Lords of Finance

Norman, by nature the more emotional, could be gushing and sentimental and fussed over his friend’s health. “Let me beg you to care for yourself more than you seem to be doing. You belong to others quite as much as to yourself,” he wrote after a 1921 visit to New York. He lectured Strong about smoking too many Camels and insisted on details about “what is happening to your pulse & sleep & pins & breathing . . . not a word have I heard for 4 weeks.” The more aloof Strong, with a large family of his own, had less need to confide. But each was the other’s closest friend. In 1927 after a visit from Norman while he was down with pneumonia, Strong too would write, “To have a sympathetic person to talk over matters is helpful anyway, but when it is a best friend, it is more than that.”

By 1923, they were seriously fearing for the future. The first few years of peace, begun so hopefully, had turned out to be a time of great frustration and disappointment for both. The United States had washed its hands of European affairs and retreated into isolation. Currencies in Europe remained unstable. Neither of them could do much about the failures of economic policy in Germany or France, both paralyzed by reparations: Germany refusing to do anything to stabilize its economy until a fairer settlement was established, France in its turn insisting that it could make no concessions until a deal was reached on its war debts to Britain and America.

Norman saw “the Civilization of Europe” at stake. But all he could do was watch gloomily from the sidelines as matters continued to deteriorate. He became increasingly pro-German and anti-French. French

obstinacy during the reparations dispute only served to reinforce his private prejudices, particularly against the French political class, which in his view was uniformly venal, underhanded, corrupt, and dishonorable. “The black spot of Europe and the world continues to be on the Rhine,” he wrote to Strong after the occupation of the Ruhr. “There you have all the conditions of war except that one side is unarmed. How long can Germany continue thus?”

For Strong the frustrations were more personal. Though he remained financially comfortable, over the years he had to adjust his lifestyle drastically. The contrast between his relatively modest way of living and those of his old colleagues in the private sector could not have been more apparent. Following his separation and divorce, he lived in a series of small apartments, initially in a suite at the Plaza Hotel, and from mid-1922, in a small two-bedroom apartment in midtown Manhattan. Harry Davison had the benefit of a mansion on Park Avenue, a sixty-acre estate on the North Shore of Long Island, and a plantation estate in Georgia, until he died suddenly of a brain tumor in May 1922. Meanwhile Thomas Lamont, the embodiment to Strong of the road not taken, lived in a large town house at Seventieth Street and Park Avenue, continued to use his property in Englewood during the spring, and summered on his estate in North Haven, Maine.

Strong continued to be plagued by illness. In February 1923, the tuberculosis spread to his larynx, forcing him to take yet another extended leave of absence in Colorado—his fourth in seven years—from which he returned to work in October, and then only part time. Since he had first contracted the disease in 1916, he had spent almost half the time away from his desk. Even when he was nominally at work, he was often incapacitated, “afflicted by the generous use of morphine,” to control the terrible pain. He had aged enormously. Compelled to give up tennis and other vigorous exercise, he had put on weight and was losing his hair. He looked haggard and overworked, almost unrecognizable from the tall, slim, confident, good-looking young man of ten years earlier.

In those days, even after his first wife’s death, he had always been very social and clubby. Now he rarely went out at night and was never seen at the theater or the opera. His job was his anodyne, his evenings devoted to quiet working dinners with other bankers and officials.

In early 1924, with both his sons talking of getting married, he wrote to Norman: “The temptation is constantly before me to wind up my work and quit, do some traveling, a little writing, and take things easy.” Neither of them foresaw that after four years of frustration they were on the verge of achieving their goals.

Maynard Keynes’s Wedding, 1925

9. A BARBAROUS RELIC

THE GOLD Standard

Time will run back and fetch the age of gold.

—JOHN MILTON, On the Morning of Christ’s Nativity

AFTER THE WAR, there was a universal consensus among bankers that the world must return to the gold standard as quickly as possible. The almost theological belief in gold as the foundation for money was so embedded in their thinking, so much a part of their mental equipment for framing the world, that few could see any other way to organize the international monetary system. Leading that quest were Montagu Norman and Benjamin Strong.

