WHEN ONE MAN WAS THE CENTRAL BANK / BARRON´S MAGAZINE ( HIGHLY RECOMMEDNED READING )

The Long View

FRIDAY, DECEMBER 24, 2010

When One Man Was the Central Bank

By JOHN STEELE GORDON

J.P. Morgan played a crucial role in stemming the panic that erupted in the 1907 financial crisis, in effect playing the role of central banker.
Until recently, one might have thought that something as arcane as central banking should not be a subject of much political dispute. But this is America. In addition to the current political controversy over quantitative easing, central banking was a front-and-center political issue in the 1790s, the 1810s, the 1830s, the 1910s and the 1930s.


Three times, this country has established a central bank. The first two were abolished, and the third was completely reorganized after two decades.


The various central banks have caused plenty of problems. The Second Bank of the U.S. was often flagrantly political in its operations. The Federal Reserve contributed mightily to creating the Great Depression by first keeping money tight after the stock market crash of 1929 and then by defending the gold standard in 1931, which resulted in severe deflation. And it has been the object of much criticism for its handling of the recent financial crisis.


BUT IF CENTRAL BANKS can cause plenty of trouble when they get things wrong, the absence of a central bank can be just as devastating to the economy. From 1836, when Andrew Jackson killed the Second Bank, until 1913, when Congress established the Federal Reserve, the U.S., uniquely among industrialized countries, did without one.


Lacking a mechanism to damp "irrational exuberance" in boom times and to be a lender of last resort in bad, the amplitude of the business cycle was much more severe in the U.S. than elsewhere. A series of acute financial crises that wracked the country—in 1837, 1857, 1873, and 1893—were followed by deep depressions.

The late 1890s and the first few years of the 20th century constituted a period of great prosperity. But early in 1907, the stock markets in Alexandria, Egypt, and in Tokyo crashed. There was pressure on the pound as British gold reserves shrank. Stocks declined sharply on Wall Street in March, and it looked as if the cycle was about to repeat again.


By mid-October, bank runs began at weaker institutions in New York. On Monday, Oct. 21, Knickerbocker Trust, the third-largest trust company in the city, became a subject of suspicion and fear. Early Tuesday morning, long lines formed outside its impressive new headquarters at 34th St. and Fifth Avenue.


The Knickerbocker opened for business as usual, hoping the gesture would instill confidence in the depositors. It did not. By midafternoon, with $8 million withdrawn, the bank declared itself insolvent.

It was clear that Wednesday would be a brutal day, as panic swept through the financial system. Immediate, decisive action was needed, but there was little Washington could do without a central bank to pump liquidity into the system.


Treasury Secretary George B. Cortelyou had come to New York over the weekend, promising to deposit $6 million in New York banks, and John D. Rockefeller offered $10 million more. But that hadn't done the trick. There was only one place to turn: J.P. Morgan & Co.


Wednesday morning, the corner of Wall and Broad was packed with people waiting for the banks to open so they could withdraw their money. By one o'clock, Trust Co. of America was down to $1.2 million on hand. An hour later, it had only $180,000. The bank's president rushed over to Morgan's office and asked for help. Morgan asked his lieutenants if the bank was sound. Told that it was, he said, "Then this is the place to stop the trouble." He ordered money sent over to allow Trust Co. of America to continue honoring withdrawals.

Morgan told Cortelyou to deposit money in the various trust companies that were under particular attack, but Cortelyou couldn't. Federal law required that Treasury deposits be placed in national banks only. So Morgan, unfazed, had Cortelyou deposit $35 million in national banks located in New York City and ordered them, in turn, to lend to the trust companies. They obeyed without question.


On Thursday, Oct. 24, leaders of the New York Stock Exchange went to Morgan and told him the Big Board would have to close unless some of the larger brokers could get money to handle their call-money operations, in which they lent to clients. Morgan flatly forbade the market to close and raised $27 million to tide the brokers over. He let it be known that any bears taking advantage of the situation would be "properly attended to."


That night, every important banker in New York met in Morgan's magnificent library on East 36th Street. While they met in one room trying to devise a plan to stabilize the situation, Morgan sat alone in his office, playing solitaire. "Why don't you tell them what to do?" his librarian asked.


"I DON'T KNOW WHAT TO DO," he answered with characteristic forthrightness. "But sometime, someone will come with a plan that I know will work, and then I will tell them what to do."


The plan that worked involved using interest-bearing certificates to settle accounts between the major banks at the New York Clearing House. 

Morgan was the hero of the hour, but people realized that he was 70 years old, would not be around forever, and that his successors might not enjoy his power and prestige. Even the bank-hating heirs of Thomas Jefferson realized that the world's greatest economic power simply could no longer do without a central bank. In 1913, the year that Morgan died, the Federal Reserve came into being.


JOHN STEELE GORDON is an author of business books, most recently An Empire of Wealth: The Epic History of American Economic Power.


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