Lords of Finance

Within days of the outbreak of war and for the next few weeks, an unnatural calm settled over the city as it basked gloriously in the August sunshine. The grand department stores for which Paris was famous were deserted; there was no traffic—the buses had disappeared to the front; and the métro ran only sporadically. Theaters and cinemas were closed; the cafés shut at 8:00 p.m., the restaurants at 9.30 p.m. Before the month was out, with all the foreigners gone, the big hotels lay empty.

At the end of August that silence was shattered. The German army swept through Belgium and across northern France in a great flanking movement around the French left wing, and by August 29 was just twenty-five miles from the city. Gunfire could be heard in Paris and there were reports that German soldiers had been seen on the outskirts. The next day, a Sunday, a lone German plane circled overhead and dropped three bombs, filled with lead bullets, near the Gare de l’Est. No one was injured. On Monday a second plane swooped across the rooftops and let go of its bombs near the Rue Quatre Septembre, intending them, it was said, for the Banque de France. Again only a few windows were broken.

Few people—certainly not the Germans—were yet aware that on August 18, with the invaders still two hundred miles away in Brussels, the Banque de France had already set in motion its emergency plan—Paris, after all, had fallen to foreigners three times in the previous hundred years. Its gold reserves—38,800 gold ingots and innumerable bags of coins valued at $800 million and weighing some 1,300 tons—had been shipped in the utmost secrecy by rail and truck to safety at prearranged sites in the Massif Central and the south of France. The massive logistical operation went off without a hitch until one of the trains carrying coins derailed at Clermont-Ferrand. Five hundred men had been required to get it back on the tracks, collect the money, and keep off curious spectators. By early September, the Banque’s vaults in Paris were empty.

6. MONEY GENERALS

CENTRAL BANKS: 1914-19

Endless money forms the sinews of war.

—Cicero, Philippics

As THE LIGHTS started to go out over Europe that fateful first week of August, every banker and finance minister seemed to be fixated not on military preparations or the movements of armies but on the size and durability of his gold reserves. The obsession was almost medieval. This was, after all, 1914, not 1814. Paper money had been in wide use for more than two centuries, and merchants and traders had developed highly sophisticated systems of credit. The idea that the scope of the war might be limited by the amount of gold on hand seems anachronistic. Nevertheless, here was the London magazine United Empire declaring that it was “the amounts of coin and bullion in the hands of the Continental Great Powers at the outbreak of hostilities” that would largely determine “the intensity ... and probable duration of the war.”

The focus on the prosaic matter of bank reserves was a symptom of the general complacency that surrounded those first few months of the war. Despite the hysteria of the crowds on the streets of Berlin, Paris, and London, an odd atmosphere of unreality hung in the air. No one could quite understand what this war was about or why it had come, but no one expected it to last very long. While the soldiers on both sides marched off to war, each one expecting to give the enemy a good pasting, the generals were promising they would be home for Christmas. Buoyed by such optimism from the military professionals, financial officials calculated that because the war was bound to be short, the important thing was to be in good financial shape, with gold reserves intact at the end.

So smug were the bankers and economists that they even allowed themselves to be convinced that the discipline of “sound money” itself would bring everyone to their senses and force an end to the war. On August 30, 1914, barely a month into the fighting, Charles Conant of the New York Times reported that the international banking community was very confident that there would not be the sort of “unlimited issue of paper [money] and its steady depreciation,” which had wrought such inflationary havoc in previous wars. “Monetary science is better understood at the present time than in those days,” declared the bankers confidently.

Sir Felix Schuster, chairman of the Union of London and Smith’s Bank, one of the City’s most prominent bankers, went confidently around telling everyone that the fighting would grind to a halt within six months—the interruption of trade would be too great. John Maynard Keynes, then a thirty-one-year-old economics don at King’s College, Cambridge, who had made himself something of an overnight expert on war finance, announced to his friends in September 1914 that “he was quite certain that war could not last more than a year” because by then the liquid wealth of Europe that could be utilized to finance the war would be “used up,” and he became quite angry at the stupidity of anyone who thought otherwise. In November 1914, the Economist predicted that the war would be over in a few months. That same month, at a dinner party in Paris given in honor of the visiting British secretary of state for war, Field Marshal Lord Kitchener, the French finance minister confidently proclaimed that the fighting would have to be over by July 1915 because money would have run out. And it was not only the Allied experts who were so blinkered. The Hungarian finance minister, Baron Janos Teleszky, when questioned in the cabinet about how long his country could pay for the war, replied three weeks.

