America's Great Depression (19 page)

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brought about by prior intervention, it would speedily eliminate the depression and particularly eradicate unemployment. Our concern, therefore, is not so much with studying the market as with studying the actions of the culprit responsible for generating and intensifying the depression—government.

THE DEFINITION OF THE MONEY SUPPLY

Money is the general medium of exchange. On this basis, economists have generally defined money as the supply of basic currency and demand deposits at the commercial banks. These have been the means of payment: either gold or paper money (in the United States largely Federal Reserve Notes), or deposits subject to check at the commercial banks. Yet, this is really an inadequate definition.
De jure,
only gold during the 1920s and now only such government paper as Federal Reserve Notes have been standard or legal tender. Demand deposits only function as money because they are considered perfect
money-substitutes,
i.e., they readily take the place of money, at par. Since each holder believes that he can convert his demand deposit into legal tender at par, these deposits circulate as the unchallenged equivalent to cash, and are as good as money proper for making payments. Let confidence in a bank disappear, however, and a bank fail, and its demand deposit will no longer be considered equivalent to money. The distinguishing feature of a money-substitute, therefore, is that people believe it can be converted at par into money at any time on demand. But on this definition, demand deposits are by no means the only—although the most important—money-substitute. They are not the only constituents of the money supply in the broader sense.1

In recent years, more and more economists have begun to include time deposits in banks in their definition of the money 1See Lin Lin, “Are Time Deposits Money?”
American Economic Review
(March, 1937): 76–86. Lin points out that demand and time deposits are interchangeable at par and in cash, and are so regarded by the public. Also see Gordon W.

McKinley, “The Federal Home Loan Bank System and the Control of Credit,”
Journal of Finance
(September, 1957): 319–32, and idem, “Reply,”
Journal of
Finance
(December, 1958): 545.

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supply. For a time deposit is also convertible into money at par on demand, and is therefore worthy of the status of money. Opponents argue (1) that a bank may legally require a thirty-day wait before redeeming the deposit in cash, and therefore the deposit is not strictly convertible
on demand,
and (2) that a time deposit is not a true means of payment, because it is not easily transferred: a check cannot be written on it, and the owner must present his passbook to make a withdrawal. Yet, these are unimportant considerations.

For, in reality, the thirty-day notice is a dead letter; it is practically never imposed, and, if it were, there would undoubtedly be a prompt and devastating run on the bank.2 Everyone acts as if his time deposits were redeemable on demand, and the banks pay out their deposits in the same way they redeem demand deposits. The necessity for personal withdrawal is merely a technicality; it may take a little longer to go down to the bank and withdraw the cash than to pay by check, but the essence of the process is the same. In both cases, a deposit at the bank is the source of monetary payment.3 A further suggested distinction is that banks pay interest on 2Governor George L. Harrison, head of the Federal Reserve Bank of New York, testified in 1931 that any bank suffering a run must pay both its demand and savings deposits on demand. Any request for a thirty-day notice would probably cause the state or the Comptroller of Currency to close the bank immediately.

Harrison concluded: “in effect and in substance these [time] accounts are demanded deposits.” Charles E. Mitchell, head of the National City Bank of New York, agreed that “no commercial bank could afford to invoke the right to delay payment on these deposits.” And, in fact, the heavy bank runs of 1931–1933 took place in time deposits as well as demand deposits. Senate Banking and Currency Committee,
Hearings on Operations of National and Federal Reserve Banking Systems,
Part I
(Washington, D.C., 1931), pp. 36, 321–22; and Lin Lin, “Are Time Deposits Money?”

3Time deposits, furthermore, are often used directly to make payments.

