European diarists uniformly recall the months before the ultimatum as among the most pleasant in memory. The assassination of Archduke Franz Ferdinand, heir to the Austro-Hungarian Empire, and his wife Sophie in Sarajevo on June 28, 1914, was at first considered an unfortunate symptom of instability that had plagued the Balkans for years, not as the casus belli it became.
The Austro-Hungarian general staff led by Count Franz Conrad von Hötzendorf had been spoiling for a fight with Serbia. They were held back by Franz Ferdinand’s moderating influence on his uncle, the Emperor Franz Josef. The assassination was a double blow to peace—it removed a moderating influence and provided von Hötzendorf with a reason to crush Serbian ambition in the Balkans. On Friday, July 23, 1914, Austria-Hungary delivered an ultimatum to Serbia. The ultimatum was intended to be unacceptable. While London and Paris basked in a glorious summer glow, the dogs of war were unleashed.
On July 24, Russia ordered a partial mobilization of land and sea forces in support of Serbia. On July 25, Serbia accepted some, but not all, of the terms of the Austro-Hungarian ultimatum and ordered a general mobilization. In response, Vienna broke off diplomatic relations with Serbia and ordered its own partial mobilization.
Once market participants saw war was inevitable, they acted in the same mechanical way as the generals with their mobilization plans and timetables. The period of the classical gold standard immediately preceding the war, 1870–1914, is best seen as a first age of globalization, a simulacrum of the second age of globalization that began in 1989 with the fall of the Berlin Wall. New technologies such as the telephone and electricity tied diverse financial centers together in a dense web of credit and counterparty risk. In 1914, global capital markets were no less densely connected than they are today. With the advent of war, French, Italian, and German investors all sold stocks in London and demanded proceeds in gold shipped to them by the fastest available means. Under the rules of the game, gold was the ultimate form of money, and it would be hoarded to fight the war. A global liquidity crisis commenced in lockstep with the political crisis.
The City of London was then the unrivaled financial capital of the world. Selling from the Continent put pressure on London banks to liquidate their own assets to meet claims. What ensued was not a classic run on the bank, but a more complex liquidity crisis. Sterling-denominated trade bills guaranteed by London banks were not rolled over. New bills were not issued. Liquidity dried up in the world’s most liquid money market. This liquidity crisis was eerily similar to the collapse of the commercial paper market in the United States in 2008.
Contagion spread to New York. Just as French banks sold London shares to get gold, London investors sold New York stocks for the same reason. The world was in a scramble for specie. Stock markets and money markets were in distress as investors dumped paper assets and demanded gold.
On July 28, 1914, Austria-Hungary declared war on Serbia. By July 30, stock exchanges in Amsterdam, Paris, Madrid, Rome, Berlin, Vienna, and Moscow had closed their doors and all major protagonists with the exception of the United Kingdom officially suspended convertibility of currency to gold. On Friday, July 31, 1914, the City did the unthinkable and closed the London Stock Exchange. A small sign posted on the members’ entrance said simply “HOUSE CLOSED.”
With London closed, all of the selling pressure in the world was now directed at New York as the last major venue where stocks could be sold for gold. The selling in New York was already intense in the days preceding the London closure. On July 31, 1914, just hours after London closed, and fifteen minutes before the New York opening bell, the New York Stock Exchange closed its doors also. This was partly at the urging of the U.S. secretary of the treasury, William McAdoo. The New York Stock Exchange would remain closed for more than four months until December 12, 1914.
The United States was officially neutral at the start of the First World War and able to trade with all of the combatant nations. While the stock exchange was closed, banks remained open. European parties who sold assets of any kind, including real estate or private equity, could demand conversion of proceeds into gold to be shipped to Hamburg, Genoa, or Rotterdam.
Stocks were still traded through private negotiation on the informal “curb exchange” that emerged on New Street in lower Manhattan in an alley behind the New York Stock Exchange building. On Monday, August 3, 1914, The New York Times carried this advertisement: “We are prepared to buy and sell all classes of securities on the following terms and conditions: Bids must be accompanied by cash to cover; offers to sell must be accompanied by the securities properly endorsed.” The ad was signed “New York Curb.”
