Some of these features were changed by subsequent legislation in the 1930s, which centralized power in the Board of Governors of the Federal Reserve in Washington, D.C., where it resides today. In more recent years the board has been dominated not by bankers but by academic economists and lawyers who ironically seem even more favorably disposed toward easy money and bailouts than the bankers. Yet, at least through the 1920s, the Fed “system” was dominated by the New York Fed under the firm hand of its first governor, Benjamin Strong, who ran the bank from 1914 until he died in 1928. Strong was a protégé of Morgan partner Henry Davison as well as of J. P. Morgan himself. Thus the circle of Morgan influence on the new central bank of the United States was complete.
History has its echoes. Decades after the Jekyll Island meeting, Frank Vanderlip’s National City Bank and Charles Norton’s First National Bank merged to become the First National City Bank of New York, which later shortened its name to Citibank. In 2008, Citibank was the recipient of the largest bank bailout in history, conducted by the U.S. Federal Reserve. The foundation laid by Vanderlip and Norton and their associates on Jekyll Island in 1910 would prove durable enough to bail out their respective banks almost one hundred years later exactly as intended.
World War I and the Treaty of Versailles—1914 to 1919
The last of the antecedents of Currency War I was the sequence of the Great War, the Paris Peace Conference and the Treaty of Versailles.
World War I ended not with surrender but with an armistice, an agreement to stop fighting. With any armistice, the expectation is that the cessation of hostilities will allow the parties to negotiate a peace treaty, but in some cases the negotiations break down and fighting resumes. Negotiation of a lasting peace was the objective of the Paris Peace Conference of 1919. England and France were well aware that the financial bill for the war was about to be presented. They saw the Paris Peace Conference as an opportunity to impose these adjustment costs on the defeated Germans and Austrians.
However, a successful negotiation in Paris was by no means a foregone conclusion. Although the German army and navy were definitely beaten by November 1918, as of the spring of 1919 no peace treaty had been concluded and it seemed increasingly unlikely that the Allies would be willing or able to resume the war. Therefore the reparations negotiations were just that: negotiations. The Allied ability to dictate terms had withered between November 1918 and March 1919, when the subject was taken up. Now Germany would have to be prevailed upon to agree to any plan the Allies devised.
The size and nature of German reparations were among the most vexing questions facing the Paris Peace Conference. On the one hand, Germany would be asked to cede territory and some industrial capacity. On the other hand, the more Germany gave up, the less able it would be to pay financial reparations that were also being demanded. France had its eye on German gold, which in 1915 had amounted to over 876 metric tons, the fourth largest hoard in the world after the United States, Russia and France.
While these reparations are often thought of solely in terms of how much Germany could afford to pay the Allies, the picture was considerably more complicated, as both the winners and the losers were in debt. As Margaret MacMillan writes in her book Paris 1919, both Britain and France had loaned vast amounts to Russia, which defaulted in the wake of the Russian Revolution. Other debtors, such as Italy, were unable to repay. Yet Britain owed $4.7 billion to the United States, while France owed $4 billion to the United States and another $3 billion to Britain. Virtually none of the debtor nations could afford to repay. The entire mechanism of credit and trade was frozen.
The issue was not just one of German reparations to the Allies but of a complex web of inter-Allied loans. Something was needed to reprime the pump and get credit, commerce and trade moving again. The optimal approach was to have the strongest financial power, the United States, begin the process with new loans and guarantees on top of those already provided. This new liquidity, combined with a free trade area, might have encouraged the growth needed to deal with the debt burdens. Another approach, also with much to recommend it, was to forgive all the debts and start the game over. While it would be difficult for France to forgive Germany, it would be a relief for France to be forgiven by the United States: the net effect on France would have been positive because the United States was more persistent as a creditor than Germany was reliable as a debtor. In fact, none of these things happened. Instead the stronger, led by England and France, prevailed upon the weaker, primarily Germany, to pay punitive reparations in cash, in kind and in gold.
Calculation of the reparations and agreement on a mechanism by which reparations would be paid was a nearly impossible task. France, Belgium and England wanted to base reparations on actual war damages, while the United States was more inclined to consider Germany’s ability to pay. The German statistics, however, were abysmal and no reliable calculation of their ability to pay could be made. The assessment of damages was also impossible in the short run. Many areas were barely accessible, let alone amenable to some sort of appraisal of needed reconstruction.
The Allies argued as much among themselves as they did with German representatives about whether reparations should be limited to actual damages, which favored France and Belgium, or should include purely financial costs such as pensions and soldiers’ salaries, which would favor England. In the end, no exact amount of reparations was specified in the Treaty of Versailles. This was the result of the technical impossibility of calculating a number and the political impossibility of agreeing to one. Any figure high enough to enjoy domestic approval in England and France might have been too high for the Germans to agree to and vice versa. American admonitions for moderation and practicality were largely ignored. Domestic politics triumphed over international economic needs. Instead of a specific number, expert panels were empowered to continue studying the question and make specific findings in the years ahead, which would form the basis for actual reparations. This bought time, but the hard issues on reparations were put off only to become entangled during the 1920s with the gold exchange standard and efforts to restart the international monetary system. Reparations were like an albatross hung around the neck of the international financial system for the next fifteen years.
