Lords of Finance: The Bankers Who Broke the World

by Liaquat Ahamed

Like most other German bankers and businessmen, he believed that the villain of the piece was a fading Britain conspiring to deny Germany its rightful place among the Great Powers.

In 1907, as one New York bank after another fell victim to a run, the financial community, without any central bank to look to, turned to J. Pierpont Morgan, the preeminent financier of his generation. He had lived through more panics than had any other banker, in 1895 actually bailing out the United States government itself when it was within days of running out of gold and defaulting on its debts to Europe.

As THE LIGHTS started to go out over Europe that fateful first week of August, every banker and finance minister seemed to be fixated not on military preparations or the movements of armies but on the size and durability of his gold reserves. The obsession was almost medieval. This was, after all, 1914, not 1814. Paper money had been in wide use for more than two centuries, and merchants and traders had developed highly sophisticated systems of credit. The idea that the scope of the war might be limited by the amount of gold on hand seems anachronistic. Nevertheless, here was the London magazine United Empire declaring that it was “the amounts of coin and bullion in the hands of the Continental Great Powers at the outbreak of hostilities” that would largely determine “the intensity ... and probable duration of the war.”

a board of directors chosen too young for it to be known whether they are able; a committee of management in which seniority is the necessary qualification, and old age the common result.” It was a strange, even eccentric way of doing things—for the most important financial institution in Britain, in fact in the world, to be in the hands of a group of amateurs, men who generally would have preferred to be doing something else but who viewed the years they devoted to steering the Bank as a form of civic duty.

In the late 1920s, the DDP, like all German centrist parties, would shrink into insignificance, squeezed from both ends of the political spectrum, particularly from the right.

The reaction within Germany to the peace treaty reached a pitch of hysteria. All forms of public entertainment were suspended for a week as a sign of protest. Flags across the country were lowered to half-mast. The chancellor, Philipp Scheidemann, characterized the terms as “unbearable, unrealizable, and unacceptable,” and proclaimed that it would make the Germans “slaves and helots . . . doing forced labor behind barbed wire and prison bars.” The Germans were given a deadline of five days to agree to the terms or face a resumption of hostilities. Scheidemann resigned rather than put his signature on the document, of which he said, “What hand would not wither which placed this chain upon itself and upon us?” On the day that Germany accepted the terms, its Protestant churches declared a day of national mourning.

Over the next few months, Germany experienced the single greatest destruction of monetary value in human history. By August 1923, a dollar was worth 620,000 marks and by early November 1923, 630 billion.17 Basic necessities were now priced in the billions—a kilo of butter cost 250 billion; a kilo of bacon 180 billion; a simple ride on a Berlin street car, which had cost 1 mark before the war, was now set at 15 billion.

Senator Reed Smoot of Utah;

“Has America which but yesterday we acclaimed for her generosity and her idealism fallen to the role of a Shylock?”

“They hired the money, didn’t they?”

The prime minister was furious. Having lost two of his sons in the war, Bonar Law had been all along deeply offended by the American view of war debts as just another commercial transaction.

As the decade went on, and the Americans insisted on extracting these payments, they were shocked to discover how intensely disliked they were in Europe.

There were essentially only two ways to restore the past balance between the value of gold reserves and the total money supply. One was to put the whole process of inflation into reverse and deflate the monetary bubble by actually contracting the amount of currency in circulation. This was the path of redemption. But it was painful. For it inescapably involved a period of dramatically tight credit and high interest rates, a move that was almost bound to lead to recession and unemployment, at least until prices were forced down. The alternative was to accept that past mistakes were now irreversible, and reestablish monetary balance with a sweep of the pen by reducing the value of the domestic currency in terms of gold—in other words, formally devalue the currency. This sounds painless. But to a generation reared on the certainties of the gold standard, devaluation was viewed as a disguised form of expropriation, a way of cheating investors and creditors out of the true value of their savings—which to some degree it was. Moreover, it was not completely costless. Central banks that resorted to devaluation as a way of cleaning up a past monetary mess were viewed as the financial equivalent of reformed alcoholics—it was hard to clear the stain on their reputations for financial discipline, and as a consequence, they generally had to pay up to borrow. A simple analogy of the choice between deflation and devaluation might be that of the man who has put on weight and is having a h...

inflation was much more than simply prices going up, but also a subtle mechanism for transferring wealth between social groups—from savers, creditors, and wage earners to the government, debtors, and businessmen.

