9. Creating the Acceptance Market

Nowadays there are two methods by which the Federal Reserve can add to bank reserves and therefore to the inflating process of pyramiding new money on top of reserves as a base. One is open-market operations; the other is changing the rediscount rate at which the Fed, as the lender of last resort, lends reserves to banks in trouble. But a third method was highly important in the 1920s: the intense subsidization—indeed, the very creation—of a market in acceptances.

Discount policy was inflationary during the 1920s. In the first place, rates were set below the market instead of a penalty rate above it, thus inducing banks to borrow reserves from the Fed. Second, the Fed decided to lend continuously rather than only in emergencies. As the Federal Reserve Board wrote in its annual report of 1923:

The Federal Reserve banks are ... the source to which the member banks turn when the demands of the business community have outrun their own unaided resources. The Federal Reserve supplies the needed additions to credit in times of business expansion and takes up the slack in times of business recession.[68]

Presidents Harding and Coolidge repeatedly pledged to lower interest rates and to keep them low during the 1920s, and each did his best to fulfill that pledge. In 1922–23, 1925, and 1928, periods when the Federal Reserve was belatedly trying to stop its inflationary policies, the discounting process, spurred by artificially low rediscount rates, came to the banks’ rescue.[69] During the onrushing stock market boom in 1927, President Coolidge and Secretary Mellon stepped in whenever the boom showed signs of flagging and egged it on, predicting lower interest rates and urging higher prices. In one of these statements, Mellon assured the market that “there is an abundant supply of easy money which should take care of any contingencies that might arise.”[70] Furthermore, both Harding and Coolidge appointed Federal Reserve members who would implement the low discount rate, low interest rate policy.[71]

The most unusual aspect of the Federal Reserve-generated inflation of the 1920s was its creation and subsidization of the acceptance market in the United States. Commercial paper in the United States had always been confined to single-name promissory notes, often discounted at commercial banks. By contrast, in Europe and particularly in Britain, foreign trade (not domestic) was habitually financed by the mechanism of an endorsement of the debt, or acceptance. The acceptance bank endorsed and purchased the note and then sold it to a “dealer,” or bill broker, who in turn sold it to a commercial bank for discount.

From the inception of the system, the Federal Reserve set out to bring a thriving acceptance market into being by massive subsidization. Since there had been virtually no naturally arising acceptance market in the United States, the demand for acceptances by discount banks was extremely slight. The Federal Reserve, therefore, undertook to buy all acceptances offered to it, either by the member banks or by a tiny group of designated dealers, and to buy them at a very low, subsidized rate. Generally, this rate was lower than the discount rate for similar commercial paper. In this way, the Federal Reserve provided reserves in a way unusually favorable to the banks. First, not only was the rate cheap, but acceptances were, like discounts and unlike open-market operations, always there to be provided by a passive Federal Reserve. And second, the acceptances never had to be repaid to the Fed and therefore, unlike discounts and like open-market purchases, they constituted a permanent addition to the reserves of the banks.[72]

The dominance of the Federal Reserve in making a market for acceptances can be seen in the proportion of acceptances held by the Fed. On June 30, 1927, over 46% of bankers’ acceptances were held by the Federal Reserve, over 26% for its own account and another 20% for foreign central banks.[73]

The subsidizing of acceptances was, from the early years, highly concentrated in New York City. In the first place, the New York Fed seized control of the acceptance policy in 1922 and kept it for the remainder of the decade. Second, the bulk of acceptances were on foreign transactions, and all of those acceptances were purchased by the Fed from only nine very large acceptance dealers located in New York City. Third, the number of acceptance banks was also quite small: 118 in the entire country in 1932, of which 40 were located in New York City. And three-quarters of all acceptances were executed by banks in New York City. The acceptance banks were generally large commercial banks but also included the huge International Acceptance Bank of New York, the world’s largest acceptance bank, which in the 1930s merged with the Kuhn, Loeb-dominated Bank of Manhattan Company.[74]

Fed policy on acceptances played an inflationary role at crucial periods during the 1920s. In late 1922, this policy supplemented the role of discounts by far more than offsetting the open-market sale of securities by the Fed. In the 1924 credit expansion, almost twice as many acceptances as government securities were purchased in the open market. And in the fateful 1927 inflationary surge, acceptances (“bills bought”) were equally as powerful in adding to reserves as the Fed’s purchase of securities. Furthermore, during the latter half of 1928, when the Fed stopped buying securities in an attempt to get the runaway boom under control, massive purchases of acceptances kept the boom going.

Benjamin Strong was, of course, the man who instituted and maintained the Federal Reserve creation and subsidizing of the acceptance market. Indeed, Strong often took the lead in urging cheaper and cheaper rates to intensify the subsidy. For Strong, this policy was vital for the promotion of foreign trade and for facilitating international central bank collaboration and management of the world financial system.[75]

But by far the most enthusiastic and tireless advocate of ever greater Federal Reserve aid to the acceptance market was Strong’s close friend Paul Moritz Warburg. From the very beginning of Warburg’s promotion of a central bank in 1907, that bank’s subsidization of acceptance paper was crucial to his plan. He scoffed at the prevalence of single-name promissory notes in the United States, a practice, he opined, that left the backward United States “at about the same point that had been reached by Europe at the time of the Medicis, and by Asia, in all likelihood, at the time of Hammurabi.” Warburg envisioned a money supply issued by a central bank based on acceptance paper purchased by that bank.[76]

We have seen that Paul Warburg was one of the most influential founders and shapers of the Federal Reserve System. He was on the board from 1914 to 1918, when he resigned because of his German ancestry, but he continued to be highly influential through the 1920s as chairman of the Fed’s Federal Advisory Council. In January 1923, Warburg boasted before the American Acceptance Council, a trade association of acceptance banks and dealers organized four years before, that he had been largely responsible for the Fed’s acceptance-buying policy as well as for the repeated statutory widening of eligibility for those purchases. In 1922, Warburg demanded still lower buying rates on acceptances, and in the spring of 1929, when he began to worry about the developing boom, he still called for the Fed to create a wider acceptance market.[77]

It is certainly plausible to hold that Warburg’s unremitting zeal for massive Federal subsidy of the acceptance market, as well as its cartelization in the hands of a few New York acceptance bankers and dealers, was connected to his status as a leading acceptance banker. For Paul Warburg was chairman of the board of the world’s largest acceptance bank, the International Acceptance Bank of New York, from its inception in 1920. He also became a director of the important Westinghouse Acceptance Bank and of several other acceptance houses and was the chief founder and chairman of the executive committee of the American Acceptance Council. His vaunting speech to that council in early 1923 was his presidential address.[78]