The Alchemists: Three Central Bankers and a World on Fire

by Neil Irwin

  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.

  As word started to spread that the bank was paying back depositors slowly and irregularly, closing on some days, and generally behaving as if it had something to hide, the loss of public confidence fed on itself. Stockholms Banco notes were traded at a 6 to 10 percent discount to what they theoretically represented—which just made people all the more eager to withdraw their money. Suddenly those paper notes were worth less than they had been, each one buying less herring or tin or lumber than it had before—the phenomenon now called inflation. As Palmstruch single-handedly increased the supply of money, the price of most everything rose.

  The government was getti
ng rather concerned, and it ordered Palmstruch to call in loans so that the bank could pay depositors. This wasn’t a move taken lightly: The chancellor was strongly opposed, surely in no small part because he was the bank’s single largest borrower. After considerable debate, the parliament decided not to dissolve the bank, despite some evidence of “irregularities and inconveniences.” As it turns out, the decision to cut back on loans and vastly reduce the paper money in circulation had a negative rather than a positive effect: Businesses that had become accustomed to operating using borrowed funds couldn’t do so. Money, which had been all too readily available just two years earlier, became very hard to get, and a deep economic downturn followed. It was the first recession (or possibly depression—economic statistics hadn’t been invented yet) caused by a contraction of the money supply.

  By 1667, the Swedish government had taken over and then liquidated Stockholms Banco. Palmstruch was tried for fraud and lost his privilege of running a bank. But Sweden’s experiment with a central financial authority wasn’t over. For all the tumult Stockholms Banco had caused, the problems it was created to solve still remained. The Swedish parliament realized it needed to replace the bank with something—ideally, something that would be under tighter government control and more stable.

  The Swedish government was, for its era, uncommonly democratic. There were four estates represented in parliament—the nobility, the merchant class, the clergy, and the peasantry. It was the nobility and the merchants who were most eager to rebuild a central bank. After all, such an institution would benefit them most, allowing more availability of cash and the smoother flow of commerce. But after the Palmstruch debacle, they believed it needed the explicit financial and legal backing of the government. These bank supporters eventually persuaded the clergy, the intellectuals of the day, to their side. The peasants represented in the Riksdag were a tougher sell. They didn’t want to give the government’s financial backing to an entity that would primarily benefit the upper classes. More important, the peasantry also submitted to the government that it had “no understanding of the matter” and that “the other good gentlemen of the other Estates may do what seems best to them in the case and what for them could be beneficial, but allow the peasant to be free from such things as he does not comprehend.”

  So they did. The wealthy, the business interests, and the intellectuals combined to create the world’s first true central bank, without the participation of the working class. The Bank of the Estates of the Realm set up shop in a palace in central Stockholm in 1668. It would later become the Sveriges Riksbank, which remains the central bank of Sweden to this day.

  It wouldn’t be the last time that a central bank would be established with something less than enthusiastic endorsement from the working class.

  • • •

  While Sweden was at work setting up a modern financial institution, modern science was quickly overtaking the ancient study of alchemy. For centuries, across Europe and in the Islamic world, mankind had sought ways to turn mundane materials into far more precious gold and silver. In the medieval world, alchemists included everyone from garden-variety con artists to skilled technicians of metallurgy to some of the most brilliant scientists of the day. Sir Isaac Newton, it was once said, was not in fact the first modern scientist, but the last of the alchemists. (This was said, as it happens, by an economist of wide-ranging intellectual interests named John Maynard Keynes.) Alchemists were an insular group, speaking a language that outsiders couldn’t grasp and disdainful of the uninitiated. Those outside the club viewed it as a shadowy cabal.

  As it turns out, though, mankind didn’t need a magic potion to create gold from thin air. As Johan Palmstruch and the Swedes had discovered, all it took to create wealth where there had been none was some paper, a printing press, and a central bank, imbued with the power from the state, to put it to work.

  TWO

  Lombard Street, Rule Britannia, and Bagehot’s Dictum

  On Thursday, May 10, 1866, at 3:30 p.m., customers of banking giant Overend, Gurney & Co. came upon something very disconcerting indeed. Pinned to the door of the firm’s headquarters on London’s Lombard Street, where the financiers of that great imperial capital did their work, was a note. “Sir,” it said. “We regret to announce that a severe run on our deposits and resources has compelled us to suspend payment, the course being considered under advice the best calculated to protect the interest of all parties. . . . I remain your faithful servant, William Bois, Secretary.”

