The Rationale of Central Banking and the Free Banking Alternative
By Vera C. Smith
The Rationale of Central Banking invites us to reassess our monetary institutions and give reform proposals due consideration. The decades since it first appeared in 1936 have restored its themes to relevance. Government-dominated monetary systems have continued to perform poorly. Other experience, as well as the work of James Buchanan and the Public Choice School, has heightened skepticism about government generally. People are now willing to discuss what Vera Smith set out to examine: “the relative merits of a centralized monopolistic banking system and a system of competitive banks all possessing equal rights to trade” (p. 3)…. [From the Preface, by Leland B. Yeager]
First Pub. Date
Indianapolis, IN: Liberty Fund, Inc. Liberty Press
The text of this edition is under copyright.
Discussions in America Prior to the Foundation of the Federal Reserve System
After 1875 the central banking systems of those countries which already had them were accepted without further discussion, and the practical choice of the one system in preference to the alternative was never again questioned. Moreover, the declared superiority of central banking became nothing less than a dogma without any very clear understanding of the exact nature of the advantages, but there remained one among the chief commercial countries of the world which still lacked a central banking organisation: this was the United States of America. It is the purpose of this chapter to examine some of the motives which led to the final adoption of such an organisation by that country in 1913.
As we have previously described, the banking structure of the United States consisted of a multitude of small independent banks, each with its business confined to a narrow area. There were in 1913 over 20,000 banks, of which about 7,000 were National Banks issuing notes and the rest non-note-issuing banks operating, not under the National Bank Law, but under the banking law of the States in which they lay.
This was frequently cited as an example of the practical application of the principles of free banking. But while it was true that any person or group of persons complying with certain requirements could open a bank of issue, and that the business was open to all on the same terms, there were at least two important points of divergence between the American “free banking” so called and free banking in the more general sense in which the term was used by the writers on the continent of Europe. Firstly, the banks were excluded from practically all possibilities of developing branch organisation, and most banks outside the big cities approached more or less to local monopolies. Secondly, the National Banking Law, under which the “free” banks operated, specified a peculiar system of note issue. It is at least a supportable view that the American bank organisation lacked the advantages of both central banking and of free banking proper.
Practically all tendencies to the growth of branch banking which had manifested themselves as part of the natural evolution of banking development elsewhere had been expressly excluded in the United States. In the days before the National Banking Law, banks had come exclusively under the jurisdiction of the individual States, and banking firms authorised to set up in one State had no possibility of extending their operations by branch office or otherwise beyond the boundaries of this State into the territory of another. So far as the allowance of branch banking within the confines of the individual State was concerned, the practice varied. Some States, mostly in the south, had permitted it; others had passed legislation forbidding it. The National Bank Act did nothing to alter this situation. It expressly stated that a bank formed under its provisions should not carry on business elsewhere than at the offices in places specified in its certificate of association. All that the law allowed was that State banks which had previously had branches should have the right to retain them if they came into the National Banking System.
The method of issuing notes against bond deposit instead of against commercial assets had shown weaknesses at a very early stage, as we have already intimated in a previous chapter. Its advantages became increasingly doubtful as time went on.
The obligation to tie up capital in a particular type of asset as a condition for the issue of notes made the volume of the note issue dependent in the long run on the profitability of these assets, and besides affecting the distribution of a bank’s assets had reactions also on the form of its liabilities.
When note issue does not entail bond deposit, the bank has an unhindered choice in determining how much of the sight liabilities it can safely create against a given cash reserve shall be in the form of notes and how much in the form of deposit credits. Since both are payable on demand in legal tender, it would be a choice ruled by the public’s preference for notes as against deposits which can be checked against, and it would be a matter of some indifference to the bank if it were suddenly called on by the public to vary the proportion between the two.
But if a bank is forced as a condition of note issue to invest in State bonds, it will, if these are unprofitable, be encouraged to get out its loans as far as possible by way of deposit credits rather than by the issue of notes.
