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For the world’s most important central banker to have a nervous breakdown as the global economy sank yet deeper into the second year of an unprecedented depression was truly unfortunate.
Production in almost every country had collapsed—in the two worst hit, the United States and Germany, it had fallen 40 percent. Factories throughout the industrial world—from
Armies of the unemployed now haunted the towns and cities of the industrial nations. In the United States, the world’s largest economy, some 8 million men and women, close to 15 percent of the labor force, were out of work. Another 2.5 million men in Britain and 5 million in Germany, the second and third largest economies in the world, had joined the unemployment lines.
Unemployment led to violence and revolt. In the United States, food riots broke out in Arkansas, Oklahoma, and across the central and south-western states. In Britain, the miners went out on strike, followed by the cotton mill workers and the weavers. Berlin was almost in a state of civil war. During the elections of September 1930, the Nazis, playing on the fears and frustrations of the unemployed and blaming everyone else—the Allies, the Communists, and the Jews—for the misery of Germany, gained close to 6.5 million votes, increasing their seats in the Reichstag from 12 to 107 and making
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collapsing banking system.
Later that month the crisis spread to the City of London, which, having lent heavily to Germany, found these claims now frozen. Suddenly, faced with the previously unthinkable prospect that Britain itself might be unable to meet its obligations, investors around the world started withdrawing funds from London. The Bank of England was forced to borrow $650 million from banks in France and the United
States, including the Banque de France and the New York Federal Reserve Bank, to prevent its gold reserves from being completely depleted.
The historian Arnold Toynbee, who knew a thing or two about the rise and fall of civilizations, wrote in his annual review of the year’s events for the Royal Institute of International Affairs, “In 1931, men and women all over the world were seriously contemplating and frankly discussing the possibility that the Western system of Society might break down and cease to work.”
Norman had acquired his reputation for economic and financial perspicacity because he had been so right on so many things. Ever since the end of the war, he had been a fervent opponent of exacting reparations from Germany. Throughout the 1920s, he had raised the alarm that the world was running short of gold reserves. From an early stage, he had warned about the dangers of the stock market bubble in the United States.
But a few lonely voices insisted that it was he
and the policies he espoused, especially his rigid, almost theological, belief in the benefits of the gold standard, that were to blame for the economic catastrophe that was overtaking the West. One of them was that of ...
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THE COLLAPSE of the world economy from 1929 to 1933—now justly called the Great Depression—was the seminal economic event of the twentieth century. No country escaped its clutches; for more than ten years the malaise that it brought in its wake hung over the world, poisoning every aspect of social and material life and crippling the future of a whole generation. From it flowed the turmoil of Europe in the “low dishonest decade” of the 1930s, the rise of Hitler and Nazism, and the eventual
slide of much of the globe into a Second World War even more terrible than the First.
When the First World War ended in 1918, among its innumerable casualties was the world’s financial system. During the latter half of the nineteenth century, an elaborate machinery of international credit, centered in London, had been built upon the foundations of the gold standard and brought with it a remarkable expansion of trade and prosperity across the globe. In 1919, that machinery lay in ruins. Britain, France, and Germany were close to bankruptcy, their economies saddled with debt, their populations impoverished by rising prices, their currencies collapsing. Only the United States had
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They had to operate, however, in old-fashioned ways with only primitive tools and sources of information at their disposal. Economic statistics had only just begun to be collected. The bankers communicated by mail—at a time when a letter from New York to London took a week to arrive—or, in situations of real urgency, by cable. It was only in the very last stages of the drama that they could even contact one another on the telephone, and then only with some difficulty.
The world in which they operated was both cosmopolitan and curiously parochial. It was a society in which racial and national stereotypes were taken for granted as matters of fact rather than prejudice,
Though the WASPs were, like so many people in those days, casually anti-Semitic, the two groups treated each other with a wary respect. They were all, however, snobs who looked down on interlopers. It was a society that could be smug and complacent, indifferent to the problems of unemployment or poverty. Only in Germany—and that is part of this story—did those undercurrents of prejudice eventually become truly malevolent.
Boiled down to its essentials, a central bank is a bank that has been granted a monopoly over the issuance of currency.1 This power gives it the ability to regulate the price of credit—interest rates—and hence to determine how much money flows through the economy.
