copy of any and all subscription blanks to be used in the 
 sale thereof, which subscription blanks shall have printed 
 thereon, "These are speculative securities" 
 
 13. A statement as to the manner in which the securities are to 
 be offered and sold 
 
 At any time, either before or ofter the filing of such state- 
 ments, the secretary of state may designate certified public 
 accountants to make examination of the books, records, and 
 documents of the issuer and make a report thereon. 
 
 If the statement discloses that any of such securities are 
 intended to be issued for any patent right, copyright, trade- 
 mark, process, or good-will, for promotion fees or expenses, 
 or for other intangible assets, the amount or nature thereof should 
 be fully set forth and the securities issued in payment therefor 
 should be delivered in escrow to a bank or trust company desig- 
 nated by the secretary of state, under an escrow agreement 
 that the owners of such securities shall in the case of dissolution 
 or insolvency not participate in the assets of the corporation 
 until after the owners of all other securities have been paid in 
 full. 
 
 In case any statement or document filed in the office of the 
 secretary of state shall in his judgment be inadequate or not in 
 compliance with the act, or in case the plan disclosed by such 
 documents would in his judgment tend to work a fraud upon
 
 202 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 the people, or if it appears that the documents are false in any 
 important particular, the secretary of state shall apply for an 
 injunction to restrain the further sale of such securities. 
 II. Provisions affecting dealers in securities 
 
 When Class D securities are to be sold through a solicitor, 
 agent, or broker, a statement must be rendered giving the names, 
 residences, qualifications, occupations, and business experience 
 of such solicitor, agent, or broker for the preceding ten years. 
 The signatures of each and every solicitor, agent, or broker 
 shall be attached to such statement. 
 
 Any dealer or owner may sell Class D securities only after 
 filing in the office of the secretary of state a statement of the 
 amount of description of the securities to be sold by him, the 
 maximum price for which they are to be sold, and giving his 
 address by street and number, qualifications, occupations, and 
 business experience for the preceding year. 
 
 An irrevocable contract must be executed by such solicitor, 
 agent, and broker authorized to offer or sell such securities to 
 the effect that the issuer will receive in cash not less than 80 
 per cent of the proceeds of the sale of the securities, without 
 liability to pay any further expenses or commission. 
 
 So long as any security continues to be offered for sale, new 
 and supplementary statements must be filed at the expiration 
 of each six months' period, showing: (i) the amount of securities 
 sold, sale price, the amount of cash proceeds received therefore; 
 (2) all changes in the financial conditions of the issuer or in its 
 management or property, accompanied by a copy of the most 
 recent balance sheet, which must be not more than thirty 
 days prior to the date of filing. 
 
 Each financial statement, prospectus, advertisement, etc., 
 published or distributed for the purpose of selling securities 
 in Class D shall contain the following words in bold-face type: 
 "Securities in Class 'D' under Illinois Securities Law. These 
 are speculative securities." But it shall be unlawful to make 
 any other reference to the fact that the provisions of the law 
 have been complied with. Furthermore, all such advertising 
 literature shall contain a statement of the assets, liabilities, 
 income, and expenses of the issuer, the law under which the issuer 
 was incorporated or organized, and the names and addresses 
 of all officers, directors, and trustees of the company. A copy
 
 MARKETING OF LOW-GRADE SECURITIES 203 
 
 of such financial prospectus, etc., shall be filed in the office of 
 the secretary of state within ten days after the first circulation, 
 publication, or distribution. It shall be unlawful to publish 
 or circulate therewith a statement of the earnings of other com- 
 panies engaged in a similar business. 
 
 Under a recent ruling by the secretary of state, dealers may 
 offer and provisionally sell all classes of securities before they 
 have been accepted by the secretary as properly qualified, 
 actual delivery of the securities themselves not being made 
 until after qualification. 1 
 
 HI. Penalties 
 
 The penalties attached to the Act are severe. Attempts 
 to sell securities without full compliance with the provisions of 
 the Act are punishable, in the case of dealers, with fines as 
 high as $10,000, or one year's imprisonment, or both; and for 
 sale of securities in case the issuer is known to be insolvent, 
 when the purchaser loses by such sale, $10,000, or five years, 
 or both. In addition, dealers who sell in violation of any 
 provision are liable for the full purchase price to the purchaser, 
 plus reasonable attorney's fees; and for misrepresentation of 
 the facts contained in the filed statements, "to a maximum fine 
 of $5,000 or one year's imprisonment, or both." 
 
 Two main questions present themselves in connection with 
 this comprehensive law. First, is it adequate to prevent mis- 
 representation and fraud ? Second, does it impose undue burdens 
 on the development and conduct of business ? 
 
 The law does not reach certain important evils. With reference 
 to the first question, the general conclusion appears to be that 
 the law is effective as far as it goes; but that it completely fails 
 to reach various classes of operations among which are some 
 of the most important that such a law is designed to control. 
 In the regulation of reputable dealers in securities, it appears to 
 be successful enough; but in the regulation of dealers who are 
 of questionable character, it has thus far made but little progress. 
 
 1 The necessity and justice of this ruling is obvious. The process of 
 qualification is often long, and if the dealers have to wait during this period 
 before they can solicit purchases, the securities will be moved to some other 
 part of the country where they can find a quicker market; and profit 
 that should normally accrue to the Illinois dealers will be lost to them.
 
 204 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 The same holds true for the marketing of such securities. 
 The two agencies by which doubtful securities are most com- 
 monly disposed of advertising and direct correspondence 
 do not in fact come under its jurisdiction at all. In the latter 
 case, the federal government exercises some control; and in the 
 former, efforts have been made to enlist the Chicago news- 
 papers against the acceptance of spurious advertisements; but 
 the effect upon the general situation has not been great. Fin- 
 ally, in the case of doubtful securities handled through Illinois 
 dealers, and especially of securities issued by corporations of 
 other states, there is to date absolutely no means of insuring 
 the detection of non-compliance with the law, or of failure to 
 file and qualify before sale. This is perhaps the greatest single 
 weakness that has appeared in the Illinois law;- it is one which 
 is common, moreover, to nearly all the blue sky legislation of 
 the present. 
 
 The law handicaps legitimate Illinois dealers. With reference 
 to the second question, the restrictions it places upon the 
 development of new enterprises are probably not great, although 
 it is too soon to be sure. A bona fide concern can qualify 
 its securities under the law without much difficulty; and the 
 slight handicap here is more than compensated for by the par- 
 tial suppression of fraudulent enterprises. But upon the con- 
 duct of established banking and brokerage businesses in Illinois 
 the law has already had some ill effects. Because of the red 
 tape, expense, and delay involved, it is operating to drive 
 securities away from Illinois markets, for the issuers find it less 
 costly to sell their securities, by mail, in other states. More- 
 over, by requiring the dealer to pay his fees and undergo the 
 expense of qualification before any sale can be made, the law, 
 hi the case of the smaller issues, frequently wipes out prac- 
 tically all profit. Because of this, various New York bankers 
 have already shifted a considerable portion of their business 
 from the western to the eastern markets. Moreover, the 
 delays incident to qualification often make it impossible for 
 dealers to take advantage of a sudden favorable turn of the 
 market.
 
 MARKETING OF LOW-GRADE SECURITIES 205 
 
 It is of interest to note that under the working of the 
 Illinois law in the first twelve months of its existence, a great 
 many applications for permission to sell securities in Illinois 
 were denied. Out of a total of 519 applications to sell securities 
 in Illinois, 208 were disapproved, the sums involved totaling 
 $66,917,410, of which $57,636,840 was in Class D and the 
 remainder hi Class C. 
 
 IV. SUGGESTED CONTROL OVER THE FORMATION 
 OF CORPORATIONS 
 
 The experience up to date under the new Illinois Securities 
 Law, and with blue sky legislation in general, raises the funda- 
 mental question, Is this the right way to attack the problem ? 
 The Committee on Legislation of the Investment Bankers' 
 Association of America has issued the following statement: 
 
 To the present time such acts as have been passed and put into 
 effect have been fundamentally wrong in the way they sought to 
 go about solving the problem The theory of licensing repu- 
 table dealers in investment securities has proved to be worse than 
 useless, in that reputable people do not need to be controlled, and 
 .... a person already violating the law, and subject to criminal 
 prosecution will not be deterred from his ways by the placing of one 
 or more additional statutes on the books. 1 
 
 There is undoubtedly much truth in this statement. Even 
 the very comprehensive Illinois law, as we have seen, completely 
 misses a large field in which misrepresentation and fraud are 
 common, while at the same time it imposes heavy burdens on 
 another field which is normally free from questionable practices. 
 And with the exception of the Illinois law, blue sky legislation 
 has applied only to the sale of securities already issued. The 
 question is therefore pertinent, Is not the only effective form of 
 control that which is imposed at the source which actively 
 governs, as none of our laws now do, both the actual issu- 
 ing of the securities and the formation of the corporations 
 
 1 Investment Bankers' Association of America Bulletin, Vol. VIII (De- 
 cember 10, 1919), 125-30,
 
 206 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 themselves ? If so, a federal law, or uniform state laws, woul J 
 have to be devised on lines radically different, from any 
 now in existence, providing comprehensive administrative 
 machinery and conveying wide discretionary powers to a 
 responsible executive department. 
 
 With reference to federal control, it may be noted that some 
 federal experience in this field was gained during the war. 
 Because of the necessity of disposing of great quantities of 
 Liberty Bonds, it became necessary to restrict the issue and 
 sale of securities to corporations which were essential to the 
 winning of the war. There was accordingly organized in the 
 Treasury Department a Capital Issues Committee, which passed 
 upon all applications for new financing. This committee was 
 demobilized shortly after the armistice, along with the rest of 
 our war machinery. Numerous suggestions have since been 
 made, however, that such a committee be organized as a per- 
 manent part of the machinery of federal regulation. And a 
 bill for a national blue sky law was introduced in Congress by 
 Representative Volstead in January, 1920. This bill, which 
 has been approved by the Legislative Committee of the Invest- 
 ment Bankers' Association, provides for placing the supervision 
 of securities' sales in the hands of the Attorney-General and 
 gives him considerable discretionary power. The aim of the 
 proposed law is not to handicap legitimate trading, but to pre- 
 vent the issue of fraudulent securities. 
 
 Control of the issue of securities should not prohibit new finan- 
 cing. The suggestion that both the formation of the corpora- 
 tions and the actual issuing of securities be subjected to effective 
 control raises, however, another fundamental question. If 
 new industries are to be developed, they must be enabled to 
 secure capital through the issue and sale of securities. Free- 
 dom from legal restriction in the issue of securities has, as we 
 have seen, given rise to very grave abuses and heavy financial 
 loss to nearly all classes of people. But it has left the door open 
 for the financing of new, and hence uncertain and speculative, 
 industries; it has hi many ways facilitated our industrial 
 progress. In endeavoring to protect the investing public
 
 MARKETING OF LOW-GRADE SECURITIES 207 
 
 from fraudulent securities, we should not go so far as to prevent 
 entirely the marketing of speculative issues; on the contrary, 
 we must permit the ready financing of new enterprise or become 
 industrially stagnant. 
 
 If we are to do more than guard against fraud in the market- 
 ing of securities, and furnish the necessary information on which 
 an intelligent investor can form a reasonably sound judgment 
 if we are to go back of the selling process and place in the hands 
 of government officials the power to veto an honest issue of 
 securities, merely on the ground that such an issue would 
 be highly speculative, we should be lodging with government 
 officials a substantial control in directing our industrial develop- 
 ment. Or if we refuse to permit any securities to be issued 
 for public sale until the issuing corporation has proved successful 
 over a period of years, we compel a corporation to pass its 
 novitiate either as a partnership or as a closed corporation where 
 the funds are derived entirely from a small group of interested 
 investors. 
 
 All things considered, it is doubtless wise to attempt a more 
 rigid control over the formation of new corporations; for it is 
 conceivable that such control may be so safeguarded that only 
 good would result from its inauguration. It would seem that 
 two results, at least, might reasonably be achieved. On the 
 one hand, a plan might well be devised that would shift the 
 risks of starting and financing new enterprises to the classes 
 which can best afford to bear the risks; namely, the larger 
 private investors and capitalists, rather than the rank and 
 file of small investors. On the other hand, the promotion 
 business should be made unprofitable; indeed, it should be 
 made impossible for men to float new schemes, take their 
 profits out of the promotion process, and then sell out, 
 leaving the enterprise to work out its own salvation, as best 
 it may. 
 
 This is not the place, however, either to attempt a formula- 
 tion of the details of securities legislation or to reach any 
 final judgment on the whole question of blue sky regulation. 
 It will be sufficient if the foregoing consideration of the nature
 
 208 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 of the promotion business, and the difficulties that have been 
 encountered in connection with blue sky legislation make it 
 clear that we still have before us some very baffling problems 
 in regulating the issue and sale of low-grade securities. 1 
 
 QUESTIONS FOR DISCUSSION 
 
 1. What is meant by low-grade securities? Might bonds ever be 
 included ? 
 
 2. What are some of the principal types of low-grade securities? 
 Classify them by different branches of industry. 
 
 3. Examine the quotations of securities on the New York and Chi- 
 cago stock exchanges. Do you find among the shares there 
 traded in any belonging to (a) the industrial group? (>) the 
 mining group? (c) the automobile group? (J) the oil group? 
 Are the issues of these companies low grade? 
 
 4. Examine the quotations of securities on the New York curb 
 Are all of these highly speculative low-grade issues ? 
 
 5. Do you imagine that all of the oil and mining companies whose 
 stocks are daily being bought and sold are fraudulent or worthless 
 concerns ? 
 
 6. May low-grade securities in tune become high-grade securities ? 
 If so, under what circumstances ? Would it have been a good 
 thing to have prevented the raising of capital for such enterprises ? 
 
 7. What classes of people are most frequently besought to buy 
 low-grade securities ? What classes of people take the greatest 
 risk when buying such securities ? What classes of people can 
 least afford to buy highly speculative securities? 
 
 8. What ways are available to newly organized corporations for 
 raising the capital required ? Which way would you adopt ? 
 Under all circumstances ? 
 
 9. Do you think it is necessary to protect the people from invest- 
 ing their funds in such schemes as those promoted by George 
 Underbill? 
 
 10. Judging by the number of oil and mining companies that have 
 been organized since the Great War, do you think investment 
 knowledge has advanced much since the time of the South Sea 
 Bubble? 
 
 'For this material on securities' regulation the author has drawn 
 heavily upon a paper prepared by one of his students, Mr. J. W. Angell. 
 Much of the phraseology, even, has been borrowed. See Journal of Politi- 
 cal Economy, April, 1919, pp. 307-21.
 
 MARKETING OF LOW-GRADE SECURITIES 209 
 
 n. Is the post-war speculative craze attributable to any lack of 
 conservative investment opportunities ? 
 
 12. Do you think the Ranger-Texas Oil Company has any possibility 
 of proving successful ? 
 
 13. What ways are available for preventing fraud in the promotion 
 of new companies ? 
 
 14. Why is it so difficult to apprehend and punish the guilty parties ? 
 
 15. What features of the advertisement of the Waltham Motor Car 
 Corporation appear suspicious to you ? Do these features 
 necessarily prove the issue of doubtful value ? 
 
 1 6. Do you think any of the provisions governing the issues of 
 securities in Class C, under the Illinois Securities Law, are unduly 
 onerous ? 
 
 1 7. Do you regard any of the provisions governing the issue of Class D 
 securities as unduly severe ? 
 
 1 8. Under the Illinois Securities Law, as it stands, would it be possible 
 to raise capital for a new concern by the sale of securities to the 
 general public ? 
 
 19. Can a concern furnish a balance sheet and an income statement 
 if it is not already a going concern ? 
 
 20. Do you favor the abolition of all promotion? 
 
 21. "All that the state can hope to do is to prevent fraud in the selling 
 of securities and to see to it that only reliable parties engage 
 either in the issue or sale of securities." Do you agree? 
 
 22. "All agree that the solicited investor should not be permitted to 
 buy blindly, even if he is willing to do so. But should we go 
 further ? Should the state administrator say ' this is an unsound 
 venture; finance it privately, if you can, but you cannot finance 
 it by a general solicitation or offering' ? In the answer to this 
 question lies the fundamental diversity of opinion among the 
 advocates of blue sky legislation." What is your opinion on 
 the subject ? 
 
 23. "When a company applies for a charter, it should be the duty 
 of the state to ascertain whether the individuals who are organiz- 
 ing the concern are men of ability and integrity, and whether 
 the company has any possibility of success." How could the 
 state know whether a concern had any possibility of success ? 
 
 24. "We cannot afford to make either our corporation laws or the 
 regulations governing the issue and sale of securities so strict 
 that the raising of capital for new concerns in established lines
 
 210 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 of industry, or for concerns in new lines of industry, is rendered 
 impossible, or is seriously hampered." Do you agree ? 
 25. "Newly organized corporations should be required to raise the 
 capital necessary for making the enterprise a going concern 
 without offering the securities to the general public; or if offered 
 to the general public, subscriptions should not be taken for less 
 than a minimum, say, of $1,000, in order to insure that only 
 people of some means and some ability in judging values shall 
 risk their funds in the enterprise." Do you agree ? 
 
 REFERENCES FOR FURTHER READING 
 Reed and Washbum : Blue Sky Laws.
 
 CHAPTER XIV 
 
 THE MARKETING OF HIGH-GRADE 
 SECURITIES 
 
 The marketing of high-grade securities, such as those 
 enumerated in Classes A and B under the Illinois Securities 
 Act, 1 is largely effected nowadays through the intermediation 
 of financial houses called investment banking institutions. 
 At the present time the principal sources of demand for invest- 
 ment funds are: first, the raising of capital for business enter- 
 prises; second, the needs of governments, national, state, and 
 local; and third, the purchase and improvement of real estate. 
 All these sources of demand have increased tremendously in the 
 last half-century; and it is this fact, together with the develop- 
 ment of the corporate form of organization, that has forced the 
 development of the elaborate investment banking machinery 
 of the present day. 
 
 The securities that are marketed by these financial institu- 
 tions include the issues of railroad, public utility, industrial, 
 and other corporations, and of federal, state, city, county, 
 township, and other local government bodies. Real estate 
 issues are usually not marketed through the regular investment 
 channels. 2 The types of securities handled now comprise 
 stocks, bonds, and short-term notes; although until recently 
 bonds have occupied a dominant position in the investment 
 market. Some houses specialize hi the marketing of bonds; 
 some are mainly concerned with issues of high-grade stock, 
 common as well as preferred; while others handle both bonds 
 and stock. In general the drift appears to be away from narrow 
 specialization, with the emphasis, however, always upon con- 
 servative, as distinguished from speculative, securities. 
 
 1 See classification on pp. 198-99 above. 
 
 * For a discussion of the marketing of real estate bonds and mortgages 
 see chap, xxvi below.
 
 212 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 I. HISTORY OF INVESTMENT BANKING 
 
 The investment banking institutions, with their various 
 functions of investigation, underwriting, and marketing securi- 
 ties, are of comparatively recent development, their history 
 running parallel with that of the corporate form of industry, 
 outlined hi chapter xi. Investment financiers, however, have 
 existed for many centuries. In medieval times kings and 
 governments received their revenues, as now, largely from 
 taxes. Since the need for funds was practically continuous, 
 while the taxes were received only intermittently, there devel- 
 oped the practice of securing "advances" from powerful 
 financiers, to whom the collecting of the taxes was "farmed 
 out " as security for the loan. The financial needs of the various 
 European rulers were at times so great that the financiers to 
 whom they looked for aid came practically to dominate the 
 political as well as the financial life of Europe. Where the 
 "tax security" was insufficient, valuable property was some- 
 times mortgaged to the financiers. For instance, in 1487 
 Jacob Fugger, having grown tremendously wealthy through 
 operations in trading, mining, and banking, received the rich 
 mines of Tyrol as a guaranty for the payment of a loan to 
 Duke Sigismund. This was followed by large loans to Sigis- 
 mund's successor, Maximilian, and to Pope Julius II; while 
 after the death of Maximilian, Charles V succeeded in becoming 
 Roman emperor by the purchase of electors on funds borrowed 
 from " the Fuggers." By 1524 the Fuggers had assumed control 
 of a large part of the Spanish land taxes and mines; they had 
 establishments in Poland, Hungary, Antwerp, and Naples; 
 and their operations and power extended from Belgium to India. 
 
 Before the Civil War there was little investment banking in the 
 United States. From colonial days until the Civil War period, 
 hi our own history, most businesses were conducted on the 
 individual or partnership basis, with the funds furnished directly 
 by those immediately interested in the enterprises. During this 
 period the financial dealings of governments were also relatively 
 unimportant, except in times of war. The Revolutionary War, 
 however, was financed largely by the issue of paper currency;
 
 MARKETING OF HIGH-GRADE SECURITIES 213 
 
 and the War of 1812 did not involve any extensive bond-selling 
 campaign. Not until the Civil War did the issue of securities 
 by the federal government become important. Even then 
 the government securities were largely sold direct to banking 
 institutions and individuals of means, rather than to the general 
 investing public; so that the market mechanism involved 
 was relatively simple. 
 
 In these early days demands for a large aggregation of 
 capital came principally in connection with the development of 
 public highways, rivers, canals, railroads, banking, and insur- 
 ance. The financing of public works and railroads was effected 
 partly through loans from banking institutions often directly 
 affiliated with the enterprise and partly by the issue and sale 
 of securities to the investing public. The funds were generally 
 obtained for these early corporations from local investors, 
 principally of the merchant class, "ranging from the small 
 country storekeeper to the wealthy metropolitan merchant 
 importer; there were others, however, as well: retired farmers 
 or merchants; widows of substance; children who had inherited 
 well; landed proprietors who had picked up public securities; 
 successful speculators in stocks; and a considerable body of 
 small savers in town and country." 1 
 
 In numerous cases funds were also secured from outside 
 the locality principally in financial centers such as New York, 
 Boston, and Philadelphia, and in foreign countries. Before 
 1800, state subscriptions were important elements only in the 
 larger Virginia canals and the early New York canals, and in the 
 Bank of North America, the United States Bank, the Union 
 Bank of Boston, and the Bank of Pennsylvania. Occasionally 
 towns took a stake in bridge or canal companies, but rarely, if 
 ever to any large extent. 3 In the twenties and thirties, however, 
 state assistance played a leading role in the development of 
 public works. 
 
 From the beginning some capital has also been drawn from 
 abroad. In the colonial period a considerable volume of funds 
 
 1 Davis, Essays in Early History of American Corporations, TV, 279-302. 
 'Ibid.
 
 214 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 was annually brought in by immigrants and there were some 
 loans to this country by European capitalists. It was not until 
 after 1825, however, that European purchasers of American 
 securities became important. In that year nine issues of 
 government bonds and a number of state and city bonds were 
 quoted on the London Stock Exchange. In the construction era 
 of the thirties, a large volume of foreign capital sought invest- 
 ment in this country, the total being estimated in 1839 at 
 $200,000,000. The railroad developments of the forties and 
 fifties induced additional foreign investments, the first railway 
 loan floated in London being a $2,000,000 issue of the Baltimore 
 and Ohio road, brought out by Baring Brothers in 1846. The 
 Civil War halted developments; but in 1866 the total of 
 British and French capital in this country was estimated at 
 $350,000,000, while by 1869 it had increased to a billion. In 
 that year David A. Wells estimated the total of all foreign 
 investments in the United States at $1,465,000,000; while in 
 1910 Sir George Paish- placed the amount at $6,500,000,000. 
 
 In the period before the Civil War, the domestic invest- 
 ment market was a very simple affair. The bulk of the invest- 
 ments were made directly without the intermediation of any 
 significant banking machinery. Local banks, it is true, often 
 assisted in bringing borrower and lender together and mortgage 
 companies were developing for the purpose of facilitating the 
 making of agricultural loans. But it was not until after the 
 Civil War period that investment banking institutions assumed 
 an important position in our financial system. Indeed, it was 
 not until the turn of the century that investment banking 
 really came into its own. 
 
 II. MODERN INVESTMENT BANKING 
 DEVELOPMENT 
 
 The investment banking business, as we now know it, 
 appears to have originated in connection with the issues of 
 municipal subdivisions cities, counties, townships, etc. In 
 the early days of this investment business, municipal bond
 
 MARKETING OF HIGH-GRADE SECURITIES 215 
 
 issues were first disposed of almost entirely in the local market 
 through the aid of local banks, who engaged in the bond business 
 as a side-issue to their regular banking operations. But as 
 the issues increased in volume, the local banker was forced to 
 seek outside sources of funds. He was handicapped in his 
 operations, however, because securities were floated only 
 periodically and his bond-selling was therefore but an inter- 
 mittent activity. Specialization in investments, with a large 
 variety of offerings, and a regular clientele were necessary to 
 an effective organization of the business. 
 
 It was the custom in the early days for municipalities to 
 sell their bonds privately and without public advertisement. 
 Accordingly, as the business grew and as energetic specialists 
 entered the field of investment, buyers were sent about the 
 country to locate new issues and effect as advantageous a 
 purchase as possible. Finally, as the numbers of buyers in- 
 creased and competition became keener, the practice of adver- 
 tising bond issues at public sale developed, with the result 
 that several buyers would appear at each sale and make 
 competitive bids for the privilege of disposing of the issue. 
 This practice greatly improved the market for securities and 
 placed the business upon a much more efficient and econom- 
 ical basis. 
 
 In a similar way the distribution end of the business was 
 broadened. So long as investors were relatively few in number 
 and composed mainly of well-to-do business men, insurance 
 companies, and savings banks, bond dealers usually found 
 it possible to distribute the larger portion of their bond issues 
 directly over the counter, and the remainder by correspondence. 
 But as the volume of securities offered for sale increased, it 
 became necessary to extend the field of distribution, and sales- 
 men were employed to secure new customers, both locally and 
 in other communities, as well as to keep closely in touch with 
 the existing clientele. 
 
 There are many specialized investment banks. With the 
 development of large-scale corporate industry and the extension 
 of the investment banking field to include railroad, public
 
 2l6 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 utility, and industrial securities of every description, there 
 developed specialized investment institutions. Some bond 
 houses devote themselves almost exclusively to the marketing 
 of municipal securities; others specialize in the financing of 
 steam railroads ; still others are concerned only with public 
 utility financing and there is specialization even within this 
 field, for instance, in the securities of gas or electric light com- 
 panies, power corporations, or street railways. In recent years, 
 certain houses are specializing in industrial securities. 
 
 It is not to be understood that such specialization means an 
 exclusive dealing in a particular type of security. An invest- 
 ment house specializing in railroad securities may also buy 
 and sell or trade other securities to a limited extent, for the 
 convenience of its regular customers. Houses do this, how- 
 ever, in the capacity of brokers, or as a result of an ex- 
 change of securities with other houses, rather than in the 
 capacity of financial adviser and underwriter for the issuing 
 corporations. 
 
 There are houses, also, which sometimes combine the work 
 of engineering and operating establishments with the function 
 of financing. 
 
 Though such organizations are not numerous, they are impor- 
 tant. By reason of special skill and ability in their chosen fields 
 they have effected economies in operation and construction. They 
 purchase plants which have not proved profitable under the exist- 
 ing management and through their special skill turn them into profit- 
 able enterprises. Through the magnitude of their operations they 
 can also effect economies in the purchase of supplies. Such 
 engineering-banking organizations specialize in the field of public 
 utilities more than do bankers who are not also engineers. A house 
 of engineering bankers confines itself to gas plants or to electric- 
 light properties or to street railways. 1 
 
 With the exception of a few lines of business, notably 
 banking, and of relatively small corporations, the issues of 
 which are sold directly to members of a family or to a small 
 
 1 Lyon, Corporation Finance, II, 40.
 
 MARKETING OF HIGH-GRADE SECURITIES 217 
 
 group of "inside stockholders," most corporations seek the 
 aid of investment bankers in raising capital. As will presently 
 be seen, it is an admirable division of labor for the raising of 
 funds to be turned over to specialized institutions that are 
 well equipped for the purpose in hand. 
 
 For some lines of industry, however, adequate investment 
 banking machinery has not as yet been developed. Municipal, 
 railroad, public utility, and the larger industrial enterprises 
 have little difficulty in securing capital through investment 
 bankers. But in the case of the smaller industrial concerns, 
 the machinery, though rapidly improving, is still inadequate. 
 The cost of investigation and of advertising, in order to make a 
 little-known enterprise sufficiently popular to attract investors, 
 is often disproportionate to the amount of capital required. 
 The banker would thus have to charge so much for his services 
 that it would impose a very heavy burden upon the business. 
 This is one of the reasons why the smaller industrial concerns 
 have had to raise their funds through promotion schemes, as 
 outlined in the previous chapter. 
 
 m. FUNCTIONS OF INVESTMENT BANKING 
 INSTITUTIONS 
 
 The terminology that is commonly employed in speaking 
 of the work of investment banking institutions is somewhat 
 confusing. Some writers speak of houses of first purchase, of 
 underwriters, and of distributing bond houses in a way that 
 would lead one to believe that they are distinct and specialized 
 institutions, each performing a particular task and that only. 
 If a clear view of the work of investment banks is to be gained, 
 it will be necessary to make a classification that runs in terms 
 of functions rather than in terms of institutions. The diagram 
 on page 218 attempts to set forth the several functions that 
 are performed by investment banks. 
 
 In brief, the function of investigation and analysis is to 
 determine whether a proposed bond issue has sufficient merit 
 to be offered to a conservative investing public. It is the 
 function of underwriting to assume the risks that inhere in
 
 218 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 the raising of the funds required and insure the corporation 
 that it shall have its funds on a specified date, whether or not 
 the securities have been sold to the investing public. It is 
 the function of distribution to sell an issue of securities to 
 investors. All of these functions may be, and usually are, 
 
 performed by a single institution, although there is some degree 
 of specialization by investment bankers. Such concerns, for 
 instance, as Morgan & Co., are chiefly interested in original 
 investigation and in underwriting, while, on the other hand, 
 there are many small bond houses whose activities are mainly 
 confined to the retail marketing of securities. 
 
 IV. INVESTIGATION AND ANALYSIS 
 
 The original investigation and analysis of an issue of 
 securities may be undertaken by any investment banker, 
 large or small. There are a great many relatively small issues
 
 MARKETING OF HIGH-GRADE SECURITIES 219 
 
 of securities put out by medium-sized concerns that are handled 
 by small and inconspicuous investment bankers. In the case 
 of very large issues, however, there are a few great financial 
 houses which now more or less occupy -the field. As we shall 
 presently see, this is mainly because the underwriting of such 
 issues requires very large resources. 
 
 The problem of investigation and analysis arises whenever 
 a corporation approaches an investment banker with a request 
 for assistance in the marketing of an issue of securities. The 
 task of the investigation is, first, to ascertain whether the pro- 
 posed issue is sound, and second, to name a selling price that 
 will be satisfactory to the corporation and at the same time 
 enable the banker to make a profit on the transaction. It 
 must be clearly understood that the investment banking insti- 
 tutions which we are now considering have nothing to do with 
 speculative securities. They aim to establish a reputation for 
 conservatism; they make their appeal primarily on the basis 
 of safety of the principal and certainty of the interest or divi- 
 dends, and their greatest satisfaction is in achieving a long 
 record of no financial losses to customers. 
 
 In the light of these ideals it is obviously necessary for the 
 investment banking house to make a most careful investigation 
 and analysis of the corporate securities which it handles. To 
 this end: 
 
 The investment banker avails himself of all possible information 
 that furnished by the engineer, the accountant, the banker and the 
 successful business leader and reduces it all in the crucible of his 
 experience and training. The security which passes the acid test 
 of this process may be regarded as possessing the merits to which the 
 reputable investment banker certifies. 1 
 
 The fixing of a price by the investment banker is sometimes 
 easy and sometimes difficult. In the case of a corporation that 
 has outstanding issues enjoying a broad and active market, 
 the naming of a satisfactory purchase price is under ordinary 
 circumstances not difficult. The existing market for an issue of 
 
 1 From an article published by A. H. Bickmore & Company.
 
 220 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 this character is carefully studied, as well as the general bond 
 market situation at the time. A bid is then made at a figure 
 sufficiently under current quotations for such securities to 
 insure a reasonable profit to the investment banker. The 
 fixing of a price on a new and untried issue, however, requires 
 the most careful judgment. The best that can be done is to 
 make comparisons with the current prices of the issues of a 
 similar character. Since the investment market is often capri- 
 cious, many losses are sustained by the investment banker. 
 
 The task of investigating and analyzing the numerous 
 factors which govern the value of investment securities varies 
 considerably with the different types of issuing bodies. In the 
 case of governmental issues, the security rests primarily with the 
 adequacy of the taxing power possessed by the issuing govern- 
 ment; but there is also involved a consideration of the legality 
 of the issue. The analysis of public-utility securities involves 
 the question of franchise rights and of regulation by public- 
 utility commissions, as well as the potential earning power of 
 the public utility in question. Similarly with railroad issues, 
 there must be considered the earning possibilities of the road, 
 together with the regulations imposed both by the federal 
 government and the various states through whose territory 
 the railroad runs. With industrial securities, the analysis is 
 largely concerned with the ascertainment of earnings, although 
 in the case of monopolies the problem of governmental regula- 
 tion is also a factor. With all classes of securities, the character 
 and ability of the management is, of course, a matter of par- 
 amount importance. 
 
 The diagram on page 222 is designed to show the factors 
 that enter into a determination of bond values. The author 
 holds no brief for the detailed classification under each heading; 
 many writers would doubtless arrange the items somewhat 
 differently. It is believed, however, that the broad classifica- 
 tion into legal, technical, psychological, and economic factors 
 will assist the reader in understanding the nature of the analysis 
 required.
 
 MARKETING OF HIGH-GRADE SECURITIES 221 
 
 How an investment banker analyzes a proposition. The 
 following analysis 1 of bond values indicates the technical and 
 economic factors that must be weighed in the balance. 
 
 To the task of investment analysis should be brought an equip- 
 ment that consists not merely of a knowledge of accounts; that is 
 useful chiefly to open the gates of knowledge. As much information 
 as possible should be gathered with respect to the nature of the busi- 
 ness, its methods and possibilities of operation, and the relation oi 
 the enterprise to the remainder of the industrial or commercial 
 community. It has been said that the newspaper mail should be a 
 Jack-of-all-trades. It might well be said that the dealer hi securities 
 should be the master of all trades. Through all the investment 
 analysis should be applied the horse sense of a sound business 
 experience, for financial miracles ceased with Aladdin and his lamp. 
 
 Investment analysis is concerned primarily with just three 
 things, as follows: (a) profits; (&) the relation of assets to liabilities; 
 and (c) physical property. Secondary factors are (a) the nature of 
 the specific security offered; and (b) the conditions at present existing 
 and likely to exist in the investment market. Under these five 
 headings can be taken into account all the facts that make or unmake 
 security investments. And out of the answers obtained by sub- 
 jecting questions to facts and figures is constructed that projection 
 of opinion that prophetic vision which constitutes the only real 
 investment judgment. 
 
 I confess to an uncontrollable prejudice for a scrutiny of the 
 income account as the first method of approach to the problem of 
 bond values. When an enterprise makes real money for its share- 
 holders, it also makes values in use for the physical property it owns. 
 .... Physical values out of use, even temporarily, shrink to 
 distressingly small proportions, as the records of the bankruptcy 
 courts disclose. 
 
 Preliminary investigation should subordinate the other elements 
 of safety to the question of earnings. Current earnings and expenses 
 should be compared with similar items at least for the preceding 
 year, but preferably with those of a number of years preceding. 
 Gross earnings or gross sales of merchandise should be expected to 
 
 1 From an article in Chicago Banker, January 18, 1913, by H. S. Mott, 
 manager of the bond department, Bankers Trust Company, New York.
 
 222 
 
 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
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 SHO1DVJ DIWONOD3 
 
 
 
 
 .
 
 MARKETING OF HIGH-GRADE SECURITIES 223 
 
 show more or less steady increases, for the business, like the indi- 
 vidual, that merely stands still goes backward. 
 
 If one company manufactures harvesting machines, another a 
 standard, moderate-priced automobile, and another conducts a large 
 mail-order business in the rural districts, will the demand for their 
 goods be affected by large or small crops the prosperity or the adver- 
 sity of the farmers ? If a network of trolleys is built in the territory 
 of a railroad, will the road's passenger traffic be curtailed ? If natural 
 gas is discovered near a large city and shortly will be delivered to 
 consumers at thirty cents a thousand feet, how will the company 
 manufacturing gas for ninety cents a thousand feet to the consumer 
 be affected ? To what extent is the market for a company's product 
 dependent upon tariff duties? Do the records of other similar 
 cases guide opinion? Or is experience of little service? In any 
 event before we make an investment, wisdom dictates that we 
 form some solidly based opinion on these or other matters that may 
 be pertinent. It is the future status of our securities that interests us. 
 
 But suppose, as is frequently the case, we find that the demand 
 for a commodity is fairly stable or, better still, shows a well-marked 
 tendency from year to year to expand, with a likelihood that 
 the tendency will continue. It is not, after all, gross earnings that 
 are applicable to dividends on stocks, or, for that matter, to interest 
 on bonds; it is net income. If expenses increase as rapidly as gross 
 earnings, the values of the securities involved stand still or, in the 
 comparative appraisals of the market, decline. What do the expense 
 accounts show ? Does the cost of conducting the business increase 
 more rapidly than do gross earnings or by a larger percentage? 
 If so, in what items and why? When these questions sKall be 
 adequately answered, we shall be in a position reasonably to deter- 
 mine whether the increase in expenses, if there be an increase, 
 is due to avoidable or unavoidable causes, whether the increase is a 
 fluctuation or discloses a tendency, and whether part or all of the 
 increase in expenses, such as outlay for betterment and reconstruction, 
 is likely to yield larger profits in the future. 
 
 The creation of reserve funds for depreciation, insurance, etc., 
 and periodical charges to net earnings for their continuation and 
 expansion according to the probable needs of the business greatly 
 enhance the investment values of securities. Property in use derives 
 a large part of its value for a going concern and, therefore, for
 
 224 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 security holders by having worn-out parts constantly replaced and 
 by being protected against unusual hazards. If, then, net earn- 
 ings increase by a percentage as large as, or larger than, gross 
 earnings, and if good judgment dictates that the conditions surround- 
 ing the volume of business done, the prices obtainable, and the 
 expenses, are unlikely to change for the worse, the securities of such a 
 corporation, other things being equal, should be desirable investments. 
 
 Assets and liabilities. The financial status of an enterprise at 
 the close of business on a particular day makes an exhibit with which 
 bankers as loaners of money are familiar. As an exhibit of a com- 
 pany's ability to repay loans in a short time, it is of more service 
 than the income account. For the purpose of investment analysis 
 it is subordinate only to the income account. It is presumed to 
 be an exact statement of all assets and all liabilities. Actually, in 
 many cases, it is nothing of the sort. The property accounts among 
 the assets sometimes contain items of intangible, as well as items of 
 tangible, property. Good- will, franchises, patents, etc., when they 
 are rated high as assets, produce water in securities purer than that 
 to be brought to New York by the new Catskill aqueduct. Capital 
 stock theoretically is full paid and in a balance sheet is treated 
 as money owed to stockholders. But actually it is often not fully 
 paid, and, except as required through dissolution and liquidation, the 
 amount it represents is never legally owed to anybody. The surplus 
 of current assets over current liabilities, or, as surplus is called, 
 "net quick assets," constitute the working capital of a concern. 
 Its proportions in relation to the need for working capital are of the 
 utmost importance. Many a soundly based enterprise has passed 
 into control of the courts because its promoters failed to supply it 
 with the sinews of war or its management paid out all profits in 
 dividends. 
 
 In the balance sheet also should appear the accumulations of the 
 various reserve funds which, to the extent that they are profits 
 reserved against remote contingencies, may be considered as part of 
 the surplus of profit and loss account. A profit and loss account, 
 surplus itself, may mean much or little, according to the nature of the 
 equities in assets that it represents. A profit and loss deficit never 
 should appear except in the construction states of an enterprise. 
 
 Among assets almost invariably the largest account is "cost 
 of property." This account includes all fixed, or more or less per- 
 manent, assets needed in the conduct of the business, such as real 
 estate, plants, machinery, equipment, etc. As it is against part or all
 
 MARKETING OF HIGH-GRADE SECURITIES 225 
 
 of the physical property included in this account that mortgage bonds 
 usually are issued, the make-up of the account obviously is important. 
 In it might be included the original cost of a branch railroad that 
 long had ceased to yield profits or to be kept in good repair, and of 
 which the value in use of the physical property would be hard to 
 discover. Or it might be found that a plant was adapted to profitable 
 production only under circumstances of manufacture or of competi- 
 tion that have passed. Or worse than all, good-will may become 
 the basis for the issuance of "mortgage" securities through the 
 purchase of another going concern. The methods of arriving at 
 "cost of property" through betterments, additions, depreciation 
 and reserve deserve careful consideration. These all have to do 
 with the future" status of the mortgaged fixed property. We should 
 make some reasonable determination that its value in use in the 
 future shall be as much as, if not actually more than, at present. 
 
 An analysis of public utility values. The following outline- 
 analysis affords a general idea of the sort of investigation 
 that must be made in appraising the value of public utility 
 securities. 1 
 
 The data factors which should enter into the exercise of judgment 
 involve balance sheets, statements of income and profit and loss, 
 and statistics. 
 
 The balance sheet should set forth with appropriate detail the 
 following items: 
 
 ASSETS LIABILITIES 
 
 1. The permanent investment in i. Mortgage bonded or secured 
 operated property debt 
 
 2. The investment in non- 2. Debenture notes 
 
 operated property 3. Customers' deposits (in the 
 
 3. The investment in securities case of gas companies) 
 
 or advances of affiliated com- 4. Current liabilities (notes, ac- 
 panies counts, dividends, salaries, and 
 
 4. The liquid assets (cash, receiv- wages payable) 
 
 ables, materials, etc.) 5. Reserves for depreciation and 
 
 5. Deferred debit items losses 
 
 6. The cost of valuation carried 6. Capital, surplus, and un- 
 for franchise and good-will divided profits owing to share- 
 holders 
 
 1 Adapted from an article by Homer A. Dunn in Investment News, 
 March 24, 1917.
 
 226 THE FINANCIAL ORGANIZATION OF SOCIE1Y 
 
 From such a balance sheet four things of importance to the 
 investor may be readily determined, viz. : 
 
 1. The excess of the tangible assets over the liabilities. 
 
 2. The financial progress of the company as disclosed by the increase 
 or decrease in such excess and its composition. 
 
 3. The cost or valuation of franchises or good-will. 
 
 4. The total capital (not capitalization) invested and employed in 
 the business, which, as courts have ruled, is the difference between 
 the total assets and the total liabilities, or the sum of the reserves 
 and shareholders' accounts. 
 
 By such determinations there would be afforded bases for estab- 
 lishing the ratio of net income to the capital tangibly invested and 
 employed in the business. 
 
 In contemplating investment in mortgage, bonded, or secured 
 debt or in debenture notes or similar obligations, the interest of the 
 investor should center upon comparison of the ratio of net income - 
 producing power to the capital tangibly invested and employed in the 
 business. If investment in the common capital stock should be 
 under consideration, the ratio of the net income-producing power to 
 the total capital invested and employed in the business would be the 
 effective comparison. 
 
 In analyzing the income account, a classification of operating 
 revenues and operating expenses is necessary. But the classification 
 will vary with the nature of the public utility in question. The 
 items could not be the same for an electric utility, a gas utility, and 
 a traction utility. A summary of the operating revenues of an electric 
 utility, for example, might well cover (i) commercial lighting and 
 power; (2) municipal lighting and power; (3) sales of current to 
 other utilities; (4) profit on wiring and installation; (5) profit on 
 sales of merchandise; (6) miscellaneous operating revenue. 
 
 Again using an electric utility as an example, such a summary of 
 the operating expenses might well cover (i) generation and storage 
 operation; (2) transmission and distribution operation; (3) utiliza- 
 tion expenses; (4) commercial expenses; (5) repairs of generation 
 and storage structures; (6) repairs of generation and storage equip- 
 ment; (7) repairs of transmission and distribution systems; (8) depre- 
 ciation of generation and storage structures; (9) depreciation of 
 generation and storage equipment; (10) depreciation of transmission 
 and distribution structures; (u) depreciation of transmission and 
 distribution equipment; (12) general expenses; (13) administration 
 expenses.
 
 MARKETING OF HIGH-GRADE SECURITIES 227 
 
 The income derived from sources other than operating activities 
 should be disclosed in such items as (i) rentals from non-operated 
 property; (2) interest earned on investments in mortgage, bonded, 
 and secured debt; (3) dividends declared on investments in capital 
 stocks of other companies; (4) interest earned on bank balances and 
 notes and accounts receivable; (5) cash discount earned on purchases; 
 (6) unclaimed salaries and wages written off. 
 
 Income charges. The income charges should consist of such 
 items as (i) interest on mortgage, bonded, and secured debt; (2) inter- 
 est on debenture notes or similar obligations; (3) interest on current 
 liabilities; (4) rent of property used in operations; (5) excise and 
 franchise taxes; (6) income tax (property taxes being included in 
 general expenses). 
 
 Throughout this summary of income there should be a series of 
 totals and remainders, a recapitulation of which, followed by the 
 items which ordinarily should enter into the profit and loss account, 
 is as follows: 
 
 Total operating revenue 
 Total operating expenses 
 Net operating revenue 
 Total other income credits 
 Gross income 
 Total income charges 
 Net income 
 
 Profit and loss surplus at beginning of the year 
 
 Profit realized on investment securities sold 
 
 Profit realized on non-operated property sold 
 
 Profit and loss gross surplus 
 
 Profit and loss charges: 
 Loss sustained on investment securities sold 
 Loss sustained on non-operated property sold 
 Dividends declared during the year (stating the amount and 
 
 rate for each class of capital stock) 
 Total charges 
 
 Profit and loss surplus at the end of the year 
 
 The illustrations above serve only to reveal the nature of 
 the investment banker's task of investigation and analysis; 
 they do not supply the reader with the golden key to the 
 treasure-houses of industry. It is enough for the present to
 
 228 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 note that the success of the investment banker will vary with 
 the degree of his mastery of the legal, technical, psychological, 
 and general economic factors which enter into the determina- 
 tion of investment values. 
 
 V. THE UNDERWRITING FUNCTION 
 
 The ability of a corporation to construct new plant and 
 equipment or to extend the scope of its operations in any direc- 
 tion is dependent upon an available supply of funds. Since 
 an issue of bonds or stock is subject to the conditions of a 
 capricious market, the securities can sometimes be quickly 
 sold to the investing public at a favorable price, while at other 
 times it may require months or even years for them to be 
 absorbed at almost any price. The function of underwriting 
 has arisen as a means of protecting the borrowing corporation 
 from the vagaries of the investment market of insuring that it 
 shall obtain possession of the funds required at the precise time 
 that they are needed. 
 
 It is difficult to give a clear presentation of the function 
 of underwriting for the reason that the" term is often loosely 
 used, having a different meaning for different people. It will 
 make for clearness of understanding, however, if we keep always 
 hi mind the fact that whoever participates in underwriting 
 agrees, if a slang expression may be pardoned, to "hold the bag" 
 hi case the securities are not sold to ultimate investors. Some- 
 times a single institution may underwrite an entire issue; but in 
 more cases a considerable number of houses unite for the purpose. 
 
 In the diagram on page 218, underwriting is placed in an 
 intermediate position between investigation and analysis, and 
 distribution. There is good reason for this, because in point 
 of time the underwriting arrangement follows the investigation 
 and analysis and precedes the distribution of securities. In the 
 case of a small issue handled by a single house, which makes 
 the investigation, assumes the underwriting and distributes 
 .the entire issue, there is, of course, little point to such a differ- 
 entiation; but the reader will find it of distinct assistance in
 
 MARKETING OF HIGH-GRADE SECURITIES 229 
 
 reaching an understanding of the process of marketing securities 
 in cases where an underwriting syndicate is formed. 
 
 A joint-account arrangement, or an underwriting syndicate, 
 is formed whenever a house has in charge an issue that is larger 
 than it can handle conveniently with its own resources. There 
 are a number of investment banks in the larger cities of the 
 country with sufficient resources to handle an issue of securities 
 of $2,000,000 or $3,000,000. With issues in excess of this 
 amount, however, there are only a few concerns equipped to 
 handle them without assistance. In New York there are per- 
 haps seven or eight, in Boston three or four, in Chicago and 
 Philadelphia two or three each, that can handle issues in excess 
 of $5,000,000. 
 
 The nature of the entire process of underwriting and 
 marketing securities may best be revealed by some concrete 
 illustrations involving the joint-account arrangement and the 
 underwriting syndicate. 
 
 Under a joint-account arrangement several investment bankers 
 "participate" in the underwriting. Suppose, for instance, that 
 company A has in charge an issue of securities which it cannot 
 handle satisfactorily alone. It seeks the assistance of com- 
 panies B, C, and D. Let us assume that the amount of the issue 
 is ten million dollars and that the A company takes four millions 
 and the B, C, and D companies two millions each. Under this 
 arrangement each banking house agrees to advance to the cor- 
 poration on a stipulated date a sum of money proportionate to 
 the extent of its participation. To be concrete, let us suppose 
 that the A company had decided that the bonds could be 
 marketed at $98 per share and that in view of the expenses 
 incident to the marketing process, the corporation should 
 receive $95 per share. The corporation would therefore receive 
 $9,500,000, four-tenths of which would be underwritten by A 
 and two- tenths by B, C, and D respectively. If the bonds 
 were sold at $98, the gross profit to the four concerns for bring- 
 ing out the issue and underwriting and distributing it would 
 be $30,000, from which, ol course, would have to be deducted 
 the expenses incident to the business.
 
 230 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 Let us suppose that the issue had been underwritten on 
 January i and that the date fixed for payment of the funds to 
 the corporation was April i. If investors look upon the issue 
 with favor at the price of $98, it may be that it can all be sold 
 during the interval; but if the investors are not favorably dis- 
 posed it may be that only a small portion or indeed none of 
 the issue can be sold before April i. In this event, the par- 
 ticipating investment bankers must advance the balance to 
 the corporation out of their own resources or with funds bor- 
 rowed from commercial banks. Since their own resources are 
 usually relatively small in proportion to the volume of securities 
 which they are handling, it is generally necessary to borrow 
 heavily, on the basis of promissory notes, backed by the securi- 
 ties that are being underwritten as collateral. 
 
 If the bond market continues to be apathetic with reference 
 to this particular issue, the participants will either have to 
 "carry the securities" on borrowed funds for a considerable 
 period, sometimes several years, or offer them at a lower price 
 to the public. The former alternative involves tying up funds 
 for an indefinite period, with a loss of interest during the interval; 
 the latter involves accepting a loss through selling at a price 
 that will not cover the expenses that have been incurred. 
 
 Under this joint-account arrangement the houses concerned 
 act both as underwriters and distributors. They divide the 
 profits, or losses, in direct proportion to the participation, 
 regardless of the number of shares each house may be able to 
 sell. The joint-account is a species of partnership. It usually 
 calls for an undivided, or unlimited, liability of the participants, 
 though sometimes the agreement provides for a division of the 
 liability. The securities are also handled as a "lump," under 
 the management of some member of the group of associated 
 houses; even the borrowing from the banks is a joint affair. 
 
 The underwriting "syndicate" assumes the risks of marketing. 
 In the case of large issues, and oftentimes with small issues 
 handled by a banking house or houses of limited resources, a 
 syndicate is formed for the purpose both of distributing more 
 widely the risks involved and of facilitating the sale of the
 
 MARKETING OF HIGH-GRADE SECURITIES 231 
 
 securities. Such a syndicate may be formed by an individual 
 house, or by a group of houses handling an issue of securities 
 on joint-account, as described above. 
 
 To make the illustration as concrete as possible, let us 
 assume that Lee Higginson & Co. have investigated a proposi- 
 tion for an issue of $50,000,000 of 7 per cent bonds. Since the 
 issue is larger than could be handled successfully by a single 
 house, or even by a group of houses operating on joint-account, 
 Lee Higginson & Co. proceed to organize a syndicate to under- 
 write the issue. Lee Higginson & Co. alone deal with the 
 borrowing corporation, acting as an intermediary between the 
 houses which participate in the underwriting and the corpora- 
 tion whose securities are being issued. The issue is their 
 proposition and, as we shall see, they get a special return as 
 a reward for bringing out the issue and for organizing and 
 managing the syndicate. 
 
 In the case under consideration, suppose that Lee Higginson 
 & Co. have agreed to pay to the corporation $92 per bond, and 
 that they have decided to offer the issue to the investing public 
 at 96. Assume also that a commission of i per cent must be 
 paid to those who assist in the selling of the securities. 1 This 
 leaves a possible three-point difference for profits to the mana- 
 gers of the issue. If no underwriting syndicate were formed, this 
 would all go to Lee Higginson & Co. ; but since this house has 
 not sufficient resources to assume conveniently the risks involved 
 in so large a venture, they forego the chance of securing all 
 the profits and of standing all the losses and distribute the 
 opportunity and the risk among a number of houses. 
 
 Let us now assume that the underwriters in the case above 
 agree to buy at 93 any bonds that are not taken by the public 
 at 96, before the date set for advancing the funds to the cor- 
 poration. Lee Higginson & Co. are thus assured of a profit 
 of $i per $100 bond, less expenses for their services in con- 
 nection with the original analysis and investigation and the 
 
 1 If the investment market improves, the securities, of course, might 
 be sold at more than $96; but if the market is dull they may have to be 
 sold for less.
 
 232 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 organization and management of the underwriting syndicate. 
 By virtue of their agreement with the underwriters they have 
 contracted themselves out of any risk of loss, except as they also 
 may participate in the underwriting process, as noted below. 
 
 It is often good business policy for a large house to organize 
 an underwriting syndicate, even though it could assume the 
 entire risks alone. By calling in a number of houses to partici- 
 pate in the underwriting it conserves some of its own resources 
 and thereby is enabled to take on additional issues as oppor- 
 tunity offers additional issues on which it will receive a return 
 for its work as original investigator and as organizer and 
 manager of a new syndicate. 
 
 If the sale is a success, the underwriters who have agreed 
 to buy at 93 the bonds which are sold at 96 receive 2 per cent 
 for the risk they have assumed the distributors getting the 
 other i per cent as noted above. If the sale is not a success, 
 the underwriters must buy in the bonds at 93, and then either 
 tie up capital indefinitely by holding the securities for a more 
 favorable market, or accept a heavy loss by selling at a figurt 
 below their purchase price. If they elect to "carry" the 
 securities it will be necessary for them to borrow most of th 
 requisite funds from the commercial banks. 
 
 Many institutions participate in the underwriting. In the 
 case of an underwriting syndicate of the sort just described, 
 the house of first purchase may also participate in the under- 
 writing, thus acting in a double capacity. Similarly, the partici- 
 pating underwriting houses may perform a double function, 
 that of taking subscriptions for the sale of bonds and assuming 
 the risks of underwriting. In the example above, an invest- 
 ment banker would receive $i per bond as a distributing agency, 
 and $2 as an underwriter. It is important to bear in mind, 
 however, that the actual amounts received for any of the 
 functions connected with the marketing of securities vary with 
 different issues and at different periods of time. 
 
 Large investors in securities often participate hi under- 
 writings, in order to reap the advantage of a lower price in 
 their purchase of securities. Insurance companies have also
 
 MARKETING OF HIGH-GRADE SECURITIES 233 
 
 at times participated in such undertakings, but owing to alleged 
 abuses the state of New York has now made it illegal for these 
 institutions to engage in syndicate activities. 
 
 One of the things to be guarded against by the underwriting 
 syndicate is the passage of an issue of securities into the hands 
 of speculators before the expiration of the underwriting agree- 
 ment. If purchased by speculators who have misjudged the 
 potential demand, securities will often be thrown on the market 
 at a loss. Such precipitate selling may serve greatly to depress 
 the price, with resulting losses to the underwriters. In an 
 endeavor to prevent the disposition of securities to speculators 
 it is stipulated that when individuals participate in under- 
 writing it must be for investment purposes only. A new issue 
 of securities may, however, pass indirectly into the hands of 
 speculators by way of the regular dealers. Every effort is 
 made to prevent this and to restrict the sale to investment 
 channels. In case an issue does not "go well," however, and 
 the underwriters are forced to sustain their losses, the securities 
 then pass in large blocks into the stock market, where for years 
 they are the object of speculative activity. The economic 
 consequences of this aspect of the problem will be considered 
 in the next chapter. 
 
 Syndicates are always temporary organizations, being 
 dissolved as soon as a particular transaction is completed. 
 They are being formed continuously, however, and a given 
 house may at one time be a member of several syndicates. It 
 is usually good business policy to form an underwriting syn- 
 dicate, apart from the reason noted on page 232, for syndicate 
 operations enable a wider distribution of risks. Invitations 
 to participate in syndicate operations are usually reciprocal; 
 and the risks are obviously more widely distributed if a house 
 has underwritten a million of securities issued by five different 
 companies than when it has underwritten a million of a single 
 issue. 1 
 
 1 For additional data on syndicate questions see chap. ra.
 
 234 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 VI. THE DISTRIBUTION FUNCTION 
 
 The volume of corporate securities has attained such 
 enormous proportions in recent years that the distribution 
 function has required the development of elaborate selling 
 organizations. It has been estimated that the par value of 
 the American bonds sold each year averages more than $2,000,- 
 000,000; while the high-grade stocks distributed by bond houses 
 are now doubtless of equal amount. In 1914 there were about 
 1,000 large investment banking institutions in the United States 
 and a large number of small retail dealers. This number 
 has probably been substantially increased as a result of 
 the impetus that was given to the investment business by the 
 financial exigencies of war and reconstruction. Besides the 
 large houses, which exercise at once the functions of investiga- 
 tion and analysis, underwriting, and distribution, there are 
 many small dealers and brokers who assist in the retailing 
 of securities. 
 
 The larger houses maintain offices in the leading financial 
 centers, such as New York, Boston, and Chicago, and also in 
 London. The American offices are all connected by private 
 wires and it is not unusual for a single concern to dispose of 
 $5,000,000 worth of bonds in a day. In order to accomplish 
 such a feat it is necessary for the banking house to be in close 
 communication with institutions, brokers, and groups of indi- 
 viduals who can act quickly and buy in large quantities. 1 
 A considerable percentage of such sales would be to the smaller 
 dealers and brokers, and much of the remainder to savings 
 banks, and insurance and trust companies. 
 
 As already indicated, distribution relates to the selling end 
 of the bond business, to the placing of securities in the hands 
 of ultimate investors. To guard against confusion of thought 
 it may again be stated that distribution is not a function which 
 is specialized in exclusively by certain houses. All of the invest- 
 ment banks perform this as well as the other functions. For 
 instance, when a single house brings out an issue of securities 
 
 1 See list of these on pp. 237-38.
 
 MARKETING OF HIGH-GRADE SECURITIES 235 
 
 and underwrites it without assistance, it also markets the issue. 
 Similarly, when a group of houses, operating on joint-account, 
 together underwrite an issue, they also unite in the selling 
 process. And when a syndicate has been organized, the various 
 houses participate both in the underwriting and in the distri- 
 bution of the issue; indeed, the participating houses are often 
 spoken of as a "selling syndicate." In general it may be said, 
 however, that the tendency is for only one house, or a small 
 group of houses, to bring out an issue and organize the syndi- 
 cate; for a considerable number of houses to participate in the 
 underwriting; and for a much larger number to take part in 
 the selling campaign. 
 
 With any given issue, however, there may be a considerable 
 number of houses that have not participated hi the under- 
 writing who do undertake to sell some of the securities. Among 
 those assisting in the distribution, but usually not participat- 
 ing in the underwriting, are also local banks throughout tht 
 country, with bond departments, formally or informally organ- 
 ized, small securities' dealers, and brokers working for a small 
 commission. 
 
 It should be noted, also, that a member of the syndicate is 
 not necessarily obliged to sell the same amount of securities 
 that it has underwritten. For instance, a house may agree to 
 underwrite $100,000 worth; but it may undertake to sell only 
 $50,000. If the entire issue is successfully marketed, the house 
 in question receives its underwriting profit on $100,000 and its 
 distributing commission on $50,000. If the issue is not alf 
 sold, it must buy in its proportion of the unsold amount and 
 assume the risks of marketing them at a loss. It would still 
 receive its selling commission, however, on whatever amount 
 it had individually succeeded in marketing. It will be observed 
 that it is quite possible that any particular house may be able 
 to sell all the securities for which it has subscribed, despite the 
 fact that the entire issue is not sold. 
 
 All who participate in the distribution of securities, whether 
 members of the syndicate or not, are entitled to a selling com- 
 mission. The amount of this commission varies somewhat,
 
 236 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 depending upon the nature of the issue and the condition of 
 the investment market. It varies also with the size of the 
 subscription. The commission to brokers is usually very 
 small, typically one-fourth of i per cent. The commissions 
 given to local banks and dealers run typically from to i 
 per cent. 
 
 The distributors assume some of the risks. In a sense the 
 outside distributors, that is, those not members of the under- 
 writing syndicate, also perform an underwriting function; for 
 they are not permitted to return any securities for which they 
 have subscribed. This rule applies to brokers, as well as to 
 banks and dealers. Since the outside distributors buy at a 
 fixed price, say $i less than the price to the public, they are 
 taking a chance of not being able to market the securities at a 
 profit. If the issue does not go well, they will have either to 
 sell at a price below what they have paid for the securities, or 
 to hold them for a rise. It will be noted, however, that while 
 these small houses and brokers thus assume some of the risks 
 involved, their risks as distributors are only in proportion to 
 their purchases; they do not guarantee that the entire issue 
 will be bought, as does the original underwriting syndicate. 
 Another way of stating it is that the original underwriters 
 assume the risks first, and then distribute them, in whole or in 
 part, as the case may be, to the distributing houses. 
 
 Not being members of the syndicate, these retail dealers, 
 banks, and brokers are not debarred from selling below the 
 syndicate price before the termination of the syndicate under- 
 writing agreement, as is the case with the participants in the 
 syndicate. The dealers and local banks seldom cut prices 
 before the expiration of the underwriting agreement, through 
 fear of incurring the ill will of the syndicate, and thereby 
 lessening their chances of assisting in the distribution of future 
 issues. The brokers, however, usually feel little of this com- 
 pulsion; and to guard against their underselling and thereby 
 increasing the risks of the underwriting syndicate, brokers' 
 commissions are usually very small one-fourth of i per cent. 
 In other words the price quoted them is one-fourth of a pei
 
 MARKETING OF HIGH-GRADE SECURITIES 237 
 
 cent below the regular price. They cannot, therefore, cut 
 more than one-eighth of a per cent without wiping out the 
 entire profit. 
 
 There is usually a public announcement of an offering of 
 securities. When an underwriting syndicate has been perfected 
 and an issue of securities is ready for distribution, it is neces- 
 sary to attract the attention of potential investors. This is 
 customarily done by means of a public announcement, which 
 formally calls attention to the amount of the issue, the terms, 
 and the date by which subscriptions must be in. In many cases 
 a great deal of general advertising has been quietly done before 
 the public announcement is made; indeed, the securities may 
 all have been subscribed for in advance, in which case the public 
 announcement might be regarded as superfluous, except that 
 it affords an opportunity to call attention to the significant 
 fact that the bonds have already been disposed of, thereby 
 adding to the prestige of the house or syndicate. The public 
 announcement is aimed at investors en masse, and it is effective 
 in proportion to the attractiveness of the particular issue and 
 the condition of the investment market. 
 
 The subscribers include, as already noted, the houses which 
 have participated in the syndicate, other bond houses, dealers 
 and brokers, and a number of closely associated financial 
 institutions. One writer has listed the following among these 
 associated institutions : 
 
 1. An insurance company and its directors, who, if rich men, will 
 probably buy for their own account some portion of a bond issue 
 that their company has taken. 
 
 2. A firm of bankers or a bank in a smaller city that supplies a 
 local investment demand. 
 
 3. A European group or syndicate that acts as a secondary dis- 
 tributor or buys securities against which it issues its own debentures, 
 as in the case of the Scotch trust companies and the investment 
 associations of Holland. 
 
 4. Individual trustees or lawyers charged with the investment 
 of large estates, who are generally willing to anticipate their require- 
 ments if anything especially choice is for sale.
 
 238 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 5. Trust companies and their correlated banks, whose purchases 
 may be either for the trust funds of the former or as an investment 
 for the deposits of both. 
 
 6. Savings banks, which, taken as a class, are the largest insti- 
 tutional buyers of the classes of bonds to which they are restricted 
 by the laws of the various states. 
 
 The list of the various subsidiary groups among wMch the dis- 
 tributor of bonds finds his best market might be extended almost 
 indefinitely, but those described will give a reasonably clear idea of 
 what may be called the headwaters of the investment stream that 
 must be kept continually flowing into the bond market. 1 
 
 Since each subscription is made in ignorance of the amount 
 that is being subscribed for by other houses, an issue may be 
 considerably over- or considerably undersubscribed. In the 
 case of an oversubscription, allotments of bonds for distribution 
 are made in such proportion as the total number of bonds to be 
 issued bears to the total amount subscribed for. For instance, 
 if an issue has been oversubscribed by 25 per cent, the number of 
 bonds available would be to the number of bonds subscribed 
 for as 100 to 125, or 4 to 5; hence if a house has subscribed for 
 $100,000 of bonds it would be allotted $80,000 and the dis- 
 tributor's commission would be paid on only $80,000. If, on the 
 other hand, the issue is undersubscribed, the subscribing house 
 receives its commission on the amount actually subscribed 
 for. It will be recalled, however, that the receipt of the com- 
 mission is contingent upon the ability of the house to sell the 
 amount for which it has subscribed at a price above its purchase 
 price. 
 
 The second part of the selling program is the more difficult 
 that of convincing individual investors by direct and personal 
 appeal of the soundness and attractiveness of the issue in ques- 
 tion. If the bond market is apathetic or crowded with issues 
 if, as the phrase goes, there are many undigested securities 
 floating around the selling of the entire issue may prove a 
 very difficult and long-drawn-out affair. It involves the use 
 of advertising literature sent through the mails, and to an 
 
 1 Theodore H. Price, The Outlook, CVI (1014), 5Q8.
 
 MARKETING OF HIGH-GRADE SECURITIES 239 
 
 ever-increasing extent it requires expert salesmanship. In 
 former days when the issues of securities were few and when 
 the announcement of a new offering was always an event of 
 importance, advertising literature made an effective appeal; 
 but under present conditions, with a large number of bond 
 houses and with thousands of different issues, the mails are to 
 some extent losing their effectiveness. Much of this advertis- 
 ing literature is consigned to the waste-paper basket by the 
 busy man of affairs without so much as a glance at the offer. 
 Personal appeal through salesmen is increasingly necessary to 
 bring results. 
 
 The following is a typical letter to regular clients and poten- 
 tial purchasers: 
 
 A REMARKABLE OFFERING 
 
 Insuring the Investor 
 Safety of Principal and Income of Practically 8% 
 
 $500,000 
 
 HURLEY MACHINE COMPANY 
 (An Illinois Corporation) 
 
 7% Cumulative Sinking Fund Preferred Stock 
 
 The Hurley Machine Company, established in Chicago eleven 
 years ago, is the World's largest producer of electric washing devices, 
 the "Thor Electric Washing Machine," standing alone in its class 
 as the most efficient in use and protected by valuable patent rights. 
 The vacuum cleaner, also produced by this Company, has tremendous 
 possibilities, as indicated by the sales the week before Christmas 
 of more than 3,000 cleaners. The products manufactured are 
 standard articles in universal and increasing demand for the home. 
 They are so well constructed that expense for repairs is practically 
 negligible. 
 
 Through this new capital the Company is provided with facilities 
 to increase its output from 400 to 600 per cent over its 1917 sales 
 and at a lower unit of cost of production. Each month of its exist- 
 ence the Company has shown an increase in business over the corre- 
 sponding month of the previous year. The Hurley Company 
 products are essential labor-saving devices, particularly necessary 
 under existing conditions. They are a war-time as well as a peace 
 necessity.
 
 240 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 After making every provision for expenses, depreciation, federal 
 income, and other taxes, the NET PROFITS for 1917 applicable to 
 the Preferred Stock AVERAGED EVERY SIXTY DAYS MORE THAN. SUFFI- 
 CIENT TO PAY THE DIVIDEND FOR THE ENTIRE YEAR. 
 
 After allowing for dividends on the Preferred, the Common 
 Stock during 1917 earned more than $15.50 per share, while the 
 dividend rate of 6% per annum is being paid quarterly, January, 
 April, July and October 15, as for a number of years past. 
 
 The connection of Mr. Edward N. Hurley with the enterprise, 
 originated by himself, and an exceptionally able board of directors 
 should insure the continued success of the business. 
 
 PRICE 
 
 The Preferred Stock is offered at $100 per share and accrued 
 dividend from January i, 1918, carrying with it 15% in Common 
 Stock. 
 
 There is a firm bid of $75 per share for the Common Stock and 
 we will pay this price for any of this stock which you may acquire, 
 or we would be willing to purchase or sell any fractional share on 
 the same basis. 
 
 Recommended without qualification by 
 
 JOHN BURNHAM AND COMPANY 
 
 January 26, 1918 
 
 (Company's descriptive folder, including balance sheet, certified by 
 chartered accountant, accompanies the letter.) 
 
 VII. SUNDRY SERVICES OF INVESTMENT BANKERS 
 
 One of the chief problems of any bond house is that of build- 
 ing up a clientele a task which usually requires several years 
 of activity in the cultivation of cordial relations based on service. 
 Investment bankers aim to make satisfied customers by selling 
 only such securities as are safe and at the same time yield a 
 satisfactory interest return. They also render a number of 
 important incidental services to their clients. 
 
 The investment banker often becomes an adviser to his 
 customers and assists them in selecting the best types of securi- 
 ties for their particular requirements. He also furnishes a
 
 MARKETING OF HIGH-GRADE SECURITIES 241 
 
 great deal of general information on all matters pertaining to 
 the investment business, and frequently offers a general inves- 
 tor's service, as distinguished from the special service rendered 
 when a particular security is sold. Bond houses furnish reports 
 to customers on any securities, municipal or corporate, which 
 are of public record; and they answer questions about securi- 
 ties based upon information which the investment house has 
 accumulated and which it believes to be reliable. Tabloid 
 investment lessons are often printed in the columns of news- 
 papers and periodicals, in pamphlets and monographs; and 
 some houses even put out a daily news sheet containing items 
 of interest to investors and suggestive discussions of investment 
 problems. 
 
 While bond houses cannot guarantee the payment of prin- 
 cipal and interest, they sometimes do assume customers' losses. 
 "In some instances losses amounting to hundreds of thousands 
 of dollars have been made good; in many instances the firms 
 have volunteered to pay interest which has been suspended." 1 
 And in every case a reputable house assumes a moral responsi- 
 bility of "seeing the clients through" default, reorganization, 
 etc. It takes the lead at its own expense in upholding the 
 mortgage rights and legal claims of the bondholders. 
 
 Bond houses assist in giving marketability to securities. 
 One of the most interesting developments in connection with the 
 maintenance of the good will of customers is the practice of 
 buying back securities from those to whom they have been sold, 
 thus giving to the securities a ready marketability. While the 
 practice cannot be said to be universal and while circumstances 
 might alter the practice of any given house, it is nevertheless 
 customary for conservative bond houses to agree to repurchase 
 securities at the market price then obtaining, and sometimes 
 at the price at which they originally sold. Some houses state, 
 "We shall put our issues as nearly as possible on a plane of 
 marketability with active listed securities. We make no 
 promises, but, except in times of panic, when it may be impos- 
 sible to raise money to satisfy everybody, we hope and expect 
 
 1 Chamberlain, Principles of Bond Investment, p. 522.
 
 242 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 to be so situated as to buy back at the fair market price the 
 securities we have sold." 
 
 The investment banker also makes it a point to be able to 
 supply his client with any security that he may desire to pur- 
 chase. If the stock or bond required is one of which the house 
 has been a distributor, it will endeavor to repurchase from 
 customer B the securities required by customer A. If the 
 securities sought by the customer have never been handled 
 by this house, it is necessary for the banker to "pick them up" 
 in the market. In order to repurchase securities once sold and 
 to furnish its customers at any time with the securities required 
 it is necessary for the banking house to have funds available 
 for the purpose and to maintain a "trading position" in the 
 investment market. Whenever a house wishes to buy or sell 
 a few shares or bonds of a given issue it gets in touch with 
 other houses which may have such securities on hand or may be 
 able to get them from some of their customers. 
 
 There are also street brokers who make a small commission 
 of 1/16 or 1/8 per cent as go-betweens in the buying and selling 
 of such securities. In the else of an active issue it is of course 
 always possible to buy and sell the securities desired on the 
 stock exchange. But the commissions that must be paid the 
 exchange brokers serve to make the purchase of securities on 
 the exchange a last-resort measure; it is usually cheaper to make 
 use of the street brokers. 
 
 Investment banks also act as financial advisers to corporations. 
 An investment bank not only finances a corporation in its 
 initial stages, at the time of its original organization; it serves 
 the company continuously in connection with refunding and 
 expansion operations. The banker becomes a financial adviser 
 to his client. Additional securities need to be issued from time 
 to time and the banker is in a position to recommend favorable 
 periods for putting out such issues and also to advise as to the 
 best type of security to issue under the existing circumstances. 
 It is not to be understood from this, however, that the larger 
 corporations depend entirely upon any one investment banker. 
 There is competition among the bankers for business; and the
 
 MARKETING OF HIGH-GRADE SECURITIES 243 
 
 wide-awake house studies carefully the financial needs of the 
 various corporations, with a view to acquiring the business 
 of those which have maturing obligations to be refunded or new 
 issues to be sold for the provision of additional funds. 
 
 VIII. CAPITAL REQUIREMENTS AND PROFITS OF 
 INVESTMENT BANKS 
 
 As compared with manufacturing or producing establish- 
 ments the capital requirements of the investment banker are 
 relatively small; they are small even as compared with those 
 of the ordinary commercial or savings bank. Since the invest- 
 ment banker deals merely in credit instruments rather than 
 in concrete material goods, a large plant is obviously unneces- 
 sary ; and since the investing public is largely reached by sales- 
 men and correspondence, the building and equipment are small 
 as compared with those of commercial or savings institutions 
 whose customers must frequent the bank. All that is needed is 
 office space for those who are engaged in the legal, engineering, 
 accounting, and economic analysis that is required and in the 
 preparation of advertising literature. 
 
 As the foregoing description of the investment business has 
 indicated, bond houses are, however, often required to invest 
 their own funds in the securities which they are handling, 
 particularly in connection with the function of underwriting. 
 But the amount of their own capital that is required is not so 
 great as might be expected, for the reason that they are in a 
 position to borrow heavily from the commercial banks, using 
 securities as collateral for the loans. For instance, the under- 
 writer can borrow from 50 to 90 per cent of the value of the 
 securities in his possession, the percentage depending upon the 
 character, particularly upon the marketability, of the securities. 
 
 The profits obtained by investment bankers have evoked much 
 controversy. There has been much discussion of the profits 
 made by investment bankers and it has often been asserted that 
 the returns in this field of enterprise are exorbitant. This 
 view is in part attributable to a failure to appreciate that the
 
 244 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 "spread" between the price paid to the corporation and the 
 price at which the securities are marketed represents gross 
 rather than net profits; and in part it is due to the common 
 practice of generalizing on the basis of a particular instance of 
 handsome profits forgetting the cases where profits were low 
 and even where losses were actually sustained. The truth is 
 that the risks and expenses involved vary widely with different 
 securities and at different times, depending upon the character 
 of the security and the state of the investment market. 
 Accordingly the gross profit, represented by the margin between 
 buying and selling prices, will vary markedly with different 
 issues. The net profits also show extreme variations. 
 
 With all the experience and skill the merchant can bring to 
 bear on his purchases, the conditions under which he works are so 
 complex that he often cannot foresee the outcome. If the hoped-for 
 per cent of profit is not made, the transaction may turn to the loss 
 of many per cent, besides the cost of selling. If a dealer has not 
 been shrewd enough to sell out in advance of falling prices, or does 
 not gauge accurately the duration and rapidity of the decline, he 
 may take heavy losses. Probably no investment banker went 
 through the transition, from the period of rising security prices 
 culminating in 1905 to the subsequent period of declining prices 
 and the panic of 1907, without taking large losses. Bonds bought 
 in the hope of selling at three-fourths of i per cent above the price 
 were sold at a loss of from 4 to 5 per cent. Except in the case 
 of specialty bonds sold through a careful education of the investor 
 in the merits of the particular security, a sale in a declining market 
 must be practically immediate in order to be really profitable. If a 
 dealer misjudges the appetite of purchasers, he gets "hung up" 
 with an issue of securities which the investor will not even masticate, 
 to say nothing of digesting. 
 
 A closing-up of the market, the refusal of investors to purchase, 
 is a common, periodic phenomenon, which becomes particularly 
 acute in London. It takes place whenever investors generally 
 think the present is not a good time to buy. If an investment 
 merchant fails to foresee its coming, he has to carry a heavy burden 
 of securities that he cannot sell. 1 
 
 'Lyon, Corporation Finance, II, 58-59.
 
 MARKETING OF HIGH-GRADE SECURITIES 245 
 
 Granted that underwriters assume large risks, that they 
 may have to buy in the securities at the price stipulated and 
 thus tie up their own capital for a considerable period of time, 
 it is still pertinent to inquire whether on the whole they are not 
 in a position to charge more than the risks and expense and the 
 services performed warrant. The answer to this inquiry will 
 obviously depend upon the extent of competition among under- 
 writers. Given competition, one may be sure that by and large 
 the returns to capital will be no greater here than in other 
 lines of industry. 1 
 
 IX. THE REGULATION OF INVESTMENT BANKING 
 
 The investment banking business has developed as a private 
 enterprise and has been subject only to such legal control as 
 applies to any corporation, partnership, or individual business. 
 That is to say, the law of agency, contracts, etc., relates to 
 investment bankers precisely as to other business. But except 
 where blue sky laws, as outlined in the previous chapter, con- 
 tain provisions relating to securities dealers, there has been 
 no governmental regulation and control of the investment 
 banking business. 
 
 So far as the rank and file of the older bond houses are con- 
 cerned there is probably little occasion for any regulation 
 beyond what is provided by ordinary legal processes. The 
 long-established and conservative bond houses are very much 
 alive to the necessity of eliminating the fraudulent promoter and 
 of safeguarding in every way their own reputation for probity 
 and conservatism. But the number of investment banking 
 institutions has been increasing so rapidly in recent years that 
 there is plenty of opportunity for the practice of fraud and for 
 the selling of highly speculative securities by houses who 
 trade on the reputation that has been built up by the older and 
 more conservatively operated institutions. 
 
 There is need of additional control of investment banking. 
 "As the investment business is now organized," says Paul M. 
 Warburg, formerly chairman of the Federal Reserve Board, 
 
 1 Se chap, xrri for a discussion of the so-called money trust.
 
 246 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 "the writers of investment circulars may emphasize and omit 
 what suits them best, and printed underneath their often 
 meager and arbitrary announcement they insert a statement 
 that the 'information is not guaranteed but is based on state- 
 ments from what they consider to be reliable sources.'" 1 
 
 Mr. Warburg suggests the appointment of a voluntary 
 committee in each Federal Reserve district, 
 
 which would be prepared to examine a prospectus before the securi- 
 ties are offered, and would certify that certain papers necessary to 
 authenticate the facts have been filed .... that it is published over 
 the signature and under the responsibility of the corporation or 
 government issuing the securities, or of the investment house offering 
 the same .... and that important facts have not been omitted. 
 .... If a committee of this character were organized, the public 
 could soon be warned that no security should be considered unless 
 the prospectus or offering showed the certification number of the 
 securities committee of the district. 
 
 Unless something of this sort be done, it is only a question of time 
 for some grave disappointments or scandals to occur, discrediting 
 future issues and interfering with the free and healthy development 
 of our security markets. If, on the other hand, the strong and 
 reputable investment houses, of their own accord, subject themselves 
 to whatever little delay and red tape may be necessary in dealing 
 with their issues, they will, in the long run, best protect their own 
 interests. Because in doing so they will help in keeping the crook 
 out and preserve a clear field for those who are not afraid to have 
 the searchlight turned. upon the securities they are about to offer. 
 
 It will be seen that the argument for the regulation of invest- 
 ment banking is not that all investment banking houses require 
 close supervision, but only that some of them do; and in order 
 to make sure that these shall be effectively regulated it is 
 believed that all houses should gladly submit to regulation- 
 cither by a committee appointed by themselves or by some 
 governmental agency. As has been the case with private com- 
 mercial bankers in times gone by, there will be many efficient 
 
 1 From an address by Paul M. Warburg, delivered before the Bond, 
 Club of New York, May 23, 1919,
 
 MARKETING OF HIGH-GRADE SECURITIES 247 
 
 and time-tried investment bankers who will oppose such regu- 
 lation as an unwarranted interference with private initiative 
 and as entirely unnecessary in their particular cases. But, as 
 has been the case with the commercial banks and other financial 
 institutions, there will nevertheless be a gradual extension oi 
 the scope of investment banking regulation. And it should be 
 welcomed by the conservative institutions ; for the general plane 
 upon which the investment banking business is conducted may 
 thereby be substantially raised. All houses may well be com- 
 pelled to meet at least certain minimum requirements which 
 have been found to be indispensable to efficient investment 
 banking. 
 
 X. INVESTMENT BANKS AND THE GENERAL 
 ECONOMIC ORGANIZATION 
 
 We have thus far been discussing the nature of the opera- 
 tions engaged in and the services performed by investment 
 banks, with only incidental reference to the social importance 
 of such institutions. It remains to indicate the larger signifi- 
 cance of investment banking houses, in relation to the general 
 economic organization of the present time. 
 
 Investment bankers assist in directing the distribution of 
 industrial energy. In the first place, investment bankers play 
 a dominant role in directing the flow of capital and labor 
 between different industries and between different establish- 
 ments in any given industry. As the economic system is now 
 organized, business managers reach a tentative judgment that 
 the development of a new industry or the construction of an 
 additional plant within an existing industry will prove profitable. 
 The proposal for an issue of securities as a means of raising the 
 necessary capital is then submitted to the investment banker 
 for approval. Since the banker occupies a detached position 
 and since he will suffer financial loss as well as a lessening of 
 his reputation for sound and conservative judgment if his 
 estimate of the proposition proves in error, he may be counted 
 on to bring to bear in his investigation and analysis all the
 
 248 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 technical, legal, and accounting knowledge and economic 
 prescience that can be mustered. There is thus every incentive 
 to make the investigation as comprehensive and as penetrating 
 as possible. 
 
 Every year a great many hopeful enterprises are denied 
 funds by those who hold the purse strings. And while mistakes 
 are often made, there is little question but that the veto power 
 resting in the hands of the investment bankers prevents each 
 year much dissipation of capital in fruitless ventures. It is, 
 of course, always possible, in the event a given enterprise is 
 turned down by the conservative investment banking houses, to 
 float the securities without bankers' assistance, through the 
 processes described in the preceding chapter. But despite this 
 possibility, it remains true that the conservative bond house, 
 by virtue of its strategic position in the investment market, 
 is a dominating factor in the distribution of social energy. It 
 will be noted that a banking house may deny an enterprise 
 funds because the men who are back of it are lacking in 
 integrity or business ability, as well as because the enterprise 
 does not promise well from a business standpoint. The invest- 
 ment banking houses thus tend to insure both that the manage- 
 ment of industries shall be in the hands of honest and able 
 men, and that social energy shall be directed into the most 
 profitable channels. 
 
 Under the conditions imposed by the gigantic scale on 
 which industry is now conducted, control of the distribution 
 of capital is a task of paramount importance. Because of the 
 great quantity of fixed capital required, the waste of social 
 energy entailed is enormous whenever an industry proves 
 unprofitable or a large enterprise in any given industry goes on 
 the financial rocks. 
 
 Investment banking lessens the cost of producing goods. In 
 the second place, the investment banker relieves the borrowing 
 corporation of a very difficult and expensive task, that of rais- 
 ing the funds required for its operations. It is conceivable 
 that a corporation, however large, might take care of its own 
 financing that is, issue its own securities, send out adver-
 
 MARKETING OF HIGH-GRADE SECURITIES 249 
 
 Using literature and salesmen, and await the inflow of 
 funds from ultimate investors before beginning its business 
 activities. Most corporations are, however, poorly equipped 
 for the marketing of securities, and the costs involved would 
 be much greater to them than to a regularly organized bond 
 house. 
 
 The advantages possessed by an institution that specializes 
 in the raising of capital are obvious enough. First, it has 
 a great deal of skill in advertising and salesmanship, which can 
 be acquired only as a result of repeated experiences in such work. 
 In the nature of things the acquisition of such skill is out of the 
 question for a corporation, which has the task of raising capital 
 only periodically, perhaps two or three times in a generation. 
 It should be observed that, under these circumstances, it would 
 not be feasible for a corporation to have a specialized "capital- 
 raising department" as a permanent part of its organization. 
 It must accordingly either use relatively unskilled officials for 
 the task of raising capital or employ (at high cost) specialists 
 whenever the necessity arises. Second, a bond house can do 
 much of its advertising of any particular issue along with other 
 issueSj thus dividing the advertising expense involved. In 
 addition to the disadvantages inherent in raising its own 
 capital, the corporation usually finds that the task of organizing 
 the business and making preparation for an effective utilization 
 of the funds to be raised requires its full energy. 
 
 In the third place, and of even greater significance, the 
 investment bankers make it possible for a corporation to 
 enter into contracts and to proceed with the development of 
 its business in the light of definite knowledge, both as to the 
 amount of the funds that will be received and as to the tune at 
 which they will be available. The investment market is 
 capricious; securities may be sold quickly ppssibly sooner 
 than is necessary for the purposes of the corporation and at a 
 favorable rate; or it may be that years will be required for their 
 final absorption by investors, and that the price at which they 
 can be sold will be much below what the corporation had 
 estimated. But the underwriters, as we have seen, guarantee
 
 2 SO THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 to the corporation a definite amount of funds at a definite 
 time. If a corporation did not know in advance what the 
 total quantity of funds would be, it could not be certain, 
 when making contracts incident to the development of the 
 enterprise, that such contracts could be carried out. And 
 if it did not know when its financial resources whatever the 
 total amount would be available, it would have no assurance 
 that its contracts could be fulfilled promptly or that production 
 could be carried out according to schedule. Indeed, the risks 
 involved here would be so great that many an enterprise 
 partly launched would have either to curtail its operations or 
 else completely wind up its affairs, owing, not to any funda- 
 mental weakness on the part of the enterprise, but only to the 
 exigencies of the investment market. Such failures carry in 
 their train a great waste of industrial resources. 
 
 What has been said above with reference to the advantages 
 that investment banks confer upon corporations amounts 
 merely to saying that the underwriting and distributing func- 
 tions serve to reduce substantially the cost of raising capital 
 required by modern large-scale enterprise. This reduction in 
 the cost of capital-raising makes it possible for enterprises to 
 produce more cheaply than would otherwise be the case and, 
 where competition prevails, the result is a lower selling price 
 for the commodities than would otherwise obtain. 
 
 Investment bankers are financial educators. In the fourth 
 place, the investment banking institutions render a social 
 service of inestimable value in educating the general public 
 along. financial lines. Were it not for the hives tment educa- 
 tion that has been given to the American people by invest- 
 ment bankers, through conversations with clients, actual 
 and prospective, through general advertising literature, and 
 through folders and circulars which discuss investment prin- 
 ciples, it is not improbable that the annual losses in this country 
 from fraudulent and worthless investments would be many 
 times their present staggering total. 
 
 Quite as important from the standpoint of economic develop- 
 ment is the emphasis that has been placed by investment
 
 MARKETING OF HIGH-GRADE SECURITIES 251 
 
 bankers upon the necessity for thrift. Where the public 
 schools, the daily press, and the magazines of the country have 
 been generally silent on the subject, the investment bankers 
 have been urging the national importance of eliminating waste- 
 ful and unnecessary expenditures of income hi order to make 
 provisions for the proverbial rainy day, and the necessity of 
 supplying through "saving" the funds required for the develop- 
 ment of new and the expansion of the existing industrial facilities 
 of the country. 
 
 QUESTIONS FOR DISCUSSION 
 
 I. THE DEVELOPMENT OF INVESTMENT BANKING 
 
 1. What were the chief sources of demand for capital in medieval 
 times ? How were these demands met ? 
 
 2. When did investment banking have its origin in the United 
 States ? When was its period of greatest development ? 
 
 3. Why did the development of investment banking institutions 
 wait upon the growth of the corporate form of industry ? 
 
 4. Can you suggest any handicaps to private enterprise before 
 the development of investment banking houses ? to government 
 enterprise ? 
 
 5. The first stage of railway development in the United States was 
 carried out by government rather than by private enterprise. 
 It has been suggested that this was because of the impossibility 
 of raising the necessary capital without the aid of the govern- 
 ment. Might the absence of investment banks in the early days 
 have had some bearing on this ? 
 
 6. In the light of your knowledge of our industrial development 
 suggest the order in which the various types of specialized 
 investment houses probably originated. 
 
 7. "The one big task of investment bankers is to bridge the gap 
 between investors and borrowers to raise funds from a multitude 
 of individual and institutional investors and turn them over to 
 corporations and governments who are in need of them." Into 
 what secondary functions is this task divided ? 
 
 8. Study the chart on page 218 and enumerate as many different 
 groups of people, organizations, and institutions as you can that 
 are interested in or dependent upon investments. 
 
 9. Consult an official of a local bond house or commercial bank and 
 ascertain what functions his institution participates in.
 
 252 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 10. Ascertain, by local inquiry, how many different types of securi- 
 ties are handled by a given investment institution. 
 
 n. Ascertain, by local inquiry, how the smaller corporations in the 
 community have raised their capital. 
 
 H. INVESTIGATION AND ANALYSIS 
 
 12. Which of the various types of securities government, railway, 
 public utility, and industrial do you think present the most 
 difficult problems of analysis ? 
 
 13. Study carefully the chart depicting the various aspects of the 
 problem of bond values. Classify the different questions in the 
 order of their difficulty of correct appraisal. Which do you 
 regard of greatest importance ? 
 
 14. What is meant by the "equity" ? How much, if any, in excess 
 of the amount of the bond issue should the equity of a company 
 be? (Refer back to provisions affecting Class B under the 
 Illinois Securities Law.) 
 
 15. "In analyzing an income account one must observe, particularly, 
 the excess of the total net earnings above the amount of the 
 interest on bonds; and in the case of stocks above the amount 
 of the dividend payments." Why ? 
 
 1 6. Enumerate as many factors as you can which might affect the 
 "condition of the money market"? the general industrial 
 situation ? 
 
 17. Draw up in outline form what you think would be a necessary 
 course of study for one who hoped to be a successful analyst of 
 investment values. 
 
 18. What is meant by a house of original purchase or issue ? May 
 any house make an original purchase ? 
 
 19. What sort of houses tend to specialize somewhat in investigation 
 and first purchase ? 
 
 20. The original purchasers are sometimes called wholesale concerns. 
 Do you think this is a correct description of their activities? 
 Do they have anything to say about the terms on which the 
 retailing is to be effected ? 
 
 m. THE UNDERWRITING FUNCTION 
 
 21. What is the practical necessity for underwriting? Is there a 
 greater necessity with large than with small undertakings ? 
 
 22. May a single house underwrite an entire issue ?
 
 MARKETING OF HIGH-GRADE SECURITIES 253 
 
 23. What would determine whether a given issue would be handled 
 by an individual house or on joint -account ? 
 
 24. What is the difference between a joint-account and a syndicate 
 operation ? What would determine which would be used ? 
 
 25. In the case of a joint -account do the associated houses merely 
 underwrite the issue ? Who sells it ? 
 
 26. What factors would determine the choosing of houses for a 
 joint-account participation ? 
 
 27. When a syndicate is formed, is it merely for the purpose of 
 underwriting an issue ? 
 
 28. Show concretely how a house of original purchase may contract 
 itself out of the risks of underwriting through the organization 
 of a syndicate. 
 
 29. Is it fair for a house of original purchase to take, say, $1.00 per 
 share for its work? Precisely what is the work for which it 
 receives this $i .00 per share ? 
 
 30. "The houses of first purchase do not assume any risks." Do 
 you agree? 
 
 31. "It is usually good policy for a very large investment house to 
 form an underwriting syndicate, even though its resources 
 be sufficient to swing the entire amount, because it is safer 
 to underwrite 5 per cent of twenty different issues totaling 
 $100,000,000 than 100 per cent of a single $100,000,000 issue." 
 If so, why ? 
 
 32. Is it possible for a house to secure the profits incident to original 
 purchase in a larger number of issues, if it does not tie up its 
 full resources in underwriting a single issue ? 
 
 33. Do you understand that an underwriting syndicate is a permanent 
 organization ? 
 
 34. Define: participation, subscription, allotment, "carrying securi- 
 ties." 
 
 35. Is it necessary for underwriters who participate in an issue that 
 is brought out by a house or group of original purchasers to make 
 an investigation of the enterprise ? 
 
 36. Do the original purchasers also participate in the underwriting ? 
 Do you fancy that in practice every underwriting participant 
 makes an independent analysis ? 
 
 IV. THE DISTRIBUTION FUNCTION 
 
 37. Enumerate as many sources of demand for investment securities 
 as possible. Which would be the most easily reached ?
 
 254 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 38. "A bond well purchased is half sold." What does this mean? 
 
 39. "The distributing houses do not assume any risks." Do you 
 agree? 
 
 40. Work out the steps involved in an issue of one million dollars of 
 bonds of Corporation X. Use actual figures and indicate the 
 division of the profits as between original purchasers, under- 
 writers, and distributors. Sell the same issue at a loss and 
 indicate the distribution of the losses. 
 
 41. Does the typical letter to potential purchasers giveji on page 239 
 furnish sufficient data for a reliable judgment ? 
 
 42. What is the purpose of "buying back" securities? Of what 
 advantage is it to the individual investor ? Do you fancy many 
 people would not buy "unlisted securities" if it were not for the 
 marketability given to them by the willingness of the bond 
 houses to buy them back ? 
 
 43. What is the function of the "street brokers" ? Are they "profi- 
 teering" middlemen, or do they render a service greater than 
 the amount of the commissions ? 
 
 44. Why cannot a bond house guarantee bonds? How can it 
 usually assume the losses, in actual practice ? 
 
 45. For what purpose does an investment bank need fixed capital? 
 working capital? 
 
 46. In connection with which function is the largest amount of capital 
 required ? 
 
 47. What other financial institutions are necessary in order to 
 enable the investment banker to engage in underwriting on a 
 large scale ? 
 
 48. Is it necessary for the houses of distribution to have connections 
 with commercial banks ? 
 
 49. What determines the amount of profit an investment bank can 
 make: (a) as a distributor of securities; (6) as an underwriter; 
 (c) as original purchaser ? 
 
 50. "The investment banker must charge enough more than the 
 expenses involved to compensate for the risks assumed and 
 obtain a profit." Does this mean that the costs involved to 
 the corporation in raising its capital are greater than they would 
 be if raised directly by the corporation itself ? 
 
 51. Do you see any dangers in leaving investment banks unregu- 
 lated ? Would you favor federal incorporation ? 
 
 52. Write a summary of the social benefits of the investment banking 
 business.
 
 MARKETING OF HIGH-GRADE SECURITIES 255 
 
 53. How do you account for the development of the investment 
 banking business ? Did society, in any organized capacity, have 
 anything to do with it? 
 
 54. In the exercise of his veto power over the development of a 
 given enterprise, is the investment banker actuated by consider- 
 ations of social well-being? What is the test on which he bases 
 his decision ? 
 
 55. In a socialistic society how would the distribution of industrial 
 energy between different industries be determined? between 
 different establishments in a given industry ? Can you suggest 
 any possible shortcomings in this method ? 
 
 REFERENCES FOR FURTHER READING 
 
 Annals of the American Academy of Political and Social Science, 
 Vols. XXX and XLII. 
 
 Bulletins of the Investment Bankers' Association of America. 
 
 Chamberlain, Lawrence: Principles of Bond Investment, 1911, 
 chap. xl. 
 
 Gerstenberg, Charles W.: Materials of Corporation Finance, 
 pp. 374-76; 404-11- 
 
 Lough, William H.: Business Finance, 1917, chaps, xiv and xv. 
 
 Lyon, Hastings: Corporation Finance, 1916, chaps, ii and iii.
 
 CHAPTER XV 
 
 FOREIGN INVESTMENT TRUSTS 
 
 The marketing of investment securities, as discussed in 
 the preceding chapter, related primarily to the placing of 
 domestic issues in the American investment market, with only 
 incidental reference to the marketing of securities abroad 
 through the participation of foreign bankers in American 
 syndicates. The placing of investments in foreign markets 
 gives rise to problems of peculiar difficulty, owing to the risks 
 and uncertainties involved in loaning at great distances. It is 
 the purpose of this chapter to describe the investment ma- 
 chinery that has been developed by other countries to meet 
 these difficulties and to indicate the problems that now con- 
 front the United States in this connection. 
 
 Great Britain has investments all over tlie world. Great 
 Britain has for so many years been the financial center and the 
 great creditor nation of the world that a brief statement of 
 British overseas financial relations will best reveal the nature 
 of the problem. There are now listed on the London Stock 
 Exchange 1,156 foreign and colonial securities, classified as 
 follows: colonial and provincial government, 185; Indian and 
 colonial city, 176; foreign city, 76; foreign government, 210; 
 railways in British colonial possessions, no; Indian railways, 
 68; American railroad securities, 56; foreign railways, 276. 
 These foreign issues appear to be substantially in excess of 
 the domestic securities traded in on the London exchange. 
 
 The distribution of British foreign investments in 1913 has 
 been estimated as follows: railways, $7,402,014,631.50; 
 governments, $4,669,518,679.50; mines, $1,327,527,668.50; 
 financing land investments, $1,188,336,035.50; municipal, 
 $718,037,475.00; commerce and industrial, $707,258,178.00; 
 tramways, $37 8 >5 6 5>35-; banks, $345,811,648.50. Of the 
 total, $8,662,345,667.50 were invested in India and the British 
 
 256
 
 FOREIGN INVESTMENT TRUSTS 257 
 
 colonies. The United States stood next with $3,672,343,630 . 50; 
 with Argentina a good third at $1,555,163,072.50. Nearly 
 every country in the world was represented, in amounts varying 
 from $30,000,000 .00 in the case of Germany, to $718,000,000 .00 
 in the case of Brazil. The grand total of British foreign invest- 
 ments was placed at $18,075,441,423.50, exclusive of a large 
 amount of capital privately loaned abroad, estimated to equal 
 about $i ,400,000,000 . oo. 
 
 These vast investments have afforded a highly profitable 
 outlet for British savings, which could be reinvested in Great 
 Britain only under conditions of substantially diminishing 
 returns. They have also made possible the development of the 
 railroad systems of the United States, the Argentine, Australia, 
 etc., and have thus opened up for cultivation in all portions 
 of the world vast tracts of rich agricultural lands that must 
 otherwise have long remained unused. They have furnished 
 the funds necessary for exploiting immense stores of minerals and 
 raw materials, thus tremendously augmenting the producing 
 power of the world. Sir George Paish has estimated that the 
 increase in the annual production of wealth in the United States 
 made possible by the investment of foreign capital here has 
 been at least twenty times the sum paid in the way of interest. 
 
 I. BRITISH INVESTMENT TRUSTS 
 
 The overseas investments of Great Britain have largely 
 been effected by means of the investment trust, an institution 
 that has been developed during the past twenty-five years. 
 Because of the long-range investigation that is involved it is 
 usually impossible for the foreign investor to form an adequate 
 judgment of the value of securities; moreover, the very fact 
 of a "foreign" investment leads to timidity. It was to over- 
 come this difficulty, as well as to permit the diversification of 
 investments, and thus minimize the risks involved, in a manner 
 shortly to be described, that the investment trust was developed. 
 
 This institution is based on the law of averages; that is, on 
 the principle that in a group of well-selected securities there
 
 258 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 will be only a few which will result in losses to investors. Hence 
 if a large number of investors can get together, form an organiza- 
 tion to make a thoroughgoing investigation of the corporations 
 whose securities seem attractive for purchase, and with com- 
 bined funds buy shares in a large number of companies, the 
 risks of loss to any one individual will be greatly reduced. 
 
 Individuals may diversify their risks by direct investments 
 in the capital of investment trusts, or they may purchase as 
 outsiders the obligations of these trusts, secured by the invest- 
 ments that the trust has made. Each of these methods may 
 be briefly considered. 
 
 Under the first method the shareholders, or partners, as 
 the case may be, are part owners of all the trust's holdings 
 and are thus entitled to pro rata participation in the aggregate 
 earnings. The trust organization has thus made possible a 
 co-operative investigation of foreign enterprises which reduces 
 the costs of investigation and gives to each individual investor 
 the benefit of the investment experience of the officials of the 
 company. 
 
 Under the second method the securities purchased are held 
 "in trust" by the company and replaced by its own obligations 
 for the purpose of sale to individual investors. The individual 
 thus purchases the obligation of a well-known domestic financial 
 institution, rather than one of a relatively little-known foreign 
 corporation. His security is in effect the combined earnings 
 of all the companies whose issues are held by the trust, in 
 addition to the resources of the trust itself. 
 
 The trusts are usually, though not always, organized on a 
 corporate basis. The size of the trusts in England, as also in 
 Scotland, Belgium, Switzerland, Holland, and Germany, is 
 usually not very large. The largest in Great Britain, for 
 instance, is the British Investment Trust, Limited, of Edin- 
 burgh, which had on the date of its last report $9,300,000 of 
 4 per cent debenture stock (ordinary bonds), $6,000,000 
 of 5 per cent preference, or preferred stock, and $4,000,000 of 
 ordinary or common stock. 1 
 
 1 The total capital of the investment trusts of Great Britain is about 
 $350,000,000.
 
 FOREIGN INVESTMENT TRUSTS 259 
 
 The "trust" makes possible a very wide diversification of risks. 
 The nature of the diversification that is secured by these 
 institutions may best be appreciated by actual reference to the 
 capital holdings of some of the leading British trusts. The 
 Investment Trust Corporation, Limited, of London, for example, 
 shows in its statement for 1917 investments in 315 different 
 securities; the Second Edinburgh Investment Trust, Limited, 
 of Edinburgh, for the same year had 235, and the Metropolitan 
 Trust Company, Limited of London, 220.' Nearly half of the 
 investments of the Metropolitan Trust Company were railways 
 and street railways. About a fifth were government issues, 
 in which there had been a considerable gain due to subscriptions 
 for the successive British war loans. The rest were in the 
 securities of commercial and industrial concerns, electric light- 
 ing plants, and other public works, and in the issues of other 
 investments trusts. No less interesting than their industrial 
 diversification was their distribution by countries. More 
 than a third were in the United States, although the Metro- 
 politan Trust, like other foreign investors, had sold back to 
 this country many of our own securities early in the war. 
 More than a fourth of the investments were at home (an 
 abnormal war condition), but the remainder were spread out 
 over the growing parts of the world, the countries represented 
 in the order of the amount of funds they have attracted from 
 this one investment trust being: the Argentine, British colonies 
 and dependencies, Brazil, Mexico, Central America, other 
 South American countries, the Philippine Islands, Cuba, and 
 other countries. The captain of this investment ship is now 
 turning his eyes to the East and to Africa. 2 
 
 It is of interest to note that certain of our American railroads 
 have been largely owned in the past by these English trusts, 
 while one American industrial company has been distinguished 
 by having its securities in the boxes of twenty-one different 
 English trusts. 
 
 1 Foreign Financing under the Edge Act, a pamphlet published by the 
 Guaranty Trust Company of New York. 
 
 3 Adapted from "Introducing American Investors to the Investment 
 Trust," The World's Work, July, IQIQ.
 
 200 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 There are some trusts which specialize geographically, as in 
 Russian, South American, or Oriental enterprises. And there 
 are others which devote themselves entirely to the securities of a 
 particular industry, endeavoring to reduce the risks not so much 
 by extensive diversification as by intensive analysis of the 
 status of the issuing concern. 
 
 II. THE SHIFT IN AMERICA'S FINANCIAL 
 POSITION 
 
 Throughout the nineteenth century, and in only lessened 
 degree in the first decade of the twentieth century, the United 
 States was a leading market for the capital of the Old World, 
 the great development era in this country requiring, as already 
 noted, more funds than could be provided from local savings. 
 But the Great War suddenly changed the financial balance of 
 the world. The economic requirements of the war were such 
 that it was necessary for France and England, particularly, 
 to utilize their past investments as a means of buying supplies 
 from the United States; and a large percentage of the total 
 of American securities held in Europe was re-sold to the United 
 States during the first two years of the war. 
 
 After the United States entered the conflict we also made 
 loans to the Allies to the extent of nearly $9,000,000,000, a 
 sum which has been increased since the armistice to approxi- 
 mately $10,000,000,000. The events of the war thus made of 
 the United States a creditor nation; and in the view of many 
 this country is to be the future "banker of the world." The 
 thought behind this contention is that the tremendous drain 
 upon European financial and economic resources has rendered 
 it impossible for the nations of Europe to make large external 
 loans for many years to come. On the contrary, it is urged that 
 because of the great reduction in European supplies both of 
 raw materials and capital goods, it is imperative that the 
 European nations assume the role of borrowing rather than 
 lending nations. And the only important source of capital 
 supply is in the United States.
 
 FOREIGN INVESTMENT TRUSTS 261 
 
 European reconstruction was dependent upon American loans. 
 The agitation for the extending of great loans to Europe for 
 reconstruction purposes, both in the form of goods sold on long- 
 time credit and by purchases of the securities of European 
 governments and railways, public utility and industrial enter- 
 prises, began immediately after the armistice was signed. 
 Close students of the question, both in the United States and 
 abroad, early felt that the task of European reconstruction 
 would be extremely difficult, if not impossible, without the 
 financial and material aid of this country, and large foreign 
 loans were repeatedly urged by numerous financial writers. 
 But like other reconstruction proposals, the matter was allowed 
 to drift throughout the winter and spring of 1919. 
 
 Upon the return of Mr. Vanderlip, then president of the 
 National City Bank of New York, from an extended investi- 
 gation of European financial and economic conditions, in May, 
 1919, the need of extending financial assistance to Europe was 
 strikingly presented, both in a public address in New York and 
 in an interesting small volume entitled What Happened to 
 Europe. Mr. Vanderlip 's view in brief was that if Europe 
 were to recover from the enormous losses of the war and escape 
 a complete political and social collapse, it was imperative that 
 the wheels of industry be everywhere started immediately, 
 something which could be accomplished only by means of a 
 vast loan from the United States. But since the securities of 
 individual European enterprises would not find a ready market 
 with American investors, and since every portion of Europe 
 must be given assistance if the specter of bolshevism were to 
 be effectively laid, there must be a pooling of all European 
 resources, whereby one gigantic loan might be extended to 
 Europe as a whole, secured by the joint guaranty of the Euro- 
 pean governments, with liens upon customs revenues. Even 
 then, Mr. Vanderlip believed, the loan would have to be 
 marketed indirectly, through having our government issue its 
 own bonds, backed by these European securities as collateral. 
 
 Such a scheme would obviously require a mobilization of 
 world financial resources on a scale hitherto undreamed of.
 
 262 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 While it challenged the imagination of many American business 
 men and financiers, it nevertheless appeared to be so gigantic in 
 its nature and so difficult of accomplishment that little headway 
 was ever made with the plan. It will be noted that it would 
 involve, among other things, the peaceful co-operation of the 
 former Central Powers with the Allies and the United States, 
 under an arrangement which could not possibly satisfy the 
 nationalistic ambitions of all the parties to the proposed contract. 
 
 Falli.ig exchange rates finally led to constructive legislation. 
 It was repeatedly pointed out by financiers and economists 
 throughout the spring and summer of 1919 that a gradual fall 
 in exchange rates would sooner or later and sooner rather than 
 later cause a sharp curtailment in our exports to European 
 nations. The bearing of depreciated exchanges upon foreign 
 trade is not difficult to see. If French exchange, for example, 
 is quoted at 10.36 par being 5.18 French importers from 
 the United States must pay 10.36 francs for goods valued at 
 5.18 francs, or, to put it in terms of American money, the 
 French must pay $2 for every $i of goods purchased in the 
 United States. Contrariwise, American purchasers in France 
 need pay but $i for $2 worth of goods. Under such conditions 
 exports to France are necessarily discouraged and imports from 
 France encouraged. 
 
 But notwithstanding, the volume of our exports, with some 
 notable variations in the totals, continued to assume record- 
 breaking proportions, and the average "favorable balance of 
 trade " was more than $300,000,000 per month during the year 
 1919. The dire need of European countries for goods was so 
 great that they purchased almost regardless of price. These 
 vast exports were largely sold on credit, extended in part by 
 the American government and in part by American banks and 
 exporting companies. In the meantime the European nations 
 could not pay gold without still further depleting their gold 
 reserves, already quite inadequate to permit the redemption of 
 European currency in specie (see pp. 270-73), with the result 
 that the balance of indebtedness to the United States rapidly 
 increased.
 
 FOREIGN INVESTMENT TRUSTS 263 
 
 As exchange on European countries steadily declined, it 
 gradually became apparent that what the experts had long 
 been prophesying was soon to be a reality, namely, that our 
 foreign trade was to suffer a very substantial reduction in 
 volume. This realization finally led to the passage by Congress 
 on December 24, 1919, of a bill known as the Edge Act, which 
 authorized the establishment of a new type of financial insti- 
 tution for the purpose of international financing, modeled after 
 the English investment trusts. 
 
 HI. AMERICAN INVESTMENT TRUSTS 
 
 As a preliminary to a consideration of the new type of 
 financial institution authorized by the Edge law, it will be 
 of interest to review very briefly our previous policy and situa- 
 tion with reference to foreign financing. Prior to the estab- 
 lishment of the Federal Reserve banking system in 1913, most 
 of our overseas business was financed by London banking 
 houses. The Federal Reserve System made it possible, as will 
 later be shown, for American banks to participate in the short- 
 time financing of exports. 1 
 
 In the belief that finance is an essential hand-maiden to 
 trade, the Federal Reserve Act also provided that any national 
 bank, the capital and surplus of which was in excess of 
 $1,000,000, could, upon* approval of the Federal Reserve Board, 
 establish branches in foreign countries and dependencies. 
 Relatively little was accomplished hi this connection, however, 
 for the risks involved appeared large, and our banks had 
 abundant opportunity to utilize their funds in other ways, 
 particularly after the outbreak of the European war. 
 
 This Act was amended on September 17, 1916, in order to 
 permit national banks with a capital and surplus in excess of 
 $1,000,000 to co-operate in the establishment or ownership 
 of American banks or corporations, principally engaged hi 
 foreign banking, by authorizing the banks to invest in the capital 
 stock of such institutions in amounts not to exceed 10 per cent 
 
 1 See chap. xx.
 
 264 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 of their capital and surplus. While some foreign financing 
 institutions were organized under this law, it was felt that the 
 movement would be greatly accelerated if such corporations 
 were chartered by the federal government, foreign financing 
 being regarded as a matter of national significance. 
 
 The next step in the development of overseas financing was 
 the passage of the McLean Act on September 17, 1919, which 
 permitted national banks, without regard to size, to invest up 
 to 5 per cent of their capital and surplus in the stock of corpora- 
 tions of the kind contemplated by the Edge Bill, then under 
 consideration by Congress. 
 
 The Edge law provides for the federal incorporation and 
 regulation of banking institutions for the purpose of engaging 
 hi international or foreign banking or other foreign financial 
 operations. A capital stock of at least $2,000,000 is required 
 for incorporation. 
 
 The law provides for two different classes of operations. 
 The first consists of commercial banking operations connected 
 with foreign trade. These institutions are, however, not per- 
 mitted to compete with existing banks hi the field of domestic 
 commerce. The second type of operation is investment in its 
 nature and it is this only that concerns us in the present 
 chapter. 
 
 The Edge Act hermits the development of investment trusts. 
 The law authorizes these banking institutions: (i) to purchase 
 and sell, with or without their indorsement or guaranty, securi- 
 ties, including the obligations of the United States or any state 
 thereof, but not including shares of stock, except as hereafter 
 explained; (2) to issue debentures, bonds, and promissory 
 notes under such general conditions as to security and under 
 such limitations as the Federal Reserve Board may prescribe, 
 but in no event having liabilities outstanding thereon at any 
 one tune exceeding ten times the capital stock and surplus of 
 the issuing corporation; and (3) with the consent of the Federal 
 Reserve Board " to purchase and hold stock or other certificates 
 in any other corporation authorized under the Edge Act, or 
 under the laws of any foreign country, colony, or dependency,
 
 FOREIGN INVESTMENT TRUSTS 265 
 
 or of any state, dependency or insular possession of the 
 United States, where such corporation is not engaged in the 
 general business of buying or selh'ng goods, wares, merchandise 
 or commodities in the United States and transacts only such 
 business hi the United States as in the judgment of the 
 Federal Reserve Board is incidental to its international or 
 foreign business." 
 
 The extent of such purchases without the approval of the 
 Federal Reserve Board is limited to 10 per cent of its own capital 
 and surplus, except when the investment is in the shares of a 
 banking corporation, in which case 15 per cent is permissible. 
 
 The idea of these corporations is explained by Senator 
 Edge, the author of 'the bill, in the following language: 
 
 The procedure under the prospective law is simplicity itself; 
 it is merely the application to international trade of the accepted 
 method by which Joe Doe sells his business to penniless Richard Roe 
 and yet obtains actual cash payments in the transaction. The 
 American exporter ormanufacturer may sell his goods to an impover- 
 ished purchaser a foreign government or a private concern. One 
 of the proposed corporations then may accept collateral from the 
 purchaser, acceptable to the Federal Reserve Board, and against 
 this issue debentures to sell to investors, and the money so received 
 will be paid to the American seller. Through the powers granted to 
 these proposed corporations they may accept even mortgages on 
 
 the plants or other real property of the purchasers Thus a 
 
 foreign concern in need of raw material may obtain it by giving a 
 mortgage on its plant, and eventually by turning this raw material 
 into finished product will be able to redeem its collateral and to put 
 aside a little profit besides. 
 
 The importance of such institutions for the extending of 
 long-term credits to European purchasers is expressed by the 
 Guaranty Trust Company of New York as follows: 
 
 Let us suppose, for instance, that a corporation whose properties 
 are in the devastated section of France desires to buy American 
 machinery to start rebuilt factories in operation, and that it desires to 
 buy on credit, giving as security for the purchase price only corporate 
 bonds which mature eight or ten years hence. Even though satisfied 
 as to the safety of the security offered as collateral for the extension
 
 266 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 of the credit, the American manufacturer is in most cases unable 
 to carry it until maturity because this would tie up and deprive him 
 for many years of the use of the capital which he requires in his 
 business. Therefore, the seller is compelled to lose the sale unless 
 the bonds can be quickly converted into cash. It is possible here to 
 relieve the situation by an arrangement made with a corporation 
 organized under the Edge Act to take such foreign securities, advance 
 the cash, and, within such limitations as the law and the Federal 
 Reserve Board prescribe, issue its own notes which could then be 
 offered to the public for investment. By this method the purchaser 
 at once receives the purchase price, and the European buyer obtains 
 the goods. The credit is successfully passed to the American 
 investor. 1 
 
 The principle underlying this law was appjied during the 
 war by the American Foreign Securities Company in making 
 possible a purchase by the French government of $100,000,000 
 worth of supplies from American manufacturers. 
 
 On July 14, 1916, the American Foreign Securities Company was 
 incorporated in Delaware by a group of American bankers, to acquire, 
 by purchase or otherwise, and to hold or dispose of stock, bonds, or 
 obligations of any foreign or domestic government or corporation. 
 On July 18, 1916, the Company entered into a contract with the 
 Government of the French Republic, whereby the Company made the 
 French Republic a loan of one hundred million dollars, bearing 
 
 interest from August i, 1916, and payable July 31, 1919 
 
 The Company not only took the note of the French Government 
 but also insisted that the French Government deposit collateral with 
 the note. To secure the payment of principal and interest of the 
 loan, the French Republic pledged various securities with the Com- 
 pany and authorized the Company to rehypothecate these securities. 
 The value of these securities was calculated to be one hundred and 
 twenty million dollars, and the French Government agreed to pledge 
 from tune to time additional securities so that the calculated value 
 of the collateral should always be 20 per cent in excess of the 
 principal of the loan. The collateral pledge included obligations 
 of the Governments of Argentina, Sweden, Norway, Denmark, 
 Switzerland, Holland, Uruguay, Egypt, Brazil, Spain, Province of 
 Quebec, Suez Canal, and various United States and Canadian 
 
 1 Foreign Financing under the Edge Act (see n. i, p. 259).
 
 FOREIGN INVESTMENT TRUSTS 267 
 
 corporations. Under its authority to rehypothecate these securities, 
 the Company deposited $i 26,526,534 worth of them with "a financial 
 institution" in New York, as trustee, under a trust agreement to 
 secure $94,500,000 of the Company's three-year 5 per cent gold 
 notes, dated August i, 1916, and payable August i, 1919, which 
 notes the Company publicly offered for general sale in July, 1916, 
 at 98 and interest. Throughout the war these notes maintained a 
 high value, and on August i, 1919, they were paid in full. Mean- 
 while the Company paid dividends averaging more than 8 per 
 cent per annum upon its $10,000,000 of capital stock. 1 
 
 American investment trusts are being formed. Several 
 American investment trusts have already been organized. 
 The first in the field was the Foreign Bond and Share Corpo- 
 ration, organized under state law in the spring of 1919. The 
 announcement states: 
 
 The organizers include private banking firms and some of the 
 strongest financial institutions throughout the United States. Among 
 them are Brown Brothers & Co., J. and W. Seligman & Co., Guaranty 
 Trust Company, Chase Securities Corporation, Central Union 
 Trust Company, Columbia Trust Company, Hayden, Stone & Co., 
 all of New York; First National Corporation of Boston, Hibernia 
 Bank and Trust Company, New Orleans; First Trust and Savings 
 Company, Cleveland; Anglo and London Paris National Bank, 
 San Francisco; Mercantile Trust Company, Mississippi Valley 
 Trust Company, and interests associated with the National Bank 
 of Commerce, all of St. Louis; and the Central Trust Company of 
 Chicago. 
 
 A number of subscribers of the Foreign Bond and Share Corpora- 
 tion are now actively identified with the Asia Banking Corporation, 
 Mercantile Bank of the Americas, the American Foreign Banking 
 Corporation, Banco Mercantil Americano de Cuba, the China and 
 Japan Trading Company, and other American financial institutions. 
 For this reason, the new corporation is particularly well qualified to 
 develop American trade, to pass upon the value and to oversee the 
 management of enterprises which it finances. 2 
 
 1 Gilbert H. Montague, quoted in Foreign Financing under the Edge Act, 
 pp. 11-12. Published by the Guaranty Trust Company of New York. 
 
 2 "America's First Investment Trust Makes Its Appearance," National 
 Acceptance Journal, May, 1919, p. 35.
 
 268 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 The second in the field, apparently, is the Foreign Finance 
 Corporation,' organized under the auspices of J. P. Morgan & 
 Company, which will confine its investments to the issues of 
 private corporations. Other trusts with a capital varying from 
 $10,000,000 to $50,000,000, are reported as now being favorably 
 considered. 1 
 
 Regulation of investment trusts appears to be necessary. 
 The need of regulation of these investment trusts is pretty 
 generally recognized. "The trusts have been praised; they 
 have also been criticized, denounced, and exposed." But most 
 students have concluded that they can be very good under 
 good management, while under irresponsible management they 
 offer opportunity for gross abuse of the investing public's 
 confidence. The National City Bank of New York suggests: 
 
 If we are to have an upgrowth of "investment 'trusts" in this 
 country, it would seem advisable to safeguard the public by some 
 protective legislation in advance of abuses. Publicity in regard to 
 holdings has been called for by English critics as a preventive of 
 fraud. It might be feasible to have "trusts " write into their charters 
 of incorporation the plan under which they would operate, stating 
 specifically whether they would trade in securities for a speculative 
 profit, accumulate straight investment, underwrite, or promote 
 enterprises or groups of them, not forbidding or hindering freedom 
 of activity in any character of business, but providing for publicity 
 and the protection of investors against the perversion of their funds 
 out of the use to which they have consented. Holding companies 
 or control schemes might be forbidden, and mergers of "trusts" 
 permitted only under safeguards designed to protect against dilutiot 
 of valuable holdings with worthless securities. "Founders' shares" 
 are designed as a substitute for commissions on the investment 
 business handled by managements for "trusts," the commission 
 thus paid being a permanent share in income instead of a certain 
 per cent of the principal. Our law might well limit the share of 
 "founders' shares" in the income of "trusts" to a moderate per- 
 centage of, say, 5 per cent. The possibilities of abuse of "invest- 
 ment trusts" are so easy that a very careful study of legislation 
 designed to protect investors without hampering honest management 
 
 1 Date of February, 1920.
 
 FOREIGN INVESTMENT TRUSTS 269 
 
 should be made before any considerable development in this kind of 
 financial institution gets under way. The "trust" has the faults of 
 its virtues. Its success depends entirely upon the free skill and judg- 
 ment of the men who manage its investments. A certain measure 
 of supervision and requirement of publicity may not hurt, but the 
 plan is ineffective if the discretion of managers is limited by such 
 rules as govern savings banks and insurance companies. The free- 
 dom of action that managers must have is a constant temptation, 
 as the history of some English "trusts" has demonstrated, for them 
 to use the investors' money in schemes of their own, or for "wildcat " 
 financiers to perpetrate actual fraud, and it is very difficult to prove 
 fraud even in flagrant instances of it. But in the hands of men or of 
 companies of known responsibility and ability, the "investment 
 trust" can be made a powerful machine for comprehensive enter- 
 prises abroad. 
 
 IV. FUTURE OF AMERICAN FOREIGN 
 INVESTMENTS 
 
 There is a very real doubt, however, whether the growth of 
 American investment trusts will be rapid and whether the 
 volume of our foreign investments will show a notable expansion 
 in the next few years. In opposition to the view presented 
 above with reference to the need of extending vast credits' to 
 Europe, a contrary opinion may be advanced, one that is held 
 by many prominent financiers and economists, both in the 
 United States and abroad. 
 
 It is pointed out that the economic relations between the 
 United States and Europe are very different from those that 
 existed during the years of our greatest absorption of European 
 capital. In the first place, the United States was in a position 
 to export large quantities of foodstuffs and raw materials 
 paying therewith the interest on accumulated European 
 investments here and preventing thereby a depreciation of 
 American exchange. At the present time, Europe cannot 
 well offset by exports to us the amount of the annual interest 
 due us, roughly $600,000,000. Nearly all students agree that 
 interest payments must be postponed for many years, if not 
 indefinitely, if the exchanges are to be brought back to an
 
 270 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 equilibrium. So long as this huge interest charge enters into 
 the balance against Europe, exchange rates must remain 
 unbalanced. Moreover, an extension of additional credits 
 to the European countries obviously serves to place them under 
 an ever-growing burden of indebtedness and thus only delays 
 and makes more difficult the task of ultimate readjustment. 
 
 In the second place, the European monetary systems are 
 very seriously deranged, redemption of paper currency in 
 gold having been suspended early in the war. In most of the 
 continental countries, indeed, the depreciation of paper money 
 is quite as notorious as in any of the striking historical examples 
 of fiat currency. In Germany, for instance, the gold reserve in 
 the central bank, in which is impounded practically the entire 
 national supply, is now less than 2 per cent, as against over 
 70 per cent, normally, before the war; and the situation is 
 steadily growing worse. 1 Under such circumstances it is 
 impossible for Europe to allow any considerable export of specie, 
 the means normally relied upon to correct trade and financial 
 maladjustments, for the European monetary systems would be 
 completely demoralized in a few weeks' time if the present 
 scanty gold reserves were much further depleted. 
 
 It is important to bear in mind in this connection that while 
 an excess of American exports over imports is a factor in the 
 present depreciation of the exchanges (see chap, viii), the depre- 
 ciated European currencies are themselves very important, 
 factors in the situation; for we are no longer comparing Ameri- 
 can gold dollars with gold pounds, francs, marks, etc.; we are 
 comparing them with depreciated paper pounds, francs, and 
 marks. 
 
 The chart on the following page indicates the great shift- 
 ing of the world's gold supplies that occurred during the 
 war, as a result of the dire needs of the European belligerents for 
 supplies. If Europe's depleted gold resources should be 
 further reduced by gold exports, the vast amount of paper 
 currency outstanding in Europe would be depreciated still 
 
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 272 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 further than at present, with a resulting disastrous effect upon 
 the exchange rates. It is accordingly urged that the only 
 means whereby any of these countries with depleted exchanges 
 can hope to rectify trade balances and restore the gold standard 
 is by immediately bending every energy toward increasing 
 exports and decreasing imports as much and as rapidly as 
 possible. Reduced consumption, the elimination of all non- 
 essential activities, and unremitting work are regarded as the 
 only means to economic salvation. 
 
 It should be noted that the twelve billion dollars that 
 Europe now owes to the United States involves an annual inter- 
 est charge, to be met by the export of goods, of nearly six 
 hundred million dollars, 1 making no allowance for the repay- 
 ment of the principal of the indebtedness, before an inflow of 
 gold to Europe can be secured. It may be observed also that 
 in the case of Germany, since indemnity payments must take 
 the form of exports, the excess of exports over imports must 
 be greater than the amount of the indemnity payments to the 
 allied countries before an influx of gold will Be possible. 
 
 A study of the accompanying chart, showing the redistribu- 
 tion of the world's gold supply during the war, will help to 
 visualize the problem of international economic readjustment. 
 There cannot be a restoration of normal international com- 
 mercial and financial operations until the world's gold supply is 
 in considerable measure redistributed among the commercial 
 nations of the earth and until trade and financial relations are 
 restored substantially to the pre-war basis. This will doubt- 
 less require many years to accomplish; and it is certain to 
 involve many grave problems of adjustment, not the least of 
 which is the effect of a large outflow of gold upon the reserves of 
 American banking institutions, upon the level of prices in the 
 United States, and in consequence of both of these factors upon 
 American industrial activity. Further consideration of this 
 question is to be found in chapter xxvi below. 
 
 1 This is assuming we insist on interest payments. The student should 
 also bear in mind that there are other than trade factors which figure in 
 the international scalepans. Refer back to chap. viii.
 
 FOREIGN INVESTMENT TRUSTS 273 
 
 In the third place, it is also pointed out by many students 
 that a stage has now been reached when, even if it were wise to 
 make large loans to Europe, the risks involved have become 
 virtually prohibitive. The great depreciation of the foreign 
 exchanges, the increasing depreciation of continental paper 
 money, the disruption of the general European economic organi- 
 zation, with fundamental industries such as transportation and 
 public utilities in a deplorable condition, taken in conjunction 
 with the widespread industrial and political unrest, make it 
 highly improbable that American investors would now be 
 willing to assume the risks involved in large European loans, 
 particularly in view of the preferred investment opportunities 
 at home. The longer the delay in providing machinery for 
 the extension of foreign credits, the weaker has become the 
 European credit position. 
 
 Finally, it is urged that the American financial and industrial 
 situation is now such that it would be undesirable, if not impos- 
 sible, from the American standpoint to make large credit 
 extensions to Europe. Mainly as a result of the rapid rise of 
 prices in this country, the supplies of available funds are now 
 inadequate to provide for European needs and at the same 
 time to meet our own financial requirements in connection 
 with raising new capital for railroad, public utility, housing, 
 and other construction activities. There is a notable scarcity 
 of capital for the needs of business. 1 Readjustments that 
 appear to be in store for us may in the course of a year or so 
 conceivably alter this situation; but for the present it is believed 
 that we are virtually estopped from any large participation in 
 overseas loans. 
 
 In this chapter we have been considering certain of the 
 international aspects of the financial organization of society. 
 What now is to be said by way of conclusion as to the efficiency 
 with which the international financial system performs its 
 part in promoting the economic development of the world ? 
 
 'This is mainly reflected in very low bank reserves. See chap. xxv.
 
 274 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 What of its adaptability to the varying requirements of the 
 international economic organization ? 
 
 We have seen how the system of credit, assisted by invest- 
 ment trusts and the stock exchange, has enabled the people of 
 England, for example, to utilize their capital resources in 
 promoting the economic development of the remote and back- 
 ward regions of the earth, thus enlarging the field within which 
 economic specialization may be carried out and increasing 
 thereby the volume of wealth production throughout the 
 world. There would seem to be little doubt that so far as 
 purely economic considerations are concerned this "financial 
 exploitation" has been distinctly advantageous. 
 
 We have also found, however, that the economic rehabili- 
 tation of the world following the Great War presents a problem 
 of extraordinary difficulty; and some of this difficulty, it would 
 seem, may fairly be attributed to the financial system itself. 
 The very fact that international trade is dependent upon the 
 international exchanges renders it practically impossible for the 
 world to do in this time of acute economic crisis what most 
 needs to be done. Depreciated exchanges, as we have seen, 
 render the cost of imported goods virtually prohibitive to those 
 countries which stand in greatest need of imports. And 
 depreciated exchanges, it should be recalled, reflect not only a 
 present excess of imports over exports; even more they reflect 
 accumulations of past indebtedness and the depreciated cur- 
 rencies of the various European countries. Should Europe 
 be forced to undergo, perhaps, a generation or more of near 
 chaos economic and social merely because the depreciated 
 exchanges left as a legacy of the war make it practically impos- 
 sible, financially speaking, for the United States and other 
 little afflicted countries to furnish the materials required for 
 European reconstruction ? From the viewpoint of enlightened 
 self-interest the rest of the world cannot afford to take the stand 
 that Europe must pay the piper; for because of the inter- 
 dependence of nations under the world-economic organization 
 of the present, the economic collapse of Europe could not 
 fail to produce very serious economic consequences throughout
 
 FOREIGN INVESTMENT TRUSTS 275 
 
 the world; it is clearly to the interest of the rest of the world 
 almost as much as to that of Europe that Europe be placed on 
 her feet, economically speaking, at a very early moment. But 
 unfortunately the state of the exchanges renders this consum- 
 mation virtually impossible of achievement. 
 
 It is not without significance in this connection that numer- 
 ous efforts have been made since the war to circumvent the 
 financial barrier to international trade that is imposed by the 
 depreciated exchanges through a resort to a species of inter- 
 national barter. In order to enable German manufacturers 
 to procure raw materials certain Dutch concerns, for example, 
 have shipped raw materials to Germany under an agreement 
 that the German manufacturers will subsequently pay for 
 the materials by reshipping to Holland a specified amount of 
 finished product. Some of the international financing cor- 
 porations recently organized in the United States hope to 
 stimulate American export trade and the economic recovery 
 of Europe by supplying materials particularly to Germany, 
 Austria, and the Balkan states which are there to be worked 
 up into finished products and sold under the supervision of 
 American financial interests. There are obviously some very 
 interesting political problems relating to the economic control 
 involved in this method of restoring European economic life. 
 It remains to be seen, however, to what extent either of these 
 interesting and suggestive devices will prove a practicable 
 substitute for the ordinary financial method of conducting 
 international business. 
 
 As a means of lessening the depreciation of the exchanges 
 and facilitating thereby the importation of the materials 
 required for European reconstruction, the cancellation of 
 allied indebtedness to the United States and of the German 
 indebtedness to the allies has been urged by numerous students. 
 But the utter lack of understanding on the part of even ordi- 
 narily well-informed people of the fundamental principles 
 involved makes such a suggestion seem absurd, if not criminal. 
 Shall those who brought on the war be permitted to escape 
 the financial penalties they so richly deserve! And shall the
 
 276 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 United States donate twelve billions of dollars to our former 
 allies, who are even now perfecting their plans to undersell us 
 in all the markets of the world, including our own! It is too 
 much to expect the "unseen forces" which we have been 
 discussing to stand in the balance against such apparently 
 conclusive considerations as are suggested in these current 
 exclamations. The pecuniary system here again tends to 
 obscure the underlying economic factors which alone are 
 important. 
 
 But even if indemnities were foregone and international 
 debts canceled, the exchanges would still not be completely 
 restored to par for the reason that the depreciated currencies 
 of Europe would not thereby be corrected; hence a purely 
 financial barrier would still serve to impede the process of 
 world-economic recovery. So long as nations organize their 
 economic activities on the basis of currency systems the founda- 
 tion of which is the gold standard, disruptions of these currency 
 systems will inevitably entail very serious economic conse- 
 quences and render peculiarly difficult the conduct of inter- 
 national commercial operations. 
 
 All this is not to argue, however, that the financial system 
 should necessarily be abandoned. For we must always reckon 
 with alternatives; and notwithstanding its apparent short- 
 comings under conditions such as we have been discussing, it 
 may still be found that all things considered the financial 
 mechanism is superior to any other that could be suggested. 
 It is, however, not a part of our present task to speculate upon 
 this interesting subject. We must remain content with the 
 portrayal of the actual working of the system of international 
 finance in the world as it is now organized, with pointing out 
 its shortcomings as well as its elements of strength in perform- 
 ing the tasks assigned to it.
 
 FOREIGN INVESTMENT TRUSTS 277 
 
 QUESTIONS FOR DISCUSSION 
 
 1. How do you account for the pre-eminence of Great Britain in the 
 field of foreign investment ? 
 
 2. Indicate the economic consequences of British foreign invest- 
 ments to (a) Great Britain, (b) to the countries in which the 
 investments were placed. 
 
 3. State the essential principle of the investment trust. 
 
 4. Does the investment trust always sell its own obligations to an 
 investing public ? 
 
 5. What is the security of an individual who invests in fo'reign 
 securities through the intermediation of an investment trust ? 
 
 6. Enumerate the factors which led to a shift in America's financial 
 position during the war from a debtor to a creditor nation. 
 
 7. Review the last part of chapter viii on the effect of the war on 
 the European exchanges and then summarize the causes of the 
 present depreciation of foreign exchange. 
 
 8. Look up the present exchange rates on the leading European 
 countries. Compute the effect in each case on the cost of 
 imported goods. 
 
 9. Just how would the development of American investment trusts 
 affect exchange rates ? 
 
 10. State the important principles of the Edge law. 
 
 11. Describe concretely what security you would have in purchasing 
 one of the bonds of an institution organized under the Edge law. 
 
 12. What regulation and supervision do you think is needed for the 
 control of investment trusts ? 
 
 13. Two schools of thought have developed in connection with the 
 relationship of America to European reconstruction: one holds 
 that vast loans must be made by the United States to Europe ; 
 the other that the only remedy for the situation is European 
 thrift, hard work, and the early development of favorable trade 
 balances for the European belligerents. With which do you 
 agree ? 
 
 14. "To grant large loans would be an unwise and uncharitable 
 policy for all parties concerned, because it would push nearer the 
 precipice both debtor and creditor country instead of leading 
 them in the opposite direction toward gradual recuperation." 
 Discuss.
 
 278 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 15. "Europe cannot greatly increase exports without large imports 
 of raw materials, and prices of raw materials are prohibitive in 
 view of present exchange rates." What would be your way 
 out of the dilemma ? 
 
 16. What effect would the cancellation of indemnities and niter- 
 national debts have upon exchange rates? Would you favor 
 such cancellation ? 
 
 17. "For the vast number of American consumers, a recession of 
 prices is of infinitely greater importance than boosted exports sold 
 at high prices to purchasers whose natural limit of credit has been 
 fairly exhausted." Discuss. 
 
 1 8. What conclusion do you draw from a study of the chart on page 
 271 showing the shift in the world's gold supply during the war ? 
 
 19. Do you conclude that the emergence of the United States as a 
 creditor nation is an unmitigated good fortune? 
 
 REFERENCES FOR FURTHER READING 
 
 America's Opportunity. A booklet published by the Mechanics 
 and Metals National Bank, New York. 
 
 Foreign Financing under the Edge Act. A pamphlet published 
 by the Guaranty Trust Company of New York. 
 
 Kahn, Otto H.: Impressions from a Journey in Europe. A 
 pamphlet distributed by the Committee of American Business Men, 
 47 West 34th St., New York. 
 
 Keynes, J. M.: The Economic Consequences of the Peace, chaps, 
 v-vii. 
 
 Vanderlip, Frank A.: What Happened to Europe? 
 
 Warburg, Paul M. : "Europe at the Crossroads," Political Science 
 Quarterly, December, 1920. 
 
