The Alchemists

1. Central Banks: Modern Alchemy's Foundation

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.

From Copper to Confidence. The story begins with Johan Palmstruch in 17th-century Sweden, grappling with the unwieldy copper plates used as currency. His solution—paper notes redeemable for copper—marked the birth of modern money, backed not by precious metals, but by the credibility of a financial institution. This innovation, like alchemy, created wealth from thin air, establishing central banks as the underpinnings of modern economies.

Enablers of Modernity. Central banks facilitate long-term investments, enabling infrastructure projects like electric utilities and transportation systems. They stand in the way of financial collapse, ensuring a stable currency and sustained prosperity. This stability allows for the complex, long-term investments that power modern life.

The Power to Create and Destroy. Central bankers wield immense power, influencing job creation, savings security, and national prosperity. Their decisions, often conveyed through seemingly innocuous phrases, can trigger market rallies, affect oil prices, and alter borrowing costs. This power, granted by democracies, demands a deep understanding of history and a commitment to stability.

2. Bagehot's Dictum: A Central Bank's Crisis Playbook

They must lend to merchants, to minor bankers, to ‘this man and that man,’ whenever the security is good.

Overend & Gurney's Fall. The 1866 collapse of Overend, Gurney & Co., a British banking giant, triggered a financial panic that threatened the empire. Walter Bagehot, chronicler of the era, distilled lessons into a dictum for central banks facing crises. This crisis highlighted the importance of trust in the banking system.

Lend Freely, Securely, and Expensively. Bagehot's dictum advises central banks to lend freely during panics, using their resources to support solvent institutions with good collateral. A penalty interest rate discourages unnecessary borrowing. This strategy, updated for the electronic age, became a model for crisis response.

Beyond the Dictum. The Overend & Gurney crisis also revealed that even aggressive intervention may not prevent economic downturns. Massive lending can spark political backlash, as the public questions the use of public funds to aid wealthy bankers. These lessons, learned in Victorian Britain, would resonate in the 21st century.

3. The Fed's Jekyll Island Birth: A Political Compromise

If it were to be exposed publicly that our particular group had got together and written a banking bill, that bill would have no chance whatever of passage by Congress.

Distrust of Central Authority. The United States' history with central banking is fraught with distrust of centralized power. The absence of a central bank in the 19th century led to frequent banking panics, highlighting the need for a more stable financial system.

The First Name Club. In 1910, a group of powerful men secretly convened on Jekyll Island to devise a plan for a U.S. central bank. Their challenge was to balance the need for a central authority with the deep-seated American aversion to concentrated power.

A Network of Regional Banks. The solution was the Federal Reserve System, a network of regional banks with a national board. This compromise aimed to distribute power while providing a lender of last resort. The Federal Reserve Act, passed in 1913, marked a turning point in American finance, though debates over its structure and purpose continue to this day.

4. Central Banking Failures: Hyperinflation and Depression

Life was madness, nightmare, desperation, chaos.

Havenstein's Folly. Rudolf von Havenstein, head of the German Reichsbank, oversaw the hyperinflation of the 1920s. His decision to print money to fund government spending led to economic devastation and social unrest, creating conditions for the rise of Nazism. This serves as a cautionary tale about the dangers of unchecked monetary expansion.

The Great Depression's Roots. The U.S. stock market crash of 1929 triggered a global depression exacerbated by central bank failures. The Federal Reserve's tight monetary policy and adherence to the gold standard worsened the crisis, leading to bank failures, unemployment, and widespread economic misery.

Lessons Learned (and Forgotten). Both German hyperinflation and the Great Depression underscore the importance of responsible central banking. Too much or too little money can have devastating consequences. These historical failures serve as a constant reminder of the awesome power and responsibility wielded by central bankers.

5. The Great Inflation: Political Interference and Economic Misunderstandings

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.

Nixon's Pressure on Burns. In the 1970s, Fed Chairman Arthur Burns faced political pressure from President Richard Nixon to keep interest rates low. This interference, combined with economic misunderstandings, led to runaway inflation.

The Vicious Cycle of Inflation. Rising prices fueled wage demands, which in turn led to even higher prices. The oil shock of 1973 further exacerbated the problem, creating a period of stagflation—high inflation and high unemployment.

Volcker's Bold Move. Paul Volcker, appointed Fed chair in 1979, took decisive action to break the cycle of inflation. His high-interest-rate policies triggered a recession but ultimately restored price stability, setting the stage for a quarter-century of economic prosperity. This period highlighted the importance of central bank independence and the willingness to make unpopular decisions.

6. The Eurozone's Design Flaws: A House Divided

This therefore is the reason why Lombard Street exists.

The ERM's Failure. The European Exchange Rate Mechanism (ERM) aimed to stabilize currencies within Europe, but it ultimately failed. George Soros's bet against the British pound in 1992 exposed the system's weaknesses and led to Britain's exit.

Maastricht Treaty. The Maastricht Treaty paved the way for the euro, a common currency intended to foster economic unity. However, the eurozone lacked the fiscal and political integration necessary for a truly stable monetary union.

