America's Bank: The Epic Struggle to Create the Federal Reserve (4 page)

Laughlin and other theorists were supremely naïve; monetary management is far too complicated to submit to an “automatic” guide.
*
And they appeared not to notice that America’s growing financial strength was tugging the U.S. Treasury away from the laissez-faire principles they held so dear. Indeed, various Treasury secretaries had begun to experiment with lending government reserves to banks. This is what central bankers do. Lyman Gage, secretary of the Treasury under McKinley, was a perfect illustration: even though he preached the gospel of noninterference, in practice he began to act like a forerunner of Ben Bernanke.

Born and educated in upstate New York, Gage was a former president of the First National Bank of Chicago and an enthusiastic supporter of the Indianapolis idea of
getting the government out of banking
. However, McKinley’s high-tariff policies tended to augment Gage’s power. Higher tariffs meant more government revenue to throw around in money markets. Secretary Gage, fashionably
coiffed in a full beard and mustache, may not have wanted a government bank but, with tariff collections streaming into the Treasury, he had one.

What further amplified the Treasury’s
influence was an economic boomlet, spurred by a combination of bumper wheat crops at home and a string of gold discoveries, including in the Klondike region of the Canadian Yukon. With wheat sales surging and gold more plentiful, money growth soared; deflation was finally over. In a sense, Bryan was vindicated: more money had indeed fostered prosperity. It was Bryan’s ill luck that the additional metal, as it happened, wasn’t silver, but gold.

Gage now faced a question unknown to his predecessors: What to do with the Treasury’s surplus? As Gage was aware, the bullion stowed in the Treasury’s vaults was idle; it wasn’t out stimulating trade. His solution was to increase deposits in the national banks. In other words, he began to try his luck as a central banker.

War with Spain, launched by McKinley in 1898, raised the profile of the Treasury even more (wars inevitably involve governments in banking). To finance the battle of San Juan Hill, Gage offered $200 million in bonds, to which the public eagerly subscribed. The war spending ignited a genuine boom. Arthur Housman, a stockbroker who traveled the country by rail in 1899, testified to good times in a report to J. P. Morgan. “
Money is plentiful throughout the country
,” Housman wrote in June. “In the smallest towns, money is freely offered at 5%.” Chugging across the prairie, Housman approvingly observed that farmers were building new fences and barns and that ranchers were improving their breeds of cattle.

Yet the McKinley prosperity did not disguise the underlying weakness in the banking system. In the fall, country banks, needing cash for the harvest, pulled their deposits. Liquidity in New York suddenly evaporated. The city’s banks had whittled their reserves to the legal minimum; now, they had little—or nothing—to lend. “
The
cry everywhere
,” said the lawyer and investor Henry Morgenthau, “was for money—more money—and yet more money.”

Gage did not have to ponder long before deciding on a use for the Treasury’s reserves. He loaned them to banks. Gage’s idea, again, was to get the Treasury’s money into circulation. Although he still affirmed the desirability of reducing the government’s profile, he observed with alarm in his report for 1899 that “
havoc was wrought in the regular ongoing
of our commercial life.” This he would not abide. The “periodical regularity” of autumnal shortages grated on him. The lack of “stability” in the currency, the want of flexibility for “needful expansion,” suggested a profound inadequacy in the system.

By 1900, Gage had deposited more than $100 million of the American people’s money in four hundred different banks. Outraged, Congress investigated.
Legislators were irate that Gage
had distributed a disproportionate sum, in particular, to National City Bank of New York. Such coziness between Wall Street and Washington inflamed old fears of bankers’ conspiracies.
The Coming Battle,
a populist tract by M. W. Walbert, warned that money dealers had formed “a gigantic combination” to thwart the interests of the people.

Impervious to the criticism, the restless Treasury secretary plowed ahead. In the same year that saw Walbert’s attack on banks, Gage averred, “It is a popular delusion that [a] bank deals in money.” For the most part, Gage elaborated, banks deal in
credit.
Expounding on this theme, he pointed out that no more than 10 percent of a bank’s daily receipts are in the form of cash. The rest consists of checks or, as Gage precisely put it, “
orders for the transfer of existing bank credits
from one person to another.”

This 90 percent
—the credit network—was where the breakdowns occurred. That credit could dry up at a time of prosperity and rising gold reserves was especially troubling. No sooner do the symptoms of trouble appear, Gage observed, than banks, guided by the “
ruling principle of self-preservation
,” suspend or greatly inhibit their loans.
At that point, people carrying goods and securities are obliged to sell with little regard to cost. “Contemplated enterprises are abandoned; orders for future delivery of goods are rescinded.” Finally, what should be an orderly contraction becomes “a disorderly flight, an unreasoning panic.”

