by Neil Irwin
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Bakers make bread. Watchmakers make watches. What is it, precisely, that bankers make? The answer goes a long way to understanding how important British banking was to that nation’s great empire—and why crises, whether in 1866 or 2008, have always been a fact of modern finance.
The idea of giving one’s money to a bank doesn’t come naturally. When people save money, they generally like to be able to see it rather than have it exist as a paper record of a deposit at an institution in the center of town. For centuries, banks in Europe were more a logistical necessity for businesses that wanted to trade with each other over long distances than places for savers to keep their money. That had changed in Britain and a few other countries by the nineteenth century, thanks in part to the paper banknote that Johan Palmstruch invented in Sweden 150 years earlier.
As Bagehot wrote:
When a private person begins to possess a great heap of bank-notes, it will soon strike him that he is trusting the banker very much, and that in return he is getting nothing. He runs the risk of loss and robbery just as if he were hoarding coin. He would no more run the risk by the failure of the bank if he made a deposit there, and he would be free from the risk of keeping the cash. . . . So strong is the wish of most people to see their money that they for some time continue to hoard bank-notes. . . . But in the end common sense conquers.
As an increasingly affluent merchant class came to that commonsense conclusion, banks in Britain became something more than grease for the wheels of commerce. But that didn’t happen in the other major European powers, the potential rivals to the British in global supremacy. In 1873, total deposits at the banks of London amounted to £91 million, compared to £15 million in France and £8 million in Germany. Why? Banknotes—and the bank deposits that result from their existence—are possible “only in a country exempt from invasion, and free from revolution,” Bagehot explained. That’s because “in such great and close civil dangers a nation is always demoralized; everyone looks to himself, and everyone likes to possess himself of the precious metals. These are sure to be valuable, invasion or no invasion, revolution or no revolution.” The Netherlands and Germany were at the time in perpetual danger of invasion, and France, of course, was destabilized for decades after its 1789 revolution.
“This therefore is the reason why Lombard Street exists,” Bagehot wrote. “That is, why England is a very great Money Market, and other European countries but small ones in comparison. In England and Scotland a diffused system of note issues started banks all over the country; in those banks the savings of the country have been lodged, and by these they have been sent to London. No similar system arose elsewhere, and in consequence London is full of money, and all continental cities are empty as compared with it.”
What Overend & Gurney and its competitors did, in other words, was take the savings of millions of merchants and farmers from across Britain and gather them into great stockpiles of capital in London. This matters a great deal. Money saved under a mattress is useful only to its owner—and only on the day that he needs to spend it. But a dollar saved in a checking account is simultaneously available to the account holder at a moment’s notice—in the modern world, it can be withdrawn from any of millions of automated terminals in any city on earth—and available to fund enormous long-term investments by others. Economists call this “liquidity transformation.”
One individual can’t easily amass enough capital to build a rail line from New Delhi to Mumbai or a giant textile factory capable of producing hundreds of bolts of cloth each day. But if you put together the savings of thousands of people and have a smart banker choosing which projects are promising enough to deserve loans, suddenly you have the savings of the masses going to fund the large, complex, and risky endeavors that are essential to an industrial economy. “A million in the hands of a single banker is a great power; he can at once lend it where he will,” Bagehot wrote. “Concentration of money in banks, though not the sole cause, is the principal cause which has made the Money Market of England so exceedingly rich, so much beyond that of other countries.”
The place where all that wealth was concentrated was the Square Mile—1.1 square miles, to be precise—known as the City of London, a warren of winding medieval streets that is a mere speck in the great metropolis of London. In the mid-nineteenth century, the most important intersection in global finance was at what is now the Bank tube stop. Toward the northeast is Threadneedle Street, home of the Bank of England. Across the street from the bank is the Royal Exchange, which for centuries was where stocks and bonds were traded. (Now it’s a luxury shopping mall.) And off to the southeast goes Lombard Street, where the bill dealers did their work.
Bills of exchange were the lifeblood of nineteenth-century British finance, the method by which the savings of millions of Britons were channeled into productive use. A shipbuilder constructing oceangoing steamships would issue these paper bills, essentially IOUs, to buy the iron and lumber he needed. The seller of the iron could hold on to the bill and wait for payment, if he wanted, or he could take it to his banker, who could buy the bill at a “discount”—say, £970 for a £1,000 bill. That £30 gap represents interest earnings for the bank, compensation for getting the iron dealer his money there and then rather than in three or six months. (The closest present-day equivalent is commercial paper.) When money was tight—when there were more borrowers looking for cash than bankers ready to extend credit—the discount increased. And vice versa.
Typically, the market for these bills was, to use modern terminology, deep and liquid. Merchants could always get easy access to cash by selling their bills to bankers, who could in turn manage their own balance sheets by going to Lombard Street, where the bill brokers could find a ready buyer at a reasonable price. It was a machine that ran as smoothly as any great new invention of the Industrial Revolution.
Until, at least, Mr. William Bois, Secretary of Overend Gurney & Co., posted that note on the door of 65 Lombard Street.
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After the Overend collapse, savers all over Britain didn’t know which institutions they could trust. Would their bank be next? They had no idea, so they thought it safest to withdraw their money and wait out the storm. But this very act makes the failure of more banks that much more likely. No bank has the cash on hand to pay off withdrawals if everybody wants to pull their deposits out at the same time. The institution must try to sell off whatever it can to come up with the money—in Overend & Gurney’s case, bills of exchange. As more bills were dumped onto the market, their price fell, meaning that even sound banks ended up incurring a loss—which made their depositors all the more eager to withdraw their funds.
The details may vary, but this type of vicious cycle is at the core of any financial panic, whether in 1866 or 1929 or 2008. If not stopped, it can shutter businesses on a mass scale and wipe out the savings of a nation. In any case, it has a psychological effect. As Bagehot described it, “The peculiar essence of our banking system is an unprecedented trust between man and man. And when that trust is much weakened by hidden causes, a small accident may greatly hurt it, and a great accident for a moment may almost destroy it.”
On Threadneedle Street, the leaders of the Bank of England viewed it as their job to stop that cycle cold. Their goal in such situations wasn’t to act like private bankers, hoarding cash for themselves, but to prevent the banking system as a whole from shutting down. On the morning of Black Friday, May 11, 1866, the bankers of London lined up at the Bank of England’s Discount Office. “The bankers accustomed to pledge their securities with Overend and Gurney went wild with fright,” according to one contemporary account, “besieged the Bank of England and the Chancellor of the Exchequer, and communicated their apprehensions to the public . . . for four or five hours it was believed that half the banks in London would fail.” Bank governor Henry Lancelot Holland had to decide whether to fulfill the demands for liquidity—
which would mean exposing his institution to far greater risk than it had taken in the past.
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.
THREE
The First Name Club
The 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 s
olve an economic problem—they were trying to solve a political problem as old as their republic.
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The 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.