Two groups of people from elite backgrounds, Boston merchants of the early 19th century and Stanford professorate alumni of the early 21st century, founded institutions that made important changes to the U.S. financial system. Yet the financial institution founded by the Boston merchants played an important stabilizing and constructive role, while that founded by Stanford alumni was intrinsically destabilizing and ended in a record-breaking disaster. The structural differences between an unregulated yet sound financial system in the early 19th century and an over-regulated yet utterly unsound one in the 21st century explain the differences in outcomes.
Turning first to the case with which readers of this column are probably less familiar (one never knows) a group of Boston merchants around 1810 decided that international trade outside the British Empire was not as stable, financially enriching and enhancing of their social position as it had been before the Revolution. They therefore decided to get into manufacturing, which offered the possibility of more stable and possibly higher profits, if it was done right.
The progenitor of the group was Francis Cabot Lowell (1775-1817), who made a trip “for his health” to England in 1810-12 where, as a well-off Boston merchant he was treated by the textile industry as a potential buyer rather than as a competitor. This enabled him to do a fine job of industrial espionage, bringing back without any visible papers the ability to make the complex new power looms that were revolutionizing the British textile industry at the time (power looms integrated spinning and weaving, thus revolutionizing output per worker).
Raising $400,000 from other merchants, who later became known as the “Boston Associates,” for a total of 12 initial shareholders, he established the “Boston Manufacturing Company” with a state-of-the-art textile mill by a stream at Waltham, Mass (no steam power — coal was too expensive in the U.S.) and was quickly making good profits. The new mill paid its workers well, using mostly unmarried women rather than the child labor that was common in Britain’s early textile mills (Lowell had been shocked by conditions in the British mills, which were at their worst when he visited after 15 years of war). The unmarried ladies working in Boston Associates mills were much admired, notably by Charles Dickens on a visit in 1842. After Lowell’s death in 1817 the Waltham mill was managed by Patrick Tracy Jackson (1780-1847), Lowell’s brother-in-law.
Once the Waltham mill was in operation, Lowell’s partners looked for other opportunities to diversify their capital beyond the uncertain returns of international trade. The obvious opportunity was in banking. One partner, Nathan Appleton (1779-1861) had already taken on the task of marketing Boston Manufacturing’s products through a domestic sales vehicle B.C. Ward & Co., which would clearly provide a substantial volume of relatively low-risk trade finance opportunities to a bank. Jackson and Appleton, together with a group of Boston Associates (slightly different from the Boston Manufacturing group) on February 10, 1818 chartered the Suffolk Bank.
The Suffolk Bank was larger and more conservative than most of its competitors, and it quickly made a business of trading in bank notes of “country banks” – those outside Boston. It would buy them at a steep discount and then present them to the country bank for payment in gold or more frequently silver. During the “Panic of 1819” this was a lucrative if risky business, but the discounts at which their notes traded in Boston were very expensive for the country banks and their customers. Accordingly, from 1825 Suffolk Bank began a new policy, whereby they would undertake to redeem country bank notes at par, provided the country bank kept an interest free deposit with Suffolk Bank of their total amount of notes outstanding. This effectively created a banking system without fractional reserves, or rather, where the reserve fraction was 100%.
This made Suffolk Bank a universal clearing house for Massachusetts banks, identifying forgeries and increasing the volume of notes redeemed by the bank to $6 million per month by 1836. Having this clearing house became enormously beneficial to the Massachusetts banking system when the Second Bank of the United States lost its Federal charter, causing the United States to fall into a deep recession, the “Panic of 1837” which remained severe until 1843. In that year, most of the Pennsylvania banks went bankrupt, as did the remnant of the Second Bank of the United States, but the Massachusetts banking system remained solid, to the great benefit of its customers, which by now included over a dozen textile mills controlled by the Boston Associates.
It was this period, with the Boston Associates controlling one fifth of the nation’s textile industry and providing good working conditions, and the Suffolk Bank effectively acting as a central bank for Massachusetts’ banking system and preventing the over-leveraging that occurred elsewhere, that gave Boston business its reputation for exceptional probity and quality that lasted well into the 20th century. (Pre-revolutionary Boston had been a very different place, with the notorious smuggler John Hancock among the worst of its “cowboys” and no banking system at all.)