The hidden irony was that every one of Keynes’s main recommendations—that the link between gold balances and the creation of credit be severed, that the automatic mechanism of the gold standard be replaced with a system of managed money, that credit policy be geared toward domestic price stability—corresponded precisely to the policies Strong had instituted in the United States.

The system was being swamped by so much excess gold that to have followed the traditional dictates of the gold standard would have led to a massive expansion of domestic credit, which inevitably would have led to very high rates of inflation—Strong calculated that it would cause prices to double. It made no sense to him for the United States to import, in effect, the inflationary policies of Europe and destabilize its own monetary system just because the Old World had been hit by political and financial disaster.

The Fed’s primary goal should be, he believed, to try to stabilize domestic prices. But he thought that it should also respond to fluctuations in business activity—in other words, the Fed should try to fine-tune the economy by opening the spigot of credit when commercial conditions were weakening and closing it as the economy strengthened.

The plan was to introduce a totally new currency, the Rentenmark, to be backed not by gold but by land. The bank issuing the new currency was granted a “mortgage” on all agricultural and industrial property, on which it could impose an annual levy of 5 percent—in effect, a tax on commercial real estate.

And so, when the new currency was introduced on November 15, 1923, Germany found itself in the curious position of having two official currencies—the old Reichsmark and the new Rentenmark—circulating side by side, issued by two uniquely parallel central banks.

Over the years, Germany had had no shortage of foreign “experts” willing to tell it how to stabilize its currency. The British ambassador, Viscount d’Abernon, himself a currency expert, remarked that on arriving in Berlin, these advisers would be invited to “entertainments after dinner—like actresses with doubtful pasts,” thereafter generally to meet a “sad fate. During life, they empty every room in which they hold forth, and death finds them in madhouses.” The monetary technicians had universally failed because it was not intellectual but financial help that Germany needed. This time, however, the “experts” were Americans, coming with the blessing of the U.S. government and the promise, so everyone hoped, of American money.

The war had cost it dearly—in blood and money. In the immediate aftermath it was forced to spend $4 billion on reconstructing the liberated territories. Still unreconciled to its enormous sacrifices, the French government refused to raise taxes to pay for this, stubbornly clinging to the illusion that the costs would eventually be recouped from Germany. “Les Boches paieront” “The Krauts will pay”—was the refrain.

At the invitation of Prime Minister MacDonald, the two bankers set forth the main conditions that investors would demand before lending money under the Dawes Plan. Recognizing that those who would provide the capital had enormous leverage, Norman insisted that neither British nor American bankers touch the loan “until the French are out of the Ruhr bag and baggage”; and to preclude any further such preemptive and unilateral military actions by France, the right to declare Germany in default of its payments was to be vested, not in the Reparations Commission, dominated as it was by the French, but in an independent agency to be run by a neutral American.

In that sense, the debate that evening, though dressed up as a technical discussion among experts, reflected, at bottom, a philosophical divide between those who believed that governments could be trusted with discretionary power to manage the economy and those who insisted that government was fallible and therefore had to be circumscribed with strict rules.

The state of mind that likes to stick to the straight old-fashioned course, rather regardless of the pleasure or the pain . . . is not to be despised. . . . Like other orthodoxies it stands for what is jejeune and intellectually sterile; and since it has prejudice on its side, it can use claptrap with impunity.

