Uncle Sam: Mr. Farmer isn't here yet. He left in such a huff the other night, possibly he is sore—no, he is not, here he comes.
Mr. Lawyer: When our meeting broke up last Wednesday night, Mr. Banker had just outlined the different forms of credit, and I was very glad that he did, because it gave me an opportunity to read up on the subject and be prepared to listen intelligently, at least, to what any of you may say tonight.
Mr. Merchant: I did some investigating, too, and found the subject far more interesting than I supposed it could possibly be. Indeed, that is true of any subject. Your interest is always measured by your knowledge, and many matters that seem to us difficult to understand, become exceedingly simple as you get into them, and comprehend them. How often the apparently impossible task completely dissolves under persistent attacks.
Mr. Banker: I am more than pleased that you gentlemen have given your spare time to this subject. Simple in function it is, but it is immeasurably great in its possibilities, extent and responsibilities from the standpoint of the banker.
Just as we parted last Wednesday I had described or defined the different forms of credit, so far as they enter into banking directly or indirectly. As I then stated, the first and simplest use of credit is that granted for the production of something to eat, wear or use—what we call consumable commodities, that is, credit granted to aid in production.
If Mr. Farmer over there should come into my bank now as he used to before he got rich, and ask[Pg 119] for a thousand dollars to pay his expenses while he was planting, cultivating and harvesting his crop, and then in the fall should come again and ask me for three thousand dollars more to buy some steers and hogs with, because he thought he could make more money feeding than by selling his corn outright, and I had let him have the total amount of $4,000 from time to time as he wanted it, because I believed in his honesty and intelligence, and also because I regarded the venture as a good one, that would be granting credit for the production of beef and pork, food products—the very necessities of life.
Just as soon as his steers and hogs had become fit for market, and had ceased to gain anything to speak of, by holding them and further feeding, he must sell or lose the cost of holding on the chance of a rise in the market. But even this delay must be temporary. Virtually he is compelled to sell from the very nature of the case. When he sells his steers and hogs, suppose he should receive $5,000. First, he pays me the $4,000 and interest, and has about $1,000 profit on the transaction. You will all perceive and understand, that as I gave Mr. Farmer this credit of $4,000 from time to time, he gave me his promissory note for an equal amount, so that as fast as I granted credit he created a debt. I acquired the right to demand payment of $4,000 and he incurred the duty or obligation to pay $4,000.
So for every credit granted a corresponding debt is created; and if every debt is paid every credit will be canceled. Though the credit granted to Mr. Farmer was for the production of the necessities of life, it was not the safest kind of a loan to make as we shall soon see—his personal responsibility aside of course; because after I had given the $1,000 he might have to replant his corn. The summer might be dry and the frost might come early and cut off his crop; but passing over these possible dangers to his crops, if we assume that his crop is the biggest he ever raised, and that that very fact makes it desirable to borrow the additional $3,000, pleuro-pneu[Pg 120]monia might strike his cattle, and cholera might seize his hogs and the transaction might result in a loss of $1,000 instead of a profit of $1,000; or even a greater loss than $1,000.
It is these risks that the banker takes in making loans to farmers that justifies higher interest rates than are charged under some other circumstances. Again it is these risks that lead a banker out of caution to take real estate loans in addition, to cover the accidents of crop raising, although the National Bank Act forbids making loans upon real estate.
Mr. Farmer: Under such circumstances, I think it ought to be possible for a bank to take real estate loans. I believe it would help the farmer to get his money at a trifle lower rate of interest.
Mr. Banker: I agree with you, and provision should be made for just such cases; but the rule of the National Bank should still prevail with regard to loans upon real estate so far as a regular business is concerned, unless the bank is doing a savings bank business or a trust company business, in which event it would be entirely proper to use such funds for that purpose.
Mr. Merchant: Mr. Banker, a moment ago you said that the loan to Mr. Farmer, apart from his personal standing, was not the safest kind of a loan to make. Just what did you mean by that?
