The Alchemists: Three Central Bankers and a World on Fire (4 page)

To understand fully how these three men came to wield such incredible power, one first must know where central banks came from to begin with. That story starts, of all places, in Sweden, a very long time ago.

RISE OF THE ALCHEMISTS, 1656–2006

Johan Palmstruch and the Birth of Central Banking

H
e was a broken and desperate man, at the end. Johan Palmstruch, a Latvian-born, Dutch-raised, Swedish-residing banker defended himself against a prosecution that likely seemed more like an inquisition. A nation wanted to know where its money had gone, and the best answer Palmstruch could muster was to describe the chaos of those final days of the world’s first central bank, when depositors and government investigators lined up outside the bank’s doors, “
snork, pork,
scolding and swearing
.” Who, he asked, “in the midst of such daily tumult, threatening, swearing, scolding and parleying, in danger of life and limb . . . could note and thereby keep a book?”

The investigation into Palmstruch’s Stockholms Banco had discovered not only that tens of thousands of daler were missing from its vault, but also that the near failure of the bank had cost the Swedish crown a vast sum. Palmstruch was ordered to repay what the bank had lost. When he couldn’t, he was to be executed. This was, after all, 1668, not 2008, and Palmstruch’s actions as a man with the power to print money at will had decimated Swedes’ personal savings, wrecked their national economy, and forced the government to intervene to prevent complete catastrophe.

Palmstruch’s sentence was commuted in 1669, and he was released from prison in 1670. When history’s first central banker died a year later, he was known not as a monetary wizard, but as a criminal who’d taken the economy of one of Europe’s great powers on a wild ride. During the course of half a decade, there had been a credit boom and an accompanying rise in the standard of living, then a surge of inflation, followed by a credit bust and a recession.

In other words, over just a few short years, Sweden had experienced both the best and the worst of central banking. But Johan Palmstruch and everyone else involved in Stockholms Banco had also done something more: They had begun the modern era of global finance, and all that is great and awful that would emerge from it. To properly understand how the Boys in Basel responded to the financial conflagration of 2007 to 2012, it helps to understand how they came to wield such power to begin with. And that is a story that begins with Johan Palmstruch.

•   •   •

T
he country may now be better known for minimalist furniture and pop music than for imperial designs, but for much of the seventeenth century Sweden was one of Europe’s great powers. It commanded an empire that stretched across Scandinavia and into what are now the Baltic nations and parts of present-day Germany, Poland, and Russia.

The nation attained its prominence on the global stage despite lacking some of the advantages of its rivals in continental Europe. With one million or so citizens, Sweden was only one sixth as populous as Britain and one twentieth the size of France. Its agricultural sector wasn’t terribly productive either—after all, the country is dark and cold eight months a year. Food was so scarce that peasants mixed tree bark into their bread dough to make it go farther. But the Swedish economy wasn’t without strengths: Without the productive farming of France or Britain, it relied heavily on fishing and iron and copper mining. But for a truly vibrant commercial sector to exist, of course, there needs to be a medium of exchange, a method of trade more flexible than mere barter: salt, perhaps, or seashells or metal coins. In 1534, with Sweden newly established as an autonomous state, it minted its first daler. The similarity in pronunciation to the present-day U.S. currency is no coincidence.

Well into the seventeenth century, however, the Swedes were having a hard time getting their daler into the hands of people who wanted them. They needed a system of institutions to store, distribute, and lend money. In Amsterdam, Hamburg, and London there had emerged companies that did just that, and in parts of Italy variations on the idea had been around for centuries. But the Swedish language had no word for it in the early 1600s.
So in 1619 the king and members of the merchant class got together
, borrowed the Italian term
banca,
and turned it into the Swedish word
bank.
They couldn’t agree on who would provide the start-up financing for these new institutions. King Gustavus Adolphus and his powerful chancellor, Axel Oxenstierna, wanted the towns of Sweden to fund the banks. The merchants in those towns wanted the king to take on the expense—and the risk. During the stalemate, three decades would go by in which Sweden lost ground in commerce because there wasn’t enough money circulating. The Swedes had a word for a banking system, but not the system itself.

