America’s Money Machine

THE SPLENDID THEORY of central banking championed by Paul Warburg and adopted into the Federal Reserve System did not survive the first strain to which the System was put. This came from the entry of the United States into the European conflict in April, 1917, and the immediate need for large sums not only to meet the U. S. war costs but to finance our European allies. While the war appears as the overt cause of the profound change that now came about in Federal Reserve policy and operations, a deeper cause was the fissures within the System itself, the cleavages of principle and theory that were merely compromised and never fused.

In addition, there were two other weaknesses that would inevitably cause collapse or transformation. Both of these are traceable to Paul Warburg, the leading exponent of central banking theory and practice, an original member of the Board and its vice governor after Delano’s resignation on August 9, 1916. Some further notice of Warburg’s background and outlook is therefore in order.

Paul Moritz Warburg was born at Hamburg, Germany, August 10, 1868. He was graduated from the University of Hamburg in 1886, and spent the following two years in business apprenticeship with a Hamburg commission firm. He then entered his father’s banking firm for a further period of seasoning. This was M. M. Warburg & Co., which had been founded in 1798 by Paul’s great-grandfather. Subsequently Warburg studied English banking methods while working with a prominent London discount and brokerage house. In 1891 he extended his studies to French banking methods, and in 1892 and 1893 traveled through the Orient and around the world. During these journeys he visited for the first time the United States where he was later to migrate and become one of its distinguished citizens and bankers. After these journeys he reentered his father’s banking firm as a partner, a relationship he continued to hold long after he came to the United States.

For a decade Warburg engaged in banking and public affairs in his native city of Hamburg, eventually becoming a member of the Municipal Council; but in 1902 he moved to New York to accept a partnership in the firm of Kuhn, Loeb & Co. This was another banking house with German-Jewish antecedents that became influential in New World finance by means of its access to Old World capital. Much of the business of this and similar firms was in finding capital for U. S. industrial expansion through the sale of securities in the European markets. Kuhn, Loeb & Co., in particular, acquired a reputation as a leading banker for the railroads and, as we have noted, helped Harriman acquire control of the Union Pacific when J. P. Morgan &Co. declined to assist.

Warburg’s intimate experience with, and study of, banking methods abroad led him inevitably into the debate on the reform of the American currency system, especially after the Panic of 1907. In December, 1906, when anxiety ruled the financial markets, Warburg was invited by the New York Times to write an article on the banking situation. The piece, published January 6, 1907, entitled “Defects and Needs of our Banking System,” became at once the lodestone toward which all subsequent discussion turned. It was followed by other essays and addresses. Warburg became the leading exponent of monetary reform. At the same time he was increasingly active in civic affairs, and particularly in politico-fiscal questions. He was a member of the Merchants Association Committee on Currency and Finance, and also of a similar committee of the Chamber of Commerce of New York. He was active in various philanthropic and educational enterprises and was one of the founders of the National Child Labor Committee, and he took a deep interest in settlement house work.

Warburg’s views exercised profound influence not only upon the actual form of legislation that emerged, but upon the subsequent policy and administration of the Federal Reserve System. He was an indefatigable and persuasive advocate. He argued first that the gold holdings of the country should be concentrated in one central institution (or group of institutions) where they would be employed as the ultimate reserve of the money system. Second, he advocated a circulating medium that should consist mainly of paper currency, or note issue, the amount of which should be regulated both in relation to the quantity of gold in reserve and the demand for payments media represented by commercial notes and bills. That is, the actual quantity of money in circulation at one time would be determined by the volume of commercial bills and notes available to secure the notes (in addition to the gold) and the need for circulating notes as evidenced by the amount of commercial bills which the banks were willing to discount (sell) to the central reserve institution for the purpose of obtaining notes.

It was these two tenets that were adopted as the basis of the new monetary system, and this triumph is largely due to Warburg’s skill and logic, his influence as a banker and philosopher, and his persistence in arguing his views.

In Europe, where Warburg had learned his banking, the customary form of commercial obligation was the acceptance, which, as we have noted earlier, was a document in the form of an order to such an one to pay such an one a certain sum at a certain date. It was commonly used by a seller of goods. When he sent the invoice for the goods he would also send a draft on the buyer for the amount of the invoice. This was simply an order to the buyer to pay, after so many days, the sum designated. The buyer would accept the obligation by writing across the face of the draft the word “Accepted,” together with the place at which he wished to pay the draft when it came due, sign it, and return it to the seller. Commonly in international trade, the draft would accompany the invoice and shipping documents and would be sent through a bank. Upon acceptance by the buyer the bank would release the shipping documents to the acceptor, thus permitting him to take delivery of the goods from the transport company.

