Lords of Finance

by Liaquat Ahamed

  Though the meeting continued into the early hours of the morning, he was unable to persuade the few recalcitrants to change their mind. The Fed, believing that it could throw a ring fence around the BUS and prevent its troubles from spreading, decided to close the bank’s doors the next morning. “I warned them that they were making the most colossal mistake in the banking history of New York,” Broderick would later testify at a trial. Marcus and one of his lieutenants were tried, convicted, and sentenced to three years’ imprisonment. Broderick was separately indicted for alleged negligence in not closing the bank earlier. The case ended in a mistrial; after a second trial, he was acquitted.

  Dramatic as it was, the failure of the Bank of United States was in fact not that unusual. 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 $450 million dollars left the banking system, less than 1 percent of total deposits.

  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 even more loans. By the middle of 1931, bank credit had shrunk by almost $5 billion, equivalent to 10 percent of outstanding loans and investments.

  FIGURE 7

  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 streak seemed to end up so often in the minority, joined him. But the Board was legally powerless to initiate action.

  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 any responsibility for these nonmember banks, despite their impact on the nation’s overall supply of credit.

  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 were undermining public confidence in banks as a repository of savings and were causing the U.S. credit system to freeze up.

  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 Europe. If the banking system can be compared, as it often is, to the plumbing of the world’s economy, then the double drain of cash was like two invisible leaks. Their effects were not immediate and would only become apparent gradually.

  It was during the spring of 1931 after Norman had returned from the United States that he wrote his infamous letter to Moret, foreseeing the wreck of “the capitalist system throughout the civilized world” within a year and asking that his prediction “be filed for future reference.”48 He could sense that the world’s credit supply was beginning to dry up. 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. The letter, a poor substitute for action, was undoubtedly shrugged off within the Banque de France as only old Montagu Norman going on about the end of Western civilization for the umpteenth time.

  19. A LOOSE CANNON ON THE DECK OF THE WORLD

  1931

  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. And this did not include another 2 million forced into part-time work. Pawnshops multiplied as did astrologers, numerologists, and other charlatans. Even before Hoovervilles had become common in cities across America, shantytowns of tents and packing cases had sprung up in the parks and forests around Berlin. These camps, displaying the German gift for organization, soon had their own “mayors,” “town councils,” and community kitchens where women cooked turnips.

  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. No sooner had the Young Plan been signed in Paris in July of that year, than the campaign to repudiate it had gone into high gear. A national committee led by Dr. Alfred Hugenberg, chairman of the right-wing German Nationalist Party—third largest in the Reichstag, where it held 73 seats out of a total of 491—was formed to organize a referendum on the plan. Known as the German Randolph Hearst, Hugenberg, a former chairman of the famed arms manufacturer Krupps, had branched out into the news business after the war and now controlled some of the country’s largest papers, including Der Tag, the biggest movie production company, and the large
st independent telegraph agency.

  Norman and Schacht, 1935

  Among those whom Hugenberg enlisted was Adolf Hitler, then still regarded as something of a joke, a minor figure from a fringe far-right group with an embarrassing past as the leader of the 1923 “beer cellar Putsch.” In the previous year’s national elections, the Nazis had won a bare 2.6 percent of the vote and only twelve seats in the Reichstag. They did, however, add their own distinctive brand of venom to the referendum campaign. Arguing that the Young Plan would submit Germany to “three generations of forced labor,” they branded it a “Jewish machination” and a “a product of the Jewish spirit.” The referendum, which would have required the government to renegotiate the repeal of the hated War Guilt clause, suspend all payments on reparations, and to make it a crime for any official to enter into any further agreement thereon, received 4,135,000 votes, a sign of the growing popular disenchantment with the policy of fulfillment.

  No one provided a better weather vane for the shifting political winds than Hjalmar Schacht. The Young Plan negotiations left him disappointed and bitter. 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.

  In October 1929, three weeks before the Wall Street crash, Stresemann died suddenly of a stroke at only fifty-one, a victim of stress and overwork. After the grim letdown of the Young Plan negotiations and Stresemann’s death, Schacht lost any remaining faith in the American solution.

  He was now in a quandary. Disillusioned with the Americans, he was more willing to explore alternatives, including the unilateral repudiation being advanced by the nationalist right. But it was hard for him to jettison the Young Plan at this stage—after all, the document bore his signature—without looking like a shameless opportunist.

  In November, during negotiations at The Hague, the German government agreed to modest adjustments to the Young Plan terms. In return, the Allies agreed to advance the date for withdrawing their remaining troops from the Rhineland, and reached a settlement on the status of German citizens in lands previously part of East Prussia but ceded to Poland at Versailles. The effect of all these modifications was to add some 4 to 5 percent to the Young Plan payments, amounting to about $25 million a year. The economic significance was trivial—nevertheless, it provided Schacht with just the excuse he needed to break with the government.

  Moreover, 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.

  On December 5, he dropped his bombshell on Berlin. Without warning he issued a public statement in which he accused the government in inflammatory language of “twisting” the Young Plan and failing to take the necessary steps to control its own finances. Declaring that it would be “self-deception” for the German people to believe that the nation could pay a pfennig more than it had agreed to in Paris, he publicly repudiated the plan’s latest revisions. A few weeks later, he sabotaged the government’s attempt to raise a loan in New York through the American investment house of Dillon Read.

  Such an open declaration of war on the government by the head of the central bank in the middle of an economic crisis threatened to plunge the country into chaos. The government was barely able to survive financially and then only by tapping the loan from the munificent Ivar Kreuger.

