If the first half of the nineteenth century in Britain was dominated by the Napoleonic wars and their aftershocks – strikes, demonstrations, suffrage demands – the nation settled down after 1850 to the far happier decades of the Victorian Era. One conception of revolution replaced another. What had been universally recognized as an age of democratic revolutions around the world gave way to an age of industrial revolutions, one following on the heels of another: Adam Smith and the steam engine in the first instance (as the economic historian Arnold Toynbee put it in 1884); electricity. chemistry, the internal combustion engine and oil in the second. The periodic panics continued – another in 1837, the year Victoria inherited the throne.
A great boom in the 1850s created the foundation of a global industrial economy, with London as its financial capital. Cotton led the way, also grain; almost everywhere food riots became a thing of the past. The discovery of new gold fields in California and Australia accelerated the pace. In the 1870s and ’80, Germany and Japan became manufacturers and built out railway networks of their own. The British fought periodic wars to enforce their ideas about free trade: in China, India, the Crimea, Africa, New Zealand, Afghanistan.
The new technologies, especially railroads, required great quantities of capital. The banks that had grown large financing armies during the Napoleonic wars were well suited to convert savings into investment in the new age – the Barings, the Rothschilds and, in North America, the Morgans. Joint-stock banks appeared in increasing numbers, as the law allowed, channeling the savings of ordinary persons – freed from the unlimited liability of the sort that had threatened to ruin the partners in the Ayr Bank.
In 1856 there was another panic. Karl Marx had become the New-York Tribune’s man in London. He wrote, “What distinguishes the present period of speculation in Europe is the universality of the rage.” There had been manias before, Marx wrote – corn, railway, mining, banking, cotton, and one or another had lent its name to each of the great commercial crises of 1817, 1825, 1836, 1847. This one was different, he said: it appeared to have started in France, and involved a new sort of institution, called a credit mobilier, supposedly to supply a degree of missing entrepreneurship, succeeding mainly in centralizing the swindling. It took ten days for a dispatch to cross the Atlantic in those days; it turned out the panic probably had started in New York.
About the same time, a young country banker, writing on the life of Edward Gibbon for a literary quarterly reflected on the Great South Sea bubble (in which, it turned out, the historian’s great-grandfather had made, and lost, and regained a fortune):
Much has been written about panics and manias, much more than with the most outstretched intellect we are able to follow or conceive, but one thing is certain, that at particular times, a great deal of stupid people have a great deal of stupid money…, at intervals, from causes which are not the present purpose, the money of these people – the blind capital, as we call it of the country — is particularly large and craving; it seeks for someone to devour it, and there is a “plethora”; it finds someone, and there is “speculation”; it is devoured, and there is “panic.”
This was Walter Bagehot, working in his family’s business in Somerset, in the west country of England. James Wilson, proprietor of The Economist, by by now in service in the Treasury in Palmerston’s government, was looking for an editor. He invited Bagehot to write for the paper (as its staffers call the thriving weekly magazine down to the present day). Before long Bagehot married Wilson’s daughter. When Wilson died of dysentery, in Calcutta, at 52, Bagehot succeeded his father-in-law.
. “Money Will Not Manage Itself”
Bagehot was relatively little known in London when he became the second editor of The Economist, in 1860. He was 33. But he was an accomplished writer and a forceful personality; and even if the little weekly had a circulation of no more than 3,000 copies, he quickly rose to prominence. British trade was soaring, led by cotton and the opium trade in China. Civil war had broken out in the United States. Then, as now, the paper had a network of well-connected correspondents all around the world; Bagehot’s connections to the City as a banker were especially valuable. The Economist wielded influence out of proportion to its size.
Then came the crisis in 1866, the failure of the Overend Gurney bank, which nearly wrecked the entire City of London. Alarmed by the risks London banks had taken that led to the Panic of 1857, the Bank of England announced in 1858 that no longer would it lend to bill-brokers who found themselves in trouble – credit-monitoring intermediaries one step away in the risk-bearing chain that led to the banks. Instead of damping the old Quaker bank’s appetite for risk, it was whetted. As Bagehot late wrote,
In six years [the immensely rich partners] lost all their own wealth, sold the business to the company, and then lost a large part of the company’s capital. And these losses were made in a manner so reckless and so foolish, that one would think a child who lent money in the City of London would have lent it better.