 Boss, John F. and Moulton, Harold G: America and the Balance 
 Sheet of Europe, chap, xix
 
 CHAPTER XVI 
 
 THE STOCK EXCHANGE AND CAPITAL 
 RAISING 
 
 In the chart on page 136 showing the financial institutions 
 associated with the raising of capital under modern conditions, 
 the stock exchange was placed at one side and designated "a 
 great central market place." The reason for this, as already 
 indicated, is that the exchange is not a direct intermediary 
 between the borrowing corporation and the lender of funds, its 
 services being rather of an indirect nature. We shall find, 
 however, that the stock exchange is of vital importance to 
 practically all of the institutions that make up the financial 
 structure of society. 
 
 In considering the importance of the stock exchange from 
 the point of view of capital raising, it will not be pertinent to 
 enter upon a discussion of the evils of speculation, manipulation, 
 "wash sales," the ethics of future trading, the system of "puts 
 and calls," etc. The purpose here is merely to reveal the 
 part that the stock exchange actually plays in connection with 
 the process of capital raising. 
 
 I. HISTORY OF STOCK EXCHANGES 
 
 The rise of stock exchanges is directly associated with the 
 development of the corporation as a capital-raising device. 
 From the moment shares of stock were issued by corporations, 
 trading in them by both investors and speculators began. " No 
 sooner were there bits of paper to deal in than jobbers or brokers 
 sprang up to handle them, and by natural gregarious processes 
 these dealers gathered in one spot." The nature of the earliest 
 stock speculation in England is described in the quotation from 
 Bagehot given on pages 144-46 above. Twenty years later 
 there developed a great speculative mania, which culminated in 
 
 279
 
 280 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 the South Sea Bubble of 1717. In this early speculation jobbers 
 and brokers first congregated on the rotunda of the Bank of 
 England and at the Royal Exchange, which had been estab- 
 lished for the purpose of exchanging abraised and clipped, 
 foreign and domestic coins. Later, as the business expanded, 
 neighboring streets an,l coffee houses were utilized, and 
 Exchange Alley, Old Jonathan's Coffee House, Corn Hill, 
 Lombard Street, and Sweeting's Alley became the centers of 
 activity. When Old Jonathan's burned down in 1748, New 
 Jonathan's, located in Threadneedle Street, succeeded it. 
 By common consent of the brokers who traded there, New 
 Jonathan's was converted in 1773 into The Stock Exchange, 
 which was "wrote over the door." 
 
 The New York Stock Exchange, as at present organized, is 
 the result of more than a century of evolution. The first 
 organization of stock brokers in the metropolis dates from 
 1792, though it was not until 1817 that the organization assumed 
 a very definite form. The rules and regulations governing its 
 operations have been modified and extended from time to time 
 to meet the changing requirements of a rapidly expanding 
 industrial and financial system. 
 
 The New York Curb, or outside market, really antedates 
 the New York Stock Exchange, the latter indeed having been 
 an outgrowth of street trading in the eighteenth century. Long 
 before the organization of the Stock Exchange in 1792, a group 
 of brokers was accustomed to congregate daily around a tree in 
 the old-time financial district of New York and there execute 
 orders for customers. The incorporation of these brokers into 
 a formal organization did away for a time with outside trad- 
 ing; but under varying conditions and more or less continu- 
 ously there has been curb trading throughout the nineteenth 
 century. It was not, however, until the great development in 
 stock operations, brought about by the great era of corporate 
 development and financial consolidation beginning about 1898, 
 that the Curb market became of real importance. It now 
 affords a public market place where persons can buy and sell 
 securities which are not listed on any organized exchange.
 
 THE STOCK EXCHANGE AND CAPITAL RAISING 281 
 
 The Consolidated Stock Exchange was organized in 1875 
 for trading in mining securities; but it altered its name, as well as 
 the scope of its business, in 1886. At the present time by far 
 the greater part of the trading on the consolidated exchange 
 is in securities that are listed upon the New York Stock 
 Exchange. The Consolidated also deals in shares, however, 
 that are not listed on the main exchange, as well as in certain 
 mining securities that are excluded therefrom. It further 
 differs from the big exchange in that it makes a specialty of 
 broken lots, that is, transactions in less than one hundred 
 share units, which is the minimum on the regular exchange. 
 
 The average annual sales of shares of stock on the New York 
 Stock Exchange in the decade 1899-1909 was 196,500,000, at 
 prices which involved an annual average turnover of $15,500,- 
 000,000. During this same decade bond transactions averaged 
 about $800,000,000 a year. This is at the rate of about 650,000 
 shares per day of a par value of $100 for stock, and about 260,000 
 one-hundred-dollar bonds. During the great stock market 
 activity of the summer of 1919, as high as 2,000,000 shares 
 were traded in a day, while for many weeks the daily sales never 
 were less than a million shares. Curb transactions were roughly 
 as follows for the year 1908 : bonds $66,000,000; stocks, of which 
 90 per cent were industrials, $46,595,000. The sales on the 
 Consolidated Exchange average around 50,000,000 shares per 
 annum. 
 
 H. THE ORGANIZATION OF EXCHANGES 
 
 The New York Stock Exchange is a voluntary association, 
 limited to 1,100 members, of whom about 700 are active. 
 Of the remainder, some are residents of other cities. Member- 
 ships on the Exchange have usually been sold for about $80,000, 
 though a record of more than $100,000 was recently established. 
 Numerous prominent capitalists hold memberships merely for 
 the purpose of availing themselves of the reduced commission 
 charges which the rules authorize between members. The 
 Exchange as such does no business; it merely provides facilities 
 to members, and regulates their conduct, Insuring that all
 
 282 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 transactions are conducted in accordance with the highest 
 standards of business integrity. The governing power is an 
 elective committee of 40 members. 
 
 The patrons of the Exchange have been divided into the 
 following groups: 
 
 i.. Investors, who personally examine the facts relating to 
 the value of securities or act on the advice of reputable and 
 experienced financiers and pay in full for what they buy. 
 
 2. Manipulators, whose connection with corporations issu- 
 ing or controlling particular securities enables them under 
 certain circumstances to move the prices up or down, and who 
 are thus in some degree protected from dangers encountered by 
 other speculators. 
 
 3. Floor traders, who keenly study the markets and the 
 general conditions of business and acquire early information 
 concerning the changes which affect the value of securities. 
 From their familiarity with the technique of dealings on the 
 exchange and ability to act in concert with others and thus 
 manipulate values, they are supposed to have special advan- 
 tages over other traders. 
 
 4. Outside operators having capital, experience, and knowl- 
 edge of the general conditions of business. Testimony is clear 
 as to the result which in the long run attends their operations. 
 Commissions and interest charges constitute a factor always 
 working against them. Since good luck and bad alternate in 
 tune, the gains only stimulate these men to larger ventures, and 
 they persist in them till a serious or ruinous loss forces them 
 out of the "Street." 
 
 5. Inexperienced persons, who act on interested advice, 
 " tips," advertisements in newspapers, or circulars sent by mail, 
 or "take flyers" in absolute ignorance and with blind confi- 
 dence in their luck. Almost without exception they eventually 
 lose. 1 
 
 The "listing" of securities is a safeguard against fraud 
 and irregularities. Before securities can be traded in on the 
 
 1 From report of Governor Hughes's Committee on Speculation in 
 Securities and Commodities (1909), Money Trust Investigation, pp. 2186-87.
 
 THE STOCK EXCHANGE AND CAPITAL RAISING 283 
 
 exchange they must be listed by a committee of the Stock 
 exchange which passes on applications. The Hughes Com- 
 mittee on Speculation states the importance of listing in the 
 following language: 
 
 While the Exchange does not guarantee the character of any 
 securities, or affirm that the statements filed by the promoters are 
 true, it certifies that due diligency and caution have been used by 
 experienced men in examining them. Admission to the list therefore 
 established a presumption in favor of the soundness of the securities 
 so admitted. And securities authorized to be bought and sold on 
 the Exchange which have not been subjected to such scrutiny are 
 said to be hi the unlisted department, and traders who deal in 
 them do so at their own risk. 1 
 
 The "Committee on Stock Lists" lays down detailed 
 requirements with reference to the engraving and printing of 
 bonds and shares, the form in which these securities shall be 
 made out, and the specific information that must be recited 
 on the securities, the purpose being to prevent the counter- 
 feiting of securities. The application for listing must be 
 accompanied in the case of stocks by the following and other 
 papers: copies of the charter of incorporation; by-laws; leases 
 and special agreements; copy of resolutions of stockholders 
 authorizing issue; certificate of proper public authority for 
 issue; opinion of independent counsel as to legality of (a) organi- 
 zation, (b) authorization, (c) issue, (d) validity of the securities; 
 detailed distribution of securities; certificate of registrar 
 showing amount of securities registered; report of a qualified 
 engineer covering actual physical condition of property; map of 
 property; contemplated expansion; specimens of all securities 
 to be listed. The requirements with reference to bonds are 
 even more detailed, owing to the many different kinds of 
 mortgage liens and the rights of bondholders thereunder. 
 The cost of listing is $50 for each one million dollars or fraction 
 of the par value of securities. With securities of no par value, 
 it is $50 for each ten thousand shares, 
 
 *Ibid., p. 2190.
 
 284 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 A corporation whose shares are listed on the exchange 
 must agree to publish and submit an annual report to its 
 stockholders at least fifteen days before its annual meeting, 
 showing an income account and balance sheet of itself and 
 of constituent and subsidiary conpanies which it owns or con- 
 trols. The report must also contain a statement of the physi- 
 cal condition of the corporate properties at the tune. 
 
 The Consolidated Exchange has a membership of 1,527, 
 about 450 of whom are active. Methods of conducting business 
 here are very similar to those at the stock exchange. It is of 
 note that strained relations have existed between the two 
 exchanges since the lesser one undertook in 1886 to' deal in 
 other than mining shares. In cases where the Consolidated 
 Exchange permits dealing in shares which are not listed on the 
 Stock Exchange, as noted above, it prescribes a form of listing 
 requirements. It appears, however, that securities are seldom 
 listed before actual trading in them has begun. 
 
 The Curb market 1 is an important auxiliary institution. The 
 New York Curb market is held in the open air and now occupies 
 a section of Broad Street, where an inclosure is made in the 
 center of the road by means of a rope, within which the traders 
 are supposed to confine themselves, leaving space on each 
 side for street traffic. During the period of active trading, 
 however, the crowd often extends from curb to curb. There are 
 about 200 subscribers, of whom about 150 appear on the Curb 
 each day, together with about an equal number of messenger 
 boys and clerks. Many of the members of the Curb are also 
 members of the New York Stock Exchange, and a large pro- 
 portion of its business about 85 per cent comes through the 
 offices of members of the New York Stock Exchange. The 
 reason why this trading remains on the street is, interestingly 
 enough, that the constitution of the New York Stock Exchange 
 prohibits its members from engaging in any transaction in any 
 other authorized stock exchange in New York. If the Curb 
 were put under a roof and definitely organized as an exchange, 
 the bulk of its trading could not be maintained without a 
 revision of the constitution of the Stock Exchange. 
 
 'In 1921 the curb market was moved indoors.
 
 THE STOCK EXCHANGE AND CAPITAL RAISING 285 
 
 The services performed by the Curb have been stated as 
 follows: 1 
 
 "First, it is the market place for the issues' of many of the 
 industrial, mining, and miscellaneous enterprises that are con- 
 stantly being created. 
 
 "Second, it provides a ready market for the securities of 
 small concerns whose capitalization may be of relatively 
 moderate size. With par values ranging from ten cents to 
 twenty-five dollars, a satisfactory market for these securities 
 would be impossible but for the existence of the Curb market, 
 notwithstanding that these securities possess a relative merit 
 in many cases as great as those listed on the regular exchange. 
 
 "Third, it affords facilities for holders of securities that are 
 not listed on either board to get accurate quotations thereon 
 and to market their holdings quickly when so desired. The 
 Standard Oil stocks, which admittedly rank as high-class 
 issues, are included in this group." 
 
 Curb securities are obviously not listed; and, on the whole, 
 the opportunities for abuse and fraud are, therefore, greater 
 than on the regular Stock Exchange. It is important to note, 
 however, that many securities have been graduated after a 
 period of seasoning from the Curb market to the organized 
 Stock Exchange. 
 
 III. THE BROKERAGE BUSINESS 
 
 The purchase and sale of securities on the Stock Exchange 
 is participated in by the members of the Exchange and their 
 agents. While for many years the members acted only in the 
 capacity of brokers, at the present time many of them are princi- 
 pals as well as agents, trading on their own account as well as 
 for their customers. The following statement by a well-known 
 New York brokerage house outlines the methods by which 
 stock exchange operations are carried out : 
 
 i. Purchasing outright. There are two methods of buying or 
 selling stocks through members of the New York Stock Exchange, 
 
 1 From a pamphlet by Edward E. Epps & Co., curb securities dealers, 
 New York.
 
 286 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 viz., buying or selling outright for cash, and buying or selling on 
 margin. 
 
 When purchasing stock outright, or what is commonly termed 
 "for cash," a person pays the entire cost of the stock plus commission, 
 | of i per cent (or 12^ cents per share). For instance, if one pur- 
 chased 100 shares of United States Steel at 70 he would pay $7,000 
 plus commission, $12.50, total $7,012.50, and a certificate for the 
 loo shares would be delivered to him in due course. When stocks 
 are purchased outright it is customary to have them transferred to 
 the name of the buyer, especially if the stock is one upon which 
 dividends are paid, the same being paid to the party in whose name 
 the certificate is made out. At times, however, the purchaser desires 
 to leave the stock with the broker in order to facilitate its sale when 
 desired, and the certificate is placed in an envelope marked as property 
 of the owner to be delivered when called for. In this case the stock 
 is often left in the broker's name and the customer is credited with 
 the dividend when payable, or a check for that amount is forwarded 
 to him. Thus the buyer receives the dividend but does not have the 
 trouble of endorsing the certificate and sending it to the broker when 
 he desires to sell. Non-dividend paying stocks when purchased out- 
 right are also often left in the original "street name," as a certificate 
 endorsed by a stock exchange house is a good delivery at any tune 
 one may wish to sell and he has no trouble about endorsing, wit- 
 nessing, etc. 
 
 2. Purchasing on margin. When purchasing on margin, the 
 broker buys the stock, paying for same in full, but loans the customer 
 a certain amount, holding the certificates as collateral and charging 
 interest on this debit balance. The difference between the amount 
 loaned and the purchase price is deposited by the customer, being 
 what is commonly termed "margin." The customer may at any 
 tune pay off this loan, together with any interest which may have 
 accrued since the purchase, and take up the stock. Ten points, that 
 is, $10 per share, is the usual amount required on a majority of 
 stocks, and the broker will carry same as long as the market price 
 is sufficient to protect him. This does not mean that he will 
 carry the stock until a sale is made at the exact limit of the 
 margin, however, as he might not be able to obtain that amount 
 if he attempted to sell. For instance, if United States Steel 
 were purchased at 70 on a lo-point margin, the broker would 
 call for additional margin when the market price was, say, approxi-
 
 THE STOCK EXCHANGE AND CAPITAL RAISING 287 
 
 mately 65, and if no further additional margin was forthcoming after 
 notification, he would hold same to within from one to two points of 
 the limit or until whatever time he might deem it necessary to sell 
 for his own protection. The round commission of per cent must 
 be figured out of the ten points, together with whatever interest 
 may have accrued on the money loaned. Many figure that stock 
 is held to the exact limit of the margin, but it must be remembered 
 that while there might still be a margin of a fraction or even a point 
 at the close of the day, the market might open off more than that 
 the next morning and the broker be unable to close out the commit- 
 ment except at a loss to himself. Many of the inactive stocks also 
 have wide quotations, and sales might be one, two, or three, or more 
 points apart, thus affording no opportunity to sell at the desired 
 figure. The distance which a stock will be carried depends to a 
 great extent upon the condition of the market and the character of 
 the stock. Even active stocks which in ordinary times would be 
 carried to within from one to two points of exhaustion could not be 
 carried on such a small margin in panicky times when there is a 
 chance that they might open off several points the following morn- 
 ing. A customer is, of course, always given every opportunity to 
 deposit additional margin, which should always be done when it has 
 been reduced to approximately five points, whether a margin call 
 is received or not, it being assumed that a person either long or short 
 of stock is sufficiently interested to keep track of market movements. 
 There is no limit to the length of time stocks may be carried on 
 margin as long as the amount of margin is sufficient to protect the 
 .broker. 
 
 We have endeavored to point out the features of marginal trading 
 which ofttimes lead to discussion and annoyance to both broker and 
 customer, but if a customer understands marginal requirements 
 fully, it is often the most convenient and profitable manner of trading 
 if conservatism is observed. For instance, one may believe that a 
 certain stock is due for an advance and have only sufficient funds 
 to purchase, say, 50 shares, but is enabled to take 100 shares by 
 borrowing the difference from the broker. When the stock advances 
 he may procure just double the profits he would have if the stock 
 were purchased outright. He thus has a 50 per cent margin, which 
 should be a very conservative amount on a stable stock and is in 
 the same position as a man who purchases a house and secures a 
 mortgage thereon.
 
 288 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 We would require ten points ($10 per share) margin on a majority 
 of stocks, but will accept five points on some low-priced issues having 
 a ready market for purchase or sale, although even more than ten 
 points is often necessary on some of the very high priced shares, or 
 stocks which have a very wide market, that is, in cases where the 
 bid and asked prices are far apart and fluctuation apt to be abnormal. 
 If only this minimum amount be provided for, one may obtain 
 profits many times as great as if purchasing the stock outright, but 
 we always endeavor to impress upon our customers the advantage of 
 a heavier margin. The greater the number of points with which 
 a customer fortifies his account, the greater is his protection against 
 possible adverse market movements. 
 
 3. Selling outright. In selling stock held outright in a customer's 
 name, the customer must endorse the certificate, spelling the name 
 exactly as it is spelled on the face and have same witnessed, but 
 should fill in none of the other blank spaces on the back of the certif- 
 icate. The commission for selling is the same as for buying, and in 
 addition the seller pays taxes of 4 cents per every $100 par value, 
 which is levied by the state of New York and the federal govern- 
 ment. 
 
 4. Selling margin stock. When selling stock is held on margin, 
 the customer simply gives the order to the broker, who sells the stock, 
 delivers the certificate, and credits the customer's account with the 
 proceeds, less commission and state and federal taxes. 
 
 In selling stock short, the broker sells the stock, borrows it, and 
 delivers same on regular delivery day. The margin required is the 
 same as when purchasing stock, but is a protection against a rise in 
 the market instead of a decline. If the market reacts, the customer 
 may repurchase the stock at a lower figure, his profits being the 
 difference between the sale price and the purchase price, and if the 
 market advances and he buys in, or "covers," at a higher figure, 
 his loss is also the difference between the sale price and the purchase 
 price. This is simply the reverse of purchasing stock and then selling, 
 the sale being made first and the purchase later. When the stock is 
 covered, the broker returns same to the party from whom he originally 
 borrowed it. No interest is charged a customer on the transaction, 
 except when the stock is loaning at a premium because of a great 
 scarcity; that is, when he is forced to pay a certain amount for the 
 privilege of borrowing the stock. This, however, is a very rare 
 occurrence.
 
 THE STOCK EXCHANGE AND CAPITAL RAISING 289 
 
 5. Deliveries. When stock is bought or sold, the certificate is 
 not delivered until the following day, at which time the purchasing 
 broker pays the selling broker the amount due. Stocks or bonds 
 purchased on Friday or Saturday are not deliverable until Monday, 
 as Saturday is a non-delivery day. It is necessary for the broker to 
 receive from a customer at least a deposit against the purchase of 
 the stock before the stock is bought, as he obligates himself to take 
 the stock from the other broker on the regular delivery day, and if 
 any unforeseen accident occurs to the customer overnight, preventing 
 him from paying for the stocks, the broker would have to take it 
 himself and stand any loss which might be incurred by a possible 
 decline in the market price. When stock is sold, payment is not 
 received until the next day, when it is delivered. It is necessary, 
 however, for the broker to have the stock in his possession before 
 selling, unless it is a short transaction. 
 
 6. Stop loss orders. Stop loss orders are used by a great many 
 traders to limit the amount of possible loss on any transaction and 
 ofttimes save one from losing his entire margin. A stop loss order 
 for the purchase or sale of a stock means that the purchase or sale, 
 as the case may be, is to be made "at the market" when a certain 
 price is reached. For instance, if United States steel is selling at 70, 
 and an order is placed to sell one hundred shares at 68 stop, it means 
 that when a sale of one hundred shares or more is made on the Stock 
 Exchange at 68 or less, 100 shares are to be sold "at the market," that 
 is, at the best price obtainable. At times, however, it might close 
 above 68 one day and open below 68 the next morning, or even during 
 the day might break from a price above to below 68 without a sale at 
 that figure, in which case the stop loss order would be executed as 
 soon as a sale was made under 68. Conversely, if an order is given 
 to buy 100 shares at, say, 72 stop, it means that 100 shares are to 
 be purchased "at the market" when a sale of 100 shares or more is 
 made at 72 or higher. 
 
 7. Commissions and other charges. Our commission charges for 
 transacting on the Stock Exchange are f per cent for buying and 
 J per cent for selling, which is equal to \2\ cents per share/except 
 in the case of mining shares selling below $10, upon which the charge 
 is -rV per cent, but the minimum charge upon any transaction is$i. The 
 commission on outside securities varies according to the selling price. 
 
 Interest is charged on any unpaid balances, the rate being 
 governed by the prevailing money rates, the size and activity of the 
 
 'This charge is now 15 cents per share.
 
 290 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 account, the amount of margin maintained, and the character of the 
 stock in question, having ranged from 3 per cent to 6 per cent during 
 the past year. 1 We can, of course, make more favorable rates upon 
 stocks which we can readily place in loans with a bank than on those 
 upon which we cannot borrow money, and must, therefore, lie idle 
 in our safe deposit vault. 
 
 Interest is credited the customer on daily balances of over $500 
 which are awaiting investment. Aside from the fact that we require 
 a deposit on all orders many find it both convenient and profitable 
 to leave their funds on deposit with us pending stock or bond trans- 
 actions, inasmuch as they receive interest on daily balances, whereas 
 at times they lose interest when they have to withdraw their funds 
 from a savings bank, where interest is allowed only on money left 
 until a certain date. 
 
 Broker's organizations make it possible to speculate by wire. 
 A large part of all the stock bought and sold in the Wall Street 
 offices of brokerage firms is of course for the account of operators 
 who live in New York. But in addition to this the large 
 brokerage concerns have a remarkably extensive telegraph 
 system whereby orders are gathered from far distant points. 
 The "wire map" of any one of a half-dozen or so of the large 
 houses looks like a complete railroad guide of the United 
 States. One particular firm reaches by private leased duplex 
 wire from its main Wall Street office to such cities as Baltimore, 
 Washington, Charlotte, Charleston, Atlanta, Savannah, 
 Augusta, Jacksonville, New Orleans, Memphis, Chicago, 
 Cleveland, Cincinnati, Omaha, Colorado Springs, Denver, 
 Salt Lake City, Butte, Spokane, San Francisco, Pasadena, Los 
 Angeles, Coronado Beach, and San Diego. It also has wire 
 connections to Boston, Portland, Montreal, Toronto, Detroit, 
 Gary, Indianapolis, Louisville, St. Louis, Kansas City, Mil- 
 waukee, St. Paul, and Winnipeg. This particular firm has 
 six branches in the state of California alone. These wires may 
 connect with branch offices or merely with correspondent firms. 
 
 The relative importance of this outside business may be 
 judged from the following figures. On two successive days in 
 
 'This was written in 1916. With the present (1920) enormously high 
 money rates the charges are proportionately higher,
 
 THE STOCK EXCHANGE AND CAPITAL RAISING 291 
 
 the summer of 1919, 75,ooo and 60,000 shares respectively 
 were handled by branch offices; while 38,000 and 46,000 
 shares respectively were handled by the main office in New York. 1 
 The extent of this "outside" participation in New York Stock 
 Exchange speculation is, of course, very much increased in times 
 of active bull markets, such as prevailed in the early summer 
 and again in the autumn of 1919. 
 
 Brokerage offices are storehouses of information. These 
 brokerage houses render a great deal of service both to specula- 
 tors and investors. Through weekly market letters sent out to 
 their customers, they furnish reliable information bearing on 
 inactive and unlisted securities; they give the history of the 
 corporations issuing particular securities, together with a survey 
 of the commodities markets and other pertinent facts as they 
 relate to the values of the issues in question; they present 
 general data on stock market developments of the week; 
 and they discuss (often with no little bias) the probable trend 
 of the market in the light of general economic and financial 
 conditions. 
 
 Some of the brokerage concerns which deal in highly specu- 
 lative issues traded in on the Curb and the Consolidated Ex- 
 change have developed elaborate organizations. For instance, 
 one of the large houses engaged in the marketing of "Curb, 
 mining, oil, and industrial securities" has a large number of 
 branch offices in various parts of the United States connected 
 with the main office by a leased wire system. It secures "wire" 
 news relating to the industries in question from correspondents 
 in the field, and it distributes a weekly market letter, containing 
 from 7,000 to 10,000 words, to between 15,000 and 20,000 
 investors, actual and potential. It has also developed a report 
 system, which, as a result of several years of accumulation, 
 affords a fairly comprehensive record of mining history in this 
 country. From these data special reports are made to interested 
 clients on the history of mining corporations. One company 
 avers that it is "prepared at a few hours' notice to furnish 
 
 1 Data taken from an article by Albert W. Atwood, Saturday Evening 
 Post, June 21, 1919.
 
 292 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 complete detailed reports on more than 750 mining securities" 
 reports which embrace corporate history, financial and physical 
 statistics, details of mine development, including estimates of 
 tonnage, progress of the work, and equipment. Upon written 
 request it issues to interested clients special letters and special 
 telegrams bearing on developments affecting the value of their 
 holdings. 
 
 There is need of more adequate regulation of the brokerage 
 business. Evils arise, however, in connection with many of 
 these brokers, for there is opportunity for fraud here, as in the 
 case of the sale of securities for investment purposes. The 
 literature sent out by "fly-by-night" brokerage houses makes 
 quite as interesting and instructive reading as that of the 
 promoter of speculative and fraudulent companies, and the 
 losses of the victims of such alluring literature are quite as 
 stupendous as those of the dupes of promotion swindles. There 
 are many brokerage houses which have been in existence for a 
 generation, whose fraudulent dealings have eventually been 
 made the basis for legal action and penalty. 
 
 Among the evils of the brokerage business must be noted 
 the operations of the so-called bucket-shops. These are 
 ostensibly brokerage offices; but securities are neither bought 
 nor sold in pursuance of customers' orders, the transactions 
 being closed by the payment of gains or losses as determined by 
 price quotations. They are thus merely places for the regis- 
 tration of bets or wagers. The bucket-shop machinery, more- 
 over, is generally controlled by the keeper, who is in a position 
 to delay or manipulate the quotations at will. Despite the 
 fact that bucket-shops are illegal and that their operators are 
 punishable by fine and imprisonment, it has been very difficult 
 to check their operations, particularly in periods of great 
 speculative activity.
 
 THE STOCK EXCHANGE AND CAPITAL RAISING 293 
 
 IV. ECONOMIC FUNCTIONS OF THE STOCK 
 EXCHANGE 
 
 The stock market makes possible investments for short periods. 
 The functions performed by the organized stock exchanges in 
 connection with the raising of capital for corporations are 
 numerous. In the first place, the fact that the exchange pro- 
 vides a market where shares and bonds can be readily disposed 
 of induces a great deal of investment in securities that would 
 otherwise not occur. Many individuals, business firms, and 
 corporations have on hand funds that are temporarily not 
 required, either because of seasonal variations in the volume 
 of business or a general dulness of trade. By virtue of an 
 organized market these funds may be invested in securities, 
 with assurance that the securities can at any time be recon- 
 verted into cash at the market price then current. In the 
 absence of the stock market these funds would either remain in 
 idleness or be deposited in commercial or savings banks, where 
 the interest return would be substantially lower. 
 
 It may be noted, in passing, that the operations of commercial 
 and savings banks and insurance companies are to a large extent 
 dependent upon the Stock Exchange. In providing a market 
 for securities it makes it possible for these financial institutions 
 to accept the funds of customers, convert them into paying 
 investments with the risks widely distributed, and yet remain 
 in a position to pay depositors on demand or short notice and to 
 meet insurance obligations with promptness and certainty. 
 The relation of the commercial bank to the stock market will 
 be more fully discussed in chapter xxiv below. 
 
 The stabilization of securities' values safeguards and pro- 
 motes investment. In the second place, the activities of specula- 
 tors result in price quotations which reflect with a fair degree 
 of accuracy the relative investment merits of different types 
 of securities. Specialized financial experts devote their energies 
 unceasingly to a scrutiny of values; "bulls and bears, bankers 
 and brokers, speculators and investors, all over the world bid 
 and offer against each other by cable and telegraph and record
 
 294 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 the epitomized result of their bidding in the prices current on 
 the stock exchange." 
 
 While personal gain is the motive of these speculators, the 
 net result of their activities is to give general stability to stock 
 market prices and to reveal the relative investment values of 
 the different issues. It is to be noted that the larger the number 
 of operations and the greater the number of securities traded in 
 on the various exchanges, the more accurate becomes the stock 
 exchange index of values. 
 
 The effect of this is also to stabilize the prices of securities 
 in different markets. This is most clearly revealed in con- 
 nection with international securities, such as the bonds of the 
 principal governments and of large corporations, like the 
 Pennsylvania Railroad and the General Electric Company of 
 Germany. For bonds of this class 
 
 the telegraph keeps prices at almost exactly the same level in all the 
 stock exchanges of the world. If the price of one of them rises in 
 New York or in Paris, in London or in Berlin, the mere news of the 
 rise tends to cause a rise in other markets; and if for any other reason 
 the rise is delayed, that particular class of bonds is likely soon to be 
 offered for sale in the high-priced market under telegraphic orders frorc 
 the other market, while dealers in the first market will be making 
 telegraphic purchases in other markets. These sales on the one hand, 
 and purchases -on the other, strengthen the tendency which the price 
 has to seek the same level everywhere ; and unless some of the markets 
 are in an abnormal condition, the tendency soon becomes irresistible. 1 
 
 This equalization of values in different markets, with the 
 published price quotations of all the securities traded in, makes 
 it possible for an individual, wherever located, to buy or sell 
 securities at prices which reflect fundamental values. Thus 
 the holder of securities listed on the Stock Exchange is 
 
 exposed to no fraud and is at the mercy of no rumor and no 
 unscrupulous dealer. He has positive assurance that in case of 
 necessity, at a moment's notice, he can obtain at the prevailing 
 price the value in cash of every stock exchange security in his box. 
 The ticker gives him instantaneous quotations; all the newspapers 
 
 
 
 1 Alfred Marshall, Principles of Economics, I (4th edition, 1898), 403.
 
 THE STOCK EXCHANGE AND CAPITAL RAISING 295 
 
 publish authorized prices for his benefit He knows, more- 
 over, that the price thus established is not merely the opinion as to 
 value today, but that it represents a critical look into the future. 1 
 
 The result of this stabilizing of securities' values and the 
 publishing of quotations is to encourage the investment of funds 
 in corporate securities by great numbers of people who would 
 otherwise not be in a position to ascertain with any degree of 
 accuracy what price should be paid for securities and who would 
 also be unable to protect themselves from fraud and sharp 
 dealings. It also promotes the development of a world financial 
 organization, the concrete evidence of which is best shown by 
 reference to the list of over eleven hundred securities which are 
 traded in on the London Stock Exchange, representing industries 
 in all parts of the world. 
 
 The service of pecuniary accounts in directing the flow of 
 capital is made effective by means of the stock exchange. In the 
 third place, the stock market facilitates the profitable distribu- 
 tion of capital among different industries, among different 
 plants in a given industry, and among different countries and 
 regions of the world. In chapter ii we discussed the role of 
 the pecuniary unit in this connection. It is now in point to 
 note that the distribution is worked out through the purchase 
 and sale of shares of stock and bonds which find quotations in 
 terms of the pecuniary unit on the organized exchanges. The 
 fluctuations in the prices of different securities, being reflections 
 of fundamental underlying conditions, indicate in general in 
 what directions capital can find its most profitable investment. 
 If the earnings of the railroad companies are low and the outlook 
 for the future dark, the low prices of bonds and shares resulting 
 from speculative activities make it clear to investors that rail- 
 roads do not offer a promising field for future investment. 
 Incidentally it is also made clear to rate-controlling commissions 
 that, if capital is to be attracted into the railroad industry, 
 rates must be readjusted to a level which will permit railroad 
 profits. If, on the other hand, the earnings of automobile 
 
 1 Van Antwerp, The Stock Exchange from Within, p. 22.
 
 296 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 concerns are very large, the high prices of automobile securities 
 indicate the opportunity for large profits in the automobile 
 industry and capital is attracted into that line. The stock 
 market index of values thus facilitates the movement of capital 
 to the places of greatest temporary demand. 
 
 While there are often miscalculations and over-hopeful esti- 
 mates of the future, and while there may at times be manipulation 
 which results in a false picture of the situation, the nature of 
 the service that is performed in this connection by the stock 
 exchange will be clear if one reflects as follows: 
 
 Suppose for a moment that the stock markets of the world were 
 closed, that it was no longer possible to learn what railways were 
 paying dividends, what their stocks were worth, ,how industrial 
 enterprises were faring whether they were loaded up with surplus 
 goods or had orders ahead. Suppose that the information afforded 
 by public quotations on the .... exchanges were wiped from 
 the slate of human knowledge; how would the average man, how 
 would even a man with the intelligence of a Pierpont Morgan, 
 determine how new capital should be invested ? He would have no 
 guide except the most isolated facts gathered here and there at great 
 trouble and expense. A greater misdirection of capital and energy 
 would result than has been possible since the organization of modern 
 economic machinery. 1 
 
 Stock speculation "carries" and "tests" the merits of unsea- 
 soned securities. Finally, one of the greatest functions of the 
 stock exchange is that of "carrying" masses of new securi- 
 ties during their seasoning period. In the event that a new 
 issue of securities does not go well and remains unsold at the 
 expiration of the underwriting agreement, it becomes necessary 
 for the underwriters either to carry these securities on borrowed 
 funds in the hope of a favorable turn in the market or to sell 
 them at a convenient opportunity and pocket their losses. The 
 stock market provides the means either for holding or disposing 
 of the securities. 
 
 If the underwriters decide to carry the securities, they 
 must, as indicated in the preceding chapter, borrow heavily 
 
 1 Charles A. Conant, Wall Street and the Country, pp. 02-93.
 
 THE STOCK EXCHANGE AND CAPITAL RAISING 297 
 
 from the commercial banks. This they are enabled to do only 
 because the stocks and bonds in which they are dealing are a 
 satisfactory collateral security for bank loans, hi consequence 
 of their ready salability through the mechanism provided by 
 the stock exchange. In case the underwriters elect to dispose 
 of their holdings, it is obvious that the stock market provides 
 the opportunity. 
 
 The securities that are unloaded by the underwriters, 
 moreover, become subject to speculative activities, largely 
 through "margin" trading, with the commercial banks again 
 furnishing a large percentage of the funds required. Many 
 securities, particularly those of a highly speculative nature, 
 are also traded in on the curb before any of them are purchased 
 for investment, these operations again being made possible 
 mainly by margin trading on borrowed funds. 
 
 These unmarketed, or "undigested," securities may remain 
 subject to speculative activity for considerable periods of time, 
 not infrequently for several years, depending upon the state of 
 the investment market and the character of the security in 
 question. This speculation, conducted with funds borrowed 
 from commercial banks on amply margined collateral security, 
 thus makes it possible for a corporation to procure the funds 
 required in developing its business, even though its securities 
 do not as yet commend themselves to ultimate investors. 
 The corporation is thus enabled gradually to demonstrate by 
 industrial achievement its merits as an enterprise. Meanwhile 
 the subjecting of its securities to the test of speculation gradually 
 serves to indicate their actual value and thus to induce indi- 
 viduals to "pick them up" for investment purposes. 
 
 It should be observed that at this place the analysis ties 
 back with that in the chapter on the marketing of low-grade 
 or speculative securities. Here is clearly one way of raising 
 capital for untried enterprises that does not place the risks 
 upon the investing public. It is, moreover, a method of 
 very great importance; for many of the high-grade stocks of the 
 present time that are held largely by investors, have passed 
 through a probationary period as purely speculative issues.
 
 2gS THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 It has been estimated, indeed, that stock speculation served as 
 a means of furnishing probably the largest share of the fixed 
 capital that was used in the great period of industrial expansion 
 following 1898. The volume of stocks and bonds that was 
 annually being issued by new corporations far outran the 
 absorbing power of the investment market, and hundreds of 
 millions in securities could not be sold to ultimate investors. 
 The National City Bank of New York estimates that in 1900 
 over 60 per cent of the stock of our largest corporations whose 
 securities were listed on the New York Stock Exchange was 
 held hi the names of stock brokerage houses and represented 
 speculative accounts. "The history of the capitalization of 
 our leading corporations shows that new stock issues almost 
 invariably run through a period in which they are largely held 
 by the speculative public in brokers' names (on funds borrowed 
 from the commercial banks), the proportion so held gradually 
 diminishing through a number of years as the investment 
 buyers gradually purchase them to keep. " 
 
 Stock markets, investment banks, commercial banks, 
 speculators, and investors are thus intricately related to the 
 process of marketing corporate securities; and the entire 
 mechanism would break down if any of its interdependent 
 parts should cease to function. In the absence of a securities' 
 market borrowing corporation and investing public including 
 savings banks and insurance companies would alike be with- 
 out an indispensable index of relative values. Without both 
 the stock market and the commercial banking system, under- 
 writers and distributors of securities would find it impossible 
 to conduct their operations. The stock market could not 
 perform its function in "carrying and testing" unseasoned 
 securities in the absence of commercial bank loans to specu- 
 lators; and the commercial banks, hi turn, could not make 
 loans to speculators if it were not for the stock exchange, which 
 at once indicates the value of the collateral offered as security 
 for the loans and makes possible its ready sale in case of need. 
 The full significance of the part that the commercial banks 
 play in the process cannot, however, be made clear until we have
 
 THE STOCK EXCHANGE AND CAPITAL RAISING 299 
 
 studied the commercial banking mechanism in some detail. 
 We shall also find that the stock exchange performs a very 
 important r61e in connection with the raising of working capital. 
 
 QUESTIONS FOR DISCUSSION 
 
 1. "The Stock Exchange provides a market for the purchase and 
 sale of securities of relatively high grade. The Curb and the 
 Consolidated Exchange furnish a market place for the purchase 
 and sale of securities of low grade and in small lots." Do you 
 think that the Consolidated Exchange and the Curb market are 
 less important than the Stock Exchange ? 
 
 2. Show in what way the stock market is of service to each of the 
 financial institutions with which it is connected in the chart 
 on page 136. 
 
 3. Do the requirements for listing stock on the New York Stock 
 Exchange insure that the stocks quoted will have a high value ? 
 Precisely what is the advantage of these "listing" requirements ? 
 
 4. What is meant by: bulls? bears? speculators? brokers? 
 
 5. What is meant by short selling ? How is delivery of the securities 
 effected ? 
 
 6. If short selling were prohibited, would there be as accurate an 
 adjustment of the prices of securities to their real values ? 
 
 7. Would it be possible to have a stock market and quotations of 
 shares without a pecuniary unit of values ? 
 
 8. What is meant by margin trading ? Of what significance is it ? 
 
 9. What sources of information as to stock and bond values are 
 available for the general public ? 
 
 10. Consult the financial section of your daily newspaper, the Com- 
 m-ercial and Financial Chronicle, the New York Evening Post 
 (Saturday edition), and the Wall Street Journal; and write a 
 statement of the nature of the information there available. 
 
 11. Are the weekly market letters, daily newspaper quotations, 
 special quick news, and "ticket services" of importance to the 
 investor or only to the speculator ? 
 
 12. What are the services rendered by brokerage houses? How do 
 they make their earnings? 
 
 13. What is the purpose of the leased wire system? 
 
 14. What are bucket shops? Specifically how do they differ from 
 brokerage offices ?
 
 3<x> 
 
 15. Show concretely how the stock exchange aids in directing the 
 distribution of capital. 
 
 1 6. If the stock market indicates that larger returns are to be derived 
 from investments in industries that are manufacturing luxuries 
 than in those that are producing necessities, and capital (and 
 labor) are in consequence directed in increasing amounts to the 
 luxuries trades, is the result necessarily socially advantageous ? 
 
 17. Enumerate as many groups of people or institutions as possible 
 that make use of the stock exchange. 
 
 1 8. In what ways does the stock exchange promote investment ? 
 
 19. "If it were not for speculation in securities, a large percentage of 
 the issues of newly organized corporations would not be ulti- 
 mately absorbed." Why ? 
 
 20. Several years of speculation often result in the adjusting of stock 
 prices at a very low figure, due to the low earning power of the 
 issuing corporation. In a case of this kind, speculation finally 
 ceases, and it is impossible to induce the investing public to 
 purchase the securities for investment. Who has borne the 
 loss in such a case ? What is the economic advantage of such 
 speculation ? 
 
 REFERENCES FOR FURTHER READING 
 
 Conant, Charles A. : Wall Street and the Country, 
 
 Emery, Henry C.: Speculation on the Stock and Produce Ex- 
 changes of the United States. 
 
 Fayant, Frank H.: Some Thoughts on Speculation. 
 
 Van Antwerp, William C.: The Stock Exchange from Within. 
 
 Report of Governor Hughes's Committee on Speculation in 
 Securities and Commodities (1909). Published in Money Trust 
 Investigation, 1913.
 
 CHAPTER XVII 
 
 TRUST COMPANIES AND THE MODERN 
 FINANCIAL SYSTEM 
 
 In many respects the most interesting financial institution 
 of the present day is the trust company. The growth of these 
 institutions, called into being to meet the diverse requirements 
 of a capitalistic economic system, has been nothing short of 
 phenomenal during the past forty years, and especially since 
 the era of financial consolidation which began with the turn of 
 the century. Popularly confused with the type of business 
 organization that was declared illegal under the Sherman Anti- 
 Trust law, the trust company is, in truth, only a new kind of 
 financial institution that has developed to fill the gaps in a 
 hitherto incomplete financial structure. In the course of its 
 evolution, however, it has not only rounded out the financial 
 system; it has invaded the field of most of the other financial 
 institutions as well. The trust company has thus been felici- 
 tously designated "the department-store of finance," and "the 
 omnibus of financial institutions." 
 
 The first trust companies in the United States, organized 
 early in the last century, combined the business of insurance 
 with that of trustee for individuals and estates. Now, however, 
 all forms of insurance except fidelity and suretyship have been 
 taken over by the regular insurance companies; and even these 
 two are more and more being surrendered to specialized fidelity 
 institutions. Although the rapid increase in the number and 
 size of private fortunes and estates in the second half of the 
 nineteenth century has greatly expanded the volume of trustee 
 business for individuals, it has been the growth of the corpora- 
 tion which has given the trust company its largest and most 
 distinctive field of enterprise. The great variety of ways in 
 which the trust company is of service to the corporate system 
 of finance will be revealed below. 
 
 301
 
 $02 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 I. THE SCOPE OF TRUST COMPANY OPERATIONS 
 
 The nature and variety of financial operations engaged in 
 by trust companies may be seen from a summary of the powers 
 conferred upon such institutions by the law of the state of 
 New York: 
 
 1. Banking: A trust company may 
 a) Receive deposits of money. 
 
 6) Lend money on. real or personal securities. 
 
 c) Accept for payment at a future date drafts drawn upon 
 it by its customers. 
 
 d) Buy and sell exchange, coin, and bullion. 
 
 e) Discount and negotiate drafts, promissory notes, bills of 
 exchange, and other evidences of indebtedness. 
 
 /) Issue letters of credit authorizing the holders thereof to 
 draw drafts upon it or its correspondents at sight, or upon 
 time not exceeding one year. 
 
 g) Give its bonds or obligations when moneys, or securities 
 for money, are borrowed or received on deposit, or for invest- 
 ment. 
 
 2. Investment: A trust company may 
 
 Purchase, invest in, sell stocks, bonds, bonds and mortgages, 
 and other securities. 
 
 3. Agency: A trust company may act as 
 
 a) Fiscal agent, transfer agent, registrar of the United 
 States, any state, municipality, body politic, or corporation, 
 and in such capacities may receive and disburse money, trans- 
 fer, register, and countersign certificates of stock, bonds, and 
 other evidences of indebtedness. 
 
 b) Attorney in fact for any lawful purpose, for any person 
 or corporation (foreign or domestic). 
 
 c) Agent. 
 
 d) Agent for married women in respect to their separate 
 property. 
 
 4. Fiduciary: A trust company may 
 
 Take, accept, execute any and all such legal trusts, duties, 
 powers of whatever description, not prohibited by law, as may
 
 TRUST COMPANIES AND THE FINANCIAL SYSTEM 303 
 
 be granted to, confided in, conferred upon, intrusted to, trans- 
 ferred to, vested in it by any court of competent jurisdiction 
 or surrogate, and may act under the order or appointment of 
 such court, as 
 
 a) Guardian, receiver, trustee of the estate of any minor. 
 
 6) Depositary of moneys paid into court whether for the 
 benefit of any minor, person, corporation, party. 
 
 c) Trustee, guardian, receiver, committee of the estate 
 of any lunatic, idiot, person of unsound mind, habitual 
 drunkard. 
 
 </) Receiver, committee of the property or estate of any 
 person in insolvency or bankruptcy proceedings. 
 
 e) Executor of or trustee under the last will and testament, 
 or administrator with or without the will annexed, of the estate 
 of a deceased person. 
 
 /) In any other fiduciary capacity. 
 
 For person, persons, municipality, body politic, corporation 
 (foreign or domestic), or authority by will, grant, assignment, 
 transfer, or otherwise, it may act as 
 
 a) Executor or trustee under will or deed. 
 
 b) Trustee for married women in respect to their separate 
 property. 
 
 c) Trustee under marriage settlements. 
 
 d) Trustee under separation agreements. 
 
 e) Depositary under stipulations between persons engaged 
 in litigation. 
 
 /) Depositary in escrow of cash, securities, agreements. 
 
 g) Depositary under lease contracts. 
 
 K) Depositary under syndicate and reorganization agree- 
 ments. 
 
 *) Depositary or agent of voting trustees under voting 
 trusts. 
 
 j) Trustee under mortgages issued by corporations (foreign 
 or domestic), municipalities, bodies politic. 
 
 k) Trustee under equipment trusts. 
 
 And according to the terms of, and being accountable to 
 all persons in interest for the faithful discharge of every such
 
 304 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 trust, duty, or power which it may accept, it may receive, 
 take, manage, hold, dispose of, sell any property, real or personal, 
 wherever located, and the rents and profits thereof. 
 
 5. Safe keeping: A trust company may 
 
 Let out receptacles for the safe deposit of personal property. 
 
 Receive for safe-keeping bonds, mortgages, jewelry, plate, 
 stocks, securities, valuables, upon such terms and conditions 
 as it may prescribe. 
 
 The first two types of operations engaged in by trust com- 
 panies, namely, banking and investment, are in this treatise 
 discussed in other chapters banking hi the chapters on sav- 
 ings and commercial banking respectively, and investment in 
 connection with the marketing of high-grade securities. 1 In 
 this chapter, therefore, we shall consider only the operations 
 listed above under agency, fiduciary, and safe-keeping. 
 
 H. SERVICES RENDERED TO INDIVIDUALS 
 
 The trust company performs its services for individuals, 
 for estates, and for corporations. The nature of the services 
 rendered to individuals may in the main be readily ascer- 
 tained by reference to the powers of trust companies, as shown 
 in the outline above. Only one of the operations involved 
 requires explanation, that of depositary in escrow. 
 
 An escrow is usually defined as "a deed placed by the 
 grantor in the hands of a third party to be delivered to the 
 grantee upon the fulfilment by the latter of certain specified 
 conditions." Mortgages and notes as well as deeds may, how- 
 ever, be placed in escrow; and trust companies are often made 
 depositaries of various articles of value which are to be held 
 for delivery under conditions similar to those under a'n escrow 
 arrangement. While not escrows in the strictly legal sense, 
 they amount practically to the same thing and are sometimes 
 called "informal" escrows. It is the duty of the holder of an 
 escrow to deliver the instrument to the grantee upon his per- 
 
 1 See also charts on pp. 359, 360, and discussion on pp. 725-30.
 
 TRUST COMPANIES AND THE FINANCIAL SYSTEM 305 
 
 
 
 formance of his part of the contract, or to withhold the instru- 
 ment in case the contract is not fulfilled. 
 
 An additional feature is the acceptance of "living trusts." 
 One of the most interesting services performed for individuals 
 is not indicated in the above grant of powers, that of a "living 
 trust." Under a living trust a customer may deposit with a 
 trust company funds or securities of any kind and during his 
 lifetime may counsel with the company regarding investments 
 and other estate matters. This enables the trust company to 
 become familiar with the client's wishes as to the method of 
 handling his estate, so that his policies may continue to be 
 carried out after his death. At the same time, the individual 
 is relieved of all details hi connection with the handling of his 
 affairs and receives the benefit of much valuable information 
 and advice from investment experts. 
 
 HI. SERVICES PERFORMED FOR ESTATES 
 
 For estates the following services may be enumerated: 
 
 (1) administrator, executor, guardian, and conservator; 
 
 (2) trustee under wills; (3) receiver and assignee; (4) depositary 
 for money and property of estates under order of the Probate 
 Court; (5) depositary for alien property custodian. 
 
 The advantages of the trust company over an individual 
 in acting as trustee of estates are stated by one trust com- 
 pany as follows: 
 
 It is a fiduciary organization manned by trained officers, experi- 
 enced in the technique of modern trust a,nd agency duties. It is the 
 trustee for many estates the property of which requires manifold 
 skill and composite knowledge to produce the maximum income 
 therefrom. It is a trustee with continuous existence and therefore 
 not subject to the limitations of an individual and the frailties of 
 human life; it is able to give uninterrupted service from generation to 
 generation. It is a trustee that has no family prejudices to bias its 
 judgment. It is a trustee that has the financial ability to carry on 
 an estate without embarrassment to the beneficiaries, while property 
 matters are in an unsettled condition. It is a trustee that has at 
 its command a great many sources of counsel and knowledge in
 
 306 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 
 
 regard to investments. It is a trustee that does not need to give 
 bond (for which an estate or trust must pay), because of its own 
 ample capital and surplus. 
 
 It is now a common practice for a trust company to tender 
 the services of its officers for the drawing of wills and to act 
 as their custodian until the death of the testator. Such service 
 is usually performed without charge in case the company is 
 appointed executor of the estate. 
 
 Trust companies sometimes manage insurance funds. A 
 service related to the management of estates, that of handling 
 insurance funds for beneficiaries, has of recent years been 
 developed by trust companies. This is done by means of 
 a trust agreement. The policies are made payable, or are 
 assigned, to the trust company as trustee, and at the death of 
 the insured the company collects the proceeds of the policy, 
 of which it has meantime been the custodian, and applies such 
 proceeds according to the terms of the trust agreement. Since 
 many insurance companies do not write policies allowing stated 
 payments to be made to beneficiaries, this plan furnishes an 
 opportunity for the insured to have his insurance paid in any 
 manner desired. Trust agreements are sometimes made so 
 that the beneficiary may be paid stated annuities out of the 
 proceeds of life insurance. This arrangement is especially 
 valuable where a man is not able to carry an amount of insur- 
 ance such that the income alone will support his family. For 
 instance, one of the leading companies of the central states 
 advertises that with $10,000 of insurance it is able to pay an 
 annuity of $500 for forty years. 
 
 IV. TRUST COMPANIES AND CORPORATION 
 FINANCE 
 
 Among the services of trust companies none are more 
 important than those rendered to corporate enterprise. A 
 corporation is dependent upon the trust company alike in con- 
 nection with the raising of fixed capital, with the management of 
 certain of its financial affairs as a going concern, and with safe-
 
 TRUST COMPANIES AND THE FINANCIAL SYSTEM 307 
 
 guarding the interests of both creditors and shareholders in the 
 event of insolvency and financial reorganization. We shall 
 find, moreover, that the investors in corporate securities are 
 also largely dependent upon the performance of certain trust 
 company operations. At this point therefore the analysis 
 supplements that given in the chapters deah'ng with the 
 marketing of securities. 
 
 The principal ways in which the trust company is of service 
 in connection with corporate financing are as follows: (i) as 
 trustee under mortgages and indentures, securing bond and 
 note issues; (2) as trustee under equipment trust agreements; 
 (3) as transfer agent; (4) as registrar of securities; (5) as 
 depositary under reorganization agreements; (6) as fiscal agent. 
 
 i) Trustee under mortgages. Under the system of corporate 
 finance, bonds of small denomination are sold, as we have seen, 
 to the general investing public on the security of a mortgage, 
 which recites the conditions under which foreclosure proceed- 
 ings may be started and states what property is to be turned 
 over to the bondholders in case of insolvency. The appoint- 
 ment of a reliable trustee for the protection of the mortgage is 
 accordingly indispensable to the successful operation of the 
 system of issuing securities. 
 
 Before a trust company accepts a mortgage trust, great care 
 is taken to ascertain the correctness of statements that are 
 made and the legality of the mortgage. It is customary to 
 require an opinion from a counsel of the corporation issuing the 
 mortgage that the document has been drawn up in proper 
 form and that it fulfils the requirements of the state in which 
 the property to be mortgaged is situated. It is also customary 
 to submit a draft of the proposed mortgage and bonds to the 
 trust company for inspection, in cases where the bonds are 
 passed upon by the legal counselors of the trust company. 
 When the preliminary arrangements have been completed, 
 the mortgage is executed in duplicate and acknowledgment of 
 the acceptance of the trust is made by the trust company. 
 
 A closely related service is in connection with the engraving 
 and issuing of the bonds. Bonds are usually engraved by
 
 308 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 responsible engraving companies from plates especially pre- 
 pared for the purpose. Precautions are taken by the trustee 
 to prevent any impressions being lost or stolen ; and sometimes 
 the engravers are required to give security against loss resulting 
 from negligence on their part. After the bonds have been 
 printed, they are sealed with the corporate seal, attested by the 
 officers of the issuing corporation, and then sent to the trust 
 company, which certifies and delivers them as provided in 
 the mortgage. Before certification, however, each bond is 
 examined to insure its being in proper form. 
 
 Where the mortgage provides for a sinking fund for a 
 gradual retirement of the bonds or for their payment at 
 maturity, it is the duty of the trust company to see that such 
 sinking-fund provisions are complied with. It thus acts as a 
 sort of enforcing agent for the bondholders. 
 
 In the case of "collateral trust" bonds, 1 the collateral is 
 held by the trust company for the protection of the bond- 
 holders. Sometimes the terms of the mortgage provide that 
 the issuing corporation may make a substitution of collateral, 
 in which case it is the duty of the trustee to make sure that 
 the substituted securities are fully equal in value to the original 
 ones. 
 
 2) Trustee of equipment trusts. Equipment trusts arise 
 from a special type of financial borrowing that by railroad 
 companies for the purpose of acquiring new rolling stock. As a 
 means of making securities attractive to buyers, an arrangement 
 is effected with the builder of railway cars, whereby a partial 
 payment may be made by the railroad company upon the 
 delivery of the cars and notes given for the remainder. These 
 notes, which usually mature serially over a period of years, are 
 sold to investors. The title to the cars is vested in a trust 
 company as trustee and the railroad company leases the cars 
 from this trustee. The rental received by the trustee from 
 the railroad is sufficient in amount to meet the annual interest 
 on the notes and to retire a certain number of them each year. 
 In this way the railroad is enabled to borrow the funds with 
 
 "See p. 157 above.
 
 TRUST COMPANIES AND THE FINANCIAL SYSTEM 309 
 
 which to purchase equipment at fairly low rates of interest 
 and to pay off the obligation during the life of the rolling stock. 
 
 3) Transfer agent. Trust companies are usually chosen to 
 act as agents for transferring the ownership of corporate 
 securities. This function may involve merely the transfer of 
 existing shares from one holder to another; or it may involve 
 the substitution of a new issue for an old ; or of an issue of bonds 
 for an issue of stock. As an instance of the latter, if a railroad 
 company should decide to call in some of its outstanding 
 securities and replace them by an issue of a different type, a 
 trust company would be chosen to receive the old bonds from 
 their holders, issue receipts for them, and later issue the new 
 securities to the owners of these receipts. If money is to be 
 paid on either side, it is distributed by the trust company, 
 which thus acts as custodian of the interests of both the public 
 and the corporation. 
 
 The services of a transfer agent have been described as 
 follows: 1 
 
 The duty of the transfer agent is to act for the issuing corpora- 
 tion in the matter of making transfers of the ownership of its stock 
 from one holder to another. This involves the passing upon the 
 regularity and legality of the assignment of title; the noting of the 
 transaction upon the transfer books of the corporation; the cancel- 
 lation of the old certificates and the execution and delivery of new 
 certificates. Incidentally it involves the furnishing to the corporation 
 of a certified list of the stockholders whenever the books are closed 
 for the payment of dividends, and at other times as demanded. 
 
 The performance of these duties requires that the transfer agent 
 be the custodian of the stock books and the seal of the issuing cor- 
 poration and of a supply of blank certificates. The certificates, 
 bound in book form so that each certificate and its stub form one 
 page, and numbered consecutively, are before delivery to the trans- 
 fer agent signed by the proper officers of the corporation. The face 
 of the certificate usually contains the provision that it is not valid 
 unless countersigned by the transfer agent. On its back is usually 
 printed an assignment of the stock and an irrevocable power of 
 attorney 
 
 1 Clay Herrick, Trust Companies, pp. 413-16.
 
 310 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 Before making delivery of a certificate, the transfer agent dates 
 it, fills in the name of the new holder and the number of shares 
 represented, affixes the seal of thfc issuing corporation, and attaches 
 the proper signature to the transfer agent's certificate. 
 
 The practical work of transferring stock requires a high degree 
 of intelligence and care and a thorough knowledge of the law govern- 
 ing such transfers. The risks involved, aside from possible clerical 
 mistakes, errors in bookkeeping, dishonesty or gross carelessness on 
 the part of the employees who actually do the work, include mis- 
 takes of law or of fact in making transfers on forged indorsements) 
 or on insufficient authority, or in violation of law, especially in cases 
 of certificates held by persons as trustees for others. Certificates 
 indorsed in blank are often presented for transfer by persons other 
 than the holders of record. The transfer agent must know the 
 signatures of stockholders or otherwise identify them beyond ques- 
 tion. Where stock is held in fiduciary capacities, the agent must 
 know the terms and powers under which it is held. When a cer- 
 tificate is presented for transfer, the transfer clerk should know that 
 the certificate itself and the power of attorney accompanying it are 
 genuine; that the transferor is legally competent to make the 
 transfer; that no notice has been given the company of any out- 
 standing claims against the stock; that, in the absence of direct 
 notice, there is no implied notice of claims, such as the certificate 
 itself may give when standing in the name of a trustee. 
 
 On the subject of the exact liabilities assumed by the transfer 
 agent in agreeing to perform these services, there is a considerable 
 difference of opinion, which is readily accounted for by the fact 
 that there is no statute law covering the case, and very little law in 
 the shape of court decisions. While the office is sometimes under- 
 taken under special contract which details the liabilities to the issuing 
 corporation, the more common method of appointment is by a mere 
 resolution of the directors of the issuing corporation appointing the 
 Blank Trust Company as the transfer agent of its stock, and the 
 acceptance of the appointment by the latter. This method assumes 
 that the duties and liabilities of the position are so well known as to 
 require no definition; an assumption which is justified so far as 
 routine duties are concerned, but which as to liabilities seems incon- 
 sistent with the divergent opinions held by officers of banks and 
 trust companies which act as transfer agents. The difference of 
 opinion does not concern what the trust company accepting an
 
 TRUST COMPANIES AND THE FINANCIAL SYSTEM 311 
 
 appointment expects and intends to undertake, but has reference to 
 possible implied and incidental obligations which it does not intend 
 to assume, but for which, in the opinion of some writers, the courts 
 may hold it responsible. "It is well understood in banking and 
 trust circles that the transfer agent undertakes to say to the pur- 
 chaser of the stock which it has countersigned no more nor less than 
 that such stock is a genuine portion of the capital stock of the issuing 
 company, that the said company has been duly authorized to do 
 business by the secretary of the state in which the company is incor- 
 porated, and that the signatures of the officers to the certificates of 
 stock are genuine. 
 
 4) Registrar of securities. The purpose of having an inde- 
 pendent registrar of stock, or of registered bonds, may best be 
 disclosed by reference to the origin of the practice. In 1863 
 occurred the notorious Schuyler frauds, in which Robert 
 Schuyler, who was president and also transfer agent of the 
 New York & New Haven Railroad Company, apparently 
 over-issued the stock of his company. Since such practices, if 
 unchecked, would soon bring the entire securities business into 
 disrepute, the New York Stock Exchange, in order to prevent 
 a recurrence of such frauds, adopted a rule in January, 1869, 
 which required all active stocks to be registered by an agency 
 approved by it. The duties of a registrar are stated by Herrick 
 as follows: 1 
 
 The duty of the registrar of stock is to register, or record the 
 issue of, certificates of stock after they have been issued b>, the 
 transfer agent, for the purpose of preventing an over-issue of such 
 stock. Before assuming its duties the registrar must be furnished 
 with authentic information as to the total amount of stock author- 
 ized to be issued, if none has been issued; or as to the total amount of 
 stock authorized to be issued and the amount outstanding, if part 
 or all has been issued. After the total amount of shares authorized 
 to be issued has been registered, new certificates are not registered 
 except upon the cancellation of outstanding certificates for the same 
 number of shares. 
 
 In practice the registrar keeps a registry list, and as stock is 
 transferred by the company or its transfer agent it receives in each 
 
 1 Herrick, Trust Companies, pp. 425-26.
 
 312 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 case the old certificate as surrendered and the new certificate as pre- 
 pared to take its place, it compares the two, it notes upon its registry 
 list the surrender and cancellation of the old and the issue of the 
 new in substitution, and it thereupon identifies the new certificate 
 by its signature upon its face as a part of a stated authorized 
 issue. 
 
 The liabilities involved are at the present purely a matter of 
 opinion, as there is practically no law on the subject. 
 
 It is almost a universal practice for a corporation to select 
 as registrar a different trust company from the one which 
 serves as transfer agent. The function of the registrar is to 
 operate as a check upon any error or irregularity; and with 
 a single institution acting both as registrar and as transfer 
 agent there is obviously a greater possibility that an over-issue 
 of securities will not be detected. Where registrar and transfer 
 agent are separate institutions, collusion would be necessary to 
 permit an over- issue; the separate agents in a sense act as 
 checks upon each other. 
 
 5) Depositary under reorganization agreements. In case of 
 the default of interest on bonds, a committee is usually formed 
 to represent the bondholders. This committee formulates a 
 plan of financial reorganization; and pending the reorganiza- 
 tion the committee calls for the deposit of the bonds, the 
 interest on which has been defaulted, with some trust com- 
 pany, which is designated as depositary. In exchange for 
 these securities the trust company gives temporary receipts, 
 good for a limited number of days only. Since the process of 
 reorganization usually requires several months if not years 
 these temporary receipts are later exchanged for engraved 
 certificates of deposit which are in transferable form and 
 available for trading on the stock exchange like regular bonds 
 and shares. These certificates specify the kind and value of 
 the security deposited and the terms under which the certificate 
 is issued, and state that the trust company holds the securities 
 on terms agreed to by the owners thereof. 
 
 Financial reorganization is also necessary whenever a con- 
 solidation of several corporations into a single company is
 
 TRUST COMPANIES AND THE FINANCIAL SYSTEM 313 
 
 effected. The trust company is here also called upon to act as 
 depositary during the process of financial reorganization. 
 
 The trust company may also act as assignee and receiver 
 when a firm or corporation becomes insolvent. The appoint- 
 ment of a trustee as assignee may be made either at the request 
 of the owners of the business, who wish to protect their property, 
 or at the instance of creditors, who wish to safeguard their 
 interests. The property may be turned over to the trust com- 
 pany by an assignment, in which case the assignee's duties 
 usually consist of collecting the debts and requiring creditors 
 to prove their claims. 
 
 The trust company acts as receiver under appointment by 
 a court, and the object is generally to tide an embarrassed 
 enterprise over a period of difficulty. Since the receiver is 
 merely an officer of the court, it has no powers other than 
 those conferred upon it by the court. The court authorizes 
 the issue of receiver certificates to provide funds for the pur- 
 chase of equipment, the maintenance of the property, and the 
 conduct of the business. Such certificates may be made a 
 first lien on all assets, even taking precedence over mortgages 
 and other secured obligations. In this way the receiver is 
 enabled to secure the necessary capital with which to place 
 the company upon a satisfactory financial footing. 
 
 6) Fiscal agency. As fiscal agent for a corporation, the 
 company takes either general or special charge of the finances 
 of the corporation, according to the terms of the agreement. 
 It may assume the role of treasurer, having charge of all receipts 
 and disbursements; or it may merely act as agent for the 
 payment of coupons, interest, and dividends, either under 
 the terms of a mortgage or independently of any trustee- 
 ship. 
 
 A certain trust company states that as fiscal agent it will 
 assume custody of securities, give notice of maturities, and 
 collect coupons as they come due; take custody of title deeds, 
 insurance policies, and other documents, keeping all necessary 
 records incident thereto; examine periodically the condition of 
 corporations whose securities are held and advise with the
 
 314 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 proper officers of the organization with respect to the replace- 
 ment of securities that are becoming less valuable; examine 
 periodically real estate when under lease, especially where the 
 lease requires the payment of taxes and observance of obliga- 
 tions by tenants in the matter of repairs and replacements; 
 keep separate general books under such accounts as the 
 corporation may direct. 
 
 One trust company suggests that 
 
 The management of business corporations may well consider 
 the advantage of having general salary accounts, dividend, interest, 
 investment, bills payable, profit and loss, and other general and 
 controlling accounts kept separate from the accounts of the operat- 
 ing office and from the observation of employees therein. 
 
 In many cases the volume of such general office business, even 
 inclusive of records of directors' and stockholders' meetings, would 
 not warrant the considerable expense of a suitable separate corporate 
 office. In such cases the fiscal agency service of this company gives 
 all the benefits of such an office at a nominal cost. 
 
 As agent for the payment of interest, dividends, etc., the 
 trust company receives from the corporation hi advance of the 
 date when interest or dividends are due, a sum of money equal 
 to the total amount to be paid. In the case of coupon bonds 
 the interest is held subject to the call of the owner, while in 
 the case of dividends on stock and interest on registered bonds 
 a check is sent to the owners whose names appear on the 
 register held by the registrar. 
 
 Although coupons are made payable to bearer, a record is 
 made of the names of the persons who present them for pay- 
 ment at the counter of the trust company, or of the names of 
 the banks presenting them on behalf of their customers. The 
 trust company keeps a record of the numbers of the bonds 
 from which the coupons are cut. When paid the coupons are 
 canceled by the punching of holes in them ; and they are then 
 filed away by bond numbers, to be returned at intervals, usually 
 monthly, to the issuing corporation. 
 
 Trust companies also act as fiscal agents for educational and 
 charitable institutions, clubs, lodges, etc. The nature and sig-
 
 TRUST COMPANIES AND THE FINANCIAL SYSTEM 315 
 
 nificance of such service is stated by one trust company in the 
 following language: 
 
 The functions of educational, charitable, and similar institutions 
 continue uninterruptedly from generation to generation. Execu- 
 tive officers, serving for the most part without compensation, change 
 frequently, involving a transfer of records and securities, always 
 with the danger of loss of records and of inadequate attention to the 
 changing values of securities. It is therefore highly desirable to 
 secure continuity of service, permanent housing of important records, 
 and prompt and efficient handling of the routine work of the organi- 
 zation. 
 
 The Trust Company will provide such secretarial and steno- 
 graphic service as may be required for giving necessary notices 
 of meetings; will transcribe minutes and resolutions accurately and 
 uniformly into the permanent records; will give notice of all dues 
 and other obligations payable to the organization; will receive and 
 acknowledge all payments made for the organization's account, and 
 deposit the same, reporting at regular and special meetings the 
 collections made and the items in default; will draw checks for 
 authorized amounts covering all items payable, including annuities, 
 interest, salaries, and current accounts, and will mail the same. 
 
 Oftentimes the secretary and the treasurer of an organization 
 are persons who are absorbed in the duties of their own calling or 
 are frequently absent from home. It is highly desirable that the 
 responsibilities of these offices be in hands where routine will be 
 promptly and efficiently handled. 
 
 In many cases the treasurer is aUowed a fund for clerical assist- 
 ance. Such a fund, applied to secure fiscal agency service, will 
 relieve the treasurer of responsibility of oversight and will guarantee 
 the accuracy and integrity of the records. 
 
 It is certainly an advantage and a matter of prestige to be able 
 to obtain in the handling of the securities, accounts, properties, and 
 investments of any organization the degree of accuracy, the absolute 
 responsibility, and the safeguards of state supervision which are to 
 be found in a trust company alone. Whatever the high character 
 or ability of an individual, it is out of the question that he can bring 
 to bear on such duties all of the highly specialized forces of a large 
 banking institution.
 
 3i6 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 V. THE TRUST COMPANY AS CUSTODIAN OF 
 SECURITIES 
 
 While trust companies are not the only financial institu- 
 tions that maintain safety-deposit vaults and boxes for the 
 safe-keeping of valuables and securities, they have from the 
 beginning made a specialty of such business, trust company 
 legislation having recognized it as an important feature of trust 
 company work. The law of New York, for example, author- 
 izes trust companies 
 
 To receive, on terms and conditions to be prescribed by the com- 
 pany, upon deposit for safe-keeping, bonds, mortgages, jewelry, 
 plate, stocks, securities and valuable papers of any kind, and other 
 personal property, for hire, and to let out receptacles for safe deposit 
 of personal property. 
 
 Some of the larger companies have gone much farther than 
 merely to maintain safety-deposit boxes. The growth of large 
 fortunes, which under modern conditions are mainly invested 
 in corporate securities, has opened up a new field of work for 
 the trust company that of custodian of the securities and 
 papers deposited with them by individuals. The amount of 
 detail that must be looked after if the owner of a large volume 
 of securities is to avoid losses and make the most of oppor- 
 tunities is so great that a responsible financial secretary and 
 adviser is practically indispensable. In this capacity trust 
 companies render a variety of important services, outlined by 
 a large New York trust company in the following language: 
 
 A. AVAILABIUTY 
 
 When securities are locked up in a safe deposit box, they are 
 not available to the owner in case of sickness or absence from home. 
 From this cause serious embarrassment often results, for, while a 
 person may be entirely solvent, his securities may not be available 
 in time of need, merely because for some reason he is unable to go 
 to his safe deposit box in person. 
 
 On the other hand, when securities are held in safe-keeping, they 
 are alway available to the depositor at any time. By letter, telegraph, 
 or cable, he may direct their delivery or sale, and may withdraw
 
 TRUST COMPANIES AND THE FINANCIAL SYSTEM 317 
 
 them at any time to be used as collateral to loans. No matter 
 where the depositor may be, his securities are always subject to his 
 control and direction. 
 
 In order that our clients readily may direct the sale or delivery 
 of stocks or registered bonds, the securities should be endorsed in 
 blank with the signatures properly witnessed or guaranteed. 
 
 Where prolonged absence is contemplated, it is especially desirable 
 to have the stocks or registered bonds stand in the name of a nominee of 
 the trust company. This is especially the case where the securities 
 stand in the names of women, whether married or unmarried, as a 
 certificate in a woman's name is not a "good delivery" in accordance 
 with the rules of the New York Stock Exchange, and must be trans- 
 ferred to the purchaser's name or to the name of one of our clerks 
 before delivery can be made. This transfer necessitates the payment 
 of a double transfer tax. 
 
 A further advantage in having securities stand in the name of 
 a nominee is that it makes it possible to sell a portion of the stock 
 represented by a certificate and still have the remainder in negotiable 
 form. For instance, if a depositor has a certificate for 100 shares of 
 stock registered in his name and endorsed in blank, and while absent 
 from the city desires to sell only 50 shares, the i co-share certificate 
 must be split into two so-share certificates, one of which may be 
 registered in the name of the pending purchaser, but the other 
 would stand in the name of the depositor and would necessarily not 
 be endorsed and therefore would not be negotiable. The remaining 
 50 shares, therefore, would not be available for sale until endorsed by 
 the depositor for that purpose. If, however, the certificate stood in 
 the name of a nominee, the new certificate upon its receipt from 
 transfer would be immediately endorsed by the nominee in blank, 
 and would be ready for immediate sale upon proper instructions 
 from the depositor. 
 
 The Trust Company is at all times responsible for the acts of 
 its nominees, and requires them to file written instruments with the 
 Company, declaring that the nominee has no ownership in the 
 certificates standing in his name for that purpose, thus insuring that 
 no claim of ownership may be made by the executors or personal 
 representatives of a deceased nominee. 
 
 The Company makes no charges to its depositors for purchasing, 
 selling, or delivering securities for their account. Depositors, if they 
 desire, may direct purchases or sales through their own brokerage
 
 318 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 houses, requesting their brokers to receive or deliver the securities 
 at this office. At the same time instructions should be given to this 
 Company to receive and pay for the securities purchased, or to 
 deliver and receive payment for the securities sold, and to charge 
 or credit the depositor's account. 
 
 Orders may also be placed directly with the Company, which 
 will effect the purchase or sale of securities through brokers. 
 
 Whether the order is placed directly through the broker or 
 through the medium of the Trust Company, the broker's commission 
 is (of course) added to the purchase price or deducted from the pro- 
 ceeds of the sale, but the Trust Company makes no charge for its 
 services. In order to insure the genuineness of all orders and to 
 protect our depositors against fraud, their signatures are filed with 
 the Trust Company, and are compared with all written instructions. 
 
 It is advisable for our. depositors to arrange secret code signa- 
 tures known only to the depositors and the officers of this Company, 
 which will identify all instructions sent by cable or telegraph. If 
 desired, secret code words may be agreed upon to cover any specific 
 transaction concerning which the depositors may desire to give 
 nstructions, thus saving the expense of long messages. 
 
 Persons traveling will find it very economical to make use of the 
 public codes, such as Lieber's code and the Western Union code, 
 which are especially adapted for general communications, and Hart- 
 field's New Wall Street code which is expressly designed to cover all 
 transactions in securities. One or the other of these codes may be 
 found at the offices of all our correspondents and very generally in 
 any telegraph office or large banking house. 
 
 B. ROUTINE CARE 
 
 i. Collection of principal and income: 
 
 a) Collection of principal of maturing bonds: The principal of 
 bonds as they mature is collected and the proceeds either remitted 
 to the depositor or credited to his account, under advice. Notice 
 of principal of bonds becoming due and payable is given a month 
 in advance in order to allow the depositor to arrange for reinvest- 
 ment without the loss of interest. 
 
 6) Collection of bond interest: Coupons upon bonds are detached 
 and deposited for collection when due, the proceeds being either 
 remitted to the depositor or credited to his account, under advice. 
 
 c) Collection of dividends: Where the stock stands in the name 
 of a depositor, in order that the Trust Company may receive the
 
 TRUST COMPANIES AND THE FINANCIAL SYSTEM 319 
 
 dividends as they are paid, the depositor must sign a "dividend 
 order." Where stocks are held in our care, it is recommended that 
 the dividends be made payable to this Company, for account of the 
 customer, in order that it may be assured that the dividends are 
 received. Failure to receive a dividend when due causes an immedi- 
 ate investigation, the depositor being notified in case the dividend 
 is passed. Similarly, the depositor is notified in case the dividend 
 is either increased or reduced. 
 
 2. Preparation of certificates required under the Federal In- 
 come Tax Law preliminary to the collection of coupons, registered 
 interest, or dividends: The Federal Income Tax Law surrounds the 
 collection of income with considerable detail more or less vexing to 
 the investment holder. This detail the Trust Company is pre- 
 pared to assume under an agency appointment, and thereafter such 
 information as may be required by the Federal Income Tax Law 
 incident to the collection of the income of its depositors is prepared 
 and submitted by the Trust Company without further action of its 
 depositors. 
 
 3. Statements: 
 
 Depositors receive periodically, at such times as they may 
 request, statements of securities which they have deposited in safe 
 keeping, showing 
 
 a) The amount of each security 
 
 o) Its description 
 
 c) Its due date 
 
 d) Dates on which interest or dividends are paid and the income 
 return 
 
 C. SUPERVISION OF DEPOSITED SECURITIES 
 
 The average individual is kept informed concerning his holdings 
 only through his own efforts. Unless he personally keeps constantly 
 in touch with the information published from time to time relative 
 to his securities, he may lose many opportunities either to act to his 
 advantage or to save himself from possible loss. For instance: 
 
 a) His bonds may be called for payment either at the option 
 of the issuing company or through the operation of some sinking 
 fund. After the date on which a bond is called for payment, interest 
 ceases. If the holder's attention is not called to this he loses the 
 interest which he would have received had his money been invested 
 immediately.
 
 320 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 6) His bonds may have the valuable right of being converted 
 into stock on or before a certain date, upon the expiration of which 
 the privilege is lost. 
 
 c) He may have the right to subscribe to new issues of stocks or 
 bonds. Generally, this privilege is evidenced by a certificate, which 
 is commonly known as "a right," which entitles the holder to sub- 
 scribe to stocks or bonds upon paying a certain sum not later than a 
 certain date, after which the privilege ceases. 
 
 d) In time of business depression, committees are often formed 
 for the protection of securities and may require their immediate 
 deposit. Committees usually fix a certain date on which securities 
 must be deposited; after this date a penalty attaches. Further, 
 committees sometimes protect only the securities deposited with 
 them, and the non-co-operating security holder, especially in the 
 case of stocks, may not receive substantial advantages which might 
 be gained by acting with the committee. 
 
 e) Receivers may be appointed for property in which he is 
 interested. This may make it advisable to dispose of the holdings 
 immediately, before greater loss is incurred. 
 
 /) Notice of opportunity to sell bonds to sinking funds. We 
 endeavor to keep our depositors in touch with these opportunities, 
 as they often afford the best opportunity of disposing of securities 
 which have a narrow market. 
 
 In addition to the above services, which are rendered auto- 
 matically but only at the express request of our depositors, periodical 
 examinations of their holdings are made by investment experts 
 with a view to determine whether it seems advisable to recommend 
 either a change in their securities because of new conditions which 
 have arisen, or in order to secure a more balanced and conservative 
 investment. 
 
 D. ADDITIONAL SERVICES RENDERED TO DEPOSITORS 
 The services already enumerated are those directly connected 
 with the care and supervision of securities, but there are many other 
 matters which we are pleased to attend to when requested, such as 
 i. Payment of: 
 
 Taxes on real estate 'and personal property 
 
 Interest on bonds, mortgages, and bank loans 
 
 Premiums on life and fire insurance policies 
 
 Rent of houses or apartments 
 
 Storage charges 
 
 Allowances to children, relatives, or dependents
 
 TRUST COMPANIES AND THE FINANCIAL SYSTEM 321 
 
 In other words, the service is not confined within formal limits, 
 but responds to the needs of our depositors. 
 
 2. Transfer of securities. We are pleased to undertake to effect 
 the transfer of stock certificates and registered bonds which our 
 clients desire to have transferred either to their own names or to 
 the names of beneficiaries under wills or deeds of trust. 
 
 3. Care of securities for executors, administrators, guardians, and 
 committees. Individuals acting in the capacity of executors, admin- 
 istrators, guardians, trustees, or as committee for incompetent per- 
 sons having securities in their charge, instead of placing the securities 
 in safe deposit, may be relieved of the routine care and trouble 
 in handling securities by depositing them in the custody of the 
 Company. 
 
 The foregoing services as custodian are performed for 
 individuals. Trust companies also act as custodians of the 
 securities of firms and corporations. Modern enterprises often 
 invest surplus funds, reserves, etc., in securities, and the 
 deposit of such securities with a trust company eliminates the 
 expense of providing costly and secure vaults and renders it 
 unnecessary to require the giving of bonds by employees for 
 the faithful discharge of their responsibilities. 
 
 Trust companies perform many services for "correspondent 
 banks" and brokerage houses. In connection with out-of-town 
 banks and brokerage houses, both in the United States and 
 abroad, correspondent banking houses which deposit securities 
 for safe-keeping in New York are given practically all the 
 facilities of a branch office. A trust company in New York 
 provides a place where all matters pertaining to the purchase 
 and sale of securities may be cared for, thereby obviating 
 (a) delay in making settlement, (b) delay in shipping securities 
 to and from New York, (c) expense of postage, expressage, 
 and insurance. The trust company also collects interest 
 coupons and credits the amount to the correspondent banks, 
 thus saving delay and expense in making collections. (This 
 service is of importance for the reason that most large 
 corporations maintain an agency for the payment of their 
 coupons in New York City.) The trust company also prepares 
 income-tax certificates for out-of-town banks; it looks after
 
 322 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 the collection of dividends, in many cases; and it provides facili- 
 ties for effecting transfers of ownership of securities. Nearly 
 all of the great corporations of the country maintain offices or 
 agencies in New York where their securities may be transferred 
 and registered. A representative of the trust company is thus 
 in a position by personal interview " to discuss difficult questions 
 with the various offices or agencies and to ascertain the proper 
 papers to effect transfers, thus obviating the delay which 
 usually occurs when the matter is handled by letter. " 
 
 Foreign correspondent banks which deal in American 
 securities find it of very great service to have an agency in 
 New York. This is especially true when securities issued 
 stand in the name of decedents, executors, administrators,' 
 trustees, or guardians; for hi cases of this sort, the trust com- 
 pany relieves the correspondent banks from the necessity of 
 familiarizing themselves with the diverse requirements of the 
 different corporations and of the particular laws of the several 
 states. 
 
 VI. THE REGULATION OF TRUST COMPANIES 
 
 There is little to be said on the subject of trust company 
 regulation, for the reason that the trust companies, like the 
 investment banks, have developed without being subjected to 
 much legislative control, except in connection with their 
 banking departments. 1 In general, the state laws under 
 which they are chartered have conferred upon them very 
 broad grants of power and they have been enabled to develop 
 along pragmatic lines. While practically free from legislative 
 restrictions so far as their non-banking departments are con- 
 cerned, trust companies are, however, subject to the laws 
 pertaining to trust and agency business in general. There 
 appears to be little doubt that these laws have, on the whole, 
 been sufficient to insure the faithful performance of the manifold 
 duties which trust companies assume. 
 
 1 This phase of trust company regulation will be considered in chap, 
 xxix below.
 
 TRUST COMPANIES AND THE FINANCIAL' SYSTEM 3 23 
 
 This general survey of the broad scope of trust company 
 operations is sufficient to disclose the very important part that 
 these institutions play in the modern economic system. In a 
 very real sense it may be said that the development of some 
 such institution was indispensable to the growth of the large- 
 scale corporate form of capitalistic enterprise involving so 
 many details of financial management and so difficult a task of 
 safeguarding the equities both of the corporate enterprise itself 
 and the owners of its securities. Similarly, the great accumu- 
 lation of wealth during the last few generations has rendered it 
 practically impossible for individuals to serve efficiently as 
 trustees of estates, etc. 
 
 As pointed out at the beginning, however, the analysis in 
 this chapter pertains only to certain phases of the work per- 
 formed by the department-store financial institution that is 
 organized under the title of trust company. While the banking 
 and bondhouse functions of trust companies are necessarily 
 discussed in other chapters of this functional analysis, it is 
 important to point out here that an institution such as the 
 trust company, which performs practically every type of 
 financial operation under one roof, is in many ways a highly 
 advantageous type of business organization. We shall see in 
 chapter xxix how its development is rapidly serving to eliminate 
 specialization in the field of financial enterprise and forcing all 
 financial institutions to assume in greater or less degree the 
 department-store form of organization. 
 
 QUESTIONS FOR DISCUSSION 
 
 1. How do you account for the fact that the growth of trust com- 
 panies did not become rapid until about 1880? Why was it 
 especially rapid after 1900? 
 
 2. Before the development of trust companies, how were individual 
 "trusts" handled? 
 
 3. Which types of trust company operations, as shown on pages 
 302-3, are most important from the standpoint of (a) individuals, 
 (6) corporations? 
 
 4. Make a list of the services that are rendered to: (a) individuals, 
 (6) corporations.
 
 324 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 5. Do you regard "living trusts" as important? 
 
 6. "A trust company is preferable to individual trustees, because 
 it possesses every quality of desirability which the individual 
 lacks, to wit: 
 
 "a) It does not die. 
 
 "&) It does not go abroad. 
 
 "c) It does not become insane. 
 
 "d) It does not imperil the trust by failure or dishonesty. 
 
 "e) It does not refuse to act from caprice or on the ground of 
 
 inexperience. 
 "/) It does not resign. 
 
 "#) It has no sympathies or antipathies and no politics. 
 "&) It is absolutely confidential. 
 "*) It is invariably on hand during business hours and can be 
 
 consulted at all times. 
 ".;') It never neglects its work or hands it over to untrustworthy 
 
 people. 
 "&) Its experience and judgment hi trust matters are beyond 
 
 dispute." 
 Do you agree with all of these contentions ? 
 
 7. "Trust companies to a considerable extent do away with the 
 element of personal risk attaching to an individual trustee; but 
 they lack the advantages of personal management. These com- 
 panies sometimes fail from improper management as utterly as 
 individuals do, and as a rulfe the lack of personal management 
 results in securing the minimum return, only, on the amount 
 invested, and lacks the great advantages often secured by the 
 able personal oversight of individual trustees." 
 
 8. "No doubt there are some objectionable features in having for 
 trustee a corporation which has neither a body to be kicked nor 
 a soul to be damned. It has sometimes been said that the trust 
 companies lack the advantage of personal interest that attaches 
 to an individual trustee. While there have undoubtedly been 
 cases where trust companies have been inefficient and lax in the 
 handling of trusts, it cannot fairly be made as a general criticism 
 that the interests of the client suffer for lack of the personal 
 touch. It all comes back to the question of the qualifications 
 and integrity of the corporation's officers and officials." What 
 is your judgment on the issue raised in this and the preceding 
 question ?
 
 TRUST COMPANIES AND THE FINANCIAL SYSTEM 325 
 
 9. In what respects is a trust company superior to an individual in 
 the performance of agency functions ? 
 
 10. Draw up a list of all the ways in which the trust company assists 
 in the marketing of securities. 
 
 11. How is the borrower safeguarded in the "equipment trust" 
 plan of raising capital ? 
 
 12. Why is a transfer agent necessary? Could not the issuing cor- 
 poration take care of this work quite as satisfactorily as an agent ? 
 
 13. What liabilities do you think the trust company should assume 
 as transfer agent ? 
 
 1-4. Would it not be better to require the state government which 
 charters the corporation to act as transfer agent, rather than to 
 have an independent trustee ? 
 
 15. Precisely how might frauds arise in the absence of an independent 
 registrar of stock ? 
 
 16. Why is it important _to have different trust companies serve as 
 transfer agent and registrar for a given issue ? 
 
 17. Do you understand that a given trust company might be the 
 transfer agent for one corporation and registrar for another? 
 
 18. State the different ways in which a trust company is of service 
 in connection with financially embarrassed or insolvent cor- 
 porations. 
 
 19. In the absence of trust companies how would problems such as 
 those mentioned on pages 312-13 be handled? 
 
 20. Which of the various services listed under fiscal agency do you 
 regard as of greatest importance to a corporation ? 
 
 21. If you were manager of a corporation, would you employ a trust 
 company to act as fiscal agent or would you manage the problems 
 involved yourself and "save the fees" ? 
 
 22. Do non-profit-making institutions have a greater or less need for 
 fiscal agency service than business corporations ? Why ? 
 
 23. Do you think the statement is true that the custodian services 
 of trust companies are essentially an outgrowth of the develop- 
 ment of corporate enterprise? 
 
 24. In what respects is a trust company a more desirable custodian 
 of securities than an individual agent ? 
 
 25. Would the amount of routine work required in caring for the 
 collection of interest, dividends, principal, etc., be really irksome 
 to an individual of large means? Is not "clipping coupons" 
 supposed to be a congenial vocation ?
 
 326 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 26. Draw up a brief statement showing what it would be necessary 
 for an individual to do in order to prevent avoidable losses on 
 his investment holdings. 
 
 27. As manager of a corporation, would you employ a trust company 
 to take the custody of reserve and other funds ? 
 
 28. Is it only the trust companies of the great financial centers that 
 are in a position to render important services to correspondent 
 banks and brokers ? 
 
 29. Do you think trust company operations aside from banking 
 should be subjected to special legislation, or are the general laws 
 of trusts and agency sufficient ? 
 
 30. Draw up a statement of the economic significance of trust 
 companies. 
 
 REFERENCES FOR FURTHER READING 
 
 Barnett, George E.: Growth of State Banks and Trust Companies 
 since 1865. 
 
 Herrick, Clay: Trust Companies, Their Organization, Growth, and 
 Management. 
 
 Kirkbride, F. B., and Sterrett, J. E.: The Modern Trust 
 Company. 
 
 Ferine, E. T.: The Story of the Trust Company. 
 
 Noyes, A. D.: "Trust Companies," Political Science Quarterly, 
 Vol. XVI (1901). 
 
 Kilburn, F. D.: "Control and Supervision of Trust Companies," 
 Annals of American Academy, Vol. XXIV (1904). 
 
 Trust Companies of the United States. An annual volume 
 published by the United States Mortgage and Trust Company, 
 New York. 
 
 Trust Companies. A monthly magazine published by tho New 
 York Trust Companies Publishing Association.
 
 CHAPTER XVin 
 
 THE FUNCTIONS OF SAVINGS INSTITUTIONS 
 
 The savings bank was indicated, in the charts on pages 134 
 and 136, as a financial intermediary in the raising of capital for 
 business enterprises. It should be understood, however, that 
 savings institutions also assist in the raising of funds required 
 by governments federal, state, and local; in the furnishing 
 of capital for agricultural purposes; 1 and in the financing of 
 urban real estate operations, particularly in the construction of 
 apartment buildings. 
 
 There are several different types of savings institutions, 
 which may be classified as: (i) mutual or trustee; (2) stock; 
 (3) postal; and (4) co-operative. The mutual and stock sav- 
 ings banks are by far the most important, and it is through 
 them that the bulk of savings in the United States has been 
 effected. Postal savings institutions, which are designed to 
 encourage and facilitate the making of savings by people in 
 very moderate circumstances, have been in existence in the 
 United States for about ten years only. Co-operative savings 
 banks are institutions organized mainly for the purpose of 
 promoting thrift, through co-operative action, among special 
 groups of individuals. They include building and loan asso- 
 ciations, fraternal societies, credit unions, etc.; consideration 
 of these institutions will be reserved for the chapter on co- 
 operative credit. 2 
 
 I. STOCK SAVINGS BANKS 
 
 If one is clearly to understand the work that is performed 
 by savings institutions, he must be able to interpret the accounts 
 that are shown on the balance sheet, or financial statement. 
 The following financial statement shows the combined resources 
 
 1 See chart on p. 650. a See chap, xxviii. 
 
 327
 
 328 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 and liabilities of 1,194 stock savings banks in the United 
 States, which reported to the Comptroller of the Currency 
 in the year igiS. 1 
 
 RESOURCES 
 
 Loans secured by real estate $ 26,485,117.31 
 
 Loans secured by other collateral 6,462,262.32 
 
 Loans unclassified 753>836,47i.52 
 
 Overdrafts 1,164,240.28 
 
 United States bonds 30,856,802.85 
 
 State, county, and municipal bonds .... 1,175,832.03 
 
 Railroad bonds 2,663,188.31 
 
 Other public service bonds 997,471 . 29 
 
 Unclassified bonds and securities 174,064,438.26 
 
 Banking house, furniture and fixtures . . . 30,990,907.34 
 
 Other real estate owned ....... 7,584,861.65 
 
 Due from banks 106,965,023.20 
 
 Checks and other cash items 3,487,606.09 
 
 Cash on hand 32,475,269.59 
 
 All other resources 3,980,174.68 
 
 Total . . . . - $1,183189,666.72 
 
 LIABILITIES 
 
 Capital stock $ 68,984,602.22 
 
 Surplus fund 34,639>33 6 - 2 9 
 
 Undivided profits 12,958,063.95 
 
 Due to banks 2,672,459.56 
 
 Dividends unpaid 168,506.10 
 
 Individual deposits 1,049,483,555.47 
 
 Postal savings deposits , 670,962 . 70 
 
 Notes and bills rediscounted 253,392.33 
 
 Bills payable 7,608,359.66 
 
 Other liabilities 5,750,428.44 
 
 Total $1,183,189,666.72 
 
 The purpose of a balance sheet is to show at a glance the 
 financial condition of the institution. All of the debts, or 
 obligations, of the bank are arrayed under the heading "liabili- 
 ties," and all of the property of the bank, together with the 
 debts and obligations owing to it, are grouped under "resources" 
 or "assets." The liabilities of a stock savings bank are of 
 
 1 Report of the Comptroller of the Currency, I (1918), 88-94.
 
 THE FUNCTIONS OF SAVINGS INSTITUTIONS 329 
 
 two classes: those to the stockholders, and those to the creditors, 
 or customers, of the institution. The stockholders' liabilities 
 are classified under three headings: capital, surplus, and undi- 
 vided profits. These items, taken together, represent the dif- 
 ference between the total amount of resources and the liabilities 
 to the creditors; they thus represent the net worth of the 
 business what is owned by the proprietors. 
 
 Many accountants refer to these items as "proprietorship 
 items," and do not list them among the liabilities; but since the 
 financial statements of banks always include them as liabilities, 
 we shall here follow the latter practice. The reason for classify- 
 ing them as shareholders' liabilities may be understood, if one 
 conceives of the banking corporation as a business entity to 
 which the stockholders have intrusted their funds in the capacity 
 of investors. Capital, surplus, etc., are thus owned, not by the 
 bank, but by the individuals who have bought its certificates of 
 stock. The stockholders have the shares as evidence of the 
 obligation of the bank to them; and in turn the bank must 
 enter on its books a statement of the amount of capital it owes 
 to shareholders. 
 
 The origin and nature of the remaining items on the balance 
 sheet may best be made clear if we proceed to organize a bank 
 and work out by the use of entries on the balance sheet the 
 nature of its operations as a going concern. Suppose we 
 organize a bank with a capital of $100,000, to be derived from 
 the sale of 1,000 shares of stock at $100 per share. The two 
 original entries would be as follows: 
 
 RESOURCES LIABILITIES 
 
 Cash $100,000 Capital stock . . . $100,000 
 
 Many persons confuse the capital of a bank with its cash. The 
 making of this balance sheet' reveals at once the difference 
 between them. Capital stock is a statement on the books of 
 the bank of the amount that has been contributed by share- 
 holders; and the entry of $100,000 under cash on the resources 
 side is a declaration that the bank has $100,000 of cash in its 
 vaults.
 
 330 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 The meaning of surplus and undivided profits may also be 
 made clear at this place. Let us assume that the stock, whose 
 par value was $100 per share, was actually sold at $110 per 
 share. The statement would then stand: 
 
 RESOURCES LIABILITIES 
 
 Cash $110,000 Capital stock . . . $100,000 
 
 Surplus .... 10,000 
 
 The surplus is thus a statement that the stockholders have con- 
 tributed more than the par value of the stock. The surplus 
 may, however, also be increased from year to year through a 
 policy of not disbursing all the earnings among the stockholders 
 in the form of dividends. If, for instance, at the end of the year 
 the directors of the bank should decide that $10,000 of net 
 earnings should be retained in the business, the surplus would 
 be increased by $10,000. This additional $10,000 would be 
 represented on the resources side by cash or investments. 
 
 The undivided-profits item states the amount of accumu- 
 lated earnings, aside from the surplus; and, like the other items, 
 it is represented on the resources side by cash, or other assets. 
 When dividends are declared and paid, the undivided-profits 
 account is lessened by the amount of the dividend payment and 
 cash is reduced by the same amount. 
 
 To return to the statement as it stands above, it is obvious 
 that before we can engage in the banking business it will be 
 necessary for us to have a building. Let us assume that we 
 buy a building properly furnished and equipped for the pur- 
 pose in hand at a cost of $35,000. A new statement of the 
 bank's financial position would then read as follows: 
 
 RESOURCES LIABILITIES 
 
 Bank building, furni- Capital stock . . . $100,000 
 
 ture and fixtures . $35,000 Surplus .... 10,000 
 Cash 75,000 
 
 We now open the doors of the bank for business and make 
 public announcement of the fact that we are ready to receive 
 deposits; and in the course of a few weeks we receive $50,000
 
 from individuals for deposit. The accounts would then stand as 
 follows : 
 
 RESOURCES 
 
 Bank building, etc. . $35,000 
 Cash 125,000 
 
 LIABILITIES 
 
 Capital stock . . . $100,000 
 
 Surplus 
 Deposits 
 
 10,000 
 50,000 
 
 In the course of time the following transactions are also 
 concluded: (i) $10,000 is deposited by our bank in a large 
 commercial bank in a nearby city, on which we are to receive 
 2 per cent interest; (2) the local post-office deposits with us 
 $10,000 of postal savings; (3) $10,000 of United States bonds, 
 $6,000 of state, county, and municipal bonds, $10,000 of railroad 
 bonds, $10,000 of other public service bonds, and $24,000 of 
 unclassified bonds and securities are purchased; (4) $20,000 of 
 loans are made on real estate security; (5) $15,000 of loans are 
 made on other collateral, mainly stocks and bonds; (6) $30,000 
 of other loans (unclassified) are made, mainly on the promissory 
 notes of individuals; and (7) $5,000 is borrowed from another 
 bank. 
 
 A financial statement of the bank's affairs would then stand 
 as follows: 
 
 RESOURCES 
 
 Bank building, etc 
 
 Due from banks. 
 
 United States bonds . 
 
 State, county, and mu- 
 nicipal bonds 
 
 Railroad bonds 
 
 Other public service 
 bonds .... 
 
 Unclassified bonds and 
 securities 
 
 Loans secured by real 
 estate .... 
 
 Loans secured by other 
 collateral 
 
 Loans unclassified 
 
 Cash 
 
 $35,000 
 10,000 
 10,000 
 
 6,000 
 10,000 
 
 10,000 
 24,000 
 20,000 
 
 15,000 
 30,000 
 5,000 
 $175,000 
 
 LIABILITIES 
 
 Capital stock . 
 Surplus .... 
 Deposits .... 
 Postal savings deposits 
 Bills payable . 
 
 $100,000 
 
 10,000 
 
 50,000 
 
 10,000 
 
 5.000 
 
 $175,000
 
 332 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 As a result of these operations it will be seen that the 
 bank's cash has been very greatly reduced and that funds have 
 been advanced through loans and the purchase of securities to 
 governments and to the various types of private enterprise. 
 In these operations we have accounted for nearly all of the 
 items that appear upon the combined statement of the stock 
 savings banks in the United States. 
 
 A word of explanation will indicate the origin of the other 
 items. "Overdrafts" arise whenever a depositor is permitted 
 to withdraw from the bank more than he has on deposit; it 
 is thus an unsecured loan, and represents bad banking practice. 
 "Checks and other cash items" will become cash as soon as 
 presented for payment to the banks or individuals upon which 
 they are drawn. "Due to banks" is a statement of deposits 
 that have been made in this bank by other banks; the entry 
 might be designated "bank deposit," in contrast with "indi- 
 vidual deposit" and "postal savings deposit" accounts. The 
 item "notes and bills rediscounted" shows that some of the 
 notes which lie back of the unclassified loans on the resources 
 side have been used by the bank as a basis for borrowing from 
 other banks. 
 
 II. MUTUAL SAVINGS BANKS 
 
 While stock savings banks are located mainly in the Middle 
 West, the mutual institutions are confined chiefly to the manu- 
 facturing centers and towns of the New England and eastern 
 states. The mutual, or trustee, savings bank does not possess 
 any capital stock, the funds being derived solely from deposits. 
 The depositors are thus the mutual owners of the bank. They 
 do not receive interest on deposits; but the net earnings of the 
 company are divided among them in the form of interest and 
 profits. The mutual institutions are not managed by a board 
 of directors elected by the stockholders, but by a body of 
 non-depositing trustees, who usually hold office perpetually 
 and who are actuated mainly by the desire to render a 
 public service through the faithful discharge of a responsible 
 trust.
 
 THE FUNCTIONS OF SAVINGS INSTITUTIONS 333 
 
 The "guaranty savings bank" is a mongrel type. The state 
 of New Hampshire has what is known as the "guaranty savings 
 bank," a combination of the mutual and stock institution. The 
 guaranty savings bank accepts both regular and "special" 
 deposits. The latter are in effect its capital stock. The mutual 
 or regular depositors are paid a certain stipulated rate of inter- 
 est, and any excess of earnings above this is available for 
 dividends on the "special deposits." It is in this agreement 
 to pay a stipulated rate of interest to mutual depositors that 
 the guaranty savings bank differs essentially from the mutual 
 institution. The term "guaranty" is derived from the fact 
 that the special deposits comprise, like capital stock and 
 surplus in a stock savings bank, a sort of guaranty fund for 
 the general depositors, the earnings derived from the use of the 
 special deposits being available for payment of interest to 
 mutual depositors. 
 
 There follows a statement of the total resources and liabili- 
 ties of 625 mutual savings banks reporting to the Comptroller 
 of the Currency in 1918:' 
 
 RESOURCES 
 
 Loans secured by real estate $2,065,553,657.87 
 
 Loans secured by other collateral security . . 128,216,466.69 
 
 Loans unclassified , 120,972,809.58 
 
 United States bonds 77,719,949.27 
 
 State, county, and municipal bonds .... 214,257,761.62 
 
 Railroad bonds 406,272,168.88 
 
 Other public service bonds 79,015,464.73 
 
 Unclassified investments 1,396,556,360.70 
 
 Banking house, furniture and fixtures . . . 41,160,918.63 
 
 Other real estate owned . 24,333,145.89 
 
 Due from banks 202,898,003.08 
 
 Checks and cash items 1,253,422.47 
 
 Cash on hand 24,132,875.91 
 
 Resources not classified 36,217,357.37 
 
 Total $4,818,560,362.69 
 
 1 Report of the Comptroller of Currency, I (1918), 88, 91.
 
 334 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 LIABILITIES 
 
 Surplus $ 315,631,490.78 
 
 Undivided profits 58,792,522.91 
 
 Due to banks 341,519.02 
 
 Individual deposits 4,422,096,393.15 
 
 Postal savings deposits . 757 .00 
 
 Notes and bills rediscounted 2,259.42 
 
 Bills payable 1,572,718.83 
 
 Other liabilities 20,122,701.58 
 
 Total $4,818,560,362.69 
 
 It will be noted that in the mutual banks investments are 
 larger relatively to loans than in the stock banks, and that the 
 volume of investments in state, county, and municipal bonds, 
 railroad bonds, and public service bonds is much larger rela- 
 tively than in the stock institutions. Loans secured by real 
 estate are proportionally much greater in the mutual institu- 
 tions. These differences are for the most part attributable to 
 the differences in the legal regulations pertaining to investment 
 in the eastern and western states. 
 
 HI. SAVINGS DEPARTMENTS IN COMMERCIAL 
 BANKS 
 
 The mutual and stock savings banks are not the only 
 savings institutions, for the commercial banks of the country 
 also have savings departments which have come to play a very 
 important role in the raising of funds. Most state commercial 
 banks, particularly in the South and West, have always received 
 savings accounts to a greater or lesser degree; in many cases, 
 indeed, it has been found that a so-called commercial bank 
 does mainly a savings business. Trust companies, moreover, 
 almost universally have savings departments. 
 
 The development of savings departments in national banks 
 is a matter of the last twenty years; for until an important 
 decision was rendered by the Comptroller of the Currency in 
 1903, there were only a few national banks that had savings 
 departments, the majority of them believing that it was illegal
 
 THE FUNCTIONS OF SAVINGS INSTITUTIONS 335 
 
 to accept savings accounts. In answer to a question from a 
 western banker whether a national bank could operate a sav- 
 ings department, Comptroller Ridgeley stated: 
 
 There does not appear to be anything in the National Bank Act 
 which authorizes or prohibits the operation of a savings department 
 
 by a national bank The expediency of the National Bank 
 
 Association, organized for the purpose of doing the business of dis- 
 count and deposit, engaging in the business of a savings bank is 
 one for the determination of the Board of Directors. 
 
 Because of the strong competition for deposits among the 
 different types of banks, the national institutions rapidly 
 availed themselves of the privilege granted under this decision 
 and established savings departments. By 1912 about 45 per 
 cent of all national banks had taken action in this direction. 
 The movement was further facilitated when the Federal 
 Reserve Act of 1913 formally recognized the existence of sav- 
 ings departments in national banks and provided that a reserve 
 of only 3 per cent need be kept against "time deposits." The 
 growth of the savings business in national banks since then is 
 shown by the following figures: on August 9, 1913, the aggre- 
 gate of savings deposits was $820,000,000; on December 19, 
 1919, it was $2,293,000,000. This growth is obviously not 
 entirely attributable to the general rise in prices that has 
 occurred. 
 
 IV. POSTAL SAVINGS BANKS 
 
 The agitation for a postal savings bank system in the 
 United States began as early as 1871, when the first postal 
 savings bill was introduced into Congress. In the ensuing 
 years about eighty bills for the establishment of a postal sav- 
 ings system were advanced, and the system was strongly 
 advocated by eight different postmasters-general of the United 
 States. It was not until 1910, however, that postal savings 
 banks were finally established in this country. 
 
 The chief argument for the postal savings system was that 
 it would stimulate saving among people in moderate circum- 
 stances, particularly the immigrant class, who either distrusted
 
 336 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 the regular savings institutions or found their facilities incon- 
 venient or inadequate. The panic of 1907, which made it 
 impossible for many of the savings banks to pay deposits on 
 demand, greatly augmented the dissatisfaction with private 
 savings banks and accelerated the movement for public insti- 
 tutions. The savings facilities of the country were not, in 
 fact, evenly distributed, a large percentage of the savings 
 banks being concentrated in a few states of the union. In the 
 South and West, particularly, opportunities for depositing 
 money in savings banks were said to be quite inadequate, 
 although those who made this statement usually overlooked 
 the fact that state and national commercial banks, particularly 
 the former, furnished facilities for savings. Nevertheless, it was 
 widely believed that if the Post-Office Department should 
 open offices in cities, towns, and villages not provided with 
 adequate savings facilities, economy and thrift would be greatly 
 promoted and funds which would otherwise be hoarded or sent 
 abroad by immigrants for deposit in European postal savings 
 banks would be made available for investment purposes in this 
 country. 
 
 The main objection to the postal savings system was raised 
 by a special interest, namely, the existing savings and commer- 
 cial banks of the United States. These banks urged that the 
 existing facilities were fairly adequate and that for the govern- 
 ment to invade the field of banking was an unwarranted inter- 
 ference with private initiative. As we shall see, the fear on 
 the part of bankers that postal savings would lessen the volume 
 of their deposits has been rendered groundless by certain pro- 
 visions of the act designed to protect the regular savings 
 institutions. 
 
 The following are the important provisions of the postal 
 savings law: 
 
 An account may be opened and deposits made by any person of 
 the age of ten years or more, in his or her own name, and by a married 
 woman in her own name, and free from any control or interference 
 by her husband; but no person may at the same time have more 
 than one postal savings account.
 
 THE FUNCTIONS OF SAVINGS INSTITUTIONS 337 
 
 Deposits will be accepted only from individuals and no account 
 will be opened in the name of any corporation, association, society, 
 firm, etc., or in the names of two or more persons jointly. No account 
 will be made in trust for another person (as is the case in many foreign 
 countries). 
 
 No person may ordinarily have a deposit account in excess of 
 $1,000, exclusive of accumulated interest, except by special authoriza- 
 tion of a board of trustees (an official board for the supervision of the 
 system, composed of the Postmaster General, Secretary of the Treas- 
 ury, and the Attorney General of the United States). With such 
 authorization additional deposits may be accepted "not to exceed in 
 the aggregate $1,000 for each depositor, but upon which no interest 
 shall be paid." 
 
 No account may be opened for less than one dollar, nor will 
 fractions of one dollar be accepted for deposit at any time. 
 
 The interest rate shall be 2 per cent on deposits which have 
 remained for at least one year, and will be computed only from the 
 first of the month following the day on which the deposit was made. 
 
 Postal savings deposits will be evidenced by certificates of deposit 
 issued in the name of the depositor. These will be non-transferable 
 and non-negotiable. 
 
 To enable any person to accumulate and deposit amounts less 
 than one dollar, depository offices will keep for sale postal savings 
 cards at ten cents each and ten-cent postal savings stamps which 
 may be affixed to the cards. One card and nine stamps will be 
 accepted as a deposit of one dollar. 
 
 Any depositor may withdraw the whole or part of his funds by 
 surrendering at the depository office the savings certificates properly 
 indorsed. The postal savings funds shall be deposited by the post- 
 masters in certain designated depository banks, which may be either 
 national or state, savings or commercial banks. If no local bank has 
 qualified in a particular town or locality, then the funds shall be 
 deposited in a qualified bank which is most convenient to such locality. 
 The depository banks pay interest of z\ per cent per annum on the 
 funds received. No bank, however, is allowed to receive a total 
 sum greater than its capital and half of its surplus. 
 
 Five per cent of the funds received by any depository bank shall 
 be turned over to the board of trustees and be kept with the Treasurer 
 of the United States as a lawful money reserve against postal savings 
 deposits.
 
 338 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 Before any bank is qualified to receive postal savings deposits, 
 it must turn over to the board of trustees of the postal savings system 
 public bonds or other securities approved by the board of trustees 
 and deemed sufficient and necessary to insure the safety and prompt 
 payment of such deposits on demand. 
 
 If at any time the postal savings deposits in any city exceed the 
 amount which the qualified banks therein are willing to receive under 
 the terms of this act, the board of trustees may invest all or any part 
 of such amount in bonds and other securities of the United States. 
 And if, in the judgment of the President of the United States, the 
 general welfare and interest of the United States require it, the board 
 of trustees may invest all or any part of the postal savings funds, 
 except the reserve fund of 5 per cent, in bonds and other securities of 
 the United States. 
 
 Any profits received by the Post-Office Department shall be 
 covered into the Treasury of the United States as a part of the postal 
 revenue. 
 
 The limitation of the account of any one depositor to 
 $1,000 does not measure the full possibility for further utilizing 
 the postal savings banks, for the law provides a means whereby 
 individuals may purchase United States postal savings bonds 
 paying 25 per cent interest. 
 
 Any depositor may surrender his deposit or any part thereof in 
 sums of twenty dollars, forty dollars, sixty dollars, eighty dollars, 
 one hundred dollars, and multiples of one hundred dollars and five 
 hundred dollars, and receive in lieu of such surrendered deposits, 
 under such regulations as may be established by the board of trustees, 
 the amount of the surrendered deposits in United States coupon or 
 registered bonds of the denominations of twenty dollars, forty dollars, 
 sixty dollars, eighty dollars, one hundred dollars, and five hundred 
 dollars, which bonds shall bear interest at the rate of i\ per centum 
 per annum, payable semiannually, and be redeemable at the pleasure 
 of the United States after one year from the date of their issue and 
 payable twenty years from such date. 
 
 The results attained under the postal savings system have, 
 on tJte whole, fulfilled the expectations of its advocates. By 
 the end of the fiscal year 1913 there were 12,151 post-offices 
 which were receiving postal savings. A great number of these,
 
 THE FUNCTIONS OF SAVINGS INSTITUTIONS 339 
 
 however, had very small accounts and during the next few 
 years a considerable percentage of them were discontinued. 
 On June 30, 1916, there were 8,421 postal savings banks in 
 the United States. Of this number 1,648 had deposits of less 
 than $100; while 509 of them did not have a single dollar on 
 deposit at the end of that fiscal year. It is thus evident that 
 there are still too many small offices. 
 
 As was anticipated, the depositors in the postal savings 
 banks are largely of the immigrant class. On September 26, 
 1916, 60 per cent of the 625,000 depositors were born outside 
 of the United States; and this 60 per cent owned three-fourths 
 of all the deposits. It appears also that the proportion of 
 foreign born among the depositors has been increasing. 
 
 The returns also show that the postal savings funds have 
 come, as was again anticipated, largely from hoards and from 
 accumulations that would otherwise be sent abroad by our 
 foreign-born inhabitants. It is interesting to note also that 
 87 per cent of the postal savings bonds purchased are in regis- 
 tered form and are presumably held as permanent investments. 
 
 V. THE MANAGEMENT OF SAVINGS INSTITUTIONS 
 
 The successful management of a savings bank depends upon 
 the recognition of two main principles: first, that the loans 
 and investments must be of a conservative type and widely 
 distributed, both geographically and by industries; second, that 
 a sufficient reserve of cash must be maintained to enable the 
 bank to pay current bills and to meet the withdrawal require- 
 ments of those who have placed funds in deposit with the bank. 
 
 With a view to insuring the conservative management of 
 savings institutions, legislation has been developed which pre- 
 scribes the character of the loans and investments that may be 
 made and lays down provisions regarding the maintenance of 
 reserves. These laws, however, vary widely in different states; 
 and in some, mainly in the South and West, there is no legisla- 
 tion at all. The New York law, applying to mutual savings 
 banks, has served as a model for many other states, and a
 
 340 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 summary of its provisions will therefore indicate the most 
 approved form of savings bank legislation at the present tune. 
 The following are the types of investment that may be made: 
 
 1. In the bonds of the United States and New York state. 
 
 2. In the bonds of other states which have not defaulted within 
 ten years. 
 
 3. In the municipal bonds of New York state municipalities. 
 
 4. In the bonds of any city in a state admitted to statehood prior 
 to 1896, and which has not defaulted on any of its bonds since 1861. 
 The debt of such a city, however, must not exceed 7 per cent of its 
 assessed valuation. 
 
 5. In the first mortgages on real estate in New York state. Such 
 mortgages must, not exceed 60 per cent of the value of unproved 
 property or 40 per cent of the value of unimproved property. 
 
 6. In the first mortgage bonds of strong railroads which have 
 paid for at least five years dividends at the rate of 4 per cent on 
 their stock; but the stock must be at least equal in amount to one- 
 third the debt of the road. 
 
 7. In the first mortgage bonds of railroads in New York on the 
 same conditions. Not more than 25 per cent of the deposits shall 
 be invested in railroad bonds and not more than 10 per cent in the 
 bonds of any one road. 
 
 The provisions of this law do not permit, much less insure, 
 a wide distribution of risks; emphasis is rather placed upon the 
 necessity of "patronizing home industry." The distribution by 
 industries is also somewhat restricted, owing to the emphasis 
 that has necessarily been placed upon very conservative 
 securities. 
 
 As a rule mutual savings banks are not required by law 
 to hold any minimum cash reserve; but interestingly enough 
 a maximum reserve is usually named, on the theory that 
 unnecessary reserves constitute idle money and that the trustees 
 need to be discouraged from allowing funds to accumulate. 
 The New York law, for example, provides that any mutual 
 savings bank may keep on hand or on deposit with any national 
 bank, New York state bank, or trust company an available 
 fund not exceeding 20 per cent of its deposits. Stock sav- 
 ings banks, on the other hand, are in many states required to
 
 THE FUNCTIONS OF SAVINGS INSTITUTIONS 341 
 
 maintain a minimum reserve in specie, commonly from 5 to 
 10 per cent. 
 
 The maintenance of a proper reserve is the pivotal problem 
 in savings bank management. The cash reserve of a bank may 
 tfe denned as the ratio of its cash resources to its deposit 
 liabilities. For instance, in the final statement of the bank 
 that we have organized above, the cash stands at $5,000 and the 
 individual deposits at $50,000, giving a reserve of 10 per cent. 
 The bank has thus committed- itself to pay $50,000 to indi- 
 viduals, although it has at the moment only $5,000 in cash on 
 hand. The. ability of a savings bank to "get by" with a small 
 cash reserve it may, in fact, be much less than 10 per cent- 
 depends in part upon the nature of the agreement with the 
 depositors whether the depositors are to be paid upon demand 
 or only at the expiration of a thirty- or sixty-day notice of 
 withdrawal; it also depends in part upon the readiness with 
 which the bank can convert some of its assets into cash at a 
 moment's notice or borrow the funds required from some other 
 financial institution. 
 
 Legally, savings banks have the right to require a notice of 
 withdrawal from depositors; and it is commonly said that sav- 
 ings banks, therefore, do not need to keep their resources in a 
 form where they can be readily converted into cash. But in 
 practice this right to demand a notice is nowadays seldom 
 exercised. As an accommodation to the depositors, the savings 
 banks early developed the practice of paying depositors on 
 demand, whenever it was convenient for them to do so. The 
 result was that the depositors soon came to consider that the 
 savings bank informally agreed to return their funds whenever 
 they were needed, notwithstanding the formal requirement that 
 notice of withdrawal be given. The keen competition for 
 deposits among savings banks gradually led to an all but 
 universal abandonment of the practice of requiring notice of 
 withdrawal, even though at times it was not convenient for 
 the savings banks to meet depositors' demands. The competi- 
 tion of commercial banks, who never have required notice of 
 withdrawal, also aided in nullifying the withdrawal provision;
 
 342 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 for the typical depositor regards a bank as a bank and does 
 not carefully distinguish between savings and commercial insti- 
 tutions. The following quotation from a prominent savings 
 bank president indicates the prevailing attitude on the question 
 of enforcing the provision that notice must' be given before 1 
 withdrawal: 
 
 In the final analysis it is the ability to pay depositors on demand 
 that constitutes good banking and inspires confidence. Your funds 
 may be invested in securities of the highest order, your loans made 
 with the greatest care, but if, whenever there is a depression, deposi- 
 tors are required to give notice of withdrawal, their confidence is 
 shaken and they will eventually cease doing business with savings 
 banks and deposit their moneys with institutions which will pay 
 without notice. 
 
 Savings institutions now make many loans for working capital 
 purposes. It has always been difficult in times of financial 
 strain for savings banks to pay depositors on demand. Legis- 
 lation often restricted investments to a very narrow range 
 of securities municipal securities, few of which are listed on 
 the exchanges, and real estate mortgages having originally been 
 the two chief types of savings bank investments. The difficul- 
 ties encountered in time of financial strain finally led to an 
 agitation for broadening the field of investments to include 
 certain readily marketable securities, principally railroad bonds. 
 While the agitation was successful, it was again found in the 
 panic of 1907 that deposits could not be paid on demand. 
 
 Since the panic of 1907 the belief has steadily gained ground 
 that savings banks should invest a considerable portion of 
 their assets in short-time promissory notes of business men 
 and in bank and trade acceptances, to the end that in time of 
 strain they may be in a stronger position to acquire cash. 1 
 And the savings banks have, in fact, steadily expanded the 
 volume of their short-time loans in recent years. The financial 
 statements for stock savings banks, given above, show that the 
 total advances made in the form of loans, exclusive of those on 
 
 1 We shall find, however, in connection with our study of commercial 
 banking in succeeding chapters that assets of this sort do not, in fact, 
 guarantee that the bank can withstand a heavy financial strain.
 
 THE FUNCTIONS OF SAVINGS INSTITUTIONS 343 
 
 real estate, are nearly four times the total investments. While 
 many of these loans are doubtless for fixed capital purposes, a 
 considerable, and an increasing, percentage of them are for 
 short-time purposes. Therefore, hi the diagram on page 136 
 a line might well have been drawn from savings banks to the 
 working capital side of the corporation, for many of their loans 
 to customers and all of their purchases of commercial paper 
 and acceptances furnish funds for working capital purposes. 
 
 It has been customary for writers on banking to state that 
 it is the function of commercial banks to furnish funds for 
 current needs, that is, for working capital purposes, and of the 
 savings banks to furnish permanent, or fixed capital. How- 
 ever true this statement may have been in the past, the bank 
 statements above show conclusively that, so far as savings 
 banks are concerned, they are no longer institutions which 
 specialize exclusively in the raising of funds for fixed capital 
 purposes. 1 
 
 VI. THE PROFITS OF SAVINGS BANKS 
 
 The profits made by mutual savings banks are derived from 
 loaning or investing the funds of the mutual depositors. The 
 interest received, less the expenses of managing the institution, 
 and whatever amount is kept in the business as surplus or 
 undivided profits, is distributed to the depositors semiannually 
 in the form of dividends. The dividend rates vary some- 
 what in different states, and they fluctuate within narrow 
 limits from year to year in any given state or locality. On 
 the whole, they may be said to average about 4 per cent. 
 In 1914 the general average was 3.86, and in 1913, 3.94 per 
 cent. The highest state average was in West Virginia, 4.5 
 per cent, and the lowest in Pennsylvania, 3.57 per cent. 
 
 The profits of stock savings institutions are in part derived 
 from loans and investments of the funds contributed by share- 
 holders, and in part from the use of the funds of depositors. 
 The returns from the latter source may in a sense be said to 
 represent the difference between the interest rate paid to 
 
 1 See pp. 731-32.
 
 344 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 depositors and the interest rate received on the bank's loans 
 and investments. Such a statement does not, however, 
 adequately disclose the nature of the problem of making a 
 savings bank pay. 
 
 The stock savings institution must tie up a considerable 
 proportion of its capital in building and equipment; it must 
 incur no little expense in maintaining an official and clerical 
 force, providing supplies, etc.; and it must keep a reserve of 
 cash. In general it may be said that the funds contributed 
 by the shareholders are largely absorbed in these ways in 
 providing, as it were, a necessary foundation for the business 
 of receiving deposits. Directly speaking, the profits are there- 
 fore derived from loans and investments of depositors' funds. 
 
 Let us assume that a savings bank has a capital of $100,000 
 and deposits of $1,000,000 and that the funds derived from 
 shareholders are all absorbed in providing the building, main- 
 taining a reserve, etc. If the bank pays 3 per cent interest on 
 the $1,000,000 of deposits, and loans out $1,000,000 at 5 per 
 cent, the profit would be 2 per cent, or $2 on every $100 of 
 deposits; $2 on every $100 of deposits is equal to $20 on every 
 $100 of capital stock, .or earnings of 20 per cent. It will be 
 seen therefore that the amount of dividends that may be paid 
 on capital stock largely depends upon the volume of deposits. 
 
 VII. INSURANCE COMPANIES AS SAVINGS 
 INSTITUTIONS 
 
 Discussion of the work of insurance companies is ordinarily 
 approached from the standpoint of their primary function of 
 affording protection to life and property. It is nevertheless 
 commonly recognized that the savings feature of life insurance 
 is very important. Have we not all been told times without 
 number that an endowment policy is the safest investment in 
 the world and that the most certain way of making provision 
 for old age is by taking out insurance? However accurate 
 this statement may be, it is certainly true that the insurance 
 company is performing a service that is identical with that of
 
 THE FUNCTIONS OF SAVINGS INSTITUTIONS 
 
 345 
 
 the ordinary savings bank; it is an intermediary between the in- 
 dividual savers and the borrowing enterprises of modern society. 
 
 The insurance company, moreover, assists in the raising of 
 capital, even when the individual payers of premiums do not 
 have in mind the savings feature of insurance. For all of the 
 operations of each of the various types of insurance companies 
 life, fire, marine, etc. result in the transfer of funds from 
 individual savers to borrowers. Whatever the reason for tak- 
 ing out insurance, if the company is to make effective use of 
 the premiums paid in, it is necessary to invest the funds so 
 received. These investments always mean a transfer of funds 
 from the individuals who furnish them to the corporations 
 whose securities are purchased. 
 
 The insurance company is sometimes the only intermediary 
 between the borrower and the saver of funds; and sometimes 
 it is a secondary intermediary between the saver and the 
 investment banks (see the diagram on p. 136). Besides making 
 investments in securities, insurance companies make a good 
 many short-time loans to business concerns. They also make 
 very large "policy loans" to the individuals whom they have 
 insured, and thus play an important part in the extension of 
 funds for temporary consumptive or productive needs. 
 
 The following table of the assets of American life insurance 
 companies for the years 1904 to 1914 shows the nature of 
 their loans and investments. During the war, life insurance 
 
 ASSETS OF AMERICAN LIFE INSURANCE COMPANIES 
 
 
 December 31, 1904 
 
 December 31, 1914 
 
 Real estate 
 
 $ 180,875,035 
 
 $ 171,173,551 
 
 Real estate mortgages 
 
 671,^77,813 
 
 1,706,36^,401; 
 
 Bonds 
 
 1,067,027,851 
 
 I,o8l,7sl,6o8 
 
 Stocks 
 
 172,1:82,071; 
 
 &2,ZZ2,<H2 
 
 Collateral loans 
 
 42,715,261 
 
 20,^^1,766 
 
 Policy loans and premium notes . . . 
 Cash 
 
 189,738,779 
 104,027,124 
 
 735,348,014 
 
 05, 160,368 
 
 Deferred premiums 
 
 4<;,87Q,4.<5 
 
 68,832,680 
 
 All other assets 
 
 24,636,705 
 
 73,716,779 
 
 
 
 
 Total admitted assets 
 
 $2,400,060,008 
 
 $4,935,252,793 
 
 

 
 346 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 companies, like all other financial and business institutions, pur- 
 chased a great number of liberty bonds; but aside from this 
 there has been no important change in the distribution of 
 investments since 1914.* 
 
 The assets of American fire insurance companies are not 
 available for a similar exhibit. Because of the nature of their 
 operations .the total assets are, however, much smaller than 
 those of the life insurance companies. The distribution of 
 their -investments probably does not differ essentially from 
 that shown in the table. All in all it can safely be said 
 that the table above fairly illustrates the role that insurance 
 companies play in the raising of capital. 
 
 A consideration of the distribution of life insurance invest- 
 ments throws light upon the importance of these institutions 
 in financing different types of business enterprise. It will be 
 observed that investments in bonds are slightly in excess of 
 loans on real estate mortgages. The mortgage loans of 148 life 
 insurance companies, comprising 985 per cent of all such loans, 
 were divided between loans on farm property and other real 
 estate in an interesting way. Seventeen companies made loans 
 only on farm property; 15 only on real property in cities, towns, 
 and villages; and 116 made loans on both farm and city proper- 
 ties. The amount loaned by the 17 farm loan companies was 
 $12,827,709; by the 15 city loan companies, $426,260,163; 
 and by the 116 companies loaning on both farm and city 
 property, $1,158,014,595. Of the total mortgage loans of 
 these 148 companies, 39.03 per cent were in United States 
 farms, 59.24 per cent on other real property in the United 
 States and 1.73 per cent on real estate mortgages of Porto 
 Rico and foreign countries, mainly Canada. 
 
 The geographical distribution is also interesting. In the 
 eastern states the amount loaned on farms is negligible; in 
 the central, northern, and southern groups farm loans rise to 
 considerable totals; but it is in the southwestern and north- 
 western sections of the country that the great bulk of life 
 
 1 The author has been unable to find complete data for a later year. 
 This table was taken from Investment News, V, No. 2 (1916), p. 24. At the 
 present time (1920) they are investing heavily in government bonds.
 
 THE FUNCTIONS OF SAVINGS INSTITUTIONS 347 
 
 insurance farm loans has been placed. On the other hand, the 
 loans on city real estate, other than land, have mainly been 
 placed in the populous commercial and manufacturing centers 
 of the New England and Middle Atlantic states, which contain 
 almost half of the total of such loans. 
 
 Insurance companies may keep very small cash reserves. 
 The cash reserves of insurance companies may ordinarily be 
 very small for the reason that they have no deposits subject 
 to withdrawal on demand. Payments are made whenever 
 losses are sustained or whenever policies mature; and in the 
 case of a large company these payments run in fairly uniform 
 amounts and can be met out of current receipts. In the case 
 of unusual losses, larger payments of course have to be made; 
 but some time necessarily elapses, while the company is making 
 an investigation of the claim, and in the interval there is 
 usually plenty of opportunity for the company to dispose of 
 some of its investments. It is obviously necessary, however, 
 to keep a fair proportion of the assets in readily marketable 
 securities. This fact accounts for the large volume of bond 
 investments shown hi the foregoing table, as well as for the 
 argument that they should invest in commercial paper and 
 acceptances. 
 
 The growing practice of making loans to policy holders has 
 given rise to a new reserve problem. Policy loans are made 
 in accordance with an agreement to loan a certain percentage 
 of the surrender value of the policy at a fixed rate of interest 
 at any time the insured desires such a loan. The growth of 
 this practice has raised the question: In view of the agreement 
 to make loans on demand, should not insurance companies, 
 like the banks, be required to maintain a substantial cash 
 reserve, and to invest a portion of their assets in short-time 
 commercial paper and acceptances ? 
 
 In the absence of a reserve of cash or liquid assets, it is 
 urged that insurance companies must rely in times of stress 
 upon the commercial banks; and that thjey therefore serve to 
 bring added pressure upon a severely strained credit structure. 
 Since it is precisely in times of financial stress that "policy
 
 348 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 loans" are sought most largely, and since the marketing of 
 securities involves the withdrawal of funds from commercial 
 banks by the purchasers of securities, it is hardly to be denied 
 that the lack of cash reserves in insurance companies imposes 
 additional burdens upon the reserves of the banks. 
 
 In practice, there has been a growing tendency in recent 
 years to keep both larger cash reserves and a large amount of 
 readily marketable securities. To date, however, the insur- 
 ance companies have shown little disposition to purchase short- 
 term paper. Whether investments in commercial paper and 
 acceptances would serve to relieve the strain that is now trans- 
 ferred by the insurance companies to the banks in time of crisis 
 is a question which cannot be advantageously discussed at 
 this place. 1 
 
 VIII. THE ECONOMIC SIGNIFICANCE OF 
 SAVINGS INSTITUTIONS 
 
 In the foregoing pages we have described the different 
 types of savings institutions in present-day society and con- 
 sidered the chief problems arising in connection with their 
 practical operation. We may now consider in some detail the 
 economic services that savings institutions perform in the 
 modern economic system. 
 
 We have already seen that in the large the function of sav- 
 ings institutions is to assist in the raising of capital for modern 
 business enterprise to bridge the gap between the individual 
 saver and the borrowing corporation or other enterprise. It 
 will be pertinent to inquire now whether savings institutions 
 are necessary middlemen; whether the function ascribed to 
 them could not more efficiently be carried out without such 
 financial intermediaries. 
 
 So far as their short-time loans are concerned and we 
 have found that savings banks, contrary to general belief, make 
 large loans for working capital purposes it is clear that it 
 would be practically impossible for corporations desiring to 
 
 1 See pp. 532-33-
 
 THE FUNCTIONS OF SAVINGS INSTITUTIONS 349 
 
 borrow funds for short periods of time to make connections 
 with individual lenders. A financial intermediary, which can 
 gather together small savings from a number of individuals and 
 turn them over in large aggregations to corporations for short- 
 time uses, is an indispensable institution. While the savings 
 bank now performs an important role in this process, the com- 
 mercial banks could doubtless readily assume the entire 
 burden. 
 
 In the raising of fixed capital through the sale of securities, 
 the case for the savings institutions is more conclusive, though 
 not very obvious. It may be asked, Why should not the 
 individual savers buy the securities directly, and thus receive 
 5 or 6 per cent instead of 3 or 4, as is the case when they 
 deposit their funds in savings institutions and allow the savings 
 banks to do the investing? We shall find that there are 
 several reasons why it is better for many people to make 
 savings deposits rather than to invest in securities directly. 
 
 Savings institutions facilitate the making of investments in 
 numerous ways. First, there are a great many people whose 
 knowledge of investment values is so negligible that direct 
 investment in securities involves the assumption of very great 
 risks. It is true that they may nowadays avail themselves of 
 the advice and counsel of investment bankers; but many 
 people are not aware of this opportunity, or, if they are aware 
 of it, they are unwilling or unable to establish connections with 
 an investment banking house. 
 
 Second, the savings of a very large percentage of people are 
 too small in amount to make direct investments in securities 
 through the established channels practicable. While in recent 
 years bond houses have been cultivating the small investor 
 increasingly and are now offering "baby bonds" and "partial 
 payment" plans as a means of inducing investments of small 
 amounts, they still remain essentially institutions which serve 
 the upper rather than the lower strata of investors. One should 
 ordinarily have several hundred dollars of savings before 
 attempting to invest in securities. Savings institutions, how- 
 ever, do reach the smallest accumulations; they gather in even
 
 350 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 the penny savings of society and make them available in larger 
 aggregations for the purposes of business. 
 
 Third, unless one has a considerable volume of savings, the 
 problem of safekeeping is a deterrent to bond investments. A 
 safety deposit box costs from three to five dollars a year; and if 
 one has only a hundred-dollar bond, the interest is largely 
 absorbed in paying for the safety box. The savings bank 
 deposit, however, is taken care of by the bank. 
 
 Fourth, the savings bank method of effecting savings is 
 generally more convenient than making direct investments in 
 bonds. Savings institutions are usually located conveniently 
 for the investor of small means and are kept open for business 
 at hours which facilitate the making of deposits. Moreover, 
 the making of a deposit is simplicity itself merely handing the 
 funds through a window and receiving an entry in a deposit 
 book. The postal savings banks, as we have seen, offer still 
 greater conveniences in this connection. 
 
 Fifth, a deposit in a savings bank can usually be more easily 
 recalled in case of need than an investment in bonds. While 
 this is not so true in the case of large investments, where the 
 investors maintain close relations with bond houses and select 
 their securities with a view to ready marketability, it is practi- 
 cally always true of small investments in securities. As we 
 have seen, a savings bank deposit is ordinarily payable on 
 demand and payable in full. A bond of small denomination 
 very frequently cannot be quickly disposed of; and even bonds 
 of large denomination may be marketed at a given time only at 
 a loss. 
 
 Savings banks and insurance companies lessen the risks of 
 investment. More important than any of the foregoing services 
 that are performed by savings institutions is the fact that they 
 enable one to lessen the risks of investment. No matter how 
 excellent one's knowledge of the value of securities may be, 
 there is always some risk of loss with any given security. And, 
 in accordance with the theory of probability, the percentage of 
 loss is always less, the wider the distribution of investments. 
 This is simply an application of the old adage, "Don't put all
 
 THE FUNCTIONS OF SAVINGS INSTITUTIONS 351 
 
 your eggs in one basket." By virtue of its very large invest- 
 ments, the savings bank can always distribute its risks widely; 
 while an individual can do so only if he is comparatively 
 wealthy. 
 
 The mutual savings institutions are, in reality, nothing but 
 a device for pooling the investments and the losses of the 
 depositors, thereby lessening the risks assumed by each. The 
 stock savings bank accomplishes the same result by a more 
 roundabout process. Individuals turn their funds over to the 
 bank and receive the promise of the bank to pay them in full; 
 the bank diversifies its investments as much as possible in 
 order to reduce the chances of loss. The resources contributed 
 by the shareholders of the bank may also be drawn upon to 
 prevent loss to depositors. The risks of loss to the individual 
 are thus very greatly lessened. 
 
 The large insurance companies perhaps present the best 
 examples of widely diversified risks. By virtue of their very 
 great size, these companies are enabled to invest in bonds and 
 securities of any number of corporations and in real estate mort- 
 gages on farms throughout the length and breadth of the 
 United States, not to mention foreign countries. It is thus 
 impossible for a large company to suffer a total loss, except in 
 the event of a complete destruction of the existing economic 
 order. A very small percentage of loss on the total investments 
 is absolutely assured. In a word, every depositor in a large 
 savings institution, and every person insured in a large insur- 
 ance company, is in effect a part-owner of all the corporations, 
 farms, etc., whose securities and mortgages have been purchased 
 by the bank or insurance company, and his potential losses are 
 thereby reduced to a negligible minimum. 
 
 A further word is in point with reference to the savings that 
 are effected through life insurance companies. When one takes 
 out life insurance, he places a premium, albeit a negative 
 premium, upon making additional savings; for if one does not 
 meet his payments as they mature, he stands to lose the savings 
 that he has previously made. Since a large percentage of 
 people are so constituted that they cannot resist the impulse to
 
 352 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 spend unless they have a heavy penalty hanging over their 
 heads, savings through insurance is a most useful device for com- 
 pelling people to make provision for the rainy day. 
 
 In the light of these considerations it is clear that the savings 
 banks do perform important services as middlemen in the pro- 
 cess of bringing borrowers and lenders together. The stock 
 savings banks and the insurance companies are accordingly 
 entitled to the difference between the interest which they pay 
 on deposits and the' interest which they receive from their 
 loans and investments in securities. The various conveniences 
 of savings institutions, and the reduction of risks that is afforded 
 by virtue of the wide distribution of loans and investments, 
 more than compensate the individual saver for the lower rate 
 of return which he receives when he invests in savings insti- 
 tutions than when he invests in bonds. It may be observed, 
 moreover, that no one is compelled to make investments 
 through savings institutions; if one prefers, he can secure the 
 higher rate of interest by investing hi securities directly. 
 
