Saturday, February 7, 2009

Blaming the Bankers

Many conspiracy theories revolve around people like JP Morgan, John D Rockefeller and Andrew Carnegie. Some people point to the foundations the endowed, claiming they engineered everything from the collapse of the constitution,to the Russian Revolution, gay rights, animal rights, environmentalism and the creation of the United Nations.

My problem with these kinds of conspiracy theories is that these men loomed so large in history and spent so much money on so many causes that you can link them to just about anything. They are like oil tankers on a small pond, leaving a flood of money, decisions and philanthropic endeavors in their wake.

So instead of another conspiracy theory that cites obscure meetings or letters from a century ago, I would like to offer a different narrative based on commonly accepted facts. It is my own unique interpretion of well established history.

First, I would like to blame the current mess in the economy on JP Morgan Jr., who died in 1943 -- 65 years before the collapse of Lehman Brothers. That might sound like a long time, but I actually trace the mistake even further back, to 1915.

Here's the sequence of events:
  • At the start of WWI, France and Britain hired JP Morgan as their purchasing agent for war materiel in the USA.
  • Secretary of State William Jennings Bryan resigned in protest of the U.S.'s implicit support of the Allies in June 1915. He was replaced by State Dept lawyer Robert Lansing, who wanted the U.S. to support trade with and lend to the Allies.
  • By August 1915, France and Britain were running out of money.
  • In October JP Morgan syndicated a $500mln loan so they could keep fighting and continue buying America's guns and butter.
  • The U.S. economy enjoyed massive growth supplying the Allied war effort, doubling in nominal terms in just four years.
  • By early 1917, millions of men had been killed, but France and Germany were again on the brink of defeat. By now their debt to JP Morgan had trebled to $1.5bln. If they had defaulted, it would have represented about 3% of U.S. GDP -- a big enough loss to trigger financial crisis.
  • In April 1917, the U.S. declared war on Germany and immediately lent hundreds of millions of dollars to France and Britain, which promptly used the money to repay the Morgan loan.

Most of the historical information referenced here comes from Ferdinand Lundberg's 1937 book America's 60 Families. I own the original, but the key chapter is replicated online here. For correspondence by some of the officials involved, see this link.

Many people have argued that the U.S. went to war to save JP Morgan. This may or may not be true, but it's not the kind of historical finger-pointing/conspiracy theory that interests me.

My concern is about how resources get allocated. I believe that when loans and investments are made "improperly," bad things inevitably happen.

Before WWI, the global financial system relied on the British gold standard. Countries needed to have possession of physical gold in order to print paper money. When one country spent too much money on imports, it lost gold and thus lost money. This would then force its interest rates higher, which in turn would attract gold from abroad in the form of loans.

This system worked remarkably well for over a century. All currencies were valued in ounces of gold, and you could bring your paper money to the government and get physical gold in return.

One of the best best things about the gold standard is it limited the ability of countries to wage war. During war, a country devotes money to fighting, rather than producing goods and services. As was the case with Britain and France, they needed to import large amounts of materiel from the U.S. Germany, on the other hand, was in a much stronger position. Europe's biggest economy, it had a diverse industrial base, large population and short supply lines. It was much less dependent on foreign trade to survive.

As a result, the war drained gold from Britain and France. If it hadn't been for JP Morgan Jr.'s original $500mln loan, they would have been forced to sue for peace sometime during 1915. (They knew very well the lessons of the 17th and 18th centuries, when war bankrupted Spain and France.)

My key point is that, when Morgan made that loan, it marked the end of the old gold-standard system. He gave them the loan despite their ability to repay it. While this has never been established historically, I think it is safe to say that he always knew that the U.S. would eventually enter on the Allies' side to bail him out. After all, President Woodrow Wilson and Sec. of State Lansing had already endorsed the policies of providing loans and armaments. Furthermore, Morgan's investors included some major figures of American society, such as Andrew Carnegie (steel magnate), George F. Baker (banker who endowed Harvard business school), Samuel Untermyer (prominent corporate lawyer and Democratic party insider), along with many of Morgan's corporate clients.

