CHAPTER VI
THE EUROPEAN MONETARY SITUATION
European Central Banks
There has been no end of discussion in the literature of post-war finance of the continued inflation of European currencies. It is a matter of common knowledge that many of the European countries have been able to keep their financial heads above water only by the continuous resort to the desperate expedient of the printing press. The truth is that in nearly all of Europe east of the Rhine the manufacture of paper currency has proceeded since the Armistice at a much more rapid rate than during the war period itself, and at a rate that hardly finds a parallel in history. In the nations of western Europe the only difference is one of degree. This chapter analyzes the condition of the European monetary and banking systems for the light they throw upon the general economic situation in Europe.
The increase of paper money in circulation in Europe has largely been brought about by bank note issues. That is to say, the paper money has been issued mainly by the banks rather than by the governments direct. Accordingly, an appreciation of the significance of the monetary situation requires an understanding of the process by which the currency is issued and of the effects of such issues upon the condition of European bank reserves. Only a few relatively simple considerations are involved.
In each of the European countries there is a central bank, comparable in its functions to the federal reserve banks of the United States. In brief, these central banks are bankers' banks, that is to say, they make loans to and hold deposit accounts for the individual private banks, much as the individual banks make loans to and hold deposits for private individuals. In normal times the ordinary banks do not need to borrow much from the central institutions, as they have sufficient funds of their own to take care of all business requirements. But whenever there arises a very active demand for money, these banks are compelled to borrow the additional funds required from the central banks, whose duty it is to maintain large reserves for just such emergencies.
Currency Inflation
When early in the war there arose an abnormal demand for funds with which to finance the production of war materials, it immediately became necessary for the individual banks to enlarge their borrowings from the central reserve institutions. Now since on the continent of Europe it is customary to employ bank notes rather than checking accounts, borrowing from the central bank usually resulted in an issue of central bank notes to the individual bank. These notes were in turn loaned out by the individual banks for the purposes of business. If it had not been for the steadily rising prices during the war and the period which followed, the expansion of loans by this process would not have continued indefinitely. But the higher prices rose and the more wages advanced, the more funds it took to finance a given volume of business. 1 11 There is divided opinion among students of finance as to whether the rise in prices was caused by the expansion of loans. One group holds that if the banks had refused to advance loans, prices would not have risen and the additional volume of funds would, therefore, not have been required; another group holds that prices rose for other reasons and that the expansion of loans was a result rather than a cause of rising prices. Accordingly, every business man had steadily to increase the volume of his borrowing from banks, and in turn every individual bank had steadily to increase the volume of its borrowing from the central bank.
At the same time, the various governments when in need of funds usually found it more expedient to borrow the amounts required from the central banks than to raise them exclusively through taxation. Moreover, when government bonds were sold to the general public, a considerable percentage of the funds used in buying them was borrowed from the central bank. The process may perhaps best be made clear by reference to what happened in the United States, where similar financial methods were followed.
The people were asked to borrow on the security of previous Liberty bonds, or other collateral, to the limit of their capacity, and to invest the funds thus procured in Liberty bonds. The banks from which the people borrowed, in turn, secured the funds which they loaned through borrowing from the federal reserve banks, on Liberty bonds as collateral. The individual banks also invested huge sums in Liberty bonds on their own account, again borrowing the funds from the reserve banks.2 2There is also divided opinion among students of finance as to the merits of this method of financing the war. We are, however, interested here only in showing the effects of the process upon the condition of bank reserves. It must be noted, in this connection, that the funds which are thus drawn from the reserves of the central banks constitute additional money in circulation. The process described is what is commonly known as currency inflation.
