The Power of Gold: The History of an Obsession
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n the early days after the crash of 1929, Andrew Mellon-then Secretary of the Treasury and one of the wealthiest men in the United States-gave the following advice to President Hoover: "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate ... purge the rottenness out of the system."' At about the same time, Russell Leffingwell of Morgan offered his prescription for how to get the economy out of the depression: "The remedy is for people to stop watching the ticker, listening to the radio, drinking bootleg gin, and dancing to jazz ... and return to the old economics and prosperity based upon saving and working. 112
The sins of the speculators were to be laid upon the children, as the Shakespearean proverb goes,' but in this case they were also to be laid upon the sinners themselves, to say nothing of the millions of innocents caught up in the whirlwind by circumstances beyond their control. No one was to be allowed to escape the choking grip that the process of deflation cum moral redemption was to impose.
Mellon and Leffingwell were far from alone in expressing these themes. On the contrary, their views encapsulated the conventional wisdom of the times: the rallying cry for deflation and purge would recur in many variations but with a terrible and oppressive monotony. That was by no means the worst. The policymakers-the central bankers as well as the leading politicians-would actually follow this advice as they faithfully translated these grim turns of phrase into policy decisions at every level and in every country. When viewed from the perspective of the past sixty years, these people seemed to be speaking the language of another planet.
There were a few brave souls who were convinced that it was the entire economic system that suffered from looming maladjustments, not the morals of the players in the stock market. These men argued that the way out of the Depression was to attempt to short-circuit the misery, not intensify it. They sought means to reliquefy the tottering banking system and somehow put money into people's pockets so that they would be both willing and able to go out and spend it. They found themselves either talking to a brick wall or facing such vigorous opposition that in time they gave up and retired from the fray.
One of these was Herbert Hoover himself. Hoover was shocked by Mellon's advice, especially as "Mellon was not hard-hearted. In fact he was generous and sympathetic with all the suffering."a Mellon's error, Hoover wisely pointed out, was his insistence that this was "just an ordinary boom-slump," which led him to underestimate the seriousness of the European situation. Nevertheless, Hoover's efforts to be pro-active were far too modest in scale to stem the cyclone sweeping around the world. Nor did he ever abandon the conventional notion that people could not look to government to solve their problems, no matter how helpless they felt. Sounding rather like Ronald Reagan fifty years laterunder radically different circumstances-Hoover reminded his audience in a radio address on February 12, 1931, that:
The evidence of our ability to solve great problems outside of government action and the degree of moral strength with which we emerge from this period will be determined by whether the individuals and local communities continue to meet their responsibilities.... Victory ... will be won by the resolution of our people to fight their own battles ... by stimulating their ingenuity to solve their own problems, by taking new courage to be masters of their own destiny in the struggle of life.'
Another believer in positive action was George Harrison, Benjamin Strong's successor at the Federal Reserve Bank of New York.* Within days of the crash, Harrison proposed that the Federal Reserve banks should buy government securities in the open market to inject some liquidity into the system. Harrison believed this strategy was essential in order to satisfy the insatiable demand for money-the only asset that households, corporations, and financial institutions wanted to own in the panic environment. Bank lending had been clamped shut, forcing commodity prices to collapse, which led in turn to proliferating bankruptcies and bank failures.6 As jobs were vanishing by the millions, Harrison did make a few brief efforts on his own to conduct open-market purchases at the New York Federal Reserve, but once again the Washington authorities and the presidents of the other Federal Reserve banks frustrated Harrison and his staff by calling a halt to such "inflationary" activities.
Poor Harrison-when the United States began to lose gold during the autumn of 1931, even he abandoned his expansionary views and fell into line with the mainstream views. Now he promptly agreed with his colleagues that the only proper policy under such conditions was to raise interest rates-and to raise them by a lot. Eugene Meyer, Chairman of the Federal Reserve Board in Washington and one of Harrison's few supporters in his earlier notions, hastened to agree, declaring that the sharp increase in interest rates "was called for by every known rule, and that ... foreigners would regard it as a lack of courage if the rate were not advanced."7
At this moment, wholesale prices in the United States were already 24 percent below 1929, unemployment was climbing to over 15 percent of the labor force, and three thousand banks had failed. There was no such thing as deposit insurance in those days, which meant that depositors lost every dollar that they had on deposit at every bank that failed. This money simply disappeared into thin air. As the Federal Reserve drove interest rates even higher, prices would drop by another 10 percent, unemployment would reach 25 percent of the labor force, and over three thousand more banks would fail."
Meyer was without doubt correct: the contractionary policy was called for by every known rule. Meyer's analysis reveals how profoundly the basic mindsets of the gold standard dominated policymakers far into the Depression-a situation that even Herbert Hoover recognized as something never before confronted in all of history. Politicians, monetary authorities, business leaders and bankers, and even most academics continued to genuflect before the gold bricks as though these gleaming hoards were all that mattered. They forgot that this was also the stuff that the Parthians had poured down the throat of Crassus after he had been defeated in battle.