When doubts about its solvency finally led to a run on the bank, Overend appealed to the Bank of England for aid. It was refused, much as was Lehman Brothers’ appeal in 2008, on the grounds that the Bank wasn’t permitted to save a single firm. The entire system nearly collapsed. Only the news that the government had removed the Bank’s ceiling on lending ended the Panic. The recession that followed was the worst since 1825.
Bagehot decided that the crisis resulted from ignorance on the part of the men who ran the central bank that was too deep to be borne. He took leave from his editorship and, in 1873, published Lombard Street, or, a Guide to the Money Market. His little book would be no lofty text of high abstraction, he wrote. The money market was as real and concrete as the street in London’s financial district, the ancient Roman City of London, along which its most important firms were arrayed. Its operations could be described in plain words in a couple hundred pages.
From the first chapter, Bagehot targeted those policy-makers who routinely invoked the principle of laissez-faire in banking (he didn’t include the sainted Adam Smith, naturally). He was no alarmist, Bagehot wrote; the system could be operated safely, as long as it was well studied and understood. But “we must not think we have an easy task when we have a difficult task, or that we are living in a natural state when we are really living in an artificial one. Money will not manage itself, and Lombard Street has a great deal of money to manage.”
By now the rhythms of the periodic crises were pretty well recognized if not understood. Every dozen years or so, for at least 150 years, there had occurred a financial crisis. Credit – “the disposition of one man to trust another” – would be threaten, and then somehow mysteriously restored. “[A]fter a great calamity, everybody is suspicious of everybody; as soon as that calamity is forgotten, everybody is again confident in everybody.”
Why should this pattern persist? There were the occasional accidents that could trigger a sudden demand for cash in a country that had learned to operate a system of credit in order to economize on gold: a bad harvest, the threat of invasion, the unexpected failure of a respected firm. But the constantly changing industrial organization of the economy itself tended to generate surprises of its own, giving rise to the notion that panics come according to a fixed rule, “that every ten years or so we must have one.”
What to do about them? The first rule was to keep a great reserve of gold stored up in the Bank of England against the fear of shortage. The second was to use it when needed, lending freely to banks threatened by runs until confidence was restored, at a higher rate than usual, to discourage recklessness, and against food collateral, meaning mainly their performing loans. An insolvent bank should be closed, its owners deprived of their investment, its assets taken over by better capitalized firms, its depositors made whole by the bank.
The third rule was to make certain that the bank’s directors were men who understood the workings of the first two rules. Bagehot was hard on those who greased the rails to earlier crises, then abdicated adequate emergency lending when the panic finally arrived, throwing the whole expense of rescue in the Exchequer. “It is not easy to rouse men of business to the task,” he wrote. “They let the tide of business float before them: they make money or strive to do so while it passes, and they are unwilling to think where it is going.” (Bagehot’s story is laid out in Alastair Buchan’s splendid little 1958 biography, The Spare Chancellor: The Life of Walter Bagehot.)
When it appeared in 1872, Lombard Street was an immense success. It seemed to encapsulate nearly all that was necessary for the safe operation of a system of paper money, in this case, under the discipline of a gold standard. Bagehot began a running battle with Thomas Hankey, a longtime director of the bank, who maintained that the doctrine of lender of last resort was ”the most mischievous doctrine ever breathed in the monetary or banking world,” for what Hankey believed was its tendency to encourage irresponsible behavior. Bagehot dismissed the argument, stressing the desirability of there being a standard operating procedure. Both men missed the inevitable ambiguity. Charles Kindleberger put it this way in 1984:
Knowledge that a bank or firm will be saved from folly does, in fact, increase its temptation to relax high standards and indulge in folly. On this score, one must swear not to rescue it. On the other hand, once the folly has been perpetrated, it is in the nature of bankruptcy and failure to spread, like fire, avalanche, runaway horses and panic in a crowd. At such times, it is incumbent on responsible authorities to take steps to arrest collapse.