 Finally, the savings institutions, like the bond houses, 
 assist to some extent in directing the flow of industrial energy. 
 This is particularly the case with the stock savings bank of the 
 south and west, whose investments are not circumscribed by 
 legislation, as is usually the case with the mutual institutions 
 of the east. Such savings institutions, as we have seen, invest 
 directly in the securities of local and other enterprises and they 
 make short-time loans to corporations and businesses, both at 
 home and in other centers. In making these direct invest- 
 ments the savings bank officials must pass judgment upon the 
 honesty and integrity of the management and upon the ability 
 of the borrowing enterprise to pay the loans at maturity. Like 
 the bond house analysts, they hold a veto power over the 
 expenditure of funds 'for any given purpose; and in proportion 
 as the judgment of savings bank managers is superior to that 
 of the rank and file of savings depositors, the distribution of 
 industrial energy is thus more efficiently directed.
 
 THE FUNCTIONS OF SAVINGS INSTITUTIONS 353 
 QUESTIONS FOR DISCUSSION 
 
 I. THE DIFFERENT TYPES OF SAVINGS INSTITUTIONS 
 
 1. What is the essential difference between stock and mutual sav- 
 ings banks ? 
 
 2. How does the guaranty savings bank differ from the mutual 
 institutions? Has it any advantages over either the stock or 
 the mutual bank ? 
 
 3. Which class of savings banks is the more numerous? Which 
 does the larger volume of business ? 
 
 4. How do you account for the geographical distribution of mutual 
 and stock savings institutions ? 
 
 5. If you were organizing a savings institution, which type should 
 you choose ? 
 
 6. Do you see any good reason why a commercial bank should not 
 accept savings deposits ? Do you see any reason why the 
 accounts of the savings department should be kept distinct 
 from those of the commercial department ? 
 
 7. Do you think that the postal savings institutions have filled a 
 genuinely important need ? 
 
 8. Were the objections to the development of the postal savings 
 institutions well founded ? 
 
 9. What provisions of the postal savings law are designed to elimi- 
 nate competition with savings banks ? 
 
 10. Does it seem to you probable that the postal savings institutions 
 have on the whole been a source of gain to the banks? If so, 
 how do you account for the failure of bankers to appreciate 
 this in advance? 
 
 11. What is the purpose of permitting investments in postal savings 
 bonds ? 
 
 12. What is the purpose of authorizing the president of the United 
 States, at his discretion, to require the board of trustees to invest 
 all or any part of the postal savings funds in United States 
 bonds and securities ? 
 
 13. What is the purpose" of requiring the depository banks to put up 
 bonds ? 
 
 14. How large is the reserve of postal savings banks ? 
 
 15. Is there need for additional or better savings facilities in the 
 communities with which you are familiar ?
 
 354 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 H. THE OPERATION AND MANAGEMENT OF SAVINGS BANKS 
 
 1 6. Define capital stock; surplus; undivided profits; shareholders' 
 liabilities; balance sheet. 
 
 17. What is the net worth of the bank whose statement appears on 
 page 331 ? 
 
 18. Indicate what changes in the items of the balance sheet of a 
 stock savings bank would occur as a result of the following 
 transactions: 
 
 NOTE. Method to be used: The purpose in this exercise is 
 merely to show what assets or liabilities are increased or decreased 
 as a result of each operation. It will facilitate matters, therefore, 
 if the student merely uses the plus or minus symbol to indicate a 
 change. For example, if deposits have been received, one 
 should note that fact by marking on the liabilities side deposits 
 + $1,000; or if cash has been paid out, one should mark on the 
 assets side cash $1,000. 
 a) The bank receives $10,000 composed of the following items: 
 
 (1) Specie, $100 
 
 (2) Paper currency, $100 
 
 (3) Checks on commercial banks, $5,000 
 
 (4) Bank drafts, $3,000 
 
 (5) Cashier's checks, $1,800 
 
 b) 
 
 (1) It makes investments of $20,000 in bonds 
 
 (2) It makes $10,000 of loans secured by real estate 
 
 (3) It buys zoo U.S. liberty bonds at $86.50 
 
 (4) It buys 100 railroad bonds at 62! 
 
 c) The bank deposits $10,000 in a commercial bank 
 
 d) The bank, which has a capital stock of $100,000, a surplus 
 of $50,000, and an undivided profits account of $15,000 
 declares a semiannual dividend of 4 per cent. 
 
 19. A mutual savings institution with deposits of $100,000 has 
 earnings for the half-year of $4,500. At what rate may a divi- 
 dend be declared, and what would determine how much each 
 person entitled to the dividend would receive ? 
 
 20. Compare the percentage of loans to investments in securities in 
 both stock and mutual savings banks. 
 
 21. Which way of using the funds of a savings bank would you con- 
 sider preferable: in purchasing bonds and stock; or in making 
 loans?
 
 THE FUNCTIONS OF SAVINGS INSTITUTIONS 355 
 
 22. Draw up a list of the types of loans that you should consider it 
 safe for a savings bank to make. 
 
 23. Criticize the provisions of the New York savings bank law. 
 
 24. Draw up a negative statement showing the types of loans and 
 investments that cannot be engaged in under the New York law. 
 Do you think it necessary to prohibit all such loans and invest- 
 ments ? 
 
 25. What is the purpose of keeping a cash reserve ? What factors 
 will govern the amount of such reserve that must be carried ? 
 
 26. How much is the average reserve, as shown by the combined 
 financial statements given above, of the stock and of the mutual 
 savings banks of the United States ? 
 
 27. Do you think savings banks should attempt always to pay 
 deposits on demand ? 
 
 28. Why have savings banks tended more and more to make short- 
 time loans for working capital purposes ? 
 
 29. Should savings banks adopt the principle of "safety first," or 
 should they have in mind other things as well ? If so, what ? 
 
 30. If savings banks no longer require the notice of withdrawal, 
 ought they not to be subject to the same reserve regulation as 
 commercial banks ? 
 
 31. How does a mutual bank make its profits? How does a stock 
 institution make profits ? 
 
 m. INSURANCE COMPANIES AS SAVINGS INSTITUTIONS 
 
 32. Show how life insurance companies promote savings, even when 
 the purpose of taking out insurance is merely to secure pro- 
 tection. 
 
 33. Draw up a statement showing what types of business life insur- 
 ance companies assist most in financing. 
 
 34. Do the insurance companies promote the raising of working 
 capital as well as fixed capital ? 
 
 35. What is the purpose of policy loans ? Enumerate as many pur- 
 poses as possible for which one might wish to borrow on a life 
 insurance policy. 
 
 36. It is said that, because of the practice of loaning on policies on 
 demand, the insurance companies should be required to keep a 
 cash reserve. Do you agree ? 
 
 37. Under what conditions would the greatest volume of life insur- 
 ance policy loans be demanded ? What is the result of this ?
 
 356 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 IV. ECONOMIC SIGNIFICANCE OF SAVINGS INSTITUTIONS 
 
 38. Draw up a statement indicating what groups of people find sav- 
 ings institutions an advantage. 
 
 39. Do you think savings institutions are as important now as before 
 the development of the investment banks ? 
 
 40. Will savings institutions always be necessary as a means of dis- 
 tributing the risks of investors of small means ? 
 
 41. In which type of savings bank, stock or mutual, do you think 
 the risks to the individual saver are smaller ? 
 
 42. Do you think it is correct to say that the principal difference 
 between a savings bank and a commercial bank is that one pro- 
 vides capital for long-time permanent needs and the other 
 provides the current funds required by business enterprises ? 
 
 43. Can you think of any good reason why savings banks should be 
 organized as specialized institutions making loans and invest- 
 ments for only fixed capital purposes ? 
 
 44. What is the distinctive advantage of the insurance company in 
 promoting savings ? 
 
 45. Would you as soon do your savings through an insurance 
 company as through a savings bank ? How does the rate of 
 return compare ? How do the risks of loss compare ? 
 
 46. Would you favor the abolition of savings banks on the ground 
 that their functions can be as well performed by insurance com- 
 panies and bond houses ? 
 
 REFERENCES FOR FURTHER READING 
 
 Kniffin, William H. : The Savings Bank and Its Practical Work, 
 1916. 
 
 Hamilton, James H.: Savings and Savings Institutions, 1908. 
 
 Notes on the Postal Savings Bank Systems of the Leading 
 Countries: National Monetary Commission, 1910. 
 
 Kemmerer, Edwin W.: Postal Savings, 1917. 
 
 Savings Banks Monthly Journal.
 
 CHAPTER XIX 
 
 With this chapter we pass to a consideration of the raising 
 of the working, or operating, capital required by modern business 
 enterprise. By reference to the charts on pages 134 and 136 
 it will be seen that individual firms, partnerships, and cor- 
 porations borrow their working capital largely from com- 
 mercial banks, using promissory notes and bills of exchange as 
 evidences of the credit obligations involved. 1 The charts also 
 indicate that to some extent this borrowing from commercial 
 banks is done through commercial paper houses and com- 
 mercial credit or discount companies, which act as intermediaries 
 in the process. The remaining chapters of the volume will be 
 largely devoted to a discussion of the functions of the financial 
 institutions that are associated with the raising of working 
 capital. 
 
 As has been suggested at various points in the preceding 
 chapters, however, commercial banks also play an important 
 role in connection with the raising of fixed capital. Indeed, 
 the charts in chapter x are designed to indicate that the com- 
 mercial banks, including the Federal Reserve System, occupy 
 a position of paramount importance in the entire financial 
 structure. In studying the commercial banking system, 
 therefore, it will be our purpose to reveal the manifold relations 
 of commercial banking with the other parts of the financial 
 system; and especially to show its significance to the general 
 economic organization of modern industrial society. Several 
 chapters will be required to work out these larger aspects of 
 commercial banking. The present chapter is designed to lay 
 
 1 See also the chart on p. 650 in Part HI. 
 357
 
 358 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 the basis for an analysis of the significance of commercial 
 banking by outlining the practical organization and operations 
 of an individual commercial banking institution. 
 
 I. CLASSIFICATION OF COMMERCIAL BANKS 
 
 Before considering the nature of commercial banking 
 operations, it should be pointed out that commercial banks 
 are classified into national, state, and private institutions. A 
 national bank, as the name indicates, receives its charter from 
 the federal government; while a state bank receives its charter 
 from the particular state in which it is located. It may be 
 recalled that trust companies, chartered under state laws, 
 usually operate commercial banking departments. Private 
 banks, as the name implies, are unchartered institutions, 
 conducting their operations without specific grant of authority. 
 They have usually been subject only to those legal regulations 
 which surround other private businesses; although in recent 
 years most state laws have come to require that private 
 banks submit to the same supervision as incorporated insti- 
 tutions. 
 
 The existence of both national and state banks is merely 
 the result of our dual form of government. And it would be a 
 distinction without significance, were it not for the fact that 
 the regulations imposed on banking operations vary somewhat 
 in the different states and that state legislation is typically 
 somewhat less stringent than that of the federal government. 
 While the nature of these regulations and the essential differ- 
 ences may best be reserved for subsequent discussion, 1 it 
 will be of interest to observe at this place the relative number, 
 size, and rate of growth of national and state banks. The 
 national banking system was inaugurated during the Civil War 
 by an act of 1863, with amendments in 1864. The following 
 diagrams indicate the development of banking in the United 
 States from 1867 to 1918: 
 
 1 For the nature of commercial bank regulations see chap, xriv below.
 
 tt 
 
 8 
 
 1 
 
 
 
 8 
 
 < 
 
 OT 
 
 
 
 o 
 
 u 
 
 
 o 
 u 
 
 w 
 
 9 ^ 
 
 PH H 
 
 V 
 
 National B 
 State Ban 
 Trust Com 
 
 C6gi 
 
 I88 1 
 
 9*8' 
 
 oigi 
 6 98 i 
 898'
 
 PRACTICAL OPERATIONS OF THE COMMERCIAL BANK 361 
 
 IT. INCIDENTAL SERVICES OF COMMERCIAL 
 BANKS 
 
 Commercial banks perform a great variety of services, 
 some of them being in the nature of incidental conveniences to 
 individuals and businesses, and others of fundamental impor- 
 tance from the standpoint of the general economic system. The 
 less significant ones may conveniently be disposed of at this 
 place once and for all. 
 
 First, commercial banks serve as places of security for the 
 keeping of funds that are temporarily not needed by their 
 owners. Having well-equipped vaults, and being managed 
 (with rare exceptions) by men of integrity, the risk of loss to 
 the owner from fire, theft, or other contingencies is very greatly 
 minimized. 
 
 Second, commercial banks serve as money changers. In 
 accommodating each individual customer with the kinds and 
 denominations of money desired, they supply the community 
 as a whole with the forms of currency best adapted to its 
 commercial needs. They perform this function in part through 
 the issue of their own notes, and in part by acting as agencies 
 of the government for its issues of paper currency, subsidiary 
 silver, and minor coins. 
 
 Third, through the system of checks, or deposit currency, 
 the commercial banks make possible the use of a form of currency 
 which is a particularly convenient means of payment. A 
 check may be written for odd amounts, as well as for even 
 figures. This is a great economy of time; for it is a very 
 simple matter to write a check for $27,965.29, whereas to 
 count that amount of money, even if large denominations are 
 used, requires no little time; and the risk of error in counting 
 is at the same time of course eliminated. The use of checks 
 rather than specie in the settlemjnt of large transactions 
 obviates the necessity of weighing and testing the fineness of 
 metallic currency; and, similarly, it greatly lessens the possible 
 abrasion of metallic money. Both checks and bank notes 
 are also inexpensive media of exchange.
 
 362 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 Fourth, the use of checks greatly reduces the risks of 
 monetary transactions. Unless indorsed in blank, checks are 
 good only in the hands of the person to whose order they are 
 drawn; and accordingly the risks from possible loss or theft 
 are virtually negligible. 
 
 Fifth, the check system greatly facilitates the keeping of 
 accounts by individuals. Indeed, the banker may virtually 
 take over the individual's bookkeeping; for if a person deposits 
 with his bank all the money he receives in a year and makes all 
 his payments by check, he always has an accurate record of his 
 financial status. The statement rendered at the end of each 
 month presents a record of all funds received and all funds 
 paid out, and shows the balance on hand. The canceled 
 checks, moreover, serve as valid receipts for the payment of 
 obligations. 
 
 Sixth, the commercial banks perform important services 
 for individuals in transmitting money from one part of the 
 country to another. Upon receipt of the necessary funds, 
 the bank draws a draft upon a correspondent bank in the city 
 where the payment is to be made, asking it to pay the designated 
 party a specified amount of money. Settlements between the 
 two banks may be made only periodically; and by virtue of 
 the machinery of domestic exchange already discussed (see 
 pp. 115-16 above), cash seldom moves in the transmission of 
 such funds. The risk of loss or theft is of course reduced to a 
 minimum, and the use of specie is economized by lessening the 
 amount that needs to be in transit. Banks perform a similar 
 service for individuals in cashing checks which are drawn on 
 banks in other localities. The work of banks in effecting 
 international exchanges should be recalled in this connection. 
 
 Seventh, bankers act as collection agents for their customers, 
 for promissory notes, drafts, coupons, etc. At or before matur- 
 ity, the individual turns his credit instrument or claim over to 
 the bank for collection. Upon receiving the funds, through its 
 messenger service or by way of correspondent banks, the bank 
 credits the individual's account with the amount received. 
 If the obligations are not paid, the individual is notified and
 
 363 
 
 the bank officials are in a position to serve as witnesses in proof 
 that the claim has been duly presented. 
 
 Eighth, bankers undoubtedly exert a very great influence 
 in the promotion of financial integrity and business ability. 
 In the protection of their own interests banks always pay 
 close attention to the moral character and the ability of the 
 parties with whom they deal. They inquire whether they be 
 honest or tricky, industrious or idle, able or inefficient, prudent 
 or speculative, thrifty or prodigal. Since the banker is used 
 as- a continual reference to one's "respectability" and to one's 
 honesty and punctuality in meeting pecuniary engagements, 
 it is necessary for individuals always to have regard for such 
 considerations and to qualify as well as may be for the good 
 opinion of the banking fraternity. 
 
 These various services are only the simpler ones performed 
 by the commercial banks. Their functions in connection 
 with the issue of bank notes and the creation of bank credit 
 or deposit currency remain for later consideration. It need 
 merely be stated here that it is these functions, particularly 
 the latter, in modern times, which constitute the distinguishing 
 characteristics of commercial banking; they are what give it 
 its paramount importance in the general economic organization 
 of the modern world. 
 
 III. ANALYSIS OF COMMERCIAL BANKING 
 OPERATIONS 
 
 The nature of commercial, like that of savings bank opera- 
 tions, may best be revealed through an analysis of a balance 
 sheet or financial statement of condition. Indeed, only by 
 employing the technical terms used in commercial banking and 
 by working through in concrete fashion on a balance sheet the 
 effects of practical banking operations, can one obtain a clear 
 understanding of the nature of commercial banking. The two 
 financial statements below the one of a very large national 
 bank, and the other of a relatively small state institution will 
 be found to furnish most of the data necessary to the analysis 
 which follows:
 
 364 
 
 CONTINENTAL AND COMMERCIAL NATIONAL BANK 
 OF CHICAGO' 
 
 RESOURCES 
 
 Loans and discounts 3 $216,489,390.61 
 
 Overdrafts, unsecured 32,959.47 
 
 Customers' liability on account of drafts paid under 
 
 letters of credit for which this bank has not 
 
 been reimbursed 3,623.38 
 
 Customers' liability on account of "acceptances". 6,057,234. 50 
 
 United States Government securities: 
 
 a) Deposited in United States 
 Treasury to secure note 
 circulation .... $ 50,000.00 
 
 b) Pledged to secure United 
 
 States deposits . . . 355,000.00 
 
 c) Pledged to secure state 
 or other deposits or bills 
 
 payable 22,542,500.00 
 
 d) Unpledged .... 727,476.02 
 
 23.674,976.02 
 
 United States certificates of indebtedness . . . 2,181,610.00 
 
 Other bonds, securities, etc 15,712,978.22 
 
 Stocks other than Federal Reserve bank stock . 746,233.80 
 
 Stock of Federal Reserve bank 1,020,000.00 
 
 Securities bought under agreement to resell . . 1,071,906.98 
 
 Equity in banking house 6,000,000 . oo 
 
 Exchanges for the clearing house 15,147,311.99 
 
 Checks on out-of-town banks 733,163.34 
 
 Items with Federal Reserve bank in process of col- 
 lection (not available as reserves) .... 3,733,iS 2 -27 
 Lawful reserves with Federal Reserve banks . . 31,598,419.05 
 Cash in vaults and due from national banks . . 42,309,635. 51 
 
 Due from state and private banks 35,487,907.63 
 
 Redemption fund with United States Treasury 
 ($2,500) and due from United States Treasury 
 
 ($9,000) total 11,500.00 
 
 Other assets 318,184.13 
 
 Total $402,330,186.90 
 
 1 Report of condition in Nov. 17, 1919. 
 
 7 $25,361,992.36 of other loans have been rediscounted with the Federal 
 Reserve bank of Chicago. This involves a contingent liability to this bank 
 as indorser.
 
 PRACTICAL OPERATIONS OF THE COMMERCIAL BANK 365 
 
 LIABILITIES 
 
 Capital stock paid in $ 21,500,000.00 
 
 Surplus 12,500,000.00 
 
 Undivided profits 4,479,734-73 
 
 Reserved for taxes accrued 2,168,664.93 
 
 Circulating notes outstanding 50,000.00 
 
 Due to national banks 65,384,485.59 
 
 Due to state and private banks 65,870,828.70 
 
 Certified checks 1)653,461.55 
 
 Cashier's checks outstanding 1,806,298.51 
 
 Individual deposits subject to check .... 183,893,262.19 
 
 Certificates of deposit due in less than thirty days 5,885,634.47 
 Time certificates of deposit (payable after thirty 
 
 days) 772,156.80 
 
 United States deposits 4,284,439.15 
 
 Dividends unpaid 9,763.00 
 
 Bills payable with Federal Reserve banks . . . 22,450,000.00 
 Letters of credit and travelers' checks sold for cash 
 
 and outstanding 209,458.71 
 
 Acceptances 6,057,234.50 
 
 Other liabilities 3,354,764.07 
 
 Total $402,330,186.00 
 
 MAYWOOD (ILLINOIS) STATE BANK* 
 
 RESOURCES 
 
 Loans and discounts 
 
 Overdrafts 
 
 Bonds and securities 
 Real estate . . . . 
 Due from banks and bankers 
 Exchanges for clearing house 
 Checks and other cash items 
 Cash on hand .... 
 Accounts receivable . 
 
 . . . . . . $ 720,871.40 
 
 21.89 
 
 260,568.95 
 
 25,880.00 
 
 172,879.85 
 
 3,010.12 
 
 2,113.79 
 
 50,589.51 
 
 1,112.05 
 
 Total $1,237,047.56 
 
 'Report of condition at the close of business November 17, 1919.
 
 366 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 LIABILITIES 
 
 Capital stock paid in $ 100,000 . oo 
 
 Surplus fund 85,000.00 
 
 Undivided profits 19,213.80 
 
 Dividends unpaid 42.00 
 
 Time deposits, savings 464,425.23 
 
 Time deposits, certificates 13,417.15 
 
 Demand deposits, individual 470,688.78 
 
 Certified checks 3,358.45 
 
 Cashier's checks outstanding 13,209.73 
 
 Due to other banks 54,145.84 
 
 Reserved for taxes and interest 5,684.77 
 
 Postal savings fund 7,861.81 
 
 Total $1,237,047.56 
 
 Following the method used in the chapter on savings 
 institutions, let us organize a commercial bank and carry 
 through a series of practical operations. We may start by 
 issuing 10,000 shares of stock which sell at $110 per share. 
 After spending $100,000 for a bank building and the necessary 
 furniture and fixtures, the preliminary statement of the bank 
 would stand as follows: 
 
 RESOURCES LIABILITIES 
 
 Cash $1,000,000 Capital stock . . $1,000,000 
 
 Banking house, fur- 
 niture, and fixtures 100,000 Surplus .... 100,000 
 
 Commercial bank deposits are mainly a result of loaning 
 operations. The essential difference between commercial and 
 savings banking operations may best be made clear if we con- 
 sider at the outset the loan item on the assets side of the balance 
 sheet, together with the deposit item on the liabilities side. 
 When the savings bank was ready for business, we saw that 
 individuals brought funds to the bank for deposit, thus giving 
 rise to deposit accounts on the liabilities side of the statement. 
 Commercial banks also receive deposits of cash; but the 
 striking characteristic of commercial banking will be seen most 
 clearly if we first assume that when this bank which we have
 
 PRACTICAL OPERATIONS OF THE COMMERCIAL BANK 367 
 
 organized opens its doors for business it does not solicit deposits 
 of cash, but merely states in its preliminary announcement 
 that it is in a position to make loans to manufacturers, 
 merchants, etc. 
 
 Suppose now that a number of business men come to the 
 bank for loans with which to conduct their business operations. 
 Mr. A is given a loan of $100,000 for four months, the interest 
 at 6 per cent being deducted in advance. What changes, 
 immediately speaking, would this cause on the bank's balance 
 sheet ? On the assets side an entry would be made, under the 
 heading "Loans and discounts, " of $100,000. Mr. A is entitled 
 to withdraw from the bank $98,000, the other $2,000 being 
 the amount of the interest deducted in advance. A may with- 
 draw the $98,000 in actual cash if he desires; or if he finds it more 
 convenient, he may ask the bank to enter it to his credit as a 
 deposit account against which he may write checks at his 
 convenience. In the great majority of instances, indeed almost 
 universally nowadays, when business men borrow from banks 
 they take the entire amount in the form of a checking account, 
 except of course insofar as they may require pay-roll or till 
 money. Let us assume in this case that the entire amount is 
 taken in the form of a checking account. The balance sheet, 
 for the moment, will then stand as follows: 
 
 RESOURCES LIABILITIES 
 
 Loans and discounts $ 100,000 Capital stock . . $1,000,000 
 Banking house, fur- 
 niture, and fixtures 100,000 Surplus .... 100,000 
 
 Cash 1,000,000 Deposits . . . 98,000 
 
 Undivided profits . 2,000 
 
 Total . . . $1,200,000 Total . . . $1,200,000 
 
 It is thus apparent that this commercial bank has created a 
 deposit account without the receipt of any actual cash merely 
 as a result of a loan operation. But suppose now that Mr. A 
 writes a check for $98,000 in favor of Mr. X. Suppose, also, 
 that Mr. X, another business man in this community, desires 
 to be a customer of this bank. Upon receipt of the check Mr. X
 
 368 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 presents it at the bank and asks that an account be opened in 
 his name, with the $98,000 credited to the account. The 
 result of this operation, so far as deposits are concerned, would 
 be merely to deduct $98,000 from Mr. A's account and add 
 $98,000 to Mr. X's account. The total deposits in the bank 
 would be unchanged. While X's deposit account came over 
 the counter in the form of a check presented to the bank, it is 
 obvious that it is still indirectly the result of the loan that was 
 made to A. No cash has as yet been brought to the bank; 
 nor has any been paid out. 
 
 Mr. X, however, now has the right to withdraw $98,000 
 in cash from the bank, if he so desires; but since it is more 
 convenient in the great majority of instances to meet his 
 obligations by means of checks, he will probably have occasion 
 to withdraw little, if any, cash. Let us assume that Mr. X 
 writes four checks of $24,500 each to M, N, O, and P respec- 
 tively. M, N, O, and P, desiring to do business with this 
 bank, in turn present the checks for deposit. The net result is 
 to leave the total of deposits unchanged; though instead of 
 being credited to X, the deposits are now credited to the accounts 
 of M, N, O, and P, $24,500 to each. In then- turn M, N, O, 
 and P may write checks against their deposit accounts, for 
 varying amounts and to the order of various people. If all 
 the people receiving such checks in turn present them to this 
 bank for credit to their accounts, it is obvious that, while there 
 will be an ever-changing personnel of depositors, the total of 
 deposits will remain at $98,000. 
 
 Now in practice not every business man would desire to 
 bank with this particular institution, and not everyone who did 
 keep his account there would always refrain from withdrawing 
 any cash. Suppose, for instance, one of these checks comes 
 into the hands of Z and that Z is a depositor in another bank 
 in the same city. Z will take the check to the other bank and 
 there deposit it to his credit. But if bank No. 2 gives Mr. Z 
 a deposit account of, say, $10,000 upon the presentation of a 
 check on bank No. i for that amount, it is obvious that bank 
 No. 2 must collect that amount from bank No. i. While
 
 PRACTICAL OPERATIONS OF THE COMMERCIAL BANK 369 
 
 we shall later see that as a rule this does not ordinarily involve 
 the parting with much cash by bank No. i, 1 for the present 
 it is important merely to note that, even though some of the 
 checks drawn against the deposit accounts in bank No. i are 
 presented to other banks, the total deposit accounts resulting 
 from the original loan remain unchanged. Unchanged, except 
 of course insofar as cash may be actually withdrawn from some 
 bank by some individual into whose hands a check has come. 
 If, for example, Mr. Y elects to cash a check for $10,000 that has 
 been drawn against bank No. i, he would of course not receive a 
 deposit account; but on the assets side cash would be reduced by 
 $io,ooo. 2 
 
 Commercial banks also receive deposits of cash and of claims 
 to cash. Let us now carry through some additional operations 
 with this newly organized national bank. It has already been 
 stated that in practice commercial bank deposits also arise as a 
 result of the bringing of cash to the bank by individuals. Let 
 us assume that a customer desires to open a checking account 
 with the bank. He presents through the paying teller's window 
 the following things: (i) $1,000 in cash; (2) $1,000 in checks 
 on other banks which are members of the Clearing House 
 Association; (3) $2,000 in checks on other banks in this town, 
 not members of the Clearing House Association; (4) $2,000 
 in checks on banks in other cities; (5) $3,000 in certified checks 
 on this bank; (6) $3,000 in cashier's checks on this bank: 
 (7) $4,000 in drafts on correspondent banks; and (8) $4,000 in 
 notes of other national banks. The depositor will have entered 
 to his credit as a deposit the sum of these items, or $20,000. 
 On the assets side, the cash would be increased by $1,000 
 and the remaining items would find reflection on the balance 
 sheet under the headings: exchanges for the clearing house; 
 checks on other banks in this city; checks on out-of-town banks; 
 due from banks and bankers; and notes of other national 
 
 * See pp. 476-77. 
 
 * A more complete explanation of the process of creating deposits here 
 suggested and the general significance of this phenomenon must be reserved 
 for subsequent discussion (see pp. 475-83).
 
 370 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 banks. On the liabilities side, the cashier's checks outstanding 
 would be decreased by $3,000, and the certified checks by a 
 like amount. 
 
 Investments in securities are analogous to loans. Let us 
 suppose the bank makes investments of $50,000 in Liberty 
 bonds and $20,000 in other bonds. These items on the assets 
 side of the balance sheet would of course be increased by the 
 amounts specified; and the individual, government, or cor- 
 poration from whom these bonds were purchased could either 
 ask for payment in actual specie or take a deposit account with 
 the bank, against which checks might be written at will. The 
 process here is identical with that discussed above hi the case 
 of loans. 
 
 Issuing notes is an important feature of national bank opera- 
 tions. Another type of banking operation is that of note 
 issue an operation which at ' the present time is confined 
 to the national banks. The process of issuing notes may best 
 be stated as an analogy to the process of creating deposits 
 through the making of loans. An individual who secures a 
 loan from the bank may be paid by an issue of bank notes as 
 well as by the taking of a deposit account. Under our banking 
 laws, however, an issue of notes must have a special form of 
 security. If a bank wishes to make an issue of $1,000 worth of 
 bank notes, it must first deposit with the United States Treasury 
 $1,000 worth of bonds. 1 The Treasury then prepares the notes 
 and sends them to the bank, where they must be signed by the 
 proper officials before being issued. Thus, every note out- 
 standing is backed dollar for dollar by government bonds 
 in the vaults of the United States Treasury as trustee, and in 
 addition by the resources of the bank, against which the notes 
 have a prior lien. It is also required that the bank deposit in 
 the Treasury at Washington a cash reserve fund of 5 per cent, 
 to be used in the redemption of any notes that may be pre- 
 
 x The law holds that if the bonds are worth more than par, notes can 
 nevertheless be issued only to the par value of the bonds, and that, if the 
 bonds are worth less than par, the amount of notes must not be in excess 
 of the market value of the bonds.
 
 PRACTICAL OPERATIONS OF THE COMMERCIAL BANK 371 
 
 sented there for payment, the law making them redeemable 
 at par by the United States government. 
 
 National bank notes do not possess full legal tender power. 
 Such notes are a direct liability of the bank which issues them 
 and they are redeemable in cash upon demand at the bank of 
 issue as well as at the federal Treasury. Every bank in the 
 national system must also accept at par the notes of every 
 other national bank; and such notes are also receivable at par 
 in payments to the United States government, except for 
 duties on imports. The government, moreover, may use them 
 in paying all of its obligations, except interest on the public debt 
 and in the redemption of other national bank notes. National 
 bank notes, however, have never been made legal tender in the 
 settlement of private accounts. 
 
 The issue of notes has been declining in importance during 
 the last fifty years. The issue of bank notes was once the chief 
 method of making loans by commercial banks; and in the 
 nations of continental Europe it is still the most important 
 means of extending credit. But in England and the United 
 States bank note issues have in the last hundred years steadily 
 declined hi importance. The table on page 372 reveals the 
 changes in the relative proportion of notes and deposits hi dif- 
 ferent classes of national banks in the last fifty years. It will 
 be seen that the relative importance of note issue has been 
 growing less in all classes of banks; and that its significance 
 varies inversely with the size of the financial center in which 
 the issuing bank is located. A word of explanation of this 
 classification of national banks is necessary. The national 
 banking law divides the national banks of the country into 
 three classes: first, those in central reserve cities, namely, 
 New York, Chicago, and St. Louis; second, those in reserve 
 cities, which constitute about sixty of the remaining larger 
 cities of the country; and third, country banks, which include 
 all those not located in central reserve and reserve cities. 
 
 Of the remaining items on the balance sheet on pages 364-65 
 a few words of explanation will suffice. "Customer's liability 
 on account of drafts paid under letters of credit for which this
 
 372 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 bank has not been reimbursed" represents money paid out for 
 the purpose indicated and is in the nature of a loan to a cus- 
 tomer. 1 This item should be compared with "Letters of credit 
 and travelers' checks sold for cash and outstanding" on the lia- 
 bilities side. It will be seen that except for the $3 ,6 23 . 38 carried 
 under "Customers' liability on account of drafts, etc.," the 
 bank has already received funds for the remainder of the 
 
 DECLINING IMPORTANCE OF NOTE ISSUES 
 (In millions of dollars)* 
 
 YEAR 
 
 NEW YORK CITY 
 
 OTHER CENTRAL 
 RESERVE AND 
 RESERVE CITIES 
 
 COUNTRY BANKS 
 
 TOTALS 
 
 Notes 
 
 Deposits 
 
 Notes 
 
 Deposits 
 
 Notes 
 
 Deposits 
 
 Notes 
 
 Deposits 
 
 1870. . 
 
 3 2 -9 
 18.3 
 18.6 
 9-9 
 3-6 
 H-3 
 29-3 
 53-7 
 52.8 
 49-0 
 37-3 
 37-7 
 
 167.0 
 
 173-5 
 242.0 
 
 250.5 
 25L4 
 299.7 
 420.7 
 
 657.7 
 780.0 
 962.5 
 849.1 
 1,912.9 
 
 68.4 
 69.4 
 72.4 
 55-3 
 iS-i 
 32.7 
 63-7 
 120.4 
 181.8 
 191 .6 
 204. i 
 183.9 
 
 134-7 
 197.9 
 
 234-3 
 302.1 
 469.6 
 509.3 
 775-2 
 1,086.5 
 
 1,477-2 
 2,134.7 
 1,621.0 
 4,603.4 
 
 190.5 
 230.7 
 226.4 
 203.7 
 104.2 
 
 135-4 
 190.9 
 294.9 
 423-5 
 449-3 
 477-1 
 460.0 
 
 199.7 
 293-2 
 397-2 
 549-8 
 843-8 
 892.7 
 1,312.3 
 2,076.5 
 2,754-9 
 3,108.8 
 2,171.4 
 4,235-2 
 
 291.8 
 318.4 
 317.4 
 268.9 
 122.9 
 182.5 
 283.9 
 459-0 
 658.1 
 680.4 
 718.5 
 681.6 
 
 501.4 
 664.6 
 
 873.5 
 1,102.4 
 1,564.8 
 1,701.7 
 2,508.2 
 3,820.7 
 5,012.1 
 6,206 o 
 
 4,641.5 
 9,751-5 
 
 1875. . 
 
 1880 
 
 1885.. 
 
 l800. . 
 
 l8<X. . 
 
 IQOO. . 
 
 IOOC. . 
 
 I OOO. . 
 
 I9iof 
 I9*5t 
 i9*9t 
 
 *From Statistics of Banks and Banking in the United States, 1867-1909. (National Mone 
 tary Commission, 1910.) 
 
 t From annual reports of the Comptroller of Currency. 
 
 $209,458. 71. "Customers' liability on account of acceptances" 
 will be clear after reading the discussion of bank acceptances 
 below. 8 This item should be compared with "Acceptances" 
 on the liabilities side. 
 
 "United States government securities deposited .... to 
 secure note circulation" has already been explained. It should 
 be compared with the item "circulating notes outstanding" OP 
 the liabilities side of the balance sheet. " United States govern 
 
 1 For a discussion of letters of credit see pp. 411-17. 
 'See pp. 601-3.
 
 PRACTICAL OPERATIONS OF THE COMMERCIAL BANK 373 
 
 ment securities pledged to secure United States deposits" 
 indicates that this bank holds some of the funds of the United 
 States Treasury and has put up government bonds as security. 
 The Secretary of the Treasury is authorized by law to denote 
 certain national banks as depositaries of government funds 
 the purpose being to minimize at all times the volume of funds 
 that is withdrawn from circulation in connection with the 
 fiscal operations of the Treasury. 1 "United States govern- 
 ment securities pledged to secure state or other deposits" is of 
 similar nature and purpose. "United States government 
 securities pledged to secure bills payable" indicates that this 
 bank has borrowed from the Federal Reserve bank on its own 
 promissory notes and has deposited government bonds as 
 collateral.* This item should be compared with " Bills payable 
 with Federal Reserve banks" on the liabilities side. "United 
 States certificates of indebtedness" refers to the short-term 
 notes issued by the Treasury Department as a means of raising 
 revenue to meet current expenses pending the receipt of regular 
 income. 
 
 "Items with Federal Reserve bank in process of collection" 
 refers to checks which this bank has received from its depositors 
 which the Federal Reserve Bank of Chicago is collecting from 
 the banks upon which they are drawn. 3 The "Lawful reserve 
 with the Federal Reserve bank" is the amount of funds which 
 the law requires this bank to keep on deposit with the Federal 
 Reserve Bank of Chicago. 4 
 
 "Due from national banks" and "Due from state and 
 private banks" indicate that this bank has funds on deposit 
 with other national and state banks. This item should be 
 compared with "Due to national banks" and "Due to state 
 and private banks" on the liabilities side. It will be noted 
 that the total "Due to banks "in the Continental and Commercial 
 National Bank statement is much greater than the amount 
 "Due from Banks"; while with the Maywood bank the reverse 
 
 1 See pp. 502-5. 
 
 "See p. 592. See pp. 610-11. 
 
 4 See reserve requirements under Federal Reserve System, pp. 590-91.
 
 374 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 is true. The banks in the central reserve and reserve cities 
 characteristically hold large volumes of funds for outlying 
 banks; and it is necessary for them to have some of their own 
 funds deposited in other centers, also, to facilitate financial 
 operations in such centers. 1 
 
 "Redemption fund with United States Treasury" is 5 per 
 cent of the "national bank notes outstanding," in accordance 
 with the legal requirements, as already outlined. 
 
 On the liabilities side, the item "Reserved for taxes accrued" 
 indicates that preparation is being made for meeting the tax bill 
 payments by creating a reserve for the purpose. When the 
 payment is made, this item will disappear and there will be a 
 corresponding reduction hi cash on the assets side. Deposits 
 are divided into: "Individual deposits subject to check"; 
 "Certificates of deposit due in less than thirty days;" "Time 
 Certificates of deposit"; and "United States deposits." The 
 "Individual deposits subject to check" are the ordinary check- 
 ing accounts of individuals and businesses. The "Certificates 
 of deposit" represent funds which cannot be checked against, 
 but can be withdrawn only by presentation of certificates, which 
 are receipts for the money deposited. "Tune certificates of 
 deposit" are listed separately because of a separate reserve 
 requirement. 2 "United States deposits" are deposits of the 
 United States government against which no reserve need be 
 carried. 
 
 IV. ANALYSIS OF COMMERCIAL BANK LOANS 
 
 Since a commercial bank's profits are mainly derived from 
 loans and investments, the test of efficient bank management 
 is to be found hi the wisdom with which such extensions of 
 credit are made. The making of loans and investments by 
 commercial banks is a matter of exceptional importance, more- 
 over, by virtue of the fact that these institutions are by their 
 very nature committed to paying depositors upon demand. 
 If a bank has insufficient funds on hand with which to meet 
 
 n See discussion on pp. 470-75. 'See p. 591.
 
 PRACTICAL OPERATIONS OF THE COMMERCIAL BANK 375 
 
 demands for cash and if it is unable to secure them from any 
 source, it must close its doors and announce insolvency, not- 
 withstanding the fact that ultimately its assets may prove 
 ample to meet the claims of depositors in full. Since the 
 entire modern business structure is dependent upon the smooth 
 functioning of financial institutions, commercial banks are in a 
 position of exceptional responsibility. They are the final 
 repositories of the cash resources of the nation; and upon the 
 efficiency of their operation depends the safety, as well as the 
 adaptability to the needs of business, of the whole complex 
 credit structure. Bank failures and bank suspensions of 
 specie payments, due to inadequate cash reserves, always bring 
 in then* train more or less disaster to business in general. 
 Accordingly the development of a "loan policy" is the most 
 vital problem of bank management. 
 
 In the making of bank loans there are two main problems. 
 First, there must be assurance that the borrowers are all in 
 sound financial position that the loans will surely be safe. 
 Second, the maturities of loans must be arranged so as to 
 facilitate meeting the varying demands for cash at different 
 times and at different seasons. We shall presently see that 
 the problem of maintaining adequate cash resources with 
 which to meet these varying needs largely depends, in a highly 
 developed banking structure, upon inter-bank relations, upon 
 the organization of the banking system as a whole. But since 
 the individual bank is the unit of the system, we may best 
 begin our study by a consideration of the various types of 
 lending operations that are engaged in by the typical commercial 
 banking institutions. 
 
 There are several types of bank loans. The ordinary com- 
 mercial bank has the option of loaning funds (extending credit) 
 in the following ways: (i) on single-name promissory notes of 
 individuals and corporations; (2) on two-name paper indorsed 
 notes and accepted drafts (trade acceptances); (3) on the 
 security of real estate mortgages; (4) on promissory notes 
 secured by other notes as collateral; (5) on promissory notes 
 secured by stocks and bonds; (6) on drafts secured by bills of
 
 376 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 lading; (7) on promissory notes and drafts secured by ware- 
 house receipts; (8) by investments in stocks, bonds, short- 
 term notes, mortgages, etc. 
 
 Loans may also be classified according to whether they are 
 time loans (thirty, sixty, ninety days or more) or demand loans. 
 Demand loans are of two types: (i) the so-called "call" loans, 
 where the loan is of indefinite duration but terminable at a 
 moment's notice at the option of either the bank or borrower; 
 these are found only in New York City, and are used in con- 
 nection with stock market speculation; 1 (2) demand loans, 
 where it is understood that the bank will allow the loan to run 
 indefinitely, in the absence of any untoward development 
 which might imperil its ultimate safety. Such a loan is in 
 effect ordinarily terminable only at the option of the borrower. 
 
 The table on page 377 shows the different classes of loans 
 made by the national banks on June 30, 1919: 
 
 Another classification of bank loans one which runs in 
 terms of the use to which the funds borrowed are to be devoted 
 is that of commercial and investment loans. Commercial 
 and investment loans present no new phenomenon to the 
 reader; for they have already been discussed in chapter ix 
 under commercial and investment credit. It may merely be 
 recalled here that commercial loans are used for working 
 capital purposes. Whether with producer of raw materials, 
 manufacturer, commission merchant, wholesaler, or retailer, 
 the funds borrowed are employed in meeting pay-roll require- 
 ments or hi buying the materials or goods required in the 
 operation of the business. They usually run for short periods 
 by virtue of the fact that the time required to carry to fruition 
 the productive process in which they are assisting is ordinarily 
 of relatively short duration. 2 
 
 With investment loans, on the other hand, the funds are 
 devoted to fixed capital purposes; hence such loans are usually 
 of relatively long duration. In the course of our analysis we 
 
 See discussion below, pp. 391-93. 
 
 "We shall later see, however, that commercial loans are not so 
 commonly paid at maturity as is generally assumed. See pp. 532-33-
 
 PRACTICAL OPERATIONS OF THE COMMERCIAL BANK 377 
 
 shall have occasion to show that the commercial banks furnish 
 funds for fixed capital purposes in various ways some of 
 them direct, others indirect. We shall also have occasion, 
 in a succeeding chapter, to consider the relative liquidity of the 
 
 CLASSIFICATION OF NATIONAL BANK LOANS' 
 (In thousands of dollars) 
 
 
 New York 
 
 Chicago 
 
 St. 
 Louis 
 
 Total 
 Central 
 Reserve 
 Cities 
 
 Other 
 Reserve 
 Cities 
 
 Country 
 Banks 
 
 Total 
 United 
 States 
 
 On demand, paper with one 
 or more individual or 
 firm names (not secured 
 
 36 166 
 
 
 
 78 766 
 
 
 
 
 On demand, secured by 
 
 
 78,373 
 
 
 
 
 
 
 On demand,' secured by 
 other personal securities, 
 including merchandise, 
 warehouse receipts, etc. . 
 On time, paper with one or 
 more individual or firm 
 names (not secured by 
 collateral) 
 
 88,455 
 954,023 
 
 3*,637 
 
 6,471 
 67 587 
 
 127,563 
 i 271 851 
 
 102,593 
 i 532 805 
 
 87,130 
 2 446 668 
 
 317,286 
 
 On time, secured by stocks 
 
 679,867 
 
 85 910 
 
 
 789 606 
 
 
 596 882 
 
 
 On time, secured _ by other 
 personal securities, in- 
 cluding merchandise, 
 warehouse receipts, etc. . 
 Secured by real estate mort- 
 gages or other liens on 
 realty not in accordance 
 with section 24, Federal 
 Reserve Act as amended . 
 Secured by improved real 
 estate under authority oi 
 section 24, Federal Re- 
 serve Act as amended . . . 
 
 109,605 
 725 
 
 47,643 
 734 
 
 io,495 
 
 374 
 1,009 
 
 i67,743 
 
 1,833 
 
 1,009 
 
 312,747 
 
 19,175 
 
 7>3O4 
 
 533,583 
 
 69,650 
 85,011 
 
 1,014,073 
 
 90,658 
 93,324 
 
 Acceptances of other banks 
 discounted 
 
 78,830 
 
 559 
 
 6,871 
 
 86,260 
 
 58,701 
 
 5,888 
 
 150,849 
 
 Acceptances of this bank 
 purchased or discounted . 
 
 22,119 
 
 2,387 
 
 737 
 
 25,243 
 
 21,567 
 
 9,937 
 
 56,747 
 
 Total 
 
 2,424,718 
 
 533,095 
 
 154,964 
 
 3,112,777 
 
 3,421,041 
 
 4,476,388 
 
 11,010,206 
 
 
 
 
 
 
 
 
 
 various types of investment and commercial loans. For the 
 present, however, we are merely concerned with describing 
 the different types of commercial bank loans and showing 
 the uses to which the funds thus borrowed are devoted. 
 
 i. Single-name borrowing. Borrowing on the single-name 
 promissory notes of individuals or corporations has come to be 
 
 1 From Report of the Comptroller of the Currency. I (1919), 50
 
 378 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 one of the most common means of obtaining loans in the United 
 States. The reason for this has already been suggested in 
 the chapter on commercial credit instruments. 1 Such borrowing 
 may or may not be for working capital purposes, though in 
 practice it is in the great majority of cases of a general com- 
 mercial nature. It is often assumed that a loan made on a 
 single-name promissory note, unsecured by collateral, must 
 in the nature of things be less satisfactory from the standpoint 
 of safety than two-name or collateral paper. We shall find, 
 however, that this is by no means the case. In fact, single- 
 name paper is on the whole just as safe as any other. 
 
 As between single-name paper and indorsed notes, it may be 
 observed that loans for business purposes are seldom obtained 
 by business man A on the accommodation indorsement of 
 bjisiness man B. The most common form of two-name paper 
 in the United States has until recently been that which arises 
 out of the discounting of customers' notes.* Mr. A. sells goods 
 to Mr. B, and requires B to give a promissory note as evidence 
 of the transaction. Now A may discount this note with the 
 bank, indorsing it in the process. Many people feel that in 
 numbers there is strength and that since the bank here has two 
 persons to whom it may look for payment, the note is doubly 
 secure. The truth of the matter is, however, that as a rule 
 the bank looks for payment only to the party who presented 
 the note to the bank, namely, to the indorser the reason for 
 this being that the ordinary drawer of the note is generally 
 unknown to the bank, whereas the indorser is usually a regular 
 customer. The safety of the bank loan, therefore, primarily 
 depends upon the standing of the individual upon whom the 
 bank relies for payment. And whether a note be two-name 
 or single-name, the bank makes the loan on the basis of its 
 knowledge of the integrity and ability of the borrower that is, 
 of the indorser in the case of a discounted customer's note. 
 
 Lending on single-name paper requires a careful analysis of 
 the borrower's financial integrity and ability. Since the safety 
 
 1 See p. 169. 
 
 3 For a discussion of the trade acceptance see pp. 384-85.
 
 PRACTICAL OPERATIONS OF THE COMMERCIAL BANK 379 
 
 of loans depends upon the accuracy of the bank's knowledge 
 of the borrower, it is incumbent upon the bank to make a 
 careful investigation of his integrity, ability, and financial 
 resources. As a preliminary to a consideration of the making 
 of bank loans, it will be of service to recall the outline of the 
 factors involved in credit extension given on page 126 above. 
 
 In its analysis of the character and integrity of the borrower 
 of his intention and willingness to pay the credit department 
 of a bank has recourse to various sources of information. It 
 sends out letters to references given by the credit applicant and 
 to others whose opinions might be of value; and it secures 
 reports from the commercial agencies, and from other banks 
 with whom this borrower has had relations. A personal 
 interview is usually requested hi order that a first-hand impres- 
 sion may be gained; and considerable collateral information 
 is often "picked up" from trade reports, newspaper comments, 
 etc., as well as from the general "gossip" of the business 
 community. 
 
 The commercial agencies, of which the chief are Dun's 
 and Bradstreet's, assemble data on the history and present 
 status of the various businesses of the country and give to 
 each a general credit "rating" good, bad, or indifferent. 
 These mercantile reports aim to cover the entire field of business 
 and include every corporate and individual enterprise; but 
 with new concerns springing up daily, it is of course impossible 
 in practice to furnish recent information on all establishments. 
 A serious handicap to reliable information lies in the fact that 
 the agency reporters are not always treated with the greatest 
 freedom and confidence; in some instances, indeed, there is an 
 evident desire on the part of businesses to strengthen their 
 rating by deliberate deception. Moreover, the reporters are 
 relatively poorly paid and hence many of them are not par- 
 ticularly well qualified for the work in hand. Nevertheless, the 
 service rendered is invaluable in the case of many small enter- 
 prises, and it is an important source of collateral information 
 in nearly all instances. It may be added that upon request the 
 agencies furnish special up-to-date reports to their customers.
 
 380 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 In the large financial centers analysis of the borrower's finan- 
 cial statement is now regarded as indispensable to an intelligent 
 extension of credit. By far the most important source of credit 
 information, nowadays, is the financial statement, with supple- 
 mentary information that is furnished directly by the borrower. 
 The use of the financial statement as a basis for loans dates 
 back only to the nineties, and its great development has been 
 mainly a matter of the last fifteen years. Even now the use of 
 the statement is chiefly confined to the larger cities; though it 
 is steadily gaining in vogue in the smaller cities and towns. 
 Before the advent of the financial statement the banker relied 
 only upon his general knowledge of the borrower's honesty 
 and business ability. And so long as industry was conducted 
 on a relatively small scale and business relations were of a 
 highly personal sort, by direct observation and by the current 
 gossip of the community with which he was in intimate touch 
 the banker could obtain a fairly accurate line on credit risks. 
 But with the great growth in the size of business undertakings 
 in the last generation, together with the inherent impersonality 
 of urban life, the bankers of the financial centers have found it 
 imperatively necessary to supplement personal impression and 
 gossip by investigation based upon the financial records of 
 the borrowing corporation or business. The development of 
 systematic accounting methods necessitated by the great size 
 and complexity of business was of course an indispensable 
 hand-maiden to the change in the methods of credit extension; 
 for without accounting records it would be quite impossible to 
 make an investigation of the condition of a large-scale enterprise 
 that would have any meaning. 
 
 Different banks use somewhat different forms of financial 
 statements. A typical form for corporations 1 is shown on page 
 381. It will be observed that it contains an income or profit and 
 loss account, as well as a statement of resources and liabilities. 
 
 Besides the balance sheet and profit and loss account, 
 collateral information is requested as follows: (i) contingent 
 liabilities; (2) fire insurance on merchandise, on buildings, 
 
 1 There is a separate form for individuals and partnerships.
 
 PRACTICAL OPERATIONS OF THE COMMERCIAL BANK 381 
 
 and on the machinery and tools; (3) life insurance on officers' 
 lives; (4) average amount of goods on hand; (5) at what time 
 
 III 12-2215 B*H 
 
 BORROWER'S STATEMENT Corporation. 
 
 Name (Corporate style under charter). 
 
 Busine 
 
 Addres. 
 
 To the UNION TRUST COMPANY. 
 
 Tie (oHowins i. a true statement of ike financial condition of this corporation on the '. day 
 
 * , " <1 < 'e UNION TRUST COMPANY, (or ike p.rpo*t of obuinin, credit. We ai.ee to 
 
 nobfy Bid Bank promptly of an, material charge in our condition. 
 
 FILL ALL BLANkS WRITING 'NO 1 OR 'NONE' WHERE NECESSARY. 
 
 ASSETS 
 
 LIABILITIES 
 
 c-i. k.,,j 
 
 
 
 
 Notes Payable for Merchandise 
 Note. Payable to own banks for borrowed money ... 
 Note. Payable to other banks or for paper .old 
 Oth.r Note P.v.kb. 
 
 
 
 
 
 
 
 Note. Receivable, all good, owing 07 
 
 LCM Note* Receivable, discounted and 
 
 Kid * 
 
 Balance Note. Rec. on hand . 
 Account. Receivable, all good, owing by customer* 
 
 Note, or Account. Receivable, owing by Director., 
 Stockholder, and Agent. 
 
 Merchandise finished, at actual present each value 
 Merchandise anfrnuhed, at actual prevent each value 
 Raw Material 
 
 
 
 
 
 
 
 Open Account* no* ^p^ , ^ ____ 
 Open Account* past due 
 Dnf to Foreign Bank* on account of credit. 
 Accounts due Director, and StockhoUer* 
 Bonded Debt (when due ) 
 Interest on Bonded Debt 
 Chanel Mortgage. 
 Deport* of money with u. 
 Other Indebtedness and of what composed 
 
 Capital 
 Surplu*. includin undivided profit. 
 
 
 
 
 
 - 
 
 Real EUate 
 Market Value $ 
 
 Machinery and Tools ! : _ 
 Stock*, Bond* and Investment. ,- 
 Other Asset* and of what composed . 
 
 
 
 
 
 TOTAL 
 
 
 
 
 TOTAL 
 
 
 
 
 PROFIT AND LOSS ACCOUNT. FISCAL YEAR ENDING 
 
 Actusl expense of conducting *"*-- 
 Bad debt* charged oft 
 
 , 
 
 
 
 ..__. 
 
 GROSS PROFITS 
 
 p, Injere.1 1 ni^.t 
 
 
 
 
 
 
 
 
 
 
 
 
 Net Profit. 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 MtUL 
 
 
 
 
 TCLU. 
 
 
 
 of the year liabilities are heaviest and at what time lightest; 
 (6) total sales for last fiscal year; (7) average terms of sales 
 and average terms of purchases; (8) regular time of taking
 
 382 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 
 inventory; (9) suits pending against the corporation; 
 
 (10) authorized capital, subscribed and paid in; (n) annual 
 dividends. The names and addresses of the officers and 
 directors are also called for with a statement of the number of 
 shares of stock held by each. There are also blanks for trade 
 and for bank references. 
 
 There is no occasion here for making a detailed analysis of a 
 financial statement. Suffice it to say that from the standpoint 
 of bank management the most significant items on the balance 
 sheet are the liquid assets and liabilities, or, as the phrase 
 usually goes, the quick assets and current liabilities. The 
 quick assets are: cash on hand and in banks; notes and accounts 
 receivable; merchandise; and. raw materials. The current 
 liabilities are: notes and accounts payable; and any other 
 debts that are payable within a few months. All of the items 
 on the liabilities side except capital and surplus may usually be 
 regarded as current. 
 
 Suppose now that a borrower who desires a loan of $100,000 
 presents a financial statement to the bank which shows quick 
 assets totaling $800,000 and current liabilities amounting to 
 only $200,000. Can the loan safely be granted, assuming 
 that the management of the concern is in honest and capable 
 hands ? The banker sees that within the next few months the 
 company will have to meet $200,000 of obligations, besides the 
 $100,000 which would be owing to the bank in ccae the loan 
 were made. By reference to the quick assets he discovers that 
 the company either has on hand as cash, or will have as cash 
 income during the same period, $800,000, to which may be added 
 the $100,000 borrowed from the bank, which we may assume is 
 to be used in buying additional raw materials. This is $600,000 
 more than the current liabilities. The company could thus 
 suffer substantial losses through the failure of its debtors to pay 
 notes and accounts in full and through depreciation of merchan- 
 dise and raw materials before its ability to meet all current 
 liabilities would be imperiled. Indeed, the quick assets would 
 have to diminish more than two-thirds before the business 
 would be unable to meet its current obligations in full.
 
 PRACTICAL OPERATIONS OF THE COMMERCIAL BANK 383 
 
 The excess of quick assets over current liabilities consti- 
 tutes the margin of safety for the banker. There is a general 
 credit rule to the effect that the quick assets should be at least 
 double the current liabilities. The margin required for safety, 
 however, varies widely in different lines of business, at different 
 times, and even in different localities. One must accordingly 
 regard this rule as only a very rough approximation. 
 
 Fixed assets and long-time liabilities, the profit and loss 
 account, and the information contained in the answers to the 
 appended questions are used as collateral information and as 
 checks on the accuracy of the financial statement. Concretely, 
 if the ratio of quick assets to current liabilities were in a given 
 case a scant two to one, and if the account in general looked 
 very doubtful, the information presented in the statement of 
 fixed assets and liabilities, in the profit and loss account, and 
 in the answers to the appended questions might nevertheless 
 indicate that the loan could safely be granted. On the other 
 hand, an apparently satisfactory statement, so far as quick 
 assets and current liabilities are concerned, sometimes appears 
 very different in the light of these collateral data. 
 
 Funds borrowed on single-name paper are sometimes devoted 
 to fixed capital purposes. It has already been stated that the 
 funds borrowed on single-name promissory notes are usually, 
 though not always, devoted to working capital purposes. 
 In the illustration above we assumed that the loan of $100,000 
 was used for the purchase of additional raw material, thereby 
 increasing the quick assets by $100,000. If the funds were 
 used, however, to build additional warehouses, or to buy 
 additional equipment, there would be an increase in the fixed 
 and not in the quick assets. In this case the ratio of quick 
 assets to current liabilities, after the loan had been made, would 
 be $800,000 to $300,000 rather than $900,000 to $300,000. The 
 use of these funds for fixed capital purposes would not, however, 
 necessarily make the loan unsafe or much less likely to be paid 
 at maturity; the inflow of funds to the business within the life 
 of the loan might still be more than sufficient to permit the pay- 
 ment of the loan at maturity.
 
 384 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 While funds borrowed from the commercial banks are thus 
 frequently employed for fixed capital purposes, it nevertheless 
 remains true that most of the credit extended in this form by 
 commercial banks is devoted to the purchase of raw materials 
 or stocks of goods to be used in the operation of the factory, 
 store, or other business establishment. 
 
 2. Two-name borrowing. One type of two-name borrowing, 
 that on indorsed customers' notes, has already been discussed. 
 There remains for consideration only the trade acceptance. It 
 has often been said that the trade acceptance is of particular 
 advantage in that it enables the business man to obtain much 
 more working capital than would otherwise be the case. The 
 trade acceptance, it is said, represents an actually completed 
 business transaction the sale of goods by A to B a draft 
 being drawn by A against B, accepted by the latter, and 
 returned to the former. Accordingly when A wishes to borrow 
 from the bank it is said that all that he needs to do is to 
 present the trade acceptance for discount. But if B lives in 
 a different town from A and from the bank, the bank, as we 
 have seen, usually has little information with reference to B's 
 financial standing. Hence, if it discounts the trade acceptance 
 it will ordinarily do so only on the basis of a knowledge of 
 A's financial standing. It cannot rely upon B, an unknown 
 party, without investigation, and it is much simpler as well 
 as safer to rely upon A, a regular customer, well known to the 
 bank. 
 
 Now if the bank were to discount all of the acceptances 
 possessed by A, A would indeed be securing larger loans than 
 if he borrowed on his single-name promissory note, with the 
 bank requiring quick assets of $2 to every $i of current lia- 
 bilities. But will a conservative bank be willing to ignore the 
 ratio of quick assets to current liabilities in A's business, and 
 rely merely on the fact that A has sold goods to B and has a 
 trade acceptance to show for it? The answer is that most, 
 if not all, of the conservatively managed banks of the country 
 have recognized that to discount trade acceptances without 
 regard to the ratio of quick assets to current liabilities would be
 
 PRACTICAL OPERATIONS OF THE COMMERCIAL BANK 385 
 
 dangerous and that the security for their loans would be less 
 substantial than in the case of loans on single-name paper. 
 While the trade acceptance may have certain advantages 
 from the commercial point of view, it does not possess the 
 advantage so vigorously claimed for it by most of its pro- 
 ponents that it enables business men to borrow much greater 
 quantities of funds than would otherwise be possible. A 
 sufficient answer to the contention that all businesses, by the 
 use of trade acceptances, could greatly expand the volume of 
 their working capital is apparent in the fact that the change 
 from one method of financing credit operations to another does 
 not increase the volume of bank reserves and reserves limit 
 the total lending power of banking institutions. 
 
 3. Loans secured by real estate mortgages. It has long been a 
 contioversial question whether commercial banks should be 
 allowed to make' real estate loans. From the organization of 
 the national banking system in 1863 until 1913 national banks 
 were, in fact, forbidden to make any loans on real estate security; 
 but under the Federal Reserve law of 1913 the national banks, 
 except in central reserve cities, are permitted to make such 
 loans to a limited degree. On the other hand, the laws of 
 the various states have always permitted the making of loans 
 on real estate security, and we find from the financial statements 
 of state banks that large quantities of such loans are 
 characteristically made. 1 
 
 We are not for the present concerned with the advisability 
 of the practice of making loans on the security of real estate 
 mortgages; we are here interested only in the fact. It should 
 be noted, however, that real estate loans are ordinarily devoted 
 to the raising of funds for fixed capital requirements. 
 
 4. Loans secured by promissory notes as collateral. Loans 
 are often made by banks to individuals where the borrower 
 gives his own promissory note and deposits as collateral security 
 the notes of other persons which he holds. In case the borrower 
 does not pay his note, the bank may take possession of the 
 
 1 For further information on this subject see p. 555.
 
 .$86 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 collateral notes and collect the amount due from the makers 
 thereof. The volume of such loans is. however, relatively small. 
 
 5. Loans secured by stocks and bonds. The great growth 
 of the corporation in modern times and the enormous issue of 
 securities that this has entailed have given rise to a very exten- 
 sive practice of making loans on the security of stocks and 
 bonds as collateral. The individual gives the bank a promis- 
 sory note as in the case of an unsecured loan; but, in addition, 
 he hypothecates with the bank stocks and bonds, which may be 
 sold by the bank in the event that the loan is not paid. On 
 page 387 is a copy of an ordinary promissory note with col- 
 lateral agreement. 
 
 The integrity of the borrower is important even when collateral 
 is given. While in making loans on collateral the bank has 
 security to fall back upon in case the loans are not paid at 
 maturity, it nevertheless cannot ignore tne integrity and 
 honesty of the borrower. Many cases have arisen where a 
 dishonest borrower has pledged securities to which he had no 
 title, or an imperfect one; and there are many other ways in 
 which a dishonest or unscrupulous individual may cause the 
 bank much trouble and inconvenience, if not actual loss, even 
 with collateral loans. Accordingly, bankers feel it necessary 
 to make a careful analysis of the borrower's general moral and 
 financial standing before making collateral loans. 
 
 There is a difference, however, between a non-collateral 
 and a collateral loan in that hi the case of the latter the bank 
 has an exclusive claim to assets which have been deposited 
 with it, while in the case of the former it is merely one of several 
 creditors; although it must be remembered that where the 
 ratio of quick assets to current liabilities is large the chance of 
 loss to the bank is very slight indeed. In the case of a collateral 
 loan, nevertheless, the stocks and bonds if well selected can be 
 very quickly disposed of; whereas in case a non-collateral loan 
 is not paid, considerable time must ordinarily elapse before 
 the bank can hope to come into possession of funds. 
 
 Collateral loans must be protected by a margin of value. In 
 Order to make sure, however, that the bank will not suffer loss
 
 PRACTICAL OPERATIONS OF THE COMMERCIAL BANK 387 
 
 
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 388 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 when selling the collateral that has been placed for a loan, the 
 banker insists upon a margin. That is to say, if a loan of 
 $100,000 is secured by high grade, readily marketable bonds, 
 the bank would require the deposit of bonds the market value 
 of which was at the time, say, $110,000. In the case of stocks 
 the margin required is ordinarily considerably greater than 
 with bonds; and of course the amount of margin that is required 
 with any particular class of bonds or stock will vary widely 
 depending upon the relative fluctuations in value of the differ- 
 ent securities. It may be observed that a highly important 
 factor to consider is the quickness with which such securities 
 can be sold. This depends upon the number of units that are 
 daily bought and sold on the exchanges. 
 
 Many collateral loans are made for commercial purposes. 
 Loans on collateral owe their origin to various circumstances 
 Sometimes collateral is required by the bank because there is 
 doubt as to the individual's ability to pay the loan promptly at 
 maturity from the proceeds of his ordinary business operations. 
 For instance, if the borrower's ratio of quick assets to current 
 liabilities is rather narrow and general conditions not particu- 
 larly favorable, the bank might refuse to make an unsecured 
 loan. But if the individual had collateral to offer, the bank 
 could make the loan with safety. In a case such as this the 
 funds borrowed would doubtless be used for commercial 
 purposes. 
 
 Collateral loans are sometimes devoted to consumptive uses. 
 Many collateral loans are also made to individuals who are not 
 engaged in the producing, manufacturing, or marketing of 
 goods. These individuals borrow in the main for three purposes : 
 consumption, investment, and speculation. In the case of a 
 consumptive loan, the bank knows that the employment of 
 the funds will not directly result in creating the means of 
 repaying the loan. The collateral deposited at the bank is 
 accordingly looked to as the main security. If the individual 
 is able to pay the loan out of income received, well and good; 
 if not, the collateral may be sold by the bank in settlement of 
 the obligation.
 
 PRACTICAL OPERATIONS OF THE COMMERCIAL BANK 389 
 
 Loans secured by stocks and bonds are extensively used for 
 fixed capital or investment purposes. Commercial banks make 
 investment loans to the investment .bankers to assist them in 
 connection with the underwriting and distributing of securities; 
 to individual investors who find it necessary to borrow tem- 
 porarily a portion of the funds required in the making of an 
 attractive investment; and to business men who wish to use 
 the funds for fixed capital requirements. In all these cases, 
 the collateral protects the bank in case the loans are not paid 
 at maturity, through enabling it to obtain cash by the sale 
 of the collateral in the securities markets. 1 
 
 It is of interest to inquire why investment bankers, who are 
 engaged in the buying and selling of securities, are required to 
 put up collateral as a basis for loans, while business men who 
 are engaged in the buying and selling of commodities commonly 
 borrow on their single-name promissory notes. It will be 
 noted that, from the point of view of the investment banker, 
 the funds which he borrows provide him with working capital. 
 If an investment banker borrows $100,000 with which to buy 
 securities, cannot the commercial banker rely upon the invest- 
 ment banker's paying the loan at maturity out of the proceeds 
 derived from the sale of the securities bought with the borrowed 
 capital, just as he can rely upon a merchant's paying a loan 
 out of the proceeds of his business ? The answer is, not with 
 the same certainty, for the reason that the security markets are 
 more capricious than the commodity markets. There is less 
 certainty as to the time at which the sale will be made; and 
 there is also a greater chance of loss than in the case of ordinary 
 manufacturing and mercantile enterprises. 
 
 But there is another reason why collateral is ordinarily 
 employed by the investment bankers in their borrowing opera- 
 tions, namely, because they chance to have in the securities in 
 which they are dealing instruments which are in a convenient 
 form to serve as collateral. A manufacturer of raw materials 
 cannot use his raw materials as collateral for a loan and at the 
 
 1 But for the difficulties which arise in time of monetary stringency see 
 below, pp. 531-33.
 
 390 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 same time convert them into finished product; nor can a 
 merchant at the same time have his wares on display and on 
 deposit as collateral with the commercial bank. And obviously 
 the bank could not handle such collateral. 1 But stocks and 
 bonds do not need to be displayed in order to be sold, and, by 
 virtue of their transferable and negotiable qualities, they can be 
 conveniently deposited with the bank in a collateral capacity. 
 While investment bankers would doubtless be able to borrow 
 without collateral on the strength of their reputation for 
 business integrity and ability, they find it advantageous to use 
 collateral because they can usually borrow on more favorable 
 terms than they could on unsecured notes. 
 
 It remains to point out that in making loans to investment 
 bankers the commercial bank is in the last analysis furnishing 
 funds for fixed capital purposes. While the investment banker 
 uses the funds thus borrowed as his working capital, he of 
 necessity turns them over to the corporation whose securities 
 are being marketed. Thus all the loans that we have classified 
 under investment are devoted to fixed capital purposes.' 
 
 Collateral loans are also devoted to speculative purposes. Specu- 
 lative loans are of "two main sorts, those made to real estate 
 and similar dealers, and those made to traders on the stock 
 exchange. With both types collateral security is practically 
 always required. In the case of real estate and similar loans 
 it may perhaps be asked, Why should collateral be required, 
 in view of the fact that the funds borrowed are used for working 
 capital purposes, that is, in the purchase of real estate or other 
 commodities that are shortly to be sold at a profit? Are 
 such operations not as much commercial in their nature as the 
 buying and selling of ordinary merchandise ? The reason for 
 denoting such loans as speculative in their nature is that the 
 time at which the sale will be made is much less certain than 
 
 'To the extent that commodities serve as collateral, as we shall pres- 
 ently see, it is usually through the issue of warehouse receipts and bills of 
 lading. See pp. 397-400. 
 
 *It should, however, be recalled (see chart on p. 136) that the funds 
 raised from the sale of securities are not exclusively devoted to 6 red 
 capital purposes.
 
 PRACTICAL OPERATIONS OF THE COMMERCIAL BANK 391 
 
 in the case of ordinary merchandising; and there is also a greater 
 likelihood of a loss in connection with the transaction. Accord- 
 ingly, the bankers commonly insist upon collateral security in 
 the form of stocks and bonds. 
 
 Stock exchange speculation is largely conducted with "call" 
 loans. A discussion of the process of loaning to stock exchange 
 speculators requires first a description of the call loan system. 
 While a "call" loan is one that is terminable at a moment's 
 notice at the will of either the borrower or the bank, in practice 
 such loans always run at least one day, payment on demand 
 meaning that they are subject to call on the day following. 
 There is also a rule thatloans cannot be called by the bank or 
 paid by the borrower after 1:00 P.M., unless notice has been 
 given before that hour. 1 
 
 The reason for the development of the call loan system 
 lies in the nature of stock market speculation. An individual 
 who buys securities with borrowed funds does not know at the 
 time of the borrowing just when he will be able to pay the loan 
 for it all depends upon the trend of the market. If he were to 
 contract a loan for thirty days, and at the end of four days 
 should have sold his stock he would find it necessary to pay 
 interest for twenty-six days, during which time he might have 
 no further use for the money. The cost of speculation is 
 accordingly very greatly reduced if one is enabled to repay the 
 loan at any time desired. The call loan system also has its 
 advantages from the viewpoint of the banker. By virtue 
 of the fact that a metropolitan bank can demand immediate 
 payment of a call loan, it does not need to carry so large a cash 
 reserve as would otherwise be the case. It can keep its funds 
 more fully utilized and thereby increase its earning power. 2 
 
 The interest rates on call loans are subject to very wide 
 fluctuations. They have ordinarily been lower than any other 
 
 1 While the only call loan market in the United States is that in New 
 York, there has recently been an agitation for the establishment of one in 
 Chicago. 
 
 2 We shall later see, however, that in time of crisis, there are serious 
 weaknesses in the call loan system:
 
 392 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 rates; but on several occasions they have gone beyond 100 
 per cent. For instance, the call loan rate rose to 127 per cent 
 on October 29, 1896; to 186 per cent on December 16, 1899; 
 and to 125 per cent on December 28, 1905. During the year 
 1919 rates were frequently as high as 15 or 20 per cent, and once 
 they reached 30 per cent. These high rates occur at times 
 when there is a great dearth of loanable funds and a heavy 
 demand both for commercial and speculative purposes. A 
 flurry on the stock exchange will often give rise to a very 
 great temporary demand for funds. The reason why call 
 rates average lower than unsecured and collateral time loans 
 is that the call loan funds are whaf may be designated as 
 residuary funds. The bank's first business is to take care of 
 commercial borrowers and others who secure time loans on 
 collateral. Funds not required for these purposes are available 
 for market operations. If the supply chances to be fairly 
 large, as it normally is at certain seasons of the year, the rates 
 will be low. If the supply is scanty, the rates will be high. 
 Over a period of years the statistics show that the supply of 
 funds for the purpose has on the whole been fairly large. The 
 diagram on page 393 indicates the average monthly rates in 
 the New York money market on different classes of loans for a 
 period of eleven years, 1896 to 1906, inclusive. 1 
 
 The making of loans for stock market speculation is associ- 
 ated with margin trading, discussed in chapter xvi. We there 
 saw that the individual who bought securities on a margin paid, 
 say, 10 per cent down and borrowed the rest from the broker. 
 But the broker is not a banker and has no funds of his own to 
 lend. His ability to permit the speculator to buy on a margin 
 is contingent upon his own ability to borrow the funds from 
 his bank. To take a concrete case, suppose a broker buys 
 10,000 shares of stock on a 10 per cent margin for a customer. 
 $1,000,000 will be required to pay for the stock. The customer 
 advances $100,000. Most of the remainder is borrowed by the 
 broker from the commercial bank; most, but not all, for the 
 
 'Taken from William A. Scott, "Rates on the New York Money 
 Market," Journal of Political Economy, XVI, 273-98.
 
 PRACTICAL OPERATIONS OF THE COMMERCIAL BANK 393 
 
 reason that the banker will not usually loan so large an amount 
 as 90 per cent of the value of the stock, and especially to a 
 broker who has no funds of his own on deposit with the bank. 
 Typically speaking, a broker is required to keep a balance 
 with the bank equal to 10 or 15 per cent of the amount of his 
 borrowings. In the case before us, therefore, we may assume 
 that the broker would borrow from the bank $800,000. Now 
 
 MONEY RATES IN NEW YORK CITY 
 
 "S J2 'a, 
 fe S < S 
 
 3> a 
 3 w 
 < vi 
 
 tJ o & 
 
 O fc 
 
 A = Commercial paper double name 6o-day. B=6o-day time. C=Callloan. 
 
 the $100,000 received from the customer, plus the $800,000 
 borrowed from the bank, taken in the form of a deposit account, 
 plus $100,000 which the broker already had on deposit in the 
 bank, enable the broker to write a check for $1,000,000 with 
 which to buy the stock in question. 
 
 Loans to stockbrokers are temporarily unsecured. The broker 
 cannot buy the stock until he has secured a loan and he cannot 
 obtain a loan except on the security of the identical collateral 
 which is to be purchased with the borrowed funds. The way 
 out of this dilemma that has been developed is for the bank to
 
 394 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 certify a check for $1,000,000 drawn by the broker against his 
 account of $200,000 a process known as overcertification. 
 With this check the broker buys the stock and then deposits it 
 as security for the loan. It is apparent, therefore, that in 
 certifying the broker's check the bank has in effect given him 
 temporarily an unsecured loan. Such a practice, however, 
 ordinarily involves very little risk, since a good credit standing 
 is absolutely indispensable to the broker a primary requisite 
 for success. 
 
 The practice of overcertification was long indulged in by 
 both national and state banks. But since it is akin to an 
 ordinary overdraft the practice was eventually frowned upon 
 by the Comptroller of the Currency and the national banks 
 have gradually abandoned the practice, substituting therefor 
 a system of making "morning" loans to brokers for whatever 
 amount appears to be necessary for their daily business. These 
 loans are based on the single-name paper of the broker, that 
 is, on his unindorsed individual note. The only difference 
 between this and overcertification is that with the morning 
 loan the bank has the broker's written promise to pay, while in 
 the case of the overcertification it has not ; both are temporarily 
 unsecured loans. 
 
 The amount of overcertification and morning loans required 
 for stock market operations is simply stupendous in a period of 
 active stock market speculation. In the year 1901, for instance, 
 such loans in New York totaled nearly $13,000,000,000 for 
 stock transactions and another billion for bonds, an average of 
 about $45,000,000 daily. 
 
 6. Loans secured by bills of lading. Among the forms of 
 collateral available as security for bank loans none is more 
 interesting or more important than the bill of lading. This 
 instrument, which is issued by a transportation company, is of a 
 threefold character, that is, it performs at once three different 
 services: first, it is a receipt for designated goods, accepted for 
 shipment by the carrier; second, it is the written evidence of 
 a contract to transport and deliver the designated goods to a 
 designated person upon terms specified in the instrument;
 
 PRACTICAL OPERATIONS OF THE COMMERCIAL BANK 395 
 
 and, third, it is a document of title to the goods. The impor- 
 tance of these instruments in connection with banking operations 
 may be readily indicated. 
 
 A dealer in cotton, grain, or merchandise purchases goods 
 for sale in another market. Some little time must necessarily 
 elapse between the date of shipment and this receipt of funds 
 from the buyer the length of time of course varying with 
 the distance and with the terms of payment. The seller, 
 however, usually needs the funds immediately, in order to pay 
 for the produce which he has just shipped, or to buy more, in 
 case the present consignment has already been paid for. 
 Accordingly, he draws a draft upon the purchaser of the goods 
 and discounts this with the local bank, turning over to the bank 
 at the same time the bill of lading that has been received from 
 the railroad company. The bank thus has in its possession a 
 draft not yet accepted and also an instrument which bears 
 on its face evidence that there has been an actual shipment of 
 goods and which at the same time conveys the title of these 
 goods to the banker for only the holder of the bill of lading 
 has the right to demand the goods from the railway company. 
 
 The bank sends the bill of lading, attached to the draft, to a 
 correspondent bank in the city where the buyer lives. The 
 draft is presented to the purchaser of the goods for payment, 
 in case it is a demand draft, and for acceptance in case it is a 
 time draft. If the goods are to be paid for immediately, the 
 bill of lading will of course be surrendered forthwith to the 
 buyer of the goods, who can then secure their release from 
 the railroad company. In the case of a time instrument, it is 
 still necessary for the buyer to get possession of the goods if 
 he is to use them in his business. The bank therefore directs 
 that the goods shall be delivered to the purchaser, but on 
 conditions which protect its interests. 1 Both sellers and buyers 
 of goods thus borrow with bills of lading as collateral security: 
 the sellers during the period while the goods are in transit; 
 and the buyers for such additional time as may be necessary. 
 
 x This ordinarily involves the use of a "trust receipt." See illustra- 
 tion on p. 415 below.
 
 396 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 There are two kinds of bills of lading, classified from the 
 point of view of the ease with which they may be transferred: 
 first, the straight bill, which states that the goods are con- 
 signed or destined to a specified person; and second, the order 
 bill, which is made payable to the order of some person. In 
 the nature of the case, a straight bill cannot be transferred by 
 indorsement, while an order bill is always thus "negotiable' 
 under the federal Bill of Lading Act, unless it is specifically 
 made "non-negotiable" by the shipper. It should be observed 
 that the transfer of order bills of lading by indorsement does 
 not render them available as substitutes for currency; they do 
 not possess all the requisites of a fully negotiable instrument, 
 in that they do not call for the payment of a specific sum of 
 money. The purpose of giving them a ready transferability 
 by indorsement is to permit the title to the designated goods 
 to be easily passed from one party to another, and thus to 
 facilitate the use of these instruments as collateral for loans. 
 
 Bills of lading arose with the development of transportation; 
 and, as in the case of other instruments, a considerable body of 
 law has been developed by our various legislative agencies for 
 facilitating their use hi the capacities for which they were 
 designed. The law left much to be desired, however, until 
 after the passage of the federal Bill of Lading Act, which became 
 effective January i, 1917. Before this time there were many 
 irregularities and frauds in the use of bills of lading, particularly 
 in connection with the shipment of cotton to Europe. Indeed, 
 it was feared for a time, not many years ago, that the cotton 
 frauds, which ran into millions of dollars annually, would imperil 
 our entire cotton export trade. The sources of loss to bankers 
 on bills of lading have been enumerated as follows: (i) the 
 issue of bills of lading without the receipt of the goods; (2) the 
 delivery of the goods to the purchaser without cancellation 
 of the bill of lading; (3) the alteration of bills of lading; (4) the 
 forgery of bills of lading; (5) the issue of duplicate bills of 
 lading, the originals being still outstanding and uncanceled. 
 The agitation for an improvement in the law regulating bills 
 of lading finally became acute. It was participated in by
 
 397 
 
 the shippers and commission merchants, by transportation 
 companies, and by the bankers of the country. The interests 
 of these several groups did not precisely coincide at all points, 
 but an agreement on the main principles was finally reached, 
 and a number of states were led to pass what was known as 
 the Uniform Bill of Lading Act, after which the federal Bill of 
 Lading law above referred to was modeled. 
 
 The volume of business that is financed on bills of lading 
 is tremendous in quantity. It has been estimated that about 
 twenty-five billion dollars' worth of transactions now annually 
 involve their use, and that about five billions of this amount 
 are financed by the commercial banks. Bills of lading are 
 used in connection with two main classes of goods, as follows: 
 first, general merchandise and groceries; second, commodities, 
 such as live stock, grain, cotton, and perishable produce. It 
 appears that a very large percentage of the business of the 
 wholesale grocers in the large financial centers, that the bulk 
 of the business in poultry and game, and about 75 per cent of 
 the business in the butter and egg trade is handled on order 
 bills of lading. 
 
 On the following page is a copy of a straight (non- 
 negotiable) bill of lading. 
 
 7. Loans on warehouse receipts. Another form of borrowing 
 is that on the promissory note of an individual secured by a 
 warehouse receipt as collateral. As in the case of ordinary 
 single-name borrowing, the underlying security is goods, but 
 there is a difference in that the warehouse receipt is issued 
 against specific goods held in storage; where the ordinary 
 single-name commercial loan is based upon the general assets 
 of the borrower, a loan protected by a warehouse receipt is 
 based upon the specific assets. Moreover, the holder of a 
 warehouse receipt, like the possessor of a bill of lading, has 
 control of the disposition of the goods in question. 
 
 The warehouse receipt is employed as a basis of credit 
 wherever it is convenient to do so. We have already seen that 
 it is impossible for a manufacturer to so use materials that are 
 in process of manufacture; and that, similarly, it is usually
 
 398 
 
 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 impossible for a merchant to use his merchandise as collateral 
 for a loan for the reason that it must be on display. But 
 certain kinds of goods, notably whiskey and other beverages 
 
 BILL OF LADING 
 
 STRAIGHT BILL OF LADING ORIGINAL NOT NEGOTIABLE. 
 
 Shipper'* No . 
 
 Agenu No. 
 
 at... 
 
 to the ctawfictioo ami tarifc in c&ct oa the date of iaat of thij Shippio* Order. 
 
 MgC>L.lfi* 
 
 Allis-ChalmerG lite . 
 
 ' m of contents of package* unknown), market 
 usual place of deurery at said destination, if 
 
 .19 17. 
 
 ,_the property described below, in apparent good order, except * noted 
 , consigned and destined as indicated below, which uid Company 
 
 agree* to carry to its usual place of debTery at said destination, if on its road, otherwise to delirer to another carrier on the route to 
 aid destination- Ic ia mutually agreed, a* to each carrier of all or any of said property orer all or any portion of laid ronte to tltKf 
 nation, oul aa to each party at any time Interested in all or any of said propertj, that every errice to be performed bereuodcr shul] bt 
 abject to all the condition*, whether printed or written, heron contained (mduding coo&tioa* oa back bcrcofj aaJ wbidi axe agreed to 
 by Uc ahipper aad accepted for himseU aud hia aat^n*. 
 
 The RaU of Frci&t frmn 
 
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 w in. Centt -per 1.00 Lbs. 
 
 IFSp.clM 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 Construed t-T T .Tyns Continental 
 
 Destiaatioo, _ fifalg 
 
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 803 So. Dearborn St. 
 
 State o^_HJ.( . -------- ^County of. ___ 
 
 Car Initial: __ CtllTft _____ ............. Car No. 383898 ...... . 
 
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 DESCRIPTION OF ARTICLES AND SPECIAL MARKS 
 
 WEIGHT 
 dcttn(>nleri> 
 
 CmjiBor 
 Rate 
 
 Check 
 
 Column 
 
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 boxes steam Pqnp -parts 
 
 
 
 
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 cr^te "ac^lnery 
 
 
 
 
 
 
 
 
 
 
 MtoOTllM.* 
 
 _L.-. 
 
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 thecls . .. 
 Punp skidded 
 
 6fl9 it* 
 
 
 
 If eharget re to be pre- 
 paid, writ* or tump her* 
 
 
 
 
 
 
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 MARKED 
 
 
 
 
 
 
 
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 Received $ 
 
 
 HOholulu, T.H. 
 
 
 
 
 charge! on the property deecrib-' 
 
 
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 .Shipper. 
 
 (in the past?), grain, cotton, hides, sugar, canned goods, etc., 
 are commonly held for considerable periods of time in ware- 
 houses; and receipts against such goods are well adapted to 
 serve as collateral for loans. The warehousing business has
 
 PRACTICAL OPERATIONS OF THE COMMERCIAL BANK 399 
 
 developed very rapidly in recent years and accordingly loans 
 on warehouse receipts as collateral have been rapidly expand- 
 ing in volume. 
 
 Improving legislation is, moreover, rapidly placing the 
 warehousing business upon a secure basis. In recent years 
 various states have passed warehousing laws and installed 
 systems of licensing and inspection so that warehouse receipts 
 have become among our most reliable forms of commercial 
 instruments. A United States Warehouse Act was also passed 
 on August n, 1916, which provides for the issuance of licenses 
 by the Secretary of Agriculture for the operation of warehouses 
 for the storage of agricultural products. The license brings the 
 operation of the warehouse under an inspection service of 
 the Department of Agriculture and makes it incumbent upon 
 the owner of the warehouse to give bonds for the faithful 
 discharge of his obligations to the owners of commodities placed 
 in his custody. The inspection service includes an examination 
 of the warehouse before the license is issued, and from time to 
 tune thereafter, together with an examination of the competency 
 of the warehouseman in classifying, weighing, and certifying 
 the produce received. 
 
 Every warehouse receipt issued under this law shall state 
 the following things: (a) location of warehouse; (6) date of 
 issue; (c) consecutive number; (<$) to whom deliverable; 
 (e) rate of storage charges; (/) description of products; (g) grade 
 or other class; (h) that it is, issued under the United States 
 Warehouse Act; (i) the interest of warehouseman, if any; 
 (j) advances and liabilities for which warehouseman claims 
 a lien. 
 
 Warehouse receipts, like bills of lading, are documents of 
 title to the goods in storage. They are sometimes negotiable 
 and sometimes not, depending upon the conditions under 
 which they are issued. Like bills of lading, however, they are 
 not substitutes for currency and do not embody all the requisites 
 of a full-fledged negotiable instrument; they do not call for 
 payment hi money, for example, but only for the delivery of 
 certain specified goods.
 
 400 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 Below is a copy of an ordinary "negotiable" warehouse 
 receipt. 
 
 WAREHOUSE RECEIPT 
 
 ORIGINAL DOE WAREHOUSE. RZCOTT No 
 
 NEGOTIABLE ffUff, (K5TJ DATE 
 
 INCORPORATED VNDEB. TH LAW* or ; PAID w CAMTAL'STOCE: $ 
 
 WAREHOUSE RECEIPT 
 
 FOR 
 ONE B-A.LE OF COTTON 
 
 the below described one bale oi cotton lor Morage by the Doe Warehouse m its warehouse located at Tt)n r" ' Tl 
 
 Bubi*ct to the conditions hereinafter let out Said bale oi cotton ia identified by the tag numbers and marks, and, subject to re 
 variations and concealed defect*, is of the weight, grade (according to the official cotton standards of the United SUteo, unless e 
 stated otherwise), length of staple, and condition set out below. 
 TAO No M.uia WEIGHT GHADE LENGTH or STATU CONDITION.. 
 
 Insured tcaimt li 
 f. I'pco I 
 
 If Klvwl<s.l 
 
 .. diAUIrlo. 
 
 With bills of lading and warehouse receipts as security, as 
 with stocks and bonds, the bank usually requires a margin of 
 safety. That is to say, on a bill of lading or warehouse receipt 
 of high standing and against a commodity which is not subject 
 to wide fluctuations in value, such as grain and cotton, the 
 bank may loan as high as 90 or 95 per cent of the market value 
 of the produce against which the receipt is issued. 
 
 It may also be pointed out that the giving of collateral 
 in the form of a bill of lading or warehouse receipt is not required 
 by the bank on the ground that, the loan would otherwise be 
 unsafe. Indeed the business out of which warehouse receipts 
 and bills of lading grow is essentially commercial in its nature. 
 The use of the warehouse receipt and bill of lading as collateral 
 for loans is mainly attributable to their convenience for the 
 purpose, and to the fact that through their hypothecation as 
 collateral security the borrower is enabled to secure somewhat 
 larger advances than would otherwise be the case. Indeed, 
 produce dealers are commonly granted large loans on their 
 single-name notes granted a "line of credit"; and it is only 
 when loans in excess of this amount are desired that the collateral 
 is required.
 
 PRACTICAL OPERATIONS OF THE COMMERCIAL BANK 401 
 
 8. Investments in stocks, bonds, short-term notes, mortgages, 
 etc. Investments in securities are not listed among the types 
 of loans in the table on page 377. An investment, however, 
 does represent a loan of funds quite as truly as any of the 
 lending operatipns that we have been discussing, the only real 
 difference being the length of time for which the credit is 
 extended. 
 
 In general, it may be said that the investments of commer- 
 cial banks in stocks are negligible in amount. Because of 
 the wide fluctuations to which stock values are subject, it is 
 regarded as bad banking practice to hold shares, except tem- 
 porarily, as a means of salvaging bad debts. But most com- 
 mercial banks have long followed the practice of investing a 
 considerable portion of their assets in high-grade bonds, and 
 to a lesser degree in mortgages, warrants, etc. The following 
 table shows the amount and character of bond and stock 
 investment holdings of the national and state banks of the 
 United States in 1916: 
 
 INVESTMENTS OF COMMERCIAL BANKS 
 (In thousands of dollars) 
 
 ALL NATIONAL BANKS 1 
 
 United States bonds* $731,205 
 
 State, county, and municipal bonds 278,180 
 
 Railroad bonds 467,629 
 
 Other public-service corporation bonds 274,928 
 
 All other bonds 301,503 
 
 Claim warrants 43>8i8 
 
 Judgments 4.703 
 
 Foreign government securities 116,768 
 
 Other foreign securities 4>33 
 
 Stocks 39, 2 7 2 
 
 Total $2,298,309 
 
 * These are, of course, mainly held as security for note issues. 
 
 1 Report of the Comptroller of the Currency (1916), pp. 166-69.
 
 4O2 
 
 15,45 STATE BANKS 1 
 
 United States bonds $ 1,311 
 
 State, county, and municipal bonds 31,440 
 
 Railroads 2,006 
 
 Bonds of other public-service corporations (including 
 
 street and interurban railway bonds) . . . . . 14,809 
 
 Other bonds, stocks, warrants, etc 643,721 
 
 Total $693,287 
 
 The figures for later years would show a much greater 
 volume of government bond investments, as a result of the 
 exigencies of war finance. An attempt is now being made, 
 however, to reduce the total of bank investments in govern- 
 ment bonds by encouraging their absorption by the general 
 investing public. 
 
 In this chapter we have merely been presenting the facts 
 as to the nature of commercial bank loans and investments; 
 there has been no attempt to consider the wisdom of this or 
 that particular type of credit extension, or the results of the 
 loan policy of banks upon the safety and efficiency of the com- 
 mercial banking system in general. These issues will be con- 
 sidered in subsequent chapters. 
 
 QUESTIONS FOR DISCUSSION 
 
 I. GENERAL CONSIDERATIONS 
 
 1. Are the banks of your community national or state institutions ? 
 Ascertain by local inquiry why they were organized under state 
 or national law, as the case may be. 
 
 2. Are there any private banks in your community? If so, are 
 they subject to state supervision of any kind ? 
 
 3. Enumerate as many ways as you can in which the commercial 
 banks of your community render services to their customers. 
 Which do you regard as of greatest importance ? 
 
 4. Do you keep your own financial accounts by means of a check 
 book and a monthly bank statement ? If not, why not ? 
 
 1 Report of the Comptroller of the Currency (1916), p. 852.
 
 PRACTICAL OPERATIONS OF THE COMMERCIAL BANK 403 
 H. ANALYSIS OF COMMERCIAL BANKING OPERATIONS 
 
 5. What is the difference between loans and discounts? "All 
 discounts are loans but not all loans are discounts." Explain 
 this statement. 
 
 6. What is the difference between bank and true discount ? Figure 
 the bank and the true discount respectively on $100,000 at 
 6 per cent for three months. 
 
 7. What is an overdraft ? Why is it listed as an asset ? 
 
 8. In what different ways do commercial bank deposits arise? 
 Which is the more common ? 
 
 9. It is sometimes stated that a commercial bank lends out the 
 funds of its depositors. Do you think this is an accurate and 
 adequate statement of the nature of commercial banking 
 operations ? 
 
 TO. "The commercial bank acts as an intermediary between lenders 
 and borrowers. It collects funds from certain people and lends 
 them to others. " Do you agree ? 
 
 11. "The commercial bank assembles cash resources from original 
 capital contributions, from earnings, and from (cash) deposits, 
 and on the basis of these cash resources it makes loans and creates 
 deposit accounts. " Do you agree ? 
 
 NOTE. This aspect of commercial banking will be more fully dis- 
 cussed in chapter xxii. The student's conclusion at this place should 
 therefore be only tentative. 
 
 12. Indicate the changes in a commercial bank's balance sheet that 
 would result from the following operations, using + or signs 
 as in the problem on page 354 above: 
 
 a) Discount a promissory note of $100,000 for two months at 
 6 per cent. Assume that the borrower does not wish to 
 withdraw his funds in actual cash. 
 
 b) Assume that a depositor writes three checks against his 
 account, each for $30,000; one of them is deposited in this 
 bank; one in another bank in the same community; and the 
 third in a bank in another town. 
 
 c) The loan made in (a) above is paid at maturity in the following 
 manner: (i) one-half by check against the borrower's account 
 in this bank ; (2) one-eighth by a certified check of a depositor 
 in this bank; (3) one-eighth by a cashier's check on another 
 bank in the same city; (4) one-eighth by a bank draft on
 
 404 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 New York; (5) one-sixteenth by notes of this bank; and 
 (6) one-sixteenth by cash. 
 
 d) Receive a deposit of $25,000 composed of the following items: 
 (i) $5,000 in cash; (2) $5,000 in checks on other banks, 
 members of the same clearing house; (3) $5,000 in drafts on 
 an out-of-town bank; (4) $5,000 in notes of other national 
 banks; and (5) $5,000 in checks on this bank. 
 
 e) Make a loan of $10,000 to Mr. X in the form of an issue of 
 bank notes. Assume the price of 2 per cent government 
 bonds to be $101. 
 
 f) Purchase $10,000 in bonds, paying for them by cashier's 
 checks. 
 
 g) Declare a semi-annual dividend (using the figures in the 
 Continental and Commercial National Bank statement on 
 p. 365 above) of 10 per cent, crediting one-half of the amount 
 to the accounts of stock-holding depositors and paying the 
 remainder by drafts on New York. Carry the remainder of 
 the undivided profits account to surplus. 
 
 13. In which class of national banks do you find note issue of relatively 
 greatest importance? least importance? (See table on p. 372.) 
 How do you explain this ? 
 
 14. How do you explain the relative decrease in the volume of 
 national bank notes in all classes of banks between 1870 and 1909 ? 
 Who determines in practice whether a bank shall issue notes or 
 create deposits when making a loan ? 
 
 m. ANALYSIS OF COMMERCIAL BANK LOANS 
 
 a) The Various Types of Loans 
 
 15. "The pivotal thing in sound banking is the character of a bank's 
 loans." Why? 
 
 16. Which is the more significant classification of bank loans, by 
 time or by the character of the security ? 
 
 17. Study the classification of bank loans on page 377 and draw up a 
 statement of the points of significance and interest. 
 
 1 8. What is the meaning of the last two items in this classification 
 of loans ? 
 
 19. X, a real estate dealer, borrows $10,000 from a bank for three 
 months, giving as security a mortgage on real estate which he 
 purchases with the money. Is this a commercial, investment, 
 or speculative loan ?
 
 PRACTICAL OPERATIONS OF THE COMMERCIAL BANK 405 
 
 20. X Railroad Company borrows $100,000 from a bank on six 
 months' time, giving the bank its unsecured promissory note: 
 (a) the company uses the funds in buying equipment; (b) the 
 funds are used for meeting operating expenses. Is this, in each 
 case, a commercial or an investment loan ? 
 
 21. Would it make any difference in the preceding example if the 
 loan were secured by collateral ? 
 
 22. A bank lends a lawyer $1,000 for two months on his single-name 
 promissory note. Is this a commercial, speculative, or invest- 
 ment loan? Suppose the note were indorsed: would this 
 change its nature ? What if collateral were required ? 
 
 23. J. P. Morgan & Company borrows $100,000 from a bank for 
 three months, putting up stocks and bonds as collateral. Is 
 this an investment, speculative, or commercial loan ? Are the 
 funds used as working or fixed capital by J. P. Morgan & Com- 
 pany ? What is the ultimate disposition of the funds ? 
 
 24. A manufacturer borrows for three months $20,000 with which to 
 buy raw material, giving his unsecured note to the bank. Is 
 this a commercial or an investment loan ? 
 
 25. A producer of raw materials borrows for ninety days $20,000 
 and uses the funds to meet pay-rolls. Is this commercial or 
 investment borrowing ? 
 
 26. A wholesaler discounts at his bank a trade acceptance, due in 
 sixty days. Is this an investment or a commercial loan ? 
 
 27. A retailer borrows $10,000 from a bank on his single-name 
 promissory note^or three months and uses the funds in erecting 
 an addition to his store. Is this a commercial or an investment 
 loan? Would you hold that a commercial bank should never 
 make such a loan without collateral security ? 
 
 28. A bank makes a loan to an individual who uses the money in 
 perfecting an invention on which he hopes to realize a fortune. 
 How would you classify such a loan ? 
 
 29. A bank loans money to a man who is a promoter of industrial 
 combinations. How would you classify such a loan ? 
 
 30. What sort of loan would you call one to a country preacher? 
 to a new doctor in a small town ? 
 
 31. What are "character loans"? 
 
 32. How would you classify a loan made to a broker on the stock 
 exchange ?
 
 406 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 33. Would you regard a loan to the son of a retired merchant on the 
 basis of his father's good reputation a safe loan ? Would it be 
 wise to make many such loans ? Should collateral be required ? 
 
 34. Is the significant element in a "commercial" loan the short 
 duration or the use to which the funds are put ? 
 
 3 5. Why are commercial loans commonly of short duration ? Strictly 
 speaking, what principle should govern their duration ? 
 
 NOTE. The student should reserve final judgment on this question 
 until after he has studied chapter xxiii, particularly pages 532-33. 
 
 b) Single-Name versus Double-Name Paper 
 
 36. In the case of a loan on a single-name promissory note, who owns 
 the hote ? Who owns an indorsed note ? 
 
 37. Who owns notes that are deposited as collateral for loans ? 
 
 38. X brings to the bank a promissory note of Y and indorses it 
 over to the bank. As a banker, would you base your confidence 
 that the loan would be paid on X or on Y ? Which one is pri- 
 marily liable ? 
 
 39. Which would you prefer to have, an indorsed promissory note 
 or trade acceptance arising from a specific and already con- 
 summated sale of goods from X to Y, or a single-name promissory 
 note of X who presents a financial statement showing total 
 quick assets equal to four times the total current liabilities ? 
 
 40. In general do you see any inherent advantage in basing a loan 
 on a specific transaction of a given business man, rather than on 
 his transactions in general, as revealed by his financial statement 
 and profit and loss accounts ? If so, what ^ 
 
 41. Classify, in the order of their importance, the various sources of 
 credit information that are available to a bank. 
 
 42. What is the supposed especial advantage of loans on trade 
 acceptances? Is a trade acceptance superior in any way to a 
 trade note ? 
 
 43. As a banker, would you discount trade acceptances, without 
 regard to the general financial standing of the borrower ? 
 
 c) Loans on Collateral 
 
 44. Who owns the collateral during the life of the loan ? 
 
 45. In what respects is mortgage collateral inferior to bonds and 
 stocks ? 
 
 46. Why are not promissory notes more commonly used as collateral 
 for bank loans ?
 
 PRACTICAL OPERATIONS OF THE COMMERCIAL BANK 407 
 
 47. Name as many reasons as you can why collateral may be required. 
 
 48. In the case of loans to investment bankers and stock exchange 
 operators, is collateral security indispensable to a safe extension 
 of credit ? 
 
 49. Indicate the changes on a bank's balance sheet that would result 
 from the following collateral loaning operations: 
 
 a) A loan of $40,000 for three months at 6 per cent is made on the 
 basis of collateral composed of bonds and stock, the margin 
 being 20 per cent. 
 
 b) The foregoing loan is paid at maturity by a check on this 
 bank. Meanwhile the value of the collateral had shrunk 
 until the margin was only 10 per cent. 
 
 c) The bank makes a $50,000 call loan, the call rate at the 
 moment being 6 per cent. Collateral is deposited with a 
 market value of $60,000. 
 
 d) The bank calls the foregoing loan (c) and the broker is unable 
 to pay, whereupon the bank sells the collateral for $55,000, 
 receiving in payment a check on another bank in New York. 
 The loan had run for thirty days, and the call rate during 
 this period had averaged 8 per cent. 
 
 50. What governs the rates on call money? How do they compare 
 at present with other rates ? 
 
 51. How is it ever possible for an individual to pay as much as 
 100 per cent for the use of money ? 
 
 52. How can banks afford to accept only 2 or 3 per cent on money 
 loaned at call ? Are they not losing on such money ? 
 
 53. What is the difference between the demand loans of banks out- 
 side of New York and the call loans in New York ? 
 
 54. How do you account for the different rates on the different 
 types of loans, as shown by the chart on page 393 ? 
 
 55. What is the purpose of overcertification ? of "morning loans"? 
 Are the latter any safer than overcertification ? 
 
 56. How large a margin should be required with the following col- 
 lateral: (a) unlisted common stock of a good substantial concern ? 
 (b) listed preferred stocks of an industrial corporation ? (c) rail- 
 road bonds ? (d) municipal bonds ? (e) grain warehouse receipts ? 
 
 57. What is meant by "mixed" collateral? Is there any advantage 
 in it? 
 
 58. Do you see any objection tQ fflakin.g collateral loans for fixed 
 capital purposes ?
 
 408 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 59. In what respects does a bill of lading differ from other collateral ? 
 
 60. Would you prefer a bill of lading as collateral to stocks and 
 bonds ? Why, or why not ? 
 
 61. Could produce dealers and others who borrow on bills of lading 
 as collateral not obtain loans on their unsecured notes? 
 
 62. As a banker, would you grant loans more readily and for larger 
 amounts where bills of lading were given as security ? Why, or 
 why not ? 
 
 63. In what respects does a warehouse receipt differ from securities 
 as collateral ? 
 
 64. As a banker, would you refuse to lend to, say, a produce dealer 
 except upon the deposit of a warehouse receipt as collateral? 
 
 65. Would you lend a larger sum with than without a warehouse 
 receipt as collateral ? Would you grant any lower rates ? 
 
 66. Do you think it probable that warehouse receipts and bills of 
 lading are used as collateral whenever they are available for the 
 purpose ? Why, or why not ? 
 
 d) Investments of Commercial Banks 
 
 67. Study the financial statement of your local banks and ascertain 
 how many different types of investments they hold. 
 
 68. In what respects are bonds better investments for commercial 
 banks than stocks ? than mortgages ? 
 
 69. In what respects are short-term notes superior as bank invest- 
 ments to bonds ? 
 
 70. Why are United States certificates of indebtedness a popular 
 form of bank investment ? 
 
 71. Why are bonds with an early maturity date regarded as par- 
 ticularly desirable types of bond investments for commercial 
 banks? 
 
 72. Do you see any general disadvantage in investments as compared 
 with collateral loans ? 
 
 73. Would you support the doctrine that commercial banks should 
 not invest in securities and thereby furnish funds for fixed 
 capital purposes ? 
 
 NOTE. Final judgment on this issue should be reserved until 
 after reading chapter xxiii.
 
 PRACTICAL OPERATIONS OF THE COMMERCIAL BANK 409 
 
 REFERENCES FOR FURTHER READING 
 
 Agger, Eugene E. : Organized Banking, chap. i. 
 
 D unbar, Charles F.: Chapters in the History and Theory of 
 Banking, 3d edition, revised and enlarged by O. M. W. Sprague, 
 chaps, ii and iii. 
 
 Holdsworth, John Thorn: Money and Banking, chap, viii, x 
 and xvi. 
 
 Kniffin, William H.: The Practical Work of a Bank, chap. xiii. 
 
 Moulton, Harold G.: Principles of Money and Banking, Part II, 
 chap. iv. 
 
 Phillips, Chester A. : Readings in Money and Banking, chap. ix. 
 
 Scott, William A.: Money and Banking, chap. vii. 
 
 Shaw Banking Series: Credits and Collections, chaps, vi, vii 
 and viii. 
 
 White, Horace: Money and Banking, Book III, chap. ii. 
 
 Willis, H. Parker: American Banking, chap. xiii.
 
 CHAPTER XX 
 
 COMMERCIAL BANKING AND THE FINAN- 
 CING OF FOREIGN TRADE 
 
 In the foregoing discussion of the practical operations of 
 commercial banks, the analysis related primarily to the part 
 these institutions play in financing local or domestic business 
 requirements. In the present chapter our attention will be 
 specifically directed to the relations of commercial banks to 
 the financing of foreign commerce and industry. - 
 
 I. FINANCING IMPORT TRADE 
 
 In illustrating the principles of foreign exchange in chapter 
 viii it was pointed out that the American exporter customarily 
 draws a bill of exchange on a London importer, or on a bank 
 designated by him, and then offers the bill for sale in the New 
 York market. It has, however, not been true that the British 
 exporter to this country commonly draws a bill upon the New 
 York importer, or a designated bank, and offers this bill for 
 sale in London. The practice has rather been for the American 
 importer to buy a sterling bill of exchange from an American 
 bank and remit this in payment, or for the foreign exporter to 
 draw a draft against a London bank rather than against a New 
 York institution. In considering the part that commercial 
 banks play in the financing of import trade, we must therefore 
 first consider the reasons for the common practice of drawing 
 these bills on London rather than on New York. 
 
 Until after the adoption of the Federal Reserve System in 
 1913 United States banks were not permitted to accept drafts 
 drawn against them. Now a British exporter would not 
 draw on an individual in New York because of the difficulty 
 in disposing of such a bill at a reasonable rate unless the 
 
 410
 
 COMMERCIAL BANKING AND FOREIGN TRADE 411 
 
 individual importer chanced to have an international reputa- 
 tion. It was accordingly much cheaper for the exporter to 
 receive a bill drawn on a London bank; for this could be 
 promptly discounted at a low rate in the London discount 
 market. And even were a draft accepted by an American 
 importer of international reputation, it could still not be 
 discounted in the London market on as favorable terms as 
 London bills. Through the use of London bills the British 
 exporter was, moreover, enabled to avoid the " risk of exchange, " 
 that is, changes in the rate of exchange between the two coun- 
 tries; for if he possessed a British bill, payable in sterling in 
 London, subsequent changes in the rate of exchange would not 
 affect the volume of funds which he would receive. 
 
 Commercial letters of credit are widely used in financing 
 imports. The financing of import trade is typically effected 
 through the use of an extremely interesting financial device, 
 developed during the last twenty-five years, and known as the 
 commercial letter of credit. A concrete illustration will reveal 
 the nature of this form of credit operation. 
 
 Suppose an importer in New York desires to buy $10,000 
 worth of silk from a firm in Hongkong. The American importer 
 is not known to the Chinese exporting house and it is out of 
 the question for the Chinese exporter to draw a bill of exchange 
 upon the New York importer and secure the funds by dis- 
 counting the bill at a Hongkong bank. Moreover, since the 
 importer's credit standing is unknown to the Hongkong 
 merchant, the latter cannot well afford to take the chance of 
 shipping the goods oh credit and waiting, say, six months for 
 payment. An arrangement is therefore made whereby the 
 credit of the New York house is, in a sense, guaranteed by a 
 financial institution in which the Hongkong exporter may 
 have confidence. 
 
 The New York importer goes to his banker and secures a 
 commercial letter of credit. The letter of credit is addressed 
 to the exporter, and it authorizes a bank, say, in London, to 
 accept the six-months sight drafts of the Hongkong exporter 
 of silk up to a certain total sum and under certain prescribed
 
 412 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 conditions, pertaining to the attaching to the draft of bills of 
 lading, insurance certificates, etc., these terms all being set 
 forth in the letter of credit. The banker in London is of 
 course notified that the letter of credit has been issued. The 
 letter of credit itself is sent to the Hongkong exporter. Not 
 until the receipt of this letter of credit, which (when confirmed 
 by the London bank) assures him that a responsible financial 
 house is willing to accept drafts drawn upon it and specifies 
 the terms on which the goods are to be shipped, does the Chinese 
 exporter proceed with the shipment of the silk. 
 
 As soon as the goods have been shipped, the exporter draws 
 a bill of exchange on the London bank, pins to it the bill of 
 lading and the insurance certificate, and then takes the draft 
 to his local bank in Hongkong, where it is discounted. The 
 whole transaction is then closed so far as the exporter is con- 
 cerned. It may be added that the Hongkong bank will have 
 no hesitation in buying the draft, because it can either sell it to 
 Chinese importers who must make remittances to London or 
 send it to London directly for collection. It may be added, 
 also, that the development of the American acceptance market 
 would not necessarily lead to a general practice of drawing on 
 American banks in this connection, for the reason that American 
 bills would not be in active demand in Hongkong, the financial 
 relations of which are primarily with England, and also because 
 of the lower discount rate that characteristically obtains in the 
 London market. 
 
 The goods are meanwhile on the way to New York. The 
 draft, with bill of lading and insurance certificate attached, 
 is now sent by the Hongkong bank to its correspondent bank 
 in London, which presents it to the bank that has agreed to 
 accept it. It is accepted and marked payable at a definite 
 date, say, April i. When the draft is accepted, the bill of 
 lading and insurance certificate are detached (in case it is a 
 "documents acceptance" as distinguished from a "docu- 
 ments payment" instrument), the accepted bill is returned to 
 the bank that presented it, and the bill of lading and insurance 
 certificate are sent to the New York bank which originally
 
 COMMERCIAL BANKING AND FOREIGN TRADE 413 
 
 arranged the commercial letter of credit. It may be noted 
 that the accepted draft (bank acceptance) may be sold by the 
 bank which has it in its possession to other banks in London, 
 or to individuals desiring high-grade short-term investments. 
 In fact, such an acceptance often changes hands many times 
 during the interval between the date of acceptance and the 
 date upon which it is due. 
 
 By the time the bill of lading and insurance certificate 
 have reached the bank in New York, the consignment of goods 
 may also have arrived there. The New York bank there- 
 fore turns the bill of lading and insurance certificate over to the 
 importer of the silk, thus permitting the importer to secure 
 the release of the goods and offer them for sale. 1 It will be 
 noted that unless the individual can secure possession of the 
 goods he cannot sell them, and if he cannot sell them, he cannot 
 well turn over to the bank with which the letter of credit has 
 been arranged the funds necessary to pay the London dis- 
 counting bank. For it must be remembered that in the last 
 analysis it is the importer who does pay for the goods. Con- 
 cretely the process of payment is as follows: 
 
 The importing house pays to the New York bank $10,000 
 some time before April i. The New York bank turns these 
 funds over to the London accepting bank before April i. On 
 April i the London accepting bank pays $10,000 to whatever 
 individual or bank may present the bill for payment. It will 
 be seen, however, that if the importer fails to put the bank in 
 funds before it has to remit to London, the New York bank 
 will have to advance the funds out of its own resources. And, 
 in turn, if the London bank did not receive funds from its New 
 York correspondent before April i, it would have to pay the 
 bill out of its resources. Both banks, therefore, assume some 
 risk; and as compensation each receives a commission, the 
 amount varying, but commonly being from one-fourth to one- 
 half of i per cent of the amount of the bill for every thirty 
 days that it runs. 
 
 I In the case of long shipments duplicate documents are often sent 
 direct to New York, in order that the importer may not be delayed in 
 obtaining possession of the goods.
 
 4H 
 
 It will be seen that after the London bank parted with the 
 bill of lading and insurance certificate it possessed no document 
 of title to the goods; it merely relied upon the good faith of 
 its New York correspondent. Here is credit in its most highly 
 developed form. 
 
 In turn, when the New York bank turned the bill of lading 
 over to the importer it no longer possessed title to the goods. 
 An arrangement has been developed, however, whereby the 
 banker does have more than an unsecured promise to pay, 
 even though he parts with the bill of lading which constitutes 
 the title to the goods. For when the bill of lading is offered 
 to the importer, he gives to the bank a "trust receipt," which 
 states that he has received the merchandise and that he will 
 sell the goods and turn the proceeds over to the bank before 
 or at maturity of the bill of exchange. Trust receipts are of 
 various sorts; but it is usual for them to specify that the 
 merchandise is to be kept separate from other merchandise 
 held by the firm, and that the specific funds derived from the 
 sale of the goods are to be turned over to the bank. On the 
 accompanying page is a copy of a typical trust receipt. The 
 "letter of credit agreement" also includes provisions designed 
 to protect the interests of the bank. (See copy on p. 416.) 
 
 American banks can now accept "dollar" import drafts. The 
 Federal Reserve Act of 1913, as amended, authorizes national 
 banks of the United States to accept drafts drawn for the 
 purpose of financing both imports and exports, 1 and accord- 
 ingly the process of financing imports has entered upon a new 
 phase. Instead of drawing bills of exchange against London 
 banks, it is now possible to draw "dollar drafts," that is, 
 drafts against American banks and expressed in terms of 
 dollars. It is believed that the practice of drawing upon 
 American rather than foreign banks will gradually increase. 
 On page 417 is a copy of a dollar "import letter of credit." 
 
 1 New York state banking legislation shortly fell into line with the 
 Federal Reserve Act and authorized state bank acceptances.
 
 TRUST RECEIPT. 
 
 RECEIVED from the GUARANTY TRUST Co. OF NEW YORK the following 
 goods and merchandise, their property, specified in the Bill of Lading per 
 
 S. S Dated 
 
 marked and numbered as follows: 
 
 r i I 
 
 and, in consideration thereof, 4 \ HEREBY AGREE TO HOLD SAID GOODS IN 
 
 I we J 
 
 TRUST for them, and as their property, with liberty to sell the same for their 
 account, and further agree, in case of sale to hand the proceeds to them to 
 apply against the acceptances of the GUARANTY TRUST Co. OF NEW YORK on 
 
 f my 1 
 
 j \ account, under the terms of the Letter of Credit No~ issued 
 
 [ our J 
 
 f my 1 
 for -j > account and for the payment of any other indebtedness of 
 
 [ our J 
 mine | 
 
 \ to the GUARANTY TRUST Co. OF NEW YORK. 
 
 ours J 
 
 The GUARANTY TRUST Co. OF. NEW YORK may at any time cancel this 
 trust and take possession of said goods, or of the proceeds of such of the same 
 as may then have been sold, wherever the said goods or proceeds may then 
 be found and in the event of any suspension, or failure, or assignment for the 
 { my 1 
 
 benefit of creditors, on < V part, or of the non-fulfillment of any obli- 
 
 [ our J 
 
 f me 1 
 
 gation, or of the non-payment at maturity of any acceptance made by < > 
 
 I us J 
 
 under said credit, or under any other credit issued by the GUARANTY TRUST 
 f my ] f my 1 
 
 Co. OF NEW YORK on ) > account or of any indebtedness on < } 
 
 { our J [ OUT j 
 
 part to them, all obligations, acceptances, indebtedness and liabilities what- 
 soever shall thereupon (with or without notice) mature and become due and 
 
 { my 1 
 payable. The said goods while in < \ hands shall be fully insured against 
 
 [ our J ' 
 loss by fire. 
 
 Dated, New York City, 191 
 
 (Signed) _ 
 
 , Stg.
 
 4i6 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 LETTER OF CREDIT AGREEMENT 
 To the NATI0^ 7 AL BANK OF THE REPUBLIC. 
 
 Chicago. 
 
 Gentlemen: 
 
 Having received from you Letter of Credit No ___ 
 
 for _ 
 
 on copy of which is herewith annexed hereby 
 
 agree to its terms and in consideration thereof bind to reimburse 
 
 you for any draft or drafts drawn thereunder,^ days prior 
 
 to maturity thereof, at the current rate of exchange for first- class Bankers' Bills. It is 
 
 understood that the commission for accepting under this credit is to~ be per cent. 
 
 ^__ hereby give you a specific claim and lien on all goods or merchandise 
 
 (and the proceeds thereof) for which you may have paid or come under any engagements 
 
 under this credit, and on all policies of insurance (which.: agree to effect) 
 
 on such goods or merchandise to an amount sufficient to cover your advances or engage* 
 ments under this credit, and on all bills of lading given for same, with full power and 
 authority to take possession and dispose of the same at discretion, for your security or 
 reimbursement, and to charge all expenses including commission for sale and guarantee. 
 
 And further agree to give you any additional security that may be demanded. 
 
 And . further pledge to you as security for any other indebtedness 
 
 of to you, any surplus that may remain, either in foods or the proceeds 
 
 thereof after providing for the acceptance under this credit. . We further authorize you to 
 cancel this letter of credit at any time to the extent it shall not have been acted upon when 
 notice of revocation is received by the user. This obligation is to continue in force ana to 
 be applicable to all transactions, notwithstanding any change in the individuals composing 
 the- respective firms, parties to this contract, or either of them, or in that of the user of this 
 credit, whether such change shall arise from the accession of one or more new partners, or 
 from the death or secession of any partner or partner* 
 Yours respectfully,
 
 COMMERCIAL BANKING AND FOREIGN TRADE 417 
 
 Import Letter of Credit (Dollars) 
 Credit No.-J**Z Guaranty Trust Company of New York 
 
 Foreign Department 
 9100,000 UJS.C. 
 
 New York.. 
 
 Messrs. John Doe it Company, 
 
 Yokohama, Japan 
 
 Dfear-Sirs: 
 
 At the request and for the account of **> Johnson Crawfard & CotnpanlJ ' N York 
 .we hereby authorize you to value on 
 
 Guaranty Trust Company of New York, New York 
 
 a t Four (4) Months sight j or tne gum or sums no t exceeding a total of 
 
 One hundred thousand dottan (S100,000) L _^____^_ 
 
 accompanied by commercial invoice, consular invoice, bills of l.Hin,. Marine and war-risk, in- 
 surance certificates 
 
 reprinting cost, insurance and freight a >,;p men t r.t Raw Silk from Yokohama. Japan, to 
 New York 
 
 Insurance Marine and war-rink insurance to be effected by the shippers 
 
 Bills of lading for such shipments must be drawn to the order o f Guaranty Tt Company of 
 New York, New York ^_ 
 
 A COPY OF THE CONSULAR INVOICE AND ONE BILL OP LADING MUST BE SENT BY THE BANK 
 NEGOTIATING DRAFTS, DIRECT TO GUARANTY TRUST COMPANY OF NEW YORK, NEW YORK. 
 
 The amount of each -draft negotiated must be endorsed hereon. 
 
 We hereby agree with bona fide holders that all drafts drawn by virtue of this Credit, and in 
 accordance with the above stipulated terms, shall meet with dueionor upon presentation at the 
 
 Guaranty Trust Company of New York, New York, if drawn and negotiated prior to May ^ l < 
 
 1919 
 
 Guaranty Trust Company of New York 
 
 N. B. Drafts drawn under this Credit must bear 
 the clause "drawn under Letter of Credit 
 N ^ 134667 paM February It, 1919"
 
 418 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 II. FINANCING EXPORT TRADE 
 
 Before the establishment of the Federal Reserve System, 
 foreign banks, particularly those of London, played a dominant 
 part in the financing of our export trade. An exporter of 
 wheat from the United States under a letter of credit charac- 
 teristically drew a bill of exchange on an English bank a bank 
 that had been designated by the importer of the grain. This 
 accepting bank charged the importer a commission for the 
 loan of its name; and the British banks which have speciah'zed 
 in this acceptance business have found it a source of remunera- 
 tion that has long been coveted by American bankers. 
 
 It should be noted that while the bill of exchange was 
 drawn against a foreign bank, the seller of the grain, in case he 
 desired his funds immediately, took the draft, with bill of 
 lading and other shipping documents attached, to his bank in 
 New York or Chicago and had it discounted. While American 
 banks thus first advanced the funds, the bills were typically 
 soon sent to London where they were carried by London 
 banks which henceforth received the interest thereon. 
 
 The use of "dollar" export letters of credit is developing. 
 With the authorization to American banks to engage in the 
 acceptance of bills drawn for both import and export purposes, 
 it has become possible for American banks to supplant foreign 
 institutions as acceptors of bills, both in the case of direct sales 
 to Great Britain and of shipments to South America, or else- 
 where. Suppose A in Chicago sells goods to B in London and 
 requests B to arrange it so that the bill may be drawn against 
 a New Ydrk rather than a London bank. The buyer in London 
 accordingly goes to his London bank and asks the bank to open 
 for him a dollar credit with some New York institution. If 
 the credit standing of the British importer is satisfactory, 
 the bank will agree to arrange a dollar credit with its corre- 
 spondent bank in New York. It thereupon writes or cables 
 to its correspondent in New York asking that a credit be 
 opened for, say, $10,000 in favor of A, a Chicago exporter. 
 In this arrangement the terms on which the exporter is to be
 
 COMMERCIAL BANKING AND FOREIGN TRADE 419 
 
 allowed to draw upon the New York bank are set forth and 
 the documents that accompany the draft are designated. As 
 soon as the exporter has been notified that a credit has been 
 arranged with a New York bank, he draws a draft for $10,000 
 on the New York bank, and then discounts it at his local bank. 
 The Chicago bank in turn sends the draft to New York for 
 payment. The attached documents are then sent by the 
 New York bank to its correspondent in London, which turns 
 them over to the importer in order that the goods may be 
 claimed and released. 
 
 The bill in these cases may be a sight draft, in which case it 
 is paid before the documents are given up. But if it is a time 
 bill payable, say, in sixty days, it is obvious that the London 
 bank in parting with the bill of lading is running some risk of 
 loss. If the bank has any doubt as to the credit standing of 
 the importer, it will retain control of the merchandise as security 
 and parcel it out to the importer as partial payments on the 
 amount due are made in accordance with the terms of a 
 trust receipt or, it may be, merely on terms laid down in the 
 letter of hypothecation. 
 
 It will be noted that in this case both the London and the 
 New York banks receive commissions for services rendered: 
 the London bank for arranging with its correspondent in New 
 York to accept the draft, and the New York bank for its 
 service as acceptor. In general, it may be said that the com- 
 missions are about equally divided between the British and 
 the American banks. The size of the commissions of course 
 varies in different cases, depending upon the risks involved 
 and the length of the credit extended. 
 
 Similarly, in financing trade transactions between the 
 United States and South America, it is no longer necessary to 
 call upon a London banking house to accept the drafts drawn 
 under letters of credit. They may now be drawn directly upon 
 American banking institutions. In this connection there has 
 arisen a particularly interesting use of the commercial letter of 
 credit, known as the system of "re-financing." Let us assume 
 that X in New York has sold structural materials of iron and
 
 420 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 steel to Y in Uruguay. Since the foreign exchange facilities 
 between Uruguay and New York are not well developed, it 
 would be practically out of the question for the importer in 
 Uruguay to buy in Montevideo a draft drawn in dollars, which 
 he could send to X in payment. And since there are few 
 banking facilities in Uruguay, it is also not practicable for the 
 American exporter to draw a draft upon a designated Monte- 
 video bank. At the same time, it will be seen that a draft 
 drawn against the importer in Uruguay could not readily be 
 discounted in New York. Accordingly, the exporter arranges 
 with a New York bank an export letter of credit, under which 
 he may draw a draft upon the New York bank. 
 
 The distinguishing feature of this operation is that it 
 involves the drawing of two bills of exchange,- the one a trade 
 draft and the other a bank draft. Concretely, the exporter 
 first draws a mercantile bill of exchange on the importer in 
 Uruguay. This instrument, together with the bill of lading 
 and other shipping documents, is turned over to the New York 
 bank which arranges the export credit, and is then forwarded 
 with the shipping documents to Uruguay. Meanwhile, a 
 second draft is drawn by the exporter upon the New York 
 bank, as a means of enabling the seller of the goods to obtain 
 immediate command of funds. It may be noted, also, that 
 the bank draft runs for a somewhat longer period than the mer- 
 cantile instrument, the purpose of this being to insure ample 
 time to receive from Uruguay the funds which the New York 
 bank uses in meeting at maturity the draft which it has 
 accepted. 
 
 // is argued that the use of dollar exchange will encourage 
 export trade. The drawing of dollar credit, it is said, will 
 enable the American exporter to avoid paying commissions and 
 shift this burden to the foreign importer. This common 
 argument, however, overlooks the fact that the question of 
 commissions is usually ironed out in the terms of contract 
 between exporter and importer. While it may appear to the 
 exporter that the use of dollar drafts relieves him of commission 
 charges, such is not necessarily the case.
 
 COMMERCIAL BANKING AND FOREIGN TRADE 421 
 
 There is more point to the argument that the use of dollar 
 exchange will encourage foreign export trade through simplifying 
 the financial side of the operation for the American dealer. 
 While the development of foreign exchange facilities by Ameri- 
 can banks in the last twenty years has made it possible for any- 
 one who knows the ropes readily to arrange export letters of 
 credit and to discount with banks the bills of exchange drawn 
 against foreign banks, many American business men desirous 
 of engaging in export trade are not familiar with the foreign 
 exchange mechanism and they accordingly hesitate to enter 
 into operations which involve perplexing exchange computa- 
 tions. When bills are drawn in dollars, however, the exporter 
 knows exactly where he stands; he is dealing with his own 
 money; he feels on certain ground. Moreover, the arrange- 
 ment does enable him to shift the "risks of exchange" to the 
 foreign importer. 
 
 The Federal Reserve Act authorized the establishment of 
 foreign branches of American banks. The authorization of 
 dollar acceptances by the Federal Reserve Act was calculated, 
 as already noted, to encourage foreign trade. It was felt, 
 however, that our foreign trade, particularly that with South 
 America and other relatively undeveloped countries, would be 
 further facilitated by granting permission to American banks 
 to establish branches in foreign countries. Accordingly, 
 authorization was given under the Federal Reserve law for 
 the development of foreign branch banking. 
 
 That the absence of legislation authorizing foreign branch 
 banks is not, however, the sole cause of our restricted exports to 
 South America and other countries may be seen from the fact 
 that under the laws of various states it has long been possible for 
 state banks to establish branches abroad; and private banking 
 houses have always been able to establish such foreign agencies, 
 some private banking houses having in fact done so. 
 
 While the advantages of developing branches of American 
 banks in foreign countries have no doubt been greatly exag- 
 gerated, it is nevertheless true that the expansion of our foreign 
 trade would be expedited in some degree by the development
 
 422 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 of American banking facilities abroad. The intimate asso- 
 ciation of the branch bank managers with business men and 
 importers in foreign countries, together with the acquisition of 
 knowledge on the part of American bankers of the credit 
 standing of foreign buyers, are matters of first importance in 
 developing overseas trade and will no doubt improve our 
 opportunities for a lucrative expansion of our foreign business. 
 
 HI. THE EDGE LAW AND THE FINANCING OF 
 FOREIGN TRADE 
 
 There was in fact a considerable expansion of American 
 banking in foreign countries following the authorization of 
 branch banks by the Federal Reserve Act ^of 1913. The 
 facilities provided by the law were, however, felt to be inade- 
 quate to meet the needs of post-war foreign financing. Accord- 
 ingly the Edge Act of December, 1919, has added some new 
 features to our system of financing foreign trade. While the 
 Federal Reserve Act merely made it possible for existing 
 national banks to establish foreign branches, the Edge law 
 provides for the organization of a new type of financial cor- 
 poration a specialist in foreign trade and finance. 
 
 The features of the Edge law which relate to the furnishing 
 of fixed capital to foreign countries through the purchase of 
 foreign securities by institutions modeled after the foreign 
 investment trust have been considered in chapter xvi. We 
 need therefore consider here only the provisions of this law 
 which relate to the financing of ordinary shipments of goods 
 abroad. 
 
 The general banking powers of the corporations authorized 
 under the provisions of the Edge law are as follows: (i) to 
 purchase, sell, discount, and negotiate, with or without their 
 indorsement or guaranty, notes, drafts, checks, bills of exchange, 
 acceptances, including bankers' acceptances, cable transfers, 
 and other evidences of indebtedness; (2) to accept bills and 
 drafts drawn upon them subject to such restrictions as the 
 Federal Reserve Board may impose; (3) to issue letters of 
 credit; (4) to purchase and sell coin, bullion, and exchange;
 
 COMMERCIAL BANKING AND FOREIGN TRADE 423 
 
 (5) to borrow and lend money; (6) to receive deposits outside 
 of the United States, and only such deposits within the United 
 States as may be incidental to, or for the purpose of, carrying 
 out transactions in foreign countries, or dependencies, or 
 insular possessions of the United States; (7) to exercise such 
 powers in general as are incidental to those conferred by the law, 
 or such .... as may be usual in connection with the trans- 
 action of the business of banking or other financial operations 
 in foreign countries, colonies, etc. 
 
 Finally, these corporations are authorized, under prescribed 
 regulations, to establish and maintain, for the transaction of 
 their business, branches and agencies in foreign countries and 
 in the dependencies or insular possessions of the United 
 States, at such places as may be approved by the Federal 
 Reserve Board. 
 
 Up to the present time 1 only one company appears to have 
 been organized under the Edge law, namely the First Federal 
 Foreign Banking Association. This association has been 
 formed by a group of New York financial interests and manu- 
 facturers engaged in export tiade. Under the plan of operation 
 fhe manufacturer sells his products abroad on long-term credit. 
 The foreign buyers give their notes to the Foreign Banking 
 .Association, and the latter sells its own debentures, or notes, 
 secured by the foreign paper as collateral, and turns the proceeds 
 over to the exporter. It is the plan to sell these securities in 
 the localities where the exported products are manufactured, 
 an appeal being made for their purchase as a means of pro- 
 moting the industrial activity of the district. 
 
 
 
 IV. CONCLUSION 
 
 It remains to be seen to what extent these various measures 
 will be effective in expanding the volume of our foreign trade, 
 and in strengthening the position of New York in the field of 
 international finance. The use of dollar drafts has already 
 gained some momentum, the development having been given 
 an impetus in consequence of the enormous war demands of 
 Europe for American goods. Owing to this rapid development, 
 
 1 August, i Q 20.
 
 424 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 many people have been led to believe that New York bids 
 fair soon to rival London as a financial center engaged in 
 the acceptance of international bills of exchange. Those who 
 hold this view, however, are usually not particularly well 
 informed as to the principles governing international trade and 
 financial operations. Just as there is a prevalent misunder- 
 standing of the importance of foreign trade, particularly of 
 the' so-called "balance of trade," and just as there is a funda- 
 mental misconception on the part of most people as to the 
 advantage of obtaining a creditor position among nations, 
 so also the benefits to be obtained from the development of insti- 
 tutions for financing foreign trade are grossly exaggerated. 
 The problem is stated by one leading student of international 
 trade and finance in the following language: 1 
 
 In current discussions of foreign trade and of the use of the 
 acceptance, it is often assumed that foreign trade can be financed 
 simply as a result of current sales and purchases. From this it 
 naturally follows that if appropriate banking machinery be available 
 to carry the trade, there would be little difficulty in securing a satis- 
 factory development of the business. This assumption, however, 
 is not in accord with the facts of modern international commerce. 
 International trade is not carried on upon a money basis, but in 
 many countries payment for large quantities of staple purchases is 
 made in the form of securities based on the enterprises in which the 
 goods thus bought are employed. For example, shipments of steel 
 rails to China for the construction of the railways of that country 
 have been paid for in bonds which have been taken by banking 
 concerns in the country which sold the rails, and then have been 
 transferred to the investors, who, in the last analysis, supply the 
 rrtbney. Similar methods of financing have been adopted in dealing 
 with Brazil, and with other South American countries where trade 
 grew up on a basis of borrowed capital. While trade between older 
 nations, as, for example, France and Germany, is not necessarily 
 founded upon international loans of this kind, they nevertheless 
 figure to a considerable extent. Capitalists in one country are 
 constantly looking for openings in another, and a general interchange 
 of securities has resulted. From this it follows that, as a rule, the 
 country which exports to another is obliged to provide capital for 
 
 1 H. Park;r Willis, The Federal Reserve, pp. 292-95.
 
 COMMERCIAL BANKING AND FOREIGN TRADE 425 
 
 the development of business in that other. In South America, for 
 example, there will be little development of American trade unless 
 the United States is willing to supply the capital for the financing 
 of enterprises on a long-time basis. Even in those classes of opera- 
 tions which are not founded on bonds, it is frequently necessary that 
 banks should stand ready to finance the trade by carrying the mer- 
 chants who are conducting it during a crop period, instead of expect- 
 ing to be paid immediately upon arrival of the goods. In other 
 words, foreign operations are not exclusively of a banking nature, 
 but are also financial in the larger sense of the term. 
 
 The plain conclusion to be drawn from the state of things just 
 described is that although the Federal Reserve Act has provided the 
 mechanism for conducting foreign trade by permitting the organiza- 
 tion of branches of national banks, and although it has furnished a 
 means for bringing the banking paper of the United States into 
 harmony with that of other countries through the introduction of 
 the acceptance, there is no reason why international banking should 
 be developed by Americans very much more largely than at present, 
 pending the time when the United States is ready to furnish the 
 capital that is needed by business men and producers in the countries 
 with which trade is being built up. 
 
 While it was believed that this handicap to export trade 
 would in large measure be overcome by means of the financing 
 corporations authorized by the Edge Act, it should be observed 
 that the ability of the United States to participate extensively 
 in furnishing the investment funds required by foreign countries 
 is limited by the conditions outlined in chapter xv, and also by 
 the condition of our own investment market and of the reserves 
 of our commercial banking institutions. These will be dis- 
 cussed at some length in chapter xxvi. 
 
 QUESTIONS FOR DISCUSSION 
 
 1. How do you account for the importance of London in the field 
 of international finance ? Do you think the adoption of the 
 single gold standard at as early a date as 1816 has had anything 
 to do with it ? 
 
 2. Can you think of any good reason why American banks should 
 not have been allowed to accept bills of exchange until very 
 recently ?
 
 426 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 t . Why should the London discount rate be characteristically very 
 low? 
 
 4. Using the import letter of credit case given in the text, show just 
 how each party to the transaction makes a profit and how each 
 is reimbursed for funds advanced ? 
 
 5. Read the copy of the " dollar " import letter of credit on page 41 7 , 
 and then show how the American bank in question would finance 
 an importation from the Japanese firm named in the instrument. 
 
 6. Do you think the trust receipt is of any especial importance? 
 Would the bank accept the drafts if it had not found by investi- 
 gation that the importer was good for the amount ? 
 
 7. Is it important that the bank should have a claim to the specific 
 goods ? Answer this in the light of the discussion in the preceding 
 chapter of the various ways of extending credit. 
 
 8. Why would not an American exporter to Uruguay draw a draft 
 on a bank in Montevideo ? 
 
 9. Could not the importer in Uruguay pay for his goods by means 
 of a bill of exchange on London ? 
 
 10. Is it of any particular advantage to the United States to have its 
 own banks do its own financing ? Do you object to our paying 
 toll to London ? Answer in the light of your knowledge of the 
 principles of international exchange. 
 
 11. "Every bank created abroad is the pioneer of national industry 
 and the initial step in uninterrupted relations between the 
 foreign country hi question and the United States." Do you 
 agree ? 
 
 12. "There exist at Rio de Janeiro three German banks who support 
 their compatriots, facilitate their business, and form a valuable 
 aid to German trade. In face of an obscure French and Italian 
 bank only the haughty Transatlantic German Bank is capable of 
 competing in prestige with the famous bank of London. " Does 
 this seem to you probable ? 
 
 13. "Trade follows the bank even more zealously than the flag." 
 Do you agree ? 
 
 14. Is there any limit to the amount of trade that can be developed ? 
 Do you mean by "trade" exports only, or both exports and 
 imports ? 
 
