Lords of Finance: The Bankers Who Broke the World

by Liaquat Ahamed

Boiled down to its essentials, a central bank is a bank that has been granted a monopoly over the issuance of currency.1 This power gives it the ability to regulate the price of credit—interest rates—and hence to determine how much money flows through the economy.

Unlike today, however, when central banks are required by law to promote price stability and full employment, in 1914 the single most important, indeed overriding, objective of these institutions was to preserve the value of the currency.

At the time, all major currencies were on the gold standard, which tied a currency in value to a very specific quantity of gold.

Since all currencies were fixed against gold, a

corollary was that they were all fixed against one another. Thus there were 113/23.22 or $4.86 dollars to the pound. All paper money was legally obligated to be freely convertible into its gold equivalent, and each of the major central banks stood ready to exchange gold bullion for any amount of their own currencies.

While central banks had been granted the right to issue currency—in effect to print money—in order to ensure that that privilege was not abused, each one of them was required by law to maintain a certain quantity of bullion as backing for its paper money. These regulations varied from country to country.

The Federal Reserve (the Fed), on the other hand, was required to have 40 percent of all the currency it issued on hand in gold—with no exemption floor.

In order to control the flow of currency into the economy, the central bank varied interest rates. It was like turning the dials up or down a notch on a giant monetary thermostat. When gold accumulated in its vaults, it would reduce the cost of credit, encouraging consumers and businesses to borrow and thus pump more money into the system. By contrast, when

gold was scarce, interest rates were raised, consumers and businesses cut back, and the amount of currency in circulation contracted.

Because the value of a currency was tied, by law, to a specific quantity of gold and because the amount of currency that could be issued was tied to the quantity of gold reserves, governments had to live within their means, and when strapped for cash, could not manipulate the value of the currency. Inflation therefore remained low. Joining the gold standard became a “badge of honor,” a signal that each subscribing government had pledged itself to...

The most famous spokesman for looser money and easier credit was Williams Jennings Bryan,

While it may have succeeded in controlling inflation, the gold standard was incapable of preventing the sort of financial booms and busts that were, and continue to be, such a feature of the economic landscape. These bubbles and crises seem to be deep-rooted in human nature and inherent to the capitalist system. By one count there have been sixty different crises since the early seventeenth century—the first documented bank panic can, however, be dated to A.D. 33 when the Emperor Tiberius had to inject one million gold pieces of public money into the Roman financial system to keep it from collapsing.

In 1909, the British journalist Norman Angell, then Paris editor of the French edition of the Daily Mail, published a pamphlet entitled Europe’s Optical Illusion. The thesis of his slim volume was that the economic benefits of war were so illusory—hence the title—and the commercial and financial linkages between countries now so extensive that no rational country should contemplate starting a war. The

Angell’s pamphlet was issued in book form in 1910 under the title The Great Illusion. The argument that it was not so much the cruelty of war as its economic futility that made it unacceptable as an instrument of state power

Angell’s most prominent disciple was Reginald Brett, second Viscount Esher, a liberally minded establishment figure, and close confidant of King Edward VII.

Lord Esher

Committee of Imperial Defense,

In February 1912, the committee conducted hearings on issues related to trade in time of war.

The possibility that while Britain and Germany were at war, British insurance companies would be required to compensate the Kaiser for his sunken tonnage made it hard even to conceive of a European conflict.

It was no wonder that during a series of lectures on The Great Illusion delivered at Cambridge and the Sorbonne, Lord Esher would declare that “new economic factors clearly prove the inanity of war,” and that the “commercial disaster, financial ruin and individual suffering” of a European war would be so great as to make it unthinkable. Lord Esher and Angell were right about the meager benefits and the high costs of war. But trusting too much in the rationality of nations and seduced by the extraordinary economic achievements of the era—a period the French would later so evocatively call La Belle Époque—they totally misjudged the likelihood that a war involving all the major European powers would break out.

the Federal Reserve Act by Woodrow Wilson on December 23, 1913.

In the final outcome, should the Europeans not accept dollars, Americans always had the option of paying in gold. But how to get the gold into a Continent now at war? Insurance rates on private shipping had skyrocketed to prohibitive levels overnight. Strong persuaded the government to ship private gold over on a warship, and on August 6, the cruiser Tennessee left the Brooklyn Navy Yard with $7.5 million in gold aboard.

By the end of 1915, eighteen million men were mobilized

Britain, France, Russia, Germany, Austria-Hungary—were spending a massive $3 billion each month, nearly 50 percent of their collective GDP. No other war in history had absorbed so much of the wealth of so many nations at one time.

the belligerents resorted principally to borrowing.

inflation.

In four years of fighting, the government spent a total of $43 billion on the war effort, including $11 billion in loans, which it funneled to its poorer Continental allies, principally France and Russia. To pay for all this, it raised about $9 billion, or 20 percent, through additional taxes and almost $27 billion by long-term borrowing, both domestically and in the United States. The remainder it borrowed from banks, including a large chunk from the Bank of England. As a result, the quantity of money in circulation within Britain doubled in four years, doubling prices with it.

Though the directors of the Bank were charged with governing the supply of credit in Britain, and by extension around the globe, they did not pretend to know very much about economics, central banking, or monetary policy. An economist of the 1920s once described them as resembling ship captains who not only refused to learn the principles of navigation but believed that these were unnecessary.

