In contrast to The Economic Consequences, the new book had almost no practical impact. At a time when the currencies of Central Europe had completely collapsed and the franc was perilously close to the edge, few people could be convinced to entrust the management of national moneys and currency values to the discretion of treasury mandarins, politicians, or central bankers. There were too many examples to point to—Germany, Austria, Hungary, admittedly some of them pathologically extreme—of what could happen when the discipline of gold was removed. But the experience of the next decade would, in the words of one of Keynes’s biographers, win for the Tract “the allegiance of half the world.”
NORMAN’S RESPONSE To the Tract was predictably to dismiss it as the froth of a clever dilettante. As he wrote to Strong, “For the moment Mr. Keynes seems to have rather outdone himself, a fact that perhaps comes from his trying to combine the position of financial mentor to this and other countries with that of a high-class speculator.”
What separated Norman from Keynes had less to do with economics and more to do with philosophy and worldview. For Norman, the gold standard was not simply a convenient mechanism for regulating the money supply, the efficiency of which was an empirical question. He thought about it in much more existential terms. It was one of the pillars of a free society, like property rights or habeas corpus, which had evolved in the Western liberal world to limit the power of government—in this case its power to debase money. Without such a discipline to protect them, central banks would inevitably come under constant pressure to help finance their governments in much the same way that they had done during the war with all the inflationary consequences that were still all too apparent. The link with gold was the only sure defense against such a downward spiral in the value of money.
His reaction to the Tract was colored by his personal dealings with Keynes. After the war, Norman, agreeing with much of Keynes’s argument on reparations, had consulted him at the height of the German hyperinflation. But Keynes’s vocal opposition to the war-debt settlement with the United States, which Norman had been responsible for engineering, created a rift. Norman, acutely sensitive to public criticism, harbored grudges for a long time—“the most vindictive man I have ever known,” according to one close friend. Thereafter, though their social circles overlapped somewhat and though Keynes, for all his youthful iconoclasm, was already widely recognized as the most brilliant monetary economist of his generation, Norman studiously ignored him professionally, and refused ever to invite him to advise the Bank.
Strong’s reactions were on the surface similar to Norman’s. He had never met Keynes, but given his puritan background, he would have vehemently disapproved of the Bloomsbury irreverence and mockery of authority. When The Economic Consequences came out, he had written of Keynes, “He is a brilliant but, I fear, somewhat erratic chap, with great power for good and, unfortunately . . . some capacity for harm.” Many in his circle had taken offense at Keynes’s merciless lampooning of Woodrow Wilson at the Peace Conference. He echoed this again in his reaction to the Tract. “Keynes’ little book arrived safely and I am just now reading it,” he wrote to Norman on January 4, 1924, from the Arizona desert. “I have a great respect for his ability and the freshness and versatility of his mind, but I am much afraid of some of his more erratic ideas, which impressed me as being the product of a vivid imagination without very much practical experience.”
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.
During the war, the flow of gold into the United States had pushed up prices by 60 percent. When the fighting ended, but turmoil in Europe continued and the gold still kept arriving, Strong decided that it was time to abandon the conventional rules of the gold standard and insulate the U.S. economy from the flood of bullion. The system was being swamped by so much excess gold that to have followed the traditional dictates of the gold standard would have led to a massive expansion of domestic credit, which inevitably would have led to very high rates of inflation—Strong calculated that it would cause prices to double. It made no sense to him for the United States to import, in effect, the inflationary policies of Europe and destabilize its own monetary system just because the Old World had been hit by political and financial disaster. The Fed therefore began to short-circuit the effects of additional gold on the money supply by contracting the amount of credit that it supplied to banks, thus offsetting any liquidity from gold inflows.
Having jettisoned the simple operating procedures of the gold standard, which linked credit creation solely to gold reserves, Strong began to improvise an alternative set of principles to guide monetary policy. The Fed’s primary goal should be, he believed, to try to stabilize domestic prices. But he thought that it should also respond to fluctuations in business activity—in other words, the Fed should try to fine-tune the economy by opening the spigot of credit when commercial conditions were weakening and closing it as the economy strengthened.
This new set of principles, somewhat cobbled together on the fly, represented a quiet, indeed carefully unheralded, revolution in monetary policy. Until then central bankers had seen their primary task as protecting the currency and confined their responsibilities to ensuring that the gold standard was given free rein, only stepping in at times of crisis or panic. The credit policy of every industrial country had been driven by one factor alone: gold reserves. The United States was, however, now so flush with gold that the solidity of its currency was assured. Led by Strong, the Fed had undertaken a totally new responsibility—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.