 REFERENCES FOR FURTHER READING 
 
 Agger, Eugene E. : Organized Banking, chap. vii. 
 
 Escher, Franklin: Elements of Foreign Exchange, chap. ix. 
 
 Holdsworth, John Thorn: Money and Banking, chap. xv. 
 
 Whitaker, Albert C. : Foreign Exchange, chap. vii. 
 
 Willis, H. Parker: American Banking, chap, vii and pp. 292-94.
 
 CHAPTER XXI 
 
 COMMERCIAL PAPER HOUSES AND 
 DISCOUNT COMPANIES 
 
 While the chart on page 136 indicates that working capital 
 is typically loaned directly by commercial banks to their cus- 
 tomers, it also shows that such credit is often extended indirectly 
 through the intermediation of commercial paper houses and 
 discount or commercial 'credit companies. It is the purpose of 
 the present chapter to reveal the nature and the economic 
 significance of the services that are rendered by these recently 
 developed financial institutions. 
 
 The commercial paper house is an outgrowth of the note 
 brokerage business that existed in this country in the early 
 years of the nineteenth century. It was not until well after 
 the Civil War, however, that the modern phase of the business 
 developed the phase, that is, that distinguishes the work of 
 the commercial paper house from pure brokerage; and its 
 greatest growth has come only during the last fifteen or twenty 
 years. The discount companies are of even more recent 
 development. While some of them purchase accounts receiv- 
 able from many different types of business, these companies, 
 as we shall see, owe their most significant development to the 
 automobile industry and the exigencies with which its financing 
 has been confronted. 
 
 A. Commercial Paper Houses 
 
 The early business of note brokerage arose in response 
 to a very definite economic need. It was often found by the 
 business men of a given locality that at times it was impossible 
 for them to secure from local banks all the funds which they 
 required; and at certain seasons it was accordingly necessary 
 to seek banking accommodation in other centers. And since 
 it was not always possible, or at least convenient, for the 
 
 427
 
 428 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 borrower personally to arrange for loans at a distance, certain 
 individuals seized the opportunity of obtaining commissions 
 by acting as brokers in effecting the sale of notes and bills of 
 exchange owned by merchants and traders. It should be 
 understood that the note broker did not advance the funds to 
 the borrower: he merely undertook to sell the customer's 
 paper in return for a commission; and in case no sale was 
 effected the paper was returned to the borrower. It goes 
 without saying that in order to effect a sale the broker usually 
 undertook to convince the lending banker that the borrower 
 was a man of high character and ability. It must be borne 
 in mind, however, that the broker iri no sense guaranteed 
 the paper; his service was merely that of intermediary between 
 borrower and lender. 
 
 With the rapid development of the country following the 
 Civil War and the increasing volume of intersectional borrowing 
 that attended the ever-widening scale of our economic and 
 financial structure, the note brokerage business was gradually 
 superseded by the work of the commercial paper house an 
 institution that has aptly been called a quasi-banking estab- 
 lishment. 
 
 I. PRACTICAL OPERATIONS 
 
 The commercial paper house acts as a broker in that it brings 
 buyer and seller that is, lending bank and borrowing customer 
 together, and receives a commission, regularly one-quarter 
 of i per cent of the face value of the note; but it is more than 
 a broker in that it advances the funds to the borrower and 
 runs the risk of having to hold the paper until maturity. Where 
 the note broker merely said to the borrower, "I will sell your 
 note to a bank if I can and charge you a commission for the 
 service," the commercial paper house says, "We will advance 
 you the funds on your note and then dispose of the note to a 
 banker if we can; but if we cannot dispose of the paper we 
 will carry the loan until maturity. " 
 
 It should be understood that the commercial paper house 
 never desires to hold the paper to maturity, that it seeks to
 
 COMM' RCIAL PAPER AND DISCOUNT COMPANIES 429 
 
 make its profits out of the commissions which it receives as 
 middleman. And since its chance of large profits lies in obtain- 
 ing commissions on a very large volume of sales, it will be 
 seen that carrying paper serves to reduce the profits that can 
 be made. In fact, moreover, the cases where the commercial 
 paper house does hold the paper until maturity are relatively 
 few. It should be observed, however, that in all cases the 
 commercial paper house may have to make a temporary advance 
 of funds, during the interval of time between the purchase of 
 the paper from the borrower and the sale of it to a commercial 
 bank. This interval is normally very brief, for the marketing 
 mechanism has been developed to a point where most paper 
 can ordinarily be very quickly marketed. 
 
 The commercial paper house requires relatively small financial 
 resources. The fact that the commercial paper house buys 
 the paper outright and agrees to hold it to maturity in case 
 it is not marketed suggests that the commercial paper house 
 must have large resources of its own. The truth is that the 
 capital employed by commercial paper houses, as in the case 
 of the investment banks, is relatively small in proportion to 
 the volume of business conducted for the reason that they 
 are in a position to borrow heavily from the commercial banks. 
 In case a house has on hand paper that the market will not 
 absorb, it can borrow the funds necessary to hold the paper 
 until maturity, by using the notes of customers as collateral 
 for a loan. At all times, indeed, the commercial paper house 
 usually borrows a very large percentage of the funds required 
 to finance its temporary holdings of paper. 
 
 Suppose during its active season a house has on hand a 
 daily average of $1,000,000 worth of paper. On the basis of 
 its own promissory note, secured by customers' notes as col- 
 lateral, it could borrow from eight to nine hundred thousand 
 dollars from the commercial banks. As the notes which are 
 deposited as collateral are sold, either the volume of loans from 
 the banks will have to be reduced or else other notes (newly 
 acquired) will have to be substituted for those withdrawn from 
 the banks. Through its ability to acquire funds for the purchase
 
 430 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 of additional paper by pledging the notes of its customers 
 as collateral, a house may pyramid its resources many times 
 and thus receive commissions on a tremendous volume of 
 business. Some houses, indeed, handle several hundred million 
 dollars' worth of paper annually. The capital of the commercial 
 paper house, it will be observed, is thus mainly employed as a 
 basis for credit with the banks from which it borrows. 
 
 We have said that the commercial paper house seeks to 
 derive its profits from brokerage commissions rather than in 
 the form of interest on loans. It will be noted, however, that 
 interest is received on all paper during the time it is in the 
 possession of the commercial paper house. The profits derived 
 in this connection may be said to represent the difference 
 between the rate which the paper bears and the rate at which 
 the commercial paper house borrows the required funds from 
 the banks. Since the commercial paper house is a very high- 
 grade risk, owing to the fact that it is a responsible financial 
 institution and offers excellent collateral besides, the rate at 
 which it can procure funds is typically a little lower than that 
 of an ordinary borrower on unsecured paper. 
 
 The commercial paper house may, however, sometimes make 
 a profit and sometimes sustain a loss, owing to a difference 
 between the rate at which it discounts the borrower's note 
 and the rate at which it disposes of the paper to banks. In an 
 ordinarily steady market there is seldom any difference between 
 these rates, but during periods of rapidly changing financial 
 conditions, there may be an appreciable margin. When there 
 is a precipitate fall in money rates, the commercial paper 
 house finds its commission, in effect, supplemented; but when 
 there is a sudden rise in interest rates it may find that the loss 
 sustained is more than enough to cancel the amount of the 
 commission. 
 
 The commercial paper house car ef idly analyzes credit risks. 
 Since the commercial paper house is a lender of funds, pending 
 the sale of the paper to the banks, and since it risks its own 
 resources in making such advances, it is obviously incumbent 
 upon it to make a careful investigation both of the conditions
 
 COMMERCIAL PAPER AND DISCOUNT COMPANIES 431 
 
 of the money market in general and of the credit standing of 
 each particular borrower. 
 
 The broker must exercise great prudence and foresight in making 
 his loans. He must follow closely the trend of the times, be possessed 
 of a good knowledge of business conditions in general, understand 
 and anticipate the effects of larger seasonal demands for money, such 
 as attend the moving of the crops hi the fall; he must study the 
 possible results of pending legislation and international entangle- 
 ments, and be prepared for a multitude of other situations that 
 might affect the status of money and credit hi the country. 1 
 
 Since the paper dealt in by commercial paper houses is 
 largely single-name, it is necessary for them to make a careful 
 analysis of the business integrity and of the financial position 
 of the borrower, as recorded by a balance sheet or financial 
 statement. The better houses have, in fact, developed elaborate 
 credit departments, which are equipped to analyze credits with 
 an efficiency equal to that of the credit departments of the 
 large commercial banks. While commercial paper houses 
 analyze the credit standing of borrowers before purchasing their 
 paper, it is important to note that they do not guarantee the 
 paper they merely warrant that it is legally executed and that 
 it is the. genuine promise to pay of an actual person or corpora- 
 tion. The banker buys the paper, not on the strength of the 
 commercial paper house's indorsement, but on the strength of 
 the borrower's own financial standing. Indeed, the commercial 
 paper house does not indorse the paper which it handles. A 
 note is made out "pay to the order of ourselves," rather than to 
 the order of the commercial paper house; and is then indorsed in 
 blank by the makers. It is accordingly unnecessary for the 
 commercial paper house to attach its name to the document, 
 for the title is transferable by mere delivery. 
 
 In lending funds through the purchase of commercial 
 paper, the bank must either rely upon the analysis that has 
 been made by the commercial paper house or make an inde- 
 pendent credit investigation of its own. It will be seen that, 
 since the commercial paper house has risked- its own funds, 
 
 1 From an address by Walter McAvoy delivered before the Mississippi 
 Bankers' Association, March 12, 1918.
 
 432 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 a banker might well assume that the commercial paper house 
 has made a reasonably careful investigation. And the com- 
 mercial paper house does in fact recommend its paper in much 
 the same manner that the investment banking institution 
 recommends, but does not guarantee, the bonds which it 
 handles. In the case of the larger banks, however, an inde- 
 pendent investigation is usually conducted, the paper being 
 bought on a ten-day option, thus giving the bank an opportunity 
 to make its own investigation. If after investigation the bank 
 does not wish to carry the paper, it is returned to the commercial 
 paper house, which then seeks another buyer. 
 
 Small country banks, with inadequate facilities for credit 
 investigation, particularly at long range, find it practically 
 impossible to make an independent investigation. Accordingly, 
 they rely either upon the recommendation of the commercial 
 paper house or upon that 6f a large correspondent bank which 
 has had dealings with the concern whose paper is being offered 
 for sale. A very great amount of paper is now, in fact, annually 
 sold by the commercial paper houses to banks which purchase 
 the paper merely on the recommendation of the commercial 
 paper houses. The credit analysts in these houses therefore 
 play an important part in directing the flow of funds, and thus 
 of labor and capital, between the different divisions of industry 
 and the different individual establishments in any given line 
 of enterprise. 
 
 It is of interest to note, also, that in recent years many 
 commercial paper houses frequently make loans that are 
 secured by stocks and bonds as collateral. Some banks prefer 
 such paper, since it relieves them of the necessity of making 
 a careful credit analysis, the confidence being based mainly 
 on the collateral rather than on the financial standing of the 
 borrowers. Such paper, however, usually bears a slightly higher 
 rate than that which is unsecured, for the reason that the 
 bank which holds it is not permitted to rediscount it at a 
 Federal Reserve bank. 1 
 
 1 For provisions of the Federal Reserve Act governing rediscounting 
 see p. 584.
 
 COMMERCIAL PAPER AND DISCOUNT COMPANIES 433 
 
 The operations of commercial paper houses are conducted on a 
 national scale. A large percentage of the business of commercial 
 paper houses is inter-city in its nature. A house in Chicago, 
 for instance, will solicit paper from business concerns all over 
 the Middle West and West; indeed, it may solicit business 
 practically anywhere in the United States. Many of the 
 larger borrowers, however, have an eastern and a western 
 broker, and it is then agreed that the eastern broker shall 
 place no loans west of Pittsburgh and vice versa. 1 Not only 
 is the paper solicited over a wide area, but purchasing banks are 
 sought everywhere. Thus a note of a borrower in Akron, Ohio, 
 may be sold to a bank in Minneapolis; and paper of a cor- 
 poration in New Orleans may find lodgment with a banker in 
 Pittsburgh. 
 
 Commercial paper houses, however, also act as intermedi- 
 aries between borrowers and banks within the same city. In 
 Chicago, for instance, the paper of the packing houses is sold to 
 a large number of Chicago banks, both to the larger institutions 
 of the financial district proper and to the many outlying sub- 
 urban banks. Such paper, it may be noted, is purchased by 
 banks largely without independent investigation. 
 
 Notes sold through commercial paper houses usually run 
 from four to six months' time, the latter duration being ordi- 
 narily by far the more common. Since the borrower pays a 
 commission on the amount borrowed usually one-quarter of 
 i per cent it is to his interest, where he has a continuous 
 need for funds, to secure one loan for six months rather than 
 two loans for three months each. Indeed, it would often be 
 to his interest to borrow for even longer periods; but the banks 
 prefer not to tie up funds at a given rate of interest for a very 
 long interval.* Commercial paper notes until recently were 
 usually made out in five and ten thousand dollar denominations. 
 But during the last few years the entrance into the commercial 
 
 1 The Pacific Coast states have also recently been set off by some 
 houses as a separate territory. 
 
 * For a consideration of the problem of the liquidity of bank loans 
 see pp. 531-33, below.
 
 434 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 paper market of a large number of small state and national 
 banks, whose lending power is restricted, has led to the issue of 
 a very large volume of notes in denominations of twenty-five 
 hundred dollars. 
 
 It remains to be noted that, the commercial paper business 
 was given a great impetus by the development of the Federal 
 Reserve System. As we shall later see, the Federal Reserve 
 law places great emphasis upon commercial paper not specifi- 
 cally on paper handled by the commercial paper houses, 1 but on 
 paper that owes its origin to actual commercial operations. 
 Suc % paper was intended to constitute, in fact, the basis of all 
 borrowing operations between individual banks and the Federal 
 Reserve institutions.* The paper handled by these institutions 
 was thus placed in a preferred class and given an exceptional 
 amount of free advertising. The growth of the commercial 
 paper business has accordingly been very rapid in recent years. 
 
 At the present time there are about thirty commercial paper 
 houses in the United States whose business is national in scope, 
 and about as many more smaller concerns which do mainly a 
 local business. The larger houses have numerous branch 
 offices, one New York house, for example, having branches in 
 Boston, Hartford, Philadelphia, Pittsburgh, Detroit, Chicago, 
 St. Louis, Atlanta, New Orleans, Los Angeles, San Francisco, 
 and Seattle. The total volume of paper handled by these 
 institutions in the year 1919 was in the neighborhood of 
 $4,000,000,000. 
 
 The commercial paper houses are unregulated institutions. 
 Although the old note brokers have emerged into quasi-banking 
 corporations, they have never been subjected to any restrictive 
 or guiding legislation, their principles of operation having been 
 developed by strictly pragmatic methods. There was some 
 agitation a few years ago for the registration with a central 
 agency of all the commercial paper issued by business concerns, 
 
 'The term "commercial paper," as used on the street and in the 
 financial press, means only paper purchased through commercial paper 
 houses. 
 
 ' See pp. 584-86 in Part HI.
 
 COMMERCIAL PAPER AND DISCOUNT COMPANIES 435 
 
 as a means of preventing the selling of notes by any one borrower 
 through a large number of houses simultaneously, and thereby 
 greatly overextending its credit ; but little has been heard of this 
 proposal in recent years. While there are undoubtedly some 
 dangers to be guarded against in this system of credit extension, 
 there is no question but that on the whole the commercial 
 paper business has been conducted on a highly efficient and 
 conservative basis. 
 
 II. THE ECONOMIC SIGNIFICANCE OF COM- 
 MERCIAL PAPER HOUSES 
 
 The commercial paper house is of service alike to borrowers 
 and banks. It is of service to borrowers in that it makes it 
 possible for any business in good credit standing to secure needed 
 funds, even though the supply that can be furnished by the 
 local banks has been exhausted. In view of the marked seasonal 
 variations in the demand for funds, it is the rule rather than 
 the exception that at certain seasons of the year the supply 
 of local funds is insufficient for the community's needs. In 
 many cases, moreover, a large borrower is effectively debarred 
 from securing from a local bank all the accommodation required 
 by the legal provisions of our banking laws, which restrict, in the 
 interest of a wide diffusion of risks, the loans that may be made 
 to any one borrower. 1 
 
 Quite as important to the borrower is the fact that the com- 
 mercial paper house enables him to secure his funds in the 
 cheapest market. It may be that the supply of available funds 
 in a given community is merely low not exhausted or that the 
 local bank itself could procure funds from correspondent banks 
 in other centers. Under such circumstances the borrower 
 would have to pay very high rates for funds, were it not for the 
 ready access to the general credit market which the commercial 
 paper house makes possible. 
 
 From the standpoint of the bank, the purchase of com- 
 mercial paper offers an opportunity for broadening the field 
 
 1 See legal provisions, pp. 554-55.
 
 436 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 of its operations it opens up avenues for the profitable invest- 
 ment of funds that are not needed during periods of slack 
 local demands. It also relieves the banker in times of local 
 stringency from the responsibility of straining unduly his own 
 credit resources in caring for customers' needs. 
 
 Not only does the purchase of commercial paper permit 
 the investment of a plentiful supply of "seasonal" money in 
 other sections; but it permits banks whose resources have be- 
 come permanently greater than the needs of the communities in 
 which they are located to enlarge, notwithstanding, the volume 
 of their business. The normal growth of many a bank has 
 been more rapid than that of the community in which it is 
 located; and it is of the highest practical importance that an 
 outlet for its surplus earnings should be available. The total 
 volume of business in many communities is, moreover, not 
 sufficient to absorb all of the lending power of even a very 
 small bank; hence access to the general lending market is 
 indispensable to the success of the institution. This is particu- 
 larly the case with small suburban banks which find restricted 
 lending opportunities in their immediate environs. 
 
 Even where the total resources of a given community are 
 sufficient to absorb all of a bank's available funds, it is still 
 often important that an outside source of lending be available 
 as a means of more widely distributing its risks. Where the 
 local industry is of a specialized nature or where the number of 
 borrowers is relatively few, a local bank cannot secure a wide 
 distribution of risks unless it resorts to the open market for the 
 purchase of paper. The wider diffusion of risks that is made 
 possible by the commercial paper house thus tends to lessen 
 the possibility of bank failures and to strengthen the general 
 credit structure. There are many cases of suburban banks, 
 particularly, where the purchase of commercial paper opens 
 up an avenue of investment which is highly desirable from the 
 standpoint of the bank's ability to meet its deposits on demand. 
 
 Commercial paper houses act as distributors of tlie supply 
 of liquid capital. From the viewpoint of the larger economic 
 organization, it may be noted that the commercial paper houses
 
 COMMERCIAL PAPER AND DISCOUNT COMPANIES 437 
 
 are distributors of capital from places where it is relatively 
 abundant to places where it is relatively scarce. In a country 
 of great geographical area and of very diverse economic interests, 
 there is frequently a considerable variation in the demand for 
 funds in different sections. Periods of tight money in one 
 region may be periods of relatively easy money in others. 
 As intermediaries between banks and borrowers in different 
 parts of the country, the commercial paper houses give flexi- 
 bility to the financial system by quickly moving funds to the 
 places of greatest need. This not only tends to equalize 
 interest rates throughout the country but it facilitates pro- 
 ductive activities in regions which at times would be cramped 
 for want of funds; and in general it permits a fuller and a more 
 constant utilization of the financial resources of the nation than 
 would otherwise be possible. 
 
 This equalization of the supply of funds in different centers, 
 together with the fuller utilization of productive resources that 
 is thereby made possible, is obviously not without its effect 
 upon the cost of conducting business. It may therefore be 
 said that the commercial paper house finds both its opportunity 
 for obtaining profits and its social justification in the contri- 
 bution that it makes to the efficient utilization of financial 
 and economic resources in the production of wealth. 
 
 B. Discount Companies 
 
 In recent years there have developed a number of other 
 financial institutions, whose work, like that of the commercial 
 paper houses, is mainly that of intermediary between borrowing 
 businesses and lending banks. The institutions in question 
 are variously designated as discount houses, finance companies, 
 commercial credit companies, commercial acceptance trusts, 
 automobile banks, etc. It is somewhat difficult to describe 
 the work of these companies, for the reason that the terminology 
 commonly employed in describing their operations is far from 
 uniform and the principles of operation themselves not highly 
 standardized. Moreover, since certain houses specialize in a 
 particular type of operation, while others engage in more than
 
 438 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 one form of financial enterprise, it is impossible to state that 
 the financial institutions in question are always conducted on 
 principles thus and so. There are, however, at least two dis- 
 tinct types of financial enterprise which may be differentiated: 
 (i) the purchase of accounts receivable from business concerns 
 in various lines which are in need of additional working 
 capital; and (2) the financing of the distribution of automobiles 
 and other products that are commonly sold on the instalment 
 plan. 
 
 I. PURCHASING ACCOUNTS RECEIVABLE 
 
 There are two principal reasons why business concerns on 
 occasion sell or assign accounts receivable: (i) to secure the 
 necessary funds with which to postpone or forestall financial 
 insolvency; and (2) to secure additional working capital with 
 which to expand the volume of business. The first practice is 
 usually regarded as "illegitimate" financing, something to be 
 frowned upon by all conservative and constructive business 
 men. The second a development of the last ten years is, as 
 we shall see, in a very different category. Let us consider each 
 in turn. 
 
 i. Assigning of accounts by concerns that are financially 
 involved. Suppose a certain business, which has $10,000 of 
 accounts receivable, is in financial straits and must have 
 immediately, say, $5,000 in cash. Unable to borrow on its own 
 note, and having neither customers' notes nor trade acceptances 
 available for discount at a commercial bank, it still has in its 
 accounts receivable a resource which can be converted into 
 cash through the intermediation of a discount house. By 
 purchasing these accounts at a substantial discount and collect- 
 ing them in full at maturity, a discount company can at once 
 provide the necessary financial assistance to the enterprise in 
 question and earn a profit for itself. The discount company 
 receives the funds which it advances partly from its shareholders, 
 but more largely from the commercial bank from which it 
 borrows on its promissory note, secured by the purchased 
 accounts as collateral. The amount of the discount varies
 
 COMMERCIAL PAPER AND DISCOUNT COMPANIES 439 
 
 somewhat, but in the nature of the case the rates are very 
 high, usually ruinously so. 
 
 Concerns which sell accounts receivable are commonly 
 viewed with suspicion by the commercial bankers. It is argued 
 that the high interest rates at which such loans are secured 
 are prohibitive, and that the credit standing of the concern is 
 thereby seriously impaired, with the result that eventual 
 bankruptcy is rendered the more certain. While this is unde- 
 niable, generally speaking, there are doubtless numerous cases 
 where enterprises, temporarily embarrassed, have thus been 
 tided over a difficult period in their history. 
 
 2. The sale of accounts by "well-rated" concerns as a means of 
 increasing working capita!. There has been developed hi the 
 last few years a new type of discount or commercial credit 
 company one whose function is to furnish funds, not to con- 
 cerns that are financially involved, but to well-rated enterprises, 
 which are in a position to make an effective use of more money 
 than they can secure through regular banking channels. 
 
 In periods of very active business, particularly, many 
 concerns find that after they have utilized the full lines of 
 credit extended them by the commercial banks they could make 
 a profitable use of more funds. Indeed, even before the maxi- 
 mum line of credit at the bank has been utilized, a concern 
 often resorts to the sale of receivables in order to keep some 
 of its bank credit available for an emergency. The money 
 borrowed may be devoted to expanding the volume of business 
 through the purchase of additional raw materials or mer- 
 chandise, or it may be used to pay off trade bills, thereby saving 
 the discount that is offered for early cash payments. While 
 the rates charged for such funds are high, the cost is usually 
 less than the amount of the cash discount on trade bills which 
 can thus be saved. 
 
 The character of the' business concerns which make use of 
 such credit sources may be seen from the fact that one discount 
 house in 1918 made 77! per cent of its $55,000,000 of loans to 
 customers whose commercial ratings were of the first or second 
 classes. Nearly 75 per cent of tte customers, moreover, were
 
 440 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 concerns rated above $35,000, some of them at more than 
 $1,000,000, the average size being between $50,000 and $75,000. 
 It should be clearly understood, however, that while the con- 
 cerns which borrow in this way may typically be well rated 
 and of fair size, the resort to the sale of accounts receivable as 
 a means of raising funds indicates a credit condition temporarily 
 such that commercial banks are unwilling to lend them more. 1 
 Concretely, the concern's ratio of quick assets to current 
 liabilities is as a rule considerably less than what is customarily 
 insisted upon by the commercial bankers. 
 
 The high-grade credit companies engaged in such financing 
 operations sometimes discount the accounts receivable, but 
 more commonly they make a "service charge" instead. For 
 instance, one large commercial credit company advances about 
 80 per cent of the face value of each account at the tune of 
 purchase, and the balance as it is collected. It derives its 
 profit by a gross charge of one-twenty-fifth of i per cent on the 
 net face of accounts for each day, or a little over i per cent a 
 month, plus $5 per $1,000 on the first $100,000 worth of 
 purchases from any concern in any one year. In order that 
 the customers of a concern may not be disturbed, an arrange- 
 ment is made whereby the borrower may do his own collecting; 
 thus the customers need not know that their accounts have 
 been sold. This is known as the "non-notification" plan. 
 
 This company makes a careful credit investigation both 
 of the customers who owe the accounts receivable and of the 
 seller of the accounts. It makes use of Dun's and Bradstreet's 
 commercial ratings, and will not buy from any one concern the 
 accounts of customers having a poor credit rating to an amount 
 in excess of 20 per cent of the total volume of accounts pur- 
 chased. As a further means of minimizing risks it also seeks 
 to have its accounts from each borrower as widely distributed 
 as possible. 
 
 The company makes a careful investigation of the credit 
 standing of the seller of accounts, including an analysis of his 
 
 1 Except of course in cases where tbe bank credit line is being held 
 open, as noted above,
 
 COMMERCIAL PAPER AND DISCOUNT COMPANIES 441 
 
 financial statement, for the reason that in the last analysis th 
 seller of the accounts is looked to for payment. Indeed, the seller 
 is required to warrant the accounts, thus assuming a secondary 
 or contingent liability. Inquiry is also made as to the use to 
 which the borrowed funds are to be put; and the loan is ordi- 
 narily refused if the money is to be devoted to an increase in 
 fixed rather than working capital. The discount company is 
 thus reasonably well protected from loss. These methods are 
 typical of the largest institutions. 
 
 Discount companies borrow heavily from commercial banks. 
 The capital and surplus of these concerns serve largely as a 
 basis for credit with the banks from which they borrow (usually) 
 on single-name promissory notes secured by collateral. One 
 conservative company with a capital stock of $1,320,000 in 
 1920 had a maximum loan account at the banks of $4,302,000, 
 with an additional $402,000 borrowed through a commercial 
 paper house. It is not uncommon, however, to find the volume 
 of borrowed funds from five to ten tunes the amount of the 
 company's capital. In seeking a loan the company always 
 presents a financial statement showing its resources and lia- 
 bilities. The average cash balance on hand, plus the average 
 monthly collections, usually exceeds the total of all notes payable. 
 It is necessary for these companies to maintain a high credit 
 standing with the banks, for they are almost continuously 
 dependent upon them for funds. 
 
 The selling of accounts receivable by a business concern 
 in need of funds with which to expand its business is usually 
 justified economically on the ground that it is the most con- 
 venient as well as the cheapest means of securing the additional 
 capital required. It is more convenient than a resort to the 
 sale of additional stock and at the same time it does not per- 
 manently increase the capital. Because of the necessity of 
 formulating business policy with a view to long-run conditions 
 for periods of depression as well as for times of great business 
 activity this ability to expand capital resources by short-time 
 borrowing rather than by permanent capital contributions 
 is a matter of genuine importance.
 
 442 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 Does credit extension by credit companies result in dangerous 
 business expansion ? One question of general moment may be 
 raised here, however. Is the expansion of business that is 
 thus made possible economically desirable? Would it not be 
 better if the verdict of the commercial bankers were allowed 
 to stand the verdict that the concerns in question have 
 already borrowed as much as their financial status warrants? 
 Does such credit extension not lead to undue or dangerous 
 expansion? It should be observed in this connection that 
 while the commercial banks would not directly extend so large 
 a volume of credit to borrowers as they secure through the aid 
 of these financing corporations, the funds secured are neverthe- 
 less largely drawn from the commercial banks by an indirect 
 process. Where it would be regarded as unsafe to make 
 additional direct loans to the borrowers in question, the inter- 
 position of a strong financial intermediary renders the indirect 
 extension of such credit eminently conservative. But safety 
 to the loaning banks, immediately speaking, is one matter 
 and safety to the general business and credit structure in the 
 longer run, is another. It may reasonably be contended that 
 during periods of great business activity and attending financial 
 strain the added expansion of credit which these institutions 
 make possible only serves to make the task of eventual 
 credit contraction and business readjustment the more difficult. 
 While this question cannot advantageously be pursued further 
 at this place, the discussion of the phenomena of business cycles 
 in chapter xxiii below will throw much additional light on the 
 issue raised. 
 
 From another point of view, however, such credit extension 
 presents itself hi a much more favorable light. If the funds 
 borrowed are used to save the cash discount offered by mer- 
 cantile creditors, rather than to attempt an expansion of the 
 total volume of business through the purchase of additional raw 
 materials or stocks, the result is undoubtedly beneficial from 
 the point of view of the general credit situation. 
 
 Finally, it may be observed that these institutions have thus 
 far had little experience with the financial problems incident
 
 COMMERCIAL PAPER AND DISCOUNT COMPANIES 443 
 
 to a long period of business depression. An outgrowth, in the 
 main, of the financial conditions of the war period since 1914,* 
 these companies to date have had nothing but fair weather. 
 Business failures have been almost negligible and the oppor- 
 tunities for making profits quite unprecedented. In -conse- 
 quence, the risks assumed by these houses have been very small 
 and their profits almost unbelievably large. During a period 
 of depression, however, they will doubtless find that they must 
 greatly reduce the volume of their loans; for in periods of 
 declining business, credit lines at the local banks are ample for 
 all concerns that are in a sound financial condition. As a means 
 of forestalling financial disaster, however, weakened enterprises 
 at such a time will, of course, seek credit accommodation 
 from these companies with renewed vigor. It is a safe guess 
 however, that such concerns will find little encouragement from 
 the high-grade conservative credit companies which we are 
 here considering. 
 
 II. THE FINANCING OF AUTOMOBILE 
 DISTRIBUTION 
 
 The extensive growth of the automobile industry during 
 the last twenty years has given rise to a very interesting system 
 of financing the distribution of the product. The institutions 
 engaged in this financing are variously known as commercial 
 credit companies, discount houses, and automobile banks. 
 Some of them are specialists in this field and others are not. 
 For instance, the commercial credit company described above 
 devotes a large percentage of its resources to the purchase of 
 automobile paper. It should also be kept in mind that some 
 houses also deal in piano, furniture, and other paper, growing 
 out of the sale of goods on the instalment plan. For con- 
 venience of expression, we shall, however, here designate the 
 institutions in question as automobile banks. 
 
 The reasons for the development of the automobile bank 
 are inherent in the nature of the distribution end of the 
 
 1 Very few companies were in existence before 1914 and none, appar- 
 ently, for more than two or three years,
 
 444 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 automobile business. The automobile, despite the current 
 assertions that it is a necessity, has always been looked upon 
 by the commercial bankers as in a different class from staple 
 products as involving relatively large risks. Automobile deal- 
 ers, as distinguished from the manufacturers, commonly have 
 relatively small resources; they buy cars largely on credit and 
 in turn sell them largely on credit. It has been estimated, 
 indeed, that 65 per cent of the passenger cars and 90 per cent 
 of the trucks are sold on time. Since the automobile is ordi- 
 narily in the nature of a luxury, it quickly becomes a drug on 
 the market in a period of business depression, and since second- 
 hand cars are subject to very heavy depreciation, commercial 
 banks have not been willing to extend credit to automobile 
 dealers in proportion to their requirements in periods of rapid 
 expansion. The automobile discount company was developed 
 to meet the financial requirements incident to this situation, to 
 enable the automobile industry to grow as rapidly as the 
 demand for its products required. 
 
 The work of the automobile bank is similar to that of the 
 commercial paper houses and discount companies described 
 above. It is something more than a broker in that it advances 
 the funds to borrowers, and it is something less than a bank in 
 that as a rule it promptly shifts to the regular banks the burden 
 of carrying the loan. While similar to the institutions already 
 described, it has nevertheless evolved certain distinct financial 
 methods. 
 
 There are two types of automobile financing operations to 
 be described. First, certain large credit companies extend 
 what may be called wholesale credit to automobile dealers; 
 second, there are many smaller financing corporations which 
 specialize in the making of retail loans secured by the instalment 
 notes of the ultimate purchasers of the cars. While some 
 companies engage in both types of operations, as well as hi the 
 purchase of accounts receivable from other businesses, as 
 described in the section above, it will make for clearness if we 
 describe the different operations as though the institutions 
 engaging in them were specialists.
 
 COMMERCIAL PAPER AND DISCOUNT COMPANIES 44$ 
 
 i. The wholesale plan. The financing conducted under 
 the first plan is designed to enable the dealer to secure the funds 
 
 Chattel Mortgage 
 
 Xrurai all 0ni hg tfersr ? Bftttfl, That.. 
 
 alled fhe Mortgagor, hi consideration of 
 _ Dollars ($ ) received to the niD ga6sfaction. of flic 
 
 Mortgagor: of : of . 
 
 -...__ ; :_.. hereinafter called fhe Mortgagee, has granted, bargained, sold, assigned, transferred and sd over, and b> 
 
 (hese presents does grant bargain, sell, assign, transfer and set over, unto the said Mortgagee, fhe following described personal property. 
 now remaining and being in the possession of the Mortgagor, to wil; 
 
 One Motor vehicle manufactured by , _ No 
 
 Model. _ - Lisl price together with all added and 
 
 substituted parts and equipment placed upon the property during fhe life of this mortgage, whether because of necessary repairs or other- 
 wise, to have and to hold all and singular said personal property and additions (hereto, above granted, bargained, and sold or intended 
 ID be granted, bargained and sold unto (he Mortgagee. 
 
 The conditions of (his mortgage are such. Thai whereas fhe Mortgagor has executed and delivered unto fhe Mortgagee a certain 
 promissory note of even dafe herewith, for fhe purchase money tor fhe hereinbefore described property in fhe sum f 
 
 Now if fhe Mortgagor shall well and truly pay said promissory note with interest as heranbefoi 
 keep and perform all fhe conditions hereof, at fhe time and in the manner specified (time being of the cssei 
 mortgage shall be void, otherwise the same shall be and remain in full force and effect, 
 
 And fhe Mortgagor hereby declares fhaf he is fhe true and lawful owner of fhe above described property, and has good right 
 to sell, convey and encumber the same, and that (he same is free from all encumbrances whatsoever. 
 
 The Mortgagor agrees (hal fhe said motor vehicle shall be located and kept at* 
 
 in fhe city of ____ .....,..,..--,-.- - _____ ....... ,... ........ ..... _______ _. __ _... Stafe of _______ .^. .... .... r .....^, , , and 
 
 not be removed' therefrom except tor installation of body ; then same must be returned to said premises within thirty (30) days thereafter 
 and further agrees not to rent said motor vehicle or transfer his interest (herein, and that while said motor vehicle is in possession of Mort- 
 gagor it shall not be operated or moved under its own power and shall be kept in good repairs, free of all liens, charges and (axes. 
 
 The Mortgagor further agrees fhaf if default be made in payment of said note or said amount of money end interest, or in the 
 performance of any of fhe conditions herein contained on the 'part of fhe Mortgagor to be performed at the time and in (he manner 
 herein specified or in case fhe Mortgagor should commit any waste or misuse and not keep the property in first class condition or should 
 attempt to sell, secrete, convert or remove the property without the written consent of (he Mortgagee, or if the property should be seized 
 upon mesne or final process had against fhe Mortgagor, or if the Mortgagee, at any 6me before or after fhe maturity of said promissory 
 nole. or before any of said amount of money and interest becomes due. snail deem it necessary for fhe more perfe^J and complete security 
 of the claim of the Mortgagee, then fhe Mortgagee is hereby authorized, and empowered to enter any premises of fhe Mortgagor, or other 
 place where the properly may be, and fake possession of the property, without notice or demand ana without legal procedure, said notice 
 arid demand being hereby expressly waived, and immediately sell the property^ at public or private sale, without notice. The Mortgagor 
 hereby Grants unto (he Mortgagee (he right to become the purchaser thereof, and out of foe proceeds thereof, to retain and pay said 
 note with interest and all other amounts that may become due under the conditions of (his mortgage and to pay fhe expenses of said 
 sale, including eipenses incurred in taking possession of end keeping fhe property, and to pay any and all liens that may be thereon 
 having priority over (his mortgage, to pay charges for placing the property in good saleable condition and to render the surplus money 
 to the Mortgagor. If is expressly agreed fhaf if the unpaid balance on the note due to the Mortgagee together with the interest provided 
 and all other amounts thai may become due under the conditions of this mortgage shall not be realized by said sale, the Mortgagor 
 shall pay to (he Mortgagee such deficiency upon demand. 
 
 No waiver of any of, (he conditions of (his mortgage shall be deemed to have been given by (he Mortgagee, unless fhe same be 
 in writing and signed by the Mortgagee, and the Mortgagor further agrees, thai (his mortgage contains the entire agreement entered into 
 with the Mortgagee. 
 
 The terms hereof are and shell be binding upon and for fhe benefit of fhe heirs, executors, administrator*, successors and assigns 
 of both the Mortgagor and Mortgagee. 
 
 EXCEPT AS HEREINTOFORE PROVT&ED. THE MORTGAGOR SHALL REMAIN AND CONTINUE IN POSSESSION 
 OF THE PROPERTY AND IN FULL ENJOYMENT OF THE SAME. 
 
 ......... hand and Seal 'hb -,_,..._.. day of .__., __A. D. 19. 
 
 - [SEAL] 
 
 with which to pay the manufacturer for the cars without waiting 
 for their sale to, or at least without waiting for final payments 
 from, customers. In a sense they are therefore financing the
 
 446 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 manufacturers themselves. The loans are made to the auto- 
 mobile dealer, who gives his promissory note to the automobile 
 bank, together with chattel mortgages on the cars in his pos- 
 session. It should be stated, however, that it is only in certain 
 states that we find the chattel mortgage. In some states a 
 trust receipt is used, and in still others a conditional sale agree- 
 ment is employed, the particular type being determined by the 
 varying laws of different states. Specimens of a chattel mort- 
 gage and of a conditional sale agreement will be found on pages 
 445 and 447. Both have the regular forms for assignment on 
 the back. 
 
 When cars are stored ''on the floor" the chattel mortgage 
 or other document covers a particular car, which can be disposed 
 of only on terms laid down in the agreement with the 
 automobile bank. There have been many cases of fraud and 
 deception, however, in connection with this floor plan, chattel 
 mortgages often being given on cars which do not exist, or 
 which are not owned by the dealer in question ; and there have 
 been cases of secret sale of the car against which the mortgage 
 stands. Where cars are stored in a warehouse, however, the 
 warehouse receipt is turned over to the automobile bank. In 
 such a case the bank is much more adequately protected; and, 
 it may be added, the loan is usually more nearly equal to the 
 full value of the car. 
 
 Since the dealer is constantly selling cars, it will be seen 
 that the security commonly passes out of his possession during 
 the life of the loan. But under the terms of the agreement 
 with the dealer, the claim against the car still rests with the 
 automobile bank. It should be observed, however, that the 
 bank does not look to the individual who has purchased the car 
 on the instalment plan for a payment; he still looks to the dealer, 
 to whom he has made the loan and whose note he holds. 
 
 It will be seen from the foregoing that the credit standing 
 of the dealer to whom the loan is made is of paramount impor- 
 tance. Accordingly, the automobile bank makes a careful 
 investigation of the dealer's moral and financial standing, even 
 requiring him, as a rule, to furnish a statement showing his
 
 Conditional Sale Agreement 
 
 ORIGINAL 
 
 GUjre AgrPPUtPttt. made Ihis dny of . ,-\0.. 
 
 between _ 
 
 (Siamp'dealer's name and' address here) 
 
 Brsf party, his or its successors, agents or assigns (hereinafter, collectively called "Seller") and 
 
 ('Purchaser's name and address here) 
 
 second parly (hereinafter called "Purchaser"). W1TNES5ETH: 
 
 THAT Seller in consideration of the payments, covenants, agreements and condifions herein contained which 
 on the part of the purchaser are fo be made, done and performed, has this day sold and delivered, but upon the con- 
 difions hereinafter recited, to the Purchaser one - _ 
 
 (Make of car here) 
 
 Moder. _ _ (hereinafter called the "Car") for , 
 
 Dollars ($' : ). paid or lo be paid by the Purchaser to the Seller or order,. . 
 
 ....Dollars ($ ) upon fhe execution of this agreement and the balance' 
 
 _ ) in instalments as follows: 
 
 $ 
 
 
 i IO j 
 
 ^ 
 
 on , 19 ........ 
 
 $ 
 
 
 10 
 
 $ 
 
 on _ ._ .. ,19 
 
 s. . 
 
 on. 
 
 . 19 
 
 
 
 - on 19 
 
 $ on , 19__. $ , . on __ _, I9._ 
 
 which instalments of purchase price shall bear interest at the rate of six per cent, per annum from date and are to . 
 be evidenced by promissory notes made by the Purchaser lo the order of the seller, bearing date hereof and maturing 
 on the due dates of said respective instalments. 
 
 The Car is subject only to manufacturer's warranty, if copy of such warranty is annexed hereto: and if not so 
 annexed. Purchaser buys Car as it stands, and no warranty, guaranty or representation as to the Car or any of its 
 equipment is otherwise made or given by Seller. 
 
 THE CONDITIONS OF THIS AGREEMENT ARE. that delivery of the Car by Seller lo. Purchaser does 
 not pass title thereto, but both the Car and the title thereto shall not pass by such delivery but are and shall remain 
 vested in and be the property of the Seller and assigns (and any extension or assignment of said notes shall not waive 
 this or any other condition herein contained) until said notes evidencing said instalments of parchase price are paid 
 in full. 
 
 Upon any default in the payment of the principal or interest of any of said nofes. then any holder of any of the 
 notes then unmatured may at his option declare all of said notes immediately due and payable and the same shall . 
 thereupon become immediately due and payable. The Purchaser until said nofes are paid in full shall not sell.- let. 
 assign, encumber, use for hire or dispose of the Car (without written consent of the Seller) and the Purchaser shall 
 keep and maintain the Car in good order and repair. Purchaser shall keep the Car free of -all liens, taxes and charges and 
 shall at his expense and in his name cause the Car to be registered and licensed in compliance with law. Upon any 
 default in payment or breach of condition or covenant herein made by the Purchaser, or if the Seller shall deem the 
 security for the payment of said nofes intended to be afforded hereby insufficient or unsafe, the Purchaser shall on 
 demand by (he Seller forthwith deliver the Car in as good condition as when received by Purchaser upon sale thereof 
 (ordinary wear and (ear excepted) to Seller, and should Purchaser fail or refuse upon such demand to deliver the Car 
 as aforesaid to Seller, the Purchaser agrees thai the Seller shall have the right without any further notice or demand 
 forthwith to fake possession of the Car. wherever found, and for such purpose Purchaser hereby licenses and authorizes 
 Seller to enfer any premises of the Purchaser with or without force or process of law, and forthwith fake possession 
 of the Car: if Seller shall so fake possession of the Car by reason of any default or breach hereof or with respect to 
 said nofes by Purchaser. Purchaser agrees that all payments made by Purchaser with respect lo the indebtedness 
 represented by said notes shall belong to and retained by Seller, as liquidated damages for the non fulfillment 
 or breach of performance of this agreement, for loss in value with respect to the Car. and for the rental value thereof. 
 Seller may. at option, by collection suit or otherwise, enforce payment of said notes, and no- suits, or legal proceedings 
 with respect thereto shall, however, be deemed any waiver of said right of Seller to take possession on default or breach 
 as aforesaid. Upon the Seller so taking possession of the Car. Seller may sell the Car at public or privale sale at any 
 time- thereafter without any notice to the Purchaser, and if upon such sale the proceeds thereof are insufficient to pay 
 the sums remaining unpaid with respect to said nofes. and the expense caused by such repossession, removal, reparation, 
 storage, liens and sale, any deficiency shall be paid by, and any overplus shall be paid lo fhe .Purchaser. Purchaser 
 acknowledges, receipt from Seller of a true copy of this agreement. 
 
 IN WITNESS WHEREOF, Seller and Purchaser, parlies hereto, have hereunto subscribed their signalures and 
 set (heir seals hereto in duplicate on the day and year first above written.
 
 448 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 financial condition. While each particular loan is in fact 
 secured by a chattel mortgage on a particular car, the main reli- 
 ance is nevertheless placed upon the dealer's general responsi- 
 bility. Loans made to dealers in this way commonly run for 
 two or three months. While the loans are made to the dealer, 
 it should be added, however, that where cars are held in storage, 
 it is customary for the manufacturer to guarantee the payment 
 of the loan. Thus the automobile bank often has two-name 
 paper. 1 
 
 Such companies derive their profits from a gross "service 
 charge" similar to that described above in connection with the 
 purchase of accounts receivable. This charge covers interest 
 and profits and also insurance against theft and fire. The 
 company will not make a loan on an uninsured car; and by 
 acting as agent for an insurance company, it obtains a large 
 commission on all insurance that is written. The "service 
 charge" varies somewhat, but is always high enough to insure 
 a very handsome return to the company. 
 
 2. The retail plan. A concrete illustration of the practice 
 followed by a particular company will indicate the difference 
 between the retail method of financing and that which we 
 have just described. Let us assume that a dealer has sold 
 a car valued at $6,000 and has received $1,000 down and for 
 the remainder instalment notes of $500 each, payable monthly. 2 
 A chattel mortgage is also given by the purchaser. The 
 dealer borrows $4,000 from the automobile banker, putting 
 up the $5,000 in instalment notes as collateral security. The 
 dealer usually guarantees the payment of such notes. The 
 bank loan is typically, as in this case, 80 per cent of the value 
 of the notes offered as collateral security. Since the purchaser's 
 notes are paid in monthly instalments and the dealer is required 
 to pay his loan to the automobile bank in monthly instalments, 
 it will be seen that the margin of security possessed by the 
 automobile banker gradually increases. 
 
 1 The manufacturers, however, practically never guarantee the pay- 
 ment of retail loans. There is apparently but a single exception to this rule. 
 The average duration of such credit extension is about eight months.
 
 COMMERCIAL PAPER AND DISCOUNT COMPANIES 449 
 
 It is the common practice with these smaller companies to 
 discount the dealer's notes, usually at 5 per cent. And since 
 the notes usually bear interest at 7 or 8 per cent, the company 
 always secures 5 per cent on the face of the note plus, say, 
 7 per cent interest on that portion of the loan which it finances 
 out of its own resources. Moreover, since the company can 
 usually borrow from the commercial bank on its own note, 
 secured by the instalment notes received from dealers as col- 
 lateral, at a rate lower than that which the notes themselves 
 bear, it will be seen that some additional profit is thus procured. 
 It will be apparent, however, that it is the 5 per cent discount 
 that constitutes the main source of income. 
 
 The extent of the gross profits that may be obtained there- 
 fore depends largely upon the volume of loans that can be made. 
 Since the dealer is required to pay his loan to the automobile 
 bank in monthly instalments, this bank is in fact in a position 
 at the end of each month to make a new loan of several thousand 
 dollars on the basis of the instalment receipts, borrowing as 
 before So per cent of the amount from a commercial bank, on 
 the collateral security of a new dealer's note and chattel mort- 
 gage. These monthly payments, it will be observed, will prove 
 cumulative as additional loans are extended, each of which 
 calls for monthly payments. In fact, by virtue of its ability to 
 borrow from the commercial banks, a company is in a position 
 rapidly to pyramid the volume of its business. It is commonly 
 believed that loans may safely be made to eight or ten times 
 the amount of the company's capital. 
 
 The profits of such companies have, in fact, often been very 
 large, though the earnings fluctuate widely, varying with 
 changing conditions in the automobile industry. It may be 
 noted that the clerical force required to run such an institution 
 is very small. There is usually only a manager, an assistant 
 manager, a bookkeeper, and a stenographer, with one or more 
 salesmen. 
 
 These companies have also, to some extent, financed auto 
 trucks and tractors. But the hazards here have been found 
 considerably greater than in the case of passenger cars. This is
 
 450 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 particularly true of tractors, which are subject to a rapid depre- 
 ciation because of the farmer's customary failure to house them 
 properly against inclement weather. Trucks are also subject 
 to heavy depreciation; and it appears that the moral hazard 
 has proved somewhat greater with trucks than with passenger 
 cars. 
 
 The funds employed by automobile banks are procured in a 
 variety of ways. Thus far we have been placing emphasis upon 
 the methods by which the automobile bankers both wholesale 
 and retail extend credit to the automobile industry, only 
 incidental reference having been made to the sources of the 
 funds used by these institutions. There are, in fact, several 
 different methods by which the automobile bankers secure the 
 funds which they lend. In all cases, of course, a part of it is 
 derived from the capital contributions of the company's share- 
 holders; but this capital is mainly, employed to serve as the 
 basis of the company's own credit. These institutions secure 
 the funds which they loan, in four different ways, some com- 
 panies using but a single method, others at one time employing 
 one means and again another, and some of them now and then 
 using a combination of methods simultaneously. 
 
 First, they may borrow from the commercial banks, or 
 through commercial paper houses, on their single-name prom- 
 issory notes, without other security. So far as the author is 
 aware, there is only one company using this method. Second, 
 they may borrow from commercial banks on their promissory 
 notes, secured by the instalment notes of the purchasers of cars. 
 The officers of the credit company also frequently indorse the 
 notes. Third, they may raise the funds by selling the company's 
 unsecured debenture bonds in the investment market. This 
 method is apparently not very commonly employed. Finally, 
 they may secure the money by selling in the investment market 
 collateral trust notes or bonds. 
 
 The last method, only, requires explanation. The com- 
 pany assigns the notes received from its customers, together 
 with the chattel mortgages or other documents, to a trust 
 company where they are held in trust as collateral for the bonds
 
 COMMERCIAL PAPER AND DISCOUNT COMPANIES 451 
 
 to be issued. Guaranties from the various dealers who have 
 given notes, to the effect that both principal and interest will be 
 promptly paid, are also turned over to the trust company. The 
 financing corporation then issues its own obligations, secured by 
 these commercial notes, mortgages, and guaranties, and offers 
 them for sale in the general investment market. They are 
 usually issued as short-term serial notes, some of which mature 
 every few months. 
 
 The following statement of a commercial security company 
 which purchases mortgages and leases on cars and pianos will 
 serve to show the exact nature of the security possessed by 
 the purchasers of the company's bonds. 
 
 First: Financial statement of dealer on form supplied. 
 
 Second: Execution of an agreement in duplicate on forms fur- 
 nished, covering details and conditions of purchase of 
 mortgages and leases. 
 
 Third: Naming of someone in vendor's employ to be authorized 
 to make collection on mortgages and leases purchased, 
 who shall be bonded by fidelity bond to make prompt 
 remittance of collections, as provided in agreement. 
 
 Fourth: Listing of mortgages and leases offered for sale on blanks 
 furnished, duly assigning and guaranteeing mortgages 
 and leases listed. 
 
 Fifth: Mortgages and leases must show that they have been 
 recorded, if required by state law, and recorder's certificate 
 of filing must be attached. 
 
 Sixth: Mortgages and leases must show a minimum cash pay- 
 ment of 20 per cent of purchase price. 
 
 Seventh: Mortgages and leases must draw at least 6 per cent 
 interest per annum. 
 
 Eighth: Final instalments on mortgages and leases must mature 
 within thirty-one months of date of sale to the Com- 
 pany. 
 
 Ninth: Under the terms and agreements to be entered into, 
 mortgages and leases are to be purchased for 90 per cent 
 of the balance due and owing thereon, payable 70 per cent 
 at the time of purchase, and the balance in quarter-annual 
 payments of 20 per cent of amounts collected and remitted 
 on mortgages and leases, provided that no payments on 
 same are in default, in which case same will be held until 
 such defaults are settled.
 
 To & used in the States of New Jersey, Illinois, 
 
 Lease Agreement 
 ORIGINAL 
 
 Ift0 AgrWmfttf. made this __day of 
 
 between . . 
 
 (Lessor's name and address here) 
 first party, his or its successors, agents or assigns hereinafter collectively called "Lessor") and 
 
 (Lessee's name and address here) 
 second party (hereinafter called Lessee") 
 
 WITNESSETH: 
 
 THAT the Lessor has this day delivered in good condition and hereby leases upon the terms, rental, and 
 
 for the time below specified, to the Lessee one No , 
 
 (Make of vehicle hen) 
 Model (hereinafter called 'the "Car") valued at 
 
 Dollars <$ . ) for the use of which during this lease the Lessee has this day paid 
 
 _ ____-j , , Dollars ($u-^_ , =_) as first instalment of rental 
 
 and agrees to pay the Lessor or order a total of . . . 
 
 Dollars ($ > in further instalments of rental as follows: 
 
 i ... ..-. on . . .,, . 19 
 
 $ on , 19 
 
 19- 
 
 _, 19- 
 -,19- 
 
 I 
 
 nn . , 10.. 
 
 $ 
 
 nn 19 
 
 f 
 
 on 10 
 
 $ 
 
 on 10 
 
 
 
 on 19 
 
 $ 
 
 0" 10 
 
 $ 
 
 $- 
 
 on 19 
 
 on . 19. 
 
 and further agrees to payand reimburse the Lessor with respect to any damage to the Car while the Car is in 
 the Lessee's _ possession under this lease, except such depreciation as may be occasioned by ordinary wear and 
 tear. Said instalments of rental shall bear interest at the rate of six per cent, per annum from date, and are to be 
 evidenced by promissory notes made by the Lessee to the order of the Lessor bearing date hereof and maturing 
 on the due dates of said respective instalments. The term of this lease is from date hereof until the due date 
 of said final instalment,' unless sooner .determined subject to the provisions and terms hereof. 
 
 The Car is subject only to manufacturer's" warranty, if copy of such warranty is annexed hereto, and if not 
 so annexed, Lessee leases Car as it stands and no warranty, guaranty or representation as to the Car or any of 
 its equipment is otherwise made or given by Lessor. 
 
 IT IS FURTHER AGREED that the Lessee shall not use for hire, underlet or encumber the Car or 
 permit the same to pass from his possession ; nor shall the Lessee assign this lease. Upon default by the Lessee 
 with respect to any rental payments evidenced by sajd notes, principal or interest, then the holder of any notes 
 then unmatured, may at his option declare all of said notes immediately due and payable, and the same shall 
 thereupon become immediately-due and payable. The Lessee shall keep and maintain (he Car in good order 
 and repair and free from all taxes, liens and charges, and surrender the same to the Leftor at the expiration of 
 this lease. Upon any default in payment of any instalment of rental, or upon breach of any condition or coven- 
 ant herein made by the Lessee, the Lessee shall on demard of the Lessor forthwith deliver the Car in as good 
 condition as when received by the Lessee (ordinary weae and tear excepted) to Lessor, and should Lessee fail 
 or refuse upon such demand to deliver the Car as aforesaid to Lessor, the Lessee agrees that the Lessor shall 
 have the right without any further notice or demand, to terminate this lease forthwith and to take possession 
 of the Car, wherever found, and for such purpose Lessee hereby licenses and authorizes Lessor to enter the 
 premises of the Lessee with or without force or process of law, and take possession of the Car. Lessor may, at 
 option, by collection, suit or otherwise, enforce payment of said notes, and no suits or legal proceedings with 
 .respect thereto shall, however, be deemed any waiver of said right of Lessor to take possession on default or 
 breach as aforesaid. Lessee acknowledges receipt from Lessor of a true copy of this agreement. 
 
 IN WITNESS WHEREOF, Lessor and Lessee, parties hereto, have hereunto subscribed their signatures and set 
 their seals hereto in duplicate on the day and year first above written. 
 
 .Witnesses: 
 
 By- 
 
 LMM ten her* 
 By 
 
 .(SEAL)
 
 COMMERCIAL PAPER AND DISCOUNT COMPANIES 453 
 
 Tenth: Mortgages and leases must be guaranteed both as to 
 principal and interest by the dealer or manufacturer 
 from whom they are purchased. 
 
 The leases referred to relate to the loan of a car to the 
 purchaser during the period when it is being paid for. On 
 page 452 will be found a specimen form. 
 
 These credit companies render important economic services. 
 The nature of the service rendered by these financing corpo- 
 rations in connection with the automobile and similar industries 
 was suggested in the introductory paragraph of this section, 
 on page 443 above. The process of marketing automobiles, 
 pianos, etc., is such that the regular financial institutions have 
 neglected the financial requirements of these industries, 
 particularly in periods of rapid expansion. Credit companies 
 have therefore filled a breach in the financial structure and 
 devised methods which at once minimize their own risks and 
 insure the earning of large profits, while at the same time they 
 make it possible for the commercial banking institutions and 
 the investing public indirectly to furnish the funds required. 
 Without them it is believed that the development of such 
 industries would have been very seriously impeded. 
 
 In the city of Chicago alone there are more than thirty 
 financing corporations of the types which we have been consider- 
 ing above, while in New York there is an even greater number. 
 They are, moreover, found in nearly all parts of the country 
 wherever the need for them has been manifested. An interest- 
 ing development in the last year or so has been the organization 
 of auto-finance credit associations in New York and Chicago. 
 The purpose of these associations is to exchange information 
 with reference to the credit standing of borrowers; and to co- 
 operate in every way in raising the general plane of the business. 
 Like the commercial paper houses, the discount companies 
 are subject to no special legal regulations, being governed only 
 by the general laws relating to ordinary corporate and business 
 activities. While their operations have, as a rule, not yet been
 
 454 
 
 placed upon so efficient a basis as those of the commercial paper 
 houses, they are being rapidly improved, and will no doubt 
 eventually assume a highly standardized form. In any event 
 these institutions have already achieved a permanent place in 
 the American financial system. 
 
 QUESTIONS FOR DISCUSSION 
 
 I. THE WORK OF COMMERCIAL PAPER HOUSES 
 
 1. How does the work of the commercial paper house differ from 
 that of pure brokerage ? How does it differ from pure banking ? 
 
 2. Why does the commercial paper house not wish to indorse the 
 notes which it handles ? How is title passed without indorse- 
 ment? 
 
 3. Tell in your own words precisely how the commercial paper house 
 makes its profit. 
 
 4. Do you think a commercial paper house would be equipped to 
 make as good a credit investigation as a small-town bank ? 
 As a large metropolitan bank ? 
 
 5. If you were a small-town banker desiring to purchase commercial 
 paper of borrowers in other cities, would you be willing to trust 
 the recommendation of a commercial credit house ? If not, how 
 might you secure the information which you desire ? 
 
 6. State the services that are rendered by the commercial paper 
 house: (a) to borrowers; (6) to bankers. 
 
 7. State in your own words the economic significance of commercial 
 paper houses. 
 
 II. THE PURCHASE OF ACCOUNTS RECEIVABLE 
 
 8. Do you agree with the common contention that a concern that 
 buys accounts receivable from businesses which are hi financial 
 straits is engaged in "illegitimate" financing ? 
 
 g. If you were managing an enterprise that was in financial difficul- 
 ties, would you resort to the sale of accounts receivable as a 
 means of relief ? 
 
 10. Why is it necessary for a concern which purchases accounts 
 receivable from such a concern to charge very high rates ? 
 
 11. State in your own words how the second type of institution that 
 purchases accounts receivable differs from the first one mentioned 
 in the text.
 
 COMMERCIAL PAPER AND DISCOUNT COMPANIES 455 
 
 12. Using the data given in the text, figure what the gross service 
 charge amounts to in terms of percentage on the funds borrowed. 
 
 13. If you were managing an enterprise that was in need of additional 
 funds, would you be willing to pay a service charge as large as is 
 indicated by the figures derived in question 12 ? Would you not 
 prefer to issue more stock or sell more bonds ? 
 
 14. Show concretely the relation of the commercial banks to the work 
 of companies which purchase accounts receivable. 
 
 15. If you were a commercial banker and were unwilling to extend 
 credit to a concern in the form of a direct loan, would you be 
 willing to extend it funds indirectly, through the intermediation 
 of a discount company ? 
 
 1 6. What is your conclusion as to the economic justification of the 
 practice of selling accounts receivable ? 
 
 m. THE FINANCING OF AUTOMOBILE DISTRIBUTION 
 
 17. What is the essential difference between the financing of retail 
 distribution and the financing of the wholesale end of the busi- 
 ness? 
 
 1 8. Are there any respects in which you think the security back of 
 the loans made by the automobile banks is inadequate ? 
 
 19. Study the copies of the chattel mortgage, conditional sale agree- 
 ment, and lease agreement, and state what rights are granted to 
 the lender in each case. 
 
 20. How do the larger automobile-financing corporations make their 
 profits ? 
 
 21. How. do the smaller discount houses which finance the retail 
 end of the trade make their profits ? Do you see any advantage 
 in one method as compared with the other ? 
 
 22. If you were managing one of these companies, would you attempt 
 to secure the funds required by borrowing from commercial 
 banks or by selling either debentures or collateral trust notes 
 in the investment market? Why? 
 
 23. In case you elected to borrow from a commercial bank, what 
 would determine whether you would borrow on an unsecured 
 promissory note, or on the collateral consisting of customers' 
 notes ? In case you borrowed in the investment market, what 
 would determine whether you would issue simple debenture 
 bonds or collateral trust notes ? 
 
 24. What is the purpose of the serial feature of the collateral trust 
 notes?
 
 456 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 25. In the case of the serial notes described on page 451, do you 
 think the investment would be reasonably safe ? How would 
 you compare it with bonds of an industrial concern, where the 
 funds are devoted to fixed capital purposes ? 
 
 26. State in your own words what you consider the economic justi- 
 fication of the automobile and piano bankers. Have you any 
 criticisms to make with reference to their operations ?
 
 CHAPTER XXII 
 
 THE COMMERCIAL BANKING SYSTEM 
 
 The commercial bank was studied in chapter xix as a 
 special type of financial institution, and as such it was discussed 
 in isolation, that is, independently of its relations to other 
 banks. We shall find, however, that commercial banks are 
 closely interrelated, each individual institution being in the 
 ordinary course of its business brought into contact with 
 other banks with those hi the same city or community, with 
 those in other cities, and even with the institutions of other 
 countries. Taken as a whole, the commercial banks constitute 
 what may be called a commercial banking system. In the 
 present chapter we shall consider the nature of these inter- 
 relations and the reasons for their development, together with 
 the origin and nature of the phenomenon of credit currency. 
 
 I. CLEARING-HOUSE ASSOCIATIONS 
 
 The banks of all the important financial centers of the 
 country have worked out certain of then* relations through 
 clearing-house associations. A clearing-house association may 
 be defined as an organization of banks designed to promote 
 in every possible way the mutual interests of the members. 
 The most common of these mutual services and the one that 
 has excited by far the greatest popular interest is that of clearing 
 checks. The practical operation of the clearing-house in this 
 :apacity may be readily described. 
 
 Let us assume that in a given city there are twenty banks 
 which are members of the clearing-house association. Each 
 day bank No. i receives from its depositors a considerable 
 number of checks which have been drawn against each of the 
 other nineteen banks; and, in turn, each of the other banks 
 receives checks drawn on all the rest. Bank No. i credits 
 
 457
 
 458 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 to the deposit accounts of its customers the checks as it receives 
 them; and it must then collect these checks from the banks 
 against which they have been drawn. Before the hour set 
 for exchanging the checks at the clearing-house the clerks in 
 bank No. i assemble them in bundles, so that all of those that 
 are payable by each bank will be together. The total amount 
 of the checks to be presented to each bank is also added up on 
 a sheet of paper. At the hour of clearing, messengers from the 
 several banks appear at the clearing-house for the purpose of 
 securing payment of the checks. The process by which these 
 checks are "cleared" is as foUows: 
 
 Within the clearing-house is a large circular desk, with 
 twenty compartments or stalls. In compartment i is a clerk 
 representing bank No. i ; in compartment 2, a clerk representing 
 bank No. 2, etc. The messenger from bank No. i deposits in 
 compartment 2 the checks payable by bank No. 2; in com- 
 partment 3, the checks payable by bank No. 3; and, in turn, 
 in each of the nineteen compartments. In his turn, the mes- 
 senger from bank No. 2 deposits in compartment i the checks 
 payable by bank No. i; in compartment 3 those payable by 
 bank No. 3, and so on around the circle. The messengers 
 from banks Nos. 3, 4, etc., likewise deposit their bundles in 
 the nineteen compartments representing the nineteen banks 
 against which the checks have been drawn. At the conclusion 
 of this presentation of the checks to the proper 'compartments, 
 each clerk will find in his compartment nineteen bundles of 
 checks, all of which are payable by his bank. These checks 
 are turned over to the messengers, who take them immediately 
 back to then" respective banks. Thus the physical transfer 
 of the checks has been accomplished. 
 
 Many checks are traded directly between banks. It should be 
 stated, parenthetically, that as a means of relieving the con- 
 gestion of work in the banks in the larger financial centers a 
 considerable percentage of the checks that are cleared are not 
 actually sent through the clearing-house, although their totals 
 are included in the sums which appear upon the clearing-house 
 records. The reason for this is as follows: The clearing usually
 
 THE COMMERCIAL BANKING SYSTEM 459 
 
 occurs at 10:30 A.M.; and after that hour the bank continues 
 to receive checks from its customers, so that by the end of 
 the day it has assembled a large number of checks payable by 
 other banks. Again at the opening of the bank the following 
 morning a large number of checks is soon received. Now, 
 if bank No. i, for instance, did not present any of the checks 
 to the other banks until, say, eleven o'clock, the end of the 
 clearing period, there would then be an enormous rush in 
 assorting them and crediting them to the proper accounts. 
 It facilitates matters very greatly if the checks accumulated 
 after the clearing hour are sent to the banks upon which they 
 are drawn in the afternoon of that day, and if, say, the first 
 hour's collection in the morning is sent over in advance of the 
 10:30 A.M. clearing hour. Bank No. i therefore sends its 
 accumulated checks drawn on banks Nos. 2, 3, etc., to these 
 banks and trades them for a "batch" of checks drawn against 
 itself, which the other, banks have received from their depositors. 
 Each bank can thereupon begin at once the work of debiting 
 the checks to the proper accounts. By having the receipt 
 of the checks spread over the entire day, it is much easier to 
 take care of the enormous amount of routine clerical and account- 
 ing work that is necessarily thrust upon the larger institutions. 
 
 The greater part of interbank obligations are canceled. It 
 remains to note how the balances are struck and paid at the 
 clearing-house. We have already seen that bank No. i has a 
 record of the total checks which it presents to the other banks. 
 It also receives from each of the other banks, along with the 
 checks, a statement of the total presented by each of the other 
 banks against it. (This includes the totals of the checks that 
 have been traded directly, as well as those actually brought to 
 the clearing-house.) Suppose now that the clerk in com- 
 partment i has on his statement $1,000,000, due from the other 
 banks; and that upon footing up the total of the nineteen 
 statements deposited in his compartment he finds that his 
 bank owes to the other banks $1,200,000. Bank No. i has 
 therefore an unfavorable balance with the rest of the banks of 
 $200,000.
 
 460 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 Suppose the clerk of bank No. 2, in turn, finds that his 
 balance shows $100,000 due from the other banks; the clerk 
 of bank No. 3 finds that $50,000 is due from the other banks; 
 the clerk from bank No. 4 finds that $40,000 is due to other 
 banks, etc. After finding his balance each clerk presents to the 
 clearing-house manager a slip showing the amount due to or 
 from the other banks. And when the manager receives these 
 slips from the twenty different banks, he writes the amounts 
 down hi two columns, one showing the sums due to the 
 clearing-house and the other showing the sums due from the 
 clearing-house. Since the checks presented to the clearing- 
 house by all the banks are the identical checks received through 
 the clearing-house from all the banks, these totals must obviously 
 balance. The clearing-house manager thus has 'a ready means 
 of "proving" the correctness of the figures presented to him. 
 
 There are numerous ways of paying the balances. Various 
 means have in fact been employed in the past in the settlement 
 of these accounts, not all of which are of sufficient importance 
 to require description. The most common method in the 
 larger financial centers, prior to the adoption of the Federal 
 Reserve System, was through the use of clearing-house certifi- 
 cates. Under this method each member of the clearing-house 
 association deposited a portion of its cash resources with the 
 clearing-house and was given in exchange clearing-house cer- 
 tificates. These certificates were commonly of large denomi- 
 nations one, five, and ten thousand dollars. It should be 
 noted that, so far as the bank's balance sheet was concerned, 
 these certificates appeared under the heading of Cash, just 
 as do gold certificates, which are claims against gold in the 
 Treasury Department at Washington. 
 
 Now when bank No. i owed to the clearing-house $200,000, 
 as in the foregoing illustration, it would turn over to the 
 clearing-house manager $200,000 in clearing-house certificates. 
 Since bank No. 2 had a balance of $100,000 due from the 
 clearing-house, the clearing-house manager would pay to 
 bank No. 2 $100,000 of the clearing-house certificates which he 
 had received. In a word, the clearing-house manager merely
 
 THE COMMERCIAL BANKING SYSTEM 461 
 
 acted as intermediary in the transfer of these clearing-house 
 certificates from the banks which had unfavorable balances 
 to the banks which had favorable balances. 
 
 It will be seen that the use of these clearing-house certifi- 
 cates greatly lessens the risk of transferring funds. For if a 
 messenger carrying them were robbed, no loss would be sus- 
 tained by the banks, since the clearing-house certificates are 
 acceptable only hi the paying of balances between banks. 
 
 Clearing-house balances are now settled by book entries at the 
 Federal Reserve bank. Since the establishment of the Federal 
 Reserve System, and the affiliation with that system of all 
 the important state banks and trust companies in the larger 
 financial centers, the process of settling clearing-house balances 
 has been still further simplified. In Chicago, for instance, 
 each bank belonging to the clearing-house association has funds 
 on deposit with the Federal Reserve Bank of Chicago. Accord- 
 ingly, when the clearing has been completed, the manager of 
 the clearing-house notifies the Federal Reserve Bank that 
 the deposit account of bank No. i should be decreased by 
 $200,000; the account of bank No. 2 increased by $100,000; 
 the account of bank No. 3 increased by $50,000; the account 
 of bank No. 4 decreased by $40,000, etc. Thus by means of 
 simple bookkeeping entries on the books of the Federal Reserve 
 Bank, each bank in the clearing-house association has added 
 to or subtracted from its funds the amounts necessary to 
 settle its account. 
 
 The banks of the clearing-house of Milwaukee are also 
 all members of the Federal Reserve Bank of Chicago. And 
 as soon as the clearings have been completed hi Milwaukee, 
 the manager of the Milwaukee clearing-house telegraphs to 
 the Federal Reserve Bank of Chicago the amounts which 
 should be debited and credited to the accounts of the different 
 Milwaukee banks. 
 
 Not all the banks of a given city are members of the clearing- 
 house association. The reason for this is that it would com- 
 plicate too greatly the process of clearing if a large number of 
 institutions were involved. Most banks which are not members
 
 462 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 of the clearing-house association, however, clear through 
 banks which are members. For instance, the Woodlawn 
 Trust and Savings Bank of Chicago clears through the Fort 
 Dearborn National Bank. Every day all the checks which 
 are received by the Woodlawn Trust and -Savings Bank against 
 other banks in Chicago are sent to the Fort Dearborn National 
 Bank, which presents them, along with its own items, at the 
 clearing-house. Similarly, when other banks of the city 
 receive checks drawn against the Woodlawn Trust and Savings 
 Bank they present them through the clearings to the Fort 
 Dearborn National Bank. If on a given day the Fort Dearborn 
 National Bank sent $10,000 worth of checks to the clearing- 
 house for the Woodlawn Trust and Savings Bank, and received 
 from the clearing-house $8,000 worth of checks drawn against 
 the Woodlawn Trust and Savings Bank, the latter would have 
 a favorable balance with the Fort Dearborn of $2,000, which 
 would be credited to its deposit account in that bank. On the 
 other hand, if the balance of the Woodlawn Trust and Savings 
 Bank should be unfavorable to a like extent, $2,000 would 
 be subtracted from the credit which the Woodlawn Bank has 
 with the Fort Dearborn. 
 
 Suburban banks have an independent clearing. In addition 
 to these two types of banks those that are members of the 
 clearing-house and those that clear through members there 
 may be a considerable number of small suburban institu- 
 tions in the larger cities which still use the messenger service 
 in the presentation and payment of checks. In 1919 there was 
 established in Chicago, however, what is known as a suburban 
 clearance, by means of which clearings are made at 9 o'clock 
 in the morning before the regular clearing hours. The 
 suburban banks are thus enabled to effect their transfers by 
 the same process that obtains in the regular clearings described 
 above. 
 
 The clearing-house is a very efficient business agency. The 
 function of the clearing-house in this connection is, therefore, 
 to perform certain tasks in a minimum of time and with 
 a minimum of risks. It is a mere business device for the
 
 THE COMMERCIAL BANKING SYSTEM 463 
 
 simplification of routine clerical work. The speed with which 
 the work of a clearing-house is transacted is very great, and 
 the clerks are exceptionally accurate and remarkably rapid 
 in their calculations. The actual time required to make the 
 exchanges varies from about two to ten minutes; and only 
 about a half-hour elapses from the opening of the clearing- 
 house until the entire morning's work is completed. The daily 
 clearance in New York averages in excess of three hundred 
 million dollars. 
 
 The clearing-house makes a great appeal to the imagination 
 of many people, because of the enormous volume of exchanges 
 that are so quickly effected. In large measure, however, this 
 appeal is merely fanciful. If one has visions of enormous 
 volumes of cold cash countless millions of dollars changing 
 hands with lightning-like celerity, he will be disappointed in 
 visiting a clearing-house; for instead of the glitter of gold, 
 or even of the green of bills, he will see merely a number 
 of clerks filing hi and out with inconspicuous packages of 
 checks, other clerks busily engaged hi adding columns of 
 figures, and then he will shortly hear the clearing-house manager 
 announce the total of clearings that has been effected. It is on 
 the whole a pretty drab performance much less exciting than 
 many other phenomena of business organization that dis- 
 tinguish our capitalistic industrial system. 
 
 Clearing-house associations have eliminated certain com- 
 petitive banking practices. While the greatest interest in the 
 clearing-house association has always centered in the clear- 
 ing of checks, some of its most important functions are of 
 another nature. I refer to the use of the clearing-house 
 association as a means of controlling certain competitive 
 banking activities, in the interests not alone of larger bank 
 profits, but also of the stability and soundness of the commercial 
 banking system as a whole. 
 
 The origin of the New York clearing-house, indeed, appears 
 to have been attributable as much to a desire to escape 
 from certain competitive evils as to reduce the time required 
 for exchanging checks. Before the establishment of the
 
 464 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 clearing-house in 1853 the difficulties involved in settling balances 
 between banks hi the metropolis were so great that no attempt 
 was made to effect a daily settlement of accounts. While 
 checks were presented each day, the banks by informal agree- 
 ment settled their balances only once a week every Friday 
 morning following the exchange of checks. The cashier of 
 each bank then drew a check against each of the banks from 
 which credit balances were due and sent a messenger to collect 
 them. 
 
 This weekly settlement made it possible for any bank 
 which so desired to take advantage of the others. For instance, 
 on Monday bank A might make a large number of loans, 
 against which the borrowers would draw checks. These 
 checks, in the main, would be presented at other banks; and 
 since these banks had to wait until Friday before they could 
 collect from bank A, it was possible for bank A greatly to 
 expand the volume of its loans at the expense of the other 
 institutions. A settlement would of course have to be made on 
 Friday; and in order to have the necessary funds with which 
 to meet its adverse balances, bank A would borrow on Thursday 
 the money with which to make its Friday settlements. When 
 these loans were paid on Saturday, the bank would again be 
 in debt to all the others, and by repeating the practice of 
 making large loans it would again secure the use of the other 
 banks' funds. 
 
 As a means of preventing certain speculative institutions 
 from indulging unrestrainedly in this practice, it became 
 necessary to agree that any bank could draw against its credit 
 balance with another at any time without waiting for the 
 settlement on Friday. And when any bank was in need of 
 specie, this privilege was commonly utilized. An old bank 
 officer of New York who had experience with these practices 
 has stated that so far did many banks expand their loans that 
 "a single small draft by one bank on another would induce a 
 general drawing involving them all in confusion and virtual 
 war on each other. Three o'clock would arrive with a line of 
 drafts incompleted, thus frequently enabling the debtor banks
 
 THE COMMERCIAL BANKING SYSTEM 465 
 
 to add $50,000 to their specie holdings. "' The losses sustained 
 by the unfortunate banks, together with the perpetual annoy- 
 ance and the bitterness of feeling that was often engendered by 
 these sharp competitive practices, must have been quite as 
 responsible for the organization of a clearing-house association 
 as the prevalent costly and cumbersome method of settling 
 balances. 
 
 Once established, the clearing-house associations became 
 the agencies for the elimination of competitive evils and the 
 strengthening of commercial banking practice in numerous 
 connections. James G. Cannon, the authority on clearing- 
 house practices, says: "The tendency has been marked, 
 especially in recent years, to include within the legitimate 
 field of clearing-houses all questions affecting the mutual 
 welfare of the banks and the community as a whole." The 
 most important of the special functions designed to raise the 
 plane of banking operations are as follows: (i) fixing uniform 
 rates of interest on deposits; (2) fixing uniform rates of exchange 
 and charges on collections; (3) conducting clearing-house 
 bank examination; (4) effecting mutual co-operation among 
 banks hi time of acute financial strain. 
 
 i. Fixing uniform rates of interest on deposits. Like the 
 savings banks, commercial banks have sought to expand the 
 volume of their resources available for lending purposes by 
 attracting deposits through the offer of interest on commercial 
 accounts. The necessity of paying deposits on demand was 
 of course recognized; but where an average balance above a 
 certain minimum was kept by any individual, it was recognized 
 that interest could be paid on such portion of the funds as was 
 left more or less continuously with the bank. As a means of 
 attracting as large a volume of deposits as possible, some 
 banks offered rates of interest that were higher than usual, 
 thereby endangering their solvency. 
 
 It is of course possible that a bank might succeed in paying 
 higher interest rates on deposits than the going rate, if by 
 this means it secured a substantial increase in its volume of 
 
 1 See James G. Cannon, Clearing Houses, p. 150.
 
 466 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 business. But where competition is keen the raising of interest 
 rates by one bank usually forces the others to follow suit; 
 and when all banks pay higher interest rates on deposits, they 
 merely lessen the margin of banking profits that can be obtained 
 and imperil hi no small degree their own financial security. 
 
 It gradually became apparent that hi the interest of sound 
 banking the raising of rates on deposits as a means of attracting 
 business was detrimental to the banks as a whole and thus to 
 business in general. The clearing-house associations provided 
 a means whereby, through concerted action, the associated 
 banks could agree to regulate such competitive practices. 
 Rates of interest were agreed upon as early as 1881 in Buffalo; 
 and other associations have gradually fallen into line. While 
 the agreements differ somewhat in different cities, 2 per cent 
 per annum has hi recent years been the usual rate on deposit 
 balances above a certain minimum, commonly $1,000. This 
 applies both to bankers' balances and to the deposits of indi- 
 viduals. 1 
 
 The legality of agreements of this sort has of course been 
 questioned and some associations still regard it as a moot 
 practice, and are hence reluctant to establish and enforce any 
 particular rate. Even hi these cases, however, there seems 
 to be more or less tacit assent to uniform rates. 
 
 The fixing of interest rates on loans has also been considered 
 by many clearing-house associations. But in most instances 
 the suggestion has not met with favor, for two reasons: first, 
 the individual banks look upon the loaning of money as their 
 most distinctive prerogative and would regard agreements 
 upon the rates at which money should be loaned as a virtual 
 elimination of all individual initiative in bank management; 
 second, such agreements whatever the rates determined 
 upon would doubtless smack of monopoly control and invite 
 restrictive legislation. 
 
 It is an interesting observation that there is much more 
 likely to be agreement on interest rates in country towns and 
 
 1 During the Great War the rate was raised to 2$ per cent, at least in 
 some centers.
 
 THE COMMERCIAL BANKING SYSTEM 467 
 
 villages than in the large financial centers. There appear to be 
 many cases where there are informal agreements between 
 banks in small towns that money shall not be loaned for less 
 than 6, 8, or 10 per cent, as the case may be. In the larger 
 cities, however, there is undoubted independence in this matter, 
 although in the nature of things there is seldom any wide 
 disparity in rates, owing to the very close competition that 
 obtains and to the equalizing effect of the operations of the 
 commercial paper houses. Since the establishment of the 
 Federal Reserve System, moreover, the rates of rediscount at 
 the Federal Reserve banks exercise a controlling influence. 1 
 
 2. Fixing uniform rales of exchange and collection charges. 
 Everyone dislikes to pay exchange and collection charges; 
 and one of the best devices for attracting additional business, 
 therefore, has been the elimination, or the reduction, of such 
 charges. Now any particular bank might well more than make 
 good the losses sustained by furnishing drafts to customers 
 and collecting items free of charge, out of the enlarged volume 
 of business obtained as a result of such a policy. But when 
 all the banks of a given community, under the impetus of 
 competition, engage in rate cutting, it is obvious that the 
 collection costs to the banks as a whole cannot be counter- 
 balanced by an increased volume of business for the banks as a 
 whole. We have here a case of cut-throat competition similar 
 to that which for so long a period led to the financial embar- 
 rassment of railroads and industrial concerns. The clearing- 
 house associations again provided the mechanism for agreements 
 on uniform exchange and collection charges; and again it was 
 in Buffalo, in 1881, that the first agreement was made. A scale 
 of charges was adopted and put into successful operation, 
 the rates not being high, but arranged as nearly as possible to 
 cover the cost incurred by the banks in performing the service 
 in question. 
 
 While many difficulties have been encountered in some 
 places in controlling this phase of banking competition, the 
 practice of agreeing upon uniform charges has been graduallv 
 
 1 See pp. 593-94 and 597-98.
 
 468 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 extended throughout the country. The adoption of the Federal 
 Reserve Act, however, and the development of a new collection 
 system, now accomplish the same results by other means. 1 
 
 3. Conducting clearing-house bank examinations. Clearing- 
 house bank examinations are of still more recent development, 
 the first one having been organized in Chicago on June i, 1906. 
 The examination of banks by an agent of the clearing-house 
 association constitutes an attempt by the banks themselves to 
 control and safeguard the interests of the credit structure as a 
 whole through a system of supervision which greatly reduces 
 the chances of bad banking practice and consequent banking 
 failures. A statement of the origin of the system of clearing- 
 house bank examinations in Chicago will best serve to reveal 
 the reasons for this significant development. 
 
 In the autumn of 1905 it was discovered by the federal 
 bank examiner that a large national bank in Chicago, of which 
 a prominent financier was president, was insolvent. The 
 president of this bank was also in control of two state banking 
 institutions and it was conceded that the three institutions 
 were involved in mutual difficulties. The status of affairs was 
 discovered on a Saturday morning; but owing to the fact that 
 .the money market was in a somewhat strained condition at 
 the time, it was deemed inexpedient to make an immediate 
 public announcement, lest a "run" on these banks might so 
 shatter general confidence that a financial panic of serious 
 proportions might be precipitated. Accordingly, the announce- 
 ment was postponed until Monday; and during the interval a 
 committee of leading bankers and business men met with the 
 federal examiner to consider ways and means of meeting the 
 situation. In order to prevent a general loss of confidence in 
 Chicago banks, these men agreed to advance several millions 
 of dollars hi order to prevent a "run" upon the insolvent 
 institutions. The president of the banks paid the personal 
 penalty of imprisonment, but the millions of dollars advanced 
 to prevent a general disruption of credit to this day remain 
 largely unpaid. 
 
 See pp. 608-13.
 
 THE COMMERCIAL BANKING SYSTEM 469 
 
 It was from no altruistic motive that the financiers of 
 Chicago thus underwrote the losses of an erring member; 
 it was rather enlightened self-interest which dictated their 
 policy. In the light of this experience, however, it was decided 
 that some means should be developed, if possible, to prevent 
 a recurrence of such a disaster. Many bankers and business 
 men had for some time been aware of the fact that the 
 banks in question were hi an unsound condition, the funds 
 of these institutions having been used for railroad and other 
 enterprises hi which the president was interested. It was 
 known that these enterprises were in financial difficulties and 
 that the good funds of depositors were being steadily diverted 
 from the financing of ordinary conservative business to the 
 rescuing of the bad funds already invested elsewhere. Upon 
 the occasion of his previous examination, six months earlier, 
 the federal bank examiner had not fully perceived the gravity 
 of the situation doubtless because there was juggling of 
 accounts between the state and national institutions. It was 
 believed therefore that the only remedy for the situation was 
 to develop a means whereby other banks could bring pressure 
 to bear to correct an obviously dangerous situation, before it 
 could get so bad as to imperil public confidence in banking 
 institutions generally. Accordingly, the clearing-house asso- 
 ciation devised the system of examinations as a means of 
 eliminating bad banking practices on the part of any of its 
 members. 
 
 The system devised for Chicago is in brief as follows: 
 A skilled examiner is employed by the clearing-house asso- 
 ciation for the purpose of making annual examinations of all 
 the associated banks and of the non-member institutions of 
 Chicago, and such additional examinations as may appear to be 
 necessary at any time. The examination includes a verifi- 
 cation of the assets and liabilities of each bank and an investi- 
 gation of the work of each department. Upon the conclusion 
 of an examination, the examiner prepares a detailed report, 
 hi duplicate, which discloses the bank's loans, bond invest- 
 ments, and other assets, mentioning particularly all loans
 
 470 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 either direct or indirect, that have been made to officers, 
 directors, or employees, or to corporations in which they may 
 be interested. One of these reports is filed in the clearing-house 
 in the custody of the examiner and the other is handed to the 
 president of the examined bank for the use of its directors, thus 
 bringing the condition of the bank sharply to the attention 
 of the responsible managers of the institution. A briefer and 
 less specific report, disclosing no essentially private information, 
 is also sent to the clearing-house committee. The clearing- 
 house examiner also co-operates with federal and state bank 
 examiners and thereby increases the efficiency of their work 
 The system thus inaugurated in Chicago has been copied 
 hi a large number of the leading cities of the country. It has 
 been uniformly successful, and thus far no bank which is 
 subject to the clearing-house examination has ever failed. In 
 the light of this record it is not surprising that the clearing- 
 house bank examination has been called the most constructive 
 banking improvement that has ever been developed as a 
 result of private enterprise. 1 
 
 II. RELATIONS BETWEEN BANKS IN DIFFERENT 
 
 CITIES 
 
 In the evolution of the commercial banking system it has 
 been found necessary for banks in different cities to develop 
 what is known as "correspondent" relations. The principal 
 services rendered to each other by correspondent banks may 
 be listed as follows: (i) acting as collecting agencies; (2) giving 
 each other advice and information pertaining to financial 
 and business affairs in their respective localities; (3) holding 
 deposits of excess funds; (4) borrowing from each other, as 
 occasion requires. 
 
 i. Acting as collecting agencies. Every important bank 
 receives from its customers in the daily course of business 
 many checks drawn on banks in other towns and cities. Such 
 
 1 The devices that have been developed for effecting mutual co-operation 
 of clearing-house banks in times of financial crisis are discussed elsewhere. 
 See pp. 533-39-
 
 THE COMMERCIAL BANKING SYSTEM 471 
 
 checks are customarily at once credited to the account of the 
 depositor who presents them; and it is accordingly necessary 
 for the bank to send them for collection to the banks upon 
 which they are drawn. Before the establishment of the Federal 
 Reserve collection system, checks and drafts upon banks in 
 other cities were sent by mail either to the bank direct or to 
 some other bank which would act as an agent in the process. 
 Since the old system of collecting checks is now practically 
 obsolete, it is unnecessary at this place to describe the process 
 in any detail. 1 It need only be said that each bank endeavored 
 to collect its checks in the easiest and cheapest way possible. 
 Sometimes this involved sending the check direct to the bank 
 upon which it was drawn; sometimes it meant sending it to a 
 correspondent bank located in the same city as the drawee 
 bank; and sometimes it meant sending it to a correspondent 
 bank in another city, whence it would be "relayed" to the 
 city where the drawee bank was located, being sent either 
 direct to the bank in question or to a correspondent bank, 
 whichever way was more convenient and less costly. Having 
 gradually developed without any concerted effort at systemati- 
 zation, the system was on the whole very cumbersome and 
 time-consuming, and withal socially inefficient and expensive. 
 Various improvements were being made, however, in the years 
 immediately preceding the adoption of the Federal Reserve 
 System. 
 
 Besides collecting checks and bank drafts for each other, 
 correspondent banks also render a great deal of mutual service 
 in collecting business notes and bills of exchange. For instance, 
 a customer of a bank in Grand Rapids, Michigan, may have a 
 promissory note due from an individual in Chicago. The 
 process of collection is greatly facilitated if he turns this note 
 over to his bank for collection. The bank sends the note to 
 its correspondent in Chicago, which then either details a 
 messenger to collect the note at maturity or notifies the maker 
 that it is due and payable at the bank on a stipulated date, 
 
 1 For a description of the Federal Reserve collection system now in 
 vogue see pp. 608-13.
 
 472 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 the procedure depending upon the terms of the agreement in 
 each individual case. 
 
 Another form of collection involving the use of correspondent 
 banks is found in connection with the payment of principal 
 and interest on bonds and mortgages. For instance, an indi- 
 vidual in Bloomington, Indiana, may own bonds the interest 
 and principal of which are payable at the First National Bank 
 of New York. As the coupons, and ultimately the principal, 
 fall due, they are presented to the local bank in Blooming- 
 ton, which sends them to its correspondent hi New York, 
 where they are presented to the First National Bank for 
 collection. 
 
 It should also be recalled at this place that it is through 
 the correspondent relations of banks that the system of domestic 
 exchanges, whereby cash moves only hi the settlement of trade 
 and other balances between different centers, is worked out. 1 
 In order to be in a position to sell bills of exchange to their 
 customers, local banks are obliged to keep funds on deposit in 
 the financial centers with which the business of their constitu- 
 ents is mainly connected. 
 
 2. Exchanging advice and information on financial and 
 business affairs. Correspondent banks render a great deal of 
 indirect service to each other. The banks in the larger cities, 
 through the publishing of monthly analyses on business con- 
 ditions, digests of important legislation, and special reports on 
 various subjects from tune to time, which are sent free to all 
 correspondents, keep the country bankers those who read 
 posted on fundamental economic conditions in a fairly effective 
 way. The city banker also advises the country banker with 
 reference to the standing of firms whose commercial paper is 
 being offered for sale, and with reference to bond and other 
 investment opportunities. The country banker, on his part, 
 supplies the city correspondent with information on business 
 conditions hi his locality and on the character and standing of 
 business men in his community with whom the city banker 
 may have dealings, either directly or indirectly. 
 
 1 See pp. 115-16 above.
 
 THE COMMERCIAL BANKING SYSTEM 473 
 
 The co-operation in the handling of financial affairs and in 
 the dissemination of information on economic questions accom- 
 plished through these correspondent relations is a most impor- 
 tant development from the standpoint of sound business and 
 economics. 
 
 3. Holding deposits of excess funds. In order to secure a 
 certain amount of financial concentration, or centralization, 
 our national banking laws have permitted the banks of the 
 smaller cities to deposit a portion of their reserves 1 in the banks 
 of the larger cities. The practice has been general for the city 
 banks to pay 2 per cent interest on these reserve deposits, 
 the banks being able to do this by virtue of the possibilities of a 
 remunerative employment of the funds thus received in stock 
 exchange and other financial operations. Besides loaning 
 a portion of their legal reserves, the outlying banks also loan 
 additional funds to their city correspondents during periods 
 of slack business in the country. Funds that would otherwise 
 be idle are thereby given employment, at a low rate of interest, 
 the while remaining subject to call for more remunerative 
 investment as soon as occasion offers. 8 
 
 The concentration of funds in financial centers both 
 large and small is a striking phenomenon of our modern 
 financial system. Professor Taylor tells us, for example, that 
 "some years ago hi a certain Michigan village which had a 
 factory with a pay-roll of $2,000 per week, it proved necessary 
 for the local bank to bring out the $2,000 in cash from Detroit 
 practically every week in the year that is, the $2,000 having 
 been paid to the workmen, instead of remaining in the village 
 ready for use the next week, before the time was up found 
 its way into Detroit, whence it had to be taken back by 
 the banker. " 3 
 
 New York is the great financial center of the United States. 
 A large percentage of the deposits of New York banks, in some 
 
 1 For details see pp. 481-82. 
 
 a We shall later see that this practice has serious weaknesses in times 
 of financial stress (p. 531). 
 
 F. M. Taylor, Some Chapters on Money (copyright 1906), pp. 139-40.
 
 474 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 cases more than half, are bankers' deposit funds sent in by 
 correspondent banks from all over the country. An investi- 
 gation made in 1901 showed that on September i of that year 
 the New York banks had more than 43 per cent of the net 
 bankers' deposits of the United States three times the volume 
 of those held by the banks of Chicago and St. Louis com- 
 bined. 
 
 * The dominance of New York in this connection is due 
 primarily to its position as the great entrepot of trade. The 
 overwhelming percentage of our foreign trade, both exports 
 and imports, passes through or is financed through New York, 
 as a result of which practically all banks find it necessary to 
 keep funds on deposit there. In 1890 information was secured 
 by the Comptroller of the Currency from 3,329 out of 3,438 
 national banks, bearing on their financial relations with New 
 York. Of the reporting banks all but three stated that they 
 drew drafts upon New York; and the returns as a whole showed 
 that the total amount of drafts on New York was 61.31 per 
 cent of all the drafts on all the banks in the country. This may 
 be compared with 9.82 per cent of the total that was drawn 
 against Chicago banks. New York is thus in a sense the 
 clearing-house for the entire country. 
 
 4. Borrowing from each other. The inter-borrowing relations 
 of correspondent banks have been developed as a means of 
 securing additional cash as occasion demands. It has often 
 been assumed that a commercial bank commonly relies upon 
 its maturing loans to provide it with ready funds when needed. 
 In practice, however, we find that to a large and steadily 
 increasing extent before the adoption of the Federal Reserve 
 System the banks of the country borrowed from each other 
 by one device or another the funds required for the replenish- 
 ment of depleted reserves. 
 
 This borrowing is accomplished by numerous devices. The 
 first, but not the most important, of these was by the rediscount 
 of customers' notes. If a bank in Richmond, Virginia, needed 
 additional cash resources, it could sell the note of one of its 
 customers to its correspondent bank in New York, thus provid'
 
 THE COMMERCIAL BANKING SYSTEM 475 
 
 ing itself with the needed funds. This practice, however, was 
 characteristically opposed by the customers themselves. It 
 appears to have been assumed that banks should have enough 
 funds of their own with which to conduct their operations and 
 that the selling of notes in Wall Street was a sign either of 
 weakness or of dangerous speculative activity. 
 
 As a means of avoiding this unwarranted criticism of the 
 practice of rediscounting, the banks resorted to various expe- 
 dients. One of these was to indorse the notes that were redis- 
 counted with a lead pencil so that the indorsement could be 
 erased when the note was returned to the maker for payment. 
 Another and much more common device was for the bank 
 officials to borrow on their own promissory notes, either with 
 or without customers' notes as collateral security. The funds 
 thus borrowed were then deposited in the bank, with the 
 understanding that the officers would not withdraw them. 
 Another method of securing funds from correspondents in 
 time of emergency was by the sale of bonds, with an agreement 
 to repurchase them at the same price, plus a fixed rate of 
 interest. This was a very common practice. An operation 
 akin to the sale of bonds was the loaning of bonds by one bank 
 to another for use as security for note issues, special deposits, 
 etc. The sale of commercial paper purchased in the open 
 market was a final method by which a bank could increase its 
 reserves, as occasion required. This practice developed rapidly 
 after the turn of the century, and particularly after the panic 
 of 1907. The development of the Federal Reserve System, 
 however, has, as we shall see, largely rendered obsolete all of 
 these methods of securing additional funds with which to meet 
 emergency demands. 
 
 III. LOANS, DEPOSITS, AND RESERVES 
 
 We have already seen that in commercial banking the 
 granting of a loan commonly gives rise to a deposit account, 
 and that a commercial bank requires a cash reserve against 
 deposits of only moderate proportions. We may now consider
 
 476 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 in greater detail the interrelations of loans, deposits, and 
 reserves in the commercial banking system as a whole. 
 
 If there were only one bank in a given community and if 
 every customer of this bank ordinarily used a checking account 
 as a means of payment, a bank which possessed at the beginning 
 of its lending operations a cash reserve of $100,000 could 
 gradually extend its loans and create deposit accounts to many 
 times the amount of its reserve. Suppose we start with tLe 
 assumption that $100,000 of loans are made, thus creating 
 deposit accounts to the extent of $100,000 (omitting for con- 
 venience the amount of the discount). If, as indicated in the 
 preceding chapter, the borrowers of this $100,000 write checks 
 for $100,000 payable to other individuals in the same com- 
 munity and these individuals bring the checks to this bank 
 for deposit in their accounts, it is obvious that a total of 
 $100,000 deposits resulting from the loans is still maintained; 
 and if, in turn, these new depositors write checks to the amount 
 of $100,000 in payment of obligations and the persons who 
 receive them in their turn bring them to this bank for deposit 
 to their respective accounts, the total of $100,000 in deposits 
 still remains; although the names appearing on the bank's 
 ledger as creditors of the bank are constantly shifting. 
 
 Suppose we now assume that $200,000 of additional loans 
 are made, creating thereby $200,000 of new deposit accounts, 
 against which checks are repeatedly drawn and deposited by 
 those who receive them, as in the case of the original $100,000. 
 This bank would now have on the assets side $100,000 in cash, 
 and on the liabilities side total deposit accounts (that is, claims 
 against cash) to the extent of $300,000. The question may 
 now be raised, Is it safe for a bank to create deposit accounts 
 of $300,000, when it has only $100,000 of cash ? The answer 
 is that it is entirely safe if, as in the case we have been assuming, 
 everyone deposits the checks received with the bank and pays 
 his obligations by writing checks against his account rather 
 than by withdrawing specie for the purpose. 
 
 In practice, however, not everyone does refrain from drawing 
 cash. A bank may safely count on having to redeem a certain
 
 THE COMMERCIAL BANKING SYSTEM 477 
 
 percentage of tys claims in actual specie. But since this per- 
 centage is ordinarily small, it is unnecessary for the bank to 
 carry a dollar in cash for every dollar of claims. In practice, 
 indeed, it has been found that, typically speaking, the banks 
 have to keep only about one dollar in cash for every ten dollars 
 of outstanding deposits. 1 
 
 Suppose we assume now that there are two banks in a given 
 community; and that when bank No. i makes a loan of $100,000 
 to Mr. A, the latter writes a check in favor of X, who deposits 
 it, not in the same bank, but in bank No. 2. In this case the 
 loan made by bank No. i gives rise to a deposit account in 
 the name of Mr. X in bank No. 2. Immediately speaking, 
 the Changes to be made on the balance sheet of bank No. 2 
 are as follows: on the liabilities side, "Deposits "+$100,000; 
 on the assets side, "Exchanges for the clearing-house" 
 +$100,000. But when bank No. 2 presents this check for 
 payment to bank No. i, will it not involve the following changes 
 on the books of bank No. i: "Deposits" $100,000 (deducted 
 from A's account); and "Cash" $100,000', the latter being 
 turned over to bank No. 2 ? The answer is that a payment is 
 usually effected without the movement of any very great 
 amount of specie. The reason for this is that bank No. 2 is 
 also engaged in making loans and creating deposit accounts; 
 and we may assume that Mr. B who received a deposit account 
 in bank No. 2, say, of $120,000, writes a check in favor of Y, 
 who deposits it in bank No. i. As a result, bank No. i has 
 due from bank No. 2, $120,000. Under these circumstances 
 the account can be settled merely by shifting $20,000 of specie 
 from bank No. 2 to bank No. i. 
 
 When we complicate the system still further by assuming 
 that there are a large number of banks in a given community 
 and that each is daily making loans and creating deposit 
 accounts against which checks are drawn and deposited (in 
 the main) in this or other banks, we approach the actual 
 
 1 We shall presently see that by virtue of a redepositing of reserves the 
 ratio of cash to deposits in the banking system as a whole is even smaller 
 than this.
 
 478 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 situation that exists in large financial centers. And, as we have 
 seen in our study of clearing-house associations, in settling 
 the counter-claims of the associated banks only so much cash 
 moves as is necessary to pay the net balances between each 
 bank and all the other members. 
 
 We may now complicate the situation one step further and 
 assume that some of the checks drawn against deposit accounts 
 in the city in question are sent to individuals in ^ther com- 
 munities. The checks that are drawn against community A 
 and deposited in banks in community B are entered on the 
 liabilities side of the bank balance sheets as "Deposits" of cus- 
 tomers and on the assets side as "Due from banks." Now 
 will not community A draw funds away from commuhity 
 B when it presents these checks for payment? The answer 
 again is no that cash will move only to effect a settlement of 
 net balances which cannot be offset in any way. Just as 
 balances between banks which are members of a clearing-house 
 association are settled without the movement of specie, so also, 
 by virtue of the correspondent relations that obtain between 
 banks hi different centers, together with the mechanism of 
 domestic exchanges, discussed elsewhere, 1 cash moves in the 
 settlement of balances between banks in different centers only 
 as a last resort. 
 
 The assumptions that we have been making in the preceding 
 paragraphs are directly applicable to the facts of the modern 
 financial system. The use of checks in making payments, while 
 of gradual development, is now almost universal hi the larger 
 cities for all except the smallest transactions. Hence the ratio 
 of cash to deposits the reserve that must be kept has been a 
 steadily declining one. Under a system where the use of checks 
 as a means of making payments is practically universal, where 
 individual depositors seldom present checks for payment in 
 cash, and where banks whether in the same or in different 
 cities largely cancel payments between each other, it has been 
 possible for the commercial banking system ordinarily to main- 
 tain convertibility of deposits into cash with a very small ratio 
 
 1 See chap, viii, pp. 115-16.
 
 THE COMMERCIAL BANKING SYSTEM 
 
 479 
 
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 margin of cash reserves in the national banking system, and it 
 also shows a striking correlation between loans and individual 
 deposits in the system as a whole.
 
 480 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 Deposits in the commercial banking system are mainly a 
 result of loans. In this analysis we have been contending 
 that the commercial banking system creates deposits. The 
 popular conception including that of most bankers and 
 some economists has always been that the commercial bank, 
 like the savings institutions, receives deposits and then loans 
 these funds out to borrowers the reverse of what we have 
 stated above. If this were true, the tot? 1 of deposits could 
 not be greater than the total cash resources of the nation; 
 for only such funds could be loaned out as were brought to 
 the banks for deposit. The truth of the matter is, however, 
 that the total of the country's bank deposits is many times the 
 amount of the total cash resources of the country. Because 
 he considers only the operations of his particular bank and does 
 not look to the working of the system as a whole, the typical 
 banker thinks that, since -A shortly writes checks against the 
 deposit account that was derived from a loan, there has been 
 only a temporary increase of deposits. When the persons who 
 have received these checks present them to the bank through 
 the receiving teller's window as deposits for their respective 
 accounts, the banker is inclined to look upon them as funds 
 received by the bank from customers. This is of course particu- 
 larly the case where checks drawn against deposit accounts 
 in bank No. i are presented for deposit in bank No. 2 ; these are 
 almost always regarded as funds received from customers. And 
 so they are, of course, when viewed from the standpoint of 
 this particular bank. Their origin, however, goes back to the 
 making of the loan which gave rise to the initial deposit account. 
 One who fails clearly to appreciate that in the banking system 
 as a whole deposits are largely the result of antecedent loaning 
 operations will never gain a clear understanding of the real 
 significance of commercial banking operations. 
 
 Commercial banks require very small till money reserves. 
 One further consideration of banking practice will serve to 
 throw additional light on the problem of commercial banking 
 reserves. As we have already seen, every commercial bank, 
 in addition to creating deposits by the process of making loans,
 
 THE COMMERCIAL BANKING SYSTEM 481 
 
 receives deposits from individual customers from day to day. 
 Some of these latter deposits are in the form of actual specie 
 which is available as reserve. And from day to day, also, 
 a large bank with many customers will find that it has some 
 cash resources flowing in from the payment of loans. There is 
 thus a continuous, though variable, flow of cash into the bank. 
 At the same time, as we have seen, there is also a perpetual, 
 though fluctuating, flow of cash out of the bank to meet adverse 
 balances, pay depositors, etc. If this inflow of funds exactly 
 coincided with the outflow, it would be unnecessary for the 
 bank to hold any specie on hand for till money purposes. 
 They do not exactly coincide, however, and hence a small 
 reserve of cash is required. 
 
 The amount of funds for till money purposes which a 
 commercial bank must keep on hand is still further reduced by 
 virtue of the fact that in ordinary times a bank has various 
 means of securing additions to its cash in case of need. All of 
 these means have already been discussed and accordingly they 
 may here be merely summarized, as follows: (i) by borrowing, 
 in various ways; (2) by selling commercial paper purchased 
 through commercial paper houses; (3) by selling securities; 
 (4) by calling loans. 1 By virtue of these means of securing a 
 quick command of funds, a w.ell-organized bank usually requires 
 cash for till money purposes only to the extent of 3 or 4 per 
 cent of the total outstanding (deposit) claims. 
 
 Banks are required by law to keep ultimate or liquidation 
 reserves. Banks are required, however, to keep substantially 
 larger reserves than are dictated by till money needs. In the 
 interest of protecting bank depositors from loss, the law requires 
 the keeping of what may be termed an "ultimate" or liquidation 
 reserve. 8 By virtue of this requirement the depositors are 
 certain to receive a considerable cash payment in case the bank 
 becomes insolvent. 
 
 Before the passage of the Federal Reserve Act in 1914, the 
 banks of the central reserve cities were required to keep a 
 
 1 It must be recalled, however, that New York is the only call loan market . 
 See pp. 556-57.
 
 482 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 25 per cent reserve, all in their own vaults; those of the reserve 
 cities, 25 per cent, of which one-half might be on deposit in 
 the central reserve cities; and the country banks, 15 per cent, 
 of which three-fifths might be on deposit in either the reserve 
 or central reserve cities. Since these reserves were minima, 
 below which the banks were not permitted to cut, they were 
 in fact the ultimate or liquidating reserves of the banks. Thus 
 a depositor in a country bank was certain to get at least 15 cents 
 on the dollar hi case the bank should fail. But since these 
 were ultimate reserves, it is obvious that the funds required 
 for till money purposes had to be in excess of this amount. 
 The statistics of bank reserves show that the till money reserves 
 were in fact usually very small indeed. 
 
 Actual net reserves in the banking system as a whole are much 
 less than the nominal reserve requirements. By virtue of the 
 duplication of reserves which was permitted under the national 
 banking law, the actual reserves were considerably smaller 
 than the above-mentioned percentages for the different classes 
 of banks would indicate. A "country bank" in Bloomington, 
 Indiana, for example, had a 15 per cent reserve: $6,000 in its 
 own vaults, and $9,000 on deposit with a correspondent bank 
 in Indianapolis, a reserve city. On the basis of this $15,000 
 of reserve, the Bloomington ba,nk would have outstanding 
 $100,000 worth of deposits. Of the $9,000 which was placed 
 with the Indianapolis bank, $4,500 would be sent by this bank 
 to a correspondent in New York and would still be counted as 
 reserve. Thus on the $9,000 of cash reserve received from 
 the Bloomington bank the Indianapolis bank would expand 
 loans and create deposits to the extent of $36,000; and at the 
 same tune the $4,500 which was sent to New York would there 
 serve as a reserve for four times that amount, or $18,000, of 
 deposits. Thus a total of $154,000 of deposits would be out- 
 standing against $15,000 of actual specie. -The same cash 
 thus served simultaneously as reserve in three different places. 
 
 The table on page 521 below shows the ratio of cash to 
 deposits in the national banks as a whole. It will be seen that 
 the net reserve of the system, while varying somewhat from
 
 THE COMMERCIAL BANKING SYSTEM 483 
 
 year to year, has typically been below the minimum reserve 
 requirements prescribed for individual banks. This phenom- 
 enon of course reflects the duplication that is permitted. 
 
 There is, finally, a still further lessening of the ratio of cash 
 to deposits in the banking system as a whole by virtue of the 
 fact that there has been a still further duplication of reserves 
 through the connections of small state banks with larger state 
 banks and of both with the national institutions of the larger 
 cities. In recent years prior to the Federal Reserve Act 
 the ratio of cash to outstanding obligations in all our commercial 
 banking institutions, state and national, has, in fact, been 
 considerably less than 10 per cent. 
 
 Under the Federal Reserve Act the reserve requirements 
 for national banks have been substantially reduced, 1 and it is 
 now possible for the banking system as a whole to conduct its 
 operations on a basis of only 4 or 5 per cent reserve." 
 
 IV. COMMERCIAL BANKING AND THE SUPPLY OF 
 LIQUID CAPITAL OR CURRENCY 
 
 Having seen that our commercial banking system, with its 
 slender basis of cash reserves, is ordinarily safe by virtue 
 of the fact that actual specie is seldom called for, and having 
 observed that deposits are mainly created through the process 
 of making loans, we may now indicate briefly some of the 
 larger results of this banking organization. In the analysis 
 that we were making on page 476 above we found that 
 a commercial bank with $100,000 of cash had expanded 
 loans to $300,000, at which point the reserves stood at 33^ 
 per cent. Since in the commercial banking system as a 
 whole the actual specie reserves now amount to only about 
 5 per cent, it is clear that this policy of expanding loans and 
 
 1 See pp. 590-91. 
 
 2 For a good discussion of this subject see H. L. Reed," Credit Expansion 
 under the Federal Reserve System," American Economic Review, VTII 
 (1918), 270-82.
 
 484 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 creating new deposit accounts has developed to a point where 
 there are approximately $2,000,000 of outstanding deposit 
 accounts for every $100,000 of cash reserve. It should be 
 borne in mind in contemplating this phenonomen that no 
 single bank can in this fashion expand its loans and deposits as 
 much as twenty-fold; for the extent to which the individual 
 bank can create deposits is limited by its specific reserve 
 requirements. In the evolution of our commercial banking 
 system, however, with the redepositing of reserves that has 
 been permitted, it has come about that the commercial banks 
 as a whole have expanded the volume of their liquid resources 
 about twenty times. 
 
 It may be said, indeed, that the commercial banking 
 system as a whole gathers together a considerable proportion of 
 the monetary resources of the nation and organizes them in 
 such a way as to expand manyfold the volume of loanable 
 funds. The cash assets of the banks are assembled, as is 
 indicated in the charts on pages 134 and 136, by two principal 
 avenues by ordinary capital contributions in the form of 
 cash and by customers' deposits of specie and lawful paper 
 money. Through the process of making loans and creating 
 deposit accounts, the commercial banking system hi effect 
 multiplies these cash resources by twenty, with a resulting 
 enormous increase in the supply of liquid capital. 
 
 The commercial banking system supplies a very important 
 part of the circulating medium. Emphasis has been placed 
 upon the work of the commercial banking system in expanding 
 the volume of liquid capital or loanable funds. From another 
 point of view this merely means that the commercial banking 
 system has served to give us a vastly increased quantity of 
 currency; it has furnished much the largest portion of present- 
 day circulating media. What now is the significance of this 
 addition to our monetary supply ? 
 
 We have already seen that from the standpoint of ordinary 
 exchange operations the checking system is usually much 
 more convenient than either metallic or paper money. And 
 from the standpoint of economic cost, checks and bank notes
 
 THE COMMERCIAL BANKING SYSTEM 485 
 
 provide very inexpensive substitutes for metallic currency. 
 But by all odds the most significant aspect of deposit currency 
 is the net addition that it constitutes to our total monetary 
 supply. Concretely, in the absence of the commercial banking 
 mechanism, the total currency supply of the United States 
 on February i, 1920, would have been $3,672,069,502. Including 
 bank notes and deposit currency, it was about $29,000,000,000. 
 
 One of the most vital -and controversial questions in eco- 
 nomic literature is the effect of this increase in our monetary 
 supply upon the efficiency of wealth production and upon the 
 level of prices. Has the evolution of this commercial banking 
 currency been attended merely by a rise in the level of prices, 
 with no increase in production, or has the multiplication of the 
 volume of loanable currency that has been effected tended to 
 stimulate production and increase the wealth of nations ? 
 
 Two schools of thought have developed, the one contending 
 that the quantity of money is a matter of entire indifference 
 and that the net result of the creation of deposit currency is 
 merely to change the price-level; the other holding that under 
 certain circumstances an increase hi the supply of deposit 
 currency facilitates productive operations, particularly in 
 connection with the creation of new supplies of capital goods. 
 In this elementary treatise, however, we can go no further than 
 to suggest the problem of the relation of deposit currency to 
 prices; its fuller exposition lies in the field of advanced study. 
 It may be pointed out, however, that those who argue that an 
 increase in the supply of bank currency serves only to raise 
 prices usually conceive of money only as a medium for exchan- 
 ging goods that have already been produced; they regard deposit 
 currency as of use only hi facilitating the flow of goods fron 
 producer to consumer. 
 
 Whatever may be the ultimate price consequences of our 
 evolving commercial banking mechanism, they can be intel- 
 ligently apprehended only when one approaches the study with 
 a clear appreciation of the undoubted fact that the commercial 
 banking system is fundamentally related to the productive no 
 less than to the exchange process, to the raising of fixed no
 
 486 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 less than to the raising of working capital, and to the functioning 
 of other financial institutions no less than to the functioning 
 of business organizations generally. 
 
 V. COMMERCIAL BANKING AND THE GENERAL 
 ECONOMIC ORGANIZATION 
 
 The charts on pages 134 and 136, together with the dis- 
 cussion of the various purposes for which commercial banks 
 extend credit, outlined in chapter xix, indicate the dominant 
 position that the commercial banking system occupies in the 
 entire financial structure. Our financial fabric as a whole is, 
 moreover, so constructed and operated as to concentrate a 
 very large, and a steadily increasing, percentage of our "lawful 
 money" in the vaults of commercial banks rather than in those 
 of other financial agencies. The bond houses, handling billions 
 of dollars' worth of investments annually, require relatively 
 little actual money. Their business is largely that of inter- 
 mediary, and their transactions are nearly always effected on 
 the part of both their customers and themselves by checks on 
 commercial banks. Similarly, the insurance companies require 
 specie or legal tender in almost negligible quantities. Such 
 " funds on hand " as they are required to hold may be kept in the 
 form of a checking account with a commercial bank. The sav- 
 ings banks likewise hold at best very small cash reserves; to be 
 exact, one- tenth of i per cent on the average in 1909 merely 
 till money. Our savings banks also characteristically look 
 to the commercial institutions for accommodation in case of 
 need. Accordingly all these institutions are most intimately 
 related to and dependent upon the successful functioning of 
 the commercial banking system. They are dependent upon 
 the solvency of the commercial banking institutions for the 
 safety of their deposited funds; and they are dependent upon 
 the lending power of the commercial banking institutions 
 for the conduct of their business from day to day. An inade- 
 quacy of commercial banking funds means a direct lessening of 
 the underwriting activities and other operations of investment
 
 THE COMMERCIAL BANKING SYSTEM 487 
 
 bankers; it means an impairment of the ability of the savings 
 institutions and of the insurance companies to meet their 
 financial engagements and obligations. And whenever there is 
 a breakdown of this complicated commercial banking mechan- 
 ism and an attendant collapse of the great superstructure of 
 credit that has been reared upon the attenuated reserves of 
 specie, the entire financial mechanism is thrown completely 
 out of gear. 1 
 
 All business is fundamentally dependent upon the commer- 
 cial banking system. Not only does the commercial banking 
 system constitute the center of the entire financial structure, 
 but it lies as well at the basis of all modern business operations. 
 It is, indeed, the foundation of the whole complex financial 
 and economic organization of modern society. Every business 
 concern, practically speaking, is dependent directly or indirectly 
 upon the commercial banks both for the safety of deposited 
 funds whether in commercial or in savings institutions and 
 also for a continuous supply of borrowed capital. Let it once 
 more be emphasized and let it again be visualized by reference 
 to the chart on page 136 that the operations of the commercial 
 banks are not confined merely to making loans for working 
 capital; through the loans which they make to other financial 
 institutions and through direct loans to corporations for fixed 
 capital purposes, and especially through the purchase of cor- 
 porate securities, real estate mortgages, etc., and through loans 
 on collateral, they are also vitally related to the raising of 
 fixed capital and to the entire investment market. 
 
 Especial emphasis is here placed upon the relation of the 
 commercial banking system to the furnishing of funds for 
 fixed capital purposes, for the reason that practically all banking 
 theory as well as banking legislation is based on the assumption 
 that the function of commercial banks is merely to make loans 
 for short-time commercial purposes that the engaging in 
 investment operations is outside the legitimate field of com- 
 mercial banking and dangerous in its consequences. We shall 
 have something to say in the following chapter on the possible 
 
 1 Financial crises and panics will be considered in the folio wing chapter.
 
 488 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 dangers involved. For the present we may merely emphasize 
 what has already been indicated/ namely the fact that the 
 commercial banking system does furnish a large part of the 
 fimds required for fixed capital purposes and that the in- 
 vestment markets are absolutely dependent upon commer- 
 cial banking. The writer has elsewhere made an analysis 
 of the investment business of national banks; and it appears 
 that approximately 50 per cent of all the loans that are made by 
 national and state banks and trust companies are devoted to 
 investment uses and that when direct investments hi securities 
 are included, in the neighborhood of two-thirds of the credit 
 extended by the commercial' banks goes for fixed rather than 
 for working capital. 3 The exigencies of war finance during the 
 last four years have doubtless considerably Increased these 
 percentages. 
 
 Any failure of the commercial banking system to function 
 normally therefore has its direct effect upon every phase of 
 financial and business activity. There are times when an 
 inadequacy of commercial banking funds acts as a serious 
 limiting factor upon all commercial, industrial, and financial 
 operations; and there are occasions when a collapse of the 
 superstructure of commercial banking credit virtually paralyzes 
 for a considerable period of time the entire economic organi- 
 zation. We shall consider specifically in the next chapter the 
 occasions on which the commercial banking system does fail to 
 accommodate itself to the varying needs of business, while in 
 the chapter on the Federal Reserve System, which follows, 
 we shall discuss the remedies that have been worked out for the 
 elimination of some of the weaknesses that existed under the 
 national banking system prior to 1914. 
 
 'See pp. 401-2 above. 
 
 3 See Journal of Political Economy, XXVI (1918), 638-63.
 
 THE COMMERCIAL BANKING SYSTEM _ 489 
 
 QUESTIONS FOR DISCUSSION 
 
 I. CLEARING-HOUSE RELATIONS 
 
 1. For what various reasons do banks in a given community have to 
 make settlements with each other ? 
 
 2. Why cannot the total amount due to the clearing-house exceed 
 the total amount due from the clearing-house ? 
 
 3. State the advantage in trading some checks directly rather than 
 presenting them through the clearing-house. Why should the 
 figures representing such checks still be sent through the clearings ? 
 
 4. W T hat is the amount of the present daily clearances in New York 
 City ? in Chicago ? (Consult the financial pages of the news- 
 papers.) 
 
 5. What advantages has the clearing-house certificate over cash 
 as a means of settling clearing-house balances ? 
 
 6. What is the advantage of settling clearing-house balances through 
 the Federal Reserve bank rather than by means of clearing-house 
 certificates ? 
 
 7. How can a bank that is not a member of a clearing-house collect 
 items on other banks in the same community ? 
 
 8. It is sometimes said that the "clearings" afford an excellent 
 barometer of business conditions. Why ? Which would be better 
 for this purpose, the New York or the Chicago clearings ? Why ? 
 
 9. Which seems to you to have been the most potent reason for 
 the establishment of the New York Clearing-House, the expense 
 and loss of time in settling balances, or the competitive evils 
 resulting from the fact that balances were settled only weekly? 
 
 10. Do you regard the fixing of uniform interest rates on deposits by 
 clearing-house associations as a justifiable practice ? Does it not 
 smack of monopoly ? 
 
 11. Why have clearing-house banks almost universally failed to 
 make definite agreements as to rates on loans ? 
 
 12. Do you find that there are wide variations in the discount rates 
 of local banks ? (See quotations in the daily press.) 
 
 13. It has been frequently suggested that a committee of bankers 
 should be appointed by the clearing-house to meet every day 
 and determine what the rate of call loans should be for that day, 
 and make this rate binding on all the member banks and the 
 institutions that clear through them. The membership #f this 
 
 . committee under such a system would be changed frequently, 
 say once every month. Would such a plan possess any advan- 
 tages ? Would it not be monopolistic ?
 
 4QO THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 14. Why have many clearing-houses been led to adopt uniform 
 charges on collections ? Why is such a method hard to enforce ? 
 Is it not an attempt to restrain trade ? 
 
 15. Is it your opinion that the banks make a great deal of profit 
 on their collections ? 
 
 1 6. Does the development of these various regulations and agree- 
 ments indicate that there is the same tendency in the banking 
 as in other fields to eliminate ruinous competition? Do you 
 feel that there is grave danger of monopoly here ? 
 
 17. What caused the resort to clearing-house bank examinations? 
 What right has an association of banks to examine the affairs of 
 an individual bank? Would it have any right to examine a 
 non-member bank ? 
 
 1 8. What advantage has a clearing-house examination over a govern- 
 ment examination ? 
 
 19. Do you believe that one can properly say at the present time 
 that our banks are independent, competing institutions, "looking 
 out solely for number one" ? 
 
 H. RELATIONS BETWEEN BANKS IN DIFFERENT CITIES 
 
 20. Enumerate the various occasions for making payments in other 
 towns and cities. 
 
 21. Enumerate as many ways as -possible in which a payment in 
 another city may be made. Do all these ways involve the use 
 of banks, directly or indirectly ? 
 
 22. What is meant by "correspondent" banks? 
 
 23. A in Chicago owes B in Grand Rapids $1,000. Upon the matu- 
 rity of the loan, B places the note with his bank in Grand Rapids 
 for collection. Describe the process. 
 
 24. What kinds of items do correspondent banks collect for each 
 other? Is the service thus rendered to customers of much 
 importance ? State concretely how such items would be collected 
 in the absence of a banking system. 
 
 25. In exchanging advice and information on financial and business 
 affairs, do you think the small-town country banks can be of 
 any particular service to their city correspondents ? 
 
 26. Read through in your library some of the monthly news 
 letters (or magazines) published by such institutions as the 
 National City Bank of New York, the Guarantee Trust Com- 
 pany of New York, the National Bank of the Republic of Chicago, 
 etc., and attempt to estimate the importance of the service thus 
 rendered.
 
 THE COMMERCIAL BANKING SYSTEM 491 
 
 57. For what reasons did the national banking law permit the banks 
 of the smaller cities to deposit a portion of their reserves in the 
 banks of the larger cities ? 
 
 28. Why is there so strong a tendency for funds to concentrate in 
 the financial centers ? 
 
 29. Explain why New York has become the great financial center of 
 the United States. 
 
 30. What advantages ordinarily accrue to the small-town banks 
 from the deposit of both reserve and "excess" funds in the 
 financial centers? What advantages accrue to the banks in 
 the large centers ? 
 
 31. Turn to the financial statements on pages 364 and 365 and 
 explain the items "Due to banks" and "Due from banks." 
 
 32. For what reasons do correspondent banks borrow from each 
 other ? 
 
 33. Turn to the financial statements on pages 364 and 365 and 
 indicate what accounts have arisen as a result of inter-bank 
 borrowing operations. 
 
 m. LOANS, DEPOSITS, AND RESERVES 
 
 34. A bank has $1,000,000 in cash derived from the following sources: 
 (a) shareholders' contributions, (6) deposits of customers, and 
 (c) earnings. If the law requires this, bank to hold a cash reserve 
 of 13 per cent, show how many additional deposits it may create 
 through the process of making loans. 
 
 35. What bearing does the extent to which business men and people 
 generally employ checks in meeting their obligations have upon 
 the volume of bank reserves that is necessary ? 
 
 36. What bearing does the development of the clearing-house asso- 
 ciations have upon the amount of reserve which each bank 
 must hold ? 
 
 37. What bearing does the development of the domestic and foreign 
 exchanges have upon the amount of reserves that banks should 
 hold? 
 
 38. "The more highly organized the banking and credit system 
 becomes, the smaller the cash reserves that are required." 
 Explain this statement. 
 
 39. How do you account for the fact that individual deposits in the 
 national banks as a whole are practically equal in amount to 
 loans and discounts? Are deposits always greater or always 
 less than loans and discounts ? (See the chart on p. 479.)
 
 492 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 40. "A bank cannot earn dividends by keeping the funds of its 
 depositors lying idle in its vaults. The great problem of banking 
 is to find investments which will keep these funds liquid." 
 Is this an accurate statement of the essential problem of a 
 commercial bank ? 
 
 41. Would you say that a bank makes loans out of its reserves, or 
 on the basis of its reserves ? 
 
 42. State in your own words the purpose of a cash reserve, differ- 
 entiating between ultimate and "till money" reserves. 
 
 43. What determines the amount of "till money" that is required 
 by a bank ? 
 
 44. "The more highly organized the banking system becomes, the 
 smaller the reserves that are required." Why? 
 
 45. Turn to the table on page 521 and ascertain the reserve ratio 
 in the national banks as a whole during the years there in ques- 
 tion. How do you explain the fact that they are much below 
 the minimum reserve requirements for the different classes of 
 banks ? ' 
 
 IV. THE COMMERCIAL BANKING SYSTEM AND THE SUPPLY OF 
 LIQUID CAPITAL 
 
 46. Turn to the chart on page 136 and indicate in what ways the 
 commercial banking system supports the other financial insti- 
 tutions which make up the financial structure of society. Indi- 
 cate the probable effects upon each of these institutions of a 
 failure of the commercial banking system to function in its 
 customary way. 
 
 47. Show in what ways commercial banking is related to the invest- 
 ment or fixed-capital aspect of business enterprise. Without 
 the commercial banking system, would it be possible for cor- 
 porations to raise the volume of funds required for their opera- 
 tions? 
 
 48. "The outstanding feature of the commercial banking system is 
 the ability to gather together a large portion of the monetary 
 reserves of the nation and organize them- in such a way as to 
 multiply many times the volume of loanable funds. " Of what 
 significance is this fact ? 
 
 4Q. Make a tentative statement of your views as to the probable 
 relationship of the increased supply of currency that is created by 
 the commercial banking system to the level of prices. State 
 also what doubts or questions in connection with this problem 
 occur to you.
 
 THE COMMERCIAL BANKING SYSTEM 493 
 
 REFERENCES FOR FURTHER STUDY 
 
 Agger, Eugene E. : Organized Banking, chap. vi. 
 
 Davenport, H. J.: The Economics of Enterprise, pp. 259-65. 
 
 Dunbar, Charles F.: Chapters in the History and Theory of 
 Banking, 3d edition, revised and enlarged by O. M. W. Sprague, 
 chaps, iv and vii. 
 
 Fisher, Irving: The Purchasing Power of Money, pp. 33-47. 
 
 Holdsworth, John Thorn: Money and Banking, chap. xiv. 
 
 Moulton, Harold G. : Principles of Money and Banking, Part II, 
 pp. 94-123- 
 
 Phillips, Chester A.: Readings in Money and Banking, chap. xix. 
 
 Scott, William A.: Money and Banking, pp. 116-21. 
 
 White, Horace: Money and Banking, Book III, chap. iii.
 
 CHAPTER XXIII 
 
 COMMERCIAL BANKING AND THE EBB AND 
 FLOW OF BUSINESS 
 
 In the chapters immediately preceding we have endeavored 
 to reveal the nature of commercial banking operations and the 
 general significance of the commercial banking system that 
 has been gradually evolved. In all this discussion business 
 conditions have been taken for granted; and the reader may 
 well have assumed that the demands which business enterprises 
 make upon the commercial banking system for fixed and work- 
 ing capital are constant in amount, except of course insofar 
 as there is a gradual expansion in the volume of business and 
 hence in the volume of funds required for its conduct. The 
 truth is, however, that business is never stable and the demand 
 for liquid capital is accordingly ever fluctuating. As one 
 writer so well puts it: "In the real world of business, affairs 
 are always undergoing a cumulative change, always passing 
 through some phase of a business cycle into some other phase. 
 .... In fact, if not in theory, a state of change in business 
 conditions is the only normal state. " x 
 
 There are two species of fluctuations in business activity, 
 the one seasonal and the other cyclical. In this chapter we 
 shall consider the relations of the commercial banking system 
 to the varying needs of business as determined both by seasonal 
 exigencies and by the phenomena of the larger cycles in the, 
 ebb and flow of industrial activity. We shall endeavor to 
 ascertain the nature of the demands that are placed upon our 
 banking institutions in the alternate periods of seasonal activity 
 and dulness, prosperity and depression, and the efficiency with 
 which these varying demands are fulfilled. So far as the 
 banking phase of the problem is concerned, we shall in 
 
 1 Wesley C. Mitchell, Business Cycles, p. 86. 
 
 494
 
 COMMERCIAL BANKING AND BUSINESS CYCLES 495 
 
 the present chapter consider the situation as it existed before 
 the establishment of the Federal Reserve System; for only by 
 disclosing the weaknesses in our baMing organization before 
 1914 shall we be in a position to understand the purpose of the 
 Federal Reserve System and to appraise its adaptability to the 
 onerous requirements that are placed upon it. 
 
 I. 
 
 Within the course of a given year there are normally numer- 
 ous ups and downs in business and trade and an accompany- 
 ing tension and ease in the demand for loanable funds. The 
 best means of indicating the nature and the causes of these 
 seasonal fluctuations is to outline briefly the actual variations 
 in the demand for funds that occur in some of our leading 
 financial centers. These will be found to reflect pretty 
 accurately the fluctuations of business as a whole. 
 
 The fluctuations in the demand for funds in the New York 
 and Chicago money markets, which move very closely together, 
 will best serve our purpose. In these markets there are nor- 
 mally five distinct seasonal movements, as follows: (i) from 
 early January until the middle of February; (2) from the 
 middle of February to the early part of April; (3) from the 
 early part of April to about August first; (4) from August first 
 to about October first; (5) from October first to the end of 
 the year. 
 
 The first movement is characterized by a slack demand for 
 funds and by correspondingly low interest rates. This is 
 attributable to the fact that the crop movement with its great 
 demand for money in the West and South is past and has been 
 followed by a heavy flow of cash from the country banks to 
 the primary money markets. At the same time the demand 
 for funds is relatively slight partly because of a natural 
 relaxation after the holiday season and the meeting of the large 
 interest and principal payments on corporate securities that 
 occurs on January i. Business in general is characteristically
 
 #6 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 dull for an interval following the taking of annual inventories 
 and pending the opening of the spring manufacturing and 
 trading season. 
 
 The second seasonal movement, which is marked by a 
 substantial increase in the demand for funds and by rising 
 interest rates, is largely attributable to the monetary require- 
 ments of producers and manufacturers in preparation for the 
 spring trade. This demand is supplemented, particularly in 
 the latter part of the period, by the requirements of the agri- 
 cultural regions in the South and Southwest, incident to the 
 planting of crops. There are also temporary influences at work, 
 such as the settlement of farm loan obligations on the first of 
 March and the quarterly dividend and interest payments on 
 the first of April. 
 
 The third important seasonal variation shows a weakening 
 money market in April and May and a genuine depression in 
 June and July. There is, however a temporary increase in 
 the demand for funds about the first of July incident to the 
 large semiannual interest and dividend payments. This third 
 period at its beginning reflects the declining demand for funds 
 by the manufacturing and producing interests of the industrial 
 centers; and in its later stages it reflects, also, the general 
 plethora of currency that exists after crops have been planted 
 and there has been a return of cash to Chicago and New York 
 from the country districts. 
 
 The fourth season is generally referred to as the "crop- 
 moving" period. The demand for funds in the country dis- 
 tricts for the paying of farm labor, the storing of grain, and the 
 moving of produce to the primary markets calls for an extensive 
 outflow of funds from the financial centers to the interior. 
 At the same time the demand from producing and manu- 
 facturing enterprise, which is making ready for the fall trade, 
 is very heavy in the industrial centers, thus bringing added 
 pressure to bear on the New York and Chicago money markets. 
 
 The fifth and last seasonal period is less marked than any 
 of the others. In brief, it may be said that it begins with a 
 slight easing in the demand for funds, owing to the completion
 
 COMMERCIAL BANKING AND BUSINESS CYCLES 497 
 
 of the fall manufacturing business and to the gradual passage 
 of agricultural produce from producers to ultimate consumers. 
 The date at which this easing of demand begins varies somewhat 
 with climatic conditions in the different years, and also with 
 the adequacy of transportation facilities. Typically speaking, 
 however, it may be said that the peak of demand is reached 
 about the first of October, that the western movement of cash 
 falls off rapidly in November, and that by December a return 
 flow of funds to the industrial centers has usually begun. Other 
 factors bearing on the situation at this period are the normally , 
 low gold imports during December and the making of large 
 deposits by the federal Treasury in the national banks of 
 New York and Chicago during the months of October, Novem- 
 ber, and December. A stiffening demand for funds is to be 
 noted after the middle of December, owing to the currency 
 requirements of the holiday season and the payments of interest 
 and principal on corporate and other indebtedness on the 
 first of January. On the whole this last period is one of high 
 interest rates and relatively tight money. Neither a distinctly 
 upward nor a distinctly downward movement, it is rather a 
 transitional period between the excessive demands of the 
 crop-moving period and the season of mid-winter dulness. 
 
 Seasonal movements in St. Louis, New Orleans, San Fran- 
 cisco, and other centers differ only in time and in extent from 
 those in New York and Chicago, the variations being attrib- 
 utable to differences in climatic and other local conditions. 1 
 
 The chart on page 498 shows the monthly variations in 
 reserves and in the ratio of reserves to deposits in the New York 
 clearing-house banks between 1890 and 1908. It will be 
 observed that reserves increase in every period of slack 
 demand for loans and decrease in every period of active 
 demand. The changes in the ratio of reserves to deposits 
 are accompanied by changes in the rates of interest on loans. 
 
 Our currency supply has not been sufficiently elastic. The 
 seasonal variations in the demand for funds in the primary 
 
 1 See E. W. Kemmerer, Seasonal Variations in the Relative Demand for 
 Money and Capital in the United States. (National Monetary Commission, 
 1910.)
 
 4Q8 
 
 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 markets require a certain amount of elasticity in the currency 
 supply. To some extent such elasticity has been obtained by 
 a process of shifting funds from one section of the country to 
 another. As noted in chapter xxi, this is in considerable 
 measure accomplished through the intermediation of commercial 
 paper houses. But in periods of very active demand for money, 
 particularly during the crop-moving season, which coincides 
 with the period of producing and manufacturing goods for the 
 
 RESERVES AND RATIOS OF RESERVES TO DEPOSITS OF THE NEW YORK 
 CITY CLEARING-HOUSE BANKS, 1890-1908 
 
 10 15 20 30 3S 40 <i 50 
 
 | FA. | Mr | Apr. | May | June | July | Aug | Sept | Oct. | Nov. | Pec 
 
 Months 
 
 Weeks 
 
 Munths 
 
 autumn and winter trade, the total supply of currency within 
 the country must be substantially larger than at other times 
 if the needs of business and trade are to be adequately met. 
 Accordingly, we should be able to expand the total volume of 
 currency as occasion demands. Similarly, it is regarded as 
 important that when these great seasonal demands have passed 
 we should be able to contract the volume of currency. What 
 now can be said of the elasticity of our currency supply ? 
 
 The chart on page 499 shows the average amount of gold 
 coin and gold certificates, national bank notes, deposit currency
 
 COMMERCIAL BANKING AND BUSINESS CYCLES 499 
 
 SEASONAL VARIATIONS OP VARIOUS KINDS OF MONEY AND OF DEPOSITS 
 IN THE UNITED STATES, 1890-1908 
 
 Avetage Amounts of Total Mone> 
 Average Amounts of Gear ings 
 
 Months 4 
 
 p Months 
 
 as reflected in average clearings, and total money in the 
 United States between 1897 and 1908. It will be seen that 
 the gold supply does not increase or decrease in accordance 
 with trade needs, the total supply depending upon: (i) bullion 
 deposits at the United States mints and assay offices (dependent
 
 500 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 upon gold production); (2) net imports and exports of gold 
 in the settlement of foreign balances; and (3) receipts and 
 disbursements of the United States Treasury. The general 
 upward movement of the gold line reflects the cumulative 
 supply of this metal. 
 
