The Alchemists: Three Central Bankers and a World on Fire

by Neil Irwin

  It wasn’t an issue for long. On November 20, eight days after Schacht began his work, the currency commissioner set an exchange rate: Each newly issued rentenmark would be worth a trillion papiermarks. The new currency would be worth the same against the dollar and the pound and the franc that the old one had been before the war. That very evening, Havenstein collapsed in a meeting, of a heart attack. In a single day, both German hyperinflation and its creator had died.

  • • •

  Wall Street, the writer H. L. Mencken famously said, is a thoroughfare that begins in a graveyard and ends in a river. The symbolic center of the U.S. financial industry may have always connected the Trinity Church cemetery and the East River, but the line never seemed more apt than on October 24, 1929, the day known to history as Black Thursday. Thousands of people descended on the narrow, winding streets of lower Manhattan to gawk; six hundred police officers were dispatched just to contain them. They had showed up to witness the chaos of a mass selloff in a stock market that had seen nothing but buoyant optimism for the decade preceding. Their common expression, one observer wrote, was “not so much suffering as a sort of horrified incredulity.”

  But here’s the thing about Black Thursday: Although it’s remembered as the start of what became the Great Depression, it wasn’t, in the end, all that dark a day. The Dow Jones Industrial Average fell a whopping 20 percent in the initial hours of trading, but as the day progressed, the grandees of American finance gathered at J.P. Morgan & Co.’s headquarters at 23 Wall St. and agreed to intervene. The Dow ended the day down a mere 2 percent. The headline of the next day’s Wall Street Journal read, “Bankers Halt Stock Debacle.”

  But interventions by bankers can only delay a market correction, not stop it. Black Thursday was followed by Black Monday and then Black Tuesday, on which the Dow dropped 13 percent and 12 percent, respectively. Altogether, it was enough to push stocks 40 percent below their all-time highs the previous month, an abrupt reversal for what had become the great American wealth machine.

  The crash of the U.S. stock market was a big deal, of course, and made headlines worldwide. But by all rights it should have been containable. There’s no reason why it should have caused a decline of economic activity in the industrial heartland of Germany or the mass unemployment of coal miners in Britain or a collapse of the global monetary system. The stock crash in New York wasn’t enough to have caused all those things.

  It required the help of a series of analytical misunderstandings and outright failures by the world’s central bankers.

  • • •

  Six years after Hjalmar Schacht fixed the mark, Germany was once again an industrial power on the rise. With a stable currency, factories had started churning again and the stock market had boomed. Berlin in the mid-1920s became a place of prosperity, urbanity, and artistic innovation. With its booming economy and investment opportunities, Germany was among the great destinations for foreign capital. By 1927, in fact, Schacht was getting worried that the economy was overheating, fueled by money flowing in from abroad.

  The central bankers of France and Britain, meanwhile, were grappling with tensions that had emerged between their nations due to the gold standard—as well as a bit of personal animosity. In the 1920s, most of the world’s major economic powers had returned to backing their currencies with gold, a practice they had abandoned to fund World War I. Roughly speaking, the supply of money in a national economy must match the pace of economic growth if prices are to remain stable. A growing economy, then, means an ever-growing need for gold.

  But as growth returned to each of the major industrial nations, miners didn’t suddenly become more productive. London, the prewar capital of world finance, had the gold. The surging economies of France, Germany, and the United States needed it. Those nations bought gold in London to fill their vaults—or more commonly, to make a paper notation that would reassign the ownership of gold permanently stored in the vaults of the Bank of England.

  By 1927, this had created a dilemma for Montagu Norman, the brilliant and eccentric governor of the Bank of England. He faced an unpleasant choice: He could either raise interest rates in a British economy that was failing to recover from its wartime doldrums, tightening the national money supply and thereby slowing growth and encouraging unrest. Or he could risk a crisis of the pound, if people lost confidence that Britain could keep its currency pegged to gold.

  The dilemma was compounded by Norman’s miserable relationship with his counterpart in Paris, Banque de France governor Émile Moreau, who had made life difficult for the British by hoarding huge quantities of gold. The divide between Norman and Moreau was deeper than mere policy disputes. Moreau spoke no English and Norman spoke fluent French, yet Norman insisted that their discussions occur in his native tongue. At their very first meeting, in 1926, Moreau concluded that Norman was “an imperialist seeking the domination of the world for his country which he loves passionately” and “not a friend to us French.” Norman left with the impression that Moreau was “stupid, obstinate, devoid of imagination and generally of understanding but a magnificent fighter for narrow and greedy ends.” They were even physical opposites. As author Liaquat Ahamed put it, the tall, distinguished, even dandyish Norman contrasted sharply with the Frenchman, who was “short, squat, and bald, looking like a provincial notary out of a novel by Flaubert.”

