The Alchemists: Three Central Bankers and a World on Fire (7 page)

It is true that the United States, in that fearful fall of 1907, didn’t have a central bank. That doesn’t mean it didn’t have a central banker. John Pierpont Morgan was at the time the unquestioned king of Wall Street, the man the other bankers turned to to decide what ought to be done when trouble arose. He was not the wealthiest of the turn-of-the-century business titans, but the bank that bore his name was among the nation’s largest and most important, and his power extended farther than the (vast) number of dollars under his command.

Morgan had bailed out the U.S. Treasury in 1895 during an earlier wave of panic by organizing other Wall Street titans to back federal debt. It was inevitable that when the 1907 crisis rolled around, Morgan held court at his bank’s offices at 23 Wall Street while a series of bankers came to make their requests for help.

Morgan asked the treasury secretary to come to New York—note who summoned whom—and ordered a capable young banker named Benjamin Strong to analyze the books of the next big financial institution under attack, the Trust Company of America, to determine whether it was truly broke or merely had a short-term problem of cash flow—the old question of insolvent versus illiquid. Merely illiquid was Morgan’s conclusion. The bankers bailed it out.

It wouldn’t last—with depositors unsure which banks, trusts, and brokerages were truly solvent, withdrawals continued apace all over New York and around the country. At nine o’clock on the night of Saturday, November 2, 1907, Morgan gathered forty or fifty bankers in his library—executives of the biggest banks huddled in its east wing, those from the troubled trust companies in the west. Morgan and his closest advisers assembled in a private chamber. “
A more incongruous meeting place
for anxious bankers could hardly be imagined,” wrote banker Thomas W. Lamont. “In one room—lofty, magnificent—tapestries hanging on the walls, rare Bibles and illuminated manuscripts of the Middle Ages filling the cases; in another, that collection of the Early Renaissance masters—Castagno, Ghirlandaio, Perugino, to mention only a few—the huge open fire, the door just ajar to the holy of holies where the original manuscripts were safeguarded.”

The bankers awaited, as Lamont put it, the “the momentous decisions of the modern Medici.” In the end, Morgan engineered an arrangement in which the trusts would guarantee the deposits of their weaker members—something they finally agreed to at 4:45 a.m. Medici comparisons aside, what is remarkable is how similar Morgan’s role was to that of Timothy Geithner, the New York Fed president, a century later. Both knocked heads to encourage the stronger banks and brokerages to buy up the weaker ones, bailing out some and allowing others to fail, working through the night so action could be taken before financial markets opened.

With a big difference, of course: Geithner was working for an institution that, however less than democratic its governance, was created by the U.S. Congress and acted on the authority of the government. His major decisions were approved by the Fed’s board of governors, its members appointed by the president and confirmed by the Senate. His capacity to address the 2007–2008 crisis was backed by an ability to create dollars from thin air.

Morgan, by contrast, was simply a powerful man with a reasonably public-spirited approach and an impressive ability to persuade other bankers to do as he wished. The economic future of one of the world’s emerging powers was determined simply by his wealth and temperament.

•   •   •

E
nough was enough. The Panic of 1907 sparked one of the worst recessions in U.S. history, as well as similar crises across much of the world. Members of Congress finally saw that having a central bank wasn’t such a bad idea after all. “
It is evident
,” said Senator Aldrich, he of the silk top hat and the trip to Jekyll Island, “that while our country has natural advantages greater than those of any other, its normal growth and development have been greatly retarded by this periodical destruction of credit and confidence.”

The legislation Congress enacted immediately after the panic, the Aldrich-Vreeland Act, dealt with some of the financial system’s most pressing needs, but it put off the day of reckoning with the bigger question of what sort of central bank might make sense in a country with a long history of rejecting central banks. It instead created the National Monetary Commission, a group of members of Congress who traveled to the great capitals of Europe to see how their banking systems worked. But the commission was tied in knots.

Agricultural interests were fearful that any new central bank would simply be a tool of Wall Street. They insisted that something be done to make agricultural credit available more consistently, without seasonal swings. The big banks, meanwhile, wanted a lender of last resort to stop crises—but they wanted to be in charge of it themselves, rather than allow politicians to be in charge.

The task for the First Name Club gathered in Jekyll Island in that fall of 1910 was to come up with some sort of approach to balance these concerns while still importing the best features of the European central banks.