Strong’s policy of offsetting the impact of gold inflows on domestic credit conditions meant that as bullion came into the United States, it was, in effect, withdrawn from circulation. It was as if all this treasure that had been so painfully mined from the depths of the earth was being reburied.
Strong’s policy contained a fundamental contradiction. On the one hand, he advocated a worldwide return to the international gold standard. On the other, he was doing things that not only undermined the doctrine he claimed most to believe in, but also, by preventing the gold from being recycled to Europe, he was making it all the more difficult for Europe to contemplate rejoining America on the gold standard. It was a dilemma he was never able to resolve.
European bankers argued that the massive bullion imbalance between their countries and the United States was a fundamental problem for the world and pressed for some mechanism to recycle some of this gold. “I do not intend another quarter to pass,” wrote Norman to Strong in January 1924, “without seeing you face to face, and asking you how in the name of heaven the Federal Reserve System and the United States Treasury are going to use their gold reserves.”
KEYNES WAS THE first to recognize and articulate that, for all the public rhetoric about reinstating the gold standard, the new arrangements were in fact very different from the hallowed and automatic prewar mechanism. As he put it in the Tract, “A dollar standard was set up on the pedestal of the Golden Calf. For the past two years, the US has pretended to maintain a gold standard. In fact it has established a dollar standard.”
It meant, in effect, that the Federal Reserve was so flush with gold that it had gone from being the central bank of the United States to being the ce
ntral bank of the entire industrial world. Keynes’s main concern was that Britain and other major European countries would find themselves being dictated to by a Fed that focused primarily on the needs of the domestic U.S. economy, yoking the gold-starved Europeans to U.S. credit policy. Strong was in the process of constructing a one-legged gold standard, whose European limb would be firmly tied to classical rules while the American limb would be run by the Fed according to its own set of goals and constraints.
Keynes would have been even more horrified had he probed further into how the Fed operated and the character of the men who ran it. 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.
It was not surprising that there should have been a certain amount of jockeying for control within the system. The precise locus of authority was ambiguous, and too many big egos—twelve governors of the reserve banks; the six political appointees on the Federal Reserve Board; the secretary of the treasury and the comptroller of the currency, both ex-officio members of the Board—were jostling for power.
From the start, the Board in Washington was an organization of unclear purpose and mandate. When it was created in 1913, Wilson conceived of it as a regulatory agency standing as a watchdog over the various regional reserve banks. He believed, therefore, that it should be comprised of individuals from outside banking. But he was unwilling to give it much stature. When the first governors of the Board complained to the president that the State Department expert on protocol had decided that as the most recently created of the government agencies, they should come last in social precedence, Wilson had replied that as far as he was concerned, “they might come right after the fire department.”
The Board did not even have its own quarters but operated from a dark and dreary suite of offices on the top floor of the Treasury Building, from which its long and narrow boardroom overlooked the grimy interior court. Members salaries were typical of the civil service, considerably lower than private sector compensation and even much less than the pay of the governors of the regional Federal Reserve banks. Not surprisingly, the Board found it hard to attract good people—on one occasion six different candidates turned down an offer of a position before someone could be induced to accept.
As a result, the Board was, in J. K. Galbraith’s description, “a body of startling incompetence.” In 1923, the chairman was Daniel Crissinger. Born in a log cabin in Marion, Ohio, he was a local eminence, a lawyer and banker who had risen to the position of general counsel of the Marion Steam Shovel Company and had twice run for Congress, albeit unsuccessfully. He also had the fortune to have been one of Warren Harding’s boyhood chums and, though by all accounts “utterly devoid of global or economic banking sense,” was appointed comptroller of the currency in 1922 after his old friend had become president. The following year the president elevated him to the chair of the Board.
Besides its chairman and its two ex-officio members, the Board comprised five other governors, carefully selected not for their expertise but to ensure due representation for the different regions of the country. From Memphis, Tennessee, came George Roosa James, a dry goods merchant, a man of great energy, something of a diamond in the rough. His economic ideas, however, ran on the eccentric side. Firmly rooted in the past, he held that the basic foundation of the economy lay with the horse, the mule, and hay, and that the decay of the nation had begun with the advent of the automobile.