Unlike today, however, when central banks are required by law to promote price stability and full employment, in 1914 the single most important, indeed overriding, objective of these institutions was to preserve the value of the currency.
At the time, all major currencies were on the gold standard, which tied a currency in value to a very specific quantity of gold. The pound sterling, for example, was defined as equivalent to 113 grains of pure gold, a grain being a unit of weight notionally equal to that of a typical grain taken from the middle of an ear of wheat. Similarly, the dollar was defined as 23.22 grains of gold of similar fineness. Since all currencies were fixed against gold, a corollary was that they were all fixed against one another. Thus there were 113/23.22 or $4.86 dollars to the pound. All paper money was
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Few people realized how fragile a system this was, built as it was on so narrow a base.
While it may have succeeded in controlling inflation, the gold standard was incapable of preventing the sort of financial booms and busts that were, and continue to be, such a feature of the economic landscape. These bubbles and crises seem to be deep-rooted in human nature and inherent to the capitalist system.
Each of these episodes differed in detail. Some originated in the stock market,
some in the credit market, some in the foreign exchange market, occasionally even in the world of commodities. Sometimes they affected a single country, sometimes a group of countries, very occasionally the whole world. All, however, shared a common pattern: an eerily similar cycle from greed to fear. Financial crises would generally begin innocently enough with a surge of healthy optimism among investors. Over time, reinforced by cavalier attitudes to risk among bankers, this optimism would transform itself into overconfidence, occasionally even into a mania. The accompanying boom would go on
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The central banks had powerful tools to deal with these outbursts—specifically their authority to print currency and their ability to marshal their large concentrated holdings of gold. But for all of this armory of instruments, ultimately
the goal of a central bank in a financial crisis was both very simple and very elusive—to reestablish trust in banks.
The financial spadework had begun in earnest after the Agadir crisis of 1911 when Germany decided deliberately to provoke a
confrontation with France over Morocco. In the middle of the crisis, Germany was hit by a financial panic. The stock market plunged by 30 percent in a single day, there was a run on banks across the country as the public lost its nerve and started cashing in currency notes for gold, and the Reichsbank lost a fifth of its gold reserves in the space of a month. Some of this was rumored to have been caused by a withdrawal of funds by French and Russian banks, supposedly orchestrated by the French finance minister. The Reichsbank came close to falling below the statutory minimum of gold backing
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When they hesitated, he reputedly told them, “The next time I ask that question, I expect a different answer from you gentlemen.”
After that episode, the German government was determined that it would never again allow itself to be financially blackmailed. Banks were told to build up their gold reserves, the Reichsbank itself increasing its holdings from $200 million at the time of Agadir to $500 million in 1914—by comparison, the Bank of England held only some $200 million. The government even revived a plan originally conceived by Frederick the Great back in the eighteenth century for a war chest of bullion—$75 million in gold and silver—stored in the Julius Tower in the fortress of Spandau on the western outskirts of
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The 1907 panic exposed how fragile and vulnerable was the country’s banking system. Though the panic had finally been contained by decisive action on Morgan’s part, the panic became clear that the United States could not afford to keep relying on one man to guarantee its stability, especially since that man was now seventy years old, semiretired, and focused primarily on amassing an unsurpassed art collection and yachting to more congenial climes with his bevy of middle-aged mistresses. Shaken by the crisis, the U.S. Congress decided to act. In 1908, it created the National Monetary
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comprehensive study of the banking system and to make recommendations for its reform. Over the next few years, the commission produced a voluminous set of studies on central banking in Europe but not much else. Memories of how close the system had come to imploding progressively dimmed and the momentum for reform stalled.
The plan they developed over those ten days, the final details of which were drafted by Vanderlip and Strong, was unveiled to the public on January 16, 1911. Known as the Aldrich Plan, it had at its center a single institution—the National Reserve Association—a central bank in everything but name that would have branches all over the country, with authority to issue currency and to lend to commercial banks. While the government was to be represented on the association’s board, the association itself was to be owned and controlled by banks, a sort of bankers’ cooperative.