The acceptance was a convenient form of financing trade with traders of small capital, since they could have time to re-sell the merchandise before they had to meet their acceptance obligation. The seller also was able to do business with limited capital since he could discount (sell) the acceptance to a bank and recoup the cost of his merchandise. From the banker’s standpoint it was an advantageous form of lending its capital since (a) it indicated on its face a prime requirement of sound lending, namely, the purpose for which the money was being used; (b) it was a “self-liquidating” form of obligation; (c) it carried a double guarantee of payment (“two-name” paper), the buyer (“acceptor”) being the primary obligor, and the seller the secondary obligor; and (d) it was a readily marketable form of obligation in case the bank wished to strengthen its own cash position. The rediscount privilege conferred upon such paper by the Federal Reserve Act, by which a commercial bank could in turn sell the obligation to a Reserve bank, enhanced this marketability. A further advantage conferred by the Federal Reserve Act was that it imposed no limits upon the amount of credit which member banks might extend through the acceptance mechanism. (Loans on straight promissory notes, to any one lender, were limited to 10 per cent of the bank’s capital and surplus.)

Actually, the dominant practice was that of open account purchases, whereby the buyer settled periodically for his purchases (generally on the first of the month) or cash purchases, under which the buyer was allowed a discount from the invoice price for immediate or prompt payment. Some firms allowed a discount on open accounts settled within ten days after the account was rendered.

Leading bankers had pointed out that the theory of the Federal Reserve System was defective in the U. S. market, since it would force an inferior type of credit into the banks. If paper available for rediscount must be two-name paper, they asserted, the banks would be dealing with debtors of poor risk. If the new system was to rest on the best basis it should take such paper as was issued by traders strong enough to finance themselves without a guarantor, that is, on their own name. Every day the newspapers carried long lists of single-name promissory notes issued by industrial firms for commercial uses, and accepted as final payment by their suppliers. Such notes, payable to bearer, passed almost like money, without endorsement. This was a system almost unknown in Europe.

Following passage of the Federal Reserve Act, however, bankers undertook to popularize the use of acceptances and for a time a lively acceptance market grew up.

“What we need,” said J. E. Gardin, vice president of the National City Bank, discussing the subject in an article in Trust Companies magazine, “is a standardized instrument, carrying the guarantee of the makers, acceptors, and endorsers in a natural automatic manner. This instrument is to be found in the bill of exchange, and is the instrument that is permitted by the law to be used by the Federal Reserve banks in their open market operations.

Despite these efforts to popularize acceptances, they never became a significant element in Federal Reserve credit. The fact is, as we shall note in more detail further on, the idea of paper money substantially backed by commercial paper never got off the ground. This was partly the result of the war, and the availability of the Federal Reserve mechanism to finance its costs, but it was also due to the second arm of the Warburg theory of central banking.

This was his idea that the system should be under the firm and absolute control of the government.

Glass had drafted a bill that avoided a central bank with branches, and provided for twenty Federal Reserve district banks under control of a Federal Reserve Board with forty of the forty-three members chosen by the member banks. Warburg had finally persuaded Glass to reduce the governing body of the proposed system to seven, of whom four members would be appointed by the government, but that still was not enough to suit Warburg.1

The bill, as finally passed, failed to meet all of Warburg’s ideas, as we have seen, but it left enough vagueness as to the ultimate power and influence of government to provide a handle for a firm and aggressive administrator to guide the agency in that direction, and bring it under authoritarian domination.

Warburg was such a personality, and he was now in a strategic position to mould the institution to his ideas.

Unfortunately for the complete success of his theories, Warburg’s loyalties had led him to maintain his German connections, and in 1913, only a year before the outbreak of the war in Europe, he had accepted the Order of the Cross, second class, from the Emperor Wilhelm.

When the U. S. entered the war, in 1917, all things German were suspect. Public feeling against Germany was much more fanatic than in World War II. The Metropolitan Opera, for instance, dropped German operas from its repertory (some said because this country had no singers capable of the demands of German opera), and many persons of German extraction found it convenient to anglicize their names.

Warburg, because of the importance of the Federal Reserve in war finance, also came under a cloud, and resigned from the board on August 9, 1918.

Warburg’s influence did not end, however. He continued as chairman of the influential Federal Advisory Council2 and what he urged and counselled the necessities of war seemed to confirm.

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3 Warburg had been called into administrative councils on the bill as early as April, 1913, when Col. House (Wilson’s intimate adviser) sent him a digest of a bill which had been drafted by H. Parker Willis.

4‘The group of advisers created by Sec. 12 of the Federal Reserve Act.

• 1* Warburg had been called into administrative councils on the bill as early as April, 1913, when Col. House (Wilson’s intimate adviser) sent him a digest of a bill which had been drafted by H. Parker Willis.
• 2*‘The group of advisers created by Sec. 12 of the Federal Reserve Act.
• 3Glass had drafted a bill that avoided a central bank with branches, and provided for twenty Federal Reserve district banks under control of a Federal Reserve Board with forty of the forty-three members chosen by the member banks. Warburg had finally persuaded Glass to reduce the governing body of the proposed system to seven, of whom four members would be appointed by the government, but that still was not enough to suit Warburg.*
• 4Warburg’s influence did not end, however. He continued as chairman of the influential Federal Advisory Council* and what he urged and counselled the necessities of war seemed to confirm.