Bagehot
Page 17
Bagehot welcomed these newfangled floating balances. They had financed the magnificent growth of British international trade, he pointed out, which would not have been possible without the inducement of interest payments to innumerable British capitalists large and small. It was no mystery why the growth in deposits had surged at such flourishing new institutions as the London and Westminster, the London Joint Stock Bank, and the Union Bank of London. Seeing an unfilled need in the money market, the pioneers had profitably filled it.1
Bagehot was likewise an adherent of limited liability in banking, though there was only one bank in the realm whose stockholders did not live with the threat of a ruinous contingent liability: the Bank of England. In the days before deposit insurance and the notion that some banks were too big to fail, the responsibility for a bank’s insolvency fell squarely on the owners of the collapsed institution, and this was the rule for small private partnerships as well as the newer and larger joint-stock organizations.
Traditionalists had long contended that this was where the onus of insolvency properly belonged. Personal accountability correctly focused the owners’ attention on the management of their own institution—certainly, that was the intent of the law. Bagehot, who dearly loved a paradox, denied that the intent secured the reality:
The system of unlimited liability is that which fosters the most speculative management. It is that system which makes bankers out of men who have nothing to lose—who do not object to subject all their property to liability, because they have no property—who are as reckless in the use of money as in the mode of obtaining it—who have never known the caution which the very possession of property teaches—who, like the directors of the Royal British Bank [which had failed in 1856], squander idly what they have acquired improperly.2
There was some truth to his argument, though the proprietors of many a profitable bank—Bagehot need have looked no further than his own—slept soundly in their confidence that professional managers were conducting the business as if it were their own.
In any case, the House of Commons saw the matter as the Economist did. Passage of the Companies Act of 1867 lifted the sword of Damocles of unlimited liability from any bank that wished to avail itself of the new form of organization, and it proved a powerful stimulant to new financial enterprise. To invest when one’s entire net worth was at risk was, for many a thoughtful person, unacceptable. Limited liability defined the downside; it might be steep, but one could know it. “Thousands of men, who under the old system, would rather have invested their money at 3 percent at home than risk it abroad for 50, are now ready to place it abroad for 15, rather than keep it at home for 5.”3
George Joachim Goschen, later Viscount Goschen, wrote those words early in 1865 while reflecting on the persistence of high interest rates in the United Kingdom. In 1864, they had averaged 7 percent. Though far from the highest rate on record, it was likely the highest average rate on record for a single year, and borrowers chafed at the cost. What, if anything, should the Bank of England do to reduce it? Goschen answered, nothing.
The eldest son and second of ten children born to a successful London banker, Goschen had assimilated the doctrines of pure laissez-faire from Bonamy Price, an assistant master at Rugby school when Goschen attended in 1845 who would later find an intellectual helpmeet in James Wilson. At Oriel College, Oxford, Goschen excelled at the classics and presided over the Oxford Student Union. Next came an apprenticeship at the family bank, Fruhling and Goschen, including a two-year posting to what is today Colombia. “Become a great merchant,” his father counseled him; “a little one is but a poor beast.” Upon his return to England from South America, Goschen joined the Court of Directors of the Bank of England in 1858, at the age of twenty-seven.* In 1861, he produced an influential book on the international money market, The Theory of the Foreign Exchanges, which explained what animates profit-seeking people in a self-regulating money market. Years later, a critic would say that the only other Victorian contemporary who could have written it was Bagehot. Goschen, a free-trading Liberal, entered Parliament in 1863. In the City of London, his parliamentary constituency, he earned the sobriquet “Fortunate Youth.”4
So Goschen spoke with authority when he attributed the persistence of high interest rates to the progress of the age—to the broadening of the money market that had come about by passage of the new limited liability law. Dozens of new banks and finance companies were collecting formerly stagnant puddles of English savings “into large and available streams” (an observation with which Bagehot would have agreed).5 One might have supposed that the opposite was true, that a glut of savings should depress the cost of borrowing. But the demand for savings was itself on the upswing, the argument went. It, too, was enlarged by the advent of limited liability banking. Indeed, the growth in demand was greater than the growth in supply; hence, rising interest rates.
No more, under the new system, did the prudent investor in a British financial institution confront a worst-case scenario of personal ruin. Potential loss was rather capped at the face, or par, value of the shares that he or she purchased. Investors in new flotations put down a percentage of par—perhaps a fifth or a quarter—with the understanding that another increment was callable later, in predetermined installments. There was a chance of an unscripted call from the directors in case of trouble, but a limited liability company had no further claim on its stockholders than par value.
Thus liberated from potentially limitless loss, financiers reconsidered the field of opportunity and found it to be bigger and more alluring than before, as Goschen observed. The British government borrowed at 3 percent with the assurance of absolute safety. The Turkish government, with no such assurance, willingly paid 12 percent to 15 percent; the Egyptian government, 8 percent to 9 percent; the government of the Confederate States of America, as discussed earlier, 7 percent—along with that option on the price of cotton.6 Henceforth, Her Majesty’s Treasury had to compete for funds against other riskier, and commensurately higher-yielding, sovereign borrowers. Similarly, British merchants and manufacturers faced financial competition from higher-yielding foreign businesses.
