The Alchemists: Three Central Bankers and a World on Fire

by Neil Irwin

  Who would govern the reserve banks? A board of directors comprising local bankers, businesspeople chosen by those bankers, and a third group chosen to represent the public. The Board of Governors in Washington would include both the treasury secretary and Federal Reserve governors appointed by the president and confirmed by the Senate.

  How many reserve banks would there be, and where? Eight to twelve, the compromise legislation said, not the twenty that Glass had envisioned. An elaborate committee process was designed to determine where those should be located. Some sites were obvious—New York, Chicago. But in the end, many of the decisions came down to politics. Glass was from Virginia, and not so mysteriously, its capital of Richmond—neither one of the country’s largest cities nor one of its biggest banking centers—was chosen.

  The vote over the Federal Reserve Act in a Senate committee came down to a single tiebreaking vote, that of James A. Reed, a senator from Missouri. Also not so mysteriously, Missouri became the only state with two Federal Reserve banks, in St. Louis and Kansas City. The locations of Federal Reserve districts have been frozen in place ever since, rather than evolving with the U.S. population—by 2000, the San Francisco district contained 20 percent of the U.S. population, compared with 3 percent for the Minneapolis district.

  And in a concession to those leery of creating a central bank, the Federal Reserve System, like the First and Second Banks of the United States, was set to dissolve at a fixed date in the future: 1928. One can easily imagine what might have happened had its charter come up for renewal just a couple of years later, after the Depression had set in.

  • • •

  The debate over the Federal Reserve Act was ugly. In September 1913, Minnesota representative George Ross Smith carried onto the floor of the House a seven-by-four-foot wooden tombstone—a prop meant to “mourn” the deaths of industry, labor, agriculture, and commerce that would result from having political appointees in charge of the new national bank. “The great political power which President Jackson saw in the First and Second National banks of his day was the power of mere pygmies when compared to the gigantic power imposed upon [this] Federal Reserve board and which by the proposed bill is made the prize of each national election,” he argued.

  It wasn’t just the fiery populists who opposed the bank. Aldrich, the favored senator of the Wall Street elite, complained that the Wilson administration’s insistence on political control of the institution made the bill “radical and revolutionary . . . and at variance with all the accepted canons of economic law.”

  For all the noise, the juggling of interests was effective enough—and the memory of 1907 powerful enough—for Congress to pass the bill in December 1913. Wilson signed it two days before Christmas, giving the United States, at long last, its central bank. “If, as most experts agree, the new measure will prevent future ‘money panics’ in this country, the new law will prove to be the best Christmas gift in a century,” wrote the Baltimore Sun.

  The government, of course, hadn’t solved the problem of panics—though it had gained a better tool with which to deal with them. And opposition to a central bank, rooted as deeply as it was in the American psyche, didn’t go away. Instead, it evolved. Whenever the economic tide turned—during the Great Depression, during the deep recession of the early 1980s, during the downturn that followed the Panic of 2008—the frustration of the people was channeled toward the institution they’d granted an uncomfortable degree of power to try to prevent such things from happening.

  But after more than a century of trying, the United States had its central bank. New York was poised to compete on a more level playing field with London as a capital of world finance. And as the years passed, the series of compromises that the First Name Club dreamed up a century earlier in Jekyll Island, and the unwieldy and complex organization it created, would turn out to have some surprising advantages—even in a country that had previously been better at creating central banks than keeping them.

  FOUR

  Madness, Nightmare, Desperation, Chaos: When Central Banking Goes Wrong, in Two Acts

  Rudolf von Havenstein was a civil servant of the highest order: a kind and generous man of unquestioned integrity who had trained as a lawyer, served as a judge, and made a distinguished career for himself in the Prussian Finance Ministry.

  He was also very likely the worst central banker in history.

