Financial Collapse: A Lesson from the '20s

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 It is a story of outdated ideologies, unfortunate national stereotypes, and personal likes and dislikes - a story that had tremendous ramifications for much of the world.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.

Comments

[Jake Berzon:]

Great review - thank you. Wiley just sent me the recently published "The Great Depression of Debt, Survival Tecniques for Every Investor" by Warren Brussee. It is about the current debt problems and the way the author sees them resolving themselves. Obviously, the situation now is similar to the one described in the book, yet very different. (For example, the world is not on a gold standard.) Brussee is a serious statistician, so it will be interesting to read his perspective. I'll do a review once I am done reading the book.

Feb 22 11:32 AM

[anarchist:]

The US has two wars ongoing right now and they have done little to stimulate the economy, only debt. Obama tells us he is going to get the US out of Iraq but why will it take a year and why continue in Afghanistan? Maybe the old idea of "war is good for the economy" is still alive and well?

Feb 22 12:14 PM

[mr freddo:]

Thanks for the book report. I found it very interesting, especially the point about Keynes being influenced by the threat of communist takeover. Some of our prominent Austrian School economists forget that if you let the markets work without interference, you may be answering to Fidel or Che in short order.

The other important point made is that things can always get worse and will if war breaks out. Nationalistic wars have always been a favorite tool of despots seeking to find an external enemy to blame for hard times.

As far as the debt issue is concerned, there is no doubt that debt can be a vital tool for success if used properly. It allows a company to grow faster than it otherwise would be able to on the strength of retained earnings alone. But if you aren't careful, it is like selling your soul to the devil.

Certainly debt should never be used for the purpose of entertainment, leisure, or consumption. Our American consumers are now finding out that accumulating debt is like a game of musical chairs. It's fun until the music stops.

Great Depression II is now in its early stages. Unfortunately, it will take years to work down the enormous levels of debt built up in the period of low interest rates and exuberance of 2002 - 2007. Let's all hope that we can muddle through this period without resorting to war.

Feb 22 12:14 PM

[TR1:]

Nice book report. Another aspect of that time that the book may or may not get into is that this exclusive club of four was under the great influence (one can debate) of maybe titans of Wall Street and Industry such as those associated with Morgan and Rockefeller. The Federal Central Bank not finding its feet and even the wars themselves may have more to do with undue influence than incopentence, or perhaps that is the same thing. Finally, one wonders if the comparisons to current events are indeed quite parrallel in this light.

Feb 22 02:35 PM

[TR1:]

many titans, not maybe titans, above.

Feb 22 02:37 PM

[HiSpeed:]

From what I have seen from documentaries about that time, 10:1 leverage in 1920s for traders and investors was another significant contributor to the stock market rise of that era. Leverage is a common theme/contributor to these bubbles.

Feb 22 02:49 PM

[markg:]

War isn't good, but debt financing to drive the economy is a common denominator. The output can be war materials, houses, roads, whatever. Doesn't seem to matter.

For those of you wondering why we don't just leave Afghanistan, is 9/11/2001 so far back? We are fighting a group of people that kill because they like to, and they like killing Americans most of all. Is that a good enough reason foryou?

Feb 22 03:50 PM

[Miner49er:]

Really! The first depression is to be blamed on the standard of measure-- gold! Shocking. Gold just sits in the corner now, it has no voice other than those doing it's bidding. How is today similar?

The problems then and similarities today never really involved gold. The similarities in both cases involve the unfettered creation of unbackeded debt and spending ability removed from the standard--Gold!

Feb 22 04:58 PM

[Buckoux:]

"Ahamed argues that the low interest rates resulted in a stock market bubble in the United States."

I agree. Just as low interest rates resulted in the dot.com bubble and the housing bubble. The Dollar is America's oil. It should not be devalued by pressures from commissioned money lenders. The Federal Reserve has been criminal in its incompetence. Alan Greenspan was no "maestro", as Bob Brinker referred to the Fed Chairman, but an incompetent clown.

Feb 22 05:14 PM

[Al-USA:]

Arguably, the New Deal, in combination with the enormous investment in production to secure the continued existence of the American ruling class, that is, win WWII, were factors in ending the Great Depression.

However, and this is not mentioned much in mainstream media, recall that tax rates on the wealthiest Americans increased from about 25% (around 1929) to 95% by end of 1945...

