Lords of Finance

DESPITE His belief that the war had been a mistake, Hjalmar Schacht threw himself into the war effort as energetically as most citizens of imperial Germany. He was severely shortsighted and thus exempted from military service. Convinced like everyone else that German victory was assured, only three weeks after the outbreak he was busy developing a plan for extracting reparations from France. It was a sign of how far off the mark even the most astute observers were to be about the costs of the war that Schacht came up with a working figure of $10 billion. Though ten times the amount France had paid after the Franco-Prussian war of 1870, this would turn out to be only a fifth of the eventual total costs of Germany’s war budget.

In October 1914, as the Western Front sank into stalemate, Schacht was offered a job on the staff of the Banking Commission overseeing the finances of occupied Belgium, which was run by the military administration. He soon discovered that he was temperamentally ill suited to the army. He found the rigid hierarchy, the narrowness of the military mind, and the self-importance of the professional officer caste oppressive.

He also seemed to have had an unusual talent for making enemies. Within a short period, he managed to antagonize his superior, Major Karl von Lumm, the banking commissioner, in civilian life a member of the Reichsbank directorate. Schacht, always acutely sensitive when it came to matters of status, asked to join the officers’ club then housed in the Brussels casino. Von Lumm, an old bachelor who had been part of the Bavarian reserve before the war and was very proud of his military credentials and uniform, refused, citing Schacht’s status as a civilian. Schacht disastrously went over Von Lumm’s head to General von der Goltz, the governor general of Occupied Belgium, whom he had known before the war. He was admitted to the club all right, but at the price of Major von Lumm’s enduring enmity.

As part of his duties, Schacht organized a system by which the German army, rather than simply commandeering whatever goods it needed, paid for its requisitions with a special occupation currency of “Belgian” francs, which, by design, Germans could buy at a highly favorable exchange rate.

Demand for the Belgian francs was extremely strong, and in February 1915 Schacht allowed the Dresdner Bank, his employer in civilian life, to purchase a large quantity. Von Lumm promptly accused him of having violated the civil service code of ethics and brought Schacht up before an investigating committee. It concluded that while he had done nothing illegal or unethical, Schacht had attempted to cover up his involvement and had come close to perjury by giving “insincere replies to the questions put to him; and when the insincerity was pointed out . . . he attempted to justify himself by a far-fetched explanation of his statements.” The matter eventually went up as far as the office of the secretary of state for the interior; Schacht was officially reprimanded and resigned from the Banking Commission rather than risk dismissal.

Von Lumm had undoubtedly made a mountain out of a molehill. But even Schacht was to admit in private years later that while he had not lied during the inquiry, he had been highly evasive. The incident, clouded in mystery, would dog his reputation for many years. Rumors circulated that he had embezzled large amounts of money or had personally profited from his access to state secrets.

After war service that had lasted barely nine months, Schacht returned to his banking career. Once again, his overweening ambition got the better of him. Back at the Dresdner Bank, he pressed too hard for promotion to the board, was rebuffed, and had no option but to resign. He moved on to become a director of the Nationalbank, a well-regarded, if sleepy, second-tier firm based in Berlin.

As for so many Germans, the war was a grim time for the Schacht family. He lost two of his brothers—Oluf, from disease, and William, the youngest, at the Battle of the Somme. Food was scarce—they had to grow their own vegetables and acquired a goat, which they learned to milk—and times were hard.

A SCOUTING TRIP

For the United States the war was a windfall. European demand for American materials and supplies soared, setting off an enormous boom. Though these purchases were partly financed by Britain’s and France’s borrowing some $2 billion a year within the United States, the net effect led to massive influx of gold into America, swelling its bullion reserves from under $2 billion to $4 billion. Because of the operation of the gold standard, the influx of gold created an unusual expansion of credit and the U.S. money supply doubled.