An outsider would change that.

Hans Witmacker was born in 1611 in what is now the Latvian capital of Riga, the son of a successful Dutch merchant. As a young man, he went to work as an entrepreneur in Amsterdam, which had the world’s most highly developed banking system at the time. At the age of twenty-eight, Witmacker was jailed for failing to pay his debts. Once released, he made his way to Stockholm, then a bustling world capital of forty-five thousand people, to remake himself. He even took on a new name: Johan Palmstruch.

No portraits of Palmstruch or descriptions of his personal manner have survived. But it seems fair to assume that he was a smooth talker. He must have conveyed seriousness, probity, and wisdom and been able to make people trust him without a second of doubt. Those abilities were surely coupled with enough charm and charisma to endear him to the wealthy and powerful. If that wasn’t the case, none of what happened next makes any sense.

King Karl X Gustav was hoping to realize Gustavus Adolphus’s dream of establishing a bank that would finally modernize Swedish commerce. He trusted a forty-five-year-old foreigner who presumably talked a good game about his knowledge of the Dutch banking system. By royal decree, the king authorized the creation of Stockholms Banco on November 30, 1656, to be run by Johan Palmstruch. It is unclear whether he knew anything of Palmstruch’s checkered past.

Palmstruch certainly knew how to cover all his political bases. Half of the bank’s profits were to be given over to the king. And Palmstruch gave more than a dozen powerful Swedes, the chancellor of the realm and the president of the board of trade among them, a share of the bank’s profits without requiring them to put up any capital. One of those shareholders was later named by the king as “
chief inspector of the banking system
”—which, it is safe to say, isn’t currently considered a best practice in the field of bank regulation.

Palmstruch, not unlike the investment bankers who were inventing new mortgage securities in the 2000s, was a master of what is now called financial innovation. There were numerous problems attached to using copper as the nation’s official currency standard, as Sweden had done since 1624. For one thing, when copper is stored in bank vaults, it can’t be used for all the other practical uses that it’s good for. And as later governments that tied the value of their money to a precious metal have learned, having a copper-based currency created wild swings in the value of money due to factors beyond any one country’s control. When the German economy was devastated following the Thirty Years’ War, for example, it dramatically drove down the price of copper and thus caused a collapse in the value of Sweden’s currency.

Then there was a more practical problem, one specific to a country that had recently begun to issue coinage as not so pocket-sized metal plates: Copper is really heavy.
A ten-daler plate
, the most common unit of currency, measured about twelve by twenty-four inches and weighed more than forty-three pounds. It was enough to buy sixty-six pounds of butter or thirty-three days of work from an unskilled laborer. The copper plates still turn up now and again in the waters around Stockholm, because when one was dropped while being loaded or unloaded onto a ship, there was no retrieving it. Daler plates were, presumably, hell on bank tellers’ backs.

Palmstruch’s first innovation was to hold the giant plates in Stockholms Banco’s vault, while offering a paper note as a receipt. This idea was compelling to King Karl X Gustav. In the bank’s charter, he mentioned the “
good convenience
” Swedish subjects would receive in the form of relief from “hauling and dragging and other trouble that the copper coin entails in its handling.”

The success of this innovation led to a great inflow of deposits into the bank—400,000 copper daler
by 1660, just three years after its opening,
the equivalent of $76 million in today’s dollars
. And even sooner, the leaders of the bank came up with another financial innovation. As Palmstruch would later testify, Gustaf Bonde—the shareholder in the bank who was also its chief government inspector—“came to the exchange bank towards spring 1659 in the morning, stood there looking around, and exclaimed with these words: ‘I see here in the exchange bank good stores of money and it seems to me to be best now to make a beginning with the loan bank.’” That is: Hey, guys, we have all this money just sitting around. Why don’t we lend it out and actually make a return on it!