The ruling class did what it had to only when its back was against the wall so, unless the current one is demonstrably different, a laughable prospect in light of the "financial crisis", I don't see any stimulus for getting the USA out of this recession/depression.

Of course, it is still early, and the relevance of capitalism, so strongly tilted in favor of ruling class for the last 30 years, as evidenced by the stagnant wages of the working class and record profits of the ruling class, is still not widely questioned so it remains to be seen how this current ruling class was act.

For more information see link below:

" The Fed's War on the Middle Class"
mises.org/story/2983

" What's Behind the Financial Market Crisis?"
mises.org/story/3111

"Economic Fascism and the Bailout Economy"
mises.org/story/3333

Feb 22 07:13 PM

[Donald Johnson:]

After you read Lawrence Reed's "Great Myths of the Great Depression," you'll realize the scary similarities between Presidents Herbert Hoover and his successor FDR and Presidents Bush and Obama respectively.

Feb 22 07:42 PM

[Donald Johnson:]

Link is here:

www.mackinac.org/artic...


On Feb 22 07:42 PM Donald Johnson wrote:

> After you read Lawrence Reed's "Great Myths of the Great Depression,"
> you'll realize the scary similarities between Presidents Herbert
> Hoover and his successor FDR and Presidents Bush and Obama respectively.

Feb 22 07:43 PM

[Moon Kil Woong:]

I think borscht was being cynical regarding people should keep spending like mad. However, some policy makers are not so cynical in trying to get people to keep on spending like mad. Will they ever learn.

Another takeaway point to the great depression is not only was interest rates too low leading to a massive bubble but banks were also out of control and were able to lever themselves up in fin and creative ways. Thus Glass-Stegall was created sharply curbing the silliness banks can do with your money.

That backdrop is exactly what we are feeling now from the removal of the only effective way ever devised to prevent another Great Depression. Smooth move. It shows we don't learn from history after all.

Feb 22 10:01 PM

[otbricki:]

One problem that clearly exacerbated the Great Depression was that deflation made debt repayment far more difficult. This is why students of that period are so afraid that the current deflationary pressures may cause the current situation to linger.

BUT are their efforts to prevent deflation going to be counter-productive? That is the scary part - we may have stagflation or worse down the road. At least we still have Paul Voelker around. Maybe somebody will even listen to him.

Feb 22 10:28 PM

[nova:]

I did not read the book. However, I am a student of history.

The reasons for the both WWI and WWII are not so simple as the mass media and many historians would like us to believe.

It is well known that
- England and Russia still refuse to release the majority of their archives related to the WWII even 65 years after the war. Why? What do they have to hide? The USA is also in the same category.
- The fact that Hitler has ended German's depression in just 18 months coming to the power also the fact everybody likes to keep quiet
- As for the history of the 1930s Great Depression, there are many theories explaining what and why things did happen
-- Bernanke has his own theory: if only the FED back then printed more money, the Depression might be avoided...
-- Stalin thought that if he cut off the West from its colonies then he could rule the world by permanently ruining European and America economies
-- FDR had many ideas and none worked

In my view, many things contributed to the Great Depression
- Financial speculations and over-borrowing
- The worldwide manufacturing over-capacities
- Politicians never gave a chance to a free-market to address and solve the Depression issues. Then and now, the governments were too much involved in economic manipulations
- Geopolitical considerations that later led to the WWII

Feb 23 12:11 AM

[Shonkypom:]

History doesn't teach enough people anything.

Feb 23 01:25 AM

[Teutonic Kn...:]

Rob:

Sorry to point out that your comment here is not entirely 100% true. Military defense R&D had proven time after time to have leading edge benefits flow-down to industrial products and eventual commercialization of benefits to the economy. Case in point: rockets that lauch communications satellites, nuclear reserach that leads to peaceful use of nuclear power, aeronautical research and developments that lead to better, faster, and more efficient aerodynamic civiiian aircrafts and aviation, computer and crytologic research that leads to our ground-breaking software, internet, systems and infrastructures, to name just a very very few.

On disarmament, unilateral disarmament had never proven to be realistic in human history (unless the Kingdow comes now). If we disarm unilaterally, would they (whoever our adversaries) hesitate just to move in and enslave us? I don't want to debate trust here, which is outside the scope of this forum.