Casualties of Frenchmen during the war had been twenty times that of Americans. Coolidge’s infamous remark—“They hired the money, didn’t they?”—had displayed a remarkable indifference to the human sacrifice of Britain and France that all Europeans found chilling.

Central bankers can be likened to the Greek mythological character Sisyphus. He was condemned by the gods to roll a huge boulder up a steep hill, only to watch it roll down again and have to repeat the task for all eternity. The men in charge of central banks seem to face a similar unfortunate fate—although not for eternity—of watching their successes dissolve in failure. Their goal is a strong economy and stable prices. This is, however, the very environment that breeds the sort of overoptimism and speculation that eventually ends up destabilizing the economy. In the United States during the second half of the 1920s, the destabilizing force was to be the soaring stock market. In Germany it was to be foreign borrowing.

By THE END of 1926, this quartet of central bankers had already begun to worry about three of the factors—the U.S. stock market bubble, excessive foreign borrowing by Germany, and an increasingly dysfunctional gold standard—that would eventually lead to the economic upheaval at the end of the decade.

Ever since the war, as the gold standard had been rebuilt and evolved into a sort of dollar standard with the Federal Reserve acting as the central bank of the industrial world, Strong had found it useful to consult frequently with his colleagues—he generally used his summers in Europe as an occasion to meet all of his European counterparts.

Over the years, each of the central banks had acquired its distinctive architectural signature, somehow expressive of the institution’s character. While the Bank of England, for example, looked like a medieval citadel, the Banque de France like an aristocrat’s palace, the Reichsbank like a government ministry, for some reason—perhaps in a salute to those first international bankers, the merchant princes of Renaissance Italy—the New York Federal Reserve had chosen to dress itself up as a Florentine palazzo.

Coolidge, who had elevated inaction into a philosophical principle, had become increasingly irritated by his secretary of commerce’s constant insistence not only that something must be done about everything but that he, Hoover, knew exactly what was needed.

They argue that by artificially depressing interest rates in the United States to prop up the pound, the Fed helped fuel the stock bubble that subsequently led to the crash two years later.

THE GREAT BEAR of Wall Street legend, Jesse Livermore, once observed that “stocks could be beat, but that no one could beat the stock market.” By that he meant that while it was possible to predict the factors that caused any given stock to rise or fall, the overall market was driven by the ebb and flow of confidence, a force so intangible and elusive that it was not readily discernible to most people.

“You could talk about Prohibition, or Hemingway, or air conditioning, or music, or horses, but in the end you had to talk about the stock market, and that was when the conversation became serious.” Anyone trying to throw doubt on the reality of this Promised Land found himself being attacked as if he had blasphemed about a religious faith or love of country.

“When the time comes that a shoeshine boy knows as much as I do about what is going on in the stock market,” concluded Kennedy, “it’s time for me to get out.”

The new president was so well known to be a fervent opponent of the speculation on Wall Street that in the week of his nomination to the Republican candidacy, the stock market had gone down 7 percent. Like all of Washington, he faced a quandary. While he believed that the market was now living in a world of fantasy, the underlying economy was healthy and doing well. It was almost impossible to craft his comments in such a way as to talk the stock market back to earth without at the same time damaging the economy and laying himself open to accusations of undermining the American dream.

Immediately after the crash, Hoover, who liked nothing better than emergencies, threw himself into action. He was one of the hardest-working presidents in the history of the office, at his desk by 8:30 a.m and still there into the early hours of the next morning. Within a month, his administration had pushed through an expansion in public works construction and submitted a proposal to Congress to cut the income tax rate by a flat 1.0 percent. The federal government, however, was then tiny—total expenditures amounted to $2.5 billion, only 2.5 percent of GDP—and the effect of the fiscal measures was to inject barely a few hundred million dollars, less than 0.5 of 1.0 percent of GDP into the economy. Hoover had, therefore, to content himself with playing the part of chief economic cheerleader.

