Lords of Finance: The Bankers Who Broke the World

by Liaquat Ahamed

These men had all been reared on Walter Bagehot’s nineteenth-century classic Lombard Street, which described how the Bank of England, then the financial center of the world, handled financial crises and panics. Bagehot argued that during normal times a central bank should follow the gold standard rule book, allowing credit to expand and contract in line with bullion reserves. But in a financial crisis, it should throw away the rule book and “lend freely, boldly, and so that the public may feel you mean to go on.” As he put it, “A panic . . . is a species of neuralgia, and according to the rules of science you must not starve it.” In other words, a central bank had to be willing to inject as much money as was necessary to satisfy the public demand for cash and safe assets. But Bagehot did inject one caveat. Though he argued that in a panic the

central bank should lend without hesitation or question, it should do so only to banks facing a temporary squeeze on liquidity and never to those actually insolvent. The problem this time was that the BUS was not just temporarily short of funds, it was insolvent and could not hope to cover its obligations.

The Fed, believing that it could throw a ring fence around the BUS and prevent its troubles from spreading, decided to close the bank’s doors the next morning. “I warned them that they were making the most colossal mistake in the banking history of New York,” Broderick would later testify at a trial. Marcus and one of his lieutenants were tried, convicted, and sentenced to three years’ imprisonment. Broderick was separately indicted for alleged negligence in not closing the bank earlier. The case ended in a mistrial; after a second trial, he was acquitted.

During the 1920s, the United States was still populated with some 25,000 banks, many of them so tiny,

undiversified, and dependent on the economic conditions of their localities that every year roughly 500 went under. In the first nine months of 1930, as a result of the deepening hard times, 700 had closed their doors.

That October, two months before the BUS crisis, the terrible drought across the Midwest and South led to the collapse of the Tennessee investment bank, Caldwell and Company, which controlled the largest chain of banks in the South, leaving a string of failures in its w...

Shaken by such a high-profile failure, depositors started becoming more cautious about where they placed their money. Unable to tell whether a bank was sound or not, they began pulling their cash indiscriminately out of all banks,

good and bad. At first it was a mere ripple—in the months after the twin failures a total of $450 million dollars left the banking system, less than 1 percent of total deposits.

Because of the way banking works, however, such withdrawals had a negative multiplier effect. In an effort to maintain a prudent balance between their own liquidity and their loan portfolios, banks had to call in three or four dollars of loans for each dollar in cash withdrawn. Moreover, as their loans were called, borrowers in turn withdrew their deposits from other banks. The effect was to spread the scramble for liquidity right across the system. In this climate, all banks felt the need to protect themselves by building up cash reserves and thus called in e...

Meanwhile, the governors of the various Federal Reserve banks, who could have taken the initiative, refused to act. A large number of the banks in trouble,

particularly the small ones, were not members of the Federal Reserve System—only half of the twenty-five thousand banks in the country had joined the system, although they accounted for about three-quarters of all deposits. The regional bank governors did not feel any responsibility for these nonmember banks, despite their impact on the nation’s overall supply of credit.

Determined to follow Bagehot’s rule of only lending to “sound” institutions and believing that propping up failing banks would be throwing good money after bad, the regional governors made it a principle to let them go under. They failed to recognize that by doing so they were undermining public confidence in banks as a repository of savings and were causing the U.S. credit system to freeze up.

Strangely enough in the first quarter of 1931, as the world banking system was having to cope on one side with the hoarding of currency by a frightened American public and on the other by the piling up of gold bullion at the Fed and

the Banque de France, the economy went through one of its little rebounds, both in the United States and across Europe. If the banking system can be compared, as it often is, to the plumbing of the world’s economy, then the double drain of cash was like two invisible leaks. T...

No sooner had the Young Plan been signed in Paris in July of that year, than the campaign to repudiate it had gone into high gear. A national committee led by Dr. Alfred Hugenberg, chairman of the right-wing German Nationalist Party—third largest in the Reichstag, where it held 73 seats out of a total of 491—was formed to organize a referendum on the plan.

The referendum, which would have required the government to renegotiate the repeal of the hated War Guilt clause, suspend all payments on reparations, and to make it a crime for any official to enter into any further agreement thereon, received 4,135,000 votes, a sign of the growing popular disenchantment with the policy of fulfillment.

In November, during negotiations at The Hague, the German government agreed to modest adjustments to the Young Plan terms. In return, the Allies agreed to advance the date for withdrawing their remaining troops from the Rhineland, and reached a settlement on the status of German citizens in lands previously part of East Prussia but ceded to Poland at Versailles. The effect of all these modifications was to add some 4 to 5 percent to the Young Plan payments, amounting to about $25 million a year. The economic significance was trivial—nevertheless, it provided Schacht with just the excuse he needed to break with the government.