The 1860s were a time of upheaval. The Reform Act of 1867—enacted by a Conservative government over the protests of Liberals like Bagehot—ultimately granted the franchise to an estimated 830,000 new voters, a 61 percent expansion of the British electorate. A comparable extension of the financial franchise took place in the City of London. In the era of unlimited liability, financial institutions had been, of necessity, private clubs; not just anybody could join one, for not just anybody could meet an emergency call for capital. Private partnerships, operating behind closed doors, amassed private wealth. “The individual grew rich by a secret operation unintelligible to the masses,” Goschen observed,
who had strange visions of occult and mysterious processes by which money was coined in the City, but how they hardly tried to guess. Now, on the contrary, trade is carried on before the eyes of the general public. The public itself is admitted to the secrets of the guild. Not only does it witness the process, but it is also invited to share in the profits. 7
The new limited liability companies would operate in the open, or so the theory had it. They would admit new money, and a new class of investor, into British capitalism.
So 7 percent was a market-determined rate in a time of greater tolerance for financial risk. High rates of interest would persist for as long as foreign demand for English savings remained robust—and as long as the new financial intermediaries remained in place to channel those savings effectively. Goschen judged the chance that foreign demand for British capital would decline to be “very remote.” Yet he ventured no odds on whether the new finance companies would survive—the ones that had proliferated in the bull stock market of 1863–64, such as the Egyptian Trading Company, the Australian Mortgage Land and Finance Company, the International Land Credit Company, the English and Foreign Credit Company, the International Financial Com
pany, or the General Credit and Finance Company. Goschen did not imagine the collapse that duly ensued, and, with that wave of finance company failures, a plunge in British interest rates.8
Goschen had no claim to a literary reputation, but his long financial essays in the Edinburgh Review rose to the high standard set by Bagehot in the National Review. Both authors were bankers by trade and Liberals in politics. Both saw more good than harm in the flood of new limited-liability company formations. Lord Overstone, that most severe arbiter of financial and monetary rectitude, judged Goschen a “man of high standing as regards ability, education and integrity.”9 The same arbiter pronounced Bagehot a “fool.”10
OVERSTONE’S AVERSION TO BAGEHOT’S view of central banking is easily explained. Under Bagehot, as under Wilson, the Economist opposed Peel’s Act—which was, in good part, Overstone’s act. He had championed it as the means to prevent the Bank of England from over-issuing paper money. The Economist, among other critics, contended that the act’s rigidity contributed to the violence of the financial crises that seemed to recur every ten years.
Bagehot provoked Overstone in other ways. The older man, retired from an immensely successful banking career, bridled at Bagehot’s taste for paradox. Neither did he share Bagehot’s receptiveness to innovation. “Commercial and Monetary affairs again outrun my capacity,” wrote Overstone to his friend G. W. Norman in 1863, Overstone’s sixty-seventh year. “Joint Stock Banks and Limited Liability Companies—are the order of the day—and the boldest man seems the most likely to be prosperous—Has this state of things ever yet failed to end in a crash. The world is going up and down stairs, without laying hold of the bannister, and you too know well what the consequence of this must be. I hope they will only bruise their shoulder—and not break their necks.”11
Since the 1850s, the French had been doing wonders with companies they called “Crédit Foncier” and “Crédit Mobilier.” These were institutions that, like English banks, lent and borrowed; unlike English banks, they lent against seemingly anything, and would lend—and invest—for years, rather than months. From across the Channel, their success inspired envy at first, and later, following passage of the Limited Liability Act, imitation. Presently, the City of London was spawning “finance” companies.
The British versions of the Fonciers and Mobiliers did a little of what banks did and a lot more of what banks didn’t do—or, at least, shouldn’t do. A properly managed bank lent against prime securities and short-dated, self-liquidating trade bills, giving wide berth to loans or bonds of a speculative cast. It had nothing to do with mortgages, which, no matter how well secured, could not readily be turned into cash. Funding itself with deposits—most of them callable on demand—a bank had to be prepared to accommodate a sudden demand for cash, and thus liquidity was the heavenly banking virtue. Finance companies, by contrast, took no deposits, and instead funded themselves in the securities markets. Illiquidity held no terror for them; neither did speculative-grade bonds or risky loans, as long as the yield was commensurate with the perceived risk. They had no depositors who might demand their money in unison.
There was almost nothing that the new finance companies would not invest in or lend against, relates W. T. C. King, historian of the London discount market, writing seventy years after Bagehot. They would
build railways in any part of the world, finance every sort of public works (land development, sewerage, irrigation, road-making, swamp drainage, or even the building of museums), assist a Government, float loans, or make advances on fixed or floating property. Some were from the start, and others quickly became, concerns which hid under high-sounding titles every sort of “shady” or even fraudulent business, but a few were legitimate and substantial.12
General Credit and Finance Company of London, Ltd., was one of the sturdier specimens of the new type, and its success inspired others of less solidity. Notable among these dubious imitators was the Crédit Foncier and Mobilier of England, an 1864 promotion of Albert Grant, M.P., and the Mercantile Credit Association.