 The national bank note circulation is also very inelastic. 
 The chart shows that the total supply gradually increases 
 throughout each year ; and that the fluctuations during the year 
 do not coincide on the whole with the varying requirements 
 of trade. The chief exception to this is to be noted in the 
 autumn of the year, when there is typically a substantial 
 increase. Kemmerer explains this by saying, "Apparently 
 banks intending to increase their circulation postpone doing so 
 until the crop-moving season approaches. There is no evidence 
 of contraction, however, when the crop-moving demands are 
 over the national bank note elasticity being (to use a rather 
 inelegant expression) of the chewing gum variety. " 
 
 The reason for the inelasticity of bank note currency is 
 not difficult to find. As already explained, bank notes can be 
 issued only when secured by United States government bonds. 
 In the years under consideration the total supply of United 
 States bonds available for use in this connection was about 
 nine hundred millions and in the latter years of this period the 
 total number thus being used was in the neighborhood of 
 seven hundred millions. A restricted supply of United States 
 government bonds would therefore at best prevent any very 
 large increase in the total of bond secured currency. Of the 
 total outstanding bonds not already serving as security for 
 note issues, many were 'not in the market for sale and hence 
 not available to the banks in case of need. This restricted 
 supply of government bonds, moreover, tended to increase 
 their price when demand for them was active and thereby to 
 reduce the profits of the banks in thus employing their funds. 
 Finally, because of the red tape involved in the issue of these 
 notes, it required about three weeks for a bank located hi the 
 interior of the country to put them into circulation. After 
 the bonds were purchased, it was necessary to send them to
 
 COMMERCIAL BANKING AND BUSINESS CYCLES 501 
 
 the federal Treasury at Washington where the notes were 
 printed, bearing the name of the bank which was to issue them. 
 The notes were then sent to the bank for the signatures of the 
 officers, after which they could be put into the channels of cir- 
 culation. While this time element did not prevent the banks 
 from making preparation for autumn monetary requirements, 
 it nevertheless did prevent a very effective use of bank notes 
 in cases of sudden emergency. 
 
 The heavy black line at the bottom of the chart, showing 
 the total currency supply by months during the years hi ques- 
 tion, also ' indicates no appreciable seasonal elasticity. Tht 
 reasons why the other forms of currency besides gold and 
 national bank notes do not possess the necessary elasticity 
 may be recalled from the discussion in chapters vi and vii above. 
 
 Deposit currency alone exhibits a high degree of seasonal 
 elasticity. The line showing the average amount of clearings 
 indicates a close adjustment of the supply of deposit currency 
 to the varying requirements of trade. It expands when trade 
 needs increase and declines when trade needs decline. An 
 illustration of the way in which deposit currency gets into the 
 channels of circulation and is in turn retired will serve to indicate 
 its automatically elastic. nature. 
 
 Let us assume that X, a dealer in grain, has bought 10,000 
 bushels of wheat which is stored in warehouses, awaiting move- 
 ment to the primary grain markets. X borrows, say, $9,000 
 from the bank, giving his promissory note with the warehouse 
 receipt as collateral. Thus the security back of the deposit 
 currency that arises out of this loan is the identical wheat, the 
 necessity for the marketing of which gave rise to the increased 
 demand for currency. The needs of trade at once call forth 
 and provide the security for the currency which is created. 
 As the grain is sold, X receives funds which he places on deposit 
 with his bank ; and when the loan matures he pays it off (usually 
 and in the main) by a check against his account made payable 
 to the bank. Thus when the produce has been marketed and 
 the loan paid off, the deposit currency is automatically reduced 
 by the amount of the loan.
 
 502 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 While deposit currency thus readily responds to the varying 
 requirements of trade, there is a limit to which it can 
 be expanded, a limit imposed by the reserve requirements. 
 The chart on page 498 indicates that in the autumn season 
 bank reserves were always down almost to the minimum per- 
 mitted by law. We shall shortly see that in periods of acute 
 financial crisis inadequate reserves have on many occasions 
 prevented any further expansion of bank loans and deposit 
 currency. Ideally elastic within limits, there is neverthe- 
 less a point at which the expansibility of deposit currency 
 ceases. 
 
 Business failures are most numerous in times of seasonal 
 monetary stringency. It is of interest to note that the money 
 markets of the autumn period are normally attended by a 
 relatively large number of business failures. "As the fall 
 approaches and the money market hardens in response to 
 crop-moving demands, as interest rates rise, bank reserves 
 decline, and loans are curtailed as reserves tend to decline 
 and increased margins are called for, th^ strain on the weakest 
 business concerns is liable to become more tense. While of 
 course it would be rash to say that the tightened money market 
 in the fall is the cause of the larger number of failures at this 
 period, it seems reasonable to expect that the strained money 
 market at this, time would tend to push over many concerns 
 which were already near the verge of failure. I know of no 
 other explanation of the large number of failures during October 
 and November." 1 
 
 The federal Treasury has borne an interesting relation to the 
 money market. The supply of funds for the needs of business is 
 affected to some extent by the flow of specie to and from the 
 federal Treasury. The Treasury Department normally receives 
 funds largely from taxes. Some of the sources of taxation 
 provide a fairly regular flow of income, but others a very 
 irregular one. Similarly, some of the government's disburse- 
 ments constitute a fairly regular outflow, while others are 
 
 1 E. W. Kemmerer, op. cil., p. 222.
 
 COMMERCIAL BANKING AND BUSINESS CYCLES 503 
 
 intermittent. Accordingly, there are times when the supply 
 of funds in the Treasury is large, and there are times when it is 
 small. There have been occasions, also, when, owing to the 
 lack of a government budget, the total receipts have been 
 considerably in excess of total disbursements. In consequence, 
 the disposition of government funds has always been a prob- 
 lem of no little importance. There follows a brief summary of 
 the historical relations between the United States Treasury 
 and the banks of the country: 
 
 1. From 1789 to 1796 the federal funds were mainly left 
 in the hands of the collecting and disbursing officers, for the 
 reason that there was no specific place for the custody of public 
 money. 
 
 2. Between 1796 and 1811 public funds were kept mainly 
 in the First Bank of the United States, which was the fiscal 
 agent of the United States government. 
 
 3. Between 1811 and 1816, when the Second Bank of the 
 United States was chartered, Treasury funds were kept mainly 
 in state banks. 
 
 4. Between 1816 and 1833 the Second Bank of the United 
 States was employed, although the state banks were still used 
 to some extent. 
 
 5. Between 1833 and 1846 state banks were exclusively 
 used. Charges of favoritism in the selection of state banks 
 and the growing opposition to close relations between the 
 banks and the Treasury led to the adoption of the "inde- 
 pendent" Treasury in 1846. 
 
 6. From 1846 to 1863 public money was kept entirely in 
 the federal Treasury and the nine sub-treasuries which were 
 located in the larger financial centers of the country. 
 
 7. With the establishment of the national banking system 
 in 1863 the Secretary of the Treasury was authorized to select 
 certain national banks as depositary institutions for public 
 money. For a time these banks were required to keep a special 
 reserve against Treasury funds, although this practice was 
 finally abandoned. Under the national banking system the 
 amount of public money deposited with the banks steadily
 
 504 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 increased in volume until at times there was only a very small 
 working balance in the Treasury. 1 
 
 The Treasury has sometimes endeavored to relieve seasonal 
 stringency. The seasonal strain upon bank reserves became so 
 great hi the early autumn of 1912 that Secretary McVeagh 
 developed a plan for relieving, as far as possible, the strain 
 upon the national banks. The plan consisted of placing 
 Treasury funds in banks in advance of any importation of 
 gold that might be arranged for; such funds to be available as 
 reserve money for the banks just as soon as arrangements had 
 been completed for the import of specie. By making it possible 
 for the banks to have the immediate use of such funds, the 
 importation of specie was encouraged. 
 
 A still better plan was elaborated in the autumn of 1913. 
 To quote the words of the Secretary of the Treasury: "Toward 
 the latter part of July symptoms of uneasiness began to appear. 
 There was much talk about the difficulty of moving the fall 
 crops, and the annual apprehension on this score began to 
 
 stalk about the country with more than usual vigor 
 
 Conditions were again becoming acute when the Secretary 
 determined to deposit from twenty-five to fifty millions of 
 dollars of government funds hi the national banks in those 
 parts of the country where the necessity for funds to move 
 crops existed." These deposits were made on three different 
 sorts of securities: (i) United States bonds at par (at least 10 
 per cent were required to be so secured); (2) miscellaneous 
 bonds approved by the Secretary, at 75 per cent of their market 
 value; (3) approved prime commercial or business paper 
 indorsed by the bank, at 65 per cent of its face value (raised in 
 1914 to 75 per cent). 
 
 In the year 1913 a total of $37,386,000 was deposited in 
 the banks of the cotton-growing states. The somewhat smaller 
 amount deposited in 1914 is to be explained, in the main, by 
 the issue of emergency currency at the outbreak of the European 
 war, a considerable portion of which went directly or indirectly 
 into the agricultural states. 
 
 1 For the relation of the Treasury to the banks since the establishment 
 of the Federal Reserve System, see pp. 614-16.
 
 COMMERCIAL BANKING AND BUSINESS CYCLES 505 
 
 Treasury aid in meeting seasonal demands for currency is, 
 however, confessedly a poor expedient. It does not give the 
 requisite expansibility in the total quantity of funds; there is 
 never any assurance that the Treasury will have on hand funds 
 of sufficient volume to fill the hiatus in the supply of bank 
 currency. 
 
 II. 
 
 The ebb and flow of business activity that characterizes 
 the business cycle may most easily be shown by reference to 
 the financial history of the United States. There follows a 
 summary statement of the cycles in American financial history. 
 The brief accompanying comments are not to be regarded as 
 explanations of the phenomena in question. 1 They are intended 
 merely to recount the outstanding features in the ebb and 
 flow of business activity. 
 
 While there were some early disturbances of importance, 
 it is generally stated that the first panic in the United States 
 occurred in August, 1814. It was a direct result of the capture 
 of Washington by the British, though the disruption of trade 
 and the exigencies of war finance were contributing factors. 
 This panic, however, was not the outgrowth of ordinary com- 
 mercial and financial conditions; it was special in its nature. 
 
 The first genuine crisis in the United States occurred in 
 1819.* It may be superficially stated that it was an outgrowth 
 of the abnormal expansion of manufacturing industries occa- 
 sioned by the embargo and the War of 1812, and by the neces- 
 sary readjustments that follow a period of paper currency. 
 Not until late in 1821 did commerce and industry begin to 
 revive. 
 
 There followed a period of great prosperity and rapid 
 territorial and business expansion, which continued with but 
 slight interruptions until 1837. In 1824 there was an industrial 
 boom, and in 1826 there was a reaction, due, in part, to the 
 
 1 For an analysis of the causes of business cycles see pp. 512-18. 
 
 a The first in American history was the one which occurred during the 
 Confederation period, in 1786.
 
 So6 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 European crisis of December, 1825; but these were merely 
 temporary deviations from an otherwise fairly continuous 
 expansion. 
 
 The crisis culminating in the disastrous panic of May, 1837, 
 is associated with an undue extension of banking and credit, 
 an over-provision of public roads, canals, and railways, and 
 excessive speculation in western lands. Recovery from the 
 panic was very slow; indeed, it was more than a year before 
 the banks resumed specie payments. A period of depression 
 followed until the summer of 1843, a premature revival in 
 1838 and 1839 resulting in a multitude of failures. 
 
 A general revival of trade began in the autumn of 1843 and 
 continued without much interruption until 1857. The Euro- 
 pean crisis of 1847 exercised little influence here, owing to good 
 crops and heavy exportations. There was, however, a minor 
 crisis in 1848, occasioned in the main by the Mexican War. 
 The period of rapid expansion came to a head in the very 
 sudden and sharp crisis of August, 1857. While the financial 
 disturbance appears to have been more acute than in 1837, 
 industry and commerce were much less seriously affected, and in 
 consequence the succeeding period of depression was less 
 universal in its effects. The depression reached its worst phase 
 in 1859. Conditions were rapidly on the mend in 1860, but the 
 outbreak of war in 1861 so disarranged the financial and indus- 
 trial affairs of the nation that the return of prosperity was 
 postponed for a half-dozen years. There was a great crisis in 
 England in 1866 which the war, no doubt, enabled us to escape. 
 
 Following the Civil War we entered upon a new era of 
 industrial expansion. Wide areas of agricultural lands were 
 opened up, immigration was heavy, railroads were built on a 
 scale hitherto undreamed of built far ahead of settlements 
 and the demands of trade. It was a period also of wild specu- 
 lation, dishonesty, and extravagance. The great crisis of 1873 
 affected practically every operation of commerce and finance, 
 and shook the credit structure to its very foundations. The 
 succeeding depression was unprecedented in severity and 
 duration, continuing in most branches of industry until the
 
 COMMERCIAL BANKING AND BUSINESS CYCLES 507 
 
 end of 1878, and in some lines until 1879. The largest number 
 of failures occurred in the year 1878. 
 
 Prosperity returned with bountiful harvests and the resump- 
 tion of specie payments hi 1879. A period of world- wide 
 prosperity was marked in the United States by another era of 
 enormous railroad building, industrial expansion, and extrava- 
 gant living, which ended in the minor crisis of May, 1884. The 
 downward movement continued until 1886; after the recovery 
 there was a season of moderate activity until 1890. The 
 great crisis in Europe, attending the failure of the famous 
 English banking house of Baring Brothers, near the end of the 
 year 1890, was felt acutely in the United States, though we 
 escaped a complete breakdown, the enormous crops and heavy 
 exports of 1891 tiding us over the threatening situation for 
 another year or two. But in May, 1893, we again went to the 
 wall with a panic which in many respects was even more severe 
 than that of 1873. This crisis, however, was complicated by 
 the unstable monetary standard of the time; and by many 
 it has been called a monetary rather than a financial crisis. 
 It was doubtless a result of combined influences. The depres- 
 sion continued until 1896. 
 
 Along with the entire commercial world, in 1897 we entered 
 upon another great period of expansion, which was accelerated 
 after the Spanish War. It continued with but minor reactions 
 until the autumn of 1907. The crisis which ended in the 
 panic of October, 1907, was accompanied by all the usual 
 manifestations of such periods, and the depression which 
 followed continued for more than a year. The succeeding years 
 were marked by business and banking uncertainty, consequent 
 upon extensive legislative experiments, Mexican troubles, and 
 the European war. The outbreak of war in Europe occasioned 
 a severe financial crisis and near-panic hi the United States, 
 fortunately tided ove- successfully by the use of emergency 
 currency. Beginning with the autumn of 1915 we again 
 entered upon a period of great business expansion, superinduced 
 by European demands for American goods. 1 
 
 1 For a consideration of the subsequent history of this boom see chap, 
 xxviii.
 
 508 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 The panic stage of the cycle has attracted most attention. 
 Of the various stages which comprise the complete round of 
 the business cycle, the panic stage which is marked by the 
 breakdown of the financial mechanism and the suspension of 
 specie payments has of course attracted the greatest attention. 
 Indeed, until comparatively recent times panics have been 
 treated by many writers as more or less independent phenomena, 
 rather than as merely the culmination of a series of economic 
 and financial developments than as but a single stage in a 
 general process. Thus they are often referred to as sudden 
 earthquakes or volcanic eruptions which appear when least 
 expected and profoundly disrupt the normal economic structure. 
 It is not surprising, perhaps, that writers should have stressed 
 the phenomenon of the panic to the exclusion of other phases of 
 the business cycle, for the outstanding features attending the 
 financial panic are sensational in a high degree, and its social 
 consequences are appalling. 
 
 In brief, a financial panic involves a practically complete 
 breakdown of the delicate credit structure on which virtually 
 the entire economic organization has been erected. On the 
 business and commercial side, confidence, which lies at the 
 basis of all lending or credit operations, is temporarily shattered ; 
 and on the banking side, the slender margin of specie reserves, 
 on which has been reared the huge superstructure of deposit 
 currency, fails to perform its function, with the result that the 
 credit system breaks down and deposits are no longer redeemable 
 in specie. And to make the immediate situation worse, the 
 banks refuse to part with any specie ; all of them are temporarily 
 insolvent. The result is a currency famine for the ordinary 
 needs of trade, a famine which can only in part be overcome 
 by a resort to substitute means of payment in the form of 
 clearing-house loan certificates, etc. 1 
 
 The credit and business structure is extremely delicate. The 
 evolution of our credit system has resulted in a very close 
 interdependency within the different divisions of industry and in 
 the industrial system as a whole. For instance, producers of 
 
 'See pp. 537-39.
 
 COMMERCIAL BANKING AND BUSINESS CYCLES 509 
 
 raw materials sell goods on credit to manufacturers; manu- 
 facturers sell goods on credit to wholesalers and jobbers; and 
 these in turn sell goods on credit to the retailers, who in their 
 turn characteristically sell on open or charge accounts to the 
 ultimate consumers. Nor is it merely the different steps in 
 the productive and distributive process within a given industry 
 that are closely related; the different divisions of industry are 
 all interdependent. For example, a decline in the demand for 
 automobiles is shortly manifested in a reduced demand for 
 steel, and for rubber and cotton used in making tires; while 
 the laying off of workmen all along the line results in a slackening 
 demand for the products of every industry. And as we have 
 seen in preceding chapters, practically all of these various 
 business concerns are in turn dependent upon the banks for 
 at least a portion of the funds which they require. In con- 
 sequence a breakdown of the complicated credit structure at any 
 point involves a wholesale wreckage of established relationships. 
 The failure of A to pay B makes it impossible for B to pay C, for 
 C to pay D, for D to pay E, etc. Just as an entire row of 
 dominoes is toppled down by tipping over the one at the 
 beginning of the row, so also when credit relations are disrupted 
 the whole chain of business establishments is involved in 
 eommon loss or failure. 
 
 One of the outstanding features of the financial crisis, 
 therefore, is wholesale failures of business concerns, many of 
 which are forced into insolvency only because of their depen- 
 dency upon other institutions which are unfortunately caught in 
 the financial vortex. In the case of a major collapse literally 
 thousands of business concerns, some of them of the highest 
 standing, are involved in ruin. Many large financial institutions 
 are among them, although it should be noted that the temporary 
 insolvency of the banks, of which we have spoken, does not 
 usually denote a permanent inability to pay depositors in full. 
 After a period of liquidation has elapsed, the great majority of 
 banks are enabled to resume their normal operations. 
 
 The period of depression involves enormous economic losses. 
 Less striking, perhaps, but of greater social import, is the
 
 510 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 grave business depression that follows in the wake of a financial 
 panic, involving an enormous volume of unemployment and 
 acute suffering for millions of people. We may conceive of 
 industrial society as a huge complex machine engaged in the 
 process of turning out commodities and services in the form of 
 necessities, conveniences, and luxuries. At the height of the 
 period of business prosperity this vast industrial machine 
 may be regarded as running at maximum capacity, with virtu- 
 ally all of the industrial equipment and all of the labor-power 
 of the nation fully employed and with returns in the form of 
 profits and wages at a maximum level. Immediately following 
 a panic, on the other hand, this machine is thrown completely 
 out of gear. It is able to run, often for a period of several years, 
 at from perhaps 50 to 60 per cent capacity, with business 
 profits at a minimum; with wages at a low level; and with 
 attendant suffering and misery for the unemployed millions. 
 The results of a panic may be indicated by the following 
 statement of conditions that prevailed in 1908, shortly after 
 the panic of October, 1907. For the first two weeks of January, 
 1908, gross earnings of the railroads were about 13 per cent 
 less than in 1907. Where in September, 1907, there were not 
 enough railroad cars with which to .move the traffic of the 
 country, there were approximately 320,000 freight cars and 
 8,000 locomotives standing idle, representing an investment of 
 more than $400,000,000; and there were also more than 30,000 
 unemployed trainmen. The net earnings of the United States 
 Steel Corporation declined from $17,052,211 in October, to 
 $10,467,253 in November, and to $5,034,531 in December a 
 decline of over 70 per cent. The Bradstreet commercial agency 
 report informs us that "it is safe to say that estimates of 
 shrinkages of 30 to 50 per cent in sales and general turnover 
 are not unreasonable. Iron output will probably be 50 per 
 cent below a year ago. Shoe shipments are about 30 per 
 cent below January, 1907. Lumber and all kinds of build- 
 ing material are very quiet the country over. There are 
 widespread reports of unemployment in all sections of the 
 country. "
 
 COMMERCIAL BANKING AND BUSINESS CYCLES 511 
 
 There have been numerous explanations of these financial 
 cataclysms. The phenomenon of financial crises, or panics, 
 arose with the development of the modern credit and banking 
 structure of society. And since this credit society of ours is 
 now nearly two centuries old, 1 there has naturally been a 
 great deal of discussion on the subject of financial panics. 
 This is not the place to enter upon an analysis of the many 
 causes that have been suggested. It is sufficient to note that 
 the periodicity of panics early attracted attention, and this 
 naturally led to a study of the influences that might account 
 for their more or less regular recurrence. One of the most 
 interesting of the explanations of the phenomenon is the famous 
 sun-spot theory, elaborated by Professor Jevons, who gained a 
 reputation both as an astronomer and as an economist. At 
 first blush the sun-spot explanation of panics appears extremely 
 far-fetched. Jevons reasoned, however, that changes in indus- 
 trial activity are a reflection of changes in weather conditions, 
 the argument being that a poor crop year would result in a 
 lessened demand for commodities at the retail stores in all the 
 rural communities and this in turn would be reflected throughout 
 the entire industrial system in declining demand and consequent 
 industrial stagnation leading to business failures and financial 
 collapse. The sun-spots were invoked as an explanation of 
 the periodicity of weather conditions, the idea being that the 
 appearance of sun-spots was reflected in untoward weather. 
 This theory, however, has been entirely discredited by virtue 
 of the fact that there is no close correlation between observed 
 sun-spots and weather conditions. 
 
 The most comprehensive study of the problem, however, is 
 that made by Professor Mitchell and published in 1910 in a 
 large quarto volume entitled Business Cycles. In evolving 
 his theory of business cycles Professor Mitchell first made a 
 statistical study of all of the financial, commercial, and economic 
 data bearing on the ebb and flow of business activity in the 
 
 1 Historians, however, record similar phenomena in connection with 
 the credit and banking organization of early Italian cities and of certain of 
 the commercial nations of antiquity.
 
 512 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 four greatest commercial and credit nations of the world during 
 four complete cycles, from 1873 through 1907. On the basis 
 of his study of the concrete facts of the situation, Professor 
 Mitchell has worked out a statement of the rhythm of business 
 activity, which shifts the emphasis from a study of the financial 
 panic, which is but one phase of the business cycle, to a study 
 of the cycle as a whole with its various phases of depression, 
 prosperity, crisis, and panic; and he shows conclusively, in my 
 judgment, that our modern industrial and financial system is 
 controlled by forces which are always at work to produce change, 
 sometimes gradually, sometimes abruptly, but always cumu- 
 lative change change, however, which moves with a certain 
 precision, and which gradually passes from one rather clearly 
 defined stage to another. 1 We cannot do better than to give 
 at this place Mitchell's own summary statement of the rhythm 
 of business activity. 2 
 
 With whatever phase of the business cycle analysis begins, it 
 must take for granted the conditions brought about by the preceding 
 phase, postponing explanation of these assumptions until it has 
 worked around the cycle and come again to its starting-point. 
 
 A revival of activity, then, starts with a legacy from depression: 
 a level of prices low in comparison with the prices of prosperity, 
 drastic reductions in the costs of doing business, narrow margins of 
 profit, liberal bank reserves, a conservative policy in capitalizing 
 business enterprises and in granting credits, moderate stocks of 
 goods, and cautious buying. 
 
 Such conditions are accompanied by an expansion in the physical 
 volume of trade. Though slow at first, this expansion is cumulative. 
 In time an increase in the amount of business which grows more 
 rapid as it proceeds will turn dulness into activity. Left to itself 
 this transformation is effected by slow degrees; but it is often hastened 
 by some propitious event, such as exceptionally profitable harvests 
 or heavy purchases of supplies by the government. 
 
 1 A more recent statistical study of the phenomena of business cycles 
 is that made by Professor Warren M. Persons. See reference at end of this 
 chapter. 
 
 2 Wesley C. Mitchell, Business Cycles, pp. 571-79. (Copyright by 
 the author, 1913. Published by the University of California Press.)
 
 COMMERCIAL BANKING AND BUSINESS CYCLES 513 
 
 A partial revival of industry soon spreads to all parts of the 
 business field. For the active enterprises must buy materials and 
 current supplies from other enterprises, the latter from still others, 
 etc. Meanwhile all enterprises which become busier employ more 
 labor, use more borrowed money, and make higher profits. There 
 results an increase in family incomes and an expansion of consumers, 
 demands, which likewise spreads out in ever-widening circles. Shop- 
 keepers pass on larger orders to wholesale merchants, manufacturers, 
 importers, and producers of raw materials. All these enterprises 
 increase the sums they pay to employees, lenders, and proprietors. 
 In tune the expansion of orders reaches back to the enterprises from 
 which the initial impetus was received, and then the whole compli- 
 cated series of reactions begins afresh at a higher pitch of intensity. 
 All this while the revival of activity is instilling a feeling of optimism 
 among business men. 
 
 The cumulative expansion of the physical volume of trade stops 
 the fall in prices and starts a rise. For when enterprises have in 
 sight as much business as they can handle with existing facilities, 
 they stand out for higher prices on additional orders. This policy 
 prevails because additional orders can be executed only by breaking 
 in new hands, starting new machinery, or buying new equipment, 
 The expectation of its coming hastens the advance. Buyers are 
 anxious to secure large supplies while the quotations continue 
 low, and the first signs of an upward trend bring out a rush of 
 orders. 
 
 The rise of prices spreads rapidly, for every advance puts pressure 
 on someone to recoup himself by advancing the prices of what he has 
 to sell. The resulting changes in price are far from even: retail 
 prices lag behind wholesale and the price of finished products behind 
 the price of raw materials. Among the last mentioned the prices 
 of mineral products reflect changed business conditions more regu- 
 larly than do the prices of forest and farm products. Wages rise 
 more promptly but in less degree than wholesale prices; interest 
 rates on long loans always move sluggishly in the earlier stages of 
 revival, while the prices of stocks both precede and exceed commodity 
 prices on the rise. 
 
 In the great majority of enterprises larger profits result from 
 these divergent fluctuations, coupled with the greater physical 
 volume of sales. For while the prices of raw materials and of bank 
 loans often rise faster than selling prices, the prices of labor lag
 
 514 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 behind, and the prices making up supplementary costs are mainly 
 stereotyped by old agreements. 
 
 The increase of profits, under the spell of optimism, leads to a 
 marked expansion of investments. The heavy orders for machinery, 
 the large contracts for new construction, etc., which result, swell 
 still further the physical volume of business and render yet stronger 
 the forces which are driving prices upward. 
 
 Indeed, the salient characteristic of this phase of the business 
 cycle is the cumulative working of the various processes which are 
 converting a revival of trade into intense prosperity. Not only 
 does every increase in the volume of trade cause other increases, 
 every convert to optimism make new converts, and every advance 
 in price furnish an incentive for new advances; but the growth of 
 trade also helps to spread optimism and to raise prices, while opti- 
 mism and rising prices support each other. Finally, the changes going 
 forward swell profits and encourage investments, while high profits 
 and heavy investments react by augmenting trade, justifying opti- 
 mism, and raising prices. 
 
 While the processes just sketched work cumulatively for a time 
 to enhance prosperity, they also cause a slow accumulation of stresses 
 within the balanced system' of business stresses which ultimately 
 undermine the conditions upon which prosperity rests. 
 
 Among these is the gradual increase in the cost of doing business. 
 The decline in supplementary costs per unit ceases when enterprises 
 have secured all the business they can handle with their standard 
 equipment, and a slow increase in these costs begins when the expi- 
 ration of old contracts makes necessary renewals at higher rates. 
 Meanwhile prime costs rise at a relatively rapid rate. The price of 
 labor rises both because of an advance hi nominal wages and because 
 of higher rates for overtime. More serious is a decline in the effi- 
 ciency of labor, because of the employment of undesirables and 
 because crews cannot be driven at top speed when jobs are more 
 numerous than men. The prices of raw material rise faster on the 
 average than the selling prices of products. Finally, numerous 
 small wastes creep up when managers are hurried by press of orders. 
 
 A second stress is the accumulating tension of investment and 
 money markets. The supply of funds available at the old rates 
 fails to keep pace with the swelling demand. It becomes difficult to 
 negotiate new issues of securities except on onerous terms, and men 
 of affairs complain of the "scarcity of capital." Nor does the
 
 COMMERCIAL BANKING AND BUSINESS CYCLES 515 
 
 supply of bank loans, limited by reserves, grow fast enough to keep 
 up with the demand. Active trade keeps such an amount of money 
 in circulation that the cash left in the banks increases rather slowly. 
 On the other hand, the demand for loans grows, not only with the 
 physical volume of trade, but also with the rise of prices, and with 
 the desire of men of affairs to use their own funds for controlling as 
 many businesses as possible. 
 
 Tension in the bond and money markets is unfavorable to the 
 continuance of prosperity, not only because high rates of interest 
 reduce the prospective margins of profit, but also because they check 
 the expansion of the volume of trade out of which prosperity develops. 
 Many projected ventures are relinquished because borrowers con- 
 clude that interest would absorb too much of their profits. 
 
 The group producing industrial equipment suffers especially. 
 In the earlier stages of prosperity this group enjoys exceptional 
 activity. But when the market for bonds becomes stringent and 
 the cost of construction high, business enterprises defer the execution 
 of plans for extending old or erecting new plants. As a result, con- 
 tracts for this kind of work become less numerous as the climax 
 of prosperity approaches. Then the steel mills, foundries-, machine 
 factories, lumber mills, construction companies, etc., find their 
 orders for future delivery falling off. 
 
 The larger the structure of prosperity, the more severe become 
 these internal stresses. The only effective means of preventing 
 disaster while continuing to build is to raise selling prices time after 
 time high enough to offset the encroachment of costs upon profits 
 and to keep investors willing to contract for fresh industrial equipment. 
 
 But it is impossible to keep selling prices rising for an indefinite 
 time. In default of other checks the inadequacy of cash reserves 
 would ultimately compel the banks to refuse a further expansion of 
 loans on any terms. But before this stage has been reached the rise 
 of prices is stopped by the consequences of its own inevitable inequali- 
 ties. These become more glaring the higher the general level is 
 forced; after a time they threaten serious reductions of profits to 
 certain business enterprises, and the troubles of these victims dissolve 
 that confidence in the security of credits with which the whole 
 towering structure of prosperity has been cemented. 
 
 In certain lines in which selling prices are stereotyped by law. 
 by contracts for long terms, by custom, or by business policy, selling 
 prices cannot be raised to prevent a reduction of profits. In other
 
 516 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 lines prices are always subject to the incalculable chances of the 
 harvests. In some lines the recent construction of new equipment 
 has increased the capacity for production faster than the demand 
 for wares has expanded under the repressing influence of high prices. 
 The unwillingness of investors to let fresh contracts threatens loss 
 not only to the contracting firms but to the enterprises from which 
 they buy materials. Finally, the success of some enterprises in 
 raising prices fast enough to defend their profits aggravates the 
 difficulties of the men who are in trouble. 
 
 As prosperity approaches its height, then, a sharp contrast develops 
 between the business prospects of different enterprises. Many are 
 making more money than at any previous stage in the business 
 cycle. But an important minority faces the prospect of declining 
 profits. The more intense prosperity becomes, the larger grows 
 this threatened group. In time these conditions bred by prosperity 
 will force radical readjustment. 
 
 Such a decline of profits threatens consequences worse than the 
 failure to realize expected dividends; for it arouses doubt about the 
 future of outstanding credits. Business credit is based primarily 
 upon the capitalized value of present and prospective profits, and the 
 volume of credits outstanding at the zenith of prosperity is adjusted 
 to the great expectations which prevail when affairs are optimistic. 
 The rise of interest rates has already narrowed the margins of security 
 behind credits by reducing the capitalized value of given profits. 
 When profits begin to waver, creditors begin to fear lest the shrinkage 
 in the market rating of business enterprises which owe them money 
 will leave no adequate security for repayment. Hence they refuse 
 renewals of old loans to enterprises which cannot stave off a decline 
 in profits and press for settlement of outstanding accounts. 
 
 Thus prosperity ultimately brings on conditions which start a 
 liquidation of the huge credits which it has piled up. And in the 
 course of this liquidation prosperity merges into crisis. Once begun, 
 the process of liquidation extends rapidly, partly because most 
 enterprises called upon to settle put similar pressure on their own 
 debtors, and partly because news presently leaks out and other 
 creditors take alarm. 
 
 While this financial readjustment is under way the problem of 
 making profits is subordinated to the more vital problem of main- 
 taining solvency. Business managers nurse their financial resources 
 rather than push their sales. In consequence the volume of new
 
 COMMERCIAL BANKING AND BUSINESS CYCLES 517 
 
 orders falls off rapidly. The prospect of profits is dimmed. Expan- 
 sion gives place to contraction. Discount rates rise higher than 
 usual, securities and commodities fall in price, and working forces 
 are reduced. But there is no epidemic of bankruptcy, no run 
 upon banks, and no spasmodic interruption of ordinary business 
 processes. 
 
 Crises, however, may degenerate into panics. When the process 
 of liquidation reaches a weak link in the chain of interlocking credits 
 and the bankruptcy of some conspicuous enterprise spreads unreason- 
 ing alarm, the banks are suddenly forced to meet a doubled strain 
 a sharp increase in the demand for loans and the demand for repay- 
 ment of deposits. If the banks meet both demands, the alarm 
 quickly subsides. But if many solvent business men are refused 
 accommodation at any price and depositors are refused payment 
 in full, the alarm turns into a panic. A restriction of payments by 
 banks gives rise to a premium on currency, to hoarding of cash, and 
 to the use of various unlawful substitutes for money. Interest rates 
 may go to three or four times their usual figures, causing forced 
 suspensions and bankruptcies. There follow appeals to the govern- 
 ment for extraordinary aid, frantic efforts to import gold, the issue of 
 clearing-house loan certificates, and an increase in bank-note cir- 
 culation as rapidly as the existing system permits. Collections fall 
 into arrears, workmen are discharged, stocks fall to extremely low 
 levels, commodity prices are disorganized by sacrifice sales, and the 
 volume of business is violently contracted. 
 
 There follows a period during which depression spreads over the 
 whole field of business and grows more severe. Consumer's demand 
 declines in consequence of wholesale discharge of wage-earners. With 
 it falls the business demand for raw materials, current supplies, and 
 equipment. Still more severe is the shrinkage in the investor's 
 demand for construction work of all kinds. The contraction in 
 the physical volume of business which results from these shrinkages 
 in demand is cumulative, since every reduction of employment 
 causes a reduction in consumer's demand, thereby starting again 
 the whole series of reactions at a higher pitch of intensity. 
 
 With this contraction goes a fall in prices. For when current 
 orders are insufficient to employ the existing equipment, competition 
 for business becomes keener. This decline spreads through the 
 regular commercial channels which connect one enterprise with 
 another, and is cumulative, since every reduction in price facilitates
 
 5l8 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 reductions in other prices, and the latter reductions react to cause 
 fresh reductions at the starting-point. 
 
 The fall in prices is characterized by certain regularly recurring 
 differences in degree. Wholesale prices fall faster than retail and 
 the prices of raw materials faster than those of manufactured prod 
 ucts. The prices of raw mineral products follow a more regular 
 course than those of forest or farm products. Wages and interest on 
 long-time loans decline in less degree than commodity prices. The 
 only important group of prices to rise is high-grade bonds. 
 
 The contraction in the volume of trade and the fall in prices 
 reduce the margin of present and prospective profits, spread dis- 
 couragements, and check enterprise. But they also set in motion 
 certain processes of readjustment by which the depression is overcome. 
 
 The prime costs of doing business are reduced by the fall in the 
 prices of raw material and of bank loans, by the marked increases 
 in the efficiency of labor which comes when employment is 
 scarce, and by closer economy by managers. Supplementary costs 
 are reduced by reduction of rentals and refunding of loans, by writing 
 down depreciated properties, and by admitting that a recapitali- 
 zation has been effected on the basis of lower profits. 
 
 While costs are being reduced, the demand for goods begins 
 slowly to expand. Accumulated stocks left over from prosperity 
 are exhausted, and current consumption requires current production. 
 Clothing, furniture, and machinery are discarded and replaced. 
 New tastes appear among consumers and new methods among 
 producers, giving rise to demand for novel products. Most important 
 of all, the investment demand for industrial equipment revives. 
 Capitalists become less timid as the crisis recedes into the past, the 
 low rates of interest on long-time bonds encourage borrowing, and 
 contracts can be let on most favorable conditions. 
 
 Once these forces have set the physical volume of trade to 
 expanding the increase proves cumulative. Business prospects 
 become gradually brighter. Everything awaits a revival of activity 
 which will begin when some fortunate circumstance gives a fillip 
 to demand, or, in the absence of such an event, when the slow growth 
 of the volume of business has filled order books and paved the way 
 for a new rise in prices. Such is the stage of the business cycle with 
 which the analysis begins, and, having accounted for its own begin- 
 ning, the analysis ends. 1 
 
 1 It may be added that within the larger cycles are minor fluctuations 
 which are scarcely less ink-resting than the major movements.
 
 COMMERCIAL BANKING AND BUSINESS CYCLES 519 
 
 Only a few words of comment with reference to this analysis 
 are necessary. It may be noted first that the forces which 
 are at work hi producing this ebb and flow of business activity 
 are embodied in the very warp and woof of the modern indus- 
 trial and financial structure. It may be concluded therefore 
 that the ebb and flow of business prosperity will continue so 
 long as the present industrial and financial structure of society, 
 with its profit-making motivation, is maintained. And indeed 
 under any organization of society there would be some fluctua- 
 tion in the volume of business activity consequent upon the 
 mutations of climate and other uncontrollable natural phe- 
 nomena. But undoubtedly business fluctuations are most 
 pronounced under the conditions that prevail in a profit- 
 making and credit society. 
 
 While we may therefore regard the ebb and flow of business 
 activity as the normal state of affairs, it is possible that the 
 extent of the oscillations of business may be somewhat modified 
 and that in particular the panic stage may be eliminated. 
 Indeed, the panic stage has been for all practical purposes 
 eliminated in European countries, and it is hoped and pretty 
 generally believed that it has been eliminated in the United 
 States in consequence of the improved organization of our 
 banking machinery under the Federal Reserve law. 1 If the 
 reader is to appreciate the possibility of reducing the fluctua- 
 tions of business activity and preventing a recurrence of panics, 
 it will be necessary to consider in some detail the relation of 
 the commercial banking system to the business cycle. 
 
 III. COMMERCIAL BANKING AND BUSINESS 
 CYCLES 
 
 In Mitchell's analysis it was pointed out that in the period 
 of depression bank reserves are large, with abundance of 
 loanable funds at low interest rates. This reserve situation is 
 due to the contraction of deposit currency that occurred during 
 the liquidation process of the panic period, and to the industrial 
 
 1 For a discussion of the possibilities under the Federal Reserve System, 
 see pp. 589-600.
 
 520 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 stagnation during the depression, which reduced the demand 
 for loanable funds to a minimum. This plethora of funds at 
 low interest rates is not of itself sufficient to bring about a 
 revival of business activity, as is evidenced by the fact that 
 the depression often continues for many years in the face of 
 easy and cheap money. But when once business confidence 
 has been increased usually as a result of some fortuitous 
 development a plentiful supply of cheap funds becomes an 
 undoubted factor in promoting the expansion of industry. 
 
 Of more significance, however, is the relationship of the 
 supply of bank funds to the business cycle when the upward 
 movement is approaching a critical stage. By virtue of their 
 control of the purse strings the managers of commercial banking 
 institutions are in a position to exercise a restraining influence 
 to control, in fact, the rate of business expansion and to prevent 
 a continuance of the upward swing to the stage of acute crisis 
 which ends in financial collapse and panic. Under the American 
 banking system prior to 1914, however, American banks did 
 not exercise any restraining influence on business, the banking 
 statistics clearly indicating that no effort was made on the 
 part of the banks, as a whole, to restrict the rate of expansion. 
 The following table shows the changes in loans, net deposits 
 (not including government), cash reserves, and reserve ratio 
 at the time of the early autumn report on the condition of the 
 national banks from 1897 to 1907:' 
 
 The great increase in the aggregate cash reserves during this 
 period is mainly attributable to the gold imports resulting from 
 our abnormally large exports of agricultural produce in the 
 early years of the period, and to the great increase in gold 
 production. It will be seen that there was a very marked 
 decline in the ratio of reserves to net deposits. And as the 
 chart on page 498 indicates, the reserves of the individual 
 national banks were very near the minimum requirement. 
 The slight improvement that is noted between September 4, 
 1906, and August 22, 1907, does not indicate that the banks 
 
 1 From O. M. W. Sprague, Crises under the National Banking System, 
 p. 218.
 
 COMMERCIAL BANKING AND BUSINESS CYCLES 521 
 
 were exercising credit restraint during that period; for th 
 fact that the bank returns in 1907 were received by the Comp- 
 troller of the Currency two weeks earlier than in 1906 is sufficient 
 to account for the difference, since the seasonal strain on the 
 money market is normally more acute in September than in 
 August. 
 
 (Amounts expressed in millions) 
 
 
 
 Loans 
 
 Net Deposits 
 
 Cash Reserve 
 
 Ratio of 
 Reserve to 
 Deposits 
 
 Oct. <;, 
 
 l8Q7 
 
 $2 066 
 
 $2,170 
 
 $388 
 
 Per Cent 
 17 O 
 
 Sept. 20, 
 
 1898 
 
 2,172 
 
 2,404 
 
 42O.7 
 
 17. 5 
 
 Sept. 7, 
 
 1899 
 
 2,496 
 
 3,952 
 
 466. ^ 
 
 IS.8 
 
 Sept. 5, 
 
 igOO 
 
 2,686 
 
 3,187 
 
 SiS.S 
 
 16. 2 
 
 Sept. 30, 
 
 IOOI. . 
 
 3,018 
 
 7,CC4. 
 
 C2Q. C 
 
 1^. 2 
 
 Sept. 15, 
 
 1902 
 
 3,280 
 
 7,720 
 
 ^OS.O 
 
 I*. 7 
 
 Sept. o, 
 
 IOO3. . , 
 
 7,481 
 
 3,86^ 
 
 CCA * 
 
 14. ? 
 
 Sept. 6, 
 
 1904 
 
 2,726 
 
 4,400 
 
 661.5 
 
 15.0 
 
 Aug. 25, 
 
 190=;. . 
 
 2,008 
 
 4,73"> 
 
 66q.6 
 
 H. 7 
 
 Sept. 4, 
 
 1006. . . 
 
 4.,2O8 
 
 4,027 
 
 626.O 
 
 12. 7 
 
 Aug. 22, 
 
 1907. . . 
 
 4,678 
 
 e,2<;6 
 
 701.6 
 
 I.^ 
 
 
 
 
 
 
 
 The failure of the banks to exercise any restraining influence 
 on the situation cannot be attributed to any lack of evidence 
 that the situation was in need of control. As early as the 
 San Francisco earthquake, on April 18, 1906, there were numer- 
 ous indications that the upward swing of the business cycle 
 was entering upon the critical stage. There was sharp tension 
 in the money markets whenever any marked variation in the 
 demand for loans occurred; there were practically no idle 
 funds available for capital requirements and the supply of 
 loanable funds was inadequate for the needs of a still expanding 
 business, conducted at constantly rising prices. In fact, 
 practically all of the warning signs to which Mitchell makes 
 reference in his analysis were clearly in evidence. And in 
 March, 1907, occurred a stock market panic, attended by 
 some of the severest declines ever known on the New York 
 Stock Exchange. It had, however, no appreciable effect upon 
 either business or banking psychology.
 
 522 THE FINANCIAL ORGANIZATION OF SOCIETY 
 i 
 
 A few of the really studious and far-sighted bankers, it is 
 true, realized the gravity of the situation and counseled a policy 
 of extreme conservatism in the granting of loans. The following 
 statement made before the New York State Bankers' Associa- 
 tion by its president on June 27, 1907, less than four- months 
 before the panic, is indicative of the best banking thought: 1 
 
 Until very recently no one admitted that his judgment dictated 
 any policy of retrenchment. Gentlemen, we cannot hold the present 
 pace. We should not hold it, even if we could. Though our deposi- 
 tors do not realize this, our unpleasant but perfectly plain duty is to 
 curtail their accommodation lines and force retrenchment. We are 
 in an era of extravagance, both corporate and individual, of extrava- 
 gance in enterprise and of extravagance in expenditure; extravagance 
 as much beyond precedent as is our feverish business activity. 
 
 Expansion is not confined to the industrial and commercial 
 world. For years banking facilities have been expanding out of all 
 proportion to the growth of cash reserves. For several years there 
 has not been a week in which all the New York clearing-house banks 
 have held full reserves, and frequently half, or nearly half, have 
 been short. The same tendency prevails throughout the country. 
 Is it not time for bankers to check this undue expansion, to prune 
 this tree too luxuriant for its roots, this fabric of credit built on an 
 inadequate foundation of reserve ? 
 
 Independent decentralized banking was responsible for the 
 lack of credit control. "Little heed seems to have been given to 
 these warning signs, but much was made of every straw which 
 suggested a possible further advance." This statement is 
 applicable both to the business world and to the banking 
 community as a whole, as the statistics of bank loans and 
 reserves shown in the table above so clearly reveal. The 
 explanation of this failure of the banks to control the situation 
 has usually been assigned to the American system of decentral- 
 ized and independent banking, that is, a system where the 
 banks are not united through a centralized agency and where 
 each particular banker formulates his banking policy in 
 accordance with his own individual views or lack of them. 
 
 1 Elliot C. McDougal, Bankers' Magazine, LXXV, No. I, p. i.
 
 COMMERCIAL BANKING AND BUSINESS CYCLES 523 
 
 In describing the weaknesses of this system, a prominent student 
 of banking reform says : x 
 
 The managers of each bank have the power to regulate the 
 amount of its loans and discounts and the expansion of its deposit 
 liabilities in relation to reserves, having regard to the condition of 
 the particular bank which they control; but in the United States 
 bank managers have no power to regulate the expansion of credits 
 of all the banks with a view to the security of the general credit 
 situation, and have no power, through the issue and redemption of 
 bank notes, to prevent sudden and wide fluctuations in the credit 
 power of the banks resulting from the fluctuations of the volume of 
 currency used as a circulating medium. Though the managers of 
 fifty, or of a hundred, out of the seven thousand national banks may 
 be of the opinion that, having regard to existing or prospective 
 conditions, the expansion of credits has gone too far, they have no 
 power to accomplish any substantial result. They could restrict 
 the grant of credits by their own banks, and so lose profitable business 
 that would go to other banks, but they could not materiaUy improve 
 the general situation. This was the case prior to the recent panic. 
 For months before the panic many intelligent managers of banks 
 and trust companies knew that the credit situation throughout the 
 country had become strained, and accordingly, by restricting credits 
 and by making call loans instead of time loans, many of them endeav- 
 ored to strengthen their own institutions, but they could do little 
 for the protection of the general credit situation. 
 
 This failure of either business men or bankers to realize 
 the critical condition of business and to exercise any restraining 
 influence over its further expansion permits a continuation 
 of great business activity until it culminates in the stage of 
 acute crisis, followed by panic. We may now consider the 
 situation as it exists in the weeks immediately preceding the 
 suspension of specie payments. 
 
 Concreteness will be given to the problem if we preface 
 the discussion of the strain upon the banking system with 3, 
 brief outline of the events of a typical crisis. The panic ot 
 1907 that is, the suspension of specie payments and the 
 
 1 Victor Morawetz, The Banking and Currency Problem in the United 
 States, p. 36. (North American Review Publishing Co., 1909.)
 
 524 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 general collapse of the credit structure occurred on October 22. 
 During the month of September collection of business accounts 
 was very slow, and the number of manufacturing failures was 
 five tunes as great as in September, 1906. Where in the 
 preceding months there had been perhaps a few hundred 
 people who realized that economic and financial conditions 
 were in a critical state, it had now become apparent to many 
 thousands of business men that serious trouble was imminent. 
 Declining sales, poor collections, inability to secure funds 
 these were facts actually existent; foresight was no longer 
 required to adjudge the situation as grave. 
 
 The spectacular part of the crisis came with the failure of 
 certain important financial institutions. The first of these was 
 the stock exchange firm of which Otto C. Heinze was president. 
 This firm had been endeavoring, without success, to secure a 
 corner on the copper market, and was finally caught on a 
 declining market. There was a well-defined suspicion that 
 F. Z. Heinze, who was president of the Mercantile National 
 Bank, was interested in his brother's ventures in copper and 
 that funds of the bank were being used in connection with 
 copper speculation. Rightly or wrongly, he and his financial 
 allies, who dominated seven banks and a trust company, 
 possessing capital stock of $21,000,000 and deposits of 
 $71,000,000, fell into public disfavor. The New York Clearing- 
 House, either because it believed the banks in question would 
 be able to weather the storm or through fear of the effects 
 of their failure upon the credit structure in general, agreed to 
 render these banks assistance, provided Heinze and his asso- 
 ciates were eliminated from their control. An announcement 
 to this effect was made on October 21. On the very day of 
 this announcement, however, the National Bank of Commerce 
 proclaimed that after October 22 it would not be responsible 
 for the clearing of checks drawn against the Knickerbocker 
 Trust Company, whose president was thought to be allied 
 with Heinze and his associates. This action at once brought 
 the Knickerbocker Trust Company under public suspicion 
 and a run by depositors was started on the bank, which closed
 
 COMMERCIAL BANKING AND BUSINESS CYCLES 525 
 
 its doors after paying out eight million dollars in three hours. 
 The resulting loss of confidence was followed by runs on the 
 Lincoln Trust Company and the Trust Company of North 
 America. These failures were in turn followed by several 
 conspicuous commercial failures;- and banks in general shortly 
 "suspended specie payments for safety's sake." 
 
 The great need in time of crisis is for additional bank currency, 
 partly in the form of bank notes, but more largely in the form of 
 deposit or credit currency. The reason for the pressure upon 
 the banks for additional accommodation during a period such 
 as has just been outlined can best be appreciated by considering 
 the financial position of the individual business men, who 
 constitute the source of bank borrowing. In this connection 
 the reader should recall the interdependency of the credit 
 system and the strains and stresses that have already appeared 
 before the stage of acute crisis has been reached. In a period 
 when sales are falling off, with collections slow and the business 
 future shrouded in uncertainty, there is a twofold reason why 
 business men must seek unusually large accommodations from 
 the banks. 
 
 In the first place, many loans are then required which 
 would not be needed if collections were normal. Concretely, 
 Y had been counting on paying Z out of funds received from X; 
 but if X does not pay Y, then Y must either seek a loan from 
 his bank with which to pay Z or else ask Z to wait for payment. 
 In order to maintain their own credit standing in the trade, 
 many concerns thus placed, particularly those who pride 
 themselves on always meeting their obligations promptly, 
 choose the first alternative, that of seeking additional accom- 
 modation from the banks. The total added strain that is 
 thereby placed upon the banks is in fact enormous. 
 
 In the second place, many business men procure in a time 
 of credit strain what may be called "anticipatory" loans. 
 Normally, funds are not borrowed until they are needed; 
 but in times of great monetary and business uncertainty, when 
 interest rates are rapidly rising, and when there is imminent 
 possibility of one's not being able to secure funds at any price
 
 526 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 in the near future, many loans are in fact contracted before 
 the actual need for funds has arisen. It is a case of being 
 forearmed for trouble by securing banking credits while 
 the opportunity is still open. 
 
 The outstanding need iri time of crisis is therefore an 
 expansibility of the loaning power of the banks. We have 
 said that the need is partly for bank notes, but more largely 
 for deposit currency. Interestingly enough, the general public 
 has always assumed that the need in tune of crisis is primarily 
 for increased quantities of circulating media in the form of notes. 
 The fact is, however, that the great demand for actual currency 
 comes after the suspension of specie payments, when the 
 checking system has ceased to function. Then it is, and not 
 until then, that the "currency famine" impresses the general 
 public. This is not to say that there is not a need for an 
 increased quantity of bank notes in the period preceding the 
 suspension of specie payments. In the rural sections and to 
 some extent in the financial centers, owing mainly to a hoarding 
 of currency, there is an undoubted need for large additional 
 quantities of bank notes. But for the reasons that we have 
 already discussed, in studying the elasticity of our bank-note 
 currency for seasonal needs, it has proved impossible for the 
 banks to meet the demand for more notes. Here then is one 
 important source of weakness in our commercial banking system. 
 
 But where there is a demand in the pre-panic period for a 
 thousand dollars of additional bank notes, there is a demand 
 for millions of dollars of deposit currency. The banks as a 
 whole cannot, however, make additional loans and create 
 additional deposit currency unless they can secure increased 
 reserves. Hence the crux of the problem in the period of 
 acute crisis lies with the condition of bank reserves. 
 
 In the period before the establishment of the Federal 
 Reserve System, the fact is that it was impossible for the banks 
 to increase the quantity of bank reserves. It obviously was 
 out of the question to secure a quick increase in the quantity 
 of gold production and it was usually impossible to secure 
 enough specie from other countries, owing to the inability of
 
 COMMERCIAL BANKING AND BUSINESS CYCLES 527 
 
 our independent banks to unite in a policy of raising interest 
 rates to a point which would attract gold from abroad. All 
 the other forms of our currency, as we have already seen, are 
 inelastic; hence all the banks could do was to conserve their 
 existing reserves as best they might. 
 
 Hoarding cash intensifies the difficulties in time oj crisis. 
 In fact, however, they were never able to make a very effective 
 use of these reserves. As soon as a general public distrust 
 of banking institutions develops, frightened bank depositors 
 usually begin to withdraw cash so that in the event of panic 
 their money will be safe. This withdrawal of cash, however, 
 makes a bad situation very much worse; for it depletes reserves 
 at the very time when banks should be enabled to increase 
 their cash holdings as a means of extending loans with which to 
 meet the insistent demands of business for funds. Hoarding 
 thus results in a sharp restriction of the lending power of the 
 banks. It should be borne in mind in this connection that 
 for every dollar of actual cash that is withdrawn from the 
 banking system as a whole, some ten dollars of lending power is 
 curtailed. 1 
 
 Redepositing bank reserves is a potent source of difficulty. 
 The practice of depositing reserve funds of country banks 
 in the financial centers still further increases the strain upon the 
 banks of these centers in time of crisis. Indeed, Professor 
 Sprague tells us that " there has been no crisis since the estab- 
 lishment of the national banking system (in 1863), in which 
 the New York banks would have been at all likely to have 
 resorted to suspension had then* difficulties been confined to 
 those of purely local origin. " There has been a tendency when 
 confronted with acute crisis for each and every bank, under our 
 decentralized banking system, to attempt self-preservation; 
 each seeks to seize and hold all the cash that is obtainable. 
 There is in fact a wild scramble for money with the devil 
 getting the hindmost. 
 
 1 See discussion of this point on pp. 483-85. At the present time, 
 it should be recalled, it means about a twenty-to-pne curtailment,
 
 528 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 This scrambling for currency among the banks serves 
 very quickly to reduce the reserves in the central cities far 
 below the legal minima. It will be recalled that the deposits 
 of the country banks are placed in the financial centers on 
 demand, that is, subject to call at a moment's notice. It will 
 also be recalled that by virtue of our system of redepositing 
 funds, reserves often serve hi several places simultaneously. 
 Now so long as no exceptional strain is placed upon the money 
 market this system appears satisfactory enough; but in time 
 of crisis the hard truth is revealed that the only effective 
 reserve is actual specie. For if a country bank succeeds in 
 withdrawing funds from the financial centers, its position is 
 strengthened, but the bank from which its reserve is withdrawn 
 finds itself in a correspondingly weakened position. If, on the 
 other hand, the banks in the financial centers refuse to return 
 the bankers' deposits on demand, this means at once a suspen- 
 sion of specie payments and the breakdown of the credit system 
 in general. It appears to be a common view of students of 
 the question that the former alternative was the lesser of two 
 evils, and it is believed that in some, at least, of the major 
 panics of the last forty years a courageous meeting of all demands 
 for cash would have avoided the worst phases of the panic. 
 
 The strain on the banks of the financial centers was, however, 
 undoubtedly very severe. In 1907, $4,400,000 of currency 
 was shipped from New York to the West during the week 
 ending October 19, and for the week ending November 16, 
 $22,600,000 was sent to the interior. The New York Clearing- 
 House Committee, moreover, answers its critics who insist 
 that a complete breakdown of the credit structure throughout 
 the country might have been avoided if the New York banks 
 had more fully responded to the demands of country corre- 
 spondents by saying: 
 
 To have fully honored the demands that were pouring in from 
 all sections of the country would have dissipated our banking reserve 
 in a fortnight. How could it be replenished? What would have 
 been the effect on the country if the New York bank reserve had 
 been entirely depleted? It would have so intensified the panicky
 
 COMMERCIAL BANKING AND BUSINESS CYCLES 529 
 
 feeling that widespread commercial disaster would have resulted. 
 The $53,000,000 deficit in our banking reserve occurred in less than 
 ten days after the failure of the Knickerbocker Trust Company, 
 and was caused by the shipment to interior institutions of the larger 
 portion of that amount in that short time. We kept the door of 
 our treasure-house wide open until for the good of the country it 
 became necessary everywhere to close it. 
 
 Other financial institutions are dependent upon the com- 
 mercial bankers. We have elsewhere seen that the commercial 
 banks act as the repositories of funds for other financial insti- 
 tutions as well as for the general business public. Savings 
 banks, bond houses, and insurance companies keep a portion 
 of their funds on deposit with commercial institutions. More- 
 over, directly and indirectly they look to the commercial banks 
 for accommodation in time of strain; that is to say, they either 
 seek to secure from the commercial banks loans with which to 
 tide themselves over difficulties, or through the sale of securities 
 they endeavor to shift the burden of the financial strain to 
 the commercial institutions. 
 
 Trust companies have also been dependent upon the 
 commercial banks. This is particularly true of the commercial 
 banking departments of the trust companies. Maintaining 
 low reserves of their own and keeping a portion of these on 
 deposit with commercial banks, they promptly attempt to 
 shift the strain to which they are subjected in time of crisis 
 to the commercial banks, either by a withdrawal of their 
 reserve as in the case of country commercial banks or by 
 attempting to dispose of security holdings on a stagnant market. 1 
 
 Loans -were in fact typically contracted rather than expanded. 
 The banks of the financial centers are in a sense caught between 
 the upper and nether millstones. An excessive demand for 
 loans is placed upon them at a time when there is a rapid 
 depletion of reserves as a result of individual hoarding and of 
 the withdrawal of bankers' balances. It is not surprising 
 therefore that the banks were unable to expand the volume 
 of loans and prevent a general collapse of business. (It should 
 
 ' See pp. 531-32.
 
 53 
 
 be noted in passing that even if the banks had been able 
 to maintain the convertibility of deposits into cash, they could 
 not have sustained the business structure, unless they could 
 have expanded the volume of their loans.) The following 
 data 1 bearing on the crisis which came to a head on September 
 20, 1873, show what actually occurred: 
 
 
 
 Country 
 Banks 
 
 Reserve City 
 Banks 
 
 Banks in 
 New York 
 
 Total 
 
 Sept. 12, 
 
 187?.., 
 
 $478.?* 
 
 $262.5 
 
 $IOO. 2 
 
 $Q4O. 2 
 
 Oct. 13, 
 
 1873 ., 
 
 4.ce.8 
 
 247. 5 
 
 170. 1 
 
 882.4 
 
 Nov. i, 
 
 1873.. , 
 
 442.0 
 
 242.2 
 
 160. i 
 
 8.4 
 
 
 
 
 
 
 
 * 000,000 omitted. 
 
 The contraction of loans between September 12 and October 13 
 indicates the sheer inability of the banks to perform the func- 
 tions required. Rather than a contraction of loans there 
 should have been a very great expansion in order to tide the 
 business world over the critical period. In the better organized 
 European banking systems a sharp expansion of loans has 
 always occurred with a result that a general financial panic 
 has been avoided although European crises are followed by 
 a period of gradual liquidation and by a general business 
 depression of considerable duration. 
 
 The Treasury gave what aid it could. During the ten days 
 from October 21 to 31, 1907, the federal Treasury transferred 
 to the national banks of New York City $37,597,000. Since 
 the strain in this panic at the beginning was greatest upon 
 the trust companies, the national banks transferred these 
 funds to the trust companies in order to prevent a run upon 
 them. The Treasury Department also furnished the New 
 York banks about $36,000,000 in small bills with which to 
 meet the demands of the interior for currency." As the 
 stringency progressed, the Treasury gave relief in every impor- 
 tant locality where assistance seemed to be required. By the 
 middle of November the Treasury had deposited in the banks 
 
 1 From O. M. W. Sprague, History of Crises under the National 
 Banking System, p. 82.
 
 COMMERCIAL BANKING AND BUSINESS CYCLES 531 
 
 all the money it could spare; indeed, it had reduced its working 
 surplus to about $5,000,000." 
 
 By way of indirect aid the Secretary of the Treasury resorted 
 to various means of stimulating the purchase of government 
 bonds as security for note issues; but relatively little was 
 accomplished. Indeed, Treasury aid can count for little, at 
 best; whether it can be of assistance at any particular time 
 depends upon the chance possession of ample funds at such a 
 time. This fact renders the system of no value as a scientific 
 mode of relief in time of crisis. 
 
 Secondary reserves avail but little in time of crisis. Thus 
 far nothing has been said about the steps that were, or might be, 
 taken by the banks, particularly those of the financial centers, 
 for the replenishment of their cash reserves, through the con- 
 version into specie of their "liquid assets." As noted in a 
 preceding chapter, the problem of successful bank management 
 is said to involve the making of loans of such a nature that they 
 can be relied upon to furnish cash in case of need. The bank's 
 assets other than cash are looked upon as a sort of secondary 
 reserve as assets which can be relied upon to liquidate them- 
 selves in case of need. 
 
 Call loans were long regarded as an admirable form of 
 secondary reserve, for the reason that they could be converted 
 into cash upon a moment's notice. Viewed from the standpoint 
 of the individual bank, call loans appear to possess an ideal 
 liquidity; and in ordinary times, indeed, any one bank may 
 replenish its funds by calling loans. In the event that the 
 loan is paid by the borrower, well and good. In the event that 
 the loan is not paid, the collateral can readily be disposed of on 
 the stock exchange, the funds for the purpose being drawn from 
 some other banking institution. In time of crisis, however, 
 it has been found that the calling of loans furnishes no con- 
 siderable relief; for when all banks are hard put for funds and 
 all are endeavoring to sell collateral simultaneously, with 
 none wishing to buy, the market for securities becomes auto- 
 matically stagnant. Hence calling loans is a futile expedient, 
 when viewed from the standpoint of the system as a whole.
 
 532 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 Time collateral loans have never been regarded by the banks 
 as particularly liquid in time of crisis. Only a few of them at 
 such a time would be paid as they matured, and if they were 
 not paid, it would be just as impossible to sell the collateral 
 security as to dispose of call loan collateral. 
 
 Investments in readily marketable bonds have also been 
 revealed as impotent to secure the needed replenishment of 
 reserves; for, a? in the case of the collateral back of call loans, 
 there is no market for bonds when all banks simultaneously 
 are endeavoring to dispose of them. 
 
 Commercial loans are not liquid in time of crisis. But is 
 not the commercial paper of customers, when based upon 
 "legitimate business transactions involving the flow of goods 
 from producer to consumer" automatically self -liquidating 
 and hence absolutely reliable in time of crisis ? This is indeed 
 the general banking theory and it is the theory underlying the 
 banking legislation of our own and other countries. Com- 
 mercial paper, it is said, being based upon the purchase and 
 sale of goods, or, as the case may be, upon the ascertained 
 excess of income over outgo during the life of the loan, 1 is 
 certain to be paid at maturity. 
 
 The truth is, however, that this is a fundamentally fallacious 
 doctrine. Before the establishment of the Federal Reserve 
 System the most unliquid asset in a bank's portfolio, both in 
 ordinary times and in periods of stress, was the commercial 
 paper of customers. It is not true, in the first place, that even 
 in ordinary periods such loans are normally paid at maturity; 
 the fact is that they are more often renewed than paid. Banks, 
 indeed, have a general policy of requiring their customers to 
 liquidate their indebtedness only once each year. Investiga- 
 tion, moreover, reveals that in many, and in a steadily increasing 
 number of lines of industry, there is far from a complete liquida- 
 tion of indebtedness once a year. Where loans are paid off to 
 bank A the concern's working capital is commonly replenished 
 by borrowing from bank B, either directly or indirectly througb 
 the intermediary of a commercial paper house. 
 
 1 See discussion on pp. 377-83.
 
 COMMERCIAL BANKING AND BUSINESS CYCLES 533 
 
 There are seasonal variations, it is true, in the total demand 
 for bank funds and in the total of outstanding bank loans, but 
 there is never any period when it is unnecessary for the banking 
 system as a whole to carry business as a whole. In ordinary 
 times, moreover, as noted in the preceding chapter, the banks 
 rely for funds with which to meet temporary needs not primarily 
 upon maturing commercial paper, but upon the sale of collateral 
 or securities, or upon borrowing from a correspondent bank in 
 one or another of numerous ways. Liquidity is tantamount 
 to shiftability. 
 
 When the crisis has developed it would be absolutely futile 
 for the bank to rely upon an inflow of funds from maturing 
 loans as a means of replenishing its reserves. At such a time 
 renewals are certain to be almost universally demanded. It is 
 a first principle that the bank's customers must be carried in a 
 time of stress. We have already seen that there is an enor- 
 mously increased demand for accommodation at such a time, 
 that the fundamental need is for an expansion of loans, and 
 that to contract them would precipitate the panic at once. 
 
 Our own banking experience, as well as that of all othe: 
 countries, has taught with the greatest possible conclusiveness 
 that the ability to pass through a crisis without credit dis- 
 ruption rests not upon the ability of the banks to convert 
 assets into cash for nothing is liquid in time of crisis; it rests 
 upon their ability either to draw upon unused reservoirs of 
 reserves or to create new forms of reserve money that can be 
 used as a basis for an expansion of loans. 1 
 
 Banks have sought some relief through what is known as the 
 equalization of reserves and the utilization of clearing-house loan 
 cer'ificates. The equalization of reserves involves what amounts 
 lo a pooling of the cash resources of the members of the clearing- 
 house association. Some banks, of course, have larger reserves 
 than others and some links in the chain are accordingly weaker 
 than others. An equalization of reserves is thus designed to 
 
 1 For a fuller discussion of the liquidity of bank assets, see the author's 
 "Commercial Banking and Capital Formation," Journal of Political 
 Economy, XXVI (1918), 706-31.
 
 534 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 equalize the resisting power of the banks in meeting the demands 
 against them. A clearing-house loan certificate differs from the 
 clearing-house certificate discussed on pages 460-61 above in 
 that, instead of being a claim check to cash that is on deposit 
 in clearing-house vaults, it is in the nature of a loan from the 
 clearing-house, on the security of collateral deposited with a 
 clearing-house committee. 
 
 A brief statement of the history of attempts by the clearing- 
 house associations to meet the strains placed upon them in 
 time of crisis will throw light both upon an interesting phase of 
 banking competition and upon the question of the type of 
 banking organization that is needed to control the credit 
 situation at such periods. The use of these expedients by the 
 clearing-house associations grew out of a plan that was appar- 
 ently devised shortly after the crisis of 1857. They were first 
 tried out in the rather severe financial strain of 1 860-6" i, when 
 the banks succeeded in passing the crisis without suspension of 
 specie payments. In order to ascertain the efficacy of the 
 devices in question, it will be necessary to consider specifically 
 the way in which each is designed to relieve the strain. 
 
 If the clearing-house loan certificate were resorted to only 
 by those banks which had adverse balances to pay, the result 
 would be that such banks would be enabled to maintain intact 
 their existing reserves, so far as payments to other banks were 
 concerned. This would not, however, prevent a withdrawal of 
 funds by individual depositors. Now if the only banks which 
 resorted to the clearing-house certificates were those whose 
 reserves were very low, and if the others continued to pay cash, 
 there would in effect be some equalization of reserves, the 
 banks with large cash reserves paying their adverse balances in 
 specie, and the banks with low cash reserves postponing the 
 payment of theirs. But in practice all of the banks, as a matter 
 of fact, resorted to the use of the clearing-house loan certificate 
 simultaneously, with a result that this device gave only a 
 negative help to the banks whose reserves were low. It pre- 
 vented a further depletion of them by payments of adverse 
 balances at the clearing-house. So far as the relations between
 
 COMMERCIAL BANKING AND BUSINESS CYCLES 535 
 
 banks were concerned, it amounted to a maintenance of the 
 status quo in the matter of reserves. It will thus be seen that 
 the use of the clearing-house loan certificate prevented the 
 banks, to some extent, from working at cross-purposes, with 
 resulting failure for some of them and consequent reaction 
 upon all the rest. This device could not, however, prevent the 
 failure of banks whose reserves were depleted as a result of 
 heavy withdrawals of specie by depositors. In other words, 
 it could not materially strengthen the weak links of the 
 chain. 
 
 But the process of equalizing reserves, on the other hand, 
 had more than a negative effect. By pooling reserves the 
 banks whose funds were low became as strong as any other 
 banks; each bank, in effect, was considered as having the 
 same reserve as any other; no weak links remained, however 
 delicate the chain as a whole might be. While the two devices 
 differ somewhat in scope and purpose, it should be understood 
 that they were designed to be used together. 
 
 The failure of the system of clearing-house loan certificates 
 and equalization of reserves in the panic of 1873 is largely 
 attributable to the practice of paying interest upon out-of-town 
 bankers' deposits by the New York banks, a practice that 
 was largely responsible for the concentration of funds in the 
 metropolis through attracting reserves from the interior of the 
 country. It had been expected at the time the arrangement 
 for the equalization of reserves was effected that a clearing- 
 house rule would be adopted forbidding the payment of interest 
 on bankers' deposits. The banks were almost unanimously 
 agreed to abolish this practice which had so seriously hampered 
 the efforts of the New York banks to maintain specie payment 
 in time of crisis; but by the refusal of a few members to accede, 
 it failed to become a binding obligation. In 1873 it was found 
 that twelve of the clearing-house banks were offering this 
 inducement to attract deposits and were thereby securing the 
 great majority of country-bank balances. When the crisis 
 came, the strain immediately proved heaviest upon these banks, 
 because of the large shipments of currency to the interior that
 
 536 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 were required. When reserves were equalized, the non-interest- 
 paying banks found themselves contributing their cash reserves 
 to the support of these twelve institutions which had not resisted 
 the temptation to secure the profits obtainable from the practice 
 of attracting interior funds to New York. Such a situation was 
 of course not calculated to promote general good feeling on the 
 part of the non-interest-paying banks. 
 
 There were other difficulties in the administration of the 
 system which also tended to promote dissatisfaction. "It 
 was believed, and doubtless with reason, that some of the 
 banks had evaded the obligations of the pooling agreements. 
 .... Further, as the arrangement had not included bank 
 notes, banks exchanged greenbacks for notes in order either to 
 increase their holdings of cash, or to secure money for payment 
 over the counter. "' 
 
 The results of this experience so embittered many of the 
 banks that, when in 1884 clearing-house loan certificates were 
 resorted to, there was immediately a powerful opposition to 
 the equalization of reserves. "In the course of time, " Professor 
 Sprague tells us, "all recollection of the arrangement for the 
 equalization of reserves seems to have faded from the memory 
 of the banking community. " We have already indicated that 
 the use of the clearing-house loan certificate does not effect a 
 thoroughgoing redistribution of banking reserves; and when 
 it is resorted to by all banks simultaneously it only maintains 
 the status quo, preventing banks from weakening each other, 
 but effectually debarring them from rendering positive mutual 
 assistance. The clearing-house banks have all come to adopt 
 the use of clearing-house loan certificates simultaneously and 
 in the relatively early stages of "a crisis. It will be readily 
 seen that this practice renders their use largely ineffective. 
 After a thorough study of all the panics that occurred under the 
 national banking system, Professor Sprague concludes "that 
 the arrangement for equalizing the reserves, adopted in 1873, 
 would have availed to prevent suspension on subsequent 
 occasions is highly probable, indeed, a practical certainty." 
 
 1 0. M. W. Sprague, Quarterly Journal of Economics, XXIV, 232.
 
 COMMERCIAL BANKING AND BUSINESS CYCLES 537 
 
 Whether this estimate of the potency of the system as originally 
 worked out to prevent the suspension of specie payments and 
 the worst phases of the financial collapse is correct or not, it is 
 certainly clear that the simultaneous resort to the clearing-house 
 loan certificates without an attempt at the equalization of 
 reserves could not in the nature of things prevent a credit 
 collapse in a period of" acute strain. 
 
 This experience of the banks of New York furnishes another 
 illustration of the. way in which the commercial banks are 
 inextricably involved in a system; it shows that no individual 
 banker can entirely save himself or his customers in time of 
 emergency, no matter how sure his vision or how careful his 
 management. Bankers as a group and with them business 
 as a whole must stand or fall together. It required well 
 over a century of banking in this country, however, for this 
 truth to be driven home with sufficient force to secure a 
 reorganization of our banking laws in such a way as to make 
 possible the control of individual banking activities in the 
 interest of banking and business welfare as a whole. The 
 history of this attempt on the part of the banks to secure 
 co-operative control of credit in times of emergency, moreover, 
 throws no little light upon the nature of and difficulties involved 
 in the general problems of organization and control through 
 private initiative under modern financial and industrial 
 conditions. 
 
 Various substitute forms of currency are resorted to in time of 
 panic. We have already seen that after the outbreak of a 
 panic and the suspension of specie payments there is a "cur- 
 rency famine." It is impossible for individuals with deposit 
 accounts to withdraw the funds in the form of cash, and since, 
 for the time, these bank deposit accounts are not redeemable 
 in specie, checks drawn against them will not be honored. 
 The entire credit structure by means of which the overwhelming 
 majority of our exchange transactions are effected is in tempo- 
 rary disintegration. With ordinary money unobtainable, and 
 with the deposit system temporarily demoralized, it becomes 
 necessary to conduct such business operations as are conducted
 
 538 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 with substitute forms of currency. In 1907, for instance, 
 the banks of about two-thirds of our cities having more than 
 twenty-five thousand population suspended cash payments in 
 whole or in part. Many different types of substitute currency 
 have been distinguished, the most common of which are clearing- 
 house loan certificates, clearing-house checks, cashier's checks 
 payable only through the clearing-house, and customer's 
 checks marked "Payable only through the clearing-house." 
 
 The clearing-house loan certificates were most commonly 
 used, as already indicated, in settling balances between banks. 
 To some extent, however, they were issued in denominations 
 convenient for use in paying bank depositors. This was 
 particularly the case in the panic of 1907. These small- 
 denomination clearing-house loan certificates were secured by 
 collateral deposited with the clearing-house committee, and 
 were in effect guaranteed by all the associated banks, inas- 
 much as all banks in the clearing-house agreed to accept them 
 at par. 
 
 The clearing-house checks differed from clearing-house 
 loan certificates only in form. They were issued by the clearing- 
 house associations to member banks upon deposit of approved 
 collateral, and they were payable only through the clearing- 
 house; but, instead of being a promise to pay by the clearing- 
 house association, they were in the form of checks on particular 
 banks and were signed by the manager of the clearing-house. 
 Any bank in Chicago, for instance, desiring to issue clearing- 
 house checks merely deposited the corresponding amount of 
 clearing-house loan certificates of large denominations and 
 received these checks in convenient size for general use. In 
 effect they were checks secured by the clearing-house loan 
 certificates, which in turn were secured by the collateral depos- 
 ited with the clearing-house. 
 
 Many national banks also issued cashier's checks hi small 
 denominations which were in effect substitute forms of bank 
 notes. These checks commonly read "Pay to bearer," but in 
 fact they were payable only through the clearing-house. Some- 
 times such checks were unsecured and sometimes they were
 
 COMMERCIAL BANKING AND BUSINESS CYCLES 539 
 
 backed by special deposits of collateral with the committee of 
 the clearing-house. 
 
 Checks against customers' deposit accounts "made payable 
 only through the clearing-house" were mainly "pay checks" 
 drawn by large concerns as a means of meeting their pay-rolls. 
 They differed from other forms of currency in that they were 
 the liability neither of the clearing-house nor of the banks upon 
 which they were drawn, but only of the corporation for whose 
 benefit they were issued. These pay checks were issued "by 
 railroads, mining companies, manufacturers, and storekeepers 
 in a large number of cities. Shops and stores and places of 
 amusement in the neighborhood of their issue generally accepted 
 them and it is indeed surprising, considering their variety, 
 their liability to counterfeit, and their general lack of security, 
 how little real difficulty was experienced in getting them to 
 circulate hi lieu of cash." 
 
 It may be added here that these substitute forms of cur- 
 rency are retired from circulation as soon as the banks resume 
 specie payments, usually a matter of a few weeks or months 
 only, during which time the process of financial liquidation has 
 run its vicious course and the demand for bank accommodations 
 has declined to the low level which characterizes the period of 
 business depression. A tax upon these irregular forms of 
 currency expedites their return to the banks when the active 
 need for them has passed. 
 
 While the panic stage of the business cycle may be eliminated, 
 the ebb and flow of business activity and the recurring periods of 
 acute financial strain can at best only be minimized. In the fore- 
 going discussion of the stage of acute crisis the impression may 
 have been given that the eventuation of crises into panics 
 has characteristically been largely accidental that if a certain 
 bank failure had not occurred under certain precise circum- 
 stances, that if the banks had postponed for a longer period 
 the suspension of specie payments, that if people did not 
 become unduly excited and hoard currency, that if the com- 
 mercial banks and other financial institutions did not them- 
 selves join in the mad scramble for cash, panics would not
 
 540 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 have resulted. It is always true, in fact, that the beginning 
 of the end is marked by some particular event which it would 
 appear might have been avoided. But the statement of this 
 fact must not lead us to forget that there are always certain 
 fundamental conditions which precipitate these striking indi- 
 vidual events, and that if the panic had not been occasioned by 
 the failure of the Knickerbocker Trust Company, it might well 
 have been caused shortly by the failure of some other bank or 
 trust company a failure brought about by the fundamental 
 weakness of the banking credit structure at such a time. 
 
 This is not to say, however, that the match which pre- 
 cipitates the conflagration must perforce always be touched off. 
 There have been occasions, in fact, when, had events taken a 
 slightly different course, some of the periods of acute strain 
 which were passed without the suspension of specie payments 
 might have resulted in complete panic. Nor is it intended to 
 argue that the panic stage of the business cycle may not be 
 permanently eliminated; it is believed, however, that, if the 
 upward swing of the business cycle is allowed to continue to a 
 point where bank reserves are exhausted, and if there does 
 not reside in the banking system a means of then expanding 
 temporarily the volume of loanable funds, a great many business 
 failures and a very complete derangement of the entire economic 
 and financial structure is inevitable. Granted that specie 
 payments were not suspended as between the banks, and granted 
 that the banks did not scramble for each other's reserves, and 
 that in consequence they were enabled to restrict the quantity 
 of credit, it would still remain true that the industrial and 
 financial situation would be extremely serious. For unless 
 loans can be expanded, with which to meet the inordinate 
 demand for funds required to tide business over the period 
 of crisis, there must be a general crumbling of the complicated 
 credit structure, entailing a great number of failures and 
 enormous losses to business generally. 
 
 And as we shall later see, even where the banking system 
 is so constructed as to make possible a rapid expansion of loans 
 in time of crisis, it is still impossible to eliminate a period of
 
 COMMERCIAL BANKING AND BUSINESS CYCLES 541 
 
 serious industrial readjustment involving many failures and 
 accompanying losses. For the underlying conditions which 
 have narrowed margins of profit and produced the strains and 
 stresses in the economic and financial structure and precipitated 
 the period of crisis cannot be eliminated without an intervening 
 period of liquidation which means concretely the elimination 
 of poorly managed, poorly located, or poorly equipped establish- 
 ments, readjustment in the volume of output on the part of 
 practically all business, falling interest rates and declining prices 
 and wages. The problem of control, therefore, is not one of 
 eliminating the business cycle except the panic stage for this 
 is impossible, as we have seen, under a profit-making, competi- 
 tive industrial system. The problem is rather one of mini- 
 mizing the extremes of fluctuations that occur and thereby 
 reducing as far as possible the social losses that are entailed. 
 The chapter on the Federal Reserve System outlines the 
 mechanism that has been evolved in the United States for thus 
 controlling the credit system. 
 
 QUESTIONS FOR DISCUSSION 
 
 I. SEASONAL VARIATIONS IN THE DEMAND FOR FUNDS 
 
 1. Using the material on pages 495-97, draw a diagram indicating 
 the seasonal variations in the demand for funds in the New York 
 and Chicago money markets. 
 
 2. What coincidence of business events occasions the extraordinary 
 demands of the autumn season ? 
 
 3. Does the chart on page 498 indicate that the total supply of 
 available currency is always employed, in speculative if not in 
 ordinary business uses ? 
 
 4. What conclusions do you arrive at from a study of the chart on 
 page 499 ? 
 
 5. What is meant by the term "elastic currency" ? 
 
 6. Is their any elasticity in the following forms of our currency: 
 (a) greenbacks; (6) treasury notes of 1890; (c) silver dollars; 
 (d) silver certificates; (e) gold certificates; (/) gold? What 
 factors govern the total amount of gold that any county army 
 have?
 
 542 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 7. To what forms of currency must we look to give the necessary 
 elasticity to the system ? 
 
 8. What does the chart on page 499 indicate as to the relative 
 elasticity of bank notes and deposits ? 
 
 9. Explain in your own words the reasons for the inelasticity of 
 bond-secured bank notes. 
 
 10. Explain hi your own words the reasons for the elasticity of 
 
 deposit currency, 
 n. What are the limits to the expansibility of deposit currency? 
 
 Why cannot it be relied upon to meet any and all requirements 
 
 of the autumn season, however heavy ? 
 
 12. Why should business failures be more numerous in periods of 
 tight money ? Is this an unmixed evil ? 
 
 H. THE FEDERAL TREASURY AND THE CURRENCY SUPPLY 
 
 13. What determines the total quantity of funds in the Treasury 
 at any time ? 
 
 14. What are the principal sources of federal taxation ? Do they 
 yield a steady or an intermittent revenue ? 
 
 15. What is meant by the "independent treasury" ? 
 
 1 6. Is it a matter of any importance whether the Treasury keeps its 
 funds in its own vaults or in the banks: (a) in ordinary times; 
 (&) in times of seasonal monetary strain ? 
 
 17. Do you see any reason why the Treasury should not keep its 
 funds on deposit hi the banks and hi such particular banks 
 as it chooses ? 
 
 1 8. Is it necessary for the Treasury, as a practical proposition, to 
 maintain at all times a considerable cash balance? Consult 
 the financial reports made by the Treasury Department from 
 time to tune and ascertain how large a balance is usually on hand. 
 
 19. Why cannot the federal Treasury be relied upon to give the 
 necessary elasticity to the currency system ? 
 
 HI. CYCLICAL VARIATIONS IN THE DEMAND FOR FUNDS 
 
 20. Define the following terms: (a) cycle; (6) crisis; (c) panic. 
 
 21. Into what four stages may the economic cycle be divided? 
 What are their relative durations? Consult historical data on 
 pages 505-7. 
 
 22. According to Mitchell's analysis, what factors during a period of 
 depression are conducive to an expansion of business activity ? 
 
 23. What important factor is ordinarily lacking at such a period ?
 
 543 
 
 24. What fortuitous events hastened the recovery of business in 
 1897 and 1898? 
 
 25. Trace the effects of a bountiful harvest in accelerating business 
 throughout the industrial field. 
 
 26. Trace the effects of a business boom in the iron and steel industry 
 upon other lines of enterprise. 
 
 27. During periods of depression the demand for labor is slack and 
 employment in many lines is intermittent. Trace the effects of 
 the steady employment that results from the return of prosperity 
 upon the activity of business in general. 
 
 28. Would you say that the increased purchasing power of labor in 
 general is due mainly to increased money wages or to steady 
 employment ? 
 
 29. The upward swing of the business cycle may be divided into two 
 periods: first, the period during which the slack is being taken 
 up and the existing industrial equipment of the country is coming 
 to be utilized at full capacity; second, the period when, in 
 addition, there is a great increase in building activities in the 
 construction of additional capital goods. What are the effects 
 of the second stage upon: (a) the demand for labor; (6) the 
 demand for funds; (c) the cost of conducting business? 
 
 30. To what extent do you think that psychology plays a part in 
 the rapid expansion of business ? Would you say that business 
 psychology is responsible for the expansion of business, or that 
 business recovery occasioned by some fortuitous event breeds 
 business optimism ? What is it that converts business optimism 
 into business pessimism ? 
 
 31. What causes the development of "stresses and strains" in the 
 industrial system ? Why cannot the period of active prosperity 
 go on indefinitely ? 
 
 32. Why do these strains appear in certain lines before they appear 
 in others ? 
 
 33. Do you think the steadily rising prices and the resulting "high 
 cost of living" has anything to do with the precipitation of a 
 critical period ? 
 
 34. "Costs continue to rise, and with increasing rapidity, as the 
 business cycle reaches the top of its upward swing. This would 
 not, however, lessen the margins of profit if prices were raised 
 proportionally. " Why, in fact, cannot prices be proportionally 
 advanced indefinitely ?
 
 544 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 IV. COMMERCIAL BANKING AND BUSINESS CYCLES 
 
 35. What bearing has the condition of the commercial bank reserves 
 upon: (a) the extent to which prices may rise; (6) the volume of 
 business that may be conducted ? 
 
 36. Would you say that the supply of available funds in a commercia 
 bank has anything to do with the difficulties that early beset 
 the construction industries ? If so, how ? 
 
 37. The crisis stage may be divided into two parts: (a) the critical 
 period extending over a year or so; (&) the period of acute tension 
 immediately preceding the panic. During this critical period) 
 why is it that business men do not commonly heed the warning 
 signs that are in evidence ? 
 
 38. Under our national banking system as organized before 1914, 
 why did not the banks heed the warning signs and exercise their 
 control over the money supply in such a way as to compel a 
 readjustment of business ? 
 
 ,39. Do you think that bankers as a group share the general optimism 
 that pervades the industrial world during a period of great 
 prosperity ? 
 
 40. In the period of acute financial tension, immediately preceding 
 the panic, what responsibility is placed upon the commercial 
 banks ? 
 
 41. "The process by which all the banks at once are trying to 
 strengthen their reserves is an altogether impossible process, a 
 paradox, a deathblow at the very fundamental principle of 
 banking. Any general attempt to convert banking paper or 
 deposit credit into gold must promptly issue in a lamentable 
 
 collapse of the whole credit machinery When the banks 
 
 themselves join in the scramble, the last hope of supporting the 
 credit fabric has vanished. " Why ? 
 
 42- Assume a bank in New York to have deposits of $1,000,000, 
 with a reserve of $275,000, or 27.5 per cent. Assume (a) that 
 additional loans are made to the extent of $100,000, and (b) that 
 depositors withdraw $50,000 in actual specie. What is, then, 
 the ratio of reserves to deposits ? 
 
 43. "In times of crises we have it clearly revealed to us that our 
 banking institutions constitute a system, and that individual 
 bank:, cannot procure much aid from each other." In what 
 way?
 
 COMMERCIAL BANKING AND BUSINESS CYCLES 545 
 
 44. Turn to the financial statements on pages 364-66 and indicate 
 what assets could be converted into cash in time of acute financial 
 tension ? 
 
 45. At such a period are the loans made to individuals who are 
 engaged in actual commercial operations automatically liquidated 
 as they mature ? 
 
 46. Can the banks as a whole count upon having as many loans paid 
 as there are demands for new loans ? 
 
 47. Why could the national bank notes not be readily increased in 
 volume ? 
 
 48. Why could not the deposit currency be increased in volume? 
 
 49. "The fundamental need in times of crises is an increase in cash 
 resources on the basis of which additional loans may be granted. " 
 Why? 
 
 50. Why was it not possible for our banks before the establishment 
 of the Federal Reserve System to increase the total quantity of 
 cash reserves? What factors, in fact, served to decrease the 
 available cash resources of the banks ? 
 
 51. Explain the effects of the system of redepositing reserves upon 
 the banks in time of crisis. 
 
 52. Why were the banks of the United States obliged to reduce loans 
 during the period of acute crisis ? 
 
 53. Explain the difference between the equalization of reserves and 
 the use of clearing-house loan certificates. 
 
 54. How do clearing-house loan certificates differ from clearing-house 
 certificates ? 
 
 55. Why was the provision for the equalization of reserves necessary 
 to the successful use of the loan certificate ? 
 
 56. Why could not the practice of paying interest on deposits be- 
 eliminated by clearing-house action ? 
 
 57. Do you find in the history of this attempt to pool banking 
 reserves a weakness inherent in the system of independent 
 banking ? 
 
 58. Why is it that the resort to clearing-house loan certificates by 
 all. the banks simultaneously unaccompanied by the equalizing 
 of reserves largely defeats the purpose of this expedient ? 
 
 59. At best, would the use of clearing-house loan certificates, with 
 equalized reserves, reach the heart of the difficulty in time of 
 crisis ? Why, or why not ?
 
 546 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 60. Do you regard the various forms of clearing-house loan certifi- 
 cates and checks used in time of crisis as amply secured ? 
 
 61. It is sometimes said that the great need in time of crisis is for 
 more currency that will circulate from hand to hand, and that 
 the resort to clearing-house loan certificates is proof of this 
 contention. Do you agree ? 
 
 62. For which is there a greater need in time of crisis, an expansion of 
 deposit currency, or an expansion of bank-note currency ? 
 
 REFERENCES FOR FURTHER STUDY 
 
 Agger, Eugene E. : Organized Banking, chaps, iv and v. 
 
 Holdsworth, John Thorn: Money and Banking, chap. xxi. 
 
 Laughlin, J. Laurence: Banking Progress, chaps, ii, iii, and vii. 
 
 Mitchell, Wesley C. : Business Cycles, Parts I and III. 
 
 Moulton, Harold G.: Principles of Money and Banking, pp. 
 123-92. 
 
 Persons. Warren M.: In The Review of Economic Statistics, 
 Harvard University Committee on Economic Research. April, 1919. 
 
 Phillips, Chester A.: Readings in Money and Banking, chaps, 
 xxix, xxx. 
 
 Sprague, O. M. W.: Crises under the National Banking System 
 (National Monetary Commission, 1910). 
 
 White, Horace: Money and Banking, Book III, chap, xviii.
 
 CHAPTER XXIV 
 
 GOVERNMENT REGULATION OF BANKING 
 
 Commercial banking was one of the earliest forms of 
 business to be subjected to governmental regulation. Because 
 of the almost universal demand for the accommodation which 
 banking affords, and because of the tremendous power that is 
 inherent in the control of loanable funds, the banking business 
 has long been regarded as quasi-public in its nature. Indeed, 
 many people have asserted that banking operations are of 
 such importance to the public welfare that they should be 
 actually conducted by the government itself; that to permit 
 private interests to control the supply of bank currency and 
 make profits from the use of people's money is to foster one 
 of the most vicious of monopolies. This extreme view has, 
 however, never gained general acceptance; nor until recently 
 have we, in fact, subjected all banks in the United States to 
 some species of governmental control. Indeed, in some states 
 it is still possible for individuals to engage in a general banking 
 business subject virtually to no regulation whatever, although 
 the numerous disastrous failures of private banks in recent 
 years have led to an agitation against unregulated banking 
 which promises shortly to result in its complete elimination. 
 
 It is the purpose of the present chapter to outline the 
 various regulations that are commonly imposed upon national 
 and state banks, and to present the reasons for such regulations. 
 The discussion must of necessity be confined to the more sig- 
 nificant aspects of such regulation; detailed provisions of the 
 laws and of administrative decisions will be omitted. 
 
 L SUMMARY OF AMERICAN BANKING HISTORY 
 
 While each of the main principles of regulation may best be 
 presented as a separate problem and considered in the light of 
 its particular history, a brief preliminary statement of the 
 
 547
 
 548 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 history of banking regulation in the United States will serve 
 as a useful point of departure. This history may be con- 
 veniently divided into three stages: (i) from 1790 to the Civil 
 War; (2) from the Civil War to the adoption of the Federal 
 Reserve System in 1914; and (3) from 1914 to the present 
 time. 
 
 In the period before the Civil War banking operations in the 
 United States were mainly conducted either by private bankers 
 or by institutions chartered under state laws. During this 
 period there were no national banks chartered for the express 
 purpose of engaging in general banking operations, although the 
 First Bank of the United States (1791-1811) and the Second 
 Bank of the United States (1816-36) did make some loans for 
 business purposes. The history of these federal banks will 
 presently be considered. 
 
 During the pre-Civil War period the banking laws of the 
 various states were extremely diverse and, with a few exceptions, 
 notably in New England and New York, extraordinarily lax. 
 In consequence the management of the state banks was usually 
 no better than that of the private institutions which flourished 
 at the tune. While improvements were being made in the 
 latter part of the period, banking organization, on the whole, 
 remained in a deplorable condition until after the Civil War. 
 
 The National Bank Act passed in 1863 provided for the 
 incorporation of national institutions under the general super- 
 vision of a Comptroller of the Currency. These institutions 
 were designed to engage in general banking operations and to 
 supplant the state banks in the issue of bank-note currency. 1 
 The framers of the law profited much from previous state 
 banking experience and many admirable principles for the 
 regulation of banking operations were formulated. These 
 will be outlined in the pages which follow. 
 
 Under the stress of competition, and in the light of improved 
 knowledge of sound banking organization, the laws of the 
 various states have gradually been remodeled to conform more 
 
 1 The issue of state bank notes was effectively prevented in 1866 by the 
 levy of a 10 per cent tax on all notes put out by state banks.
 
 GOVERNMENT REGULATION OF BANKING 549 
 
 closely with the provisions of the national law. 1 The changes 
 in general banking organization and control that have been 
 inaugurated by the Federal Reserve System are discussed in 
 chapters xxv and xxix. 
 
 The First and Second Banks of the United States. Only a 
 brief statement is necessary with reference to the work of these 
 federal banks. The purpose of their organization appears to 
 have been a threefold one: (i) to act as fiscal agent of the 
 United States government in the collection and disbursement 
 of federal revenue; (2) to assist the Treasury in times of finan- 
 cial emergency, through the purchase of government bonds; 
 (3) to promote a sounder and more stable bank-note currency 
 and to exercise an influence in stabilizing business and financia' 
 conditions generally. 
 
 The First Bank of the United States performed a genuinely 
 important service during the first twenty years of our national 
 history. It acted as fiscal agent in the collection and disburse- 
 ment of government funds at a time when the problems involved 
 were particularly difficult because of inadequate private finan- 
 cial facilities. The First Bank also loaned several million 
 dollars to the government during a period when federal revenue 
 was both uncertain in amount and intermittently received. 
 The bank did not, however, exert any great influence on the 
 general currency and credit system. The charter expired in 
 1811 and failed of renewal by a single vote in the Senate. 
 
 The Second Bank of the United States had a very checkered 
 career. It was very badly managed during the first few years 
 of its history; it extended credit with abandon and failed to 
 maintain adequate specie reserves. It exerted no restraining 
 influence upon the activities of the state banks, and on the 
 whole it exercised an unfavorable, rather than a favorable, 
 influence during the boom period and crisis of 1817-19. In 
 the decade of the twenties, however, the Second Bank appears 
 
 1 There are some exceptions to this general statement, however, the 
 chief of which is that the prohibition of the federal law against loans on 
 real estate was not copied by the state laws. On the contrary, the Federal 
 Reserve Act authorized certain national banks, within limits, to engage in 
 real estate loaning. See p. 554.
 
 550 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 to have been competently managed and of genuine assistance 
 in conducting the fiscal operations of the government. More- 
 over, in the critical year 1826 the bank was in a position to 
 exert some influence in stabilizing business conditions. It never 
 accomplished much, however, in the way of securing a more 
 stable bank-note currency. 
 
 With the accession to power of President Jackson, in 1829, 
 owing to a combination of circumstances, the Second Bank 
 became a political issue. From this time on, the management 
 of the institution deteriorated, and its usefulness was seriously 
 unpaired; and when in 1833 President Jackson ordered the 
 withdrawal of federal deposits from the bank, its fate was 
 virtually sealed. The charter was not renewed in 1836; and 
 from then until 1863 the United States was without any national 
 banking institution. The later unfortunate history of the 
 Second Bank is attributable not to any inherent defects in 
 the bank itself, but rather to the exigencies of an era during 
 which the doctrine that the centralization of political and 
 financial power was essentially undemocratic was in the 
 ascendancy. 
 
 II. PRINCIPLES OF GOVERNMENTAL 
 REGULATION 
 
 Governmental regulation of banking is accomplished in 
 several ways: (i) by supervising the original organization; 
 (2) by prohibiting certain types of loans; (3) by requiring the 
 maintenance of adequate specie reserves; and (4) by a system 
 of bank examinations and reports. We may consider the 
 reasons for each type of regulation. 
 
 i. Supervising the original organization. Discussion of the 
 reasons for governmental supervision of the initial organization 
 of banks raises at once the whole issue _of private versus regu- 
 lated banking. The argument against private banking is, 
 in brief, that although many unincorporated banks might 
 conduct their banking operations on the most approved prin- 
 ciples, many others might not with resulting disastrous con- 
 sequences to depositors. The contention that in the long run
 
 GOVERNMENT REGULATION OF BANKING 551 
 
 honesty and efficiency in bank management constitute the best 
 policy is hardly a sufficient argument for permitting private 
 banking, for the reason that so many people, unfortunately, 
 consider that one bank is as good as another, regardless of 
 antecedents and character of management. That depositors 
 are in need of protection from inefficient and unscrupulous 
 bankers is abundantly evident from the numerous cases of 
 private bank failures in recent years, where disclosures have 
 shown that the deposits of customers had been either con- 
 fiscated outright or diverted to such speculative enterprises as 
 to make practically certain the inability of the bank to meet its 
 obligations. The incorporation of a bank, and the necessary 
 conformity with general laws that this involves, does much to 
 insure at least a minimum of honesty and efficiency in the 
 conduct of the institution. 
 
 A statement of the causes of national bank failures will 
 throw some light upon the necessity for restrictions upon 
 banking operations, as well as for the system of bank exami- 
 nations, to be discussed below. An investigation made by 
 the Comptroller of the Currency in 1911 shows that 60 per 
 cent of the failures of national banks were caused by violations 
 of the National Banking Law, 37 per cent of which were criminal 
 violations. Twenty-three per cent were caused by "injudi- 
 cious" banking, 13 per cent by shrinkage in values and general 
 stringency in the money market; while 4 per cent resulted from 
 the failure of large debtors and other minor causes. 
 
 Banks nowadays commonly take out their charters under a 
 general incorporation law, although formerly incorporation 
 under a special act of the legislature was required. The prin- 
 ciple underlying special incorporation is that it permits each 
 application for a bank charter to be considered by the 
 legislature strictly on its merits. It transpired hi practice, 
 however, that the granting of charters to engage in banking 
 commonly became a part of the political spoils system. " Char- 
 ters were granted by Whig and Democratic legislatures only 
 to their own partisans .... and shares in banks, or the 
 rights to subscribe to them, were parcelled out by 'bosses' in
 
 552 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 the several counties." The reaction from this system even- 
 tually led to the establishment of a general incorporation, or 
 "free banking, " law in the state of New York in 1838. Under 
 this fre'e banking system any group of individuals who desired to 
 engage in the banking business might be granted a charter for 
 the purpose by the administrative branch of the state govern- 
 ment, provided there was assurance that the bank would be 
 organized and conducted in accordance with certain general 
 requirements laid down by an act of the legislature. 
 
 This system of incorporation was very generally followed 
 by the western states during the decade immediately preceding 
 the Civil War; and in the National Bank Act of 1863 it was 
 adopted as an essential part of the national banking system. 
 It has since been gradually copied by all of the state govern- 
 ments, the time involved in making legislative investi- 
 gations as a prerequisite to the granting of a charter having 
 proved quite as important a factor in the drift toward general 
 "incorporation as have the political evils of the special-charter 
 system. 
 
 The principal advantage of requiring the incorporation of 
 banks is that it makes it possible for the government to control 
 the size of banking institutions. The National Bank Act, as 
 amended, for instance, lays down the following regulations 
 with reference to the minimum capital requirements for national 
 banks: in cities of more than fifty thousand population, a 
 capital of not less than $200,000; of from six to fifty thousand 
 inhabitants, a minimum capital of $100,000; of from three to 
 six thousand inhabitants, a capital of at least $50,000; and in 
 towns up to three thousand population, a minimum capital of 
 $25,000. The purpose of these capital requirements is to 
 prevent the organization of a large number of very small banks, 
 which in the nature of things would usually be less efficiently 
 managed, and which would be certain to have a less extensive 
 distribution of risks than banks of larger size. 
 
 Stockholders of banks are subjected to a double liability. 
 The stockholders of every national bank are held individually 
 responsible "for all contracts, debts, and engagements of such
 
 GOVERNMENT REGULATION OF BANKING 553 
 
 association, each to the amount of his stock therein, at the par 
 value thereof, in addition to the amount invested in such stock"; 
 and similar provisions are found in the banking laws of all the 
 states. The purpose of this double liability of shareholders 
 is to give an ampler protection to creditors of banking insti- 
 tutions than is afforded by the strictly limited liability principle. 
 The quasi-public, nature of banking institutions, which serve 
 as repositories for the cash resources of all classes of people, 
 warrants these extra precautions for the safety of depositors. 
 
 The capital stock must be fully subscribed. Another provision 
 of the national banking law is that the capital shall be fully 
 paid in before business is started. The explanation of this 
 provision is found in state banking experience before the Civil 
 War. The early state banking laws permitted banks to com- 
 mence operations as soon as a small portion of the capital stock 
 had been actually subscribed in cash, the rest of the capita) 
 usually being represented by promissory notes of the stock- 
 holders. It was made to appear to depositors that the capital 
 was really paid in and represented genuine resources of the 
 bank; but when failures occurred, the true situation was of 
 course immediately disclosed. 
 
 Accumulation of a surplus is also required. The National 
 Bank Act provides that before the declaration of a (semi- 
 annual) dividend each bank shall "carry one-tenth part of its 
 net profits of the preceding half-year to its surplus fund until 
 the same shall amount to 20 per centum of its capital stock." 
 The purpose of this provision is to make sure that national banks 
 shall gradually increase in size; for it is believed that the 
 larger a bank's resources, the greater is the security of its 
 creditors. 1 
 
 2. The regulation of loans. Since the chief source of bank 
 losses, aside from defalcations, lies in the failure of bank bor- 
 rowers to meet their obligations, it has been found expedient to 
 place certain restrictions upon the lending operations of the 
 
 'There is, however, some confusion of thought underlying this pro- 
 vision. See the author's "The Surplus in Commercial Banking," Journal 
 of Political Economy, December, 1917.
 
 554 TH E FINANCIAL ORGANIZATION OF SOCIETY 
 
 banks. The provisions of the national banking law governing 
 loaning operations are the result of previous banking experience 
 which showed that certain types of lending operations were 
 fraught with special danger. The loan provisions of the 
 National Bank Act, as amended, are as follows: 
 
 o) It shall be lawful for any such (banking) association to 
 purchase, hold, and convey real estate as follows 
 
 First. Such as shall be necessary for its immediate accommo- 
 dation hi the transaction of its business. 
 
 Second. Such as shall be mortgaged to it in good faith by way 
 of security for debts previously contracted. 
 
 Third. Such as shall be conveyed to it in satisfaction of debts 
 previously contracted in the course of its dealings. 
 
 Fourth. .Such as it shall purchase at sales under judgments, 
 decrees, or mortgages held by such association, or shall purchase to 
 secure debts due to said association. (National Bank Act, June 3, 
 1864.) 
 
 Such associations shall not hold the possession of any real estate 
 under mortgage, or hold the title and possession of any real estate 
 purchased to secure any debts due to it for a longer period than 
 five years. (National Bank Act, June 3, 1864.) 
 
 "Any national banking association not situated in a central 
 reserve city may make loans secured by improved and unencumbered 
 farm land, situated within its federal reserve district, but no such 
 loan shall be made for a longer time than five years, nor for an amount 
 exceeding fifty per centum of the actual value of the property offered 
 as security. Any such association may make such loans in an 
 aggregate sum equal to twenty-five per centum of its capital and 
 surplus or to one-third of its time deposits, and such banks may 
 continue hereafter as heretofore to receive time deposits and to 
 pay interest on the same." (Federal Reserve Act, December 23, 
 
 IQI3-) 
 
 The Federal Reserve Board shall have power from time to time 
 to add to the list of cities in which national banks shall not be per- 
 mitted to make loans secured upon real estate in the manner described 
 in this section. (Federal Reserve Act, December 23, 1913.) 
 
 b) To one person or corporation: The total liabilities to any 
 association, of any person, or of any company, corporation, or firm 
 for money borrowed, including, in the liabilities of a company or 
 firm, the liabilities of the several members thereof, shall at no time
 
 GOVERNMENT REGULATION OF BANKING 555 
 
 exceed one-tenth part of the amount of the capital stock of such 
 association actually paid in and unimpaired and one-tenth part of 
 the unimpaired surplus fund, provided that the total of such liabilities 
 shall in no event exceed thirty per centum of the capital stock of 
 the association. But the discount of bills of exchange drawn in 
 good faith against actually existing values, and the discount of 
 commercial or business paper actually owned by the person negotiat- 
 ing the same, shall not be considered as money borrowed. (National 
 Bank Act, as amended June 22, 1906.) 
 
 c) On security of own stock: No association shall make any 
 loan or discount on the security of the shares of its own capital stock, 
 nor be the purchaser or holder of any such shares, unless such security 
 or purchase shall be necessary to prevent loss upon a debt previously 
 contracted in good faith; and stock so purchased or acquired shall, 
 within six months from the time of its purchase, be sold or disposed 
 of at public or private sale; or, in default thereof, a receiver may be 
 appointed to close up the business. (National Bank Act, June 3, 
 1864.) 
 
 The restriction on real estate loans has perhaps given rise 
 to the most criticism and controversy. In brief, the objection 
 to real estate loans is that they are of an unliquid nature. They 
 are commonly made for long periods of time ; and the mortgages 
 given as security are not readily salable in a general market, 
 as is the case with stocks and bonds. The chief argument for 
 permitting national banks to make loans on real estate mortgage 
 security is that it strengthens their competitive position. (It 
 has already been noted that such restrictions are not found 
 in state banking legislation.) 1 There can be no doubt whatever 
 that the ability of the state banking institutions to make real 
 estate loans has given them a decided advantage over national 
 banks in the agricultural sections of the country. 
 
 Without going into an extended argument on the merits 
 of the subject, it may be suggested here that the discussion 
 in the preceding chapter with reference to the liquidity of 
 bank assets in general apparently leads to the conclusion that 
 real estate loans would hardly be less liquid in time of crisis 
 than would any other type of loan. As we shall see in the next 
 
 1 See p. 385. See also p. 561.
 
 556 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 chapter, the primary need in time of tension in the money 
 market is access to some unused reservoirs of cash resources. 
 It appears, therefore, that the amendment to the National 
 Bank Act made by the Federal Reserve law, which permits 
 national banks, within limits, to make loans on real estate, 
 is clearly warranted. 
 
 The purpose of the limitation on the amount of credit that 
 may be extended to any one person or corporation is to insure a 
 relatively wide distribution of risks. The exception to this 
 limitation stated in the last sentence under (b) above is attribut- 
 able to the belief that two-name paper arising out of the 
 purchase and sale of goods is always practically certain to be 
 paid. In the light of the discussion of the relative merits of 
 single and two-name paper as given in chapter xix above, 
 however, it would appear that there is very little merit to this 
 particular exception. 
 
 The restriction against making loans on the security of a 
 bank's own stock is mainly the result of some rather disastrous 
 experiences in state banking practice before the Civil War. 
 We have already seen that early state banking laws permitted 
 banks to commence operations as soon as a relatively small 
 portion of the capital stock had been paid in. Now the shares 
 of stock already received by shareholders were often used as 
 security for loans from the bank. In making the loan the 
 bank issued notes; and these notes which passed current as 
 money were then used by the shareholders as a means of pur- 
 chasing additional capital stock. Thus it came about that a 
 large amount of the bank's capital would be borrowed from the 
 bank itself. In other words, the resources received by a bank 
 from the sale of stock in large measure consisted only of its 
 own liabilities, in the form of its outstanding notes. In the 
 event of failure the true situation was of course quickly revealed. 
 
 3. The regulation of reserves. The reserve requirements of 
 the National Bank and Federal Reserve acts are given elsewhere 
 in the text. 1 The purpose of requiring banks to hold minimum 
 
 1 For the reserve requirements of the National Bank Act, see pp. 481-82; 
 for the requirements under the Federal Reserve Act, as amended, see 
 p. 589.
 
 GOVERNMENT REGULATION OF BANKING 557 
 
 reserves of cash is to prevent certain bankers, who, because of 
 inadequate knowledge of banking principles or because of a 
 disposition to take long chances with depositors' money in the 
 hope of immediate gain for themselves, might allow reserves 
 to be depleted to a point which would endanger the solvency 
 of the institutions. It is of interest to note in this connection 
 that the United States is the only important country that has 
 established minimum reserve requirements. Whatever may be 
 the case in other countries, however, our own banking experience 
 has pretty definitely shown the wisdom of such requirements. 
 In the early days of banking many institutions kept practically 
 no reserves whatever, with the result that their outstanding 
 notes depreciated in value and wrought havoc with the monetary 
 system. 
 
 One weakness should be noted, however, in the requirement 
 of minimum reserves. If there is fixed an absolute minimum 
 under which banks may not cut even in case of an emergency, 
 a rigidity is given to the banking system in time of credit strain 
 that is highly unfortunate. It may well be argued that it is 
 better to have no minimum requirements at all and to rely 
 upon the banks to maintain, on grounds of self-interest, some 
 reserves which will be available for use in time of emergency 
 than to require very high reserves which may not be used 
 in case of need. It is significant in this connection that the 
 Federal Reserve Act permits the minimum reserves that are re- 
 quired for Federal Reserve banks to be cut under in case of 
 great emergency. 1 
 
 In tunes of financial strain the publication of the fact- that 
 reserves are down to the minimum permitted by law also, 
 unfortunately, excites the general public and sometimes leads 
 to a hoarding of currency, which seriously embarrasses the 
 banks at a moment when, so far as fundamental conditions are 
 concerned, no real danger of panic is imminent. 
 
 4. Banking examinations and reports. As a means of 
 enforcing the provisions of the National Bank Act, there has 
 been established in the Treasury Department a separate bureau 
 
 ' See p. 597.
 
 558 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 under the direction of the Comptroller of the Currency. The 
 Comptroller appoints examiners whose duty it is to examine 
 each bank in the federal system at least twice each calendar 
 year, and oftener than that if considered necessary. In case 
 these examinations reveal malpractices, inefficient banking 
 methods, or a failure to conform fully with the requirements 
 of the law, action is taken to correct the weaknesses disclosed; 
 and if they are not shortly corrected, the charter is forfeited. 
 
 The national bank examiners also render assistance to the 
 Comptroller of the Currency in helping him to form a judgment 
 upon the advisability of granting an application for a national 
 bank charter. It is the duty of the Comptroller not only to 
 make certain that a new bank will conform with all the require- 
 ments of the incorporation law, but also to make sure that 
 there is a reasonable need for the organization of an additional 
 bank in the community in question; for one of the most potent 
 causes of bank failures is the multiplication of banking facilities 
 beyond the needs of business. The examiners are effectively 
 utilized in gathering information, on the basis of which the 
 Comptroller can make an intelligent decision as to the possibility 
 of success for a new bank. 
 
 Every national bank is also required to make five reports 
 each year to the Comptroller of the Currency, exhibiting in 
 detail the resources and liabilities of the institution at the close 
 of business on any past date specified by the Comptroller. The 
 Comptroller may also call for special reports from any particular 
 bank whenever it is deemed necessary. From the data thus 
 obtained the Comptroller is enabled to judge the conditions of 
 banking and general business from time to time, as well as the 
 status of each particular bank. He is also in a position to submit 
 an annual report to Congress, presenting a summary of banking 
 conditions and recommending any legislation which such 
 conditions seem to warrant. These reports, moreover, con- 
 stitute a veritable mine of information which is available for 
 the use of students of banking theory and practice. Since the 
 establishment of the Federal Reserve System, however, the 
 importance of the work of the Comptroller of the Currency has
 
 GOVERNMENT REGULATION OF BANKING $59 
 
 very greatly declined, being overshadowed by that of the 
 Federal Reserve Board. There is, in fact, no longer any good 
 reason for the continuance of the Comptroller's office; the 
 functions performed should be taken over by the Federal Reserve 
 Board. 
 
 IIL THE REGULATION OF STATE BANKING 
 
 In the foregoing discussion of banking regulation the ref- 
 erences have all been to the provisions of the national banking 
 laws. It remains to compare the banking regulations of the 
 various states with those of .the federal government. State 
 banks are under the general supervision of state officials, 
 designated by various names, the most common of which is 
 perhaps State Superintendent of Banking. They are subjected 
 to official examinations and are required to submit periodical 
 reports, as is the case with national banks. In recent years 
 there has been worked out a rather effective co-operation 
 between national and state bank examiners. Summaries of 
 the reports of state banking conditions are also included in the 
 annual volume published by the national Comptroller of the 
 Currency. 
 
 State bank legislation is similar to, though usually less strin- 
 gent than, national bank regulation. The following summary 
 statement will indicate the character of state as compared with 
 national bank legislation. 1 
 
 The minimum capital required for state banks varies in the 
 different states from nothing to $50,000. In the South and West 
 the requirement is less than the $25,000 required for national banks. 
 Some twenty states require but $10,000 or less. In twenty-nine 
 of the thirty-seven states and territories which require a minimum 
 under a general law, the amount is graded according to population. 
 In most of these states $25,000 is the maximum, though several 
 require $100,000. As compared with the national-bank minimum 
 of $25,000 for towns of less than three thousand population, three 
 
 'Adapted from J. F. Ebersole, "The Relation of State to National 
 Banks," Proceedings of the American Academy of Political and Social 
 Science, I (1911), 286-90.
 
 560 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 states have higher, seven states have the same, and seventeen have 
 lower requirements. As compared with the natinna.1-ha.nk require- 
 ment of $50,000 for places of three thousand to twenty-five thousand 
 population, over three-fourths of the states which prescribe a fixed 
 capital have lower requirements. None of the state laws require 
 more than does the national law, while several require much less. 
 For cities of twenty-five thousand to one hundred and fifty thousand, 
 three-fourths of all the states have lower requirements than the 
 national-bank requirement of $100,000. 
 
 This difference in the amount of capital required is one of the 
 noteworthy contrasts between national and state legislation, and 
 this difference exists not in legislation only. Sixty-two per cent of 
 the 11,319 state banks in operation on April 28, 1909, had less than 
 $25,000, and 27 per cent had capital ranging between $10,000 and 
 $15,000. A few states show some lack of banking ideals hi per- 
 mitting an authorized capital larger than the paid-in requirements, 
 undue prolongation of the paying hi of capital, and the payment of 
 subscriptions to capital by means other than "cash" or "money of 
 the United States." 
 
 The National Bank Act requires one-tenth of the net earnings 
 to be set aside annually toward a surplus fund until it amounts to 
 one-fifth of the capital. Nineteen states have this rule; seven states 
 have more stringent provisions; Virginia has a lower requirement, 
 and seventeen states do not require, by general law, such a surplus 
 accumulation. In addition to this surplus fund added to capital, 
 most states follow the National Bank Act in providing for the double 
 liability of shareholders. In nineteen states the shareholders are 
 responsible "equally and ratably and not for another. " In fourteen 
 states the shareholders are liable "jointly and for each other." 
 Sixteen other states are more lenient, imposing no statutory liability 
 whatever. t 
 
 With reference to the regulation of loans the state banking laws 
 are in general more liberal than the federal law. The National 
 Bank Act limits the amount of any single liability due a national 
 bank to one-tenth of its capital and surplus and to 30 per cent of 
 its capital stock. With the exception of two states the state banking 
 laws are far more liberal. Some twenty-two states allow from 
 1 5 per cent to 30 per cent of capital and surplus as the limit to each 
 individual liability to a bank, and ten states have no limitations 
 whatever.
 
 GOVERNMENT REGULATION OF BANKING 561 
 
 The National Bank Act permits an excess if it consists of advances 
 of bona fide bills of exchange and commercial paper actually owned 
 by the negotiator. The state laws, in addition to these, make 
 exceptions in favor of loans on real estate mortgages (six states); 
 loans on bills of lading and warehouse receipts (eight states); loans 
 on collateral security (fifteen states) ; and loans approved by a vote of 
 the directors (four states). This greater liberality may be accounted 
 for by the smaller size of most of the state banks and the difficulty 
 of enforcing restrictions. Even in the national system enforcement 
 is not easily accomplished, for as late as September, 1909, over one 
 thousand banks (or 15 per cent of the total) voluntarily reported 
 excessive loans. Several of the eastern states have recently set 
 limitations as to the amount of any one loan, irrespective of the 
 individual's liability. 
 
 Another important contrast between national and state banks is 
 the power conferred upon the latter and denied the former to loan 
 upon real estate. A few states limit the amount to be put into real 
 estate loans. The prevailing practice is to limit these loans to 50 
 per cent of the capital or capital and surplus. A few place the limit 
 at from 15 per cent to 40 per cent of the assets, and some at 20 per 
 cent of the loans. State laws define the character of these loans 
 as to the location of the property, the character of the lien, or the 
 proportion which the value of the real estate must bear to the amount 
 of the loan. Holdings of real estate are limited to a five-year duration 
 following a foreclosure sale. 
 
 These real estate loans are a larger proportion of the total loan? 
 in the smaller towns and cities. And "notwithstanding the dis- 
 advantages of real estate as a convertible asset, the power to loan OP 
 the security of real estate is a valuable one to many of the state 
 banks." On April 28, 1909, 20.6 per cent of the total loans and 
 discounts of state banks were based upon security of this character. 
 Insofar as the deposits of state banks are time deposits, this form of 
 lending cannot be troublesome, though it is not suitable for active 
 commercial banks in large centers of population. 
 
 The third great difference between national and state bank laws 
 is found in the reserve requirements. Here, also, the state and 
 territorial laws are the more lenient. At present (1910) in ten states 
 no reserve whatever is required for incorporated banks. In fourteen 
 states a reserve is required only against demand deposits. The 
 amount ranges from 10 per cent to 25 per cent, although 15 per cent
 
 562 
 
 is commonly required. In six other states a lower reserve is required 
 against time deposits than against demand deposits. This ranges 
 from 4 per cent to 15 per cent for time deposits as against 15 per 
 cent to 25 per cent for demand deposits. In sharp contrast the 
 National Bank Act requires from 15 per cent to 25 per cent of all 
 deposits. This example has been followed hi but thirteen states. 
 
 Not only in regard to the amount of reserve, but also as to its 
 form, do state and national laws differ. All states permit balances 
 in other banks to be counted as a part of the reserve. The amount 
 of redeposit so authorized varies from one-half to three-fourths. 
 
 In seven states "the banks determine for themselves what part 
 of their reserves shall be cash in bank and what part shall be in the 
 form of bank balances." In four states bonds may be counted in 
 the reserve. In the choice of depositaries the state banks are practi- 
 cally unrestricted. In but five states are distinctions made between 
 the reserves required of ordinary banks and reserve agents. 
 
 The trust company legislation of the various states has been 
 even more lenient than that pertaining to state commercial banks. 
 This statement applies to the granting of loans, to the main- 
 tenance of specie reserves, and to full subscriptions to capital 
 stock, though not, typically speaking, to the minimum capital 
 requirement. Trust company legislation is in recent years, 
 however, being brought into closer conformity with state 
 banking legislation. 
 
 IV. THE REGULATION OF BANK NOTES 
 
 The regulation of bank-note issues is presented here as a 
 distinct and separate phase of the problem of banking organi- 
 zation and control only because of its historical importance, 
 bank-note regulation having given rise to more discussion and 
 controversy than have all the other problems of banking control 
 combined. The discussion that from the very beginning of our 
 banking history has centered around the issue of notes is 
 attributable in part to the fact that notes were long the primary 
 form in which bank obligations were manifested; in part to 
 the fact that they pass from hand to hand as currency without 
 regard to the character of the persons passing them on, and 
 form, in consequence, a part of the money supply of the country
 
 GOVERNMENT REGULATION OF BANKING 563 
 
 and in part to the fact that we look to bank notes to provide 
 the necessary flexibility in the currency system as a whole. 
 
 There are three principal ends to be achieved when regulat- 
 ing bank-note issues: (i) they must at all times be maintained 
 at a parity with standard money; (2) they must be amply 
 secured so that there can be no question of their ultimate value; 
 and (3) they must be made elastic, that is, responsive to the 
 varying requirements of trade. During our earlier history the 
 first two of these problems were the chief sources of controversy; 
 but in recent years with immediate parity and ultimate 
 security accomplished facts the discussion has centered 
 around the problem of elasticity. 
 
 1. Maintaining the parity of bank notes. Since bank notes 
 are designed to pass from hand to hand as currency it is necessary 
 to insure at all times their parity with standard money, lest 
 their issue lead to a depreciation of the currency and a general 
 unsettling of prices. Various devices have been employed 
 for insuring the parity of bank notes, the chief of which are 
 (i) making them a legal tender in some very important con- 
 nection, such as in the payment of taxes, and (2) providing for 
 their easy, quick, and constant convertibility into standard 
 money. 1 The first of these devices has never by itself been 
 found adequate, although it no doubt may have contributed 
 somewhat to the success of the other methods. 
 
 In order to insure the continuous convertibility of bank 
 notes into standard money it is necessary, first, that the issuing 
 bank stand ready at all times to redeem its own notes when 
 presented over its counter. But in order to keep the notes at 
 par when they have wandered far from the issuing bank it has 
 also been found necessary to make them redeemable at certain 
 agencies in important banking centers with which banks every- 
 where are in close relations; or to make them redeemable at the 
 Treasury of the United States. This latter method is employed 
 in connection with our present national bank notes. 
 
 2. The security of bank notes. This aspect of the problem 
 of bank-note regulation relates to the ultimate value of bank 
 
 1 For other methods see pp. 98-100.
 
 564 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 notes rather than to their immediate convertibility into specie. 
 Several different methods have been employed to insure the 
 holders of bank notes against ultimate loss, the three most 
 common of which are as follows: (i) To rely upon the adequacy 
 of the bank's assets to meet all note obligations in full. This is 
 sometimes accompanied by a provision which gives the holders 
 of notes a prior claim against the assets of the bank. (2) To 
 require the bank to maintain a special security for a note issue, 
 such as government bonds. This is the method employed by 
 the national banking system of the United States. (3) To 
 require the bank to set aside certain of its commercial assets as 
 security for its note issues. This third method is specifically 
 designed to promote elasticity in the bank-note system rather 
 than to insure safety. It is believed, however, that both 
 safety and elasticity can thus be attained. 
 
 It is unnecessary at this place to present the history of 
 bank-note regulation, or to enter into a discussion of the 
 various problems of regulation associated with the issue of bank 
 notes, for they receive sufficient attention elsewhere in the text. 
 The weaknesses of the system of bond-secured notes from the 
 viewpoint of elasticity are discussed in the preceding chapter, 
 while the advantages of asset currency in the same connection 
 will be pointed out in the analysis of Federal Reserve notes in 
 the chapter which follows. 
 
 QUESTIONS FOR DISCUSSION 
 
 1. Can you advance any sound arguments against the abolition of 
 private banking ? 
 
 2. Draw up a statement of the arguments against private banking. 
 
 3. What is meant by free banking? What are the arguments in 
 favor of it ? 
 
 4. What are the weaknesses in the system of general incorporation ? 
 
 5. How would you determine how large a capital a particular bank, 
 to be located in a particular community, should have ? 
 
 6. Do you have any criticisms to offer of the capital requirement* 
 under the National Bank Act ? under the state banking laws, ao 
 summarized on pages 559-60?
 
 GOVERNMENT REGULATION OF BANKING 565 
 
 7. In what way does the accumulation of a surplus tend to increase 
 the security of a bank's creditors ? 
 
 8. Would you favor the abolition of the double liability requirement 
 for bank shareholders? Would you favor the extension of this 
 principle to non-banking corporations ? 
 
 .p. What is the objection to allowing a bank to commence business 
 before the capital is fully paid in ? 
 
 10. Write out a summary statement, giving the arguments for the 
 various provisions governing the making of bank loans. 
 
 11. What do you think of the argument that it is dangerous for a 
 commercial bank to make any considerable volume of loans on the 
 security of real estate mortgages ? 
 
 12. If you were asked to draw up a banking system for one of the 
 Central American states, would you follow the American practice 
 of requiring minimum specie reserves, or the European practice 
 of permitting each bank to formulate its own reserve policy ? 
 
 13. Look through one of the annual reports of the Comptroller of the 
 Currency in the library and draw up an outline statement of the 
 significant data that it contains. 
 
 14. Which of the various ends to be achieved in the regulation of 
 bank notes do you regard as most important? which the most 
 difficult of attaining ? 
 
 REFERENCES FOR FURTHER READING 
 
 Agger, Eugene E.: Organized Banking, chap. xii. 
 
 Dunbar, Charles F.: Chapters in the History and Theory of 
 Banking, 3d edition, enlarged by O. M. W. Sprague, chap. xi. 
 
 Moulton, Harold G. : Principles of Money and Banking, Part II, 
 chap. vi. 
 
 Scott, William A.: Money and Banking, chaps, ix and x. 
 
 Willis, H. Parker: American Banking, chaps, xiii and xiv.
 
 CHAPTER XXV 
 
 THE FEDERAL RESERVE SYSTEM 
 
 The adoption of the Federal Reserve Act on December 23, 
 1913, marks the beginning of a new era in American banking 
 development. For the first seventy years of our national 
 history banking as a business was conducted almost entirely 
 under the regulation of the various states, with a resulting 
 heterogeneity of banking laws and banking practice. The 
 national banking system, dating from the Civil War, gave us, 
 as we have seen, a uniform and a safe bank-note currency 
 though not a flexible one and in general marked a real advance 
 in the development of banking organization. With the passage 
 of the Federal Reserve Act, fifty years later, we have entered 
 upon a third stage in our banking evolution, a stage that may be 
 characterized as one in which a long step has been taken toward 
 centralization in the control of banking, one in which the 
 differences between state and national banking are being slowly 
 but surely eliminated, and one under which the vast economic 
 power that inevitably resides in the financial system can be 
 made to subserve as never before the larger interests of commerce 
 and industry. 
 
 I. THE HISTORY OF BANKING REFORM 
 
 The shortcomings of the national banking system, as it 
 existed before 1914, were revealed to close students of the 
 question in almost every period of seasonal or cyclical strain 
 upon the money markets. But reform of our banking laws 
 was slow in developing, in part because other financial issues 
 took precedence and in part because the defects which had 
 been disclosed appeared in the main to be such as required 
 amendment merely, rather than thoroughgoing reorganization. 
 The generation following the Civil War was one in which dis- 
 
 566
 
 THE FEDERAL RESERVE SYSTEM 567 
 
 cussion of banking regulation was largely overshadowed by 
 the agitation for greenback currency and the restoration of 
 the free coinage of silver, the principal objection to the national 
 banking system being the so-called "double-profit" on note 
 issues interest on government bonds, plus interest on the 
 notes. These controversies related rather to the total quantity 
 of money and to the sources of the national currency supply 
 than to the adaptability of the banking machinery to the varying 
 requirements of trade. 
 
 The panic of 1893 precipitated a genuine agitation for the 
 improvement of our banking system. The most noteworthy 
 proposal was the "Baltimore Plan" of 1894, modeled after the 
 Canadian system of protecting note issues by a joint guaranty 
 fund contributed to by all banks. Before any legislation on the 
 subject could be passed, however, there occurred the political 
 campaign of 1896, the issue of which was once more the silver 
 question. The success of the Republicans in this campaign 
 was followed by the appointment of a monetary commission, 
 composed of representatives of boards of trade, chambers of 
 commerce, and other similar bodies, which met in Indianapolis 
 in 1897 for the purpose of "making a thorough investigation 
 of the monetary affairs and needs of the country in all relations 
 and aspects, and submitting proper suggestions as to the 
 evils found to exist and the remedies therefor." The findings 
 of the commission were given publication and a bill embodying 
 the conclusions reached was presented in Congress in 1898. 
 
 The Currency Act of March 14, 1900, carried some of 
 these recommendations into effect. In the main, however, 
 this act was concerned with the money rather than with the 
 banking question. On the banking side all that was attempted 
 was a stimulation of the growth of national, as compared with 
 state, banks by decreasing the capital requirements and by 
 permitting the issue of notes up to the full value of the govern- 
 ment bonds held as security. It appears that with the return 
 of great business prosperity the need of reforming our banking 
 system did not seem serious to our legislators, who at best 
 perceived none too clearly the fundamental weaknesses inherent
 
 568 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 in the system. The return of the Republicans to power, 
 coupled with the establishment of a gold standard, undoubtedly 
 satisfied most congressmen that henceforth financial difficulties 
 would be unknown. Agitation for banking reform continued, 
 however, among scientific students of the question, and there were 
 also some congressmen, notable among whom was Charles N. 
 Fowler, chairman of the Banking and Currency Committee of 
 the House, who persistently endeavored to secure the passage 
 of remedial legislation, designed primarily to insure an elastic 
 bank-note currency based on commercial assets. 
 
 The disastrous financial panic of 1907 raised anew the agitation 
 for banking reform, both in and out of Congress. It was observed 
 that whereas other countries were equally subject to periodic 
 fluctuations of commerce and trade, the United States appeared 
 to be the only nation in which the banking machinery was 
 incapable of alleviating the conditions that developed in time 
 of crisis. Strong pressure, partly political, was brought on 
 Congress to pass some emergency legislation; and after a very 
 brief study of the problem there was passed the Aldrich- 
 Vreeland Act of 1908, which made possible the issue, under the 
 control of currency associations organized around the clearing- 
 house associations as nuclei, of bank notes secured by state and 
 municipal bonds or by commercial paper. This act was frankly 
 passed as an interim measure, to expire at the end of five years ; 
 and during this interval it was hoped a genuine reorganization of 
 the banking system might be effected. 
 
 The Aldrich-Vreeland emergency currency performed an 
 important service at the outbreak of the Great War. It turned out 
 that the Federal Reserve System, though authorized, was not in 
 operation at the end of five years and the Aldrich-Vreeland Act 
 was accordingly extended for a sixth year. At the eleventh hour 
 this law received a real test; for only a few months before the 
 Federal Reserve System was ready for operation the outbreak 
 of the war in Europe precipitated a sharp financial crisis in the 
 United States. Three hundred and sixty-eight million dollars 
 of emergency currency notes, nearly three-fifths of which were 
 secured by commercial paper, were issued. The effect wa$
 
 THE FEDERAL RESERVE SYSTEM 569 
 
 most salutary and the expedient carried us through a genuine 
 currency stringency which might otherwise have resulted 
 seriously. It should be chronicled, however, that this crisis 
 differed materially from such a one as follows a period of great 
 industrial activity which involves a very great expansion of 
 credit. The general business situation in 1914 had been one 
 of relative depression. 
 
 The most significant provision of the Aldrich-Vreeland Act, 
 however, was that which established a National Monetary Com- 
 mission, composed of eighteen congressmen, which was 
 instructed to make a thoroughgoing investigation of banking 
 and currency reform and to frame a bill for the creation of 
 a new and panic-proof banking system. Under the chairman- 
 ship of Senator Aldrich, this commission conducted a very 
 extensive investigation, drawing upon the experience of the 
 entire world. Public hearings were held in the leading financial 
 centers of Europe; numerous experts were drafted to make 
 special investigations on various aspects of the problem, both 
 in the United States and abroad; and a number of books and 
 monographs on special banking problems were reprinted and 
 published as part of the commission's findings. 1 
 
 Meanwhile other students of the question were also at 
 work on plans for the reorganization of our banking system. 
 Numerous proposals were advanced by independent students 
 bankers and economists and many measures were introduced 
 into Congress, the most important of which was one by Mr. 
 Fowler entitled "A bill to establish a complete financial and 
 banking system. " 
 
 The Aldrich bill, resulting from the investigations of the 
 monetary commission, was presented to Congress in January, 
 1911. In brief, this bill provided for a new banking organi- 
 zation modeled rather closely after the central banking systems 
 of Europe; but because of American opposition to centralization 
 of power, particularly financial power, and because of the 
 unfortunate experience in our early history in connection with 
 the Second Bank of the United States,* it was felt that a bill 
 proposing the establishment of a central bank would have no 
 
 1 About forty-five volumes of material were published. 
 
 See pp. S49-SO.
 
 570 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 chance of becoming a law. Accordingly, resort was had to 
 camouflage and it was proposed to establish a national reserve 
 association, with headquarters in Washington and with branches 
 in various leading financial centers throughout the land. The 
 Aldrich bill met with very vigorous opposition, however, and 
 there was at no time much chance of its enactment into law. 
 While embodying many excellent features, it also possessed 
 certain important defects; moreover, it looked suspiciously 
 like " un-American centralization of power," and above all it 
 was sponsored by Senator Aldrich, who at the time was in 
 particularly bad grace with the American people because of 
 the part he had played in foisting upon the country the objec- 
 tionable tariff law of 1909. 
 
 Currency reform shortly became the all-absorbing national 
 issue of the time. While the Aldrich bill was before Congress, 
 there was established a "National Citizen's League for the 
 Promotion of a Sound Banking System." This league, which 
 was financed mainly by the banking interests of New York 
 and Chicago in good faith and in the hope that a really efficient 
 banking system might be established undertook to educate 
 the American people on the subject of currency reform. There 
 was published a weekly magazine called Banking Reform, 
 and also a small volume with the same title, which were devoted 
 to a discussion of the defects of the national banking system 
 and to outlining in general terms the principles which any 
 legislation that would correct these evils must embody. Organi- 
 zations were formed hi a great many states and speakers for 
 the league addressed commercial clubs, bankers' associations, 
 trade conferences, agricultural associations, public schools, 
 etc., throughout the land. While the league was willing to 
 see the Aldrich bill adopted, believing that most of the essential 
 principles were incorporated, it wisely took the stand that it 
 was not sponsoring any particular bill, that its interest was only 
 in securing the adoption of a sound banking system. The evils 
 to be overcome were, however, repeatedly pointed out and 
 there was constant reiteration of the general principles which 
 any constructive banking legislation must incorporate.
 
 THE FEDERAL RESERVE SYSTEM 571 
 
 Meanwhile the Democratic party was returned to power 
 as a result of the political exigencies of 1912. Since the party 
 was traditionally weak in its treatment of financial questions, 
 and the new Congress was largely inexperienced, it was felt by 
 many that little was now to be hoped for in the way of con- 
 structive banking legislation. There were a few distinctly 
 good men in Congress, however, and the President very wisely 
 seized the opportunity presented by a united party and some 
 efficient leadership, to put through a whole series of important 
 legislative measures. The nation-wide sentiment that had 
 been developed in favor of a sound banking system made it 
 imperative that this problem be given primary attention. 
 In fact, some progress had already been made before the new 
 administration was seated. A preliminary draft of what later 
 became the Federal Reserve Act was worked out between 
 April, 1912, and June, 1913, under the auspices of the sub- 
 committee of the House Banking and Currency Committee, of 
 which Carter Glass was chairman, and, after the close of the 
 Sixty-Second Congress, under the personal direction of Mr. 
 Glass as the prospective chairman of the Banking and Currency 
 Committee of the incoming Democratic Congress. 
 
 The task of framing a currency law was conceived as one of 
 modifying the Aldrich bill in such a way as to meet the funda- 
 mental objections that had been raised to that measure and to 
 perfect a banking organization that would provide the necessary 
 centralization of power without vesting too much control in the 
 hands of the "financial interests"; it was felt that a democratic 
 spirit should pervade the organization and that it should be 
 developed in accordance with the "genius of our institutions "- 
 whatever may be meant by this well-sounding phrase. The 
 Democratic party thus reaped the fruits of the investigations 
 that had been conducted by the National Monetary Commission 
 and by other students of banking reform, as well as the advan- 
 tage of the criticisms that had been made of the Aldrich bill; 
 and especially it profited by the nation-wide discussion of the 
 fundamental principles involved in banking reform. Great 
 credit must, however, be given to the Democratic leaders for
 
 572 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 the efficient way in which the problem was handled and for the 
 speed with which the bill was enacted into law. 
 