The solution they dreamed up in those long sessions on Morgan’s sea-island retreat was to create, instead of a single central bank, a network of them around the country. Those multiple central banks would accept any “real bills”—essentially promises businesses had received from their customers for payment—as collateral in exchange for cash. A bank facing a shortage of dollars during harvest season could go to its regional central bank and offer a loan to a farmer as collateral in exchange for cash. A national board of directors would set the interest rate on those loans, thus exercising some control over how loose or tight credit would be in the nation as a whole. The men at Jekyll drafted legislation to create this National Reserve Association, which Aldrich, the most influential senator of his day on financial matters, introduced in Congress three months later.

It landed with a thud. Even though the First Name Club managed to keep its involvement secret for years to come, in a country experiencing a populist resurgence—in no small part due to the anger at the trusts generated by the Panic of 1907 and the subsequent recession—the idea of a set of powerful new institutions controlled by the banks was a nonstarter, particularly after Democrats took control of Congress following the 1912 elections. Yet the central problems that Aldrich and the First Name Club were trying to solve were still very much there.

Aldrich’s initial proposal failed, but he had set the terms of the debate. There would be some form of centralized power, but also branches around the country. And what soon became clear was that the basic plan he’d laid out—power simultaneously centralized and distributed across the country and shared among bankers, elected officials, and business and agricultural interests—was the only viable political solution. The debate over a central bank came down to how to balance power among regional banks and a central authority and among those different constituencies.

Carter Glass
, a Virginia newspaper publisher and future treasury secretary, took the lead on crafting a bill in the House, one that emphasized the power and primacy of the branches away from Washington and New York. He wanted up to twenty reserve banks around the country, each making decisions autonomously, with no centralized board. The country was just too big, with too many diverse economic conditions, to warrant putting a group of appointees in Washington in charge of the whole thing, Glass argued. President Woodrow Wilson, by contrast, wanted clearer political control and more centralization—he figured the institution would have democratic legitimacy only if political appointees in Washington were put in charge. The Senate, meanwhile, dabbled with approaches that would put the Federal Reserve even more directly under the thumb of political authorities, with the regional banks run by political appointees as well.

But for all the apparent disagreement in 1913, there were some basic things that most lawmakers seemed to be in harmony about: There needed to be a central bank to backstop the banking system. It would consist of decentralized regional banks. And its governance would be shared—among politicians, bankers, and agricultural and commercial interests. The task was to hammer out the details.

Who would govern the reserve banks? A board of directors comprising local bankers, businesspeople chosen by those bankers, and a third group chosen to represent the public. The Board of Governors in Washington would include both the treasury secretary and Federal Reserve governors appointed by the president and confirmed by the Senate.

How many reserve banks would there be, and where? Eight to twelve, the compromise legislation said, not the twenty that Glass had envisioned. An elaborate committee process was designed to determine where those should be located. Some sites were obvious—New York, Chicago. But in the end, many of the decisions came down to politics. Glass was from Virginia, and not so mysteriously, its capital of Richmond—neither one of the country’s largest cities nor one of its biggest banking centers—was chosen.

The vote over the Federal Reserve Act in a Senate committee came down to a single tiebreaking vote, that of James A. Reed, a senator from Missouri. Also not so mysteriously, Missouri became the only state with two Federal Reserve banks, in St. Louis and Kansas City. The locations of Federal Reserve districts have been frozen in place ever since, rather than evolving with the U.S. population—by 2000, the San Francisco district contained 20 percent of the U.S. population, compared with 3 percent for the Minneapolis district.

And in a concession to those leery of creating a central bank, the Federal Reserve System, like the First and Second Banks of the United States, was set to dissolve at a fixed date in the future: 1928. One can easily imagine what might have happened had its charter come up for renewal just a couple of years later, after the Depression had set in.

•   •   •

T
he debate over the Federal Reserve Act was ugly. In September 1913, Minnesota representative George Ross Smith carried onto the floor of the House a seven-by-four-foot wooden tombstone—a prop meant to “mourn” the deaths of industry, labor, agriculture, and commerce that would result from having political appointees in charge of the new national bank. “
The great political power which President Jackson saw
in the First and Second National banks of his day was the power of mere pygmies when compared to the gigantic power imposed upon [this] Federal Reserve board and which by the proposed bill is made the prize of each national election,” he argued.

It wasn’t just the fiery populists who opposed the bank. Aldrich, the favored senator of the Wall Street elite, complained that the Wilson administration’s insistence on political control of the institution made the bill “
radical and revolutionary . . .
and at variance with all the accepted canons of economic law.”

