Money (28 page)

The question struck a chord. The popular press took it up. Why was it that all those brilliant economists and highly paid bankers, with their elaborate theories and their computerised models, had failed to foresee such an enormous catastrophe lurking at the heart of the economic system? The British Academy convened a conference to formulate an answer, and in July 2009, sent a response to the Queen.
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It described a by now familiar litany of problems, including global macroeconomic imbalances, failures of risk management in banks, general over-exuberance due to a long period of low inflation, and
lax regulation. It admitted that none of the main interested parties had grasped the fact that they might precipitate such a cataclysmic crash. And it identified the reason for this—the answer to the Queen’s question—in the failure of anyone to take a sufficiently broad view of things. “[I]n summary, Your Majesty,” wrote the Academy’s representatives, “the failure … while it had many causes, was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole.”
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The British Academy’s diagnosis was that in isolation, “[e]veryone seemed to be doing their own job properly on its own merit.”
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The problem was rather that nobody had seen the big picture: that whilst “[i]ndividual risks may rightly have been viewed as small … the risk to the system as a whole was vast.”
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History does not relate what the Queen made of this answer. What is certain is that it would not have satisfied the Committee on Oversight and Government Reform of the United States House of Representatives, which had held its fourth hearing into the crisis a fortnight before the Queen posed her question at the London School of Economics. It was hardly going to be satisfied with the answer that no one saw the big picture. After all, seeing the big picture is
exactly what macroeconomists, central bankers, and other financial regulators are meant to do. It was therefore no surprise that one of the witnesses called before the Committee was Alan Greenspan—the longest-serving Chairman of the Federal Reserve in history and indisputably one of the most important world economic policy-makers in the two decades leading up to the crash. Unlike the British Academy, Mr. Greenspan did not fudge responsibility. He did not deny that his job had been precisely to understand how the economy worked as a whole. The problem was, he explained with admirable honesty, that his understanding had simply been wrong. “I found a flaw … I have been very distressed by that fact,” he testified. “I found a flaw in the model that I perceived is the critical functioning structure that defines how the world works.”
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This time it was not the Emperor—at least, not the Queen—who had no clothes.

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illustration credit 12.1
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The multitrillion-dollar question was what the flaw in the model being used by Mr. Greenspan was—and how it had crept into his thinking. Economics is not a young discipline. Central banks are not new. How could the most influential social science of the last two centuries have fallen into such catastrophic error? A third verdict was delivered in April 2011, by Lawrence Summers—recently retired as the Director of President Obama’s National Economic Council, a former Chief Economist of the World Bank, and one of the leading academic economists in the United States. Asked at a conference in Bretton Woods whether he believed that the crisis had exposed the failure of orthodox macroeconomics and financial theory to understand the economic reality, Summers made an astonishing admission. In the breach, Summers explained, the “vast edifice” of orthodox economic theory constructed since the Second World War had been virtually useless.
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It had proved to have almost nothing to say about why the economy was nose-diving and what could be done to stop it.

But, Summers said, there had been other traditions—much less heralded ones—that had come to his assistance. As the American financial system had teetered on the edge of oblivion in late 2008 and early 2009, Summers nominated a trio of economists as his chief guides during the desperate policy-making in the White House: Walter Bagehot, Hyman Minsky, and Charles Kindleberger.
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This was a selection of economic thinkers, he admitted, from well beyond
the pale of orthodox economics and from some time ago. Hyman Minsky was a economist whose unconventional theories of how a monetary economy functions were largely spurned by the core of the profession, and who died in 1996. Charles Kindleberger was an economic historian—economic history being widely considered the poor cousin of theory by most academic economists—whose best known work was published in 1978. Walter Bagehot—who is barely considered an economist at all by the modern profession—was a British finanical journalist who died in 1877 and whose major work dates from 1873. Yet it was to the understanding of banking and finance of these obscure and unfashionable thinkers that Summers had turned in the heat of the crisis. And as for the medium-term policy response, once the most acute phase of the crisis had passed, there had been Keynes. Whilst the core research programme of modern academic macroeconomics “was not something that informed the policy-making process in any important way,” Summers said, “I was heavily influenced … by the basic Keynesian … framework.”
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So what was it about this alternative tradition of economic thought that made its theories so much more useful, and so much more realistic, than the “vast edifice” on which so much effort had been spent in the post-war period? How could a book like Walter Bagehot’s
Lombard Street
—an account of the London money market in the early 1870s—have had more to say to the Director of the Council of Economic Advisers in the midst of the biggest financial meltdown in history than the most up-to-date and technically accomplished productions of the finest minds in twenty-first-century economics? As Summers put it: “I think economics knows a fair amount; I think it has forgotten a fair amount; and it has been distracted by an enormous amount.”
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The questions are, What has it forgotten? What was it distracted by? And, perhaps the biggest mystery of all, How on earth did all this happen?