During those first few years of its existence, the Federal Reserve System found itself overwhelmed. It was trying to build up its staff; it had no experience as an institution in monetary affairs, and being the product of countless political compromises, its charter was riddled with contradictions. Benjamin Strong, governor of the Federal Reserve Bank of New York, was quick to exploit the uncertainty about who was in charge. While the New York Fed, as it would come to be called, was on paper merely one among the twelve regional Federal Reserve Banks and theoretically under the supervision of the Federal Reserve Board in Washington, a body made up of political appointees, it was by a long way the largest of the reserve banks, and Strong, not a man to wait upon orders, made himself the chief pilot of the whole system. By virtue of his connections among New York bankers, his background as one of the original architects of the system, and most important, his personality, he came to dominate discussions of monetary and financial policy.

As more and more gold accumulated in the various Federal Reserve banks, Strong had two big fears. One was that at the end of the war, this gold would all pour back to Europe, radically destabilizing the U.S banking system. The other was that the gold would stay, potentially causing a shortage of reserves in Europe and threatening even greater inflation at home. In either case, he recognized that the Fed would be unable to handle the disruptions on its own and would have to coordinate its response with the European central banks. And so in February 1916, he decided to make a “scouting trip” to Europe.

As he arrived, the war, which had been going on for eighteen months, was about to enter its bloodiest year. The actual fighting in Western Europe was restricted to a narrow corridor through Belgium and eastern France, and life in London or Paris, while austere, was not especially dangerous. Since the Lusitania had been torpedoed and sunk off the coast of Ireland the year before, drowning almost 1,200 people, 124 of them Americans, the State Department had been warning its citizens not to travel to Europe.

Strong went first to Paris to meet his counterparts at the Banque de France and then to London. It was during this visit to the Bank of England that he first met Norman. Coming from the same generation, they immediately struck up a friendship. Unlike many of his colleagues in the City, Norman, having lived in the United States for two years, liked and admired Americans and he invited Strong to Thorpe Lodge one evening for a quiet dinner. Though Strong was the governor of the New York Fed and Norman a mere adviser to the deputy governor, on his return to the United States in April, Strong started to correspond with Norman. Initially both saw it just as a way to exchange information and views on the narrower aspects of credit policy. But over the months, their letters gradually become less formal and more personal, particularly when Norman took great pains to look after Strong’s eldest son, Benjamin, a sophomore at Princeton, who had gone to Europe as a volunteer with the American Ambulance Service in May 1917, after the United States entered the war on the Allied side.

Meanwhile, after Strong returned to the United States from Europe in the summer of 1916, he was buffeted by a series of personal tragedies. His wife, Katharine, still only twenty-eight, left him, taking their two young daughters with her. She moved across the country to Santa Barbara. Their marriage had been on the rocks for a while. They were temperamentally unsuited to each other—he was gregarious and social, she shy and retiring—and their age difference too great. His father-in-law, Edmund Converse, had been against his taking the Fed job from the very beginning, dismissing it as a quasi-government position with no future, and relations between the two men had steadily deteriorated. Katharine for her part had found it difficult to adjust to their diminished financial circumstances. Strong hoped for many years that they might be reconciled and was deeply hurt when in 1921 she filed for divorce without even consulting him. After the summer of 1916, they were never to meet again.

That same summer, as his marriage was falling apart, he also fell ill, developing a nagging cough that became progressively worse. He was soon bringing up blood and experiencing terrible chest pains. That June he was diagnosed with tuberculosis. Then commonly known as consumption, the highly contagious disease, caused by airborne bacteria that attack the membranes of the lungs, was then the most common cause of civilian deaths in both Europe and America, affecting people of all classes, often in the prime of life. Though the incidence of the disease had markedly declined before the war as the poorly ventilated tenements of industrial cities were replaced by better housing, the war had seen a minor resurgence of it in Europe. Strong is likely to have picked up the infection on his visit there.