The resulting infectious epidemic of disasters only strengthened the obstinate faith in the traditional approach. Indeed, as export trade shriveled in country after country, there seemed to be no choice but to restrain demand in order to hold down imports. Failure to act along those lines would be certain to lead to the most dreaded result: losses of gold to other nations. The vivid example of how gold had tortured the British economic system into deflation since 1925 was there for all to see, but Britain's path appeared to be the sole available roadmap to follow in managing the cataclysm of the 1930s. Although deflationary pressures were coming down so hard on Germany that Adolf Hitler would one day come roaring into power, and although mounting unemployment and spreading bank and business failures throughout the world were tearing into the deepest roots of the capitalist system, these horrors served only to strengthen the determination to preserve gold reserves above all else. The known rules defined the one safe policy when everything else was out of control.
Events during the first year after the Great Crash were disturbing, but 1930 in retrospect looks in many ways like the calm before the storm. On March 7, President Hoover reported that "All the evidence indicates that the worst effects of the Crash upon unemployment will have passed during the next sixty days." This was not a bad forecast under the circumstances. The domino effect of a major crisis would not make itself felt until the end of 1930, first with the failure of Caldwell & Co., a bank in Tennessee that brought down industrial companies, insurance companies, and small commercial banks in its wake, and then with the failure of a small New York bank with a big name, the Bank of United States. Some 2300 banks would follow suit over the next few months."' In Britain, the primary consequence was a series of significant losses of gold. On January 13, Norman had already warned the Chancellor of the Exchequer that he could no longer postpone the unpleasant task of raising interest rates.
The fuses were in place. They were lit on May 11 when the explosive news of the failure of the Creditanstalt Bank in Vienna stunned the world. This was Austria's largest commer
cial bank by far, holding more than half of all Austrian bank deposits. Today we would call the Creditanstalt an institution too large to fail. It was too large to fail in 1931, too, and the Austrian government had to bail it out. But to no avail. The Creditanstalt failure, in the words of the British Treasury official Ralph Hawtrey, "sent a terrible spasm of panic through the financial centers of the world."" The spasm first ignited a run on the other Austrian banks and then panic hit the schilling in the foreign exchange markets. In desperation, the Austrian National Bank tried to borrow foreign exchange from other central banks. The Bank of France insisted that no loans would be possible unless the Austrians renounced their intention to form a customs union with Germany, which the Austrian government refused to do. Meanwhile, the Bank of France, busy substituting gold for deposits in foreign central banks, acquired $539 million of gold-about 25 percent more than the entire year's production of gold at the mines.12 Nevertheless, Montagu Norman, still fighting his personal war against the French, succeeded in infuriating his enemy once more by going ahead with a loan to the Austrians from the Bank of England.
It was too late. Everything was now focused on protecting the golden stockpiles from further damage. Norman's modest efforts would prove to be nothing more than a transitory stopgap. In short order, the run on Austria provoked runs on Hungary, Czechoslovakia, Romania, and Poland. These panics were sufficient to disseminate alarm to still other countries, with the most serious repercussions coming down on Germany.
The knee-jerk response by the German Chancellor, Heinrich Bruning, was to slash government spending. Bruning tried to offset the fury unleashed by the additional unemployment and deflationary pressure he was creating by proclaiming that Germany had reached the limit of its ability to pay reparations. His statement may have been welcome at home, but it led the flight from the reichsmark to begin in earnest. The crisis became so threatening that on June 19 President Hoover, at Leffingwell's suggestion, proposed a one-year moratorium on both German reparation payments and payments by the Allies to the United States for war debts. The French were furious at this concession to the Germans and refused at first to take part in any discussions. Although temporary credits were arranged for Germany, the haggling went on for so long over the Hoover proposal that the panic started up all over again and the German hemorrhage of gold and foreign exchange accelerated. In an effort to contain the damage, the Germans began the imposition of a system of controls on foreign exchange transactions that became so tight and so complex that by 1932 Germany effectively ceased to be on the gold standard.
The crisis in central Europe rapidly communicated itself to the pound, in large part due to the actions of the French. Britain now began to suffer sharp losses of gold and heavy withdrawals of foreign-owned sterling balances. The sterling crisis was all the more remarkable because prices in Britain had already fallen 38 percent from the level in 1925 when the gold standard had been reestablished. 13 The situation appeared to be so desperate that Winston Churchill, on vacation in Biarritz, blurted out, "Everybody I meet seems to be vaguely alarmed that something terrible is going to happen financially. I hope we shall hang Montagu Norman if it does. I shall certainly turn King's evidence against him. 1114
Norman, in fact, seemed to be as lost as anyone. When Harrison at the New York Federal Reserve Bank cabled him on July 15 that "We are concerned and surprised at sudden drop in sterling today," Norman's response was, "I cannot explain this drop. It was sudden and unex- pected."15
One can only wonder at the way Norman ducked Strong's query. Two days earlier, the publication of the final report of the findings of a special governmental committee had disclosed the alarming deterioration in the condition of Britain's foreign trade position, with imports exceeding exports by an ever-widening margin. An even more immediate source of trouble was also coming to a head. London financiers had been borrowing at low interest rates in Paris and lending the proceeds to the Germans at much higher rates of interest, but now French financiers uneasy about the outlook for the pound were demanding repayment of their loans to London. The shocking sum of some 0750 million was involved.16
A week later, the situation had reached a point where Norman made the extraordinary decision to dispatch one of the Bank directors to ask the Bank of France for an immediate loan. The French were willing if the British government-in effect, the British taxpayers-would guarantee the loan. The Cabinet refused, the negotiations broke down, and the pound resumed its slide.*
This turn of events was too much for Norman. On July 28, exhausted by the sequence of defeats to all his hopes and dreams, he went home from the Bank "feeling queer."" After a week in bed, he sailed to Canada for a vacation of total rest. The last act of the drama that he had largely written and directed was about to play itself out without him. We will never know whether he was too sick to deal with the crisis or just unable to face the total failure of his efforts that loomed just ahead.
