VoxEU Column Economic history

Lessons from the financial preparations in the lead-up to the first world war

The 1907 panic affected the world, demonstrating the fragility of the international financial system. This column discusses the steps the US and Germany took in fortifying their financial systems following 1907. There is a link between the financial crisis and the escalation of diplomatic relations that led to war in 1914. And this link has implications for today as the world is recovering from the 2008 crisis.

The 1907 panic emanated from the US but affected the rest of the world and demonstrated the fragility of the whole international financial order. The aftermath of the 1907 crash drove the then hegemonic power – Great Britain – to reflect on how it could use its financial power. There is a close link between the aftermath of a great financial crisis and the escalation of diplomatic tensions that led to war in 1914.

Between 1905 and 1908, as Nicholas Lambert demonstrates in an important recent book (Lambert 2014), the British Admiralty evolved the broad outlines of a plan for financial and economic warfare that would wreck the financial system of its major European rival, Germany, and destroy its fighting capacity.

Britain used its extensive networks to gather information about its opponents. London banks discounted (financed) most of the world’s trade. Lloyds provided insurance for the shipping not just of Britain, but of the world. The financial networks provided the information that allowed the British government to find the sensitive strategic vulnerabilities of the opposing alliance. What pre-1914 Britain did anticipated the private-public partnership that today links technology giants such as Google, Apple, or Verizon to US intelligence gathering (James 2014).

US financial preparations

For Britain’s commercial rivals, the fast growing industrial powers of that age – the US and Germany – the financial panic of 1907 showed the necessity of mobilising financial power themselves. The US realised that it needed a central bank analogous to the Bank of England. American financiers thought that New York needed to develop its own commercial trading system that could handle bills of exchange in the same way as the London market (Broz 1997, Eichengreen and Flandreau 2010).

The central figure on the technical side in pushing for the development of an American acceptance market was Paul Warburg, the immigrant younger brother of a great Hamburg banker Max Warburg who was the personal adviser of the German autocrat Kaiser Wilhelm II. Paul Warburg was a key player in the bankers’ discussions on Jekyll Island, and then in drawing up the institutional design of the Federal Reserve System. The two banking brothers Warburg were in fact on both sides of the Atlantic energetically pushing for German-American institutions that would offer an alternative to the British industrial and financial monopoly. They were convinced that Germany and the US were growing stronger year by year while British power would erode.

Paul Warburg’s first major contribution had appeared well before the panic of October 1907 demonstrated the terrible vulnerability of New York as a financial centre, and was a response to the market weakness of late 1906: “The US is in fact 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 Hamurabi. […] Our immense National resources have enabled us to live and prosper in spite of our present system, but so long as it is not reformed it will prevent us from ever becoming the financial centre of the world. As it is, our wealth makes us an important but dangerous factor in the world’s financial community.”(Warburg 1907). The Cassandra warning about the danger posed by the American financial system would make Warburg look like a true prophet after a renewed period of tension after October 1907.

  • The problem of the American system in his eyes was that it relied on single signature promissory notes and when confidence evaporated in a crisis, the value of these became questionable and banks would refuse to deal with them.

Warburg proposed to emulate the trade finance mechanism of the London City, where the merchant banks (acceptance houses) established a third signature or endorsement on the bill, a guarantee that they would stand behind the payment; the addition of this guarantee provided a basis on which a particular bank favoured by a banking privilege conferred by law, the Bank of England, would rediscount the bill, i.e. pay out cash.

  • The second element of the Warburg plan was fundamentally a state bank, an innovation that recalled the early experimentation of Alexander Hamilton, but also the controversies about the charter renewals of the First and the Second Bank of the US.

The model for the initial reform proposal was not just the Bank of England system, but that of Imperial Germany, where the Central Bank – Reichsbank – existed as a deliberately created analogue to the Bank of England, but with a specific right to issue notes beyond those backed by gold on payment of a charge to the government. The language of Warburg’s public appeals made analogies to armies and defence: “Under present conditions in the US … instead of sending an army, we send each soldier to fight alone”. His proposed reform would “create a new and most powerful medium of international exchange – a new defence against gold shipments.”(Warburg 1907). The experience of US financial crises in 1893 and in 1907, where there was a dependence on gold shipments from Europe, indicated a profound fragility. Building up a domestic pool of credit that could be used as the basis for issuing money was a way of obviating the dependence. The reform project involved the search for a safe asset, not dependent on the vagaries and political interferences of the international gold market.

In the tense debates, Warburg consistently presented the issue in terms of a need to increase American security in the face of substantial vulnerability. As Warburg presented it, the term chosen in the original Aldrich Plan, as well as the eventual name of the new central bank that was launched in 1914, brought a clear analogy with military or naval reserves: “The word ‘reserve’ has been embodied in all these varying names, and this is significant because the adoption of the principle of co-operative reserves is the characteristic feature of each of these plans. There are all kinds of reserves. There are military and naval reserves. We speak of reserves in dealing with water supply, with food, raw materials, rolling stock, electric power, and what not. In each case its meaning depends upon the requirements of the organization maintaining the reserve.” (Warburg 1916). He also consistently reverted in the later discussions of US bank reform to the original theme that he had first sounded in the early months of 1907: “The stronger the Federal Reserve Banks become, the stronger will be the country and the greater its chances to fulfil with safety and efficiency the functions of a world banker. The basis of this development must be confidence.” (Warburg 1915)

German financial preparations

In Germany in 1907 Paul Warburg’s older brother Max was pushing a similar lesson to that drawn by Paul, but in a rather different way. He became consistently engaged in efforts to strengthen German-American cooperation, as a sort of balance against the threats posed by British power. In September 1907, when the American crisis was brewing, but had not morphed into a full-fledged panic, Max Warburg galvanised the German Bankers’ Association conference in Hamburg with a speech on “Financial Preparedness for War.”

