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As the mark plummeted, Germany became caught in an ever-deepening downward spiral. On June 24, 1922, the architect of fulfillment, Foreign Minister Walter Rathenau, one of the most attractive political figures in Germany—cultured, rich, scion of a great industrial family—was gunned down in his car by yet another group of crazed reactionaries. Panic set in. Prices rose fortyfold during 1922 and the mark correspondingly fell from 190 to 7,600 to the dollar.
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.
By the end of the war, the European allied powers—sixteen countries in all—owed the United States about $12
billion, of which a little under $5 billion was due from Britain and $4 billion from France. In its own turn, Britain was owed some $11 billion by seventeen countries, $3 billion of it by France and $2.5 billion by Russia, a debt essentially uncollectible after the Bolshevik revolution.
As the Peace Conference was winding to its end, Maynard Keynes, distressed at how the negotiations were going, decided on his own initiative to put together a comprehensive plan for the financial reconstruction of Europe. Reparations should be fixed at $5 billion, to be paid by Germany in the form of long-term bonds issued to the Allies, which they would in turn assign to pay their war debts to the U.S government. All other obligations were to be forgiven. It was a clever scheme. The U.S. government would be functionally lending Germany money, which in turn would go to pay reparations to the
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continued to insist that war debts must not be linked to reparations and that the former could not be forgiven on such a scale. And thus the problem of reparations and war debts would be allowed to fester over the maimed economic body of Europe.
Over the summer, the political threats to Europe had actually begun to recede. Though civil war still ravaged Russia, the risk of Bolshevik revolution in Germany had diminished. A Communist uprising in Berlin and an attempted revolution in Bavaria had both been crushed. From Strong’s point of view, the main danger was now economic. The two largest countries, France and Germany, both urgently needed food from abroad. Continental Europe was desperately short of capital to rebuild itself. Most disturbingly, he found a complete “lack of leadership” in Europe, with “people in authority . . .
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While Strong was in Paris, it became apparent that the United States was beginning its retreat from European affairs.
If REPARATIONS POISONED the relations among European countries, war debts did the same to the relations between the United States and its erstwhile associates, Britain and France. However hard the Americans tried to separate war debts from reparations, in the minds of most Europeans they remained inextricably linked. Indeed, in the middle of 1922, the British government made the connection explicit in a note drafted by Arthur Balfour, then acting foreign secretary, that Britain would collect no more on its loans to its Continental allies and on its share of reparations from Germany than the
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Bonar Law spoke for rejecting the American offer. He had consulted Maynard Keynes, who counseled him to hold out, arguing that Britain should refuse the American offer “in order to give them [the Americans] time to discover that they are just as completely at our mercy as we are at France’s and France at Germany’s. It is the debtor who has the last word in these cases.”
Watching Britain strike such a poor bargain for itself, France chose to wait it out. It would eventually settle its war debts in 1926, when it reluctantly conceded to pay 40 cents on the dollar—even then the arrangement was not ratified by the National Assembly until 1929. Italy did even better. When it settled, also in 1926, it would only agree to pay 24 cents on the dollar. As usual Keynes had been right—holding out would have given Britain a better deal. As the decade went on, and the Americans insisted on extracting these payments, they were shocked to discover how intensely disliked they
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But the really pernicious effect of war debts was that they made it hard, if not impossible, for Britain to forgo collecting its own debts from France and Germany, made France all the more obstinate in its efforts to collect reparations from Germany, and led Europe into a self-defeating vicious cycle of financial claims and counterclaims.
By 1923, they were seriously fearing for the future. The first few years of peace, begun so hopefully, had turned out to be a time of great frustration and
disappointment for both. The United States had washed its hands of European affairs and retreated into isolation. Currencies in Europe remained unstable. Neither of them could do much about the failures of economic policy in Germany or France, both paralyzed by reparations: Germany refusing to do anything to stabilize its economy until a fairer settlement was established, France in its turn insisting that it could make no concessions until a deal was reached on its war debts to Britain and America.
Even when he was nominally at work, he was often incapacitated, “afflicted by the generous use of morphine,” to control the terrible pain.
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
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The Bank wisely waited until 1815, when a defeated Napoléon was safely in exile on St. Helena, before taking this advice. Over the next six years, it almost halved the supply of paper money in Britain, driving down prices by 50 percent. And though those years from 1815 to 1821 had been years of riots and agricultural distress, Britain went back on gold in 1821.
But whereas the U.S. economy, more dynamic and unhampered by a large internal debt, was quickly able to bounce back from the recession, Britain remained stuck. The number of unemployed would not fall below one million for the next twenty years. It soon became apparent that Britain had sustained terrible damage as an economic power during the war. Industries such as cotton, coal, and shipbuilding, in which it had once led the world, had failed to modernize and the traditional markets had been lost to competitors. Labor costs had risen as unions negotiated shorter working hours.
A Tract on Monetary Reform,
But whereas before the war he had
thought that the best way to achieve this was to ensure that currencies such as the pound be fully convertible to gold at a fixed value, he had now come to believe that there was no reason why linking money supply and credit to gold should necessarily result in stable prices.
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.
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 therefore began to short-circuit the effects of additional gold on the money supply by contracting the amount of credit that it supplied to banks, thus offsetting any liquidity from gold inflows.
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.