 The Federal Reserve Act is a substantial improvement over 
 the Aldrich plan. It should be chronicled here that the Federal 
 Reserve Act is not a mere plagiarism of the Aldrich plan. In 
 certain fundamental respects the new law is markedly different 
 from and markedly superior to the Aldrich plan. A writer very 
 intimately associated with the entire banking reform movement 
 states these differences in the following language: 
 
 The Aldrich bill provided for a single central "reserve asso- 
 ciation" with scanty public oversight, with control vested practically 
 wholly in the banks, and with the preponderance of power in the 
 hands of the larger institutions which owned stock. It so arranged 
 things as to keep this "reserve association" relatively inactive except 
 upon special occasions of panic or disturbance. It made no direct 
 provision for the shifting of reserves in part from existing banks to 
 
 the proposed associations The new Act provides for twelve 
 
 reserve banks, introduces the principle of local control, calls for 
 strict government oversight, shifts reserves from present corre- 
 spondent banks to new institutions, minimizes the influence of the 
 larger banks in directorates, and generally diffuses control instead of 
 centralizing it. It leaves banking as such to be practiced by bankers; 
 it vests the control of banking in the hands of government officers. 
 The theory and purpose of the new Act are widely different from 
 those of the Aldrich bill. 1 
 
 Subject to a great deal of hostile comment by the financial 
 and business press during the period of its discussion before 
 Congress, after passage the law very quickly became recog- 
 nized at its true worth as the most constructive piece of legis- 
 lation that had ever been placed upon the American statute 
 books. For once, at least, a vitally important, though technical, 
 question had been resolved into its fundamental issues through 
 public discussion, and in this instance a measure emerging 
 into law did represent the best constructive thinking of the 
 nation. 
 
 1 H. Parker WHlis, The federal Reserve, p. 68.
 
 THE FEDERAL RESERVE SYSTEM 
 
 573 
 
 fn 
 
 I 
 
 -s 
 
 Jl
 
 574 
 
 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 IL ADMINISTRATIVE FRAMEWORK OF 
 THE SYSTEM 
 
 The Federal Reserve Act divides the United States into 
 twelve districts, chosen in the light of commercial rather than 
 geographical factors. The map on page 573 shows the boun- 
 daries of the twelve districts and the cities in which are located 
 the Federal Reserve banks which constitute the units of the 
 system; while the data given below show the number of banks 
 in each Reserve district and the paid-in capital and surplus 
 of each Reserve bank in 1920. 
 
 SIZE OF FEDERAL RESERVE DISTRICTS 
 
 District 
 
 Number of 
 Member Banks 
 
 Capital of Federal 
 Reserve Bank 
 
 Surplus of Federal 
 Reserve Bank 
 
 Boston 
 
 432 
 
 (ooo omitted) 
 7.1:32 
 
 (ooo omitted) 
 12,3<;i 
 
 New York 
 
 772 
 
 24., 677 
 
 ?I,3O8 
 
 Philadelphia 
 
 688 
 
 8,34.0 
 
 13,069 
 
 
 861 
 
 IO,l62 
 
 13,712 
 
 Richmond 
 
 601 
 
 4,876 
 
 8,067 
 
 Atlanta 
 
 438 
 
 3,841 
 
 7,0 so 
 
 Chicago 
 
 1,304 
 
 13,490 
 
 23,917 
 
 St. Louis 
 
 1562 
 
 4,266 
 
 5,884 
 
 Minneapolis 
 
 072 
 
 3.204 
 
 5,178 
 
 Kansas City 
 
 I,o62 
 
 4,314 
 
 8,395 
 
 Dallas 
 
 812 
 
 3.821 
 
 4,152 
 
 San Francisco 
 
 801 
 
 6,^o t ; 
 
 11,662 
 
 
 
 
 
 Total 
 
 9,395 
 
 95,008 
 
 164,745 
 
 
 
 
 
 The capital of the Federal Reserve banks was subscribed 
 by the member banks of each district, each bank contributing 
 a sum equal to 6 per cent of its paid-up capital stock and 
 surplus. While capital contributions were compulsory for 
 the national banks that joined the system, it was optional with 
 each bank whether or not it should join. Only in one sense 
 was there any compulsion; a national bank had to join the 
 system if it remained a national bank; but it could surrender 
 its charter as a national institution if it so desired and cither 
 take out a state charter or suspend operations. All of the
 
 THE FEDERAL RESERVE SYSTEM 575 
 
 national banks, in fact, shortly joined the system; and, as we 
 shall later see, a large number of state banks have since become 
 members. 
 
 The Federal Reserve banks are managed by boards of directors, 
 democratically chosen, and representing all classes of interest. 
 To make certain that the Federal Reserve directors shall 
 represent all classes of opinion and interest, the law provides 
 that one-third of the board of nine members shall be known as 
 class A, one- third as class B, and one- third as class C directors. 
 The class A directors are chosen by and are representative of 
 the stock-holding member banks. The class B directors must 
 consist of individuals who at the time of their election are 
 actively engaged in their district in some commercial, agri- 
 cultural, or industrial pursuit. The class C directors are 
 selected by the Federal Reserve Board, which is in effect the 
 representative of the United States government, and hence of 
 all the people. One of these directors is called the Federal 
 Reserve Agent and is the personal representative of the Federal 
 Reserve Board. Although the directors are thus chosen from 
 among many different interests, as directors they must act as a 
 unit and in the interests of the general financial welfare, as they 
 see it. 
 
 Two of the members of the board belonging to class C, 
 however, act in a dual capacity. The Federal Reserve Agent 
 and deputy Federal Reserve Agent are also representatives of 
 the Federal Reserve Board and have certain special duties to 
 perform in this capacity. 1 
 
 In still another way the Act has endeavored to secure a 
 democratic organization and control. To insure against the 
 domination of the board of directors by the larger and more 
 powerful banks, the law provides that the banks shall be 
 divided into three general groups, each group to contain roughly 
 one-third of the aggregate number of member banks of similar 
 capitalization. Thus group No. i would contain approximately 
 one-third of the total number of banks in the district, consisting 
 of banks of the largest capitalization; group No. 3 would 
 
 1 See p. 580.
 
 576 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 include the smallest banks of the district; and group No. 2 
 the banks in between. Each of these groups of banks nomi- 
 nates and elects one class A and one class B director. The 
 directors thus represent not only the stockholding banks, 
 but also the different classes of banks. 
 
 The Federal Reserve Board is the co-ordinating and controlling 
 agency of the system as a whole. This board, which is organ- 
 ized as a part of the Treasury Department, is made up of seven 
 members, of whom two are members ex qfficio the Secretary 
 of the Treasury and the Comptroller of the Currency. The 
 other five members are appointed by the president by and with 
 the advice and consent of the Senate. It is provided that not 
 more than one member of the board may come from a single 
 reserve district; and that at least two of the presidential 
 appointees must have had banking or financial experience. 
 No member of the board, however, may be an officer, director, 
 or stockholder of any bank. The term of office is ten years; 
 and the board is a perpetual body in that one of the five 
 appointed members retires every two years. Thus during 
 a given presidential administration not more than two of the 
 five members could owe their appointment to the president 
 then in office. The president is empowered to name one of 
 the five members of the board as governor and another as 
 vice-governor, and these are the chief executive officers of the 
 entire system. 
 
 The Federal Reserve Board is assisted in its deliberations 
 by a Federal Advisory Council which consists of one repre- 
 sentative from each Federal Reserve district chosen by the 
 board of directors of the Federal Reserve bank of the district. 
 This council meets quarterly in Washington and at such other 
 times and places as it may choose. Its function is purely 
 consultative; it is designed to keep the Federal Reserve Board 
 closely in touch with business and financial conditions in all 
 parts of the country. 
 
 The powers and duties of the Federal Reserve Board in 
 brief are as follows: It may suspend or remove any officer or 
 director of a Federal Reserve bank; it may suspend a Federal
 
 THE FEDERAL RESERVE SYSTEM 577 
 
 Reserve bank and take charge of it for the purpose of reorgani- 
 zation or liquidation; it may readjust or abolish altogether 
 the classification of central reserve and reserve cities. It also 
 has power, as we shall later see, to raise or lower interest rates, 
 to give preference to certain types of financial operations, 
 and in various ways to modify and influence financial con- 
 ditions. For the moment, however, we are not concerned 
 with the details of the Federal Reserve Board's operations, the 
 present purpose being merely to show the general relation of 
 the board to the system and to note that it is a co-ordinating 
 and controlling agency, in ways which will be discussed below. 
 
 HI. PROVISION OF AN ELASTIC BANK-NOTE 
 CURRENCY 
 
 Among the defects to be remedied by the new banking 
 system was the inelasticity of the bond-secured bank-note 
 currency. The Federal Reserve Act has met this problem, 
 not by a complete elimination of the bond-secured notes, but 
 by the creation of an additional form of note currency one 
 secured by commercial paper, or " assets. " Indeed, as a result 
 of this law we now have three types of bank notes in the United 
 States: (i) national bank notes secured by government bonds 
 (as before) ; (2) Federal Reserve bank notes (secured by govern- 
 ment obligations); (3) Federal Reserve notes (secured by 
 commercial paper). 1 The third is the distinctly new form of 
 currency and the one which is designed to give elasticity to 
 the bank note system. 
 
 i. National bank notes. During the period when the 
 Federal Reserve bill was before Congress it was suggested that 
 the national bank notes be entirely eliminated. It was found 
 difficult to accomplish this, however, without involving heavy 
 losses to the banks which had outstanding bond-secured cur- 
 rency. The 2 per cent government bonds, which were chiefly 
 used as security for the national bank notes, had a market 
 value substantially equal to the par value only by virtue of 
 
 1 But see p. 584 for qualifications of this statement.
 
 578 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 the fact that they carried the circulation privilege. Taking 
 away from the bonds this privilege would have meant a fall 
 in their value of approximately one- third; and for the national 
 banks as a whole this would have involved a loss of over 
 $200,000,000. The opposition of the banks to the proposal to 
 withdraw the circulation privilege from the 2 per cent govern- 
 ment bonds was so vigorous that it was deemed expedient to 
 adopt some other means of securing the ends desired. 
 
 A plan was finally worked out whereby a gradual retirement 
 of the national bank notes could be effected. It was provided 
 that any member bank which desired to retire any or all of 
 its circulating notes might sell the bonds which were serving 
 as security at par, through the intermediation of the United 
 States Treasury, to a Federal Reserve bank. Under this 
 plan the funds paid over to the Treasury by the Federal Reserve 
 bank which purchases the bonds are used to redeem the out- 
 standing national bank notes that have been secured in the 
 past by these bonds. Any balance that may be left is turned 
 over to the bank in question. 
 
 The law sets a limit on the amount of these bonds that may 
 be purchased by a reserve bank in any one year; and if every 
 bank should take advantage of its option to retire notes, it 
 would require about thirty years to retire the total amount 
 outstanding in 1914. The truth of the matter is that some 
 banks have seen fit to retire their national bank notes by 
 this process, while others have not. On the whole, we find 
 that the total quantity of national bank notes outstanding 
 was $724,338,692 on February i, 1920, as compared with 
 $756,944,194 on December i, 1913. Since the retirement of 
 the notes by member banks is not mandatory, it is altogether 
 probable that we shall continue to have a large volume of such 
 notes as a permanent part of our circulating medium. 
 
 2. Federal Reserve bank notes. These notes owe their origin 
 to the effort to provide for the retirement of the national bank 
 notes. Although all the Federal Reserve bank notes are alike 
 in form and in security, they originate in two ways: first, the 
 reserve bank, which has purchased government bonds from a
 
 THE FEDERAL RESERVE SYSTEM 579 
 
 member bank which is retiring its notes (as outlined above), 
 may deposit these in trust with the Treasurer of the United 
 States and receive an amount of circulating notes equal to the 
 par value of the bonds thus deposited. This amounts merely 
 to transferring the issuing of bond-secured notes from the 
 individual national banks to the Federal Reserve banks. 
 Second, the reserve banks are authorized to issue additional 
 notes upon the security of additional bonds, on the same 
 general terms that national banks formerly issued such notes, 
 except that the total amount is not limited to the amount of 
 the capital stock of the Federal Reserve bank issuing them. 
 By an amendment of April 23, 1918, these notes may be issued, 
 hi any denominations, against the security of United States 
 certificates of indebtedness or one-year gold notes. These 
 provisions obviously make possible an increase in the total of 
 bond-secured notes. On February i, 1920, the total volume of 
 Federal Reserve bank notes outstanding was $269,122,800. 
 
 It remains to be noted that the way is open for a gradual 
 retirement of these Federal Reserve bond-secured notes. It is 
 provided that if any reserve bank desires to retire outstanding 
 bond-secured notes, the bonds which serve as security may be 
 exchanged at the United States Treasury for one-year 3 per 
 cent gold notes of the United States, which do not carry the 
 circulation privilege; "to an amount not exceeding one-half 
 of the 2 per cent bonds so tendered for exchange; and for 
 thirty-year 3 per cent gold bonds, without the circulation 
 privilege, for the remainder of the 2 per cent bonds so tendered. " 
 As interest rates stood in 1914 this process would have enabled 
 the Federal Reserve banks to get rid of their bond-secured 
 notes without loss. The additional i per cent interest charge 
 would of course fall, immediately speaking, upon the govern- 
 ment, and ultimately upon the tax-paying public. As the 
 figures above indicate, however, this -privilege has not been 
 utilized; and in view of the great changes in financial con- 
 ditions that have been wrought by the war, we shall probably 
 continue to have an expanding rather than a diminishing total 
 volume of Federal Reserve bank notes.
 
 580 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 3. Federal Reserve notes. The process by which the Federal 
 Reserve notes which are designed to provide the elastic element 
 in our bank-note system are issued, and the regulations govern- 
 ing them, can best be shown by a concrete illustration. Let us 
 assume that there is a heavy demand for additional bank-note 
 currency with which to move uhe crops in some rural community 
 and that some of this demand is manifested at the First National 
 Bank of Ottumwa, Iowa. How can this bank expand the 
 volume of its note issues ? 
 
 It is provided by the Federal Reserve law that a bank 
 desiring to issue reserve notes may do so upon the security of 
 commercial paper rediscounted with the Federal Reserve bank 
 of its district. Accordingly, the Ottumwa bank indorses over 
 to the Federal Reserve Bank of Chicago, say, a $10,000 promis- 
 sory note of one of its customers, Mr. Jones, to whom a com- 
 mercial loan has been made. The reserve bank of Chicago 
 will give the Ottumwa bank Federal Reserve notes equal to 
 the face value of Jones's note less the interest for the time which 
 it has yet to run. The term " rediscounting " is used in this 
 connection, to indicate that a note which was originally dis- 
 counted by a member bank is now discounted a second time. 
 In a word, the Federal Reserve bank thus does for the member 
 bank precisely what the member bank does for its customers 
 advances the face value of the note, less interest until maturity. 
 
 Before the notes can be issued by the Federal Reserve 
 bank, however, the promissory note that has been received 
 (or other notes of like quality and amount) must be placed in 
 the custody of the Federal Reserve Agent of the Chicago Federal 
 Reserve bank, who, it will be recalled, is the representative of 
 the federal government on the directorate of the Federal Reserve 
 bank. This agent has in his possession Federal Reserve notes 
 that have been printed in advance; and upon receipt of the 
 commercial paper he turns over to the Federal Reserve bank 
 the quantity of notes demanded. The Federal Reserve bank 
 then sends these notes to the Ottumwa bank, which is thereupon 
 in a position to loan them to the individuals who are in need of 
 seasonal funds.
 
 THE FEDERAL RESERVE SYSTEM 581 
 
 It will make for clearness if we consider the changes that 
 would occur as a result of this operation on the balance sheet 
 of the Ottumwa bank and the Federal Reserve Bank of Chicago 
 respectively. When the Ottumwa bank sends its customer's 
 note to Chicago, its "Loans and discounts" are lessened by 
 the amount of the note. The " Federal Reserve notes " received 
 in exchange for the customer's note are carried as assets of the 
 Ottumwa bank until such time as they are loaned to a customer, 
 when "Federal Reserves notes" are decreased and "Loans 
 and discounts" are increased by a like amount. With the 
 Federal Reserve bank the rediscount has given it possession 
 of a customer's note, which is carried as an asset under "Redis- 
 counts." The "Federal Reserve notes" issued against the 
 security of this commercial paper of course become liabilities 
 of the Federal Reserve bank. 
 
 Thus we have secured an expansion of bank notes. It may 
 be noted, moreover, that the new loan which the Ottumwa 
 bank now makes gives rise to a new customer's note, which, 
 if it has resulted from an ordinary commercial operation, is also 
 available for rediscount with the Federal Reserve bank of 
 Chicago, and thus may also be used as a basis for still further 
 issues of Federal Reserve notes. Thus as long as there con- 
 tinue to be commercial transactions which require the use of 
 borrowed funds, the promissory notes arising out of these 
 transactions will provide the basis for the additional currency 
 required in financing them. Here is the same sort of expansi- 
 bility that we have elsewhere found to characterize deposit 
 currency. 
 
 It remains to consider the process by means of which 
 Federal Reserve notes, thus issued, are reduced in volume 
 when the need for them is past. For the purpose of illustration 
 let us consider the specific $10,000 of Federal Reserve notes 
 that were put hi circulation by the Ottumwa bank. The 
 individual who borrowed these notes uses them in meeting his 
 obligations, and the individuals who receive them either deposit 
 them directly in banks or use them in the payment of debts to 
 traders and others, who in turn send them to their banks for
 
 582 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 deposit. They are now out of the channels of circulation; 
 but they have not been returned to the Federal Reserve Bank 
 of Chicago. What insures their return to their source ? 
 
 We have seen that the Ottumwa bank secured funds from 
 the Federal Reserve Bank of Chicago by the rediscount of a 
 promissory note of Mr. Jones, one of its customers. At the 
 maturity of this note, it will be sent to Mr. Jones for payment, 
 by way of the First National Bank of Ottumwa. Jones will 
 pay the necessary funds over to the Ottumwa bank in whatever 
 way is most convenient for him. And, similarly, the Ottumwa 
 bank will pay the Federal Reserve bank in whatever way is 
 most convenient. Now the most convenient and least costly 
 way for the Oltumwa bank to remit, is, in fact, by sending in 
 any Federal Reserve notes which it has on hand, for the reason 
 that the law does not permit these notes to be counted as reserve. 
 It is conceivable that all of the notes that had been paid out 
 by the First National Bank of Ottumwa might meanwhile come 
 back to this very bank. If so, the Ottumwa bank might send 
 these identical notes to the Chicago Reserve bank in settlement 
 of its obligation there. 
 
 We have assumed that the very notes which had been paid 
 over to Mr. Jones were returned to the Ottumwa bank in 
 question. It does not matter, however, whether the identical 
 notes are returned to this bank, or not; indeed, the notes are 
 exactly alike and it is hence impossible to differentiate particular 
 issues. All that matters is that $10,000 worth of Federal 
 Reserve notes be returned to the Federal Reserve Bank of 
 Chicago. Some of them may be notes paid out by other banks 
 in Ottumwa, or by banks in other cities. 
 
 Suppose now that some of the notes issued through the 
 Ottumwa bank should find their way into a national bank in 
 Oskaloosa, Iowa. Will they then be returned to the Chicago 
 bank for collection? The answer is that they will, for the 
 reason that whenever it has occasion to make payments to 
 the Federal Reserve Bank of Chicago (and such occasions are 
 constantly arising) the Oskaloosa bank will use Federal Reserve 
 notes for the purpose, because such notes are not available as
 
 THE FEDERAL RESERVE SYSTEM 583 
 
 cash reserve. 1 It does not matter, therefore, what bank in the 
 district receives them; they will always be sent hi payment of 
 obligations to the bank which issued them. 
 
 It is possible, however, that some of the notes that have 
 been put into circulation in Ottumwa, Iowa, might find their 
 way into banks in other than the Seventh Federal Reserve 
 district. Concretely, let us suppose that some of them are 
 sent hi payment of obligations to the First National Bank of 
 Akron, Ohio. Will they now be returned to the Federal Reserve 
 Bank of Chicago for redemption ? They will not, hi fact, be 
 sent directly to Chicago, for the Akron bank has no direct 
 relations with the Chicago Reserve institution. The Akron 
 bank will, however, send these notes to the Federal Reserve 
 Bank of Cleveland, whenever it has payments to make there, 
 for the reason that Federal Reserve notes can never be counted 
 as reserve in any member bank in any district. When these 
 notes arrive at the Cleveland Federal Reserve Bank, they may, 
 however, be listed as assets of that bank; for they are liabilities 
 only of the particular reserve bank which issued them. What 
 now is to prevent the Federal Reserve Bank of Cleveland from 
 again putting these notes into circulation and thereby prevent- 
 ing their redemption at the source of issue ? 
 
 A simple provision is incorporated in the law which insures 
 their being sent to the Federal Reserve bank which issued them. 
 It is provided that any Federal Reserve bank which pays out 
 notes of other reserve banks shall be subject to a tax of 10 per 
 cent of the value of the notes thus paid out. Since this destroys 
 the profit that might be obtained from loaning these notes, it 
 insures their presentation to the Reserve bank which issued 
 them, in payment of obligations due or in exchange for specie 
 
 One weakness in the system remains to be noted not a 
 weakness in the Federal Reserve law as such, but a weakness 
 inherent in our dual banking system. Federal Reserve notes 
 may find their way into the vaults of state banking institutions; 
 and since state banks are not forbidden by law to count Federal 
 
 1 This point no longer holds, however, since member banks under an 
 amendment are no longer required to keep any reserve in their own vaults.
 
 584 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 Reserve notes as reserve, there is not the same occasion for 
 sending them home for redemption as when they are deposited 
 in national institutions. As state banks in increasing numbers 
 join the Federal Reserve System, however, and subject them- 
 selves to the general requirements of the system, this weakness 
 gradually disappears. 1 
 
 Federal Reserve notes are not based exclusively on commercial 
 paper. In the foregoing illustration of the elasticity of Federal 
 Reserve notes we have been giving the impression that these 
 notes are secured exclusively by commercial paper. Such is 
 not, however, strictly the case, although the theory of the law 
 was undoubtedly to make such paper the fundamental basis 
 of the elastic note currency. Specifically, the law, as amended, 
 makes possible the issue of Federal Reserve notes on the fol- 
 lowing kinds of security: (i) paper indorsed by member banks 
 and drawn for strictly commercial, industrial, and agricultural 
 purposes, or for the purpose of carrying or trading in securities 
 of the United States government; (2) bills of exchange indorsed 
 by a member bank and bankers' acceptances bought by the 
 Federal Reserve bank in the open market; (3) gold and gold 
 certificates. Since the provisions governing paper that is 
 eligible as. security for note issues are in the main identical with 
 those governing paper that is eligible for rediscount in general, 
 it is important that we consider carefully at this place the 
 significance of these provisions from the standpoint of com- 
 mercial banking theory. 
 
 i. It will be observed, first, that the provision relating to 
 the eligibility of paper as security for note issues reads " drawn 
 for strictly commercial, industrial, and agricultural" purposes. 
 Thus the ordinary narrow technical definition of "commercial, " 
 as involving merely the purchase and sale of goods by middle- 
 men, is abandoned; it is recognized that commercial banking 
 has to do with industry and agriculture as well as with 
 commerce.* 
 
 1 For a discussion of the relation of state banks to the Federal Reserve 
 System, see pp. 733~37- 
 
 a Compare this; with the discussion of commercial paper in chap, xxi, 
 P- 434-
 
 THE FEDERAL RESERVE SYSTEM 585 
 
 While great emphasis is placed upon the essential liquidity 
 of paper growing out of actually completed business trans- 
 actions, the law nevertheless recognizes that paper may be 
 eligible, even though it does not represent a completed trans- 
 action; for it defines eligible paper to include cases where the 
 proceeds of the loan have been used or "are to be used" for the 
 purposes specified in the act. Thus the law recognizes the 
 common practice of making loans on single-name promissory 
 notes to concerns which are in a liquid condition that is, with a 
 satisfactory excess of liquid assets over current liabilities as 
 legitimate commercial banking. Eligible paper, therefore, 
 need not be secured by a specific stock of goods; it may be 
 secured by the net liquid assets of a business as a whole. 
 
 While the law thus recognizes the current banking practice 
 of loaning on the basis of the general standing of the borrower, 
 as discussed on pages 377-84 above it. does not recognize the 
 practice of annual liquidation of the borrower's indebtedness; 
 that is, the practice of completely paying one's debts to the 
 bank only once a year. Paper to be eligible for rediscount or as 
 security for note issues may have a maturity of not more than 
 ninety days, except in the case of agricultural and live-stock 
 loans, where a concession from the short-time principle is made 
 by permitting for a limited amount of paper a maturity not 
 exceeding six months. The limit is to be fixed by the Federal 
 Reserve Board at some definite percentage of the assets of the 
 Federal Reserve bank discounting such paper. 
 
 In the second place, it is to be noted that paper is eligible 
 as security for note issues when it is used for the purpose of 
 carrying or trading in the securities of the United States govern- 
 ment. 1 This provision, as we shall later see, was utilized in 
 striking fashion in connection with the floating of Liberty 
 Loans during the war. 2 While the law therefore permits 
 long-time government paper to be used as security for note 
 issues, it nevertheless excludes paper drawn for the purpose of 
 carrying or trading in stocks, bonds, and other investment 
 securities, in the belief that such operations are subversive of 
 
 1 Cf. p. 592. a See pp. 628-30.
 
 586 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 sound principles of commercial banking, that they do not 
 insure the necessary liquidity of assets. 
 
 2.. The second class of paper available as security for note 
 issues, namely, bills of exchange indorsed by member banks, 
 and bankers' acceptances bought in the open market, are of 
 course essentially short-tune commercial credit instruments 
 representing ordinary commercial, industrial, or agricultural 
 transactions. 
 
 3. The authorization of gold and gold certificates as col- 
 lateral for Federal Reserve notes has opened the way to a very 
 interesting development. When notes have once been issued 
 on the security of commercial paper, it is not, in fact, necessary 
 upon the maturity of the commercial paper which is being 
 held as security by the Federal Reserve Agent, that a like 
 volume of Federal Reserve notes should be retired or else a 
 like volume of new commercial paper be turned over to the 
 Federal Reserve Agent; for the notes may be kept in circulation 
 provided the Federal Reserve bank turns over to the Federal 
 Reserve Agent a like volume of gold or gold certificates. In an 
 endeavor to concentrate the gold supplies of the country in 
 the central reservoirs provided by the Federal Reserve banks, 
 the Federal Reserve Board has adopted a deliberate policy of 
 exchanging Federal Reserve notes for gold and gold certificates, 
 the Federal Reserve notes thereby finding a wide use in the 
 channels of circulation in place of the gold and gold certificates 
 which they displace. This process of substitution has been 
 facilitated by virtue of the fact that, although the Federal 
 Reserve notes cannot count as reserve when in the vaults of 
 either Federal Reserve or member banks, in making payments 
 over the counter and in meeting the needs of the general public 
 for circulating media they are quite as satisfactory as gold or 
 other lawful money. 
 
 The issue of Federal Reserve notes in exchange for gold and 
 gold certificates has resulted in giving to the Federal Reserve 
 banks a much greater power of note and credit expansion 
 than would otherwise have been possible. For on the basis 
 of the gold secured by this process a Reserve bank can expand
 
 THE FEDERAL RESERVE SYSTEM 587 
 
 notes by two and one half times the volume of gold on hand (the 
 reserve required against notes being 40 per cent), and nearly 
 three times the volume of deposit currency (the reserve required 
 against deposits being 35 per cent). It should be understood, 
 in this connection, that the gold and gold certificates exchanged 
 for Federal Reserve notes and held by the Federal Reserve 
 Agent still count as reserves against outstanding notes. As a 
 result of this policy the Federal Reserve notes have gradually 
 supplanted gold and gold certificates in the channels of cir- 
 culation and a large percentage of the total of outstanding 
 Federal Reserve notes is, in fact, now secured by gold and gold 
 certificates instead of by commercial paper. 
 
 This policy of concentrating the gold supply of the country 
 in the Federal Reserve banks in order to make it available for a 
 larger superstructure of credit than would be possible if it 
 remained widely scattered in the vaults of individual banks, 
 in the cash tills of a multitude of business enterprises, and in 
 the pockets of innumerable individuals, was largely dictated 
 by a consideration of the enormous financial requirements of 
 the war. With our gold resources thus effectively mobilized, 
 it was believed, not without good reason, that we should be 
 able to meet all financial demands that might be imposed 
 upon us. 1 
 
 It is urged by some that this process of gradually replacing 
 the gold currency in circulation by Federal Reserve notes has 
 defeated the elastic quality of such notes. While there is no 
 question that this substitution has greatly increased the power 
 of expanding note issues, and deposit currency as well, it is 
 not, however, generally believed that it has destroyed the 
 contraction feature of elasticity. It is argued that the notes 
 will return to the issuing bank whenever the demand for cur- 
 rency is slack, and that they cannot again be pushed out by the 
 Federal Reserve banks until a new currency demand has 
 developed, giving rise to new borrowings by member banks 
 from the Federal Reserve institutions. It should be noted, 
 however, that there will be times of great business activity, 
 
 1 Cf. chap. xxvi.
 
 588 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 when Federal Reserve notes will be reissued practically as 
 fast as they are redeemed. The total quantity may steadily 
 expand for a considerable interval of time, and again it may 
 contract for a period, varying with the season of the year and 
 the stage of the business cycle. 
 
 Federal Reserve notes are adequately secured. In the effort 
 to give Federal Reserve notes an elastic quality, the question of 
 safety has not been overlooked. Let us see what is the nature 
 of the security back of these notes. In the example given 
 above, Mr. Jones had given his promissory note to the Ottumwa 
 bank. Now the Ottumwa bank had extended the credit to 
 Jones on the strength of his business integrity and ability and 
 his general financial standing. There is thus, first, a property 
 security, presumably ample to insure the payment of the loan 
 by Jones. In the second place, there is additional security in 
 that the Ottumwa bank, when rediscounting Jones's note 
 indorses it and thus becomes secondarily liable for its payment. 
 In the third place, the Federal Reserve notes are the liability 
 of the Federal Reserve bank which issues them; and as such 
 they have a prior lien upon all of the bank's assets. Moreover, 
 the law requires that for every $100 of Federal Reserve notes 
 issued, the Federal Reserve bank must hold a reserve of at 
 least $40 in gold. There is, finally, a double liability of the 
 stockholders of the Federal Reserve banks; and since the 
 stockholders of these institutions are none other than all of 
 the member banks of the district, it will be seen that so long 
 as the banking system as a whole does not crumble to pieces, 
 Federal Reserve notes will not fail of redemption. 
 
 As a last resort, however it is said this provision was 
 incorporated to please Mr. Bryan, who insisted that the Federal 
 Reserve currency must be equivalent to government currency 
 the Federal Reserve notes are the direct obligation of the 
 United States government. Thus ultimately all the taxable 
 resources of the nation are back of them. 
 
 One qualification of the foregoing statements is necessary, 
 however. The Federal Reserve notes that arise from deposits of 
 gold and gold certificates with the Federal Reserve Agent are
 
 THE FEDERAL RESERVE SYSTEM 589 
 
 not secured by specific commercial paper. Offhand these notes 
 might appear to be backed by a gold reserve of 100 per cent; 
 but since the gold that is deposited in exchange for them is also 
 counted as reserve against notes that have been issued on the 
 security of commercial paper, such is not in reality the case. 
 
 Notes issued by the Federal Reserve banks are not legal tender. 
 Neither Federal Reserve bank notes nor Federal Reserve notes 
 have been given legal tender power in the settlement of private 
 obligations resembling the national bank notes issued by 
 member banks in this respect. Owing to the provisions regard- 
 ing their acceptability and redeemability, however, this failure 
 to make them legal tender in no way tends to impair their 
 serviceability as media of exchange. 
 
 The Federal Reserve bank notes are a direct obligation of 
 the Federal Reserve bank which issues them. They are 
 redeemable at the United States Treasury and receivable by 
 all national banks and Federal Reserve institutions as well 
 as by the United States government for all practical purposes. 1 
 
 The Federal Reserve notes are redeemable in gold coin on 
 demand at the United States Treasury, from a 5 per cent 
 redemption fund provided for the purpose, and at any Federal 
 Reserve bank. They are receivable at par by all national 
 and other member banks, by Federal Reserve banks, and for 
 all taxes and customs and other public dues. 
 
 IV. THE CONTROL OF CREDIT 
 
 A fundamental weakness of our national banking system, 
 as we have seen, was the lack of any adequate machinery for 
 the control of credit, or deposit currency, and hence for the 
 control of business in general. In times of seasonal strain 
 trade was sometimes halted for want of an elastic deposit 
 currency; in years of great industrial activity there was no 
 effective means of restraining business commitments and 
 preventing thereby the development of conditions of acute 
 crisis; and when the crisis arrived, there was little chance of 
 
 1 The provisions here are exactly the same as with the national bank 
 notes; see p. 371.
 
 SQO THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 escaping a panic for the reason that the credit structure was 
 rigid and inelastic. The problem of credit control, therefore, 
 divides itself into three parts: (i) providing the requisite 
 amount of funds for seasonal business requirements; (2) check- 
 ing expansion of currency during the upward swing of the busi- 
 ness cycle at the beginning of a critical business situation; 
 (3) expanding loans in time of acute crisis in order to tide the 
 business world over the period of tension. The Federal Reserve 
 Act has attempted to meet all of these requirements. 
 
 The control of credit under the Federal Reserve System 
 has been made possible largely by means of what is commonly 
 termed "the mobilization of the reserves" of the banking 
 system. This mobilization of reserves has been effected in a 
 variety of ways. It was of course necessary, first, to divert 
 a considerable portion of our monetary supply from the indi- 
 vidual banks to the Federal Reserve institutions. This was 
 accomplished in part by requiring each member bank to sub- 
 scribe to the capital stock of the Federal Reserve bank of its 
 district; in part by requiring the member banks to keep their 
 lawful reserves with the Federal Reserve institutions; 1 and in 
 part by exchanging Federal Reserve notes for gold and gold 
 certificates, as outlined in the discussion of notes in the section 
 above. Some government deposits are also made with the 
 Federal Reserve banks. 
 
 The use of our monetary supply has been economized. This 
 great concentration of reserves, together with the provisions 
 for their effective use which we are presently to consider, have ' 
 effected in the first place a great economy of funds, and made 
 possible a great expansion in the total quantity of both notes 
 and deposit currency. The original act permitted a reduction 
 in the reserve of member banks from 25 to 18 per cent in the 
 central reserve cities, from 25 to 15 per cent in the reserve 
 cities, and from 15 to 12 per cent in the country banks. But 
 after the great concentration of reserves that was accomplished 
 during the war by means of substituting Federal Reserve 
 
 'The original law required only part of the reserve to be so kept, but 
 it was amended later to include the entire minimum reserve.
 
 THE FEDERAL RESERVE SYSTEM 591 
 
 notes for gold and gold certificates, these requirements were 
 still further reduced to 13, 10, and 7 per cent against demand 
 deposits in banks in central reserve cities, reserve cities, and 
 country towns respectively; and in each class of banks 3 per 
 cent was required against time deposits. It should be observed, 
 however, that since it was required that these minimum reserves 
 should be kept entirely in the vaults of the Federal Reserve 
 institutions, money for till money purposes constituted an 
 addition to these minimum reserve requirements. 
 
 Whether or not this economizing of reserves constitutes a 
 real gain depends upon the use to which the additional credit 
 thus made available is put. There was a tendency among 
 writers on the Federal Reserve System at the time of the 
 passage of the law and in the early days of the system's operation 
 to attach very great significance to this conservation of funds; 
 but it is now frequently argued that the great expansion of 
 credit that it has made possible is largely responsible for the 
 very great rise in prices that has occurred since the outbreak 
 of the European war. However this may be and it is a 
 highly controversial issue there is substantial agreement 
 that the chief significance of the concentration of reserves in 
 the Federal Reserve institution is its relation to an effective 
 control of credit in the various ways suggested above. We may 
 therefore now turn to a consideration of the machinery of 
 credit control that has been evolved. 
 
 i. Providing the requisite amount of funds for seasonal 
 business requirements. We found in the preceding chapter that 
 in tunes of great seasonal activity the volume of bank reserves 
 is not always sufficient to permit an expansion of bank loans 
 and thus of deposit currency. Under the Federal Reserve 
 System, however, it is always possible for an individual bank 
 in need of funds to secure them from the Federal Reserve bank 
 of its district by the rediscount of commercial paper (but see 
 the next paragraph). We have already seen that such redis- 
 counts may be made the basis for an issue of Federal Reserve 
 notes; but in the present case, instead of taking notes, which 
 are not available as reserve, the member bank receives a deposit
 
 SQ2 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 account with the Federal Reserve bank which counts as cash 
 in hand, and this serves as a basis on which additional loans 
 may be made. So long, therefore, as member banks have 
 paper eligible for rediscount and so long as the Federal Reserve 
 banks maintain adequate lending power through keeping large 
 reserves, there can never be any possibility that the supply of 
 deposit currency will prove inadequate for seasonal needs. 
 
 Collateral loans to member banks are also authorized. Under 
 the original law the Federal Reserve banks could extend credit 
 to member institutions only through the process of redis- 
 counting notes, drafts, bills of exchange, etc., bearing the 
 indorsement of a member bank. It was soon found, however, 
 that there were many occasions when member banks would 
 find it necessary to borrow from Federal Reserve banks for 
 very brief periods of time, so brief that it was inconvenient to 
 rediscount customers' paper for the purpose. An amendment 
 to the act which authorized the Federal Reserve banks to make 
 short-time loans to member institutions on the basis' of collateral 
 security was, therefore, passed on September 7, 1916. The 
 collateral may consist of notes, drafts, bills of exchange, or 
 bankers' acceptances that are eligible for rediscount, or of bonds 
 or notes of the United States. This provision has been exten- 
 sively utilized; in fact, during the war by far the largest per- 
 centage of the credit extended by the Federal Reserve banks to 
 member institutions was made on the basis of collateral, con- 
 sisting mainly of government securities, commonly referred to 
 as "war paper." 1 
 
 Whereas before the passage of the Federal Reserve Act the 
 power of each bank to expand its deposit currency depended 
 upon the possession of unused reserves and upon its ability to 
 secure accommodations from other banks, now no bank can 
 fail to meet the demands for funds in its community merely in 
 consequence of the exhaustion of its individual reserves or 
 because of its inability to secure assistance from some corre- 
 spondent bank. The central reservoir of credit that exists in 
 the Federal Reserve banks makes it possible for every bank to 
 
 1 See pp. 628-30.
 
 THE FEDERAL RESERVE SYSTEM 593 
 
 provide the necessary loan expansion regardless of its particular 
 condition. The weak links in the banking chain are thus 
 immeasurably strengthened and the supply of credit is made 
 responsive to seasonal requirements. Moreover, after the 
 seasonal strain is passed such deposit currency automatically 
 contracts; for when the loans which were procured in order to 
 finance the seasonal requirements are paid, checks are drawn 
 against deposit accounts in favor first of the member banks and 
 then of the Federal Reserve institutions, thereby reducing the 
 volume of outstanding deposit accounts. Such deposits will, 
 moreover, not reappear until there is a new demand for funds 
 to be used in connection with new business transactions. 
 
 2. Checking expansion of currency during the upward swing 
 of the business cycle at the beginning of a critical business situation. 
 This aspect of the problem of credit control involves a somewhat 
 different mechanism. When the first signs of stress and strain 
 appear within the system, when it becomes clear that further 
 expansion will carry in its tram an inevitable credit collapse, 
 it is believed that the brakes may be applied to industry in 
 such a way as to cause a gradual rather than a precipitate 
 readjustment of business conditions. Concretely, the instru- 
 mentality by means of which the business cycle is to be con- 
 trolled is the interest rate. So long as we had an independent 
 banking system, with each bank acting largely on its own 
 initiative, it was impossible to secure any concerted action in 
 the control of the discount rate, that is, in raising the rate as a 
 means of checking business expansion, for the reason that it 
 would not appear to the interest of all of the banks to raise 
 interest rates and thereby lessen loans. Moreover, an agree- 
 ment, if adopted, would probably raise the charge that the 
 bankers were attempting to profiteer at the expense of business 
 generally. Under the Federal Reserve System, however, a 
 quick raising of interest rates may be effected through the 
 action of the Federal Reserve Board, which cannot well be 
 criticized as attempting to serve profit-making ends of its own. 
 
 The means by which the Federal Reserve Board may secure 
 a general increase in the interest rates is very simple. The
 
 SQ4 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 board is given the power of fixing the rates at which the Federal 
 Reserve institutions make loans to member banks, as also 
 the rates which they shall pay when loaning funds in the general 
 market through the purchase of acceptances, etc. At a time 
 when all member banks are rinding it necessary to borrow 
 from Federal Reserve banks funds with which to meet their 
 customers' demands, a raising of the rates at which they borrow, 
 promptly results in the raising of discount rates by member 
 banks to their customers. 
 
 The result of this raising of interest rates is to make the 
 conduct of business more costly, to narrow the margins of 
 profit, and hence to apply the brakes to further industrial 
 expansion and bring about a gradual readjustment. In a word, 
 it is believed that the Federal Reserve Board, acting on an 
 understanding of the phenomena of the business cycle, could 
 through the instrumentality thus placed in its hands exercise 
 an effective control over general business. If successful, such 
 a policy would mean that the last stage in the upward swing 
 of the business cycle would be eliminated, and with it of course 
 the beneficent results of such a period of very active business. 
 But on the other hand, it would prevent a financial collapse 
 such as occurred in the past when business was allowed to 
 continue its rapid expansion to the ultimate breaking-point, 
 that is, to the point of complete exhaustion of the bank reserves; 
 and it would bring about a business readjustment more gradual 
 in its nature and hence involving less serious results to both 
 capital and labor than would be the case if the upward swing 
 were allowed to continue for a longer period, even though an 
 ultimate financial panic might still be avoided. 1 
 
 3. Expanding loans in a period of acute crisis. In the event 
 that the attempt to control business expansion and to bring 
 about a gradual readjustment by raising the discount rates 
 should prove ineffective and business should continue to expand 
 until the stage of acute crisis is reached, it is still within the 
 power of the Federal Reserve System to avoid the fourth stage 
 
 1 For a consideration of a practical test of this method of controlling 
 business expansion, see the chapter which follows, pp. 634-40.
 
 THE FEDERAL RESERVE SYSTEM 595 
 
 of the business cycle, namely, the suspension of specie payments 
 and the collapse of the entire credit structure, accompanied by 
 financial panic. We have seen in the preceding chapter that 
 in time of acute crisis the outstanding need is for an increase 
 in bank reserves and an expansion of loans. The Federal 
 Reserve System is designed to meet this need. 
 
 Under the terms of the law it was provided, as we have 
 already seen, that the member banks should contribute to the 
 capital stock of the Federal Reserve institutions; and they must 
 also keep their reserves on deposit with the Reserve banks. 
 These banks thus become central reservoirs of cash, the final 
 repositaries of the commercial banking system. Upon them 
 we have placed the responsibility of maintaining reserves 
 adequate for all emergencies. While, as we have already seen, 
 the law prescribed relatively large minima, it was deemed neces- 
 sary as a matter of policy for the Federal Reserve banks to 
 maintain in ordinary times reserves greatly in excess of these 
 figures in order that in case of emergency there might be avail- 
 able a practically "'unlimited amount" of lending power. It 
 will be recalled that before the establishment of the Federal 
 Reserve System, our decentralized system of banking led each 
 individual bank to expand its loans in time of active business 
 practically to the reserve limits; there could be no concerted 
 action whereby funds might be set aside for emergency use only. 
 A policy of providing funds for emergencies is, however, the 
 very essence of the Federal Reserve System. 
 
 To understand clearly the amount of expansion that is 
 possible in time of emergency and the way in which it is prac- 
 tically worked out, it will be necessary for us again to consider 
 some actual transactions. Suppose in time of crisis the First 
 National Bank of Chicago has a demand from its customers 
 for additional loans. While its reserve is down to the minimum, 
 it may make the additional loans by first taking, say, $100,000 
 of its customers' notes to the Federal Reserve Bank of Chicago 
 for rediscount. The result of this is to lessen the loans of the 
 First National Bank of Chicago by $100,000 and to increase its 
 cash reserve in the form of a deposit account in the Federal
 
 596 THE FINANCIAL ORGANIZATON OF SOCIETY 
 
 Reserve bank by $100,000, less, of course, the amount of the 
 interest deducted by the Federal Reserve bank. On the basis 
 of this new reserve the First National Bank can now make 
 additional loans to the extent of over $700,000 and create new 
 deposit accounts to a like amount. 1 
 
 It will be clear at once that so great an expansion of lending 
 power as here suggested would be adequate to meet any except 
 the most extraordinary credit demands. But hi case still 
 further demands for funds are manifested, the First National 
 Bank could take the $700,000 of new promissory notes that 
 have come into its possession as a result of its additional loans, 
 and rediscount them with the Federal Reserve Bank of Chicago, 
 thereby acquiring additional deposits in the Federal Reserve 
 bank, which are available as a reserve basis for still further 
 loans. So long as there is eligible paper for rediscount and so 
 long as there are reserves in the Federal Reserve banks above 
 the minima prescribed by law, there is no limit to the expansion 
 of credit that can be made. 
 
 The system of rediscounling strengthens the weak links in the 
 banking chain. It will be seen that under this system the 
 essentially weak links hi the banking system are eliminated. 
 Any bank within the First Federal Reserve District, for instance, 
 can secure loans with which to meet the demands of its con- 
 stituency regardless of its own condition so long as there is 
 money in the central reservoir at the Federal Reserve bank. 
 Rather than a scramble for reserves and a working at cross- 
 purposes, as was the case before 1914, there is here definite 
 machinery for co-operative action hi meeting credit strains 
 wherever they may appear. 
 
 Not only may the banks of District No. i continue to 
 secure accommodation from the Federal Reserve bank of that 
 district so long as its reserve is not exhausted, but the Federal 
 Reserve Board may require the Federal Reserve bank of 
 District No. 2 to extend loans to the Federal Reserve bank of 
 District No. i. Thus a process of credit expansion can continue 
 
 1 This figure is possible because the law requires a reserve of onl> 
 13 per cent in national banks in central reserve cities.
 
 THE FEDERAL RESERVE SYSTEM 597 
 
 and relief can be given to individual banks and through them 
 to business concerns, until the average reserve of all the Federal 
 Reserve banks has been drawn down to the minimum. Thus 
 not only is there no weak link within a district; there is also no 
 weak district within the Federal Reserve System as a whole. 
 Each is as strong as any other. 
 
 Finally, the reserve requirements are not irreducible minima. 
 For the law makes it possible to cut below the 35 and 40 per 
 cent reserve requirements against deposits and Federal Reserve 
 notes respectively hi case of acute emergency. The Federal 
 Reserve Board may suspend for a period not exceeding thirty 
 days, and from time to time may renew such suspension for a 
 period not exceeding fifteen days, these reserve requirements, 
 provided it establishes a graduated tax of not more than i per 
 cent per annum upon such deficiency of reserves, until the 
 reserve falls to 32^ per cent; and if they fall below this per- 
 centage the tax shall be i| per cent per annum upon each z| 
 per cent or fraction thereof. Thus if the reserve should fall 
 to 30 per cent there would be a tax of 2 per cent; if it fell to 
 29 per cent the tax would be 4 per cent; and if it fell below 
 27^ the tax would be 5^ per cent. There is no ultimate limit 
 other than zero. Whether a decline of the reserves far below 
 the legal minimum could be continued without a loss of con- 
 fidence leading to the familiar hoarding of currency and ultimate 
 collapse of the credit structure is, however, open to some 
 question. 1 It will be seen, however, that these provisions do 
 insure a very high degree of credit flexibility. 
 
 Control of the interest rate is also of aid in time of crisis. 
 It remains to observe that manipulation of the interest rate may 
 be of assistance in time of acute crisis, as well as during the 
 earlier stages of the credit strain. In case of a failure to raise 
 the interest rate before the stage of acute crisis has been reached, 
 or in the event that such increase as has been made has not 
 sufficiently applied the brakes to industry, and prevented 
 the development of acute tension, the use of this instrumentality 
 of credit control will still be of genuine service, in two ways. 
 
 ' Cf . p. 644.
 
 598 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 First, the raising of the interest rate performs an important 
 negative function in discouraging all loans that can be done 
 without. While it is highly important in time of crisis that 
 every borrower who is in a sound financial condition should be 
 "carried" through the difficult period caused by the disruption 
 of the credit structure and the consequent impairment of 
 mutual credit operations, it is the part of wisdom to raise the 
 discount rate to a very high figure as a means of deterring all 
 borrowing that is not indispensable. As we have seen in the 
 study of business cycles, it is imperative that a temporary 
 halt be called to new commitments and a period of readjustment 
 brought about. Very high discount rates discourage new 
 commitments and promote financial readjustments. 
 
 In the second place, the raising of the interest rate may 
 perform a positive function in attracting additional funds to 
 the United States. In our study of the mobilization of credit 
 we have been considering up to this point only the internal or 
 domestic financial resources of the nation. We shall now find 
 that through the control of the discount rate the way has been 
 opened under the Federal Reserve System to attract funds 
 from other countries in time of acute financial strain. High 
 money rates in the United States, it is believed, would serve 
 to attract funds from countries with low interest rates; for 
 money, like other commodities, tends to flow to the regions 
 where the return from its use is highest. European central 
 banks have, in fact, on repeated occasions attracted foreign 
 funds in time of emergency by the use of this method. If the 
 great strain is felt simultaneously in all the leading commer- 
 cial nations, however, and if the central banking institutions 
 of all of them should resort at one and the same tune to high 
 interest rates, the result of course would be merely a stalemate. 
 In any event, however, the United States will henceforth be hi a 
 position at least to prevent an outflow of funds at a tune when 
 our own reserves are in a dangerous condition. 
 
 "Open market operations" facilitate the control of credit. 
 Thus far we have been considering the Federal Reserve banks 
 only in relation to their dealings with member institutions and
 
 THE FEDERAL RESERVE SYSTEM 599 
 
 with one another. While they are primarily bankers' banks, 
 they are nevertheless given power to make certain direct 
 investments to engage in what are known as "open market 
 operations." These operations are designed both to give the 
 Federal Reserve banks opportunity for engaging in profit- 
 making transactions and to strengthen their control of the 
 general credit system. 
 
 Specifically, every Federal Reserve bank is empowered 
 
 a) To deal in gold coin and bullion at home or abroad, to 
 make loans thereon, exchange Feder.al Reserve notes for gold, 
 gold coin, or gold certificates, and to contract for loans of gold 
 coin or bullion, giving therefor, when 'necessary, acceptable 
 security, including the hypothecation of United States bonds 
 or other securities which Federal Reserve banks are authorized 
 to hold. 
 
 b) To buy and sell, at home or abroad, bonds and notes 
 of the United States, and bills, notes, revenue bonds, and 
 warrants with a maturity from date of purchase of not exceeding 
 six months, issued in anticipation of the collection of taxes or 
 in anticipation of the receipt of assured revenues by any state, 
 county, district, political subdivision, or municipality in the 
 continental United States. 
 
 c) To purchase from member banks and to sell, with or 
 without its indorsement, bills of exchange arising out of com- 
 mercial transactions. 
 
 d) To purchase and sell in the open market at home or 
 abroad either from or to domestic or foreign banks, firms, 
 corporations, and individuals, cable transfers and bankers' 
 acceptances, and bills of exchange of the kinds and maturities 
 by this Act made eligible for rediscount with or without the 
 indorsement of a member bank. 
 
 This power to deal in gold coin and bullion at home and 
 abroad makes it possible for the Federal Reserve banks to bid 
 for gold at the weekly auction of gold in London or elsewhere, 
 and thus to strengthen our own gold position in case of necessity . 
 This gold may be paid for either by the sale of securities held by 
 the Federal Reserve banks or by means o.f the purchase of foreign
 
 600 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 bills of exchange. The borrowing of gold on acceptable security 
 is also designed to give the Federal Reserve banks a greater 
 control over the nation's gold supply, by preventing an outflow 
 of specie at critical periods. If this gold is borrowed abroad 
 it will give rise to an increased supply of bills of exchange, thus 
 tending to prevent the rate of exchange from rising to the 
 gold-exporting point. If borrowed in the United 'States, it will 
 result in a shifting of gold supply from the member banks to 
 the Federal Reserve banks, thereby tending to raise the general 
 discount rate in the United States and thus to discourage the 
 export of specie. Further influence upon exchange rates may 
 be exerted by virtue of the power of the Federal Reserve banks 
 to buy and sell foreign bills of exchange in the open market in 
 Europe. 
 
 The provision enabling the Federal Reserve banks to pur- 
 chase and sell bills of exchange, etc., as listed under (d) above, 
 makes it possible for them to accomplish two important results, 
 aside from making profits for themselves: (i) It enables them 
 to purchase the paper of banks which are not members of the 
 Federal Reserve System and which are hence not in a position 
 to secure needed funds through the process of rediscounting, 
 thereby materially strengthening the general credit structure; 
 (2) it enables them to exercise a direct influence upon interest 
 rates at times when, owing to the lack of applications for 
 rediscounts, they would be unable to influence interest rates 
 through the ordinary process. But by virtue of their power to 
 buy paper in the open market at a rate either higher or lower 
 than the going rate, the Federal Reserve banks are in a position 
 to set the pace and establish such new rates as in the view of 
 the Federal Reserve Board are demanded by the situation. 
 
 V. THE CREATION OF A "DISCOUNT MARKET" 
 
 We have seen in the two preceding sections how the Federal 
 Reserve System has provided a degree of elasticity in our bank 
 note and deposit currency system hitherto unknown, and made 
 possible a substantial control over the general credit and
 
 THE FEDERAL RESERVE SYSTEM 60 r 
 
 business structure. We may now consider how the development 
 of what is known as a discount market gives a still greater 
 flexibility to the commercial banking structure. Since the 
 discount market is based upon the use of a commercial credit 
 instrument known as the bank acceptance, a description of 
 this instrument must first be given. 
 
 A photographic reproduction of a banker's acceptance will 
 be found on page 166 above. It will be noted that it is a bill 
 of exchange drawn by an individual against a bank and accepted 
 by the latter for payment at a future date. It differs from a 
 bank check in that it is not drawn against a deposit account 
 and is not an order to pay on demand. It owes its origin, like 
 the book account, the promissory note, and the trade draft, 
 to a commercial operation involving the sale of goods from 
 AtoB. 
 
 Let us suppose that A in Des Moines sells goods on time to 
 B in Chicago. He may, as we have already seen in chapter xii, 1 
 sell on open account, entering the amount in his books as an 
 account receivable; or he may ask B to give him a promissory 
 note; or he may draw a draft upon B for the amount and send 
 it to B for acceptance; or finally, he may draw a draft upon 
 a bank designated by B, who makes the necessary arrangements 
 with the bank.* Now if the Continental and Commercial 
 National Bank of Chicago accepts on behalf of B a draft drawn 
 by A, it is in a sense guaranteeing the credit of B. It is not 
 an ordinary guaranty, however, because the bank assumes a 
 position of primary liability: it does not bind itself to pay 
 in case B fails to meet his obligations; but it agrees to pay on 
 its own account. 
 
 The bank, however, looks to B to furnish it with the 
 funds required in meeting the acceptance before the date of its 
 maturity. It will be apparent that if B makes good on his 
 agreement to put the bank in funds before the acceptance is due, 
 
 1 See p. 162. 
 
 *We have already touched upon the principle involved in the bank 
 acceptance in connection with the study of the part that commercial banks 
 play in financing foreign trade. See chap. xx.
 
 602 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 the bank will not have parted with any money; it will merely 
 have loaned B the use of its name, for which service it receives 
 a small commission of one-eighth or one-fourth per cent of the 
 amount of the acceptance. A bank takes some risks, however, 
 for the reason that there is a possibility that B might fail to 
 place the bank in funds in accordance with the terms of his 
 agreement. The bank, however, makes a careful analysis of 
 B's financial standing before agreeing to accept drafts on his 
 behalf, and further protects itself by means of a trust receipt, 
 such as was discussed above in the chapter on " Commercial 
 Banking and the Financing of Foreign Trade" (see p. 415). 
 
 Reference to the liabilities side of the financial statement 
 on page 365 indicates that the Continental and Commercial 
 National Bank of Chicago had, in fact, on that particular date 
 incurred liabilities under Acceptances of $6,057,234.50; while 
 the corresponding item on the assets side shows that customers 
 had assumed a liability to the bank for a like amount. It will 
 be observed by reference to this statement that, while the 
 practice of accepting drafts opens up a new source of profit 
 to the banks, it does not increase their deposit obligations or 
 lessen the ratio of cash to deposits. 
 
 Since an accepting bank does, however, incur a liability 
 and since there is always some chance that this liability may 
 have to be met out of its own resources, it was felt necessary to 
 limit the volume of acceptances that might be made by any 
 one bank. The law as first passed permitted the making of 
 acceptances only in connection with foreign transactions 
 exports and imports; but through a subsequent amendment, 
 deemed necessary because the state banking law of New York 
 had made it possible for state banks to engage, in the acceptance 
 of domestk as well as foreign bills, the national banks are 
 now permitted to make domestic acceptances. It is provided, 
 however, that no bank shall accept for any one party to an 
 aggregate hi excess of 10 per cent of the bank's paid-up 
 capital stock and surplus, unless the bank is secured by an 
 attached document or by some other actual security growing 
 out of the same transaction as the acceptance. Moreover,
 
 THE FEDERAL RESERVE SYSTEM 603 
 
 the total volume of bills that may be accepted by any one 
 bank at one time shall not be more than one-half its paid-up 
 capital stock and surplus; although the Federal Reserve Board 
 may authorize total acceptances up to 100 per cent of the 
 capital and surplus, provided not more than 50 per cent of the 
 amount are domestic acceptances. 
 
 A bank acceptance is the highest form of credit instrument 
 for the obvious reason that it is a direct obligation of a large 
 financial institution whose practices are subject to careful 
 regulation and control. Accordingly it is admirably adapted to 
 serve as a basic credit instrument in the discount market. 
 
 For a terse and comprehensive statement of the nature and 
 function of the discount market we cannot do better than to 
 reprint at this place a statement of a prominent New York 
 banker. 1 
 
 I. FUNCTIONS OP A DISCOUNT MARKET 
 
 a) Regulating medium of the cash and investment position of 
 banks. The most important function of a discount market is that 
 it operates as a central reservoir of commercial credit by means of 
 which individual banks may regulate their investment and cash 
 position. The discount market to be of proper use must be of suffi- 
 cient breadth that a bank may be able at any time to purchase 
 therein such amount of bills as it requires to properly balance its 
 investment and cash position, with the full assurance that it can 
 re-enter the market as a seller and readily dospose of such bills 
 without materially affecting current discount quotations. This 
 naturally necessitates a broad market in which a large volume of 
 bills is constantly being handled and which can readily take or 
 furnish a substantial quantity of bills without material fluctuations 
 in its rate of discount. 
 
 b) Equalizer of interest rates between different sections of the 
 country. A broad discount market operates as an equalizer of 
 interest rates between different sections of the country. If in one 
 district the banks have surplus funds, their purchases of bills in the 
 discount market will tend to keep interest rates in that district up 
 
 1 From an address by John E. Rovensky,vice-president of the National 
 Bank of Commerce in New York, published in the Economic World, June 14, 
 1919.
 
 604 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 * 
 
 to the level of the other districts. In like manner, if in a district 
 interest rates begin to rise above the levels of the other districts, 
 the banks of that section, by selling their holdings of bills in the 
 discount market, would tend to keep interest rates approximately 
 at the level of the other districts. It must be understood, of course, 
 that to some extent inequalities in interest rates between various 
 districts would continue, but these inequalities would not be as 
 broad as they are at present. The inequalities would be limited to 
 such minor differences in interest rates as the average bank is willing 
 to forego rather than change its position and purchase or sell bills in 
 the market. As time progresses and banks become more accustomed 
 to dealing in the discount market, this difference would tend to 
 become quite small. 
 
 c) Equalizer of interest rates between the United States and foreign 
 countries. This function of the discount market Operates very much 
 in the same manner as in the case of equalizing rates between different 
 sections of the same country. The existence of a broad, healthy 
 discount market in the United States would encourage foreign banks 
 to purchase our bills as an investment when interest rates in this 
 country are higher than abroad. This would tend to move our 
 interest rates sympathetically with the level of rates the world over. 
 Should our rates decline unduly, there would be a tendency on the 
 part of foreign banks to dispose of their holdings of American bills 
 and on the part of our banks to purchase foreign bills and dispose of 
 their holdings of domestic bills, and thus a movement toward re- 
 establishing an equilibrium between rates here and abroad would 
 start. This does not mean that the rates here and abroad would be 
 at the same level, but it does mean that the spread between rates 
 here and abroad would ordinarily not be as far apart as they have 
 been in the past. 
 
 d) Stabilizer of gold movements between countries. This function 
 of the discount market is really an after-effect of its operation as an 
 equalizer of interest rates between different countries. Foreign 
 bankers would grow accustomed to having in their portfolios a line 
 of American bills just as American banks have at times lines of 
 foreign bills. As exchange rates rose in this country which means 
 that dollars would become cheap abroad foreign banks would 
 increase their holdings of American bills on account of the cheap 
 dollar exchange rate, while American banks would sell their holdings 
 of foreign bills to profit from the high foreign exchange rates. Gold
 
 THE FEDERAL RESERVE SYSTEM 605 
 
 exports would thus be warded off for a time. Gold imports would 
 be retarded by a reversal of the process. 
 
 This process of accumulating a portfolio of foreign bills in time 
 of financial ease for use when conditions are reversed has been used 
 successfully by the central banks of all leading European countries 
 and may profitably be utilized by our Federal Reserve banks when 
 international relations again become normal. I do not mean that 
 international movements of gold would be stopped by the operations 
 of our discount market, but it is certain that many unnecessary gold 
 movements would be prevented. It has actually occurred in the 
 past that gold shipments in opposite directions have passed one 
 another on the ocean. In other words, we have in the past frequently 
 exported or imported gold when it was clearly to be foreseen that 
 existing conditions were but temporary. However, it was not the 
 business of anyone to give the matter any thought beyond simply 
 calculating whether the prospective gold shipment yielded a profit, 
 however small. We had no stabilizing mechanism that would tend 
 to prevent such shifts of gold. 
 
 e) Stabilizer of interest rate levels within the country. Preventing 
 unnecessary exports and imports of gold and developing a closer 
 relation between interest rates here and abroad would result in a 
 greater stability of American interest rates. There would be a 
 closer connection between the American reservoir of commercial 
 credit and that of Europe. Large bodies are not subject to sudden 
 movements to the same extent that smaller ones are. Interest 
 rates in Europe in normal times are much steadier than ours; discount 
 rates abroad move by sixteenths of i per cent and on the whole move 
 within narrow limits. 
 
 n. THE NECESSITY OF A STANDARDIZED INSTRUMENT OF CREDIT 
 TO THE EXISTENCE OF A DISCOUNT MARKET 
 
 The truth of this proposition is so self-evident that a lengthy 
 explanation is not necessary. If we had no well-defined standards 
 in grades of cotton, dealings on the Cotton Exchange would be 
 impossible. The same holds good of wheat, oats, corn, or any other 
 commodity. Before the inauguration of the Federal Reserve System, 
 our banking system lacked a standardized credit instrument, and, 
 therefore, a broad discount market was an impossibility. The 
 Federal Reserve Act, by introducing the bank acceptance into our 
 banking mechanism, has furnished us the instrument we lacked.
 
 6o6 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 In a bank acceptance the element of credit risk has substantially 
 been eliminated by the signature of a bank of unquestioned standing. 
 The acceptance, therefore, represents absolute safety as nearly as 
 can be attained in any credit instrument. The rate of discount at 
 which such instruments sell in the market simply represents the 
 actual value of the use of the money and not, as in the case of the 
 discount of an ordinary promissory note, the value of the use of 
 money plus a premium for the credit risk assumed by the leaner. 
 In every commercial country in the world, the discount market is 
 based upon the bank acceptance, and the discount market in turn is 
 the basis of the entire money market. Our brief experience since 
 the passage of the Federal Reserve Act justifies the opinion that our 
 discount market will likewise be based upon the same instrument 
 the acceptance. 
 
 m. COMPONENT FACTORS OF THE DISCOUNT MARKET 
 
 The component factors of a discount market consist: first, of 
 the accepting banks that create the acceptance; the banks and 
 others who purchase and sell acceptances; the central banks of 
 rediscount (in our case the Federal Reserve banks) that operate as 
 stabilizers at times when the movements of the discount market 
 represent not merely the usual equalizing of the investment and 
 cash position between the individual banks but, rather, a condition 
 that is general throughout the country; and the discount corporations 
 and brokers which act as the highly essential middlemen. 
 
 a) The acceptance banks. In England a large part of the accept- 
 ances are created by the so-called acceptance houses. The English 
 deposit banks have not in the past been as active in this line as 
 those of France and Germany. 
 
 Our own experience leads me to the conclusion that the deposit 
 banks in this country will be the main creators of acceptances. 
 There is no valid reason why they should not be; in fact, it is to be 
 preferred that banks operating under close public scrutiny should 
 be the creators of the basis of our discount market rather than 
 so-called acceptance houses, the standing of which is known to 
 but few. 
 
 ft) Bank and other purchasers and sellers of acceptances. The 
 purchasers and sellers of acceptances constitute the active discount 
 market. A bank that is a purchaser one day may be a seller the 
 next. Whether a bank purchases acceptances or sells in the market
 
 THE FEDERAL RESERVE SYSTEM 607 
 
 should depend entirely upon its own individual cash and investment 
 position. When its position warrants a purchase it should step into 
 the market and acquire the bills it needs, and when its position 
 changes it should as freely sell. 
 
 c) The central rediscounting bank. The central rediscounting 
 bank in our country, the Federal Reserve bank, should operate 
 as a stabilizer in cases where the situation becomes one that is not 
 equalized by purchases between banks. There will be times when 
 a preponderant number of banks throughout the country are sellers 
 of acceptances. At such times the Federal Reserve bank should 
 purchase, under such regulations as it deems wise, either from the 
 member banks or direct in the market, a certain amount of bills. 
 On the other hand, the Federal Reserve bank should resell such 
 bills when, in its judgment, market conditions justify such action. 
 
 d) Discount corporations and brokers. Discdunt corporations 
 and other bill brokers act as middlemen between the various factors 
 of the discount market. They perform a very useful function and 
 no steps should be taken that would tend to curtail their usefulness. 
 The practice of banks holding their own bills should not be encour- 
 aged. Likewise, the practice of banks buying one another's bills 
 without the intermediation of a broker is unsound as it tends to 
 retard the development of the market. In the case of foreign or 
 domestic acceptances, it matters little whether the accepting bank 
 or the holder sells the bill to the broker; the essential part is that 
 the mediation of the brokers should be utilized and the bill should 
 not be kept off the market. 
 
 The practice has become prevalent in this country, in connec- 
 tion with domestic acceptances, of the accepting bank quoting its 
 customer (the drawer) a flat interest rate which includes both the 
 rate of discount and the acceptance charge and itself selling the 
 acceptance to the broker. So long as the bill is sold to a broker 
 who in turn puts the bill on the market, there can be no objection 
 to this practice, as the bill finds its way into the open market and 
 is there sold to such banks as require it. 
 
 The brokers operate not only as middlemen but their portfolios 
 of bills constitute the floating supply without which a stable market 
 would be impossible. This floating supply is naturally far in excess 
 of the financial resources of the brokers and consequently some 
 means must be available to them of borrowing money at rates that 
 bear some relation to the level of the discount market.
 
 608 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 There follows a financial statement of the Discount Cor- 
 poration of New York, which was established under the invest- 
 ment banking laws of New York State on January 2, 1919. 
 The statement of condition is for September 30, 1920. 
 
 ASSETS 
 
 Acceptances Discounted ..... $51,768,359.45 
 
 U.S. Government Securities. . ^ . . 350,000.00 
 
 Other Government Securities .... 985.00 
 
 Cash and Due from Banks 1,413,917.77 
 
 Sundry Debits 8,759.68 
 
 $53,542,021.90 
 
 LIABILITIES 
 
 Capital $5,000,000.00 
 
 Surplus 1,000,000.00 
 
 Undivided Profits . . 563,231.35 6,563,231.35 
 Loans Payable and Deposits .... 19,987,100.72 
 Acceptances Rediscounted 
 and Sold with Endorsement .... 26,545,179.52 
 
 Unearned Discount 308,115.58 
 
 Sundry Credits 138,394.73 
 
 $53,542,021.90 
 
 VI. CLEARINGS AND COLLECTIONS 
 
 The Federal Reserve System has effected some noteworthy 
 changes in our clearing and collection system. While not 
 disturbing the process of clearing worked out by banks in a 
 given city by means of the clearing-house associations, it has 
 materially modified the system by means of which out-of-town 
 checks are collected, and it has introduced a new clearings 
 feature, that of the gold settlement fund for the settling of 
 balances between the Federal Reserve banks themselves. 
 
 It will be recalled that under the old system of collecting 
 out-of-town checks the correspondent banks in reserve and 
 central reserve cities were utilized for the purpose, the service 
 being performed by the city banks as partial compensation for
 
 THE FEDERAL RESERVE SYSTEM 609 
 
 the use of the reserve and other funds' which were currently 
 deposited by country institutions with their city correspondents. 
 This system of collection was in many respects socially uneco- 
 nomical, often involving, as we found in chapter xxii, the round- 
 about routing of checks and long delays in securing the funds. 
 And during the entire period that a check was in transit, the 
 bank which had cashed it was counting the uncollected item as 
 a part of its available reserve. The "float," or volume of 
 checks in transit in this roundabout process of collection, was 
 characteristically very large, and it amounted to a substantial 
 reduction of the actually available reserves of the banking 
 system. 
 
 The old system, moreover, often proved an annoyance and 
 a financial burden to the customers for whom the checks were 
 collected. Collection charges were typically very diverse and 
 often appeared to be arbitrarily discriminatory. For want of 
 any standards aside from those agreed upon in some of the 
 clearing-house associations many banks undoubtedly charged 
 excessive rates, while others did not even cover the costs 
 entailed. 
 
 While authority was given by the Federal Reserve law for 
 the introduction of a new clearing and collection system, the 
 Federal Reserve Board proceeded very slowly in the formulation 
 of a new system, for the reason that it was foreseen that a thor- 
 ough reorganization of collection methods, involving losses of 
 collection revenues to certain banks and changed relationships 
 between city and country bank correspondents, would arouse 
 no little opposition. The Federal Reserve Board therefore 
 felt its way carefully, first trying out a voluntary system for 
 the member banks of each district; and it was not until July 5, 
 1916, that the new clearing system (compulsory on all member 
 banks) was put into operation. 
 
 As finally evolved, there are two parts to this Federal 
 Reserve collection system: (i) intra-district clearings, and 
 (2) inter-district clearings. The former relates to the col- 
 lection and clearing of checks between banks in the same 
 Federal Reserve district; the latter to that between banks in
 
 6lo THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 different Federal Reserve districts. We may consider each in 
 turn. 
 
 1. Infra-district clearings. Under a ruling of the Federal 
 Reserve Board every Federal Reserve bank is required to 
 exercise the functions of a clearing-house for its members and 
 for certain qualified non-member banks, known as "clearing 
 member banks." Under this system each Federal Reserve 
 bank is to receive at par, that is, without collection charges, 
 "checks drawn on all member and clearing member banks, 
 and on all other non-member banks which agree to remit at par 
 through the Federal Reserve bank of th'eir district." The 
 extension of the "privilege" to non-member banks is of course 
 designed to universalize the process. 
 
 Under this plan a member bank in Milwaukee, which receives 
 a check drawn on a bank hi Springfield, Illinois, accepts the 
 check from its customer at par and sends it to the Federal 
 Reserve Bank of Chicago, which in turn sends it directly 
 to the member bank in Springfield for collection. Since all 
 banks within a given district have deposit accounts with the 
 Federal Reserve banks, the accounting may be taken care of 
 merely by debiting and crediting the accounts of member banks 
 at the Federal Reserve bank. It should be noted, however, 
 that the proceeds of the check are not made available for 
 withdrawal by the Milwaukee bank or counted as a part of its 
 reserve until sufficient time has elapsed to permit it to be 
 actually collected and the funds returned to the Federal Reserve 
 bank. The amount of time that must elapse before it can be 
 counted as reserve varies with the distance of the bank upon 
 which the check is drawn from the Federal Reserve bank 
 which is collecting it. 
 
 2. Inter-district clearings. The system of inter-district 
 clearings is a necessary complement to the intra-district clear- 
 ings. Under this plan every Federal Reserve bank receives 
 at par checks drawn upon any bank within its district (whose 
 checks can be collected at par), when presented by banks 
 outside the district. That is to say, if a check drawn on a 
 Chicago bank is cashed by a bank in San Francisco it will be
 
 THE FEDERAL RESERVE SYSTEM 611 
 
 sent to the Federal Reserve Bank of Chicago where it will be 
 received at par and be collected from the bank upon which it is 
 drawn. The San Francisco bank, however, does not itself 
 send the check to the Chicago bank; for since it is in a different 
 reserve district it has no direct relation with the Chicago reserve 
 institution. It therefore sends the check to the Federal Reserve 
 Bank of San Francisco, which acts as agent in the process of 
 collection. Nor does the Federal Reserve Bank of San Francisco 
 send each check individually for collection to the Federal 
 Reserve Bank of Chicago. As in other clearing operations, 
 counter claims largely offset each other. The inter-district 
 clearings are effected through a system of offsets at the Federal 
 Reserve Board at Washington, involving the new feature 
 of clearings above referred to, namely, the gold clearance 
 fund. 
 
 Clearings between Federal Reserve banks are effected by means 
 of a "gold clearance fund." The Federal Reserve law has 
 required each Federal Reserve bank to forward to the Treasury 
 at Washington, or to the nearest sub-treasury, for credit to the 
 account of the gold settlement fund, under the administration 
 of the Federal Reserve Board, $1,000,000 in gold or gold cer- 
 tificates, plus an additional amount equal to its indebtedness 
 at the moment to other Federal Reserve banks. At 10:00 A.M. 
 eastern time each bank sends a telegram to the Federal Reserve 
 Board stating the amount it has credited to other Federal 
 Reserve banks during the preceding day. Just as the Federal 
 Reserve Bank of Chicago now effects the settlement of the 
 daily balances of Chicago clearing-house banks 1 by increasing or 
 decreasing the deposit accounts of each bank, as determined by 
 the record of the daily clearings, so the Federal Reserve Board 
 adds to or subtracts from the account of each Federal Reserve 
 bank in the gold settlement fund. In case the balance of any 
 Federal Reserve bank falls below $1,000,000, it must be immedi- 
 ately replenished by sending additional gold to the Treasury. 
 It should be added that the balance thus maintained by each 
 Federal Reserve bank is counted as a part of its legal reserve. 
 
 1 See p. 461.
 
 612 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 The establishment of this gold settlement fund has rendered 
 the volume of money that needs to be snipped from one section 
 of the country to another almost negligible in quantity. The 
 system of intra- and inter-district clearings has, moreover, 
 practically eliminated the "float." This result is regarded by 
 many as the greatest achievement of the system. 
 
 The cost of collecting checks was originally borne by the 
 banks which were receiving the benefit. Each Federal Reserve 
 bank kept a record of the cost of performing the service and 
 charged the amount to the bank for which the service was 
 rendered, the usual charge being one and one-half cents per item. 
 But in 1918, in order to popularize the system with the banks, 
 all service charges were abolished. This move rather effectively 
 silenced the opposition except, as we shall see, on the part of 
 certain state institutions. 
 
 As a means of extending this collection system to include 
 state institutions, the Federal Reserve banks undertook at 
 the time the compulsory feature for member banks was intro- 
 duced to collect for member banks, and for such state banks 
 as had voluntarily joined the clearing system, checks drawn 
 on any state bank which would agree to remit its items at par. 
 This many state banks agreed to do. All banks, whether 
 member or non-member, which remitted checks for collection 
 at par were henceforth known as "par" banks; and in order to 
 facilitate the collection of checks, the Federal Reserve Board 
 issued a monthly supplement to the Federal Reserve Bttllelin, 
 its official publication, giving a list with map of the par 
 institutions. At the present time 1 the par banks number nearly 
 28,000 out of a total of 29,768 commercial banks in the entire 
 country. 
 
 The final step in the effort to universalize this collection 
 system was inaugurated early in 1919. Every effort was made 
 by Federal Reserve officials to persuade the state banks volun- 
 tarily to agree to remit their checks for collection at par; and 
 during the year about 6,000 banks fell into line. (These are 
 included in the present total as given in the preceding para- 
 
 1 August, 1920.
 
 THE FEDERAL RESERVE SYSTEM 613 
 
 graph.) The Federal Reserve banks, moreover, resorted to 
 other means than peaceful persuasion; for as soon as the non- 
 par banks of any district became few in number, the Federal 
 Reserve bank of the district undertook to collect at par checks 
 drawn on all the banks of the district, whether they all agreed 
 to remit at par or not. This was to be accomplished through 
 the instrumentality of a local agent a bank, an express com- 
 pany, or a suitable person or corporation. 
 
 This attempt to coerce state banks into having their checks 
 collected at par has met with stout opposition. In the South 
 and West numerous state banks have steadfastly refused to 
 remit at par, and resort has been had to the courts to test the 
 legality of the Federal Reserve procedure. The basis of the 
 opposition is primarily a pecuniary one, for temporarily at 
 least the remission of items at par entails a loss to the par- 
 ticular bank. To some extent, also, the opposition is a reflection 
 of the principle of state rights and of the ancient doctrine that 
 federal interference with local affairs is as objectionable as 
 it is unwarranted. 
 
 With reference to the question of the losses incurred by 
 local banks, it should be understood that no bank is denied 
 the right to make a "service" charge against the customers for 
 whom the checks are being collected. Many banks, in fact, 
 levy such charges; while others prefer to assume the loss as an 
 incidental expense, believing that this method has compensa- 
 tions in promoting the good will of customers. All that is 
 necessarily lost is the fee formerly charged for remitting checks 
 for collection. 
 
 The ultimate outcome will undoubtedly be a universal 
 free collection system. The statement of the Federal Reserve 
 Board that "the par collection system is not a local or selfish 
 undertaking for the benefit of member banks, but is a national 
 enterprise for the convenience of the public and the promotion 
 of commerce" unquestionably enunciates a sound principle, 
 and the temporary pecuniary interests of local bankers can in 
 the end hardly stand against it.
 
 614 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 VH. RELATION OF THE TREASURY TO THE 
 FEDERAL RESERVE SYSTEM 
 
 In our analysis of the operation of the national banking 
 system in a preceding chapter, attention was called to the 
 relation of the federal Treasury to the banking and credit system. 
 The establishment of a series of government banks under the 
 Federal Reserve law has made it possible for the banking 
 system to assist the Treasury in its fiscal operations and in 
 general for the Treasury Department to work in harmony 
 with the banking and currency requirements of the country. 
 The Federal Reserve Act provides that 
 
 money held in the general fund of the Treasury, except the 5 per 
 centum fund for the redemption of outstanding bank notes, and the 
 funds provided in this Act for the redemption of Federal Reserve 
 notes, may, upon the recommendation of the Secretary of the 
 Treasury, be deposited in Federal Reserve banks, which banks, 
 when required by the Secretary of the Treasury, shall act as fiscal 
 agents of the United States; and the revenues of the government or 
 any part thereof may be deposited in such banks, and the disburse- 
 ments may be made by checks drawn against such deposits. 
 
 The Act did not, however, deny to the Secretary of the Treasury 
 the right still to use member banks as depositaries for public 
 funds. 
 
 The Federal Reserve banks have in fact performed a very 
 important service in connection with the fiscal operations of 
 the government. Co-operating with the federal Treasury in 
 every way, they largely assumed the burden of managing the 
 huge financial operations that were imposed upon the govern- 
 ment during the Great War. 
 
 As yet, however, the Treasury Department has not been 
 completely divorced from the member banks. It was the belief 
 at first that the Federal Reserve institutions would rapidly 
 displace the national banks and the sub-treasuries as depositaries 
 of government funds; but war conditions served to prevent the 
 withdrawal of government funds from individual banks for 
 subsequent deposit in the Federal Reserve institutions. The
 
 THE FEDERAL RESERVE SYSTEM 615 
 
 heavy financial requirements of the war, even before our 
 entrance into it, made it seem unwise to withdraw from the 
 banks the lending power which was given to them by virtue 
 of the deposit of government money. It was felt that a mini- 
 mum disturbance to the money market would be secured if 
 the government's funds were allowed to remain widely scattered 
 and kept as far as possible hi the banks of the communities 
 where the government received its funds. In consequence 
 the amount of government deposits has increased rather than 
 decreased since the inauguration of the Federal Reserve System. 
 It is of interest, also, that the law authorized the deposit of the 
 funds derived from the sale of the Liberty Bonds and certificates 
 of indebtedness issued during the war, in classified state banks 
 and trust companies as well as in national institutions. 
 
 The way has been opened by a recent act of Congress for 
 enlarging the responsibility of the Federal Reserve banks in 
 connection with the fiscal operations of the government. The 
 sub-treasury system, composed of nine sub-treasuries located 
 in different parts of the country, is to be abandoned on July 21, 
 1921, and its work will be taken over by the Federal Reserve 
 banks, which it is hoped by that time will have buildings of 
 their own and vaults adequate for the purpose. While this 
 act does away with the sub-treasury, it does not insure that all 
 government funds shall be kept with Federal Reserve rather 
 than with member banks. 
 
 Is the Federal Reserve Board under the domination of the 
 Treasury Department ? The association of the Federal Reserve 
 Board with the Treasury Department has given rise to some 
 criticism. It is asserted that Treasury fiscal requirements 
 have dominated the policy of the Federal Reserve Board at 
 times when banking requirements were paramount and did 
 not run parallel with Treasury requirements. Concretely, 
 it is urged that the desire of the Treasury Department to make 
 a record in floating huge Liberty Loans at very low rates of 
 interest was responsible for the policy inaugurated by the 
 Federal Reserve Board during the war and maintained until 
 after the Victory Loan was completed, of keeping discount
 
 616 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 rates at a very low level and hence stimulating speculation and 
 inflation of the currency. It has accordingly been vigorously 
 urged that the Federal Reserve Board should be cut loose from 
 the Treasury Department in order that it may exercise its 
 great responsibilities unhampered by the views of the Treasury 
 or by considerations of political expediency for the party in 
 power. It is unnecessary to enter upon a discussion of the 
 merits of the contention that the Federal Reserve policy of 
 maintaining low discount rates was opposed to public interest; 
 it is enough to point out the possibility of making the Federal 
 Reserve Board subservient to the Treasury. 
 
 Vin. FEDERAL RESERVE BANK STATEMENTS 
 
 The following combined statement of condition of the 
 Federal Reserve banks on February 4, 1916, and March 26, 
 1920, indicates at once the nature of the Federal Reserve banks' 
 operations and the development of the Federal Reserve System 
 that occurred during the war period. 
 
 RESOURCES AND LIABILITIES OF THE FEDERAL 
 RESERVE BANKS, FEBRUARY 4, 1916 
 
 RESOURCES 
 
 Total gold reserve $342,004,000 
 
 Legal tender notes, silver, etc 14,637,000 
 
 Total reserve $356,641,000 
 
 Bills discounted and loans: 
 
 Maturities within thirty days .... 17,355,000 
 
 Maturities within sixty days .... 20,740,000 
 
 Maturities within ninety days .... 10,391,000 
 
 Over ninety days 2,837,000 
 
 Total $ 61,323,000 
 
 Investments 45,197,000 
 
 Federal Reserve notes, net 33,710,000 
 
 Due from Federal Reserve banks, net . . 15,223,000 
 
 All other resources 11,903,000 
 
 Total resources $513,997,000 -
 
 THE FEDERAL RESERVE SYSTEM 617 
 
 LIABILITIES 
 
 Capital paid in $ 54,907,000 
 
 Government deposits 29,850,000 
 
 Reserve deposits, net 419,137,000 
 
 Federal Reserve notes, net 9,966,000 
 
 All other liabilities 137,000 
 
 Total liabilities $513,997,000 
 
 RESOURCES AND LIABILITIES OF THE FEDERAL 
 RESERVE BANKS, MARCH 26, 1920 
 
 RESOURCES 
 
 Gold and gold certificates $ 154,237,000 
 
 Gold settlement fund, Federal Reserve 
 
 Board 363,132,000 
 
 Gold with foreign agencies 112,781,000 
 
 Gold with Federal Reserve agents . . . 1,186,829,000 
 Gold Redemption Fund 117,776,000 
 
 Total gold reserves $1,934,755,000 
 
 Legal tender notes, silver, etc 122,400,000 
 
 Total reserves $2,057,155,000 
 
 Bills discounted: 
 
 a) Secured by government war. obliga- 
 tions 1,441,015,000 
 
 b) All other obligations 1,008,215,000 
 
 Bills bought in open market 451,879,000 
 
 United States government bonds . . . 26,797,000 
 
 United States Victory notes 68,000 
 
 United States certificates of indebtedness 263,056,000 
 
 Total earning assets $3,191,031,000 
 
 Bank premises 11,990 
 
 Uncollected items and other deductions 
 
 from gross deposits 768,788,000 
 
 Five per cent redemption fund against 
 
 Federal Reserve bank notes .... 13,900,000 
 
 All other resources 4,907,000 
 
 Total resources . $6,047,771,000
 
 6i8 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 LIABILITIES 
 
 Capital paid in $ 91,059,000 
 
 Surplus fund 120,120,000 
 
 Government deposits 27,711,000 
 
 Due to members reserve account . . . 1,867,125,000 
 
 Deferred availability items 546,696,000 
 
 Other deposits, including foreign govern- 
 ment credits 100,160,000 
 
 Total gross deposits $2,541,692,000 
 
 Federal Reserve notes in actual circulation 3,048,039,000 
 
 Federal Reserve bank notes, net liability 201,392,000 
 
 All other liabilities 45,469,000 
 
 Total liabilities $6,047,771,000 
 
 QUESTIONS FOR DISCUSSION 
 
 I. THE ORGANIZATION OF THE SYSTEM 
 
 1. Draw up a summary statement of the weaknesses in the national 
 banking system that called for elimination. 
 
 2. Draw up a summary statement of the chief steps in the progress 
 of banking reform legislation. 
 
 3. Study the map of the Federal Reserve districts, together with 
 the table showing the number of banks in each district and the 
 capital and surplus of each Federal Reserve bank, and suggest 
 any district changes which you think ought to be made. 
 
 4. How many branch reserve banks do you find? Would you 
 suggest any additional ones, or any eliminations ? 
 
 5. State in your own words what you think are the functions of 
 the Federal Reserve Board. In addition to the material in the 
 text, look through the copies of the Federal Reserve Bidktin in 
 the library. 
 
 6. Enumerate the devices that have been adopted to insure a 
 representative and democratic control of the Federal Reserve 
 System. 
 
 7. What is the purpose of the Federal Advisory Council ? 
 
 8. What are the duties of the Federal Reserve agent of each Federal 
 Reserve bank ?
 
 THE FEDERAL RESERVE SYSTEM 619 
 
 H. THE ELASTIC BANK-NOTE CURRENCY 
 
 9. Consult the table on page 103 and note the relative volume 
 respectively of national bank note, Federal Reserve bank note, 
 and Federal Reserve note currency. 
 
 10. What inscription is found on the Federal Reserve bank notes ? 
 on the Federal Reserve notes ? 
 
 11. What was the reason for the failure of the Federal Reserve Act 
 to provide for the complete elimination of the inelastic national 
 bank-note currency ? What is the explanation of the provision 
 of the new form of inelastic bank-note currency in the guise of 
 the Federal Reserve bank note ? 
 
 12. What is it that gives to the Federal Reserve notes an elastic 
 quality ? 
 
 13. It is crop-moving period. Show by a concrete illustration how a 
 country bank, say in Ottawa, Kansas, could procure $5,000 of 
 additional bank notes for the needs of its agricultural constitu- 
 ency. Indicate the changes that would occur on the balance 
 sheets both of the member bank and the Federal Reserve bank. 
 
 14. Is it necessary for the particular notes which have been issued 
 for an emergency to be retired in order to secure the necessary 
 contractility ? 
 
 15. Show what changes would occur on the balance sheets of the 
 First National Bank of Ottawa, Kansas, and of the Federal 
 Reserve Bank of Kansas City when $5,000 of Federal Reserve 
 notes are retired. 
 
 16. Draw up a statement in outline form showing the security back 
 of the Federal Reserve notes. 
 
 17. What different kinds of bank assets are eligible as security for 
 Federal Reserve notes ? 
 
 1 8. Show by a concrete illustration how the provision which permits 
 gold and gold certificates to be exchanged with the Federal 
 Reserve agent for Federal Reserve notes expands the loaning 
 capacity of Federal Reserve banks. 
 
 HI. THE CONTROL OF CREDIT 
 
 19. Indicate how the Federal Reserve System mobilized or con- 
 centrated the financial resources of the country. 
 
 20. "By virtue of the improved organization of our banking and 
 credit machinery which the Federal Reserve System has made
 
 620 
 
 possible, the banks are enabled to conduct their operations with 
 safety on a much slenderer margin of reserves. " Explain why 
 this is so. 
 
 21. How much, in fact, have reserves been reduced under the Federal 
 Reserve System ? 
 
 22. What will determine whether, in the case of a seasonal demand 
 for funds, rediscounting operations with the Federal Reserve 
 bank will result in the creation of Federal Reserve note or of 
 deposit liabilities ? 
 
 23. When a member bank has occasion to borrow from a Federal 
 Reserve bank, what will determine whether it will rediscount 
 the commercial paper of its customers or borrow on its own 
 promissory note with commercial paper or government securities 
 as collateral ? 
 
 24. Might a member bank in need of funds secure them indirectly 
 from the Federal Reserve bank by selling bankers' acceptances 
 in the open market, the Federal Reserve banks being the 
 purchasers? (See balance sheet on p. 617.) 
 
 25. Do you think it makes any difference from the standpoint of 
 banking safety or the liquidity of assets which method a member 
 bank uses in borrowing from the Federal Reserve banks ? 
 
 26. What provisions of the Federal Reserve Act are designed to 
 enable the Federal Reserve banks to check undue expansion of 
 business during the upward swing of the business cycle ? 
 
 27. "Raising the rates of discount has both a negative and a positive 
 effect on financial conditions. " What are these effects ? 
 
 28. Do you think the control over the rate of interest is intended 
 for use mainly in time of acute tension ? 
 
 29. It is a period of acute crisis. Bank A in Kokomo, Indiana, has 
 in its portfolio $10,000 of eligible commercial paper which it had 
 discounted on August i, at 7 per cent, the date of maturity being 
 November i. On September 15 this paper is rediscounted with 
 the Federal Reserve Bank of Chicago at 8 per cent. The paper 
 is paid at maturity by the customer of the Kokomo bank. Make 
 the necessary changes on the balance sheets (a) of the Kokomo 
 Bank, both when the loan is made and when it is paid; (&) of 
 the Federal Reserve Bank of Chicago, both when the rediscount 
 is made and when the obligation is liquidated. Assume that 
 these transactions do not involve the use of Federal Reserve 
 notes.
 
 THE FEDERAL RESERVE SYSTEM 621 
 
 30. To what extent could the Kokomo bank expand its loans as a 
 result of the rediscount operations suggested in the preceding 
 question ? 
 
 31. What is the limit to the expansion of deposit currency through 
 the process of rediscounting (a) so far as any single bank is 
 concerned; (b) so far as all the banks of a given district are 
 concerned; (c) so far as all the banks of the United States are 
 concerned ? 
 
 32. Draw up a summary statement showing how the Federal Reserve 
 System strengthens the weak links in the banking chain. 
 
 33. "The significant feature of the Federal Reserve Act is that it 
 transfers the responsibility for maintaining adequate reserves 
 for emergencies from the privately owned banks of the financial 
 centers to the governmentally controlled Federal Reserve insti- 
 tutions." Show in what ways this is advantageous from the 
 standpoint of banking control. 
 
 34. "The Federal Reserve System is panic proof. Therefore there 
 is no occasion for anyone to urge that business expansion must 
 be checked in order to prevent a financial collapse." Do you 
 agree with this statement ? 
 
 35. If you were a member of the Federal Reserve Board, what policy 
 would you favor adopting: (a) during a period of depression; 
 (ft) during the early stages of the upward swing of a business 
 cycle; (c) at the beginning of a critical period; (d) at a time of 
 acute financial tension ? 
 
 36. In what ways may the Federal Reserve Board exercise control 
 over the credit situation through "open market operations"? 
 
 37. Sell a bill of goods for $10,000 to Mr. Jones in New York, and 
 draw a bank acceptance for the amount and discount it at your 
 local bank. Show what changes would occur on the balance 
 sheet of the accepting bank and of the bank which discounts the 
 acceptance. 
 
 38. Show concretely how a bank acceptance is profitable to (a) the 
 accepting bank; (b) the person for whom the acceptance is 
 granted; (c) the seller of the goods; (d) the bank which discounts 
 the acceptance. 
 
 39. What is meant by a discount market ? Is it in any sense com- 
 parable to a stock market ? 
 
 40. If the Federal Reserve banks are always able to rediscount the 
 commercial paper of member banks or lend them funds on 
 collateral security, why is it still necessary for a member bank
 
 622 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 always to have access to an open discount market where it 
 can sell acceptances, etc. ? 
 
 4 1 . What is the relation of the bank acceptance to the development 
 of a discount market ? 
 
 42. What is the purpose of the acceptance banks of Europe? Are 
 such institutions indispensable to the development of a discount 
 market ? 
 
 43. Why is it believed that the growth of discount corporations or 
 brokers is necessary to the efficient operation of a discount 
 market ? 
 
 IV. CLEARINGS AND COLLECTIONS 
 
 44. What parts of the clearing and collection system have been 
 affected by the Federal Reserve System ? 
 
 45. What was the objection to the "float" that characterized the 
 former collection system ? 
 
 46. A bank in Grand Rapids, Michigan, receives a check from one 
 of its customers drawn against a bank in Milwaukee, Wisconsin. 
 Show how it would be collected under the Federal Reserve 
 clearing system. How would it probably have been collected 
 under the old system ? 
 
 47. A bank in Springfield, Massachusetts, receives a check drawn 
 on a bank in St. Louis, Missouri. Show how it would be col- 
 lected under the Federal Reserve System. How would it prob- 
 ably have been collected under the old system ? 
 
 48. What is the purpose of the gold settlement fund? In what 
 respect is it analogous to the system of settling clearing-house 
 balances by means of clearing-house certificates? In what 
 respects does it differ ? 
 
 49. Have the state banks not a right to oppose their attempted 
 coercion into the Federal Reserve clearing system ? 
 
 50. Do you think that in the end all of the banks will find it to their 
 advantage to use the system of par collections? Why, or 
 why not ? 
 
 V. THE TREASURY AND THE FEDERAL RESERVE SYSTEM 
 
 51. Why did not the Federal Reserve System eliminate the system 
 of depositing government funds with individual depositary banks ? 
 
 52. Would you favor the abolition of the system of depositing 
 government funds in individual banks ? Why, or why not ? 
 
 53. How does the Federal Reserve System make possible the elimi- 
 nation of the sub-treasury system ?
 
 THE FEDERAL RESERVE SYSTEM 623 
 
 54. Would you favor severing the relation of the Federal Reserve 
 banks with the Treasury Department, including the elimination 
 of the Secretary of the Treasury as a member of the Federal 
 Reserve Board ? 
 
 55. As a member of the Federal Reserve Board in time of war, would 
 you take the stand that Federal Reserve policy should be formu- 
 lated without regard to the fiscal problems of the Treasury 
 Department ? 
 
 VI. ANALYSIS OF FEDERAL RESERVE BANK STATEMENTS 
 
 56. What are the most significant changes in the combined financial 
 statements of the Federal Reserve banks in 1916 and in 1920, 
 as given on pages 616-18 ? 
 
 ^57. Under what designation do "rediscounts" appear in the balance 
 sheet on page 617 ? Collateral loans to member banks ? 
 
 58. What is the meaning of the item on the resources side, "Gold 
 redemption fund" ? 
 
 59. What is the meaning of "Uncollected items and other deductions 
 from gross deposits " ? 
 
 60. Does the large surplus fund of the Federal Reserve banks indicate 
 that these institutions have been profiteering ? 
 
 61. What is the meaning of the entry "Deferred availability items" 
 on the liability side ? 
 
 62. What is the ratio of reserves to Federal Reserve note and deposit 
 liabilities combined on each of the Federal Reserve statements 
 given in the text?* Consult the financial press and ascertain 
 the present reserve ratio. 
 
 REFERENCES FOR FURTHER STUDY 
 
 Agger, Eugene E.: Organized Banking, chaps, xiii and ;dv. 
 
 Dunbar, Charles F.: Chapters in the History and Theory of 
 Banking, third edition, revised and enlarged by O. M. W. Sprague, 
 chap. xii. 
 
 Holdsworth, John Thorn: Money and Banking, chap. xxii. 
 
 Kemmerer, Edwin W.: The A. B.C. of the Federal Reserve Act. 
 
 Laughlin, J. Laurence: Banking Progress, chaps, iv, vii, and x. 
 
 Moulton, Harold G. : Principles of Money and Banking, Part II, 
 chap. vii. 
 
 Phillips, Chester A.: Readings in Money and Banking, chap. xxxi. 
 
 Willis, H. Parker: The Federal Reserve. 
 
 : American Banking, chaps, xvi-xix.
 
 CHAPTER XXVI 
 
 THE WAR AND THE FEDERAL RESERVE 
 
 SYSTEM 
 
 Wars have always been disruptive of financial systems, and 
 none more so than the Great War which began in 1914. The 
 Napoleonic struggle a hundred years earlier, for example, 
 reduced European currency systems to chaos, and a generation 
 of currency agitation and discussion followed; while the 
 financial exigencies of our Civil War led to the issue of irre- 
 deemable paper money and the abandonment of specie payments 
 for a period of seventeen years. But after the gold standard 
 was definitely established by the leading countries of the 
 world and nearly two generations had elapsed since any great 
 western commercial nation had been subjected to the disrupting 
 influence of a great war, it was commonly felt that society had 
 learned important financial lessons and that the requirements 
 of war would henceforth be met with much less serious dis- 
 location of the financial and business fabric than had been the 
 case in the past. The present condition of the financial systems 
 of the world, however, unfortunately affords conclusive evidence 
 of the error of this conviction. 
 
 It may be recalled that the war in Europe commenced just 
 prior to the inauguration of our Federal Reserve System. 
 After the temporary financial shock incident to the outbreak 
 of hostilities was passed, the first noteworthy financial effect 
 upon the United States of the struggle in Europe was mani- 
 fested in the shipment to this country of great quantities of 
 gold in payment for war supplies, as already indicated in the 
 chart on page 271 above. These funds went, immediately 
 speaking, into the reserves of American banking institutions. 
 This augmentation of specie holdings, together with the decrease 
 in reserve requirements for member banks that the Federal 
 
 624
 
 THE WAR AND THE FEDERAL RESERVE SYSTEM 625 
 
 Reserve Act provided, resulted in a very great increase in the 
 lending power of the individual banks. 
 
 Meanwhile the volume of reserve money in the Federal 
 Reserve banks was also very large. It will be recalled that 
 the cash resources of the Federal Reserve institutions were 
 originally derived in part from the capital contributions of 
 the stock -holding member banks and in part from deposits, 
 both of member banks and of the federal government. These 
 sources yielded large funds to the Federal Reserve banks at 
 the very commencement of their operations. Later, the 
 amendment to the Federal Reserve law which made it neces- 
 sary for each member bank to keep all, rather than merely a 
 portion, of its required reserve in the Federal Reserve bank of 
 its district, the concentration of gold reserves through exchan- 
 ging Federal Reserves notes for gold, as described above, and 
 finally, the accession of the larger state banks as members of 
 the Federal Reserve System, very greatly increased the volume 
 of reserve money in the central reservoirs. In 1916 the ratio 
 of cash to notes and deposits combined in the twelve Federal 
 Reserve banks was about 87 per cent; and although for more 
 than a year we had one foot in the conflict, the net reserve was 
 about 77 per cent at the time we formally entered the war in 
 1917. Our financial structure was, therefore, in an extraor- 
 dinarily strong position for meeting the financial strain of a 
 great war. 
 
 As everyone is aware, the period from 1914 to 1920 has 
 been marked by a revolution in prices. The chart on page 626 
 indicates the extent of the price advance in each of the lead- 
 ing allied countries. Russia and the one-time Central Powers 
 have witnessed even greater price changes. The causes of 
 this price revolution have been variously assigned (in the 
 United States) to the resort to borrowing rather than to taxa- 
 tion as a means of raising the funds required by the govern- 
 ment, to the loose extension of credit in the form of bank loans, 
 to the activities of labor unions in forcing wages to higher 
 levels, to the thriftlessness and extravagance of people gener- 
 ally, to the law of demand and supply, to changed costs of
 
 626 
 
 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 production, to the Democratic party, etc. To attempt an 
 adequate discussion of the moot question of the causes that 
 produced the price revolution would require a volume in itself. 
 
 WORLD-MOVEMENT OF PRICES, 1914-20 1 
 
 600 
 
 500 
 
 400 
 
 300 
 
 1919 
 
 1920 
 
 1914 1915 1916 1917 1918 
 
 1 Wholesale prices in five leading countries. Prices for 1913 taken as 
 a base of 100. Taken from Report on Business Conditions (Second Federal 
 Reserve District), August, 1920.
 
 THE WAR AND THE FEDERAL RESERVE SYSTEM 627 
 
 And since the price problem is distinctly a controversial one, 
 lying rather in the field of advanced study than in a general 
 introductory course in financial organization, no attempt will 
 be made at this place to discuss the causes of these price changes. 
 It is in point here, however, to note the effects of the price 
 revolution that has occurred upon the condition of our banking 
 system and hence upon the problems of industrial and financial 
 reorganization during the post-war period. 
 
 I. EFFECT OF WAR FINANCE UPON BANK 
 RESERVES 
 
 As the volume of business expanded in the United States 
 between the years 1915 and 1918,' the volume of bank loans and 
 deposit currency also necessarily expanded. And as the price 
 level rose (whether the rise was caused by the expansion of 
 bank loans or not is for the present purpose immaterial), the 
 volume of funds required in the financing of a given volume of 
 business was also increased. Concretely, by 1918, when the 
 price level was substantially double what it had been in 1914, 
 there was required to conduct a given amount of business 
 about $2 to every $i that had been required before the war. 
 That is to say, every business man found that he must have 
 substantially twice the amount of money with which to meet 
 pay-roll requirements, buy raw materials, etc., that had there- 
 tofore been necessary. As we have elsewhere seen, such 
 additional working capital must characteristically be borrowed 
 from the commercial banking institutions. 
 
 The first stage in the process of expanding bank loans for 
 war purposes in 1915-16 resulted merely in drawing down 
 the excess reserves of member banks that had been accumu- 
 lated by the reduction of reserve requirements for member 
 institutions and by the inflow of specie from Europe. The 
 second stage, after the excess reserves of member banks were 
 exhausted, was marked by heavy borrowing on the part of the 
 
 1 The great expansion in the volume of business of course mainly 
 occurred before 1918; since then the physical volume of production has 
 increased but slightly, if at all.
 
 628 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 member banks from the Federal Reserve institutions. And 
 whenever a Federal Reserve bank extended accommodation to 
 member banks, either in the form of Federal Reserve notes or 
 deposit liabilities, there was, of course, a resultant reduction 
 in the ratio of its cash resources to Federal Reserve note and 
 deposit liabilities. It should be kept in mind in this connection 
 that this process did not occasion a withdrawal of cash from 
 the Federal Reserve institutions; on the contrary, the cash 
 resources were steadily increasing during the war period, 
 owing to the policy of mobilizing the gold resources, previously 
 explained. The significant fact is that the liabilities in the 
 form of Federal Reserve notes and deposits increased much 
 more rapidly than the cash, with the result that the reserve 
 ratio necessarily fell. 
 
 Government financing also reduced bank reserves. It was not 
 only the increasing demands for loans from business borrowers 
 that served to reduce the reserve ratio; for the government also 
 borrowed heavily from the commercial banking institutions in 
 connection with the flotation of the numerous war loans. The 
 truth is that a very considerable percentage of the funds raised 
 for war uses did not come from individual savings, but were 
 created by the banking institutions through a process of ex- 
 panding the ratio of deposits to cash resources. A concrete 
 illustration will serve to indicate how, at the twelfth hour, 
 the Liberty Loan drives always carried us over the top. 
 
 Let us assume that the X National Bank of St. Louis had in 
 its portfolio at the time the first Liberty Loan was being floated 
 one hundred thousand dollars of commercial paper available 
 for rediscount. On the last day of the campaign this bank 
 rediscounts its one hundred thousand of commercial paper 
 with the Federal Reserve bank of St. Louis, receiving in return 
 a deposit account at the Federal Reserve bank of one hundred 
 thousand dollars, less, of course, the amount of the discount. 
 Now since this deposit account constitutes an increase in the 
 lawful reserve of bank X, the bank is in a position to extend 
 greatly the volume of its business. Concretely, it is able to 
 invest a little over seven hundred thousand dollars in Liberty
 
 THE WAR AND THE FEDERAL RESERVE SYSTEM 629 
 
 bonds, paying for them through the creation of deposit credits 
 in the name of the United States government. 1 (It will be 
 recognized that the drawing of checks against government 
 deposit accounts, as against the accounts of individuals, seldom 
 leads to withdrawal of active specie.) By the simple process 
 of rediscounting the commercial notes of customers with the 
 Federal Reserve bank, the X National Bank has thus been 
 enabled to purchase more than seven hundred thousand dollars' 
 worth of government bonds, the wherewithal being simply 
 manufactured for the purpose. 
 
 At the time of the second Liberty Loan the X National 
 Bank is again besought to help save the city from the financial 
 disgrace that would attend if St. Louis failed to subscribe for 
 "more than its quota" of bonds. By an amendment of the 
 Federal Reserve Act, it is possible for the X National Bank to 
 borrow from the Federal Reserve bank on the collateral secur- 
 ity of the first Liberty Loan bonds. Accordingly, the seven 
 hundred thousand dollars of first Liberty bonds in its possession 
 are turned over to the Federal Reserve bank of St. Louis 
 as security for a loan of seven hundred thousand dollars. And 
 on the basis of the new seven hundred thousand dollar deposit 
 account thus received, the bank is in a position to buy, roughly, 
 $4,900,000 worth of second Liberty bonds. And since this 
 is a game that all of the banks are enabled to play, the patriotism 
 of St. Louis, and of the nation at large, is demonstrated in most 
 convincing fashion. 
 
 This process can of course be repeated with each successive 
 Liberty Loan, the only limit to it. being the adequacy of the 
 reserves in the Federal Reserve institutions. And since we 
 started the war with very large reserves, the process could, 
 in fact, be continued for a year or two without seriously strain- 
 ing the reserve position of the Federal Reserve banks. Anyone, 
 therefore, who understood the mechanism by means of which 
 the loan campaigns were, at the last moment, carried to trium- 
 phant conclusion, and who at the same time knew how large 
 
 "In accordance with the requirement that banks in central reserve 
 cities must have a reserve of 13 per cent.
 
 630 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 was the volume of unused reserves in the Federal Reserve 
 institutions never had any fear as to the nation's ability to 
 raise practically any sum of money the Treasury board of 
 strategy might decide upon. The fear rather was that by 
 virtue of this simple process of manufacture the government 
 would raise more funds than were necessary for its financial 
 requirements, with resulting evils in the form of extravagance 
 and rising prices, and particularly that the ease with which the 
 funds could thus be raised would work as a deterrent to that 
 rigid economizing on the part of all classes which was absolutely 
 hecessary if the productive machinery of the nation were to be 
 successfully shifted from the production of nonessential and 
 relatively unimportant commodities to the production of the 
 indispensable materials of warfare. 
 
 It may be added that to a considerable extent, particularly 
 in the later Liberty Loan campaigns, the Liberty bonds that 
 were purchased on borrowed funds were not purchased by the 
 banks directly but by individuals who borrowed the funds 
 from the banks, on the security of previous Liberty bonds as 
 collateral. But since the banks secured the funds necessary 
 for these loans by borrowing from the Federal Reserve banks, 
 as before, the immediate effect upon the reserve situation was 
 the same. The immediate effect but possibly not the ultimate 
 effect for the reason that a campaign was at the same time 
 inaugurated to induce the individuals who had borrowed from 
 the banks shortly to pay off their loans out of future savings. 
 In view of the insistent pressure for additional funds, however, 
 it is doubtful whether any very large volume of such loans 
 could, in practice, escape an indefinite number of renewals. 
 
 In any event, this combination of demand for bank loans, 
 from the government and from the business community, 
 resulted in drawing down the reserves of the central depositaries 
 to about 62 per cent at the end of the year 1917; while by the 
 time of the Armistice the figures stood at a little over 50 per 
 cent. It is altogether probable, moreover, that if the war had 
 continued for another twelve months the reserves would have 
 been drawn down well below the legal minima prescribed by
 
 THE WAR AND THE FEDERAL RESERVE SYSTEM 631 
 
 the Federal Reserve Act in which event we should undoubtedly 
 have had to suspend specie payments and enter upon an era of 
 depreciated paper. Indeed, for all practical purposes, specie 
 payments were, in fact, already suspended, for the banks and 
 the Treasury Department alike practically refused "on grounds 
 of patriotism" to pay out any gold. So far as the author 
 knows, however, there was never any actual premium on gold 
 as compared with paper currency. 
 
 A similar, though much more rapid, reduction of reserves had 
 been occurring in Europe. Indeed, the strain upon the financial 
 resources of the European banking systems proved so great 
 at the outbreak of the war that specie payments were shortly 
 abandoned. The European central banks, like our Federal 
 Reserve institutions, began the war with very large reserves 
 and, as was the case in this country, these reserves were added 
 to by a policy of mobilizing specie resources in the central 
 reservoirs where they could be used most effectively in meeting 
 the onerous financial requirements of the war. Thus notwith- 
 standing the great outflow of gold from Europe to the United 
 States, the central banks of the belligerent countries gradually 
 increased the aggregate of their specie resources. The financial 
 demands of the war proved so great, however, and the borrowing 
 from the central reservoir institutions so continuous, that the 
 ratio of cash resources to liabilities was rapidly reduced. In 
 the main, the resources of the European central institutions 
 were substantially lower at the beginning of the war than those 
 of our Federal Reserve banks, and as the financial strain was 
 both greater and longer continued in Europe than in the United 
 States, the decline in specie reserves was very much greater 
 there than here. 
 
 In all these European countries the result of this great 
 expansion of the superstructure of credit incident to meeting 
 the financial requirements of the war resulted, moreover, in 
 a gradual depreciation of European paper currency. The 
 standard of values ceased to be gold, contracts were made in 
 terms of paper currency, and gold was quoted at a substantial 
 premium in the money markets.
 
 632 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 II. THE MOVEMENT OF RESERVES AFTER 
 THE WAR 
 
 Following the Armistice it was widely believed for a time 
 that there would shortly be a gradual reduction in the financial 
 needs of governments and also in the level of prices, with the 
 result that the volume of funds required both by governments 
 and by business men with which to meet pay-roll requirements, 
 buy raw materials, etc., would be gradually reduced. In such 
 an event the loans extended by individual banks would be 
 decreased in volume, and, in turn, the amount of bank borrow- 
 ing from the central reserve institutions would be lessened 
 with the final much-desired result that the reserves of the 
 Federal Reserve banks would be increased. Such a con- 
 summation would have made possible a gradual resumption 
 of specie payments in Europe and an ultimate return to a con- 
 servative financial position. In the United States it would 
 have insured an early restoration of the reserves of the Federal 
 Reserve banks to something like the pre-war level and in 
 consequence a financial system strongly entrenched to meet 
 the requirements of future business cycles. 
 
 But as the result of factors which need not here be con- 
 sidered, prices did not decline for long after the Armistice, but 
 rose instead with the inauguration in April, 1919, of an upward 
 swing of a new business cycle. The process by which increasing 
 pressure had been brought to bear by business borrowers upon 
 the member banks and through them upon the Federal Reserve 
 institutions for funds during the war was thus resumed, with 
 the inevitable result of a still further decline in the reserves of 
 the Federal Reserve institutions. 1 
 
 The sources of the increased demand for fluids were numerous. 
 It should be observed in this connection that, as is always the 
 case in a period of very active business, the pressure upon 
 the commercial banks for loans did not come merely from the 
 manufacturing and mercantile interests; it came to a very con- 
 
 1 Government financing also continued as a carry-over from the war, 
 though henceforth it was of a declining, rather than a steadily augmenting, 
 volume.
 
 THE WAR AND THE FEDERAL RESERVE SYSTEM 633 
 
 siderable extent from stock exchange speculation, and from the 
 flotation of new issues of corporate securities. It will be 
 recalled from our previous analysis of the relation of the com- 
 mercial banking system to the financing of stock exchange 
 speculation, to the outright purchase of securities, to the making 
 of collateral loans for fixed capital purposes, and to the activities 
 of investment bankers engaged in the marketing of securities, 
 that the funds of the commercial banking system constitute 
 the support for the entire financial fabric, investment and 
 speculative, as well as commercial. The great stock speculation 
 of the year 1919 absorbed large quantities of bank funds, while 
 the flotation of securities which were either carried by invest- 
 ment bankers or by individuals on funds borrowed on collateral 
 served still further to reduce the reserves of the Federal Reserve 
 banks. An important factor, also, was the organization of a 
 horde of financing or stock jobbing concerns engaged in the 
 promotion of speculative enterprises, 1 all of which absorbed 
 funds; while the land booms in many states still further added 
 to the financial strain. Both speculation and investment, 
 save in government securities, had been largely held hi abeyance 
 during the war period by restrictive legislation and by the 
 activities of the Capital Issues Committee, which effectively 
 prevented in the latter part of the war the sale of securities of 
 concerns that were not deemed essential to the winning of the 
 struggle. Hence when the post-war boom period developed, 
 an extraordinary volume of new issues was floated. 
 
 Another factor in the rapid depletion of our reserves after 
 the Armistice was the outflow of specie from the United States 
 to South America and the Orient in the meeting of adverse 
 trade balances. This amounted, between June i, 1919, and 
 January i, 1920, to approximately $300,000,000. It should be 
 recalled in this connection that since in our financial system 
 the cash reserves need be only about 5 per cent of the total 
 outstanding claims against cash, every dollar of specie that is 
 exported means a curtailment of credit, or of credit possibilities, 
 to the extent of about twenty dollars. The trade balance 
 
 1 See pp. 191-92.
 
 634 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 with Europe during this interval was heavily in our favor and 
 under normal circumstances we should have had, in consequence, 
 a large inflow of specie; but because of the strained condition 
 of European bank reserves, it was deemed necessary to continue 
 the embargoes upon gold shipments. 1 Accordingly, the United 
 States was placed in a position of holding the financial fort 
 for pretty much the entire world. 
 
 The result of these various strains upon the financial system 
 was shortly to reduce the reserve ratios in the Federal Reserve 
 banks from above 50 per cent to a point dangerously near the 
 minimum reserve requirements laid down under the Federal 
 Reserve Act. By the end of the year 1919 the ratio of cash 
 to Federal Reserve note and deposit liabilities combined in 
 the twelve Federal Reserve banks was below 45 per cent. 
 The question whether the Federal Reserve System might fail 
 to control the expansion of credit and to prevent the recurrence 
 of financial panics such as occurred in the old days of unorgan- 
 ized banking therefore became of more than academic interest. 
 It was frankly feared by many that if the central reserves 
 should continue to fall until they reached the legal minima, 
 we should not be in a very much better position to meet the 
 conditions of an acute crisis than was the case under the old 
 banking system.* 
 
 III. THE ATTEMPT TO CONTROL CREDIT AND 
 BUSINESS EXPANSION 
 
 The advance in prices following the Armistice began at a 
 time when government financial requirements were still at 
 their height. The Victory Loan had yet to be floated and a 
 large volume of borrowing through the issue of Treasury 
 certificates of indebtedness was still necessary. The Treasury 
 Department was desirous of placing these loans at as low an 
 interest rate as possible, and accordingly the Federal Reserve 
 Board made no early effort to check the expansion of credit 
 and of business activity by means of its control over discount 
 
 1 Cf. pp. 270-71. * But see below, p. 643.
 
 THE WAR AND THE FEDERAL RESERVE SYSTEM 635 
 
 rates. The Board has been criticized by some for its policy 
 in this connection. In justification it may at least be said 
 that until the early autumn of 1919 it was not apparent how 
 severe the financial strain was to be. Certainly at the time 
 the details of the Victory Loan financing were arranged there 
 was no consensus of opinion that the price level was going to 
 advance and that we were to enter upon a stage of very active 
 business. Moreover, it was highly important that every effort 
 be made to promote a revival of business activity in order to 
 facilitate the absorption of the returning war workers and 
 soldiers and the early rehabilitation of the depleted economic 
 resources of the world; and a sharp rise in discount rates 
 would probably have been a deterrent to such economic recovery. 
 In any event, once committed to a policy of low interest rates, 
 it was impossible for the Federal Reserve Board to raise rates 
 during the period of the Victory Loan financing without break- 
 ing faith with the bankers of the country, who had formulated 
 policies and made loans on the understanding that the Victory 
 Loan was to be put through at a low interest rate. 
 
 There are many who believe, however, that the Federal 
 Reserve Board waited longer than was necessary before inaugu- 
 rating a policy of higher interest rates and endeavoring to 
 conserve our financial resources for more essential requirements. 
 In the early summer of 1919 an official warning was, indeed, 
 issued, urging the necessity of curtailing loans for speculative 
 purposes in the interests of "legitimate" commercial needs; 
 but it passed virtually unheeded either by the banks or by the 
 speculative community. The warning was not reiterated 
 until the middle of October; by this tune the credit situation 
 had become very grave, following an extraordinary period of 
 unrestrained speculation. On this occasion the banks of 
 New York co-operated with the Federal Reserve Board, sharply 
 raising rates on call money and actually restricting the volume 
 of credit that brokers might obtain, with a resulting abrupt 
 collapse of stock market values and the permanent dissolution 
 of the bull market that had prevailed with an August inter- 
 mission since the early spring.
 
 636 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 A curtailment of stock exchange speculation did not, 
 however, suffice, and could not in the nature of things suffice, 
 to relieve the monetary strain. What was needed was a 
 thoroughgoing readjustment of prices to a lower basis defla- 
 tion, to use a common expression even though it be accom- 
 panied by a halting of business activity. Not until January, 
 1920, apparently, did the Federal Reserve Board fully appre- 
 ciate the gravity of the reserve situation and seek to effect a 
 readjustment of conditions. After a conference with leading 
 bankers it was then decided that the necessities of the credit 
 situation demanded a real advance in discount rates. 1 The 
 increase was not very great, however, for a cautious feeling of the 
 way seemed advisable; and, moreover, it was still the belief 
 of many that an elimination of loans for speculative purposes 
 commodity speculation as well as stock exchange speculation 
 would release a sufficient quantity of funds to take care of 
 essential business requirements without necessitating any 
 drastic readjustment of business. It was hoped that a moderate 
 increase of discount rates, together with a sharp discrimination 
 by bankers against speculative loans, would accomplish the 
 desired results. 
 
 During the early months of 1920, however, the advance in 
 interest rates appeared to have little effect upon business 
 activity. The profits that might be derived, in most lines of 
 industry, from the use of borrowed funds were so great that 
 interest rates were for the time a matter of only secondary 
 importance. The volume of loans therefore continued to 
 be large, business continued to be active, and prices continued 
 to rise; and until March there was little surface indication 
 that price and business readjustments were in store. 
 
 Despite subsequent further increases in the discount rates 
 at the Federal Reserve banks, and, in consequence, almost 
 immediately at the member institutions, the credit strain 
 became increasingly acute until late in May, when the Federal 
 Reserve Board again called a conference of bankers to consider 
 how the volume of loans might be reduced and the reserves 
 
 1 Very slight advances had been made in November and December.
 
 THE WAR AND THE FEDERAL RESERVE SYSTEM 637 
 
 replenished sufficiently to accommodate the autumn seasonal 
 requirements without danger of a financial collapse. It was 
 agreed at this conference that before autumn it would be 
 necessary to curtail loans on the average by about 10 per cent, 
 if the banks were to be placed in a position to meet, without 
 serious difficulty, the demands that were certain to be placed 
 upon them during the crop-moving period. Before considering 
 the subsequent events, however, it will be well to refer briefly 
 to certain changes in economic conditions that had already 
 occurred during the spring. 
 
 Other economic factors helped to bring about a readjustment of 
 business and financial conditions. Aside from the great increase 
 in interest rates, at least two other factors of major importance 
 were conspiring to bring about a readjustment of business and 
 prices in the spring of 1920. First, there was the break-down 
 of the transportation system, owing to a combination of factors 
 which need not be considered here. The result of this break- 
 down manifested itself in two ways. In the first place, the 
 inability of the railroads to move commodities at the ordinary 
 rate slowed up the entire productive and distributive process 
 and made it necessary for business men everywhere to secure 
 extensions of credit for a longer period and for larger amounts 
 than would otherwise have been required. A new expression, 
 " frozen credit," was coined to describe this condition. The 
 result of this inability of traffic to move was thus to augment 
 the pressure on the banks for loans and thereby to reduce 
 still further the ratio of cash to deposit and note liabilities. 
 And notwithstanding the fact that there was a considerable 
 (unexpected) inflow of gold to the United States in April, 
 incident to the pre-payment of the British share of the Anglo- 
 French loan, maturing in October, the reserves of the twelve 
 Federal Reserve banks, combined, continued to decline until 
 in May they reached the low level of about 42.5 per cent. 
 A further factor which contributed to the financial uncertainty 
 of these months was the settlement of the tremendous volume 
 of farm real estate transfers that had been contracted in the 
 boom period of the preceding year.
 
 638 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 The second result of the transportation tie-up was a slowing 
 down of business activity. The inability to secure coal and 
 raw materials and to ship the finished products with any degree 
 of certainty proved to be a very depressing element, discoura- 
 ging further business commitments and substantially reducing 
 the industrial output of the country. 
 
 The other major factor that was contributing to a readjust- 
 ment of business conditions was the high cost of living. The 
 steady rise in commodity prices during 1919 and the first months 
 of 1920, accompanied as it now was by substantial increases in 
 rents, had finally reached a point where it was forcing a curtail- 
 ment of consumptive demand. Whatever may have been the 
 case earlier, it had by this time certainly become true that 
 the net annual wages of labor, speaking generally, as well as the 
 income of the salaried classes, were failing to keep pace wfth 
 advancing prices, with a resulting decline in the real purchasing 
 power of the rank and file of people. The "peak" of prices 
 was reached in the spring of 1920, among other reasons, because 
 consumptive demand was not sufficient to absorb the existing 
 volume of production at the prices for which goods were then 
 being offered. Popular hostility to the continuous marking 
 up of prices is also believed by many to have finally led to a 
 voluntary reduction of purchases. In any event the result of 
 the curtailed consumptive demand was manifested in the 
 month of May in retail price concessions in silks, textiles, 
 leather goods, and a few other commodities. 
 
 Another factor which no doubt contributed somewhat 
 to the unsettling of American business was the decline in our 
 trade balance, which became pronounced in the spring of 1920. 
 The decrease in foreign demand and the increasing competition 
 of imported commodities were alike influences tending to 
 bring about business readjustment in the United States. 
 
 Pertinence is given to the suggestion that numerous factors 
 besides the rising interest rates contributed much to the price 
 and business readjustment which we have been discussing, by 
 virtue of the fact that the readjustment is a world-wide phe- 
 nomenon and is found in countries that have not raised interest
 
 639 
 
 rates as well as in those that have. It appears to have had its 
 definite beginning in the financial crisis in the Orient, which 
 occurred in February. 
 
 We may now return to a consideration of the manipulation 
 of the interest rate. What is to be said of the effectiveness of 
 this method of control as tested in the spring of 1920 ? The 
 answer, in brief, appears to be that the increase of interest 
 rates played a part in superinducing the business reaction that 
 began in May, but that it was greatly aided and abetted by the 
 transportation, cost of living and other conditions already 
 discussed. No one will ever know, in fact, whether, in the 
 absence of these contributing factors, the raising of interest 
 rates would have succeeded in checking the volume of business 
 and bringing about a price readjustment in time to prevent a 
 financial panic of the old-fashioned sort. The unresolved 
 issue is, whether if transportation facilities had been normal, 
 and if money wages could have kept substantial pace with 
 rising prices for only a few months longer, the rise in interest 
 rates would of itself have sufficiently narrowed margins of 
 profit to precipitate a business readjustment and a reduction of 
 prices before the reserves had been reduced to the breaking 
 point. 1 
 
 In any case it is of interest to consider the events subsequent 
 to the conference of bankers with the Federal Reserve Board 
 mentioned above. While it was believed that a substantial 
 curtailment of loans was indispensable to the safety of the 
 credit system, it was felt that this curtailment, in accordance 
 with American traditions, should not be forced from above, but 
 should be worked out by individual bankers, each deciding for 
 himself the volume of loan curtailment that could reasonably 
 be effected by his institution. Under this method it is very 
 doubtful if, in the absence of the untoward business develop- 
 ments discussed above, an adequate volume of loan contraction 
 could have been effected. The pressure that is brought to bear 
 upon each individual banker to take care of the financial 
 
 1 See also p. 642.
 
 640 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 requirements of "valued customers" is, usually, too strong to 
 be resisted wholly; when it comes to the point, it is so much 
 easier to let the others carry the responsibility. If business 
 had been still straining at the leash, as it was in the autumn of 
 1919, for example, the best that could have been hoped for 
 from this method of loan contraction would probably have 
 been the prevention of still further expansion and a consequent 
 maintenance of reserves at the then existing level. 
 
 Be all this as it may, the business depression that began 
 in the spring undoubtedly very greatly aided the Federal 
 Reserve Board and the bankers generally in their efforts to 
 avert a further deterioration in the reserve position. Mer- 
 chants unable to dispose of their stocks at existing prices made 
 concessions, meanwhile canceling orders from wholesalers 
 and manufacturers and even returning large volumes of goods 
 that had already been delivered. This in turn resulted in the 
 partial suspension of operations by many mills and factories 
 and in the complete closing of others. And as is always the 
 case, the resulting increase in unemployment had its effect in 
 still further reducing consumptive demand, and thus in bringing 
 cumulative pressure to bear upon prices the price recessions 
 gradually extending to nearly ah 1 groups of commodities. More- 
 over, as is again always the case in every period of depression, 
 construction activities, that is, the creation of additional 
 capital goods, were very sharply curtailed, thus reducing the 
 purchasing power of all those engaged in the building industry, 
 as well as the demand for building materials. 
 
 This slowing down of business activity and recession of 
 prices, in fact, made it incumbent upon bankers, if they would 
 safeguard their own immediate financial position, to scrutinize 
 the making of loans with unusual care. For as soon as margins 
 of profit began to decline, inventory values to shrink, and 
 business failures to increase, the possibility of bank losses was, 
 of course, very greatly increased. That such slight loan con- 
 traction as ensued is by no means wholly attributable to the 
 efforts of the bankers to fulfil their responsibilities under the 
 informal agreement reached with the Federal Reserve Board in
 
 THE WAR AND THE FEDERAL RESERVE SYSTEM 641 
 
 May, can be seen from the following considerations: The policy 
 that had been formulated was to restrict loans only for non- 
 essential purposes, since it appeared to be the height of economic 
 unwisdom to hamper the production of the necessities of life 
 at a time when the productive capacity of the world as a whole 
 was so sadly in arrears; indeed, an increase in total produc- 
 tion concentrated in lines of basic importance was to be 
 fostered. But the truth of the matter is that the curtail- 
 ment of loans that was in fact effected through the initiative 
 of bankers was by no means confined to nonessential lines of 
 activity. For example, one of the first lines to feel the effect 
 of loan contraction was the building industry, particularly 
 the housing division of the industry, where the need for increased 
 production was doubtless greater than anywhere else. On the 
 other hand, loans to many industries which everyone would 
 place in at least the "relatively unimportant" class were 
 scarcely restricted at all. The bankers can hardly be criticized 
 for this stand since under the conditions that prevailed the 
 risks of loss and failure were undoubtedly greater in connection 
 with certain very essential lines of activity than in many lines 
 of relative unimportance. And besides having a responsibility 
 to promote the general welfare, the managers of banks have 
 quite as important a responsibility in conserving the financial 
 position of the banks in the interests of their stockholders. 
 
 Loans for commodity speculation were, however, substan- 
 tially reduced, the banks being aided in the process by virtue of 
 the fact that price recessions were rapidly placing loans for 
 speculative purposes in the highly risky class. Furthermore, 
 as soon as the price readjustment became general, such specula- 
 tors were glad to retire from the field. It is probable, however, 
 that the volume of loan contraction that was effected was much 
 less in the aggregate in speculative lines than it was in essential 
 industries. 
 
 Notwithstanding the aid that was given to the Federal 
 Reserve Board in its efforts to bring about deflation by the 
 forces which we have just been considering, there was no 
 appreciable improvement in the reserve situation during the
 
 642 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 summer and early autumn of 1920 the date of the present 
 writing. In a sense, July, August, and September witnessed a 
 credit race, with the contestants running in opposite directions, 
 as it were. That is to say, there was a race between the extent 
 to which the volume of loans might be reduced in industrial 1 
 and speculative lines and the extent to which they would have to 
 be increased elsewhere, in order to take care of the autumn 
 seasonal- demands. At the present moment it appears that 
 reserves are not likely to be carried below the 40 per cent 
 limit that the crop-moving requirements will be taken care of 
 only to the extent that funds are released in other directions, 
 with the reserves as a whole remaining slightly above the mini- 
 mum requirements.* 
 
 It is of interest to observe in this connection that a shortage 
 of credit, like a dearth of transport facilities, results in extending 
 the movement of the crops over a substantially longer period 
 of time. The farmers are, in fact, storing a much larger portion 
 of their produce this year than has ordinarily been the case. 
 It should be noted, however, that the accompanying post- 
 ponement of rural consumptive demand is not without an 
 important bearing upon the general industrial situation. In 
 any event, if the industrial depression should become more 
 rather than less severe in the ensuing months, as appears not 
 improbable, it will be possible in the end to move the crops to 
 market without seriously straining the financial resources of 
 the country. 
 
 There was a genuine business crisis in the early summer of 
 1920. One other fact remains to be mentioned hi connection 
 with the crisis of 1920. Beginning about the middle of May, 
 the credit tension became of the acute variety that has hereto- 
 fore characterized the weeks immediately preceding a financial 
 collapse. Just as soon as the decline in prices, with the con- 
 current slackening of industry and the backing up of the 
 speculative waters, began, great numbers of business men were 
 
 1 Business depression substantially reduced the autumn credit require- 
 ments of manufacturers and producers of materials. 
 * Written in early October, 1920.
 
 THE WAR AND THE FEDERAL RESERVE SYSTEM 643 
 
 panic stricken much as in former times. The cancellation 
 of business orders, the failure of creditors to meet their obliga- 
 tions promptly, the recurring slumps in inventory values, and 
 the uncertainty as to the whole future trend of events developed 
 a veritable business crisis accompanied by the usual insistent 
 pressure upon the banks for loans with which to tide over the 
 interval of readjustment. There was one noteworthy difference, 
 however, between this and former similar occasions. Wide- 
 spread confidence in the Federal Reserve System proved a 
 powerful sedative. 
 
 It is significant to note hi this connection that the short- 
 time commercial credit that was outstanding could no more be 
 liquidated than any other credit obligations; the Federal 
 Reserve System was called upon to "carry" the entire credit 
 burden. This it proved able to do by virtue of the margin of 
 unused reserves that still existed. Whether or not the Federal 
 Reserve System would have been able to prevent a financial 
 collapse if the period of expansion had been continued until 
 the reserves were down to the legal minima, it undoubtedly 
 prevented a financial panic in late May or early June 
 of 1920. 
 
 Various Federal Reserve devices for controlling credit have 
 been tested. It will now be pertinent to consider briefly the 
 extent to which the various devices for avoiding financial 
 panics other than the control of the discount rate have been 
 utilized by the Federal Reserve System in the recent crisis. 
 It will be observed, first, that rediscounting of customers' 
 notes and direct borrowing from the Federal Reserve banks by 
 member institutions, both state and national, have been a 
 conspicuous feature of the credit strain since early in the 
 war. There would seem to be little doubt that in the 
 absence of the assistance rendered to individual banks we 
 should long ago have had a serious financial collapse. The 
 advantages of the maintenance of central reservoirs of lending 
 power as a means of strengthening the weak links in the 
 financial structure appear to have been demonstrated beyond 
 any doubt.
 
 644 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 It is of note, second, that the various Federal Reserve banks 
 have rendered much assistance to each other through inter- 
 borrowing operations, the credit strain thus being disseminated 
 throughout the entire banking system. This has been a note- 
 worthy feature of the financial system ever since the tension 
 upon bank reserves became acute. It appears that most of 
 the Federal Reserve banks have at one time or another, during 
 the last year or so, been both borrowers from and lenders to 
 sister-institutions; and there have been numerous occasions 
 where the shifting of funds from one financial center to another 
 has been of large aggregate volume in a very short period of 
 time. A high degree of flexibility has thus, in fact, been 
 obtained within the financial system as a whole. In the 
 absence of this mutual co-operation of the several Federal 
 Reserve institutions it is entirely possible that certain reserve 
 districts might have suffered from actual financial collapse, 
 and this would doubtless have involved the entire system. 
 
 In the third place, as already noted, it has not been neces- 
 sary, however, to cut below the minimum reserve requirements, 
 under the method provided by the Federal Reserve Act. 1 
 We have therefore no definite means of knowing whether this 
 could be accomplished without serious alarm to the business 
 community. It is possible that if an announcement were made 
 that the combined reserves of the Federal Reserve banks were 
 below the 35 and 40 per cent minima and that the Federal 
 Reserve Board had suspended these requirements as an emer- 
 gency measure, certain timid depositors might fear the worst 
 and resort to the familiar practice of hoarding. It is also 
 conceivable that individual banks might become alarmed and 
 withdraw funds from the financial centers for hoarding in their 
 own vaults and thereby seriously imperil the ability of the 
 Federal Reserve institutions to weather the storm. If the 
 system, however, succeeds in passing through one great financial 
 
 f See p. 597. It is true, however, that on more than one occasion 
 the reserves of the New York bank have been temporarily slightly below 
 the minimum requirements a condition, however, which has been quickly 
 remedied by borrowing from other Federal Reserve institutions,
 
 THE WAR AND THE FEDERAL RESERVE SYSTEM 645 
 
 strain successfully, the confidence resulting therefrom will 
 undoubtedly practically eliminate this danger for the future. 
 
 It should be noted in this connection that the requirement 
 of the Federal Reserve Act, as amended, that member banks 
 shall keep all of their legal reserves with the Federal Reserve 
 institutions, has not accomplished one important result that 
 was expected, namely, that of preventing the sending of funds 
 for deposit to the banks of the great financial centers. In fact, 
 it is doubtful if we have ever had a greater concentration of 
 funds than has been the case during the boom period of 1919. 
 These funds were in part deposited with correspondent banks 
 in New York and other financial centers, interest being paid 
 at 2 or 2 .5 per cent on balances; but in larger measure than 
 ever before they were loaned directly by western bankers to 
 speculators on the exchanges. The ease with which member 
 banks could replenish their reserves through borrowing from 
 the Federal Reserve institutions as long as reserves there 
 were ample appears, indeed, definitely to have promoted 
 rather than retarded the accumulation of funds for stock 
 exchange speculation. 
 
 Another factor of importance and of danger in the present 
 crisis has been the existence in New York of a large volume of 
 call loans contracted by Canadian borrowers. A sudden 
 withdrawal of these funds might well have proved a serious 
 matter if it had occurred coincidently with other untoward 
 developments. 
 
 Finally, at the present juncture, the raising of interest rates 
 in our market could not have the effect normally expected in 
 influencing the international flow of specie. The disorgani- 
 zation of the foreign exchanges, coupled with the embargo upon 
 European gold exports, has for the present, at least, rendered 
 practically impotent this part of the machinery of control. 
 The most that could be accomplished would be to retard the 
 outflow of specie to those countries with which our trade 
 balances have recently been adverse. 
 
