Lords of Finance: The Bankers Who Broke the World

by Liaquat Ahamed

ON July 14, Norman returned from Basel to find the crisis now spreading to Britain. That evening Robert Kindersley, a director of the Bank of England and head of the London arm of the great investment house of Lazards, asked to see him in private and told him that Lazards itself was in serious trouble. Ironically enough it had little to do with the crisis ravaging Central and Eastern Europe. In the midtwenties, a rogue trader in the Brussels branch of the bank had made a wild bet on the collapse of the French franc and lost $30 million, almost double the bank’s capital. He had managed to cover up the loss for years with the connivance of several members of the Brussels office, by issuing IOUs on behalf of Lazards to its counterparts.

The following week two other British merchant banks, Kleinworts

and Schroders, informed Norman that they, too, were in trouble. Unable to prop up everyone, the Bank arranged for them to be rescued by loans from the commercial banks.

As the world financial system ground to halt, the City of London, with tentacles that stretched into every corner of the globe, found itself especially vulnerable. On July 13, as the German crisis reached its denouement, the Macmillan Committee on the workings of the British banking system issued its report. Considering all that was going on in Europe, the press paid little attention to it. Nevertheless, hidden in the report was a set of figures that shook the City.

But because Britain was unable to generate the same export surpluses as before the war, the City had to finance its long-term loans by relying more and more on short-term deposits. While everyone was dimly aware of this growing mismatch between liabilities and assets, no one had any idea of its magnitude.

The Macmillan Report now revealed that the City’s short-term liabilities to foreigners came close to $2 billion. This was viewed as a shocking number even though it eventually turned out to be a gross underestimate—the true figure was closer to $3 billion.

The May Committee proposed that the government seek to reverse the budgetary slide by cutting its expenditures by $500 million—including a 20 percent reduction in unemployment benefits—and raise an extra $100 million from higher taxes.

In the light of what we now know about the way the economy works, it was completely absurd for the committee to propose that the solution to Britain’s economic problems, with 2.5 million men out of work, production down by 20 percent, and prices falling at a rate of 7 percent a year, was to cut unemployment benefits and raise taxes.

But a...

time, the prevailing orthodoxy held that budget deficits were always bad, even in a depression. Maynard Keynes called the May report “the most foolish docume...

Despite the promise of Morgan money, the cabinet remained split over the cuts in unemployment benefits, and that evening the prime minister went to Buckingham Palace to tender his government’s resignation. Two days later, the Daily Herald, official organ of the Labor Party, believing erroneously that the telegram had come from the Fed and not from Morgan, carried a photograph of George Harrison on its front page under the headline “Banker’s Ramp,” a ramp being a fraudulent move by financiers to manipulate the market.

Within three days, a new National government, a coalition of fragments of Labor and the Liberals with a united Conservative Party, assumed office led by MacDonald and introduced much the same budget package that had split the previous ministry.

On August 28, the British government received a $200 million loan from a consortium of American banks led by Morgans and a further $200 million from a group of French banks. It was gone within three weeks. The budget cuts did no good, largely because they were beside the point.

In other words, Britain’s problem was not its budget deficit, but rather that it had clung to the role of banker to the world without any longer having the money or the resources to do so and at a time when most of the world was a damn poor risk.

Ironically, the one institution upon which the devaluation wrought disaster was the Banque de France. For years an urban myth insisted that it had been French selling of the pound that had set off the debacle. In fact, the Banque had hung on to every penny of its $350 million in sterling deposits. So supportive had it been during the crisis that Clément Moret was later named an honorary Knight Commander in the Order of the British Empire. The Banque de France ended up losing close to $125 million, seven times its equity capital. A normal bank would have been driven under.

After Britain left the gold standard, the financial crisis now spread across the Atlantic. Over the next five weeks, Europeans, fearing that the United States would be next to devalue, converted a massive $750 million of dollar holdings into gold.

The outflow of gold came at a particularly crucial juncture for the U.S. banking system, then reeling under the wave of failures that had begun in the spring in Chicago. By September, the panic had swept Ohio and was circling back to Pittsburgh and Philadelphia.

In one month alone after the British departure from gold, 522 American banks went under—by the end of the year, a total of 2,294, one out of every ten in the country, with a total of $1.7 billion in deposits, would suspend operations.

The Fed had begun 1931 with a massive $4.7 billion in gold reserves. Even after the fall outflow, it had more than enough bullion and was never at any risk of being stripped bare as the Bank of England or the Reichsbank had been. Nevertheless, because of a strange technical anomaly in its governing laws, it found itself facing an artificial squeeze on its reserves.

