In FED We Trust (5 page)

“A disorderly failure of AIG,” Bernanke told Congress the same week, “would have severely threatened global financial stability — and, consequently, the performance of the U.S. economy.”

It was becoming clear that Bernanke had adopted a new mantra:
whatever it takes
. He would not go down in history as the chairman of the Federal Reserve who dithered and delayed during a financial panic that threatened American prosperity. Sunday, September 14, 2008, would be the last day the Fed would say “No!” to any financial institution of significance. Just two days later, it did the AIG deal. Within weeks, the Fed would successfully press the rest of the U.S. government to guarantee the debts of all the nation’s banks, to buy shares in banks to bolster their financial conditions, and to declare that the government would not let another “systemically important” financial institution go under.

Barney Frank, the congressman from Massachusetts, proposed declaring Monday, September 15, to be Free Market Day. On Sunday, the Fed and the Treasury let Lehman fail; on Tuesday, they took over AIG. “The national commitment to the free market lasted one day,” Frank said. “It was Monday.”

I
n the fall of 1907, the U.S. economy was hanging by a thin thread over a very deep pit. With stock prices tumbling, a number of prominent brokerage houses already had closed their doors. Faced with runs on their assets, bank managers instructed tellers to count out withdrawals in slow motion. Without fresh loans, New York City was a week or two away from declaring bankruptcy. What became known as the Panic of 1907 was on, and the only man who could save the nation from financial ruin was attending an Episcopal Church convention in Richmond, Virginia.

Telegrams flew back and forth between his offices in lower Manhattan and the convention site. Racing back to work would only stoke the hysteria, it was decided. Instead, he waited until the weekend, then boarded his private railroad car and started for home. Press dispatches followed his progress breathlessly until at last seventy-year-old J. Pierpont Morgan — known by friend and foe as “Jupiter,” god of the skies — stepped onto the platform in New York on Sunday, October 20, and the work of rescuing the financial system could begin in earnest.

One hundred one years later, the same scenario would unfold in a Great Panic that remarkably parallels the earlier one, even to the point of Morgan’s progeny at the firm of JPMorgan Chase being summoned to rescue Bear
Stearns. This time the starring role of Jupiter would be played by a far more complex mechanism: the Federal Reserve.

The opening years of the twentieth century had been a time of prosperity. The nation rebuilt its economy after the depressions and deflation of the 1890s. Exports doubled between 1897 and 1907. Foreign capital flooded what was the emerging-market economy of its day, the United States, though the term hadn’t yet been invented. Banks, insurance companies, brokerage firms boomed. J. P. Morgan bestrode it all like a colossus. Campaigning to end what he called “ruinous competition,” Morgan merged companies that had been rivals to create enduring giants such as General Electric and U.S. Steel. Between 1894 and 1904, more than 1,800 companies were merged, acquired, and consolidated into just 93. A joke of the day had a schoolchild telling a teacher: “God made the world in 4004
B.C
. and it was reorganized in 1901 by J. P. Morgan.”

But the political and financial waters were far from calm. “War was fresh in mind. Immigration was fueling dramatic changes in society. New technologies were changing people’s everyday lives. Business consolidations and their Wall Street advisers were creating large, new combinations through mergers and acquisitions, while the government was investigating and prosecuting prominent executives — led by an aggressive prosecutor from New York. The public’s attitude towards business leaders, fueled by a muckraking press, was largely negative,” University of Virginia business professors Robert F. Bruner and Sean D. Carr wrote in a history published on the hundredth anniversary of the Panic of 1907.

The world economy was tethered to gold, as countries tried to maintain the value of their currencies for a fixed amount of gold, a “gold standard.” In 1900, for instance, the U.S. government declared that one dollar would be worth 1.505 grams of gold, setting the price of a troy ounce of gold at $20.67. In years when little new gold was mined, the global economy grew slowly and prices of goods and services tended to fall. After gold was discovered in Alaska and South Africa in the 1890s, the opposite occurred. The mining of gold and its flow from other countries into the United States did essentially what the Federal Reserve does today — expand and contract the supply of money.

A gold standard can restrain inflation and provide certainty for businesses trading internationally. With it, everyone the world around knew exactly
what a dollar was worth — one reason nostalgia for the standard still surfaces periodically. But the inherent rigidities of pegging the dollar or any currency to a specific quantity of gold meant that in an unwelcome economic disturbance, governments were limited in their response. The gold standard, for instance, offered no way to expand the money supply temporarily to cope with the seasonal cash flow to farm states to pay for newly harvested crops. And there was no way for the government to flood the economy with money in a crunch, as the Fed did after the stock market crash in 1987 or the 9/11 terrorist attacks in 2001. (The world flirted with a gold standard off and on until Richard Nixon finally killed it in 1971, declaring that the U.S. government would no longer exchange dollar bills for gold at any price.)

By default, the gold standard and the absence of any central U.S. bank often left it to individuals to fill the gap, and that individual was often J. P. Morgan. When the U.S. Treasury’s gold reserves fell dangerously low in 1893, Morgan rescued the government by organizing a private syndicate to raise $100 million in gold for the United States and personally guaranteeing that the gold wouldn’t flow back to Europe. It was an extraordinary show of financial courage and muscle, far in excess of the power held by modern-day financial guru Warren Buffett and the $5 billion he invested in Goldman Sachs and $3 billion in General Electric during the Great Panic. Yet while Buffett is celebrated and almost universally admired for sagacity, Morgan was often vilified. For populist, and popular, demagogues like three-time presidential candidate William Jennings Bryan, Morgan and his vast private holdings were the problem — not the solution — to the inequities and periodic turmoil in the United States. No one doubted to whom Bryan was referring when he excoriated “the idle holders of idle capital” and vowed to liberate “the struggling masses who produce the wealth and pay the taxes of the country” from “the cross of gold” in his 1896 oration to the Democratic convention.