 While it is premature to attempt any final statement of the 
 effectiveness of the machinery of credit control provided by
 
 646 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 the Federal Reserve System, as measured by the financial 
 events of the past six years, it would appear that a favorable 
 verdict must, on the whole, be rendered. While serious mis- 
 takes as to credit policy have doubtless been made, it will, 
 no doubt, be generally conceded that the financial problems of 
 the world-war and its aftermath have been of unprecedented 
 complexity and magnitude and that the fallible human admin- 
 istrators of the modern financial organization have done about 
 as well as could reasonably have been expected. It is at least 
 gratifying that the management of the new American financial 
 system has compared very favorably with that of the older 
 and more fully developed European systems. 
 
 QUESTIONS FOR DISCUSSION 
 
 1. State the various means by which the reserves of the Federal 
 Reserve institutions were built up between 1914 and 1917. 
 
 2. Evidence ha.s been presented to show that the physical volume 
 of business increased between 1914 and 1918 by about 8 per cent. 
 Assuming the price level to have remained the same, how would 
 this have affected the reserves of the Federal Reserve institutions ? 
 
 3. Show how a doubling of the price level would affect bank reserves. 
 
 4. So far as reserves were concerned, did it matter particularly 
 whether borrowing from the Federal Reserve bank took the 
 form of Federal Reserve notes or deposit accounts ? 
 
 5. What determined the maximum amount of Liberty bonds (a) that 
 any individual bank could purchase; (6) that the banks as a 
 whole could purchase ? 
 
 6. What determined the total volume of Liberty bonds that indi- 
 viduals could purchase through the use of their credit at the 
 banks, that is, on funds borrowed from the banks on collateral 
 security ? 
 
 7. Show concretely how the banks would ultimately have to give 
 up the payment of specie on demand. 
 
 8. Draw up in summary form a statement of the various sources of 
 credit absorption during the upward swing of the business cycle 
 which began in the spring of 1919. Which do you regard as 
 most important ? 
 
 9. Explain the large export of specie in 1919 and 1920. Explain 
 why for every dollar of specie exported there must be a credit 
 curtailment of substantially twenty dollars.
 
 THE WAR AND THE FEDERAL RESERVE SYSTEM 647 
 
 TO. If you had been a member of the Federal Reserve Board in the 
 spring of 1919, what policy would you have advocated? in the 
 autumn of 1919? Why? 
 
 1 1 . Why could not a curtailment of stock exchange speculation suffice 
 to relieve the monetary strain during the upward swing of the 
 business cycle ? 
 
 12. It was urged by many that an increase in production together 
 with a decrease in consumption was all that was necessary to 
 bring about a substantial reduction in prices and a consequent 
 easing of the tension in the money market. Judging from the 
 analysis of business cycles in the preceding chapter, do you 
 gather it is possible to secure an increase in the efficiency of 
 labor and capital at the height of a period of prosperity ? 
 
 13. If the increased production is attained, not as a result of increased 
 efficiency within particular plants, but only in consequence of 
 hiring hitherto unemployed labor and new immigrants to engage 
 in additional production, would there be any decrease in the 
 demand for bank funds ? 
 
 14. Judging from your previous study of business cycles, do you 
 think that a decline in consumptive demand and an increase in 
 production usually go together ? 
 
 15. Concretely, how was it expected that a decline in prices would 
 affect bank reserves ? 
 
 16. Do you see any means whereby a decline in prices might have 
 been effected without precipitating a business depression? 
 Do you see any means whereby bank reserves might have been 
 increased without either a business depression or a decline in 
 prices ? 
 
 17. If wages and salaries had everywhere been raised as fast as the 
 cost of living was advancing, could not a decline in consumptive 
 demand in the spring of 1920 have been avoided ? Would this 
 have prevented a period of readjustment ? 
 
 18. What peculiar difficulties were there in the winter of 1920 in the 
 way of an effective use of high interest rates ? 
 
 19. "The Federal Reserve System is panic proof." Do you agree 
 with this unqualified statement ? 
 
 20. "There can be no credit collapse so long as additional funds are 
 available; and under the Federal Reserve System there is unlimi- 
 ted lending power." Is this a true statement of the situation? 
 
 21. Write a summary statement of your conclusions as to the efficacy 
 of thr Federal Reserve System as tested by the crisis of 1920.
 
 648 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 REFERENCES FOR FURTHER READING 
 
 Laughlin, J. Laurence: Banking Progress, chap. xi. 
 
 Mitchell, Wesley C.: "Prices and Reconstruction," American 
 Economic Review, Vol. X, No. i (March, 1920). 
 
 Moulton, Harold G.: "Banking Policy and the Price Situation, " 
 American Economic Review, Vol. X, No. i (March, 1920). 
 
 Reed, Harold L.: "The Work of the Federal Reserve Board," 
 Journal of Political Economy, XXIX, January, 1921. 
 
 Federal Reserve Bulletin. Consult monthly bulletins for official 
 pronouncements of the Federal Reserve Board.
 
 CHAPTER XXVII 
 
 RAISING CAPITAL FOR AGRICULTURE 
 
 The analysis of financial operations in all of the preceding 
 chapters has related primarily to the financing of industry and 
 commerce, with only incidental reference to the agricultural 
 side of our economic lif e. In the present chapter we shall view 
 the financial structure from the point of view of agriculture, 
 noting in what ways the financial institutions which have already 
 been considered are associated with agricultural finance, and 
 discussing, particularly, the work of the numerous special 
 financial agencies that have been evolved for facilitating the 
 raising of capital for agricultural purposes. 
 
 As in the case of corporate and partnership enterprises 
 engaged in commerce and industry, we may classify farm capital 
 as fixed and working, the fixed capital representing invest- 
 ments in the land, buildings, and equipment, and the working 
 capital that utilized in the yearly operation of the farm. As the 
 chart on page 650 indicates, however, agriculture is, as yet, 
 almost exclusively conducted on a non-corporate basis; hence 
 the instruments utilized and the financial institutions employed 
 in raising fixed capital have ordinarily been essentially different 
 from those used by industrial and commercial enterprises. We 
 shall find that the most significant development in the history 
 of agricultural finance has been the organization of the Federal 
 Farm Loan System by means of which fixed capital for agri- 
 culture may now be raised by methods similar to those so suc- 
 cessfully employed by corporate industry. 
 
 A few words are necessary by way of explanation and ampli- 
 fication of the chart on the accompanying page. It will be 
 noted in the first place that a large amount of working, as well 
 as fixed, capital is supplied directly by the owners. While, as 
 we have elsewhere seen, some of the working capital of indus- 
 trial and commercial enterprises is necessarily furnished by the 
 
 649
 
 650 
 
 THE FINANCIAL ORGANIZATION OF SOCIETY
 
 RAISING CAPITAL FOR AGRICULTURE 651 
 
 owners of the business, the percentage of borrowed working 
 capital is typically much less in agricultural than in other lines. 
 
 Second, the chart does not make clear one important feature 
 of the farm mortgage business. Farms have been very com- 
 monly purchased by the method of paying part down and giving 
 the seller a mortgage on the property for the balance. It wilJ 
 be seen that no intermediary financial institution is necessary in 
 such a case; hence this method of borrowing could not well be 
 portrayed upon the chart. Many mortgages made subsequent 
 to the purchase are also consummated directly without the inter- 
 mediation of any third person or institution. This is indicated 
 in the chart by the straight line connecting "Fixed Capital" 
 with "Individual Purchaser." 
 
 Third, it will be seen that savings banks and trust companies 
 appear upon the fixed capital side of the chart in two different 
 places. In the upper part of the diagram they are put down 
 as distributors of farm mortgages, while hi the lower part they 
 are grouped with insurance companies as final purchasers of 
 mortgages, and also of farm loan bonds, as is indicated by the 
 lines connecting with the Joint Stock and Federal land banks. 
 
 It is necessary to add a word of explanation for placing 
 commercial banks along with savings banks and trust companies 
 as distributors of farm mortgages; for it is commonly supposed 
 that it is no part of the business of such institutions to deal in 
 mortgages. The truth is, however, that many commercial 
 banks and trust companies have farm mortgage departments and 
 engage hi the buying and selling of mortgages. This applies 
 not only to the commercial banks of the smaller towns but also 
 to some of the larger institutions of the financial centers. 
 
 Many of the small state commercial banks purchase real- 
 estate mortgages for investment purposes; and the trust funds 
 administered by trust companies are in no small degree invested 
 in farm mortgage securities. The part that savings banks play 
 as purchasers of mortgages may be seen by reference to the 
 statistics of savings bank investments as shown on pages 328 
 and 333. It will also be recalled 1 that the insurance companies 
 
 1 See p. 345.
 
 652 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 have offered the largest single outlet for the sale of farm mort- 
 gages and that without their support American agriculture 
 would in the past, at least, have found it practically impossible 
 to procure the funds required for its expansion and development. 
 In this connection it should be noted that the chart does not 
 clearly indicate the relative importance of the insurance com- 
 pany as a purchaser of farm-loan securities. On the other hand, 
 it plays up the Federal Farm Loan System out of proportion 
 to its immediate importance, though not, it is believed, to its 
 ultimate significance hi the rural credit structure. 
 
 Fourth, a line might also be drawn from "Fixed Capital" 
 to "Commercial Banks," for many loans have been made for 
 fixed capital purposes by state banks and trust companies, on 
 mortgage security, and by national banks on single- or double- 
 name promissory notes, indefinitely renewed. 
 
 Finally, the chart does not indicate the work that 
 co-operative credit associations perform in furnishing working 
 capital for agriculture. A brief discussion of the work of these 
 institutions is, therefore, in point at this place. There are 
 numerous co-operative plans in use. ' Under one method, for 
 example, dairy farmers enter into an agreement with a local 
 banker, or other money lender, to adopt an approved system of 
 dairying. The lenders of the funds buy the dairy stock and 
 sell it to the farmers at actual cost, plus a percentage to cover 
 expenses. Under this method the lender takes the farmer's 
 personal note, with or without indorsement, or, as the case may 
 be, with mortgage security on the stock purchased. Another 
 plan similar to this calls for a joint guaranty by a group of farm- 
 ers that the loans will be paid, each member of the group also 
 assuming individual liability for the entire loan. 
 
 Some very interesting credit associations have also been 
 developed for making short-time loans to Jewish farmers. The 
 Jewish Agricultural and Industrial Aid Society had, in 1913, 
 seventeen credit unions, all located hi eastern states. The 
 orinciple underlying these co-operative associations is the exten- 
 sion of credit by the association as a whole to any member who 
 is in need of funds. These unions are quasi-philanthropic
 
 RAISING CAPITAL FOR AGRICULTURE 653 
 
 enterprises, and the loans are made at exceptionally low rates 
 of interest. 
 
 A more extensive form of co-operative credit is that made 
 possible by an act of the Massachusetts legislature in 1915. 
 Under this law a group of seven or more residents of the state 
 are given the right to organize themselves into a credit union. 
 This union may receive funds from its members, either hi pay- 
 ment for shares of stock in the union, or for deposit; and in 
 turn it may lend to its members the funds so accumulated, or 
 it may invest them in accordance with certain regulations laid 
 down by law. It is not improbable that this form of credit 
 extension will gradually come to play a larger role in the system 
 of agricultural finance. 
 
 With this preliminary survey of the problem of agricultural 
 credit in mind we may turn to a consideration of the practical 
 operations of the various financial agencies that are utilized in 
 raising funds for agricultural purposes. It will be found 
 expedient to reverse the order followed in discussing industrial 
 and commercial borrowing, and take up first the raising of 
 working capital. 
 
 A. Working Capital 
 
 The working or operating capital used in agriculture is derived 
 from a variety of sources from commercial banks, cattle loan 
 companies, private individuals, implement manufacturers, can- 
 ning factories, local merchants, wholesale dealers, etc. The 
 security back of farm loans also assumes a variety of forms. 
 For example, a rough estimate made in 19 lo 1 showed that of a 
 total of $2,207,000,000 of farm loans not secured by real-estate 
 mortgages, $840,000,000 were based upon crop liens, $700,000,000 
 on chattel mortgages on live stock, farm machinery, or other 
 personal farm property, while $250,000,000 was on open book 
 accounts with local merchants. The balance of $417,000,000 is 
 classified as miscellaneous farm loans. 
 
 Since the chart on page 650 is concerned only with the 
 
 financial structure which has developed for the making of loans 
 
 f 
 1 See Grover G. Huebner, Agricultural Commerce, p. 329.
 
 654 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 in the form of funds, it does not indicate the very important 
 part that trade credit, or the sale of goods on time, plays in 
 financing agriculture. Before considering the short-time loans 
 negotiated with commercial banks, it will therefore be necessary 
 to make a brief statement of the nature and significance of 
 agricultural trade credit. 
 
 I. TRADE CREDIT 
 
 Until comparatively recent tunes the farming communities 
 have in fact borrowed the larger portion of their working capita' 
 from other than banking sources. For reasons which need not 
 here be considered, the farmer typically purchased the supplies 
 needed for current use on the farm from the local stores, paying 
 for them in the autumn after the sale of the season's crops. 
 Such credit was usually extended without the requirement of a 
 promissory note; it was book credit, with the merchants as a 
 rule keeping the only records. Since the risks were relatively 
 large, collections being slow and uncertain, the merchants neces- 
 sarily added a substantial amount to the price of the goods in 
 order to cover the risks involved. The looseness of the system, 
 moreover, opened the way to exorbitant or usurious charges. 
 
 The system of trade credit has had its most extensive develop- 
 ment in the South, particularly in connection with the growing 
 of cotton and tobacco by small land owners and tenants. Under 
 this system a local merchant or dealer at the beginning of the 
 crop-growing season extends a. line of credit at the store to a 
 cotton grower, for example, and takes a "lien" on the cotton 
 crop, or a chattel mortgage on the crop plus any other property 
 which the borrower may own. It is the custom to grant a maxi- 
 mum trade allowance per month, the amount .varying with the 
 community and with the color of the tenant. The interest is 
 nearly always deducted in advance, and it appears that the 
 borrower has, as a rule, been greatly overcharged for his goods. 
 Perhaps the worst evil of this system is the fact that the borrower 
 is virtually at the mercy of the storekeeper. 
 
 Besides the local merchant, the owner of the land not infre- 
 quently advances the trade credit to the tenant. It is also
 
 RAISING CAPITAL FOR AGRICULTURE 655 
 
 sometimes furnished by a "cotton factor" acting as the agent 
 of a large cotton dealer. In some cases, moreover, the advance 
 takes the form of actual money rather than goods. Private 
 individuals have in many communities also made money loans 
 to cotton and tobacco growers. 
 
 A very interesting development in rural credit in recent 
 years has been the furnishing of seed and supplies to farmers by 
 fruit and produce dealers, wholesale grocers, canning factories, 
 etc. It appears that in many cases the advances take the form 
 of actual money the amount of the loans being deducted 
 from the price of the crops, which are sold to the concerns which 
 have furnished the capital required. 
 
 While this trade credit is extended directly by the local 
 merchants, dealers, etc., the banks nevertheless ordinarily play 
 an important part in the process, for the local merchants and 
 dealers meanwhile usually borrow the funds from the local banks 
 or are carried by wholesalers and dealers higher up in the trade; 
 in this event these latter middlemen borrow heavily from the 
 banks of the larger centers. In many cases, moreover, particu- 
 larly in the farm-implement line, the credit is extended by the 
 manufacturers who borrow the necessary funds frcjm the banks 
 of the financial centers. 
 
 This farm-implement credit, it will be seen, is ordinarily 
 used for what may be called fixed-capital purposes. Much of 
 this credit is extended, however, for a period of only six months, 
 for the reason that many tools and supplies last for one season 
 only. In the case of harvesting machines, however, the common 
 practice has been for the manufacturer to allow three years for 
 payment, one-thirbl being paid in cash at the end of the first 
 season, with promissory notes given for the balance. These 
 notes are usually guaranteed by the retail dealer, who acts as 
 the local agent for the manufacturer. 
 
 While this system of selling farm implements still prevails 
 to some extent, 1 and while it is true that a vast amount of trade 
 
 1 It was discontinued in 1919 by the International Harvester Company, 
 in favor of cash sales, the farmers' growing affluence making the change 
 possible.
 
 656 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 credit is even now extended to farmers by local merchants, 
 recent years have witnessed marked changes in agricultural- 
 credit methods. With the gradual development of business 
 principles hi the conduct of agriculture, which came with the 
 passage of the frontier and the intervention of scientific farming, 
 farmers have come to see that paying cash for fertilizer, seed, 
 and other supplies, saves money, even if the cash required has 
 to be borrowed from the bank. The interest paid to the banks 
 is as a rule substantially less than the amount of the discount, 
 on the price of the goods that is given for cash payment. 
 
 II. COMMERCIAL BANK LOANS FOR AGRICULTURE 
 
 The chart on page 650 indicates that the operating capital 
 used in agriculture, insofar as it takes the form of funds rather 
 than goods, is borrowed largely from the commercial banks, 
 in the main directly, but in part indirectly through the inter- 
 mediation of cattle loan companies. These latter institu- 
 tions, as we shall see, occupy a position hi the rural credit 
 structure somewhat analogous to that held by the commercial- 
 paper houses and discount companies in the commercial credit 
 system. 
 
 The gradual change in farm financial methods discussed 
 above revealed that in many localities the banking facilities 
 for making short-time loans to farmers were not wholly satis- 
 factory. Under the influence of long-established custom, many 
 of the bankers regarded the farmers as unimportant borrowing 
 constituents; too often the local bankers looked merely to local 
 industries for their support. But the agitation on the subject 
 of rural credits, both long- and short-term, which preceded the 
 passage of the rural credit law in 1916, aroused the country 
 bankers to the need of cultivating their agricultural constituents. 
 The belief was widespread in farming circles at the time that 
 both the national and state commercial-banking systems were 
 designed primarily to promote industrial and commercial activ- 
 ity, and that the farmers of the country were being sorely 
 neglected. The very high rates currently paid by farmers for 
 short-time loans seemed conclusive evidence on the point.
 
 RAISING CAPITAL FOR AGRICULTURE 657 
 
 While the charge that the country bankers were neglecting 
 agriculture was unquestionably greatly overdone so far as 
 short-time loans were concerned there was, nevertheless, a 
 measure of truth hi the contention. In any event, fearing the 
 loss of an important and rapidly developing borrowing constitu- 
 ency, as the farming communities became more prosperous 
 with the era of rising prices that began in 1896, the country 
 bankers have become assiduous in fostering cordial relationships 
 with their farming constituents. It is of note in this connection 
 that the rural credit law, which was eventually passed by 
 Congress in 1916, did not concern itself with short-time agri- 
 cultural credit. 
 
 The extension of banking facilities throughout the small 
 towns of the country and the growing interest of the banker hi 
 his rural constituents have been extremely significant events 
 hi the history of American agriculture, for the bankers are now 
 in many places taking a vital interest in the improvement of 
 both farming methods and rural life; and they are co-operating 
 with the farmers in every possible way hi f urthering agricultural 
 progress. Not the least important of the bankers' services lies 
 in the dissemination of information on all phases of agricultural 
 development. The "farmers' bank" is becoming a common 
 institution in many regions; and the services that such a bank 
 may perform in promoting the interests of agriculture are of 
 incalculable importance. 
 
 The making of bank loans to farmers involves certain 
 problems essentially different from those associated with com- 
 mercial lending in the large financial centers. In the first place> 
 the relations between banker and customer are, in the nature 
 of things, personal rather than impersonal; hi the second place, 
 the farmer is seldom in a position to furnish even a rough state- 
 ment of his financial condition; and, in the third place, ther& 
 are greater uncertainties in agriculture than in most commercial 
 or industrial lines, weather conditions being a determining 
 factor. In consequence, agricultural lending is still largely 
 conducted on old-fashioned banking principles. The banker 
 drives out through the country and gets a bird's-eye view oi
 
 658 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 the farm and of the condition of the crops; he inquires as to 
 the amount and value of the live stock on hand; and in general 
 keeps in touch with the character and habits and the political 
 and financial activities of the borrower in question. 
 
 With the development of agricultural accounting, however, 
 these methods are changing somewhat, if slowly; and it is not 
 impossible that, under the conditions that will obtain when 
 farming is eventually conducted on business-like principles, 
 country-bank methods will be similar to those that now prevail 
 in the larger financial centers. 
 
 Renewals of agricultural loans are very common. Agricultural 
 loans for working-capital purposes are usually extended by the 
 banks for from four to six months, to coincide with the crop- 
 growing period. Because of the uncertainties involved, both 
 as to the time at which agricultural produce will be sold, and as 
 to the amount of the returns which depend both upon the 
 size of the crop and the price at which it may be sold renewals 
 of agricultural loans are extremely common. These renewals 
 are, moreover, not merely temporary extensions; they are very 
 commonly extensions which must be carried over for an entire 
 year, until a subsequent crop shall have been garnered and sold. 
 Indeed, it has been the rule, rather than the exception, that at 
 least a part of the loans extended to farmers during the crop- 
 growing period are carried over, extended for an indefinite 
 number of years. This practice is in part attributable to the 
 fact that the National Bank Act did not permit national banks 
 to loan on the security of real-estate mortgages, in consequence 
 of which the national institutions, in order to meet the compe- 
 tition of the state banks, made loans for fixed-capital purposes 
 to farmers merely on the security of their single or indorsed 
 promissory notes. In the nature of things such loans usually 
 had to be extended for a long period of years. 
 
 In many cases, however, this constant renewal of loans 
 merely betokened a continuous need of the farmer for borrowed 
 working capital. While unable to pa)' off a year's loan in 
 full, after meeting living requirements, the farmer was usually 
 on the up-grade, financially speaking; and the banks were
 
 RAISING CAPITAL FOR AGRICULTURE 659 
 
 merely carrying him during the years of his adversity. In many 
 other cases a bad year, or a series of them, necessitated con- 
 tinuous financial aid from the bankers. While one may reflect 
 that such loose extension of credit constituted a very dangerous 
 financial practice for commercial banks, it should be borne 
 in mind as an extenuating circumstance that it appeared to 
 the country bankers to be incumbent upon them to assist 
 agricultural borrowers in times of adversity when they needed 
 assistance most, quite as much as to extend them credit when 
 their needs were less. 
 
 On the whole, it appears that such practice has not occa- 
 sioned an extremely high mortality rate among country bank- 
 ers. Like the banks of the commercial centers, the country 
 institutions do not ordinarily rely upon maturing loans for 
 the necessary liquidity of their assets; before the establish- 
 ment of the Federal Reserve System they relied upon being 
 able to get assistance from correspondent banks hi times of credit 
 strain, through various methods, as outlined on pages 474-75. 
 The responsibility for upholding the financial structure as a 
 whole was thus placed upon the banks of the financial centers. 
 Since the passage of the Federal Reserve Act, the country banks 
 rely upon rediscounting agricultural paper with the Federal 
 Reserve banks. 1 At the present time, therefore, the responsi- 
 bility lies with the Federal Reserve institutions. 
 
 III. THE WORK OF THE CATTLE LOAN COMPANY 
 
 The cattle loan company has been developed to finance 
 the raising of cattle, 2 both on the ranges and hi the feeding 
 centers of the corn belt. In brief, the raison d'etre of the 
 cattle loan company is the inability of local banks in the cattle- 
 growing and -feeding regions, to supply the large volume of 
 loans required by the cattle men. Unlike ordinary agri- 
 cultural operations, cattle-raising is typically conducted on 
 
 1 It will be recalled that agricultural paper of six months' duration is 
 eligible for rediscount with the Federal Reserve banks. 
 
 2 Sheep-raising is also financed to some and to an increasing extent by 
 methods similar to those outlined in this section.
 
 660 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 a relatively large scale; and the cattle borrower accordingly 
 requires loans of large average size, so large that the entire 
 lending resources of local banks would often be absorbed by 
 a single loan. Since our banking laws restrict the volume of 
 loans that may be made to any one borrower, and since in 
 any event the financing of the cattle industry by the local 
 banks would result in an undue concentration of banking 
 risks, it is necessary that the funds required in financing the 
 raising of cattle be secured from the banks of the financial 
 centers. This the cattle loan company makes possible. 
 
 The development of the cattle loan companies dates from 
 about 1900. Before that time, state and national banks did 
 what they could to finance the cattle industry; and there 
 were a few large commission firms which loaned funds to cattle 
 feeders. But there was no adequate machinery for the investi- 
 gation of prospective loans, and no careful supervision of 
 loans once consummated. The losses accordingly proved very 
 heavy and cattle paper became very unpopular for many 
 years, the cattle industry meanwhile being handicapped by 
 the dearth of funds. But the growth of cattle loan companies 
 which specialize in the handling of cattle paper, and act as 
 brokers between the borrowing cattle-men and the lending 
 banks of the financial centers, has placed the business upon 
 a solid foundation. 
 
 There are two types of cattle loan companies. First, there 
 are those that are affiliated with state or national banks, 
 where the stock is subscribed by the directors and stockholders 
 of the allied institutions. The officers and staff of the bank are 
 as a rule also officers and staff of the cattle loan company. 
 The purpose of this type of organization is merely to permit 
 an expansion of the bank's activities hi ways that would not 
 be permitted under the .terms of incorporation. Nominally 
 an independently organized institution, such a company is in 
 reality but a department of an ordinary commercial bank. 
 The second type of cattle loan company is an independent 
 concern, organized and officered by individuals who make 
 this their sole business.
 
 RAISING CAPITAL FOR AGRICULTURE 661 
 
 Nearly all of the cattle loan companies are located in the 
 large packing centers, although there are a few on the Pacific 
 coast and in New Mexico. The affiliated companies are usually 
 connected with some of the large live-stock national banks 
 located in the packing centers and ordinarily owned and con- 
 trolled by some of the large packers. Such location has advan- 
 tages in that the cattle can often be inspected in the packing 
 centers, while the marketing of stolen cattle can more easily be 
 detected. The packing centers are, moreover, the focal points 
 of all important developments affecting the cattle industry, and 
 hence the policy of the company can be adjusted more promptly 
 to meet the changing conditions hi the industry. 
 
 Cattle loans are of several different types. They are usually 
 classified as follows: (i) ranch loans, on herds of cattle which 
 are being grass-fed on the ranches; (2) feeder loans, on steers 
 which are entering upon the last stage of feeding prior to their 
 sale as beef cattle; (3) stocker loans, on cattle held for breeding 
 purposes; (4) dairy loans, made for the purchase of dairy 
 cattle. 
 
 Loans on ranch cattle, which are found only in the western 
 states, are not so popular as feeder loans for the reason that 
 the risks involved are ordinarily somewhat greater. Where 
 the ranches are fenced, however, as is now usually the case, 
 such loans are reasonably safe. They are as a rule made 
 for the summer season, and are sometimes referred to as "sum- 
 mer loans"; they are paid in the fall out of the proceeds derived 
 from the sale of the cattle to packing houses or to feeders for 
 further fattening. 
 
 Feeder loans are made for periods of from three to six 
 months, according to the age of the steers and the length of 
 time during which they are to be fed. Such loans are regarded 
 as particularly satisfactory in view of the fact that the cattle 
 which constitute the security are to be sold for cash within 
 a relatively short period of time and because the value of 
 the collateral ordinarily increases as the steers put on 
 weight and improve in quality. Moreover, the dangers from 
 inclement weather, disease, and accident are relatively small
 
 662 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 Such cattle paper, therefore, ranks with the best commercial 
 paper. 
 
 Stocker loans are subdivided into loans on cows and on 
 young stock. Loans on breeding cows are usually made for 
 six months' time and are commonly renewed from three to 
 four times if the conditions continue to be favorable. Such 
 loans are therefore usually regarded as long-time advances; 
 and the cows may in a sense be regarded as fixed capital. They 
 do not enjoy the same standing, therefore, as feeder loans; 
 and a larger margin of security is required, the loan commonly 
 being made for only 50 or 60 per cent of the total value of 
 the cows, whereas hi the case of feeders, the loan is made up 
 to 90 per cent and sometimes even to 100 per cent of the value. 
 The mortgage on the cows also covers the offspring. The 
 second class of stocker loans are made upon young steers and 
 heifers intended ultimately to be marketed. While they are 
 made for periods of six months, they, also, are commonly 
 renewed from one to three times. Accordingly, they are 
 regarded as of a less liquid nature than the high-grade feeder 
 loans. 
 
 Dairy loans, likewise, are made for relatively long periods 
 of time, and are usually paid in monthly instalments from 
 the proceeds of the sale of butter fat. In consequence, such 
 loans are not considered liquid; and they cannot be redis- 
 counted at the Federal Reserve banks or be readily sold out- 
 side of the district in which they are made. Accordingly, they 
 are not commonly made by cattle loan companies, the local 
 banks usually being reh'ed upon to furnish the necessary 
 accommodation. 
 
 The cattle loan company makes a careful credit analysis. 
 Before a loan is granted the borrower is required to fill out 
 a "form" statement furnished by the cattle loan company 
 showing his assets and liabilities, the amount of insurance 
 carried, etc., and giving a detailed description of all the cattle 
 which he has available as security. The truth of the state- 
 ment is attested before a notary public. Second, the borrower 
 is required to fill out what is known as a "brand sheet," which
 
 RAISING CAPITAL FOR AGRICULTURE 663 
 
 gives in both illustrative and descriptive form the brand 
 employed by the borrower. This permits identification of the 
 cattle at any subsequent time; and it enables the lender to 
 ascertain from the county clerk whether any previous loans 
 have been made on these same cattle. Third, a careful investi- 
 gation is made*of the moral responsibility and financial ability 
 of the borrower. Commercial agencies and special references 
 are used as sources of collateral information; and particular 
 attention is paid to the reports of the inspectors who are 
 employed by the cattle loan company. 
 
 Finally, the borrower is required to sign a promissory note 
 and give a chattel mortgage on the cattle, whether they are 
 already in his possession or yet to be purchased. The reason 
 for requiring the chattel mortgage on the cattle is that the 
 loan company is usually located at a considerable distance 
 from the borrower and since the cattle are "movable" property 
 it would be easy for a dishonest borrower to dispose of them 
 without the knowledge of the company. It should be noted 
 that by virtue of the mortgage the legal title to the cattle rests 
 in the loan company, and accordingly any individual who 
 purchases the cattle is responsible for the payment of the loan. 
 An added reason for the use of collateral security in the case 
 of cattle loans, as in the previous cases where we have observed 
 the depositing of collateral, is the convenience of the process. 
 The cattle are intended to be kept during the life of the loan, 
 and it is a simple matter to give a chattel mortgage against 
 them. 
 
 Cattle paper is sold to the banks of the financial centers. The 
 cattle loans range in size from one thousand to five hundred 
 thousand dollars, the average loan being in the neighborhood 
 of twenty-five thousand dollars. The cattle loan companies 
 usually hold for investment some of the loans which they make, 
 utilizing their own capital and surplus in this way; but most 
 of the paper which they handle is promptly transferred to 
 the banks of the financial centers. Like the commercial paper 
 houses, cattle loan companies advance the funds to the borrower 
 out of their own resources; but, unlike commercial paper
 
 604 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 houses, they indorse the paper which they sell. The paper 
 is sold to investors at a rate of interest ordinarily about 2 per 
 cent less than that paid by the borrower. This 2 per cent 
 margin constitutes the principal source of the companies' 
 profits. 
 
 Large loans are usually broken up into notes of one-, five-, 
 or ten-thousand-dollar denominations, although sometimes a 
 loan of fifty thousand dollars or more is sold to a single large 
 investor. In such cases the investor is given a duplicate 
 certified chattel mortgage; but where the loan is broken 
 up into small denominations, each investor is given what is 
 known as a "certified trust receipt of chattel mortgage." 
 The purchaser of the cattle paper, however, always looks to 
 the loan company for payment; and the companies assume the 
 responsibility of collecting from the borrower. 
 
 Cattle loan companies perform important economic services. 
 We have already seen that local banks, as a rule, have inade- 
 quate lending power for the needs of cattle-growing and feeding, 
 and that access to the funds of the financial centers is indis- 
 pensable to the continued development of this basic industry. 
 The development of the cattle loan companies has undoubtedly 
 stimulated the growth of the live-stock industry and, in con- 
 sequence, the improvement of agriculture in general. For it 
 is a basic principle that soil fertility cannot be preserved 
 indefinitely in the absence of a live-stock industry. 
 
 Finally, in the words of one writer, 
 
 the cattle loan company renders an economic service to society 
 by a better distribution of capital. There has been a constant tend- 
 ency to concentrate capital in the industrial establishments of the 
 nation at the expense of the producers of raw foodstuffs. This 
 defect has been largely remedied by the activities of the cattle loan 
 companies. In making capital available to cattle-growers the loan 
 companies help to prevent a concentration of capital in the East; 
 much of the money which would otherwise drift back to New York 
 when the crop-moving season is over, being in the fall turned by the 
 loan companies into the production of finished cattle. This improve- 
 ment in the distribution of capital ba lowered the average rate of
 
 RAISING CAPITAL FOR AGRICULTURE 665 
 
 interest to cattlemen. The average rate charged by commission 
 companies during the "bonanza period" of the cattle industry was 
 10 per cent. The strain on the local banks, moreover, was so great 
 following this period that there was little decrease in the rates. The 
 advent of the modern cattle loan companies with their improved 
 methods has had the effect of lowering the average interest rate at 
 least 2 per cent. This saving is obviously a benefit to the grower 
 and augments his ultimate profit. It is, in addition, a saving to the 
 ultimate consumer, unless a monopoly somewhere intervenes to 
 prevent the working of normal competitive forces. 1 
 
 B. Fixed Capital 
 
 I. THE NATURE AND EXTENT OF THE FARM 
 MORTGAGE BUSINESS 
 
 The volume of borrowing by agricultural interests for 
 fixed-capital purposes is not fully measured by the amount of 
 mortgage and bonded indebtedness; for as we have already 
 seen, commercial and savings banks have made many loans to 
 agriculture without collateral security. Farm-mortgage indebt- 
 edness, however, assumed very large proportions in the years 
 following the Civil War. According to the census report of 
 1890, out of a total number of 3,142,746 farms, cultivated by 
 their owners, 886,957 were subject to incumbrance. There 
 were in addition 1,624,433 tenant farms for which no data were 
 collected. The aggregate value of the incumbered farms was 
 $3,054,923,165; and the outstanding mortgages aggregated 
 $1,085,905,960, the three states of New York, Iowa, and 
 Illinois together having almost one-third of the total. The 
 ratio of mortgage indebtedness to the value of the farm varied 
 among the different states, ranging from 24.23 per cent in 
 Utah to 54.54 in Mississippi, and averaging 35.55 per cent 
 for the country as a whole. 
 
 The following table indicates that the great majority of 
 these mortgages were incurred for constructive purposes, that 
 
 1 Forrest M. Larmer, "The Cattle Loan Company," Journal of 
 Political Economy, XXVI (1918), 839,
 
 666 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 they were not, as is so commonly supposed, usually acquired 
 as a means of relieving farmers' families from distress. 1 
 
 CAUSES OF FARM MORTGAGE INDEBTEDNESS 
 
 Percentage of Total 
 Purpose of Borrowing Indebtedness 
 
 For purchase of real estate 64.38 
 
 For real estate improvement 4.53 
 
 For purchase of real estate and improvement thereof 
 
 combined 5.31 
 
 For use in other business i . 95 
 
 For purchase of farm machinery, domestic animals, 
 
 etc 1.19 
 
 For farm and family expenses 2 . 83 
 
 While few such loans can fairly be placed in the "calam- 
 ity" class, it is true, however, that during the long period of 
 falling prices after the Civil War a considerable percentage of 
 the mortgage loans that would ordinarily have been paid at 
 the end of the three or five years for which they were contracted, 
 were necessarily renewed.' The census report of 1910 indicated 
 that, notwithstanding the great improvement in agricultural 
 conditions that came with the era of rising prices beginning 
 in 1896, the total mortgage indebtedness *in 1910 stood at 
 $2,293,000,000, an increase of no per cent hi twenty years. In 
 1915 the United States Department of Agriculture, computing 
 on the basis of the census figures of 1910, estimated that the 
 total farm-mortgage debt of the United States then stood 
 at $3,598,985,000; while more recent estimates have placed 
 the total in the neighborhood of $4,000,000,000. These in- 
 creases in farm indebtedness since 1890 have been mainly 
 incurred in financing the purchase and improvement of agri- 
 cultural property. 
 
 1 Data taken from report on "Farms and Homes: Proprietorship and 
 Indebtedness," Eleventh Census of the United States, 1890. 
 
 1 See question No. 17 on p. 38 above, and the discussion on pp. 33-35.
 
 RAISING CAPITAL FOR AGRICULTURE 667 
 
 II. INSTITUTIONS UTILIZED IN MARKETING 
 FARM MORTGAGES 
 
 In discussing the raising of fixed capital for agricultural 
 purposes it will be necessary to consider first the financial 
 machinery employed before the organization of the Federal 
 Farm Loan system, in 1916. The financial structure that had 
 been developed up to that time is indicated in the chart on 
 page 650; it includes everything on the fixed-capital side of the 
 diagram except the National Farm Loan associations, Federal 
 Land banks, and Joint Stock Land banks. It should be borne 
 in mind that this rural credit structure remains, even though 
 a new agricultural credit system has been devised. 
 
 While savings and commercial banks and trust companies 
 often act as middlemen in the disposition of mortgages, as is 
 indicated in the chart on page 650, the larger part of the farm- 
 mortgage business is handled by local farm-mortgage brokers 
 and by mortgage companies, comparable to the investment 
 banking institutions considered in chapter xiv above. In the 
 early days of farm borrowing the local mortgage broker was 
 practically alone in the field. But as the farm-mortgage 
 business became more extensive, mortgage companies operating 
 on a much larger scale and* employing somewhat different 
 methods have assumed a position of major importance. 
 
 i. The local farm mortgage broker. The farm mortgage 
 broker has his office in the center of an agricultural community 
 and seldom extends the scope of his operations beyond the 
 limits of a single county. His function is merely to bring the 
 farm borrower and the city lender together; he does not advance 
 any funds to the farmer or indorse the mortgage, which is 
 made out directly to the purchaser. The profit of the farm- 
 mortgage broker is derived from the difference between the 
 rate of interest which the farm borrower pays and the rate at 
 which the mortgage is sold to the investor. In the early days 
 before the development of competing mortgage companies the 
 brokers commonly secured very large profits,
 
 668 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 2. The farm mortgage company. The mortgage companies 
 conduct their operations on a much larger scale than do the 
 brokers. Through a system of local agents they solicit mort- 
 gages throughout an entire state and in some cases in more than 
 one state. They also utilize the independent mortgage brokers 
 in getting in touch with borrowing constituents. 
 
 In making a mortgage loan under this system the prospective 
 borrower fills out an application blank furnished by the local 
 agent. This application usually calls for information upon the 
 following points: (i) the amount of the property to be mort- 
 gaged that is under cultivation; (2) date of purchase; (3) the 
 amount of present incumbrance, if any; (4) the nature and 
 cash value of improvements that have been made on the land; 
 (5) the present cash value of the land; (6) crops of the previous 
 and current year; (7) the rental value; (8) the location of the 
 land with respect to railroads, towns, schools, churches, etc.; 
 
 (9) the assessed valuation and the amount of the tax thereon; 
 
 (10) the amount of live stock on the premises; (n) the total 
 valuation of the borrower's property, both real and personal; 
 (12) the state of the title to the property; and finally, (13) the 
 purpose for which the money is to be borrowed. The local 
 agent of the mortgage company and two or more disinterested 
 local residents" are required to indorse on the application blank 
 their sworn appraisal of the value of the land. Upon receipt 
 of the application* the mortgage company sends an agent to 
 inspect the property and make a report. If this report is 
 favorable an agreement is reached as to the rate of interest and 
 the commission, and the mortgage is then ready for sale. The 
 rate of interest is usually the lowest that will insure the sale of 
 the mortgage at par in the financial centers. 
 
 The commission received by the mortgage company is 
 most frequently in the form of a lump sum deducted from the 
 proceeds derived from the sale of the mortgage. But another 
 common method is to make the commission payable, in the 
 case of a five-year mortgage, in ten semi-annual instalments 
 secured by the borrower's notes and a second mortgage on the 
 property, Uftder this method, in case any instalment is not
 
 RAISING CAPITAL FOR AGRICULTURE 669 
 
 paid, the entire commission automatically becomes due. The 
 commissions received by the mortgage companies have been 
 large, particularly in the earlier days; it is said that for many 
 years such companies never received commissions of less than 
 10 per cent of the amount of the mortgage. It may be added 
 that real-estate mortgages usually run for either three or five 
 years; and since the mortgages are very commonly renewed, 
 additional commissions are commanded for securing extensions. 
 Finally, it may be noted that, in addition to the commission 
 received by the mortgage company, the local agent or broker 
 charges the borrower whatever the traffic will bear! 
 
 In making loans the mortgage companies follow a method 
 somewhat different from that of the local farm loan brokers. 
 The mortgage is commonly made out, not to the purchaser direct, 
 but to the mortgage company, which assigns it to a purchaser 
 when one is found. The mortgage companies sometimes 
 guarantee the mortgages which they handle, and sometimes 
 they do not. In the event of a foreclosure of a guaranteed loan, 
 the company takes possession of the property and pays the 
 borrower out of its own funds, recouping through the sale of 
 mortgaged property. In the case of non-guaranteed loans, 
 there is no liability upon the mortgage company, but, never- 
 theless, it often assumes the debt and takes possession of the 
 land. The purchaser of the mortgage is usually agreeable to 
 such a procedure, for it relieves him of the trouble involved in 
 making a settlement. It is said that large profits have been 
 made by the mortgage companies from the sale of land taken 
 under foreclosure proceedings. 
 
 There are numerous provisions designed to protect the 
 purchaser of the mortgage. The borrower is required to 
 assure the payment of the taxes and to keep the buildings 
 insured for the benefit of the mortgagee. In case of a default 
 in the payment of interest, or in the performance of any of the 
 agreements, the lender may declare the entire debt immediately 
 due. It may be added that if the borrower succeeds, hi such 
 a case, in securing funds with which to make up arrears and 
 have the loan reinstated, the mortgage company receives
 
 670 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 a further commission or bonus for its service in reinstating 
 the loan. 
 
 Many mortgage companies issue debenture bonds. Instead 
 of assigning the mortgages directly to investors many companies 
 issue their own debentures, secured by the mortgages which 
 the company has purchased. Such mortgages are assigned to a 
 trust company, which holds them for the protection of the 
 purchasers of the debentures. It should be noted that the 
 purchaser also has a creditor claim against all the assets of 
 the mortgage company, which are usually invested in mortgages. 
 The holder of a mortgage that is guaranteed by a mortgage 
 company is similarly protected by the company's own invest- 
 ments. 
 
 There are some serious weaknesses in the farm-mortgage 
 system. The biggest source of danger in the making of farm 
 loans lies in the local agency system. Says one writer of the 
 activities of the local agents: 1 
 
 Their earnings depend on their making loans, and the size of the 
 commission depends upon the size of the loan. Local agents and 
 examiners from the home office are sometimes bribed to overvalue 
 the land. The sworn appraisement by householders resident in the 
 county where the land lies by no means secures in every case what it is 
 meant to secure. The dishonest borrower always knows who in 
 the community entertains the wildest notions about the future 
 of his county or town, and this man makes the sworn appraisement; 
 and there is a wide difference between the appraisal made by really 
 honest men "for loan purposes," and the appraisal made by the 
 same men in their actual buying and selling. 
 
 While the majority of the farm-mortgage companies have 
 always been managed by men of high integrity and conducted 
 on sound business principles, the large profits obtainable in 
 the business, particularly during periods of land speculation, 
 have led to the organization of many irresponsible and dishonest 
 companies. Such companies offer very high rates on mortgages 
 on which they give their worthless guaranty. And hi order to 
 secure large commissions they make loans far in excess of the 
 
 1 James Willis Gleed, Forum, IX (1890), 100.
 
 RAISING CAPITAL FOR AGRICULTURE 671 
 
 value of the land which is offered as security. Such practices, 
 it is needless to say, result not only in inevitable loss to investors 
 but also in discrediting the mortgage business in general. 
 
 The following typical advertisement of an investment 
 offering of a farm-mortgage company will indicate in a general 
 way the nature of the security that is given: 
 
 J. A. B. COUPON NOTES $5,000.00 
 
 A series of Ten (10) coupon notes, in denominations of $500.00 
 each, dated January 19, 1916, maturing January 19, 1921; bearing 
 interest at the rate of 6^ per cent per annum, interest payable semi- 
 
 annually to the Trust Company, , Texas; all equally 
 
 secured by first mortgage to the Trust Company on 241 
 
 acres of land in W. County, Texas, about eight miles southeast of W. 
 
 The land is all under good fence, wire and post. About 50 per 
 cent of it is good, black, waxy soil; the balance is black sandy loam 
 all good, rich soil. About 150 acres are in cultivation, probably 
 60 acres being put in for the first time this year. Of this cultivated 
 land, about 75 acres were originally black waxy prairie, now in good 
 state of cultivation; about 75 acres were originally bottom timber 
 land, probably 30 acres put in cultivation in 1915, the balance being 
 put in this year. The tract is practically level; has one small drain 
 or slough running through it, which adds materially to the drainage. 
 
 The improvements consist of three three-room box tenant 
 houses and one two-room box house, recently completed. 
 
 Mr. B. states that it is his intention to put the entire tract in 
 cultivation except probably 25 acres, which he will use for pasturage 
 and wood for tenants. 
 
 The place is watered by wells. The tract lies in Caney Valley, 
 but is not subject to overflow. 
 
 Improved lands in this vicinity sell at $60.00 to $100.00 per 
 acre. Our appraiser considers this tract worth $45.00 per acre, or 
 a total of $10,845 . oo. 
 
 We offer these notes at par and accrued interest, accompanied, 
 by our written guarantee. 
 
 & Co., BANKERS 
 
 Founded A.D. 1858 
 
 Many of the farm mortgage companies have in recent years 
 issued coupon notes and bonds in denominations convenient
 
 672 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 for the purchaser of small means, the mortgage being held 
 "in trust" after the fashion of corporate mortgages. In some 
 instances also, the bonds run for long periods of time, rather 
 than for three or five years merely, in which event the amorti- 
 zation principle of paying off the mortgage is usually 
 incorporated. 1 
 
 The farm mortgage companies have hi recent years grown 
 rapidly in number, size, and influence. They are now united 
 hi a Farm Mortgage Bankers' Association of America, composed 
 of about two hundred members, including banks and trust 
 companies with mortgage departments. The purpose of the 
 association is to raise the standard of mortgage-bank practice, 
 promote constructive farm-mortgage legislation, and oppose 
 legislation regarded as inimical to their own and to the general 
 welfare. During the last two years, for example, the asso- 
 ciation has conducted a vigorous campaign against the Federal 
 Farm Loan System. 8 
 
 III. THE FEDERAL FARM LOAN SYSTEM 
 
 The agricultural credit structure that has been described hi 
 the preceding pages was never regarded with favor by the 
 farmers of the country. The interest rates that prevailed in 
 many sections of the country were very high in the view of 
 the farmer exorbitantly high while the commissions, legal 
 fees, and renewal charges greatly increased the actual cost of 
 the funds secured. This situation, together with the agri- 
 cultural depression that prevailed more or less continuously 
 from the end of the Civil War until the late nineties, was in no 
 small measure responsible for the greenback and free-silver 
 movements of that period. While the general prosperity that 
 began hi 1897 and continued almost uninterruptedly for a 
 decade served to quiet for a time the farmers' discontent with 
 
 1 For an illustration of the amortization principle see p. 679. 
 
 * See pp. 688-89 f r a discussion of the basis of the opposition to the 
 Federal Farm Loan System.
 
 RAISING CAPITAL FOR AGRICULTURE 673 
 
 monetary conditions, there nevertheless remained a deep- 
 seated conviction that agriculture was seriously handicapped 
 by virtue of inadequate credit facilities. 
 
 An insistent agitation for the reduction of rates on agri- 
 cultural loans and for an improvement in the general conditions 
 on which credit is extended to farmers began about ten years 
 ago. At that time the movement for the establishment of a 
 "panic-proof" commercial banking system was already well 
 under way; and an improved agricultural credit system appeared 
 to be a necessary complement. The agitation was given a 
 great impetus by the timely appearance of a number of striking 
 articles, which indicated that farmers in many sections of the 
 country were paying from 8 to 12 per cent for money, as con- 
 trasted with rates in our industrial centers of only 4 or 5 per 
 cent. It was also pointed out repeatedly that farm loans in 
 Europe could be secured in unlimited quantity at rates varying 
 from 3 to 5 per cent. 
 
 While much of the agitation on the subject of rural credits 
 is due to false assumptions and to an inadequate grasp of the 
 principles governing the rates of interest on different classes 
 of loans, there was unquestionably just cause for complaint. 
 Because of an inadequate organization of credit machinery, 
 agricultural loans bore unnecessarily high rates of interest; 
 while the short term for which mortgages were made commonly 
 necessitated the payment of additional legal fees and renewal 
 commissions, for which there was no sound economic reason 
 whatever. 
 
 As a means of affording relief numerous proposals were 
 advanced, the most popular of which was the making of govern- 
 ment loans direct to farmers at merely nominal rates of interest, 
 one or two per cent, the doctrine that the government should 
 "do something" for agriculture, the nation's basic industry, 
 always finding many eager adherents. Sounder ideas eventu- 
 ally prevailed, however, and the advocates of self-reliance and 
 self-help won the day. The ultimate outcome was the authori- 
 zation hi 1916 of a Federal Farm Loan System, modeled after 
 tbe Federal Reserve System.
 
 674 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 The Federal Farm Loan Act passed on July 17, 1916, 
 marked the beginning of a new era in agricultural finance. 
 In brief, the purpose of the law is, through an improved organi- 
 zation of credit facilities, to raise the credit standing of farm 
 borrowers, to reduce commissions and legal fees, to lessen and 
 equalize interest rates, and to enlarge the supply of funds 
 available for agricultural development. In pursuance of this 
 task the law provides for the organization of (i) Federal Land 
 banks and National Farm Loan associations; and (2) Joint 
 Stock Land banks. The former constitute the distinctive 
 feature of the rural credit system; the provision for the latter 
 marks an attempt to develop private mortgage companies 
 under constructive governmental supervision. 
 
 i. Administrative framework of the system. The rural credit 
 system is under the general supervision of the Federal Farm 
 Loan Board, composed of the Secretary of the Treasury (ex 
 officio) and four other members, appointed by the President 
 with the approval of the Senate. The members serve for 
 eight years and receive a salary of $10,000 per annum, together 
 with necessary traveling expenses. The duties of the Farm 
 Loan Board are analogous to those of the Federal Reserve 
 Board and the Comptroller of the Currency in connection with 
 the national banking system. In brief, they supervise the 
 chartering and organizing of Federal Land banks, Farm Loan 
 associations, and Joint Stock Land banks, regulate interest 
 rates and other charges on loans, supervise the issue of Farm 
 Loan bonds, conduct examinations of the banks in the system 
 and publish annual reports, which show the condition of the 
 various farm loan institutions and present such additional data 
 as may have a bearing upon agricultural credit in general. 
 
 The act provided that continental United States should be 
 divided into twelve districts, in each of which should be located 
 a Federal Land bank. In creating these districts the organi- 
 zation committee endeavored to group together, as far as 
 possible, states of diverse character and development, as a 
 means of minimizing the results of a crop failure in any one 
 region. In determining the location of the farm loan bank in
 
 RAISING CAPITAL FOR AGRICULTURE 675 
 
 each district the Board sought to secure (i) reasonable approxi- 
 mation to the geographical center of the district; (2) prompt 
 and frequent train and mail service; (3) climatic conditions 
 that would not impair the health of the officials; (4) congenial 
 environment. As a rule the larger cities were not selected; 
 but rather those which had already shown an interest in agri- 
 cultural development, or had been disappointed in not being 
 selected as sites for Federal Reserve banks. The map on page 
 676 shows the district boundaries and the cities within which 
 the Federal Land banks have been located. 
 
 2. Federal Land banks. Each Federal Land bank is man- 
 aged by a board of nine directors: six of them local directors, 
 elected by the farm-loan associations of the district; and three 
 of them district directors, appointed by the Federal Farm Loan 
 Board. The capital stock of each bank, required before 
 beginning operations, is $750,000, divided into shares of $5.00 
 each, which may be subscribed for by any person, firm, cor- 
 poration, or state, or by the United States. The law holds 
 that any part of the capital stock which is not subscribed for 
 within thirty days shall be subscribed by the United States 
 government. Stock that is owned by the government, however, 
 receives no dividends. 
 
 3. National Farm Loan associations. The Federal Land 
 banks occupy a position in the rural-credit system similar to 
 that of the Federal Reserve banks, while the National Farm 
 Loan associations, authorized by the rural credit law, may be 
 regarded as analogous to the individual member banks of the 
 Federal Reserve System. They differ from the member banks 
 in one very important particular, however, namely, that they 
 are co-operative associations organized by a group of farmers 
 for the specific purpose of securing credit through the Federal 
 Land bank; they are not privately organized institutions 
 conducting a general banking business, as is the case with the 
 units of the Federal Reserve System. 
 
 The law provides that "ten or more natural persons who 
 are the owners, or about to become the owners, of farm land 
 qualified as security for a mortgage loan under this Act," may
 
 676 
 
 THE FINANCIAL ORGANIZATION OF SOCIETY
 
 RAISING CAPITAL FOR AGRICULTURE 677 
 
 unite to form such a National Farm Loan association. No 
 persons except borrowers on farm-loan mortgages may become 
 members or borrowers. The management of the association is 
 vested in a board of five directors. The capital stock varies 
 with the volume of loans secured, one share of stock being issued 
 for every loan of $200 (or major portion thereof). Thus the 
 borrowers may receive dividends in case any are earned by 
 the association. The shareholders are "held individually 
 responsible, equally and ratably, and not one for another," 
 for all debts and obligations to double the amount of their 
 stock holdings. 
 
 4. Method of making loans. When an application for a loan 
 is submitted to a National Farm Loan Association, a loan com- 
 mittee of the association appraises the value of the property 
 and makes a detailed report on the project. No loan may be 
 approved by the directors of the farm loan association unless 
 all three members of the loan committee recommend it; and 
 before the loan is finally granted, it must also be approved by 
 an appraiser of the Federal Land bank from which the funds 
 are to be secured. 
 
 In case the loan is approved, the farm loan association 
 subscribes for capital stock in the Federal Land bank of its 
 district to an amount equal to 5 per cent of the loan desired; 
 the stock is hypothecated with the Federal Land bank as 
 partial collateral security for the loan. The farm loan asso- 
 ciation then indorses a first mortgage, which it has received 
 from the borrowing member, over to the Federal Land bank, 
 thus assuming a secondary liability for the payment of the 
 obligation. 
 
 The Federal Land bank advances the funds to the farm 
 loan association and issues its own debentures known as "farm 
 loan bonds, " for sale hi the general investment market. These 
 bonds are issued only under specific authorization of the Federal 
 Farm Loan Board. For purposes of administration each dis- 
 trict has a Farm Loan Registrar (corresponding to the Federal 
 Reserve Agent of the Federal Reserve System), appointed by 
 the Federal Farm Loan Board. When any Federal Land
 
 678 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 bank desires to issue bonds, it must deposit the mortgages 
 which have been taken from borrowers with the Registrar, 
 to whom they are assigned in trust as collateral for the 
 bonds. 
 
 The mortgage must always be a first lien on property owned 
 by the borrower, and cannot exceed 50 per cent of the value 
 of the land for agricultural purposes, and 20 per cent of the 
 value of the permanent insured improvements. Incidentally, 
 individual loans may not be for less than $100 or for more 
 than $10,000 in amount, and a charter may not be granted to 
 any farm loan association unless the total of loans applied for 
 is at least $20,000. No loans shall be made to any person 
 who is not at the time, or shortly to become, engaged in 
 the cultivation of the farm mortgaged; and the borrowing 
 must be for one of the following purposes: (a) to provide 
 for the purchase of land for agricultural purposes; (b) for 
 the purchase of equipment, fertilizers, and live stock neces- 
 sary for the proper and reasonable operation of the mort- 
 gaged farm; (c) for buildings and improvement on farm 
 land; and (d) to liquidate indebtedness incurred for pur- 
 poses (a), (ft), and (c). 
 
 Loans are made only on the amortization principle. Added 
 security is afforded to the lender by virtue of the fact that all 
 loans must be discharged through amortization payments. 
 Under this method each annual or semi-annual payment by 
 the borrower must include, besides interest on the loan, such an 
 additional fund as will amortize, or liquidate, the debt within 
 an agreed period, not less than five years nor more than forty 
 years. It is also provided that, after five years from the date 
 of the loan, additional payments of $25, or multiples thereof, 
 may be made; or, if the borrower desires, he may pay off on 
 any instalment date the entire remaining principal. The 
 table on page 679 shows how a $1,000 loan at 5! per cent interest 
 may be amortized in 35 years by means of annual instalments 
 of $65, which includes interest and a partial payment on the 
 principal. Thirty-five years is recommended by the board as 
 a preferable duration for agricultural loans.
 
 RAISING CAPITAL FOR AGRICULTURE 
 
 679 
 
 It will be seen that under this system the margin of security 
 back of the loan gradually increases. The amortization system 
 also has the very decided advantage that it enables the borrower 
 
 AN AMORTIZATION TABLE* 
 
 Payment No. 
 
 Instalment 
 
 Interest 
 
 Applied on 
 Principal 
 
 Principal Still 
 Unpaid 
 
 I 
 
 $65.00 
 
 $.<;. oo 
 
 $IO.OO 
 
 SooO.OO 
 
 2.... 
 
 65.00 
 
 C4..4.C 
 
 10. <;e, 
 
 979-45 
 
 !. . 
 
 6"5.oo 
 
 152.87 
 
 II. 13 
 
 968.32 
 
 4. . 
 
 6"C.oo 
 
 C7.26 
 
 11.74 
 
 956.58 
 
 c. . 
 
 6<c.oo 
 
 ^2.6l 
 
 12. 30 
 
 Q44.TQ 
 
 6 
 
 6<>.oo 
 
 CI .07 
 
 13.07 
 
 93 i . i 2 
 
 7. . 
 
 6<; .00 
 
 ^1 .21 
 
 13.70 
 
 917.33 
 
 8 
 
 6s .00 
 
 SO.AC 
 
 14.55 
 
 902.78 
 
 o. . 
 
 6<c .00 
 
 40- 6 < 
 
 15.35 
 
 887 . 43 
 
 10 
 
 65.00 
 
 48.81 
 
 16.19 
 
 871 .24 
 
 ii 
 
 65.00 
 
 47.92 
 
 17.08 
 
 854.16 
 
 12 
 
 65.00 
 
 46.98 
 
 18.02 
 
 836.14 
 
 
 65.00 
 
 45.99 
 
 19.01 
 
 817.13 
 
 
 65.00 
 
 /I /I ,94 
 
 2O.o6 
 
 797.07 
 
 1C. . 
 
 65.00 
 
 43.84 
 
 21. l6 
 
 775.91 
 
 16 
 
 65.00 
 
 42.68 
 
 22.32 
 
 753-59 
 
 17 
 
 65.00 
 
 41.45 
 
 23.55 
 
 730.04 
 
 18 
 
 6"j.oo 
 
 4O. I "C 
 
 24.85 
 
 705 . 19 
 
 
 65.00 
 
 38.79 
 
 26.21 
 
 678.98 
 
 20 
 
 65.00 
 
 37.34 
 
 27.66 
 
 651.36 
 
 21 
 
 6?.oo 
 
 35.82 
 
 29.18 
 
 622.14 
 
 22 
 
 6e,.oo 
 
 34.22 
 
 30.78 
 
 591.36 
 
 27. . 
 
 65.00 
 
 32.52 
 
 32.48 
 
 r-r-C QQ 
 
 55" -oo 
 
 24. . 
 
 65.00 
 
 30.64 
 
 34.36 
 
 524.62 
 
 2< . 
 
 65.00 
 
 28.85 
 
 36.15 
 
 488.47 
 
 26 
 
 65.00 
 
 26.87 
 
 38.13 
 
 45 -34 
 
 27. . 
 
 65.00 
 
 24.77 
 
 40.23 
 
 410.11 
 
 28 
 
 65.00 
 
 22.56 
 
 42.44 
 
 367.67 
 
 20. . 
 
 65.00 
 
 20.22 
 
 44.78 
 
 322.89 
 
 2O. . 
 
 65.00 
 
 17.76 
 
 47- 2 4 
 
 275.65 
 
 
 65.00 
 
 15.16 
 
 49.84 
 
 225.81 
 
 
 65.00 
 
 12.42 
 
 52-58 
 
 173-73 
 
 
 65.00 
 
 9.53 
 
 55-47 
 
 117.76 
 
 
 65.00 
 
 6.48 
 
 58-52 
 
 59-24 
 
 
 62. so 
 
 3- 76 
 
 59.24 
 
 
 
 
 
 
 
 
 $2,272.50 
 
 $1,272.50 
 
 $1,000.00 
 
 
 * Treasury Department, Federal Farm Loan Bureau Circular No. 7, p. 9. 
 
 to pay off the loan out of current funds, with the result that he 
 scarcely feels the burden of discharging the obligation. Under 
 the old system of three- and five-year mortgages, the farm
 
 68o THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 borrower usually made no preparation for payment until the 
 mortgage was about due; whereupon the preparation commonly 
 consisted in merely making arrangements for a necessary 
 renewal, involving, as we have seen, substantial additional 
 legal fees and commissions. Under the amortization plan 
 the farmer is, hi effect, compelled to save enough each year to 
 provide for the eventual liquidation of the debt. The amorti- 
 zation system is analogous to the provision of a sinking fund 
 for the liquidation of corporate indebtedness. 1 
 
 Every farm mortgage bond is the obligation of all the Federal 
 Land banks. The bonds that are issued against the farm 
 mortgages as collateral are the direct obligation not only of 
 the Federal Land bank that issues it but of the entire twelve 
 land banks, jointly. Since the investments of these banks 
 necessarily consist primarily of real-estate mortgages and since, 
 for the system as a whole, these mortgages are drawn from 
 every part of the country, it will be seen that the risks of the 
 Federal Land bank system are very widely distributed. The 
 law also provides that of the capital of the Federal Land banks 
 for which stock is outstanding in the name of farm loan asso- 
 ciations, 25 per cent must be held as quick assets, in the form 
 of cash hi vault, deposits in member banks of the Federal 
 Reserve System, or hi readily marketable securities approved 
 by the Federal Farm Loan Board. Of these, not less than 5 
 per cent must be United States government bonds. Each 
 Federal Land bank given conservative management in 
 conformity with the law is therefore practically certain to be 
 in a position to meet its obligations as they mature. Certainly 
 there would appear to be little chance that the system as a 
 whole would not be able to meet its obligations hi fulL 
 
 1 It should be observed, however, that while the theory has always 
 been that provision should be made for the liquidation of fixed-capital 
 loans when they mature, it has been a very common practice, notably in 
 the transportation industry, for the fixed-capital indebtedness to be renewed 
 rather than paid. Indeed, it can almost be said that the tendency is for 
 the fixed-capital indebtedness of corporations gradually to increase rather 
 than decrease in amount as the a.ge of the corporation increases.
 
 RAISING CAPITAL FOR AGRICULTURE 681 
 
 The maximum interest rates that may be charged by any 
 Federal Land bank is 6 per cent. It is also provided that in no 
 event shall the rate charged to borrowers exceed by more than 
 i per cent the rate of interest on the bonds issued by the banks 
 themselves. That is to say, if the Federal Land bank should 
 sell bonds bearing a rate of 4 per cent, it could not charge the 
 farm borrowers more than 5 per cent. It is important to note 
 in this connection that principal and interest are expressly 
 exempted from all federal, state, and local taxation. 1 Legal 
 fees and recording charges are also paid by the borrower; but 
 they are much less in amount than under the old system of 
 unregulated private lending. 
 
 When the farm loan system began operations the bonds 
 bore an interest rate of 4! per cent, the farmer paying 5 per cent. 
 The rise in interest rates during the war, however, made it 
 necessary to raise the rates to 5^ per cent, with the farmer 
 paying 6 per cent, leaving, as before, one-half of one per cent 
 to cover expenses incurred by the Federal Farm Loan banks. 
 At this figure the farmers were enabled to borrow at lower rates 
 than could even high-grade industrial, public-utility, and other 
 business enterprises. 
 
 5. The Joint Stock Land banks. These institutions, author- 
 ized for the purpose of placing the private mortgage busi- 
 ness upon a more efficient basis, constitute an essential 
 part of the new system of agricultural finance. Their position 
 hi the agricultural-credit structure is analogous to that of the 
 Federal Land banks, although, as the chart on page 650 indi- 
 cates, their loans are not as a rule made through the National 
 Farm Loan associations. In organization they differ from the 
 Federal Land banks only hi detail. There must be at least ten 
 incorporators, and the government may not be a stock sub- 
 scriber. The minimum capital required is $250,000, one-half 
 of which must be paid up before beginning business, and the 
 rest before any bonds may be issued. Instead of a board of 
 nine appointed and elected directors, they have a board of their 
 
 'This fact has given rise to bitter controversy. See below, pp. 
 688-00.
 
 682 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 own choice, not less than five in number. The size of the loan 
 granted to any one person and the purposes for which the loan 
 may be made, are left to the discretion of the Joint Stock bank. 
 The total amount of bonds that may be issued is restricted to 
 fifteen times the amount of the capital stock of the issuing bank, 
 as compared with twenty times in the case of the Federal Land 
 banks. 
 
 Like the Federal Farm Loan bonds, the Joint Stock Land 
 bank bonds must be secured by first mortgages on land and 
 improvements, the margin of security being identical in both 
 types of bonds. The mortgages back of the Joint Stock Land 
 bank bonds must be deposited in trust with the Federal Farm 
 Loan Registrar; 1 and the loans must be paid on the amortization 
 plan. The main difference between the two types of securities 
 lies in the fact that the Joint Stock Land bank bonds are an 
 obligation only of the issuing institution, whereas the Federal 
 Farm Loan bonds, as already seen, are the joint and several 
 obligations of the twelve Federal Land banks. 
 
 State governments have also been interested in rural credit 
 legislation. During the past few years some fifteen states have 
 enacted laws designed to improve agricultural credit facilities. 
 In general, the state laws are designed to make available for 
 agricultural purposes the cash and credit of the state through 
 the creation of land banks, the stock of which is owned by loan 
 associations. These loan associations, which are called by 
 various names, are co-operative in their nature; they receive 
 applications from their members for loans, grant the loans, 
 execute the mortgages and deposit them with the land bank. 
 The land bank deposits the collective mortgages with the state 
 comptroller and issues against them bonds which bear a lower 
 rate of interest than does the collateral. These bonds are legal 
 as investments for savings banks and trust funds. As compared 
 
 1 Incidentally, the bonds are engraved by the Treasury Department, 
 as are the Farm Loan bonds; but they must be readily distinguishable in 
 form and color from those issued by the Federal Land banks.
 
 68 3 
 
 with the Federal Farm Loan System, however, the significance 
 of these state rural credit institutions is not great. 
 
 The Federal Farm Loan System has had a substantial growth. 
 On November 30, 1919, there were 3,890 associations in actual 
 operation with an average number of members of 27^. The 
 total volume of loans was $282,007,781 giving an average per 
 association of $72,495. The number of associations hi 1920 
 has been declining, hi part because there is already in excess 
 of one for every county in the United States, and in part because 
 there is a tendency toward consolidation of smaller associations. 
 The attack that has been made in the courts upon the con- 
 stitutionality of the rural-credit law has also deterred the 
 formation of new loan associations. 1 Although they have 
 been in operation only about three years, the Federal Land 
 banks have increased their capitalization from $9,000,000 
 to $20,000,000, and several of them have been able to pay 
 dividends after meeting all expenses of organization and 
 operation and setting aside substantial sums for the reserve 
 accounts. 
 
 It is interesting to observe, however, that during the first 
 year of its history the Federal Farm Loan System experienced 
 serious financial difficulties requiring government aid. The 
 4^ per cent tax-exempt bonds could not be marketed, and, 
 as a means of avoiding a financial collapse of the system, 
 a request was made for a Congressional appropriation of 
 $200,000,000, the plea being effectively made that agriculture 
 would otherwise be seriously handicapped in its efforts to 
 increase food production, so vitally necessary to the successful 
 prosecution of the war. Somewhat reluctantly Congress 
 authorized the appropriation; and under it the Secretary of 
 the Treasury has purchased $136,000,000 of Farm Loan bonds 
 from the Federal Land banks. 
 
 There follows a consolidated financial statement of the 
 assets and liabilities of the Federal Land banks at the close of 
 business October 31, 1919. 
 
 1 See pp. 688-90.
 
 68 4 
 
 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 CONSOLIDATED STATEMENT OF FEDERAL LAND BANKS 
 
 ASSETS 
 
 Mortgage loans .... $271,317,816.00 
 Accrued interest on mortgage 
 
 loans 4,504,904.52 
 
 Subtotal . 
 Less amortization payments 
 
 $275,822,720.52 
 2,326,278.86 
 
 Net mortgage loans .... 
 United States Government bonds and securities 
 Accrued interest on bonds and securities 
 
 Other accrued interest 
 
 Farm loan bonds on hand (unsold) . 
 
 Cash on hand and in banks .... 
 
 Accounts receivable 
 
 Delinquent amortization payments . 
 
 Banking house 
 
 Furniture and fixtures 
 
 Other assets . 
 
 $273,496,441 .66 
 34,560,618.61 
 
 439,435-n 
 2,405.40 
 100,000.00 
 6,299,417.55 
 98,852.05 
 152,256.18 
 70,140.87 
 178,184.10 
 44,819.87 
 
 Total $315,442,571.40 
 
 LIABILITIES 
 Capital stock: 
 
 United States government . $ 8,265,809.00 
 National farm loan associa- 
 tions 13,536,782.50 
 
 Borrowers through agents . 44,430.00 
 
 Individual subscribers . . 47,235.00 
 
 Total capital stock $21,894,256.50 
 
 Reserve 202,175.00 
 
 Farm loan bonds authorized 285,600,000.00 
 
 Bills payable (money and bonds borrowed) . . 115,075.78 
 Accounts payable (deferred payments on loans in 
 
 process of dosing) 119,166.07 
 
 Reserved for interest on farm loan bonds . . 6,407,274.75 
 
 Other liabilities 361,327.87 
 
 Undivided profits 743,295.43 
 
 Total $315,442,571.40
 
 RAISING CAPITAL FOR AGRICULTURE 685 
 
 MEMORANDA 
 
 Net earnings to October 31, 1919 . . . . $1,278,394.41 
 Carried to reserve account to 
 
 October 31, 1919 . . . $202,175.00 
 Dividends paid to October 31, 
 
 *9*9 332,923.98 
 
 535,098.98 
 Undivided profits October 31, 1919 . . . . $743,295.43 
 
 Capital stock originally subscribed by United 
 
 States government $8,892,130.00 
 
 Amount of government stock retired to date . 626,321 .00 
 
 Capital stock held by United States government 
 
 October 31, 1919 $8,265,809.00 
 
 The following statement shows the amount of loans applied 
 for and granted up to November 30, 1919, segregated by 
 districts. 1 
 
 LOANS OF THE FEDERAL FARM LOAN SYSTEM 
 
 DISTRICT BANK 
 
 APPLIED *OR 
 
 LOANS CLOSED 
 
 No. 
 
 Amount 
 
 No. 
 
 Amount 
 
 
 8,030 
 
 9,4S 
 22,109 
 16,469 
 24,563 
 20,715 
 27,549 
 14,720 
 21,382 
 26,529 
 13,128 
 31,919 
 
 $25,953,774 
 23,823,826 
 48,313,298 
 
 44,534,937 
 45,732,800 
 49,752,250 
 77,702,704 
 73,660,284 
 56,454,309 
 82,298,449 
 43,793,201 
 94,160,222 
 
 3,834 
 4,469 
 6,990 
 6,804 
 13,283 
 9,694 
 13,720 
 7,272 
 10,293 
 
 io,945 
 4,805 
 14,820 
 
 $10,896,745 
 11,433,800 
 15,012,595 
 19,936,700 
 19,548,380 
 22,217,250 
 37,490,100 
 36,855,390 
 24,597,400 
 31,408,401 
 15,000,800 
 37,610,220 
 
 
 Columbia 
 
 Louisville 
 
 New Orleans 
 
 St. Paul 
 
 
 Wichita 
 
 Houston 
 
 
 Spokane 
 
 Total 
 
 236,158 
 
 $666,179,374 
 
 106,929 
 
 $282,007,781 
 
 
 Numerous Joint Stock Land banks have been organized. 
 
 Up to October 31, 1919, the number of Joint Stock Land banks 
 
 1 Annual Report of the Federal Farm Loan Board, January 5, 1920, p. 27.
 
 686 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 that had been organized was twenty-six, with an aggregate 
 capital stock of $7,812,050. Mortgage loans stood at 
 $48,092,816 and investments in United States government 
 bonds and securities at $8,486,879. The growth of the Joint 
 Stock banks has not been as rapid as was anticipated. Of 
 late, moreover, there has been a tendency toward consolidation 
 of existing companies. 
 
 IV. SIGNIFICANT RESULTS OF THE FEDERAL 
 FARM LOAN SYSTEM 
 
 The organization of the Federal Farm Loan System has 
 accomplished three important results: first, it has equalized 
 farm interest rates throughout the country; second, it has 
 enabled the farmers as a whole to borrow at lower rates than 
 would otherwise have been possible; and third, it has broadened 
 the scope of the market for agricultural securities. The 
 foregoing description of the system furnishes all of the informa- 
 tion necessary for understanding how each of these results has 
 been made possible. 
 
 The equalization of interest rates has been accomplished 
 by means of the provision which makes Federal Land bank 
 bonds the obligation of all the Land banks, jointly and severally. 
 It will be readily seen that so long as every bond is the obliga- 
 tion of all the banks, the investor, resident hi a financial center, 
 has no good reason for discriminating against the bonds of 
 any district, however remote it may be; from, his viewpoint, 
 the bonds of each district are exactly as good as those of every 
 other district. It should be noted, however, that this does not 
 apply to the Joint Stock Land bank bonds; for they are the 
 obligations of the issuing bank only. 
 
 The lowering of farm interest rates has been made possible 
 by means of the co-operative borrowing and the improved 
 organization of credit information for which the system provides. 
 Under the private mortgage system the primary reason for the 
 high interest rates in remote agricultural regions is the lack of 
 reliable inf ormation on the part of the lender as to the character 
 of the borrower and the adequacy of the property offered as
 
 RAISING CAPITAL FOR AGRICULTURE 687 
 
 security. Because of the distance involved the lender has to 
 rely upon the recommendation of the local farm-mortgage 
 broker or upon the uncertain appraisal of the local agent of a 
 mortgage company. 1 Under the Federal Farm Loan System 
 the lender relies upon the appraisal of a group of farmers 
 organized in a co-operative farm loan association, checked by an 
 independent appraisal of an agent of the Federal Land bank. 
 
 Moreover, as we have already seen, the payment of the 
 loan does not depend upon the character and financial standing 
 of a single individual borrower; for the loan is the joint obliga- 
 tion of a group of borrowers and of the twelve Federal Land 
 banks. Aside from the risks that inhere in distance and the 
 consequent lack of reliable information there is, in fact, no good 
 reason why a group of farmers, say, in Texas, borrowing $25 
 per acre on land valued at $50, should not secure funds at as 
 low a rate of interest as a group of farmers in Illinois borrowing 
 $100 an acre on land valued at $200. Under the Federal 
 Farm Loan System such risks have been eliminated. 
 
 Through the substitution of bonds of small denomination 
 for the single mortgage of relatively large size, the market for 
 agricultural securities has been broadened, and the volume of 
 capital available for agricultural investment consequently in- 
 creased. Individuals with small as well as with large resources 
 may now invest hi agricultural securities without unduly 
 concentrating risks. Moreover, the development of high-grade 
 agricultural bonds, which in time will no doubt possess a high 
 degree of marketability, gives greater flexibility to the system 
 of agricultural finance and thus serves to stimulate agri- 
 cultural investment. By means of the machinery provided 
 by the rural credit legislation the farmers of the country have 
 in fact been placed in a position where they can enter the 
 investment market on better than even terms with corporate 
 industry. 2 Indeed, one may say that the rural credit system 
 has, from the viewpoint of raising capital, "corporationized" 
 agriculture. 
 
 1 See above, p. 670. 
 
 2 But see criticism on pp. 680-90.
 
 688 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 V. CRITICISMS OF THE FEDERAL FARM LOAN 
 SYSTEM 
 
 There have been, as was to be expected, some minor criti- 
 cisms of certain provisions of the rural credit law and some 
 of its administration by the Federal Farm Loan Board and 
 Land bank officials. While these are not of sufficient impor- 
 tance to warrant discussion here, there have been two criticisms 
 of such significance that they do call for consideration. The first 
 is that the present Farm Loan System does not accomplish the 
 main purpose which the rural credit agitation had in view, 
 namely, that of making it easy for farm tenants and other 
 landless people to become farm owners. The second is that 
 the provisions of the law exempting Federal Land banks and 
 Joint Stock Land bank bonds from taxation is perversive in 
 its general economic and social effects. 
 
 Those who believe that the greatest evil of the American 
 agricultural system is the rapid increase of farm tenancy 
 naturally hold that the Federal Farm Loan Act, which is 
 primarily designed to assist existing land owners in making 
 improvements upon their lands or in purchasing additional 
 acres, has missed fire. Granted that the purpose of the act 
 was to decrease tenancy, this criticism is undoubtedly well 
 founded; for the present law certainly does not render essen- 
 tially easier the acquisition of farm land by those who are at 
 present dispossessed. On the other hand, there are those who 
 contend that the present act was never intended to eliminate 
 farm tenancy, and that this evil must be remedied by other 
 means. 
 
 The second criticism of the system that against the tax 
 exemption provisions of the law would never have arisen 
 except for the great rise in interest rates during the war and 
 the passage of progressive income-tax legislation. As matters 
 now stand, however, a 5$ per cent Federal Farm Loan bond is a 
 much better investment for people with large incomes than is 
 any other security. It will be seen that, since the heaviest 
 taxes are levied on the larger incomes, the tax exemption of 
 bonds is of greatest benefit to individuals receiving the highest
 
 RAISING CAPITAL FOR AGRICULTURE 689 
 
 incomes. 'And the truth is that these bonds are being pur- 
 chased in wholesale quantities by men of very large means, who 
 thereby escape the payment of a substantial portion of their 
 federal taxes. The case is put by one writer in the following 
 words: 
 
 An Iowa farmer borrowing $1,000 from a Federal Land bank 
 pays 5! per cent interest or $55.00 per year. The Federal Land 
 bank may obtain the $1,000 to loan the Iowa farmer by selling 
 $1,000 in bonds to a person having an income in excess of $1,500,000 
 per year. The bond is exempt from all taxes. When the millionaire 
 pays his income tax he is given credit to the extent of $33 .00 on the 
 $50.00 interest received on the thousand-dollar bond because it is 
 exempt from income tax. Instead of paying $33 .00 into the national 
 treasury he retains it in his pocket and the $33 .00 is collected from 
 the rest of the American tax-payers to fill the deficit caused by the 
 exemption. The loan has now cost the farmer $55.00 and it has 
 cost the American people $33.00, a total cost of $88.00. When 
 the time comes for payment of local taxes, the very wealthy owner of 
 the Federal Land bank bond declines again to pay taxes on the 
 Federal Land bank bond. A fair and moderate estimate of the tax 
 which he evades for local, state, school, and municipal purposes 
 would be five dollars. This five-dollar deficit in the local treasury 
 must be paid by his neighbors in order to keep up local and state 
 expenses. The direct cost of the Federal Land bank loan to the 
 country at large is $55.00 paid by the farmer, $33.00 exemption 
 granted to bond-holder on income tax, $5.00 exemption granted to 
 bond-holder on local, state, municipal, and school tax, a total cost of 
 $93.00 equaling 9.3 per cent. The borrower pays $55.00 and the 
 American people at large pay $38 .00. 
 
 It is further argued not only that the tax exemption pro- 
 vision plays into the hands of the rich investor, but that it gives 
 the farmer an advantage in raising capital to which his relative 
 economic position does not entitle him. Why, it is asked, should 
 the farmer be permitted to borrow at 5^ per cent at a time when 
 short-time commercial loans of the most approved variety 
 carry rates of from 7 to 8 per cent, and high-grade railway 
 and industrial corporation securities rates of from 8 to 9 per 
 cent? While the law was designed to develop an invest- 
 ment mechanism which would give the farm borrower an even
 
 690 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 chance with other borrowers to compete for capital in the 
 investment market, it was not intended that he should be 
 given an arbitrary differential in interest rates. It is merely 
 the accident of the war and the change in interest rates that 
 has brought the present situation about. 
 
 The controversy over the tax exemption provision has been 
 very sharp during the past year, the constitutionality of the 
 Federal Farm Loan Act having been challenged in the courts 
 and bills having been introduced hi Congress for the repeal 
 of the law and the complete abolition of the system. Mean- 
 while, pending the decision of the courts as to the constitu- 
 tionality of the Act, the Federal Farm Loan System has 
 practically ceased to function, as far as the taking on of new 
 business is concerned. 
 
 While nearly all students of the problem are agreed that 
 there is no sound reason for the maintenance of the tax-exemption 
 provisions of the law, there are few who would wish to see 
 the rural credit system abolished, for it is believed that the 
 evils of the system can easily be remedied by Congressional 
 amendments. While it is perhaps too early to make a final 
 appraisal of the Federal Farm Loan System, the basic principles 
 underlying the law are generally conceded to be sound, and it 
 would be a very great misfortune if the system, as amended, 
 were not given a chance to prove its merits under conditions 
 less abnormal and fluctuating than those that have obtained 
 from its inauguration to the present time. 
 
 EXERCISES AND QUESTIONS 
 
 L GENERAL CONSIDERATIONS 
 
 1. Compare the chart on page 650 with those on pages 134 and 136, 
 and note the significant differences in financial structure that 
 have developed. 
 
 2. In how many different ways may the fixed capital used in agri- 
 culture be secured ? What are the sources of working capital ? 
 
 3. In what ways are the commercial banks related to the farm- 
 mortgage business ? In what ways the trust companies ? 
 
 4. What is the advantage in the co-operative credit union as a 
 means of securing funds for agricultural purposes ?
 
 6gi 
 
 5. When a bank makes loans to a farmer to purchase seed and 
 fertilizer, and to pay for hired help during the growing season, 
 is it making what is equivalent to a commercial loan ? What is 
 the security for such a loan ? Is any mortgage required ? 
 
 6. If a farmer borrows from a bank in order to purchase farm 
 machinery, such as plows, harrows, and harvesting machines, 
 would you say that he is getting an investment or a commercial 
 loan? How long a time should such loans run? Should col- 
 lateral be required ? 
 
 7. Are the risks inherent in the nature of the industry greater or 
 less in farming than in manufacturing or mercantile lines, that 
 is to say, is a good crop more or less certain than good sales by a 
 merchant or manufacturer ? 
 
 8. Do you think the farmer is as good a personal risk as the average 
 merchant or manufacturer ? 
 
 9. "If you would sit down with the average farmer in the spring and 
 figure out the actual amount necessary to carry him through 
 until fall, and say: 'Here, Bill, is the cash; you take it and pay 
 it out as you need it, ' I will gamble dollars to doughnuts that in 
 sixty days he would have spent it all, and 90 per cent of the 
 amount would be invested in things he never intended to spend 
 it for, and he would be just as inconsiderate in paying it back 
 promptly when due as he was in spending it, and that is just 
 the reason Bill has to pay the price for his accommodation." 
 Do you consider this a fair statement ? 
 
 10. "I think that the farmer gets his money as easily and as cheaply 
 as the commercial man; you will find 8 per cent country is 
 8 per cent country for everybody. Bankers have, commercially 
 speaking, no preference, for 8 per cent looks alike to them no 
 matter who pays it, as long as they really get it." Do you 
 think that this is true ? 
 
 n. TRADE CREDIT 
 
 11. What is the basic objection to the system of trade credit extended 
 by the local store ? 
 
 12. Is the extension of credit by the landlord to the tenant in any way 
 less objectionable than store credit ? 
 
 13. How do you account for the development of the practice whereby 
 produce dealers, canning factories, etc., make loans to agricultural 
 producers ? Do you approve of the practice ?
 
 692 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 14. Criticize the system of credit extension practiced by the manu- 
 facturers of farm implements. 
 
 15. If you were a farmer would you make any use of trade credit ? 
 If so, why, and under what circumstances ? 
 
 1 6. Show how the commercial banks are related to the extension of 
 trade credit. 
 
 HI. COMMERCIAL BANK LOANS 
 
 17. State in what ways the problem of making bank loans to farmers 
 differs from that of making loans to mercantile and manufacturing 
 customers in the cities. 
 
 18. Why are agricultural loans so frequently renewed? In your 
 judgment is this an objectionable banking practice? Why, or 
 why not ? 
 
 19. On the whole, do you think the working-capital requirements of 
 agriculture can be satisfactorily met through securing loans from 
 commercial banks ? 
 
 20. Which would you prefer to have, agricultural loans secured by 
 mortgages on real estate, payable in five years, or the unsecured 
 promissory notes of farmers due in six months, but indefinitely 
 renewable ? 
 
 IV. CATTLE LOAN COMPANIES 
 
 21. What is the necessity for a special type of institution for financing 
 the cattle industry ? 
 
 22. Do you see any objection to the affiliation of a cattle loan com- 
 pany with a state or national bank ? 
 
 23. If you were engaged in the cattle loan business, how would you 
 classify the various types of cattle loans from the standpoint of 
 desirability ? What is your test of desirability ? 
 
 24. What is the purpose of the "brand sheet" used by the cattle 
 loan company ? Of the "form statement " ? 
 
 25. What is the purpose of the chattel mortgage on the cattle? 
 
 26. How is it possible in the case of feeder cattle for a loan to be 
 made with safety to 90 or 100 per cent of the value of the cattle 
 at the tune they are mortgaged as security ? 
 
 27. Who really supplies the funds used by cattle-growers and-feeders ? 
 
 28. Contrast the work of the cattle loan company with that of the 
 commercial paper house. With that of the discount or commer- 
 cial credit company. 
 
 20. What is the source of the cattle loan company's profits ?
 
 RAISING CAPITAL FOR AGRICULTURE 693 
 
 30. What is the purpose of the "certified trust receipt of chattel 
 mortgage"? 
 
 31. State in your own words the economic significance of the cattle 
 loan company. 
 
 V. FARM MORTGAGE BORROWING 
 
 32. "Doubtless you all remember having seen a picture of a gnarled 
 hand hanging over an humble farm cottage as a horrid symbol 
 of the dead pledge or mortgage. I believe that this popular idea 
 of the mortgage has changed during the past generation. The 
 average intelligent progressive farmer now regards the farm 
 mortgage as a blessing, at least in retrospect." If so, why? 
 
 33. Is there any more sympathy due a farmer who mortgages some 
 land as a means of adding to his capital than is due a railroad 
 company that issues bonds and gives a mortgage on the railway 
 property ? 
 
 34. For how long should farm mortgage loans run as a rule ? Is 
 there any justification for three- and five-year loans, which have 
 been the common form ? 
 
 35. "Every community should be financially self-sufficient. Those 
 who need to borrow should be able to do so from people within 
 the community who have funds to loan. The function of mort- 
 gage banks and brokers should merely be to bring these parties 
 
 together." Do you agree with this principle? Is it possible 
 to work it out in practice ? 
 
 36. What are the advantages of the farm mortgage company over 
 the individual mortgage broker: (a) from the viewpoint of the 
 lender; (6) from the viewpoint of the borrower ? 
 
 37. What would you say is the chief weakness of the system of 
 lending through the local farm mortgage brokers ? through mort- 
 gage companies ? 
 
 38. How do you account for the fact that farm mortgage banks have 
 not been subjected to government regulation as have commercial 
 and savings institutions? Do you think they ought to be 
 subjected to governmental supervision ? 
 
 39. How do you account for the wide variation in the rates on farm 
 mortgage loans that existed in the United States before the 
 adoption of the Federal Farm Loan Act ? 
 
 40. What items other than interest go to make up the inclusive costs 
 of mortgage loans ?
 
 694 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 41. "The difference in the rate of interest paid by the Texas farmers 
 and those of foreign countries in twenty years would macadamize 
 every road in Texas." Does this indicate that the farmers of 
 Texas should be granted loans at 3 or 4 per cent ? 
 
 42. "Money cannot be made cheap by law or by any other artificial 
 means. It will flow naturally into the channel most advantageous 
 to its owners. It cannot, therefore, be cheap where the demand 
 exceeds the supply. Foreign credit systems have the advantage 
 that money is normally cheap, the result of centuries of accumu- 
 lations. The systems of rural credit proposed may make money 
 cheaper by improving the security on which it is loaned, but they 
 cannot perform the miracle of making it absolutely cheap" 
 (Editorial in National Stockman and Farmer, 1914). Is this 
 good economic doctrine ? 
 
 43. "The whole trouble with land credit conditions today and 
 that means the dearth of money, the rate of interest, and so on 
 is nothing but the consequence of an insufficiency of market for 
 the security which the farmer offers, and the reason for this 
 insufficiency of market is not only the form in which farm loans 
 are usually offered, not only the variety of laws governing the 
 business, but also the variety of other securities, with which 
 the American market is clogged, quite in contrast to the European 
 market, which is comparatively free from municipal and railroad 
 and also some classes of public-utility securities. " What do you 
 think of this contention ? 
 
 44. "The chief difference of opinion arises over whether there should 
 be special aid furnished by the government. There seems to be 
 no emergency which requires or justifies government assistance 
 to the farmers directly through the use of the government's 
 cash or the government's credit. The American farmer is 
 sturdy, independent, and self-reliant. He is not in the condition 
 of serfdom or semi-serfdom in which were some of the European 
 peoples for whom government aid was extended in some form or 
 other during the last century. As a matter of fact, the American 
 farmers are more prosperous than any other farming class in the 
 world. As a class they are certainly as prosperous as any other 
 great section of the people as prosperous as the merchants, the 
 teachers, the clerks, or the mechanics. It is necessary only that 
 the government, so far as geographic and physical conditions 
 permit, provide machinery for the benefit of the agricultural
 
 RAISING CAPITAL FOR AGRICULTURE 695 
 
 classes as satisfactory as that provided for any other class." 
 Do you agree with this general principle ? 
 
 VI. THE FEDERAL FARM LOAN SYSTEM 
 
 45. What were the chief arguments for the establishment of the 
 Federal Farm Loan System ? 
 
 46. Study the map showing the Federal Farm Loan districts. Have 
 you any criticisms to offer as to the boundary lines or as to the 
 cities chosen for the location of the Federal Land banks ? 
 
 47. Why was it necessary in organizing the Federal Farm Loan 
 System to provide for the formation of Farm Loan associations ? 
 
 48. What is the purpose of the Joint Stock Land banks ? 
 
 49. What is likely to be the ultimate effect of the Federal Farm 
 Loan System upon the private mortgage business? Why? 
 
 50. Have you any criticisms to make of the machinery devised under 
 the Federal Farm Loan System for negotiating a loan and 
 safeguarding the position of the lender ? 
 
 51. What are the advantages of the amortization method of making 
 payments: (a), to the purchaser of the farm mortgage bonds; 
 (6) to the borrower ? 
 
 52. What is the reason for the provision of the Federal Farm Loan 
 Act that amortization payments need not be made for the first 
 five years of the loan ? 
 
 53. Do you think thirty-five years is, as a rule, the most desirable 
 length of time for a farm mortgage to run ? 
 
 54. Explain how the Federal Farm Loan System makes it possible 
 for the interest rates to be the same in all districts. Does this 
 involve what amounts to a tax on certain districts for the benefit 
 of others ? 
 
 55. Do you agree with the contention often advanced that there was 
 no real need for establishing additional agricultural credit machin- 
 ery for the benefit of those who already own farms ? 
 
 56. "The increase of farm tenancy cannot be checked by merely 
 providing purchase money on easy terms to farm tenants." 
 Why, or why not ? 
 
 57. "In the light of the changes in interest rates that have occurred 
 during the war, the Federal Farm Loan Act has placed the 
 fanner in a much better borrowing position than that of industrial 
 and commercial interests. This is not fair to the industrial
 
 696 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 and commercial borrowers and is not in the interest of the 
 general welfare. " Why, or why not ? 
 
 58. Is there any good reason for continuing the exemption of farm 
 mortgages from taxation ? 
 
 59. Write a brief statement outlining: (a) the principles underlying 
 the Federal Farm Loan System; and (b) the effects of the system 
 upon agricultural development. 
 
 REFERENCES FOR FURTHER READING 
 
 Herrick, Myron T. : Rural Credits. 
 
 Moulton, Harold G.: Principles of Money and Banking, Part II, 
 chap. iz. 
 
 Nourse, Edwin G.: Agricultural Economics, chaps, xiii and xiv. 
 
 Phillips, Chester A.: Readings in Money and Banking, chap, xxvii. 
 
 Pope, Jesse E.: "Agricultural Credit in the United States," 
 Quarterly Journal of Economics, Vol. XXVIII. Also printed in 
 Carver, T. N.: Selected Readings in Economics, pp. 936-70. 
 
 Putnam, George E.: The Land Credit Problem. 
 
 Taylor, Henry C.: Agricultural Economics, chap. xvi. 
 
 Annual Reports of the Federal Farm Loan Board.
 
 CHAPTER XXVIII 
 
 CONSUMPTIVE CREDIT INSTITUTIONS 
 
 From the point of view of the uses to which borrowed funds 
 are devoted, credit was classified in chapter vii under the 
 headings, investment, commercial, and consumptive credit. 
 In the preceding chapters, the financial structure that has 
 been developed under the modern capitalistic system in connec- 
 tion with investment and commercial credit operations, has 
 been discussed; there remain to be considered only the financial 
 agencies and institutions associated with the making of loans 
 for non-productive purposes. Such loans, it may be recalled, 
 are to be distinguished from investment and commercial loans 
 in that the use to which the borrowed funds are devoted does 
 not provide the means for paying the loan either within a 
 short or a long period of tune; they are not self-liquidating, 
 but must be paid out of other resources. With the exception 
 of the loans contracted through the building and loan associa- 
 tions, consumptive loans are, as we shall see, usually of very 
 small size; and they are contracted by persons whose credit 
 standing is commonly such that it would be impossible for 
 them to secure funds from the financial institutions which 
 we have been considering in preceding chapters. 
 
 Consumptive finance has been relatively neglected. A striking 
 feature of the modern financial system has been the almost 
 complete absence until very recent times of "legitimate" 
 financial agencies organized for the purpose of extending credit 
 for consumptive purposes. We found in chapter xix that 
 commercial banks sometimes make consumptive loans secured 
 by stocks and bonds and other collateral; and we have else- 
 where seen that a vast amount of trade credit is extended by 
 retail merchants and dealers for consumptive requirements. 
 But the lending of money in small sums for consumptive 
 
 697
 
 698 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 purposes has in the main been left to private interests which, 
 acting without public grant of power, and indeed usually 
 outside the pale of the law, have ruthlessly exploited precisely 
 those classes of society which can least afford to be exploited. 
 
 The explanation of the lack of legitimate financial institu- 
 tions in the field of consumptive credit is apparently the age- 
 old prejudice against the charging of high interest rates to 
 persons in distressed circumstances. Since consumptive loans 
 are not devoted to uses which will directly provide the means 
 of repaying the loan, and since the borrower for consumptive 
 purposes is commonly in reduced circumstances, such loans 
 necessarily bear a much higher rate of interest than those 
 made for industrial, commercial, or agricultural purposes. 
 Hence lending for consumptive purposes is foredoomed to 
 unpopularity. It will be recalled, moreover, that the Bible 
 condemns all interest as being usury, and therefore unjust. 
 The biblical law came in time to be incorporated into the civil 
 codes of western European nations and it was not until the 
 beginning of the modern era that any interest charge was 
 legal. The philosophy underlying this prohibition of all 
 interest is ascribable either to a sympathetic regard for the 
 poor or to a recognition of the economic impossibility of their 
 paying interest. In ancient times funds were borrowed almost 
 exclusively for consumptive purposes virtually to prevent 
 starvation and such loans were in consequence regarded as 
 in the nature of almsgiving. To exact interest from a poverty- 
 stricken class seemed to violate every principle of common 
 humanity. 
 
 But with the development of capitalistic industry and the 
 attendant borrowing of funds for productive purposes, the 
 charging of interest appeared in a very different light. When 
 a borrower devoted the funds procured to productive enter- 
 prise, it was readily seen that he was making a gainful use of 
 the loan and was therefore able to pay back the principal with 
 a bonus, and also that the lender was foregoing a like profitable 
 employment of the capital, and was therefore entitled to a 
 recompense. Gradually the charging of interest on such loans
 
 CONSUMPTIVE CREDIT INSTITUTIONS 699 
 
 was universally legalized; but even to the present day we 
 find survivals of the old prejudice in the usury laws of the 
 various states, which prohibit exorbitant interest rates, that 
 is, rates above a certain prescribed maximum slightly above 
 the normal going rates. 
 
 The existence of usury laws has made it necessary for 
 any financial agency which desired to make loans for con- 
 sumptive purposes to charge unlawful rates of interest, with 
 the result that the risks of fine and imprisonment involved 
 contributed to still higher charges than would otherwise have 
 prevailed. Various types of financial institutions have been 
 developed through private initiative for the extension of con- 
 sumptive credit to individuals in need of financial assistance. 
 Some of them are of long standing, among the earliest forms 
 of financial institutions, indeed; while others are of quite 
 recent development. The passage of remedial loan legislation 
 by a number of American states during recent years has, 
 moreover, done much to place the business of consumptive 
 lending on both a legitimate and a substantial basis. 1 
 
 I. THE BUSINESS OF PAWNBROKING 
 
 One of the chief recourses of individuals in need of funds 
 has always been the pawnbroker. Indeed, pawnbroking appears 
 to be the oldest form of banking operation, if such it may be 
 called; for from earliest tunes and with all peoples the pledging 
 of personal effects as security for advances of money has existed 
 in one form or another. At the present time pawnbroking 
 plays an important role in furnishing consumptive credit in 
 most if not in all of the leading cities of the world. Since 
 the business of pawnbroking requires a dense urban population, 
 it has had its greatest development in the United States during 
 the last fifty years. 
 
 A pawnbroker is defined by the laws of the District of 
 Columbia as "any person, corporation, member or members 
 of a corporation or firm who loan money on deposits or pledge 
 of personal property or other valuable things other than 
 
 'Seep. 706.
 
 700 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 securities or printed evidence of indebtedness or who deals in 
 the purchasing of personal property or other valuable things on 
 condition of selling the same back again at a stipulated price." 
 The second part of this definition, relating to the purchase of 
 property to be resold at a stipulated price, is especially impor- 
 tant because it renders it impossible for individuals to resort 
 to this means of avoiding laws which are directed only at the 
 loaning of funds. 
 
 The pawnshop makes its profits by loaning its own capital. 
 It does not as a rule borrow from banks. The earnings are 
 derived either from an interest charge on the money loaned, 
 or from a special charge of so many per cent a month, or from 
 a combination of the two methods. In the absence of restrictive 
 legislation, added profits are also often derived from the sale 
 of unredeemed property that has been pledged. 
 
 Practically all of the states in the Union have passed legis- 
 lation of one sort or another designed to control the pawn- 
 broking business; and the municipalities in which pawnbroking 
 establishments are located usually have ordinances which 
 supplement the state legislation. The laws of the different 
 states vary so widely that it is impossible to present a succinct 
 summary of pawnbroking legislation. A few general state- 
 ments will, however, suffice to indicate the nature of the regu- 
 lation to which the business is subjected. 
 
 It is a common practice for either the state or municipal 
 laws to require the taking out of a license; and in a few states 
 the pawnbroker is required to give a bond at the time he obtains 
 his license. A number of states fix the interest rates and 
 charges which may be levied; and many state laws or city 
 ordinances contain provisions governing the sale of unredeemed 
 property. The better laws provide that a certain period of 
 time usually from two to six months must elapse after the 
 period fixed for the redemption of the pledge before the effects 
 can be sold. Advertisement of the sale is also commonly 
 required. It is also the usual practice to require the pawn- 
 broker to keep a register giving the name of the pawner, the 
 description of the goods pledged, and the amount of money
 
 CONSUMPTIVE CREDIT INSTITUTIONS 
 
 701 
 
 loaned; while a number of states require, in addition, the 
 residence of the pawner and the rate of interest charged. A 
 great many laws do not make any provision for the disposition 
 of a surplus above the amount of the loan, which is often 
 received from the sale of pledged property. Those that do 
 make provision require the surplus to be returned to the owner 
 of the goods. 
 
 The interest rates and special charges vary widely in 
 different states and cities. In Baltimore, for example, the 
 interest rate is 6 per cent per annum, with the charges 2 per 
 cent per month; in Chicago the interest rate is 3 per cent per 
 month with charges forbidden; and in Philadelphia the interest 
 is 6 per cent per annum, with charges 5 per cent per month. 
 
 Where city ordinances or state laws do not fix the duration 
 of the loans, the general rule is to limit it for thirty days, though 
 renewals, so long as the accrued interest is paid, are usually 
 granted an indefinite number of times. 
 
 The following table shows the volume and the nature of the 
 business of the pawnbroking concerns of Chicago for one month 
 during the year 
 
 NATURE OF PAWNBROKING LOANS 
 
 Articles 
 
 Number 
 
 Amount Loaned 
 
 Average Loan 
 
 Gold watches 
 
 ">,l6o 
 
 $40,242. ?? 
 
 $ 7.8o 
 
 Silver watches . . . . N 
 
 2,980 
 
 S.27O. 5"? 
 
 1.77 
 
 Rings 
 
 4,822 
 
 34,141 .10 
 
 7.08 
 
 Jewelry 
 
 2,276 
 
 25,841.34 
 
 II. 35 
 
 Clothing 
 
 6,543 
 
 11,344.45 
 
 1.73 
 
 Musical instruments 
 Firearms 
 
 356 
 596 
 
 768.46 
 1,225.50 
 
 2.l6 
 
 2.06 
 
 Miscellaneous 
 
 1,724 
 
 5,415.55 
 
 3-14 
 
 
 
 
 
 Total 
 
 24.4?7 
 
 $124,240. 30 
 
 $?.o8 
 
 
 
 
 
 Since much of the property pledged with pawnbrokers 
 consists of lost or stolen goods, the regulation of the pawnshops 
 is usually vested in the municipal police. The most common 
 
 1 W. R. Patterson, "Pawnbroking in Europe and the United States," 
 Bulletin of the Department of Labor, March, 1899, p. 274.
 
 702 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 plan of control requires the pawnshops to make daily reports 
 to the police authorities, and the police to make daily visita- 
 tions of all the pawnshops. Indeed, the police often visit the 
 pawnbrokers several times a day; for it is their duty to supply 
 the pawnshops with lists of stolen or lost articles, inspect the 
 pawnshop books and pledges, assure themselves that the 
 broker has kept within the limits of the law, and recover any 
 stolen or lost articles that may have been accepted in pawn. 
 In order to facilitate the work of the police in identifying those 
 who have pledged stolen property, a few states require a minute 
 personal description of the person pledging the property. And 
 in order that stolen or lost property may be traced, some 
 states require that the pawnbroker may not disfigure the 
 property pledged during the period that it is subject to redemp- 
 tion. Some states, moreover, stipulate that no article may be 
 accepted from an employee, servant, or apprentice, until the 
 pawnbroker has assurance that the holder is the rightful owner, 
 apparently on the principle that such a person is assumed to 
 be guilty until he is proved innocent. At least one state also 
 stipulates that a person of unsound mind shall not be allowed 
 to place articles in pawn, while another prohibits brokers 
 from receiving pawns from a person appearing to be intoxicated, 
 from a notorious thief, or from an individual known to have been 
 convicted of larceny or burglary. 
 
 In recent years pawnshops of a quasi-philanthropic nature have 
 been formed. The growth of state and municipal legislation 
 designed to regulate the pawnbroking business has left much 
 to be desired. There is not only great diversity in the legis- 
 lative provisions, some of them being practically impotent; 
 but the interest rates and charges are as a rule extremely high. 
 Accordingly, an attempt has been made in recent years in the 
 United States, as well as in Europe, to place the making of 
 loans secured by personal property upon a more satisfactory 
 basis through the organization of pawnbroking companies 
 which make loans secured by personal property with as small 
 charges to the borrower as is consistent with safety and with 
 the earning of very moderate dividends on the capital stock.
 
 CONSUMPTIVE CREDIT INSTITUTIONS 703 
 
 A considerable number of companies of this type have been 
 organized in various cities of the United States. They usually 
 are distinguished by such names as "collateral loan company," 
 " workingmen's loan association," or "provident loan society." 
 These institutions are organized and financed by men of high 
 standing in the community; and while it is insisted that their 
 purpose is in no sense a charitable one, it is nevertheless a 
 definite part of the plan not to charge all that the traffic will 
 bear, but to make the institutions merely self-supporting. One 
 such company in Chicago, the officers and directors of which are 
 among the best known business men in the city, has now been 
 doing business for more than twenty years. It has outstand- 
 ing capital stock amounting to $800,000. In the year 1919 
 it made 54,624 loans, of a total value of $2,083,576.50; the 
 net earnings were $91,911, of which $48,000 were paid out in 
 dividends, a rate of 6 per cent on the capital stock. 
 
 While legislation on the subject of pawnbroking has been 
 gradually improving and while the plane of the business has 
 been substantially raised in recent years, there is still much 
 room for improvement in the conduct of the business. It 
 would seem, however, that the importance of the business of 
 pawnbroking will be substantially lessened in the future in 
 consequence of the development of other consumptive credit 
 agencies to be described below. 
 
 II. THE LOAN SHARKS 
 
 Where the pawnbroker advances money on the security of 
 property left with the pawnbroker and pledged for the payment 
 of the loan, the so-called loan shark extends credit on either 
 the unsecured promissory note of the borrower, or upon his 
 note secured by a mortgage on household furniture left in the 
 use of the borrower, or by an assignment of wages or salary. 
 Such money lenders, whether individuals, firms, incorporated 
 associations, or stock corporations, have a permanent loan 
 capital employed solely for the purpose of making small 
 loans, usuallv less than $300. It is the practice to arrange
 
 704 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 for repayment in weekly or monthly instalments, usually 
 averaging ten months. 
 
 Loans made on "plain notes" without indorsement, guar- 
 anty, or security are simple character loans. While the risk 
 involved is usually fairly high, if the loan is small, the char- 
 acter of the borrower exceptionally good, and his employ- 
 ment steady and remunerative, such loans are as satisfactory 
 as any. It is a very common practice, however, to require the 
 wife to join in the obligation; for experience has shown that 
 confidential loans made either to husband or wife without 
 knowledge of the other, carry an added risk of loss through 
 failure of the family to co-operate and economize with a view 
 to repayment. 
 
 Loans that are secured by a chattel mortgage on property 
 left in the possession of the borrower, or by an assignment of 
 the borrower's wages or salary, are not so much superior to 
 the unsecured loans as one might suppose, for the reason that 
 restrictive laws on both subjects make it practically impossible 
 to realize upon such security through legal process. Moreover, 
 since the loan shark who necessarily charges usurious rates 
 of interest is himself outside the protection of the law, he is 
 not in a position to command the aid of the law in effecting 
 collections. Many employers, moreover, refuse to recognize 
 an assignment of an employee's wages or salary. 
 
 In the case of wage and salary assignments it is important 
 to note, however, that many employers who refuse to recognize 
 wage assignments also follow the practice of discharging 
 employees who assign their incomes. Where this is the case 
 the loan shark is placed in a peculiar position, for he can carry 
 a threat to the borrower that the employer will be notified 
 if the loan is riot paid. While such a threat is of no value 
 from a legal point of view, in practice it is a very effective 
 means of collection. 
 
 Because of the lack of any real property security and 
 because of the illegality of their own operations, the loan sharks 
 have found it necessary to employ "roughhouse" collection 
 agents and "bawlersout" to intimidate and harass the l>or-
 
 CONSUMPTIVE CREDIT INSTITUTIONS 
 
 70S 
 
 rowers and their families and to embarrass them with their 
 neighbors, friends, and employers. Interestingly enough, the 
 loan sharks long ago discovered that women are the most 
 successful agents for this purpose. 
 
 The rates charged by the loan sharks vary widely, but 
 they are always ruinously high. The minimum appears to be 
 10 per cent a month, while 20 per cent is not at all unusual. 
 Many individual cases have been noted, moreover, where the 
 rates amounted to from 500 to 1,000 per cent a year. Since 
 such interest rates are illegal, the charge is not levied as an 
 interest rate, the most common method employed being to 
 add 50 per cent to the amount of the loan and make this sum 
 payable without interest in twelve weekly instalments. Thus 
 a loan of $50 would require twelve weekly payments of $6.25 
 each. The following table shows the charges expressed in 
 terms of interest fate by one representative salary loan company 
 
 in New York. 1 
 
 . 
 
 INTEREST RATES ON SALARY LOANS 
 
 AMOUNT OF CASH 
 
 
 PAYMENTS 
 
 
 TOTAL 
 
 AMOUNT 
 PAID IN 
 
 ANNUAL 
 
 RECEIVED 
 
 BY THE 
 
 BORROWER 
 
 Amount 
 of 
 Each 
 
 When 
 Due 
 
 Number 
 
 AMOUNT 
 PAID BY THE 
 BORROWER 
 
 EXCESS OP 
 THE AMOUNT 
 OF CASH 
 RECEIVED 
 
 RATE 
 
 (PER 
 
 CENT) 
 
 
 
 Weekly 
 
 
 
 $7.00 
 
 
 21.50 
 
 2.50 
 
 Weekly 
 
 
 30.00 
 
 8.50 
 
 316 
 
 
 2 45 
 
 Weekly 
 
 
 
 
 
 26.00 
 
 3.00 
 
 Weekly 
 
 
 36.00 
 
 10.00 
 
 308 
 
 
 
 Weekly 
 
 
 
 
 
 34.00 
 
 2 .65 
 
 Weekly 
 
 
 | S3 -oo 
 
 19.00 
 
 277 
 
 
 
 Bi-Weekly 
 
 6 
 
 
 15.00 
 
 286 
 
 40.00 
 
 4.50 
 
 Weekly 
 
 12 
 
 54.00 
 
 14.00 
 
 280 
 
 
 
 Monthly 
 
 3 
 
 
 
 
 
 
 
 
 
 
 
 The reasons for seeking funds from the loan sharks are 
 sometimes good and sometimes not. It has been stated by 
 students of the question that about 75 per cent of the indi- 
 viduals who borrow from the loan companies are men with 
 families who are temporarily in need, and that about 25 per 
 cent are men who could get along better without the money, 
 which is spent in gambling, intemperance and vice. For 
 
 1 From C. W. Wassam, Salary Loan Business in New York City, p. 36.
 
 706 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 temporary need of funds, sickness or death in the home is 
 perhaps the most common cause. The payment of rentals 
 in advance, moving expenses, life-insurance premiums, interest 
 on mortgages, and holiday expenses, are among the frequent 
 objects for which the money is secured. It has been estimated 
 that the volume of small loan business of this kind in the 
 United States was in 1918 about $100,000,000, the average 
 loan being in the neighborhood of $40. 
 
 The loan shark evil is now being rapidly eliminated. As the 
 result of an extensive campaign conducted by the Federation 
 of Remedial Loan Associations, co-operating with the Division 
 of Remedial Loans of the Russell Sage Foundation* much prog- 
 ress has been made during the last few years in improving the 
 status of the small loan business. The improvement has been 
 effected in two ways; first, by reform loan legislation enacted 
 by various states, and second by the organization of new forms 
 of loaning companies to be discussed below. As a result the 
 * loan shark evil is now almost a thing of the past. 
 
 When legislation governing the consumptive loan business 
 has been enacted by a* state many of the former loan sharks 
 remain hi business, taking out state licenses and henceforth 
 conforming their practices to the requirements of the law. 
 The loan sharks were admittedly a necessary evil; for in the 
 absence of constructive loan legislation, the legitimate loan 
 agencies rendered a service to the community that was indis- 
 pensable. So long as the usury laws stood upon the statute 
 books without qualification, it was, moreover, impossible for 
 the money lenders to conform to the law. The evil lay not 
 so much with the loan sharks as with the lack of remedial 
 legislation. 
 
 It is important to observe in this connection, that the 
 constructive legislation that has recently been passed, with 
 the sanction of the Remedial Loan Associations, usually legalizes 
 an interest rate of 3! per cent a month. It is recognized that 
 costs and risks attending the small loan business are such that 
 a very high rate is necessary in order to attract capital into 
 that field, and that the inevitable result of laws which unduly
 
 CONSUMPTIVE CREDIT INSTITUTIONS 707 
 
 restrict the rate of interest is to keep reputable concerns out 
 of business and force borrowers to secure their accommodations 
 from lenders who will risk violations of the law for a money 
 consideration. The practical choice appears to lie between 
 licensed loan companies charging 42 per cent a year and ille- 
 gitimate agencies which charge several hundred per cent. 
 
 Under the operation of the Small Loans Act of Illinois in 
 the year 1919, it is estimated that more than seven million 
 dollars were saved to borrowers in Chicago alone. Nearly two 
 hundred sharks were driven out of business; and the new 
 licensed lenders accommodated nearly 45,000 small tradesmen, 
 laboring men, teachers and men on salaries. 
 
 While a majority of the states now have laws requiring 
 the licensing of money lenders and many others have laws 
 regulating the making of small loans, there is still much to be 
 accomplished; for, in the words of the Director of the Legal 
 Reform Bureau "many of these laws are ill considered, inade- 
 quate, crude, impracticable, and ineffective." A uniform small 
 loan bill has recently been evolved by the interested remedial 
 agencies and it is hoped that this may in good season be adopted 
 by all the states. Over twenty states have, in fact, passed the 
 measure. In brief, this law makes it unlawful without a state 
 license to make loans to the value of $300 or less at a rate of 
 interest in excess of the legal bank rate; enumerates what the 
 license shall contain; fixes the annual fee at $100; requires a 
 bond of $ 1,000 with sureties to the state for ihs use of any 
 person or persons who may have cause of action against the 
 obligor, and binds the lender to conform to and abide by each 
 and every provision of the act. 
 
 The law also provides for the revoking of the license by 
 the state banking department which is charged with the admin- 
 istration of the act; and requires notice of removal of place 
 of business and consent of the banking department therefor. 
 For the purpose of discovering violations of the act the state 
 banking department may at any time and as often as may be 
 desired, investigate the loans and business of every licensee, 
 and for that purpose shall have free access to the books,
 
 708 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 papers, records and vaults of such licensee. It shall also have 
 authority to examine, under oath, all persons whomsoever 
 whose testimony may be required relative to such loans or 
 business. 
 
 HI. THE MORRIS PLAN BANK 
 
 Among the interesting institutions developed in recent 
 years for extending credit in small sums for consumptive 
 requirements is the so-called Morris plan of loaning on mere 
 personal responsibility. This plan, after being tried out on a 
 minor scale in the South for about fifteen years, has been 
 introduced during the last half-dozen years in a number of 
 the larger cities of the country. The method of making loans 
 under this plan is as follows: the applicant furnishes references 
 as to his character and information as to his money income. 
 In addition he is required to have at least two indorsers or 
 co-makers of situation and income at least as good as his own. 
 For each $50 borrowed he agrees to pay $i a week for fifty 
 weeks. The interest is, however, deducted in advance; hence 
 the borrower receives only $47. In case he fails to make a 
 payment on time he is fined five cents and notified of his delin- 
 quency, while if he gets a week behind his co-makers are notified. 
 They may be relied upon to see that he catches up again if 
 he can; but in case he fails to do so the indorsers or co-makers 
 must take his place in making the weekly payments. 
 
 IV. CO-OPERATIVE CREDIT UNIONS 
 
 While the function of the co-operative credit union is to 
 furnish productive as well as consumptive credit to its members, 
 it may most conveniently be discussed in this chapter. 1 The 
 explanation of the development of these organizations is usually 
 assigned to the lack of adequate banking facilities in many 
 agricultural communities and to the need for better credit 
 facilities among the small tradesmen, wage-earning and salary 
 
 1 Co-operative credit organizations among farmers were briefly discussed 
 on pp. 6<;*-53 above.
 
 CONSUMPTIVE CREDIT INSTITUTIONS 709 
 
 folk of the city: Borrowers of small sums, whether for con- 
 sumptive or productive requirements, ordinarily receive little 
 consideration from the regular banking institutions. 
 
 The credit union, moreover, is not merely a lending insti- 
 tution; it is also an agency for the promotion of thrift and 
 business responsibility among its members. To quote from 
 some of its leading proponents, 
 
 In order to be thrifty many a man requires something more than 
 agencies to receive his deposits and return them to him, when needed, 
 intact with interest: he requires an agency which wih 1 make its hours 
 of business conform to his convenience, which is conveniently located, 
 which does not require him to stand in line for a long time awaiting 
 his turn at the expense of his lunch hour and possibly of some of his 
 employer's time; he requires an agency to which he is not ashamed 
 to bring a dollar, fifty cents, or even a quarter; an agency which will 
 constantly remind him of his resolution to save and which will reward 
 his thrift by extending credit to him upon easy terms of repayment 
 secured solely by his character and personal worth credit which will 
 enable him to effect economies in purchasing and embarking in 
 productive enterprises, and will protect him from the userer. By its 
 proximity and convenience it persuades the man who has not been 
 reached by the savings bank to become thrifty, and this without 
 interfering with the growth of ordinary banking institutions; instead, 
 it actually increases the field of the banks. It makes the accumulated 
 capital available to the persons who assisted in its accumulation. 
 It does not become a substitute for the building and loan asso- 
 ciation or the remedial loan society; instead, it becomes a com- 
 plement of these agencies, for the basis of the security for its loans 
 is not collateral but character. 1 
 
 As indicated at the end of the foregoing quotation, the 
 essential basis of credit in the co-operative credit union is the 
 character of the individual borrower, the greatest asset of an 
 individual being considered the estimate of his own associates. 
 The advantage of the credit union is that it enables those 
 who make the loan to have an intimate knowledge of the per- 
 sonal habits and financial and domestic situation of the small 
 
 1 Arthur H. Ham and Leonard G. Robinson, A Credit Union Primer
 
 710 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 borrower. Being composed of a small homogeneous member- 
 ship, mutually acquainted, such loans can be made with a 
 miiiimum of risk and hence at a relatively low rate of interest. 
 Indeed, because of the close association of the membership, 
 together with their control of the credit union itself, the rate 
 of interest may be less here than in any other type of lending 
 institution engaged in the extension of consumptive credit. 
 
 The main principles and most approved form of organiza- 
 tion of credit unions may be outlined as follows: 1 
 
 a) Functions of a Credit Union 
 
 1. It encourages thrift by providing a safe, convenient, and 
 attractive medium for the investment of the savings of its members 
 through the purchase of shares and the making of savings deposits. 
 
 2. It promotes industry by enabling its members to borrow for 
 productive and other beneficial purposes. 
 
 3. It eliminates usury by providing its members, when in urgent 
 need, with a source of credit at reasonable cost, which they could not 
 otherwise obtain. 
 
 4. It trains its members in business methods and self-government, 
 endows them with a sense of social responsibility, and educates them 
 to a full realization of the value of co-operation. 
 
 6) Basic Principles 
 
 1. Equality: all members share equally in privileges and ratably 
 in profits. 
 
 2. Democracy: the one-man-one-vote principle is fundamental. 
 Each member has but one vote irrespective of the number of shares 
 he may hold. 
 
 c) Where and by Whom Organized 
 
 Any number of persons may combine to organize a Credit Union 
 in a city, town, or rural community. In states that have Credit 
 Union legislation a certain number of the incorporators must be 
 citizens of the United States, and of the state. Where a Credit 
 Union is organized as an unincorporated or voluntary association 
 this is not necessary. 
 
 1 Adapted from Arthur H. Ham and Leonard G. Robinson, ibid.
 
 CONSUMPTIVE CREDIT INSTITUTIONS 711 
 
 d) Basis of Membership 
 
 The basis of membership in a Credit Union must be some com- 
 mon bond or community of interest. This may take a number of 
 forms. It may be a neighborhood. It may be common occupation, 
 employment by the same establishment, or membership in the 
 same church, club, lodge, labor union, or other organization. In 
 rural communities the church, parish, school district, or local grange 
 furnishes a satisfactory foundation for membership. 
 
 e) Qualifications for Membership 
 
 1. Identification with the basic unit upon which the Credit Union 
 is founded the church, the club, the business establishment, etc. 
 
 2. Good moral character and a reputation for honesty, sobriety, 
 and industry. 
 
 /) Capital Requirements 
 
 1. Capital consists of payments of members for shares and of 
 unpaid dividends credited thereon. 
 
 2. There should be no limit to total number of shares. 
 
 3. Limitation upon number of shares held by one person is wise. 
 
 4. Par value of $5 . oo is desirable. 
 
 g) Funds in Addition to Capital 
 
 A Credit Union may accept the savings deposits of its members, 
 and may borrow from members and others. 
 
 Interest on savings deposits should not be more than i per cent 
 in excess of savings bank rates in the community. 
 
 Borrowing by the Union is merely an emergency measure and 
 should be employed only when absolutely necessary to meet the 
 credit demands of its members. 
 
 h) Employment of Funds 
 
 Except for the Guaranty Fund, which the law may require to be 
 invested in a particular manner, the funds of a Credit Union are 
 primarily to be used for the purpose of making loans to members. 
 Surplus funds should be deposited in banks or invested in prime 
 securities. 
 
 i) Who May Borrow 
 
 All members in good standing, except the Board of Directors, 
 officers, and members of the Credit Committee and Supervisory 
 Committee.
 
 712 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 j) Purposes for Which Loans May Be Granted 
 
 It is essential that a Credit Union should loan only for pro- 
 ductive purposes, purposes that will effect a saving, supply an urgent 
 need, or that will otherwise prove of benefit to the borrower. 
 
 k) Rate of Interest on Loans 
 
 As a matter of principle the interest charged on loans should be 
 no greater than is required to pay the opera ting cost, a moderate 
 rate of interest on deposits, to provide for a reasonable reserve or 
 guaranty fund, and to pay a moderate dividend on shares. It is 
 well to fix the maximum interest rate in the By-Laws. This rate 
 should as nearly as possible approximate the banking rate of interest. 
 (In New York the maximum rate of interest that a Credit Union 
 may charge is 12 per cent per annum.) Care should be taken that 
 the total charges upon loans do not exceed the maximum allowed 
 by law. 
 
 /) Duration of Loans 
 
 The By-Laws may fix a general maximum but the time of indi- 
 vidual loans should be fixed by the Credit Committee with due regard 
 for the nature of the employment in which the members are engaged, 
 their ability to repay, and the objects for which loans are made. 
 A maximum of one year should be sufficient, even though it may be 
 necessary at the expiration of that time to renew a portion of the loan. 
 
 Loans should be repaid in weekly or monthly instalments or in a 
 single sum. This is to be determined in each instance by the Credit 
 Committee. 
 
 m) Security for Loans 
 
 Ordinarily the security that a Credit Union demands for loans is 
 the promissory note of the borrower with one or more endorsements, 
 supplemented by a lien upon the borrower's shares and deposits in 
 the Credit Union. The requirement of endorsements may be waived 
 in some cases if the loan is for a small amount. Large loans may 
 also be made to members upon the security of a mortgage on real or 
 personal property; but unless the Credit Union has an abundance 
 of funds, preference should be given to the smaller loans. 
 
 As a rule members only should be accepted as endorsers. In 
 exceptional cases non-members may be permitted to endorse for 
 members. In either case the endorsers must be acceptable to the
 
 CONSUMPTIVE CREDIT INSTITUTIONS 713 
 
 Credit Committee. The Credit Committee may, if it deems it 
 necessary, require additional security upon any loan in the form of 
 additional endorsements, a mortgage, or other collateral. 
 
 Credit unionism has been extensively developed in foreign 
 countries. Originating in Germany about the middle of the 
 last century, in the course of its development credit unionism 
 has assumed two different forms known, after their respective 
 founders, as the Raiffeisen and Schulze-Delitzsch systems. One 
 or the other of these systems the difference between which 
 need not concern us here has been adopted with modifications 
 in most of the leading countries of the world. It was estimated 
 that at the outbreak of the Great War there were in the world 
 more than 65,000 of such associations, having an aggregate 
 membership of fifteen million people and an annual business 
 amounting to over seven billion dollars. 
 
 It was not until 1909 that credit unions were given legal 
 recognition in the United States by the enactment in that 
 year of the Massachusetts Credit Union Law. 1 Since that 
 time a number of states have passed similar legislation, but 
 on the whole the growth of such institutions has not been as 
 rapid as was expected by their advocates. This is due in part 
 to the lessened need for small loans during the period of war 
 prosperity and in part to the gradual elimination of the loan 
 shark and the introduction of licensed money lenders. There 
 is also reason to believe that just as co-operation of every sort 
 has been beset with peculiar difficulties in the United States, 
 so the co-operative credit union has found here a relatively 
 infertile soil. It appears certain, however, that credit unions 
 have come to stay and that their importance will steadily 
 increase. 
 
 Credit unions abroad have had beneficent social results. There 
 appears to be no difference of opinion as to the social benefits 
 derived from the development of credit unions in foreign 
 countries: 
 
 It has regenerated and accelerated agriculture, commerce, and 
 industry. It has stamped out usury and raised millions of human 
 
 1 See p. 653 above.
 
 714 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 souls from the depths of despair to lives of hopefulness and service. 
 It has supplanted shiftlessness by industry; improvidence by thrift; 
 intemperance by sobriety; selfishness by neighborliness; individual 
 effort by concerted action in fact, has proved to be one of the most 
 potent moral, educational, and social forces in the history of civiliza- 
 tion and in the enrichment of the life of the common people. 1 
 
 It is also agreed that the history of co-operative credit 
 unions has shown conclusively the desirability of basing these 
 institutions on the principle of self-help, rather than on philan- 
 thropy in any form; and that the organization must spring 
 from a co-operative desire and must depend upon the manage- 
 ment of its own members. The greatest student and the greatest 
 exponent of co-operative credit institutions concludes that 
 Every dallying with greed, every yielding to the spirit of patron- 
 age, foreign experience has shown, adds a toe of clay to the huge 
 brazen Colossus, and thereby threatens to overthrow it in spite of 
 its size. And the thing must grow from out of its own self, from the 
 bottom to the top. Committees and boards can do nothing. Large 
 schemes worked by public bodies are as much out of place. The 
 workingman and the farmer must become " the instruments of their 
 own emancipation." None of the systems that have succeeded 
 abroad have been organized from above. They have all risen from 
 below, built up by local associations .... which have studied to 
 keep themselves independent of outside influence, self-contained, yet 
 firmly connected among themselves by a bond of union. Nowhere, 
 moreover, has this work been "good fairy" work. Every shilling's 
 worth of success has been purchased by unremitting application, by 
 economy, gratuitous labor (so far as gratuitous labor was possible), 
 zeal, and caution. And experience has shown that it is not otherwise 
 to be obtained. 3 
 
 V. BUILDING AND LOAN ASSOCIATIONS 
 
 The building and loan association is the oldest form of 
 co-operative credit institution in the United States, the first 
 one having been organized in a suburb of Philadelphia in 1831. 
 These institutions differ essentially from some of the others 
 discussed in this chapter in that they are designed to enable 
 
 1 Arthur H. Ham and Leonard G. Robinson, ibid. 
 1 Henry W. Wolff, Peoples 1 Banks, p. 6o.
 
 CONSUMPTIVE CREDIT INSTITUTIONS 715 
 
 individuals to acquire permanent homes rather than evanescent 
 consumptive goods; in a very real sense they are a form of 
 savings institution and they might as logically have been 
 discussed in connection with investment credit institutions 
 as here. 1 
 
 In the course of their evolution the building and loan 
 associations have passed through several phases, a brief account 
 of which will best serve to indicate both their purpose and the 
 nature of their operations. The -original form of building and 
 loan association was little more than a home builders' club, 
 where each individual paid into the common treasury a certain 
 sum of money each month. The purpose was to secure enough 
 members so that a moderate monthly payment by each would 
 aggregate every month a fund sufficient to build a home for 
 one of the members. For example, if there were one hundred 
 members and each paid into the association twenty dollars per 
 month, every month one member could begin the building 
 of his home, to cost two thousand dollars; and at the end of" 
 one hundred months each would have a two thousand dollar 
 home. The club required each home builder to give a mortgage 
 on the home as security in case the member failed to continue 
 his monthly payments after receiving a loan from the associa- 
 tion. When each member had acquired a home, the associa- 
 tion, having accomplished its purpose, was dissolved. 
 
 A second step in the development of the building and 
 loan association was marked by the introduction of shares, 
 which enabled any individual who wanted to build a better 
 home than his fellows to do so by investing more money each 
 month than the others. In the foregoing illustration, if an 
 individual invested $20 per month instead of $10, he could 
 build a $4,000 instead of a $2,000 house. 
 
 A third phase was the development of the depositing 
 member. A depositing member is one who joins the associa- 
 tion, not with the expectation of borrowing funds for the 
 purpose of acquiring a home, but merely for the returns which 
 
 1 This of course holds true only in less degree for the co-operative credit 
 unions discussed in the preceding section.
 
 716 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 he may receive from the investment of his funds in the asso- 
 ciation. The profits of the association were derived from two 
 sources: (i) the payment of interest on the money advanced 
 for home building by the borrowers thereof; and (2) from 
 the system of premiums and fines which was developed. Each 
 individual who borrowed funds for home building was at first 
 supposed to pay interest to the association at the current rate; 
 but so many members often wished to build at the same time 
 that the practice developed of making the award to the one 
 who would bid the highest above the current rate of interest. 
 The fines were levied against members who became delinquent 
 in paying their dues. Both these sources of income have at 
 times proved very fruitful. It should be added here, however, 
 that the system of fines and premiums gave rise to various 
 abuses in connection with their administration, and they are 
 now being gradually eliminated. 
 
 The depositing member has played a very important part 
 in the development of building and loan associations. In 
 crowded industrial centers where the demand for loans from 
 prospective home builders has usually exceeded the ability 
 of the ordinary members to furnish the funds, the depositing 
 member has proved of great assistance. Since the depositor 
 was interested only as an investor, however, it was found 
 necessary to extend him one privilege not possessed by the 
 ordinary member that of withdrawing his shares at any time 
 in case he desired to use his funds elsewhere. 
 
 The fourth stage in the evolution of the loan association 
 was featured by the introduction of the serial plan. The 
 original associations, as we have seen, were dissolved or ter- 
 minated as soon as each borrowing member had acquired a 
 home; but under the serial plan the association becomes 
 virtually a perpetual organization. Under this plan additional 
 members may be added to the original association at stated 
 intervals, say, once a year, each new group of members con- 
 stituting an independent series which terminates when all the 
 members of the series have acquired homes. Thus the associa- 
 tion lives as long as new series of members continue to be added.
 
 CONSUMPTIVE CREDIT INSTITUTIONS 717 
 
 A BUILDING AND LOAN ASSOCIATION STATEMENT* 
 
 CASH RECEIPTS 
 
 Cash on hand, April i, 1915 . . . . $ 167.48 
 
 Instalments "A" . . . $9,528.34 
 
 Instalments "B" . . . 2,400.00 
 
 Interest 3,074.32 
 
 Premium 517.38 
 
 Fines ....... 17.00 
 
 Loans repaid 2,750.00 
 
 Expenses (rents) ... 25.00 
 
 Real estate contracts . . 1,201.52 
 
 19,603.56 
 Outstanding orders 3,166.80 
 
 Total $22,937.84 
 
 ASSETS 
 
 Real estate loans and con- 
 tracts $162,809.42 
 
 Stock loans 55,325.00 
 
 Tax certificates . . . . 681.03 
 
 Interest, taxes, etc., due and 
 
 accrued 2,218.29 
 
 Real estate owned by Asso- 
 ciation 628.14 
 
 Office furniture .... 179.00 
 
 Cash on hand .... 2,184.22 
 
 Total $224,025.10 
 
 CASH DISBURSEMENTS 
 
 Outstanding orders, April i, 1915. . . $ 2,099.08 
 
 Loans $ 2,750.00 
 
 Instalments withdrawn. . 3,170.50 
 
 Interest 238.50 
 
 Expenses 858.04 
 
 Real estate contracts . . 137.50 
 
 Matured stock .... 10,800.00 
 
 Contingent fund . . . 700.00 
 
 18,654.54 
 Cash on hand 2,184.22 
 
 Total $22,937.84 
 
 *One hundred and sixty-fifth Quarterly Statement of Peoples' Building and Loan 
 Association, Chicago.
 
 718 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 The final step was the introduction of the so-called per- 
 manent or Dayton plan which originated in 1870 in Dayton, 
 Ohio. It is merely a modification of the serial plan, the dis- 
 tinguishing feature being that it is unnecessary for an indi- 
 vidual who wishes to join a permanent association to wait 
 until the opening of a new series of membership; he may take 
 out an individual membership at any time and purchase as 
 many shares of stock as he may desire. Each borrower can 
 also pay off his debt as fast as he desires and retire from the 
 association at his own convenience. Both the permanent and 
 the serial plan are found at the present time. 
 
 The management of building and loan associations is vested 
 in a board of directors chosen by the members, while the 
 routine administrative duties are performed by elected officials. 
 The association makes two types of loans, known as stock 
 loans and real estate loans. Stock loans are secured by the 
 individual's shares in the association, the loan being limited 
 as a rule to 85 per cent, or less, of the book value of the shares 
 at the time the loan is made. The real estate loans are made 
 to members on the security of mortgages on the homes to be 
 built, or purchased. The valuation of the property is made 
 by the board of directors or by an appraisal committee appointed 
 by the directors. 
 
 An interesting problem of management has always been 
 that of the disposition of the accumulated property. In the 
 early associations the earnings were kept in a common fund 
 and were not disturbed until the time of final dissolution, losses 
 meanwhile being paid out of the accumulated funds. But 
 with the development of the depositing members, who had the 
 privilege of withdrawing before the dissolution of the associa- 
 tion, and whose interest in the organization was solely that of 
 an investor, it became necessary to apportion the profit from 
 time to time as dividends.. At present, it is the almost universal 
 rule to pay dividends semi-annually. 
 
 The growth of building and loan associations in the United 
 States has easily kept pace with the increase in population 
 and the development of other forms of financial institutions.
 
 CONSUMPTIVE CREDIT INSTITUTIONS 719 
 
 In the year 1918 there were 7,484 such associations in this 
 country, having a total membership of 4,011,401 persons and 
 total assets of $1,898,344,346. While the Eastern and Central 
 States have the largest number, the distribution, in proportion 
 lo population, is fairly uniform throughout the country. 
 
 The building and loan associations have filled a real need 
 in our financial system. The economic and social significance 
 of the building and loan association is stated, somewhat extrava- 
 gantly, by one writer in the following language: "Thrift is 
 being encouraged; economy is being taught; good citizenship 
 is being developed; communities are being improved; and 
 it may be doubted if banking in any of its forms or co-operative 
 effort in any other direction has in it so much of the promise 
 of social regeneration or the potency of true progress." 
 Certainly, it may be said that the lack of investment banking 
 institutions equipped to provide funds for the small home 
 builder, left a crying need for an institution such as the building 
 and loan association. Moreover, the especial convenience and 
 cheapness of the association method of acquiring and paying 
 for property would under any circumstances make it an insti- 
 tution capable of rendering very great service in promoting 
 thrift and economic service. 
 
 QUESTIONS FOR DISCUSSIONS 
 
 I. GENERAL CONSIDERATIONS 
 
 1. What is the explanation of the failure of the regular banking 
 institutions to make loans for consumptive credit purposes? 
 Is such loaning unprofitable ? 
 
 2. Why has there always been so strong a prejudice against private 
 money lenders ? 
 
 3. What is meant by usury? Do you favor the abolition of usury 
 laws? 
 
 4. Why does the maximum interest rate that may be charged vary 
 widely in different states ? 
 
 n. THE "SMALL LOAN" BUSINESS 
 
 5. Why has the pawnbroking business always been held in social 
 disesteem ? Does it render no economic service ?
 
 720 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 6. How does the pawnbroker avoid the usury laws ? 
 
 7. How do you account for the fact that the charges levied by 
 pawnbrokers are less than those levied by the loan sharks ? 
 