Strong’s policy contained a fundamental contradiction. On the one hand, he advocated a worldwide return to the international gold standard. On the other, he was doing things that not only undermined the doctrine he claimed most to believe in, but also, by preventing the gold from being recycled to Europe, he was making it all the more difficult for Europe to contemplate rejoining America on the gold standard. It was a dilemma he was never able to resolve.
When the Fed was conceived, it was assumed that it would primarily influence credit conditions by changes in its discount rate, the interest rate it charged on loans to member banks. By the early 1920s, this technique was proving to be too passive, depending, as it did, for its impact on how much or how little bankers
were willing to borrow at the discount window. Strong recognized that by buying or selling government securities from its portfolio, the Fed could directly and immediately alter the quantity of money flowing through the banking system.
If there was one problem with this whole process of making monetary policy, it was that it all depended too heavily on Strong—on his judgment, his skill, and his insight. He was too autocratic, operated on his own too much, and did not spend the time to build a consensus through the whole system. As a result, the rationale for many of his decisions was misinterpreted and his motives were constantly questioned. His failure to institutionalize policies and the thinking behind them meant that once he was no longer around, the Fed would become paralyzed by internal conflicts.
After the war, as the world struggled to emerge from economic chaos, with
currencies still in turmoil and gold in short supply everywhere outside America, it did not bode well that the new “conductor of the orchestra,” the Federal Reserve, was a deeply divided organization that did not fully realize the role that had been thrust upon it and, but for Strong, would have been in the hands of a motley crew of small-town businessmen and minor-league political hacks with little expertise in finance or central banking.
But in the five years since the revolution, he had steadily rebuilt his political image, transforming himself from a jingoistic warmonger to a trusted pillar of the new democracy, though many believed that his conversion was a sham.
Schacht came to the job with an array of qualifications. He was well known and admired in foreign banking circles, an attribute that would become very important when Germany had to go through its next cycle of wrangling over reparations. He was supported by the center and the left. In addition, it was
rumored that Jacob Goldschmidt, powerful in Democratic Party circles and keen to oust Schacht from the Danatbank, was actively lobbying to kick him upstairs. The post he assumed carried with it unprecedented powers. He was given cabinet rank; was to be invited to all its meetings; and most important, had the right of veto over any measures that had implications for the currency, a veto that could only be overridden by a majority of the cabinet.
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.
While Schacht, usually a realist, had suggested that Germany try to build up its gold reserves by borrowing abroad, few people believed that a country that had defaulted on reparations the previous year and was now partly occupied by foreign troops would get even a hearing from international bankers.
The most important, perhaps the defining, characteristic of the new currency was not that it theoretically rested on land, but that the amount to be issued was to be rigidly fixed at 2.4 billion Rentenmarks, equivalent to around $600 million. Grasping that the key to its credibility was to keep it sufficiently scarce, Schacht was determined to ensure that the amount in circulation did not exceed its statutory ceiling under any circumstances. And though he encountered considerable political pressure to relent, including from his cabinet colleagues, he stuck to his position. He was obstinate,
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Finally, on November 20, when the
Reichsmark stood, if that is the word, at 4.2 trillion to the dollar, he fixed the conversion rate at 1 trillion Reichsmarks to a Rentenmark. The decision to wait those extra days, allowing the old currency to sink by another 80 percent, was a brilliant tactical move. The Reichsmark became so worthless that the government was able to buy back its many trillions of debt, valued at $30 billion when first issued, for only 190 million Rentenmarks, equivalent to about $45 million.
As prices began to hold and then fall, it became profitable to hang on to cash. Farmers, their confidence in money restored,
began bringing produce to market, food reappeared in the shops, and those interminable queues began to melt away. Lord d’Abernon, the British ambassador, wrote of the “astonishing appeasement and relief brought about by a touch of the magical wand of “Currency Stability. . . . The economic détente has brought in its train political pacification—dictatorships and putsches are no longer discussed, and even the extreme parties have ceased, for the moment, from troubling. ”
Not all of this was Schacht’s doing. Stresemann and his cabinet colleagues backed the Rentenmark with a series of budgetary measures, suspending all subsidy payments to workers in the Ruhr, firing a quarter of the government workforce, and indexing all taxes to inflation, thus eliminating the incentive for taxpayers to delay payment. By January 1924, the budget was balanced. But it...
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He was asking for a mere $25 million, which, supplemented by a further $25 million that he hoped to raise from capital held abroad by German banks, would be enough to give the new subsidiary access to the London market and provide the nucleus for as much as $200 million in loans.
One element in Schacht’s plan was specifically designed to appeal to Norman: the proposal to base the new bank on the pound sterling. Not only was its capital to be denominated in sterling, it would make loans in sterling, and perhaps issue bank notes in pounds to circulate in Germany. Norman had been working to strengthen the pound by having other European central banks hold some of their reserves in sterling rather than gold. He had so far had some modest success with the idea. Austria and Hungary, like Germany ravaged by postwar inflation, had both pegged their currencies to the pound. But
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In its place, he proposed an alternative criterion: the German public should be required to shoulder the same tax burden as British and French taxpayers. Britain and France had to tap their tax revenues to pay interest on their own internal debts. Germany had inflated away its internal public debt—the Germans, therefore, had a natural surplus from which they could afford to pay
reparations.
On March 13, the French government announced that J. P. Morgan & Co. had lent it $100 million on the security of its gold reserves. The conditions attached