On December 5, he dropped his bombshell on Berlin. Without warning he issued a public statement in which he accused the government in inflammatory language of “twisting” the Young Plan and failing to take the necessary steps to control its own finances. Declaring that it would be “self-deception” for the German people to believe that the nation could pay a pfennig more than it had agreed to in Paris, he publicly repudiated the plan’s latest revisions. A few weeks later, he sabotaged the government’s attempt to raise a loan in New York through the American investment house of Dillon Read.

In a campaign dominated by the deteriorating economy, Hitler appealed across class lines, promising to reunite the nation, rebuild its prosperity, restore its position in the world, and purge the country of profiteers. He put a lid on some of his more extreme anti-Jewish rhetoric. Speaking at giant open-air rallies, many in sports stadiums lit by arrays of blazing torches, he mesmerized the tens of thousands who attended these events with his oratory. Meanwhile in the streets, his jack-booted paramilitary thugs, armed with truncheons and knuckledusters, clashed violently with Communists and Socialists. The Nazis won 6.4 million votes, and vaulted into second place in the Reichstag with 107 seats.

The election panicked the financial markets; an estimated $380 million, about half of Germany’s reserves, bolted. To halt the flight, the Reichsbank was forced to raise its rates, so that while in New York and Paris these stood at 2

percent, and in London at 3 percent, in Germany they went up to 5 percent. With prices falling at a rate of 7 percent per year, it meant that the effective cost of money had risen to 12 percent, gravely exacerbating the economic weakness. As the economy lost ground, unemployment climbed, and the budget deficit widened, Brüning focused on balancing the budget. Unemployment benefits were restricted; salaries of all high federal and state officials, including the president’s, were slashed by 20 percent. Wages of lower-level officials were cut 6 percent; income taxes were r...

Germany was unusual in the degree of deflation that the government imposed on the economy. In the United States, the Hoover administration had cut taxes and allowed the budget to go from a surplus of $1 billion in 1929 to a deficit of $2 billion in 1931, 4 percent of GDP. Britain ran a deficit of $600 million in 1931, 2.5 percent of GDP. By contrast in Germany, even though...

reduced from an already modest $200 million to $100 million, less t...

Brüning, who was now being called the “Hunger Chancellor,” would later claim that his austerity measures had been designed to prove to foreigners that Germany could no longer pay reparations, a reprise of the old perverse “hair-shirt” policy attempted in the early 1920s: to inflict so much damage on Germany’s economy that her creditors would be forced...

The problem was made much worse by one of the unintended consequences of the Young Plan. Under the Dawes Plan before it, private commercial lenders had priority over reparations at a time of crisis. In effect, Germany’s public

creditors, principally the governments of France, Belgium, and Britain, had to stand last in line. The Young Plan’s elimination of this “transfer protection,” which incidentally Schacht had tried to resist, put an end to the guarantee. In the event of a payments crisis, private lenders did not automatically move to the front of the line but had to wait their turn with the big governments. Not surprisingly, private foreign lending to Germany collapsed.

new government adopted many of the austerity policies that he himself was advocating, with catastrophic results.

Everywhere he went he was asked about the recent elections and Hitler. “If the German people are going to starve, there are going to be many more Hitlers,” he would reply. Back in Europe, when a Swedish journalist asked him, “What would you do if you were to become Chancellor tomorrow?” Schacht replied with no hesitation, “I would stop making payments of reparations that very day.”

Like many German banks, the Credit Anstalt made direct investments in industry, similar to those of a modern private equity firm. It was, however, especially vulnerable not only because it borrowed short-term money to finance what were long-term, highly illiquid, investments but also because it had an unusually large amount of foreign borrowing on its books—some $75 million out of a total deposit base of $250 million.

Over the next four days a run developed, not only on the Credit Anstalt but on all Austrian banks, which lost some $50 million in deposits, about 10 percent of the total. In an attempt to shore up its banking system, the Austrian National Bank followed Bagehot’s principle and lent freely, injecting an extra $50 million, which caused an overnight jump of 20 percent in the national money supply.

None of the central bankers had faced an international financial crisis before; they therefore had to make things up as they went along. In so doing they made two mistakes. Given the scale of the problem, they came up with far too little money; and believing that it was necessary to put together as international a consortium as possible, they did not act quickly enough. For all the frantic telephone calls, it took them three weeks to drum up the money, and then only came up with $15 million.

