MR. GOOKIN AND THE MONETARY SYSTEM
by
Arthur A. Baer

Read Before
The Chicago Literary Club
on May 17, 1971

The history of the Federal Reserve System since 1913, when the Federal Reserve Act was passed by Congress as a result of the mental anguish and political maneuvering of Woodrow Wilson, who had been dragged out by the hottest summer Washington had sweltered through in years, is a history of economic research, reasonably timid experimentation, and, in the opinion of one group of critics, questionable results.

During the period of almost sixty years since its promising but feeble beginnings to the present, when it carries on its stalwart shoulders an unreasonable share of responsibility for the solution of imponderable problems of world economy and world finance, it has mostly been a plodding thing, only stirred to brilliant activity by two World Wars, a Great Depression, a fair number of alarming recessions and an occasional international monetary crisis.

Certainly, for a number of years now, the Federal Reserve System has earned the right to be called the central bank of the United States, even though it is noticeably different in structure from the Old Lady of Threadneedle Street, the Reichsbank, and the other great central banks of Europe. Before it came into being, the economic and financial progress of the United States, the hope of the world, was befuddled and was even endangered by lack of leadership and lack of organization.

At any rate, that was the opinion of Frederick William Gookin, first secretary of The Chicago Literary Club, whose paper entitled "Our Defective American Banking System" was read at a Monday night meeting of the club on November 2, 1908, and was published in February, 1909. Its subtitle was, "A Diagnosis and a Prescription." The final paragraph of his paper reads: "Since we must eat and drink, and must supply ourselves with clothing and shelter, we may defy all the principles of finance and still continue to exist; we may even, in a country so liberally endowed by nature as is this land of ours, manage to endure the shocks and losses which such defiance entails, and by ravishing the natural resources of the land bring prosperity intermittently to our doors; nevertheless the defiance is crass stupidity, for which we pay a heavy price. We may struggle for generations yet with our wretched apology for a banking system; but when at last we supplant it by a system based on scientific principles we shall be amazed that we were so long in seeing the light."

His keen intellectual analysis of money and credit at that time was most praiseworthy and helpful. His vigorous presentation of his "diagnosis and prescription" brings to mind Ambrose Bierce's definition of the word "positive" -- being vehement at the top of one's voice. One must recall, in judging the violence of his language, that the United States had just been shaken by the disastrous panic of 1907, when "scrip" was circulated as a very inadequate substitute for currency.

Who was Frederick William Gookin that we are willing to read and consider his criticism and fit it into a brief study of the monetary history of our country? At the time he wrote this stirring paper on an abstruse economic subject he had already won a place as one of the two foremost critics of Japanese prints in the United States. As a leading authority and with a wide acquaintance in the field, he had negotiated the purchase by Clarence Buckingham of Chicago, of the famous collection of prints belonging to Ernest Fenellosa, the eminent Boston art connoisseur and writer.

The first exhibition of Japanese prints in Chicago was held at the Art Institute in the year 1903. Six hundred and forty-nine separate items were shown, the majority coming from Buckingham's collection, but many from the private collections of Frederick Gookin, Frank Lloyd Wright and others. Mr. Gookin compiled the catalogue and Wright was responsible for the imaginative installation of the show. A critic said at the time that no city, other than Paris, could have staged a comparable exhibition.

When Clarence Buckingham died in 1913, his sister Kate deposited over fifteen hundred of the magnificent prints by Masanobu, Haranobu, Hiroshige and Toyonobu and other masters at the Art Institute. Mr. Gookin became the curator and remained so for about twenty years.

But he also had a banking background. At the age of seventeen he became a messenger at the First National Bank of Joliet, spent about ten years with the private banking firm of Lunt, Preston and Kean, became assistant cashier of the Northwestern National Bank in 1881, its cashier in 1888 and remained so until it merged with the Corn Exchange Bank in 1900. He was assistant city cashier of Chicago in 1901 and 1902. When he wrote critically of the banking system of his time he knew whereof he wrote.

