Lords of Finance: The Bankers Who Broke the World

by Liaquat Ahamed

It was no wonder that during a series of lectures on The Great Illusion delivered at Cambridge and the Sorbonne, Lord Esher would declare that “new economic factors clearly prove the inanity of war,” and that the “commercial disaster, financial ruin and individual suffering” of a European war would be so great as to make it unthinkable. Lord Esher and Angell were right about the meager benefits and the high costs of war. But trusting too much in the rationality of nations and seduced by the extraordinary economic achievements of the era—a period the French would later so evocatively call La Belle Époque—they totally misjudged the likelihood that a war involving all the major European powers would break out.

’Tis a common proof That lowliness is young ambition’s ladder —WILLIAM SHAKESPEARE, Julius Caesar

Also gold coins began mysteriously to vanish from circulation. Having been burned by disastrous experiments with paper money twice before—once in the early eighteenth century during the ill-fated Mississippi Bubble, and then again by the assignats issued during the Revolution—the French had developed a healthy mistrust of banks and all but the hardest metallic currency.

Few people—certainly not the Germans—were yet aware that on August 18, with the invaders still two hundred miles away in Brussels, the Banque de France had already set in motion its emergency plan—Paris, after all, had fallen to foreigners three times in the previous hundred years. Its gold reserves—38,800 gold ingots and innumerable bags of coins valued at $800 million and weighing some 1,300 tons—had been shipped in the utmost secrecy by rail and truck to safety at prearranged sites in the Massif Central and the south of France. The massive logistical operation went off without a hitch until one of the trains carrying coins derailed at Clermont-Ferrand. Five hundred men had been required to get it back on the tracks, collect the money, and keep off curious spectators. By early September, the Banque’s vaults in Paris were empty.

So smug were the bankers and economists that they even allowed themselves to be convinced that the discipline of “sound money” itself would bring everyone to their senses and force an end to the war. On August 30, 1914, barely a month into the fighting, Charles Conant of the New York Times reported that the international banking community was very confident that there would not be the sort of “unlimited issue of paper [money] and its steady depreciation,” which had wrought such inflationary havoc in previous wars. “Monetary science is better understood at the present time than in those days,” declared the bankers confidently.

And so as the financiers of Europe watched their continent slip toward Armageddon, its credit system collapsing onto itself, world stock markets closing their doors, and the gold standard grinding to a halt,9 they clung to the illusion that global commerce would be disrupted only briefly and the world would rapidly return to “business as usual.” Few imagined that they might be witnessing the last and dying convulsions of an entire economic order.

The experts seemed to have forgotten that among the first casualties of war is not only truth but also sound finance. None of the big wars of the previous century—for example, the Napoleonic Wars or the American Civil War—had been held back by a mere lack of gold. These had been fights to the death in which the belligerents had been willing to resort to everything and anything—taxes, borrowing, the printing of ever larger quantities of money—to raise the cash to pay for the war.

On his return from Austria, he summoned his council of ministers and, in one of his imperial tantrums, fired his minister of finance. To the Banque’s three-man management committee he offered the choice between prison or a fine of 87 million francs. They chose the fine. Determined never again to be held hostage by moneymen, Napoleon changed the Banque’s statutes so that henceforth the governor and the two deputy governors would be appointed directly by the government, which at that time meant Napoléon himself. He declared at the time, “The Banque does not belong only to its shareholders, but also to the state. . . . I want the Banque to be sufficiently in government hands without being too much so.”

German physicians even diagnosed a strange malady that swept the country, which they named “cipher stroke.” Those afflicted were apparently normal in every respect except, according to the New York Times, “for a desire to write endless rows of ciphers and engage in computations more involved than the most difficult problems in logarithms.” Perfectly sensible people would say they were ten billion years old or had forty trillion children. Apparently cashiers, bookkeepers, and bankers were particularly prone to this bizarre disease. Most people simply turned to barter or to using foreign currency. Every middle-class housewife knew up to the latest hour the exchange rate for the mark against the dollar. At every street corner, in shops and tobacconists’, even in apartment blocks, minute bureaux de change sprang up, with blackboards outside, advertising the latest exchange rates.

Inflation transformed the class structure of Germany far more than any revolution might have done. The rich industrialists did well. Their large holdings of real assets—factories, land, stocks of goods—soared in value while inflation wiped away their debts. Workers, particularly the unionized, also did surprisingly well. Until 1922, their wages kept up with inflation and jobs were plentiful. It was only in the last stages, from the end of 1922 into 1923, when the implosion of confidence caused the monetary system to seize up and the economy reverted to barter, that men were thrown out of work.

Those who made up the backbone of Germany—the civil servants, doctors, teachers, and professors—were hit the worst. Their investments in government bonds and bank deposits, carefully accumulated after a lifetime of prudence and discipline, were suddenly worthless. Forced to scrape by on meager pensions and salaries, which were decimated by inflation, they had to abandon their last vestiges of dignity. Imperial officers took jobs as bank clerks, middle-class families took in lodgers, professors begged on the streets, and young ladies from respectable families became prostitutes.

