Lords of Finance: The Bankers Who Broke the World

by Liaquat Ahamed

It helped Strong enormously that the Fed’s charter had an inherent bias toward inaction. Under the then law, only the reserve banks could initiate changes in policy. While the Board had the power to approve or disapprove such changes, it could not force the reserve banks to act. It was a recipe for the worst sort of stalemate. Checks and balances may work well in politics, but they are a disaster for any organization—the

required to act quickly and decisively. But in 1925 and 1926, with Hoover and Miller pushing to tighten credit policy, Strong was able to hide behind the Fed’s charter and do nothing.

Meanwhile, profits grew strongly and the price-earnings ratio, one measure of market valuation, remained around 11, well below the danger level of 20 that is often considered a sign of overvaluation.

The Florida real estate bubble burst of its own weightlessness, helped by a devastating hurricane in 1926, and though there was much local disruption, its impact on the national economy was minor. Meanwhile, consumer prices remained almost completely flat.

their enthusiasm to save the country from overspeculation, they had fallen into the first trap of financial officials dealing with complex markets—an excessive level of confidence in their own judgments.

price-earnings ratio of less than 9,

Central bankers can be likened to the Greek mythological character Sisyphus. He was condemned by the gods to roll a huge boulder up a steep hill, only to watch it roll down again and have to repeat the task for all eternity. The men in charge of central banks seem to face a similar unfortunate fate—although not for eternity—of

naïve self assurance,”

Thursday, May 12, 1927, he made his move. The Reichsbank instructed every bank in Germany to cut its loans for stock trading by 25 percent immediately. The next day, nicknamed “Black Friday” by the Berlin press, stock prices fell by over 10 percent. Over the next six months, they would slide by another 20 percent.

By going after the stock speculators, Schacht was hoping to crack the atmosphere of overconfidence and curb inflows of foreign money into Germany. This proved to be a serious miscalculation. Even though stocks had gone up a lot in the last five years, this represented a recovery from the brink of disaster. The market was by no means overpriced—in early 1927, its total capitalization was only around $7 billion, less than 50 percent of GDP, still only 60 percent of its prewar level. More important, German municipalities, which were immune to stock market fluctuations, kept on borrowing abroad. All that Schacht had achieved with this hasty maneuver was unnecessary damage to business confidence.

Having thus failed to dam the inflow of foreign loans with his broadside against the stock market, Schacht now began to talk about doing something dramatic over reparations. A New York Fed official, Pierre Jay, passing through Berlin in June 1927, remarked that Schacht did “not wish to have things seem too good in Germany for fear that it will help the execution of the [Dawes] Plan,” and speculated that he might take some other acti...

No one was quite sure what he had in mind. Berlin was rife with rumors that he might deliberately engineer a new crisis. It was the beginning of what one historian has described as Schacht’s descent into “irresponsibility and unpredictability.” His tendency to “extreme and erratic” behavior seemed to be a deliberate ploy to keep friends and enemies alike guessing.

It certainly unnerved his counterparts, Norman and Strong. They feared that consumed as he was by reparations, he might try some reckless and foolhardy gamble to sabotage the Dawes settlement, which would not only plunge Germany into chaos and undermine its fragile new democracy, but might capsize the international monetary structure, which they had so painstakingly put together over the last few years.

he had indulged in a certain schadenfreude

The shrinkage of reserves in the country losing bullion was supposed to lead to an automatic contraction in credit and a rise in interest rates, which would thereby shrink its buying power, while attracting money from abroad. Meanwhile, the country gaining gold would find its credit expanding and its capacity to spend increasing. These “rules of the game,” as Keynes called them, were designed to set in train automatic gyroscopic forces to balance out the shifting tides of gold among countries.

By THE END of 1926,

the U.S. stock market bubble, excessive foreign borrowing by Germany, and an increasingly dysfunctional gold standard—that

None of them, however, yet anticipated the scale of the co...

By pegging the franc at 25 to the dollar, the Banque de France had kept French goods very cheap. France was therefore in a position to steal a competitive edge over its European trading partners, particularly Britain.

In 1931, Adolph Miller would testify before the Congress that the easing of credit in the middle of 1927 was “the greatest and boldest operation ever undertaken by the Federal Reserve System, . . . [resulting] in one of the most costly errors committed by it or any other banking system in the last years.”

