Lords of Finance

The Fed was now paralyzed by this standoff between its two principal arms. The Board kept insisting that the right way to deflate the bubble was through “direct action”: credit controls, particularly of brokers’ loans. New York was equally insistent that such a policy could not work, that it was impossible to control the application of credit once it left the doors of the Federal Reserve. Meanwhile, the pace of speculation was accelerating.

It did not help that the Fed seemed incapable of even exerting its control over leading bankers, let alone over the crowd psychology of investors. At the end of March, it was announced that total broker loans had increased to almost $7 billion, and the market swooned. The fear that some drastic action from the Fed to curtail the amount of credit going into the stock market was imminent drove the rate on brokers’ loans to over 20 percent. Instead, Charlie Mitchell of National City Bank, himself a director of the New York Fed, defied the Board by calling a press conference and announcing that his bank would pump an extra $25 million into brokers’ loans to support the stock market. After that, what little credibility the Fed possessed was irretrievably lost.

It is too easy to mock the Fed for entangling itself in a bureaucratic turf feud and fiddling while Rome was burning. Both parties to the debate were in fact right. The Board was undoubtedly correct that with the demand for money on Wall Street so strong, call money averaging over 10 percent, sometimes spiking as h

igh as 20 percent, and speculators counting on gains of 25 percent a year and more, a hike in the Fed’s discount rate from 5 percent to 6 percent or even 7 percent at this stage of the game was going to have almost no effect. To be sure of pricking the bubble would have required raising interest rates higher, perhaps to 10 or 15 percent, which would have caused massive cutbacks in business investment and would have plunged the economy into depression.

But the New York Fed also happened to be right. All the jawboning about reducing credit for speculators proved to be pointless. It did in fact succeed in curbing the amount of money going into brokers’ loans from banks—between early 1928, when the Board first declared war on brokers’ loans, and October 1929, banks cut their loans to brokers from $2.6 billion to $1.9 billion. Meanwhile, other sources of credit—U.S. corporations with excess cash, British stockbrokers, European bankers flush with liquidity, even some Oriental potentates—more than made up for the decline by increasing their funding of brokers’ loans from $1.8 billion to $6.6 billion. It was these players, all of them outside the Fed’s control, who were by far the most important factor supporting leveraged positions in the stock market.

Even Adolph Miller, the most vocal opponent of speculation in general and brokers’ loans in particular, could not resist the temptation to earn 12 percent on his own savings. In 1928, Fed officials discovered that he had invested $300,000 of his own money in the call market through a New York banker, personally helping to feed the very speculation that he so vociferously opposed at the Board.

One is led to the inescapable but unsatisfying conclusion that the bull market of 1929 was so violent and intense and driven by passions so strong that the Fed could do nothing about it. Every official had tried to talk it down. The president was against it, Congress too; even the normally reticent secretary of the treasury had spoken out. But it was remarkable how difficult it was to kill it. All that the Fed could do, it seemed, was to step aside and let the frenzy burn itself out. By trying to stand up to the market and then failing, it simply made itself look as impotent as everybody else.

PERHAPS THE MOST perverse consequence of the bubble was that by the strange mechanics of international money, it helped to tip Germany over the edge into recession. For five years, hordes of American bankers had descended on Berlin to press loans upon German companies and municipalities. However much Schacht had tried to wean his country from this dependence on foreign capital, there was little he was able to do about it. Over the five years between 1924 and 1928, Germany borrowed some $600 million a year, of which half went to reparations, the remainder to sustain the rebound in consumption after the years of austerity.

In fact, Germany’s appetite for foreign exchange was so great that even the deluge of long-term loans from U.S. bankers was not enough, and it was forced to supplement this with short-term borrowings in international markets closer to home. Out of the total of $3 billion for which German institutions signed up in those years, a little less than $2 billion came in the form of stable long-term loans. But more than $1 billion was “hot money,” short-term deposits attracted to German banks by high interest rates—7 percent in Berlin compared to 5 percent in New York—and subject to being pulled at any time. In late 1928, as the U.S. stock market kept climbing and call money rates on Wall Street skyrocketed, American bankers mesmerized by the phenomenal returns at home suddenly stopped coming to Berlin.