We must now examine the actual facts of the case as they presented themselves in America. State bonds, being as they were in great demand as a basis for the note issue and at the same time a decreasing rather than an increasing amount on the market, generally stood at a premium. This factor, together with the provision by which a bank could only issue notes to the extent of 90 percent of the face value of the bonds it purchased, greatly reduced the profitability of locking up funds in these bonds for the purpose of obtaining notes, and where a bank could get out its loans otherwise than by notes, it naturally preferred to do so. This caused variations from district to district as well as from year to year, and tended to increase deposit credits disproportionately to the increase in the note issue. In parts of the country where people insisted on having notes, banks charged a higher rate of interest than in those parts of the country where borrowers could be induced to take deposit credits and where check payments predominated over demands for currency withdrawals in the form of notes.
Looking at the long period movements in the circulation we find that between the inception of the National Banking System and 1900 they exhibit a trend which cannot but be considered as exceptional if compared with that of the note issues in other countries not working on a bond deposit basis. At the beginning of the ‘eighties the Federal Government began to reduce its indebtedness by paying off its bonds; so that a scarcity of note-backing medium arose, and what there was stood at a high premium and gave a correspondingly small return. There consequently ensued a rapid reduction in the National Bank circulation outstanding, and between 1881 and 1890 there was a decrease of some 60 percent. During the whole of the period, when notes were diminishing or practically constant in volume, there was on the other hand a rapid increase of bank reserves of cash (chiefly of specie; legal tender notes remained a fairly constant element), and also a steady increase in deposits. This was quite contrary to what would be expected under an ordinary asset currency, where inflows of specie, whether from abroad or from internal hoards, are accompanied by increases in note issues.
A great deal of comment was also raised by the inelasticity exhibited by the note issue in the short run. The fluctuations shown under an ordinary system in the proportion between note and deposit liabilities, especially in response to seasonal changes in demand, found no parallel in America in spite of its large agricultural interest and heavy crop-moving demands for cash. The failure of the note circulation to respond to these demands intensified the autumnal strain on the money market and the banking system.
The explanation of the inflexibility of the note circulation lay as much in its lack of contractibility as in its lack of expansibility. It was expensive and slow to negotiate the purchase of new bonds in order to obtain additional notes from the Comptroller when the need arose, and the incentive to do so was further diminished by the fact that the notes could only be retired after the need had passed, by going through the same formalities and expense. Moreover, there was a legal limit on the number of notes that might be retired in any one month.
*34 Notes once taken out by any bank were usually used by that bank to the full extent. It did not keep but a very small proportion on hand for periods of extra heavy demand for hand-to-hand currency, and so, in times when such demands arose, the banks could only meet them by drawing on their cash reserves and paying out legal tender, and they were pressed to a sharp restriction of credits all round in order to meet their obligations.
The lack of any reserve of notes led to frequent and violent fluctuations in interest rates. There was every year a steep rise in the autumn.
The popular illusion that the securing of notes by bond deposit would guarantee that they would always be paid in full had been dispelled. Later observers came, moreover, to realise that the system was responsible for suppressing some of the natural checks to over-expansions. It made the return of notes to the issuing bank for redemption in the ordinary course of business very infrequent. The uniformity of the form of the notes of different banks, as well as the semblance of indubitable security with which they were endowed by the law, caused the public to regard the notes of one bank as being as good as those of any other. More important still was the failure of the banks reciprocally to return each other’s notes. Instead of sending in the notes of its rivals for clearance, a bank usually paid them out again over its own counter. This was due, in the first place, to the trouble and expense involved in sending notes back to the redeeming agencies which, in the absence of branch banking, were few and far between,
*35 and in the second place, to the absence of any immediate incentive, in view of the costliness of the issue, for a bank to replace foreign notes by its own. These circumstances removed one of the tests which warns a bank when it is over-expanding by drawing on its reserves at an early stage.