By statute, every $100 in Federal Reserve notes had to be backed by at least $40 in gold, the remaining $60 by so-called eligible paper—that is, prime commercial bills used to finance trade. Even though the Federal Reserve banks were permitted to hold government securities, and the buying and selling of such securities—open market operations—was one of the mechanisms by which the Fed injected money into the system, government paper could not be employed as an asset to back currency. Even when first introduced in the original 1913 legislation setting up the Fed, the restriction had been redundant, since the 40

percent gold requirement was enough to prevent the central bank from being used as an instrument of inflation. By 1931, with no risk of inflation—the country in fact facing a problem of deflation—the restriction served no ...

With the Depression and the ensuing stagnation in trade, prime bills were scarce and hard to find. The Fed had to rely on gold to back its currency. Thus, in the fall of 1931, instead of having $2 billion too much gold and being grateful that some of it was finally flowing back to Europe, it found itself scrambling to hold on to its reserves. It was a manufactured problem, the result of an anachronistic re...

The bank runs, the spike in currency hoarding, and now the rising cost of money imposed a massive and sudden credit crunch upon an already fragile United States. Between September 1931 and June 1932 the total amount of bank credit in the country shrank by 20 percent, from $43 billion to $36 billion. As loans were called in, small businesses were driven into default. Lenders were forced to absorb losses and in turn lost their own cushion of capital, making depositors quite justly fearful for the security of their money and leading to further withdrawals from banks, which in turn forced more loan recalls and thus more defaults. Though depositors and bankers individually behaved quite rationally to protect themselves, collectively their actions imposed a vicious spiral of tightening credit and loan losses on the already depressed U.S. economy.

Every economic indicator seemed to fall off a cliff—1932 was the deepest year of depression in the United States. Between September 1931 and June 1932, production fell 25 percent; investment dived a stunning 50 percent; and prices dropped another 10 percent, reaching 75 percent of their 1929 level. Unemployment shot up beyond ten million—more than 20 percent of the workforce was now without jobs.

American corporations, which had made almost $10 billion in profits in 1929, collectively lost $3 billion in 1932. On July 8, 1932, the Dow, which had stood at

381 on September, 3, 1929, and was trading around 150 before the European currency crisis, hit a low of 41, a drop of almost 90 percent over the two and a half years since the bubble first broke. General Motors, which had traded at $72 a share in September 1929, was now a lit...

In February 1932, he pressed Congress to pass legislation that would make government securities an eligible asset to back currency. At the stroke of a pen the gold shortage was lifted, allowing the Fed to embark on a massive program of open market operations, injecting a total of $1 billion of cash into banks. The two new measures combined—the infusion of additional capital into the banking system and the injection of reserves—allowed the Fed finally to pump money into the system on the scale required. But Meyer had left it too late. A similar measure in late 1930 or in 1931 might have changed the course of history. In 1932 it was like pushing on a string. Banks, shaken by the previous two years, instead of lending out the money used the capital so injected to build up their own reserves. Total bank credit kept shrinking at a rate of 20 percent a year.

Until then, panics had mainly affected the smallest banks in the nation. But

as the run took on an international dimension, the most important financial institution in the country, banker to its largest banks, the New York Fed became the center of the storm. In the last two weeks of February, it lost $250 million, almost a quarter of its gold reserves. Though the Federal Reserve System as a whole had more than ample gold reserves, had the New York Fed run out of gold and been compelled to call in its loans to banks and shrink its balance sheet in a hurry, this would have created a disastrous situation for the banking system not only in New York but across the country.

On Friday, March 3, the New York Fed lost a total of $350 million—$200 million in wire transfers out of the country and $150 million in actual physical currency withdrawals from banks in the New York area. Now short some $250 million in reserves, it tried to borrow from the Chicago Fed but was turned down—the risk of the Federal Reserve System balkanizing and falling apart was becoming a reality.

The banking systems in twenty-eight states of the union were completely closed and in the remaining twenty partially closed. In three years, commercial bank credit had shrunk from $50 billion to $30 billion and a quarter

of the country’s banks had collapsed. House prices had gone down by 30 percent, leaving almost half of all mortgages in default. With the contraction in credit, mines and factories across the country had to shut down. Steel mills operated at less than 12 percent of their full capacity. Automobile plants, which had once churned out twenty thousand cars a day, were now producing less than two thousand. Industrial output had fallen in half, prices had tumbled 30 percent, and national income had contracted from over $100 billion to $55 billion. A quarter of the workforce—13 million men in all—were without jobs. In the richest nation in the world, 34 million men, women, and children out of a total population of 120 million had no apparent source of income.

By Thursday, March 9, the Emergency Banking Act was ready to be submitted to Congress. Most of it was based on the original Mills proposal. Banks in the country were to be gradually reopened, starting with those known to be sound, and progressively moving to the shakier institutions, which would need government support. A whole class of insolvent banks would never be permitted to reopen. The bill also granted the Fed the right to issue additional currency backed not by gold but by bank assets. And it gave the federal government the authority to direct the Fed to provide support to banks. The legislation was supplemented by a commitment from the Treasury to the Fed that the government would indemnify it for any losses incurred in bailing out the banking system. This unprecedented package finally forced the Fed to fulfill its role as lender of last resort to the banking system. But to achieve this, the

government was in effect providing an implicit blanket guarantee of the deposits of every bank allowed to reopen.

