Lords of Finance: The Bankers Who Broke the World

by Liaquat Ahamed

Most famously, Joseph Kennedy decided to sell completely out of the market when in July 1929, having already liquidated a large portion of his portfolio, he was accosted by a particularly enthusiastic shoeblack on a trip downtown to Wall Street, who insisted on feeding him some inside tips. “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.”

Their constituents, the farmers, had already been through hard times for most of the decade as commodity prices fell and were now being starved of credit as it was diverted into the stock market. But the senators slowly came to recognize that they would only inflict greater damage upon their people if they pressed for tighter credit to force stock prices down.

It was thus left to the Fed to wrestle with the conundrum of how to deflate the stock bubble without crippling the economy. Recognizing that the easing of credit policy in the middle of 1927 had been a mistake, it raised rates from 3.5 percent in February 1928 to 5 percent in July 1928. But just as the stock market began its second leg upward in the middle of 1928, the Fed fell silent and disappeared from view, brutally divided about how to react.

By early 1929, the bubble was not simply a problem for the Fed but for almost every European central bank as well. New York was sucking in capital from abroad at a time when Europe was still very dependent on American money. The weakest links were Germany and the other Central European countries. But the Bank of England was losing gold as well. While in early 1928, it held over $830 million in reserves, the highest since the war, by early 1929, these had fallen below $700 million and were still going down.

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.

While Harrison and Norman were pressing for rate hikes, the Board continued its campaign for direct action. On February 2, it issued a directive to all its member banks that they should not borrow from the Fed “for the purpose of making speculative loans or for the purpose of maintaining speculative loans.” Four days later, it made the directive public. The Dow fell 20 points over the next three days, but quickly recovered and by the end of the week was back at the highs.

The market’s attitude was best summarized by an editorial in the Hearst newspapers. “If buying and selling stocks is wrong, the Government

should close the Stock Exchange. If not, the Federal Reserve Board should ...

On February 11, the directors of the New York Fed voted unanimously to raise rates by 1 percent to 6 percent.

Harrison called

Young in Washington to inform him of the decision, acknowledging the Board’s right to override it. Young asked for time to consider the initiative, but Harrison insisted on a definitive answer that day. After three hours of calls back and forth in which Young unsuccessfully tried to persuade Harrison not to force a showdown, he eventually called to say that the Board had voted to disallow the hike. Over the next three...

It did not help that the Fed seemed incapable of even exerting its control over leading bankers, let alone over the crowd psychology of investors. At the end of March, it was announced that total broker loans had increased to almost $7

billion, and the market swooned. The fear that some drastic action from the Fed to curtail the amount of credit going into the stock market was imminent drove the rate on brokers’ loans to over 20 percent.

The Board was undoubtedly correct that with the demand for money on Wall Street so strong, call money averaging over 10 percent, sometimes spiking as high as 20 percent, and speculators counting on gains of 25 percent a year and more, a hike in the Fed’s discount rate from 5 percent to 6 percent or even 7 percent at this stage of the game was going to have almost no effect. To be sure of pricking the bubble would have required raising interest rates higher, perhaps to 10 or 15 percent, which would have caused massive cutbacks in business

investment and would have plunged the economy into depression. But the New York Fed also happened to be right. All the jawboning about reducing credit for speculators proved to be pointless. It did in fact succeed in curbing the amount of money going into brokers’ loans from banks—between early 1928, when the Board first declared war on brokers’ loans, and October 1929, banks cut their loans to brokers from $2.6 billion to $1.9 billion. Meanwhile, other sources of credit—U.S. corporations with excess cash, British stockbrokers, European bankers flush with liquidity, even some Oriental potentates—more than made up for the decline by increasing their funding of brokers’ loans from $1.8 billion to $6.6 billion. It was these players, all of them outside the Fed’s control, who were by far the most important factor supporting leveraged positions in the stock market.

PERHAPS THE MOST perverse consequence of the bubble was that by the strange mechanics of international money, it helped to tip Germany over the edge into recession.

Over the five years between 1924 and 1928, Germany borrowed some $600 million a year, of which half went to reparations, the remainder to sustain the rebound in consumption after the years of austerity.

Out of the total of $3 billion for which German institutions signed up in those years, a little less than $2 billion came in the form of stable long-term loans. But more than $1 billion was “hot money,” short-term deposits attracted to German banks by high interest rates—7 percent in Berlin compared to 5 percent in New York—and subject to being pulled at any time. In late 1928, as the U.S. stock market kept climbing and call money rates on Wall Street skyrocketed, American bankers mesmerized by the phenomenal returns at home suddenly stopped coming to Berlin.