Gold and silver, money and banking, the tension between urban lenders and rural borrowers, were at the center of American politics almost from the
beginning. The nation’s early history is marked by what Bray Hammond, a 1940s Fed staffer turned historian, called the “agrarian antipathy for city, commerce and finance.” Thomas Jefferson was famously suspicious of banks as well as of paper currency. “I sincerely believe … that banking establishments are more dangerous than standing armies,” he wrote in an 1816 letter. The tensions over the power of money were very close to the surface in the late nineteenth and early twentieth centuries and for good reason: thirteen banking panics careened through the economy between 1814 and 1914 by one scholarly tally, more than one a decade.

Monetary debates were even the stuff of popular culture. Indeed, L. Frank Baum’s enduring
The Wonderful Wizard of Oz
, published in 1900, has been read as an elaborate allegory for the monetary politics of the era. Dorothy stands for the American people at their best; Aunt Em and Uncle Henry, the struggling farmers; the cyclone, the financial storms and political unrest of the 1890s. Slippers of silver (not the ruby ones of the movie version) tread the path of gold (the Yellow Brick Road) that leads to the Emerald City of power (Washington). There are the unemployed urban factory worker (the rusting Tin Man), the farmer (Scarecrow), and in some interpretations, pacifist William Jennings Bryan himself (the Cowardly Lion with a frightening roar). The wizard, in allegorical readings, is a political charlatan, in some versions Mark Hanna, the strategist widely seen as manipulating William McKinley. (If only the book had been written later, literary economists could have painted the wizard as chairman of the Federal Reserve. Alan Greenspan, after all, was likened to the Wizard of Oz, the man whose aura of mystery and power exaggerated his wisdom and capacity to control events.)

Populism and the campaign to promote silver as a supplement to gold died when McKinley beat Bryan in the 1896 presidential election, but tension between borrower and lender, farmer and financier, worker and Wall Street, didn’t disappear. Hostility to big money ebbed and flowed, but American workers, farmers, and debtors had a recurrent suspicion that “Wall Street” or the “money trust” or “the robber barons” were responsible for economic misery. This recurrent American suspicion went into remission during much of the 1990s and 2000s when Americans enjoyed rising stock prices and climbing home values, but it returned with virulence during the Great Panic with
multibillion-dollar bailouts of banks and bonuses paid to executives of failing companies.

In 1901, McKinley was assassinated and succeeded by Teddy Roosevelt, who railed against “malefactors of great wealth.” Five years into his presidency, in 1906, the prosperity of the moment was disrupted by a devastating earthquake in San Francisco, then the financial center of the West, and that, in turn, sent shock waves throughout the financial markets. By the spring of 1907, the economy was weakening, stock prices were sinking, gold reserves were low, and interest rates were rising — the makings of a financial perfect storm.

As would be the case a century later, tinder was scattered throughout the financial system. All that was needed to start a calamitous fire was a match, and that was provided by a botched October 1907 attempt by speculators to corner the market for shares of United Copper Company. The idea was to buy up the bulk of the company’s shares, drive up the price, and profit by selling them to other investors who had bet that the shares would fall. It didn’t work. United Copper shares soared to $62 on October 14, then plunged to $15 two days later. The clumsy speculators couldn’t repay the loans they had taken — loans not from conventional banks, but from banklike institutions called trust companies. With that, the panic was on.

Just as lightly regulated mortgage companies and investment banks would prove troublesome in 2008, so the trust companies of a century ago were disasters waiting to happen. Trust companies weren’t full-fledged members of the consortiums of banks — called “clearinghouses” — that agreed to stand behind one another at times of stress to stabilize the financial system. Instead, trust companies had to rely on clearinghouse banks to process checks written by their customers.

Knickerbocker Trust Company, the Bear Stearns of its day, had lent heavily to the copper speculators. When word of that circulated, scores of depositors descended on its offices to withdraw money, the sort of bank run that was frighteningly frequent before government deposit insurance arrived. Never mind that just two weeks before, the state banking examiner had found the institution had funds sufficient to pay its depositors. On October 18, the National Bank of Commerce said it would no longer act as the intermediary
between Knickerbocker and the clearinghouse, a move as devastating to Knickerbocker as JPMorgan Chase’s decision to stop “clearing” — or processing payments — for Lehman Brothers in September 2008, contributing to that venerable firm’s bankruptcy.

On Monday, October 21, after paying out $8 million in less than four hours, Knickerbocker ran out of cash. J. P. Morgan sent a young deputy, Benjamin Strong, to inspect Knickerbocker’s books. Confirming Morgan’s suspicions, Strong concluded the trust company was insolvent. It would never reopen, and indeed, its president later committed suicide. The panic lit next on the Trust Company of New York.

Morgan summoned the secretary of the Treasury, George B. Cortelyou, to come to him in New York. The summons underscored Morgan’s influence and what was effectively his quasi-governmental status. A century later, Treasury Secretary Hank Paulson would demand that the chief executives of the nine largest banks come to
his
office in Washington to be told what they had to do, but Paulson had the Federal Reserve beside him and hundreds of billions of dollars at his disposal.

One constant through both panics, though, was a largely absent commander in chief. As Morgan wheeled and dealed, Teddy Roosevelt was hunting bear in the canebrakes of northern Louisiana. When he finally surfaced a few days later, the
New York Times
reported archly that “he had added several deeper shades of tan to the bronze acquired during the summer months.” Though a century later George W. Bush would be in the White House for most of the Great Panic, he turned to Paulson and Bernanke rather than leading any defense against the biggest threat to the U.S. economy in more than half a century.