The Bank of Banks
Once, on the border between the provinces of Naples and Caserta, a farmer was ploughing a field he had recently bought. The tractor kept getting stuck, as if the ground had hardened that day. Suddenly scraps of paper came flying up from under the plough. Money. Thousands, hundreds of thousands of banknotes. The farmer jumped down from the tractor and started grabbing them: he thought someone had buried a gang’s loot there.
Saviano explains what had really happened. The money was shredded and faded, and it hadn’t been buried by a bandit but by the Bank of Italy. Tons of banknotes withdrawn from circulation had been packed into sacks, and the sacks, like plenty of other waste trucked into those parts, ended up underground. The lira had been buried. And the old money was poisoning the cauliflower beds.
That’s where I’ll start on central banks. The whole truth about money is in that field. A piece of paper the central bank no longer recognises is rubbish. A piece of paper it does recognise is money. The difference isn’t in the paper. It’s in the promise.
The Banker Who Printed Too Much
The first banknotes in Europe were issued in 1661 by the Stockholm Bank, which the merchant Johan Palmstruch had founded shortly before. It was a beautiful idea. Sweden at the time used huge copper plate money, and each plate weighed several kilograms. Lugging them around was torture. A piece of paper, though, the bank promised to exchange for copper at any moment, and it was far easier to carry.
Trouble came quickly. Paper is easy to print, and the bank printed more of it than it had copper. People came to exchange it—and there wasn’t enough copper. In 1664 the bank stopped paying, and then it was wound up. Palmstruch was tried and sentenced to death, but the sentence was commuted to prison.
He got off lightly.
And then the Swedes did what everyone did after them. In 1668 they set up a new bank, this time under the control of parliament. It’s still going. It’s the Swedish Riksbank, the oldest central bank in the world. The right to print money was taken away from a private banker and given to someone who answers to the country. Sensible.
Remember the Banca Romana from the beginning of the book? It was allowed to print money, and it printed it for politicians. When it collapsed in 1893, that story also ended with a new bank—the Bank of Italy. Central banks are almost always born in the ruins of a private bank that abused the right to print.
The Bank That Paid for a War
The Bank of England was born differently. Out of a war. In 1694 King William III was fighting France and needed money. A Scot, William Paterson, made a proposal: let rich people club together and lend the Crown one million two hundred thousand pounds at eight per cent, and in return get the right to found a bank. One thousand two hundred and sixty-eight people subscribed, and the money was raised in eleven days. The new bank opened in a hall rented from one of the London livery companies: seventeen clerks and two doorkeepers.
Look at that deal through our eyes. A king is the least reliable debtor there is—we’ve discussed that already. But this time he wasn’t borrowing from a few banking families he could ruin, the way Edward III ruined the Florentines. He was borrowing from a large company with its own charter, and parliament stood behind it. Cheating a creditor like that cost far more. That’s the whole trick. A hundred and fifty years later the Bank of England had become the bank for all the other banks in the country.
The Bank of Banks
So what does a central bank actually do? Three things.
First, it prints money and makes sure it doesn’t lose value. Print too much and prices climb, as in Weimar. Too little and the economy chokes.
Second, it sets the price of money. The rate at which the central bank lends to ordinary banks is the starting point for every other rate in the country: on deposits, loans, mortgages. Raise the rate and money gets dearer, people borrow and spend less, prices calm down. Lower it and the opposite happens.
And third, the most important: it is the lender of last resort. A panic starts, depositors run on every bank at once, and nobody has the cash: it’s all been lent out. Then the central bank lends to the banks and takes whatever good assets they have as collateral. The panic dies down. It’s the bank for banks.
By 1907 America had no such bank. It had set one up twice. The First Bank of the United States ran from 1791 to 1811, the Second from 1816 to 1836. Both did part of that job, though neither looked much like today’s Federal Reserve, and Congress renewed neither charter. After that the country went nearly eighty years without a central bank. In the panic of 1907, which we’ve already talked about, the country’s banks were rescued, in effect, by one man—the financier John Pierpont Morgan, who gathered the other bankers in his library. The country got the message: everything couldn’t hang on whether one old man felt like helping. In November 1910 a few bankers and a senator slipped away in secret to Jekyll Island off the coast of Georgia. They passed themselves off as duck hunters, called each other by first names only, and there they sketched out a plan. On 23 December 1913 President Wilson signed the Federal Reserve Act.
The ducks, one assumes, survived.
Independence and Capital
Why should a central bank be independent of the government? For the same reason you don’t trust the cash box to someone who helps himself from it. A government always wants to print money before an election or for a war, and later everyone pays when prices rise. That’s why in most countries the head of the central bank is hard to sack. He doesn’t take advice from ministers.
The supervisors keep an ordinary bank on two leashes, and you mustn’t mix them up. The first is capital, the owners’ own money. It isn’t sitting in the safe in a separate bundle: it’s been lent out too. But it takes the first hit. If borrowers fail to repay part of their debts, the capital is gone and the depositors keep what’s theirs. The second leash is whatever turns into cash quickly: banknotes, reserves in an account at the central bank, paper you can sell in a day. Financiers call this liquidity. It’s what pays when depositors come for their money. A bank with good capital may not make it to tomorrow if it has lent everything out for the long term. A bank with a full till may already be dead if its loans don’t come back.
In 1974, after a German bank collapsed, bankers from the largest countries set up a committee in Basel, Switzerland. In 1988 they agreed: a bank’s capital must be no less than eight per cent of its risk-weighted assets. In that calculation a loan to a government weighs little or nothing, an ordinary loan to a company counts in full. Eight per cent isn’t much. You can’t compare it head-on with the thin cushion of Fannie and Freddie: there, capital and risk were counted differently. But the idea is the same: the more you risk, the more of your own money you have to put up.
The Don as Lender of Last Resort
Remember the year hail battered the olive trees in Sicily? We had bought our oil in time. But the mill owner was left with almost no harvest and no money for the next season: nothing to pay his workers, mend the press, buy fertiliser. The bank turned him down: bad year, bad borrower.
The Don lent him the money. No interest. Three years to pay it back. I was surprised: we sell oil, we don’t lend money. The Don explained: “If the mill dies, I’ll have to find a new one, and I’ll spend twenty years teaching another man what oil I want. It’s cheaper to keep this one going.” The debt was repaid in two years. And at the next poor harvest the mill owner warned the Don six months ahead and kept back the best oil for us.
A central bank does the same for a whole country: in a panic it props up those without whom the entire system would die. But only those who are sick for the moment, not the hopeless cases.
The Bottom Line
If your whole business depends on someone, it sometimes pays to become their lender of last resort yourself. Just check first what they’re short of: money until tomorrow, or a business for the day after. The first is cured with a loan. The second isn’t.