Bagehot set out to write a book about the relationship between economic theory and business practice – The Postulates of Political Economy— but didn’t get very far. He died in 1877, at 51. He had eclipsed James Steuart and Henry Thornton and become the premier monetary theorist of the Victorian age. Thanks to him, the Bank of England had begun to learn how to manage its reserve and use its discount rate. Business cycles continued, but such was the growing confidence with which the Bank now conducted its operations that there wouldn’t be another panic in Britain for nearly 150 years, until the run on Northern Rock, in 2007.
. Competition, perfected
Bagehot kept his eye on the community of economists. He had long recognized a young engineer, William Stanley Jevons, as a rising talent. In 1874 he noted that Jevons, of Manchester, and Leon Walras, of Lausanne, had nearly simultaneously, without benefit of communication, worked out similar mathematical theories of political economy. This was generally all to the good, Bagehot felt, as economists needed their theoretical “all-case method” as businessmen needed Bagehot’s own practical “single-case method,” but he warned:
[A]nyone who thinks what is ordinarily taught in England objectionable, because it is too little concrete in its method, and looks too unlike life and business, had better try the new doctrine, which he will find to be much worse on these points than the old.
The new doctrine would come to be known as marginalism. It had two major tenets: that value was subjective, and that the law of diminishing returns applies equally across the entire spectrum of human wants. Ricardo had thought that prices were what they were because of the labor required for their production; Jevons argued (as Richard Whately had thirty years before) that pearls were expensive not because men dived for them, but that men dived for them because other men thought them valuable. The quality that men found desirable in pearls, and in everything else under the sun – that is, the satisfaction they supplied – Jevons labeled their “utility.” The last little bit of satisfaction that possession of them supplied, their marginal utility, compared to that of all other objects of desire, “is that function upon which the theory of economics will be found to turn.” Thus understood, Jevons wrote in the preface to his Theory of Political Economy, in 1871, the problem of the individual making the most of his money budget
presents a close analogy to the science of Statical Mechanics, and the Laws of Exchange are found to resemble the Laws of Equilibrium of a lever as determined by the principle of Virtual Velocities. the nature of Wealth and Value is explained by the consideration of indefinitely small amounts of pleasure and pain, just as the Theory of Statics is made to rest upon the equality of indefinitely small amounts of energy.
In other words, the utility of one use of money was to be balanced off against all others, both in the theory, and in the mind of the consumer that the theory was intended to capture and abstract. In this way economists adopted the tool of differential calculus for the powerful support it provided of their original intuition of an Invisible Hand.
Walras took the system further. It was not just consumer markets that were determined this way, as Jevons argued, but prices and quantities in markets for all things – for commodities, products, profits, rents, and the wages of all kinds of labor.The intuition was elaborated by mathematical economists around the world as marginal productivity theory and sometimes trumpeted to the world as proof that each person was compensated in precise and just proportion to what he contributed to economic production. Consumer sovereignty” was another dubious implication of the new marginalism, which had the further advantage of relieving economists of the need to have to say anything much about the determinants of population.
Economics had, in the views of many, taken another step towards being understood as a science. Oxford appointed Francis Ysidro Edgeworth as Drummond Professor of Political Economy. Cambridge appointed Alfred Marshall. It was Marshall who published the textbook, Principles of Economics, in 1890, that finally supplanted Mill’s Principles of Political Economy. It was, he said, a book of curves, of diagrams of supply and demand that seemed to tie together all the disparate strands of what Marshall described as “the study of mankind in the ordinary business of life.” Marshall promised a second volume on money and banking and growth, but delivered only Money, Credit, and Commerce, a feeble effort, in 1923, a year before he died.
. The American System
By the time that Marshall wrote in 1890 the expense of maintaining its global empire was becoming apparent to Great Britain. The United States was becoming an industrial giant in the second half of the nineteenth century – so were the newly united German-speaking lands. English observers after 1850 began speaking of “the American system of manufacturing,” chiefly meaning interchangeable parts. First it was first arms, then sewing machines, watches, furniture, mechanical reapers, bicycles, and eventually automobiles. The “American system” grew and changed so much over seventy years, writes the historianDavid Hounshell, that by the 1920s it had a new name: “mass production.”
