In the fall of 1925, Hoover, not shy about interfering in his cabinet colleagues’ business—Parker Gilbert called him the “Secretary of Commerce and the Under-Secretary of all other departments”—decided to launch a campaign against the pervasive atmosphere of speculation that he claimed was infecting the country, from Florida real estate to the stock market.
For both Miller and Hoover, the culprit behind this speculative fever was Benjamin Strong. They believed that his policy of keeping interest rates artificially low to help European currencies was responsible for fueling the incipient bubble. Hoover had once been a prime supporter of American engagement in European affairs following the war, and had counted Strong a good friend. But he was now convinced that the policy of propping up Europe with artificially cheap credit had been taken too far. In his words, Strong had become “a mental annex to Europe.”
Like every other financial official at the time, Strong was taken aback by the surprising strength of the stock market and was himself also worried about a potential bubble. His letters to Norman are filled with misgivings about the rise in prices on Wall Street. Though he had a somewhat jaundiced view of the stock market, dominated as it was by its motley crew of outsiders—its plungers and pool operators, all of whom were very much at the bottom of the Wall Street social ladder—he was acutely aware of its power to cause trouble. Stock market crashes and banking panics had always been closely linked in the pre-Fed world and many of the country’s past financial crises had emerged from Wall Street: 1837, 1857, 1896, and 1907. In his early days as a stockbroker, he himself had been a witness firsthand to the crash of 1896, and had been an active participant in restoring order after the panic of 1907.
But as an experienced Wall Street hand, he was quite aware of how difficult it was to identify a market bubble—to distinguish between an advance in stock prices warranted by higher profits and a rise driven purely by market psychology. Almost by definition, there were always people who believed that the market has gone too high—the stock market depended on a diversity of opinion and for every buyer dreaming of riches in 1925, there was a seller who thought the whole thing had gone too far. Strong recognized his own highly fallible judgment about stocks was a very thin reed on which to conduct the country’s monetary policy. Even though his initial reaction was that the market might have gone too far, he asked himself, “May it not be the case the world is now entering upon a period where business developments will follow the recovery of confidence, so long lost as a result of the war? Nobody knows and I will not dare prophesy.” Given so much uncertainty, he was convinced that the Federal Reserve should not try to make itself an arbiter of equity prices.
Moreover, even if he was sure that the market had entered a speculative bubble, he was conscious that the Fed had many other objectives to worry about apart from the level of the market. He feared that if he added yet another goal—preventing stock market bubbles—to the list he would overload the system. Drawing a rather stretched analogy between the Federal Reserve and its various and conflicting objectives for the economy and a family burdened by many children, he ruminated, “Must we accept parenthood for every economic development in the country? That is a hard thing for us to do. We would have a large family of children. Every time one of them misbehaved, we might have to spank them all.” He wanted the Fed to focus on stabilizing the overall economy and was reluctant to allow its policies to be dominated by the need to regulate the “affairs of gamblers” who thronged the tip of Manhattan.
In Strong’s view, something about the American character—the exuberance, the driving optimism, the naive embrace of fads—lent itself to periods of speculative excess. “It seems a shame that the best sort of plans can be handicapped by a speculative orgy,” he mused almost philosophically to Norman at the end of 1925, “and yet the temper of the people of this country is such that these situations cannot be avoided.”
Despite the agitation from Hoover and Miller in late 1925, Strong concluded that with absolutely no signs of domestic inflation, the pound having only just returned to gold and the European currency situation still fragile, this was not the time to tighten credit. For the moment he would just have to ignore the stock market.
Even in combination there was little that Hoover and Miller were able to do to force his hand. As secretary of commerce, Hoover had no remit to interfere in the deliberations of an independent agency like the Fed. Miller was in a minority on the Board. And while the two of them campaigned to change the Fed’s policy by co-opting allies in Congress, senators and congressmen are rarely informed enough to be persuasive advocates for changes in monetary policy.
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 military is one example; central banks are another—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.
Nothing illustrates the dilemmas posed for monetary policy by the stock market than the push to tighten 1925. It turned out that Hoover and Miller had raised a false alarm. There was no bubble. Stock prices took a breather in the spring of 1926, falling by about 10 percent, and then resumed a steady but not yet spectacular rise. By the middle of 1927, the Dow stood at 168. 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.37 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.
In retrospect, Strong made the right decision in resisting the pressure from Miller and Hoover to tighten credit in late 1925 and 1926. In 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. Miller, the academic economist, and Hoover, the engineer, were both insulated from doubt by their ignorance of the way markets operate. In their zeal to burst a bubble that did not exist, they would have damaged the economy without any tangible benefit.