Some historians, echoing the views of Hoover and Miller, see the meeting on Long Island as the pivotal moment, the turning point that set in train the fateful sequence of events that would eventually lead the world into depression.

They argue that by artificially depressing interest rates in the United States to prop up the pound, the Fed helped fuel the stock bubble that subse...

It is hard to dismiss this view. Though the cut was small—only 0.5 percent off the level of interest rates—and short lived—reversed within six months—the fact that the market should begin the dizzying phase of its rally in the very same month, August 1927, that the easing took place has to be mor...

He also began to realize that his policy of keeping U.S. interest rates low to bolster sterling had failed to solve the fundamental problem of the

British economy—that its prices were too high and its currency overvalued. Furthermore, he had unintentionally provided the impetus for the growing bubble on Wall Street. And it had exposed him to constant criticism at home over his excessive focus on international affairs. That summer the Chicago Tribune denounced him for creating “speculation on the stock market that was growing . . . like a snowball rolling down a hill” and called for his resignation.

At particular times a great deal of stupid people have a great deal of stupid money. . . . At intervals . . . . the money of these people—the blind capital, as we call it, of the country—is particularly large and craving; it seeks for someone to devour it, and there is a “plethora”; it finds someone, and there is “speculation”; it is devoured, and there is “panic.” —WALTER BAGEHOT

the overall market was driven by the ebb and flow of confidence, a force so intangible and elusive that it was not readily discernible to most people. There would be no better evidence of this than the stock market bubble of the late 1920s and the crash that followed

The bubble began, like all such bubbles, with a conventional bull market, firmly rooted in economic reality and led by the growth of profits. From 1922 to 1927, profits went up 75 percent and the market rose commensurately with them.

During the second half of the year, despite a weakening in profits, the Dow leaped from 150 to around 200, a rise of about 30 percent. It was still not clear that this was a bubble, for it was possible to argue that the fall in earnings was temporary—a consequence of the modest recession associated with Ford’s shutdown to retool for the change from the Model T to the Model A—and that stocks were being unusually prescient in anticipating a rebound in earnings the following year.

It was in the early summer of 1928, with the Dow at around 200, that the market truly seemed to break free of its anchor to economic reality and began its flight into the outer reaches of make-believe. During the next fifteen months, the Dow went from 200 to a peak of 380, almost doubling in value.

That it was so obviously a bubble was apparent not simply from the fact that stock prices were now rising out of all proportion to the rise in corporate earnings—for while stock values were doubling, profits maintained their steady advance of 10 percent per year. The market displayed every classic symptom of a mania: the progressive narrowing in the number of stocks going up, the nationwide fascination with the activities of Wall Street, the faddish invocations of a new era, the suspension of every conventional standard of financial rationality, and the rabble enlistment of an army of amateur and ill-informed speculators betting on the basis of rumors and tip sheets.

By 1929, anywhere from two to three million households, one out of every ten in the country, had money invested in and were engaged with the market. Trading stocks had become more than a national pastime—it had become a national obsession.

But while the bubble lasted, it was the people who were the least informed who were the ones making the most money.

Paul Warburg, one of the wise men of American banking, the intellectual father of the Federal Reserve System, kept predicting that it would all end in disaster, issuing his most powerful jeremiad on March 8, 1929: “History, which has a painful way of repeating itself, has taught us that speculative overexpansion invariably ends in over-contraction and distress.” If the “debauch” on the stock market and the “orgies of unrestrained speculations” continued, he warned, the ultimate collapse in stocks would bring about “a general depression involving the entire country.”

Russell Leffingwell, a former assistant secretary of the treasury, who had become a partner in 1923, blamed the bubble on Norman and Strong. In March 1929, on the very same day that Warburg issued his ominous pronouncement, Leffingwell predicted to Lamont, “Monty and Ben sowed the wind. I expect we shall have to reap the whirlwind. . . . I think we are going to have a world credit crisis.”

It was from Washington that the bull market faced its greatest hostility. Every senior financial official in the government thought that stocks were now in a speculative bubble—everyone, that is, except the president, Calvin Coolidge.