And so as the financiers of Europe watched their continent slip toward Armageddon, its credit system collapsing onto itself, world stock markets closing their doors, and the gold standard grinding to a halt,9 they clung to the illusion that global commerce would be disrupted only briefly and the world would rapidly return to “business as usual.” Few imagined that they might be witnessing the last and dying convulsions of an entire economic order.

The experts seemed to have forgotten that among the first casualties of war is not only truth but also sound finance. None of the big wars of the previous century—for example, the Napoleonic Wars or the American Civil War—had been held back by a mere lack of gold. These had been fights to the death in which the belligerents had been willing to resort to everything and anything—taxes, borrowing, the printing of ever larger quantities of money—to raise the cash to pay for the war.

By the end of 1915, eighteen million men were mobilized across Europe. On the Western Front, two gigantic armies—three million men from the Allied nations and two and a half million Germans—sat stalemated, bogged down in trenches along a five-hundred-mile front stretching from the Channel through Belgium and France to the Sw

iss border. Like a giant sleeping reptile stretched across the face of Western Europe, the front remained immobile. By a perverse sort of logic, as hundreds of thousands of men were led to the slaughter, their terrible sacrifice was called upon to justify pressing on, and the carnage generated its own momentum.

Still, the complacency of those first few months took a long time to evaporate. Even into 1916, the dogma that this would be a short war lingered as general after general predicted victory in another six months. By then the five major powers—Britain, France, Russia, Germany, AustriaHungary—werespending a massive $3 billion each month, nearly 50 percent of their collective GDP. No other war in history had absorbed so much of the wealth of so many nations at one time.

Countries varied in how they raised the funds. Nevertheless, there were certain common themes. To pay for such a gigantic effort by taxation alone would have entailed tax rates at confiscatory levels and was therefore impossible. Daunted by the task, none of the governments even tried, and taxes accounted for but a tiny fraction of the new money raised. Instead, the belligerents resorted principally to borrowing. Once they had exhausted every potential source of loans, they relied on a technique almost as old as war itself: inflation. Unlike medieval kings, however, who accomplished this either by shaving pieces of gold and silver off the outer edge of their coins—a practice known as clipping—or of issuing coinage made of cheaper alloys—currency debasement—governments in the Great War turned to their central banks, often relying on complex accounting ruses to disguise the process. Central banks in turn, abandoning their long-standing principle of only issuing currency backed by gold, simply printed the money.

VERY, VERY RELUCTANTLY

Of all the European countries at war, Britain, in an effort to live up to its long history of fiscal prudence, was the most responsible in its financial policies. In four years of fighting, the government spent a total of $43 billion on the war effort, including $11 billion in loans, which it funneled to its poorer Continental allies, principally France and Russia. To pay for all this, it raised about $9 billion, or 20 percent, through additional taxes and almost $27 billion by long-term borrowing, both domestically and in the United States. The remainder it borrowed from banks, including a large chunk from the Bank of England. As a result, the quantity of money in circulation within Britain doubled in four years, doubling prices with it.

Turning to the Bank of England for money was not as unprecedented a policy as City bankers reared on nineteenth-century principles of finance liked to think. For the Bank had been originally created, in fact, not to regulate the currency but to help pay for a war. In 1688, James II, the last Catholic king of England and Scotland, was driven from his throne, having alienated much of his people by attempting to restore Roman Catholicism as the official religion of the country. In his place, Parliament invited his daughter Mary and her husband, William of Orange, both Protestants, to assume the crown. James found sanctuary at the court of Louis XIV of France, who used the “Glorious Revolution” as a pretext to launch against England what was to be grandly named the War of the League of Augsburg.

In 1694, after several years of fighting a country many times its size, England found itself close to bankruptcy. A group of City merchants, all Protestants, many of them French Huguenots only very recently compelled to leave France by Louis XIV’s repudiation of tolerance for Protestants, approached the chancellor of the exchequer, Charles Montagu, offering to lend the government £1.2 million in perpetuity at an interest rate of 8 percent. In return, they were to be granted the authority to set up a bank with the right to issue £1.2 million in banknotes—the first officially sanctioned paper currency in England—and to be appointed sole banker to the government. Montagu, desperate for money, jumped at the idea. Before the year was over the new bank opened its doors for business under the name The Governor and Company of the Bank of England.