What were his observations? In essence, his bitter attack was two-pronged. In the first place, he observed that the movement of bank reserves went well in one direction, but got snarled up in reverse. There were then something over 21,000 banks in the nation (there are now fewer than 14,000 to serve a much larger population and an infinitely greater commercial complex), and most of the banks were small and located in the agricultural hinterland.

As crops were sold and livestock marketed, customer deposits swelled in the local banks, with no place to invest the money. The small banks maintained reserve accounts with larger banks in their separate areas; those larger banks transferred excess funds to still larger banks in central locations; until the funds finally reached the coffers of the great New York City banks. Since interest was paid on these bank balances all along the line, the New York banks had to find the ultimate borrower who could use the money profitably. Who was he? Of course, the market speculator.

But eventually, and usually seasonably, the small banks needed their reserves to advance to their clients; step by step, the demand moved and grew, from smaller bank to larger bank, until it reached New York, where, on many an occasion, the speculators loans could not be liquidated promptly enough, if at all. The result was tight money, calling of loans, often panic.

Mr. Gookin's remedy for this stupid involvement was the establishment of a central bank.

But perhaps we might pause for a moment to read Mr. Gookin's analysis of the market speculators. He writes:

"In itself, it is well to note, speculation is not necessarily harmful to the common weal. There is no hard-and-fast line of demarcation between it and so-called legitimate business. As a matter of fact, both merge imperceptibly into one another. To an extent much greater than is commonly realized, speculation is a steadying force so far as prices are concerned. The professional speculators, sometimes known as market gamblers, are, more especially the larger operators, a remarkably astute set of men. In general, they merely anticipate normal price movements and stand to win only when they guess right, though, of course, their dealings may at times bring about artificial conditions with results sometimes profitable and sometimes disastrous. The real service of speculation comes through making a wide and quick market for staple food supplies, bonds and the shares of joint-stock corporations. Without speculation, the function of the stock exchanges would be far less effectively performed; listless markets and wide fluctuations in prices would almost certainly be the rule and not the exception. But it is just here that the harm arises and in connection with our banking system the injury that results is of stupendous magnitude. Because of the quick market for ' securities,' as stocks and bonds are dubbed in the language of ' the street, they have come to be regarded as the most desirable basis for loans by the banks. Nevertheless, they represent fixed capital, the fluidity being only apparent and disappearing when most desired. It is not sound banking for institutions whose deposit liabilities are payable on demand to invest a preponderant percentage of their assets in loans upon securities representing fixed capital."

Mr. Gookin did not accuse the bankers of being greedy and vicious and blind to the obvious facts, but merely frightened and slightly befuddled. He felt that to place the "defective American banking system" on a sound scientific basis involved, in his words, no experiment whatever.

He writes: "There is not the slightest need of trying anything that has not been tried over and over again; that is not subject to the test of every-day use in other countries of first rank."

The remedy, in his mind, was the establishment of a central bank.

But perhaps we could return for a moment to Mr. Gookin's second "positive" criticism of American banking. This had to do with the nature of credit. He abhorred our loose lending practices and the willingness of banks to renew loans, upon maturity, time after time. He uses the European term "bills receivable" for commercial loans and states, in italics, that "the bills receivable held by the banks in the United States are not liquid assets."

He continues: "Herein lies the vital difference between banking practice in Europe and America. And this difference points clearly and unmistakably to the nature of the change in our method of making loans which must be accomplished if we are ever to have a scientific banking system, and be even measurably free from the violent disturbances and distressing conditions to which we are now periodically subject."

He states that in nearly every bank in the country not more than fifteen percent of the notes in the banks' portfolios could be relied upon to be paid when due.

He objects to the lending procedure in a very clear statement: "The legitimate function of banks is to lend capital in the shape of credit, not to enter into quasi-partnerships in which either the capital of the banks or funds entrusted to their custody are embarked in manufacturing, merchandising, farming, warehousing or in any other business enterprise, taking all the risks of the business, but gaining only ordinary interest in return."

He finds the European method of making loans, at that time, in every way better and safer, and in strict conformity with sound banking principles. What was it? An agreement was made by the bank to accept bills of exchange from qualified clients for short periods, usually not more than ninety days. Such bills were placed with bill brokers for sale in the open market.

