The Alchemists: Three Central Bankers and a World on Fire

by Neil Irwin

  Over two continents, five years, thousands of conference calls, and trillions of dollars, euros, and pounds deployed to rescue the world financial system, central bankers would take the primary role in grappling with the global panic that began in earnest on August 9, 2007. They would act with a speed and on a scale that presidents and parliaments could never seem to muster. Over the next half decade, Jean-Claude Trichet, Ben Bernanke, and Mervyn King would create the world to come.

  • • •

  Ever since the first central banker set up shop in seventeenth-century Sweden, offering paper notes as a more convenient alternative to the forty-pound copper plates that had been the currency of what was then a great empire, money has been an abstract idea as much as a physical object. The alchemists of medieval times never did figure out a way to create gold from tin, but as it turned out, it didn’t matter. A central bank, imbued with power from the state and a printing press, had the same power. With that power, it creates the very underpinnings of modernity. As surely as electric utilities and sewer systems make modern cities possible, the flow of money enabled by the central banks makes a modern economy possible. By standing in the way of financial collapse, they’ve enabled the gigantic, long-term investments that permit us to light our homes, fly in jumbo jets, and place a phone call to nearly anyone on earth from nearly anywhere on earth.

  In modern times, when the amount of money exchanged electronically dwarfs the volume of commerce that takes place with paper money, even the physical work of printing paper dollars and euros is something of a sideline for the central banks. The actual work of creating or destroying money in modern times is as banal as it is powerful: A handful of midlevel workers sit at computers on the ninth floor of the New York Fed building in lower Manhattan, or on Threadneedle Street in the City of London, or at the German Bundesbank in Frankfurt, and buy or sell securities with a stroke of their keyboards. They are carrying out orders of policy-setting committees led by their central bankers. When they buy bonds, it is with money that previously did not exist; when they sell, those dollars or pounds or euros cease to exist.

  Frequently, words alone are enough. To the layperson, the phrase “additional policy accommodation may be warranted” might seem either insignificant or unintelligible. But it’s likely to inspire convulsive joy on the trading floors of Wall Street, London, and Hong Kong when spoken by the Bank of England governor or the ECB president or the Fed chairman: It’s the central banker’s way of saying he’ll soon be flooding the world with pounds or euros or dollars.

  Within an instant of the phrase’s hitting financial newswires, the stock market will typically rally, making a retiree in Liverpool wealthier. The price of oil will usually bounce upward, making it more expensive for a truck driver in Stuttgart to ply his trade. And the cost of borrowing money will probably fall, making it cheaper for a young couple in St. Louis to buy a house. Sometimes it doesn’t even take a full sentence, but a single word. When in 2006 a CNBC journalist at a weekend social event asked Bernanke whether markets had interpreted him correctly a couple of days before, he replied, “No,” believing he was off the record. After she reported the conversation on Monday, the Dow Jones Industrial Average fell eighty-five points within minutes.

  To a degree that’s rare among high public officials, central bankers feel connected to the long thread of history. The successes of their predecessors made the world as we know it. The Bank of England played a crucial, if often overlooked, role in creating the stable financial system that allowed Britain to rule vast swaths of the world in the nineteenth century. The creation of the Federal Reserve enabled New York to supplant London as the world’s financial capital in the years after World War I, enabling the rise of the United States as global superpower and setting the stage for a generation of prosperity that followed the Second World War. The (belated) achievement of the Fed and other world central banks in defeating the inflation of the 1970s laid the groundwork for a quarter century of stable prices and global prosperity—one that started crashing down on August 9, 2007.

  They are also, of course, keenly aware of central banking’s past failures, of which the Great Depression is only one. The actions of Bernanke and Trichet and King on that day in 2007—and on many days that would follow—were shaped by their knowledge of, for example, the collapse of Overend & Gurney in 1866. The mighty British bank’s failure sparked a panic so great that the streets of the City of London were mobbed with depositors scrambling to take their money out of other financial institutions. Thanks to the recent invention of the electric telegraph, the panic soon spread to the countryside, and even to the far corners of the empire. Facing a freeze-up in the money markets, the Bank of England, as the writer and public intellectual Walter Bagehot famously wrote at the time, lent “to merchants, to minor bankers, to ‘this man and that man,’” and thus stopped the run—though not the destructive economic downturn of its aftermath. What the ECB did on August 9, 2007, was an updated, electronic version of that same strategy, and Trichet, Bernanke, and King often invoked Bagehot’s words as a model for their own crisis response almost 150 years later.

  Bernanke and other Fed officials understood all too well the United States’ aversion to the type of centralized political control embodied by a central bank. The lack of a central bank in the nineteenth century had meant that banking panics were an almost constant feature of the American economy. Even farmers’ predictable need for cash each harvest season routinely brought the nation to the brink of financial shutdown. Yet the battle to establish the institution that Bernanke would one day lead was exceedingly bitter. The compromises needed to gain Congress’s support resulted in an unwieldy structure that would be a challenge to lead, especially as those old arguments against centralized power reemerged a century later.

