The Alchemists: Three Central Bankers and a World on Fire (6 page)

His decision was, in effect, to extend credit as far as the eye could see, and damn the naysayers—and there were naysayers, including on the Court of the Bank of England, the equivalent of its board of directors. The strategy was, at its core, simple: If a banker or broker or trader had a bill or other security that would be valuable in a time the markets were functioning normally, it could be pledged at the Bank of England for short-term cash—but with a “haircut,” or a discount on what it was thought to be truly worth. “Every gentleman who came here with adequate security was liberally dealt with,” Holland said later.

It was essentially using the ability of the Bank of England to issue pounds as a barrier against the further spread of the crisis. Holland had to receive special permission from the chancellor of the exchequer, William Gladstone, to surpass legal caps on the Bank of England’s lending. The first day, it extended £4 million in credit. Over the ensuing three months, £45 million was extended, “
by every possible means . . .
and in modes which we had never adopted.” Recall that this was a time when all the bank deposits in Britain totaled around £90 million. Relative to the size of the British economy at the time, it would have been the equivalent of the Federal Reserve extending about $3.5 trillion in the aftermath of the 2008 Lehman Brothers crisis.

The panic gradually subsided, preventing the economic ruin of an empire. Months later, Holland described the Bank of England’s actions this way: “
Banking is a very peculiar business
, and it depends so much upon credit that the very least blast of suspicion is sufficient to sweep away, as it were, the harvest of a whole year. . . . This house exerted itself to the utmost—and exerted itself most successfully—to meet the crisis. We did not flinch from our post.”

From these events, Bagehot drew a series of lessons now known as Bagehot’s dictum. In a panic, he wrote, a central bank must take its resources and “advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to ‘this man and that man,’ whenever the security is good.”

The shorthand version, familiar to all present-day central bankers, is this: Lend freely, on good collateral, and, as Bagehot also specified, charge a penalty interest rate, “
that no one may borrow
out of idle precaution without paying well for it.” It’s a simple guideline, but a powerful one. The central bank should open its doors, and its vaults, using its vast stores of the one thing in demand—cash—to stop that vicious cycle. And it should lend only on good collateral, which is to say, against securities whose values have been depressed only by the atmosphere of panic, not by fundamentals. However, the bank should charge a high enough interest rate on these loans that borrowers don’t take unjustified advantage of them.

But there are a couple of other lessons from the collapse of Overend & Gurney that don’t fit neatly into Bagehot’s dictum. First, even if a central bank moves aggressively to stop a financial panic, it still may not be enough to prevent a nasty economic downturn. Because the Bank of England’s lending during the panic was directed only at firms that were illiquid—and thus was little good for those that were insolvent—plenty of banks failed besides Overend: the Bank of London, Consolidated Bank, the British Bank of California. And whenever banks fail and credit tightens,
businesses of all types are forced to pull back on their activity
. The London, Chatham and Dover Railway was building major rail lines in Canada and the Crimea financed by bills of exchange when Overend & Gurney went under. The projects collapsed following the tightening of credit. The funding for a rail line under the Thames evaporated as well.

With no lending available, ironworkers and coal miners and shipbuilders and others who depended on business expansion to make a living found themselves out of work on a mass scale.
Economic statistics for this era
are unreliable, but estimates by a trade union put the UK unemployment rate at 2.6 percent in 1866, and at 6.3 percent in 1867 after the credit freeze.

A second lesson of the Overend & Gurney crisis is that when a central bank intervenes on massive scale to stop a panic, it does so at its political peril. In the aftermath, the ire of a nation was directed at the Bank of England. An institution with public backing had, after all, done a great favor to wealthy bankers whose bets had gone sour. And the economy—the conditions faced by the masses of workers and merchants—were terrible anyway. The
Times
editorialized that the bank had saved firms that were unworthy, that it had “
mulcted for the unthrifty
,” and, invoking the biblical parable of the ten virgins, that “the foolish virgins made so much clamour they compelled the wise virgins to share their carefully collected oil.”