Bank Reserves
Now all this borrowing from the banking institutions naturally reduced the reserves of the central banks. A few words are necessary as to the meaning of reserves. Experience has demonstrated that if a bank has notes (that is, promises to pay cash) outstanding in the hands of individuals of $100,000, for example, it is not necessary for it to hold as much as $100,000 in specie as a reserve for redeeming them. This is because there is little possibility that all of the notes will, at any one time, be presented for payment in cash. It is merely necessary for the bank to keep on hand such an amount of specie as experience has shown is necessary to enable it at all times to meet the actual demands that develop. In England and in the United States where checking (deposit) accounts are mainly used instead of notes, the same principle holds. It is unnecessary for a bank to keep a reserve against the deposits of individuals equal to 100 per cent of such deposits; it is necessary to keep only such a percentage of cash to deposits as experience has shown will enable the bank always to be in a position to pay cash when it is demanded.
The same principle also holds with reference to the reserve of the central, or bankers' banks. They must keep only such ratio of cash to notes and deposits as experience has shown to be necessary in order to maintain specie payments.
It will be seen at once that since the individual banks can borrow, when in need of additional cash, from the central banking institutions, they do not have to keep very much cash on hand. The truth is that not more than 5 per cent of the amount of the outstanding deposits and notes is usually kept by individual banks in the form of cash. But since the central reserve banks have no similar borrowing resources, they must necessarily keep much larger reserves. In the United States the law requires a minimum reserve in the federal reserve banks of about 40 per cent against notes and deposits.3 3 To be precise it is 40 per cent against federal reserve notes and 35 per cent against deposits. But it is the policy of the federal reserve managers to keep reserves in ordinary periods very greatly in excess of this amount, in order that in time of emergency they may be able to issue more notes and lend more money to the member banks than would otherwise be possible. In Europe it is not usually customary for the law to fix a legal minimum reserve; but the practice has nevertheless been for the managers of the central reserve institutions to keep very high reserves, usually from 50 to 70 or 80 per cent, the percentages varying somewhat at different times and in different countries.
Effect of War Finance upon Reserves
Such was the condition of affairs at the outbreak of the European war. The great demand for funds that shortly developed, however, resulted in a rapid lessening of the ratio of gold reserves to outstanding claims against gold. It was early seen that the financial strain would be extremely heavy, and as a means of conserving the gold supply the various European central banks soon suspended specie payments. That is to say, they refused to redeem the paper currency in gold when it was presented at the bank for payment. Paper currency thus ceased to be interchangeable with gold; it became irredeemable, and it depreciated in value as the chance for an ultimate resumption of specie payments became more and more remote.
The aggregate gold holdings of the central banks of Europe were actually increased in consequence of this refusal of the banks to part with gold, on the one hand, and, on the other, because of the actual transference of gold from the channels of commerce to the coffers of the banks. But it nevertheless proved impossible in all of the belligerent countries to prevent a decrease in the percentage of gold es to notes and deposits, on account of the numerous outpourings of paper currency.
For similar reasons, the reserves of the federal reserve banks of the United States were drawn down during the course of the war from a maximum of nearly 90 per cent to about 52 per cent at the time of the Armistice. The reserves of the central banks of the European belligerents were in most cases reduced much further during the war than were those of the federal reserve banks in the United States. This was because of the smaller original pre-war ratio of gold to outstanding note and deposit liabilities in the European banks, and because of the greater intensity of the financial strain in consequence of Europe's longer participation in the struggle.
The data in the table below show the changes which occurred in the percentage of gold and silver reserves to note and deposit obligations in the leading nations of the world, from the time each entered the war until (with the few exceptions noted) the spring of 1920.4 4 The table is compiled from data assembled by Louis Ross Gottlieb, published in the Bankers Statistics Corporation, New York, 1920, in an article entitled, "The Banking Situation of Foreign Countries." This table will at once reveal the disastrous effects of war finance upon the banking systems of the world, and provide a background for a consideration of the trend of monetary development in the several European countries during the past twelve months.