Max Warburg formulated the policy task as ensuring that war finance did not disturb the gold standard or the norms of the peacetime economy, and that preparations for war did not cramp German development or change the nature of its business structure. Germany would be strong enough to stand the panic sales that would come about in the case of conflict only if it could develop a really deep financial market. Hence, for different reasons but with the same logic as Paul, he recommended not only the acquisition of a substantial privately held portfolio of foreign securities, but also the development of a German acceptance market that would permit operations in government securities.

In the years after 1907, the only partially complete German financial preparations seemed slowly to be proving themselves. In the 1911 panic that followed the Moroccan crisis, the attempted financial attack was quickly thwarted. Max Warburg later proudly noted that the Paris market had been more shaken by the crisis of confidence than Berlin or Hamburg, and that his house had been able to assist a Russian bank that suffered liquidity problems in Paris (Warburg n.d.).

Lessons for today

Some of the dynamics of the pre-1914 financial world are now re-emerging. Then an economically declining power, Britain, wanted to use finance as a weapon against its larger and faster growing competitors, Germany and the US. Now, America is in turn obsessed by being overtaken by China – according to some calculations, the world’s largest economy in 2014. In the aftermath of the 2008 financial crisis, financial institutions appear both as dangerous weapons of mass destruction, and potential instruments for the application of national power.

In managing the 2008 crisis, the dependence of foreign banks on US dollar funding constituted a major weakness, and required the provision of large swap lines by the Federal Reserve. The US provided that support to some countries, but not others, on the basis of an explicitly political logic, as Eswar Prasad (2014) demonstrates in his new study.

Geo-politics is intruding into banking practice elsewhere. Before the Ukraine crisis, Russian banks were trying to acquire assets in Central and Eastern Europe. European and US banks are playing a much reduced role in Asian trade finance. Chinese banks are being pushed to expand their role in global commerce. After the financial crisis, China started to build up the renminbi as a major international currency. Russia and China have just proposed to create a new credit rating agency to avoid what they regard as the political bias of the existing (American-based) agencies.

The next stage in this logic is to think about how financial power can be directed to national advantage in the case of a diplomatic tussle. Sanctions are a routine (and not terribly successful) part of the pressure applied to rogue states like Iran and North Korea. But financial pressure can be much more powerfully applied to countries, like Russia, that are deeply embedded in the world economy.

The threat of systemic disruption generates a new sort of uncertainty, which mirrors the decisive feature of the crisis of the summer of 1914. At that time, no one could really know whether clashes would escalate or not. That feature contrasts remarkably with almost the entirety of the Cold War, especially since the 1960s, when the strategic doctrine of MAD (Mutually Assured Destruction) left no doubt that any superpower conflict would inevitably escalate.

The idea of network disruption that was as central to the pre-1914 discussions as it is to modern strategy, relies on the ability to achieve advantage by surprise, and to win at no or low cost. But it is inevitably a gamble, and raises prospect that others might, but also might not be able to, mount the same sort of operation. Just as in 1914, there is an enhanced temptation to roll the dice, even though the game may be fatal.

Editors’ note: This is the fourth in a series of Vox columns by leading economic historians on the First World War, which will be collected in a Vox eBook at the end of the year: "The Economics of the First World War", edited by Nicholas Crafts, Kevin O'Rourke and Alan Taylor.


Broz, J L (1997), The international origins of the Federal Reserve System, Ithaca, New York: Cornell University Press.

Eichengreen, B and M Flandreau (2010), “The Federal Reserve, the Bank of England and the rise of the dollar as an international currency, 1914-39,” BIS Working Paper 328.

James, H (2014), “Cosmos, Chaos: Finance, Power and Conflict,” International Affairs, 90, 1, 37-57.

Lambert, N (2012), Planning Armageddon: British economic warfare and the First World War, Cambridge, MA: Harvard University Press.

Prasad, E S (2014), The Dollar Trap: How the US Dollar Tightened its Grip on Global Finance, Princeton: Princeton University Press, 2014.

Warburg, M (n.d.), “Memoirs”, Stiftung Warburg Archive, Hamburg.

Warburg, P (1907), “Defects and Needs of Our Banking System,” The New York Times, January 6.

Warburg, P (1915), Address Of Hon. Paul M. Warburg of the Federal Reserve Board before the Twin City Bankers' Club of St. Paul and Minneapolis at the Minnesota Club, St. Paul, Oct. 22, 1915 

Warburg, P (1916), The reserve problem and the future of the Federal Reserve System, Address of Hon. Paul M. Warburg before the Convention of the American Bankers Association, Kansas City, MO.

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