Lords of Finance

The financial crisis of 2008 was not the first. In reading Lords of Finance you see some of the obvious parallels from the 1920s.

Liaquat Ahamed focuses his story on Montagu Norman of the Bank of England, Benjamin Strong of the New York Federal Reserve, Hjalmar Schact of the Reichsbank and Emile Moreau of the Banque de France.

One focus of the 1920 s financial crisis was the stock market crash. Rampant speculation caused a bubble, even though it was initially rooted in economic reality. This was the “new economy” era of automobiles and radios. The old railroad based economy was being surpassed by trucking. Stock prices were rising, but so were the profits of the companies listed on the stock exchange. But then stock prices began rising out of proportion to the rise in corporate earnings.

There was clearly a speculative bubble. Investors were clamoring to find the next Google General Motors. Amateur investors were pouring in and borrowing to make their investments. The Federal Reserve did nothing and then when it decided to act it found it was unable to find a way to curb the speculation. When the Fed pulled back on the ability of banks to lend for stock speculation, non-banks stepped in to provide capital.

There was a thought that “the Fed could pierce the bubble with a surgical incision that would bring it back to earth without harming the economy. It was a completely absurd idea. Monetary policy does not work like a scalpel but more like a sledgehammer.”

As far back as the beginning of the Federal Reserve system there was the question of whether the Fed should intervene in an asset bubble.

The 1920s financial crisis was caused more than just stock speculation, just as the 2008 crisis was caused by more than just residential real estate speculation. It was fueled by debt. The world economy was trying to recover from the economic effects of World War I. Germany began the 1920 owing $12 billion ($2.4 trillion in 2011 values) in reparations to France in Britain, France owed the US and Britain $7 billion ($1.4 trillion in 2011 values)  in war time debts and Britain owed the US $4 billion ($800 billion in 2011 values).

The book goes further back  and focuses on the gold standard as one of the core underlying economic problems that helped cause the Great Depression. Up until this point there was an “almost theological belief in gold as the foundation for money.” Gold was the international currency. Each country’s currency was pegged to the value of gold. The ability to convert paper money into gold instilled confidence in the currency.

By coincidence, the discovery of gold through the late nineteenth century kept pace with economic growth. Then came World War I. The largest economic powers in the world met in the battlefield. Pound Sterling and Franc versus the Mark. The United States and the Dollar came in eventually. After spending the first few years sitting on the sidelines and supplying the Allies, the United States had accumulated an enormous trough of reserves.

One of the problems with the gold standard is that it gives people the option to cash in that paper money for actual gold. That obviously creates some faith in the currency. But it has opposite effect in times of crisis. people will lose faith in the paper money and redeem it for gold. That drains the system of gold, causing a tightening of credit. To counter, the banking system will need to raise interest rates to encourage people to keep money in the bank instead of gold in their mattress. Raising interest rates during a financial crisis will make things worse. You want to be able to reduce interest rates to encourage the flow of capital.

The other contributing factor was the failure of banks. This was before the days of the FDIC and insured deposits. So if you thought your bank was going under, you pulled your money out. This lead to bank runs and banks hoarding cash instead of investing the cash in loans that would grow the economy.

In the end, each economy began its recovery after it suspended the gold standard.  Is some ways the gold standard is just about digging up gold and re-burying it. The huge treasure of US gold was sitting underground, literally underneath Wall Street. France’s gold reserves were underwater; its vaults sat beneath a subterranean aquifer.

As George Santayana wrote: “Those who cannot remember the past are condemned to repeat it.” Ben Bernanke was a scholar of the Great Depression. He saw what the four Lords of Finance did, leading them to the subtitle of the book: The Bankers who Broke the World. It’s worth your time to read the book.