He also knew that the war effort would enrich the American business community and entwine the country's economy in the war. By 1917, if Britain and France had surrendered and reneged on their debts, it would have caused financial crisis in the U.S. The chart below, based on data from, shows the change in nominal GDP during the war years:

The U.S. and Morgan essentially "broke the rules" of the global gold standard by allowing a loan that could not be repaid. I posit that Morgan always knew he'd get "bailed out" if the war effort went against him. (He was, in fact, bailed out, as I mention above.)

Morgan lent money to Britain and France, despite their inability to score any major victories against the Germans. He then continued to lend even more as they continued to lose on the field of battle. If there was ever an instance of throwing "good money after bad," this was it. There is simply no way he did this without an implicit sense that Washington would come to his rescue.

My key point is that this was an "improper" loan. It wasn't based on the established rules of banking or credit analysis. It was made with the knowledge a bailout was probable, allowing Morgan to engage in excessive risk-taking. Sound familiar? To borrow an expression from today, his profits were privatized while the losses were socialized.

This shows the perils of having the government bail out anyone, or providing any kind of support to something that doesn't make sense economically. It inevitably creates distortions, which in turn cause even bigger problems.

It's also worth noting that JP Morgan Jr. acted with the potency of a public official even though he never worked for the government. His father had financed much of the American industrial revolution and single-handedly saved the financial system in 1907. The younger Morgan was instrumental in the creation of the Federal Reserve in 1913 stood at the crossroads of the banking system and securities industry. Some people have also credited the Morgan group with with Wilson's victory in the 1912 election. (Morgan financed Teddy Roosevelt's Bull Moose campaign, which split the Republican ticket.)

It's safe to say that Morgan was one of the most powerful men in the world. He knew he was too big to fail, and that he had the influence to get his money back somehow. (Again, don't forget that, before we sent a single soldier to Europe, Morgan started getting paid back by the U.S. taxpayer.)

I want to take it a step further. If JP Morgan hadn't arranged this loan in 1915, history would have been very different:

  • The war would have fizzled out in about 18 months sometime in 1915. Instead it lasted for another three years.

  • Millions of men would have lived.

  • The German Kaiser and Russian Czar would have stayed in power.

  • There would have been no Hitler, no Soviet Union, and probably no Mussolini.

  • There would have been no Holocaust and no United Nations.

  • The U.S. economy would never have enjoyed such a large and unnatural growth spurt, meaning there never would have been a post-war deflation.

  • There would have been no Dustbowl, and no Great Depression.

  • There would have been no Cold War.

To go even further, without a Great Depression, the government never would have needed to encourage suburban sprawl and mass consumption as a way to absorb all the extra capacity. (The government built roads, subsidized mortgages and basically paid people to live in them.) Without the sprawl and consumption, we never would have had a subprime mortgage crisis, and the modern-day JPMorgan Chase & Co. never would have been forced to take a government capital injection with Hank Paulson holding a gun to its head.

While all it might seem a bit extreme to blame on one man and one loan, it's hard to dispute these were consequences of WWI. And, anyone looking at the sequence of events would surely conclude that the war could have ended sometime in 1915 without Morgan's money.

Morgan was a master of financial innovation and trickery rather than good, sound lending. He allocated capital -- another word for human life -- in a reckless manner because he knew he'd be bailed out. When people of such importance, controlling so much captital, make mistakes like that, the results are catastophic for everyone.

The same lesson applies to the recent credit bubble, when loan officers with "no skin in the game" originated hundreds of billions of dollars in mortgages that were securitized. Just like JP Morgan Jr., these bankers had no incentive to make good loans because they knew they'd get paid no matter what. Another good example is Bank of America's recent decision to throw itself on the pyre of the American financial system, much like the widow in a traditional Hindu funeral. Ken Lewis thought he was doing the right thing for the country and that he'd be bailed out, so he sacrificied one of the world's biggest lenders without a shard of due diligence or skepticism.

The problem was never too much profit. It was complacency by bankers who reponded to the real incentives facing them. Each time, we have tried to fix the problem by giving more money and extending more credit, when we should be doing the opposite.

Whenever crisis hits, people panic and try to suspend the rules of capitalism in favor of patriotism and altruism. At a time like this, we need to fight that urge and stick by the rules more than ever. After all, it's easy to do the right thing when everything's going well. From the very start of the credit crisis in the summer of 2007, I was critical of policymakers' state-of-seige thinking. In private emails, I correctly argued rate cuts would stoke inflation and do nothing to fix the credit market. Since then, I have argued that the rate cuts actually accelerated the credit crunch by triggering a mass liquidation of mortgage backed securities.

