America's Bank: The Epic Struggle to Create the Federal Reserve (7 page)

The charge of favoritism was, in any case, only a sideshow. The more elementary criticism was philosophical: that Shaw was encroaching in the money market, and this was still not thought to be the government’s concern. If the Treasury secretary could intervene in credit markets, the liberal
Nation
fretted, as if bewitched by a premonition of a modern central banking maestro, what would prevent
some future “autocrat
” from intervening in the stock market? In a more comprehensive critique, A. Piatt Andrew, a young assistant economics professor at Harvard, charged Shaw with skirting the law in
various ways (which he had), and flatly declared, “Gold imports are not a matter of government concern.” No European central banker would have agreed.

Andrew saved his most sizzling critique for the end. Why was it, he wondered, that the New York banks had fallen into deficiency with much greater frequency under
this
particular Treasury secretary? “Never before,” he noted, “had a Secretary declared that it was the place of the Treasury to intervene in banking operations outside of times of panic.” Evidently, he surmised, banks felt less need to keep their own reserve knowing that the Treasury was ready and eager to assist. This anticipated the “moral hazard” arguments against bailouts in the 2000s. “
Outside relief in business
, like outdoor charity,” Andrew concluded, “is apt to diminish the incentives to providence.” Andrew did not belittle the defects of the American system, or the need for reform, but he rejected “arbitrary and lawless interpretations” by an official “over whom Congress has little or no control.”

Nearly everyone wanted to reform the banking system, but no two groups agreed on the remedy. Wall Streeters did not much worry that a central bank might favor powerful bankers (that was part of the attraction). Bankers in Gotham believed that American leadership in finance would redound to the country’s benefit, and also to their own. They had unselfish reasons as well as opportunistic ones, although it is unlikely that they examined their motives so finely. They simply felt that a stronger credit system would be good all around.

Rebuffing Wall Street,
Shaw immodestly suggested
that the Treasury secretary himself be endowed with czarlike powers, which, he said, would enable him to avert any and all panics in the future. Senator Aldrich applauded this idea, which he believed would strengthen the existing currency, and dashed off a bill to enhance the secretary’s authority.

Aldrich and Shaw were opposed by yet another constituency, Chicago’s bankers, who were concentrated on La Salle Street. Chicago bankers disliked Shaw’s proposal because they feared, justifiably, that
an activist Treasury would work closely with banks in New York. For similarly parochial reasons, La Salle Street was opposed to a central bank.

The Chicago bankers were important because they were a potent industry voice outside of New York; they also dominated the councils of the American Bankers Association. Under the leadership of James Forgan, president of the First National Bank of Chicago,
the ABA championed a bill
to expand the currency by letting big-city banks operate branch offices, through which they could distribute their own notes.

But the prospect of branch banking
horrified yet another group—small-town bankers, who reckoned that if banks in the city could open branches in rural areas, country banks would be overrun. And country bankers wielded considerable clout in Congress (more than a few congressmen
were
local bankers). With the banking industry so fractured, and with Roosevelt not daring to break the impasse, reform efforts were stalemated. As one western observer put it, “
The bankers are still divided
; who shall decide when doctors disagree?”

Nicholas Murray Butler, president of Columbia University, acknowledged the lack of leadership on a visit to Germany, where he was received by Wilhelm II. The Kaiser inquired who managed the confusing business of American finance. With a fatalistic air, Butler replied that
the system was run by “God
.”

Warburg diagnosed the Americans’ malady as a fear that any reform would result in either the government’s or Wall Street’s gaining control, each an outcome dreaded by the public. Warburg would write that an “
abhorrence of both extremes
”—he might have said an abhorrence of power—“had led to an almost fanatic conviction” in favor of complete decentralization.

Thus far, Warburg had followed Schiff’s advice and kept his views from the public. However, at the end of 1906, he found himself at a dinner with a group of bankers and economists at the home of Columbia professor Edwin Seligman. The discussion turned to the
financial outlook, which many considered ominous. Warburg distilled, with his trademark clarity, just why the American financial system remained so vulnerable. His host was spellbound.

“
You ought to write
. You ought to publish,” Seligman said.

“Impossible. I can’t write English yet—not well enough for publication.”

Seligman insisted. Appealing to Warburg’s growing attachment to America, he added, “It’s your duty to put your ideas before the country.”