  The firm was among the great powers of not only British, but also global finance—which in the 1860s were more or less the same thing. It was formed when the Gurneys, a Quaker family from Norwich that ran the leading bank in the rural areas of East Anglia, sought to expand its reach into the fast-paced, big-money world of dealing bills—corporate debt, essentially—in the City of London. It wasn’t dissimilar to the successful regional American banks, like Bank of America and Wachovia, that in the 2000s dove into the sea of Wall Street.

  Samuel Gurney and his partner, John Overend, may have never heard of a subprime mortgage or a collateralized debt obligation, but that didn’t stop the company they created in 1809 from finding some exotic and unwise ways to lend money. There was the plantation in Dominica, a tiny island in the West Indies, for example, and the railroad line that connected the two bustling Irish metropolises of Portadown and Omagh. Repeatedly, there was the habit of chasing a loan gone bad with even more money on the distant hope that things would turn around. There was greed. There was avarice. There were simple analytical failures. And maybe there was even a bit of fraud.

  The result: In the spring of 1866, Overend & Gurney was in big trouble. Depositors came in in droves to withdraw their funds as rumors of losses spread. A railroad contractor, they’d heard, had defaulted on a £1.5 million loan. A group of merchants that traded with Spain and relied on Overend & Gurney for capital had collapsed. The bank’s partners were selling their country estates to free up cash. Wrote one correspondent in London, “One unlucky man, I am told, presented a cheque at Overend Gurney’s for sixty thousand pounds, and was told to call again in half an hour; on his return the shutters were up.”

  The day after the note went up on the door of 65 Lombard Street, all hell broke loose. If the great Overend & Gurney could go under, after all, then seemingly any other bank could do the same. Who could trust that money kept in some ledger in some grand building would be there come morning? On what became known as Black Friday, crowds gathered to see the letter on the door of Overend, then turned on the other banks. “The doors of the most respectable banking houses were besieged, more perhaps by a mob actuated by the strange sympathy which makes and keeps a mob together than by creditors of the Banks,” wrote the Times, “and throngs heaving and tumbling about Lombard Street made that narrow thoroughfare impassable.” Added Banker’s Magazine, “It is impossible to describe the terror and anxiety that took possession of men’s minds for the remainder of that and the whole of the succeeding day.” With the help of a recent invention, the electric telegraph, word of the panic rapidly made its way to even the rural corners of England, which experienced runs of their own.

  Sweden had long since faded from global preeminence, but the innovation of Johan Palmstruch had been copied in Britain, with the creation of the Bank of England in 1694, aiding the nation’s rise to great power status. But now its entire financial system was on the verge of collapse. What would the Bank of England do about it? The answers the central bankers of that era came up with would serve as a model of sorts for Ben Bernanke, Mervyn King, and Jean-Claude Trichet a century and a half later. The work of the men on Threadneedle Street after the Overend & Gurney collapse show how the Bank of England was a surprisingly important piece of Britain’s Victorian-era dominion over the globe.

  By the late 1860s, the United Kingdom, with a population of around thirty million, just over 2 percent of the humans on earth, ruled an empire t
hat stretched from New Delhi to Toronto, Hong Kong to Johannesburg. There are many reasons for its economic might. Among them: the coal fields of the North that provided the raw fuel for industrialization, a culture that encouraged entrepreneurship and innovation, and a political system that was able to adapt to democracy without the revolutions and bouts of Napoleonic aggression that characterized certain neighbors across the Channel.

  But even all that wouldn’t have been enough to maintain an empire on which the sun never set without the great financial power concentrated on Lombard Street.

  The most authoritative chronicler of this era in finance is an Englishman named Walter Bagehot. He was born in 1826 to a banking family in the South West town of Langport and died young, in 1877. With a lively intellect and cutting literary style, he wrote essays on Milton and Shakespeare before becoming the editor of the Economist, which was owned by his uncle, in 1860. His efforts to run for Parliament failed miserably, but he was nonetheless such an important commentator on and explicator of the politics and economics of Victorian Britain that he was known as the “Spare Chancellor”—that’s to say, nearly as influential in matters of money as the finance minister.

  Bagehot wasn’t one of history’s great practicing economists, like John Maynard Keynes or Milton Friedman. He wasn’t one of the great philosophers of political economy, like Adam Smith or Karl Marx. Indeed, most historians know him best for his work more or less inventing the concept of the English constitution as an accumulation of ideas rather than a written document. Yet among central bankers he has achieved iconic status for his 1873 book Lombard Street: A Description of the Money Market, an analysis of the demise of Overend & Gurney and the Bank of England’s response. To this day it remains something of a bible for central bankers dealing with a financial panic. At the 2009 Federal Reserve Bank of Kansas City conference in Jackson Hole, where contemporary central bankers gather every August, Bagehot’s name was mentioned forty-eight times. Keynes and Friedman and Smith and Marx combined for zero.