General affairs here are about as bad as they can be.

—J. P. “Jack” Morgan Jr., August 8, 1907

The earthquake and fire that destroyed 80 percent of San Francisco, starting on April 18, 1906, was unprecedented in U.S. history.¹ The quake was massive, with an estimated magnitude of 7.9.² In the wake of the temblor itself, broken gas mains fueled huge fires throughout the city. Disruptions to municipal water lines prevented fire suppression, and San Francisco’s mostly wood‐framed architecture only fed the fires. The conflagration eventually engulfed the city, leveling over four square miles, such that most historical accounts speak of both the earthquake and the fire as the source of the city’s destruction. San Francisco’s damages were reported to range from $350 to $500 million,³ equal to 1.2 to 1.7 percent of the U.S. gross national product in 1906.⁴

The strains from the catastrophe in California rippled quickly through the global financial system. At the time, San Francisco was the financial center of the West and home to the western branch of the U.S. Mint, so anything that disrupted business in San Francisco threatened the entire western region economically.

On the New York and London stock exchanges, news of the quake led to an immediate sell‐off in stocks and a significant drop in share prices. Economists Kerry Odell and Marc Weidenmier have estimated that the disaster led directly or indirectly to about a $1 billion decline (nearly 12.5 percent) in the total market value of New York Stock Exchange securities. Prices of railway stocks fell more than 15 percent, and those of insurance companies declined between 15 and 30 percent during the two weeks after the cataclysm.⁵

Relief funds were drawn into the city from around the country and the world: England supplied $30 million; Germany, France, and the Netherlands collectively provided another $20 million. Such international effects of the earthquake were further amplified because many foreign insurers had provided San Francisco’s underwriting protection. Disputes between the foreign insurers and San Franciscans arose over the fact that most people were insured against fire but not earthquakes. British insurance firms, for instance, had accounted for about half of the city’s fire insurance policies; after the quake, they faced losses of close to $50 million. In fact, several insurers were overwhelmed by the claims and could not meet their insurable obligations. The Fireman’s Fund Insurance Company, for example, faced liabilities of $11.5 million, exceeding its total assets by $4.5 million.⁶ Consequently, some underwriters imposed lengthy delays in paying for damages, while others discounted their claims, insisting that any earthquake‐related fire damage was not explicitly covered in their policies. The Hamburg‐Bremen Insurance Company demanded a discount of 25 percent for all San Francisco claims. Only six companies fully honored their obligations.⁷

While some British insurers funded their payments by selling their holdings of American securities in London and New York, others liquidated assets heavily in foreign markets. The payments prompted major shipments of gold from London to the United States—$30 million in April and another $35 million in September 1906, amounting to a 14 percent decline in Britain’s stock of gold—the largest outflow of gold from Britain between 1900 and 1913. Eventually, these outflows of gold created liquidity fears for the Bank of England.⁸ The declining liquidity of the London capital market sparked the spread of rumors in New York that British financial houses were in trouble and required support from the Bank of England.⁹

The Gold Standard and Britain’s Hegemony in Finance

At the time of the earthquake in the spring of 1906, London dominated the global market for capital. The British Empire was at its zenith, and its immense flows of capital traversed London markets. John Maynard Keynes later wrote that the Bank of England had the “power to call the tune … During the latter half of the nineteenth century the influence of London on credit conditions throughout the world was so predominant that the Bank of England could almost have claimed to be the conductor of the international orchestra.”¹⁰

As a practical matter, nations wished to preserve their credit standing in global markets and the strength of their financial institutions. This desire dictated the need to ensure a stable rate at which the nation’s currency could be converted into gold. Nations confronted the “impossible trilemma”¹¹ in which it was possible to control only any two of the following three levers of national financial policy:

1. Rates of currency exchange (including the rate of exchange into gold). Stable exchange rates promoted foreign trade and economic growth. Thus, national governments had an incentive to peg exchange rates at a certain target.
2. Interest rates. The cost of money influenced economic growth, and the flows of gold into and out of a country. Thus, national governments had an incentive to manage (or “fix”) interest rates, rather than let them be determined by market forces.
3. Flow of capital across borders. Outflows of gold reserves (for instance, because of trade deficits) were nettlesome because they diminished the central bank’s gold reserves. However, adroit management of interest rates by the central bank could reverse the outflows.