The War's Effect on World Banking Systems (000,000 omitted)
Gold and Note and
Silver Deposit Reserve
Country Holdings Obligations Percentage
1914 1920 1914 1920 1914 1920 (A) Allied Powers
United States (a).. $ 947 $2,078 $1,064 $5,907 89.0% 42.2% (b)
Great Britain 186 547 472 1,131 39.4 48.4 (c)
France 920 1,122 1,547 7,986 59.5 14.1
Italy (d) 288 222 462 2,891 62.3 7.7
Silver Deposit Reserve
Country Holdings Obligations Percentage
1914 1920 1914 1920 1914 1920 (A) Allied Powers—Continued
Russia (c) 937 i,948 1,408 11,236 66.5 i7-3
Japan 109 467 239 1,306 45.6 35.8
Belgium 61 69 240 1,395 25.4 4.9
Greece 45 286 89 470 50.6 60.9
Roumania 41 293 89 1,280 46.1 22.9
Portugal 18 29 98 447 184 6.5
Finland 7 8 28 259 25.0 31
Total Allied Powers $3,559 $7,069 $5,736 $34,308 62.0 20.6
(B) Central Powers
Germany $ 402 $ 255 $ 675 $i5,339 59-6 1.7
Austria-Hungary ... 312 58 491 13,443 63.5 04
Turkey 21 46 75 92 28.0 50.0
Bulgaria 25 13 80 615 3i-3 2.1
Total Central Powers $ 760 $ 372 $1,321 $29,489 57.5 1.3
Total Active Belligerents $4,319 $7,44i $7,057 $63,797 61.2 11.7
(C) Neutral Powers
Total Neutrals (f). $ 765 $i,559 $1,325 $ 3,242 57-7 48.1 Grand Total $5,084 $9,000 $8,382 $67,039 60.1 134
(a) Figures for the United States are for March 30, 1917. They include only the federal reserve banks.
(b) The ratio is computed on the basis of gross deposits.
(c) The British reserve ratio here appears to be higher than it really it; for the "currency notes," amounting to £139,000,000, which are issued by the government instead of the Bank of England, are not included. If these be included, the reserve ratio is cut in two. See special table on the following page.
(d) Figures are for the three Italian banks of issue. Legal tender notes are included in the gold and silver holdings.
(e) The Russian figures are for October, 1917. At the present time the returns would, of course, be wholly different.
(f) The neutral nations include: Argentina, Brazil, Denmark, Netherlands, and Switzerland.
Banking Position in Great Britain
In Great Britain both the Treasury and the Bank of England have issued currency with which to finance the requirements of war and reconstruction. Hence the combined accounts of the Bank and the Treasury given in the following table will best reveal the true financial status of the country and the drift during the past year. 5 5 Data taken from Federal Reserve Bulletins.
(£ 000,000 omitted)
Currency Govt.
Bank Notes & Coin & Floating
Notes Certificates Deposits Bullion Reserve* Debt
1913, average—£29 £57 £38 44-2%
1920, Jan., 84 £330 155 128 22.5 £1,319
1920, June 107 357 192 146 22.3 1,294
1920, Dec 113 367 190 157 23.4 1408
1921, June 110 324 147 157 27.0 1,374
* Ratio of coin and bullion to notes and deposits.
For the first year and a half after the Armistice, the volume of outstanding notes and deposits rapidly increased, and the reserve percentage touched bottom in June, 1920. Although outstanding liabilities expanded until the end of 1920, the increase in coin and bullion was enough to raise the reserve ratio about one per cent. The first six months of 1921 reveals a reduction in both bank and currency notes, and deposit obligations, with a resulting material improvement in the reserve ratio.
The floating debt of the government, consisting mainly of Treasury bills, or short-time promises to pay, also decreased somewhat during the first half of the current year (1921), although the amount now is larger than it was twelve months ago. It is not improbable that the second half of 1921 will show a new increase, in consequence of current budget difficulties, discussed in the preceding chapter.
Banking Situation in France
French financial statistics have not been complicated by government notes, all issues having been made through the
Bank of France. The following table giving the condition of the Bank of France shows the trend of French banking:6 6 Data taken from Federal Reserve Bulletins.