Fearing such a panic, Gage intervened in the spring of 1901, when
a raid on Northern Pacific
Railway shares roiled the stock market, and again in September, after President McKinley was assassinated. At the start of 1902, uncomfortable with the meddlesome style of his new boss, Theodore Roosevelt, Gage resigned. His final report was a parting shot at the venerable National Banking system. After five years in office, he had concluded that the system, admirable in many respects, had been “devised for fair weather, not for storms.” He lamented that individual banks stood “isolated and apart, separated units, with no tie of mutuality between them.” He lamented, too, that no association existed “for common protection or defense in periods of adversity and depression.” Not since Alexander Hamilton had a Treasury secretary come so close to demanding a central bank.

Gage even spoke the forbidden words. Perhaps, he mused, the time was ripe not for a “large central bank with multiplied branches”—in view of the sure opposition it would arouse—but for a more modest institution, one restrained by constitutional-style checks. He had in mind a bank, privately owned, with authority to loan reserves from areas of the country where credit was plentiful to regions where it was scarce. Such an entity could become the object of a “perfect public confidence,” he said hopefully—if its powers were properly circumscribed. “
We justly boast of our political system
, which gives liberty and independence to the township and a limited sovereignty to the State. . . . Can not the principle of federation be applied,” Gage wondered, “under which the banks as individual units, preserving their independence of action in local relationship, may yet be united in a great central institution?”

PRIVILEGED BANKER, SELF-MADE SENATOR

Under our clumsy laws, the currency
supply [is] often largest when demand . . . is least.

—A
LEXANDER
D. N
OYES

The study of monetary questions
is one of the great causes of insanity.

—H
ENRY
D
UNNING
M
AC
L
EOD

P
AUL
M
ORITZ
W
ARBURG
, an immigrant German banker, had barely arrived in New York in 1902 when a tempest erupted on Wall Street. The drama may have seemed routine to jaded New Yorkers, but to the newcomer, it signaled that something in America’s financial system was seriously amiss. Market busts were increasingly common.
Beginning in 1887
, there had been serious financial turmoil roughly every three years. The latest trouble had begun earlier in
1902, when the stock market suddenly cracked. Due to the fragile chain that linked the market and banks, the anxiety migrated into credit markets. Interest rates soared and reserves in the New York banks plunged below the lawfully prescribed minimum. Warburg watched in astonishment as credit quickly evaporated.

The crisis was defused by Roosevelt’s secretary of the Treasury, an Iowa banker named Leslie Shaw, who sprinkled government moneys among national banks, and who assisted the banks in more creative ways as well.
Critics roundly debated whether Shaw
had been right to intervene. From Warburg’s émigré perspective, this quarrel missed the essential point. That Shaw had been compelled to resort to such makeshift tactics was evidence of the crudeness of American banking. It proved that the system itself was the problem. “
I was not here for three weeks
,” he would say later, “before I was trying to explain to myself the roots of the evil.”

Schooled in Germany’s refined financial system, young Warburg injected a sorely needed gust of fresh thinking into the stale arguments over National Banking. There was probably no one in America who better appreciated the workings of the European central banks, and how they contrasted with the system in his adopted home.

Warburg was the third of five sons, heirs to the Hamburg banking firm M. M. Warburg, which traced its origins to the time of Napoleon. He was introspective and shy, and he harbored a melancholy whose physical manifestation was a thick mustache inevitably characterized as “drooping.” If his younger brothers, Felix and Fritz, were bons vivants, and Max, the second, was a headstrong banker, Paul had the soul of a poet, and the intellectual fire of the eldest brother, Aby, who became a prominent art historian. As the family biographer, Ron Chernow, noted,
Paul seemed to make money
without really caring for it. However, his training uniquely prepared him to be an authority in international finance.

After graduating from a European
gymnasium
at eighteen, Paul entered the family bank, spent two years in London, in a variety of
jobs, and moved to Paris and to a bank specializing in foreign trade. After a year in Hamburg, the young banker was dispatched on a world study tour, commencing by train to Genoa, where he embarked on a sail-bearing steamer to Suez, followed by a luxurious British liner to India. After stops in Singapore, Saigon, Hong Kong, and Japan, he returned home via Vancouver and the United States. The trip burnished his appreciation of the role of central banking in ensuring market stability.
Overall, his field study
had lasted seven years.

