Lords of Finance: The Bankers Who Broke the World

by Liaquat Ahamed

Moreover, once the need to keep the pound pegged to gold had been removed, Norman had been able to cut interest rates to 2 percent. The combination of the end to deflation, cheap money at home, and a lower pound abroad, making British goods more competitive in world markets, touched off an economic revival. Britain was thus the first major country to lift itself out of depression.

As he torpedoed this new agreement, he made sure on this occasion not to mince his words. “I would

regard it as a catastrophe amounting to a world tragedy,” he cabled from the naval destroyer Indianapolis, which had been escorting his boat “if the greatest conference of nations, called to bring about a real and permanent financial stability . . . allowed itself a purely artificial and temporary expedient. . . .” Condemning the “old fetishes of so-called international bankers . . . ,” he declared that the current plans for stabilization were based on a “specious fallacy.”

By October 1933, though the dollar had fallen by more than 30 percent, commodity prices began to sink again and the economy started to stall once more. Roosevelt decided that it was time for a new initiative. Warren’s original proposal to devalue the dollar had been controversial enough. Now the professor recommended that the government give the dollar another nudge downward by itself buying gold in the open market.

This worked in two ways. First, as Warren had predicted, the fall in the dollar did get prices moving upward—by roughly 10 percent per annum. Once prices began rising, the burden of interest payments and the real cost of money were automatically reduced, making businesses more willing to borrow and consumers more ready to spend. By thus shaking the country out of its funk, the dollar move reversed expectations out of their vicious and self-fulfilling downward spiral into a virtuous circle pointing the other way. For as the

economy developed momentum, the recovery fed on itself.

In 1935, Congress passed a banking act designed to reform the Federal Reserve. Authority for all major decisions was now centralized in a restructured Board of Governors. The regional reserve banks were stripped of much of their powers and responsibility for open market operations was now vested in a new

committee of twelve, comprising the seven governors and a rotating group of five regional bank heads, renamed presidents. The secretary of the treasury and the comptroller of the currency were removed from the Board, giving it theoretically even greater independence from an administration. While these measures improved the efficiency of the Fed’s decision-making machinery, they came ironically enough at a time when there were few decisions to take.

He embarked on a massive program of public works financed by borrowing from the central bank and printing money. It was a remarkable experiment in what would come to be known as Keynesian economics even before Maynard Keynes had fully elaborated his ideas. Over the next few years, as the German economy experienced an enormous injection of purchasing power, it underwent a remarkable rebound. Unemployment fell from 6 million at the end of 1932 to 1.5 million four years later. Industrial production doubled over the same period.

Under this “Schachtian” system, Germany was reoriented from an open economy integrated with the West to a closed autarkic economy connected to Eastern Europe and the Balkans, a precursor of the inefficient Soviet trade system of the 1950s and 1960s. Behind the gleaming achievements, therefore—the autobahns, the Volkswagen, the Junker bombers, and the Messerschmitt fighter planes—the Nazi economy was a rickety machine plagued by shortages and relying heavily on rationing to allocate scarce consumer goods.

In 1938, he was one of the architects of a plan to allow four hundred thousand German Jews to emigrate over the coming three-year period, their assets to be expropriated and placed in a trust as collateral for bonds that were to be sold to rich Jews outside Germany. The money so raised was to be used to resettle German Jews and to subsidize German exports—a macabre extortionary scheme in effect to ransom these desperate people. It placed the international Jewish community in a quandary—whether to agree to a plan that implicitly sanctioned seizing Jewish property in Germany and Austria, channeling money to the Nazi regime and setting a precedent for other blackmail elsewhere in Europe, but which had the potential to save lives.

He drew on many of the same themes that had informed much of his previous work—the pervasive effects of uncertainty, the ways in which the financial system could short-circuit the normal operations of the economy, the inherent instability caused by fluctuations in confidence. The book was not completed until late 1935, and was published, in February 1936, as The General Theory of Employment, Interest, and Money. By the time it came out, Britain, the United States, and Germany were all on the road to recovery and the book itself did not have much impact on immediate government policy.

Within a short time he was Britain’s principal wartime economic strategist. Determined to avoid a repeat of the mistakes of the First World War, which had largely been financed by printing money, Keynes designed the framework for paying for this war without as much recourse to inflation. He also acted as the principal negotiator for Britain with the Americans over the scope, terms, and conditions of Lend-Lease.

developing his ideas for the postwar world, Keynes sought to create an international financial system based like the gold standard on rules while tempering its rigidity. His plan called for currencies to be “pegged but adjustable.” In contrast to the gold standard, under which currency values were

supposed to be immutable fixed points, countries would be allowed to alter the value of their currencies when their economic circumstances changed. He was determined to avoid the need for the sort of straitjacket policies of the twenties and thirties when Germany and Britain had been forced to hike interest rates and create mass unemployment to protect currency values that were in any case unsuitable. A second element of the plan was an international central bank. In order to avoid the chronic shortage of gold reserves that had prevented the global financial system from functioning smoothly between the wars, Keynes proposed creating an institution that would lend money to countries in need on a temporary basis, rather like an overdraft facility at a bank.