A series of acute financial crises occurred in fairly quick succession—1873, 1884, 1890, 1893, 1907. Crises occurred on most of these occasions in London as well, but they were nothing like as stringent. Money rates in New York rose to fantastic heights as compared with London, and there was one other even more marked dissimilarity. In America there took place in three out of the five cases (1873, 1893 and 1907) widespread suspensions of cash payments, either partial or complete, with currency at a premium over claims on banking accounts. These tendencies culminated in the crisis of 1907, when suspensions lasted in some measure for a period of over two months.
There had been for some time a growing dissatisfaction with the fundamentals of the American system. The most obvious distinguishing feature, and the one to which attention was first directed, was of course the method of note issue, and some of the critics believed that the defect was connected solely with this system of issue against bond deposit, and that it would not be present under an ordinary asset currency. Its failings were summarised under the term “inelasticity.” This is a term which has frequently had a dangerous connotation, being more often than not a cloak for the advocacy of inflation, but, as we have already explained in a previous section, there was some justification in the American case for the accusation that the note issue lacked necessary elasticity. It failed to provide for fluctuating demands for cash, firstly with seasonal, and secondly with crisis needs. It was the deficiency in supplying the latter that was given most prominence. The problem was how to provide an “emergency currency.”
It was observed after 1879
*36 that it was chiefly pressure exerted on the banks by depositors to withdraw hand-to-hand cash and not by note-holders to withdraw legal tender money that precipitated suspensions. It was contended, not unreasonably by the banks that their suspensions were the direct result of their being unable to issue extra notes. If they had been able to do this, they could have satisfied the demands of their depositors for cash by giving them notes, and in these circumstances the demand of customers for cash, both in the narrower sense
and in the wider sense (that is, in the sense of paying out legal tender for either notes or deposits if and when demanded), could have been maintained. The demand of the public was only to change the form of the medium—from deposits to notes: they wanted simply hand-to-hand currency and would have been as well satisfied with bank-notes as with legal tender. Reserves of legal tender could then have been kept practically intact—the additional note-holders would not have drawn on them; but as it was in the face of the inability to issue notes, the demand for cash by the depositors could only be satisfied if at all out of the reserves of legal tender, and these would soon have been exhausted. The suspension of cash payments was, according to this view, due to the lack of variability in the
form of the currency (current accounts to notes).
Some attempts were made to remedy the situation along the lines of this argument. It had been suggested by the promoters of what was known as the Baltimore Plan in 1894 that the bond deposit system should be abandoned altogether in favour of an ordinary asset currency accompanied by a safety fund guarantee. This proposal was, however, never taken up very enthusiastically. In 1900 measures were introduced to make the note issue more profitable. An Act was passed to allow banks to take out notes equal in value to the full face value of the bonds they deposited instead of only to 90 percent of that value, and the tax on the note issue was reduced from 1 percent to 1/2 percent. After 1900, too, the Secretary of the Treasury interpreted the law in a very liberal way and accepted municipal and other stocks for note backing where previously only strictly Government securities had been eligible. The object of this step was to increase the circulation in the autumn to meet the demands of crop moving. It was intended to be purely a temporary seasonal increase, but failed to serve this purpose because the circulation did not contract again after the seasonal demand for cash had fallen off, and so there was in the next year just the same lack of provision for the autumnal cash drain as before. In general, these measures served only to make a permanent increase in the circulation without increasing its short period elasticity. It still left no slack ready to be taken up in an emergency. The result was merely a progressive increase in the circulation between 1900 and 1907 of over 90 percent, which provided currency for the inflationary boom of those years. As was evidenced by the events of 1907, the bond deposit system had proved incapable of modification in the direction of providing increased bank currency for emergencies.
Other attempts at interpreting the cause of the difficulties laid less stress on the question of note issues and sought the primary explanation more in other features of the American structure. One of these was the system of legal reserve ratios.