  Created in 1876, the German Reichsbank was crucial to the newly unified nation’s emergence as a global industrial and financial power. By the time Havenstein became its president, in 1908, the bank was well along the way to establishing a modern financial system, phasing out gold, silver, and copper coins in favor of paper banknotes. Over the last few years of the nineteenth century and the first few of the twentieth, careful monetary policy and near-miraculous economic expansion made the German economy and its financial industry an emerging rival to Britain’s. Germany became a leading exporter of iron, steel, and chemicals. But soon enough there were ominous rumblings of armed conflict on the continent as this new economic and industrial power bumped up against the existing powers of Britain and France. Havenstein viewed it as crucial that the Reichsbank be well positioned to enable the government to finance such a war.

  On June 18, 1914, ten days before two bullets fired in Sarajevo killed Archduke Franz Ferdinand and his wife and ignited a global conflagration, Havenstein summoned the leading commercial bankers of Germany. It’s ambiguous whether what he told them was a request, an order, or a threat: They would need to double the liquidity in the banking system over the next three years, he said, ensuring that marks were circulating in the economy instead of sitting around in banks. Ostensibly, this was to try to guide Germany through a bit of an economic rough patch. The true goal was to ensure that the nation would have the financial wherewithal to wage war.

  Havenstein viewed the war as a clash of economies as much as a clash of armies. He wrote that England’s “jealousy and ill-will toward our economic flowering, our growing world trade and growing power at sea is in the final analysis the basic cause of the world war.” He had no apparent reluctance to putting the Reichsbank to work financing the conflict, which in the early days was expected to be a fleeting affair. His primary objective was to keep German commerce going despite the disruption. “The precondition for this continuation of economic activity was the most extensive use of the old source of credit, the Reichsbank,” Havenstein said in September 1914.

  Ordinary Germans were encouraged to give up their stores of gold coins and jewelry in exchange for paper money issued by the Reichsbank, which gave the government greater ability to finance the war effort through the central bank. Historian Gerald D. Feldman wrote that the encouragement of paper money “took on a patriotic and fetishistic quality of previously unimaginable proportions.” Havenstein spoke warmly of individuals—the wife of a wealthy industrialist, his own brother-in-law—who moved their savings into paper money and persuaded others to do the same. A Reichsbank propaganda poster shouted, “Gold for the Fatherland! I gave gold for our defense and received iron as honorable recompense. Increase our gold stock! Bring your gold jewelry to the gold-purchasing bureaus.”

  That this mass issuance of paper money was steadily driving down the value of the mark was held back from public discussion by censorship, even as it was obvious to anyone going to the market to buy groceries. Havenstein and other Reichsbank leaders attributed the general rise in prices to hoarding. Inflation was high—but not yet catastrophically high. At the start of the war, the exchange rate was 4.2 marks to the U.S. dollar. On Armistice Day in November 1918, the rate was 7.4, which suggests an annual depreciation against the dollar of about 13 percent. That isn’t much higher than the inflation rate the United States experienced in the early 1980s.

  But a precedent had been set, and three conditions were in place that set the stage for everything that was to come: Germany was now a nation in which money was a
piece of paper, not a gold coin; that piece of paper was understood to buy less with every year that passed; and Rudolf von Havenstein had made it his mission to use his ability to print money to fund the needs of his government, whatever they might be.

  The German government’s strategy of funding itself with Herr Havenstein’s printing presses—taking on extraordinary debt in the meantime—was premised on winning the war. Transitioning to a peacetime economy would have been a challenge even if that had happened. (Managing Britain’s debt-laden economy in the 1920s was certainly no picnic.) But at peace talks in France, the victorious Allies were determined to exact vengeance—a nicer word would be “compensation”—for the war. The resulting Treaty of Versailles wasn’t so much the product of a negotiation as a list of demands made by the Allies: that Germany would give up colonies in Africa, as well as land comprising an eighth of its area, a tenth of its population, and 38 percent of its capacity for steel production.

  Most devastating of all, this now smaller, poorer country was to pay vast reparations—a total of 132 billion gold marks, equivalent to more than three years of national income. The three billion gold marks it was to owe each year represented 26 percent of the value of its exports. That debt was lowered in subsequent years, but until finally closing out the debts in 2010, Germany still owed money to foreign investors who had purchased reparations-related bonds.