It was the combination of the drying up of foreign credit due to high interest rates induced by the U.S. stock bubble and the residual lack of confidence among German businessmen following Schacht’s ill-fated strike against the stock market in 1927 that drove Germany into recession in early 1929. Moreover, as long-term American loans stopped, Germany was forced to rely more and more on hot money, some raised from London, but much from by French banks, then flush with all the excess gold that had been sucked into their country. Germany therefore found itself slipping into recession just as its foreign position was becoming increasingly vulnerable.

The collapse in foreign loans and the recession could not have come at a worse time for Germany. Under the Dawes Plan schedule, Germany was to have fully recovered by now, and was due to ramp up its reparations payments in 1929 to the full $625 million a year, about 5 percent of its GDP.

Moreover, the transfer protection clause embodied in the Dawes Plan, while useful in 1924 for restarting foreign lending, was now creating its own perverse incentives—what we now refer to as moral hazard. By providing an

escape clause in the event of a payments crunch, the plan encouraged foreign bankers to be too cavalier in their lending and allowed Germany to be too lax about the consequences of accumulating so much debt “without the normal incentive to do things and carry through reforms that would clearly be in the country’s own interests.”

With the conference now close to collapse, Pierre Quesnay of the Banque de France told one of the Americans that evening that French depositors would withdraw $200 million from German banks by noon the next day. It was unclear whether this was intended as a threat or a prediction. In any case, Germany suddenly began to lose gold at an accelerating pace—$100 million over the next ten days, forcing the Reichsbank to raise rates to 7.5 percent, despite Germany’s being deep in recession, with two million unemployed.

German banks, municipalities, and corporations owed money to everybody—$500 million to British banks, several hundred million to French banks, and some $1.5 billion to American lenders. Had it defaulted on reparations at that point, every financial institution with exposure to Germany would have tried to pull what money it could out of the country. Germany would have had to suspend payments on all its commercial loans, creating a domino effect across the globe. Half the London banks would have gone under. Britain, its reserves already depleted, would have been flung off the gold standard. The financial chaos would have been catastrophic.

The market and the banking system were too interconnected. Because the big New York City banks held their reserves in the form of call loans to stockbrokers, a collapse in stocks inevitably raised concerns about the safety of one bank or the other, often leading to a run on the system, which in turn led to a withdrawal of liquidity from the market,

which in turn drove the market down further. The Fed had been created in part to break that nexus and Harrison was determined to prevent the market turmoil from widening into a full-scale financial crisis.

The danger was that as the market fell, brokers, frantic to recoup their loans, would be forced to dump the stocks they held as collateral, creating further declines in the market and intensifying the vicious cycle of selling.

Over the next few days, as the Fed did just that, New York City banks took over $1 billion in brokers’ loan portfolios. It was an operation that did not receive the publicity of the Morgan consortium, but there is little doubt that by acting quickly and without hesitation, Harrison prevented not only an even worse stock collapse but most certainly forestalled a banking crisis. Though the crash of October 1929 was by one count the eleventh panic to grip the stock market since the Black Friday of 1869 and was by almost any measure the most

severe, it was the first to occur without a major bank or business failure.

Despite the magnitude of the losses—$50 billion wiped off the value of stocks, equivalent to about 50 percent of GNP—and the ferocity of the decline, many papers were surprisingly sanguine, calling it the “prosperity panic.” The New York Evening World even argued that the panic had only occurred because “underlying conditions [had] been so good,” that

speculators had “an excuse for going clean crazy,” creating a bubble and thus setting the stage for it to burst.

The immediate impact on the United States in fact proved to be much greater that anyone expected. Industrial production fell 5 percent in October and another 5 percent in November. Unemployment, which during the summer of 1929 had hovered at around 1.5 million, 3 percent of the workforce, shot up to close to 3 million by the spring of 1930.

Car registrations across the country plummeted by 25 percent and radio sales in New York were said to have fallen by half.

Most governors feared that “artificial” attempts to stimulate the economy by injecting liquidity into the banking system would not jump-start business activity, but just touch off another bout of speculation.

In the early summer, the Fed stopped easing. It proved to be a mistake. For just as it went on hold, the economy embarked on a second down leg, industrial production falling by almost 10 percent between June and October.

The problem was that some of these measures were now giving off the wrong signals. For example, when banks overflowed with surplus cash, this was generally an index, in a more stable and settled economic environment, the Fed had pushed more than enough reserves into the system to restart it. In 1930, however, in the wake

of the crash, banks had begun carrying larger cash balances as a precaution against further disasters, and excess bank reserves were more a symptom of how gun-shy banks had become and less how easy the Fed had been.