There is no better way to understand the stock market of those years than to return to the story of General Motors. Between 1925 and 1927 the profits of General Motors went up almost two and a half times. With earnings of almost $250 million a year, it overtook U.S. Steel to become the most profitable company in America. Though its stock price quadrupled in those two years, and by the middle of 1927 the company was valued at close to $2 billion, with a price-earnings ratio of less than 9, it was still considered to be reasonably priced.
What of Billy Durant? If General Motors was the emblematic story of the 1920s boom, its founder came to symbolize the other face of that frenetic decade. Although the company he had started had gone on to become the most successful corporation in America, he refused to look back after losing control of it for the second time in 1920. At his peak, he had been worth $100 million. In 1920, the roughly $40 million he received for his stock in General Motors had largely gone to pay off his personal loans, and he had emerged with barely a couple of million dollars.
He was, however, obsessed with the stock market. He formed a consortium of multimillionaires—many of whom were also from Detroit and had made their money in the automobile industry—to play the market. Within four years, he had rebuilt his fortune. By 1927, he was running a fund of over $1 billion, and had indirect control of another $2 to $3 billion that friends would invest alongside him. It was as if Bill Gates had been forced out of Microsoft, o
nly to reappear on Wall Street as one of the largest hedge fund managers.
THIS CHIMERA
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 watching their successes dissolve in failure. Their goal is a strong economy and stable prices. This is, however, the very environment that breeds the sort of overoptimism and speculation that eventually ends up destabilizing the economy. In the United States during the second half of the 1920s, the destabilizing force was to be the soaring stock market. In Germany it was to be foreign borrowing.
By the beginning of 1927, Germany seemed to have fully recovered from the nightmare years of hyperinflation. Schacht was in a position of unassailable power at the Reichsbank. After the Dawes Plan, he had been appointed to a four-year term during which, by the new bank law, he enjoyed complete security of tenure and independence of the government. He had consolidated his position within the Reichsbank by getting rid of the old guard from the Von Havenstein era, who had opposed his appointment, and putting his own people in charge. Moreover, though a General Council consisting of six German bankers and seven foreigners was supposed to oversee him, it met only quarterly, leaving him to operate unhampered. As one senior German politician of the time remembered, he employed the “tactic of consulting everyone and then doing exactly what he pleases.”
By virtue of position and personality, he dominated most discussions of economic policy within Germany. The liberal economist Moritz Bonn, an adviser to the Reichsbank, wrote of Schacht in those years, “He looked upon the world as Hjalmar Schacht’s particular oyster, and was very sensitive to public criticism. Having clashed with many strong and ambitious personalities in the German banking and business world, he was full of resentment against colleagues who had at some time outdistanced him. Once he arrived at the head of the central bank, he gloried in being their boss.”
To the public, Schacht remained “the Wizard,” the savior of the mark. The visit by Strong and Norman in June 1925, his own trip to the United States that fall, and his acceptance as the third member of the central banking triumvirate running the world’s finances had enormously enhanced his prestige. In the three years since their first meeting, he had developed a very strong personal bond with Norman—they met five times in 1924, three times in 1925, and four times in 1926. Norman admitted that Schacht could be difficult to work with, that among his peculiarities was a love of publicity and the habit of making too many speeches. But it was “a joy to talk finance” with Schacht, he used to say. His admiration for the German was so great that Sir Robert Vansittart, later head of the British diplomatic service, complained that Norman was “infatuated by Dr. Schacht.”
Strong, however, had not taken to Schacht to the same degree. “He is undoubtedly an exceedingly vain man. This does not so much take the form of boastfulness as it does a certain naïve self assurance,” wrote the American. Nevertheless, he was impressed by the way Schacht handled the Reichsbank. “He runs his part of the show with an iron hand. He does it openly, frankly, and courageously, and seems to have the support of his Government but it certainly would not do in America. . . . He doesn’t gloss things over; he seems actually to relish the difficulties. . . .”
Power seemed to suit Schacht. The family had moved out of their villa in Zehlendorf into the official residence of the Reichsbank president on the top floor of its headquarters on Jägerstrasse. Financially he had little to worry about—his salary was the equivalent of $50,000 and he drew a further $75,000 from the pension that he had wrung from the Danatbank. To show he had arrived, he bought a grand country house some forty miles north of Berlin, which had been the hunting lodge and estate of Count Friedrich Eulenberg.