Conclusion
By 1921, the table was set for the first modern currency war. The classical gold standard had acted as an intellectual magnet, a monetary North Star that framed the debate over what kind of system was needed in the 1920s to restart international capital flows and world trade. World War I and the Treaty of Versailles introduced a new element, not predominant in the gold standard age, of massive, interlocking and unpayable sovereign debts, which imposed an insurmountable obstacle to normalized capital flows. The creation of the Federal Reserve System and the role of the New York Fed in particular heralded the arrival of the United States on the international monetary scene as the dominant player and not just another participant. The potential for the Fed to reliquify the system through its own money printing efforts was just coming into full view. By the early 1920s, nostalgic affection for the prewar classical gold standard, tension over unpayable reparations and uncertainty about the money power of the Federal Reserve all conditioned the creation of a new international monetary system and the course of Currency War I.
CHAPTER 4
Currency War I (1921–1936)
“There is hardly a part of the United States where men are not aware that secret private purposes and interests have been running the government.”
President Woodrow Wilson
Currency War I began in spectacular fashion in 1921 in the shadow of World War I and wound down to an inconclusive end in 1936. The war was fought in many rounds and on five continents and has great resonance for the twenty-first century. Germany moved first in 1921 with a hyperinflation designed initially to improve competitiveness and then taken to absurd lengths to destroy an economy weighed down by the burden of war reparations. France moved next in 1925 by deva
luing the franc before returning to the gold standard, thus gaining an export edge on those like England and the United States who would return to gold at a prewar rate. England broke with gold in 1931, regaining the ground lost to France in 1925. Germany was boosted in 1931 when President Herbert Hoover placed a moratorium on war reparations payments. The moratorium became permanent as a result of the 1932 Lausanne Conference. After 1933 and the rise of Hitler, Germany increasingly went its own way and withdrew from world trade, becoming a more autarkic economy, albeit with links to Austria and Eastern Europe. The United States moved in 1933, also devaluing against gold and regaining some of the competitive edge in export pricing lost to England in 1931. Finally it was the turn of France and England to devalue again. In 1936, France broke with gold and became the last major country to emerge from the worst effects of the Great Depression while England devalued again to regain some of the advantage it had lost against the dollar after FDR’s devaluations in 1933.
In round after round of devaluation and default, the major economies of the world raced to the bottom, causing massive trade disruption, lost output and wealth destruction along the way. The volatile and self-defeating nature of the international monetary system during that period makes Currency War I the ultimate cautionary tale for today as the world again confronts the challenge of massive unpayable debt.
Currency War I began in 1921 in Weimar Germany when the Reichsbank, Germany’s central bank, set about to destroy the value of the German mark through massive money printing and hyperinflation. Presided over by Reichsbank head Dr. Rudolf von Havenstein, a Prussian lawyer-turned-banker, the inflation proceeded primarily through the Reichsbank’s purchases of bills from the German government to supply the government with the money needed to fund budget deficits and government spending. This was one of the most destructive and pervasive monetary debasements ever seen in a major developed economy. A myth has persisted ever since that Germany destroyed its currency to get out from under onerous war reparations demanded by England and France in the Treaty of Versailles. In fact, those reparations were tied to “gold marks,” defined as a fixed amount of gold or its equivalent in non-German currency, and subsequent treaty protocols were based on a percentage of German exports regardless of the paper currency value. Those gold- and export-related specifications could not be inflated away. However, the Reichsbank did see an opportunity to increase German exports by debasing its currency both to make German goods more affordable abroad—one typical reason for a debasement—as well as to encourage tourism and foreign investment. These methods could provide foreign exchange needed to pay reparations without diminishing the amount of reparations directly.
As inflation slowly began to take off in late 1921, it was not immediately perceived as a threat. The German people understood that prices were going up, but that did not automatically translate into the equivalent notion that the currency was collapsing. German banks had liabilities nearly equal to their assets and so were largely hedged. Many businesses owned hard assets such as land, plant, equipment and inventories that gained nominal value as the currency collapsed and therefore were also hedged. Some of those companies also owed debts that evaporated as the amounts owed became worthless, and so were enriched by being relieved of their debts. Many large German corporations, predecessors of today’s global giants, had operations outside of Germany, which earned hard currency and further insulated their parent companies from the worst effects of the collapse of the mark.