For its first 150 years, it operated like any other bank, albeit much larger than its competitors, and with certain special privileges, especially its lock on government business, which provided most of its income. Like all the other banks in the country, it issued banknotes and took deposits, maintained its reserves in gold, and discounted bills of exchange—short-term loans to merchants for financing trade and goods in transit.

While the Bank certainly did not see its job as managing the currency, over time, by virtue of its size and stability, it began to acquire a superior status among its fellow banks and its notes became the country’s dominant form of paper money. Its smaller competitors began to entrust it with their reserves, and it gradually evolved into a sort of bankers’ bank, the City’s guardian and nanny, in the process acquiring the affectionate nickname of “The Old Lady of Threadneedle Street.” But its powers were never quite formalized and much ambiguity hung about its precise role and responsibilities.

Like so many British institutions of those days, the Bank was run like a club. Control was vested in twenty-six directors of what was quaintly known as the Court of the Bank of England. Its membership was largely drawn from a closed inner circle of City bankers and merchants. They had all gone to the same small selection of schools, preferably Eton or Harrow. Some of them had even attended Oxford or Cambridge. They lived in Kensington or Knightsbridge, belonged to the same clubs, typically White’s or Boodle’s, and socialized with one another at their gracious but not grand country houses in the areas around London known as the Home Counties. Their daughters occasionally married into the landed aristocracy, but for the most part, they married among themselves. Few societies in the world were as comfortable, confident, and civilized.

Represented on the Court were all the major banking families of the City. There was always a Baring, a Grenfell, and a Goschen. Generally, there was also a partner of Brown Shipley and of Anthony Gibbs. Although the group included the usual smattering of baronets and even the occasional peer, none of the great landed families of Britain were represented—they went into politics. Only once had there been a Jew on the Court of the Bank of England, and that was, of course, Alfred de Rothschild, who had been elected in 1868 and resigned in 1889.

Directors were generally invited to join in their late thirties and were appointed for life, or at least until the onset of senility; many were in their seventies or eighties, and some had been on the Court for over half a century. It was part-time work and not too onerous. They met once a week. In addition, each director had to take his turn on the Committee of Daily Waiting, which required that each day three of the twenty-six directors be physically present at the Bank, responsible for the keys to the vaults, auditing the securities held there, and dining with the commander of the Bank piquet, the Brigade of Guards detachment that marched nightly from its barracks in Knightsbridge to protect the Bank. For these duties, a director received an annual honorarium of the equivalent of $2,500, equivalent to the annual pay of a colonel in the Guards or the stipend of a canon of Westminster.

Among the Court’s offices, only the governorship and the deputy governorship were full-time positions. Those who filled those posts were required to take a temporary leave of absence from their own businesses. Each member of the Court was given a chance—indeed was expected—to become deputy governor for two years, and then governor for two years more. To be the governor of the Bank of England in the nineteenth and early twentieth century was therefore not a mark of any particular merit, but merely a sign of the right pedigree, patience, longevity, and the luxury of having a sufficiently profitable business with partners willing to let one take four years’ leave. It was the principle of Buggin’s turn. At the end of his term—terms were very rarely extended and then only for one year—a retiring governor simply went back to being an ordinary member of the Court until he died or became embarrassingly incoherent.

As Walter Bagehot, the great nineteenth-century editor of the Economist who reveled in the quaint paradoxes of English life, described them, members of the Court were generally “quiet serious men . . . (who) have a

good deal of leisure.” Indeed, he felt it an ominous sign for a private banker to be fully employed. “If such a man is very busy, it is a sign of something wrong. Either he is working at detail, which subordinates would do better and which he had better leave alone or he is engaged in too many speculations . . . and so may be ruined.”

These arrangements, according to Bagehot, put the financial stability of London and, as a consequence, the world in the hands of “a shifting executive; a board of directors chosen too young for it to be known whether they are able; a committee of management in which seniority is the necessary qualification, and old age the common result.” It was a strange, even eccentric way of doing things—for the most important financial institution in Britain, in fact in the world, to be in the hands of a group of amateurs, men who generally would have preferred to be doing something else but who viewed the years they devoted to steering the Bank as a form of civic duty.10