Lords of Finance: The Bankers Who Broke the World

by Liaquat Ahamed

The downturn that had hit the United States in 1930 in the wake of the stock market crash had indeed been deep, but the U.S. economy had faced a similarly sharp decline in prices and production in 1921 and had bounced back. There had been as yet no major financial disaster or bankruptcy.

collapse in capital flows. After a brief revival early in 1930, U.S. foreign investment into Europe suddenly dried to a trickle. American bankers became risk averse and cautious and, claiming that it was hard to find creditworthy borrowers, pulled in their horns. With American capital bottled up at home and U.S. demand for European goods shrinking—a result of the weak U.S. economy and of higher import tariffs imposed in June 1930 by the Smoot-Hawley Act—Europe could only pay for its imports and service its debts in gold. During 1930, a total of $300 million in bullion was shipped across the Atlantic into the vaults of the Federal Reserve system.

Even more disruptive to international stability, however, was the flow of gold into France, the one country in Europe that had somehow remained immune from the world economic storm.

The United States had historically always suffered from an unstable banking system—the consequence of having no central bank compounded by an astoundingly fragmented banking structure. The creation of the Fed in 1913 had more or less solved the first problem, but did nothing to change the organization of banking in the country. During the 1920s, the United States was still populated with some 25,000 banks, many of them so tiny, undiversified, and dependent on the economic conditions of their localities that every year roughly 500 went under. In the first nine months of 1930, as a result of the deepening hard times, 700 had closed their doors. That October, two months before the BUS crisis, the terrible drought across the Midwest and South led to the collapse of the Tennessee investment bank, Caldwell and Company, which controlled the largest chain of banks in the South, leaving a string of failures in its wake—120 in all across Tennessee, Kentucky, Arkansas, and North Carolina.

After closing the BUS, the Fed did successfully manage to avoid a chain reaction among local banks. December 1930 and January 1931 saw a brief spike in bank runs in New York and Pennsylvania, but the sense of panic quickly died down. However, the failure of the BUS did mark a profound change in public sentiment toward banks.

Shaken by such a high-profile failure, depositors started becoming more cautious about where they placed their money. Unable to tell whether a bank was sound or not, they began pulling their cash indiscriminately out of all banks, good and bad. At first it was a mere ripple—in the months after the twin failures a total of...

Because of the way banking works, however, such withdrawals had a negative multiplier effect. In an effort to maintain a prudent balance between their own liquidity and their loan portfolios, banks had to call in three or four dollars of loans for each dollar in cash withdrawn. Moreover, as their loans were called, borrowers in turn withdrew their deposits from other banks. The effect was to spread the scramble for liquidity right across the system. In this climate, all banks felt the need to protect themselves by building up cash reserves and thus called in e...

After a lull during the spring, in May 1931, the bank runs resumed. A real estate bubble in the Chicago suburbs collapsed, and thirty Chicago banks with $60 million in deposits were swept away. Over the summer, the virus spread to Toledo—every large bank but one was shut down; the remaining one being saved only when, at the last minute, trucks from the Federal Reserve Bank of Cleveland drew up at its doors laden with $11 million in crisp

new currency notes. Seventy percent of the city’s deposits were frozen, retail business came to a standstill, and even the Inverness Golf Club, scene of the most recent U.S. Open, was closed.

Within the Fed, officials were fully aware of the strains on the financial system—the hoarding of currency, the growing problem of bank failures, the reluctance of banks to lend, prices falling at a rate of 20 percent per annum. Somehow they were unable to put all these pieces of the jigsaw puzzle together. At the Federal Reserve Board, Meyer pressed for a more aggressive policy and even Adolph Miller, who with his natural contrarian str...

Meanwhile, the governors of the various Federal Reserve banks, who could have taken the initiative, refused to act. A large number of the banks in trouble, particularly the small ones, were not members of the Federal Reserve System—only half of the twenty-five thousand banks in the country had joined the system, although they accounted for about three-quarters of all deposits. The regional bank governors did not feel...

The real issue for the governors was that many of the banks closing their doors—by one estimate close to half—had sustained such large losses on their loans that they were, like the BUS, insolvent. Determined to follow Bagehot’s rule of only lending to “sound” institutions and believing that propping up failing banks would be throwing good money after bad, the regional governors made it a principle to let them go under. They failed to recognize that by doing so they we...

Strangely enough in the first quarter of 1931, as the world banking system was having to cope on one side with the hoarding of currency by a frightened American public and on the other by the piling up of gold bullion at the Fed and the Banque de France, the economy went through one of its little rebounds, both in the United States and across Eu...

economy, then the double drain of cash was like two invisible leaks. Their effects were not immediate and would...

But he and his fellow central bankers had been unable to agree among themselves on what to do. Norman found himself increasingly without influence and powerless to act.

Money has no motherland; financiers are without patriotism and without decency; their sole object is gain. —NAPOLÉON BONAPARTE

IN THE SPRING of 1931, the one major country most weighed down by a sense of collective despair and individual hopelessness was Germany. The official figures indicated that 4.7 million people, close to 25 percent of the workforce, double that in the United States, were without jobs.

But then Germany, burdened by the twin problems of foreign debt and reparations, had been in a constant state of feverish turmoil ever since the middle of 1929.

policy of fulfillment.