Teutonic


On Feb 22 05:57 AM Rob Viglione wrote:

> So many people are tricked into thinking war is good for an economy.
> WWII is often seen as the catalyst for ending the Great Depression.
> Producing weapons, tanks, planes, and bombs does not make society
> wealthier. It employs lots of people, but if the goal of economics
> were simply employment we could hand everyone a shovel and have them
> dig and then fill up a hole everyday. They'd have jobs, paychecks,
> but no wealth would be produced. Same thing goes for war materiel.

Feb 23 10:49 AM

[Chris B:]

So when the US spends $2 million to drop a bomb on a mud hut that was built at a cost of $10 in Afghanistan/Pakistan, has wealth been created? If we then paid someone $2M to fill in the crater with a shovel, would worldwide GDP have increased by a total of $4M? Or would the wealth of taxpayers been squandered on fireworks?

I think this was Rob's point. The same people who think wars are economically productive should also think make-work is economically productive, as there is little monetary difference. The $2M bomb analogy also applies to equipment that is worn out, such as ships, trucks, and airplanes. Military spending should be seen as a loss-prevention measure, not economic stimuli.

Meanwhile you are correct about military technology eventually being used in productive endeavors. However, much of the money we spend on the military, is burned in the form of fuel, equipment that is trashed, or paid to employees who would otherwise be producing goods and services. If technology development is the economic and strategic goal, funding science research grants and education would be a far more efficient use of resources.



On Feb 23 10:49 AM Teutonic Knight wrote:

> Rob:
>
> Sorry to point out that your comment here is not entirely 100% true.
> Military defense R&D had proven time after time to have leading
> edge benefits flow-down to industrial products and eventual commercialization
> of benefits to the economy. Case in point: rockets that lauch communications
> satellites, nuclear reserach that leads to peaceful use of nuclear
> power, aeronautical research and developments that lead to better,
> faster, and more efficient aerodynamic civiiian aircrafts and aviation,
> computer and crytologic research that leads to our ground-breaking
> software, internet, systems and infrastructures, to name just a very
> very few.
>
> On disarmament, unilateral disarmament had never proven to be realistic
> in human history (unless the Kingdow comes now). If we disarm unilaterally,
> would they (whoever our adversaries) hesitate just to move in and
> enslave us? I don't want to debate trust here, which is outside the
> scope of this forum.
>
> Teutonic

Feb 23 01:30 PM

[Jason Rines...:]

I would not disagree. Then let's suffer a bit more pain, await the inevitable voter revolution that shows up on my three historic charts four years after the crisis begins and then issue Greenbacks at that point and cut the middle men out of the equation. It's time to settle the debate of who owns and controls the currency for all time. This debate has been ongoing since 1780's and the biggest mistake the Founding Father's made in not including it in the Articles of Confederation and/or Constitution.


On Feb 22 11:03 AM HiSpeed wrote:

> The government cannot repeal the normal business cycle with its attendant
> recessions. Major policy mistakes lead to depressions. Even under
> the best of circumstances, only time and wise leadership will slowly
> get the country out of this situation.
>
> In the end, the charts from the current time of economic malaise
> are going to look very similar to those from the last major economic
> maelstrom of the 20s-30s.
>
> From the chartists perspective, all bubbles end the same.

Feb 23 05:44 PM

[Jim Hawthorne:]

It will take a year or more to move an American Army out of Iraq simply due to the enormity of the logistics involved in relocating 135,000 military personnel, their mountains of equipment, plus additional thousands of contractors and government workers. This is no small chore, and to do it much faster involves addition costs that escalate geometrically as you try to speed it up. Contrary to public opinion, armies do not move fast, and they withdraw much slower than they advance!

Is war good for the economy? Of course not! In addition to a long list of negatives, war simply has a negative ROI as has been amply demonstrated by ourselves, the British, French, Japanese, Germans, &etc. since time immemorial.

On Feb 22 12:14 PM anarchist wrote:

> The US has two wars ongoing right now and they have done little to
> stimulate the economy, only debt. Obama tells us he is going to
> get the US out of Iraq but why will it take a year and why continue
> in Afghanistan? Maybe the old idea of "war is good for the economy"
> is still alive and well?

Feb 25 08:42 PM