Lords of Finance

By the time of the Bretton Woods conference, Keynes’s wartime efforts had taken a severe toll on his health. The drugs, which Plesch had prescribed, had not cured the bacterial infections in his heart, and he was now seriously sick. Lydia forbade Keynes to attend the cocktail parties and required him to take his dinner with her in their suite. Nevertheless, she contributed her own part to the madhouse atmosphere by doing ballet exercises late at night in her room and keeping other guests awake, including Mrs. Morgenthau in the suite below.

Much of the negotiating had been done prior to the conference between the Americans and the British. At Bretton Woods, the biggest controversy was over how much money each country would be eligible to borrow from what was now being called the International Monetary Fund. The Russians, who were there in strength though very few of them spoke English, demanded that their borrowing rights reflect not simply economic power but also military strength, and insisted on equality with the British; India wanted to be on a par with China; the Bolivians wanted parity with the Chileans and the Chileans with the Cubans. The United States, as the fund’s prime financier, set these quotas in a series of back-room deals orchestrated by White.

On July 22, the conference came to its formal close with a great banquet. Keynes gave a final address. He reminding the participants of the economic chaos that had afflicted the world for almost a generation and paid tribute to the spirit of cooperation that had informed the discussions: “If we can so continue, this nightmare, in which most of us present have spent too much of our lives, will be over. The brotherhood of man will have become more than a phrase.” As he left the room, the delegates sang “For He’s a Jolly Good Fellow.”

Two years later, Keynes’s heart finally gave out and he died at the age of sixty-one. White was appointed the U.S. executive director of the International Monetary Fund after the war, but in 1947, under investigation by the FBI, he was forced to resign, citing ill health. The next year, after being publicly named as a Soviet agent by Whittaker Chambers, he was called to testify before the House Committee on Un-American Activities. Three days after his testimony, on August 16, 1948, he, too, collapsed and died of a heart attack at the age of fifty-six.

Nevertheless, the legacy of these two men, the international monetary arrangements known as the Bretton Woods System, fruitfully endured for another thirty years. It provided the foundations for the reconstruction of Europe and Japan after the war, it allowed the global economy to boom through much of the 1950s and 1960s without any of the financial crises that had been so much a part of its history, and it set the stage for one of the longest periods of sustained economic growth the world has ever seen.

23. EPILOGUE

I have yet to see any problem, however complicated,

which, when looked at in the right way did not become

still more complicated.

—Poul ANDERSON

ANYONE who writes or thinks about the Great Depression cannot avoid the question: Could it happen again? First it is important to remember the scale of the economic meltdown that occurred in 1929 to 1933. During a three-year period, real GDP in the major economies fell by over 25 percent, a quarter of the adult male population was thrown out of work, commodity prices fell in half, consumer prices declined by 30 percent, wages were cut by a third. Bank credit in the United States shrank by 40 percent and in many countries the whole banking system collapsed. Almost every major sovereign debtor among developing countries and in Central and Eastern Europe defaulted, including Germany, the third largest economy in the world. The economic turmoil created hardships in every corner of the globe, from the prairies of Canada to the teeming cities of Asia, from the industrial heartland of America to the smallest village in India. No other period of peace time economic turmoil since has even come close to approaching the depth and breadth of that cataclysm.

Part of the reason for the extent of the world economic collapse of 1929 to 1933 was that it was not just one crisis but, as I describe, a sequence of crises, ricocheting from one side of the Atlantic to the other, each one feeding off the ones before, starting with the contraction in the German economy that began in 1928, the Great Crash on Wall Street in 1929, the serial bank panics that affected the United States from the end of 1930, and the unraveling of European finances in the summer of 1931. Each of these episodes has an analogue to a contemporary crisis.

The first shock—the sudden halt in the flow of American capital to Europe in 1928 which tipped Germany into recession—has its counterpart in the Mexican peso crisis of 1994. During the early 1990s, Mexico, much like Germany in the 1920s, allowed itself to borrow too much short-term money. When U.S. interest rates rose sharply in 1994, Mexico, like Germany in 1929, found it progressively harder to roll over its loans and was confronted with a similar choice between deflation or default.

