Lords of Finance

by Liaquat Ahamed

  Britain was therefore the only major country that truly faced the choice between devaluation and deflation. To a modern observer, less wedded to the principle that currency rates are sacrosanct, some measure of devaluation would have made sense. After all, Britain was finding it harder to compete in the postwar world economy and, having liquidated vast amounts of its holdings abroad, could only draw upon a much reduced foreign income to cushion the blow. Its exchange rate should have been allowed to fall as a means of making its goods cheaper on world markets.

  However, Norman and his generation lived in a different mental world. They saw devaluation not as an adjustment to a new reality but as something more, a symptom of financial indiscipline that might precipitate a collective loss of confidence in all currencies. When people talked of the City of London as banker to the world, this was no mere figure of speech—the City operated literally like a gigantic bank, taking deposits from one part of the world and lending to another. While gold was the international currency par excellence, the pound sterling was viewed as its closest substitute, and most trading nations—the United States, Russia, Japan, India, Argentina—even kept part of their cash reserves in sterling deposits in London. The pound had a special status in the gold standard constellation and its devaluation would have rocked the financial world.

  In the last months of the war, the British government set up a commission, chaired by the ubiquitous Lord Cunliffe, only recently departed from the Bank of England, and including Sir John Bradbury of the UK Treasury; A. C. Pigou, professor of political economy at Cambridge; and ten bankers from the City, to review postwar currency arrangements. Twenty-three parties gave evidence before the commission, every one of them, with not single note of dissent, in favor of a return to gold at the prewar rate. To a man, they believed the restoration of the traditional parity was essential if Britain was to retain its position at the hub of the world’s banking system.

  The model they had in mind, which was especially seared into the collective memory of the Bank of England, was Britain’s experience a century earlier after the Napoleonic Wars. In 1797, four years into the Revolutionary war with France, there was a run on the Bank of England, provoked by rumors that a French army had landed in Wales. The Bank, which had begun the war with gold reserves of £9 million, saw them shrink to £1 million, and was forced, as it would be in 1914, to abandon the gold standard. Under the pressures of war finance, Bank of England notes, which formed the basis for paper money in the country, increased over the next fifteen years from £10 million to over £22 million, doubling prices.

  In 1810, a parliamentary inquiry known as the Bullion Committee was formed to examine the whole issue. The committee included Henry Thornton, a banker, parliamentarian, brother to a director of the Bank of England, and the most creative monetary economist of the nineteenth century, whose insights would unfortunately be lost by succeeding generations in charge at the Bank. The committee recommended that the Bank resume gold payments as soon as possible, and in order to achieve this goal, begin to contract its credits to banks and merchants and shrink the supply of paper money by withdrawing its notes from circulation. The Bank wisely waited until 1815, when a defeated Napoléon was safely in exile on St. Helena, before taking this advice. Over the next six years, it almost halved the supply of paper money in Britain, driving down prices by 50 percent. And though those years from 1815 to 1821 had been years of riots and agricultural distress, Britain went back on gold in 1821. Over the subsequent half century, it transformed itself into the world’s largest economic power. Many believed that the “resumption” of 1821 had been the single most important defining decision in its financial history. That the Bank had been willing to inflict the pain of a 50 percent fall in prices in order to restore the gold value of the pound had set sterling apart from every other currency in Europe, and made it the world’s premier store of value.

  Inspired by this example—and in complete contrast to every other European country—in 1920, the Bank of England chose the path of deflation, matching the Fed and raising interest rates to 7 percent. The budget was balanced. The economy plunged into sharp recession, two million men were thrown out of work. Nevertheless, by the end of 1922, the Bank had succeeded in bringing prices down by 50 percent, and the pound, which had fallen as low as $3.20 in the foreign exchange market on the fear that Britain was headed for devaluation, climbed back to within 10 percent of its prewar parity of $4.86.

  But whereas the U.S. economy, more dynamic and unhampered by a large internal debt, was quickly able to bounce back from the recession, Britain remained stuck. The number of unemployed would not fall below one million for the next twenty years. It soon became apparent that Britain had sustained terrible damage as an economic power during the war. Industries such as cotton, coal, and shipbuilding, in which it had once led the world, had failed to modernize and the traditional markets had been lost to competitors. Labor costs had risen as unions negotiated shorter working hours.

  Norman now faced the uneasy prospect that the only way to follow the example set by his forerunners—his grandfather joined the Court the year of “resumption”—was by keeping unemployment high. But while before the war it might have been politically acceptable to create unemployment deliberately in order to support the currency, in the charged climate after the war—with Lloyd George promising the electorate “a land fit for heroes”—Norman would find himself constantly under pressure to find an alternative.

  THE problem of resurrecting the gold standard went much deeper than selecting new exchange rates for the key currencies, for the war had brought about such a tectonic shift in the distribution of gold reserves that it seemed to threaten the very viability of a monetary system resting on gold.

