Investment manager Liaquat Ahamed first had the idea for Lords of Finance when reading a 1999 Time story on the successful efforts of Alan Greenspan, then Federal Reserve chairman, in committing billions of dollars of public funds to head off the Asian financial crisis.
A similar story, he realised, could be told about the heads of the world’s four main central banks in the 1920s. Like Greenspan in the 1990s and 2000s, the men were considered sages, yet these ‘lords of finance’ ended up contributing to the greatest peacetime collapse of the global economy: the Great Depression.
Ahamed shows how too much faith in individual bankers and their adherence to outdated ideas carried massive risks.
Golden goose or barbarous relic
The Bank of England’s Montagu Norman, the most famous of the central bankers between the wars, had a ‘rigid, almost theological belief’ in the gold standard as being fundamental to global order and prosperity. If a nation was on the gold standard, its government could only issue amounts of currency for which there were corresponding amounts of gold in the national vaults. Governments could not simply print money to pay for their debts.
When the world economy was in full steam before World War One, the gold standard had seemed to work well, facilitating trade and growth. The war changed everything. The belligerents had indebted themselves to the tune of $200 billion. For Germany, a crippling reparations bill of around 100% of its pre-war domestic output meant its only option seemed to be to print money. This had a cataclysmic result. By 1923, the German reichsmark had become essentially worthless, and prices were doubling every couple of days.
There was a consensus among horrified central bankers that the world must return to the gold standard as quickly as possible. In the way of this was the mountain of paper currency issued by the central banks during the war. There were essentially only two ways to restore the balance between the value of gold reserves and the total money supply: deflation (contracting the amount of currency in circulation) or devaluation (formally reducing the value of domestic currency in relation to gold).
Britain chose deflation, fixing the pound to gold at the pre-war level. However, lacking large enough reserves of gold and not being able to compete internationally because its currency was too high, Britain’s economy floundered. France, on the other hand, chose devaluation and enjoyed continuous economic growth.
Because all nations were connected via the gold standard, the success of one nation could impact badly on another. This created a zero-sum game in which one country did well at another’s expense, increasing hostility.
This apparent ‘umbrella of stability’, Ahamed argues, ‘proved to be a straitjacket’. It would take an array of currency crises and a Great Depression for the paradigm to finally change.
Dumping orthodoxy, embracing prosperity
1931 was the year, Ahamed says, when a severe recession around the world turned into the Great Depression. The currency problems created by trying to adhere to the gold standard led to runs on banks, and a vicious cycle of deflationary psychology in consumption and investment set in. In America the following year, investment halved, industrial production dropped by a quarter, prices fell 10%, and unemployment hit 20%.
When Franklin D. Roosevelt replaced Herbert Hoover as US president at the start of 1933, one of his first acts was to proclaim a five-day cross-America bank shutdown, and to suspend all exports of gold.
Roosevelt’s measures increased confidence overnight. People put cash back into banks, and the stock market rebounded. Roosevelt began a Keynesian stimulus programme that got some of America working again. He also accepted an amendment to the Agricultural Adjustments Act providing for a ‘temporary’ leaving of the gold standard, with the capacity to issue $3 billion without the backing of gold, and the scope to devalue the dollar against gold by up to 50%.
‘Breaking with the dead hand of the gold standard was the key to economic revival,’ Ahamed writes. All countries that did so – Britain in 1931, the US in 1933, France in 1935, and eventually Germany – got their economies back on track.
But if the gold standard was no good, what could replace it? After World War Two, John Maynard Keynes worked to create a system based on strong but not rigid rules which would allow countries to shape their own domestic economies by having ‘pegged [to the US dollar] but adjustable’ exchange rates.
Though it is hard to believe now, at the time no one really questioned the gold standard. Yet the self-regulating market beloved of classical economists, of which the gold standard was the most powerful symbol, brought countries to their knees and invited horrifying shifts from extreme liberalism to its antithesis, fascism.
Copyright © Tom Butler-Bowdon (pictured), 2017. The above is an abridged extract from 50 Economics Classics, by Tom Butler-Bowdon, published by Nicholas Brealey Publishing.