Mr. Banker: I am glad that you asked that question, for it should be explained right here. Suppose that you, Mr. Merchant, should purchase $4,000 worth of pork and beef in the barrel, at some distant point, and should come to me for the money to pay for it. In all probability I should ask you for the bill of lading covering the shipment, and also insist upon your getting an insurance policy on the goods before giving you the money. In this case, I am loaning money upon the necessities of life, consumable commodities, and unless the insurance company fails, and the goods are destroyed, I cannot possibly lose a cent. I have, humanly speaking, eliminated all[Pg 121] chances of loss. You will observe that if I should hold the bill of lading and the insurance policy, I have the title or ownership of the pork and beef, in any event. In such cases, comparatively speaking, the rate of interest ought to be the lowest possible, as far as the risk goes.
Mr. Manufacturer: But this kind of a transaction constitutes a comparatively small part of the commerce of the country.
Mr. Banker: Yes, that is true, and if credit was limited to such transactions, credit crises would be very few, indeed, probably never would arise as a result of over trading under such circumstances; trade would be greatly hampered, and business curtailed to a destructive degree.
Mr. Manufacturer: That is certainly true. You men all know that I am a manufacturer of high class clothing. I want to give you an illustration of how business is being carried on today in the way of multiplying credit.
A manufacturer of woolen goods at Lancashire, England, sold to a wholesale merchant on the other side, $10,000 worth of goods on three months' time. The wholesale merchant sold the goods for $12,000 to an English exporter on three months' time. The English exporter sold the goods to an American importer for $20,000, duty paid; the importer sold them to an American jobber for $22,000; the jobber sold them to me for $24,000. All these sales occurred within thirty days, and not a single man paid a cent of money on account of his purchases. By way of payment, this is what happened. I gave my note due in ninety days to the jobber, and he discounted it at his bank. The jobber gave his note due in ninety days to the importer, and the importer discounted it at his bank; the English exporter sent over a draft upon the American importer at ninety days sight, and he accepted it and it was returned to England, where the exporter discounted it at his bank. In the meantime, the wholesaler drew a draft on the exporter at ninety[Pg 122] days sight, and he accepted the draft, whereupon the wholesaler discounted the draft at his bank. At the same time the manufacturer drew on the wholesaler at ninety days sight, and the draft was accepted by the wholesaler, and was discounted by the manufacturer at his bank. Thus we see that goods which sold originally for only $10,000 went through five different hands and became the basis upon which credits were granted for $88,000, and debts were created for $88,000. Every single debt was sold just as though it was so much woolen goods. Every man had his money and not one of them had paid his debt, and yet every transaction was legitimate and in the ordinary course of business.
Within sixty days I shall have turned these goods into clothes and sold and delivered them, giving my customers in turn credit upon my books, or will have accepted their promissory notes, which I may discount at my bank if I should need the money in my own business. Now mark and note this. If I should deliver to the American jobber my check today, and he should send his check to the American importer and the American importer should send a draft to the English exporter, and the English exporter should deliver his check to the wholesaler, and the wholesaler should send his check to the manufacturer, debts amounting to $88,000 would have been paid and credit amounting to $88,000 would have been canceled; and yet not a single cent of cash in the form of coin or currency has been used.
Every one of the checks, notes or drafts taken in the transaction is property, just as much as the note taken for a single sale of the goods would have been property. Indeed, every one of the five notes or drafts was just as much property as the goods themselves were, and could be bought and sold just as well as the goods themselves could be bought and sold. Now it must be evident to all of you that in the production, transportation and distribution of commodities, credit performs exactly the same function as money. So far, therefore, credit is[Pg 123] in all respects equivalent to money. So long, therefore, as the operations through credit are successful, everything goes well.
Mr. Banker: Precisely so, Mr. Manufacturer, so long as the operations are successful, everything goes well; but it is the sudden breaking of the chain of credit that brings or precipitates a disturbance.