A Single Currency, Divided Interests. The euro's success depended on the ability of diverse nations to coordinate economic policies. The absence of a unified political system and a shared sense of obligation created tensions, setting the stage for future crises. The lack of labor mobility and fiscal transfers exacerbated the problems.

7. Zero Interest Rates: Uncharted Monetary Territory

I see here in the exchange bank good stores of money and it seems to me to be best now to make a beginning with the loan bank.

Japan's Lost Decade. In the 1990s, Japan faced economic stagnation and deflation following a real estate bubble. The Bank of Japan's response, cutting interest rates to zero, proved ineffective, leading to a period of prolonged economic malaise.

The Agony of ZIRP. Masaru Hayami, governor of the Bank of Japan, struggled to combat deflation in a zero-interest-rate environment. Economists urged bolder action, including quantitative easing and a commitment to higher inflation.

Lessons for the Future. Japan's experience highlighted the challenges of central banking in a low-inflation environment. It also underscored the need for innovative monetary policies and coordination with fiscal authorities. The BOJ's caution and reluctance to experiment served as a cautionary tale for other central banks.

8. The Great Moderation: A False Sense of Security

Banking is a very peculiar business, and it depends so much upon credit that the very least blast of suspicion is sufficient to sweep away, as it were, the harvest of a whole year.

The Jackson Hole Consensus. In the years leading up to 2007, central bankers enjoyed a period of relative stability known as the Great Moderation. They believed they had mastered the art of managing the economy, leading to a sense of complacency.

Greenspan's Legacy. Alan Greenspan, chairman of the Federal Reserve, was hailed as a maestro for his role in maintaining economic stability. However, this period of apparent success masked underlying risks in the financial system.

A Warning Unheeded. Despite the prevailing optimism, some economists, like Robert Shiller, warned of a housing bubble and the potential for a severe economic downturn. These warnings were largely ignored, as the world's central bankers remained confident in their ability to manage the economy.

9. The 2008 Panic: A Global House of Cards

The peculiar essence of our banking system is an unprecedented trust between man and man.

The Subprime Mortgage Crisis. The crisis began with the collapse of the U.S. housing market and the subsequent implosion of mortgage-backed securities. This triggered a freeze in money markets and a loss of confidence in the banking system.

Lehman's Fall. The bankruptcy of Lehman Brothers in September 2008 marked a turning point, sending shockwaves through the global financial system. The interconnectedness of financial institutions meant that Lehman's failure threatened the solvency of banks worldwide.

AIG's Near Collapse. The near-failure of AIG, a giant insurance company, further destabilized the financial system. The Fed's decision to bail out AIG was controversial but deemed necessary to prevent a complete meltdown. The interconnectedness of the financial system meant that the failure of one institution could trigger a cascade of failures.

10. The Troika's Austerity Trap: Austerity vs. Growth

You’re thinking of this place all wrong, as if I had the money back in a safe. The money’s not here.

The Greek Debt Crisis. The Greek debt crisis exposed the flaws in the eurozone's design. The nation's high debt levels and inability to devalue its currency made it difficult to compete.

The Troika's Demands. The troika, consisting of the IMF, ECB, and European Commission, imposed strict austerity measures on Greece in exchange for bailout funds. These measures, while intended to restore fiscal stability, led to economic contraction and social unrest.

Austerity vs. Growth. The debate over austerity versus growth became a central theme of the eurozone crisis. While some argued that fiscal discipline was necessary to restore confidence, others warned that excessive austerity could stifle economic recovery. The Troika's actions in Greece highlighted the challenges of balancing fiscal responsibility with the need for economic growth.

11. Draghi's "Whatever It Takes": Preserving the Euro

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.

Draghi Takes the Helm. Mario Draghi succeeded Jean-Claude Trichet as president of the ECB in November 2011. He inherited a eurozone teetering on the brink of collapse.

"Whatever It Takes." In July 2012, Draghi pledged that the ECB would do "whatever it takes to preserve the euro." This commitment, backed by a new program of Outright Monetary Transactions (OMT), calmed markets and prevented a potential breakup of the eurozone.

A New Era of Activism. Draghi's leadership marked a shift toward a more activist ECB. His willingness to take bold action, even in the face of German opposition, helped stabilize the eurozone and prevent a global financial catastrophe. The OMT program, a pledge to buy bonds in unlimited amounts to combat market bets against the survival of the eurozone, was a key element of this strategy.

12. The PBOC: China's Unique Central Banking Model

The bill may have the U.S. treasury secretary’s signature on it, but at the top it reads, “Federal Reserve Note.”

China's Economic Rise. China's economic ascent has been one of the most remarkable stories of the 21st century. The nation's transformation from a centrally planned economy to a global economic powerhouse has been guided by the People's Bank of China (PBOC).

Zhou Xiaochuan's Leadership. Zhou Xiaochuan, governor of the PBOC, played a key role in shaping China's financial system. He pushed for market-oriented reforms, including the development of a bond market and the internationalization of the renminbi.

A Different Approach. The PBOC operates within a unique political context, balancing state control with market liberalization. Its approach to monetary policy reflects a blend of Western economic principles and Chinese pragmatism. The PBOC's actions during the global financial crisis demonstrated its ability to shield China from the worst effects of the downturn.

Last updated: March 3, 2025