Lords of Finance: The Bankers Who Broke the World

by Liaquat Ahamed

During a three-year period, real GDP in the major economies fell by over 25 percent, a quarter of the adult male population was thrown out of work, commodity prices fell in half, consumer prices declined by 30 percent, wages were cut by a third.

Bank credit in the United States shrank by 40 percent and in many countries the whole banking system collapsed.

Almost every major sovereign debtor among developing countries and in Central and Eastern Europe defaulted, including Germany, th...

starting with the contraction in the German economy that began in 1928,

the Great Crash on Wall Street in 1929,

the serial bank panics that affected the United States fr...

unraveling of European finances in the s...

The first shock—the sudden halt in the flow of American capital to Europe in 1928 which tipped Germany into recession—has its counterpart in the Mexican peso crisis of 1994.

There are, of course, differences. Germany in 1928 was much larger compared to the world economy—about three times the relative economic size of Mexico in 1994.51

But the biggest difference was to be found in the management of the crisis. The U.S. Treasury under Secretary Robert Rubin forestalled a default by providing Mexico an emergency credit of $50 billion with astonishing rapidity. Germany in 1929 had no such savior. Moreover, in 1994, Mexico could devalue the peso. In 1929, having only just emerged from a terrible bout of hyperinflation, Germany felt bound by gold-standard rules and sacrificed its economy to maintain the parity of the Reichsmark.

The reaction of the authorities was not that dissimilar—in the first year after the 1929 crash interest rates in the United States were cut from 6 percent to 2 percent; in 2000 they were slashed from 6.5 percent to 2.0 percent.

The present turmoil has also led to a mass run on the financial system—this time not by panicked individuals desperate to withdraw their money but by panicked bankers and investors pulling their money out of financial institutions of all stripes, not only commercial banks but investment banks, money market funds, hedge funds, and all those mysterious “off-balance-sheet special-purpose vehicles” that have sprung up over the past decade. Every financial institution that depends on wholesale funding from its peers has been threatened to a greater or lesser degree.

Offsetting this has been the response of central banks and financial officials. In 1931-33 the Fed stood passively aside while thousands of banks failed, thus permitting bank credit to contract by 40 percent.

In the current crisis, central banks and treasuries around the world, drawing to some degree on the lessons learned during the Great Depression, have reacted with an unprecedented series of moves to inject gigantic amounts of liquidity into the credit market and provide capital to banks.

Without these measures, there is little doubt that the world’s financial system would have collapsed as dramatically as it did in the 1930s. Though the net impact on credit availability of the present crisis and the remedial actions taken by central banks is still uncertain and won’t be known for...

Finally, the European financial crisis of 1931 also has its modern-day counterpart in the “emerging markets” crisis of 1997-98. In 1931, the evaporation of confidence in European banks and currencies caused Germany and much of the rest of Central Europe to impose capital controls and default on their debts, leadi...

As with all analogies, the comparisons are never exact. Nevertheless, they illustrate the scale of the economic whirlwind of 1929-32—a crisis equivalent in scope to the combined effects and more of the 1994 Mexican peso crises, the 1997-98 Asian and Russian crises, the 2000 collapse in the stock market bubble, and the 2007/8 world financial crisis, all cascading upon one and other in a single concentrated two-year period.

To the contrary, in this book I maintain that the Great Depression was not some act of God or the result of some deep-rooted contradictions of capitalism but the direct result of a series of misjudgments by economic policy makers, some made back in the 1920s, others after the first crises set in—by any measure the most dramatic sequence of collective blunders ever made by financial officials.

Who then was to blame? The first culprits were the politicians who presided over the Paris Peace Conference. They burdened a world economy still trying to recover from the effects of war with a gigantic overhang of international debts. Germany began the 1920s owing some $12 billion in reparations to France and Britain; France owed the United States and Britain $7 billion in war debts, while Britain in turn owed $4 billion to the United States. This would be the equivalent today of Germany owing $2.4 trillion, France owing $1.4 trillion, and Britain owing $800 billion. Dealing with these massive claims consumed the energies of financial statesmen for much of the decade and poisoned international relations. More important, the debts left massive fault lines in the world financial system, which cracked at the first pressure.

Similar to post-WWI, the world is now emerging from a crisis with high debt loads

Gold supplies had not kept up with prices; and the distribution of gold bullion after the war was badly skewed, with much of it concentrated in the United States. The result was a dysfunctional gold standard that was unable to operate as smoothly and automatically as before the war. The problem of inadequate gold reserves was compounded when Europe went back to gold at exchange rates that were grossly misaligned, resulting in constant pressure on the Bank of England, the linchpin of the world’s financial system, and a destructive and petty feud between Britain and France that undermined international cooperation.

The quartet of central bankers did in fact succeed in keeping the world economy going but they were only able to do so by holding U.S. interest rates down and by keeping Germany afloat on borrowed money. It was a system that was bound to come to a crashing end. Indeed, it held the seeds of its own destruction.

Eventually the policy of keeping U.S. interest rates low to shore up the international exchanges precipitated a bubble in the U.S. stock market. By 1927, the Fed was thus torn between two conflicting objectives: to keep propping up Europe or to control speculation on Wall Street. It tried to do both and achieved neither. Its attempts to curb speculation were too halfhearted to bring stocks back to earth but powerful enough to cause a collapse in lending to Germany, driving most of central Europe into depression and setting in train deflationary forces thr...

The U.S. stock market bubble thus had a double effect. On the way up, it created a squeeze in international credit that drove Germany and other parts of the world into recession...

After 1929, responsibility for world monetary affairs ended up in the hands of a group of men who understood none of this, whose ideas about the economy were at best outmoded and at worst plain wrong. Strong died in 1928.

personality or the stature to assume control. Instead, authority at the Fed shifted to a group of inexperienced and ill-informed timeservers, who believed that the economy would automatically return to an even keel, that there was nothing to be done to counteract deflationary forces except wait them out. They failed to fulfill even the most basic central banker’s responsibility: to act as lender of last resort and support the banking system at a time of panic.

As a consequence, for all of Norman’s enormous prestige and Schacht’s creativity, they were both hamstrung by the dictates of the gold standard and were forced to remain locked in with the United States, deflating as it did.

The only central banker outside the Fed with enough gold to act independently was Moreau at the Banque de France. But having stumbled inadvertently into a position of financial dominance, he seemed more intent on using France’s newfound strength for political rather than economic ends.

No one struggled harder in the lead-up to the Great Depression and during it to make sense of the forces at work than Maynard Keynes. He believed that if only we could eliminate “muddled” thinking—one of his favorite expressions—in economic matters, then society could allow the management of its material welfare to take a backseat to what he thought were the central questions of existence, to the “problems of life and of human relations, of creation, behavior and religion.” That is what he meant when in a speech toward the end of his life he declared that economists are the “trustees, not of civilization, but of the possibility of civilization.” There is no greater testament of his legacy to that trusteeship than that in the sixty-odd years since he spoke those words, armed with his insights, the world has avoided an economic catastrophe such as overtook it in the years from 1929-33.