  At the Federal Reserve, the conflict wasn’t with one of the other central banks, but within the Fed system itself. Today, the powers and responsibilities of the various parts of the Fed—its presidentially appointed Board of Governors in Washington, its powerful New York branch, the eleven other reserve banks scattered around the country—are well understood, and Washington is clearly in charge. In the 1920s, however, the lines were fuzzier. Benjamin Strong, the president of the New York Fed, led a secret meeting with Schacht, Norman, and Moreau’s deputy on a Long Island estate in 1927—but he pointedly didn’t invite anyone from the Board of Governors. He believed that managing international economic relationships was his sole concern. The position of chairman of the Board of Governors, later to be held by the likes of Alan Greenspan and Ben Bernanke, was viewed as so weak that Roy Young left the job in 1930 to become president of the Boston Fed.

  Strong died in 1928 and was replaced by George L. Harrison, a young, patrician lawyer. Harrison engineered a series of interventions during the October 1929 stock market crash, only to be overruled by his colleagues in Washington. The next week, he and the New York Fed made an overnight decision to inject $50 million into the financial markets without even seeking permission from Washington—which earned a rebuke from Young. With the U.S. financial system in crisis, the Federal Reserve, created to deal with just such an event, was paralyzed by internal power struggles.

  The global financial system constructed by Benjamin Strong, Émile Moreau, Montagu Norman, and Hjalmar Schacht had brought the world years of prosperity. But both the economic conception on which it was based, the gold standard, and the institutions and individuals charged with managing it were more feeble and fragile than anyone had imagined.

  • • •

  As news of the Wall Street crash traveled around the world, investors pulled their money out of both New York’s banks and other stock markets. In the United States, the impact was surprisingly large, with industrial production falling 11 percent in just two months. But the path to global depression was a winding one. Things actually seemed to be on the mend by early 1930, as the Federal Reserve responded to the market crash by easing credit, cutting the discount rate from 6 percent to 2.5 percent. Harrison argued for deeper, faster rate cuts, but the New York Fed president was held back by his colleagues in Washington and, even more so, at several of the other reserve banks around the country.

  Those officials viewed the crash in moralistic terms, as the inevitable consequence of the boom that had preceded it—a hangover, in essence, that was punishment for a nation that
had overindulged. It would be “inexpedient to exhaust at the present time any part of our ammunition in an attempt to stimulate business when it is perhaps on a downward curve . . . in a vain attempt to stem an inevitable recession,” said the Fed’s Open Market Committee in its official statement of January 1930. After all, it would be over soon enough, and the worst was already in the past. “Undoubtedly for a time we were in a serious condition,” said Fed governor Charles S. Hamlin in a speech in May 1930. “Fear,” however, “was at once dispelled and calm judgment and intelligent effort came to the front. I can see the dawn of normal activity, and believe the sun will soon rise.”

  At first, the impact of the crash in Europe seemed small—stock prices in London and Paris fell, but far less than they had in New York. But failures of policy turned that small shock into something much larger. The German economy had been fueled by investment from the United States, so the collapse on Wall Street had an outsized impact on growth in Germany, leading to an economic contraction in late 1929 and early 1930. The country had an unemployment insurance program that was budgeted to assist 800,000 jobless people at any given time. But the slumping global economy had put 1.9 million Germans out of work by early 1930.

  The government was inclined to pay for the extra obligations by running a budget deficit. Schacht would have none of it, though, viewing deficit spending as the route back to the hyperinflation of the early 1920s. He publicly accused the government of bungling its finances, and the government listened. Germany balanced its budget by raising a wide variety of taxes—not just on income, but also on warehouses, mineral water, and beer. Instead of counteracting the negative effects of the U.S. crash, the German government’s policies slowed the economy further.

  The old pattern between Britain and France, meanwhile, was becoming even more destructive. With the United States and Germany entering a severe recession and Britain avoiding one thanks only to the aggressive interest rate cutting of the Bank of England, comparatively prosperous France was enjoying massive inflows of gold. With more and more of the metal in French hands, central banks in other nations had less and less ability to increase the supply of money if things got worse.

  Then things got worse.

  The U.S. stock market crash set in motion what Ben Bernanke would later call the financial accelerator. Banks suffered losses from the crash and thus pulled back on lending. Less lending meant weaker economic growth. A weaker economy meant further bank losses—and so on. The distinguished gentlemen of the Federal Reserve, meanwhile, looked at an economy getting steadily worse—unemployment was about 9 percent in 1930, up from 3 percent in 1929—and drew exactly the wrong conclusion. Their interventions in late 1929 to try to encourage growth had failed. To redouble those efforts, they concluded, would be foolhardy. Federal Reserve banks “have ample reserves and stand ready to finance a growing volume of business as soon as signs of recovery express themselves in an increasing demand for credit,” said Charles Hamlin, a Fed governor who had been the first chairman of the central bank, in November 1930. In other words, the Fed is ready to pump money into the banking system—but only once conditions improve.

  Hamlin said this in a month in which 256 U.S. banks failed, unable to repay their depositors. In December, it was 352 more, including the gigantic Bank of the United States. As the banking system collapsed, millions of Americans lost their savings and the supply of money in the economy shrank. The Fed and President Herbert Hoover stood by and watched and hoped. In 1931, the unemployment rate climbed to 16 percent. In 1933, it reached 25 percent.

