The Alchemists: Three Central Bankers and a World on Fire

by Neil Irwin

  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 bo
om 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.

  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.

  • • •

  Enough 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.