He writes:

"As all the European banks except the central banks make a practice of accepting such paper, based upon collateral security, or reliable guaranty, or thorough knowledge of the financial condition, habits and ability of the makers, the market is thus supplied with bills of the highest class. To some extent the standing of the makers influences the rate at which the paper sells, but in general the standing of the accepting bank determines its salability and the question of individual credit is largely eliminated. But to the bank the preservation of its credit is of vital importance. It is incumbent that sound judgment be exercised at all times in accepting bills.

"Over-extension is thus, for the most part, effectively checked and the whole course of business made safer in consequence Such is the character of the paper held by the European banks. No stigma attaches to a bank when it sees fit to dispose of any part of its holdings, either because it needs cash or because it can reinvest the funds to advantage For such paper the market is not merely local; it is as wide as the whole world."

Mr. Gookin points our that, in order to make commercial paper or bills receivable, always a liquid asset, it is necessary that the market for prime bills should never fall and this was the primary function of the central banks of Europe.

Thus, it seems, that although Mr. Gookin attacked the then current banking system on many fronts, finding a number of its procedures, activities and philosophies inadequate, insufficient, unwise and fundamentally dangerous, he saw an overall cure in the European system of short-term bank credit operating under the umbrella of central banking. That was his prescription.

Five years and fifty-one days after Frederick Gookin read his paper to The Chicago Literary Club, Congress passed the Federal Reserve Act and so created a central bank for the United States.

Did it accomplish what he thought it would? That was almost sixty years ago and we still do not know the answer.

We do know that the development of the Federal Reserve System, including the Federal Reserve Board and the twelve regional Federal Reserve Banks, has been a constant struggle, requiring great dedication and perseverance against ignorance, a smidgeon of greed and powerful vested interests.

The nation takes pride in the group of men who formulated the principles and wrote the text of the Constitution of the United States. It must also take pride in the small group of statesmen and legislators, including Woodrow Wilson and Carter Glass, who put together in the Federal Reserve Act a sound set of principles, a clear statement of intent, a structure representing the entire nation, in depth as well as in geographical area and an impervious but flexible suit of armor resistant to political encroachment. At least, so far.

On this subject and at this time as we currently teeter on the brink of inflation, it is interesting to read the clear-headed, frank and unemotional remarks of E. A. Goldenweiser, authority on monetary policy and the Federal Reserve System: "It is naive to talk about intrusion of politics into economic decisions. The intrusion is the other way. Politics is the machinery through which a democracy functions; it has been in command in Washington for a century and a half. Economics as such, on the other hand, has been relatively a newcomer in government. It must function through established political channels and can hope to make progress toward influencing decisions only to the extent that it can gradually win popular support by inspiring confidence in its competence and integrity. The political link is there and is inevitable."

The quotation is from his volume on American Monetary Policy published in 1951, and is followed by this critical statement: "Under existing arrangements monetary policy is at a disadvantage because it is not represented at the Cabinet table and lacks the prestige of a Cabinet post for its head. It would seem to be in the best interests of the country for the head of the Federal Reserve, who shapes monetary policy, to have a rank equal to the Secretary of the Treasury, whose field of responsibility is fiscal policy."

Originally the Secretary of the Treasury was an ex officio member of the Federal Reserve Board, as was the Comptroller of the Currency. There were five other members, selected, in the language of the law, with "due regard to a fair representation of the different commercial, industrial and geographical divisions of the country." The Secretary of the Treasury, with Cabinet status, wielded influence at Board meetings.

W.P.G. Harding, who was an original Board member appointed by President Wilson and who served for six years as its chairman, was a trained banker but also a superb politician in a quiet determined way. The following incident from his memoirs is related to the point. Much too soon after the Federal Reserve Board was established, the Great War opened in Europe. At the time of initial crisis the Secretary of the Treasury proposed a huge loan of fifty million dollars for the Federal Reserve System, secured by United States Treasury Certificates of Deposit, for ninety days and at the rate of two percent per annum. A majority of the members of the Federal Reserve Board and all of the Governors of the Federal Reserve Banks (twelve in number) felt that the rate proposed was too much below the market and that it should have been at least two and one-half percent.