The gestation period was remarkably brief. On January 6, 1907, readers of
The New York Times
awoke to Warburg’s first published American article, “Defects and Needs of Our Banking System.”

“The question of the reform of the currency system is uppermost in the minds of all,” Warburg began. Mincing no words, he likened America’s system to that of Europe “at the time of the Medicis,” that is to say, in the fifteenth century.

Warburg stressed that a central bank was a requisite for developing deeper, more liquid credit markets. Even in a second tongue, Warburg waxed poetic over the centralized systems of Europe, where “the credit of the whole nation—that is, the farmer, merchant, and manufacturer . . . becomes available as a means of exchange.” Warburg wanted Americans to see that their system was weakened by its lack of unity. He vividly compared its banks to the infantry in a disorganized platoon. “Instead of sending an army,” he admonished, “we send each soldier to fight alone.”

By the time his article appeared, New York bankers had grown exceedingly edgy. The longer the boom went on, the more it relied on credit, and many felt that credit was overextended, as in a party too merry with drink. While no domestic authority existed to take away the punch bowl, America was highly sensitive to the decisions of European central banks, in particular the Bank of England.

The view in Britain was that America’s feverish economy could use some cooling down. With loan growth so rapid, the pyramid of
credit was perched on a precarious base. Was this a bubble? The Bank of England only knew that it would no longer be responsible for financing America’s expansion—particularly because the boom in the United States had been draining England’s gold. As Vanderlip was to report to Stillman, “
The Bank of England is extremely nervous
on the subject of gold exports.”

In the fall of 1906, the Bank of England took away the punch.
London raised its interest rate
from 3.5 percent to 6 percent. The Reichsbank in Berlin raised rates as well. Since international capital ever flows to where the yield is highest, these moves inevitably induced investors to ship their gold back across the Atlantic. The Bank of England further insulated the mother country from the overheated American economy by
directing British banks to liquidate
the finance bills—short-term loans—that they provided to American firms, thereby tightening credit. In the aftermath of the ensuing panic, Oliver Sprague, an assistant professor at Harvard and a reputable financial writer, judged that this was the turning point. Eighty years later, Richard T. McCulley reached a similar conclusion. When the Bank of England reversed the gold flow, McCulley wrote, “
the Wall Street boom punctured
as easily as a soap bubble.”

Wall Street tried to replace
British loans with domestic credit, but American banks, having grown so quickly, had reached a point of exhaustion. Toward the end of the year, the stock market broke. Preparing for the worst, National City tightened its lending. Vanderlip protested, but Stillman smelled a recession, possibly a nasty one. “
I have felt for some time
,” he wrote early in 1907, “that the next panic and low interest rates following would straighten out a good many things that have of late years crept into banking.” Stillman’s bank had emerged from the Panic of 1893 in a stronger position relative to competitors; he expected that prudence would pay off again. “What impresses me as most important,” he informed his chastened subordinate, “is to go into next Autumn ridiculously strong and liquid.”

The economy remained resilient into April, the mood in the
heartland one of “
buoyancy and hopefulness
”—so reported George W. Perkins of the House of Morgan to J. P. Morgan, America’s most eminent financier. But the view on Wall Street, Perkins noted, was darker.

What bankers found depressing was that banks were refusing to lend. Firms with illiquid assets were becoming nervous. As Perkins wrote to Morgan in May, there were “
a great number of people and houses
very very closely tied up with assets that they cannot either sell or borrow [longer-term] money on.” A subsequent note was nearly despairing. “As to money,” Perkins wrote, “there is still a distinct disinclination on every one’s part to
make loans for any length of time
.”

Shaw had exhausted the capacities of the Treasury—always more limited than his critics granted. What’s more, the pounding from the press had taken its toll. In March, he resigned, replaced by George Cortelyou, a political adviser and intimate of Roosevelt who was rather more timid.

Senator Aldrich, sensing the limited room for maneuvering, steered his currency bill through Congress, but it was altogether a modest one. When the bill was enacted, on March 3, the
Times
gratefully exhaled, describing the Aldrich bill as “
a partial fulfillment of hopes
that have long been entertained by the financial community for a betterment of our monetary system.” It was, in fact, no such thing.