It was the combination of the drying up of foreign credit due to high interest rates induced by the U.S. stock bubble and the residual lack of confidence among German businessmen following Schacht’s ill-fated strike against the stock market in 1927 that drove Germany into recession in early 1929. Moreover, as long-term American loans stopped, Germany was forced to rely more and more on hot money, some raised from London, but much from by French banks, then flush with all the excess gold that had been sucked into their country. Germany therefore found itself slipping into recession just as its foreign position was becoming increasingly vulnerable. A British Treasury official, recalling how much money France had pumped into Russia before the war, could not help remarking with cynical detachment, “The French have always had a sure instinct for investing in bankrupt countries.”

The collapse in foreign loans and the recession could not have come at a worse time for Germany. Under the Dawes Plan schedule, Germany was to have fully recovered by now, and was due to ramp up its reparations payments in 1929 to the full $625 million a year, about 5 percent of its GDP. This would not have been an intolerable burden by historical standards. But Schacht, for that matter most of the German leadership, had always been resolute that with its new constitution still fragile, its body politic still divided, its people still bitter over the defeat, and its middle classes decimated by the ravages of the inflation years, Germany simply could not pay this amount.

As 1929 and the scheduled rise in payments approached, Schacht was of two minds about what to do. He often spoke about simply waiting for the economic crash that so many financial experts were predicting. It was a common view in Britain, held, for example, by Frederick Leith-Ross, the top Treasury official responsible for reparations, that the world was headed for a massive payments crisis in which several European countries would default on their debts, setting the stage for a general restructuring of all international commitments arising from the war. Europe could then wipe the slate clean of both reparations and war debts and start over again. Occasionally, Schacht even talked almost too glibly about provoking such an upheaval himself.

The alternative was to reopen negotiations before the jury-rigged payments system broke down. During the Long Island central bankers’ meeting of 1927, Schacht had made enough of a stir about Germany’s foreign debt problem as to convince Strong and Norman that something had to be done soon, to the point that Strong in turn pressed Agent-General Seymour Parker Gilbert to strike a deal before the whole thing blew up in their faces.

Gilbert, effectively Allied economic proconsul for Germany for the last four years, was even then all of thirty-six years old. A precocious genius, he had graduated from Rutgers at the age of nineteen, from Harvard Law School at twenty-two, had become one of the four assistant secretaries at the U.S. Treasury at the age of twenty-five, and been promoted to under-secretary, the second most powerful official in the department at the age of twenty-eight. In 1924, at the tender age of thirty-two he had been appointed agent-general for reparations, responsible for managing Germany’s payments, and most important, for deciding how much it could afford to transfer into dollars every year. In the hands of this tall, shy, boyish, sandy-haired young man from New Jersey lay the immediate fate of the world’s third largest economy.

There was little doubt that they were very capable hands. Reserved, bookish, and taciturn, Gilbert was uncomfortable around people, speaking “with a mixture of awkwardness and arrogance, mumbling the words so that one could hardly understand his English.” But his intellectual power and capacity for work were legendary. At the Treasury, he had usually been at his desk till two or three o’clock in the morning, seven days a week. Living in Berlin for five years, he did not socialize, never learned German, did “nothing but work without interruption,” according to the German finance minister, Heinrich Kohler. “No theater, no concert, no other cultural events intruded into his life….”

That so young an American should have such enormous sway over the life of their country was greatly resented by most Germans. Government officials also suspected the staff in his office of being espionage agents, sent to report on Germany’s attempts to cheat on the limitations imposed on its armed forces by the Versailles Treaty. In February 1928, a right-wing group staged a mock coronation attended by ten thousand people in which Gilbert’s effigy was crowned “the new German Kaiser who rules with a top hat for a crown and a coupon clipper for scepter.” Schacht, always attuned to the locus of power, was one of the few German officials to befriend Gilbert.