Capital flight is a traditional response to currency collapse. Those who could convert marks into Swiss francs, gold or other stores of value did so and moved their savings abroad. Even the German bourgeoisie was not immediately alarmed as losses in the value of their currency were offset by stock market gains. The fact that these gains were denominated in soon to be worthless marks had not yet occurred to many. Finally, those who held unionized and government jobs were initially hedged as well because the government simply granted wage increases commensurate with inflation.
Of course, not everyone had a government or union job, stock portfolio, hard assets or foreign operations to insulate them. Those most devastated were middle-class pensioners who no longer qualified for raises and savers who kept their funds in banks rather than stocks. These Germans were completely financially ruined. Many were forced to sell their furniture to raise a few marks to pay for food and keep going. Pianos were particularly in demand and became a form of currency on their own. Some elderly couples whose savings had been destroyed would go into the kitchen, hold hands, place their heads in the oven and turn on the gas in a poignant form of suicide. Property crime became rampant and, in the later stages, riots and looting were common.
In 1922, the inflation turned to hyperinflation as the Reichsbank gave up trying to control the situation and printed money frantically to meet the demands of union and government workers. A single U.S. dollar became so valuable thatAmerican visitors could not spend it because merchants could not locate the millions of marks needed to make change. Diners offered to pay for meals in advance because the price would be vastly higher by the time they finished eating. The demand for banknotes was so great that the Reichsbank engaged numerous private printing firms and used special logistics teams in order to obtain enough paper and ink to keep the printing presses rolling. By 1923, the notes were being printed on one side only to conserve ink.
With economic chaos reigning, France and Belgium invaded the German industrial region of the Ruhr Valley in 1923 in order to secure their interests in reparations. The invasion enabled the occupiers to obtain payment in kind through shipments of manufactured goods and coal. The German workers in the Ruhr responded with work slowdowns, strikes and sabotage. The Reichsbank rewarded the workers and encouraged their resistance by printing more money for higher wages and unemployment benefits.
Germany finally attempted to halt the hyperinflation in November 1923 by creating an alternate currency, the rentenmark, which initially circulated side by side with the paper mark. The rentenmark was backed by mortgages and by the ability to tax the underlying properties. Their issuance and circulation were carefully managed by the newly appointed currency commissioner, Hjalmar Schacht, a seasoned private banker who would soon replace von Havenstein as head of the Reichsbank. When the final collapse of the mark came shortly after the rentenmark was introduced, one rentenmark was roughly equal to one trillion marks. The rentenmark was a temporary fix and was soon replaced by a new reichsmark backed directly by gold. By 1924, the old hyperinflated paper marks were literally being swept away into dustbins, drains and sewers.
Economic historians customarily treat the 1921–1924 hyperinflation of the Weimar Republic separately from the worldwide beggar-thy-neighbor competitive devaluations of 1931–1936, but this ignores the continuity of competitive devaluations in the interwar period. The Weimar hyperinflation actually achieved a number of important political goals, a fact that had repercussions throughout the 1920s and 1930s. Hyperinflation unified the German people in opposition to “foreign speculators” and it forced France to show its hand in the Ruhr Valley, thus creating a case for German rearmament. Hyperinflation also evoked some sympathy from England and the United States for alleviation of the harshest demands for reparations emanating from the Versailles Treaty. While the collapse of the mark was not directly linked to the value of reparations payments, Germany could at least argue that its economy had collapsed because of hyperinflation, justifying some form of reparations relief. The currency collapse also strengthened the hand of German industrialists who controlled hard assets in contrast to those relying solely on financial assets. These industrialists emerged from the hyperinflation more powerful than before because of their ability to hoard hard currency abroad and buy up assets of failed enterprises on the cheap at home.
Finally, the hyperinflation showed that countries could, in effect, play with fire when it came to paper currencies, knowing that a simple resort to the gold standard or some other tangible asset
such as land could restore order when conditions seemed opportune—exactly what Germany did. This is not to argue that German hyperinflation in 1922 was a carefully thought-out plan, only that hyperinflation can be used as a policy lever. Hyperinflation produces fairly predictable sets of winners and losers and prompts certain behaviors and therefore can be used politically to rearrange social and economic relations among debtors, creditors, labor and capital, while gold is kept available to clean up the wreckage if necessary.
Of course, the costs of hyperinflation were enormous. Trust in German government institutions evaporated and lives were literally destroyed. Yet the episode showed that a major country with natural resources, labor, hard assets and gold available to preserve wealth could emerge from hyperinflation relatively intact. From 1924 to 1929, immediately after the hyperinflation, German industrial production expanded at a faster rate than any other major economy, including the United States. Previously countries had gone off the gold standard in times of war, a notable example being England’s suspension of gold convertibility during and immediately after the Napoleonic Wars. Now Germany had broken the link to gold in a time of peace, albeit the hard peace of the Versailles Treaty. The Reichsbank had demonstrated that in a modern economy a paper currency, unlinked to gold, could be debased in pursuit of purely political goals and those goals could be achieved. This lesson was not lost on other major industrial nations.
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