MacLeod uses this language in referring to the destruction of confidence: "It is the sudden failure of confidence and extension of credit which produces what is called in commercial language, 'a pressure on the money market' and which causes money to be 'tight.' When money is said to be scarce, it does not mean that there is a smaller quantity of money actually in existence than before; there may be more, or there may be less in the country; no one can tell what the amount of money in existence is, but a great amount of credit which serves as a substitute, and was an equivalent of money, is either destroyed altogether, or is suddenly struck with paralysis, as it were, and deprived of its negotiable power, and therefore, practically useless. A vast amount of property is expelled from circulation, and money is suddenly called upon to fill the void."
It must be observed and noted right here, therefore, that streams of gold, of gold, I say, must be constantly and swiftly running through the channels of trade, and so intimately connected with a practically unlimited supply or an inexhaustible reserve of gold, in the form of a central reserve for the whole country, to immediately extinguish any conflagration of credit as soon as it breaks out, precisely as a flood of water extinguishes a fire when it first makes its appearance.
For the past ten or fifteen years, the banks of England have realized the necessity of pursuing this principle, by carrying their own individual reserves, and accordingly have been gradually accumulating cash reserves of their own, instead of depending upon the Bank of England, except as a last resort.
[Pg 124]
Germany, too, within the past year, has suffered severely because adequate reserves have not been present in her channels of trade; and having discovered this weakness in her banking practices, appointed a commission to pass upon that and other questions. The commission reported that the individual banks should carry their own reserves; and Herr Havenstein, President of the Imperial Bank, a short time ago demanded that the banks of Germany should carry their own cash reserves up to 15 per cent of their liabilities.
How much more important, then, gentlemen, must it be that we, when you consider the extent of our country, our vast and varied banking interests which are being carried on by 25,000 or 30,000 individual or independent banks, should require everyone of these banks to be in a position to test its credits with the touchstone of gold, and at the same time take the precaution of protecting itself by a central reserve of gold far beyond any possible demand that may be made upon it.
Mr. Merchant: Mr. Banker, from what you have been telling us it is perfectly clear that every promissory note, check, draft, or bill of exchange, which are acknowledgments of debt, are just as much property as land, houses, cattle, corn, iron, or anything else material that can be bought and sold. Credit itself is merchandise and the subject of a gigantic commerce of its own.
"A well-managed credit amounts to tenfold the funds of a merchant; and he gains as much by his credit as if he had ten times as much money." This maxim is generally received among all merchants. Credit is, therefore, the greatest wealth to every man who carries on commerce.
Demosthenes says: "There being two kinds of property, money and general credit, our greatest property is credit."
Again he says: "If you were ignorant of this, that credit is the greatest capital of all toward the acquisition of wealth, you would be utterly ignorant."
[Pg 125]
So Melon says: "To the calculation of values in money, there must be added, the current credit of the merchant, and his possible credit."
So also Dutot says: "Since there has been regular commerce among men, those who have need of money have made bills, or promises to pay in money. The first use of credit, therefore, is to represent money by paper. This usage is very old; the first want of it gave rise to it. It multiplies specie considerably. It supplies it when it is wanted, and which would never be sufficient without this credit; because there is not sufficient gold and silver to circulate all the products of nature and art. So there is in commerce a much larger amount in bills than there is specie in the possession of the merchants."
Mr. Banker: While it is true, as a general principle, that by the sale and transfer of the same property, as we have seen in the case of the woolen goods, many credits are granted and a corresponding amount of debts are created, it is also true that a single debt in the form of a promissory note, check, draft or bill of exchange, may be the medium of exchanging or transferring many different pieces of property. This is just the reverse of the transaction that Mr. Manufacturer has explained to us.