While the cause of the disease had been isolated in the late nineteenth

century, there was still no effective therapy. Half of those who contracted it were dead within five years. At the time, it was thought that the thin dry air in high altitudes helped to contain the infection—with some grounds because its virulence declines in low-oxygen atmospheres. It was also believed—erroneously, it turned out—that total inactivity and complete rest allowed the lungs to rebuild themselves. Luxury sanatoria catering to the rich and the middle class, cut off from the rest of the world, had sprung up in mountain resorts across Europe and America.

Strong’s doctors insisted that he take an extended leave of absence from the Fed. In July 1916, he moved to Colorado, where almost a third of the population was then made up of “consumptives” seeking to be cured. He initially checked into a sanatorium in Estes Park, in the heart of the northern Colorado Rockies, but frustrated by this hermetically sealed world where patients spent hours doing nothing but sitting outdoors taking in the mountain air, he moved to Denver that October and set up a small office that allowed him to keep in touch with New York.

Strong was still convalescing in Colorado when the United States entered the war in April 1917. Within six weeks, he was back in New York. For the next eighteen months he threw himself into the task of raising the money to pay for the war. Every other objective of the Fed was now subordinated to this goal. The United States spent in total some $30 billion on the war, a little over $20 billion on its own actual expenditures and another $10 billion in the form of loans to keep other countries going.12 Determined to avoid the mistakes that had been made in financing the Civil War, the secretary of the treasury, William McAdoo, who also happened to be the president’s son-in-law, launched an aggressive program to induce the American public to purchase war debt. The Fed, as banker to the government, was responsible for selling these so-called Liberty Bonds, which eventually brought in close to $20 billion, about half of this raised by the New York Fed.

Taking the lead in organizing the high-pressure campaigns in New York to stir public enthusiasm for the bonds, Strong suddenly found himself thrust into the limelight. Acting as the master of ceremonies for concerts at Carnegie Hall or at the Metropolitan Opera House, leading great patriotic marches down Fifth Avenue, speaking at rallies featuring such Hollywood celebrities as Mary Pickford and Douglas Fairbanks, he became something of a minor celebrity himself. Publicity stunts were a signature of these campaigns. On one occasion Strong and the other organizers had trenches dug in the Sheep Meadow in Central Park—much to the outrage of conservationists—to show how soldiers were living on the Western Front. To kick off another campaign, they arranged for every air-raid siren, police alarm, tugboat whistle, fire engine bell, and ship fog-horn across the city to be turned on for five minutes.

By the time the war drew to a close, the Fed was a transformed institution. While it was not completely immune from the pressures of war finance, unlike so many European central banks, it had resisted purchasing government bonds directly and only indirectly helped to fuel the expansion in money supply. It had therefore secured some credibility. More important, the war had irrevocably changed the economic and financial position of the United States in relation to the rest of the world. The Fed, which barely existed in 1914, now sat on the largest reservoir of gold bullion in the world, making it potentially the dominant player if and when the international gold standard was restored.

PART TWO

AFTER THE DELUGE

1919 -23

7. DEMENTED INSPIRATIONS

German REPARATIONS

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency.

—JOHN MAYNARD KEYNES, The Economic Consequences of the Peace

ON November 11, 1918, the Great War came to an end as it had begun, as a total surprise. In June 1918, the German army broke through the Allied lines, and came within fifty miles of Paris. The German public, given a distorted picture by its government, fully anticipated victory. A month later, the Allies counterattacked and suddenly the entire German war machine seemed to disintegrate. The German forces, exhausted by that last offensive, withered away; support for the war at home crumbled; civilian morale collapsed; soldiers deserted in droves; the navy, blockaded at Kiel, mutinied; and Germany’s allies began to sue secretly for peace. By October, the military, desperate to salvage what it could, turned over power to the civilians. On November 9, the kaiser was forced into exile by his generals, boarding a train for Holland. Early on November 11, in a railway carriage in the forest of Compiègne forty miles outside Paris, an armistice was signed.