From the beginning, the American way of doing things had been different in important ways from the British system. Take paper money. Benjamin Franklin had been among the most prominent advocates of it (he was enthusiastic, too, about economizing candle wax through the use of daylight savings time) His friend Adam Smith cautiously approved: this was, after all, the period in which Scotland’s banks, including the Ayr Bank, were widely admired. Revolutionary War finance all but destroyed the paper currency of the North American colonies, but the first US congresses, following a blueprint devised by Alexander Hamilton, chartered a Bank of the United States that was loosely modeled on the Bank of England; created a national currency; funded its public debt; and levied taxes, mostly in the form of import duties.
Sectional rivalries spelled doom for the Bank of the United States: after twenty years, in 1811, Congress refused to renew its charter. The second government bank met the same fate in 1836. President Andrew Jackson explained that he had been afraid of banks ever since he had read about the South Sea Bubble. There followed a quarter century of free banking, a wild and crazy time with thousands of kinds and denominations of bank notes circulating during the period. The story is surpassingly well told in Banks and Politics in America: From the Revolution to the Civil War, by Bray Hammond, which received a Pulitzer Prize in 1957.
With no federal supervision, there were panics in 1814, 1819, 1837, 1857, 1850 and 1861. The Civil War required a more elaborate system. The National Banking Acts of 1863 and1864 created a system of federally-chartered national banks, and a currency of bank notes, issued by national banks, backed by US Treasury securities held by those banks: the idea was to create a demand for government debt necessary to finance the war. An Office of the Comptroller of the Currency would examine the banks and oversee the system. The reserve requirements would eliminate banking panics, or so it was hoped. But they continued anyway: in 1873, 1893, and 1907, with incipient panics in 1884 and 1890 were quelled by bank clearing houses. These institutions originally copied from Scottish and English counterparts. The idea was to centralize the settling of accounts among banks in one place, instead of each bank sending runners to every other. They began holding specie for member banks, clearing claims with assembly-line efficiency, and, when member banks were threatened by runs, throwing temporary cloaks of collective accounting anonymity around them, and issuing clearing house notes themselves. In other words, the clearling houses resembled local central banks.
US industry grew furiously in those years and, with it, the demand for banking services. The Panic of 1907 brought matters to a head. This time it was not the run on the federally-regulated banks themselves that posed the greatest threat; it was the the money trusts, the shadow banks of their day. The New York Clearing House was stretched to the limit; in the end, only the audacity of J.P. Morgan himself saved the day: he locked bankers in his study until each agreed to contribute share of the funds necessary to staunch the run. The moral was clear. The banking industry had grown beyond the bounds of self-regulation. In the future, government would have to take over the job of regulating the banks
So the project to create a less panic-prone banking system took wing.. A more elastic currency than the National Banking Act allowed was an objective, too: a supply of money that would expand and contract with the seasons. The Federal Reserve Act of 1913 benefitted from Paul Warburg’s well-organized and well-funded lobbying effort in Congress on behalf of Wall Street, as J. Laurence Broz has argued – Warburg’s pitch was that without a central bank, New York couldn’t compete with London. Representative Carter Glass, of Virginia, is often described as the father of the Fed, since he wrote the bill, with the assistance of his legislative assistant, H. Parker Willis. But it was Senator Nelson Aldrich, of Rhode Island, who did the first heavy lifting, according to Elmus Wicker, of Indiana University, in The Great Debate on Banking Reform: Nelson Aldrich and the Origins of the Fed.
It was Aldrich who overcame opposition to central banking in the Congress dating back to Andrew Jackson and before when he sponsored the Aldrich-Vreeland Act in 1908, with its provision for “emergency currency,” which laid the foundations for the Fed; who led the successful argument for federal currency, replacing the asset-based currencies that had been issued by the banks; who arranged the clandestine meeting of young Wall Street bankers on Georgia’s Jekyll Island from which a draft bill emerged; and who graciously stepped aside when Glass became chairman of the House Banking and Currency Committee and Woodrow Wilson was elected President. Glass added a provision that as many as a dozen regional banks be added to the system, Wilson supported the bill, and Congress passed it in December 1913.
. The Fed: A Promising Beginning
The Act left almost all the details to be filled in. An Organization Committee was formed and, after much argument, chose twelve cities for the district banks, designed their elaborate governance, enlisted more than 7,000 national banks into membership in the system. Wilson nominated five “members” of the Federal Reserve Board, all of whom ran into problems with public or Congressional opinion for one reason or another. Not until August 10, 1914, was the board formally sworn in, with Charles Hamlin as its governor (its chairman), Frederic Delano as vice- governor. Germany had invaded Belgium the week before, precipitating British Entry into World War I. There was immediate panic in New York, as Europeans sought to turn their American paper into gold.