  Economist John Maynard Keynes, who had left Cambridge to aid the war effort at the British Treasury, was disgusted by what he saw at the Versailles conference. So hungry were the Allies for vengeance, so lacking in magnanimity, that they’d put an impossible set of burdens on the defeated Germany. He was so distressed at the potential legacy of the treaty that he became physically ill. He resigned from the Treasury before the agreement was signed and quickly wrote The Economic Consequences of the Peace, which presented the reparation demands put upon Germany as a great risk to the world, and the prewar peace a rarer and more delicate phenomenon than most people realized.

  “Very few of us realize with conviction the intensely unusual, unstable, complicated, unreliable, temporary nature of the economic organization by which Western Europe has lived for the last half century,” Keynes suggested at the beginning of Consequences. “If the European civil war is to end with France and Italy abusing their momentary victorious power to destroy Germany and Austria-Hungry now prostrate, they invite their own destruction also, being so deeply and inextricably intertwined with their victims by hidden psychic and economic bonds.”

  On June 28, 1919, the Treaty of Versailles was signed by two relatively obscure German officials—one “thin and pink-eyelidded,” the other “moon-faced and suffering,” and both “deathly pale,” according to a British eyewitness. They had good reason to be: Their nation’s economy was wrecked, and its political environment was a fragile coalition of centrists facing ongoing threats from left-wing Bolsheviks and right-wing nationalists alike. Germany had incurred so much debt during the war that coming up with the cash for even the first reparations payment would be tremendously difficult.

  Printing money was the only option. The war debts were denominated in gold, not paper currency. But so long as the currency held some value, it was a quick way to raise funds that could then be converted into gold to pay off the Allies. Havenstein, however, was soon to discover the brutal math of using the printing press to fund a government. As new marks circulated out into the economy, there was more money chasing the same number of goods, so prices rose a little. Each mark was now worth less. To adjust for inflation, the Reichsbank had to print even more marks to fund the same amount of government spending, which created an even steeper rate of inflation.

  Year-to-year price increases weren’t just high; they were exponential. At the end of 1920, a dollar would have bought you 73 marks. At the end of 1921, 192 marks. At the end of 1922, 7,589. In November 1923, that same dollar would have bought you 4.2 trillion marks.

  The catalog of strange anecdotes from the time is extensive. There are the restaurant meals that cost more when the bill came than when they were ordered, the thieves who stole baskets full of money—keeping the baskets and leaving the money behind. The simple act of spending money became burdensome; photographs from the time show people hauling giant suitcases of cash for routine purchases. Communities developed ersatz barter systems. A shoe factory, for example, might pay its workers in bonds for shoes, which they could use to buy food at the bakery or butcher shop. Physical goods—shoes, bread, meat—would, after all, hold their value in a way that paper money wouldn’t. In an effort to offer a stable savings vehicle, the city of Oldenburg offered “rye bills,” bonds whose value matched that of 125 kilograms of rye bread.

  For longer-term savings, people turned to other physical goods, even when they had no need for them. A 1923 report from Augsburg shows individual Germans buying six bicycles, seven or eight sewing machines, two motorcycles, all as means of savings. Pianos were also popular, Bavarian authorities reported, even among those who didn’t play. Workers rushed to spend their paychecks the moment they received them. Bankers became accustomed to doing business in trillion-mark notes; one clerk wrote that inscribing all those zeros “made work much slower and I lost any feeling of relationship to the money I was handling so much of. It had no reality at all, it was just paper.”

  German hyperinflation wiped out the savings of an entire generation of what had been an increasingly prosperous merchant class. A waiter interviewed by Ernest Hemingway said that a year earlier he had saved up enough money to buy a tavern; by that time, in 1923, “that money wouldn’t buy four bottles of champagne.” A British social worker in 1922 wrote that “in well-furnished houses there are chairs devoid of leather which has been used for shoes, curtains without linings which have been turned into garments for the children. This sort of thing is not the exception but the rule.” Strict rent-control laws meant that rents couldn’t keep up with soaring prices, so by the third quarter of 1923 the typical German household paid only 0.2 percent of its income for housing; landlords were essentially bankrupted. But whatever workers saved on rent, they spent on food as farmers hoarded harvests and drove prices up further still—92 percent of their income, up from 30 percent before the war.