At ten o’clock on the evening of Sunday, March 12, Roosevelt gave the first of

his fireside chats over the radio.

As the first banks prepared to open on Monday, March 13, no one could be sure what would happen. Many feared that after the measures restricting the convertibility of currency into gold, the panic might even continue and indeed become worse. As Harrison put it, “We had closed in the midst of a great bank run, and as far as we knew would reopen under the same conditions.”

That morning, long lines of depositors formed outside the reopened banks. But instead of taking their money out, they were putting it back in. The combination of the bank holiday, the rescue plan, and Roosevelt’s masterful speech—there is no way of distinguishing which was the more important—created one of those dramatic transformative shifts in public sentiment. As on other similar occasions where a new administration has taken charge in the middle of a crisis and introduced a radically new package of policies—for example, in Germany in November 1923 when hyperinflation was ended or in France in July 1926 when Poincaré stabilized the franc—the mood of the nation changed overnight. On March 15, when the New York Stock Exchange reopened after being closed for ten days, the Dow jumped 15 percent, the largest move in a single day in its history. By the end of the first week, a total of $1 billion in cash—half of everything that had been pulled out in the previous six weeks—had been redeposited in banks. By the end of March, two-thirds of the banks in the country, twelve thousand in total, had been permitted to resume business and

the currency hoard in the hands of the public had droppe...

Tucked away, however, in this whole motley baggage, as a last-minute amendment to the Agricultural Adjustment Act, was one step that succeeded beyond anyone’s wildest expectations in getting the economy moving again. This was the temporary abandonment of the gold standard and the devaluation of the dollar.

For in an economy where everything is connected, there is often no clear distinction between cause and effect. True, in the initial stages of the Depression the collapse in economic activity had driven prices downward. But once in motion, falling prices created their own dynamic.

By raising the real cost of borrowing, they had discouraged investment and thus caused economic activity to weaken further. Effect became cause and cause

became effect. Roosevelt would have been unable to articulate all the linkages very clearly. But he had an intuitive understanding that the key was to reverse the process of deflation and kept insisting that the s...

In 1932, he and a colleague published their work in an exhaustive monograph titled Wholesale Prices for 213 Years: 1720- 1932, which

created enough of a stir that, in 1933, it was issued as a book. Warren was able to document how trends in commodity prices correlated strongly with the balance between the global supply and demand for gold. When large gold discoveries came onto the world market and supply out-paced demand, commodity prices tended to rise. By contrast, when new supply lagged behind, this showed up in declining prices for commodities. It was easy to quibble with some of the details of the thesis—the correlation was not perfect because a variety of other factors, not least of which were wars, intervened to blur the link. Nevertheless, it was hard to argue with the general conclusion. After all, under the gold standard, there was supposed to be a direct connection between bank credit and gold reserves—thus when gold was plentiful, so was credit, which in turn caused prices to rise.

It was Warren’s policy conclusions, however, that generated the most controversy. If commodity prices fell because of a shortage of gold, he argued, then one way to raise them was to raise the price of gold—in other words, to devalue the ...

different in its effects from suddenly discovering 50 percent more of the metal. Both brought about a higher value of gold within the credit system and both would...

ROOSEVELT’S DECISION To take the dollar off gold rocked the financial world. Most people could not understand why a country with the largest gold reserves in the world should have to devalue. It seemed so perverse. Indignant bankers

lamented the loss of the one anchor that could keep governments honest. Bernard Baruch, the noted financier, went a little overboard though when he said that the move, “can’t be defended except as mob rule. Maybe the country doesn’t know it yet, but I think we may find that we’ve been in a revolution more drastic than the French Revolution.” But in the days after the Roosevelt decision, as the dollar fell against gold, the stock market soared by 15 percent. Financial markets gave the move an overwhelming vote of confidence. Even the Morgan bankers, historically among the most staunch defenders of the gold standard, could not resist cheering. “Your action in going off gold saved the country from complete collapse,” wrote Russell Leffingwell to the president. Taking the dollar off gold provided the second leg to the dramatic change in sentiment, which had begun with the bank rescue plan, that coursed through the economy that spring. Harrison, spurred into action by the threat that the government might issue unsecured currency, injected some $400 million into the banking system during the following six months. The combination of the

renewed confidence in banks, a newly activist Fed, and a government that seemed intent on driving prices higher broke the psychology of deflation, a change reflected in almost every indicator. During the following three months, wholesale prices jumped by 45 percent and stock prices doubled. With prices rising, the real cost of borrowing money plummeted. New orders for heavy machin...