During the classic gold standard era, nations typically settled for the first two and conceded the third to the markets. They sought to stabilize currency exchange rates and to manage interest rates. Thus they had to put up with variations in the flows of capital (i.e., gold) into and out of the country as market conditions determined.^a

For all practical purposes, Britain in 1906 was the financial hegemon of the world. It had the largest gold reserves; it had a massive volume of international trade (especially within the Empire); and it hosted the most significant financial markets. Thus, it could set the rules of financial behavior among nations and could enforce them—not only by virtue of its resource abundance but also, if necessary, by virtue of its powerful navy. Britain was the force to be reckoned with.

The Bank of England Reacts to Gold Exports to the United States

Charged with the responsibility of maintaining liquidity for the Empire, the Bank of England—the “Old Lady of Threadneedle Street”—held reserves of gold with which to meet the liquidity demands of banks and trading partners. Keeping the British mills, factories, and shops supplied with goods from the commonwealth was a fundamental aim of England’s economic system.

Odell and Weidenmier estimated that the San Francisco earthquake triggered insurance payments from Britain amounting to almost £19 million, more than 2.5 times the shipments to any other country. Including payments from Britain, Germany, France, and the Netherlands, the gold exports to the United States in April and May 1906 amounted to nearly $50 million.¹² By October, the insurance payments had risen to $100 million.¹³ Odell and Weidenmier reported that the drain on British gold reserves occurred in two waves: humanitarian relief payments arrived in late April and in May, and after insurance adjustment decisions, a second wave of gold shipments occurred in September and October 1906.

To compound matters, a booming stock market in New York led to the perception that American gold imports were fueling speculation, not investment in productive assets. A Berlin correspondent for the New York Evening Post reported in July that Americans “can borrow from Europe to a practically unlimited extent this season.”¹⁴ Large publicly owned corporations raised their dividends in mid‐1906. The Union Pacific Railroad advanced its payout from 6 to 10 percent. And U.S. Steel resumed paying dividends (after suspending them in 1903). As Sprague wrote, these dividends “gave encouragement to the unbridled optimism which was already too much in evidence.”¹⁵ The U.S. stock market peaked in October 1906, a dramatic recovery from a low in May 1904.

To stanch the decline in Britain’s gold supply, the Bank of England raised its benchmark interest rate from 3.5 to 4.0 percent on September 13, 1906. Fearing further demands for gold with the coming Egyptian cotton crop,¹⁶ the Bank raised its rate twice again, on October 11, 1906, from 4.0 to 5.0 percent and on October 19 from 5.0 to 6.0 percent—the highest rate posted by the Bank of England since 1899.¹⁷ Central banks in France and Germany followed suit and sharply raised their interest rates as well.¹⁸

Also on October 19, the Bank of England threatened other British lenders with a further rate hike to 7.0 percent if they did not stop financing gold imports to the United States—credit rationing, a rarely used policy by central banks, indicated the gravity of the Bank of England’s view of conditions.

Figure 2.1 suggests why the Bank took these extreme measures. The gold reserves that stood behind its paper currency had declined materially with each wave of gold shipments to the United States. By raising Bank Rate after the first wave, the Bank’s reserves had recovered. But with the second wave in August–September, the Bank’s reserves had slumped from £37 million in mid‐August to about £28 million in mid‐October—the dashed line shows that gold reserves had fallen more than two standard deviations below the average gold reserve that had prevailed from 1901 to 1905. The loss of gold reserves to exports for the United States had grown alarming.