*38 So far as the possibilities of credit expansion were concerned, the requirements of minimum reserve ratios probably did not cause the banks to expand less than they otherwise would; the legal minimum was a good deal below what the banks of their own accord thought fit to keep in normal times. But immediately the sort of event occurred for the very purpose of which such reserves should be kept, namely, an extra heavy demand for cash, the banks could only use their reserves to a very small extent before they approached the legal minimum. If they were not to be allowed to fall below the legal minimum, there was very little slack for taking up in times of pressure. So if deposits were being withdrawn rather more rapidly than usual, the situation could only be met by immediately calling in loans, thus cancelling some deposits and thereby diminishing the total amount of necessary reserve money. Such a procedure forces as much liquidation as if the banks were without cash reserves, and if the process is at all general, affecting a large number of banks, the liquidity of the individual bank is lost in the liquidity of the whole system.
The banks were faced with these alternatives: either they could suspend cash payments immediately, or they could use their cash reserves as far as possible to meet current demands in the hope of stemming the demand for cash and rendering such a suspension unnecessary. Under the American law a bank falling below its legal reserve requirements was obliged to discontinue lending operations until the deficit had been made good. This enforced on the banks endeavouring to maintain cash payments in the crisis a policy of immediate loan contraction. Given the choice, then, between falling below legal reserve requirements and suspending payments immediately, it was a much easier way out for the banks to choose the latter course. Such a procedure stopped the claims of depositors and made it possible for the banks to give their debtor customers time to repay their loans and even to give new loans so far as people were still willing to take payment in uncashable checks, or (in the case where payments were still made on a certain percentage of deposits) in partly cashable checks. The banks might find that this policy promised more likelihood of their customers being able to pay back their loans in the end than if they immediately caused them to go into liquidation.
At all events, the banks seemed to have suspended payments immediately as they approached the legal reserve limit, which means while they were still in a very strong reserve position. The figures of the reserve positions, given in the Annual Reports of the Comptroller of the Currency, are averages for all the banks in each State or Reserve City, and so cover up the individual movements, but it seems fairly certain that the banks did not in many cases allow their reserves ratios to go below the legal limit to any significant extent. The action of the banks in suspending payments was technically, of course, an act of insolvency, but this was given official sanction in a number of ways and a long tradition of wholesale suspensions both before and after the inception of the National Banking System had accustomed the public to their legality. The Comptroller allowed the banks to restrict payments for a period of several months on end and then permitted them to resume business as long as he considered their assets were “sound.” This happened in some cases even after a bank had been put into the hands of a receiver in bankruptcy.
*39 The circumstances in which the banks resorted to suspensions lent a good deal of support to the view that it was primarily an elastic reserve policy rather than an elastic currency that was in urgent need.
A third line of argument laid emphasis on the necessity for some rearrangement in the existing system of holding and utilising reserve funds. At a very early stage the practice had developed among the country banks of depositing balances, which they counted as equivalent to cash, with banks in the large cities. They kept on an average about half of their total reserves on redeposit in this way and about half in their own vaults.
*41 The banks in “redemption” cities or “reserve” and �”central reserve” cities, as they were later designated, were officially recognised as being in a special category as bankers’ banks by the National Banking Law. The conspicuous position held by the banks of New York city in this respect—in 1912 six or seven of them held between them about three-quarters of all the bankers’ balances—seemed to point to the existence of spontaneous tendencies to the pyramiding and centralisation of reserves and the natural development of a quasi-central banking agency, even if one is not superimposed.
The position as it stood was regarded as exceedingly unsatisfactory. It had been a frequent complaint in financial circles ever since 1857 that the practice of re-deposit by the country banks with the city banks, and more particularly with the banks in New York City, encouraged by a number of these banks who paid interest on demand deposits, gave an unhealthy stimulus to speculation on the Stock Exchange by flooding the call loan market with cheap accommodation. It was, what is more important, nearly always the demands for withdrawals of these bankers’ balances by their country owners which precipitated crises in the financial system of the country.