  The following weeks were a time of terrible stress for Schacht. While the ultimate severity of the coming Depression could not yet be foreseen, he could tell that after the Wall Street crash Germany was headed for a catastrophe and wished to avoid being buried by the coming disaster. And yet, if he resigned now, he would be giving up the most powerful economic position in Germany and stalking off into the political wilderness with no apparent way back. Having already alienated the right wing by signing the Young Plan, he was now falling out with the left and center by challenging the coalition’s financial policy.

  The tension of having to juggle all these competing considerations, some opportunistic, others heartfelt, began to tell. He seemed at times to be close to a breakdown. One foreign banker, meeting him in January 1930, described his paranoia as he ranted about how “he was about to be crucified by a gang of corrupt politicians.” His old friend Parker Gilbert, increasingly baffled at such erratic behavior, could only say that he thought Schacht had gone “crazy.”

  The final and dramatic denouement occurred at an intergovernmental conference on the Young Plan that opened at The Hague in early January. Shaken by the demagoguery of the German Nationalist right and by Schacht’s repudiation of the plan, the French revived the issue of what to do should Germany cease payment by introducing a new clause that in the event that Germany was held by the International Court at The Hague to have willfully defaulted on its obligations, the creditor powers would “recover full liberty of action” as envisaged by the Treaty of Versailles, a proposal that evoked memories of the occupation of the Ruhr in 1923, of French soldiers marching back into Germany.

  Schacht had promised the government that though he had broken with it, he would do nothing to embarrass Germany in an international forum. Once more his impulsiveness got the better of him. The new sanctions clause was a slap in Germany’s face, representing a radical change in the “spirit” of the Young Plan. Though the Reichsbank was powerless to prevent the revised plan from going into effect, in order to register his protest “on the highest moral grounds,” Schacht announced that it would refuse to subscribe a pfennig to the new Bank for International Settlements, declaring melodramatically that he “would stick to his position until he died.”

  The German delegation, led by the new foreign minister Julius Curtius, was furious. At a stormy closed-door meeting, Schacht was accused of fomenting “mutiny before the enemy,” of grandstanding on an issue of no material importance, of using the issue as a political gambit aimed at rebuilding his credibility with the right—a rumor was circulating in Berlin that Schacht was contemplating a run for the presidency when Von Hindenburg, who was pushing eighty-five, retired in early 1932. It was, said the Times of London, an example of the sort of “flamboyant political moves which are expected of him.” The left-leaning Die Welt accused him of being “the head not only of a state within the State, but of a state above the State.”

  The next day, however, he found himself outmaneuvered when the German delegation kept its nerve and proposed that if the Reichsbank refused to sign, the government would find a consortium of other German banks to subscribe the capital. Schacht’s tendency to overplay his hand now undid him. He negotiated a face-saving formula under which the government would pass a law requiring the Reichsbank to subscribe, thus allowing him to declare that while he still thought the Young Plan an “immoral agreement,” he was obliged as a good citizen to obey the “German law or else emigrate.” Nevertheless, his histrionics at The Hague had put him in an untenable position. Back in Berlin, on March 7, he announced his resignation. “I will now become a country squire and raise pigs,” he declared at a turbulent press conference where he lost his temper more than once at the journalists who questioned his motives for resigning a little too closely. One correspondent asked bewilderedly, “Dr. Schacht,
is there any particular point to your resignation?” “My act has nothing to do with politics,” replied an agitated Schacht. “It is merely the moral act of a self-respecting man.”

  The Vossische Zeitung, the German national paper of record, equivalent to the Times or Le Monde, expressed the general sense of puzzlement in Berlin when it asked, “What is the actual reason for his resignation? Nobody knows.” Nevertheless, alert as ever to his own self-interest, Schacht did negotiate an attractive severance arrangement, waiving his annual pension for a lump sum of $250,000.

  SCHACHT LEFT office believing that the Socialist-dominated coalition would lead Germany to financial disaster, precipitated by what he judged to be an inescapable foreign debt crisis. At this stage he still viewed Germany’s problems through the prism of the 1920s; for him the central issue was that the country had profligately saddled itself with far too much foreign debt. The solution, he thought, was to curb government expenditure and avoid borrowing abroad. His recommendations were still very orthodox, designed to prevent an exchange crisis rather than to address the growing problem of unemployment.

  Three weeks later, the government with which he had broken split over the unemployment question and fell, the Socialists wanting to finance an expansion in unemployment benefits by more foreign borrowing, the center parties to cut the budget deficit. A new center-right coalition, excluding the Socialists, took office and was led by a new chancellor, Heinrich Brüning, a dour Catholic, former army officer, and staunch monarchist.

  Unable to get anything through a divided parliament, Brüning was forced to rule by decree, moving Germany in a more authoritarian direction by his reliance on the constitution’s provisions for emergency powers. Defeated in the Reichstag, he had Von Hindenburg dissolve it and hold new elections in September 1930, two years early. The results came as an ugly shock. In a campaign dominated by the deteriorating economy, Hitler appealed across class lines, promising to reunite the nation, rebuild its prosperty, restore its position in the world, and purge the country of profiteers. He put a lid on some of his more extreme anti-Jewish rhetoric. Speaking at giant open-air rallies, many in sports stadiums lit by arrays of blazing torches, he mesmerized the tens of thousands who attended these events with his oratory. Meanwhile in the streets, his jack-booted paramilitary thugs, armed with truncheons and knuckledusters, clashed violently with Communists and Socialists. The Nazis won 6.4 million votes, and vaulted into second place in the Reichstag with 107 seats.