Apart from his power to determine transfer payments, Gilbert’s most potent weapon was his annual report. Generally viewed as the best independent assessment of Germany’s economic policy and overall situation, it was always eagerly awaited by Germany’s creditors. Though successive ministers of finance may have resented being lectured for overspending by this absurdly young whippersnapper of an American, no German politician dared challenge him because of the influence he carried abroad.

In his 1927 report released in December, Gilbert declared that the time had come for Germany to take control over her own economic destiny “on her own responsibility without foreign supervision and without transfer protection.” Germany should be told once and for all exactly how much she owed and for how long. Moreover, the transfer protection clause embodied in the Dawes Plan, while useful in 1924 for restarting foreign lending, was now creating its own perverse incentives—what we now refer to as moral hazard. By providing an escape clause in the event of a payments crunch, the plan encouraged foreign bankers to be too cavalier in their lending and allowed Germany to be too lax about the consequences of accumulating so much debt “without the normal incentive to do things and carry through reforms that would clearly be in the country’s own interests.” Though Gilbert thus announced his intention of working himself out of one of the most powerful economic positions in the world, it did help that he had just received the highly lucrative offer to join J. P. Morgan & Co. as a partner.

There were many on the British side, and even among the Germans, who thought that it was still premature for a final reckoning. The bitterness between France and Germany had yet to subside; more time was needed until the German economy had truly revived before the amount of foreign payments it could sustain could definitively be settled.

By late 1928, however, Gilbert had been successful in persuading the Allies to convene a conference in Paris in February 1929 to do just that. He had even convinced the powers in Berlin that though the current situation—no new foreign loans coming in, large debts to nervous French depositors in German banks, and rising domestic unemployment—did not provide the ideal backdrop against wh

ich to reopen negotiations, it was best to try to strike a deal now while at least the rest of the world was booming.

Gilbert and the German leadership, Schacht included, were operating, however, from two completely different assumptions about what such a deal might look like. During his campaign to get a new round of negotiations started, the Allies had very explicitly told Gilbert that any further concessions would have to be small. Receipts from Germany had to cover payments on war debts to the United States and provide France and Belgium something beyond this to cover some of the costs of reconstruction. The lowest figure that the Allies could concede was an aggregate payment of $500 million a year. In his enthusiasm to get the parties to the table, Gilbert convinced himself and told everyone on the Allied side that the Germans would be willing to accept such a settlement as the price for getting France out of the Rhineland and regaining economic sovereignty.

Meanwhile, Schacht believed that American bankers had now committed so much money to Germany—they had provided some $1.5 billion of the $3 billion it had borrowed—that they represented an effective lobby for reduction and would bring enough political pressure on the creditor governments for Germany to swing a settlement of $250 million a year. Schacht, having by now broken with the German Democratic Party (DDP), which he had helped found, was beginning to flirt with the right-wing reactionaries of the DNVP, the German Nationalist People Party. At one point, he even bragged to his new friends that he could get reparations below $200 million a year. Gilbert tried his best to disabuse the Germans of such excessive optimism and they in turn tried to convince him that Germany “was dancing on a volcano” and could not afford $500 million a year. But the two parties ended up talking past each other.

Thus as the delegations began to descend on Paris in February 1929 for yet one more summit devoted to reparations, none of the participants realized how wide the chasm of disagreement between the various sides remained. It came as an ill omen when, just as the conference convened, a massive cold front descended across Europe, bringing with it the coldest temperatures for almost a century. Temperatures in Berlin fell to their lowest level in two hundred years; in Silesia it was 49 degrees below zero, the coldest day since records had begun in 1690. Europe was icebound. Across the continent, trains were immobilized, ships lay frozen in the Baltic and on the Danube, and many rural communities, particularly in Eastern Europe, faced actual famine. The newspapers carried chilling reports evoking the Dark Ages, of packs of starving wolves attacking isolated villages in Albania and Romania and of a whole band of gypsies found frozen to death in Poland.