Just as the bill was signed, stocks broke again—this time sharply. Many railroad stocks fell 50 percent before the month was out; Union Pacific, a bellwether issue, plunged 25 points in a single day. In May, business began to contract. Although the recession of 1907 began as a modest one, at the end of May, Perkins confided to the venerable Morgan, who was spending much of his time on the Continent, “No [one] seems to have confidence in anything. . . . Call money is almost unlendable.” Longer-term funds were even scarcer—and the crops were still on the vine. With an eye on the unforgiving harvest calendar, Perkins concluded gloomily, “
There seems to be a general feeling
that we are likely to have a pretty serious time next Fall.”

PANIC

A panic grows
by what it feeds on.

—W
ALTER
B
AGEHOT

Who is to be Mr. Morgan’s successor?

—I
DA
T
ARBELL

I
N
THE
FALL
OF
1907, America suffered the worst breakdown in the history of the National Banking system. Overnight, banks were stripped of reserves and the country was plunged into a severe depression. Cash (or its equivalent in gold) was all that people wanted, and cash vanished from circulation due to people’s very attempts to secure it. No agency of government was able to stem the panic. George Cortelyou, the new Treasury secretary, had neither the capacity nor the desire. “
The present head of the department
,” he wrote of his own relatively modest efforts to relieve the crisis, “has not assumed the
obligation willingly and would be glad to be relieved of it at least in part by suitable legislation.”

The word “panic” springs from Pan, the mythological god of the wilds, depicted as a man with the horns, legs, and tail of a goat, who played on panpipes and who aroused fear among solitary travelers in the forest. The Panic of 1907 generated, according to Frank Vanderlip, a “sudden, unreasonable, overpowering fright” that swept through “all the human herd.” In the thick of the crisis, Vanderlip encountered a prospective client, a promising young author by the name of Julian Street. He was clutching fifty thousand-dollar bills—his wife’s inheritance. Previously, Street had kept the money in a trust, a lightly regulated form of bank. He had gone to the trust to withdraw his money. There, the trust officers tried to dissuade him. They argued with him and cajoled him. “For your own good, Mr. Street,” the officers wailed, beseeching him to leave his funds. “Cash!” roared the author. “I want the cash!” Came the reply—“
Not so
loud,
please, Mr. Street
.” But Street’s cries echoed throughout the city, then throughout the land.

After a decade-long boom, Americans had come to think of prosperity as a given and of the financial system as robust. Rapid electrification, new techniques for mass production, and a population that had soared to 80 million had made the nation an industrial power. Businessmen believed America would never again have a panic such as in 1893. Except for the urgings of a few financiers, mostly in New York, the impetus for banking reform had languished. Most Americans were uninterested, content with the quaint decentralized system of National Banking. The Panic of 1907 shattered their complacency overnight.

Even Wall Street was caught off guard. Such crises always arrive as a shock, even to those who had sounded alarms. That summer, the level of industrial activity was weak but far from alarming. George Perkins, the Morgan partner, wrote to his eminence of “
a little let-up in general business
.”
The New York money market tightened
in the
fall, but bankers had seen that before. In October, Theodore Roosevelt felt relaxed enough to disengage from his constitutional duties and spend a fortnight hunting in the wild canebrake country of Louisiana (on the thirteenth day, the President shot and killed a black bear). More telling was that J. P. Morgan, having returned from Europe in mid-August, took leave from Wall Street again. The banker, who when not working or acquiring art took his greatest solace in religion, was in Richmond, Virginia, attending a convention of Episcopalians. The missives he received from Perkins were singularly soothing. “
There is nothing special to report
,” the latter wrote him reassuringly. On October 12, Perkins dwelled on pleasantries, noting: “
We are all very well
, and having fine weather, and hope you are as fortunate.”

The trouble started with a case of misbegotten speculation that arose, as is often the case, in a remote province of Wall Street. A well-known and rather notorious Montana copper magnate had managed to seize control of a modest New York financial institution, the Mercantile National Bank. He then used the bank to finance an attempt to
manipulate a copper-mining stock
. In October, the manipulation collapsed, putting the Mercantile in jeopardy. The bank’s depositors now displayed a keen interest in withdrawing their money, and the Mercantile sought help from the New York Clearing House, the institution that settled balances among member banks and could also provide emergency loans to members. Assistance was provided to the Mercantile on condition that its wayward president resign. There, the disturbance might have ended.