The development of the debtor position of one group of banks, the town banks, to the other group, the country banks, and the extreme instability of this element in the financial structure, is one which would probably have been unimportant if there had been branch banking. The absence of branch organisation may have tended somewhat to raise the level of the amount of call loan money, and it most certainly made it more unstable than it would have been with branch organisation.
The difficulties of a unit bank as compared with a branch system in diversifying risks both in its assets as well as in its deposit liabilities was partly compensatable by the possibility open to the country banks of putting funds on deposit with a town bank and so indirectly taking advantage of the opportunities for investment offered by the money market. The country banks regarded these deposits as their second line of defence—as part of their liquid funds which they would be able to withdraw immediately the demands for cash from their customers increased, as happened regularly in the crop-moving season, and they were given official recognition as such by the provision of the National Bank Act, which allowed such deposits to be counted by the country banks as a certain portion of their legal reserves. It is not denied that under a branch system funds from the country would still find their way to the call loan market via the head office or town branches of the parent bank, but the much more restricted range of alternative investments available to one bank in a unit system probably caused rather more to seek this particular outlet.
The unit system with the practice of re-deposit showed great susceptibility to the spread of panic both in the case where the originating disturbance started in the affairs of a country bank, and in the case where it arose at the city bank end. Firstly, a country bank in a unit system is less able to obtain funds from outside when it is under pressure. It may, it is true, be able to borrow from another bank, but this is more difficult and takes longer to negotiate than a transfer of funds from the cash reserves of other branches of the same bank, and it is the ability to obtain funds
in time that is important in order to stop the loss of confidence among the public which leads to a panic run liable to spread to other banks as well. A single weak spot in the system is less likely to affect the whole system under branch organisation than under unit organisation.
Secondly, the call loan position in New York was rendered exceedingly vulnerable in the event of extra heavy demands for withdrawals, and especially in the circumstances associated with the break of a boom when call loans proved to be among the most illiquid of assets. Experience taught the country banks that their correspondents in New York found it difficult to cash their deposits in such a situation. Consequently, immediately the slightest indication of defect occurred, there was a scramble by the country banks to withdraw their balances
en bloc from New York. The fear that they would in a few days’ time find their balances frozen led them to withdraw them immediately, whether they were actually in need of cash themselves or not. Those banks who got their balances out in time were often found on such occasions to have far larger reserves of cash in vaults than at periods of less acute demand from the public. The New York banks were driven to suspend payment, and those country banks who had not withdrawn their funds in time had to suspend also.
The difference in a branch system would be, not that there would not still occur a flow of funds from the interior of New York, but that the greater part of these funds would be disposed of by the town branches or head offices of the banks remitting them, and each bank would retain direct control over its own reserves.
*42 And in a period of pressure, branches would not attempt to withdraw all the spare funds from their head office, regardless of whether they needed them or not. There would be a concentration of funds on points where they were needed most to satisfy the demands of customers and stop a run.
It was realised in some quarters that many of the difficulties could have been remedied by the institution of branch banking along Canadian lines, but this was regarded as a political impossibility, and so attention was turned to the more practical expedient of finding some systematic means of the more economical utilisation of reserves in a crisis within the general framework of the existing system.
It seemed increasingly apparent that it was impossible to rely on the independent and unaided efforts of the banks to secure this end. Some attempts of a somewhat unsystematic nature had already been made by them. One of these was the use of the clearing-house loan certificate.
*43 This was a practice which had been started by the banks of New York and the banks of Boston in 1860. A majority of the banks belonging to the Clearing House Association entered into an agreement under which, when a bank had an adverse clearing balance, it should, instead of paying cash to the creditor bank, deposit collateral with the Clearing House Association, against which the latter should issue clearing-house loan certificates to be received in payment by the creditor bank. The certificates bore interest at a fairly high rate, varying from 5 to 10 percent, which went to the creditor bank holding them in lieu of balances owed. The essence of the scheme was that the banks in a strong position (with favourable clearing balances) should make loans to those in a weaker position (with unfavourable clearing-house balances). It was intended to prevent each bank trying to strengthen its position at the expense of the others, because without such an arrangement, no bank could extend its lending operations and all were induced to contract because of the fear of losing reserves to other banks at a time when the demand of the public for cash was increasing. On the first occasion that the clearing-house loan certificate device was used by the New York banks it was accompanied by an agreement for treating the specie reserves of all banks as a common fund so that the banks having to bear the greatest strain not from other banks, but from the claims of the public, should be able to draw on the reserves of banks less subject to such strain. This pooling of reserves, or “reserve equalisation” as it was called, meant that it was quite impossible for a bank to affect its individual reserve position by contracting its loans.
