13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (6 page)

The Panic of 1907, which nearly brought the financial system crashing down, clearly demonstrated the risks the American economy was running with a highly concentrated industrial sector, a lightly regulated financial sector, and no central bank to backstop the financial system in a crisis. The major private banks might be able to reshape industries as they wished, but they could not be relied upon to stabilize the financial system in a crisis, especially with J. P. Morgan in his seventies. Something needed to be done. The stage was set for another political battle over the financial system.

On one side, Nelson Aldrich represented the viewpoint of the banking industry.
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“No one can carefully study the experience of the other great commercial nations,” he argued in an influential 1909 speech, “without being convinced that disastrous results of recurring financial crises have been successfully prevented by a proper organization of capital and by the adoption of wise methods of banking and of currency”—which, to him, meant a central bank that could act as a lender of last resort in a crisis.
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Aldrich was chair of the National Monetary Commission, founded in the aftermath of the Panic of 1907, which recommended the creation of a central banking system largely controlled by the private sector bankers themselves. The details of the planned system were hammered out at a secret meeting of top politicians and financiers at Jekyll Island off the coast of Georgia in November 1910. What these bankers wanted was a bailout mechanism that would protect the financial system in the event of a speculative crash like the Panic of 1907. They knew that a new central bank would need the political backing and financial support of the federal government, but at the same time they wanted to minimize government interference, oversight, or control.
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However, the Aldrich plan was politically controversial; it looked like a trick to get taxpayers to finance banks and protect them from the consequences of their risky activities. Opponents argued that the problem was a cabal of big banks that were secretly running the country. This fear was likely exaggerated, but there is no doubt that Wall Street banks played a critical role in creating the industrial trusts. In 1912, the House of Representatives, then controlled by the Democratic Party, commissioned an investigation of the “money trust” and its economic influence. (The investigation was proposed by Representative Charles Lindbergh Sr., who called the Aldrich plan a “wonderfully devised plan specifically fitted for Wall Street securing control of the world.”
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) The Pujo Committee concluded that control of credit was concentrated in the hands of a small group of Wall Street bankers, who had used their central place in the financial system to amass considerable economic power.
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The committee report provided ammunition to Louis Brandeis, a prominent lawyer and future Supreme Court justice. Beginning with a 1913 article entitled “Our Financial Oligarchy,”
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Brandeis spoke out strongly in favor of constraining banks. He accused the powerful investment banks of using customer deposits and other money that passed through their hands in order to take control of large companies and promote the interests of those companies. The “dominant element in our financial oligarchy is the investment banker,” he concluded.
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Brandeis served as an adviser to the new Democratic president, Woodrow Wilson, who eventually brokered the compromise that led to the Federal Reserve Act of 1913. The final bill reduced the autonomy of the central bank and gave the government a stronger hand in its operations, notably through a Federal Reserve Board appointed by the president. However, the Federal Reserve banks were (and remain) technically private entities, and private sector banks were given the power to appoint two-thirds of their directors.
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While the private bankers didn’t get everything they wanted in the new Federal Reserve, they did get the most important thing: an institution that could bail them out with public funds when financial crises occurred. Support by the Federal Reserve can take two broad forms: liquidity loans, where the Fed gives a bank a short-term loan that can be rolled over repeatedly; and lower interest rates, which help banks by promoting economic growth and increasing the chances that bank loans will be paid back.
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These steps can mitigate individual disasters. However, the existence of government insurance against a worst-case scenario creates “moral hazard”—the incentive for banks to take on more risk in order to maximize shareholder returns—thereby laying the groundwork for the next system-wide crisis. Each emergency rescue only increases banks’ confidence that they will be rescued in the future, creating a cycle of repeated booms, busts, and bailouts.
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In principle, in exchange for providing this insurance, the Federal Reserve would supervise the banks it was protecting, preventing them from taking too much risk. But as Brandeis spotted, echoing Jefferson, this overlooked the political dimension: “We believe that no methods of regulation ever have been or can be devised to remove the menace inherent in private monopoly and overweening commercial power.”
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Although Brandeis supported the Federal Reserve Act as a means of giving the government more control over the financial system, he would have preferred to break up large concentrations of industrial or financial power. As it turned out, the original Federal Reserve lacked the modern regulatory powers necessary to constrain the banks. In addition, the first president of the powerful Federal Reserve Bank of New York was none other than Benjamin Strong, J. P. Morgan’s lieutenant and the ultimate Wall Street insider. As a result, the initial “solution” to the problem revealed by the Panic of 1907 would prove to be anything but. Instead, light regulation and cheap money would encourage banks to take on enough speculative risk to threaten the entire economy.

Theodore Roosevelt was able to curtail the growth of industrial trusts and shift the mainstream consensus so that large concentrations of economic power came to be seen by most people as dangerous to society.
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But despite this success against the trusts, the movement to constrain the power of big banks failed, even with one of its leading advocates, Louis Brandeis, as an adviser to President Wilson. The compromise of 1913 prevented private banks from directly controlling the new central banking system. However, the Federal Reserve Act did little to constrain the banks themselves, leaving them free to engage in risky lending and generate huge economic booms that would be politically difficult to rein in. The problem that was glimpsed but not fully understood in 1907 was that when a crash finally arrived, the government would face the hard choice between letting the system collapse and bailing out the banks that had been responsible for the bubble. The original Federal Reserve, with its combination of strong private sector influence and weak regulatory authority, had the power to engineer a bailout, but not to curb the risky activities that could make one necessary.