After the San Francisco earthquake and fire, the mid‐October policy move by the Bank of England proved to be the second major shock of 1906 to the U.S. financial system. Professor Sprague argued that the Bank of England precipitated a general credit‐tightening cycle. American institutions that had issued finance bills in London for the purpose of importing gold now found that they could not “roll over” or refinance those bills. Sprague wrote, “From December 1906, the liquidation of these bills was the most potent single factor in the situation.”¹⁹

Money Conditions Tighten

In New York City, credit was becoming scarce, too, as its gold reserves also migrated to San Francisco. The timing of these relief shipments to the West Coast was particularly unfortunate since they coincided with the ordinary demands for funds induced by the U.S. agricultural cycle: the harvesting and shipment of crops required credit until the crops reached the consumer. As a result of the credit shortage, the price of money in New York grew dear, and other sectors of the American economy started to feel the pinch. By the winter of 1906–1907, a severe credit shortage had set in.

Panic had not yet arrived, but telegrams flew across the Atlantic between the world’s leading financiers, reflecting a growing anxiety within the financial community about liquidity and the likely actions of the Bank of England.²⁰ On December 18, 1906, Jack Morgan, who had assumed day‐to‐day responsibility for J.P. Morgan & Co. from his father, writing to his affiliate partners in London, offered stark language about these stringent credit conditions: “Things here are very uncomfortable owing to the tightness of money … we are likely to have a stiff money market for some time to come.”²¹ A few days later he wrote with a clarification: “There is plenty of money in the country everywhere except in New York, and the only really alarming thing about the situation appears to be a very undefined feeling that there is something wrong in New York. This feeling extending to the large centres in the West has interfered with the natural flow of money to this centre to take advantage of the high rate.”²² As the year 1907 began, there was a deep sense of foreboding among the nation’s money men.

Complicating the money scarcity problem was a bull market in stocks, which had been spurred by the buoyant economic growth of the American economy. A “mammoth bull movement,” in the words of one observer, was running its course on the New York Stock Exchange. Jack Morgan noted a speculative sentiment prevailing in the stock market:

For the first time in three years the public—with stocks at their present high prices—have begun to come in and buy heavily with the result that the so called market‐leaders are no longer in charge, and that the stock market is running away in a fashion which I must say suggests to me possible trouble in the future although not in the immediate future.²³

Meanwhile, enormous new issues of securities, particularly by railway and industrial companies, placed further demands on the resources of the money market. Henry Clews, a contemporary Wall Street authority, said, “Indeed, the year 1906 from beginning to end witnessed a continuation of those inordinately heavy demands for money from Wall Street and corporations, and these led to the disturbed monetary conditions.”²⁴ French economist Pierre Paul Leroy‐Beaulieu estimated that the global economy provided $2.4 billion annually in investment in new security issues, but that in 1906, issuers sought $3.25 billion in funding—a demand the financial system could not fill.²⁵ The railway magnate James J. Hill estimated in November 1906 that U.S. railroads would require financing of $1 billion per year for the next five years, an unheard‐of ambition for investment or financing.²⁶

While the equity market was attracting popular attention, the debt markets (i.e., bonds and loans) overshadowed stocks in both volume and significance. During 1906, debt market conditions diverged sharply from equities: While stock prices rose, bond prices fell (and thus, interest rates increased). The price movement in the debt markets coincided with the increasing demand for credit driven by the continued real economic growth in the United States, the agricultural cycle that drew financing to bring the bumper crop of 1906 to market, and the shock of the San Francisco earthquake. Alexander Dana Noyes, a leading observer of Wall Street, wrote in 1909, “Beginning about the middle of 1905, a strain on the whole world’s capital supply and credit facilities set in, which increased at so portentous a rate during the next two years that long before October 1907, thoughtful men in many widely separated markets were discussing, with serious apprehension, what was to be the result.”²⁷