Lords of Finance: The Bankers Who Broke the World

by Liaquat Ahamed

were made public, including the usual clauses about the government taking steps to balance its budget, reduce expenditures, and float no new loans. But it was also rumored that Morgans, normally considered one of the most pro-French of all American investment houses, had also secretly insisted that the French government bind itself to accepting whatever plan the Dawes Committee might issue. Just the announcement of the loan was enough to turn things around and the franc rebounded from 29 to 18 to the dollar, an appreciation of more than 60 percent in two weeks. As for Germany, the Dawes Committee quickly recognized that much had changed in the month since it had been appointed. The economic situation had been transformed: the currency was stabilized and the budget was swinging back into balance. Meanwhile, everyone was acclaiming Schacht “the miracle worker.”

But the plan’s most novel feature was to put in place an ingenious mechanism to ensure that reparations could not undermine the mark as they had in 1922-23. The money to pay reparations was to be raised initially in marks by the German government and paid into a special escrow account in the Reichsbank, where it would fall under the control of an agent-general for reparations who would be responsible for deciding whether these funds could be safely transferred abroad without disrupting the value of the mark.

The power was vested in this new office to decide how these funds should be put to use—whether to be paid out abroad, used to buy German goods, or even to provide credit to local businesses. The agent-general would be in a remarkably strong position, a sort of economic proconsul or viceroy. To make his impartiality completely transparent, the committee recommended that he be an American.

A second and ultimately the central feature of the Dawes Plan was that a loan of $200 million be raised abroad to help pay the first year of reparations, to recapitalize the Reichsbank and build up en...

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.

All voted for acceptance, except for Schacht, who said, in his harsh Frisian accent, “We cannot accept the terms—we can never fulfill them.” He insisted that the Dawes Plan’s failure to reduce the total level of reparations was its fatal flaw. But it was Stresemann who had the final word. “We must get the French out of the Ruhr. We must free the Rhineland. We must accept.”

In September, the loan that formed the basis of the plan was successfully floated in New York and London. It started a boom in lending to Germany by American banks that was to fuel a recovery in its economy for the next several years and bring stability to the new currency.

The comparison between Britain and France was striking. Solid conservative Britain had pursued the most orthodox and prudent financial policies of any European power, refusing to inflate its way out of debt or to allow its currency to

collapse, and had been rewarded with the highest unemployment rate in Europe and a limping economy. By contrast, France had been invaded during the war, suffered the highest ratio of casualties of any country other than Serbia, and seen large tracts of its most productive land leveled and destroyed. After the war, the French had resorted to inflation to lighten the burden of debt and to a weak franc to steal a march on the British by cheapening their goods.

Though the government had continuously staggered on the edge of insolvency since the war, the overall economy had done well; exports had boomed. The number of unemployed in France was a fraction of that in Britain. As one contemporary journalist summarized it, “While England is financially so...

Strong did not have to persuade Norman of the consequences should Britain not return to gold. They agreed that this could only lead to “a long period of unsettled conditions too serious to contemplate. It would mean violent fluctuations in

the exchanges, with probably progressive deterioration in the values of foreign currencies vis-a vis-the dollar; it would prove an incentive to all those who were advancing novel ideas for nostrums and expedients other than the gold standard to sell their wares; and incentives to governments at times to undertake various types of paper money expedients and inflation; it might indeed result in the United States draining the world of gold.” It could but end, they believed, “with a terrible period of “hardship, and suffering, and . . . social and political disorder,” culminating in some kind of “monetary crisis.”

He was acutely aware that British prices were still

10 percent too high, and that further deflation to cut them would bring further hardship. But he had become increasingly convinced that the British needed to be pushed into making the big decision—force majeur, he called it. The shock therapy of forcing Britain to compete in world markets, while painful, would bring about the necessary realignment in prices more efficiently than a long drawn-out policy of protracted tight credit.

His main point was that under current arrangements, given that U.S. gold reserves were so dominant, to tie the pound to gold in effect meant tying it to the dollar and the British economy to that of the United States—and by implication, to Wall

Street.

theme—that Britain, suffering from a slow rate of growth, exhausted finances, and “faults in her economic structure,” was simply too weak to tether itself to a United States that seemed to “live in a vast and unceasing crescendo.” The United States, with all its strength and dynamism, could “suffer industrial and financial tempests in the years to come, and they will scarcely matter to her; but England if she shares them, may almost drown.”