However, banking in New York was particularly exposed due to the emergence of the trusts, whose assets had swelled over the previous decade because of their willingness to pay higher rates of interest. Trusts had begun as quiet repositories for trust funds and estates, but over time they started to mimic the lending and deposit-taking operations of banks. They also invested in riskier assets than banks, such as real estate. Trusts could do this because they existed outside the regulated ecosystem of National Banking—not unlike the way, in
a future generation, special off-balance-sheet vehicles would help commercial banks to circumvent the rules. Indeed, in the panic that began one hundred years later, it was a non-bank, Bear Stearns, where the trouble started, and for similar reasons. In 1907, more than 40 percent of all deposits in New York were parked in trusts—on the periphery of the financial system.
And while a dollar in the national banks
was backed, on average, by 25 cents of cash in the till, each dollar in the trusts was supported by only 6 cents. This meant that trusts had far less protection for a rainy day.

Not only were the trusts vulnerable individually, but they (like banks in general) were linked by a chain of interlocking boards or, as it were, by a chain of reputation. The collapse of the Mercantile drew attention to another of its directors, a certain Charles W. Morse, who had interests in, and sat on the boards of, no fewer than six other local banks, three of which he controlled. Morse was a shady operator; his business methods, Oliver Sprague tactfully observed, “
had been of an extreme character
.”

Now, with unease spreading,
two of the Morse banks
were forced to seek assistance from the New York Clearing House. In return, Morse resigned
his
positions, a development
The New York Times
reported with relief. However,
Morse seems to have ratted out
one of his confreres, Charles T. Barney, a central figure in developing the New York City subways and the president of a considerably larger institution, the Knickerbocker Trust Company.
Barney and the unsavory Morse
were partners in various deals, and their association rattled the Knickerbocker’s depositors. Thus the bad coin passed from hand to hand. By Saturday, October 19, when the seventy-year-old Morgan boarded a
private railcar
to return to New York, he was aware of a widening crisis.

The next day, Morgan assembled a command staff consisting of himself, James Stillman, and George F. Baker, who for thirty years had been president of the First National Bank of New York. This venerable trio appointed a small team of younger bankers to evaluate
the worthiness of troubled banks and determine which might merit assistance. Henry P. Davison, vice president of Baker’s First National, directed this team.
Davison was immediately confronted
with a crisis at the Knickerbocker, which, as a trust and a non–Clearing House member, was deemed ineligible for assistance. The New York Clearing House, in other words, took a narrow view of its role, and no institution with a broader mandate existed. Barney resigned and, with time running short, Davison dispatched Benjamin Strong, his thirty-four-year-old protégé, to inspect the failing trust’s books.

The Knickerbocker was housed on Thirty-fourth Street and Fifth Avenue in an opulent, Corinthian-columned temple designed by Stanford White.
The sidewalk in front was besieged
by a mob of depositors, some of whom bore satchels with which they hoped to carry off sackloads of cash. Inside the bank, “
stacks of green currency
, bound into thousand dollar lots, were piled on the counters beside the tellers,” so reported the
Washington Post
.

As Strong went over the books in the rear of the bank, he could hear depositors in the
green-marbled public area
clamoring for their money. He later wrote, “
The consternation of the faces
of the people in that line, many of them men I knew, I shall never forget.”

By a little after noon on Tuesday, October 22, the Knickerbocker had paid out $8 million; it then suspended operations. Strong reported that he could not, in such little time, vouch for the Knickerbocker’s solvency. Morgan, therefore, decided not to intervene. In letting the Knickerbocker fail, Morgan knew he would be unleashing frantic runs on every other trust in the city. The resulting panic, as Schiff had predicted, made previous debacles look like child’s play indeed.

Secretary of the Treasury Cortelyou hurried to New York on the afternoon train. He met that evening with a coterie of bankers—“
with Mr. Morgan presiding
,” the
Times
reported. In a later era, no private banker would think of holding court over his federal overseers. Notwithstanding that Morgan’s was a private bank, far smaller than the big commercial banks, Pierpont Morgan had, by a country
mile, more prestige than any other banker in America. By force of reputation, he stood the best chance of corralling other banks into a cooperative rescue effort, and he was the man to whom the others turned.

