Lords of Finance: The Bankers Who Broke the World

by Liaquat Ahamed

The Fed was now paralyzed by this standoff between its two principal arms. The Board kept insisting that the right way to deflate the bubble was through “direct action”: credit controls, particularly of brokers’ loans. New

York was equally insistent that such a policy could not work, that it was impossible to control the application of credit once it left the doors of the Federal Reserve. Mean...

It did not help that the Fed seemed incapable of even exerting its control over leading bankers, let alone over the crowd psychology of investors. At the end of March, it was announced that total broker loans had increased to almost $7 billion, and the market swooned. The fear that some drastic action from the Fed to curtail the amount of credit going into the stock market was imminent drove the rate on brokers’ loans to over 20 percent. Instead, Charlie Mitchell of National City Bank, himself a director of the New York Fed, defied the Board by calling a press conference and announcing that his bank wo...

It is too easy to mock the Fed for entangling itself in a bureaucratic turf feud and fiddling while Rome was burning. Both parties to the debate were in fact right. The Board was undoubtedly correct that with the demand for money on Wall Street so strong, call money averaging over 10 percent, sometimes spiking as high as 20 percent, and speculators counting on gains of 25 percent a year and more, a hike in the Fed’s discount rate from 5 percent to 6 percent or even 7 percent at this stage of the game was going to have almost no effect. To be sure of pricking the bubble would have required raising interest ...

But the New York Fed also happened to be right. All the jawboning about reducing credit for speculators proved to be pointless. It did in fact succeed in curbing the amount of money going into brokers’ loans from banks—between early 1928, when the Board first declared war on brokers’ loans, and October 1929, banks cut their loans to brokers from $2.6 billion to $1.9 billion. Meanwhile, other sources of credit—U.S. corporations with excess cash, British stockbrokers, European bankers flush with liquidity, even some Orien...

these players, all of them outside the Fed’s control, who were by far the most important factor supporting leverag...

Even Adolph Miller, the most vocal opponent of speculation in general and brokers’ loans in particular, could not resist the temptation to earn 12 percent on his own savings. In 1928, Fed officials discovered that he had invested $300,000 of his own money in the call market through a New York banker, personally ...

One is led to the inescapable but unsatisfying conclusion that the bull market of 1929 was so violent and intense and driven by passions so strong that the Fed could do nothing about it. Every official had tried to talk it down. The president was against it, Congress too; even the normally reticent secretary of the treasury had spoken out. But it was remarkable how difficult it was to kill it. All that the Fed could do, it seemed, was to step aside and let the frenzy burn ...

PERHAPS THE MOST perverse consequence of the bubble was that by the strange mechanics of international money, it helped to tip Germany over the edge into recession. For five years, hordes of American bankers had descended on Berlin to press loans upon German companies and municipalities. However much Schacht had tried to wean his country from this dependence on foreign capital, there was little he was able to do about it. Over the five years between 1924 and 1928, Germany borrowed some $600 million a year, of which half went to reparations, the remainder to sustain the rebound in consumption after the years of austerity.

In fact, Germany’s appetite for foreign exchange was so great that even the deluge of long-term loans from U.S. bankers was not enough, and it was forced to supplement this with short-term borrowings in international markets closer to home. Out of the total of $3 billion for which German institutions signed up in those years, a little less than $2 billion came in the form of stable long-term loans. But more than $1 billion was “hot money,” short-term deposits attracted to German banks by high interest rates—7

percent in Berlin compared to 5 percent in New York—and subject to being pulled at any time. In late 1928, as the U.S. stock market kept climbing and call money rates on Wall Street skyrocketed, American bankers mesmerized by the...

It was the combination of the drying up of foreign credit due to high interest rates induced by the U.S. stock bubble and the residual lack of confidence among German businessmen following Schacht’s ill-fated strike against the stock market in 1927 that drove Germany into recession in early 1929. Moreover, as long-term American loans stopped, Germany was forced to rely more and more on hot money, some raised from London, but much from by French banks, then flush with all the excess gold that had been sucked into their country. Germany therefore found itself slipping into recession just as its foreign position was becoming increasingly vulnerable. A British Treasury official, recalling how much mo...

The collapse in foreign loans and the recession could not have come at a worse time for Germany. Under the Dawes Plan schedule, Germany was to have fully recovered by now, and was due to ramp up its reparations payments in 1929 to the full $625 million a year, about 5 percent of its GDP. This would not have been an intolerable burden by historical standards. But Schacht, for that matter most of the German leadership, had always been resolute that with its new constitution still fragile, its body politic still divided, its people stil...

As 1929 and the scheduled rise in payments approached, Schacht was of two minds about what to do. He often spoke about simply waiting for the economic crash that so many financial experts were predicting. It was a common view in Britain, held, for example, by Frederick Leith-Ross, the top Treasury official responsible for reparations, that th...

default on their debts, setting the stage for a general restructuring of all international commitments arising from the war. Europe could then wipe the slate clean of both reparations and war debts and start over again. Occasionally, Schacht even ...