Some historians concluded that the New York Stock Exchange was closed because its board thought heavy selling from abroad would cause stock prices to collapse. Research conducted by William L. Silber in his classic book When Washington Shut Down Wall Street reveals another more intriguing explanation. Silber shows that U.S. buyers were ready to pounce on bargains offered by desperate European sellers, and stock prices would have stabilized.
According to Silber, the real reason the exchange was shut, and the reason the U.S. Treasury was involved, was not stock prices but gold. European sellers were entitled to convert their sales proceeds into gold at the U.S. subtreasury building located on Wall Street across from the exchange. Treasury was concerned that U.S. banks would quickly run out of gold so it shut down stock trading to hoard the gold. The exchange closure was an early application of the ice-nine approach.
The Great Depression, and the years leading up to the Second World War, brought the most radical ice-nine freezes in the twentieth century. The depression in the United States is conventionally dated from the stock market crash in October 1929. Yet the global depression began even earlier in the United Kingdom, which experienced depressed conditions through the late 1920s. Germany entered a downturn in 1927. In the United States, stocks and industrial output plunged and unemployment soared beginning in 1929. The most acute phase of the depression, including a global banking panic, was concentrated in the years 1931–33.
The European bank panic started in Austria with the failure of Creditanstalt on May 11, 1931. This led quickly to bank runs throughout Europe and the evaporation of commercial credit in London in a dynamic similar to the Panic of 1914. City bankers informed the Bank of England and the U.K. Treasury they would be insolvent in a matter of days if a rescue was not organized by the government.
Unlike 1914 when gold convertibility was nominally maintained, this time the U.K. Treasury broke with the gold standard and devalued sterling. The devaluation eased financial conditions in the United Kingdom and shifted pressure to the United States, which now had the strongest currency in the world. The United States became a magnet for global deflation.
In December 1930, the Bank of United States (a private bank despite its official sounding name), which catered to immigrants and small savers, suffered a bank run and closed its doors. The bank may have been solvent. Prejudice against Jewish and immigrant customers of the bank played a role in the refusal of the large New York Clearing House banks to rescue it.
The clearinghouse believed the damage could be contained to the Bank of United States. They were wrong. Bank runs spread like an out-of-control prairie fire. Parts of the United States literally ran out of money. Communities resorted to barter and use of “wooden nickels” to buy food. More than nine thousand U.S. banks failed during the Great Depression. Many depositors lost their savings when the bank liquidations were completed.
In the winter of 1933, President Hoover sought agreement from President-elect Roosevelt to announce some form of general bank closure or debt relief. Rather than join forces with Hoover, FDR preferred to wait until he was sworn in on March 4, 1933. Panic reached epic proportions. Savers around the country lined up at banks to withdraw funds. They stored cash in coffee cans or under mattresses at home.
Roosevelt acted decisively. Less th
an thirty-six hours after being sworn in, at 1:00 a.m. on Monday, March 6, 1933, Roosevelt issued Proclamation 2039, which shut every bank in America. FDR gave no indication when they might reopen.
Over the next week, bank regulators purported to examine the books of closed banks and proceeded to reopen banks deemed solvent based on that examination. This process was similar to the “stress tests” conducted by Treasury Secretary Tim Geithner in 2009 in response to another financial panic.
What matters most in such cases is not the actual health of the banks, but the U.S. government’s ability to give a “seal of approval” to relieve savers’ anxiety. In fact, the banks reopened on March 13, 1933, after a one-week “holiday.” Confidence was restored. Customers lined up again—this time not to withdraw cash, but to deposit.
The bank holiday was followed on April 5, 1933, with the notorious Executive Order 6102 requiring with limited exceptions that all gold held by U.S. citizens be surrendered to the U.S. Treasury under pain of imprisonment. FDR also prohibited gold exports. These gold strictures were not removed until President Ford issued Executive Order 11825 on December 31, 1974, which revoked prior executive orders on gold.