By the time the loans had been agreed to, the promised money had already been used up and the run on Austrian banks had become a run on the Austrian currency. The National Bank lost $40 million of its $110 million of gold reserves. Faced now with both a banking system under threat and a currency under siege, it now pleaded for another $20 million.

The crisis was made immeasurably more complicated by the politics of the situation. In March 1930, Germany and Austria had announced that they would form a customs union. Germany’s neighbors, in particular the French and the Czechs, remembering that the nineteenth-century Zollverein, the historic customs union among the states of the German Confederation, had been a prelude to German unification, and fearing that this ...

As money started escaping Germany, rumors circulated that Berlin might soon request a suspension of reparations. Lamont feared that to cope with the political turmoil and flight of capital that would ensue, Germany might impose exchange controls. With American institutions holding about a billion dollars in short-term credits to Germany, such a move could threaten the solvency of more than one U.S. bank.

J. P Morgan & Co: “One last thing, Mr. President, if anything by any chance ever comes out of this suggestion, we should wish to be forgotten in the matter. This is your plan and nobody else’s.”

On Saturday, June 20, Hoover’s plan was publicly announced. The United States would forgo one year’s principal and interest of $245 million on the war debts due from Britain, France, Italy, and some of the smaller European powers, provided, and only provided, that the Allies themselves suspend $385 million in reparations due from Germany. The effect was electric. The following Monday, the German stock market jumped 25 percent in a single day.

The administration had consulted everyone—everyone, that is, except the French. In the most astoundingly inept piece of diplomacy of his whole presidency, the one party Hoover neglected to prepare not only happened to be Germany’s largest creditor but was at the moment the dominant financial power in Europe. The French government reacted with astonishment and then fury.

A bank cannot survive without confidence; when it is forced to deny rumors that it is in trouble, it is by definition in serious trouble.

On July 8, Luther called Norman. The Reichsbank was in a desperate situation. It had lost a huge slice of its gold reserves. If it tried to bail out the Danatbank, it would fall below the minimum reserve threshold it was required to maintain by law which, in the current environment, was bound to provoke a run on its currency. It therefore faced a terrible dilemma: support its currency

and let the Danatbank fail or try to support its domestic banking system and watch what reserves it had left fly out of the country. It was one of those situations in which there are no good options—only the choice between a bad outcome and a disastrous one.

It was on that journey, as Luther described the deteriorating situation in Germany, that it finally dawned on Norman that the game was up. The German economic position was now irretrievable. As a central banker, all he could do

was provide a temporary loan to buy a little more time. Germany was now in deep water and sinking. The numbers would not add up. It had a GDP now of $13 billion that was shrinking by the month, reparation debts of $9 billion, and foreign private obligations of $6 billion, $3.5 billion of it short-term that could be pulled at any moment. Over the last year, $500 million in capital had fled the country.

His only hope, Norman told him, lay in a long-term loan from France, the one European nation with sufficient gold reserves to bail out Germany. But he warned that French money would only come with draconian political conditions. Luther and Norman separated at Calais, Norman to go on to Basel, Luther to Paris.

The French government informed him that it might be prepared to lend as much as $300 million, provided that Germany abandon the customs union with Austria, suspend the construction of two new pocket battleships, raise interest rates sharply to halt the flight of capital abroad, and “orient itself definitely towards a policy of democracy and pacifism” by banning public demonstrations by Nationalist organizations.

On the morning of Monday, July 13, as Luther was setting off for Basel, the Danatbank had failed to open. On the locked doors of all its branches was posted a government decree guaranteeing its deposits.

The Reichsbank, hoping that the impact might be contained, kept the rest of the banking system open that day. By lunchtime, branches of every bank in the country were besieged. The leading banks restricted withdrawals to no more than 10 percent of a depositor’s balance.

That evening President Hindenburg proclaimed a two-day bank holiday.

All the banks in Hungary were closed for three days. In Vienna, another of the large banks shut its doors. In Danzig and Riga, in Poland, Yugoslavia, and Czechoslovakia, banks were suspended. German tourists across Europe, even in fashionable sophisticated cure resorts like Marienbad and Carlsbad, were stranded when no hotels or shops would accept their marks.

The collapse of the German banking system in the summer of 1931 sent the economy lurching downward once again. Over the next six months production fell by another 20 percent. By early 1932, the industrial production index reached 60 percent of its 1928 level. Nearly six million men—a third of the labor force—were without work.

An equally big stir occurred, however, when Schacht, in his first public appearance as an associate of the Nazis, ascended the stage to speak.