In the 1860 crisis the banks in both Boston and New York succeeded in maintaining cash payments with the aid of the loan certificate. In the 1873 crisis the device was used again, this time by the clearing-house associations in no less than seven of the principal cities. It did not succeed in averting entirely a suspension of cash payments, but the suspension lasted the comparatively short period of less than three weeks.
In subsequent crises the clearing-house loan certificates were used by the associations in nearly all the leading cities, but without the equalisation of reserves. The banks could not reach agreement to pool their reserves in these later crises. Those of 1884 and 1890 were, however, slight, and the banks did not suspend, but in 1893 and 1907 the use of clearing-house loan certificates, without the equalisation of reserves, itself led almost immediately to suspension.
The issue of certificates without the equalisation of reserves proved fatal to individual banks. A bank which received a large number of checks drawn on other banks from customers who wanted to withdraw cash, experienced heavy drains on their reserves. At the same time they might have favourable clearing-house balances with other banks (those on which the checks were drawn) but be unable to obtain any cash from these banks on account of the clearinghouse arrangement, while these other banks might be exceptionally strong in cash reserves because customers did not happen to be drawing directly on them for cash. The banks which were subjected to the heavy demand for cash by the public, or the country banks, as the case might be, tried to sidetrack this effect of the clearing-house agreement by encouraging their customers to take checks for cash direct to the banks on which they were drawn instead of handing them into their own banks for settlement in the clearings. This was, however, impossible to do beyond a certain measure; the banks adversely affected by the issue of the loan certificates had to suspend payment; this started a run on the others and they suspended also.
Both the successes and the failures of the clearing-house loan certificate device gave force to the conclusion, firstly, that there should be somewhere an adequate reserve of lending power for use in the crisis, and, secondly, that this should be available for the collective benefit of all banks. Further, the idea was gaining ground that it could only be provided by an organisation in some manner aloof from the operations of ordinary commercial banks. It must be a bank that was in normal times not fully “lent up.”
Some such sort of relief during a crisis had been provided by the Treasury. The principle had been established in 1846 that the Treasury should be independent of the banks, that is, that it should keep its own surplus funds instead of depositing them with the banks. It was objected that this had an inconvenient effect on the money market if collections exceeded disbursements for any length of time, because in that case it caused sudden withdrawals and returns of funds from and to the market; and from the time of the Civil War onwards the Independent Treasury System was not strictly preserved. The Treasury began depositing funds in selected National Banks and adopted the practice of giving relief in times of crisis. The methods of using its funds in a way to make the money market more liquid were various.
*44 As early as 1857, even before the National Banking System had come into being, it had helped the market by purchasing bonds. In 1873 it again bought bonds and also sold $5,000,000 of gold, the proceeds of which it put on deposit in certain banks. In 1884 it prepaid some of the interest on the public debt. In 1890 it again prepaid interest and bought bonds. In 1893 the Treasury was unable to give any aid at all; it actually had a deficit and needed to borrow itself from the banks. In 1907 it transferred some funds to the banks, but the amount it had on hand was small, since it had already deposited most of its surplus with them before the crisis.