Over the next few months, much to Strong’s dismay, Progressives and midwestern Republicans joined forces to kill the plan; but in early 1913, the Democrats in Congress, led by Senator Carter Glass, salvaged the idea by modifying it. Rather than creating a single central bank, which would involve too great a concentration of power, the Glass Plan called for a number of autonomous regional institutions: Federal Reserve Banks, as they were to be named. While these individual entities were to be controlled and run by local bankers, a capstone—the Federal Reserve Board, a public agency whose
members were to be appointed by the president—was placed in an oversight role over the whole structure. Although Glass’s bill copied many of the essentials of the Aldrich Plan, Strong actively campaigned against it, predicting that its decentralized structure would simply perpetuate the fragmentation and diffusion of authority that had so bedeviled American banking and would only lead to conflict and confusion. Eventually New York bankers—pragmatic as ever and recognizing that the Glass Plan at least offered something better than the status quo—came around and it was signed into law as the
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Thus, when the order for general mobilization was issued at 4:00 p.m. on Saturday, August 1, French gold reserves were immediately immobilized.
By then the five major powers—Britain, France, Russia, Germany, Austria-Hungary—were spending a massive $3 billion each month, nearly 50 percent of their collective GDP. No other war in history had absorbed so much of the wealth of so many nations at one time.
The United States spent in total some $30 billion on the war, a little over $20 billion on its own actual expenditures and another $10 billion in the form of loans to keep other countries going.
By the time the war drew to a close, the Fed was a transformed institution. While it was not completely immune from the pressures of war finance, unlike so many European central banks, it had resisted purchasing government bonds directly and only indirectly helped to fuel the expansion in money supply. It had therefore secured some credibility. More important, the war had irrevocably changed the economic and financial position of the United States in relation to the rest of the world. The Fed, which barely existed in 1914, now sat on the largest reservoir of gold bullion in the world, making
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Across Europe some 11 million men lay dead, including 2 million Germans, 1.4 million Frenchmen, and 900,000 British. Another 21 million had been wounded, very many maimed for life. Nine million civilians had perished, mostly of hunger, cold, or lowered resistance to the monstrous epidemics. But for all the horrendous human carnage, the actual material destruction of the war was limited to a long but narrow strip of northern France and Belgium. The costs of rebuilding the mines, farms, and factories destroyed on the Western Front amounted to only $7 billion.
Most European economies had contracted—Germany’s and France’s by 30 percent, Britain by less than 5 percent—as men and capital were siphoned off, as factories diverted to producing arms, and livestock slaughtered. The war had been a boon for the United States. Entering late, it had suffered fewer casualties, while the massive expansion
in exports of foodstuffs, raw materials, and war supplies to its allies had provided a gigantic boost to its economy. Before the war, its GDP of $40 billion per annum was roughly the equivalent of that of Britain, France, and G...
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Everyone arrived in Paris expecting France, which had suffered the worst civilian damage and
heaviest casualties, to be the strongest advocate of punitive reparations against Germany. Instead, it turned out to be Britain.
They adopted the position that a large reparations bill was incompatible with the initial terms of the armistice agreement under which Germany had laid down its arms. Moreover, they argued that punitive reparations would act as a millstone, not simply around Germany’s neck but around that of all Europe.
The Americans preferred a settlement in the region of $10 to $12 billion and would go no higher than $24 billion. Although President Wilson was, for the most part, outnegotiated and outfoxed by the other leaders in Paris, on this point the American delegation stuck to their guns and refused to agree to reparations that exceeded these limits.
Only on reparations did Germany seem able to fight back. It discovered what every large debtor at some point discovers: that when one owes a large amount of money, threatening to default can give one the upper hand.
The German delegation was subjected to a litany of petty humiliations: they were forced to stay at the worst hotel, given bad food, their movements restricted, and they were openly followed. Finally, during the negotiations themselves, they were not even provided with chairs but were required to stand.
In the book Keynes argued that in order for Germany to earn the money to pay the Allies, it would have to sell more goods than it bought, and its trade partners would have to be willing to absorb this large influx of goods, with potentially crippling consequences for their own industries. It was therefore in the Allies’ own self-interest to moderate their demands. As he put it, “If Germany is to be milked, she must not first of all be ruined.” He concluded that the most Germany could afford to pay, without causing a massive disruption of world trade, was around $6 billion.
It was not simply their bad manners. They calculated, very correctly, that the longer they could string out the bargaining over reparations, the less they would end up paying. Their whole strategy was therefore to negotiate in bad faith. In the first two years after signing the treaty, Germany desperately scraped together what it could, and paid $2 billion out of the $5 billion of interim payments due.