It is a commonplace that the market has a short memory. It had been only a few years since the last financial crash had threatened to
destroy the banking system, the economy, perhaps even capitalism itself, and yet it had all been forgotten in the subsequent boom. And this time there really did seem a reason why it might all be different, for both the world economy and finance itself seemed to be in the throes of an epochal transformation. The previous decade had witnessed unprecedented growth and innovation in the capital markets. The leading actors in the creation of credit for the new globalising economy were no longer the traditional banks but a new breed of dealers that originated and distributed tradable debt securities. Individually, these novel forms of credit seemed risky and perhaps illiquid—but another class of firms had appeared that specialised in parcelling them up into well diversified, and hence low-risk, bundles. Those who doubted the wisdom of all this were dismissed as economic Luddites—until the pyramid of credit developed the odd crack when interest rates spiked and a few of the smaller firms went under. Then came rumours that a really big fish was in trouble. It seemed inconceivable that the regulators would let it go: everyone knew that it was “too big to fail.” Yet the sanctimonious talk of the dangers of moral hazard emanating from the central bank was far from reassuring. And then, taking everyone by surprise, it happened. There was a full-blown run, and the central bank let it fail. All hell broke loose: a panic the like of which hadn’t been seen for decades. As financial markets tanked, credit seized up, and the economy capsized, moral hazard was suddenly the last thing the central bankers were worrying about. The policy-makers realised that the time had come to run the printing press at full tilt and bail out the financial sector before it disintegrated completely.

This, of course, is the story of the crisis of 2008–9 in which Lawrence Summers played such a critical policy-making role. What is perhaps less well known is that it is also exactly the story of another great financial crisis—one that occurred more than a hundred and forty years earlier, in 1866.

In the two generations following the publication of Adam Smith’s
Wealth of Nations
Britain underwent an economic and technological transformation so thorough that it was almost immediately christened the Industrial Revolution.
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Like all good revolutions, it had a
vanguard; albeit a rather unexpected one. For an astonishing number of the entrepreneurs who created Britain’s industrial supremacy were members of one marginal Protestant sect: the Religious Society of Friends, or, to give them their more familiar name, the Quakers.
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Jealous contemporaries often ascribed the conspicuous success of Quaker businessmen to nothing more than a greater capacity to tolerate the hypocrisy of Christian money-making. Their pious brethren, it was whispered, not only “Grip’d Mammon as hard as any of their Neighbours,” but even “call Riches a Gift and a Blessing from God.”
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Yet there was a great deal about the Quaker way of life that was conducive to success in the new world order. Central to the Quaker ethos were personal honesty, hard work, and conservatism. The Society placed great emphasis on education. And above all, the movement stressed the importance of solidarity amongst the Friends, reinforced in everyday intercourse by distinctive dress and language, and over the generations by the strong encouragement of marriage within the faith. All these features of Quakerism were ideally suited to the burgeoning commercial economy, based as it was on reliability, personal trust, literacy, and numeracy.

In no sector of the economy were these traits more valuable than in banking. An exclusive commercial club, knit together by implicit trust and bound to an ulterior ideology, is the dream environment for private monetary networks to flourish in. So it is hardly surprising that in banking, even more than in other fields, Quakers were unusually pre-eminent. Even today, two of Britain’s four high street banks—Lloyds and Barclays—were originally Quaker firms.
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But the greatest of all the mid-nineteenth-century Quaker banks no longer exists. In the days when Lloyds and Barclays were still little more than provincial counting houses, one bank ruled the City like no other before or since. This was the famous Quaker firm of Overend, Gurney and Co., or the “Corner House” as it was known to a generation of Victorian financiers, because it stood as a rival to the Bank of England itself, not only metaphorically in the financial markets, but in hard reality on the corner of Lombard Street and Birchin Lane in the heart of the City of London.

The Gurney family had begun as wool merchants in the prosperous
farming district of East Anglia, and had evolved naturally into merchant bankers by borrowing on their good name in London and lending to the local sheep-farmers. As Britain’s economy grew and diversified, the opportunity to capitalise on this generic line of business—connecting the local capitalists in need of credit at the base of the pyramid to the London banks in its higher echelons—became more and more attractive. Eventually, the Gurneys of Norfolk decided to seed a London operation, and in 1807 they acquired the small London firm of Richardson, Overend. In the beginning, the firm’s business was brokerage pure and simple. A potential borrower in the provinces would bring his bills to Overends for scrutiny. If Overends liked the credit, they would find a London commercial bank that would lend against security of the bill—a procedure called “accepting” it. The more practised in this art brokers like Overend, Gurney became, the more readily were their recommendations accepted by the banks. Bill-broking became big business, and the market in debt securities that they intermediated became the governing mechanism of the Industrial Revolution.

As time went on, the bill brokers began to act not only as agents of the commercial banks, but as finance houses in their own right. Banks would deposit their excess funds with the brokers on demand, and the brokers themselves would discount the provincial or foreign entrepreneur’s bills.
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The risk now resided on the brokers’ balance sheets—and they would reap any profits: in modern terminology, they had ceased to be just brokers and had become dealers. By the middle of the nineteenth century, the London bill brokers were the merchant bankers at the very heart of the global financial system—the direct heirs of the Italian exchange bankers of medieval Europe, but lords and masters of an estate incomparably more international, more complex, and more wealthy. When Parliament established a committee to investigate the London capital markets in 1857, the reaction of its members to an account of the bill brokers’ role was nothing short of astonishment. Did the Governor seriously mean to say that “[a] man cannot buy … tea in Canton without getting credit from Messrs Matheson or Messrs Baring?” they asked. “That
is so,” came the reply matter-of-factly. Even six thousand miles away, it was the name of a bill broker in Lombard Street that was wanted to persuade a merchant to part with his goods. It was via the bill brokers that “English credit supplies the capital of almost the whole world.”
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