The irrepressible gentlemen on Capitol Hill were not so reticent. In February and March of 1928, the Senate Committee on Banking and Currency held hearings on brokers’ loans and, from March to May, its House counterpart opened its own investigation into stock market speculation—overall a spectacle somehow both embarrassing and uplifting. It was painful to watch the good senators flailing around trying to understand the workings of a complicated financial system and hurling foolish questions at the expert witnesses. But there was also something admirable as they voiced the outrage of the common man at the absurdities of Wall Street.

But the senators slowly came to recognize that they would only inflict greater damage upon their people if they pressed for tighter credit to force stock prices down.

It was thus left to the Fed to wrestle with the conundrum of how to deflate the stock bubble without crippling the economy. Recognizing that the easing of credit policy in the middle of 1927 had been a mistake, it raised rates from 3.5 percent in February 1928 to 5 percent in July 1928. But just as the stock market began its second leg upward in the middle of 1928, the Fed fell silent and disappeared from view, brutally divided about how to react.

Any further measures to bring the market to earth were bound to inflict collateral damage to the economy, especially on farmers. Moreover, capital had once again begun flowing in from abroad, attracted by the returns on Wall Street. Were the Fed to raise interest rates now, it might well pull in even more gold, possibly even forcing sterling off the gold standard.

Strong was still grappling to the very end with these issues. He was willing to concede that it had been a mistake to delay tightening credit so long in early 1928, thus letting the bull market build up such a head of steam. Nevertheless, in the last weeks before he died, he had begun arguing that the Fed should not t...

Alger Hiss,

By early 1929, the bubble was not simply a problem for the Fed but for almost every European central bank as well. New York was sucking in capital from abroad at a time when Europe was still very dependent on American money.

Norman thought the Fed could pierce the bubble

with a surgical incision that would bring it back to earth, without harming the economy. It was a completely absurd idea. Monetary policy does not work like a scalpel but more like a sledgehammer. Norman could neither be sure how high rates would have to go to check the market boom nor predict with any certainty what this would do to the U.S. economy.

Nevertheless, such was his power that Harrison embraced the idea. He did, however, warn Norman that since Strong had died, things had changed within the Fed. The conflict between the Board and the New York Fed had become even greater than in the past. There was now general agreement that the United States was faced with a stock market bubble. But the system was deeply divided about how to respond. While the reserve banks wanted to raise rates, it was now the Board that was resisting, and it had become more aggressive about getting its way. Harrison himself had just emerged from a collision with the Board over issues of jurisdiction, Chairman Young warning him that he and the other Board members did not “any longer intend to be a rub...

On February 5, Harrison, fortified by his discussions with Norman, himself went down to Washington and proposed exactly the Norman strategy to Young. He rejected the idea that his old chief, Strong, had been advocating in his last few months—that the Fed should passively sit by and “let the situation go along until it corrects itself.” Instead, he now pressed for “sharp incisive action,” a rise in rates of 1 percent. He had come to the conclusion, as he would put in later, that it would be better “to have the stock market fall out of the tenth story, instead of the twentieth later on.” Once the speculative fever had been broken, rates could be brought down again. The next day, Norman also turned up in Washington, bearing the same message. Members of the Board could not help but remark o...

While Harrison and Norman were pressing for rate hikes, the Board continued its campaign for direct action. On F...

to all its member banks that they should not borrow from the Fed “for the purpose of making speculative loans or for the purpose of maintaining speculative loans.” Four days later, it made the directive public. The Dow fell 20 points over the next three days, but quickly recovered and by the end of the week was back at the highs. The market’s attitude was best summarized by an editorial in the Hearst newspapers. “If buying and selling stocks is wr...

On February 11, the directors of the New York Fed voted unanimously to raise rates by 1 percent to 6 percent. Harrison called Young in Washington to inform him of the decision, acknowledging the Board’s right to override it. Young asked for time to consider the initiative, but Harrison insisted on a definitive answer that day. After three hours of calls back and forth in which Young unsuccessfully tried to persuade Harrison not to force a showdown, he eventually called to say that the Board had voted to disallow the hike. Over the next three months, the directors in New York voted ten times to raise rates and each time were overridden by Washington.