Agent-General Seymour Parker Gilbert

In his 1927 report released in December, Gilbert declared that the time had come for Germany to take control over her own economic destiny “on her own responsibility without foreign supervision and without transfer protection.” Germany should be told once and for all exactly how much she owed and for how long. Moreover, the transfer protection clause embodied in the Dawes Plan, while useful in 1924 for restarting foreign lending, was now creating its own perverse incentives—what we now refer to as moral hazard.

By providing an escape clause in the event of a payments crunch, the plan encouraged foreign bankers to be too cavalier in their lending and allowed Germany to be too lax about the consequences of accumulating so much debt “without the normal incentive to do things and carry through reforms that would clearly be in the country’s own interests.”

There were many on the British side, and even among the Germans, who thought that it was still premature for a final reckoning. The bitterness between France and Germany had yet to subside; more time was needed until

the German economy had truly revived before the amount of foreign payments it could sustain could definitively be settled.

By late 1928, however, Gilbert had been successful in persuading the Allies to convene a conference in Paris in February 1929 to do just that. He had even convinced the powers in Berlin that though the current situation—no new foreign loans coming in, large debts to nervous French depositors in German banks, and rising domestic unemployment—did not provide the ideal backdrop against which to reopen...

Gilbert and the German leadership, Schacht included, were operating, however, from two completely different assumptions abou...

The lowest figure that the Allies could concede was an aggregate payment of $500 million a year.

Meanwhile, Schacht believed that American bankers had now committed so much money to Germany—they had provided some $1.5 billion of the $3 billion it had borrowed—that they represented an effective lobby for reduction and would bring enough political pressure on the creditor governments for Germany to swing a settlement of $250 million a year.

The local economy, fueled by soaring exports, high savings, and large capital inflows, was expanding at 9 percent a year, making it the fastest growing major country. In the last two years, the French stock market had enjoyed the best performance in the world, beating even Wall Street’s—having gone up 150 percent since the end of 1926, while the Dow had risen 100 percent.

Marthe Hanau was a forty-two-year-old divorcée who in 1925 had started a stock tip sheet, La Gazette du Franc.

On February 11, the Young Conference—as it would come to be called but was for the moment referred to as the Second Dawes Conference—opened

On the second day, seated around the horseshoe table, Schacht made his opening offer—$250 million a year for the next thirty-seven years. Moreau conveyed to Young that France would accept nothing less than $600 million a year for the full sixty-two years and might even demand as much as $1 billion.

Moreau by contrast sat there obstinate and ill-tempered, his mouth shut, Revelstoke observed, “like a steel trap when Schacht pleads poverty and inability to pay.”

The German delegates found the atmosphere in Paris menacing. They were not being paranoid. The French secret police were tapping their phones. All communications with their government had to be conducted by courier or by cipher telegrams, with each of the twenty-eight participants assigned a code name. The three senior representatives, Schacht included, took turns traveling back to Berlin by train every two weeks in order to brief the cabinet.

Finally, in early April, Young felt ready to allow the Allies to unveil their proposal. Germany would have to make annual payments of $525 million for the first thirty-seven years and, in order to match exactly the Allied war debts to the United States, $400 million a year for the subsequent twenty-one years.

The Allies made it clear that the only reason they were saddling two generations of Germans with reparations was that they themselves were in debt to the Americans for the same length of time. On hearing the Allied proposal, Schacht turned pale an...

By now he realized how totally he had miscalculated. The American bankers’ power to pressure the Allies had foundered on the U.S. government’s unwillingness to contemplate any further reduction in war debts. Without such an easing, the Allies would not reduce their claims on Germany. Schacht was now caught between letting the conference collapse thus very likely provoking a financial crisis in Germany for whic...

He now argued that Germany would be unable to meet the victors’ demands unless its former colonies were restored. Even more provocatively, he demanded that the Danzig corridor, the most contentious strip of land in all Europe, taken from Germany to give Poland access to the sea, should also be returned.

In seeking to tack what amounted to a territorial revision of Versailles upon what was supposed to have been a purely financial negotiation, Schacht had gone out on a limb, and without the permission, or even the knowledge, of his own government. The détente between Germany and the Allies, so painstakingly achieved since the withdrawal from the Ruhr five years before, had rested on the principle that Germany would not seek to overturn the political or territorial clauses of the 1919 settlement. Here was Schacht in one stroke trying to undermine the whole fragile basis of European peace.

It has always been something of a mystery what Schacht was hoping to achieve. He did have a habit of shaking things up without quite knowing where it would all end. But he must have known that no one at the Young Conference had the authority to renegotiate crucial parts of the Treaty of Versailles, that the gambit was bound to end in failure. Some thought he was just grandstanding for domestic consumption to prepare for a political career on his return to Germany, others that h...

