Bernanke’s Recession-Fighting Weapon Developed by 1900s BankerCraig Torres
The first weapon Federal Reserve Chairman Ben S. Bernanke deployed against the worst recession since World War II owes a singular debt to Paul M. Warburg, a banker in the 1900s who understood money markets more than any contributor to the Federal Reserve Act.
When President Woodrow Wilson signed the act on Dec. 23, 1913, its central purpose was to serve as a backstop to a financial system that had lurched from one crisis to the next in the preceding decades. The concept of backstop lending came from Warburg, a native of Germany whose writings reveal concern that he never got appropriate credit for his role.
Nearly 100 years later, his ideas were vindicated when Bernanke used the so-called discount window on Oct. 29, 2008, to provide banks with $111 billion in loans as short-term credit markets nearly froze in the wake of the Sept. 15 bankruptcy of Lehman Brothers Holdings Inc. The Fed chairman also used emergency powers to support money markets, which Warburg had flagged as critical to financial-system liquidity.
Warburg “is the father of the discount window in the United States” and “the grandfather of the Federal Reserve,” said Michael Bordo, director of the Center for Monetary and Financial History at Rutgers University in New Brunswick, New Jersey. If his “plan had been followed, the Fed would have done a lot better in the 1920s, and the Great Depression might not have been so bad.”
Warburg, who served from 1914 to 1918 as one of the first Fed governors and the second vice chairman, was an unusual political choice for a foundational seat on America’s new central bank. He was an investment banker at Kuhn, Loeb & Co. when Congress was suspicious of financial power. He disliked the decentralized scheme the American political system devised for the Fed and fought to consolidate it. At the heart of his concern was the need for a centralized money market the Fed would support if a panic erupted.
The U.S. was still on a gold standard, and Warburg saw that one way to create flexibility in such a rigid currency system was for banks to be able to discount, or sell, short-term liabilities in exchange for money. Today, they routinely fund themselves with short-term commercial paper and repurchase agreements that allow them to use securities as collateral for short-term loans.
In the course of daily business, the central bank wouldn’t be an active player, simply a buyer of last resort if a bank couldn’t secure funding. The cost of direct loans from the Fed would be the discount rate, which banks would pay to access the discount window.
During a January 1913 hearing on banking and currency reform before a House subcommittee, Warburg told its chairman, Carter Glass -- who guided the Federal Reserve Act into law -- that he was “aghast” at the conditions of U.S. money markets when he arrived in America.
“I saw money rates of 25 and 30 percent,” he told Glass. “There was then one of those discussions going on, as they have been going on ever since, as to what to do.”
Later in the hearing, he said he knew exactly what action should be taken.
“Neither the banks nor the central reserve itself would be safe without the introduction of commercial or banking paper as a means of exchange,” Warburg said. “The key, if you please, to the vaults of the central reserve is furnished” by short-term debts that banks could turn quickly into cash.
Wilson and Glass opposed some of his ideas, with Glass even criticizing the notion that Warburg contributed anything to the act.
“Warburg did not draft a sentence of the bill,” Glass wrote to his life-long friend Robert Latham Owen in a letter that was found in an archive of Glass’s papers at the University of Virginia’s Albert and Shirley Small Special Collections Library. Owen sponsored the act in the Senate.
Still, both Wilson and Glass insisted Warburg serve on and help navigate the central bank in its formative years. His expertise was broadly recognized at the time, even among the general public.
“Such appointments as yours and your colleagues must tend to restore confidence toward establishing the new financial system,” F.W. Kelsey, head of a Manhattan nursery company, wrote Warburg in a May 8 letter found in the Paul Moritz Warburg papers, manuscripts and archives of the Yale University Library in New Haven, Connecticut.
Marcus Marks, Manhattan borough president, called Warburg “the best equipped man in the country to take on the duties of this position” in a May 5 letter. William Sproule, president of the Southern Pacific Railroad, wrote on May 6 he had a “sense of refreshment” that “a professional banker of the highest standing” accepted the job.
After graduating from school in Hamburg at 18, Warburg began apprenticeships in various financial houses, including the British investment bank Samuel Montagu & Co. and his great-grandfather’s firm, M.M. Warburg & Co., founded in 1798. He came to the U.S. in 1902, following his marriage to Nina Loeb, daughter of the founder of Kuhn Loeb.
Warburg’s European experience in import-export financing and commercial trade in the money markets would define his approach to central banking. In his view, the financial system needed a centralized, secondary money market where banks could immediately raise funds by taking commercial paper and trade credits, known as bankers acceptances, and selling them. He called them “quick assets,” a term that reflected his sense of securities almost as fungible as cash itself.
A century later, Gary Gorton, a professor of management and finance at the Yale School of Management, wrote that one of the critical lessons from the 2008 financial turmoil was that short-term debt can serve as a form of private money.
“An important misunderstanding revealed by the crisis is that regulators and economists did not know what firms were banks or what debt was ‘money,’” he said in his 2012 book “Misunderstanding Financial Crises: Why We Don’t See Them Coming.” “They thought that banks were only the firms that had bank charters and that money was only in currency and demand deposits.”
As Gorton points out, investors can write checks against their money-market mutual funds, which hold commercial paper, as easily as they can against cash deposits in their bank accounts. The financial crisis was mainly a modern-day run on these forms of money as confidence in the firms or assets that sponsored them eroded, which is what caused Bernanke to support these markets with emergency facilities.
The central bank “has rediscovered its roots, in the sense that the Fed was created to stabilize the financial system in times of panic,” Bernanke said at a Dec. 18 press conference explaining the contributions of his chairmanship, which ends Jan. 31. “And we did that, and we used tools that were analogous in spirit to what the central banks have done for many hundreds of years, but of course adapted to a modern financial system.”
Warburg’s papers at Yale show tireless effort to start the market for bankers acceptances, which were more secure than commercial paper because they were backed by a bank that had “accepted” or put its name on the short-term credit, enhancing its appeal in secondary markets.
He spent hours refining regulations, drafts in his notes show, and scolded Benjamin Strong, the first head of the Federal Reserve Bank of New York, for not being more excited about the market.
“Do not get into the most discouraging and disappointing attitude of saying that no business can be done by the Federal Reserve Banks when, as a matter of fact, I know it can be done, and if I were in charge in New York, I know I could buy millions of bank acceptances,” Warburg wrote to Strong on Feb. 17, 1915.
However much Glass, Owen and others might have tried to minimize Warburg’s contribution to the act, the original document bears his unmistakable fingerprint in the preamble.
In addition to establishing regional reserve banks and furnishing an elastic currency, the third directive reads: “to afford means of rediscounting commercial paper.”
In his 1930 memoir, Warburg called Glass and others who took credit for the act “pleaders in their own cause.”
“The Reserve System is the product of the labors of many minds,” Warburg wrote. The development of America’s central bank “must be looked upon as a national monument, like the old cathedrals of Europe, which were the work of many generations and of many masters and are treasured as symbols of national achievement.”