Mr. Farmer: That is right. I want to tell you fellows something. One day about six months ago I was thinking of taking an automobile trip, but hesitated on account of the weather signs. I hung around town here for an hour or two and happened to drop into the office of a certain lawyer (I never go there any more now). We talked politics. While there, I asked him what he thought of the weather, and the political situation, and then went out. At the end of the month I got a bill from that lawyer for $50. I called upon the gentleman (I suppose I have got to call him a gentleman on account of his neighbor here) to find out what his bill meant, and he claimed that while we talked about politics, the Presidential election prospects and the weather, that I had pumped him about[Pg 126] some very important legal matters upon which he had given me valuable advice. Upon my soul I never knew it, but what could I do. My only possible escape was to pay some other lawyer, possibly Mr. Lawyer over there, $100 to defend the case. As is the practice nowadays, I took the short cut and paid it by sending him my check. That lawyer indorsed and gave that check to a neighbor of mine for a Jersey cow. My neighbor indorsed and gave the check to a country grocery store out there and paid his bill with it. The country storekeeper indorsed and gave the check to Mr. Merchant over there for $50 worth of boots and shoes. Mr. Merchant indorsed and gave the check to Mr. Manufacturer for $50 worth of clothing. Mr. Manufacturer indorsed and deposited that check with Mr. Banker, right here, who charged it up to my account. Now, by Jove, you wouldn't think that was possible, but here is the check with those five indorsements.
Mr. Manufacturer has just given us an instance where the same identical property worth only $10,000 in Lancashire, England, was sold five times, and that credits amounting to $88,000 were being granted, and a corresponding amount of debts were created. Now here is a case where my debt to that blasted lawyer acknowledged by my check, paid him $50; paid my neighbor for a Jersey cow $50; paid the country grocery store for groceries $50; paid Mr. Merchant for boots and shoes $50; paid Mr. Manufacturer for clothing $50; paid the bank on account of Mr. Manufacturer's debt $50; or six separate debts in all, amounting to $300. And the joke is, I never ought to have given the check at all. This is the reverse side of the use of credit. The instance given by Mr. Manufacturer was one illustrating the tremendous expansion of credit. The instance I have given is one of the contraction of credit.
Mr. Banker: Right on that point Mr. MacLeod says that sixty years ago almost the entire circulating medium of Lancashire, England, consisted of bills of exchange[Pg 127] in no way different from Mr. Farmer's debt, and that they sometimes had as many as 115 indorsements upon them before they came to maturity. So that the useful effect of a bill of exchange is indicated by the number of indorsements upon it, supposing that every transfer is accompanied by an indorsement, which is not always the case. We see here the fundamental difference between bills of lading and bills of exchange, because the indorsements on the former denote the number of transfers of the same identical property; the indorsements on the latter denote the number of transfers of distinctly different property.
Mr. Merchant: Mr. Banker, in every form of credit granted so far and debts created, we have certainly been dealing only in a legitimate way with consumable commodities, the necessities of life, and ordinarily, if not always, this kind of credit will take care of itself. And yet the marvelous facility and power of credit has been illustrated so vividly, that I am sure all of us appreciate it and can readily see how it might be abused and lead to disaster if not confined to the actual production of articles of food, clothing and daily use, or, in a word, to the production of the necessities of life.
Mr. Farmer: I object to your including that lawyer's bill as one of the necessities of life.
Mr. Lawyer: I beg your pardon, but we lawyers are a necessity. Possibly necessary evils, but nevertheless, I insist that we are necessary.
Mr. Banker: Passing over this little quarrel between Mr. Farmer and Mr. Lawyer, Mr. Merchant has hit upon the vital distinction that should always be maintained in commercial banking as distinguished from investment banking as we shall soon see.
Mr. Lawyer: There is not one man in a thousand that comprehends the distinction that you have just called our attention to, and I include the bankers when I say that, too. I did not appreciate it myself a week ago, but it is fundamental and must not be overlooked. I want[Pg 128] to call your attention to one form of credit that does not grow out of actual transactions in the production and distribution of consumable commodity, and that is accommodation paper.
Mr. Laboringman: Accommodation paper? It strikes me as though that was just the kind of paper I wanted. I certainly will take any accommodation that Mr. Banker over there will give me.