“real bills” theory of credit,

rather than for financial speculation in stocks and bonds or for long-term investments then no inflation could result. It is simple to see why this is nonsense. In periods of inflation, as the price of goods in inventory keeps rising, this doctrine would call for banks to keep on expanding credit, thus adding further fuel to the inflationary fire. That this doctrine did not lead to monetary disaster was due to the gold standard, which by keeping prices roughly stable, ensured that the “real bills’ doctrine was never given a chance to be applied in an environment of rising prices.

Walter Cunliffe,

If Britain was the most responsible of the belligerents, its ally France balanced it out by choosing to be the most feckless. The French government spent a total of $30 billion on its war effort. Few nations resisted paying their taxes more vigorously than the people of France—they seemed to view even the slightest official inquiry as to their financial circumstances as an unjustified intrusion by the state “into the most holy recesses of private life” and an infringement of their fundamental rights as citizens. As a result, at least for the first two years of the war, the government balked at raising taxes, not reversing itself until 1916 when it seemed on the verge of financial collapse. In total, France paid for less than 5 percent of its war expenditures out of higher taxation.

The republic was saved from complete economic disaster only by its government’s ability to tap two sources: first, the notoriously thrifty French middle classes, which bought $15 billion worth of government bonds; and second, foreign governments, specifically those of Britain and America, which, seeing France bear the brunt of the human cost of the war, lent a total of $10 billion. This still left a substantial gap, which was filled by printing money. While currency in circulation doubled in Britain, in France it tripled.

Germany’s strategy for paying for its military effort was dominated by the absolute conviction of the men around the kaiser that the war would be short, that the Reich would prevail, and that it would then present the bill to the vanquished. The German government raised barely 10 percent of the $47 billion it spent on the war from taxes.

it had to resort to an unusually high degree of inflationary finance. Whereas during the war, money in circulation doubled in Britain and tripled in France, in Germany it went up fourfold.

Strong’s doctors insisted that he take an extended leave of absence from the Fed. In July 1916, he moved to Colorado, where almost a third of the population was then made up of “consumptives” seeking to be cured.

The United States spent in total some $30 billion on the war, a little over $20 billion on its own actual expenditures and another $10 billion in the form of loans to keep other countries going.

Liberty Bonds, which eventually brought in close to $20 billion, about half of this raised by the New York Fed.

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. —JOHN MAYNARD KEYNES, The Economic Consequences of the Peace

Across Europe some 11 million men lay dead, including 2 million Germans, 1.4 million Frenchmen, and 900,000 British. Another 21 million had been wounded, very many maimed for life. Nine million civilians had perished, mostly of hunger, cold, or lowered resistance to the monstrous epidemics. But for all the horrendous human carnage, the actual material destruction of the war was limited to a long but narrow strip of northern

France and Belgium. The costs of rebuilding the mines, farms, and factories destroyed on the Western Front amounted to only $7 billion.

The most pernicious and insidious economic legacy of the war was the mountain of debt in Europe. In four years of constant and obsessive battle, the governments of Europe had spent some $200 billion, consuming almost half of their nations’ GDP in mutual destruction. To pay for this, they had raised taxes, borrowed gigantic amounts of money both from their own citizens and from the Americans, and simply printed more and more currency.

THE problem of German reparations—that

The British prime minister, David Lloyd George, pandering to public opinion, appointed to the British delegation to the Reparations Commission in Paris three of the most hard-line advocates of a punitive settlement: William Hughes, the doggedly aggressive prime minister of Australia; Lord Sumner, a law lord with a reputation for being “stony-hearted”; and Lord Cunliffe, the boorish and irascible former governor of the Bank of England.

France was therefore determined to weaken Germany by every means possible—by disarmament, by slicing off as many parts of its neighbor as it could, and by extracting reparations.

It fell to the American delegation, which included the famous stock market speculator Bernard Baruch; Thomas Lamont of J. P. Morgan and Co.; and

a young aide, the thirty-one-year-old John Foster Dulles, to act as the advocates for moderation. They adopted the position that a large reparations bill was incompatible with the initial terms of the armistice agreement under which Germany had laid down its arms. Moreover, they argued that punitive reparations would act as a millstone, not simply around Germany’s neck but around that of all Europe.

The Americans preferred a settlement in the region of $10 to $12 billion and would go no higher than $24 billion. Although President Wilson was, for the most part, outnegotiated and outfoxed by the other leaders in Paris, on this point the American delegation stuck to their guns and refused to agree to reparations that exceeded these limits.

Lloyd George’s maxim was never to enter into “costly frontal attacks, either in war or politics, if there was a way round”

In May 1919, when the terms of the peace treaty were finally unveiled to Germany, the whole country exploded in shock and anger. It was to lose one-eighth of its territory. Alsace and Lorraine were to revert to France; the Saar coal mines were also ceded to France; North Schleswig was to be subject to a plebiscite as to whether it wished to become part of Denmark; Upper Silesia, Posen, and West Prussia went to Poland. Both banks of the Rhine were to be permanently demilitarized; the army was to be cut to no more than one hundred thousand men, the navy was to be dismantled, and the merchant marine distributed to the Allies. Though the Allies had delayed fixing the size of reparations, it was widely known that the amounts being mooted were gigantic. In the interim, Germany was required to pay an initial $5 billion before May 1, 1921. A new Reparations Commission, to be based in Paris, was created specifically to determine Germany’s liability and to supervise its collection. The worst humiliation was Article 231, the “article of shame,” which branded Germany as solely responsible for the war.