The Man Behind the Fed

It was a matter of curiosity and some resentment that the only person to foresee the crash of 1907, the resounding culmination of a half-century of intermittent bank failures in America, was a stern Jewish banker with an imposing German accent. “If this condition of affairs is not changed,” the balding, brown-eyed and thickly mustached immigrant, Paul Warburg, told the New York Chamber of Commerce in 1906, “we will get a panic in this country” that will make its predecessors “look like child’s play.” He was right, and it didn’t take long before politicians were knocking at Warburg’s door.

A member of a Jewish banking dynasty in Hamburg, Germany, Warburg and his wife Nina Loeb arrived in Manhattan in 1902 to care for Nina’s ailing mother. Warburg took a position at Kuhn and Loeb, a firm owned by his father-in-law but run by the noted philanthropist Jacob Schiff.
Unusually academic for a banker and familiar with the Reichsbank, Germany’s central bank, Warburg was wary of America’s financial structure from the day he stepped off the boat. “He was flabbergasted by the wild boom-and-bust swings on Wall Street, the weak, fragmented banking system, the giddy stock market gyrations,” writes Ron Chernow, author of the The Warburgs. Warburg called the system “bewildering and strange.”

A month after the October crash, at The New York Times’ behest, Warburg wrote an article titled “Defects and Needs of our Banking System,” proposing the creation of a central bank. The United States had twice established a national bank, but President Andrew Jackson decisively eliminated it in 1836. By the turn of the century, famed banker J.P. Morgan functioned as the nation’s de facto central bank, providing money to prop up the economy during crises. Morgan alone could not protect the U.S. economy forever, though, and Warburg felt it was dangerous for this rising economic power to be without a bank of its own.

Despite the economic crisis, says Niall Ferguson, a professor of history at Harvard University, “there was much political resistance to the idea of a central bank.” People assumed that such a bank would benefit bankers, not average citizens. Warburg himself warned that political control of the bank could undermine its effectiveness: It was essential, he wrote, to establish “reliable safeguards against control of the system’s passing into the hands of either ‘big business’ or the politician.” Only then, he felt, could it prevent, or at least minimize, financial crises.

Warburg succeeded in winning over Senator Nelson Aldrich of Rhode Island and, at a top secret meeting on Jekyll Island, off the coast of Georgia, they worked out the details of what would eventually become the 1911 Aldrich Plan to found a central bank. But the Congress of 1912 nixed it. Warburg was frustrated by the plan’s rejection, but did not give up.

Under President Woodrow Wilson, who took office in 1913, political support grew. On December 22, Congress passed the Federal Reserve Act, creating a Washington Federal Reserve Bank with seven board members appointed by the president, as well as subservient regional banks. Although Warburg worried that the new bank wasn’t strong enough to withstand political interference, he was pleasantly surprised when Wilson named him to its board.

He became the bank’s vice-governor in 1916, but rumors swirled during the war that he doubled as a spy for the German Kaiser. Moreover, a rivalry had developed between him and Treasury Secretary William G. McAdoo, whose position as chairman of the Fed Warburg opposed on grounds of excessive political meddling. He was not reappointed in 1918.

Warburg served as an advisor to the Fed from 1921 to 1926, but was increasingly displeased with the bank’s direction. In March 1929, in what Chernow describes as “one of the great calls in American financial history,” Warburg predicted the scope and severity of the looming crisis. He warned that Washington had decided to “leave the gamblers in control until a crash will bring speculation to an end,” adding that “if orgies of unrestrained speculation are permitted to spread too far…the ultimate collapse is certain not only to affect the speculators themselves, but also to bring about a general depression involving the entire country.”

Warburg never intended for the Fed to serve as a perfect antidote to America’s large and unwieldy economy, and he would have been unhappy with its subsequent evolution. Its history is rife with political meddling, notes Greg Robb, a reporter for Marketwatch.com. Richard Nixon, he says, was highly involved with the Fed, and one famous story has Lyndon Johnson driving Fed Chairman William McChesney Martin around his Texas ranch, yelling at him to cut interest rates. Alan Meltzer, a professor of political economy at Carnegie Mellon University, suggests that Warburg, an anti-inflationist, would also criticize current monetary policy, which could cause inflation in the future. “You don’t want the power to create money to be used to finance the government deficit the way we’re doing now,” Meltzer says.

But even as today’s economy flounders and the Fed is criticized on any number of grounds, there is reason to be thankful for Paul Warburg’s success in establishing it. “The Fed has made mistakes,” says David Wessel, economics editor of The Wall Street Journal, “but the history of the Great Depression shows the consequences when the Fed does nothing at a time like this.”—Helen Grove