The next day, a furious stampede struck the Trust Company of America, the city’s second-largest trust, and also other trusts. Strong, once more, was sent to inspect the books. When he returned to the Morgan office, at 23 Wall Street, he found Morgan with Stillman, Baker, Perkins, and Davison. He told the group that although Trust of America’s surplus had vanished, it remained solvent. Calmly, Morgan said, “
This, then, is the place
to stop this trouble.”

Morgan had not been previously acquainted with Strong. He placed confidence in him on the say-so of Davison, whose unflappable steadiness was perfectly calibrated to put the eminent banker at ease.
Harry Davison had been reared in
Troy, Pennsylvania, the son of a farm implement salesman. He was orphaned early and went to work for a small bank, where he laboriously copied figures in a leather-bound book. Davison was a striver, ambitious but possessed of an easy manner and gracious charm, qualities that sped his rise from small-town banking to the pinnacle of finance.

Davison was close to Strong partly because the latter had also tasted hardship.
Strong had been raised
in a comfortable family, but his father suffered a financial setback, forcing Strong to forgo college—a bitter pill. He entered the trust field and caught the attention of Davison, who was five years his senior, and his neighbor in the bedroom community of Englewood, New Jersey. Through Davison, Strong joined the up-and-coming Bankers Trust, and seemed on the verge of a bright future. In 1905, however, Strong’s wife became depressed and, one day, while her husband was at work, availed herself of a revolver that had been purchased to ward off burglars, and shot herself. Davison, recalling his own lonely childhood, felt compassion and took in Strong’s children. Thus the two had a bond.

By the time Strong reported to Morgan, Trust of America had less than $200,000 in the till. The Morgan group approved an emergency loan, on condition that the borrower show sufficient collateral. Employees of the beleaguered trust ferried boxes of securities to 23 Wall Street, and Strong and Morgan sat around a table assessing their worth. “Mr. Morgan,” Strong recalled, “had a pad in front of him
making figures as we went along
.” When Morgan was satisfied as to the collateral’s value, he would notify Stillman, who was in an adjacent room. Then, Stillman telephoned his underlings at National City Bank, which promptly supplied the requisite cash, with the loan to be divided among a syndicate of banks.

But the panic did not subside. On Thursday, October 24, frightened trusts pulled their loans to the stock market—laying bare the domino-like fragility of American credit. Desperate stockbrokers offered to pay 125 percent interest on call loans (short-term loans that were callable at any time). With dozens of brokers on the verge of failure, the president of the New York Stock Exchange threatened to shutter the market. Morgan felt that closing would be a mistake. He summoned the bank chiefs to his office and in roughly a quarter of an hour obtained a pledge for $23.5 million to shore up the market. National City committed to the largest share, $8 million. Stillman was discovering—true to Warburg’s prophecy—that his bank’s granite strength foisted on it unwanted responsibility in a crisis. The next day,
the fifth straight of panicky conditions
, the call rate on the stock exchange for overnight loans soared to 150 percent and the Morgan syndicate had to pledge $10 million more.

By then, a new crisis was erupting
: New York City was running desperately short of cash. Morgan summoned Baker and Stillman to his private library, a palazzolike structure adjacent to his home on Madison Avenue and, once again, the bankers arranged for an emergency loan, which kept the city government afloat.

Morgan, of course, was not the only one to provide assistance.
Over a period of four critical days, Secretary Cortelyou deposited $35 million in the city’s banks. However, at that point,
the Treasury’s surplus was exhausted
.

Now more than ever, Morgan became indispensable. He filled the vacuum of central banker like a Medici prince, holding council in the evenings in his library, which was studded with hanging tapestries, ancient Bibles, and rare medieval manuscripts. Frequently he met with Baker and Stillman, and with the unflappable Davison, into the late hours. One night, as the group debated the merits of a rescue, Frank Vanderlip was also present; Morgan puffed on his cigar, which was rolled in his particular style, forming a bulge at the outer end. After a bit, Vanderlip noticed the hand that was holding the cigar had relaxed on the table, and Morgan’s head had sunk forward. Vanderlip would write: “
We sat quietly
, saying nothing. The only sound that could be heard was the breathing of Mr. Morgan.”