From Iowa came Edward Cunningham, who had started life as a dirt farmer and gone on to become Speaker of the Iowa legislature; from Poughkeepsie, New York, came Edmund Platt, a local newspaper publisher, who had entered politics as a member of the town’s board of water commissioners and gone on to serve as its three-term Republican congressman. Boston furnished George Hamlin, longest serving of the governors, having been appointed chairman by Woodrow Wilson in 1914. By profession a lawyer, he had run unsuccessfully for governor of Massachusetts in 1902 and 1910—a failed political career, it seems, was not an impediment, indeed was almost a qualification, for Board membership.
One member, however, who could legitimately claim some relevant expertise was Dr. Adolph Miller. Having studied economics at Harvard, he had been a professor at the University of California at Berkeley for twenty-five years. A deeply insecure man, he resented that his qualifications were not fully appreciated by his colleagues—they in turn tended to dismiss him as an ivory-tower theoretician with no practical experience. He liked to argue, and when his colleagues grew weary of the interminable wrangling, would begin to argue with himself. Not surprisingly, he was often confused and indecisive, with a tendency to adopt extremely dogmatic but contradictory positions on many topics. He had also developed a particular animus against Strong, resenting the younger man’s influence and authority.
It did not help that Miller had learned his economics at a time when monetary economics, as a discipline, was very much in its infancy, thus leading him to espouse a series of outmoded beliefs about the way monetary policy was supposed to work. Among these was the now defunct doctrine of “real bills,” that as long as the Federal Reserve and commercial banks restricted themselves to providing only short-term credit to finance inventories, nothing much could go wrong.
Faced with overseers such as this, it was not surprising that Strong was able to step into the vacuum of leadership and dominate the institution. Unlike his nominal superiors, he made a concerted attempt—particularly during those many trips to Europe—to educate himself about central banking. It was he, for example, who was most responsible for introducing the biggest innovation in the way the Fed operated—so-called open market operations. When the Fed was conceived, it was assumed that it would primarily influence credit conditions by changes in its discount rate, the interest rate it charged on loans to member banks. By the early 1920s, this technique was proving to be too passive, depending, as it did, for its impact on how much or how little bankers were willing to borrow at the discount window. 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.
It was inevitable that control of open market operations should become the object of an intense power struggle. The purchase and sale of securities out of their portfolios had initially been left to the reserve banks; but in 1923, the Board, recognizing the potency of the new tool, tried to take charge by requiring the committee that made these decisions to operate under its umbrella. Strong was away in Colorado at the time, recuperating from his bout of tuberculosis of the throat. He was furious. “I’ll see them damned before I’d be dismissed by that timid bunch!” he wrote to one of his fellow governors. Eventually, though, he did acquiesce in giving the Board oversight over such operations. But as the most knowledgeable official on the new open market committee, he was easily able to call the shots on virtually all decisions.
In the process he stepped on a lot of toes, not concealing his impatience with the members of the Board. Some complained that he had an overblown sense of his own abilities, that he was too confrontational, that he lacked judgment, particularly about people. But as the intellectual leader of the Federal Reserve, he had acquired a large following within the organization and was “worshipped” by the younger men.
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 questio
ned. 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.
Keynes once compared the role of the Bank of England under the prewar system to that of the “conductor of an orchestra.” Even though the Bank had then been administered by a club of old and established City patricians, the gold standard had been managed well, in part because circumstances were so favorable, in part because the directors of the Bank, however dull and unimaginative, were solid. After the war, as the world struggled to emerge from economic chaos, with currencies still in turmoil and gold in short supply everywhere outside America, it did not bode well that the new “conductor of the orchestra,” 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.
PART THREE
SOWING A NEW WIND
1923-28
10. A BRIDGE BETWEEN CHAOS AND HOPE
Germany: 1923
Let me issue and control a nation’s money and I care not who writes the laws.
—MAYER AMSCHEL ROTHSCHILD (1744-1812), founder of the House of Rothschild
AT 10:00 p.m. on November 8, 1923, two men could have been seen arriving at the Hotel Continental in Berlin for an intimate dinner in one of its private dining rooms. Each was in his own way a caricature of a type of German and could almost have come from central casting. The tall, thin figure with the clipped military mustache, hair cut short and parted very precisely in the center, was Hjalmar Schacht, now one of the most prominent bankers in Berlin, a director and board member of the Danatbank, third largest in Germany.
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