In short order, Proclamation 2039 and Executive Order 6102 were used to subject all of America’s gold and cash in the bank to an ice-nine lockdown. Executive authority to do this again today exists under current law. Congress cannot stop it.
The global financial system stabilized after 1933, then collapsed again in 1939 with the advent of the Second World War. Warring nations, led by the United Kingdom, once again suspended the convertibility of their currencies to gold and prohibited gold exports. Because gold was money at the time, these prohibitions represented another systemic freeze.
The global financial system started to thaw in anticipation of an Allied victory in the war. The seminal event was the July 1944 Bretton Woods conference. The conference itself was the end result of two years of intense behind-the-scenes struggles between the United States and United Kingdom, represented by Harry Dexter White and John Maynard Keynes respectively, as vividly described by Benn Steil in his book The Battle of Bretton Woods.
An alternative to periodic panic and lockdown is a system that is coherent, controlled, and rigorously rule based. That was the case under the classic Bretton Woods system from 1944 to 1971. During that twenty-seven-year golden age, signatories to the Bretton Woods agreement pegged their currencies to the U.S. dollar at fixed exchange rates. The U.S. dollar was pegged to gold at the fixed rate of $35 per ounce. The dollar-gold peg meant the other currencies, notably pounds sterling, French francs, German marks, and Japanese yen, were indirectly pegged to gold and one another via the dollar. The U.S. dollar was the common denominator of global finance, exactly as White and his boss, Treasury Secretary Henry Morgenthau, intended.
Importantly, there was more to the Bretton Woods system than fixed exchange rates. The system would be administered by the International Monetary Fund, a de facto world central bank. IMF governance was structured in such a way that the United States maintained a veto over all important decisions. Bretton Woods participants were allowed to use capital controls to maintain dollar reserves and limit volatile capital flows in order to support their obligations under the fixed rate system. Capital controls in major Western economies were lifted in stages beginning in 1958. Full convertibility of all major currencies was not achieved until 1964.
Currency pegs to the dollar were not immutable. Members could apply for exchange rate adjustments under IMF supervision. The IMF would first offer to make temporary funding available to the nation whose currency was under stress. The goal was to give that nation time to make structural reforms to improve its balance of trade, and bolster foreign exchange reserves so the peg could be maintained. Once the adjustments were made, and the reserves bolstered, the borrower could repay the IMF and the system continue as before.
In more dire cases, where temporary measures proved insufficient, devaluation was approved. The most high-profile devaluation under Bretton Woods was the 1967 sterling crisis. There the sterling peg was adjusted from $2.80 to $2.40, a 14 percent decline. One peg that could not be adjusted was the dollar-to-gold ratio. Gold was the anchor of the entire system.
The international system of capital controls and fixed exchange rates overseen by the IMF and the United States was complemented by a regime of financial repression. At the end of the Second World War, the U.S. debt-to-GDP ratio stood at 120 percent. Over the next twenty years, the Federal Reserve and U.S. Treasury engineered a monetary regime in which interest rates were kept artificially low and mild inflation was allowed to persist. Neither rates nor inflation surged out of control. The slight excess of inflation over rates from financial repression was barely noticed by the public. Americans enjoyed the postwar prosperity, rising stocks, new amenities, and a congenial culture.
Financial repression is the art of keeping inflation slightly higher than interest rates for an extended period. The old debt burden melts from inflation while new debt creation is constrained by low rates. Just a 1 percent difference between inflation and rates cuts the real value of the debt by 30 percent in twenty years. By 1965, the U.S. debt-to-GDP ratio was down to 40 percent, a striking improvement from 1945.
Diminution in the dollar’s value was so slow there seemed no cause for public alarm. It was like watching an ice cube melt. It happens, yet slowly.
There were few financial crises in the tranquil time from 1945 to 1965. Russia and China were not integrated with the global financial system. Africa was barely a blip on the global scale. Emerging Asia had not yet emerged, and India was stagnant. Latin America was subordinate to U.S. hegemony.
