Lords of Finance

by Liaquat Ahamed

  His problem was that there was very little he could do about the situation. If he tried to tighten credit to curb the domestic boom, he would simply end up encouraging borrowers to look abroad for cheaper loans and thus exacerbate the already excessive foreign borrowing.

  He was not a man to agonize too long over dilemmas. In many ways, for someone with the reputation of being a calculating opportunist, he was oddly impulsive. On 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 action deliberately to undermine Germany’s fragile prosperity in order to prove that reparations were too burdensome. Parker Gilbert, the American agent-general for reparations, who was as close to Schacht as anyone, observed that he had begun “openly and actively working for a breakdown” of the Dawes agreement, and described him during this period as “changeable and moody,” “temperamental and mercurial.”

  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.

  They had always worried about Schacht’s tendency to embroil himself in highly visible political conflicts. Never much of a diplomat, he had always been very open in his criticisms of government budgetary policy, particularly of the states and municipalities borrowing so much abroad. Back in 1925 during the central bankers’ visit to Berlin, Strong had remarked on Schacht’s tendency to “get into political matters which would be [better] left alone by the head of the Reichsbank,” and Norman had gently tried to warn him to be more discreet. But it always seemed that Schacht had enough of an instinct for survival to avoid rocking the political boat too hard. Now, however, he became increasingly indiscreet and strident in his remarks.

  One episode in particular brought his confrontation with the government to a head. At a cabinet meeting in June, Schacht launched into a vituperative attack, which left the ministers speechless with outrage. It was typical of the man that having insulted the cabinet, he was not content to leave ill enough alone. He was overhead bragging to the other guests at a private dinner that evening about how he had taken on the politicians. He revealed confidential details of the whole cabinet debate, made insulting comments about individual ministers, dismissed the finance minister as incompetent, and called for his resignation. Even his old supporter Stresemann agreed that Schacht’s behavior was a problem and that his constant and naked self-aggrandizement was becoming intolerable. It was but a small harbinger of things to come.

  IMPERIALIST DREAMS

  The miracle of the franc’s recovery may have been good for France but imposed its own financial strains upon Europe. The money drawn back to the franc on Poincaré’s coattails continued to flow in throughout the spring and early summer of 1927, mostly out of sterling. The Banque de France, in an effort to prevent this flood from pushing the franc to uncompetitive levels, kept buying foreign currencies, and by the end of May, had accumulated a foreign exchange war chest totaling $700 million, half of which was in pounds.

  The rebound in the financial position of the Banque took Norman completely by surprise. He had never made a secret of his disdain for the French and their way of doing things—the constant intrigue and infighting, the chronic instability of governments, the overweening role of the state. During 1924, and especially 1925 after Britain had gone back to the gold standard, he had indulged in a certain schadenfreude at France’s financial travails. As the franc plunged, he confessed to Strong that the position of France, held up since the war as an example of the advantages of unorthodox financial management, made him “smile.”

  Moreau, for his part, reciprocated the enmity. From his very first few days in office, he had been irritated by the presumption of Anglo-Saxon bankers that the French would be unable to stabilize the franc without their help. Much of his animosity was specifically directed against Norman, a reflection of a wider and more pervasive suspicion toward the governor of the Bank of England throughout Europe, except in Germany. Strong had picked up on it in the summer of 1926, noting that Continental financial officials “seem to be afraid of him and somewhat distrust him.”

  With the Banque flush with hard currency and the franc stable, Moreau was determined to use his newfound independence to reestablish French financial prestige. He had not forgotten that before the war Paris had been the second most important money center in the world.

  His first opportunity to assert himself on the international stage came in connection with a loan to Poland, which had regained its independence after the war and was historically seen as a partner of France in containing German power. In late 1926, a consortium of central banks, including the Federal Reserve, the Bank of England, the Reichsbank, and now the Banque de France, put together a financial package to help stabilize the Polish zloty. When Norman tried to grab the lead role, the French objected strongly to what they saw as a British attempt to muscle in on France’s traditional sphere of influence in Eastern Europe. For Moreau it was one more example of Norman’s “imperialist dreams.”