FDR AND ANDREW JACKSON

It took only sixteen years for this flaw in the system to become catastrophically apparent. Rampant speculation in the 1920s led to the Crash of 1929, which was initially followed by a generous bailout for elite New York financial firms, and then by the repeated bungling of attempts to save the rest of the financial system. Not only did the Federal Reserve’s safety net encourage excessive risk-taking by bankers; the safety net, it turned out, had gaping holes that could not be fixed in the intense pressure of a crisis. The result was the Great Depression.

Speculation on its own is not necessarily a problem. Entrepreneurs’ willingness to speculate on new technologies or new ways of organizing production is a key source of growth and prosperity. However, speculation combined with large amounts of borrowed money can produce dangerous financial crises. Cheap debt makes more money available to bid on assets, driving up prices, creating vast amounts of paper wealth, and attracting new investors who borrow even more heavily so they can double their bets on a rising market. When the market turns, highly leveraged investors can be wiped out quickly, forcing them to liquidate anything that can be sold and causing asset prices to plummet. This sudden collapse in the value of almost everything can trigger widespread bank failures, corporate bankruptcies, and mass unemployment.

The 1920s were a period of significant deregulation, as Republican administrations dismantled the system of state control developed in order to fight the First World War.
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By the time the war ended and President Warren G. Harding came to power in 1921, there was a determined effort to restore laissez-faire capitalism.
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Harding’s philosophy was “The business of America is the business of everybody in America”; his successor, Calvin Coolidge, famously said, “The chief business of the American people is business.”
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But the two people who best embodied the hands-off philosophy of the decade were Andrew Mellon, treasury secretary from 1921 to 1932, and Herbert Hoover, secretary of commerce under both Harding and Coolidge and president from 1929 to 1933. Mellon’s message was clear: government should just get out of the way.
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Regulation of private business, as espoused by Brandeis and Wilson, slipped out of fashion.
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The antiregulatory policies of the 1920s helped make possible a period of rampant financial speculation, driven by investment banks and closely related firms that sold and traded securities in an unregulated free-for-all. Investor protection was minimal; small investors could be lured into complex financial vehicles they didn’t understand, and were offered large margin loans to leverage their positions.
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While the market rose, everyone benefited. But the result was a stock market bubble fueled by borrowing and psychological momentum.
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Low interest rates set by the Federal Reserve also fueled an economic boom for much of the decade and encouraged increased borrowing by companies and individuals.
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By 1929, financial assets were at all-time highs, sustained by high levels of leverage throughout the economy. The stock market crash of October 1929 not only destroyed billions of dollars of paper wealth and wiped out many small investors; it also triggered an unprecedented wave of de-leveraging as financial institutions, companies, and investors sold anything they could in an attempt to pay off their debts, sending prices spiraling downward.
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The Federal Reserve could have slowed down the boom and avoided the sharp crash of 1929 if it had been willing early enough to “take away the punch bowl” (in the words of later Fed chair William McChesney Martin)
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by raising interest rates to discourage borrowing and slow down economic growth. But this is never popular with politicians concerned about the next election, banks making large profits from the boom, or ordinary people benefiting from a strong economy. Instead, the Fed was reluctant to slow down the economy; it kept interest rates low for most of the 1920s and even lowered them in 1927, citing few signs of inflation and concerns about financial fragility outside the United States. The markets responded with a strong rally in the second half of 1927, and the Fed raised rates from 3.5 percent to 5 percent in 1928.
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But there they stopped. Higher rates, it was feared, would choke off farmers who needed capital; they would also end the bonanza of stock price gains that benefited the financial sector and investors.
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For similar reasons, the Fed also declined to use what regulatory powers it had to rein in debt-based investment strategies and deflate the bubble by using either moral suasion or informal arm-twisting to pressure banks to cut back on loans to finance stock purchases; this too might have ended the boom and slowed down the real economy.
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Under considerable pressure from the banking lobby, the Fed decided to stand aside.
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When the crash came, however, the Fed initially rushed to the rescue. Despite internal debate, the man on the spot—George Harrison, president of the New York Fed—provided liquidity to troubled institutions; “I am ready to provide all the reserve funds that may be needed,” he told bankers, urging them to lend to troubled brokers.
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By the fall of 1930, Harrison could be proud that despite a 40 percent fall in the stock market, not a single major bank had failed. The Aldrich bailout mechanism seemed to work. Instead of J. P. Morgan stepping in to stop the Panic of 1907, this time the Federal Reserve answered the call.
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And yet the United States, and the world, still experienced the Great Depression.

For the last seventy years there has been heated debate over whether the Fed could have prevented the financial crisis of 1929 from evolving into the Great Depression, or at least limited its impact through more assertive action. A leading view, advanced by Milton Friedman and Anna Schwartz and subscribed to (in amended form) by current Fed chair Ben Bernanke, is that a spreading bank panic in the early 1930s caused a severe contraction of the money supply and credit, producing the Great Depression. If the Fed had acted assertively to expand the supply of credit, it could have stabilized the banking system and limited the damage to the real economy;
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the Fed’s mental model at the time, however, focused on “free reserves,” rather than broader measures of money or credit that would have shown the need for more aggressive action. In addition, rescuing the financial system would have required printing money, which, it was feared, would have adverse consequences; generous bailouts of failing insolvent banks would have created incentive problems for the future. But instead, forced liquidation meant bankruptcy not just for companies and farmers, but also for banks.
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Widespread bank failures encouraged people to withdraw their money from sound banks; this further dried up the credit available to businesses, causing major collateral damage to the economy, and once the financial system began contracting the process became impossible to stop.
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As a result, unemployment rose above 20 percent and much of the American population suffered through a terrible decade of lost jobs, poor living standards, and severe dislocation.