Schacht’s proposal was initially received in stunned silence. Once the other delegates had had time to absorb his demands—and he had made them sound like an ultimatum—the table dissolved into an uproar, with cries of astonishment and outrage. Moreau was so furious that he ...

Seeing this as the first salvo in an economic war, Schacht accused the Banque de France of having secretly orchestrated the withdrawals to force his hand and threatened that if Germany’s reserves continued to fall, he would have no option but to invoke the transfer clause of the Dawes Plan to default on all further reparations. At that moment, such a move would have set off a global financial meltdown. German banks, municipalities, and corporations owed money to everybody—$500 million to British banks, several hundred million to French banks, and some $1.5 billion to American lenders. Had it defaulted on reparations at that point, every financial institution with exposure to Germany would have tried to pull what money it could out of the country. Germany would have had to suspend payments on all its commercial loans, creating a domino effect across the globe. Half the London banks would have gone under. Britain, its reserves already depleted, would have been flung off the gold standard. The financial chaos would have been catastrophic.

The Banque de France had in fact considered launching such a preemptive financial strike against Germany but rejected the idea as too risky. Moreau did not want to be blamed for a world economic collapse. Some French banks undoubtedly did pull some deposits home but this was mere commercial prudence in the light of the deteriorating turn of events. Meanwhile, in an effort to forestall a breakdown in world finances, Norman and George Harrison of the New York Fed had begun mobilizing money to support the Reichsbank.

At this point, with a financial crisis looming, Lord Revelstoke saved the day by...

had unemployment already reached two million, but a wave of strikes was now threatening to put another million men out of work. Schacht’s gamble threatened to plunge Germany into even deeper recession.

Schacht fought back. He blamed Gilbert for having misled him. He even turned on his erstwhile patron Stresemann, whom he accused of having undercut him by caving in to the Allies behind his back even before the conference had started and of now making him the scapegoat for the political fallout at home.

While Schacht, even at this stage, would have been willing to go for broke and risk a global banking crisis, his government was not. Fearing that Germany would once again become a pariah nation, the cabinet disavowed his position, forced him to recant, and insisted that he return to Paris and resume negotiations on the basis of the last Allied proposal. He reluctantly agreed, provided the cabinet gave him political cover by publicly accepting final responsibility for a...

few weeks later a compromise was reached. Germany would pay a little under $500 million for the next thirty-six years and $375 million a year for the twenty-two after that to cover the Allies debt to the United States. A new bank, the Bank of International Settlements (BIS), jointly owned by all the major central banks, would be set up to administer and where possible to “commercialize”—the modern term is securitize—these future payments, that is, to issue bonds against them. Any profits generated by the Bank were to accrue to Germany to help defray the burden. All foreign control over German economic policy was to be removed—Gilbert

The transfer protection clause was eliminated, although a small safety valve was retained whereby should

Germany get into economic trouble, it could postpone two-thirds of its p...

But for the last four years, he had been hard at work on a new book. After The Economic Consequences of the Peace and A Tract on Monetary Reform, both monographs devoted to the immediate and practical concerns of the chaotic postwar world, he was now struggling with a more ambitious work, a theoretical treatise on the interactions between the monetary sphere—the world of banks and other financial institutions—and the underlying real economy—the world of stores and factories and farms. He had begun this line of thought in the Tract, but that had been built on a very simple picture, almost a cartoon, of the economy. In this new book, he was trying to paint a richer portrait of the paths along which money flowed in order to understand better the fundamental source of the instability he believed to be inherent in the credit system of modern capitalism.

Buying and selling on margin, he was able to leverage his positions substantially and his portfolio could be very volatile.

But as 1928 progressed, his portfolio began to unravel. He sustained substantial losses in April when rubber prices collapsed by 50 percent as the world cartel broke down, forcing him to liquidate large holdings at a loss to meet margin requirements. The Fed’s tightening of early 1928 to cap the stock market took Keynes by surprise. After all, he argued, U.S. prices were stable and there was “nothing which can be called inflation yet in sight.” In September 1928, with the Dow at 240, he circulated a short note among friends titled “Is there Inflation in the U.S.?” which predicted that “stocks would not slump severely [that is,] . . . unless the market was discounting a business depression,” which the Fed “would do all in its power to avoid.”

His big error was a failure to take into account the deflationary forces that had begun to sweep the world. After Strong’s death in October and as the Fed initiated its campaign of words against the exuberance of the market, he began slowly to realize that the risk had now shifted “on the side of business depression and a deflation.” But by his own admission, even in early 1929, he still did not comprehend the impact that the scarcity of gold would have on central banks. He had thought that over time they would liberate themselves from the hold of the “barbarous relic.” He completely failed to foresee the sort of scramble for gold that emerged in 1929. “I was forgetting that gold is a fetish,” he confessed.