  In February 1927, the Banque also tried to renegotiate terms on a loan from the Bank of England dating back to 1916 and secured by French gold. As usual when it came to the French, Norman was unhelpful, putting numerous obstacles in the way. Frustrated by Norman’s obstructionism, the Banque surprised the Bank of England in May by announcing that it would pay off the loan and take back the $90 million of gold reserves pledged as security. The next month, without even consulting the British, the Banque issued instructions that $100 million of its sterling balances be converted into gold. The effect would have been to drain almost $200 million of gold out of the Bank of England’s reserves. Both actions came as a shock to Norman. Moreau’s demands were “capricious” and would “menace the gold standard,” he complained to Strong.

  Norman and Moreau met repeatedly during the first few months of 1927—in Paris in February, in London in March, and at the Terminus Hotel in Calais in early April—to try to resolve some of these issues. Though the tensions between them never quite broke into open conflict—they were careful to maintain a frosty politeness in all their dealings—their mutual dislike and mistrust were apparent. Moreau had clearly not forgotten how unwill
ing Norman had been to come to the aid of France at the height of the previous year’s crisis, a sharp contrast to the way the Englishman had bent over backward to help Schacht and the Germans in 1924.

  The gold standard did offer a traditional safety valve for dealing with shifts in gold holdings. 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.

  But in early 1927, the Bank of England and the Banque de France could not agree how to apply these rules. A conference was arranged and on May 27, Norman revisited the Banque. It was a very different meeting from that first disastrous encounter a year earlier. Now it was Norman’s turn to plead for help. He claimed that it would be politically impossible to tighten credit in Britain, that “he could not do so without provoking a riot.” Arguing that most of the money flowing into France came from speculators betting that the franc would have to appreciate, he pressed Moreau to cut interest rates.38

  Moreau, on the other hand, had just weathered a decade of high inflation, which he did not wish to risk repeating by easing credit. He insisted that under the rules of the gold standard, he had the complete right to convert his sterling holdings into bullion, and should this put Britain’s reserves under pressure, the Bank of England could always raise rates.

  Quite aware that too precipitate an action by the Banque de France would threaten the Bank’s ability to keep the pound on gold, he tried to reassure Norman that he had no intention of destabilizing the gold standard or trying to undermine sterling, declaring melodramatically, “I do not want to trample on the pound.” Both parties claimed to be committed to the game, but each was adamant that it was the other who was not following the rules.

  The British were not completely on the defensive. They did point out that while France held some $350 million in sterling that it could convert into gold, the British government held $3 billion of French war debts on which it could theoretically demand immediate repayment. The meeting closed in an inconclusive truce. In the following weeks, both sides somewhat halfheartedly backed down, the Bank of England allowing rates in Britain to rise modestly and the Banque de France engineering a fall in its rates. For the moment, outright financial conflict had been averted.

  Schacht, Strong, Norman, and Rist on the Terrace at the New York Fed, July 1927

  15. UN PETIT COUP DE WHISKY

  1927-28

  Not every mistake is a foolish one.

  —CICERO

  By THE END of 1926, this quartet of central bankers had already begun to worry about three of the factors—the U.S. stock market bubble, excessive foreign borrowing by Germany, and an increasingly dysfunctional gold standard—that would eventually lead to the economic upheaval at the end of the decade. None of them, however, yet anticipated the scale of the coming storm. Hjalmar Schacht was locked in combat with his own government; Montagu Norman and Émile Moreau were squabbling with each other; and Benjamin Strong was, as always, battling on two fronts—with his health and with his colleagues within the Federal Reserve System.

  In 1926, after almost two years without an attack of tuberculosis, Strong developed pneumonia on his return from his summer in Europe. While lying sick with the new disease, at one point close to death, he was again scarred by personal tragedy, this one carrying with it a hint of scandal.

  Confined to the Cragmore Sanatorium at Colorado Springs in 1923, he had struck up a friendship with another tubercular patient, Dorothy Smoller, a twenty-two-year-old actress from Tennessee. She had once been a dancer with Anna Pavlova’s ballet company, had had several parts on Broadway, and had even had a bit part in a movie. After a few months in the sanatorium, her money had run out and Strong and some other rich patients stepped in to support her. In November 1926, she resurfaced in New York, to be treated by Dr. James Miller, a Park Avenue physician and Strong’s personal doctor—like most tuberculosis patients, she had not fully shaken off the disease. She had just landed a part in another Broadway play when on the morning of December 9, after receiving a mysterious letter that reportedly distressed her, she killed herself by drinking a bottle of liquid shoe polish.