The first shock—the sudden halt in the flow of American capital to Europe in 1928 which tipped Germany into recession—has its counterpart in the Mexican peso crisis of 1994.

The second crisis of the series, the Great Crash, has a very obvious modern-day parallel in the fall of the stock market in 2000.

The 1931-33 sequence of banking panics that started with the failure of the

Bank of United States has many of the same characteristics as the current global financial crisis that began in the summer of 2007 and, as I write, is still sweeping through the world’s banking system.

Offsetting this has been the response of central banks and financial officials. In 1931-33 the Fed stood passively aside while thousands of banks failed, thus permitting bank credit to contract by 40 percent. In the current crisis, central banks and treasuries around the world, drawing to some degree on the lessons learned during the Great Depression, have reacted with an unprecedented series of moves to inject gigantic amounts of liquidity into the credit market and provide capital to banks.

Finally, the European financial crisis of 1931 also has its modern-day counterpart in the “emerging markets” crisis of 1997-98. In 1931, the evaporation of confidence in European banks and currencies caused Germany and much of the rest of Central Europe to impose capital controls and default on their debts, leading to a contagion of fear that culminated in forcing Britain off the gold standard. In 1997, a similar sequence of rolling crises afflicted Asia. South Korea, Thailand, and Indonesia all had to suspend payments on hundreds of billions of dollars of debt. Asian currencies collapsed against the dollar, undermining all confidence in emerging-market securities and eventually setting off the default of Russia in 1998 and of Argentina two years later. But in 1931, that part of Europe affected by the crisis was about half the size of the U.S. economy; in 1997, the GDP of the emerging markets that defaulted represented about a quarter of U.S. GDP.

To the contrary, in this book I maintain

that the Great Depression was not some act of God or the result of some deep-rooted contradictions of capitalism but the direct result of a series of misjudgments by economic policy makers, some made back in the 1920s, others after the first crises set in—by any measure the most dramatic sequence of collective blunders ever made by financial officials.

The first culprits were the politicians who presided over the Par...

The second group to blame were the leading central bankers of the era, in particular the four principal characters of this book, Montagu Norman, Benjamin Strong, Hjalmar Schacht, and Émile Moreau.

the decision to take the world back onto the gold standard.

Gold supplies had not kept up with prices; and the distribution of gold bullion after the war was badly skewed, with much of it concentrated in the United States. The result was a dysfunctional gold standard that was unable to operate as smoothly and automatically as before the war. The problem of inadequate gold reserves was compounded when Europe went back to gold at exchange rates that were grossly misaligned, resulting in constant pressure on the Bank of England, the linchpin of the world’s financial system, and a destructive and petty feud between Britain and France that undermined international cooperation.

The quartet of central bankers did in fact succeed in keeping the world economy going but they were only able to do so by holding U.S. interest rates down and by keeping Germany afloat on borrowed money. I...

The U.S. stock market bubble thus had a double effect. On the way up, it created a squeeze in international credit that drove Germany and other parts of the world into recession. And on the way down, it

shook the U.S. economy.

The stresses and strains of trying to keep the limping gold standard going may have made some sort of financial shakeout inevitable. It was, however, not necessary for the crisis to metastasize into a worldwide catastrophe. European central bankers had been dealing with financial crises for more than a century. They had long absorbed the lesson that while most of the time the economy works very well left in the care of the invisible hand, during panics, that hand seems to lose its grip. Markets, particularly financial markets, became unthinkingly fearful. To reestablish sanity a...

After 1929, responsibility for world monetary affairs ended up in the hands of a group of men who understood none of this, whose ideas about the economy were...

They failed to fulfill even the most basic central banker’s responsibility: to act as lender of last resort and support the banking system at a time of panic.

And so what began as modest and corrective recessions in the United States and Germany were transformed by sheer folly and short-sightedness into a worldwide catastrophe.

More than anything else, therefore, the Great Depression was caused by a failure of intellectual will, a lack of understanding about how the economy operated. No one struggled harder in the lead-up to the Great Depression and during it to make sense of the forces at work than Maynard

Keynes. He believed that if only we could eliminate “muddled” thinking—one of his favorite expressions—in economic matters, then society could allow the management of its material welfare to take a backseat to what he thought were the central questions of existence, to the “problems of life and of human relations, of creation, behavior and religion.” That is what he meant when in a speech toward the end of his life he declared that economists are the “trustees, not of civilization, but of the possibility of civilization.” There is no greater testament of his legacy to that trusteeship than that in the sixty-odd years since he spoke those words, armed with his insights, the world has avoided an economic catastrophe such as overtook it in the years from 1929-33.