The biggest obstacle to such a return was the mountain of paper currency issued by the central banks of the belligerent powers during the war. Take Britain, for example. In 1913, the total amount of money circulating in the country—gold and silver coins; notes issued by the Bank of England and by the large commercial banks; and the largest category, bank deposits—amounted to the equivalent of $5 billion. This supply of money, in all its various forms, was backed in aggregate by the country’s $800 million of gold, surprisingly only $150 million of which was held in the vaults of the Bank of England, the remainder consisting of gold coins in circulation or bullion held by the commercial banks, such as Barclays or Midland. By 1920, the Bank of England had lent so much money to the government to help pay for the war effort that the total money supply had ballooned to the equivalent of $12 billion, which in turn had driven prices up by two and a half times. Britain’s gold reserves meanwhile remained roughly the same. Thus, whereas in 1913, there had been 15 cents worth of gold within the country for every $1 dollar in money, in 1920 each $1 of money was backed by less than 7 cents. The Bank of England made every effort to economize on gold, for example, by replacing gold coins with paper currency, and by concentrating the bullion originally held by commercial banks into its own holdings. Nevertheless, at war’s end it was clear that the country’s reserves would not provide enough of a monetary cushion for Britain to contemplate returning to gold at the old 1914 exchange rate.

Every nation involved in the war, even the United States, faced the same dilemma. For all had resorted to inflationary finance to a greater or lesser degree. There were essentially only two ways to restore the past balance between the value of gold reserves and the total money supply. One was to put the whole process of inflation into reverse and deflate the monetary bubble by actually contracting the amount of currency in circulation. This was the path of redemption. But it was painful. For it inescapably involved a period of dramatically tight credit and high interest rates, a move that was almost bound to lead to recession and unemployment, at least until prices were forced down.

The alternative was to accept that past mistakes were now irreversible, and reestablish monetary balance with a sweep of the pen by reducing the value of the domestic currency in terms of gold—in other words, formally devalue the currency. This sounds painless. But to a generation reared on the certainties of the gold standard, devaluation was viewed as a disguised form of expropriation, a way of cheating investors and creditors out of the true value of their savings—which to some degree it was. Moreover, it was not completely costless. Central banks that resorted to devaluation as a way of cleaning up a past monetary mess were viewed as the financial equivalent of reformed alcoholics—it was hard to clear the stain on their reputations for financial discipline, and as a consequence, they generally had to pay up to borrow.

A simple analogy of the choice between deflation and devaluation might be that of the man who has put on weight and is having a hard time fitting into his clothes. He can either choose to lose the weight—that is, deflate—or alternatively accept that his larger waistline is now irreversible and have his clothes altered—that is, devalue. Whether to deflate or devalue became the central economic decision for every country after the war. The burden of deflation fell on workers, businesses, and borrowers, that of devaluation on savers. The fate of the world economy would hinge over the next two decades on which path each country took. The United States and Britain took the route of deflation, Germany and France that of devaluation.

Of all the belligerents, the United States, having come late to the war and having spent the least of any of the major powers, was in the best financial shape. Though it, too, had allowed its currency to expand by 250 percent during the war, and prices to double, it also had seen its gold reserves more than double as the enormous European purchases of war materials and the massive flight of European capital seeking safety across the Atlantic, carried over $2 billion worth of gold into the United States. By 1920, the country held close to $4 billion in gold. Even allowing for war inflation, therefore, it still had a comfortable reserve of bullion to back its expanded currency base, and was able to return to the gold standard almost immediately after hostilities ceased.

Even in the United States, the return to gold and monetary stability was not completely painless. In 1919 and 1920, after the years of wartime austerity, consumers let rip and went on a buying binge; inflation began to accelerate and for a brief moment, seemed about to spin out of control. Strong reacted forcefully, leading a move by the Fed to tighten credit policy dramatically by raising interest rates to 7 percent and keeping them there for a full year. This constriction was accompanied by a similar move by the federal government to bring its budget into balance. The economy plunged into recession. Over two and a half mill

ion men lost their jobs. Bankruptcies soared. But by the end of 1921, with prices down by almost a third, the economy once again began to recover. During the next seven years, the U.S. economy, led by new technologies such as automobiles and communications, would experience an unprecedented period of strong growth and low inflation.

At the opposite end of the spectrum from the United States was Germany, which had taken the path of least resistance during the war and expanded its money supply by 400 percent. By the end of 1920, German prices stood at ten times their 1913 level. Germany had issued so much currency that it had no hope of being able to reverse the process, and when the war ended, seemed clearly headed for a massive devaluation. In retrospect, that would have been a blessing. But instead of trying to rebuild its finances, the German government adopted a policy of systematic inflation, in part to meet reparations, and thus launched itself on that voyage of fantasy into the outer realms of the monetary universe.