  By her bedside were three letters, one for her mother in Long Beach, California, one for a friend, and one for Strong. She left instructions that the photograph of Strong in her possession be returned to him. No one can know whether she and Strong were romantically involved. Perhaps she was just a lost and unhappy young woman, a victim of the Broadway version of the boulevard of broken dreams, who had developed a fixation upon a distinguished and kindly man who had helped her. Whatever the case, her suicide, with its echoes of his wife’s death twenty years earlier, must have shaken him profoundly.

  In December, he again left New York to recuperate, for a few weeks at the Broadmoor Hotel in Colorado Springs and thereafter in North Carolina. He returned to work six months later, in May 1927, to find the strains and stresses within Europe again building. The quarrel between Moreau and Norman was threatening to derail the pound, and had the potential to undermine the stability of the entire structure of the worldwide gold standard. Meanwhile, Schacht was beginning to clamor for some sort of international initiative to control the flow of foreign money into Germany, which, he feared, would never be able to repay all of its various accumulating debts.

  Strong had always hoped that once the other major countries were back on gold, the lopsided maldistribution, which had left so much of the world’s gold stock in the United States, would correct itself. But that had not happened. Sterling had returned to gold at an unrealistically high exchange rate, leaving British goods expensive and difficult to sell in the world market. France, on the other hand, had done exactly the opposite. 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. While this discrepancy between British and French prices persisted, the tensions could only fester. There was a natural tendency for money to move from overpriced Britain to underpriced France. To correct the situation, either prices had to fall further in Britain—which the authorities were trying to bring about without much success—or rise in France—which the Banque de France would not permit. The only alternative was to change the gold parity of sterling. But everyone feared that such a devaluation would so shock the banking world as to undermine any hope of order in international finances and even destroy the gold standard.

  The Germans had avoided the British mistake. At the exchange rate of 4.2 marks to the dollar set by Schacht back in late 1923, German goods were cheap. Germany had a different problem. It had been denuded of gold during the nightmare years of the early 1920s and was now spending so much on reconstruction and reparations that, despite its large foreign borrowing, it was unable to build up new reserves. Thus, of all the countries in Europe, only France had enjoyed any success in attracting gold, although even this had been done, not so much by drawing gold from America as by weakening the position of Britain.

  There was one way for the Fed to help Europe out of these dilemmas, or at least buy it some time. It could lower its interest rates further. In addition to giving Britain some breathing room, there were good domestic reasons to justify such a cut. Prices around the world were falling—not precipitously, but very gradually and very steadily. Since 1925, U.S. wholesale prices had fallen 10 percent, and consumer prices 2 percent. The United States had also entered a mild recession in late 1926, brought on in part by the changeover at Ford from the Model T to the Model A. The two main domestic indicators that Strong had come to rely on to guide his credit decisions—the trend in prices and the l
evel of business activity—argued that the Fed should ease. But interest rates at 4 percent were already unusually low.

  Ever since the early 1920s when he had embarked on his policy of keeping interest rates low to help Europe, a faction within the Fed, led by Miller, had argued that Strong was too influenced by international considerations and especially by Norman. During Britain’s return to gold in 1925, he had been accused by some members of the Board of having exceeded his authority in providing the line of credit to the Bank of England. But at the time, there had been so much support within U.S. financial circles for Britain’s return to gold, and when the British did not even have to draw on the line of credit, the dissenting voices had died away. In 1926, while Strong was in France, he was again criticized by Board members for freelancing and acting too much on his own initiative. He responded that unless they were willing to come to Europe as frequently as he did, and familiarize themselves with the people and the situation, they would just have to trust him. While he did not shy away from conflict—quite the contrary, according to one colleague he seemed to “thoroughly enjoy getting into a fight and coming out on top”—the constant sniping over international policy became so wearing that he even threatened to resign.

  The same faction that had opposed him on Europe had pressed him to tighten in 1925 and 1926 to bring down equity prices. While they had then sounded a false alarm on a bubble in stocks, with the market still strong—the Dow was hovering close to 170—he knew that were he now to loosen monetary policy to bail out the pound, he risked severely splitting the Fed.