Individuals may obtain
cashier’s checks
from the bank, and use them directly as money. Even D.R. French, who tried to deny that time deposits are money, admitted that some firms used time deposits for “large special payments, such as taxes, after notification to the bank.” D.R. French, “The Significance of Time Deposits in the Expansion of Bank Credit, 1922–1928,”
Journal of Political Economy
(December, 1931): 763. Also see Senate Banking–Currency Committee,
Hearings
, pp. 321–22; Committee on Bank Reserves, “Member Bank Reserves” in Federal Reserve Board,
19th Annual Report, 1932
(Washington, D.C., 1933), pp. 27ff; Lin Lin, “Are Time Deposits Money?” and
Business Week
(November 16, 1957).

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time, but not on demand, deposits and that money must be non-interest-bearing. But this overlooks the fact that banks
did
pay interest on demand deposits during the period we are investigating, and continued to do so until the practice was outlawed in 1933.4 Naturally, higher interest was paid on time accounts to induce depositors to shift to the account requiring less reserve.5

This process has led some economists to distinguish between time deposits at commercial banks from those at mutual savings banks, since commercial banks are the ones that profit directly from the shift. Yet, mutual savings banks also profit when a demand depositor withdraws his account at a bank and shifts to the savings bank.

There is therefore no real difference between the categories of time deposits; both are accepted as money-substitutes and, in both cases, outstanding deposits redeemable
de facto
on demand are many times the cash remaining in the vault, the rest representing loans and investments which have gone to swell the money supply.

To illustrate the way a savings bank swells the money supply, suppose that Jones transfers his money from a checking account at a commercial bank to a savings bank, writing a check for $1,000 to his savings account. As far as Jones is concerned, he simply has $1,000 in a savings bank instead of in a checking account at a commercial bank. But the savings bank now itself owns $1,000 in the checking account of a commercial bank and uses this money to lend to or invest in business enterprises. The result is that there are now $2,000 of effective money supply where there was only $1,000 before—$1,000 held as a savings deposit and another $1,000 loaned out to industry. Hence, in any inventory of the money supply, the total of time deposits, in savings as well as in 4See Lin Lin, “Professor Graham on Reserve Money and the One Hundred Percent Proposal,”
American Economic Review
(March, 1937): 112–13.

5As Frank Graham pointed out, the attempt to maintain time deposits as both a fully liquid asset and an interest-bearing investment is trying to eat one’s cake and have it too. This applies to demand deposits, savings-and-loan shares, and cash surrender values of life insurance companies as well. See Frank D. Graham,

“One Hundred Percent Reserves: Comment,”
American Economic Review
(June, 1941): 339.

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commercial banks, should be added to the total of demand deposits.6

But if we concede the inclusion of time deposits in the money supply, even broader vistas are opened to view. For then all claims convertible into cash on demand constitute a part of the money supply, and swell the money supply whenever cash reserves are less than 100 percent. In that case, the shares of savings-and-loan associations (known in the 1920s as building-and-loan associations), the shares and savings deposits of credit unions,
and
the cash surrender liabilities of life insurance companies must also form part of the total supply of money.

Savings-and-loan associations are readily seen as contributing to the money supply; they differ from savings banks (apart from their concentration on mortgage loans) only in being financed by shares of stock rather than by deposits. But these “shares” are redeemable at par in cash on demand (any required notice being a dead letter) and therefore must be considered part of the money supply. Savings-and-loan associations grew at a great pace during the 1920s. Credit unions are also financed largely by redeemable shares; they were of negligible importance during the period of the inflationary boom, their assets totaling only $35 million in 1929. It might be noted, however, that they practically began operations in 1921, with the encouragement of Boston philanthropist Edward Filene.

Life insurance surrender liabilities are our most controversial suggestion. It cannot be doubted, however, that they can supposedly be redeemed at par on demand, and must therefore, according to our principles, be included in the total supply of money. The chief differences, for our purposes, between these liabilities and others listed above are that the policyholder is discouraged by all manner of propaganda from cashing in his claims, and that the life 6See McKinley, “The Federal Home Loan Bank System and the Control of Credit,” pp. 323–24. On those economists who do and do not include time deposits as money, see Richard T. Selden, “Monetary Velocity in the United States,” in Milton Friedman, ed.,
Studies in the Quantity Theory of Money
(Chicago: University of Chicago Press, 1956), pp. 179–257.