Stockholms Banco began lending money to companies to finance their inventories of tar, salt, and sugar. And to noblemen and -women and holders of high government office, it began guaranteeing the loans with all manner of collateral. Land was the most common, but less conventional lending occurred as well: One woman borrowed 2,700 daler
against a silver candelabrum. And some loans weren’t collateralized at all, but were given only on the personal guarantee of one noble or another.

The system worked great for a while. The country’s nobility enjoyed cheap access to credit and was able to live more comfortably than it might have otherwise. Merchants were able to borrow money to invest in the future. No longer reliant on their own savings to fund expansion, they could use somebody else’s savings for that purpose, with Stockholms Banco as the intermediary. Commerce flourished.

That is, until King Karl X Gustav died in 1660, and the council that replaced him to lead the country—the new ruler was a small child at the time—decided to devalue the daler
.
The new currency had less copper in it than the old currency did, so the old plates were worth more than their official value would suggest. It would be as if the value of paper suddenly skyrocketed so that a dollar bill contained $1.10 worth of paper. The people of Sweden had a logical response: They all showed up at Stockholms Banco en masse to withdraw their old daler
.

Palmstruch, of course, had lent out much of the money; it was no longer sitting in the vault waiting for depositors to show up. He dealt with this by trying to call in loans. This caused further problems: His clients, of course, had become accustomed to living in part off of borrowed money, and they either wouldn’t or couldn’t readily pay the bank back. Palmstruch wrote that people were showing up “every day in large numbers not only while the Bank is open but even extraordinarily at my home to assail me morning, afternoon, and evening, presenting their pledges and entreating me to be allowed to borrow money, which so moves me to Christian compassion and troubles my heart that also the burden of my office feels almost too great and unbearable.”

One can almost imagine a distressed Palmstruch standing at the doors of his bank on the winding, narrow streets of central Stockholm, buffeted by the cold Scandinavian wind, crying like George Bailey in
It’s a Wonderful Life:
“You’re thinking of this place all wrong, as if I had the money back in a safe. The money’s not here.
Why, your money’s in the Petersson estate! And in Mr. Nilsson’s inventory of pickled herring! And in Mrs. Kristensson’s silver candelabrum!”

Then, in 1661, Palmstruch found a solution that changed the course of finance forever.

He might not always have had enough copper in the vaults to meet the demands of his depositors, but he could always print paper. He would issue paper notes that the holder could redeem for daler at will. He got the idea from paper receipts that copper mines issued to their workers and traded in their communities like modern currency. China had used paper money centuries earlier, but this was the first time something so closely resembling modern money was used in Europe. Unlike earlier notes issued by European banks over the centuries, these weren’t tied to a specific account or deposit but could be freely traded from person to person. The government went along with the plan, agreeing that the banknotes could be used to pay tax bills. Modern money—backed not by some precious metal, but by the credibility of a single financial institution and its leader, Palmstruch—had arrived in Europe.

With that, one understanding of money—as a physical object, its value rising and falling depending on supply and demand for the metal it’s made of—was replaced by another. Money was instead an idea, something unrelated to the actual value of the material on which it is printed. Instead, its value is set by the institution—specifically, the central bank—that issues it. Like Palmstruch’s printed paper, modern currency holds its value ultimately because of public confidence in the authority that stands behind it. A government can say that one dollar or pound or krona is equal to a certain amount of gold or silver or copper—but it is always within the power of that government to change that ratio, or abandon the relationship entirely. (Western nations would use gold and other metallic standards for their money for centuries to come; not until 1971 would most major industrial nations’ currencies fully decouple from gold.)

In Sweden in the 1660s, paper money was wildly popular. Palmstruch literally couldn’t print it fast enough; it started to be traded in all the great financial centers, Amsterdam and London and Paris and Venice. No longer held back by the need to have backing for loans in the form of copper holdings, the bank increased its lending dramatically and opened new branches. The royal family alone borrowed 500,000 daler.

Before long, there was vastly more paper money floating around than there was copper daler in the vault. By 1663, the bank was down to a piddling 4,000 copper daler in its vault—and a depositor had notified it that he wished to withdraw 10,000.