Mr. Lawyer: Speaking of accommodation paper, Mr. MacLeod says: "We now come to a species of credit which will demand great attention, because it is the curse and plague spot of commerce, and it has been the great cause of those frightful commercial crises which seem to occur periodically; and yet, though there can be no doubt that it is in many cases essentially fraudulent, yet it is of so subtle a nature as to defy all powers of legislation to cope with it."
The obvious distinction between accommodation paper and promissory notes or bills of exchange here referred to, and all legitimate commercial paper, is this: the accommodation paper represents a future transaction, something to be done, while the true commercial paper represents a past transaction, or something that has been done; for example, goods that had been manufactured and are ready for sale or have been sold and shipped.
Mr. Banker: Mr. Lawyer, will you allow me to illustrate that distinction?
Mr. Lawyer: Certainly.
Mr. Banker: If Mr. Manufacturer there should make ten different sales of clothing of $5,000 each, and then send out ten drafts to his ten customers, who accepted them and returned them, these ten drafts would be called real bills of exchange, or let us call them true commercial bills, because the ten men have purchased and agreed to pay for the goods received by them. Should the ten men have sent their promissory notes to Mr. Manufacturer, they would be identically the same thing as the[Pg 129] drafts which they had accepted, and answer identically the same purpose.
The real beneficiaries in these ten transactions are the ten purchasers of the goods which they have received; and if Mr. Manufacturer should sell me these ten bills of exchange or promissory notes as the case might be, with his indorsement, the ten men would all individually regard themselves as primarily liable; and they will, therefore, each of them, prepare to pay his note when it comes due, although Mr. Manufacturer is the guarantor. But if Mr. Manufacturer should go to these same ten men and ask each of them as a favor or accommodation to him to accept the draft or indorse his note for the same amount of $5,000, each due in 90 days, no goods having been purchased by any one of them, all these drafts would be accommodation paper, and no one of these men would look upon his note as his debt, and therefore would expect that Mr. Manufacturer would take care of the paper when it came due.
In the latter case, Mr. Manufacturer, having gotten the money and the ten men having no interest in the transaction, except as an accommodation to Mr. Manufacturer in the form of a favor, Mr. Manufacturer becomes the real maker of the ten notes, and the ten men who are indorsers are, as I have said, without any interest in the transaction, except that of accommodation acceptors.
Mr. MacLeod has described this whole transaction so fully and forcibly I want to read it to you: "There is in fact only one real principal debtor and ten sureties. Now these ten accommodation acceptors are probably ignorant of each other's proceeding. They only give their names on the express understanding that they are not to be called upon to meet the bill: and accordingly they make no provision to do so. If anyone of them is called upon to meet his bill, he immediately has a legal remedy against the drawer (or the note maker). In the case of real bills, then, the bank would have ten persons who would each take care to be in a position to meet his own engagement;[Pg 130] in the case of accommodation paper there is only one person to meet the ten engagements. Furthermore, if one of the ten real acceptors fails in his engagement, the bank can safely press the drawer: but if the drawer of the accommodation bill fails to meet one of the ten acceptances, and the bank suddenly discovers that it is an accommodation bill, and they are under large advances to the drawer, they dare not for their own safety press the acceptor, because he will, of course, have immediate recourse against his debtor, and the whole fabric will probably tumble down like a house of cards. Hence the chances of disaster are much greater when there is only one person to meet so many engagements, than when there are so many each bound to meet his own.
"We see, then, that the real danger to a bank in being led into discounting accommodation paper is that the position of principal and surety is reversed. They are deceived as to who the real debtor is, and who the real surety is, being precisely the reverse to what they appear to be, which makes a great difference in the security to the holder of the bills...." In carrying on a legitimate extension of credit, the bank never permits the advance to exceed a certain definite limit; but it never can tell to what length it may be inveigled to discounting accommodation paper until some commercial reverse happens, when it may discover its customer has been carrying on some grea............