Churchill, however, questioned whether this was also to Britain’s advantage and worried that while the return to gold was in the interest of City financiers, it might not be equally in the interest of the rest of Britain: “the merchant, the manufacturer, the workman, and the consumer.” It was a document that could almost have been written by Maynard Keynes.

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 initial consequences of the move were relatively benign. Britain, with its higher interest rates, attracted enough money that the credits provided by the Federal Reserve and J. P. Morgan were never needed. Britain’s gold reserves actually increased during 1925.

By the late summer, the rise in the exchange rate began taking its toll on the staple export industries of coal, steel, and shipbuilding. Particularly hard hit was the weakest of these, coal, much of which was threatened with bankruptcy after the resumption of production in the Ruhr and the squeeze on prices from the rise in the exchange rate. The owners demanded a cut in wages and an increase in hours from the coal miners.

The return to gold proved to be a costly error. That the money attracted by the high interest rates was speculative—“hot”—and not a source of permanent investment left a constant threat hanging over the currency. Just to prevent it from flooding back out again, interest rates had to be kept significantly higher than that in other countries for the balance of the decade. With prices falling at around 5 percent per annum, the burden of these charges on borrowers was heavy. Meanwhile, British manufacturing, hobbled in world markets by its high prices, limped painfully along for the next few years while elsewhere in the world industry boomed.

What happened over the next few days illustrates the overwhelming power that psychological factors had come to exercise over the currency market. On the day that Poincaré became prime minister, the franc touched 50 to the dollar. But even before he had had a chance to outline his financial program or introduce any new tax measures, his presence alone seemed to reassure investors. Within the space of two days, the franc had rebounded to 43 to the dollar and by the following week, it

was back at 35, a rise of more than 40 percent. This astonishing recovery seems to confirm the thesis that in the last stages of its collapse, the currency had lost all connection to economic reality and was being driven downward by speculators.

He recognized that the choice of the exchange rate ultimately determined how the financial burden of the war was to be shared. It was Maynard Keynes who had first articulated the political dimension to exchange rate policy in the Tract, back in 1923: “The level of the franc is going to be settled, not by speculation or the balance of trade, or even the outcome of the Ruhr adventure, but by the proportion of his earned income which the French taxpayer will permit to be taken from him to pay the claims of the French rentier.”

The higher the Banque de France let the franc rise, the higher would be the value of the government debt, the better for the French rentier and the worse for the taxpayer. As Moreau put it, fixing the exchange rate was a matter of balancing “the sacrifices demanded of the different social classes in the population.”

Whatever the reason, his decision to fix the franc at an undervalued rate would eventually help to undermine the stability of the very standard to which he had now hitched his currency.

In retrospect, Strong made the right decision in resisting the pressure from Miller and Hoover to tighten credit in late 1925 and 1926. In their enthusiasm to save the country from overspeculation, they had fallen into the first trap of financial officials dealing with complex markets—an excessive level of confidence in their own judgments. Miller, the academic economist, and Hoover, the engineer, were both insulated from doubt by their ignorance of the way markets operate. In their zeal to burst a bubble that did not exist, they would have damaged the economy without any tangible benefit.

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.

After the fiasco of the Beer Hall Putsch, most people treated Hitler as a laughingstock. Nevertheless, there were ominous undercurrents of the convulsions to come. On March 21, 1927, a band of six hundred Nazi brownshirt storm troopers of the Sturmabteilung , the SA, beat up a group of Communists in eastern Berlin and marched into the center of the city, attacking anyone on the Kurfürstendamm who looked Jewish. The city authorities responded by banning Nazi activity from Berlin for a year.

But the economy was booming. Over the three years since the mark had been stabilized, output rose close to 50 percent and exports by over 75 percent. The GDP had surpassed its prewar level by a good 20 percent, unemployment was now at a modest 6 percent, and prices were steady.

But Germany was now borrowing too much abroad. Schacht worried that the foreign debt buildup was becoming so large that when the day came for it to be repaid, it would precipitate a gigantic payments crisis and national bankruptcy. It made no sense to him for Germany to be borrowing dollars to build wonderfully modern urban amenities, such as opera houses, which could never generate the foreign currency to repay the loans.