By 1895, though still only twenty-seven, Warburg was basically
running the family bank
. In that same year, he married Nina Loeb, the daughter of an American financier. Like Paul, Nina hailed from a tribe of German-Jewish bankers who lavished attention on their children’s education, musical training, and cultural upbringing in preparation for lives of wealth and civic involvement. Like him, as well, she carried a sadness, the result of an accident when she fell from a cart, injuring a leg and ending her dream of a career in ballet. The couple settled in Hamburg, crossing to America for summers, but Nina’s ailing parents yearned for their daughter to be nearer, and in 1902, the thirty-four-year-old Paul bowed to the inevitable and moved his family to New York, where he joined his in-laws’ firm, Kuhn, Loeb & Company.

Warburg was shocked by the primitiveness
of American finance. Whereas banks in Germany functioned with near-military cohesiveness, banking in America, he concluded, suffered from an ethos of extreme individualism. As credit tightened, each bank pulled its loans, thereby accentuating the scarcity for all the rest. In 1903, soon after the plunge on Wall Street, Warburg let on to Jacob Schiff, his brother-in-law and the senior partner at Kuhn, Loeb, that he had penned some thoughts on the defects of American banking and how to cure them. The key problem that Warburg outlined was the lack of a central reserve. In effect, each of the country’s
approximately fifteen thousand banks
stood watch over its own cache of gold, which neutralized what could have been a potent collective reserve. Another
problem was the lack of a liquid market in so-called bills of trade—pieces of paper representing loans that were endorsed by banks. In Europe, banks could sell, or “discount,” such loans to the central bank, freeing up reserves so they could issue more loans; by contrast, such loans were illiquid and inert in America. The final defect was the lack of an elastic currency. Warburg believed that each of these problems could be met by a single remedy—a central bank such as existed in his homeland.

Although his English was flawed, Warburg wielded an unusually lucid and forceful pen. The act of writing seemed to liberate him, transforming the self-effacing, studiously correct gentleman into a passionate and persuasive advocate. Schiff read Warburg’s paper and agreed with the substance of it. However, Schiff said, Warburg had misread the psychology of the American people, who would “never” accept any institution resembling a central bank. He warned his junior partner not to share his paper with others. A generation older than Warburg, Schiff had immigrated to the United States after the Civil War and become one of the country’s leading railroad financiers. No doubt he feared that Warburg would alienate local bankers by lecturing them on the shortcomings of their own system. But, as a teaching exercise for his protégé, he offered to show the paper, on a confidential basis, to two well-placed friends. One was Edward H. Harriman, a railroad tycoon and Schiff’s sometime ally in business. The other was James A. Stillman, president of the National City Bank and one of the preeminent bankers in New York. Harriman read Warburg’s memorandum and dismissively told Schiff that Old World institutions couldn’t be replicated in America.

A day or two later, Warburg looked up from his desk and found Stillman looming over him. Stillman was a man of legendary laconicism, highly eccentric. He was silent now, looking at Warburg through half-closed, heavy eyes.

Finally, adopting a tone of gentle sarcasm, Stillman spoke:
“How
is the great international financier?”
He added, somewhat defensively, “Warburg, don’t you think the City Bank has done pretty well?”

Warburg agreed that it had—very well indeed.

“Why then not leave things alone?”

Warburg hesitated before daring to reply. “Your bank is so big and so powerful, Mr. Stillman, that when the next panic comes, you will wish your responsibilities were smaller.”

Stillman—no longer quite so friendly—huffed that Warburg had it all wrong. America’s banking system, far from being inferior to those in Europe, actually represented an improvement. Indeed, had not America tried a central bank during the Jackson era and discarded it?

Warburg put his paper on a shelf. For the moment, he had plenty else to do, learning the ins and outs of railroad finance and corporate mergers.

•   •   •

V
ARIOUS
OTHER
BANKERS
—heirs to the Indianapolis convention—carried on the fight for reform. However, unlike Warburg, they favored establishing an asset currency, a decentralized scheme based on each individual bank’s loans. Charles Fowler, chairman of the House Committee on Banking and Currency, introduced a bill to the bankers’ liking, but the legislation was stillborn. For one thing, the issue was rather too technical for President Roosevelt, who preferred to expend his energies on social problems on which he could act as the nation’s moral leader. Moreover, the existing National Banking system had a fierce defender in the Senate, who stubbornly and consistently blocked reform.

Nelson W. Aldrich, chairman of the Senate Finance Committee, was arguably the most influential figure in Congress at the turn of the century. In this time of Republican hegemony, his word went practically unchallenged; so great was his authority that newspapers
called him the “general manager of the United States.” Strongly identified with business interests, Aldrich resisted popular efforts to regulate industry and railroads, or to protect labor. The decades since the Civil War had seen America transformed by the Industrial Revolution, and Aldrich viewed the task of government as essentially ensuring that American business would continue its upward course. In banking as in other fields, he reflexively defended the status quo. However, late in life, Aldrich would experience a stunning conversion to Warburg’s cause. He then became the first ardent champion of a central bank in a position of power.

