Lords of Finance: The Bankers Who Broke the World

by Liaquat Ahamed

it was called the Diktat.

Germany had meekly agreed to reduce its military machine to a shadow of its former power, thus leaving it impotent to do anything about the loss of territory or of its colonies. Only on reparations did Germany seem able to fight back. It discovered what every large debtor at some point discovers: that when one owes a large amount of money, threatening to default can give one the upper hand.

Wilson, “his thought and his temperament . . . essentially theological not intellectual”; “his mind . . . slow and unadaptable”;

It was not simply their bad manners. They calculated, very correctly, that the longer they could string out the bargaining over reparations, the less they would end up paying. Their whole strategy was therefore to negotiate in bad faith. In the first two years after signing the treaty, Germany desperately scraped together what it could, and paid $2 billion out of the $5 billion of interim payments due.

Meanwhile, the Reparations Commission, established in Paris in mid- 1920, finally put a figure of $33 billion on the table as its estimate of the amount Germany should pay. The Germans responded by subjecting this figure to a series of adjustments to take into account what they had already paid—so transparently bogus as to embarrass even its own representatives in Paris—and concluded this meant they now owed the Allies just $7.5 billion, provoking Lloyd George to say that if the discussions continued any further in this vein, Germany would soon be claiming reparations from the Allies.

In May 1921, British Treasury officials developed a proposal that they believed to be so reasonable that Germany would find it difficult to turn down. The reparations bill was to be set at the equivalent of $12.5 billion, roughly 100 percent of the German prewar GDP. To meet the annual interest and principal repayments on this new debt, Germany was requ...

The problem was that the Germans never really believed that they could meet even this commitment.

Of the $1.2 billion that Germany owed during the first eighteen months of the schedule, it paid little more than half.

To finance the gap, the various governments of Germany resorted to the Reichsbank to print the money.

In 1914, the mark stood at 4.2 to the dollar, meaning that a mark was worth a little under 24 cents. By the beginning of 1920, after the full effects of the inflationary war finance had worked through the system, there were 65 marks to the dollar—the mark was now worth only 1.5 cents—and the price level stood at nine times its 1914 level.

Over the next few months, Germany experienced the single greatest destruction of monetary value in human history. By August 1923, a dollar was worth 620,000 marks and by early November 1923, 630 billion.

As German society was overturned, the traditional values that had made it so conservative and ordered a community were jettisoned. Stefan Zweig, the writer, tried to capture the mood of that time in his autobiography: “How wild, anarchic, and unreal were those years, years in which, with the dwindling value of money, all other values in Austria and Germany began to slip. It was an epoch of high ecstasy and ugly scheming, a singular mixture of unrest and fanaticism. Every extravagant idea . . . reaped a gold harvest.”

THE OFFICIAL MOST responsible for the reckless policy of inflation was none other than Rudolf von Havenstein, the sober and dedicated president of the Reichsbank who had so disastrously overseen Germany’s wartime finances.

Why did Von Havenstein submit without any apparent effort to resist? Two very conflicting pictures have been drawn of his motives: that he deliberately engineered the whole monetary explosion as a way of destroying the financial fabric of Germany, a collective self-immolation designed to prove to the Allies that reparations were uncollectible, or alternatively, that his conduct reflects nothing subtler than sheer economic ignorance. Trained as a lawyer, he had learned the banking business during the gold standard era, when the rules of monetary policy were dictated by the requirement that the Reichsmark be kept convertible at a fixed gold equivalent, and was completely at sea in a world not hitched to gold.

printing money to finance the deficit would bring on inflation.

Instead of admitting that he had made a terrible mistake, Von Havenstein, with his dogged Prussian sense of duty, dug in his heels, refusing to change any of his policies and continuing to print as much money as the government “needed.” The inflation had initially been beneficial to private business because it had the effect of wiping out their debts. By 1923, however, the crisis had moved to a new stage, and without a functioning currency, commerce became impossible.

Here was the president of the Reichsbank, whose principal obligation was supposed be the preservation of the value of the currency, proudly proclaiming to a group of parliamentarians that he now had the capacity to expand the money supply by over 60 percent in a single day and flood the country with even more paper. For many people, it was just one more sign that German finance had entered an Alice-in-Wonderland phantasmagoria.

“No-one could anticipate such an ingenious revelation of extreme folly to which ignorance and false theory could lead . . . The Reichbank’s own demented inspirations give stabilization no chance,” wrote the British ambassador, Lord d’Abernon, an expert on state bankruptcies who had thought that he surely had to have witnessed the worst financial excesses in the lunacies of the Egyptian khedives and the Ottoman Turks, only to find them almost Swiss in their rectitude compared to the Germany of 1923.

To pay for the four long, destructive years just past, every country in Europe had tried to borrow as much as it could from wherever it could.