 8. Would you favor the abolition of the pawnbroking business ? 
 If not, what sort of regulation would you require ? 
 
 q. To what is the origin of the loan shark attributable ? 
 
 10. What are the different types of security back of "small loans" ? 
 
 11. What is. the weakness and the possible strength of loans secured 
 by assignments of wages or salaries ? 
 
 12. "'Character' loans are safe only among a stable and frugal 
 population, entirely non-speculative, and steadily engaged in 
 some regular avocation which the people thoroughly understand 
 and which they expect to follow. " Do you agree ? 
 
 13. Under the uniform Small Loan Law a rate of interest of 35 per 
 cent a month has been legalized. Do you regard this as legisla- 
 tion designed to promote the welfare of the masses ? 
 
 14. Do you believe that philanthropic or semi-philanthropic loans 
 will in the long run lead to the most desirable results ? 
 
 15. Do you consider the security offered under the Morris plan as 
 reasonably satisfactory ? 
 
 16. What rate of interest is charged under the Morris plan? Note 
 that the nominal rate does not tell the whole story. 
 
 HI. CO-OPERATIVE CREDIT UNIONS 
 
 17. In what ways do the functions of credit unions differ from those ot 
 the private lending institutions ? 
 
 1 8. What is the point to having a club or other organization as the 
 basis of membership ? 
 
 19. Do you believe in the principle of one man, one vote ? 
 
 20. Why is it important to make the par value of shares only $5 ? 
 To limit the number of shares held by one person ? 
 
 21. Does it seem to you that the savings feature of the credit union 
 is as important as the loaning feature ? 
 
 22. Why should not the officers and directors be permitted to borrow 
 from the union ? 
 
 23. Do you regard the security for loans ample? Is it, primarily, 
 character or property security ? 
 
 24. Just how is it possible for credit unions to make loans at lower 
 rates than private loaning agencies ?
 
 CONSUMPTIVE CREDIT INSTITUTIONS 721 
 
 25. Which do you regard as of greater importance the direct or 
 the indirect benefits of the credit union ? 
 
 26. Is there any reason why such institutions should not be exten- 
 sively developed in the United States ? 
 
 IV. BUILDING AND LOAN ASSOCIATIONS 
 
 27. "The building and loan association is a co-operative means of 
 effecting savings. " How ? 
 
 28. "The building and loan association is both a source of loans and 
 a place where money may be invested at interest. " How ? 
 
 29. How has it ordinarily been determined which member of the 
 association should have the privilege of building first ? Do you 
 think this is a good principle? What is the objection to the 
 system of premiums ? 
 
 30. Do you regard the security back of the loan made by the loan 
 association as ample ? 
 
 31. What is the advantage of the serial plan of organization as 
 compared with the terminating plan? 
 
 32. What are the practical advantages of the permanent, or Dayton, 
 plan ? Do you see any disadvantages in it ? 
 
 33. How does the building and loan association differ from the 
 credit union in its purpose and method of organization ? Would 
 you say that it is a true co-operative institution ? 
 
 34. In the absence of the building and loan association what rate of 
 interest would the man of small means probably have to pay 
 for funds used in the purchase of a home ? 
 
 35. Not all home building is effected by means of the building and 
 loan association. What are the other means of securing the 
 funds that are now available ? 
 
 REFERENCES FOR FURTHER READING 
 
 Dexter, Seymour: Building and Loan Associations. 
 
 Ham, Arthur H., and Robinson, Leonard G.: A Credit Union 
 Primer. 
 
 Hodson, Clarence: Money Lenders, License Laws and the Business 
 of Making Small Loans (Legal Reform Bureau. 29 Cortlandt St., N.Y.). 
 
 Levine, Samuel W.: The Business of Pawnbroking; A Guide 
 and a Defense.
 
 722 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 Moulton, Harold G.: Principles of Money and Banking, Part II, 
 chap. viii. 
 
 Patterson, W. R.: Paumbroking in Europe and the United States 
 (United States Department of Labor, Bulletin No. 21, March, 1899, 
 
 PP- i73-3io)- 
 
 Wassam, Clarence H.: The Salary Loan Business in New York 
 City. 
 
 Wolff, Henry W.: Co-operative Credit for the United States.
 
 CHAPTER XXIX 
 
 FINANCIAL INTEGRATION 
 
 The desirability of specialization by financial institutions 
 has long been emphasized in the writings of both economists 
 and practical bankers and in legislative acts and court decisions. 
 Just, as specialization became the dominant characteristic of 
 industry and commerce during the greater part of the nineteenth 
 century, so specialization in the field of finance came to be 
 regarded as in the natural order of things. A few brief state- 
 ments will be sufficient to indicate the prevailing views as to 
 what constitute the "legitimate" functions of the different - 
 types of financial institutions that we have been discussing in 
 the preceding chapters. 
 
 In the writings of economists and practical bankers are 
 found repeated statements to the effect that the business of 
 commercial banking is merely to facilitate commercial trans- 
 actions through the making of short-time loans to manufacture 
 credit and furnish an important part of the medium of exchange. 
 Emphasis is also very commonly placed upon the relation of 
 commercial banking to the marketing or mercantile process; 
 indeed the term "commercial" bank owes its origin to this 
 emphasis the words commercial and mercantile being used as 
 practically synonymous terms. Banking literature and legis- 
 lation unite in condemning the making by commercial banking 
 institutions of long-time loans for fixed capital purposes. 
 
 Savings banks, on the other hand, are in theory intended to 
 facilitate only the raising of fixed capital, to collect the little 
 rivulets of individual savings and turn them over in larger 
 amounts for investment uses. Investment banks similarly 
 act as intermediaries in the raising of funds for fixed capital 
 purposes. Even the trust company was originally designed to 
 act primarily in the capacity of trustee, its banking functions 
 
 723
 
 724 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 being limited, at best, to investment operations incidental to 
 the employment of trust funds. 
 
 There is nowadays relatively little specialization by financial 
 institutions. From our analysis in preceding chapters, we have 
 already seen that in practice financial specialization is far from 
 complete. We have seen, for instance, that savings banks do a 
 considerable volume of commercial banking business; some 
 of them, particularly in the Middle West, are, in fact, difficult 
 to distinguish from commmercial banks, since they handle both 
 commercial and savings accounts and make loans for com- 
 mercial as freely as for investment purposes. Indeed, a large 
 majority of all savings banks make loans for working capital 
 purposes directly to customers and indirectly through the 
 purchase of commercial paper and acceptances in the open 
 market. 1 
 
 We have seen that commercial banks do not now confine 
 their loaning operations to mercantile establishments, but 
 extend credit to all classes of enterprise, industrial and financial 
 as well as commercial; we have seen that some of then: unse- 
 cured loans are devoted to fixed capital purposes this being 
 particularly the case with the state institutions, and we have 
 found that they make a huge volume of loans on collateral, a 
 large percentage of which is devoted to fixed capital purposes.* 
 It has Been noted that commercial banks now usually have 
 savings departments; 3 and it may be noted that many of them 
 also have investment banking or bond departments. Some of 
 the largest commercial banks of the great financial centers are 
 extensively engaged in underwriting activities, while many of 
 the state commercial banks are actively interested in the 
 financing of urban real estate operations, particularly the con- 
 struction of apartment buildings. Investment banks nowadays 
 frequently have commercial banking departments; while even 
 the commercial paper houses have in some instances, at least, 
 broadened the scope of their operations to include underwriting 
 and bond distribution. Finally, in our study of trust com- 
 
 1 See chap, xviii, particularly the financial statements on pp. 328 
 and 333-34 above. See also pp. 731-32 below. 
 
 1 See chap. xxi. a See pp. 334-35 above.
 
 FINANCIAL INTEGRATION 725 
 
 panics we have seen that the laws now permit them to engage 
 in a great variety of financial operations, including trustee- 
 ship, agency, suretyship, and both investment and commercial 
 banking. 1 
 
 In a general way it is, therefore, already clear that there is 
 in fact no such clean-cut specialization among financial insti- 
 tutions as has been commonly supposed. But if we are fully 
 to appreciate the extent to which integration has been carried 
 out in the financial world and the reasons for this trend, it will 
 be necessary to study the development of the trust company 
 as a type of financial institution and to indicate the effects of 
 this development upon the operations of commercial banks. 
 
 I. CAUSES OF THE GROWTH OF FINANCIAL 
 INTEGRATION 
 
 While the laws of most states did not in the early days 
 give to trust companies specific power to engage in commercial 
 banking operations, the opportunity to increase their profits 
 by accepting demand deposits and making short-time loans 
 was so enticing that these institutions gradually assumed the 
 functions of discount and deposit. This of course brought 
 them into direct competition with national and state commercial 
 banks, which were denied the power to engage in trust company 
 business; and for a generation vigorous opposition was waged 
 by the commercial banks to this "unwarranted" invasion of 
 their sacred field of enterprise. It was contended, moreover, 
 that this broadening of the scope of trust company operations 
 was as dangerous as it was illegitimate. Numerous cases came 
 before the courts and at first the decisions supported the con- 
 tention that commercial banking was not a legitimate field of 
 trust company operation. But as the trust companies of 
 various states continued to extend the commercial side of their 
 business, the state courts gradually came to accept the move- 
 ment as inevitable. 2 
 
 1 See also statement on p. 762 below. 
 
 1 See Tso Hang Mai, The Banking Functions of Trust Companies 
 (a Master's thesis of the University of Chicago), 1930.
 
 726 
 
 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 It was during the decade of the eighties that the trust 
 companies first actively engaged in the commercial banking 
 business. Flying in the face of banking theory and the power- 
 ful opposition of the commercial banks, both state and national, 
 the trust companies continued to expand the commercial side 
 of their business and to grow with amazing rapidity. It will be 
 seen from the charts on pages 359-60 that while the number of 
 trust companies is still much smaller than the number of 
 national and state banks, the rate of increase has been quite as 
 rapid, more rapid indeed than that of the national banks; and 
 that the average size of trust companies is about three times 
 that of national and twelve times that of state banks. The 
 greater number of national and state banks, particularly of 
 the latter, is largely attributable to the fact that until recently 
 the trust company has found a remunerative field of enterprise 
 only hi the larger cities a fact which is also the explanation 
 of the large average size of the trust company. In the last few 
 years, however, the number of trust companies has been rapidly 
 increasing in the smaller cities. 
 
 That the rapid growth of the trust companies has not 
 been confined to the investment and trust features of the 
 business may be seen from the following statistics of deposits in 
 trust companies, and in state and national banks respectively 
 in the year igiS: 1 
 
 CHARACTER OF DEPOSITS IN COMMERCIAL BANKS AND 
 TRUST COMPANIES 
 
 (In millions of dollars) 
 
 
 Trust Companies 
 
 State Banks 
 
 National Banks 
 
 Demand deposits 
 
 $2,215 
 I,5 2 3 
 2,323 
 
 $2,929 
 2,098 
 1,087 
 
 $7,838 
 2,344 
 
 Time deoosits 
 
 Not classified* 
 
 Total deposits 
 
 
 *S,97i 
 
 $6,114 
 
 $10,182 
 
 
 *Some state institutions do not differentiate in their reports between time and 
 demand deposits. 
 
 1 Report of the Comptroller of the Currency, H (1918), 170, 794, 818.
 
 FINANCIAL INTEGRATION 
 
 727 
 
 It will be noted that the deposits of trust companies, both 
 demand and time, compare favorably in volume with those of 
 the commercial banks. Quite as significant in indicating the 
 growing similarity of commercial banks and trust companies 
 are the comparative figures of time ' deposits, which show 
 conclusively that the liabilities of commercial banks are far 
 from being exclusively of a demand nature. 
 
 The following statistics on the loans of the various types of 
 institutions afford further evidence of the same trend: 1 
 
 CHARACTER OF LOANS IN COMMERCIAL BANKS AND 
 TRUST COMPANIES 
 
 (In millions of dollars) 
 
 
 Trust 
 Companies 
 
 State 
 Banks 
 
 National 
 Banks 
 
 Loans secured by farm lands, 
 and other real estate 
 
 $ 556 
 
 $20 1 
 
 $ 185 
 
 Loans secured by collateral other 
 than real estate 
 
 lidos 
 
 4O3 
 
 3,8^8 
 
 All other loans 
 
 2,378 
 
 4,041 
 
 5.0l8 
 
 
 
 
 
 Total loans and discounts. . 
 
 $4,399 
 
 $4,734 
 
 $9,941 
 
 The extraordinary growth of the trust companies is largely 
 attributable to the inherent competitive advantages of the non- 
 specialized type of financial institution. The fact that many 
 types of financial operations are conducted in one building and 
 under one management makes possible a most efficient utiliza- 
 tion of the financial resources of the institution, for by virtue 
 of the variety of services that are rendered, the officials of such 
 an institution can be more closely in touch with all phases of 
 financial and business problems than can those of a specialized 
 institution. The analysis of the interrelations of financial 
 operations and of the interdependence of finance and business 
 that has been made in preceding chapters should make it 
 apparent that an institution which by the nature of its work 
 
 1 Report of the Comptroller aj ' tla,e Currency, II (1918), 144, 790, 814,
 
 728 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 must keep in touch with every aspect of the economic and 
 financial system would naturally be more far-seeing and hence 
 more efficient hi its management than would one which from 
 the nature of its operations was brought into contact with only 
 certain phases of the system. 
 
 The department-store type of financial institution also 
 has certain direct advantages hi attracting business. One class 
 of service naturally calls the attention of customers to the 
 other classes of service; each department reinforces the others. 
 
 If the trustee needs to deposit money, the banking department is 
 at hand; if the investor wishes to buy or sell, be it real estate, or 
 stocks or bonds, the corporation is ready; if the agent finds a pur- 
 chaser or a renter, that person is attracted toward the company; 
 if the depositor wishes any of the services of the company, he is made 
 to realize the helpfulness of his banker; if a new company is to be 
 opened up through promotion of the enterprises incident thereto, 
 then there is a distinct drawing of the general patronage in the 
 direction of the company; if the individual has any of the needs 
 which are supplied by the company in active life and business, he is 
 drawn to the company when he has a special trust to be performed 
 whether during his life or after death .... and so it is one interest 
 attracts another. 1 
 
 Aside from these administrative advantages the trust 
 companies have also possessed certain special advantages over 
 commercial banks because of the less rigid legal requirements 
 governing loans, reserves, etc. While there were undoubtedly 
 certain dangers attending such lax regulation, particularly 
 in view of the diversity of operations conducted, the trust 
 companies were nevertheless enabled so long as failures did 
 not shatter the public's confidence to earn very large profits. 
 And, on the whole, trust company failures have not been much 
 more common than those of state and national banks, the 
 number between 1893 and 1908 equaling .70 of one per cent 
 of the total number of trust companies, as compared with .61 
 and . 49 of one per cent for state and national banks respectively. 
 
 1 Bankers' Magazine (April, 1909), p. 637.
 
 FINANCIAL INTEGRATION 729 
 
 It is possible, however, that this comparatively good showing 
 of the trust companies may be attributed to the fact that the 
 commercial banks, particularly the national banks of the 
 reserve centers, were obliged to serve as the repositories of 
 cash which supported the entire credit structure, including 
 that erected on slender trust company reserves. 
 
 Commercial banks ultimately found it expedient to engage in 
 trust company operations. When the commercial banks found 
 it impossible to prevent the development of this "dangerous 
 and illegitimate" type of financial institution known as the 
 trust company, with interesting inconsistency they promptly 
 sought to extend the scope of their own operations to include the 
 whole range of trust business. This development in turn 
 incurred the enmity of the trust companies which henceforth 
 inconsistently exerted all possible influence to confine the 
 activities of commercial banks to their "legitimate" field of 
 financial enterprise. 
 
 But the drift toward financial integration could not be 
 checked; and by 1910 fifteen states had, in fact, granted to 
 commercial banks the power to accept and execute trusts. 
 While national banks were not successful in securing permission 
 to engage in trust company business until the passage of the 
 Federal Reserve law, they had, however, by devious methods 
 succeeded in engaging in trust company business long before 
 1914. The method most commonly employed was for the 
 managers of a national bank, or a state bank, in states where 
 commercial banks were not permitted to engage in trust com- 
 pany business, to organize an affiliated trust company, which 
 would be conducted with a "community of interest" with the 
 commercial bank. The common management of the Mercan- 
 tile Savings and Trust Company and the Mercantile National 
 Bank of St. Louis is an example. According to the Secretary 
 of the Treasury, MacVeagh, there were in 1911 some three 
 hundred cases of this sort. A second method was also fre- 
 quently practiced that of selling a majority of the stock of a 
 national bank to a trust company, thereby effecting in practice 
 a virtual consolidation of the two institutions.
 
 730 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 The Federal Reserve Act authorizes national banks to engage 
 in trust business. The facts as to the inevitable trend of 
 financial development were eventually looked in the face, 
 for we find that the Federal Reserve Act has empowered the 
 Federal Reserve Board to grant by special permit to national 
 banks applying therefor "when not in contravention of state or 
 local law, the right to act as trustee, executor, administrator, 
 registrar of stock and bonds, under such rules and regulations 
 as the said board may prescribe." Under this authorization 
 a number of national banks promptly made application for 
 permission to assume trust functions. 
 
 This threatened deprivation of the special advantages so 
 long enjoyed by trust companies, led them to charge that the 
 Federal Reserve authorization was unconstitutional, and two 
 test cases were shortly brought before the state courts, in 
 Illinois and Michigan. Both decisions, handed down in 
 December, 1915, and September, 1916, respectively, held that 
 the granting of trust powers to national banks was unconsti- 
 tutional. But upon appeal to the Supreme Court of the 
 United States, the decisions were reversed and congressional 
 authority to grant trust powers to national banks was con- 
 clusively established, the issue being decided on the principle 
 of implied powers laid down in the famous case of McCulloch 
 versus Maryland. 
 
 State commercial banks are also being granted trust powers. 
 One further step was required to make department-store bank- 
 ing a universal phenomenon in the United States; for there 
 were still many states that had not granted trust powers to 
 commercial banks. Unable longer to withstand the tide, 
 the New York legislature, on July 9, 1919, amended the state 
 banking law and gave to the Superintendent of Banking the 
 power to grant to banks applying therefor the right to "act as 
 trustee, executor, administrator, registrar of stocks and bonds, 
 guardian of estates, trustee and receiver of estates of lunatics, 
 or in any other fiduciary capacity in which trust companies 
 are permitted to act." It is believed that the remaining 
 states will promptly fall into line.
 
 FINANCIAL INTEGRATION 731 
 
 There has been a similar integration in the field of savings 
 banking. Attention has elsewhere been directed to the assump- 
 tion of savings bank functions by commercial banks and to the 
 specific recognition by the Federal Reserve law of the existence 
 of savings accounts in national banks. 1 The truth is that during 
 the last ten years the volume of savings accounts in savings 
 banks has increased only about 10 per cent; while that in 
 state and national commercial banks has increased 20 and 
 35 per cent respectively. Moreover, the volume of savings 
 accounts in all commercial banks now constitutes over 40 per 
 cent of the total savings deposits in the United States. 
 
 We have also seen that in recent years the savings banks 
 have invaded the field of commercial banking, and that in 
 consequence the problem of savings bank management is now 
 very nearly identical with that of commercial bank manage- 
 ment. Most savings bank deposits are in fact payable on 
 demand; and it is recognized that the maintenance of liquid 
 assets, 2 or of a ready access to the reserve resources of com- 
 mercial banks is a first requisite in sound savings bank 
 management. 
 
 This integrating movement in the field of savings banking 
 has passed through practically the same stages as the trust 
 company development. Just as the commercial banks resorted 
 to the courts to prevent the encroachment of trust companies 
 upon their "legitimate" field of enterprise, so the savings banks 
 appealed to the courts for protection when the commercial 
 banks first began to invade their financial preserves; 3 and just 
 as the commercial banks, when they could not prevent the 
 usurpation of commercial banking functions by trust companies, 
 retaliated by entering the field of trust enterprise, so in like 
 manner the savings banks unable to check the invasion of 
 
 1 See pp. 334-35- 
 
 3 See pp. 341-43. In the light of this recognition many states have, 
 during the last few years, legalized bank acceptances as savings bank 
 investments. 
 
 a See, for example, The People v. Binghamion Trust Company, 139 
 New York, 185 (1890).
 
 732 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 their traditional field by the commercial banks (and of course 
 by the trust companies), have broadened the scope of their 
 operations by taking over commercial banking functions. They 
 are, moreover, now aspiring to assume trust functions as well. 1 
 
 II. POSSIBLE DANGERS OF DEPARTMENT-STORE 
 BANKING 
 
 It has been urged by some that department-store financial 
 institutions contain elements of serious weakness and that 
 great care must be taken if we are to avoid a substantial deterio- 
 ration in banking methods. There are two grounds for this 
 contention. First, it is urged that such an institution becomes 
 a Jack-of -all-trades and master of none that "only by speciali- 
 zation can the highest efficiency be attained." A sufficient 
 answer to this contention, at least with large institutions, 
 appears to lie in the fact that there may be just as efficient 
 management of the specialized departments of a single business 
 as of specialized distinct businesses. And in addition, as we 
 have already seen, there is a decided advantage in bringing to 
 bear upon the organization of the institution as a whole the 
 varied knowledge and ability of the different department 
 managers. The slightly greater percentage of trust company 
 failures in the past is not to be attributed so much to the 
 diversity of functions performed as to the low reserve 
 requirements and other lax regulations imposed by state laws 
 in the past. 
 
 Of more significance, however, is the possibility that such 
 an institution might fail to keep the accounts of the different 
 departments separate and to conduct each department on the 
 principles demanded by the nature of its particular type of 
 operation. Mindful of this possibility, the Federal Reserve 
 Board requires of the national banks exercising trust company 
 powers that "the funds, securities, and investments held in 
 
 1 For a study of integration in the field of savings banking see W. K 
 Tang, Savings Bank Development in the United States (a Master's thesi- 
 at the University of Chicago), 1920.
 
 FINANCIAL INTEGRATION 733 
 
 each trust shall be held separate and distinct from the general 
 funds and securities of the bank, and separate and distinct 
 one from another. The ledger and other books kept for the 
 trust department shall be entirely separate and apart from the 
 other books and records of the bank." 
 
 If the legal regulations governing the operations of the 
 various types of financial institutions are sound and if through 
 regulation and supervision we make certain that the work of 
 each department shall be conducted on correct principles, there 
 would seem to be little occasion for concern over the future 
 efficiency of our department-store financial administration. 
 
 III. THE UNIFICATION OF THE BANKING SYSTEM 
 
 The development of banking, as of other economic insti- 
 tutions in the United States, has been profoundly influenced 
 by our dual system of government. We have already seen 
 that until the period of the Civil War our banking system was 
 quite chaotic because of the diverse legal regulations or 
 absence of them in the different states of the Union. With 
 the establishment of the national banking system we secured a 
 uniform bank note currency and, so far as the national banks 
 were concerned, uniform regulation of banking operations. 
 But the diverse regulations of state banking still persisted. 
 Moreover, in consequence of the lessening importance of the 
 note issue function of commercial banks and the greater range 
 of powers generally granted under state banking laws, state 
 banks increased in number after 1885, as is indicated in the 
 chart on page 354, even more rapidly than did national banks. 
 
 There is undoubtedly something to be said for this dual 
 system in that it has given a greater scope for experimentation 
 in banking than would otherwise have been possible. For 
 example, the development of the department-store type of 
 financial institution would probably not have been possible 
 if all financial institutions had been chartered from the beginning 
 by the national government ; and certain it is that the extension 
 of the privilege of making loans (within limitations) by national
 
 734 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 banks on real estate would long have been delayed had it not 
 been for the competitive influence of state banks, which have 
 always been permitted to loan at least a portion of their funds 
 for such purposes. The establishment of the Federal Reserve 
 System, however, revealed a striking weakness in our banking 
 organization, one inherent in the dual system of government. 
 
 Under the simple conditions of industry that prevailed in 
 colonial days the regulation of banking could well be conceived 
 as essentially a local or state problem. But with the evolution 
 during the nineteenth century of our system of large-scale 
 interdependent industry which is intimately interwoven with 
 the delicately adjusted financial structure, the problem of 
 banking organization and control has been entirely changed. 
 The interdependence of financial institutions, as we have 
 repeatedly seen, is a striking characteristic of the credit system; 
 whether under state or federal law, whether engaging in opera- 
 tions intra-state or inter-state, the failure of any important 
 bank has its effect upon the entire banking and credit structure. 
 
 When the Federal Reserve Act, therefore, undertook to 
 mobilize the nation's resources and to prevent the recurring 
 collapse of the credit system in times of panic, as well as to 
 minimize the ebb and flow of business activity, it was apparent 
 that the lack of confol >ver state financial institutions was a 
 matter of serious concern. How could a system half-organized 
 and half-unorganized, survive the credit strains of a period of 
 financial crisis and how could such a system effect any substan- 
 tial control during the upward swing of the business cycle ? 
 In a word, how could a financial house divided against itself 
 stand ? 
 
 The admission of state banks into the Federal Reserve System 
 has strengthened the credit structure. The Federal Reserve Act 
 made possible the entrance of state banks and trust companies 
 into the Federal Reserve System under conditions to be for- 
 mulated by the Federal Reserve Board. And in order to 
 strengthen the financial structure as much as possible the 
 board early prepared and issued regulations relating to the 
 admission of state banks to membership in the Federal Reserve
 
 FINANCIAL INTEGRATION 735 
 
 System. Foreseeing the impossibility of inducing state insti- 
 tutions to enter the system if the broad powers that had been 
 conferred upon them under state laws were curtailed, the 
 Federal Reserve Board felt that the conditions of membership 
 should not preclude state institutions from exercising their 
 statutory rights under state laws as before. For example, 
 they are therefore permitted to make loans on real estate 
 security without regard to the restrictions imposed upon the 
 making of such loans by national banks; although the Board 
 reserved the right to refuse entrance into the system to a state 
 bank which had so large a percentage of its loans invested in 
 real estate as to impair, in the view of the Board, its liquid 
 condition. The state banks were also given permission to 
 withdraw from the system on a year's notice if after trial they 
 did not find membership advantageous. 
 
 A vigorous effort was made on the part of the Federal 
 Reserve Board to induce the state banks to join the system. 
 The great advantages of membership were pointed out; and 
 veiled threats were made to the effect that in case the state 
 banks did not join, in time of crisis they would be unable to 
 secure any assistance in meeting the strain to which they would 
 be subjected. But until after the United States had entered 
 the European war the state banks were very reluctant to 
 associate themselves with the Federal Reserve System. The 
 arguments, misconceptions, and prejudices which explain their 
 refusal to take early advantage of the opportunity to enter 
 the system are best presented in the words of a state banker, 
 as follows: 
 
 There are many reasons why state banks and trust companies 
 should act with great deliberation with reference to entering the new 
 Federal Reserve Banking System, and I will undertake to mention a 
 few of them very briefly. 
 
 First, the law is made for national banks only. Until it shall be 
 so amended as to be helpful and not detrimental to state banks and 
 trust companies they should remain out of the system. 
 
 Second, those entering the new system will probably be subject 
 to double examinations, both state and national, double reports,
 
 736 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 conflicting laws, unusual expenses, and a curtailment of privileges 
 now enjoyed under state laws. 
 
 Third, at the present time state banks and trust companies are 
 able to supply needs in their various communities for the develop- 
 ment and promotion of business that cannot be supplied by national 
 banks. This then brings us face to face with the best protection of 
 the public and the fullest development of the country. The new law 
 appears to me to have been especially constructed for and is now 
 being administered largely for the benefit of big business and big 
 undertakings. It has no functions thus far developed that appeal 
 personally and directly to the small business man, merchant, small 
 farmer, small stock-raiser, small manufacturer, or plain ordinary 
 citizen. Of course, by aiding the large institutions, the system will 
 probably indirectly aid the small ones. 
 
 In the fourth place, commercial paper is the great and important 
 item to be used for rediscounts at the Federal Reserve banks. This 
 can be issued and is issued only by large concerns moving great 
 quantities of merchandise or products and receiving quick returns 
 on the same in cash. Theoretically this is fine, but unfortunately 
 all of the business of the country is not and cannot be turned over 
 inside of thirty, sixty, or ninety days. There should therefore be 
 some financial institutions in the country that can take on at least a 
 limited amount of such business which is sound, safe, and secure, 
 but not as quickly liquid as the preferred classes mentioned in the 
 reserve bank act. 
 
 Fifth, customers of country banks know very little about making 
 statements, and it would be very difficult for a country bank to meet 
 the "red-tape" requirements of the Federal Reserve banks when 
 discounts are needed. A statement must be filed for the maker of 
 each note offered for rediscount, certain application blanks must be 
 filled out and filed, and a great deal of necessary routine gone through 
 before a loan can be secured or paper rediscounted. I believe the 
 small member banks and non-member banks must rely, as heretofore, 
 largely upon their correspondents in the larger centers to supply them 
 with funds as needed for emergencies. Fortunately, such banks do 
 not need accommodations very often. 
 
 Sixth, it would be very dangerous to place the entire banking 
 business of the country under the control of a federal board at Wash- 
 ington. No other free country that I know of has ever succeeded in 
 forcing all banking institutions to come under absolute governmental 
 control.
 
 FINANCIAL INTEGRATION 737 
 
 Is it not unwise to take on the risks and the obligations entailed by 
 becoming members of the reserve system when it is not necessary to 
 do so ? While there are benefits and advantages to those banks that 
 are members of the system, these are more or less counterbalanced 
 at this time by the risks, curtailment of privileges, limitation of func- 
 tions, added expenses, and other disadvantages offered by the system. 
 
 State banks and trust companies are in a very fortunate position, 
 both for themselves and for their patrons, in being able to stand aside 
 during the formative period we might say the experimental stage of 
 the new national banking system and steady the financial ship while 
 the national banks trim their sails and adjust their craft to suit the 
 current of the new stream. These twenty thousand or more state 
 banks and trust companies, remaining serene and undisturbed, are 
 able to take care of their business in the usual way, co-operating at all 
 times in a most friendly and patriotic spirit in bringing the new 
 national system to its highest efficiency and most perfect state of 
 usefulness. 1 
 
 Shortly after the entrance of the United States into the 
 war a new drive for securing the membership of the state banks 
 was undertaken. Mobilization was the task of the time, 
 mobilization of the army and navy, mobilization of manpower 
 and womanpower, mobilization of labor, mobilization of 
 industrial resources. Why not, therefore most important 
 of all mobilization of the nation's financial resources ? Presi- 
 dent Wilson seized the psychological opportunity and issued 
 a stirring appeal to state bankers to join the Federal Reserve 
 System and thereby to effect a complete mobilization of the 
 banking resources of the United States. He urged "that 
 co-operation on the part of the banks is a patriotic duty at 
 this time and membership in the Federal Reserve System is 
 a distinct and significant evidence of patriotism. " 
 
 While this appeal doubtless had no little effect, the credit 
 strain to which the individual banks were already subjected 
 was probably a more potent influence in inducing the state 
 banks to affiliate with the Federal Reserve System. The 
 expanding volume of business conducted at ever-increasing 
 
 1 Frank N. Briggs, adapted from an address before the Colorado 
 Bankers Association, June 30, 1915.
 
 738 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 prices as explained in chapter xxvi necessitated access, 
 directly or indirectly, on the part of the state banks to the 
 central repositories of reserve money. The apathy that had 
 previously prevailed with reference to the rediscount privilege 
 was thus changed as if by magic to the liveliest interest. It 
 had become highly profitable to affiliate with the Reserve 
 System. 
 
 The number of state banks and trust companies that had 
 been admitted to membership in the Federal Reserve System 
 by August i, 1920, was 1,401, having a total capital and surplus 
 of $986,045,028, with combined resources of $9,840,912,065. 
 Although only about one-fifteenth of the total number of state 
 banks have as yet become members of the Federal Reserve 
 System, about one-third of all the state banking resources are 
 now joined with the system, since nearly all the large state 
 institutions, including trust companies, have entered the fold. 
 
 We shall no doubt ultimately find, therefore, that the growth 
 of department-store banking and the development of the 
 Federal Reserve System as a means of controlh'ng the credit 
 mechanism and rendering it subservient to the varying require- 
 ments of business, will have given us a unified and genuinely 
 national system of finance. While there has been little suggestion 
 as yet that savings banks should be admitted to membership in 
 the Federal Reserve System, in view of the growing similarity 
 of the business conducted by savings and commercial banking 
 institutions, it is difficult to find any good reason for excluding 
 them. On the contrary, the admission of savings banks to 
 membership in the Federal Reserve System and the extension 
 to them in times of emergency of the privileges of rediscount, 
 would appear to add one more pillar of strength to the financial 
 structure. 
 
 QUESTIONS FOR DISCUSSION 
 
 1. To what extent do the banks with which you are familiar specialize 
 in some particular form of financial enterprise ? 
 
 2. Do you imagine that some one department of a non-specialized 
 institution is of paramount importance, with the others merely 
 incidental, or that all are of relatively equal importance ?
 
 FINANCIAL INTEGRATION 739 
 
 3. If you were to organize a bank of ample resources, how many 
 departments would you create? What conditions would 
 determine your policy in this connection ? 
 
 4. Examine the mutual and stock savings bank balance sheets on 
 pages 328 and 333-34 and estimate the relative importance of 
 the commercial business in each class of savings institution. 
 
 5. Do savings bank balance sheets show whether the bank conducts 
 a bond or trust department ? 
 
 6. Would the balance sheet of a trust company indicate the extent 
 of (a) its trust business (of the various types); (ft) its under- 
 writing activites; (c) its savings business? 
 
 7. Does the balance sheet of a commercial bank indicate (a) its 
 savings business; (ft) its bond transactions; (c) its trust business ? 
 
 8. What conclusions do you draw from a study of the tables on 
 pages 726 and 727 ? 
 
 Q. "The tendency toward financial integration is caused by the 
 same forces that have produced integration in industry." Dis- 
 cuss this statement. 
 
 10. Draw up a list of the advantages of the department-store type of 
 financial institution. Draw up a list of the disadvantages. 
 
 n. "All that is necessary to safeguard department-store banking 
 is to require the operations and accounts to be kept entirely 
 separate. " Why ? 
 
 12. "It is only in the larger cities that the department-store type 
 of institution could prove successful. " Do you agree ? 
 
 13. "In towns and smaller cities there is not enough financial business 
 to support several different types of financial institutions. If 
 the community is to be adequately served with financial facilities, 
 therefore, a single bank must be permitted to do various kinds of 
 business. " What do you think of this statement ? 
 
 14. How do you account for the fact that financial legislation origi- 
 nally intended to force the development of specialized financial 
 institutions ? 
 
 t v How do you account for the fact that writers on the theory of 
 banking have usually written as though the different types of 
 financial operations were conducted by specialized institutions ? 
 
 1 6. "The enormous profits from promotions, underwritings, and 
 security purchases in the investment field have led to a revolu- 
 tionary change in the conduct of our leading banking institutions. 
 It was obvious that control by the investment bankers of the
 
 740 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 deposits in banks and trust companies was an essential element in 
 their securing these huge profits. And the bank officers naturally 
 asked, 'Why, then, should not the banks and trust companies 
 share in so profitable a field ? Why should not they themselves 
 become investment bankers, too, with all the new functions 
 incident to Big Business ? ' To do so would involve a departure 
 from the legitimate sphere of the banking business, which is the 
 making of temporary loans to business concerns. But the 
 temptation was irresistible. The invasion of the investment 
 banker into the bank's field of operation was followed by a 
 counter-invasion by the bank into the realm of the investment 
 banker." Do you regard this tendency as inimical to sound 
 banking ? 
 
 17. "Unquestionably the special temptation to which our banks are 
 now subjected is the temptation to turn from commercial to 
 financial banking; to change from the buying and selling of 
 commercial credit to investments in securities and loans extended 
 to promote financial enterprise ; in short, to change their business 
 from that of commercial banks to that of finance companies. 
 Concentration in banking, 1 which is going on at such a rapid rate 
 in New York, would not be open to much or any criticism if 
 such concentration was employed for the purpose of facilitating 
 the commerce of the country instead of being used in purely 
 financial undertakings. " Criticize this statement. 
 
 1 8. A few years ago the president of a large New York bank stated 
 in a public address that it was bad banking practice for a com- 
 mercial bank to invest its funds in anything but paper growing 
 out of short-time commercial transactions. At the time his own 
 bank's balance sheet showed "Investments in bonds, securities, 
 etc.," equal to nearly 25 per cent of the total "Loans and dis- 
 counts. " How do you account for his statement ? 
 
 19. How do you explain the development of savings departments by 
 commercial banks ? of bond distributing departments ? 
 
 20. Should the commercial paper house be allowed to invade the 
 field of investment banking ? 
 
 2 1 . Why does not the commercial paper house assume trust, saving, 
 and commercial banking functions? May it some day con- 
 ceivably do so ? 
 
 1 See pp. 761-62.
 
 FINANCIAL INTEGRATION 741 
 
 22. Why do the commercial banks not organize affiliated com- 
 mercial paper houses, as they do, in fact, organize affiliated 
 cattle loan companies ? 
 
 23. How do you explain the extension of commercial banking powers 
 to trust companies ? Do you think it was a mistake ? 
 
 24. How do you explain the active opposition of the commercial 
 banks to the invasion of their field by the trust companies? 
 Would the opposition have been as bitter as it was if the trust 
 companies had been subjected to as strict legislative regulation 
 and supervision as were the commercial banks ? 
 
 25. How do you account for the extension of trust powers to com- 
 mercial banks ? Do you think it unwise ? 
 
 26. How do you account for the opposition of the trust companies 
 to the entrance of national and state banks into the trust field ? 
 
 27. In what respects has the banking system been "unified" as a 
 result of recent banking legislation ? 
 
 28. How do you account for the persistent growth of state banking 
 in the United States? In what respects may this be regarded 
 as having had advantages ? Disadvantages ? 
 
 29. "The industrial and financial structure is essentially national in 
 scope. Therefore the control of our banking organization 
 should be exclusively vested in the national government." 
 Do you agree ? 
 
 30. "The phenomena of the business cycle conclusively demonstrate 
 the desirability of a unified banking organization. " If so, how ? 
 
 31. Do you regard any of the arguments advanced on pages 734-35 
 against the entrance of state banks into the Federal Reserve 
 System as sound ? How do you explain the advancing of such 
 arguments ? 
 
 32. Until the year 1916 nearly hal of the national banks of the 
 country were opposed to the Federal Reserve System. How 
 do you explain this fact ? How do you explain the recent 
 unanimous indorsement of the system by the American Bankers 
 Association, whose membership consists of both national and 
 state banks ? 
 
 33. "The financial system will not be completely unified nor sub- 
 jected to adequate government control until all forms of financial 
 enterprise are placed under the supervision of the federal govern- 
 ment." Review the charts on pages 136 and 650; re-read 
 pages 486-88; paragraphs 2 and 3 on page 529; and paragraph 2 
 on page 537 and then discuss the above statement.
 
 CHAPTER XXX 
 
 THE FINANCIAL SYSTEM AND THE GENERAL 
 ECONOMIC ORGANIZATION 
 
 Our study of the work of the various financial agencies 
 and institutions which together comprise the financial structure 
 of the modern economic system is now completed. It remains 
 to attempt in this final chapter a statement, however inade- 
 quate, of the significance of this financial structure from the 
 point of view of the general economic organization of which 
 it forms so integral and so important a part. What, in general, 
 are the elements of strength and of weakness in an economic 
 system that is organized on a pecuniary basis ? What problems 
 of economic or social control have resulted from the evolution 
 of the modern financial system? Does this system in all 
 respects give rise to a well-ordered economic life and to borrow 
 a statement of the ends and aims of human society that has 
 yet to be improved upon does it on the whole "promote the 
 greatest good of the greatest number" ? It is scarcely necessary 
 to say that a satisfactory or adequate answer to these questions 
 is impossible; all that can be attempted in this chapter is to 
 make some suggestive statements with reference to the economic 
 significance of the modern financial system and to the nature 
 of the unsettled problems of economic control to which this 
 system has given rise. 
 
 The economic services rendered by the various parts of the 
 financial structure have in preceding chapters been discussed 
 in connection with the work of particular financial institutions 
 and agencies. Here and there also in the course of the treatise 
 there have been some suggestions of the interrelations of 
 financial institutions of the development of a financial struc- 
 ture and of the larger significance of this financial system in 
 relation to the general economic organization by means of which 
 
 742
 
 FINANCE AND ECONOMIC ORGANIZATION 743 
 
 the wants of mankind are supplied. The analysis of the present 
 chapter will therefore consist in part of a drawing together of 
 the threads of our previous discussion. It is believed that such 
 a recapitulation, with the necessary elaboration and restate- 
 ment, will present a reasonably complete and accurate view of 
 the interdependence of finance and business of the relation of 
 the financial system to the general economic organization. 
 
 I. MERITS AND DEFECTS OF THE 
 PECUNIARY MECHANISM 
 
 The pecuniary system has undoubtedly rendered economic 
 services of the greatest importance. It will be recalled that 
 the evolution of the pecuniary unit rendered both language and 
 numbers intelligible for the purposes of business and thus fur- 
 nished the necessary basis not only for all trade but for all business 
 activity. In a very real sense the pecuniary unit of calculation, 
 together with the medium of exchange and the standard of 
 deferred payments, have not only made possible but have been 
 responsible for the development of our large scale co-operative 
 exchange society, which, with all its weaknesses and evils, is 
 almost universally conceded to be a highly efficient form of 
 economic organization, so far as its productive aspects are 
 concerned. It will also be recalled that the system of pecuniary 
 accounting stimulates and hastens the development of improved 
 productive processes and fosters industrial progress. 
 
 In the main it may also be said that the financial system has 
 been fairly responsive to changing business requirements. The 
 growing size of business establishments and the gradual uni- 
 versalizing of the credit method of conducting business has 
 been attended by a commensurate though often lagging 
 development of facilitating financial agencies and institutions. 
 Indeed the whole complex financial structure, pictured in the 
 charts on pages 134, 136, and 650, and discussed in the accom- 
 panying chapters, evolved to meet the needs of a rapidly 
 changing economic organization a changing organization for 
 which the motivating force was mainly the prior development of
 
 744 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 the pecuniary unit and the capitalistic form of . enterprise, 
 dominated by the spirit of gain. It will doubtless be conceded 
 that the various financial institutions thus developed, notwith- 
 standing the numerous weaknesses that have been pointed 
 out in the foregoing chapters, have, in view of the remarkable 
 rapidity with which the capitalistic industrial system has ex- 
 panded, fulfilled in reasonably satisfactory fashion the require- 
 ments imposed upon them. 
 
 The financial organization also has sbme very real short- 
 comings. At various places in the foregoing analysis attention 
 has been called to certain perversions and evils in the pecuniary 
 system. In chapter v, for example, emphasis was placed upon 
 the dominating and pervasive influence of the pecuniary system 
 over social and economic standards and ideals. It was seen 
 that the almost universal expression of modern economic 
 activities and achievements in pecuniary terms has led to an 
 exaltation of the significance of money that has done much to 
 pervert the ideals of society. While even under a non-pecuniary 
 system individuals would no doubt place great emphasis upon 
 things material; and while it is highly important to bear in 
 mind that the modern worship of the "almighty dollar" is in 
 a sense only the worship of the material goods which dollars 
 will buy, there is little doubt that the development of the 
 pecuniary system has tended to strengthen materialistic 
 impulses and to intensify the struggle for gain. The acquisitive 
 instincts of mankind appear to find greater encouragement as 
 well as fuller scope for development under a pecuniary system 
 than under any other suggested form of social organization. 
 
 Moreover, as we have seen, the importance to the individual 
 of a large supply of money has led to the all but universal 
 assumption that it is equally important that the nation as a 
 whole have a large and a rapidly increasing supply of money. 
 This fallacy has been responsible for numerous and persistently 
 recurring social movements for increasing, in one way or another, 
 the national supply of currency. All men are instinctively 
 mercantilists and all instinctively rejoice when the per capita 
 circulation increases; hence a not inconsiderable portion of
 
 FINANCE AND ECONOMIC ORGANIZATION 745 
 
 organized political activity in every country has centered 
 around the attempt to achieve through an increase in the 
 quantity of currency an improvement in economic conditions 
 which can come only through an increase of productive effi- 
 ciency. It remains true, however, as has been noted in various 
 connections, that the supply of currency as manifested in bank 
 reserves is at times a matter of no little significance. 
 
 Among the shortcomings of the pecuniary order we have 
 also noted the social and economic consequences of changes 
 in the level of prices. This is no doubt the most serious weak- 
 ness of the financial system. While no attempt has been made 
 in this treatise to discuss the complex forces which control 
 price movements in a capitalistic society, we have seen that 
 prices are in a more or less constant state of flux, with minor 
 oscillations in connection with the various stages of the business 
 cycle, and with major secular movements, as indicated in the 
 diagram on page 31. Price changes, as noted in chapter iii, 
 often cause very serious maladjustments in the incomes of 
 different classes of society and result in social discontent, which 
 on occasion may lead to a very general disorganization of 
 economic, social, and political life. The individual, compelled 
 to order his life in pecuniary terms and through pecuniary 
 agencies, is powerless to control his destiny in the face of price 
 movements that depend, so far as he is concerned, upon entirely 
 adventitious circumstances. 
 
 The modern business man also finds his productive activities 
 circumscribed at every point by financial considerations, over 
 many of which he has but little control. Sudden changes 
 either in the price of his particular product or in the general 
 level of prices may at one time give him exceptional profits and 
 at another bring him to the verge of bankruptcy. While price 
 movements may to some extent be forecasted and, in conse- 
 quence, preparations may be made for taking advantage of a 
 rise or for discounting the effects of a fall, it is seldom possible 
 to avoid all losses incident to price changes; and for the rank 
 and file of business men who are quite without knowledge 
 of the influences governing price movements, price changes
 
 746 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 constitute perhaps the most baffling problem with which they 
 have to deal. 
 
 Prices should be stabilized if possible. The economic and 
 social losses resulting from price changes have naturally given 
 rise to various suggestions for controlling or stabilizing the 
 level of prices. We cannot here enter upon a discussion of the 
 different methods proposed, or of the possibility of stabilizing 
 prices by any conceivable method. It must suffice to say that 
 as yet no method of general price control has been devised 
 which commands sufficient support hi government circles to 
 secure a thoroughgoing practical test. The method of price 
 stabilization that has attracted the greatest attention is that 
 advanced by Professor Irving Fisher, and known as the com- 
 pensated or stabilized dollar. Under this plan it is proposed 
 to vary the weight of the gold dollar hi which prices are 
 expressed, hi proportion to changes hi the number of monetary 
 units, thereby preventing variations in the general level of 
 prices. 1 Among students of money and prices this method of 
 price control has many supporters and numerous opponents. 
 Another method of price regulation lies in the control of the 
 supply of bank credit through the machinery set up by the 
 Federal Reserve System. This will be briefly considered on 
 page 753 below. 
 
 The price mechanism is not always a satisfactory guide to the 
 distribution of social energy. One of the most difficult problems 
 associated with the pecuniary system is that of maintaining 
 and developing, in periods of rising prices, our basic "quasi- 
 public" enterprises such as transportation and public utilities. 
 In a financially organized society, we rely upon price and profit 
 levels to direct the flow of labor and capital into the various 
 lines of enterprise. But owing to a fear of exploitation by 
 private interests in naturally monopolistic fields of enterprise, 
 society has assumed the control of rates (prices) hi such indus- 
 tries, with the inevitable result that in periods of rising prices 
 these enterprises are unable to compete with uncontrolled 
 industries for the necessary supply of labor and capital with 
 
 I See Irving Fisher, The Stabilized Dollar.
 
 FINANCE AND ECONOMIC ORGANIZATION 747 
 
 which to maintain and develop their properties. We rely upon 
 price and profit levels to guide industrial development and then 
 refuse to allow the mechanism to function freely in precisely 
 those fields of enterprise which are of greatest social importance. 
 Here is an inherent weakness in the system of distributing 
 social energy through pecuniary means. True, we are coming 
 to recognize that rates must be raised, in order to permit such 
 industries to live; but as yet the practical difficulties in the 
 way of a ready adjustment of rates to rising prices are such 
 that quasi-public enterprises are tremendously handicapped, to 
 the great detriment of the entire economic system. This 
 analysis, moreover, applies almost equally well to government 
 service and the public school system, where advances in salaries 
 are dependent upon increases in taxation which can be secured 
 only very tardily at the best. We have also noted the inherent 
 weakness of the financial mechanism in effecting a rapid and 
 thoroughgoing mobilization of economic resources for the 
 purposes of war. 1 
 
 One is tempted at this place to enter into a general discus- 
 sion of the adequacy of the price and profit mechanism as a 
 means of effecting the distribution of social energy, under 
 conditions where it is allowed free play subject to no govern- 
 mental interference in the form of price or rate control. Does 
 the price-and-profit method of industrial motivation always 
 promote social welfare? Does it, for example, have as its 
 goal "necessities for all before luxuries for any"? Does it 
 not often lead to the rapid and visionless exploitation of natural 
 resources ? Is it not in fact essentially a system where rela- 
 tively short-run pecuniary considerations govern, whereas the 
 promotion of national welfare requires essentially a long-run 
 point of view? Since these considerations are not, however, 
 exclusively of a financial nature, but involve the whole ques- 
 tion of individual initiative, private property, free competi- 
 tion, etc., they do not properly come within the scope of the 
 present treatise, which is concerned only with the pecuniary 
 aspects of the modern economic system, 
 
 1 See pp. 45-48 above.
 
 748 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 H. THE ROLE OF FINANCE IN MODERN 
 ECONOMIC ORGANIZATION 
 
 One of the most striking features of the modern economic 
 world is the institution of credit. Whether in commerce, 
 industry, or agriculture, modern business enterprise is almost 
 always dependent upon the use of borrowed funds; and, as we 
 have seen, the numerous financial agencies and institutions of 
 the present time have been developed largely for the purpose 
 of facilitating the raising of the fixed and working capital 
 required in the conduct of business. The evolution of this 
 "credit society," as it is often called, has resulted in creating an 
 economic organization in which all business enterprises, all 
 institutions, and all individuals share in a common dependence 
 upon the smooth working of an intricate and exceedingly 
 sensitive financial mechanism, over which they have little 
 control, either individually or collectively. 1 The chart on page 
 136 indicates that the borrowing corporations at the top are 
 dependent for the fixed capital required in developing their 
 properties upon the supply of funds procurable in a general 
 investment market, which, in last analysis, means upon the 
 diversion of individual incomes from consumptive spending to 
 the purchase of securities, either directly or through the inter- 
 mediation of savings institutions. (The role that commercial 
 banks play in the investment market should, however, be 
 recalled in this connection.) Similarly, for working capital, they 
 are dependent upon the commercial credit market, that is to 
 say, upon the commercial banking system and the supply of 
 liquid capital which it possesses. 
 
 Under ordinary circumstances, and considered individually, 
 no business enterprise, which is in a sound financial position, 
 need find this dependence a cause of any concern. But col- 
 lectively speaking, borrowing corporations not infrequently find 
 that the supply of credit both for fixed and for working capital 
 purposes is inadequate to their requirements either because 
 
 'Bankers are excluded here, to be considered in the section which 
 follows.
 
 FINANCE AND ECONOMIC ORGANIZATION 749 
 
 of an insufficient volume of saving, an outflow of reserve funds 
 from the country, an increase in the volume of business beyond 
 the credit capacity of the banks, or a rising price level which 
 requires a steadily expanding volume of liquid capital with 
 which to effect a given volume of production. Whatever the 
 particular cause, every individual business finds its productive 
 operations seriously hampered, and society as a whole suffers 
 in consequence of restricted output. Moreover, because of the 
 phenomena of the business cycle, itself a result of the evolution 
 of the credit system, there are times, as we have seen, when 
 the entire business and credit structure is completely disrupted, 
 resulting in unemployment for millions of persons and financial 
 failure for thousands of business concerns whose only fault lies 
 in being unfortunately placed in the economic system. 
 
 Business corporations and individual workers are dependent 
 upon the smooth functioning of the credit system not merely 
 for the regularity of profits and wages; as investors in corporate 
 securities they are also dependent upon it for the safety of their 
 savings and the perpetuity of interest payments. As the chart 
 on page 218 indicates, literally almost every individual and 
 every institution is, under modern conditions, vitally interested 
 as an investor in the efficient working of the financial system. 
 Corporations and other business concerns are obliged to invest 
 reserve and similar funds hi the securities of other corporations ; 
 banks, insurance companies, clubs, educational and charitable 
 institutions, labor union organizations, and trust estates all 
 are of necessity holders of corporate securities; and, under 
 a pecuniary order, the individual laborer or salaried man can 
 effect the savings required for sickness and age only through 
 the investment of pecuniary income, directly or indirectly, in 
 the bonds and shares of corporate enterprises. To a greater or 
 less degree all classes are thus mutually dependent upon the 
 efficient functioning of the pecuniary mechanism; all have a stake 
 in the promotion of financial solidarity and financial prosperity; 
 and, what is more significant, all have vested pecuniary interests 
 in the maintenance of the existing economic system.
 
 750 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 III. THE DOMINANT POSITION OF THE 
 FINANCIER 
 
 The evolution of the credit system has also resulted in 
 placing those who control the distribution of liquid capital in 
 a position of supreme importance in the modern scheme of 
 things; it has given rise to "a class of pecuniary experts 
 whose business is the strategic management of the interstitial 
 relations of the system." We have already indicated, in the 
 chapters on the marketing of corporate securities, that there 
 is lodged in the hands of investment bankers a substantial 
 measure of control in distributing the flow of labor and capital 
 among the various divisions of industry and among the different 
 establishments within any given field of enterprise. . We shall 
 presently have more to say with reference to this control under 
 conditions of large scale and highly concentrated finance and 
 business such as exist at the present time; but before entering 
 upon the discussion it is necessary to indicate, more precisely 
 than has been done in preceding chapters, the role that the 
 commercial banker plays in guiding and controlling industrial 
 activity. 
 
 In the making of loans for working capital purposes com- 
 mercial bankers, as we have seen, form their judgment as to 
 the safety of the loan on the basis of personal knowledge of 
 the applicant's moral integrity and of his financial ability and 
 resources, as revealed in a financial statement of condition. If, 
 in the judgment of the commercial bankers, a particular bor- 
 rower in a given line of industry is not entitled to credit, there 
 is little chance of his survival in competition with others whose 
 credit standing is unimpaired. Since the possession of adequate 
 working capital is quite as indispensable as the possession of 
 fixed capital, the commercial banker thus in a sense holds the 
 veto power over the decision of the investment banker, even 
 as the investment banker holds the veto power over the decision 
 of the manager of a corporation which is seeking to raise fixed 
 capital. And certainly, it will be observed, the dependence of 
 almost every business upon both investment and commercial
 
 bankers results in giving to these financiers a preponderant 
 influence in the control of the development of industry. 
 
 The influence of the commercial bankers is of particular 
 importance by virtue of the fact that their relations with 
 borrowers are usually continuous, rather than intermittent. 
 Since they are called upon to furnish credit year in and year 
 out, it is necessary for the commercial bankers to scrutinize 
 continuously the financial status of their customers; accord- 
 ingly, they are privy to the most intimate affairs of producers, 
 manufacturers, and distributors of goods, as well as of those 
 who are engaged in financial or speculative activities. They 
 find it expedient to give advice and counsel in the formation 
 of business policies; and because of their control of the requisite 
 financial resources, they are commonly in a position to exercise 
 a restraining influence. Moreover, when occasion arises they 
 can withhold credit and compel a financial reorganization of a 
 business and a change of management and policies. Whether 
 such financial power will be exercised for good or for ill with 
 or without sinister intent obviously depends upon the per- 
 sonnel of the banking profession. On the whole, there has been 
 remarkably little legitimate criticism leveled against the control 
 over commerce and industry by commercial bankers. One of 
 the oldest of business professions, the banking fraternity, has 
 developed a tradition that it is a duty to exercise the great 
 power which it possesses without fear or favor and in such 
 ways as to promote the development of sound business enter- 
 prise. Everyone with business experience can of course cite 
 instances where this tradition has not been realized; but such 
 cases are undoubtedly the exception rather than the rule. 1 
 
 The control of credit by individual bankers proved inadequate 
 for the requirements of the modern business cycle. The analysis 
 in chapters xxiii and xxiv revealed a very striking weakness in 
 the system of banking control over business. With the evo- 
 lution of our delicately adjusted interdependent credit system 
 national and international in scope it became impossible for 
 
 x But see pages 764-65.
 
 752 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 bankers, acting as individuals, to exercise the degree of control 
 over general business conditions that was required. While any 
 particular banker might withhold or extend credit to his indi- 
 vidual customers in accordance with their respective moral and 
 financial merits, under our decentralized banking system bankers 
 in general could not, however, control business in general, in 
 accordance with the requirements of the various stages of the 
 business cycle. The result, as we have seen, was a periodic 
 disruption of the entire credit structure. The supersedure of 
 this decentralized method of banking control by a system of 
 government supervision, vested in the Federal Reserve Board, 
 has resulted in materially lessening the functions of the private 
 financier in the control of business, and has brought into 
 existence a body of what may be called public financiers, whose 
 influence over economic affairs is of far-reaching importance. 
 
 Extraordinary economic power has been vested in the Federal 
 Reserve Board. It is the duty of the Federal Reserve Board 
 and of the directors of the Federal Reserve banks to so control 
 the operation of economic and financial forces in connection 
 with the business cycle that financial panics may be eliminated 
 and the extent of the fluctuations in business activity may be 
 substantially lessened. To this end there has been lodged in 
 their hands a control over interest rates and over the supply of 
 credit that enables them to wield a tremendous influence over 
 general business conditions. It should be recalled that by 
 virtue of the dominant place that commercial banking occupies 
 in the entire financial and business structure, the control of the 
 Federal Reserve Board extends to the utmost confines of the 
 economic organization. Concretely, the fixing of very high 
 interest rates and the restriction of credit can precipitate a fall 
 in general prices, a great contraction of the volume of business 
 and consequent decline of profits, a reduction of wages, and a 
 great increase in the volume of unemployment, together with 
 a collapse of stock-market values, a limitation of the activities 
 of underwriters and bond distributors, and an unsettling of the 
 entire credit system; and conversely, by a policy of very low 
 discount rates, together with the release of all restrictions
 
 FINANCE AND ECONOMIC ORGANIZATION 753 
 
 on credit extension, as a means ot encouraging business opti- 
 mism, the Federal Reserve Board is frequently though not 
 under all circumstances in a position to stimulate business 
 activity, increase profits and wages, give steady employment 
 to all who care to work, and facilitate the marketing of invest- 
 ment securities and the financing of new business enterprises. 
 Because of the nature of the modern pecuniary and credit 
 system, as revealed in the phenomena of the business cycle, 
 such a stimulation of business activity, however, always eventu- 
 ally leads to rising prices, unaccompanied by a continuous 
 increase in the output of wealth, and culminates in an economic 
 crisis, followed by an era of liquidation and a readjustment of 
 prices and business conditions generally. Such enormous power 
 and so great a responsibility have never before, in this country, 
 been conferred upon any group of individuals. 
 
 The measure of control that may conceivably be exercised 
 by the Federal Reserve 'Board in stabilizing prices and in 
 minimizing the ebb and flow of business activity is open to a 
 great deal of question. The experience of European countries, 
 where the directors of the Central banks have long held a posi- 
 tion in the European financial and business world similar to that 
 occupied by the Federal Reserve Board in the United States, 
 throws no little light on the problem. In brief, it has been 
 possible for the European Central bank directors to prevent 
 acute financial panics and to control in some degree the extent 
 of the upward swing of the business cycle. But they have by 
 no means been able to control prices, or to eliminate or even 
 greatly reduce the ebb and flow of business activity, and thus 
 to usher in the "normal" or static state which is at once the 
 point of departure and the goal of classical economic analysis. 
 In the face of the financial requirements of war, moreover, the 
 European Central banks as well as our own Federal Reserve 
 System, have found it practically impossible to prevent a very 
 general disruption of the entire price and credit system. 
 
 While the centralization of financial control in the hands of 
 the Federal Reserve Board will likewise doubtless result in 
 preventing panics and in lessening somewhat the oscillation of
 
 754 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 business, judging from experience there is little ground foi 
 hope that it can give us either stable prices or continuous 
 prosperity. The extent of the influence that can thus be 
 exerted will, moreover, largely depend upon the wisdom and 
 impartiality with which the vast power that has been 
 placed in the hands of the Federal Reserve Board is utilized; 
 and this in turn will depend upon the degree of knowledge 
 which its members possess of the working of the complex 
 economic forces that operate in the modern capitalistic and 
 industrial system, as also upon their freedom from the influence 
 of either personal or political considerations. 
 
 IV. INTERNATIONAL ASPECTS OF FINANCIAL 
 ORGANIZATION 
 
 Of necessity this .volume has been largely devoted to a 
 discussion of the financial organization of society as revealed 
 in the United States of America. While here and there reference 
 has been made to the financial institutions of other nations, 
 there has been no attempt to make a comparative study of the 
 financial systems of different countries, nor has it been an 
 essential part of our task to indicate the relationship of the 
 financial system to the world-aspects of modern economic 
 organization. At a few places in the treatise, however, we have 
 necessarily been drawn into a discussion of certain phases of 
 the system of international finance. In the chapter on the 
 foreign exchanges we saw how international commercial and 
 financial obligations are largely canceled through the use of 
 bills of exchange; how the world-supply of metallic currency 
 is ordinarily distributed among the various nations of the 
 world in rough accordance with their relative needs; and, how 
 the international financial equilibrium is maintained through 
 the operation of the foreign-exchange mechanism. And in 
 chapter xvi we considered some of the economic and social 
 consequences to the world as a whole of the overturning of the 
 international financial equilibrium and the dislocation of the 
 international financial structure that were caused by the 
 requirements of the Great War.
 
 FINANCE AND ECONOMIC ORGANIZATION 755 
 
 We have also seen in various connections that the system 
 of interdependent credit relations is now world-wide in scope. 
 When the great speculative mania in the Argentine in the 
 decade of the eighties, accompanied by the issue of vast quan- 
 tities of irredeemable paper currency, collapsed in 1890 it 
 resulted in the failure of one of the greatest international bank- 
 ing houses of England, all but precipitated a general financial 
 panic in Europe, and led to a very serious unsettling of American 
 financial conditions. Similarly, financial difficulties in Japan 
 and Egypt in 1906 contributed to the forces that were bringing 
 on the American panic of 1907, while the repercussions of this 
 panic in the United States were felt in every market of the 
 world. In a word, business cycles are world-phenomena and 
 the modern financial structure is essentially international in its 
 scope. The world has reached a point in the development of 
 its organized economic activities where national boundaries are 
 of relatively little significance, notwithstanding the numerous 
 economic barriers that have been erected by political states. 
 
 A very interesting result of the development of an inter- 
 national financial structure was strikingly suggested ten years 
 ago by Normal Angell in The Great Illusion. The illusion, as 
 Mr. Angell saw it, was the belief that modern warfare pays, 
 and he proceeded to demonstrate that in consequence of the 
 interlocking financial systems of modern nations, even a success- 
 ful war would inevitably result in economic loss to the victor 
 as well as to the vanquished. While it may be true that the 
 victor, notwithstanding certain absolute losses, may possibly 
 emerge in a relatively stronger position than the vanquished, 
 the present chaotic conditions in all the European belligerent 
 nations and the practical difficulties in the way of the settlement 
 of international financial obligations and indemnities constitute 
 fairly conclusive proof that modern war is bad business for all 
 concerned. 1 Germany can pay indemnities to France, in the 
 
 'It needs reiterating that Mr. Angell did not contend, as so many 
 of his critics state, that war was no longer possible; he merely argued 
 that it did not pay, and he believed that if knowledge of this fact were 
 disseminated it would constitute an important barrier against international 
 conflict.
 
 756 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 main, only by the export of goods to France; but French 
 industry is unwilling to submit to this competition in its own 
 markets, or even in foreign markets where conceivably Germany 
 might be able to pay by roundabout methods. In similar 
 fashion, Europe can pay her large war indebtedness to the 
 United States only by diminishing her imports from, and 
 increasing her exports to, this country. Are the American 
 people willing that these obligations shall be paid? The 
 present attempt to organize financing corporations for main- 
 taining and increasing our foreign exports, and the growing 
 agitation for increasing tariff rates in order to protect American 
 industry from the reviving competition of Europe afford suffi- 
 cient answer. 
 
 The growing interdependence of the financial systems of 
 different countries and the development of an international 
 financial structure give rise to the suggestion that if the finan- 
 cial system is effectively to perform its functions in assisting 
 and regulating the modern economic organization, some system 
 of international control must ultimately be devised. It may be 
 argued that just as the growth of a national, as distinguished 
 from a local, basis of economic organization destroyed the 
 efficacy of local and state control of finance and business and 
 required the development of a system of national supervision, 
 so the evolution of a world economic and financial system 
 requires the creation of an international supervisory board or 
 commission. It required, in all countries, the greater part ot 
 a century following the development of a national economy 
 to evolve a system of financial control that was of commensurate 
 scope and power. Who can say what another century may 
 not bring forth in the way of an international financial organi- 
 zation ? 
 
 V. THE CONCENTRATION OF FINANCIAL 
 POWER 
 
 One of the most striking features of the modern economic 
 and financial systems has throughout the discussion of the pre- 
 ceding chapters been neglected, namely, the development of
 
 FINANCE AND ECONOMIC ORGANIZATION 757 
 
 huge financial institutions and consolidations akin to those in 
 the field of commerce and industry. So significant is this 
 development in view of the potential power and influence over 
 the general economic organization that it may give to the 
 directors of the financial system, that it merits special con- 
 sideration in this concluding chapter. The discussion will, it 
 is believed, give added point to the problems of national and 
 international control outlined in the preceding section. 
 
 There was presented in the chapter on "The Corporation 
 as a Capital-Raising Device," a general outline of the various 
 stages in our industrial development since the Middle Ages. 
 It will be recalled that the last stage of this industrial evolution, 
 beginning shortly before the end of the nineteenth century, 
 was marked by a phenomenal consolidation movement in 
 commerce and industry and the emergence of what is commonly 
 designated as an era of monopoly or trust control. Now the 
 development of this large-scale corporate enterprise, together 
 with the uniting of hitherto independent concerns into gigantic 
 combinations in the field of transportation, manufacturing and 
 commerce, were necessarily paralleled in the field both of 
 commercial and investment banking. Indeed, the two move- 
 ments have developed hand in hand, each having been necessary 
 to the continuance of the other: the growth of huge banking 
 institutions made possible the assembling of the capital required 
 by corporate consolidations; and, conversely, the development of 
 giant-scale corporate industry required and made profitable the 
 development of financial institutions of commensurate resources. 
 
 The concentration of financial resources was effected to 
 some extent by the organization, de now, of banking institutions 
 of very large size, but more largely by a process of affiliation 1 
 and consolidation of existing institutions. The period of most 
 rapid evolution in this direction coincided with the era of indus- 
 trial combination, namely, the fifteen years from 1897 to 191 2. 2 
 
 1 For a statement with reference to the affiliation of commercial banks 
 and trust companies see p. 729 above. 
 
 a The last two years have witnessed a renewal of the movement in the 
 United States; and post-war financial concentration has been especially 
 marked in England.
 
 758 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 The total number of banks in New York decreased from 130 
 to 120 during the ten years from 1901 to 1911. In 1896 the 
 largest bank in New York City had less than 30 millions of 
 deposits; by 1911 there were six New York institutions with 
 more than 100 millions each; while in the five years from 1907 
 to 1912, one New York trust company increased its deposits 
 from 20 to 166 millions. 1 In the year 1911 there were ten 
 banks in the United States with deposits in excess of 75 million 
 dollars each, seven of them located in New York and two in 
 Chicago. 
 
 A factor of no little importance in furthering the movement 
 toward financial concentration, particularly in the years after 
 1907, was the desire to strengthen the financial structure and 
 to render less abortive the efforts of the banks to co-operate 
 in future emergencies for the control of financial crises. In the 
 words of Noyes: 
 
 The bank suspensions, in New York particularly, during the 
 panic of 1907, emphasized the dangers created for the community 
 at large by weak or ill-managed institutions in a central money 
 market. Finally, the incidents of that panic including the tem- 
 porary breakdown of credit facilities, the distrust by banks of one 
 another, the lack of quick and effective co-operation to relieve the 
 crisis taught the supreme necessity for a banking power strong 
 enough to meet the worst emergency. Concentration of the banking 
 resources at the country's money center is, in the absence of a central 
 institution such as the Bank of England, the only means of control- 
 ling, promptly and effectively, a crisis of that kind. 2 
 
 A similar consolidation of banking institutions has occurred 
 in other countries, particularly in Germany, where it has been 
 carried much farther than in the United States. The move- 
 ment in Germany is attributable to the same forces that were 
 operating in the United States, plus the added one of govern- 
 mental support as a means of furthering Germany's financial 
 and trading operations overseas. The financial crisis of 1901 
 
 1 Some allowance should be made in these figures of growth, for the 
 30 per cent increase in the price level between 1900 and 191 1. 
 Alexander D. Noyes, Atlantic Monthly, CXI (1913), 653.
 
 FINANCE AND ECONOMIC ORGANIZATION 759 
 
 was a particularly potent factor in promoting the consolidation 
 of German banks, a large number of small banks being rescued, 
 as it were, from the financial rocks on which they found them- 
 selves by incorporation into or affiliation with the oowerful 
 institutions that survived. Within five years the Deutsche 
 Bank absorbed forty-nine smaller banks, the Dresdner Bank 
 forty-one, and the Discontogesellschaft twenty-eight. Of such 
 unparalleled magnitude has been this German financial con- 
 centration and of such importance is it to an adequate appre- 
 ciation of the possibilities of control of all economic life which 
 under favoring conditions may be vested in a relatively small 
 group of financial directors, that a fuller statement is warranted 
 before returning to a consideration of the results of the financial 
 concentration movement in the United States. According to 
 Hauser: 
 
 In some cases the great banks simply annexed those institutions 
 which were previously autonomous, and took over the business of 
 menaced establishments, converting them into branches. More often 
 they allowed them to continue in existence for form's sake, contenting 
 themselves with financing them, or perhaps acquiring a sufficiently 
 large number of shares in these concerns to assume their effective 
 control. Sometimes, also, in order to study appearances still more, 
 an exchange of shares was the medium employed; the absorbing 
 bank and the bank absorbed reciprocally delegated their directors 
 from one board to the other. 
 
 With these banks they formed groups. As the banks thus 
 absorbed or mediatised had themselves in most cases arrived at a 
 certain stage of concentration, as they had their branches and 
 daughter institutions, it followed that groups of groups, formidable 
 unions, were formed. When the Deutsche Bank by means of an 
 exchange of shares made itself master of the Bergisch-Markische 
 Bank of Elberfeld in 1897, the latter had already thirteen branches, 
 having successively absorbed half a score of Rhenish banks. A 
 whole block of concerns thus passed into the control of the great 
 Berlin bank at one stroke. 
 
 To achieve transformations of this magnitude enormous aug- 
 mentations of capital were necessary; that of the Deutsche Bank 
 rose in two years from 1,000,000 to 9,000,000 and in the following 
 year to 10,000,000. This total was also in 191 1 that of the Dresdner
 
 760 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 and the Disconto. The Darmstadter capital reached 8,000,000, the 
 Schaafhausen 7,250,000, the Berliner Handelsgesellschaft 5,500,000 
 a total of more than 50,000,000 for the six institutions. Some 
 provincial banks, the Rheinisch-Westfalische Discontogesellschaft 
 and the Rheinische Credit Bank, each with 4,750,000, exceeded the 
 other metropolitan banks such as the Nationalbank, the Commerz 
 and Disconto Bank, etc. Banks whose capital in each case exceeded 
 3,000,000 represented a total capital of 87,250,000. 
 
 But side by side with the actual power of each bank, it is neces- 
 sary to consider that of the group which it directs. By the absorp- 
 tion or the affiliation of the Bergisch-Markische, the Schlesischer 
 Bankverein of Breslau, the Hannoversche Bank, the Mecklenburger 
 Hypotheken and Wechselbank, and the Essener Creditanstalt, the 
 Deutsche Bank has attained the position of controlling in reality a 
 total capital of 34,550,000, or of 48,950,000 with the reserves. 1 
 
 The Disconto (with the Norddeutsche Bank of Hamburg, the 
 Allgemein-Deutscher Creditanstalt of Leipzig, the Barmer Bank- 
 verein, the Siiddeutsche Discontogesellschaft of Mannheim, and the 
 Bayerische Disconto and Wechslerbank of Nuremberg) controls 
 25,200,000 with reserves 33,100,000. The Dresdner controls the 
 Markische Bank of Bochum, the Rheinische of Essen, and the Mul- 
 heimer Bank, 12,650,000 and 16,150,000. The Darmstadter 
 represents 10,950,000 and 13,000,000; the Schaafhausen (principal 
 satellite the Mittelrheinische Bank of Coblenz) 8,600,000 and 
 10,450,000. In all, the share capital and reserves of these groups 
 represent a total of. 13 7,500,000. 
 
 At times banks pass from one group to another, for there exists 
 among the controlling houses of the banking groups a spirit of emu- 
 lation and rivalry which drives them to absorb as many concerns 
 as possible. It was in consequence of a struggle between the 
 Deutsche Bank and the Dresdner for the domination of Westphalian 
 industry that the former absorbed the Bergisch-Markische. The 
 Dresdner in its turn nearly absorbed the ancient Schaafhausen 
 Bank; and on the eve of war the Disconto was trying to make 
 similar conquests. 
 
 By the side of these rivalries we find ententes. The great banks 
 sometimes form among themselves " Interessen-gemeinschaften"- 
 communities of interest "species of banking cartels which con- 
 centrate formidable amounts of capital to one definite activity "- 
 
 1 "Reserves" here means surplus and undivided profits.
 
 FINANCE AND ECONOMIC ORGANIZATION 761 
 
 maybe for the exploitation of a particular industry, or perhaps for 
 the creation and the management of a secondary bank. At times 
 also this community of interest unites two banks of secondary rank. 
 Thus we read in the financial announcements hi the German news- 
 papers: "Interessen gemeinschaft: Rheinische Creditbank Mann- 
 heim Pfalzische Bank, Ludwigs-hafen" not a "consortium" for 
 a pre-determined transaction, but a permanent alliance. 1 
 
 The extent of financial concentration and the nature of the 
 intricate interrelations of finance and business that have de- 
 veloped in the United States were disclosed by the Pujo Investi- 
 gation of igi2. 2 It was shown that 
 
 eighteen selected financial institutions, namely, I. P. Morgan & Co., 
 New York; First National Bank, New York; Guaranty Trust Co., 
 New York; Bankers Trust Co., New York; National City Bank, 
 New York; Kuhn, Loeb & Co., New York; National Bank of 
 Commerce, New York; Hanover National Bank, New York; Chase 
 National Bank, New York; Astor Trust Co., New York; New 
 York Trust Co., New York; Blair & Co., New York; Speyer & Co., 
 New York; Continental & Commercial National Bank, Chicago; 
 First National Bank, Chicago; Illinois Trust & Savings Bank, 
 Chicago; Kidder, Peabody & Co., Boston and New York; and 
 Lee, Higginson & Co., Boston and New York, were affiliated 
 through a system of interlocking directorates with banks, trust 
 companies, transportation systems, public utility companies, and 
 trading corporations. In the aggregate they held 385 directorships in 
 41 banks and trust companies having total resources of $3,832,000,000 
 and total deposits of $2,834,000,000; 50 directorships in n insurance 
 companies having total assets of $2,646,000,000; 155 directorships 
 in 31 railroad systems having a total capitalization of $12,193,000,000 
 and a total mileage of 163,200; 6 directorships hi 2 express companies 
 and 4 directorships in i steamship company with a combined capital 
 of $245,000,000 and gross income of $97,000,000; 98 directorships in 
 28 producing and trading corporations having a total capitalization 
 of $3,583,000,000 and total gross annual earnings in excess of 
 $1,145,000,000; 48 directorships in 19 public utility corporations 
 
 1 Henri Hauser, Germany's Commercial Grip on the World, pp. 48-50. 
 
 3 Report of the Committee Appointed to Investigate the Concentration of 
 Control of Money and Credit, 626! Cong., 3d Sess., "Money Trust Investiga- 
 tion: Interlocking Directorates."
 
 762 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 having a total capitalization of $2,826,000,000 and total gross annual 
 earnings in excess of $428,000,000; in all, 746 directorships in 
 134 corporations having total resources or capitalization of 
 $25,325,000,000. 
 
 A smaller group of the more powerful institutions, known as the 
 inner, or primary, group, to wit, J. P. Morgan & Co., The First 
 National Bank, The National City Bank, The Guaranty Trust Co., 
 and The Bankers Trust Company, together have 118 directorships 
 in 34 banks and trust companies having total resources of $2,679,- 
 000,000 and total deposits of $1,983,000,000; 30 directorships in 10 
 insurance companies having total assets of $2,293,000,000; 105 
 directorships in 32 transportation systems having a total capitaliza- 
 tion of $11,784,000,000 and a total mileage (excluding express com- 
 panies and steamship lines) of 150,200; 63 directorships in 24 
 producing and trading corporations having a total capitalization of 
 $3)339) ooo . oo ) 2 5 directorships in 12 public utility corporations 
 having a total capitalization of $2,150,000,000; in all, 341 director- 
 ships in 112 corporations having aggregate resources or capitalization 
 of $22,245,000,000. 
 
 It will be observed that some of the financial institutions 
 enumerated above originated as investment banking insti- 
 tutions, that others began as trust companies, and still others 
 as national banks; but regardless of their original functions 
 or their present designation as investment, commercial, or 
 trust institutions, all are now engaged in similar financial 
 operations; all are interested in underwriting and distributing 
 investment securities; all maintain commercial banking depart- 
 ments and all are affiliated with other financial institutions and 
 business corporations. Here is financial and business integra- 
 tion in its most highly developed form. 
 
 The affiliation of the smaller banks and bankers throughout 
 the country with the inner groups and subgroups of the so- 
 called "money trust" is set forth by the Pujo committee in 
 the following terms: 
 
 Beyond these inner groups and subgroups are banks and bankers 
 throughout the country who co-operate with them in underwriting 
 or guaranteeing the sale of the securities offered to the public, and 
 who also act as distributors of such securities. It was impossible
 
 FINANCE AND ECONOMIC ORGANIZATION 763 
 
 to learn the identity of the corporations, owing to the unwillingness 
 of the members of the inner group to disclose the names of their 
 underwriters, but sufficient evidence appears to justify the state- 
 ment that there are at least hundreds of them and that they extend 
 into many of the cities throughout this and foreign countries. 
 
 The patronage thus proceeding from the inner group and its 
 subgroups is of great value to these banks and bankers, who are 
 thus tied by self-interest to the great issuing houses and may be 
 regarded as a part of this vast financial organization. Such patronage 
 yields no inconsiderable part of the income of these banks and bankers 
 without much risk on account of the facilities of the principal groups 
 for placing issues of securities through their domination of great 
 banks and trust companies and their other domestic affiliations 
 and their foreign connections. The underwriting commissions on 
 issues made by this inner group are easily earned and do not ordi- 
 narily involve the underwriters in the purchase of the underwritten 
 securities. Their interest in the transaction is generally adjusted, 
 unless they choose to purchase part of the securities, by the payment 
 to them of a commission. There are, however, occasions on which 
 this is not the case. The underwriters are then required to take 
 the securities. Bankers and brokers are so anxious to be permitted 
 to participate in these transactions under the lead of the inner group 
 that as a rule they join when invited to do so, regardless of their 
 approval of the particular business, lest by refusing they should 
 thereafter cease to be. invited. 
 
 In the case of the New York subway financing of $170,000,000 
 of bonds by Messrs. Morgan & Co. and their associate, Mr. Davison 
 estimated that there were 100 to 125 such underwriters who were 
 apparently glad to agree that Messrs. Morgan & Co., the First 
 National Bank, and the National City Bank should receive 3 per 
 cent, equal to $5,100,000, for forming this syndicate, thus relieving 
 themselves from all liability, whilst the underwriters assumed the 
 risk of what the bonds would realize and of being required to take 
 their share of the unsold portion. 
 
 The possibility of competition between these banking houses 
 in the purchase of securities is further removed by the understanding 
 between them and others that one will not seek, by offering better 
 terms, to take away from another a customer which it has hereto- 
 fore served, and by corollary of this, namely, that where given 
 bankers have once satisfactorily united in bringing out an issue of a
 
 764 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 corporation they shall also unite in bringing out any subsequent issue 
 of the same corporation. This is described as a principle of banking 
 ethics. 1 
 
 The significance of this consolidation movement in the field 
 of finance lies not so much in the mere size of the institutions 
 in question or in the community of interest that has been estab- 
 lished among them, as in the control which they may possibly 
 exercise over the industries with which they are affiliated, 
 directly and indirectly. The enormous changes in the eco- 
 nomic system which were effected between the years 1897 and 
 1912 constitute an industrial revolution of quite as far-reaching 
 importance as those which marked the breakdown of the old 
 handicraft regime and the emergence of the factory system. 
 So swift has been the change in the nature and scope of indus- 
 trial and financial enterprise since the turn of the century, that 
 as yet we have little understanding of its possible ultimate 
 significance. 
 
 The extent of the power that is exercised by the great 
 German banking consolidations is stated, rightly or wrongly, by 
 Riesser, the foremost German writer on banking problems, as 
 follows: 
 
 The great banks are able to elaborate programmes for joint 
 action. United by a kind of quasi-contract,- forming practically a 
 tacit syndicate, they are able to raise themselves above the mere 
 policy of dividends, to keep count of interests both general and 
 national, to adopt an industrial policy, to direct the placing of capital, 
 colonial undertakings and the business of exportation, canals, navi- 
 gation, and cables. They are able to exercise control of the Press 
 and of public opinion, to anticipate crises and weaken their effect, 
 to prevent panic. Thanks to the "entente" between the State and 
 a small number of banks which have their headquarters or (as in the 
 case of the Darmstadter and the Dresdner) their center of gravity 
 at Berlin, intervention becomes rapid and efficacious.* 
 
 While in the United States there has long been popular 
 distrust of Wall Street, the movement toward financial con- 
 
 1 Report of the Committee Appointed to Investigate the Concentration of 
 Control of Money and Credit, 62d Cong., 3d Sess., No. 1593, pp. 132-33. 
 
 * Riesser, Jacob, Grossbanker, p. 614.
 
 FINANCE AND ECONOMIC ORGANIZATION 765 
 
 centration attracted very little attention until the panic of 
 1907. At that time there developed a widespread, though 
 mistaken, 1 belief that the panic was engineered by a group of 
 financiers who through manipulation of the financial markets 
 were in a position to reap a golden harvest of unprecedented 
 proportions at the expense of their unfortunate victims. The 
 belief that a relatively small group of financiers had acquired 
 a commanding control over the major industries of the country 
 was strengthened in the succeeding years by the increasing 
 financial concentration that immediately followed, by the 
 acknowledged affiliation of the larger banking institutions of the 
 financial centers with the great industrial, railroad, and other 
 consolidations which had developed, and by various stories which 
 circulated freely in financial and business circles, during the 
 latter years of the period in question, to the effect that the 
 underwriting of securities as well as the extension of short- 
 term credit were denied to certain corporations for no other 
 reason than that they chanced to be competitors of corpora- 
 tions in which the directors of the great banking institutions 
 were personally interested. None of these charges, it should 
 be added, was ever subsequently shown to be true. The 
 agitation on the subject, however, finally led to the congressional 
 "money trust" investigation of 1912, to which reference has 
 already been made. 
 
 On behalf of the financial interests whose integrity was 
 impugned by the money trust investigation of the Pujo com- 
 mittee, J. P. Morgan & Co., upon invitation of the committee, 
 submitted a defense of financial concentration. While this 
 argument is not altogether conclusive it so definitely discloses 
 the fundamental issues involved that it is presented, in abbre- 
 viated form, herewith: 
 
 Just as grain and cotton and manufactures are commodities 
 subject to the unchanging laws of supply and demand, so, in the same 
 way, money and credits are commodities subject to the same unvary- 
 ing laws, but far more intensely; for while bulky merchandise is 
 not always immediately transferable upon demand, money and 
 
 1 See the analysis on pp. 511-29 above.
 
 766 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 credits are so liquid as to be transferable by telegraph all over the 
 world. Since the beginning of organized industry and commerce, 
 covering more than two centuries in England, France and Germany 
 and one hundred years in America, men never yet have succeeded 
 in overriding economic law; and, further, such an achievement is 
 impossible, even though one were willing to attribute sinister 
 motives to the leading business men in the chief cities of this 
 country. 
 
 In the preamble to the House Resolution under which your 
 Committee acts we find this statement: "Whereas it has been further 
 charged and is generally believed [the italics are our own] that these 
 same groups of financiers are enabled to regulate the interest rates 
 for money, to create, avert, and compose panics, etc." The factors 
 which determine interest rates are not local in their source, but are 
 world-wide, being determined and owing to the freedom of inter- 
 national exchange being regulated by the average demand for 
 credit throughout the world's money markets. If any man or group 
 of men had the ability and resources which they have not to 
 withhold credits in any one market, like New York, the situation 
 would ordinarily be promptly relieved by the automatic inflow of 
 credits from some altogether source. 
 
 We regret that a belief so incredible, so abhorrent, and so harmful 
 to the country as that the panic of 1907 was actually due to the 
 machinations of certain powerful men should for a moment have 
 found lodgment anywhere. 
 
 No one will deny that men frequently are selfish, ambitious, and 
 reckless, but in order to sustain the theory that the panic of 1907 
 was "engineered" one must attribute some motive for their assumed 
 achievements. And by no process of reasoning can such motive 
 be imagined, because of the fact that men possessing even a fraction 
 of the influence and resources attributed to them always are the 
 ones holding the largest amounts of fixed investments which, by 
 disturbed financial conditions, always suffer most severely. It is 
 impossible, therefore, to imagine a motive on the part of such persons 
 as would lead to a campaign of self-destruction. 
 
 The resolution under which your Committee acts further states 
 that a comparatively small group of men "have wielded a power 
 over the business, commerce, credits, and finances of the country 
 that is despotic and perilous and is daily becoming more perilous 
 to the public welfare."
 
 FINANCE AND ECONOMIC ORGANIZATION 767 
 
 For the maintenance of such an impossible economic theory 
 there have been spread before your Committee elaborate tables of 
 so-called interlocking directorates from which exceedingly mistaken 
 inferences have been publicly drawn. In these tables it is shown 
 that 1 80 bankers and bank directors serve upon the boards of cor- 
 porations having resources aggregating twenty-five billion dollars, 
 and it is implied that this vast aggregate of the country's wealth 
 is at the disposal of these 180 men. But such an implication rests 
 solely upon the untenable theory that these men, living in different 
 parts of the country, in many cases personally unacquainted with 
 each other, and in most cases associated only in occasional trans- 
 actions, vote always for the same policies and control with united 
 purpose the directorates of the 132 corporations on which they serve. 
 The testimony failed to establish any concerted policy or harmony 
 of action binding these 180 men together, and as a matter of fact 
 no such policy exists. The absurdity of the assumption of such 
 control becomes more apparent when one considers that on the 
 average these directors represent only one-quarter of the member- 
 ships of their boards. It is preposterous to suppose that every 
 "interlocking" director has full control in every organization with 
 which he is connected, and that the majority of directors who are not 
 "interlocking" are mere figureheads, subject to the will of a small 
 minority of their boards. 
 
 Perhaps the greatest harm in the presentation referred to lay 
 in the further unwarranted inference, to which has been given wide 
 publicity, that the vast sum of $25,000,000,000 was in cash or liquid 
 form, subject to the selfish use or abuse of individuals. Such an 
 idea excites the public mind to demand the correction of a fancied 
 situation which does not exist. 
 
 The steady growth in the size of banks in New York and Chicago 
 and the frequent merger of two or more banks into one institution 
 have erroneously been designated before your Committee as "con- 
 centration." This steady growth and these mergers, however, are 
 a development due simply to the demand for larger banking facilities 
 to care for the growth of the country's business. As our cities double 
 and treble in size and importance, as railroads extend and industrial 
 plants expand, not only is it natural, but it is necessary, that our 
 banking institutions should grow in order to care for the increased 
 demands put upon them. Perhaps it is not known as well as it 
 should be that in New York City the largest banks are far inferior
 
 768 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 in size to banks in the commercial capitals of other and much smaller 
 countries. The largest bank in New York City today has resources 
 amounting to only three-fifths of the resources of the largest bank 
 in England, to only one-fourth of the resources of the largest bank 
 in France, and to less than one-fifth the resources of the largest 
 bank in Germany. As the Committee is aware, in New York City 
 thore are only three banks with resources in excess of $200,000,000, 
 while there are ten such institutions in London, five in Berlin, and 
 four in Paris. 
 
 It is also perhaps not sufficiently recognized that, even as it is, 
 .\merican banks have not fully kept pace with the development of 
 American business. Hundreds of the financial transactions of today 
 are so large that no single bank commands sufficient resources to 
 handle them. This is especially true with respect to the great 
 public utilities which are essential for the development and welfare 
 of the community. Even our largest banks are seldom able sepa- 
 rately to extend the credit which such undertakings require, no one 
 national bank being permitted by law to loan in excess of 10 per 
 cent of its capital and surplus to any one individual or concern. 
 When it is remembered that literally hundreds of corporations in 
 this country are now obliged to borrow annually sums of a million 
 dollars and upward apiece, it is obvious that the size of our banks 
 must grow to keep pace with this demand. 
 
 We lay perhaps especial stress upon this point, because of what 
 seemed to us a readiness upon the part of your Committee to adopt 
 the idea that in such co-operation by bankers there lies the germ 
 of something sinister and dangerous, and that "these groups of 
 individuals" can "prevent competition with the enterprise in which 
 they are interested, to the detriment of interstate commerce and 
 of the general public." So far as our observation and experience 
 go, we can make the positive statement that, except under unfavor- 
 able money-market conditions, we have never heard of any respon- 
 sible and deserving individual, firm, or corporation, being unable 
 to secure ample credit. 
 
 Many questions were asked before your Committee as to the 
 wisdom in having representatives of private banking houses sit upon 
 the boards of corporations whose securities the same bankers fre- 
 quently offer for sale. This practice, which has been in vogue ever 
 since the creation of limited companies has arisen, not from a desire 
 on the part of the banker to manage the daily affairs of the corpora-
 
 FINANCE AND ECONOMIC ORGANIZATION 769 
 
 tion or to purchase its securities more cheaply than he otherwise 
 could, but rather because of his moral responsibility as sponsor of 
 the corporation's securities, to keep an eye upon its policies and to 
 protect the interests of investors in the securities of that corporation. 
 For a private banker to sit upon such a directorate is in most instances 
 a duty, not a privilege. Inquiry will readily develop the fact that 
 the members of the leading banking houses in this country and 
 it was the leading houses only against which animadversions were 
 directed are besought continually to act as directors in various 
 corporations, whose securities they may handle, and that in general 
 they enter only those boards which the opinion of the investigating 
 public requires them to enter, as an evidence of good faith that they are 
 willing to have their names publicly associated with the management. 
 
 As the final point of this memorandum we venture to submit 
 tl consideration that in a strong public opinion, such as exists in 
 this country, there lies the greatest safeguard of the community. 
 The public, that is, the depositors, are the ones who entrust bankers 
 with such influence and power as they today have in every civilized 
 land, and the public is unlikely to entrust that power to weak or 
 evil hands. Your counsel asked more than one witness whether 
 the present power held by bankers in this country would not be 
 a menace if it lay in evil hands. Such an inquiry answers itself. 
 All power physical, intellectual, financial, or political is dangerous 
 in evil hands. If Congress were to fall into evil hands the results 
 might be deplorable. But to us it seems as little likely that the 
 citizens of this country will fill Congress with rascals as it is that 
 they will entrust the leadership of their business and financial affairs 
 to a set of clever rogues. The only genuine power which an indi- 
 vidual, or a group of individuals, can gain is that arising from the 
 confidence reposed in him or them by the community. Every town, 
 large or small, seems to choose a limited number of men (merchants, 
 manufacturers, lawyers, and bankers) to represent it in the manage- 
 ment of its chief local industries. Those men are entrusted with 
 such heavy responsibilities because of the confidence which their 
 records have established, and only so long as their records are 
 unblemished do they retain such trusts. 
 
 These are axioms which it seems almost idle to repeat. They apply 
 to all business, but more emphatically, we believe to banking than 
 to any other form of commerce. To banking the confidence of the 
 community is the breath from which it draws its b'fe.
 
 770 
 
 While the congressional investigating committee succeeded 
 in disclosing this extraordinary degree of financial consolidation 
 and affiliation that have been indicated above, it was, however, 
 unable to prove the existence of a money trust or any extensive 
 abuse of the vast financial power that had gravitated by the 
 forces of industrial and financial integration into the control 
 of a small group of financiers. The committee was obliged 
 to conclude its report with this statement: 1 
 
 If by a "money trust" is meant: 
 
 "An established and well-defined identity and community of 
 interest between a few leaders of finance which has been created and 
 is held together through stock holdings, interlocking directorates, 
 and other forms of domination over banks, trust companies, railroads, 
 public-service and industrial corporations, and which has resulted 
 in a vast and growing concentration of control of money and credit 
 in the hands of a comparatively few men," your committee has 
 no hesitation in asserting as the result of its investigation that this 
 condition, largely developed within the past five years, exists in 
 this country today. 
 
 It may be that this recently concentrated money power so far 
 has not been abused otherwise than in the possible exaction of 
 excessive profits through absence of competition. Whilst no evidence 
 of abuse has come to the attention of the committee from impartial 
 sources, neither has there been adequate proof or opportunity for 
 proof on the subject. Here again th data have not been available. 
 
 Your committee is convinced that however well founded may be 
 the assurances of good intentions by those holding the places of 
 power which have been thus created, the situation is fraught with 
 too great peril to our institutions to be tolerated. 
 
 Although the congressional investigation failed to prove 
 the existence of a money "trust," it clearly indicated that the 
 latest phase of our financial evolution has placed in the hands 
 of the financial interests an enormous power which, if wielded 
 with sinister intent, or merely with unwisdom, would be fraught 
 with tremendous social and economic consequences. It is the 
 
 1 From the Report of the Committee Appointed to Investigate the 
 Concentration of Control of Money and Credit, 62d Cong., 3d Sess., 
 PP- I30-33-
 
 FINANCE AND ECONOMIC ORGANIZATION 771 
 
 consensus of opinion among students of finance and the belief 
 is shared by many of the leading financiers themselves that 
 the present concentration of financial resources contains ele- 
 ments of very real danger and that the movement has pro- 
 ceeded quite far enough. 
 
 Interlocking financial directorates have been made illegal. 
 The practical outcome of the money trust investigation was 
 the incorporation in the Clayton Act of October 15, 1914, of 
 certain provisions designed to break up the system of inter- 
 locking directorates. This act provides, 
 
 that no person shall at the same time be a director or other officer or 
 employee of more than one bank, banking association, or trust com- 
 pany organized or operating under the laws of the United States, 
 either of which has deposits, capital, surplus, and undivided profits 
 aggregating more than $5,000,000; and no private banker or person 
 who is a director in any bank or trust company, organized or operating 
 under the laws of any state, having deposits, capital, surplus, and undi- 
 vided profits aggregating more than $5,000,000, shall be eligible to 
 be a director in any bank or banking association organized or operating 
 under the laws of the United States. 
 
 The law further provides that no bank, banking association, or 
 trust company operating under the laws of the United States which 
 is located in a city of more than 200,000 population shall have as a 
 director, officer, or employee any private banker, or any director, 
 officer, or employee of any other bank, banking association, or trust 
 company located in the same city. 
 
 There are three exceptions to the prohibition against interlocking 
 directorates, besides the qualifications respecting the size of institu- 
 tions and the population of the places where located. These are: (i) 
 the prohibition does not apply to mutual savings banks which have 
 no capital stock; (2) the director, officer, or employee may be an 
 officer where the entire capital stock of one is owned by the stock- 
 holder in the other; and (3) the prohibition does not apply to a 
 Class A director in a Federal Reserve bank who serves as a director, 
 or employee, in a member bank. 
 
 In accordance with the requirements of the Clayton Act 
 there has been a more or less complete readjustment of director- 
 ates among the institutions concerned. No evidence has at
 
 772 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 yet been advanced, however, to indicate that this formal 
 compliance with the law has any more effectively destroyed the 
 "communities of interest" that existed than was the case follow- 
 ing the dissolution proceedings in the field of industrial and 
 railroad consolidations. 
 
 VI. FINANCIAL POWER AND THE CONTROL OF 
 UNDEVELOPED REGIONS 
 
 One further phase of the problem of financial power and 
 control must be briefly mentioned. Under a capitalistic 
 economic regime the backward regions of the earth can be 
 brought within the fold of commercial civilization and their 
 economic wealth made available for world-uses^ only through 
 the use of very large financial resources. Accordingly, financial 
 penetration and exploitation has been the necessary fore- 
 runner and handmaiden of modern colonial development. 
 While all of the leading commercial nations of Europe have 
 long utilized their financial resources to this end, it remained 
 for imperial Germany to carry the process to its final degree 
 of perfection. A detailed study of the financial methods em- 
 ployed in this connection and of the economic and social sig- 
 nificance of this union of finance and politics would, however, 
 carry the present discussion so far afield that it cannot be 
 undertaken here. 
 
 It should be noted, however, that the animus for the 
 extension of financial assistance to undeveloped countries need 
 not be entirely imperialistic. Such, for instance, appears to 
 be the case with the consortium of American, British, French, 
 and Japanese groups of bankers that is now being organized 
 for extending to China credit to be used in the development of 
 public works. While opinions may differ as to the motivating 
 force back of this arrangement, there is at least some basis 
 for the contention that it is more in the nature of an ordinary 
 business proposition than of a scheme for imperial aggrandize- 
 ment, for the reason that the nations involved have, themselves, 
 sharply conflicting national interests. In any event the pre-
 
 FINANCE AND ECONOMIC ORGANIZATION 773 
 
 liminary announcement of the terms of the arrangement reveal 
 in a most striking manner the tremendous power that is inherent 
 in the control of modern finance. 
 
 It is reported that the Chinese government has pledged 
 with the banking consortium as security for a loan, the surplus 
 revenue derived from the salt "gabelle," customs duties, and 
 other national income, and has agreed, with the aid of foreign 
 capital, to work for the promotion of the following economic, 
 political, and social program: the development of mining, 
 manufacturing, and agriculture; the colonization of the 
 unsettled portions of Chinese territory; the moderization of 
 the country, including the introduction of universal education 
 and the development of the legal system along western lines, 
 especially in regard to the procedure of arrest and trial by 
 jury with a view to the ultimate abolition of extra-territoriality ; 
 the introduction of local self-government; the stabilization of 
 the foreign policy of the nation; the reunification of the North 
 and the South; and the reduction of the Army and Navy to 
 the requirements necessary for the maintenance of the domestic 
 peace and order. The use of these military forces for foreign 
 aggression is forbidden. It is thus apparent that the destiny 
 of China largely rests in the hands of the financiers of the 
 world mainly of the Western World. 
 
 Such is the financial system that has resulted from the 
 great changes in economic organization that have attended 
 the transformation from the medieval handicraft and manorial 
 system to the era of twentieth-century capitalistic enterprise. 
 For good or for ill the economic system has become predomi- 
 nantly pecuniary; modern life is largely organized about the 
 pecuniary unit of calculation; business processes are every- 
 where worked out through financial means; and even the 
 larger aspects of economic organization are in no small measure 
 regulated through the intermediation of financial institutions 
 and agencies. There is little exaggeration in saying that the 
 economic society of our times is financially organized and 
 controlled.
 
 774 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 This study has endeavored neither to demonstrate that the 
 modern financial system is the embodiment of economic per- 
 fection or that it is inherently vicious in its economic and social 
 consequences. The effort has rather been to reveal the forces 
 responsible for its development, to disclose the various economic 
 services rendered by the numerous individual financial insti- 
 tutions and agencies that make up the financial structure, and 
 to indicate the functions performed by this larger financial 
 system in the general economic organization. The definite 
 purpose has been to describe the financial system as it is to 
 portray its weaknesses, as well as its elements of strength 
 in performing the tasks assigned. Certain specific problems of 
 regulation and control, and certain fundamental issues concern- 
 ing the relationship of finance to the larger economic organiza- 
 tion have been raised, but not resolved. The working out of 
 such reformation or reorganization of the system as is necessary 
 to render it more fully subservient to the requirements of 
 economic society is rather the task of the present and of the 
 succeeding generations. If this volume contributes something 
 to that understanding of the problems of financial organiza- 
 tion without which intelligent reconstruction is impossible, its 
 purpose will have been amply fulfilled. 
 
 QUESTIONS FOR DISCUSSION 
 
 1. Draw up a statement in outline form, indicating all of the ways 
 in which the pecuniary system renders economic services. 
 
 2. Draw up in summary form a statement of all of the weaknesses 
 which you find in the financial organization of society. 
 
 3. Draw up a statement showing the interrelations of finance and 
 the general economic system. 
 
 4. "The growth of large scale industry necessitated the development 
 of national supervision of the banking system." Why? 
 
 5. Concretely, how great is the control of the individual commercial 
 banker over the business of his community, where there are 
 competing banks in the field ? 
 
 6. Do you know of any cases where commercial bankers have 
 misused the power which they possess by virtue of their control 
 over loanable funds ?
 
 FINANCE AND ECONOMIC ORGANIZATION 775 
 
 7. Draw up in outline form a statement of the ideal qualifications 
 which members of the Federal Reserve Board should possess. 
 
 8. "The world has become an economic unit." Do you think this 
 statement holds true so far as the financial aspects of things are 
 concerned ? 
 
 9. "There is just as much reason why we should have a system of 
 international financial control as a system of national financial 
 control." Why or why not ? 
 
 10. Cite as many illustrations as possible-of the difficulties arising 
 from the control of finance by individual nations, rather than by 
 an international organization. 
 
 11. Account for the concentration movement in finance in the United 
 States. Do you see any means by which it could have been 
 prevented ? 
 
 12. Show in what ways the growth of financial concentration was 
 necessary to the growth of corporate consolidations in the fields 
 of industry and commerce. 
 
 13. If you had been in a position to control our economic destiny, 
 would you have prevented the industrial and financial revolution 
 that occurred between 1897 and 1912. Why or why not? 
 
 14. Is the financial concentration that now exists confined to the 
 investment banking field? Is it in any sense specialized con- 
 centration ? 
 
 15. Do you think it possible for a group of large financial interests 
 to charge what rates they please for money ? Can they charge 
 more to some people than to others ? 
 
 16. Are not the interests of financiers and of the people identical in 
 that without general business prosperity the operations of the 
 financiers would be impossible ? 
 
 17. Do you agree that the investment bankers could have no possible 
 motive for causing a panic in 1907, or at any other time ? 
 
 1 8. In view of your previous study of the economic cycle and the 
 history of the panic of 1907, does it seem to you likely that that 
 panic was "engineered" by the interests? 
 
 19. Do you think that it is necessarily "preposterous" to suppose 
 that an interlocking director may have full control of the policy 
 of a company ? substantial control ? Why ? 
 
 20. In your opinion is it likely that credit has often been refused 
 to deserving borrowers merely because such borrowers were com- 
 petitors of enterprises in which the investment bankers them- 
 gelves were interested ? What is to prevent such a practice ?
 
 776 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 21. "The so-called money trust is in a position to prevent the pro- 
 curing of credit only in the case of very large issues of securities." 
 Why? 
 
 22. "Supposing the general control of the country's greater banking 
 institutions to be in the hands of a financial group which also 
 dominated certain railway companies and certain industrial 
 corporations, would it, or would it not, be possible for an impor- 
 tant legitimate enterprise, competing with those railways or 
 industrial corporations, to be organized as easily as before? 
 Human nature being what it is, the answer must be in the nega- 
 tive. " Do you agree ? 
 
 23. Have you known of cases in small towns where the banker has 
 refused loans to those who were competitors of his in non-banking 
 lines? 
 
 24. Are interlocking directorates necessarily developed for sinister 
 purposes ? 
 
 25. On the whole, do you believe that there is an effective "Money 
 Trust" ? 
 
 26. Do you feel, with J. P. Morgan & Company, that the public can 
 safely rely upon our financial representatives to safeguard our 
 interests through peril of deposition as soon as they do not 
 warrant our confidence ? Concretely, how is the process of 
 deposing those whom we no longer trust brought about ? 
 
 27. "Although the present directors of huge financial resources may 
 owe their position to a process of competitive selection by means 
 of which the especially faithful and capable administrators have 
 been brought to the top, it does not necessarily follow that the 
 descendants, and inheritors of the wealth, of these magnates will 
 have the same ability or integrity." Discuss this statement. 
 
 28. If you were in a position of power, what would you do to minimize 
 the dangers of financial concentration ? 
 
 29. "China should be allowed to work out her own economic salvation 
 without financial assistance from the great commercial countries." 
 What do you think of this statement ? 
 
 30. " Private financiers should not be allowed to control the develop- 
 ment of backward nations. Such aid as is given should come 
 from governments instead of from private interests." Discuss 
 this suggestion. 
 
 31." The greatest safeguard in connection with the economic develop- 
 ment of backward regions lies in having the necessary financial
 
 FINANCE AND ECONOMIC ORGANIZATION 777 
 
 assistance rendered, not by the bankers or by the government 
 of a single country, but by groups of bankers in different countries, 
 affiliated with their respective governments." Discuss. 
 
 REFERENCES FOR FURTHER READING 
 
 Angell, Norman: The Great Illusion. 
 
 Brandeis, Louis D.: Other People's Money. 
 
 Hauser, Henri: Germany's Commercial Grip on the World. 
 
 Keynes, J. M.: The Economic Consequences of the Peace, chaps, ii 
 and vi. 
 
 Moulton, Harold G.: Principles of Money and Banking, pp. 471-95. 
 
 Phillips, Chester A.: Readings in Money and Banking, chap. 
 xxviii. 
 
 Report of the Committee Appointed to Investigate the Concentration 
 of Control of Money and Credit, 62d Cong., 3d Sess.
 
 INDEX
 
 INDEX 
 
 Accommodation draft, 164 
 
 Accounts payable, 162, 168 
 
 Accounts receivable, 162, 168 
 
 Affiliated banks, 729 
 
 Agricultural credit, chap, on, 640-96; 
 chart of institutions involved in, 
 650; legislation of states, 682-83 
 
 Aldrich Bill, 569-70, 572 
 
 Aldrich-Vreeland Act, 568 
 
 Aldrich-Vreeland emergency cur- 
 rency, 568-69 
 
 American Foreign Securities Co., 
 266 
 
 Amortization loans, 678-80 
 
 Arbitrage, 114 
 
 Assay commission, 71 
 
 Assay offices, 73 
 
 Assigning accounts, 438-39 
 
 Automobile bank (see Discount 
 companies) 
 
 Balance of trade, significance of, 
 57-59, since the war, 262-63, 4 2 4 
 
 "Baltimore plan" of currency re- 
 form, 567 
 
 Bank acceptance, illustration of, 
 166; 372, 413; basis of discount 
 market, 601-21 
 
 Bank checks, 164; in a sense not 
 credit instruments, 164; illustra- 
 tion of, 167 
 
 Bank draft, 163; not true credit 
 instrument, 164; illustration of 
 foreign, 167 
 
 Bankers' deposits, 473-74; and 
 financial panics, 527-29 
 
 Bank examinations and reports, 
 557-59 
 
 Bank failures, causes of, 551; of 
 various classes of banks, 728-29 
 
 Bank loans (see Commercial bank 
 loans) 
 
 Bank notes, 164; regulation of, 
 562-64 (see also National Bank 
 notes. Federal Reserve Bank 
 notes, and Federal Reserve notes.) 
 
 Baring Brothers, 214 
 
 Barter, inconvenience of, 41 ; inter- 
 national post-war, 275 
 
 Bill of exchange, finance, 112, 164; 
 trade (or commercial) 113, 164; 
 definition of, 162; foreign versus 
 domestic or inland, 162; illustra- 
 tion of banker's, 167; sterling, 410 
 
 Bill of lading, nature of, 394-95; as 
 security for loans, 395; kinds of, 
 396; illustration of, 398; in foreign 
 trade, 413 
 
 Bill of Lading Act, 396 
 
 Bimetallism, and Gresham's Law, 
 73-79; reasons for adoption of, 
 73; weakness of, 74; history of, 
 in U.S., 74-75; and compensatory 
 action, 77-79; international, 77, 
 78-79; possible restoration of, 
 80-81 
 
 Bland-Allison Act, 77, 100 
 
 Blue Sky legislation, 197-210; of 
 Kansas, 191-92; of Illinois, 198- 
 205; bill in Congress, 206 
 
 JBonas, advantages of, 140; types oi, 
 ^S-S?; illustration of, 158-59; 
 determination of value of, chart, 
 
 222 
 
 Buuk credit (Sobk accounts), 162, 
 169 
 
 Borrower's statement, illustration 
 of, 381 
 
 Brokers (see chart 136); street, 242; 
 stock exchange, 285-92; com- 
 missions of, 289; branch offices, 
 290; regulation of, 292. 
 
 Bubble Act of 1719, 142 
 
 Bucket shops, 292 
 
 Building and loan associations, 
 714-19 
 
 781
 
 782 
 
 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 Business booms, (see Business cydes) 
 
 Business cycles, chap, on, 494-546; 
 in U.S., 505; causes of, 511-19; 
 and commercial banking, 519-41; 
 and the economic system, 
 749; and individual banker's con- 
 trol, 752-3 
 
 Business depression (see Business 
 cycles) 
 
 Business failures and seasonal mone- 
 tary stringency, 502; in time of 
 depression, 509-10 
 
 Call loans, definition of, 376; and 
 stock exchange speculation, 391- 
 94; in time of crisis, 531; of 
 Canadian borrowers, 645 
 
 Capital formation, under a capital- 
 istic system, 49-50 
 
 Capital Issues Committee, 206 
 
 Capital raising, the corporation and, 
 chap, on, 139-50; through reinvest- 
 ment, 135; by direct subscription, 
 135; through promotion, 186-97 
 
 Cash discount, 26 
 
 Cashier's check, 164; illustration of, 
 167 
 
 Cattle loan company, chart, 650; 
 functions of, 659-65 
 
 Cattle paper, 663 
 
 Central banks, opposition to, 569; 
 European and credit control, 753 
 (see also First and Second Banks 
 of the United States.) 
 
 Central reserve cities, meaning of 
 term, 371 
 
 Certificates of deposit, 374 
 
 Certified check, 164 
 
 Chattel mortgage, illustration of, 
 445 
 
 Checks (see Bank checks) 
 
 Clayton Act, 773 
 
 Clearing-house associations, 457-70 
 
 Clearing-house bank examinations, 
 468-70 
 
 Clearing-house certificates, 460-61 
 
 Clearing-house checks, 538 
 
 Clearing-house loan certificates, 
 533-38 
 
 Clearings under Federal Reserve 
 System, 608-13 
 
 Coinage, necessity of, 65; a govern- 
 ment function, 66; effects of bad 
 system of, 67-69; regulations in 
 United States, 69-73; abrasion of, 
 72; counterfeiting of, 72 
 
 Collateral loans, 386-90; to member 
 banks, 592-93 
 
 Collateral trust bond, 157, 308 
 
 Collection charges, 467; diversity 
 of, 609; reduction of, under 
 Federal Reserve System, 612-13 
 
 Collections, 470-72; under Federal 
 Reserve System, 608-13 
 
 Commercial Acceptance Trust (see 
 Discount companies) 
 
 Commercial agencies, 379 
 
 Commercial banker, dominant posi- 
 tion of, 751-53 
 
 Commercial bank investments, 374; 
 kinds of, 401; volume of, 401-2, 
 488 
 
 Commercial banking system, chap. 
 on, 457-93, and business cycles, 
 chap, on, 494-546 (see also 
 Commercial banks) 
 
 Commercial bank loans, analysis of, 
 374; importance of, 375; type of, 
 375-76; classification of, in 
 national banks, 377; capital pur- 
 
 Kses, 383-84, 487, 724; secured 
 mortgages, 385; secured by 
 promissory notes, 385; secured 
 by stocks and bonds, 386; secured 
 by bills of lading, 394; secured by 
 warehouse receipts, 397; and 
 deposits compared, 479; for 
 fixed in time of crisis (table) 
 530; regulation of, 553-56 
 Commercial banks, chap, on practi- 
 cal operations of, 357-409; posi- 
 tion hi financial structure (see 
 charts 134, 136, 650), 375, 488, 
 529; classification of, 358; growth 
 and importance of, charts, 359, 
 360; incidental services 0^361-63; 
 investments of (see Commercial 
 bank investments); and foreign 
 trade, chap, on, 410-426; relation 
 to commercial paper houses, 429; 
 relation to discount companies,
 
 INDEX 
 
 783 
 
 441; and economic organization, 
 486-88; and business cycles, 
 519-41; and agricultural credit, 
 656-69; engaging in trust com- 
 pany operations, 729-30 
 
 Commercial credit, 124 
 
 Commercial credit companies (see 
 Discount companies) 
 
 Commercial credit instruments, 162- 
 69 (see also credit instruments) 
 
 Commercial letters of credit (see 
 Letters of credit) 
 
 Commercial loans, nature of, 376 
 (see also Single-name and Two- 
 name paper) 
 
 Commercial paper, street use of 
 term, 434; as secondary reserve, 
 475; not liquid in time of crisis, 
 532-33 
 
 Commercial paper houses, chart, 
 136, 427-37; economic signifi- 
 cance of, 435 
 
 Common denominator of value (see 
 pecuniary unit) 
 
 Common stock, 140, 153-54 
 
 "Community of interest," 729, 772 
 
 "Compensated" dollar (see "Stabil- 
 ized" dollar) 
 
 Comptroller of the Currency, 394; 
 duties of, 558 
 
 Comstock Lode, 80 
 
 Concentration of money and credit 
 (see Financial concentration) 
 
 Conditional sale agreement, illustra- 
 tion of, 447 
 
 Consolidated stock exchange, 281, 
 284 
 
 Consortium of international bankers, 
 772-73 
 
 Consumptive credit, definition of, 
 125 
 
 Consumptive credit institutions, 
 chap, on, 697-722 
 
 Contingent liabilities, 380 
 
 Control of discount rates, under 
 Federal Reserve System, 593, 
 597-98; after the war, 634-39 
 
 Co-operative credit associations, 
 agricultural, 652; 708-14 
 
 Corporate reorganizations, 312 
 
 Corporation, relation to financial 
 structure, (chart 136), 750; "close," 
 135; as capital raising device, 
 chap, on, 139-50 
 
 Correspondent banks, 470-75 
 
 Cotton "factor," 655 
 
 Country banks, meaning of term, 
 37i 
 
 Credit, nature and functions of 
 121-31; kinds of, 122-23; invest- 
 ment, 124; commercial, 124; 
 consumptive, 125; basis of, 125- 
 27; significance of, 127-29; book, 
 162 
 
 Credit analysis, 378-83 
 
 Credit currency (see Deposit cur- 
 rency) 
 
 Credit department, 379 
 
 Credit instruments, 122; chap. on. 
 151-84; hives tment, 1 51-61; com 
 mercial, 162-69; as media of 
 exchange, 170 
 
 Creditor nation, 118, 260, 424 
 
 Credit unions (see Co-operative 
 credit associations) 
 
 Crime of 1873, 77. 79 
 
 Crises (see Business cycles) 
 
 Crop liens, amount of, 653; nature 
 of, 654 
 
 Curb market, 280; volume of 
 transactions on, 281; importance 
 of, 284-85 
 
 Currency act of 1900, 85; banking 
 provisions of, 567 
 
 Custodian of Securities, 316-21 
 
 Cyanide process, 80 
 
 Debenture bond, 157 
 Decentralized banking, 521-23 
 Deflation, process of, 639-43 
 Demand loans, definition of, 376 
 Department-store finance (see Finan- 
 cial integration) 
 Depositary banks, for government 
 
 funds, 373; 614-15 
 Deposit currency, origin of, 366-70 
 475-80; increasing importance of 
 372; amount of, 483-85; and
 
 784 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 prices, 485; elasticity of (chart), 
 499; reasons for elasticity, 501-2; 
 elasticity of, under Federal Re- 
 serve System, 594-96 
 
 Depressions (see Business cycles) 
 
 Discount companies, chart, 136; 
 437-54J economic significance 
 of, 453 
 
 Discount Corporation of New York, 
 608 
 
 Discount market, nature and func- 
 tions of, 600-608 
 
 Discount rates, control of, 593, 
 597-98, 634-39 (see also Interest 
 rates) 
 
 Discounting receivables (see Assign- 
 ing accounts) 
 
 Dollar drafts, import, 414; export, 
 418, 420 
 
 Domestic exchange, 115-16, 472 
 
 Double liability of bank share- 
 holders, 552-53 
 
 Draft (see Bills of exchange, trade 
 acceptance, bank draft, accom- 
 modation draft) 
 
 Edge Act, passage of, 263; and 
 American foreign investments, 
 264-67; and direct financing of 
 exports, 422-23 
 
 Elastic currency (see also Inelastic 
 currency), under Federal Reserve 
 System, 577-96 
 
 Equalization of reserves, 533-37 
 
 Equipment trust obligations, 156, 
 308 
 
 Escrow, meaning of, 304 
 
 Essential credits, 641 
 
 European debt to U.S., 272; can- 
 cellation of, 275-76 
 
 European reconstruction, and 
 American loans, 267 
 
 Farm mortgage broker (chart, 650), 
 
 667 
 Farm mortgage companies (chart, 
 
 650), 668, 672 (see also Mortgage 
 
 companies) 
 Farm indebtedness, working capital, 
 
 653; fixed capital, 665-66 
 
 "Farmers' bank," 657 
 Federal Advisory Council, 576 
 Federal Farm Loan Act, passage of, 
 
 674 
 Federal Farm Loan Board, nature 
 
 and general powers of, 674 
 Federal Farm Loan districts, map of, 
 
 676 
 
 Federal Farm Loan Registrar, 677, 
 682 
 
 Federal Farm Loan System, organi- 
 zation of, 672-82; loans of, 685; 
 results of, 686-87; criticisms of, 
 688-90 
 
 Federal Land banks (chart 650), 
 675; financial statement of, 
 684-85 
 
 Federal Reserve Act, evolution of, 
 570-72 
 
 Federal Reserve Agent, 575, 580, 588 
 
 Federal Reserve banks, collateral 
 loans of, 373; financial state- 
 ments of, 616-18; interborrowing 
 operations of, 644 
 
 Federal Reserve bank notes, amount 
 of, 103; regulation of, 578-79; 
 legal tender of, 589 
 
 Federal Reserve Board, and ad- 
 ministration of Edge Act, 264-65, 
 423; general powers and duties 
 of, 576-77; extraordinary power 
 of, over economic system, 752-54 
 
 Federal Reserve districts, map of, 
 573; size of, 574 
 
 Federal Reserve notes, amount of, 
 103; regulation of, 580-89; legal 
 tender of, 589 
 
 Federal Reserve System, chaps, on, 
 566-648; and export financing, 
 264-65; 410-21; and foreign 
 branch banks, 421-22; position 
 in financial structure, charts, 
 134, 136, 650; and control of 
 business cycle, 593-608; and war 
 finance, 624-31; and state 
 banks, 735-39; and savings 
 banks, 742 
 
 Fiat currency, 91 
 
 Finance companies (see Discount 
 companies)
 
 INDEX 
 
 785 
 
 Financial concentration, 756-57; 
 in New York, 758; in Germany, 
 758-61; Congressional investi- 
 gation of, 761-64; defense of, 
 by Morgan and Company, 765- 
 69; and control of undeveloped 
 regions, 772~73 
 
 Financial crises (see Business cycles) 
 
 Financial integration, 137, 323; 
 chap, on, 723-42; and concentra- 
 tion, 762 
 
 Financial organization, international 
 aspects of, 273-76; 7S4-5 6 
 
 Financial panics (see Business cycle) 
 
 Financial reorganizations, 312 
 
 Financial statement, illustration of, 
 38i 
 
 Financial structure, 3; 132-38; 
 charts of, 134, 136, 218, 650; 749 
 
 Financial system, and the general 
 economic organization, chap, on, 
 743-777; interdependence of, 
 748-49 (see also Pecuniary system) 
 
 First Bank of the United States, 549 
 
 First Federal Foreign Banking 
 Association, 423 
 
 Fiscal agency, 313-15 
 
 Fixed capital, 2, 8, 132; charts on, 
 134, 136, 650 
 
 Foreign Bond and Share Corpora- 
 tion, 267 
 
 Foreign branch banks, 421-22 
 
 Foreign exchange, chap. on, io7~r2o; 
 during the war, ITO-I?; pegging 
 of, 117; depreciation of, 117-18, 
 and export trade, 262-63; an ^ 
 international indebtedness, 269-72 
 
 Foreign Finance Corporation, 268 
 
 Foreign financing, chaps, on, 256- 
 78, 410-26 (see also Investment 
 trusts and Foreign trade) 
 
 Foreign investments, and free silver 
 agitation, 28; of U.S., 118; in 
 the U.S., 214; of Great Britain, 
 256; future of American, 269-73 
 
 Foreign Investment Trusts (see 
 Investment trusts) 
 
 Foreign trade, since the war, 
 262-63; financing of (see Foreign 
 financing) 
 
 Fractional silver coins, redemption 
 of, 84; legal tender of, 86; amount 
 of, 103 
 
 "Free banking" law of New York, 
 552 
 
 Free silver agitation, and interna- 
 tional finance, 27-28; and domes- 
 tic finance, 28; and farmers, 38; 
 and pensions, 39; and creditors, 39 
 
 German banking, concentration of, 
 
 German financial concentration, 
 758-61, 764 
 
 German indemnity, and the foreign 
 exchanges, 274; cancellation of, 
 275-76; difficulty in paying, 755 
 
 Gold, why chosen as standard, 19, 
 79-83; durability of, 19; relative 
 stability of, 20; production of, 
 82; commercial ratio of, to silver, 
 83; international flow of, 115; 
 domestic flow of, 1 16; holdings of 
 leading nations (chart), 271 
 
 Gold certificates, 100; redemption 
 of, 102; amount of, 103; legal 
 tender of, 104; exchanged for 
 Federal Reserve notes, 577 
 
 Gold clearance (see Gold settlement 
 
 fund) 
 Gold coin, weight of, 4; legal tender 
 
 of, 85; amount of, 103 
 
 Gold dollar, definition of, 21 
 Gold exchange standard, 77 
 Gold points, 112 
 Gold settlement fund, 611 
 
 Gold standard, history of, 75-77; 
 law of 1900, 77 
 
 Government regulation of banking, 
 
 chap, on, 547-65 
 Great Illusion, the, 755 
 
 Greenback currency, and trading 
 methods, 25-27; and debtor class, 
 32; purpose and nature of, 101; 
 amount of, 101, 103; redemption 
 of, 102; legal tender provisions 
 of, 104 
 
 Gresham's Law, and defective coin- 
 age, 66; and bimetallism, 73-79
 
 786 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 High-grade securities, chap, on, 
 
 211-55 
 Hoarding, and financial panics, 527; 
 
 and Federal Reserve System, 644 
 
 Indemnity (see German indemnity) , 
 
 Independent treasury, 503 (see also 
 Depositary banks) 
 
 Index numbers, purpose of, 22; 
 method of computing, 22; nature 
 of, 23 
 
 Inelastic currency (see also Elastic 
 currency), under national banking 
 system, 497-502; and financial 
 crises, 525-26 
 
 inflation, process of, 628-30; in 
 Europe, 630-31 
 
 Insurance companies (charts) 134, 
 136, 650; and bond distribution, 
 237; as savings institutions, 
 344-48 
 
 Integration (see Financial integra- 
 tion) 
 
 Inter-bank borrowing, 474-75 
 
 Interest rates, in New York City 
 (chart), 393; on deposits, 465; 
 on loans, 466 (see also Discount 
 rates) 
 
 Interlocking directorates, system of, 
 761-64; declared illegal, 771 
 
 International barter, 275 
 
 International finance, control of, 
 754-56 (see also Foreign exchange) 
 
 International indebtedness, and for- 
 eign exchange, 269-72; cancel- 
 lation of, 275-76; difficulty in 
 paying, 756 
 
 Investment banking, interrelations 
 with financial system (chart) 136; 
 history of, 212-17; functional 
 chart of, 218; function of investi- 
 gation and analysis, 218-28; 
 function of underwriting (see 
 Underwriting); function of dis- 
 tribution, 234-40; sundry services 
 of, 240-43; profits of, 243-45; reg- 
 ulation of, 245-47; and economic 
 organization, 247-51; concentra- 
 tion and integration of, 761-62 
 
 Investment credit, 124 
 
 Investment loans, nature of, 376-90 
 
 Investment trusts, chap, on, 256-78; 
 of Great Britain, 257-60; Ameri- 
 can authorized, 263-69 
 
 Joint-stock land banks chart, 650, 
 681-82; growth of, 685-86 
 
 Klondike gold mines, 80 
 
 Lease agreement, illustration of, 
 452 
 
 Legal tender, purpose of, 85; of 
 metallic money, 85-86, of govern- 
 ment paper money, 103-5; f 
 national bank notes, 371; of 
 Federal Reserve Bank and Federal 
 Reserve notes, 589 
 
 Letter of credit agreement, illustra- 
 tion of, 416 
 
 Letters of credit, 372, 411-14; 
 illustration of, 417 
 
 Limited liability, advantages of, 
 I4I-43 
 
 "Limping standard," 76 
 
 Liquidation of loans, automatic 
 theory, 532; annual, 532 
 
 "Living trusts," 305 
 
 Loan sharks, 703-8 
 
 London stock exchange, 214, 256 
 
 Low grade securities (see Speculative 
 securities); and stock exchange 
 speculation, 296 
 
 "Margin" trading, 286-87, 392 
 
 McLean Act, 264 
 
 Medium of exchange, function of, 
 41-42; and capitalistic produc- 
 tion, 43 
 
 Mercantilism, 57-59, 744 
 
 Metallic currency, regulation of, 
 65-90; subsidiary forms of, 84-85 ; 
 legal tender of, 85-86 
 
 Minor coins, redemption of, 84; 
 legal tender of, 86 
 
 Mint, charges at, 69-70; tolerance 
 of, 71; of United States, 73 
 
 Monetary unit (see Pecuniary unit) 
 
 Money, as store of value, 42; and 
 business organization, 43-44; use 
 in production, 43-45; and war
 
 INDEX. 
 
 787 
 
 finance, 45-48; and peace finance, 
 48-50; and distribution of pro- 
 ductive energy, 49-50; and capital 
 formation, 40-50; confusion of 
 with wealth, 56-60; quantity 
 required, 60-62; regulation of 
 metallic, chap, on, 65-90; regula- 
 tion of paper, chap, on, 91-106; 
 stock of, and kinds, in U.S., 103 
 
 Money rates (see Interest rates) 
 
 Money trust (see Financial concen- 
 tration) 
 
 Morgan & Co., 217, 268, 761; 
 defense of financial concentration, 
 765-69 
 
 "Morning" loans, 394 
 
 Morris Plan Bank, 708 
 
 Mortgage companies (chart), 134 
 (see also Farm mortgage com- 
 panies) 
 
 Mortgage security, 152; significance 
 of, 156; trustee for, 307 
 
 National Bank Act, 548 
 
 National bank notes (see also Bank 
 notes); amount of, 103; regula- 
 tion, 370; legal tender of, 371; 
 declining importance of, 371-72; 
 inelasticity of (chart), 499; 
 reasons for, 500-501; under 
 Federal Reserve System, 577-78 
 
 National banks, 358; loans of, 377; 
 
 investments of, 401. 
 National Citizens' League, 570 
 National Farm Loan associations, 
 
 chart, 650; 675 
 
 Negotiability vs. salability and 
 transferability, 171; principle 
 of, 172; essentials of, 175-78; of 
 bonds, 180; of stock, 180; legal 
 procedure with, 175-77; of checks, 
 bank notes, and bank drafts, 1 79 
 Negotiable Instruments Law, 174 
 New York Stock Exchange, 280, 281 
 Note brokerage (see Commercial 
 paper houses) 
 
 Open accounts (see Accounts receiv- 
 able) 
 
 Open market operations (see also 
 Discount market), 598-600 
 
 Overcapitalization, 155 
 Overcertification, 394 
 Overdrafts, 332 
 
 Panic of 1907, and savings banks, 
 336 
 
 Paper currency, in France, 24; regu- 
 lation of government, 91-106; 
 representative, 91; convertible 
 fiduciary, 91; inconvertible or 
 fiat, 91; irredeemable, 92; con- 
 federate, 93-96; revolutionary, 
 97; value of, 98; depreciation of 
 European, 262, 270, 271 
 
 Par collections, 610-13 
 Par of exchange, 109, 115 
 Pawnbroking, 699-703 
 
 Pecuniary system, and economic 
 and social standards, chap, on, 
 53-64; advantages of, 744; dis- 
 advantages of, 745-48 
 
 Pecuniary unit, definition and origin 
 of, 4-6; and business administra- 
 tion, 6-1 1 ; and apportionment 
 of family expenditures, 11-13; 
 and economic organization, 13-15 
 
 Pittman Act, 101 
 
 Preferred stock, 140, 153; "modern" 
 153-54; illustration of, 160-61 
 
 Price changes, charts of, 31, 626; 
 causes of, 23; economic con- 
 sequences of, 23-30; and social 
 maladjustments, 30-37; and Ger- 
 man trade, 29-30; in United 
 States, 1840 to 1920, 31; after 
 Civil War, 33; and debtor class, 
 33~34> an d creditor class, 34; 
 after 1896, 34; and real salaries 
 and wages, 35-36, 37, and fixed 
 incomes, 35, 37; and savings, 
 36-37 
 
 Price level, definition of, 22; reasons 
 for decline of, in 1920, 639-43; 
 control of, by stabilized dollar, 
 748, by credit restrictions, 753-54 
 (see also Price changes) 
 
 Prices, relation of money to, 21; 
 
 relation of deposit currency to, 
 
 485 
 Private banks, 358
 
 788 THE FINANCIAL ORGANIZATION OF SOCIETY 
 
 Promissory note, definition of, 162; 
 illustration of, 163; similarity to 
 trade draft, 168-69 
 
 Promotion, methods of, 186-97 
 
 Prosperity, periods of (see Business 
 cycles) 
 
 Real estate loans, of national banks, 
 385; of state banks, 385; con- 
 troversy over, 555-56; without 
 mortgage security, 658 
 
 Redemption fund, for national 
 bank notes, 374 
 
 Rediscounting, before Federal Re- 
 serve Act, 474-75; under Federal 
 Reserve System, 591-92 
 
 " Refinancing," definition of, 419-20 
 Registrar of securities, 311-12 
 Reorganization, corporate, 312 
 Reserve cities, meaning of, 371 
 
 Reserves, of savings banks, 341-42; 
 of commercial banks, 475; net 
 in banking system (chart), 479, 
 482-83; till money, 480-81; ulti- 
 mate or liquidation, 481 ; redepos- 
 iting of, 482; ratio of, to deposits 
 in New York (chart), 498; re- 
 quirements under National Bank 
 Act, 482; under Federal Reserve 
 Act, 590-91; and deposits, 1897- 
 19074 (table), 521; and financial 
 panics, 526; redepositing of, and 
 financial panics, 527-29; equaliza- 
 tion of, 533737; regulation of, 
 556-57; requirements for Federal 
 Reserve notes, 588; of reserve 
 banks not irreducible minima, 597 
 
 Rural credit (see Agricultural credit) 
 
 Safety deposit vaults, 316 
 
 Savings banks, and bond distribu- 
 tion, 238; chap, on, 327-56; 
 stock, 327-32; mutual, 332-34; 
 "guaranty" 333; departments in 
 commercial banks, 334-35; pos- 
 tol* 335-39> management of, 
 339-43; and agricultural credit, 
 651; with commercial accounts, 
 731; seeking trust powers, 732; 
 and Federal Reserve System, 739 
 
 Scandinavian monetary union, 76 
 Seasonal variations in demand for 
 
 currency, 495-502 
 Secondary reserves in time of panic, 
 
 531-33 
 Second Bank of the United States, 
 
 549-50 
 
 Serial notes (see Short-term notes) 
 Sherman Silver Purchase Act, 77; 
 
 repeal of, 101 
 Short-term note, 157 
 Silver certificates, 100; and treasury 
 
 notes, 101; redemption of, 102; 
 
 amount of, 103; legal tender of, 
 
 104 
 
 Silver dollar, now a subsidiary coin, 
 84; coinage of, 85; method of 
 maintaining parity, 85; legal 
 tender of, 86; amount of, 103 
 
 Silver, price fluctuations of, 80-83; 
 production of, 82; commercial 
 ratio to gold, 83; regulation of 
 subsidiary, 84; fractional coins, 
 84 
 
 Single name paper, 377-84; used 
 in stock exchange speculation, 
 393-94 
 
 South African gold fields, 80 
 
 Speculation, in 1688, 145; in 1719, 
 142; in 1919, 191-92; on 
 "margin," 286-87, 392; control 
 of, 636 (see also Stock Exchange) 
 
 Speculative securities, 185-210, 291 
 
 Stabilized dollar, 746 
 
 Standard for deferred payments, 
 
 importance of, 18; why gold was 
 
 chosen as, 19 
 Standard of value (see Pecuniary 
 
 unit) 
 State banks, 358; investments of, 
 
 402; regulation of, 558-62; and 
 
 Federal Reserve System, 735-39 
 
 Stock, advantages of, 140; preferred, 
 140, 141; common, 141; preferred 
 cumulative, 153; preferred partici- 
 pating, 153; modern preferred 
 almost equal to bonds, 153; with- 
 out par value, 154 
 
 Stock exchange (chart, 136), 183; and 
 capital raising, chap, on, 279-300:
 
 INDEX 
 
 789 
 
 of London (see London stock 
 exchange) ; of New York (see New 
 York stock exchange); consoli- 
 dated (see Consolidated stock ex- 
 change); committee on stock lists, 
 283; brokers (see Brokers); eco- 
 nomic functions of, 293-98; and 
 the distribution of capital, 295; 
 and marketing of low grade secu- 
 rities, 296; interrelations with fi- 
 nancial structure, 298; panic of 
 March, 1907, 521 
 Stockholders' "rights," 155 
 Surplus, accumulation of, required, 
 
 553 
 Syndicate (see Underwriting) 
 
 Token coins, 84 
 
 Trade acceptance, definition of, 164; 
 illustration of, 165; similarity 
 to promissory notes, 168-69 
 
 Trade credit, 135; in agriculture, 
 654-56 
 
 Trade draft (see Trade acceptance) 
 
 Transfer agent, 309-11 
 
 Traveler's checks, 372 
 
 Treasury notes of 1890 diffi- 
 culties with, 27, 101; redemption 
 of, 102; legal tender of, 104; 
 amount of, 103 
 
 Trial of the Pyx, 71 
 
 Trust companies and bond dis- 
 tribution, 238; chap, on, 301-26; 
 and corporation finance, 306-15; 
 as transfer agent, 309; and cor- 
 porate reorganizations, 312-13; 
 as registrar, 311; as fiscal agent, 
 313-15; as custodian of securities, 
 316-22; regulation of, 322-23; 
 
 growth and importance of, 359- 
 60; and agricultural credit, 
 65 1 ; commercial banking features 
 of, table, 726-27 
 
 Trust receipt, 414, illustration of, 
 
 415, and bank acceptance, 602 
 Two-name paper, 384-85 
 
 Underwriting, function of, diagrams, 
 136, 218; 228-33; joint account 
 arrangement, 229; syndicate, 2; 
 230-32; participation, 232; de- 
 pendence upon commercial banks, 
 232, 297; relation to stock 
 exchange, 297; and financial con- 
 centration, 761-64 (see also Con- 
 sortium of international bankers) 
 United States deposits, 374 
 United States notes (see Greenback 
 
 currency) 
 
 United States treasurer, 84, 85 
 United States Treasury, and bank 
 note issues, 370, 501; relation to 
 money market 502-5; and finan- 
 cial crises, 530-31; and Federal 
 Reserve notes, 589; and Federal 
 Reserve System, 614-16 
 
 Victory loan, 634-35 
 
 Warehouse Act, of United States, 
 
 399 
 Warehouse receipts, nature of, 397; 
 
 loans on, 397; illustration of, 400 
 War Finance, and Federal Reserve 
 
 System, 624-31 
 
 "War paper," 592; origin of, 628-30 
 Working capital, 2, 8, 132, 137; 
 
 charts on 134, 136, 760 
 
 PRINTED IN THE D.S.A.
 
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