Mr. Harding's comment: "However, it was wartime and the Fed took the loan."

Not many, in the beginning, were attracted by the glamour of appointment to the Board. Of course, the term of office was fourteen years, but the salary was so-so. A proposed candidate from Chicago asked Harding if the Board met once or twice a month. I told him "Every day." He said, "But, of course, no one ever comes back in the afternoon?" On the contrary, few members left for the day before five in the afternoon, frequently not until six or seven. What patronage was there? He could appoint his own secretary and stenographer, no more. I told him that the only prerogative of office was that he would find it a little easier than other people to be admitted into the building, providing he went to the right door.

But things moved along, despite discouragement and harassment. Very quickly the System set up reserve requirements for member banks and so one of Mr. Gookin' s prescriptions went into use. Very quickly the arrangement for clearing checks through the network of twelve regional banks was inaugurated and has proven a great boon to banks and business alike.

Changing loan and credit ideas in the direction of European practice, as championed by Mr. Gookin, was never really attempted, but control of credit was a primary concern of the Federal Reserve System at its beginnings. The founders believed that the amount of currency and credit would be just right if issued against "real bills," that is, short-term, self-liquidating paper based on commercial, industrial and agricultural transactions. But this policy did not survive for long. As early as 1916 the Federal Reserve Banks were authorized to make direct advances to member banks on their promissory notes secured by Government bonds or eligible paper, which broke the link between self-liquidating transactions and the flow of credit. In 1934, with the depression developing, the Federal Reserve Banks were authorized to make working capital loans direct to existing industrial and commercial businesses unable to get credit through usual channels.

As the years passed, it became clear that the System could not control the quality of loans, as Mr. Gookin had hoped. It recognized its responsibility for a smooth economy and the need to direct its policies on money and credit toward that goal. It developed powerful tools and sharpened them as occasion demanded. It used its power to control credit by raising or lowering reserve requirements of the member banks, which are constrained to tighten up on loans as they are forced to increase the amount of idle funds carried in the Federal Reserve Banks.

Another effective tool in this area is the Open Market Committee of the System, which has the authority (and uses it) to buy or sell Government securities in the market, thus raising or lowering the yields and so affecting the interest rate, which becomes effective immediately in the rate at which member banks are ready or eager to make loans, as the case may be.

A third important tool is the Discount Rate, which the member banks are required to pay when they come to the Discount Window to borrow funds from the Federal Reserve Banks in order to lend to their customers.

All of these tools are directed toward the goals of making credit less expensive, or easier, in times of sluggish or declining economic activity or more expensive (tighter) when booms loom on the horizon.

But the System has another effective means of influencing the quality of credit. That is the arrangement for periodic examinations of the member banks all over the country. The surprise audits by the Federal Reserve teams of examiners include a classification of questionable loans into categories titled Substandard, Doubtful and Loss, and loans included in the third category must be written off as bank assets.

However, there was a serious defect in this arrangement for a great many years in that only about a third of the nation's banks were member banks. State banks may apply for membership, but many do not, foregoing the advantages of membership principally in order to be free of the System's reserve requirements. But now, since practically all banks operate under the benevolent wing of the Federal Deposit Insurance Corporation, established in 1933, and since that body has adopted the supervisory habits and forms of the Federal Reserve System, the System's ability to influence the quality of bank loans has come to be nationwide. Congress has pressed for more central direction of banking and the entente between the two agencies, with the Comptroller of the Currency approving, has tightened appreciably. In fact, bankers today are apoplectically inclined to compare themselves with the railroads as far as governmental regulation is concerned.

All national banks are examined by national bank examiners. Those Federal Reserve member banks which are not national banks are examined by Federal Reserve examiners. All state banks which are not members of the Federal Reserve System are examined by state bank examiners and by examiners of the Federal Deposit Insurance Corporati on. The latter organization is very much interested in the quality of bank loans, since, in bank failures, it must pay off depositors, to a top limit of $20,000 each, whether the cause of failure is inadequate management, embezzlement or bad loans.