For all the noise, the juggling of interests was effective enough—and the memory of 1907 powerful enough—for Congress to pass the bill in December 1913. Wilson signed it two days before Christmas, giving the United States, at long last, its central bank. “
If, as most experts agree
, the new measure will prevent future ‘money panics’ in this country, the new law will prove to be the best Christmas gift in a century,” wrote the
Baltimore Sun
.

The government, of course, hadn’t solved the problem of panics—though it had gained a better tool with which to deal with them. And opposition to a central bank, rooted as deeply as it was in the American psyche, didn’t go away. Instead, it evolved. Whenever the economic tide turned—during the Great Depression, during the deep recession of the early 1980s, during the downturn that followed the Panic of 2008—the frustration of the people was channeled toward the institution they’d granted an uncomfortable degree of power to try to prevent such things from happening.

But after more than a century of trying, the United States had its central bank. New York was poised to compete on a more level playing field with London as a capital of world finance. And as the years passed, the series of compromises that the First Name Club dreamed up a century earlier in Jekyll Island, and the unwieldy and complex organization it created, would turn out to have some surprising advantages—even in a country that had previously been better at creating central banks than keeping them.

Madness, Nightmare, Desperation, Chaos: When Central Banking Goes Wrong, in Two Acts

R
udolf von Havenstein was a civil servant of the highest order: a kind and generous man of unquestioned integrity who had trained as a lawyer, served as a judge, and made a distinguished career for himself in the Prussian Finance Ministry.

He was also very likely the worst central banker in history.

Created in 1876, the German Reichsbank was crucial to the newly unified nation’s emergence as a global industrial and financial power. By the time Havenstein became its president, in 1908, the bank was well along the way to establishing a modern financial system, phasing out gold, silver, and copper coins in favor of paper banknotes. Over the last few years of the nineteenth century and the first few of the twentieth, careful monetary policy and near-miraculous economic expansion made the German economy and its financial industry an emerging rival to Britain’s. Germany became a leading exporter of iron, steel, and chemicals. But soon enough there were ominous rumblings of armed conflict on the continent as this new economic and industrial power bumped up against the existing powers of Britain and France. Havenstein viewed it as crucial that the Reichsbank be well positioned to enable the government to finance such a war.

On June 18, 1914, ten days before two bullets fired in Sarajevo killed Archduke Franz Ferdinand and his wife and ignited a global conflagration, Havenstein summoned the leading commercial bankers of Germany. It’s ambiguous whether what he told them was a request, an order, or a threat: They would need to double the liquidity in the banking system over the next three years, he said, ensuring that marks were circulating in the economy instead of sitting around in banks. Ostensibly, this was to try to guide Germany through a bit of an economic rough patch. The true goal was to ensure that the nation would have the financial wherewithal to wage war.

Havenstein viewed the war as a clash of economies as much as a clash of armies. He wrote that England’s “
jealousy and ill-will toward our economic flowering
, our growing world trade and growing power at sea is in the final analysis the basic cause of the world war.” He had no apparent reluctance to putting the Reichsbank to work financing the conflict, which in the early days was expected to be a fleeting affair. His primary objective was to keep German commerce going despite the disruption. “
The precondition for this continuation
of economic activity was the most extensive use of the old source of credit, the Reichsbank,” Havenstein said in September 1914.

Ordinary Germans were encouraged to give up their stores of gold coins and jewelry in exchange for paper money issued by the Reichsbank, which gave the government greater ability to finance the war effort through the central bank. Historian Gerald D. Feldman wrote that the encouragement of paper money “
took on a patriotic and fetishistic quality
of previously unimaginable proportions.” Havenstein spoke warmly of individuals—the wife of a wealthy industrialist, his own brother-in-law—who moved their savings into paper money and persuaded others to do the same. A Reichsbank propaganda poster shouted, “Gold for the Fatherland! I gave gold for our defense and received iron as honorable recompense. Increase our gold stock! Bring your gold jewelry to the gold-purchasing bureaus.”

That this mass issuance of paper money was steadily driving down the value of the mark was held back from public discussion by censorship, even as it was obvious to anyone going to the market to buy groceries. Havenstein and other Reichsbank leaders attributed the general rise in prices to hoarding. Inflation was high—but not yet catastrophically high. At the start of the war, the exchange rate was 4.2 marks to the U.S. dollar. On Armistice Day in November 1918, the rate was 7.4, which suggests an annual depreciation against the dollar of about 13 percent. That isn’t much higher than the inflation rate the United States experienced in the early 1980s.