(In francs, 000,000 omitted)
Note Deposit Gold and Reserve*
Circulation Obligations Silver Ratio
1913, Dec 5,723 984 4,164 62.1%
1918, Dec 30,200 2,484 3,765 11.5
1919, Dec 37,336 3,211 3,874 9.5
1920, June 37,915 3,751 3,972 9,5
1920, Dec 37,902 3,575 3,8i8 9.3
1921, June 37422 2,861 3,846 9.5
* Gold and silver to note circulation and deposit obligations.
It will be seen that although the reserve percentage has improved slightly during the past year, the ratio is still lower than it was at the time of the Armistice. While the note circulation has declined but little, there has been a material reduction in deposit obligations since the end of 1920.
Italian Financial Situation
The following data 7 7 The figures are for the Italian banks that are privileged to issue notes. They differ somewhat from those on page 68, because they include foreign specie holdings. show the condition of Italian banking:
(In lire, 000,000 omitted)
Note Deposit Gold Reserve*
Circulation Obligations Reserve Ratio
1913, Dec 2,284 318 1,661 63.9%
1920, Jan 15,634 2,376 2,021 11.2
1920, June 17,817 2,379 2,110 10.S
1920, Dec 19,731 2,559 2,077 9-3
1921, March 18,765 2,461 2,043 9.6
1921, June 18,159 2,366 1,989 9.7
* Gold reserve to note circulation and deposit obligations.
The Italian situation, it will be seen, resembles very closely that of France. There has been a slight improvement in the reserve ratio during the past year (1921).
Banking Situation in Germany
The following data show the trend of banking conditions in Germany during and since the war. The figures are for the central Reichsbank:
(In marks, 000,000 omitted)
Notes in Gold Reserve*
Circulation Deposits Reserve Ratio
1913, Dec 1,958 668 1,068 40.7%
1918, Dec. 31 22,206 13,828 2,281 6.3
1919, Dec. 31 35,723 17.095 1,109 2.1
1920, Dec. 31 66,806 22,327 1,093 la
1921, May 31 71,839 14,093 1,093 1.3
1921, July 31 77,391 15,814 1,093 1.17
* Gold reserve to note circulation and deposit obligations.
The figures for Germany reveal an appalling situation. The enormous expansion in note issues and deposits carried the reserve ratio down from 40.7 to 6.3 per cent during the period of the war. Since the Armistice the gold supply of the Reichsbank has been cut in two, and the volume of outstanding notes and deposits has been considerably more than doubled. During the single year 1919, the note issues of the Reichsbank were increased over 60 per cent, and in the year 1920 almost 100 per cent.
There is still another form of paper currency in Germany, known as darlehnkassenscheine. 8 8 For a further statement with reference to these notes, see footnote on page 83. These notes are issued by certain so-called "loan banks." Though they are now permitted to be used as reserve money, they are not redeemable in gold. The volume at present in circulation is
8,358,000,000 marks. To measure the full extent of the inflation in Germany this figure should he added to the I in the above table.
Reserves of Other Countries
There is no need of going into detailed figures for other European countries. It is enough to point out that the condition of Belgium and of neutral countries resembles that of France and Italy, in that the volume of outstanding notes and deposits has ceased to expand within the past year and the proportion of gold to paper money is now increasing slightly. The minor countries of central and eastern Europe are in most cases in a worse condition than Germany. The manufacture of paper money is still a major industry, and gold reserves are still rapidly declining.
Inflation Still Unchecked
Many American students of European conditions contend that European inflation has now been definitely checked; and they find in this asserted fact the most hopeful, single evidence of European recovery. This oft-repeated statement is not true. Inflation is as violent as ever in central and eastern Europe, and continues everywhere on the continent, notwithstanding the figures in the foregoing tables.