Some of the hand-wringing came from Threadneedle Street itself: Many of the Bank of England’s directors were aghast at what Governor Holland had done in the crisis. Thomson Hankey, a director on the Court of the Bank of England, wrote that the idea of the central bank acting as a lender of last resort was “
the most mischievous doctrine ever broached
in the monetary or banking world in this country; viz, that it is the proper function of the Bank of England to keep money at all times to supply the demands of bankers who have rendered their own assets unavailable.” Although the bank had secured the blessing of the chancellor of the exchequer, its actions during the crisis were undertaken without formal legal authority.
Legislation to empower the bank
to play such a role in the future went nowhere in Parliament.

A century and a half later, Ben Bernanke & Co. would discover once again that lending freely to “this man and that man” may be the best course of action in a financial panic—but that not all men will approve.

The First Name Club

T
he mustachioed man in the silk top hat strode to his private railcar parked at a New Jersey train station, a mahogany-paneled affair with velvet drapes and well-polished brass accents. Five more men—and a legion of porters and servants—soon joined him. They referred to each other by their first names only, an uncommon informality in 1910, intended to give the staff no hints as to who the men actually were, lest rumors make their way to the newspapers and then to the trading floors of New York and London.
One of the men
, a German immigrant named Paul Warburg, carried a borrowed shotgun in order to look like a duck hunter, despite having never drawn a bead on a waterfowl in his life.

Two days later, the car deposited the men at the small Georgia port town of Brunswick, where they boarded a boat for the final leg of their journey. Jekyll Island, their destination, was a private resort owned by the powerful banker J. P. Morgan and some of his friends, a refuge on the Atlantic where they could get away from the cold New York winter. Their host—the man in the silk top hat—was Nelson Aldrich, one of the most powerful senators of the day, a lawmaker who lorded over financial matters in the burgeoning nation.

For nine days, working all day and into the night, the six men debated how to reform the banking and monetary systems of the United States, trying to find a way to make this nation just finding its footing on the global stage less subject to the kinds of financial collapses that had seemingly been conquered in Western Europe. Secrecy was paramount. “Discovery,” wrote one attendee later, “simply must not happen, or else all our time and effort would have been wasted. If it were to be exposed publicly that our particular group had got together and written a banking bill, that bill would have no chance whatever of passage by Congress.”

For decades afterward, the most powerful men in American finance referred to each other as part of the First Name Club. Paul, Harry, Frank, and the others were part of a small group that, in those nine days, invented the Federal Reserve System. Their task was more than administrative. After all, some of the same motivations that had driven the American Revolution—distrust of central authority, of big money, of out-of-touch elites—had ensured that the United States wouldn’t have a successful central bank for the first 130 years of its history.

The men at Jekyll Island weren’t just trying to solve an economic problem—they were trying to solve a political problem as old as their republic.

•   •   •

T
he U.S. financial system needed remaking. The United States had a long but less than illustrious history with central banking. When the republic was formed, the states were burdened with debts they had racked up to finance the revolution; fighting off British control hadn’t come cheap. Alexander Hamilton, the first treasury secretary, believed a national bank would stabilize the government’s shaky credit and support a stronger economy—and was an absolute necessity to exercise the new republic’s constitutional powers. The century-old Bank of England had shown the usefulness of a central authority to guide national finances. It could issue debt on behalf of the government and thus ensure that the nation could always fund itself. It could issue paper money so a single currency could be used wherever the national flag flew. And it could guide the use of the nation’s savings, making sure they funded investment instead of sitting around as gold in a vault, waiting for a rainy day.

But Hamilton’s proposal faced opposition, particularly in the agricultural South, where lawmakers believed a central bank would primarily benefit the mercantile North, with its large commercial centers of Boston, New York, and Philadelphia. “
What was it drove our forefathers to this country
?” asked James “Left Eye” Jackson, a fiery little congressman from Georgia with a proclivity for getting into duels. “Was it not the ecclesiastical corporations and perpetual monopolies of England and Scotland? Shall we suffer the same evils to exist in this country? . . . What is the general welfare? Is it the welfare of Philadelphia, New York and Boston?” Some founding fathers, including Thomas Jefferson and James Madison, believed that the bank was unconstitutional.