At each stage policy could be vetoed or stymied. As a consequence, even though the two most prominent members of the Fed, Harrison and Meyer, both believed that it should be more aggressive, they were defeated by the system.

European stock markets dropped in sympathy with Wall Street, but not having gone up so much, they fell much less precipitously. While the U.S. market slid almost 40 percent, Britain’s went down 16 percent, Germany’s 14 percent, and France’s only 11 percent.

Moreover, as credit conditions eased in the United States, foreign lending revived. Money suddenly became more freely available. Central banks across Europe, no longer having to defend their gold reserves against the pull of New York, were able to follow the Federal Reserve in cutting interest rates. By June 1930, with U.S. rates at their postwar low of 2.5 percent, the Bank of England was down to 3.5 percent, the Reichsbank to 4.5 percent, and the Banque de France to 2.5 percent.

Far more damaging than the effect of the protectionist Smoot-Hawley Act was the collapse in capital flows. After a brief revival early in 1930, U.S. foreign investment into Europe suddenly dried to a trickle. American bankers became risk averse and cautious and, claiming that it was hard to find creditworthy borrowers, pulled in their horns. With American capital bottled up at home and U.S. demand for European goods shrinking—a result of the weak U.S. economy and of higher import tariffs imposed in June 1930 by the Smoot-Hawley Act—Europe could only pay for its imports and service its debts in gold. During 1930, a total of $300 million in bullion was shipped across the Atlantic into the vaults of the Federal Reserve system.

Émile Moreau’s strategy of keeping the franc pegged at a low rate had meant that French goods remained attractively priced. As a result the economy held up very well in 1929 and 1930, and capital, in search of safety, started flooding into France: a total of $500 million of gold during 1930. It was one of the startling ironies of that whole period that France, viewed by bankers in the years after the war as irresponsible and suspect, had now become the world’s financial safe haven. By the end of 1930, the Banque de France, in addition to the $1 billion it held in sterling and dollar deposits, had accumulated a gold reserve mountain of over $2 billion, three times that of the Bank of England. French officials, who only a few years before had been quick to blame their woes on the work of international currency “speculators,” now began touting the superior wisdom of these selfsame “investors” for the votes of confidence they had cast on French economic management.

By the end of 1930, the Banque de France had begun to understand that this accumulation of gold was harming the rest of the world by starving it of reserves. It was especially damaging because of the idiosyncrasies of the French banking system. In most countries, banks worked to make every dollar of gold support a multiple of that amount in currency and credit. The French banking system, however, was unusually inefficient in putting its bullion to use. As a result, the newly arrived $500 million of gold was translated into less than $250 million in circulating currency.

In fact, it was clear that during 1930, the Banque under Émile Moreau had been very consciously and deliberately offsetting—the technical term was sterilizing—the natural tendency of an influx of gold to expand the currency, lest it lead to inflation. With prices around the world collapsing, this may sound strange, but it was a symptom of how badly scarred he and other French officials had been by the currency crises of 1924 and 1926.

The specter of communism, which would persuade a later generation of Americans to pour vast amounts of money into Europe, did not have the same potency in 1931.

By the afternoon, a small horde of depositors had begun lining up outside the branch’s tiny neoclassical limestone building to withdraw their savings before closing time. Until now, despite the Depression, there had been no bank runs in New York, and soon a crowd of twenty thousand curious bystanders had gathered to watch.

The Bank of United States had fifty-seven branches across the four larger boroughs of New York, and over four hundred thousand individual depositors, more than any other bank in the country. Rumors of the trouble quickly swept the city and similar scenes were enacted that afternoon at many other branches, with armored trucks being called in to deliver extra cash.

The bank lent some $16 million, a third of its capital, to officers of the company and their relatives to allow them to buy its stock.

When the price began to fall in the spring and summer of 1929, many investors held Marcus to his guarantees. In order to take up all the stock coming on the market, he created a series of affiliate companies—in today’s parlance, off-balance-sheet special-purpose vehicles—that repurchased the equity with money borrowed from the bank itself. Marcus was in effect using depositors’ money to support the shares of his bank.

Thus by the middle of 1930, while the official books gave the impression of a bank that had $250 million in deposits, $300 million in good quality assets and $50 million in equity, the operational reality behind these numbers was quite different. The true value of assets was worth no more than $220 million, all its equity had been wiped out, and the bank was $30 million in the hole.