  The men who led the global economy in the crisis that began in 2007 had come of age in the 1970s, when central bankers were so fearful of an economic downturn—and the political authorities—that they allowed prices to escalate out of control. “I knew that I would be accepted in the future only if I suppressed my will and yielded completely—even though it was wrong at law and morally—to his authority,” wrote Fed chief Arthur Burns in his diary in 1971. “He” in this case was Richard Nixon, who insisted that Burns keep interest rates low and the U.S. economy humming in the run-up to the 1972 election. Prices rose so fast that steakhouses had to use stickers to update their menus according to that week’s cost for beef. Central bankers have been vigilant about inflation ever since—for better and, especially in the 2000s, for worse, when some saw inflationary ghosts where there were none.

  But no specters of the past loomed larger for Trichet, Bernanke, and King than the missteps taken by the central bankers of 1920s and ’30s. It was then that the Reichsbank of Germany printed money on a massive scale to fund the nation’s government, so much so that people needed wheelbarrows to carry cash to the grocery store and would buy bicycles or pianos to hold value that reichsmarks couldn’t. That hyperinflation led to the desperate circumstances that allowed the Nazis to gain support. What came next would enable their rise to power.

  The Great Depression was at its core a failure of central banking. Just a few blocks away from the building in Basel, Switzerland, where the central bankers of the early twenty-first century drank good wine and plotted their response to the contemporary crisis, the central bankers of the early 1930s met in a hotel and found far less to agree upon. Blinkered by nationalistic distrust, a misguided commitment to keep their currencies tied to gold, and the lack of a common understanding of how economies work, they concluded that the global economic crisis of 1931 was beyond their ability to combat. Even the technological limits of communication in that era—transatlantic phone calls were accomplished with great difficulty, and jet travel wasn’t yet an option—stood in the way of men like the Reichsbank’s Hjalmar Schacht and the Bank of England’s Montagu Norman. Their shortcomings led millions of people i
nto dire poverty and created a fertile environment for World War II.

  The European currency union that Trichet led—and which in a later phase of the crisis he would take extraordinary steps to try to preserve—was itself a direct result of that conflict. Born in Lyon in 1942, during the German occupation of his homeland, the ECB president grew up in a country rebuilding after the devastations of occupation and war. Like other postwar leaders, he was so intent on creating a continent where armed conflict might never break out again that he made a unified Europe the mission of his lifetime. The euro was their crown jewel, the physical embodiment of that effort—and an accomplishment that the great global crisis of the twenty-first century would eventually threaten to destroy.

  • • •

  The partnership between Trichet, Bernanke, and King was one between men of different backgrounds, temperaments, and intellectual proclivities—differences that would loom large in the events yet to unfold. Beginning that Thursday, the three men atop the central banks of the major Western powers could only look to each other to find ways to see beyond those differences.

  When they took their respective jobs—in 2003 for Trichet and King, in 2006 for Bernanke—they joined a brotherhood of uncommon intimacy. The world’s top central bankers meet in person frequently—at an economic conference each summer in Jackson Hole, Wyoming, on the sidelines of countless global summits, and, most significantly, six times a year in Basel, where they take brief refuge from the politics, personal attacks, and hard choices that come with doing a job most people don’t quite seem to understand and more than a few regard as sinister.

  They speak the same language, literally and figuratively: All speak good English and are deeply versed in the discourse of economics. Foreign ministers, finance ministers, and defense ministers may have cordial relations with their counterparts from other nations. Some may even become friends. But none of those leaders have the same sustained, intimate exposure as the central bankers to the personalities and thinking, idiosyncrasies and blind spots of their international colleagues. Central bankers understand more deeply than perhaps anyone else where other countries are coming from. They share a closeness unheard of elsewhere in international relations, knowing with great confidence that what is said at the table in Basel will stay there.

  There were some older connections between the leaders of the ECB, the Fed, and the Bank of England, too: King and Bernanke had shared an office suite as young faculty members at MIT; Trichet and King had met when King was a student at Cambridge and Trichet, a young civil servant, had gone abroad to study the British tax system. But the panic that began that August day in 2007 would test their bonds as well as their ability to come together to guide the global economy toward prosperity.

  Mankind had given them incredible power. Now was the time to show that they had learned history’s lessons. As the consequences of a generation of bad lending and rising debt started to unfold, this committee of three knew better than anyone just how high the price of failure could be.

  To understand fully how these three men came to wield such incredible power, one first must know where central banks came from to begin with. That story starts, of all places, in Sweden, a very long time ago.

  Part I

  RISE OF THE ALCHEMISTS, 1656–2006

  ONE

  Johan Palmstruch and the Birth of Central Banking

  He was a broken and desperate man, at the end. Johan Palmstruch, a Latvian-born, Dutch-raised, Swedish-residing banker defended himself against a prosecution that likely seemed more like an inquisition. A nation wanted to know where its money had gone, and the best answer Palmstruch could muster was to describe the chaos of those final days of the world’s first central bank, when depositors and government investigators lined up outside the bank’s doors, “snork, pork, scolding and swearing.” Who, he asked, “in the midst of such daily tumult, threatening, swearing, scolding and parleying, in danger of life and limb . . . could note and thereby keep a book?”