By the end of the war, the European allied powers—sixteen countries in all—owed the United States about $12 billion, of which a little under $5 billion was due from Britain and $4 billion from France. In its own turn, Britain was owed some $11 billion by seventeen countries, $3 billion of it by France and

$2.5 billion by Russia, a debt essentially uncollectible after the Bolshevik revolution.

At an early stage of the Paris Peace Conference, both the British and the French tried to link re...

He was, of course, not so naive that he did not recognize that many Europeans remained cynical about U.S. motives—accusing it, for example, of having deliberately waited until Europe had come close to bankruptcy before entering the war.

There was considerable bitterness at how long the United States had sat out the war, many of Strong’s English acquaintances believing that America had deliberately waited for Europe to wear itself out before stepping in to pick up the pieces. Now those same people argued that the U.S. government was morally obliged to forgive part of their European Allies’ war debts.

If REPARATIONS POISONED the relations among European countries, war debts did the same to the relations between the United States and its erstwhile associates, Britain and France. However hard the Americans tried to separate war debts from reparations, in the minds of most Europeans they remained inextricably linked. Indeed, in the middle of 1922, the British government made the connection explicit in a note drafted by Arthur Balfour, then acting foreign secretary, that Britain would collect no more on its loans to its Continental allies and on its share of reparations from Germany

In March 1922, Congress created the five-man World War Foreign Debt Commission, which was chaired by the secretary of the treasury, Andrew Mellon, and included the secretary of state, Charles Evans Hughes; the secretary of commerce, Herbert Hoover; Senator Reed Smoot of Utah; and Representative Theodore Burton of Ohio. The commission was to negotiate

the terms on which American loans were to be repaid. Concerned that the administration might be too lenient on the debtors, Congress imposed a floor on any settlement—the commission would not be permitted to accept anything less than 90 cents on the dollar.

The burden of deflation fell on workers, businesses, and borrowers, that of devaluation on savers. The fate of the world economy would hinge over the next two decades on which path each country took. The United States and Britain took the route of deflation, Germany and France that of devaluation.

between devaluation and deflation.

Its exchange rate should have been allowed to fall as a means of making its goods cheaper on world markets.

The pound had a special status in the gold standard constellation and its devaluation would have rocked the financial world.

this example—and in complete contrast to every other European country—in 1920, the Bank of England chose the path of deflation, matching the Fed and raising interest rates to 7 percent. The budget was balanced. The economy plunged into sharp recession, two million men were thrown out of work. Nevertheless, by the end of 1922, the Bank had succeeded in bringing prices down by 50 percent, and the pound, which

had fallen as low as $3.20 in the foreign exchange market on the fear that Britain was headed for devaluation, climbed back to within 10 percent of its prewar parity of $4.86.

The bigger concern among bankers after the war was not so much that the world was short of gold, but that too much of the gold was concentrated in the United States.

By 1923, the United States had accumulated close to $4.5 billion of the $6 billion in gold reserves of the four major economic powers, far in excess of what it needed to sustain its economy.

The largest hoard lay under lower Manhattan, about $1.5 billion in the Treasury repository at the legendary intersection of Broad and Wall Streets, and at the New York Fed.

The hidden irony was that every one of Keynes’s main recommendations—that the link between gold balances and the creation of credit be severed, that the automatic mechanism of the gold standard be replaced with a system of managed money, that credit policy be geared toward domestic price stability—corresponded precisely to the policies Strong had instituted in the United States.

that of promoting internal economic stability.

It was Strong more than anyone else who invented the modern central banker. When we watch Ben Bernanke or, before him, Alan Greenspan or Jean-Claude Trichet or Mervyn King describe how they are seeking to strike the right balance between economic growth and price stability, it is the ghost of Benjamin Strong who hovers above him. It all sounds quite prosaically obvious now, but in 1922 it was a radical departure from more than two hundred years of central banking history.

The Federal Reserve Act of 1913 had been a political compromise. Decisions about the level of interest rates and credit conditions were vested in the hands of the twelve banker-dominated regional reserve banks. This network was overseen by an eight-member central Board of Governors, all presidential

appointees based in Washington. Broadly speaking, only the reserve banks could initiate policies, but these policies had to be approved by the Board.

called open market

operations.

Strong recognized that by buying or selling government securities from its portfolio, the Fed could directly and immediately alter the quantity of money flowing through the banking system.

open market committee,

If there was one problem with this whole process of making monetary policy, it was that it all depended too heavily on Strong—on his judgment, his skill, and his insight. He was too autocratic, operated on his own too much, and did not spend the time to build a consensus through the whole system. As a result, the rationale for many of his decisions was misinterpreted and his motives were constantly questioned. His failure to institutionalize policies and the thinking behind them meant that once he was no longer around, the Fed would become paralyzed by internal conflicts.

the Federal Reserve, was a deeply divided organization that did not fully realize the role that had been thrust upon it and, but for Strong, would have been in the hands of a motley crew of small-town businessmen and minor-league political hacks with little expertise in finance or central banking.

Hjalmar Schacht,

Gustav Stresemann,

become chancellor of Germany.