Hamilton won the battle after persuading President George Washington that although the Constitution didn’t explicitly permit the creation of a national bank by the federal government, it also didn’t explicitly prohibit it. Washington signed Hamilton’s bank bill into law in February 1791. By the end of the year, the Bank of the United States was open for business in Philadelphia. By 1805, it had an additional seven branches along the East Coast and in New Orleans. But by the time the bank’s charter expired six years later, Hamilton had died in a duel of his own, Madison was in the White House, and private banking interests had begun to view the national bank as competition. The Bank of the United States closed down.

In 1812, though, that came to seem like a mistake. The United States found itself at war with Britain—Madison’s time in the White House would even be interrupted by the British burning it down. If there is one thing central banks have proved themselves very good at over their three and a half centuries of history, it is financing wars. And without a central bank to issue government debt, the United States faced financial challenges that would have been unimaginable for its Bank of England–backed opponent. Madison, who had a few years earlier judged a central bank to be unconstitutional, reluctantly supported starting up the Bank of the United States all over again.

The Second Bank of the United States was founded in 1816 and run most prominently by
Nicholas Biddle
, a brilliant young man of a literary bent who had finished first in his class at Princeton at age fifteen and helped negotiate the Louisiana Purchase. He did a lot of things that a modern central banker would applaud. He worked to eliminate the tendency for the dollar to have different values in different parts of the country, with western-issued banknotes generally being viewed as less valuable than eastern ones. He figured out that
he could either tighten or loosen credit conditions
—thus either fighting inflation or boosting economic growth—by buying and selling banknotes to influence the availability of credit across the nation. And at first, Biddle tried to keep himself away from partisan politics. Referring to Jonathan Swift’s assertion that “Money is neither Whig nor Tory,” he told a correspondent that “
the Bank is neither a Jackson man
nor an Adams man, it is only a Bank.”

But once the continued existence of the national bank came into question, Biddle became not just political, but positively Machiavellian.

When rural southerner Andrew Jackson was elected president in 1828, it was on the strength of a vigorously populist campaign. Jackson was anti-urban, anti-intellectual, anti–big business—and very much anti–Bank of the United States. “
Both the constitutionality and the expediency
of the law creating this bank are well questioned by a large portion of our fellow citizens, and it must be admitted by all that it has failed in the great end of establishing a uniform and sound currency,” Jackson said in his first message to Congress. He would, he said, veto any extension of the bank’s charter, which was set to expire in 1836.

With the help of powerful pro-bank senator Henry Clay, Biddle in 1832 pushed for an early renewal of the charter. The advice was more than a little self-serving: Clay hoped to be elected president himself, and he knew the bank issue was divisive enough to build a campaign around. The debate in Congress was furious. The existence of a national bank, Missouri senator Thomas Hart Benton argued, would lay the groundwork for “
the titles and estates of our future nobility
—Duke of Cincinnati! Earl of Lexington! Marquis of Nashville! Count of St. Louis! Prince of New Orleans! . . . When the renewed charter is brought in for us to vote upon, I shall consider myself as voting upon a bill for the establishment of lords and commons in this America, and for the eventual establishment of a king!”

“Czar Nicholas,” as Biddle became known among his opponents, resorted to dirty tricks to try to save the bank. He put politicians on the bank’s payroll. He offered newspaper editors the then vast sum of $1,000 to publish his own articles in favor of the institution—and to keep their authorship secret. He even contracted credit in the West, where antibank fervor was strongest, a thuggish use of the power of the national bank to punish his enemies.

The rechartering of the Second Bank of the United States squeaked through Congress, but Jackson made good on his promise to veto it. With the bank’s end in sight, Biddle took to an aggressive campaign of tightening credit, causing a deep economic downturn. His thinking was that this would show the country what it would be like not to have a central bank. But the tactic backfired: Biddle and the bank took the blame for the recession, making Jackson’s decision seem like a wise one.