That the Fed was not yet open for business didn’t matter. Treasury Secretary William McAdoo invoked his powers under the Aldrich-Vreeland Act, which ordinarily would have expired; its life had been extended for a year until the Fed was ready. He closed the Stock Exchange for four months and permitted national banks to issue notes of their own without the usual requirement that they be backed by government securities – “emergency currency.” By November the crisis had abated.
Before long, it became clear that the real power resided in the New York bank. Its president was hired by the bankers who dominated its board of directors. They chose Benjamin Strong, a J.P. Morgan partner who been served as Morgan’s lieutenant in the 1907 crisis. Strong was ”a new kind of public servant, a banker who organized expertise on behalf of the government,” according to his biographer, Lester Chandler, of Princeton University. In Congressional testimony many years later, Strong described the beginning of the Fed this way:
The men who were engaged in running the Federal Reserve System were handed this Act as a printed document… and told to open Federal Reserve Banks in sixteen days; and from that time on, with a great war raging, we were expected to construct, out of thin air, something that had not existed here for over eighty years. And I am frank to say that we knew mighty little about it.
In 1916, Strong learned he had tuberculosis. After that he was less involved; he led mainly through force of personality. The New York Fed did pretty well in 1920, when restrictive policies broke post-war inflation and commodity prices plunged. Strong, in a letter to Montague Norman, governor of the Bank of England, wrote that the bank has cut short the resulting slump by following “the principle, first enunciated by Bagehot,” that in such times the bank should lend feely to those who came to its discount window, though at a penalty.
The 1920s – the Roaring Twenties — have been described by scholars as the “high tide” of the Fed. The economy grew rapidly for most of a decade without interruption. The New York bank learned how to influence the tides of business, manipulating short-term interest rates by buying and selling government bonds in the open market. It experimented with techniques for controlling stock market bubbles. Bankers debated its powers and adapted to them. Nobody did more than Strong to translate the Fed into “a unified system of institutions operating with dignity, power and devotion to the public interest,” according to biographer Chandler.
Unfortunately, Strong died in 1928, just as things were getting interesting.
. Economics: a 150th Birthday Party
Here matters stood in 1926, when the sesquicentennial of the publication of The Wealth of Nations was celebrated in London and, in Chicago, with a series of lectures. What remained of Adam Smith?
“Very little,” replied Edwin Cannan, a student of Jevons who had prepared the edition of 1904 of the great book. Ricardo had come to be thought of as the founder of economics. Smith was dismissed for his errors, patronized for his penchant for narrative, mocked for his modest talents. Paul Douglas, then a young Chicago professor and a future US senator, considered skipping over Smith’s theories of value and distribution “in discreet silence,” dilating perhaps on the division of labor instead, “where [Smith’s] realistic talent enabled him to appear to better advantage.” But Douglas didn’t – instead he described the newfound understanding of how the Invisible Hand determines the shares and payments received by landowners, capitalists and laborers, the theory of marginal productivity. The pin factory, with its economics of scale, would remain almost entirely unexamined for another fifty years.
And the Daedalean wings, as Smith had characterized modern paper money? John Maurice Clark, of Columbia University, reckoned that Smith’s zeal to dethrone money from its high rank in mercantilist thought “probably carried with it a certain underestimate of its importance as a tool: an error we are now attempting to rectify.”
The exception was Jacob Viner, a Chicago professor even then recognized as the world’s most learned student of Smith. Smith’s unifying concept of coordinated and mutually interdependent relationships of cause and effect had brought order to the wilderness of economic phenomena, Viner wrote – in others words, a model, probably more than one. So what if Smith approached his subject with “more catholicity than scientific discrimination?” Viner concluded his essay this way:
In these days of contending schools, each of them with the deep, though momentary conviction, that it, and it alone, knows the one and only path to economic truth, how refreshing it is to return to The Wealth of Nations with its eclecticism, its good temper, Its common sense, and its willingness to grant that those who saw things differently from itself were only partly wrong.