But a precedent had been set, and three conditions were in place that set the stage for everything that was to come: Germany was now a nation in which money was a piece of paper, not a gold coin; that piece of paper was understood to buy less with every year that passed; and Rudolf von Havenstein had made it his mission to use his ability to print money to fund the needs of his government, whatever they might be.

The German government’s strategy of funding itself with Herr Havenstein’s printing presses—taking on extraordinary debt in the meantime—was premised on winning the war. Transitioning to a peacetime economy would have been a challenge even if that had happened. (Managing Britain’s debt-laden economy in the 1920s was certainly no picnic.) But at peace talks in France, the victorious Allies were determined to exact vengeance—a nicer word would be “compensation”—for the war.
The resulting Treaty of Versailles
wasn’t so much the product of a negotiation as a list of demands made by the Allies: that Germany would give up colonies in Africa, as well as land comprising an eighth of its area, a tenth of its population, and 38 percent of its capacity for steel production.

Most devastating of all, this now smaller, poorer country was to pay vast reparations—a total of 132 billion gold marks, equivalent to more than three years of national income. The three billion gold marks it was to owe each year represented 26 percent of the value of its exports. That debt was lowered in subsequent years, but until finally closing out the debts in 2010, Germany still owed money to foreign investors who had purchased reparations-related bonds.

Economist John Maynard Keynes, who had left Cambridge to aid the war effort at the British Treasury, was disgusted by what he saw at the Versailles conference. So hungry were the Allies for vengeance, so lacking in magnanimity, that they’d put an impossible set of burdens on the defeated Germany. He was so distressed at the potential legacy of the treaty that he became physically ill. He resigned from the Treasury before the agreement was signed and quickly wrote
The Economic Consequences of the Peace,
which presented the reparation demands put upon Germany as a great risk to the world, and the prewar peace a rarer and more delicate phenomenon than most people realized.

“Very few of us realize with conviction the intensely unusual, unstable, complicated, unreliable, temporary nature of the economic organization by which Western Europe has lived for the last half century,” Keynes suggested at the beginning of
Consequences
. “If the European civil war is to end with France and Italy abusing their momentary victorious power to destroy Germany and Austria-Hungry now prostrate, they invite their own destruction also, being so deeply and inextricably intertwined with their victims by hidden psychic and economic bonds.”

On June 28, 1919, the Treaty of Versailles was signed by two relatively obscure German officials—one “
thin and pink-eyelidded
,” the other “moon-faced and suffering,” and both “deathly pale,” according to a British eyewitness. They had good reason to be: Their nation’s economy was wrecked, and its political environment was a fragile coalition of centrists facing ongoing threats from left-wing Bolsheviks and right-wing nationalists alike. Germany had incurred so much debt during the war that coming up with the cash for even the first reparations payment would be tremendously difficult.

Printing money was the only option. The war debts were denominated in gold, not paper currency. But so long as the currency held
some
value, it was a quick way to raise funds that could then be converted into gold to pay off the Allies. Havenstein, however, was soon to discover the brutal math of using the printing press to fund a government. As new marks circulated out into the economy, there was more money chasing the same number of goods, so prices rose a little. Each mark was now worth less. To adjust for inflation, the Reichsbank had to print even more marks to fund the same amount of government spending, which created an even steeper rate of inflation.

Year-to-year price increases weren’t just high; they were exponential. At the end of 1920, a dollar would have bought you 73 marks. At the end of 1921, 192 marks. At the end of 1922, 7,589. In November 1923, that same dollar would have bought you 4.2 trillion marks.

The catalog of strange anecdotes
from the time is extensive. There are the restaurant meals that cost more when the bill came than when they were ordered, the thieves who stole baskets full of money—keeping the baskets and leaving the money behind. The simple act of spending money became burdensome; photographs from the time show people hauling giant suitcases of cash for routine purchases.
Communities developed ersatz barter systems
. A shoe factory, for example, might pay its workers in bonds for shoes, which they could use to buy food at the bakery or butcher shop. Physical goods—shoes, bread, meat—would, after all, hold their value in a way that paper money wouldn’t. In an effort to offer a stable savings vehicle, the city of Oldenburg offered “rye bills,” bonds whose value matched that of 125 kilograms of rye bread.