Grant, born Abraham Gottheimer in 1831, was destined to become the model for the crooked financier Melmotte in Anthony Trollope’s 1874 novel The Way We Live Now. He came to the attention of Trollope and the British investing public through a long series of finance company promotions, each of them paying himself (and, at length, innumerable lawyers) much more handsomely than the public investors. In some of these transactions Grant and his accomplice Henry John Barker became entangled with the illustrious bill brokers and money dealers Overend, Gurney & Co.
Overend Gurney, the “Corner House,” occupied a place on Lombard Street as lofty as that secured at a later date by J. P. Morgan & Co. on Wall Street. Or a loftier position—“incomparably the greatest monetary house in London, and no doubt in the world,” judged W. F. Finlason, barrister-at-law and author of the official summary of the litigation that followed the spectacular failure of this preeminent British financial institution in 1866.13
Never before had there been such a firm—and never such a bankruptcy. The Gurneys, Norfolk Quakers, were people of storied wealth and rectitude. Their stock-in-trade was turning English trade bills into cash: they accepted deposits, and with those funds they discounted prime commercial bills—essentially, lent against the collateral of business IOUs. It was a low-margin, high-turnover, and eminently profitable business.14 In the 1850s, Overend Gurney generated average annual earnings in the neighborhood of £180,000.15
Distinguishing prime from second-class quality took knowledge and application, a point of pride for the firm, and so it broke the heart of senior partner Samuel Gurney when a negligent junior partner compounded a devastating commercial misjudgment with a bigger moral lapse. In 1853, upon discovering that the collateral pledged against a £200,000 advance was fraudulent, the subordinate, David Barclay Chapman, covered it up by extending further credit to the felonious pledgers. Before long, Gurney, seventy-one, was dead.
It was to D. W. Chapman, the disgraced Chapman’s handsome son, that H. E. Gurney, another member of the founding family, unwisely delegated the sensitive work of appraising the securities presented as collateral against the firm’s loans and discounts.16
To earn a profit, the business of bill broking required innumerable careful decisions on small amounts of money. Only the most painstaking credit analysis on the largest scale yielded a large profit. An alternative approach—more exciting, more potentially profitable, more risk-fraught and utterly alien to the old Overend Gurney—was to extend long-term speculative loans against illiquid collateral. It was to this line of lending and investing that the younger Chapman now committed the firm. H. E. Gurney, now the firm’s chief acting partner, seemed unaware of it.17
Edward Watkin Edwards, an accountant whose experience as official assignee of the Bankruptcy Court afforded him intimate knowledge of the destination toward which Overend Gurney was hurtling, first gained access to the firm as a confidential adviser to Chapman. Edwards then made himself indispensable to his high-living sponsor when, in 1859, Chapman became heavily overextended. Now on Overend Gurney’s payroll at a salary of £5,000 a year, Edwards accepted his first-year compensation in a lump sum, a lump he immediately slipped into Chapman’s pocket. For all intents and purposes, Edwards now headed the firm’s unconventional financing division, and just as H. E. Gurney had delegated the job of risk control to Chapman, so Chapman turned that critical function over to Edwards.
Yet—his experience in bankruptcy notwithstanding—never were man and work less congenially matched. “Within a few months,” according to King, “Gurney’s became grain traders and speculators, iron-masters, shipbuilders, shipowners, large-scale railways financiers, and partners in almost every kind of speculative and lock-up business.” The phrase “lock-up” would resound over the next decade as Overend Gurney careered from phantom prosperity, to secret insolvency, to explicit failure, and ultimately to lengthy court proceedings. Having made its fortune in the most liquid kind of com
mercial collateral, Overend Gurney now plunged into the most fraudulent.
John Barker and Albert Grant, partners in previous financial calamities, now turn up in the Overend Gurney narrative. One Barker-initiated transaction, involving loans to the Galway steamship line, wound up costing the firm more than £1.4 million. Then, the case of the ill-starred Atlantic & Royal Mail Steam Packet Company, along with the associated construction of five large steamers—financing arranged by Barker and Grant—left the owners of Overend, Gurney & Co. poorer by another £1.4 million.18
How could a loan applicant, as opposed to a customer dealing in Overend Gurney’s old specialty, trade bills, approach the eminent Corner House? Edwards had become the gatekeeper, Chapman his factotum. One customer described the negotiation for a sizable advance against the collateral of steamships as follows:
After some little time, Mr. Edwards called us in, and then he informed me that Messrs. Overend, Gurney & Co. had decided on advancing me £80,000 for six months, to enable me to overcome my difficulties; but for that advance I should have to pay them a bonus of forty thousand pounds, and interest at the rate of 10 percent.