As long as oil flowed, only Europe, Japan, and Canada mattered to U.S. economic interests, and they were locked in to the Bretton Woods system. No ice-nine solution was imposed because it already existed. The Bretton Woods system was a global ice-nine. The United States controlled over half the world’s gold, as well as the dollar—the only forms of money that mattered.
The Bretton Woods system began to wobble badly beginning in 1965. The system suffered combined blows from U.S. inflation, sterling devaluation, and a run on U.S. gold. The United States was unwilling to make structural adjustments it required of other nations. In February 1965, French president Charles de Gaulle famously called for the end of dollar hegemony and a return to a true gold standard. De Gaulle’s finance minister, Valéry Giscard d’Estaing, called the dollar’s role under Bretton Woods “an exorbitant privilege.”
The United Kingdom, Japan, and Germany were willing to play along with the pretense that the dollar was as good as gold. The United Kingdom was broke. Germany and Japan relied on the U.S. nuclear umbrella for their national security. None were yet in a strong position to challenge the United States.
The rest of Western Europe, urged on by de Gaulle, took a different view. France, Spain, Switzerland, the Netherlands, and Italy increasingly cashed in their dollar reserves for gold. A full-scale run on Fort Knox ensued.
In the most famous example of an ice-nine solution in the twentieth century, President Nixon closed the gold window on August 15, 1971. It was no longer possible for U.S. trading partners to exchange dollar reserves for gold at a fixed price. Nixon put up a “HOUSE CLOSED” sign for the world to see.
The Money Riots
The period from 1971 to 1980 in international finance is best described as chaotic, not only in a colloquial sense, but in a scientific sense. Equilibrium was perturbed. Values wobbled violently. IMF members tried, and failed, to reestablish fixed exchange rates at new parities along with a new dollar parity to gold.
Monetarists such as Milton Friedman urged the world to abandon gold as a monetary standard. Floating exchange rates became the new normal. Countries could make their goods cheaper by letting their currencies devalue instead of making structural adjustments to improve productivity.
Keynesians
embraced the new system because inflation caused by devaluation lowered unit labor costs in real terms. Workers would no longer have to suffer pay cuts. Instead their wages were stolen through inflation in the expectation that they wouldn’t notice until it was too late. Monetarists and Keynesians were now united under the banner of money illusion.
In this brave new world of elastic money and zero gold, ice-nine solutions were no longer needed. If panicked savers wanted their money back, there was no need to close the system—you could print money and give it to them.
The ice-nine process had been reversed. With floating exchange rates, an ice age ended, glaciers melted, and the world was awash in a sea of liquidity. This was the financial equivalent of global warming. There was no problem that could not be solved with low rates, easy money, and more credit.
Easy money did not end financial crises; far from it. There was a Latin American debt crisis beginning in 1982, a Mexican peso crisis in 1994, an Asian-Russian financial crisis in 1998, and the 2007–9 global financial crisis. In addition, there were occasional market panics including October 19, 1987, when the Dow Jones Industrial Average fell 22 percent in one day. Other market crashes included the burst dot-com bubble in 2000, and the market break after the 9/11 attacks.
What was new was that none of these crises involved widespread bank defaults or closures. Without a gold standard, money was now elastic. There was no limit to the liquidity central banks could provide through money printing, guarantees, swap lines, and promises of extended ease called forward guidance. Money was free, or nearly free, and available in unlimited quantities.
This new system was not always neat and tidy. Investors suffered losses on the real value of their principal in the 1970s and 1980s. Still, the system itself stayed afloat. The Latin American debt crisis was solved with Brady bonds, named after U.S. treasury secretary Nicholas Brady. Brady bonds used U.S. Treasury notes to partially guarantee repayment on new bonds used to refinance defaulted debt. Treasury Secretary Robert Rubin tapped the Exchange Stabilization Fund (ESF) to provide loans to Mexico in 1994 when Mexico could not roll over its debts to Wall Street. The ESF had been created with profits from FDR’s 1933 gold confiscation and still exists as a Treasury slush fund. The ESF was a way to go around Congress, which had refused a Mexican bailout.
The Road to Ruin Page 5