FIGURE 1

Britain and France lay somewhere in between. During the war, France had expanded its currency by 350 percent, pushing up prices equivalently. After the war, the Banque de France avoided German-style hyperinflation and currency collapse by putting a lid on the issue of new currency. However, France continued to flirt with disaster by running budget deficits of $500 million and was saved once again only by the remarkable thriftiness of its people. While there was a group within the Banque who harbored the fantasy of reversing the more than threefold price increase and returning the franc to gold at its prewar parity, most rational observers agreed that when France returned to the gold standard, it would have to be at a radically lower exchange rate—and even that still seemed many years away.

Britain was therefore the only major country that truly faced the choice between devaluation and deflation. To a modern observer, less wedded to the principle that currency rates are sacrosanct, some measure of devaluation would have made sense. After all, Britain was finding it harder to compete in the postwar world economy and, having liquidated vast amounts of its holdings abroad, could only draw upon a much reduced foreign income to cushion the blow. Its exchange rate should have been allowed to fall as a means of making its goods cheaper on world markets.

However, Norman and his generation lived in a different mental world. They saw devaluation not as an adjustment to a new reality but as something more, a symptom of financial indiscipline that might precipitate a collective loss of confidence in all currencies. When people talked of the City of London as banker to the world, this was no mere figure of speech—the City operated literally like a gigantic bank, taking deposits from one part of the world and lending to another. While gold was the international currency par excellence, the pound sterling was viewed as its closest substitute, and most trading nations—the United States, Russia, Japan, India, Argentina—even kept part of their cash reserves in sterling deposits in London. The pound had a special status in the gold standard constellation and its devaluation would have rocked the financial world.

In the last months of the war, the British government set up a commission, chaired by the ubiquitous Lord Cunliffe, only recently departed from the Bank of England, and including Sir John Bradbury of the UK Treasury; A. C. Pigou, professor of political economy at Cambridge; and ten bankers from the City, to review postwar currency arrangements. Twenty-three parties gave evidence before the commission, every one of them, with not single note of dissent, in favor of a return to gold at the prewar rate. To a man, they believed the restoration of the traditional parity was essential if Britain was to retain its position at the hub of the world’s banking system.

The model they had in mind, which was especially seared into the collective memory of the Bank of England, was Britain’s experience a century earlier after the Napoleonic Wars. In 1797, four years into the Revolutionary war with France, there was a run on the Bank of England, provoked by rumors that a French army had landed in Wales. The Bank, which had begun the war with gold reserves of £9 million, saw them shrink to £1 million, and was forced, as it would be in 1914, to abandon the gold standard. Under the pressures of war finance, Bank of England notes, which formed the basis for paper money in the country, increased over the next fifteen years from £10 million to over £22 million, doubling prices.

In 1810, a parliamentary inquiry known as the Bullion Committee was formed to examine the whole issue. The committee included Henry Thornton, a banker, parliamentarian, brother to a director of the Bank of England, and the most creative monetary economist of the nineteenth century, whose insights would unfortunately be lost by succeeding generations in charge at the Bank. The committee recommended that the Bank resume gold payments as soon as possible, and in order to achieve this goal, begin to contract its credits to banks and merchants and shrink the supply of paper money by withdrawing its notes from circulation. The Bank wisely waited until 1815, when a defeated Napoléon was safely in exile on St. Helena, before taking this advice. Over the next six years, it almost halved the supply of paper money in Britain, driving down prices by 50 percent. And though those years from 1815 to 1821 had been years of riots and agricultural distress, Britain went back on gold in 1821. Over the subsequent half century, it transformed itself into the world’s largest economic power. Many believed that the “resumption” of 1821 had been the single most important defining decision in its financial history. That the Bank had been willing to inflict the pain of a 50 percent fall in prices in order to restore the gold value of the pound had set sterling apart from every other currency in Europe, and made it the world’s premier store of value.

Inspired by this example—and in complete contrast to every other European country—in 1920, the Bank of England chose the path of deflation, matching the Fed and raising interest rates to 7 percent. The budget was balanced. The economy plunged into sharp recession, two million men were thrown out of work. Nevertheless, by the end of 1922, the Bank had succeeded in bringing prices down by 50 percent, and the pound, which had fallen as low as $3.20 in the foreign exchange market on the fear that Britain was headed for devaluation, climbed back to within 10 percent of its prewar parity of $4.86.