In the late 1920s, he and his old protector Gustav Stresemann had allowed Germany to borrow vast amounts of money from U.S. banks in the hope of forcing American involvement in the reparations question. Their strategy of binding the German republic to American money had, however, not paid off. In Schacht’s view, the American bankers had failed to deliver. He and Stresemann had clearly exaggerated the power and influence of Wall Street to impose a resolution of the reparations issue.

as the German unemployment rolls kept rising, the cost of unemployment benefits mounted with them and the budget deficit kept increasing. The government, a grand coalition of all democratic parties led by the Socialist Hermann Müller, proposed to finance itself by more borrowing abroad. For Schacht, who had been on a campaign against excessive foreign debt since 1927, this was one more sign that a coalition that included the Socialists was incapable of governing Germany. Having failed to control either its spending or borrowing abroad during the good times, it was now repeating the mistake as times turned bad. He feared that Germany was heading for national bankruptcy.

All of these measures made the Depression worse.

Germany was unusual in the degree of deflation that the government imposed on the economy. In the United States, the Hoover administration had cut taxes and allowed the budget to go from a surplus of $1 billion in 1929 to a deficit of $2 billion in 1931, 4 percent of GDP. Britain ran a deficit of $600 million in 1931, 2.5 percent of GDP. By contrast in Germany, even though revenues fell as activity faltered, expenditures were cut even more, and the deficit was actually reduced from an already modest $200 million to $100 million, less than 1 percent of GDP.

Brüning, who was now being called the “Hunger Chancellor,” would later claim that his austerity measures had been designed to prove to foreigners that Germany could no longer pay reparations, a reprise of the old perverse “hair-shirt” policy attempted in the early 1920s: to inflict so much damage o...

Historians have debated whether the government had any alternative. Borrowing abroad was not an option. By the middle of 1930, foreign lending throughout the world had collapsed. Moreover, Germany had borrowed so much during the boom years, living by the standards of the time so high on the hog that when bad times finally arrived and it real...

The problem was made much worse by one of the unintended consequences of the Young Plan. Under the Dawes Plan before it, private commercial lenders had priority over reparations at a time of crisis. In effect, Germany’s public creditors, principally the governments of France, Belgium, and Britain, had to stand last in line. The Young Plan’s elimination of this “transfer protection,” which incidentally Schacht had tried to resist, put an end to the guarantee. In the event of a payments crisis, private lenders did not automatically move to the front of the line but had to wait their turn with the big governments. Not surprisingly, private forei...

Reichsbank—in other words, financed its budget deficit by printing money. But memories of the hyperinflation of the early 1920s were too fresh. Moreover, the Dawes and Young plans severely limited the Reichsbank’s ability to buy government debt. The only way Germany could have followed such a policy...

The new government adopted many of the austerity policies that he himself was advocating, with catastrophic results.

Schacht’s wife was well known to hero-worship Hitler and was a devoted supporter of the party.

None of the central bankers had faced an international financial crisis before; they therefore had to make things up as they went along. In so doing they made two mistakes. Given the scale of the problem, they came up with far too little money; and believing that it was necessary to put together as international a consortium as possible, they did not act quickly enough. For all the frantic telephone calls, it took them three weeks to drum up the money, and then only came up with $15 million.

The crisis was made immeasurably more complicated by the politics of the situation. In March 1930, Germany and Austria had announced that they would form a customs union.

The French government now saw its opportunity. Indeed it helped to create it by secretly encouraging French banks to pull money out of Austria.

Austria was still waiting anxiously for the second loan when it received word that France had offered to provide it—but only if Austria would abandon the customs union.

offered a poisoned chalice,

In the light of what we now know about the way the economy works, it was completely absurd for the committee to propose that the solution to Britain’s economic problems, with 2.5 million men out of work, production down by 20 percent, and prices falling at a rate of 7 percent a year, was to cut unemployment benefits and raise taxes.

at the time, the prevailing orthodoxy held that budget deficits were always bad, even in a depression.

were wedded to the belief that the budget must be balanced, no matter that Britain was in depression.

The New York Fed, itself precluded by statute from lending directly to foreign governments,

Bankers confronted with a country in need of money almost instinctively reach for budget cuts, preferably achieved by slashing public expenditure, as the right solution for almost any problem.

The chancellor put together a package of measures cutting $350 million in expenditures, including a 10 percent reduction in the dole, and raising taxes by $300 million and submitted it, through back channels at the Bank of England, for Morgan’s consideration.

On Saturday, August 22, the Morgan partners assembled at the house of F. D. Bartow in Glen Cove, Long Island, and after a long weekend of debate, gave the budget their blessing on Sunday afternoon.

telegram signaling their approval, its language suitably camouflaged to hide any hint that the budget had been submitted to the American bankers for vetting, was dispatched to Sir Ernest Harvey, deputy governor of the Bank of England, anxiously waiting at his City office.

introduced much the same budget package that had split the previous ministry.

On August 28, the British government received a $200 million loan from a consortium of American banks led by Morgans and a further $200 million from a group of French banks. It was gone within three weeks. The budget cuts did no good, largely because they were beside the point.

In other words, Britain’s problem was not its budget deficit, but rather that it had clung to the role of banker to the world without any longer having the money or the resources to do so and at a time when most of the world was a damn poor risk.

one month alone after the British departure from gold, 522 American banks went under—by the end of the year, a total of 2,294, one out of every ten in the country, with a total of $1.7 billion in deposits, would suspend operations.

government paper could not be employed as an asset to back currency.

the restriction served no purpose.

It was a manufactured problem, the result of an anachronistic regulation that had no basis in economic reality but which tied up a large amount of U.S. gold unnecessarily.

dominant was the view that abiding by these reserve requirements trumped every other consideration, there was no internal resistance at the