When in town, the Schachts entertained frequently. With his “ugly clown mask of a face, curiously alive and attractive,” Schacht, always sporting a big cigar and accompanied by his matronly wife, Luise, who kept a “vigilant watch” on him—he was said to have a wandering eye—became something of a fixture on the social circuit. He had a pompous habit of wearing his culture conspicuously on his sleeve, which some found irritating, while others ridiculed him behind his back for his arriviste pretensions—one acquaintance remarked that “he dresses with the taste of a socially ambitious clerk.” Nevertheless, he was a popular guest, something of a catch celebrated for his “cutting and devastating humor.” The Aga Khan remembered the Schacht of those years as one of the most charming of dinner companions, who could hold “a whole table enthralled” with his sparkling conversation. Priding himself as something of a poet, he would compose amusing little pieces of doggerel to entertain his fellow guests.
Before the war, social life in Berlin had been especially stultifying. Under the oppressive hierarchy imposed by the Junker elite around the court, there had been little interaction between the various circles in the city. However, the overthrow of the old Prussian nobility and the destruction of the middle class by inflation had transformed Berlin into a rootless society of politicians and profiteers, former aristocrats and foreign diplomats. It would have been an arid soulless sort of place but for its demi-monde of artists. With its past swept away, the city had an unhinged nervous energy, an edge to it, that no other city in Europe could match, and it had attracted the best of the European avant-garde: writers, painters, architects, musicians, and playwrights. William Shirer, the journalist who would chronicle the rise of Nazism, first came to Berlin during those years and was captivated. “Life seemed more free, more modern and more exciting than in any place I had ever seen.”
But for all its “jewel-like sparkle,” the city was wrapped in an atmosphere of impending doom. Norman sensed it when visiting Schacht in late 1926: “You feel all the time that politically as well as economically Germany is still not far from a precipice.” After the fiasco of the Beer Hall Putsch, most people treated Hitler as a laughingstock. Nevertheless, there were ominous undercurrents of the convulsions to come. On March 21, 1927, a band of six hundred Nazi brownshirt storm troopers of the Sturmabteilung , the SA, beat up a group of Communists in eastern Berlin and marched into the center of the city, attacking anyone on the Kurfürstendamm who looked Jewish. The city authorities responded by banning Nazi activity from Berlin for a year.
But the economy was booming. Over the three years since the mark had been stabilized, output rose close to 50 percent and exports by over 75 percent. The GDP had surpassed its prewar level by a good 20 percent, unemployment was now at a modest 6 percent, and prices were steady. The recovery was reflected in the stock market. During the hyperinflation, few people had believed that capitalism would even survive in Germany and equities had become dirt cheap, having fallen to less than 15 percent of their 1913 inflation-adjusted value—the whole of the Daimler-Benz motor company, for example, could have been bought for the price of 227 of its cars. By 1927, however, the market had quadrupled in value from its low point in 1922.
The Dawes Plan had been an enormous success. In fact it had worked almost too well. American bankers, assured under the plan of being repaid first ahead of reparations owed to France and Britain, had fallen over one another in their enthusiasm to lend to Germany. In the two years since the plan, $1.5 billion flowed into the country, giving Germany the $500 million due for reparations and still leaving it an enormous surplus of foreign cash. Some of this money had gone to finance the reconstruction of industry; but a very large amount had been taken up by the newly empowered states, cities, and municipalities of the budding democracy to build swimming pools, theaters, sports stadiums, and even opera houses. The zeal with which foreign bankers promoted their wares led to a great many imprudent investments and a lot of waste—one small town in Bavaria, having decided to borrow $125,000, was persuaded by its investment banks to increase the amount to $3 million.
By every indication, Schacht, as one of the architects of this authentic economic miracle, should have been a happy man. Instead, he continued to be obsessed with reparations. Even at the time of the Dawes Plan, he had never been fully convinced that Germany could or even should pay the amounts envisaged. Nevertheless, he had grudgingly supported the plan and the foreign loans that came with it. He had hoped that as the credits from the United States built up and began to rival reparations as a claim on Germany’s foreign exchange, they would create a powerful lobby of American bankers, who would share a common interest with the German authorities in getting future payments to the Allies reduced.
But Germany was now borrowing too much abroad. Schacht worried that the foreign debt buildup was becoming so large that when the day came for it to be repaid, it would precipitate a gigantic payments crisis and national bankruptcy. It made no sense to him for Germany to be borrowing dollars to build wonderfully modern urban amenities, such as opera houses, which could never generate the foreign currency to repay the loans. Moreover, Germany was so awash with foreign capital, and was being driven by so conspicuous a boom, that it was getting progressively harder for him to argue that the republic could not afford to meet its reparations obligations. The artificial boom was giving everyone at home and abroad a false sense of prosperity—a “chimera,” as he called it.
Lords of Finance Page 29