  The investigation into Palmstruch’s Stockholms Banco had discovered not only that tens of thousands of daler were missing from its vault, but also that the near failure of the bank had cost the Swedish crown a vast sum. Palmstruch was ordered to repay what the bank had lost. When he couldn’t, he was to be executed. This was, after all, 1668, not 2008, and Palmstruch’s actions as a man with the power to print money at will had decimated Swedes’ personal savings, wrecked their national economy, and forced the government to intervene to prevent complete catastrophe.

  Palmstruch’s sentence was commuted in 1669, and he was released from prison in 1670. When history’s first central banker died a year later, he was known not as a monetary wizard, but as a criminal who’d taken the economy of one of Europe’s great powers on a wild ride. During the course of half a decade, there had been a credit boom and an accompanying rise in the standard of living, then a surge of inflation, followed by a credit bust and a recession.

  In other words, over just a few short years, Sweden had experienced both the best and the worst of central banking. But Johan Palmstruch and everyone else involved in Stockholms Banco had also done something more: They had begun the modern era of global finance, and all that is great and awful that would emerge from it. To properly understand how the Boys in Basel responded to the financial conflagration of 2007 to 2012, it helps to understand how they came to wield such power to begin with. And that is a story that begins with Johan Palmstruch.

  • • •

  The country may now be better known for minimalist furniture and pop music than for imperial designs, but for much of the seventeenth century Sweden was one of Europe’s great powers. It commanded an empire that stretched across Scandinavia and into what are now the Baltic nations and parts of present-day Germany, Poland, and Russia.

  The nation attained its prominence on the global stage despite lacking some of the advantages of its rivals in continental Europe. With one million or so citizens, Sweden was only one sixth as populous as Britain and one twentieth the size of France. Its agricultural sector wasn’t terribly productive either—after all, the country is dark and cold eight months a year. Food was so scarce that peasants mixed tree bark into their bread dough to make it go farther. But the Swedish economy wasn’t without strengths: Without the productive farming of France or Britain, it relied heavily on fishing and iron and copper mining. But for a truly vibrant commercial sector to exist, of course, there needs to be a medium of exchange, a method of trade more flexible than mere barter: salt, perhaps, or seashells or metal coins. In 1534, with Sweden newly established as an autonomous state, it minted its first daler. The similarity in pronunciation to the present-day U.S. currency is no coincidence.

  Well into the seventeenth century, however, the Swedes were having a hard time getting their daler into the hands of people who wanted them. They needed a system of institutions to store, distribute, and lend money. In Amsterdam, Hamburg, and London there had emerged companies that did just that, and in parts of Italy variations on the idea had been around for centuries. But the Swedish language had no word for it in the early 1600s. So in 1619 the king and members of the merchant class got together, borrowed the Italian term banca, and turned it into the Swedish word bank. They couldn’t agree on who would provide the start-up financing for these new institutions. King Gustavus Adolphus and his powerful chancellor, Axel Oxenstierna, wanted the towns of Sweden to fund the banks. The merchants in those towns wanted the king to take on the expense—and the risk. During the stalemate, three decades would go by in which Sweden lost ground in commerce because there wasn’t enough money circulating. The Swedes had a word for a banking system, but not the system itself.

  An outsider would change that.

  Hans Witmacker was born in 1611 in what is now the Latvian capital of Riga, the son of a successful Dutch merchant. As a young man, he went to work as an entrepreneur in Amsterdam, which had the world’s most highly develo
ped banking system at the time. At the age of twenty-eight, Witmacker was jailed for failing to pay his debts. Once released, he made his way to Stockholm, then a bustling world capital of forty-five thousand people, to remake himself. He even took on a new name: Johan Palmstruch.

  No portraits of Palmstruch or descriptions of his personal manner have survived. But it seems fair to assume that he was a smooth talker. He must have conveyed seriousness, probity, and wisdom and been able to make people trust him without a second of doubt. Those abilities were surely coupled with enough charm and charisma to endear him to the wealthy and powerful. If that wasn’t the case, none of what happened next makes any sense.

  King Karl X Gustav was hoping to realize Gustavus Adolphus’s dream of establishing a bank that would finally modernize Swedish commerce. He trusted a forty-five-year-old foreigner who presumably talked a good game about his knowledge of the Dutch banking system. By royal decree, the king authorized the creation of Stockholms Banco on November 30, 1656, to be run by Johan Palmstruch. It is unclear whether he knew anything of Palmstruch’s checkered past.

  Palmstruch certainly knew how to cover all his political bases. Half of the bank’s profits were to be given over to the king. And Palmstruch gave more than a dozen powerful Swedes, the chancellor of the realm and the president of the board of trade among them, a share of the bank’s profits without requiring them to put up any capital. One of those shareholders was later named by the king as “chief inspector of the banking system”—which, it is safe to say, isn’t currently considered a best practice in the field of bank regulation.