Financial Collapse: A Lesson from the '20s

by: John M. Mason

Lords of Finance: The Bankers Who Broke the World is a book of biography, according to author Liaquat Ahamed, a former hedge fund manager, advisor, and a member of the board of trustees of the Brookings Institute. It is also a book of history, although the author would deny it since it supposedly doesn’t contain any theory. It is a book to read and contemplate, because it gives us a picture of, and insight into, what happened in another time of financial collapse and economic turmoil.

The focus of the book is four central bankers, members of “the most exclusive club in the world” as they were referred to back in the 1920s. The members: Montagu Norman from England; Émile Moreau from France; Hjalmar Schacht from Germany; and Benjamin Strong from the United States. The author weaves together the interactions of these four fascinating individuals throughout the 1920s and 1930s. The aim: to tell a story of how and why decisions were made during this time period and the apparent consequences of these decisions. It is a story of outdated ideologies, unfortunate national stereotypes, and personal likes and dislikes - a story that had tremendous ramifications for much of the world.

One thing that can be taken away from this book is that economics is more than just a set of equations that produces some kind of equilibrium in the future. In other words, the free market economy does not work in a world without independent, “exogenous” shocks resulting from the decisions and personalities and personal relationships of the individuals that influence or control important aspects of an economy or a government. For better or worse (for worse, in the case of the events described in this book) individuals and governments and other large organizations “shock” the world and impact the future course of the economy and the people making up those economies. Just relying on historical economic models is an insufficient process to understand the world.

With this said, let me concentrate on just a few of the major highlights captured in the book. The first takeaway from this book is that war is good for no one! This is true for the winners of a war as well as for the losers of a war.

Ahamed sets the stage for the drama to follow by describing the feelings of many people before the advent of World War I. These people argued that the economic benefits of war were illusionary and that the commercial and financial linkages between countries were so extensive that “no rational country should contemplate starting a war.” The economic chaos, especially the disruptions to international credit, that would ensue from a war among the Great Powers would harm all sides and the victor would lose as much as the vanquished. If war were to break out “by accident” it would speedily be brought to an end.

Four things happen in a war. First, a lot of people get killed. Second, a lot of the infrastructure is destroyed. Third, an enormous amount of debt is created for all concerned. Fourth, hatreds carry over. And this is just what happened in the war that began in 1914. The latter two hung over the countries that were involved for about 14 years, dominating everything that the nations did and how they related to one another. Little of it was good.

The primary problem for the decade of the 1920s was the debt problem. This exhibited itself in two forms. The first was the “reparations” that England and France believed they were owed due to the fact that Germany started the war, and also lost that war. Germany must pay! (which it never really did). The second was the debt that England and France owed America, since America essentially financed the Allies through the war. (Much of this debt was never paid.) “Dealing with these massive claims consumed the energies of financial statesmen for much of the decade and poisoned international relations.” The debts contributed to a very fragile financial system that cracked at the first pressure.

The second major actor in this little play was the gold standard. For decades, this “totem” had served as the linchpin of free trade and economic stability. Participants in the Paris Peace Conference that followed the end of the war saw a return to the gold standard at pre-war parities as the essence of a return to peace and free world trade. It was also seen as the prerequisite for certain nations to regain the pre-eminence in financial affairs that they had held prior to the war. Of course, the United States was a roadblock to this because it prospered economically during the war and it ended up with a majority of the entire world’s gold supply due to the fact that it was a “safe haven.”

There is not time to go through the full story of the 1920s here, but Ahamed does an excellent job of it.

The major consequences of the huge debt buildup and the return to the gold standard was that eventually the United States ended up keeping interest rates too low for an extended period of time, while Germany was kept going through a large influx of international capital. This was because gold supplies had not increased during the war and the distribution of the gold in the world contributed to weaknesses in the functioning of the system. Ahamed argues that the low interest rates resulted in a stock market bubble in the United States. The Federal Reserve System was just learning how to become a central bank during this period and responded half-heartedly to the situation, raising interest rates modestly. The consequence was devastating. The Fed actions were too little to stop the stock market from continuing to rise, yet was large enough to stop and then reverse the flow of capital going into Germany.

The result: the German economy, which lost massive amounts of American capital, began to contract in 1928; the Great Crash on Wall Street came in October 1929 (the National Bureau of Economic Research has dated the start of the depression in August 1929); the serial bank panics in the United States began in late 1930; and European finances came unraveled in the summer of 1931. Other dates of importance: Germany stopped paying reparations in June 1932; England went off the gold standard in 1931; the United States went off in 1933; and France went off in 1936. Germany did not officially go off the gold standard, but did not act in a way that was consistent with a nation on the gold standard.

Two other aspects of history are covered in The Lords of Finance. The first relates to the financial and economic contagion that engulfed the world. We tend to focus on just the four major countries included above, but this depression was a worldwide depression. The second relates to the labor unrest that existed during this time. Policymakers and intellectuals constantly expressed concern about the possibility of a revolution or a labor upheaval that would overthrow the existing social structure. The Russian revolution was in the background and much of what was done during this time was to prevent the possibility of a Bolshevik or Communist takeover of the western way of life. Keynes was very concerned that this might happen, and this fact biased much of his polemic, as well as his theoretical, writing.

To me, the basic underlying truth of the picture that is drawn in this book is that overwhelming amounts of debt create problems that can take decades to unwind. As Colin Powell said about the entry of the United States into Iraq: ”You break it, you own it.” A situation that results in the creation of an enormous amount of debt “breaks” the system. Once the system is broken, you own it! In other words, once huge amounts of debt are created, there are no good options available for getting yourself out of the mountain of debt you have created. Sound familiar?

Lords of Finance: The Bankers Who Broke The World, by Liaquat Ahamed. January 2009: The Penguin Press, hardcover, 576 pp.