There are, of course, differences. Germany in 1928 was much larger compared to the world economy—about three times the relative economic size of Mexico in 1994.51 But the biggest difference was to be found in the management of the crisis. The U.S. Treasury under Secretary Robert Rubin forestalled a default by providing Mexico an emergency credit of $50 billion

with astonishing rapidity. Germany in 1929 had no such savior. Moreover, in 1994, Mexico could devalue the peso. In 1929, having only just emerged from a terrible bout of hyperinflation, Germany felt bound by gold-standard rules and sacrificed its economy to maintain the parity of the Reichsmark.

The second crisis of the series, the Great Crash, has a very obvious modern-day parallel in the fall of the stock market in 2000. Both followed a frenzied bubble in which stocks completely lost touch with economic reality, becoming grossly overvalued—by most measures 30 to 40 percent. In both cases, after the sell-off it became apparent that much of the rise had been pushed by a rogue’s gallery of Wall Streeters and corporate insiders. Both resulted in similar losses initial in wealth expressed as a percentageof GDP—roughly 40 percent in the first year—and were followed by a sharp contraction in investment. The reaction of the authorities was not that dissimilar—in the first year after the 1929 crash interest rates in the United States were cut from 6 percent to 2 percent; in 2000 they were slashed from 6.5 percent to 2.0 percent.

The 1931-33 sequence of banking panics that started with the failure of the Bank of United States has many of the same characteristics as the current global financial crisis that began in the summer of 2007 and, as I write, is still sweeping through the world’s banking system. Both originated with doubts about the safety of financial intermediaries that had sustained large losses. In 1931-33 those fears precipitated a series of bank runs, as depositors pulled their money out of banks and hoarded currency, that over a two-year period spread in waves across the United States. The present turmoil has also led to a mass run on the financial system—this time not by panicked individuals desperate to withdraw their money but by panicked bankers and investors pulling their money out of financial institutions of all stripes, not only commercial banks but investment banks, money market funds, hedge funds, and all those mysterious “off-balance-sheet special-purpose vehicles” that have sprung up over the past decade. Every financial institution that depends on wholesale funding from its peers has been threatened to a greater or lesser degree.

In some respects the current crisis is even more virulent than the banking panics of 1931-33. In the 1930s most depositors had to line up physically outside their bank to get their money. Now massive amounts of money are being siphoned off with the click of a mouse. Moreover, the world’s financial system has become both larger compared to GDP and more complex and interconnected. There is much greater leverage, and many more banks rely on short-term wholesale sources of funding that can evaporate overnight. The world’s banks are therefore much more vulnerable than they were then. As a result panic has swept through the system faster and more destructively.

Offsetting this has been the response of central banks and financial officials. In 1931-33 the Fed stood passively aside while thousands of banks failed, thus permitting bank credit to contract by 40 percent. In the current crisis, central banks and treasuries around the world, drawing to some degree on the lessons learned during the Great Depression, have reacted with an unprecedented series of moves to inject gigantic amounts of liquidity into the credit market and provide capital to banks. Without these measures, there is little doubt that the world’s financial system would have collapsed as dramatically as it did in the 1930s. Though the net impact on credit availability of the present crisis and the remedial actions taken by central banks is still uncertain and won’t be known for many months, the authorities seemed to have at least staved off a catastrophe.

Finally, the European financial crisis of 1931 also has its modern-day counterpart in the “emerging markets” crisis of 1997-98. In 1931, the evaporation of confidence in European banks and currencies caused Germany and much of the rest of Central Europe to impose capital controls and default on their debts, leading to a contagion of fear that culminated in forcing Britain off the gold standard.

In 1997, a similar sequence of rolling crises afflicted Asia. South Korea, Thailand, and Indonesia all had to suspend payments on hundreds of billions of dollars of debt. Asian currencies collapsed against the dollar, undermining all confidence in emerging-market securities and eventually setting off the default of Russia in 1998 and of Argentina two years later. But in 1931, that part of Europe affected by the crisis was about half the size of the U.S. economy; in 1997, the GDP of the emerging markets that defaulted represented about a quarter of U.S. GDP.

As with all analogies, the comparisons are never exact. Nevertheless, they illustrate the scale of the economic whirlwind of 1929-32—a crisis equivalent in scope to the combined effects and more of the 1994 Mexican peso crises, the 1997-98 Asian and Russian crises, the 2000 collapse in the stock market bubble, and the 2007/8 world financial crisis, all cascading upon one and other in a single concentrated two-year period. The world has been saved in part from anything approaching the Great Depression because the crises that have buffeted the world economy over the past decade have conveniently struck one by one, with decent intervals in between.