The Treasury had thus been undertaking some of the functions of a central bank by carrying out what was equivalent to open market operations (purchases of securities) and by lending directly to the banks. The rather fortuitous nature of this kind of relief led bank reformers to demand a more “scientific” mode of relief in crises. It was only a lucky chance if the Treasury happened to have surpluses at the time when the crisis came. There was, on the other hand, a considerable body of opinion which denounced the Treasury relief on the grounds that it gave an impetus to expansion. Banks expected to receive assistance if they got into difficulties, and therefore expanded on the basis of these anticipations.
It became also part of the positive programme for banking reform that it should provide for an institution which could act as the Government’s fiscal agent.
*45 The Treasury experiences during the course of the previous century, both of the system of keeping its own funds and of the system of depositing them with various State or National Banks at the risk of not being able to obtain them in the event of the failure of these banks, had directed attention towards the possibility of finding some depositary which was free from the objections of both these systems. In other countries the necessary services were performed by the Central Bank.
One other feature of the American system which the reformers hoped to remedy was the high cost of check collection. The majority of the banks in America were in the habit of making a charge known as the “exchange” charge for paying their own checks. This charge purported to cover the cost of providing funds to pay the check in a distant place because the bank had either to shift currency or to maintain a balance in a distant centre. What the banks were actually able to charge was probably much above the real expense involved, but there is little doubt that there was room in the old system for a considerable reduction in the real cost of check collection by reducing the necessary amount of transmission of funds.
It was the crisis of 1907 which gave the final impetus to the growing agitation for banking reform, but there was still a difference of opinion as to whether the chief fault lay with the system of note issue or with the lack of branch organisation or with the legal reserve regulations. On the whole, there was a strong majority in favour of the introduction of some kind of co-operative organisation of existing banks for the purpose of providing reserve funds for panic financiering. Authoritative support was given to the suggestion that the necessary changes could best be made through the establishment of a central bank of issue and reserve.
*47 But even after the 1907 crisis there was still a good deal of opposition to the introduction of real central banking, and the idea persisted that a purely emergency organisation for “relief” would meet the case. This was the attitude behind the Aldrich-Vreeland Act of 1908, which provided for the issue of emergency currency against securities other than United States Bonds and adopted commercial bills as a basis for note issue for the first time. The Act authorised banks to form voluntary associations under the arrangement that a bank belonging to such an association could deposit with it any securities (including commercial bills) against which it might receive additional notes. All the banks belonging to the association were then jointly and severally liable for the redemption of the additional circulation. National Banks were also given the option of applying to the Comptroller of the Currency for additional notes secured by assets other than United States Bonds.
The same Act set up the National Monetary Commission to report on banking reform. The Commission sat four years and carried out investigations, not only into the details of the American system, but also into the experiences and practices of European countries with central banks. The fact that these countries had escaped general suspensions of cash payments was attributed to the strength of the central institutions, the concentration and mobilisation of reserves and the prompt use of these reserves in a crisis. Stress was, moreover, placed on the part played by these central banks of issue in regulating the money market via the discount system.
*48 The influence of the publications of the Commission was to turn the favour of the reformers towards a permanent central organisation which should issue a currency based on gold and commercial paper, act as a lender of last resort and control the credit situation through the bank rate and open market dealings.
The final outcome of the recommendations was the creation of the Federal Reserve System. Its organisation differed considerably from the European central bank: it consisted of twelve regional Federal Reserve Banks in the ownership of which those banks who became members of the system—and membership was compulsory on all National Banks—took a share by contributing to their capital. On these, under the guidance of the Federal Reserve Board, there devolved the tasks of issuing notes, keeping the reserves of the member banks and acting as lending agency to them by rediscounting.
A retrospective consideration of the background and circumstances of the foundation of the Federal Reserve System would seem to suggest that many, perhaps most, of the defects of American banking could, in principle, have been more naturally remedied otherwise than by the establishment of a central bank; that it was not the absence of a central bank
per se that was at the root of the evil, and that, although this was admittedly a partial remedy for things for which other remedies were politically or technically impossible of realisation, there remained certain fundamental defects which could not be entirely, or in any great measure, overcome by the Federal Reserve System.