In FED We Trust (6 page)

In a late-night October 1907 meeting with the heads of New York’s biggest banks, Cortelyou offered to deposit $25 million of government money in New York City banks at Morgan’s direction. When the meeting broke at 2
A.M.
, it was clear to Morgan and the others that rescuing the Trust Company of New York was crucial. Just as he had been with Knickerbocker Trust, Benjamin Strong was dispatched to look over the Trust Company’s books and told to report back by noon.

Strong recalled the scene in a twenty-two-page letter written years later:

The meeting lasted forty-five minutes. At the end, Morgan asked Strong if he thought a rescue of the Trust Company was justified. Strong said it was. Morgan then turned to the bankers and said: “This is the place to stop the trouble, then.” And he did. As nearly 1,200 depositors thronged the Trust Company’s offices to take out their money, Morgan tried to persuade other trust companies and banks to raise the money the Trust Company needed to avoid collapse — much as Paulson and Geithner attempted to do with Lehman Brothers a century later. When that effort failed, Morgan instructed the Trust Company’s president to bring his most valuable securities to Morgan’s office. Morgan then went over them one at a time until he had enough collateral to reach the $3 million the Trust Company needed to stay afloat for another day. The next day Morgan persuaded other banks to come up with $10 million.

The crisis, though, did not end there. “The closing months of 1907 … were marked by an outburst of fright as widespread and unreasoning as that of fifty or seventy years before,” Harvard economist A. Piatt Andrew, later a Republican congressman from Massachusetts, wrote in 1908. The United States, he said, had experienced “what was probably the most extensive and prolonged breakdown of the country’s credit mechanism which has occurred since the establishment of the national banking system,” a reference to the embryonic network of nationally chartered banks established after the Civil War.

The next acts would involve New York City, the New York Stock Exchange, a major brokerage firm, banks outside New York, and, eventually,
steel, rail, and coal companies. But the pattern was established. Morgan ruled and pushed others to do what was necessary to avoid the depressions that had followed previous banking panics. In November, the Treasury issued $150 million in bonds and permitted banks to use the securities to create new currency. (In 1907, paper currency printed by banks circulated freely alongside government-printed greenbacks.) Depression was avoided, but the economy suffered a yearlong recession. Commodity prices fell 21 percent, erasing nearly all the increase that had occurred since 1904. The dollar volume of bankruptcies rose 47 percent in one year. Unemployment went from 2.8 percent to 8 percent. Some 240 banks failed.

J. P. Morgan initially was lauded for his role in turning aside the Panic of 1907. “Crowds cheered when he walked down Wall Street, and world political leaders and bankers sent telegrams expressing their awe that one man had been able to do that,” one of his biographers, Jean Strouse, told an interviewer. “But the next minute a democratic nation was really quite horrified at the idea that one man had this much power.”

Republican senator Nelson Aldrich of Rhode Island, who was among Wall Street’s best friends in Washington, put the matter more practically: “Something has got to be done. We may not always have Pierpont Morgan with us to meet a banking crisis.”

The idea of a centralized monetary authority was hardly novel. The Bank of England had been around since 1694, and as early as the mid-nineteenth century had developed the practice of printing cash and lending it to smaller banks at times of crisis. This “lender of last resort” role for central banks was codified by British journalist and economist Walter Bagehot in his 1873 book,
Lombard Street
. To an astounding degree, Bagehot’s description remains the basic guide for central bankers more than 125 years later. They cite it as an authoritative guide to behavior and refer to it with the same reverence that ministers and rabbis use when quoting from the Bible.

“A panic,” Bagehot wrote, “is a species of neuralgia, and according to the
rules of science you must not starve it. The holders of the cash reserve [the central bank] must … 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. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them.”

In a panic, Bagehot advised, a central bank should lend freely on good collateral and charge a high interest rate to discourage overuse. And a central bank, he said, should lend only to those who were ultimately solvent — that is, to banks with loans and other assets greater than their deposits and other borrowing. The last condition was significant: the point was to keep otherwise healthy banks from being wiped out in a panic, not to sustain banks that were broke or, in the jargon of the trade, “insolvent.” In other words, the central bank was the solution to a shortage of liquidity, but not the solution to insolvency. Identifying that fine line between liquidity and solvency in the midst of a financial panic would be perhaps the biggest challenge for the Bernanke Fed. Its biggest gambles hinged on getting this diagnosis right: the difference between lending to Bear Stearns (liquidity) and not lending to Lehman (insolvency), the choice between buying smelly loans and securities from the banks (liquidity) or investing taxpayer money in them (solvency.)

Bagehot understood that — provided the authorities had the right diagnosis — central banking was not simply a matter of turning valves to regulate the flow of money, but also was about offering reassurance and bolstering confidence, what Geithner called “theater.” “What is wanted and what is necessary to stop a panic is to diffuse the impression that though money may be dear, still money is to be had. If people could be really convinced that they could have money if they wait a day or two, and that utter ruin is not coming, most likely they would cease to run in such a mad way for money,” Bagehot wrote. “Either shut the Bank [of England] at once, and say it will not lend more than it commonly lends, or lend freely, boldly, and so that the public may feel you mean to go on lending. To lend a great deal, and yet not give the public confidence that you will lend sufficiently and effectually, is the worst of all policies.”

In ordinary times, a central bank’s role was mostly to be seen but not
heard: to keep an eye on the banking system and to manage the overall supply of credit in the economy to avoid the problems caused by too many dollars chasing too few goods (the recipe for inflation) or those caused by the opposite condition of not enough dollars (the recipe for recession and deflation). All that changed in the case of financial fires. Then a central bank became the first responder — the lender of last resort.