Now consider the Bankman-Fried empire. Sam Bankman-Fried’s origins were very similar in our society to the Boston merchants of 1810 – there was not a huge amount of money around, but the parents were affluent and ineffably well-connected, with leading Democrat politicians on speed-dial. There was never a danger that young Sam would have to be contented with a salaried occupation, like the rest of us poor slobs.
After four years at Jane Street Capital, the kind of high-paying trading outfit you don’t get into without excellent connections (yes, they democratized the merchant banks as far as me, but hedge funds and trading operations pay far more than the old merchant banks, and so are kept correspondingly more select) and a year as Director of Development for a connection-building charity, Bankman-Fried tapped his network to provide capital for a quantitative trading operation, Alameda Research. He opened a crypto-currency exchange FTX the following year and the rest is history.
Boston Associates ended respected by all, although their business empire stagnated after about 1845; Bankman-Fried’s career appears to have ended in disaster (though he is yet a young man.) There are considerable similarities between them, however.
- Both came from elite backgrounds to an extent unusual among innovators and entrepreneurs and used their elite connections to achieve a rocket-powered takeoff in their chosen direction.
- Both operated on a larger scale than their competitors and were genuinely innovative in their business approach – Boston Associates with the power loom and the clearing house for out-of-town banknotes; Bankman-Fried doing business in the very new field of crypto-currencies and attempting to operate therein on an institutional scale.
- Both operated at a high level in the political system – Appleton was Whig Congressman and a major New England power-broker, who was instrumental in the “Crittenden Compromise” attempt to keep the Union together as late as 1861, while Bankman-Fried purchased political influence in great bucketfuls with his gigantic political donations, mostly to those liberal Democrats connected with his parents’ influence circle.
- Both skated the borders of prevailing ethics – Lowell with his industrial espionage, Bankman-Fried with his transfers between FTX and Alameda and use of customer funds, which appear to have been illegal as well as unethical (though that is still sub judice).
The difference in outcomes between the two ventures can be explained by one factor: monetary policy. In 1820-1850, the United States was not bound internationally by a Gold Standard (it did not join the international Gold Standard until the Coinage Act of 1873). However, the U.S. minted both gold and silver coins at fixed parities against each metal (effectively a bimetallic standard), depending on which was cheaper at any given time – silver until 1850, gold (with near-simultaneous discoveries in California and Australia) from then until 1873. Banknotes, whether of the two Banks of the United States or of other banks, were theoretically redeemable in “specie” (gold or silver) but banks rarely kept enough bullion or coins to allow full redemption, relying instead on their notes circulating in the market.
In practice, with an atomized banking system, a shortage of either bullion or coinage in the United States, and quasi-central banks chartered for only 20 years and in practice making several egregious policy errors, the U.S. monetary system was thoroughly unreliable. The Suffolk Bank, by making the system more solid for individual and business users in New England, thus performed a genuine economic service, and was duly rewarded.
In Bankman-Fried’s case, decades of monetary madness both enabled his misdeeds and prevented his company from becoming a profitable, useful enterprise. Crypto-currencies only exist because of many decades of paper money, all the time being devalued by profligate governments and an inept Fed. The Bernankeist policy of 2010-22, maintaining interest rates far below their free market level for over a decade, is especially to blame; the crypto-currency bubble was just the most egregious of the follies and manias that decade produced.
Had monetary policy been sensible, crypto-currencies would still have existed, but they would not have grown to preposterous valuations without the decade’s asset bubble. Equally, by over-regulating the banking system and pumping up money supply, the Fed made an explosion of scam activity inevitable, as the “shadow banking system” beyond the reach of regulation grew larger than the regulated banking remnant.
Bankman-Fried can consider himself unlucky; in a less regulated system with a better monetary policy, his venture would still have been possible and his innovative talents might, like those of the Boston Associates, have led to enterprises with genuine economic benefit for mankind.
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)