The Reichsbank instructed every bank in Germany to cut its loans for stock trading by 25 percent immediately. The next day, nicknamed “Black Friday” by the Berlin press, stock prices fell by over 10 percent. Over the next six months, they would slide by another 20 percent.

By going after the stock speculators, Schacht was hoping to crack the atmosphere of overconfidence and curb inflows of foreign money into Germany. This proved to be a serious miscalculation. Even though stocks had gone up a lot in the last five years, this represented a recovery from the brink of disaster. The market was by no means overpriced—in early 1927, its total capitalization was only around $7 billion, less than 50 percent of GDP, still only 60 percent of its prewar level. More important, German municipalities, which were immune to stock market fluctuations, kept on borrowing abroad. All that Schacht had achieved with this hasty maneuver was unnecessary damage to business confidence.

The miracle of the franc’s recovery may have been good for France but imposed its own financial strains upon Europe. The money drawn back to the franc on Poincaré’s coattails continued to flow in throughout the spring and early summer of 1927, mostly out of sterling. The Banque de France, in an effort to prevent this flood from pushing the franc to uncompetitive levels, kept buying foreign currencies, and by the end of May, had accumulated a foreign exchange war chest totaling $700 million, half of which was in pounds.

Frustrated by Norman’s obstructionism, the Banque surprised the Bank of England in May by announcing that it would pay off the loan and take back the $90 million of gold reserves pledged as security. The next month, without even consulting the British, the Banque issued instructions that $100 million of its sterling balances be converted into gold. The effect would have been to drain almost $200 million of gold out of the Bank of England’s reserves.

The shrinkage of reserves in the country losing bullion was supposed to lead to an automatic contraction in credit and a rise in interest rates, which would thereby shrink its buying power, while attracting money from abroad. Meanwhile, the country gaining gold would find its credit expanding and its capacity

to spend increasing. These “rules of the game,” as Keynes called them, were designed to set in train automatic gyroscopic forces to balance out the shifting tides of gold among countries.

The British were not completely on the defensive. They did point out that while France held some $350 million in sterling that it could convert into gold, the British government held $3 billion of French war debts on which it could theoretically demand immediate repayment.

Before the war, when the gold standard had worked automatically, the system had simply required all central banks, operating independently, to follow the rules of the game. Collaboration had not needed to go beyond occasionally lending one another gold. 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.

A few days after the European central bankers left, the New York Fed and eight of the other reserve banks voted to cut interest rates by 0.5 percent to 3.5 percent. It was a move that split the system. Four reserve banks—Chicago, San Francisco, Minneapolis, and Philadelphia—insisting that such a move would only fuel stock market speculation, refused to follow.

In August, following the Fed cut in rates, the market immediately took off. By the end of the year, the Dow had risen over 20 percent, breaking 200. In January 1928, the Fed revealed that the volume of broker loans had risen to a record $4.4 billion from $3.3 billion the previous year. By early 1928, the calls on the Fed to do something about the market had become a clamor. The United States had come out of its brief recession, and for the first time since the war, gold was flowing into Europe. Even the pound seemed in better shape. In February 1928, Strong, recognizing that the cut might have been a mistake, bowed to pressure and agreed to reverse course. Over the next three months, the Fed raised its rates from 3.5 percent to 5 percent.

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.

It is hard to dismiss this view. Though the cut was small—only 0.5 percent off the level of interest rates—and short lived—reversed within six months—the fact that the market should begin the dizzying phase of its rally in the very same month, August 1927, that the easing took place has to be more than mere coincidence. The Fed’s move was the spark that lit the forest fire.

He also began to realize that his policy of keeping U.S. interest rates low to bolster sterling had failed to solve the fundamental problem of the British economy—that its prices were too high and its currency overvalued. Furthermore, he had unintentionally provided the impetus for the growing bubble on Wall Street. And it had exposed him to constant criticism at home

over his excessive focus on international affairs.

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.

That it was so obviously a bubble was apparent not simply from the fact that stock prices were now rising out of all proportion to the rise in corporate earnings—for while stock values were doubling, profits maintained their steady advance of 10 percent per year. The market displayed every classic symptom of a mania: the progressive narrowing in the number of stocks going up, the nationwide fascination with the activities of Wall Street, the faddish invocations of a new era, the suspension of every conventional standard of financial rationality, and the rabble enlistment of an army of amateur and ill-informed speculators betting on the basis of rumors and tip sheets.