From the end of the Second Bank in 1836 until 1863, during the so-called Free Banking Era, there was no effective national currency in the United States. Money was issued and backed by individual private banks chartered by their respective states. A $10 note might have been worth $10 if issued by a financially healthy local bank, but only $7 if the bank that issued it was viewed as less healthy or was farther away from where the money was spent. That meant paper money couldn’t serve as a reliable store of value. And there was no lender of last resort, which meant that banking panics like the ones Walter Bagehot wrote about in Britain could be devastating for the national economy. There were severe panics—and accompanying recessions—in 1837, 1839, and 1857, as well as many smaller ones.

Even more problematic, when the Civil War broke out in 1861, the federal government lacked a central bank to finance it. Privately owned U.S. banks bought government bonds only reluctantly, and foreign financiers refused to buy the debt of a country whose very existence was in question. The dilemma prompted an overhaul midway through the war. With the National Banking Act of 1863, the federal government began chartering banks—institutions that were the predecessors of modern-day behemoths like Citibank and J.P. Morgan Chase—and put them under tighter regulation than their state-licensed counterparts.

But some problems remained unsolved. For example, the supply of dollars was tied to banks’ holdings of government bonds. That would have been fine if the need for dollars was consistent over time. But one overarching lesson of financial history is that that’s not the case. In times of panic, for example, everybody wants cash at the same time. The U.S. banking system wasn’t elastic, meaning there was no way for its supply of money to adjust with demand. That meant a panic could rapidly ripple across the country, with every bank seeing more demand for cash than it could fulfill, resulting in a wave of bank failures and an economic depression. It happened in 1873, when Philadelphia investment bank Jay Cooke & Co. failed after losing money on railroad securities.
The downturn was so severe
that until the 1930s, the 1870s were the decade known as the “Great Depression.”

It didn’t take much to trigger a panic in those days of inelastic currency. Just the routine passing of the agricultural seasons caused problems. Every fall, farmers across the nation needed money to pay workers to harvest their crops and bring them to market; the money could be repaid a few months later, once the farmers had sold their goods. Until then, though, there was more demand for dollars than banks could easily match—after all, new gold and Treasury bonds didn’t suddenly appear just because the grain harvest was ready. To deal with this problem, banks created private clearinghouses to transfer funds among themselves, so that money made its way from big-city banks to more-rural places each fall.

In typical years, the seasonal shortage of dollars wasn’t catastrophic. But if it coincided with other economic problems, it could be disastrous. Thus, besides the 1873 crisis, there were lesser panics in 1884, 1890, and 1893.

Then came the Panic of 1907, the one that finally convinced American lawmakers to deal with their country’s backward financial system. It started with a devastating earthquake in San Francisco in 1906. Suddenly, insurers the world over needed access to dollars at the same time. They dumped bonds and other assets to come up with the cash they needed to pay claims.

In what was then still an agricultural economy, it was also a bumper year for crops, and an economic boom was under way—so companies nationwide wanted more cash than usual to invest in new ventures.
In San Francisco itself, deposits were unavailable
for weeks following the quake: Cash was locked in vaults so hot from fires caused by broken gas lines that it would have burst into flames had they been opened.

All of that meant the demand for dollars was uncommonly high, at a time when the supply of dollars couldn’t increase much. This manifested itself in the form of rising interest rates and withdrawals. In the pattern that should look familiar—Johan Palmstruch experienced it in the 1660s—withdrawals begat more withdrawals, and before long, banks around the country were on the brink of failure.

Then, in October 1907, the copper miner turned banker F. Augustus Heinze and his stockbroker brother Otto tried to corner the market of his own United Copper company by buying up its shares. Money gushed out of the banks and brokerages with which Otto did business. But the corner failed, and the price of United Copper stock tumbled. Investors rushed to pull their deposits out of any bank even remotely related to the disgraced F. Augustus.

First a Heinze-owned bank in Butte, Montana, failed. Next came the huge Knickerbocker Trust Co. in New York, whose president was a Heinze business associate. Depositors lined up by the hundreds in its ornate Fifth Avenue headquarters, holding satchels with which to remove their cash.
Bank officials standing
in the middle of the room and yelling about the bank’s alleged solvency did nothing to dissuade them. The failure of the trust led every bank in the country to hoard its cash for itself, unwilling to lend it even to other banks for fear that the borrower could be the next Knickerbocker.