  “You could see mail carriers in the streets with sacks on their backs or pushing baby carriages before them, loaded with paper money that would be devalued the next day,” said Erna von Pustau, a German woman who was interviewed by Pearl S. Buck. “Life was madness, nightmare, desperation, chaos.”

  So what on earth was Rudolf von Havenstein thinking? He understood what the fragile German government would face if he cut off its cash: massively higher costs to borrow money, which would force it to slash spending, likely bringing on an economic depression. That, in turn, might bring political revolution. But even if he did have some grand strategy—albeit an unsuccessful one—this accomplished, honorable man stubbornly persisted in viewing the inflation problem as everyone’s fault but his own. It was the fault of the government for running huge budget deficits, he argued—which was true enough, but the inflation only resulted when the Reichsbank printed money to fund those deficits. It was also the fault of currency speculators, who sold marks in hopes of profiting from their decline. And there were plenty of those—but it was the Reichsbank’s policies that proved their bets correct.

  A speech Havenstein gave on August 17, 1923, at the zenith of the hyperinflation, shows the extent of his myopia. “The Reichsbank,” he said, “today issues 20,000 milliard [billion] marks of new money daily. In the next week the bank will have increased this to 46,000 milliards daily. . . . The total issue at present amounts to 63,000 milliards. In a few days we shall therefore be able to issue in one day two-thirds of the total circulation.”

  In a single day, Havenstein would increase the money supply by two thirds—and this, he seemed convinced, was a good thing. He took an almost perverse pride in the Reichsbank’s ability to
conquer the technical problem of producing and distributing such vast sums. “The running of the Reichsbank’s note-printing organization, which has become absolutely enormous, is making the most extreme demands on our personnel,” he said in that August speech. “Numerous shipments leave Berlin every day for the provinces. The deliveries to several banks can be made . . . only by aeroplanes.”

  The streets of Berlin, Munich, and Düsseldorf were thick with discontent, their populations having weathered a decade of misery and ruin and looking for answers wherever they might find them. Communists and fascists competed with each other as beneficiaries of this mass anger. “People just didn’t understand what was happening,” wrote the publisher Leopold Ullstein. “All the economic theory they had been taught didn’t provide for the phenomenon. There was a feeling of utter dependence on anonymous powers—almost as a primitive people believed in magic—that somebody must be in the know, and that this small group of ‘somebodies’ must be a conspiracy.”

  On November 8, 1923, a group of nationalists stormed a beer hall in Munich where high Bavarian officials were gathered. A charismatic young veteran named Adolf Hitler took the stage. “A new national government will be named this very day in Munich!” he said to roars from the crowd. “A new German National Army will be formed immediately. . . . The task of the provisional German National Government is to organize the march on that sinful Babel, Berlin, and save the German people! Tomorrow will find either a National Government in Germany or us dead!” Neither of those things happened after the Beer Hall Putsch. But forces had been unleashed that would shape Europe, and the world, for generations to come.

  Four days later, Finance Minister Hans Luther had had enough of hyperinflation. He summoned Hjalmar Horace Greeley Schacht, a brash and ambitious banker whose father had admired the American abolitionist. Schacht was to become currency commissioner, charged with introducing a new German currency that would, it was hoped, be the reliable store of value that the papiermark was not. From a small, dark former broom closet in the finance ministry, with a single secretary, he worked the phones day and night, hoping to introduce a new currency backed by the nation’s land. Though working just down the street from each other in Berlin, Schacht and Havenstein didn’t speak, and the latter, though physically weak and deluded about his role in the disaster that had befallen the country, refused entreaties to resign.