Obviously, the tremendous range of bank loans in the increased complexity of the economic scene, from supposedly secured loans of the local land speculator to the involved debt structure of the Penn Central, makes it impossible for the limited examining forces to control adequately the quality of bank credit. Mr. Gookin's exemplary European "bills receivable" have gone out the window, along with cuckoo clocks and in their place we have a galaxy of thirty-year-maturity real estate mortgage loans, lease lending, term loans, auto loans, vacation loans, equipment loans, factoring, revolving credit, credit cards, repurchase agreements, participation loans, warehousing loans, brokers' loans and a great range of loans partly or fully guaranteed by various and sundry agencies of the Federal government. Mr. Gookin' s prescription for a system based on scientific principles has come into being, has been written into the law of the land, but the monetary authorities are still unable, because of the tremendous size and complexity of the credit structure and also because of the ingenuity of the lenders, to control satisfactorily either the quantity or the quality of credit.

As an aside, one might ask, despite Mr. Gookin, should it be otherwise? As a nation, do we need something called an incomes policy to maintain our place in the sun, or do we have the courage to place our faith in the free market even when the clouds of financial crises are blackest?

Even though the central bank has not found the specific cure for a banking system that was sick in Mr. Gookin' s day and is somewhat feverish now, it has been the heart of the scientific spirit, in governments facing imponderable and deeply involved, monetary, financial and economic problems.

If there is any hope that inflation, as a social disease, may be cured through the scientific process, the Federal Reserve System is likely to be the agent presenting the diagnosis and prescription.

In the meantime, the range of its interests and activities has broadened to include the monetary, financial and economic problems of the entire world, a world being cut down to size through the miracles of modern transportation and communication.

Robert P. Mayo, president of the Federal Reserve Bank of Chicago, gave a talk before the Bankers Club of Chicago on December 2, 1970. The title was "The Federal Reserve System -- Vital and Viable in the Seventies." In it he reminded System officials, bankers and the general public that the primary function of the central bank, in a nutshell, is the promotion of the public interest. "However," he said, "the public interest is in a state of flux, affected continuously by rapid change, innovation and new dimensions of sophistication. These facts of life will vastly modify our interpretations of our objective and also how the System's functions relate to the whole fabric of society -- not just to the economic process or our financial machinery."

He did not renounce the System's responsibility in three specific areas: monetary control, a smoothly running payments mechanism and banking supervision.

"But," said President Mayo, "I feel that we should interpret these goals in an environment where effective action may be blocked by relics of a bygone era in the form of legislation, by structural rigidities or just by plain lethargy."

He looks forward to a Federal Reserve System which, through its influence on banking structure, bank performance and availability of credit, will provide the environment within which banks can meet the needs of agriculture, housing, urban areas, state and local governments and the international payments mechanism.

The System is involved in the World Bank, the Export-Import Bank and the International Monetary Fund. It has a vital interest in the implications of the Edge Act for international banking, in Eurodollars, in Special Drawing Rights and even in old-fashioned gold.

If its economics and administrators are smart enough and able enough, and if it hangs on to its rich relationship with a free and independent Committee for Economic Development, we may yet live to see the System sitting contentedly on the brink, wiggling its toes, watching with glee three life-saving balloons filled with helium, entitled Unemployment Achieved at Five Percent, Inflation Checked at Three Percent, Balance of Payments Deficits Turned into Surpluses. Oh happy day!

William McChesney Martin Jr., who headed the System so ably for a number of years, under Republican and Democratic administrations, wrote recently: "What is this Federal Reserve policy that some people are so anxious to change? It is a policy of endeavoring, at all times, to assure monetary and credit conditions that will foster high levels of business and employment, maintain the stability of the currency and promote sustainable growth in the economy. It is a policy of combating, with equal vigor, the excesses of inflation and deflation alike."

Surely Frederick Gookin would have endorsed that policy. He had the vision, in his day, to see in the idea of a central bank the cure for the ill health of a society ravaged by a defective banking system.

True, his vision did not encompass Bretton Woods, nor the ingenuity of the money lenders.

Moreover, Mr. Gookin, being fundamentally an artist, gratuitously abandoned to science the solution of banking problems. The trouble is that banking is not an exact science. Neither is economics.

Neither is the monetary system.

We still have work to do, new prescriptions to write.