In October 1922, Lloyd George’s government precipitously fell and a new Conservative government under Andrew Bonar Law took office in Britain. The incoming chancellor of the exchequer, Stanley Baldwin, was a practical and sensible businessman who believed strongly in settling one’s debts—he was so firm an advocate of this principle that in 1919 he had anonymously donated $700,000 of his own money, a fifth of his net worth, to the government as his contribution to paying off the national debt after the war.

the decade went on, and the Americans insisted on extracting these payments, they were shocked to discover how intensely disliked they were in Europe. Journalists sent home articles dissecting the various sources of American unpopularity under such titles as “Europe Scowls at Rich America” or “Does Europe Hate the U.S. and Why?” or even “Uncle Shylock in Europe.” One informal poll revealed that 60 percent of the French regarded the United States as their least favorite nation.

What separated Norman from Keynes had less to do with economics and more to do with philosophy and worldview. For Norman, the gold standard was not simply a convenient mechanism for regulating the money supply, the efficiency of which was an empirical question. He thought about it in much more existential terms. It was one of the pillars of a free society, like property rights or habeas corpus, which had evolved in the Western liberal world to limit the power of government—in this case its power to debase money. Without such a discipline to protect them, central banks would inevitably come under constant pressure to help finance their governments in much the same way that they had done during the war with all the inflationary consequences that were still all too apparent. The link with gold was the only sure defense against such a downward spiral in the value of money.

KEYNES WAS THE first to recognize and articulate that, for all the public rhetoric about reinstating the gold standard, the new arrangements were in fact very different from the hallowed and automatic prewar mechanism. As he put it in the Tract, “A dollar standard was set up on the pedestal of the Golden Calf. For the past two years, the US has pretended to maintain a gold standard. In fact it has established a dollar standard.”

To Norman and the purists within the Bank of England, this was unacceptable. They continued to press for a return to the old gold rate of $4.86, seeing it as a moral commitment on the part of the British nation to those around the world who had placed their assets, their confidence, and their trust in Britain and its currency.

No one changed his mind that night. There was considerable agreement about the facts. All accepted that British prices were too high and that to bring them down would involve some pain, although they disagreed about its extent. All acknowledged that tying Britain to the gold standard would mean tethering it to the United States, with all the risks that entailed. But whereas the “gold bugs” believed that the costs were worth bearing in order to reinstate the automatic mechanism of the gold standard, Keynes and McKenna thought otherwise. There were too many imponderables for anyone to be sure of the answer. Both parties were making a leap of faith. 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.

While overall economic growth was exceptionally strong, even stronger and more exceptional was the rise in profits. Powered by new forms of organization and by a surge in factory mechanization, productivity accelerated in the 1920s while hourly wages grew only modestly. Most of the benefits, therefore, of the “new era” flowed to the corporate bottom line—by 1925, earnings were double their level in 1913.

Strong recognized his own highly fallible judgment about stocks was a very thin reed on which to conduct the country’s monetary policy.

Even though his initial reaction was that the market might have gone too far, he asked himself, “May it not be the case the world is now entering upon a period where business developments will follow the recovery of confidence, so long lost as a result of the war? Nobody knows and I will not dare prophesy.” Given so much uncertainty, he was convinced that the Federal Reserve should not try to make itself an arbiter of equity prices.

Moreover, even if he was sure that the market had entered a speculative bubble, he was conscious that the Fed had many other objectives to worry about apart from the level of the market. He feared that if he added yet another goal—preventing stock market bubbles—to the list he would overload the system. Drawing a rather stretched analogy between the Federal Reserve and its various and conflicting objectives for the economy and a family burdened by many children, he ruminated, “Must we accept parenthood for every economic development in the country? That is a hard thing for us to do. We would have a large family of children. Every time one of them misbehaved, we might have to spank them all.” He wanted the Fed ...

The first signs that other, more psychological, factors might be at play emerged in the middle of 1927 with the Fed easing after the Long Island meeting. The dynamic between market prices and earnings seemed to change. During the second half of the year, despite a weakening in profits, the Dow leaped from 150 to around 200, a rise of about 30 percent. It was still not clear that this was a bubble, for it was possible to argue that the fall in earnings was temporary—a consequence of the modest recession associated with Ford’s shutdown to retool for the change from the Model T to the Model A—and that stocks were being unusually prescient in anticipating a rebound in earnings the following year. The market was still well behaved, rising steadily with only a few stumbles, and without the slightly crazed erratic moves and frenetic trading that were to come.