For many years people believed—even today many continue to do so—that an economic cataclysm of the magnitude of the Great Depression could only have been the result of mysterious and inexorable tectonic forces that governments were somehow powerless to resist. Contemporaries frequently described the Depression as an economic earthquake, blizzard, maelstrom, deluge. All these metaphors suggested a world confronting a natural disaster for which no single individual or group could be blamed. To the contrary, in this book I maintain that the Great Depression was not some act of God or the result of some deep-rooted contradictions of capitalism but the direct result of a series of misjudgments by economic policy makers, some made back in the 1920s, others after the first crises set in—by any measure the most dramatic sequence of collective blunders ever made by financial officials.

Who then was to blame? The first culprits were the politicians who presided over the Paris Peace Conference. They burdened a world economy still trying to recover from the effects of war with a gigantic overhang of international debts. Germany began the 1920s owing some $12 billion in reparations to France and Britain; France owed the United States and Britain $7 billion in war debts, while Britain in turn owed $4 billion to the United States. This would be the equivalent today of Germany owing $2.4 trillion, France owing $1.4 trillion, and Britain owing $800 billion. Dealing with these massive claims consumed the energies of financial statesmen for much of the decade and poisoned international relations. More important, the debts left massive fault lines in the world financial system, which cracked at the first pressure.

The second group to blame were the leading central bankers of the era, in particular the four principal characters of this book, Montagu Norman, Benjamin Strong, Hjalmar Schacht, and Émile Moreau. Even though they, especially Schacht and Norman, spent much of the decade struggling to mitigate some of the worst political blunders behind reparations and war debts, more than anyone else they were responsible for the second fundamental error of economic policy in the 1920s: the decision to take the world back onto the gold standard.

Gold supplies had not kept up with prices; and the distribution of gold bullion after the war was badly skewed, with much of it concentrated in the United States. The result was a dysfunctional gold standard that was unable to operate as smoothly and automatically as before the war. The problem of inadequate gold reserves was compounded when Europe went back to gold at exchange rates that were grossly misaligned, resulting in constant pressure on the Bank of England, the linchpin of the world’s financial system, and a destructive and petty feud between Britain and France that undermined international cooperation.

The quartet of central bankers did in fact succeed in keeping the world economy going but they were only able to do so by holding U.S. interest rates down and by keeping Germany afloat on borrowed money. It was a system that was bound to come to a crashing end. Indeed, it held the seeds of its own destruction. Eventually the policy of keeping U.S. interest rates low to shore up the international exchan

ges precipitated a bubble in the U.S. stock market. By 1927, the Fed was thus torn between two conflicting objectives: to keep propping up Europe or to control speculation on Wall Street. It tried to do both and achieved neither. Its attempts to curb speculation were too halfhearted to bring stocks back to earth but powerful enough to cause a collapse in lending to Germany, driving most of central Europe into depression and setting in train deflationary forces throughout the rest of the world. Eventually in the last week of October 1929, the bubble burst, plunging the United States into its own recession. The U.S. stock market bubble thus had a double effect. On the way up, it created a squeeze in international credit that drove Germany and other parts of the world into recession. And on the way down, it shook the U.S. economy.

The stresses and strains of trying to keep the limping gold standard going may have made some sort of financial shakeout inevitable. It was, however, not necessary for the crisis to metastasize into a worldwide catastrophe. European central bankers had been dealing with financial crises for more than a century. They had long absorbed the lesson that while most of the time the economy works very well left in the care of the invisible hand, during panics, that hand seems to lose its grip. Markets, particularly financial markets, became unthinkingly fearful. To reestablish sanity and restore some sort of equilibrium in these circumstances required a very visible head to guide the invisible hand. In a word, it required leadership.

After 1929, responsibility for world monetary affairs ended up in the hands of a group of men who understood none of this, whose ideas about the economy were at best outmoded and at worst plain wrong. Strong died in 1928. His successor, George Harrison, tried his best to fill his shoes but did not have the personality or the stature to assume control. Instead, authority at the Fed shifted to a group of inexperienced and ill-informed timeservers, who believed that the economy would automatically return to an even keel, that there was nothing to be done to counteract deflationary forces except wait them out. They failed to fulfill even the most basic central banker’s responsibility: to act as lender of last resort and support the banking system at a time of panic.