The United States had no lender of last resort in 1907, though not for lack of trying. In 1790, Alexander Hamilton, the first secretary of the Treasury, overcame fierce opposition from Jefferson and agrarian interests and persuaded Congress to charter the first Bank of the United States. The bank was largely an economic success, issuing a stable national currency and regulating private state-chartered banks, but its efforts to restrain commercial banks from lending too readily made it persistently unpopular. Congress narrowly refused to renew the bank’s charter when it expired in 1811.

Five years later, after the inflation and financial instability that accompanied the War of 1812, Congress tried again. But the Second Bank of the United States proved, at first, incompetent and corrupt and later came to be seen as a threat to American democracy. Andrew Jackson neutered it in 1832, vetoing legislation that would have extended its charter ahead of schedule and declaring it to be “unauthorized by the Constitution, subversive of the rights of the States, and dangerous to the liberties of the people.” During the Civil War, Congress created national banks — previously, only states could charter banks — and the federal Office of the Comptroller of the Currency. But from 1832 onward, the nation was left without a central bank, which was why J. P. Morgan was called upon to fill the role.

The year 1907 proved to be a turning point, and not only because the mortal Morgan, then seventy, couldn’t go on forever. Earlier panics had struck banks that came under the sheltering umbrella of the clearinghouses. This panic hit the trust companies, which lived outside the clearinghouse safety net. That led New York bankers to realize the financial system had grown too
big and complex for them to manage, while at the same time the public and many politicians decided that the time had come to rein in “money trust.”

“The Panic of 1907 was an indication of the extent to which the ability to control crises had moved out of the hands of the New York bankers,” historian Gabriel Kolko wrote.

But if the need for a central monetary authority was obvious, there was little agreement on who should control it or even what its objectives should be. A Federal Reserve Bank of Boston monograph captured the conflict succinctly: “While most bankers were interested in reforming the financial structure of the nation to make it more efficient and centralized, the progressives were interested in reforming the financial structure by making the banking system less centralized.”

To address these issues, Congress created a National Monetary Commission, but the appointment of Wall Street’s friend Nelson Aldrich to chair it inflamed suspicions that it was a front for bankers. (Aldrich’s grandson and namesake, Nelson Aldrich Rockefeller, the governor of New York and vice president, would never escape the same suspicions.) Conspiracy theories were further fueled when it was later learned that Aldrich arranged a weeklong secret meeting in November 1910 at Jekyll Island, Georgia, a resort owned by John D. Rockefeller and J. P. Morgan himself, to design a new central bank for the United States.

At Jekyll Island, a handful of bankers — among them Benjamin Strong, the Morgan lieutenant — had agreed to back a version of a plan based on one crafted by investment banker Paul Warburg, who was later a member of the Federal Reserve Board. A twenty-four-volume report released in January 1911, the plan called for a National Reserve Association with branches spread throughout the country that would issue currency and make loans to member banks. The association was not to be an arm of the government but would be controlled instead by a board of directors dominated by bankers.

Proponents said the absence of centralized authority was threatening the national well-being. “The whole world is united in agreement that we have about the worst system of banking that there is anywhere in existence,” Frank Vanderlip, then president of National City Bank, forerunner of today’s Citibank, said in 1911. “It makes of us … an international nuisance.” A century
later, Hank Paulson would look at the archaic maze of regulatory agencies in his own time and come to a similar conclusion.

Opposition to the new central bank was fervent. William Jennings Bryan charged that the plan would leave bankers “in complete control of everything through control of our national finances.” In May 1912, Representative Arsène Pujo, a Louisiana Democrat and dissenting member of the National Monetary Commission, convened high-profile hearings into “the money trust.” Among those called to testify was J. Pierpont Morgan, less than a year away from his grave, his great service to the nation of five years earlier largely forgotten. Pujo’s final report found “a great and growing concentration of the control of money and credit in the hands of a few men.”

In 1912, Wilson — standard-bearer of the Progressive movement, governor of New Jersey, and former president of Princeton University — was elected president, beating both Republican William Howard Taft, the incumbent, and Teddy Roosevelt, who ran as a third-party candidate. Wilson had promised “speedy and sweeping” financial reform and stood on a Democratic Party platform that rejected the Aldrich proposal, but he had been vague about specifics. The day after Christmas 1912, the incoming chairman of the House Committee on Banking and Finance, Carter Glass of Virginia, and his economic adviser, H. Parker Willis, came to Princeton to lay out an alternative to Wilson. They proposed twenty or more privately controlled regional banks that would issue currency and lend to other banks, a plan crafted to dilute New York’s dominance and avoid the creation of a central bank in Washington. Wilson insisted that a presidentially appointed board oversee the regional banks to serve as the “capstone” of the system. Glass eventually acquiesced, preferring Wilson’s government-controlled board to Aldrich’s banker-dominated scheme.

Months of political wrangling ensued. Wilson eventually turned to Louis Brandeis, later a Supreme Court justice, to fashion a compromise, which the president outlined to a joint session of Congress in June 1913. For six more months bankers and agrarian populists battled over every aspect of the proposal, but the bill finally passed. Wilson signed the Federal Reserve Act on December 23, 1913, the most significant achievement of his first year in office. Proponents were irrationally exuberant. Senator Claude Swanson, a Virginia Democrat, said the creation of the Fed made “impossible another panic in this country.”