  The banking crisis spread to Europe when Credit-Anstalt, one of Vienna’s largest and most important banks, failed spectacularly in May 1931, as years of lending for questionable projects caught up with it. The Austrian government guaranteed the bank’s deposits—and suddenly found its own creditworthiness in question. The global bank run was on. If Credit-Anstalt could collapse, what about similarly overextended banks in Amsterdam and Warsaw? Or in Frankfurt and Munich?

  When large-scale withdrawals began at the major German banks, the Reichsbank was in an impossible position. A collapse of the German banking system would be a catastrophe for the economy. Yet for the central bank to backstop the system would mean expanding the money supply at a time when its gold reserves were already dwindling. That would require abandoning the gold standard in a nation with fresh memories of the bad things that can happen when a currency is backed only by the credibility of the government.

  The only option open for Hans Luther, Schacht’s successor as head of the Reichsbank, was to go to his neighbors and ask for help, hat in hand. On July 9, 1931, Luther boarded a private plane from Berlin. He met with Dutch officials in Amsterdam, then with Montagu Norman and other British officials at the Croydon Aerodrome, London’s main airport in the days before Heathrow. But there was only one country with the resources to backstop the German banking system, only one that had experienced massive inflows of gold over the previous five years: France, the nation that Germany had supplanted as the great European power leading up to the war, and the one most eager to punish Germany at Versailles.

  Luther went to Paris and pleaded his case. But years—centuries, really—of resentment and fear stood in the way. The French would make the sorts of massive loans that Germany needed to avert economic collapse only if it could extract its pound of flesh: a ban on nationalistic political activity, abandonment of plans to build battleships, a closer union with Austria. It was a deal that Germany couldn’t accept.

  Luther’s last, desperate attempt at a deal was to travel to Basel to plead his case to the Bank for International Settlements (BIS), which had been created only a year before. Then, as now, central bankers’ weekends in Basel were filled with delicious food and wine and a rare opportunity for brotherhood. Norman had played a crucial role in creating the organization, and had “made the central banker into a kind of archpriest of monetary religion,” as a BIS executive once said, with other central bankers flocking to his room to meet. It was for Norman, as biographer Andrew Boyle wrote, “a spiritual home away from home.” But efforts to craft a coherent international policy among the central banks were hobbled.

  There was no common framework for understanding what was happening in the global economy, so the bankers all had different understandings of the causes of the disaster. Reliable economic data was sparse in most countries. The absence of jet travel made regular participation by U.S. and Japanese officials all but impossible, so Basel was overwhelmingly a European club. And the Americans weren’t even allowed to participate initially: The U.S. government, always skeptical of international entanglements, forbade the Federal Reserve from becoming a member of the BIS. The crisis facing Germany in the summer of 1931 was, Norman concluded, just “too big for the central banks.”

  The seeds of World War II were planted on the day Hans Luther finally ran out of potential saviors, July 13, 1931. Had the Germans and French been able to work out a deal, it might well have prevented all-out economic collapse and steered Germany away from nationalism and militarism. Instead, the Reichsbank hiked interest rates to try to maintain the gold standard. A two-day “bank holiday” was declared and foreign exchange controls put in place to reduce outflows. Unemployment soared to 34 percent. So did hostility to the French and to most other non-Germans. The Nazis went from fringe party to ruling power. Even clever, urbane Hjalmar Schacht became an ally of Hitler, serving as a top economic official throughout the 1930s. (He would turn away from the Nazis as their anti-Semitism became more pronounced, and he collaborated with the anti-Hitler resistance during World War II.) The vision of a peaceful, democratic Germany crashed against the rocks of a monetary system with no give, no flexibility.

  In Britain, the squeeze created by the gold standard similarly became too much to bear. The collapse of the German banking system only heightened fears that the London banks would be next, and withdrawals began on a vast scale. The British government its
elf had to turn to J.P. Morgan and other American banks for an emergency loan. Like the Reichsbank, the Bank of England would have to hike interest rates to try to maintain the value of the pound relative to gold and stop outflows—which would further slow the economy at a time when unemployment already topped 20 percent. As Keynes told a group of parliamentarians privately, “I declare to you, and I will stake on it any reputation I have, that we have been making in the last few weeks as dreadful errors of policy as deluded statesmen have ever been guilty of.”

  Montagu Norman’s deputies—Norman himself was suffering from one of his periodic bouts of illness and was on a ship in the middle of the North Atlantic—concluded that they had no choice but to abandon the gold standard. Norman, the great central banker of his age, received a cable on his ship back from Canada that read, “Sorry we have to go off tomorrow and cannot wait to see you before doing so.” Norman interpreted this to mean that his deputy, Sir Ernest Harvey, wouldn’t be greeting him on his return. In fact, it meant that the Bank of England was going to go off the gold standard. Keynes, a friend remembered, was “chuckling like a boy who has just exploded a firework under someone he doesn’t like.”