Unlike Warburg, Aldrich was of humble background. Born in 1841 in a farmhouse in the tiny town of Foster, Rhode Island,
Aldrich had high aspirations
tempered by a steely pragmatism. During the Civil War, he showed no appetite for glory, much less for risking his hide. Assigned to guard Washington, D.C., he was enthralled by the sight of the Capitol—“
its splendid white marble staircase
,” in particular—but contracted a fever and was promptly discharged. It was not that Aldrich lacked ambition; rather, his ambition was centered on his material advancement.
His father, a skilled machinist
who was learned in Rhode Island history, had been checked in his career by periodic drinking binges. Not unlike Carter Glass,
Aldrich felt acutely
his father’s failure to advance in the world and harbored a deep yearning to succeed. As a young man, he fell in love with an independent woman of some means, Abigail P. T. Chapman, who rebuffed him.
Rejection furnished Aldrich
with an urgent motive to raise his station, a worldly zeal that persisted even after he had won her hand, for Aldrich was to write his young wife, “I grow sick with the thought that I am to remain one of that herd of ‘dumb, driven cattle’ which makes up the mass of men.”

By dint of tireless work,
Aldrich elevated himself
from the position of clerk at a wholesale grocer in Providence to junior partner. He also engaged in the lively debates in the local lyceum—such public lecture halls were a fixture in American towns of that era—on issues
ranging from the tariff to the currency. Although he was hardly rich, he identified with the propertied class, and coveted Old World
objets
as though aristocracy were his natural entitlement. While still a young man, he began acquiring land on Narragansett Bay, where the state’s blue-blood families traditionally vacationed and where he himself one day would build a ninety-nine-room Renaissance château, with three sides majestically facing the sea.

Abby tried to moderate his ambition; early in their marriage, as if fighting a premonition, she expressed her “
most earnest and cherished hope
” that her husband might leave “an unstained record, without one single blemish.” His own inner torment nearly derailed his career. In 1872, racked by insomnia, stomach pains, and mental exhaustion, Aldrich set off on
a rambling tour of Europe
, and though the couple had recently lost a child, his depression seemed driven by a deeper, more personal malady of the soul. He ventured from the South of France to Naples and Rome, where he gazed upon the Colosseum. Somewhere amid the paintings and palazzi, according to Jerome L. Sternstein, author of an unpublished narrative of Aldrich’s early life, he rediscovered purpose, “
a basis for his commitment
to worldly success.” As he wrote to Abby, “
If I am deeply impressed
with the insignificance and unimportance of man’s life, I also feel what a grand thing it is to live and how much a man may accomplish even in this short and transitory existence.” He returned, after a journey of five months, determined to placate the bruised sensibilities of his abandoned-feeling wife and—more than ever—to claim an august place in the affairs of men.

In the 1870s, Aldrich was elected to the city council in Providence; thanks to his close relations with local businesspeople, he also became a director of a small bank. Meanwhile, he advanced to the statehouse and then to the House of Representatives. Aldrich had no ken for dramatic speechifying. He did not give interviews, much less engage in Lincolnesque yarn spinning, and when a joke was told he
smiled rather than laughed out loud
. Unabashedly elitist, he had
an aversion to crowds; the common touch was never his. But what Aldrich lacked in charisma or warmth was offset by his capacity to coolly analyze the facts. Over six feet tall, with a flowing handlebar mustache, he dressed in well-tailored suits and black bow ties and was a man of presence and intelligence.
Rarely did he debate
in public; the cloakroom, the back corridor, was where his work was done. A reporter with the
New York Tribune
noted the “
side whiskers close cut
” and the “brilliant dark eyes which he fastens closely upon the person with whom he is conversing.” Another journalist described him, more succinctly, as “
a blindness to inessentials
masquerading as a human being!” Aldrich simply comprehended the issues, down to their intricate details, better than did his adversaries.

In 1881, the
Rhode Island legislative bosses
elevated Aldrich to the U.S. Senate. Now forty, he held a seat that was less subject to democratic challenges than it might have seemed. Rhode Island restricted the franchise to property owners and native-born citizens willing to pay a poll tax. Even when the franchise was broadened, the legislature was gerrymandered in favor of small Republican towns, shielding Aldrich from the swelling ranks of immigrants, who voted Democratic.