  Before the war, the four largest economies—the United States, Britain, Germany, and France—had operated their monetary systems with about $5 billion worth of gold among them. The amount of new gold mined during the war was small, and by 1923, monetary gold had increased only to $6 billion. Meanwhile, prices in the United States and the UK, even after the postwar deflation, were still 50 percent higher than before the war, which meant that in effect the real purchasing power of gold reserves had contracted by almost 25 percent.

  FIGURE 2

  In 1922, Norman worked with officials at the British Treasury to develop a plan whereby some of the European central banks would, as did many countries in the British Empire, hold pounds rather than gold as their reserve asset—in much the same way that many central banks hold dollars nowadays. He argued that substituting pounds for gold would allow the world to economize on the precious metal and thus reduce the risk of worldwide shortage. Few people failed to notice that by creating a captive source of demand for sterling, the plan would add to its privileged position in the constellation of currencies and greatly ease his job of returning the pound to gold. The plan never really did take off, except in a few minor Central European countries.

  The bigger concern among bankers after the war was not so much that the world was short of gold, but that too much of the gold was concentrated in the United States. Before the war, there had been some parity among the major economic powers between the amount of gold in each banking system and the size of its economy. For example, the United States, with a GDP of $40 billion, accounted for about half the output of the four great economic powers and held about $2 billion in gold, a little less than half of the total gold of these four countries. The balance was only rough and ready—France held proportionately more and Britain less—but the system worked with remarkable smoothness.

  By 1923, the United States had accumulated close to $4.5 billion of the $6 billion in gold reserves of the four major economic powers, far in excess of what it needed to sustain its economy. About $400 million circulated in the form of coins; the remainder consisted of ingots, small bars the size of a quart of milk, each weighing about twenty-five pounds, stored in the vaults of the Federal Reserve Banks and the Treasury. The largest hoard lay under
lower Manhattan, about $1.5 billion in the Treasury repository at the legendary intersection of Broad and Wall Streets, and at the New York Fed. The remainder was scattered among the eleven other Federal Reserve Banks across the country.20 By one estimate, excess gold reserves in the United States amounted to about a third of its holdings, roughly $1.5 billion.

  While the U.S. monetary system was swamped by this enormous surplus, Europe, particularly Britain and Germany, suffered a chronic shortage. The three big European economies, which had operated before the war on $3 billion worth of gold, were left with barely half that. Faced with constant demands to pay out gold, European central banks had resorted to a complex of measures, the most important being to withdraw gold coins from circulation. All those solid talismans of turn-of-the-century middle-class prosperity had gradually disappeared from Europe’s pockets, to be replaced by shabby pieces of paper. By the mid-1920s, the United States was the only large country where one could still find gold coins.

  The concentration of the world’s key precious metal in the United States had left the rest of the world with insufficient reserves to grease the machinery of trade. The world of the international gold standard had become like a poker table at which one player has accumulated all the chips, and the game simply cannot get back into play.

  ONE MAN WHO had no difficulty liberating himself from the strictures of the gold standard was John Maynard Keynes. After the Peace Conference, he had gone back to teaching at Cambridge. But following the resounding success of The Economic Consequences of the Peace, he reduced his involvement with the university and became increasingly caught up on the grander stage of world affairs. He joined the board of an insurance company and became chairman of the weekly British magazine the Nation, for which he wrote regular pieces, as he did for the Manchester Guardian, articles that were syndicated around the world, including in the U.S. weekly the New Republic. And he began making his fortune as a currency speculator.

  In 1919, it was a novel way of making money. Before 1914, currencies had been fixed, and opportunities to profit from the instability of exchange rates had been almost nonexistent. In the aftermath of the war, as exchange rates of the major currencies lurched up and down, it became possible to make large returns—and also lose equally large amounts—by betting on the direction of such moves. In the latter half of 1919, convinced that the inflationary consequences of the war would undermine the currencies of the main belligerents, Keynes went short on the French franc, the German Reichsmark, and the Italian lira, buying the currencies of countries that had sat out most of the war: the Norwegian and the Danish kroner, the U.S. dollar, and interestingly enough, the Indian rupee. He made $30,000 in the first few months. In early 1920, he set up a syndicate, with his brother, some of the Bloomsbury circle, and a financier friend from the City of London. By the end of April 1920, they had made a further $80,000. Then suddenly, in the space of four weeks, a spasm of optimism about Germany briefly drove the declining European currencies back up, wiping out their entire capital. Keynes found himself on the verge of bankruptcy and had to be bailed out by his tolerant father. Nevertheless, propped up by his indulgent family and by a loan from the coolly acute financier Sir Ernest Cassel, he persevered in his speculations—built for the most part around the view that the German and Central European currencies were headed for disaster. By the end of 1922, he had amassed a modest nest egg of close to $120,000.