The German delegation, weighed down with twenty-seven boxes of files, arrived by train from Berlin on February 8. Paris had escaped the worst of the cold—the temperature was only 10 degrees below zero. Nevertheless, the city authorities had lined the streets with braziers. But for all the chill, in contrast to Central and Eastern Europe, the French capital was visibly booming. The local economy, fueled by soaring exports, high savings, and large capital inflows, was expanding at 9 percent a year, making it the fastest growing major country. In the last two years, the French stock market had enjoyed the best performance in the world, beating even Wall Street’s—having gone up 150 percent since the end of 1926, while the Dow had risen 100 percent. With the good times had come a renewed self-confidence, even arrogance, and this being Paris, scandals. As the delegates arrived, the city was still abuzz with L’Affaire Hanau.

Marthe Hanau was a forty-two-year-old divorcée who in 1925 had started a stock tip sheet, La Gazette du Franc. By 1928, she had a following of hundreds of thousands of investors. Taking advantage of the gullibility and cupidity of the small-town savers who were her clients—local priests, retired soldiers, schoolteachers, and shopkeepers—she promoted stocks that were often little more than paper companies. When her success brought her to the attention of the authorities, Hanau, nicknamed by the press “La Grande Catherine de Finance,” kept investigators at bay by bribing politicians. The archbishop of Paris was one of her clients. But eventually her extravagance—she always traveled in a convoy of two limousines, in case one of them broke down; regularly splurged $100,000 on diamonds; and periodically spent the weekend at the Monte Carlo gaming tables—caught up with her. In December 1928, she was arrested and forced into bankruptcy, owing $25 million dollars. Now in prison, she was awaiting trial threatening to name names.43

The Germans were put up at the Royal Monceau, a new luxury hotel near the Arc de Triomphe, and furnished with four new limousines by Mercedes-Benz for the duration. This was the first conference at which they felt themselves treated as equals rather than as the enemy. They were even invited to the opening lunch at the Banque de France on Saturday, February 9, hosted by the head of the French delegation, Émile Moreau. Representing the United States were Owen Young and Jack Morgan, with Thomas Lamont as Morgan’s alternate; from Britain came Sir Josiah Stamp, one of the original members of the Reparations Commission of 1921, and Lord Revelstoke, one of the five peers in the Barings family and chairman of the bank; the industrialist Alberto Pirelli, one of the richest men in Italy, and the banker Émile Francqui, the richest man in Belgium, represented their countries. Also attending was a delegation from Japan. It was a reunion for many of the men, who like Young and Stamp, had been on the Dawes negotiating teams.

Over a six-course lunch—Huîtres d’Ostend washed down with a 1921 Chablis, Homard à l’Américain with a 1919 Pouilly, Rôti de Venaison accompanied by an 1881 Château Rothschild, Faisans Lucullus with a 1921 Clos de Vougeot, Salade d’Asperge with a 1910 Château d’Yquem, a 1910 Grand Fine Champagne with desserts, and finally a bottle of the 1820 Cognac Napoléon over coffee—the delegates selected Owen Young, with his perfect diplomatic skills, as their chairman.

On February 11, the Young Conference—as it would come to be called but was for the moment referred to as the Second Dawes Conference—opened in the Blue Room at the Hotel George V. During the previous decade Paris had been the scene of so many international gatherings that every other grand hotel—the Crillon on the Place de la Concorde, the Bristol on the Rue Saint Honoré, the Majestic on the Avenue Kléber, and the Astoria on the Champs-Élysées—carried in its faded corridors and meeting rooms the echoes of some gathering of statesmen that had ended in acrimony. It seemed only fitting, a sort of rite of passage, for the George V only recently opened for business to host this new meeting before it could claim its place in the ranks as a true Parisian hôtel-de-luxe.

On the second day, seated around the horseshoe table, Schacht made his opening offer—$250 million a year for the next thirty-seven years. Moreau conveyed to Young that France would accept nothing less than $600 million a year for the full sixty-two years and might even demand as much as $1 billion. Young was shocked at the huge gap between the main protagonists. Being the consummate financial diplomat, and recognizing that a premature discussion of numbers on reparations would merely lead to an early breakdown in negotiations, he arranged for all the delegates to be tied up in subcommittees for the next six weeks talking around the subject, while he used the time in back-channel shuttle diplomacy between the Germans and the French.