This is why I have criticized the tendencies of altruism and patriotism in our response to the credit crisis. These values meant nothing during the boom times. These same banks that now take hundreds of billions of dollars in taxpayer money gladly financed the rise of factories in Asia that "took American jobs" and were intimately involved in every stage of the gloablization movement.

They were just following the rules of capitalism. But now that their backs are to the wall, those rules should still apply. This is why the Fed never should not have cut interest rates at the onset of the crisis cuts, and why it would be better to let all banks fail and simultaneously encourage the creation of new ones. There is no lack of private money willing to capitalize new banks. But as long as the government is so intricately involved in "fixing the sector," it will never happen. We're doing everything just right if our intention is to perpetuate this state of crisis for the next 5-10 years. This is also why the various solutions proposed on this blog, like at the end of this entry, are all based on the profit model. Furthermore, the post-WWII boom was so successful because it created opportunities for private-sector firms to profit from things like road building, house construction and mass consumption. That's why the process succeeded and became self-perpetuating even though it was originally founded on government fiat. For more, see this blog entry.

Of course, JP Morgan Jr. never intended to cause massive imbalances in the global financial system, the Russian Revolution, the rise of Fascism or WWII. He was just trying to make money the best way he knew -- just like any other normal human being.

The episode teaches us the unintended consequences of mixing free-market practices with the Leviathan powers of the state and the money-printing capacity of the Fed. At times like this, it is more important than ever to play by the rules.


David said...

[ A history professor with an expertise on the 20th century wished me to post this comment - David ]

I enjoy reading this blog, and its discussion of international finance.
But I feel compelled to add a note of skepticism about its use of history.
When J.P. Morgan provided loans to the British and French in 1915, he
could have no assurance that the United States would enter the war.
Wilson had some sympathy for the Allied cause, but America was divided, and there were strong anti-war sentiments within his own political party.
Indeed, he would actually win re-election in 1916 on a slogan of "He kept us out of war." The fact that the German High Command decided to unleash indiscriminate submarine warfare in January 1917 forced Wilson's hand. My point is only that it is simply not correct to place so much weight on the
idea that any banker could have clearly foreseen the results of his
In the 1930s the Nye Committee of the US Senate tried to blame the First World War on the bankers as well, with the result that a series of
Neutrality Laws were passed to keep the US out of future conflicts.
Unfortunately they served to delay America's entry into World War II, one of those unintended effects of trying to apply history in a mechanistic and simplistic manner.
Bankers certainly deserve a lot of blame for the current crisis, but let's not exaggerate their importance.

David said...

I will now respond to the comment from the history professor.

He is correct that I cannot prove JP Morgan knew the U.S. would enter WWI in 1915.
What we do know is that JP Morgan was the purchaser of war materiel, so by providing this loan, he was ensuring the continuation of that business. His customers, France and UK, were going broke. So, just like General Motors over the last decade, he lent them money to keep the revenue coming in.
He then continued to loan more and more money.
The point of the original posting was that loans made for anything other than the profit motive tend to produce bad outcomes. Perhaps JP Morgan was more influenced by his desire to earn commissions buying armaments for the Allies. Or perhaps he knew he'd be bailed out in some way.
In the big picture, it doesn't make any difference. Either way, he didn't chose to lend based on his honest belief that France and the UK were good credits. He was conflicted -- in many ways, just like a mortgage broker who originated a subprime loan and then sold it to Lehman Brothers to be securitized.
My point is that money is power, and large amounts of money can do great harm to humanity when it's misallocated. I believe that, one way or the other, JP Morgan's loan perpetuated WWI, and that continuation produced distortions that caused the Great Depression. In the 1914-19 period, we churned out too much grain and steel. In the 2001-2008 period, the world produced too many houses, flat screen TVs and handbags.
Both of these production bubbles were caused by bad lending practices and financial crisis.

One more point I would make in response to the comment from the professor is that JP Morgan knew the American business community. As the war progressed in 1916, he knew how much money people were making. I suspect he believed the country would come to support the Allied effort in one way or another.