Two days later, the Treasury issued an alarming report on the state of the government's burgeoning budget deficit. The deficit for 1932 was now projected to be (170 million, which was k50 million above the previous estimate. The news shook the entire financial world. No one understood why the report had to be published at that most sensitive moment; Keynes characterized it as "the most foolish document I have ever had the misfortune to read."'s
As the exodus of Britain's stock of gold persisted, sentiment was building for the government to take drastic action to put its financial house in order. The state of the economy made the task extremely disagreeable: by August, nearly one in four workers was unemployed, up from one in six a year earlier, while prices and wages continued to fall. The Economist of August 22 chose this moment to declare that Britain was living beyond its means, that the budget must be balanced, and that "every extravagance in dole [relief payments to the unemployed] and other expenditures should be eliminated." That kind of talk had gone on intermittently ever since the war, but this time it was not just talk. Nevertheless, with the Labour Party in power, headed by Ramsay MacDonald, the decision to cut the dole was turning out to be even more agonizing than if the Tories had been leading the government. Another emergency effort was undertaken to borrow from French and American bankers, including J. P. Morgan, but the bankers refused further credits without the imposition of budget cuts deeper than the government could accept, especially in the dole. Word of the bankers' conditions caused "pandemonium" in the Cabinet room.19
Yet something had to be done. On August 24, King George invited MacDonald to form a National Government, a coalition of Labour, Liberal, and Conservative parties, to make the pain of the budget cuts more politically palatable. The tonnent suffered by the country's leaders is vividly illustrated by a letter dated September 12 from the King to the Prime Minister, which MacDonald read aloud to Parliament in an emergency session. His Majesty expressed the desire "in the grave financial situation with which the country is confronted personally to participate in the movement for the reduction of national expenditure." The King proposed to forgo k50,000 a year in his annual allowance, a reduction of about 10 percent. Hailing the King's offer-and evoking the noble sacrifice of Dickens's Sidney Carton-MacDonald proclaimed that "It is far, far better for all of us to go with tight belts into stability than with loose ones into confusion." He went on to express his determination to perform in accordance with this credo by assuring the country that he would keep Parliament in emergency session until "the world is convinced once again that sterling is unassailable."'"
It was a good thing that no one bothered to hold MacDonald to his promise. If they had, Parliament would still be sitting in that same emergency session.
Keynes's was a lonely voice in opposition to the mainstream thinking that only thrift could cure the world's awful economic diseases. "Suppose we were to stop spending our incomes altogether and were to save the lot," he suggested in a radio broadcast in January 1931. "Why, everyone would be out of work.... Therefore, oh patriotic housewives, sally out tomorro
w early into the streets and go to the wonderful sales which are everywhere advertised. You will do yourselves good-for never were things so cheap.... And have the added joy that you are increasing employment [and] adding to the wealth of the country because you are setting on foot useful activities.""
Keynes's logic may have made sense to the patriotic housewives, but it had no effect on the intentions of the nation's political leaders. The National Government's Budget and Economy Bill provided for a £70 million reduction in government spending and a tax increase of r86 million. Keynes lost no time in characterizing this legislation as "replete with folly and injustice." Nevertheless, the Government was convinced that the defense of sterling was the primary objective, regardless of human cost in Britain. As a further lure to foreigners to hold sterling, the Bank Rate-the rate charged by the Bank of England to banks needing immediate credit-had been raised in a giant leap to 6 percent from 2%z percent in June. The combination of higher taxes, reduced spending, and higher interest rates was lethal. The economy sank even lower and unemployment rose even higher, pulling tax revenues down along with the shrinking payrolls and profits. In the end, the government was left with a much larger deficit than the experts had predicted.
Before the Economy Bill had much opportunity to rescue the pound, a bizarre but shocking event occurred while the debate on the legislation was under way, a strange echo of the invasion of Fishguard in February 1797. A small contingent of sailors at the British navy station of Invergordon went on strike against the pay cuts that were part of the proposed legislation. The press, both at home and abroad, gave the pocket mutiny huge black headlines. Foreigners received the news in a state of high alarm: if such a thing could occur in the British navy, of all places, the whole country must be on the verge of revolution. Nearly L40 million of gold was swept out of the Bank's vaults in a single week; X200 million had been lost since the middle of July.