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91

insurance company keeps almost none of its assets in cash—

roughly between one and two percent. The cash surrender liabilities may be approximated statistically by the total policy reserves of life insurance companies, less policy loans outstanding, for policies on which money has been borrowed from the insurance company by the policyholder are not subject to immediate withdrawal.7

Cash surrender values of life insurance companies grew rapidly during the 1920s.

It is true that, of these constituents of the money supply, demand deposits are the most easily transferred and therefore are the ones most readily used to make payments. But this is a question of form; just as gold bars were no less money than gold coins, yet were used for fewer transactions. People keep their more active accounts in demand deposits, and their less active balances in time, savings, etc. accounts; yet they may always shift quickly, and on demand, from one such account to another.

INFLATION OF THE MONEY SUPPLY, 1921–1929

It is generally acknowledged that the great boom of the 1920s began around July, 1921, after a year or more of sharp recession, and ended about July, 1929. Production and business activity began to decline in July, 1929, although the famous stock market crash came in October of that year. Table 1 depicts the
total money
supply
of the country, beginning with $45.3 billion on June 30, 1921 and reckoning the total, along with its major constituents, 7In his latest exposition of the subject, McKinley approaches recognition of the cash surrender value of life insurance policies as part of the money supply, in the broader sense. Gordon W. McKinley, “Effects of Federal Reserve Policy on Nonmonetary Financial Institutions,” in Herbert V. Prochnow, ed.,
The Federal
Reserve System
(New York: Harper and Bros., 1960), pp. 217n., 222.

In the present day, government savings bonds would have to be included in the money supply. On the other hand, pension funds are not part of the money supply, being simply saved and invested and not redeemable on demand, and neither are mutual funds—even the modern “open-end” variety of funds are redeemable not at par, but at market value of the stock.

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roughly semiannually thereafter.8 Over the entire period of the boom, we find that the money supply increased by $28.0 billion, a 61.8 percent increase over the eight-year period. This is an average annual increase of 7.7 percent, a very sizable degree of inflation. Total bank deposits increased by 51.1 percent, savings and loan shares by 224.3 percent, and net life insurance policy reserves by 113.8 percent. The major increases took place in 1922–1923, late 1924, late 1925, and late 1927. The abrupt leveling off occurred precisely when we would expect—in the first half of 1929, when bank deposits declined and the total money supply remained almost constant. To generate the business cycle, inflation must take place via loans to business, and the 1920s fit the specifications. No expansion took place in currency in circulation, which totaled $3.68 billion at the beginning, and $3.64 billion at the end, of the period. The entire monetary expansion took place in money-substitutes, which are products of credit expansion. Only a negligible amount of this expansion resulted from purchases of government securities: the vast bulk represented private loans and investments. (An “investment” in a corporate security is, economically, just as much a
loan
to business as the more short-term credits labeled “loans” in bank statements.) U.S. government securities held by banks rose from $4.33 billion to $5.50 billion over the period, while total government securities held by life insurance companies actually fell from $1.39 to $1.36 billion. The loans of savings-and-loan associations are almost all in private real estate, and not in government obligations. Thus, only $1 billion of the new money was not cycle-generating, and represented investments in government securities; almost all of this negligible increase occurred in the early years, 1921–1923.

The other non-cycle-generating form of bank loan is consumer credit, but the increase in bank loans to consumers during the 8Data for savings-and-loan shares and life-insurance reserves are reliable only for the end-of-the-year: mid-year data are estimated by the author by interpola-tion. Strictly, the country’s money supply is equal to the above data minus the amount of cash and demand deposits held by the savings and loan and life insurance companies. The latter figures are not available, but their absence does not unduly alter the results.