Meeting with Harrison at the New York Fed, Norman now surprised everyone by arguing for a sharp rise in U.S. rates, possibly by 1 percent, even by 2 percent, taking the discount rate to 7 percent. The Fed should try to break “the spirit of speculation,” “prostrating” the market by a forceful tightening of credit. Once a change in psychology had been achieved, interest rates could be then brought down again and capital flows to Europe would resume. For some reason Norman thought the Fed could pierce the bubble with a surgical incision that would bring it back to earth, without harming the economy. It was a completely absurd idea. Monetary policy does not work like a scalpel but more like a sledgehammer. Norman could neither be sure how high rates would have to go to check the market boom nor predict with any certainty what this would do to the U.S. economy.

His big error was a failure to take into account the deflationary forces that had begun to sweep the world. After Strong’s death in October and as the Fed initiated its campaign of words against the exuberance of the market, he began slowly to realize that the risk had now shifted “on the side of business depression and a deflation.” But by his own admission, even in early 1929, he still did not comprehend the impact that the scarcity of gold would have on central banks. He had thought that over time they would liberate themselves from the hold of the “barbarous relic.” He completely failed to foresee the sort of scramble for gold that emerged in 1929. “I was forgetting that gold is a fetish,” he confessed.

He came back even more pessimistic than after his February trip. He was now convinced that some sort of stock market crash in the United States was inevitable. No one could be sure what might set it off or how bad it would be. The longer the bubble continued, the more unavoidable would be the breakdown. And though the Fed was finally beginning to act, it had left things very late and still remained a bitterly divided institution.

Babson had some other quirkier ideas. Having suffered a bout of tuberculosis as a youth, he believed in the benefits of fresh air and insisted on keeping all the windows in his office wide open. In winter, his secretaries, wrapped in woolen overcoats, sheepskin boots, and thick mittens, had to type by striking the keys with a little rubber hammer that Babson had himself expressly invented. He was a strict Prohibitionist, believed that the gravity of Newtonian physics was a malevolent force, and had published a pamphlet entitled Gravity—Our Number One Enemy.44 He had been predicting a market crash for the past two years and until now had been completely ignored.

The official chronicler of business cycles in the United States, the National Bureau of Economic Research, a not-for-profit group founded in 1920, would declare, though many months later, that a recession had set in that August. But in September, no one was aware of it. There were the odd signs of economic slowdown, especially in some of the more interest-rate-sensitive sectors—automobile sales had peaked and construction had been down all year, but most short-term indicators, for example, steel production or railroad freight car loadings, remained exceptionally strong.

Hoover had, therefore, to content himself with playing the part of chief economic cheerleader. Unfortunately, it was a role for which he was poorly suited. Shy, insecure, and stiff, he was ill at ease with people and surrounded himself with yes-men. He was also “constitutionally gloomy,” according to William Allen White, “a congenital pessimist who always saw the doleful side of any situation.” Unable to inspire confidence or optimism, he resorted, according to the Nation magazine, to “trying to conjure up the genie of prosperity by invocations” that things were about to get better. On December 14, 1929, barely six weeks after the crash, he declared that the volume of shopping indicated that country was “back to normal.” On March 7, 1930, he predicted that the worst effects would be over “during the next sixty days.” Sixty days later he announced, “We have passed the worst.” To some degree he was caught in a dilemma that all political leaders face when they pronounce upon the economic situation. What they have to say about the economy affects its outcome—an analogue to Heisenberg’s principle. As a consequence, they have little choice but to restrict themselves to making fatuously positive statements which should never be taken seriously as forecasts.

Finally asked by the chairman what the reasons were for a particular policy decision, he initially said nothing but simply tapped the side of his nose three times. When pressed, he replied, “Reasons, Mr. Chairman? I don’t have reasons. I have instincts.”

By statute, every $100 in Federal Reserve notes had to be backed by at least $40 in gold, the remaining $60 by so-called eligible paper—that is, prime commercial bills used to finance trade. Even though the Federal Reserve banks were permitted to hold government securities, and the buying and selling of such securities—open market operations—was one of the mechanisms by which the Fed injected money into the system, government paper could not be employed as an asset to back currency. Even when first introduced in the original 1913 legislation setting up the Fed, the restriction had been redundant, since the 40 percent gold requirement was enough to prevent the central bank from being used as an instrument of inflation. By 1931, with no risk of inflation—the country in fact facing a problem of deflation—the restriction served no purpose. Nevertheless, it remained obstinately on the books. With the Depression and the ensuing stagnation in trade, prime bills were scarce and hard to find. The Fed had to rely on gold to back its currency. Thus, in the fall of 1931, instead of having $2 billion too much gold and being grateful that some of it was finally flowing back to Europe, it found itself scrambling to hold on to its reserves. It was a manufactured problem, the result of an anachronistic regulation that had no basis in economic reality but which tied up a large amount of U.S. gold unnecessarily. And so early that October, in the midst of the Depression, as bank runs raged ac...

Norman himself provided the most poignant assessment of his own career. In 1948, he wrote: “As I look back, it now seems that, with all the thought and work and good intentions, which we provided, we achieved absolutely nothing . . . nothing that I did, and very little that old Ben did, internationally produced any good effect—or indeed any effect at all except that we collected money from a lot of poor devils and gave it over to the four winds.”