To understand why the assertion that inflation remains unchecked can be made in the face of the evidence that bank note obligations have ceased to expand in western Europe, one must appreciate that there are two kinds of inflation. The first results from rising prices and booming business, with heavy borrowing from banks by business and commercial interests. It may be designated as "commercial" inflation. The second results from government borrowing for the purpose of meeting government deficits. It may be called "governmental," or "fiscal" inflation. Now it is only the former type of inflation that has been checked.
The business depression and accompanying price liquidation has, in Europe as in the United States, very greatly reduced the demands made upon the banks for commercial and business loans. The business depression has checked business inflation; but it has not checked government inflation. Indeed, the business depression, through increasing the amount of the government Treasury deficits, will this year cause a greater recourse to government loans from the banks—in nearly every European country—than at any time heretofore. Fiscal inflation is on the increase.
The total volume of outstanding notes of the Bank of France, for example, has declined slightly since last autumn. But this merely indicates that the reduction in the volume of note issues for commercial purposes has during this period been somewhat greater than the increase in the volume of note issues for government fiscal purposes. Now when the process of business liquidation shall have run its course, there will be no further reduction in the volume of business borrowing. And thereafter, so long as government borrowing for the purposes of balancing budgets continues, the volume of outstanding note issues will again increase and reserves will again fall.
Germany and other central and eastern European (countries now differ from those of western Europe chiefly in that in them the expansion of government borrowing has more than offset the recent contraction of business borrowing.9 9 That there has been commercial contraction in Germany early in 1921 may be seen from the decline of deposits, as shown in the table on page 72. This is mainly because the budgets of these countries are less nearly balanced than are those of the western belligerents. In consequence, the total of outstanding notes continues to expand, even in the face of business depression.
General Conclusions
What, now, are we to conclude from this analysis? What if the volume of outstanding notes and deposits is enormous; what if the reserve percentage is unprecedentedly low, and in a large part of Europe still declining? Does the present situation necessarily foreshadow disaster? Of England it may be dogmatically stated that there is little occasion for alarm, so far as the purely banking aspects of the situation are concerned. The reserve is increasing steadily—in aggregate volume—and the percentage of gold to paper money is steadily increasing. The Bank of England is headed in the right direction—moving toward a condition where specie payments can be resumed and the British monetary system restored to a gold basis. That the progress will be slow, however, is evident from the renewed borrowing by the government from the Bank of England in recent months—in consequence of the severe business depression and the resulting decline in receipts from taxation.
The same conclusion does not hold, however, in regard to continental Europe. The condition of the central banks of France, Belgium, and Italy is such that it will be many years, at best, before specie payments can possibly be resumed. Indeed, there are many who believe that it will be quite impossible for them ever to restore the pre-war gold value of their currencies. It is pointed out that no bank in history—in similar condition—has ever succeeded in building up a gold reserve and in reducing outstanding note les sufficiently to permit the resumption of specie payments.
The principal reasons for doubting the ability of these nations to resume specie payments and thus to restore the pre-war value of their paper currencies, is the budget situation discussed in Chapter V. Unless budgets can be balanced there is no escape from a progressive deterioration of the banking position. This, of course, applies equally well to the neutral countries.
Unless the truth of this observation is clearly perceived, one cannot reach a full understanding of the gravity of the European situation. Unbalanced budgets will in time wreck the entire monetary and banking situation. Moreover, so long as irredeemable paper remains the basis of values in Europe, prices will remain unstable, and foreign exchange, for reasons discussed in Chapter II, will remain depreciated and continue to fluctuate to the serious detriment of both foreign and domestic business.
In Germany the depreciation of the currency and the demoralization of the financial system has already reached an acute stage. The German financial situation represents an intermediate stage between that of the distressed countries of western Europe and the bankrupt countries of the east. It, therefore, offers an excellent opportunity for an analysis of the process whereby a nation whose budget is seriously unbalanced and which is committed to the unlimited issue of home-grown currency, must inevitably end in financial disaster. Accordingly, the succeeding chapter is devoted to a study of the future of German currency.