The government, a grand coalition of all democratic parties led by the Socialist Hermann Müller, proposed to finance itself by more borrowing abroad. For Schacht, who had been on a campaign against excessive foreign debt since 1927, this was one more sign that a coalition that included the Socialists was incapable of governing Germany. Having failed to control either its spending or borrowing abroad during the good times, it was now repeating the mistake as times turned bad. He feared that Germany was heading for national bankruptcy.

ARNOLD TOYNBEE, IN his magisterial review of the year’s events on behalf of the Royal Institute of International Affairs, would later compare the events of the summer of 1931 to the summer of 1914. Both began with relatively minor events far from the hub of the world that nevertheless set in train a cascade that plunged out of all control and brought down an entire world order. In 1914, it was the assassination of the Austrian heir presumptive, the archduke Franz Ferdinand, at Sarajevo. In 1931, it was the failure of the Credit Anstalt, the oldest and largest bank in Austria.

“On the ruins of the wealth, prosperity, and stability of other nations, France has succeeded in establishing her much desired politico-financial hegemony over Europe.”

“Never has the incapacity of the economic leaders of the capitalist world so glaringly demonstrated as today. . . . A capitalism which cannot feed the workers of the world has no right to exist. The guilt of the capitalist system lies in its alliance with the violent policies of imperialism and militarism. . . . The ruling classes of the world today have as completely failed in political leadership as in economic.

The currency and banking convulsions of 1931 changed the nature of the economic collapse. As prices fell and businesses were unable to service their debts, bankruptcies proliferated, further chilling spending and economic activity. A corrosive deflationary psychology set in. Fearing that prices would fall further, consumers and businesses cut spending, adding to the downward spiral in consumption and investment.

Bankers were now increasingly viewed as crooks and rogues.

“If you steal $25, you’re a thief. If you steal $250,000, you’re an embezzler. If you steal $2,500,000, you’re a financier,”

On economics, Roosevelt had a breezy and disconcerting ability to put forward contradictory policies without the slightest embarrassment. So while he pledged to increase federal relief for unemployment, supported higher tariffs, government development of power projects, increased regulation of securities markets, and the separation of commercial and investment banking, he also criticized Hoover for fiscal extravagance, accused him of encouraging inflation, and promised to balance the budget and commit himself to “sound money.”

ONE DAY into office, the very first action that Roosevelt took was to close every bank in the country. Invoking an obscure provision of the 1917 Trading with the Enemy Act, designed to prevent gold shipments to hostile powers, he imposed a bank holiday until Thursday, March 9. Simultaneously, he suspended the export or private hoarding of all gold in the United States.

By Thursday, March 9, the Emergency Banking Act was ready to be submitted to Congress. Most of it was based on the original Mills proposal. Banks in the country were to be gradually reopened, starting with those known to be sound, and progressively moving to the shakier institutions, which would need government support. A whole class of insolvent banks would never be permitted to reopen. The bill also granted the Fed the right to issue additional currency backed not by gold but by bank assets. And it gave the federal government the authority to direct the Fed to provide support to banks. The legislation was supplemented by a commitment from the Treasury to the Fed that the government would indemnify it for any losses incurred in bailing out the banking system.

As a protégé of Benjamin Strong, Harrison believed fervently in what he called the “separation of the central bank from the state”—the financial equivalent of the separation of the powers in the political sphere. The new legislation would give the president unprecedented control over the Fed.

“Our President took such a dry subject as banking . . . [and] he made everyone understand it, even the bankers.”

The Glass-Steagall Act, also passed in the middle of June, divorced commercial and investment banking and guaranteed bank deposits up to a maximum of $2,500,

The string of measures was a strange mixture of well-meaning steps at social reform, half-baked schemes for quasi-socialist industrial planning, regulation to protect consumers, welfare programs to help the hardest hit, government support for the cartelization of industry, higher wages for some, lower wages for others, on the one hand government pump priming, on the other public economy.