For longer-term savings
, people turned to other physical goods, even when they had no need for them. A 1923 report from Augsburg shows individual Germans buying six bicycles, seven or eight sewing machines, two motorcycles, all as means of savings. Pianos were also popular, Bavarian authorities reported, even among those who didn’t play. Workers rushed to spend their paychecks the moment they received them. Bankers became accustomed to doing business in trillion-mark notes; one clerk wrote that inscribing all those zeros “
made work much slower
and I lost any feeling of relationship to the money I was handling so much of. It had no reality at all, it was just paper.”

German hyperinflation wiped out the savings of an entire generation of what had been an increasingly prosperous merchant class. A waiter interviewed by Ernest Hemingway said that a year earlier he had saved up enough money to buy a tavern; by that time, in 1923, “
that money wouldn’t buy four bottles of champagne
.” A British social worker in 1922 wrote that “
in well-furnished houses
there are chairs devoid of leather which has been used for shoes, curtains without linings which have been turned into garments for the children. This sort of thing is not the exception but the rule.” Strict rent-control laws meant that rents couldn’t keep up with soaring prices, so by the third quarter of 1923 the typical German household paid only 0.2 percent of its income for housing; landlords were essentially bankrupted.
But whatever workers saved on rent
, they spent on food as farmers hoarded harvests and drove prices up further still—92 percent of their income, up from 30 percent before the war.

“
You could see mail carriers
in the streets with sacks on their backs or pushing baby carriages before them, loaded with paper money that would be devalued the next day,” said Erna von Pustau, a German woman who was interviewed by Pearl S. Buck. “Life was madness, nightmare, desperation, chaos.”

So what on earth was Rudolf von Havenstein thinking? He understood what the fragile German government would face if he cut off its cash: massively higher costs to borrow money, which would force it to slash spending, likely bringing on an economic depression. That, in turn, might bring political revolution. But even if he did have some grand strategy—albeit an unsuccessful one—this accomplished, honorable man stubbornly persisted in viewing the inflation problem as everyone’s fault but his own. It was the fault of the government for running huge budget deficits, he argued—which was true enough, but the inflation only resulted when the Reichsbank printed money to fund those deficits. It was also the fault of currency speculators, who sold marks in hopes of profiting from their decline. And there were plenty of those—but it was the Reichsbank’s policies that proved their bets correct.

A speech Havenstein gave on August 17, 1923, at the zenith of the hyperinflation, shows the extent of his myopia. “
The Reichsbank,” he said, “today issues
20,000 milliard [billion] marks of new money daily. In the next week the bank will have increased this to 46,000 milliards daily. . . . The total issue at present amounts to 63,000 milliards. In a few days we shall therefore be able to issue in one day two-thirds of the total circulation.”

In a single day, Havenstein would increase the money supply by two thirds—and this, he seemed convinced, was a good thing. He took an almost perverse pride in the Reichsbank’s ability to conquer the technical problem of producing and distributing such vast sums. “
The running of the Reichsbank’s note-printing organization
, which has become absolutely enormous, is making the most extreme demands on our personnel,” he said in that August speech. “Numerous shipments leave Berlin every day for the provinces. The deliveries to several banks can be made . . . only by aeroplanes.”

The streets of Berlin, Munich, and Düsseldorf were thick with discontent, their populations having weathered a decade of misery and ruin and looking for answers wherever they might find them. Communists and fascists competed with each other as beneficiaries of this mass anger. “
People just didn’t understand what was happening
,” wrote the publisher Leopold Ullstein. “All the economic theory they had been taught didn’t provide for the phenomenon. There was a feeling of utter dependence on anonymous powers—almost as a primitive people believed in magic—that somebody must be in the know, and that this small group of ‘somebodies’ must be a conspiracy.”

On November 8, 1923, a group of nationalists stormed a beer hall in Munich where high Bavarian officials were gathered. A charismatic young veteran named Adolf Hitler took the stage. “A new national government will be named this very day in Munich!” he said to roars from the crowd. “A new German National Army will be formed immediately. . . . The task of the provisional German National Government is to organize the march on that sinful Babel, Berlin, and save the German people! Tomorrow will find either a National Government in Germany or us dead!” Neither of those things happened after the Beer Hall Putsch. But forces had been unleashed that would shape Europe, and the world, for generations to come.