  But by far the most important development in his life was that he had fallen in love—this time with a woman, Lydia Lopokova, a married Russian émigrée ballerina, no less. The daughter of a Russian father, an usher at the Imperial Alexandrinsky Theater, and a Scottish-German mother, Lydia came from a family of dancers—her two brothers and a sister had also gone to the Imperial Ballet School in St. Petersburg. When Maynard met her in 1918, she was traveling with the Diaghilev Ballet, having spent seven years in the United States as a cabaret artist, model, and vaudeville performer, and was married to the business manager of the company, Randolfo Barrochi. After her marriage broke down, she disappeared into Russia, then in the thick of civil war, with a mysterious White Russian general, but reappeared in Keynes’s life at the end of 1921.

  Though they would not get married until 1925 when her divorce finally came through, they began living together in 1923. They made an unlikely couple—he a brilliant and all too cerebral intellectual with a genius for exposition, she an unpredictable artist with a risqué past, a flighty and vivacious chatterbox with an equal skill for stumbling into the most memorable malapropisms. She once complained that she “disliked being in the country in August, because my legs get so bitten by barristers.” On another occasion, after visiting an aviary, she remarked on her hostess’s “ovary.” And though the rest of Bloomsbury looked down on her, Keynes was to remain completely enchanted with her for the rest of his life.

  In December 1923, Keynes published a short monograph, A Tract on Monetary Reform, much of which had already appeared as a series of articles in the Manchester Guardian during 1922 and early 1923—his first systematic attempt to unravel the sources and consequences of the chronic monetary instability that plagued the postwar world. Like his earlier book, A Tract was a strange hybrid, this time a half-theoretical treatise—with sections on “The Theory of Purchasing Power Parity” and “The Forward Market in Exchanges” and half pamphlet for the laity. It was, however, very different in tone from The Economic Consequences. That had been an angry, passionate work, written in the heat of debate and controversy. This one had a lighter touch, a “tentative almost diffident tone,” as if the author himself were searching for the answer to the quest for monetary stability.

  Before the war, however much he had enjoyed challenging conventional nostrums about morality, conduct, and society, in economics Keynes had fully embraced the liberal orthodoxy that dominated his still nascent profession. He believed in free trade, in the unfettered mobility of capital, and in the virtues of the gold standard.

  There were times when, like so many other economists, he might speculate whether gold was the right foundation for money. But those had been largely theoretical ruminations; and ultimately, when it came down to it, there seemed no other practical basis so tried and tested upon which to organize the world’s currencies. Asked at the height of the 1914 crisis to brief the chancellor of the exchequer as to whether the pound should remain tied to gold, he had come down very strongly in favor of maintaining the link: “London’s position as a monetary center depends very directly on complete confidence in London’s unwavering readiness” to meet its obligations in gold and would be severely damaged if “at the first sign of emergency” that commitment was suspended.

  Even during the first years after the war, he was still advocating a return to gold. But the shift in the world’s economic landscape was beginning to give him doubts. He still believed that the prime goal of central bank policy should be to keep prices broadly stable. But whereas before the war he had thought that the best way to achieve this was to ensure that currencies such as the pound be fully convertible to gold at a fixed value, he had now come to believe that there was no reason why linking money supply and credit to gold should necessarily result in stable prices.

  The gold standard had only worked in the late nineteenth century because new mining discoveries had fortuitously kept pace with economic growth. There was no guarantee that this accident of history would continue. Moreover, while the original rationale for a gold standard—the commitment that paper money could be converted into something unequivocally tangible—might have been necessary to instill confidence at some point in history, this was no longer the case. Attitudes toward paper money had evolved and it was not necessary to allow the supply of precious metals to regulate the creation of credit in a sophisticated modern economy. Central banks were perfectly capable of managing their countries’ monetary affairs rationally and responsibly, he argued, without any need to shackle themselves to this “barbarous relic.”

  Though the
Tract was a technical monograph, the Cambridge undergraduate in Keynes could not resist lacing the book with the playful sarcasms that had made The Economic Consequences such a success. He flippantly dedicated the book, “humbly and without permission, to the Governors and the Court of the Bank of England,” knowing very well that the members of that august body would disagree with almost everything he had to say. He poked fun at the self-importance of those “conservative bankers” who “regard it as more consonant with their cloth, and also as economizing on thought, to shift public discussion of financial topics off the logical on to an alleged moral plane, which means a realm of thought where vested interest can be triumphant over the common good without further debate.” And he peppered it with the sort of bons mots—the most famous being “in the long run we are all dead”—that made him so scintillating a conversationalist.

  But more than anything else it was Keynes’s ability to strip away the surface of monetary phenomena and reveal some of its deeper realities and its connections to the society at large that has made the Tract such an enduring classic. For example, by tracing through the consequences of rising prices on different classes in a stylized picture of the economy—what economists today might call a model—he showed that inflation was much more than simply prices going up, but also a subtle mechanism for transferring wealth between social groups—from savers, creditors, and wage earners to the government, debtors, and businessmen. He thus highlighted the fact that the postwar inflation in countries such as France and Germany was not just the result of an error in monetary policy. Rather, it was a symptom of the fundamental disagreement that had wracked European society since the war about how to share the accumulated financial burden of that terrible conflict.