The Alchemists: Three Central Bankers and a World on Fire (5 page)

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 getting 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.

•   •   •

W
hile 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.

Lombard Street, Rule Britannia, and Bagehot’s Dictum

O
n 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 that 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.

•   •   •

B
akers 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.

•   •   •

A
fter 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.