Lords of Finance: 1929, the Great Depression, and the Bankers Who Broke the World (24 page)

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
²³⁷
in August, because my legs get so bitten by barristers.” On another occasion, after visiting an aviary, she remarked on her hostess’s “ovary
²³⁸
.” 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
²³⁹
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
²⁴⁰
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
²⁴¹
, 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
²⁴²
” 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.

In contrast to
The Economic Consequences,
the new book had almost no practical impact. At a time when the currencies of Central Europe had completely collapsed and the franc was perilously close to the edge, few people could be convinced to entrust the management of national moneys and currency values to the discretion of treasury mandarins, politicians, or central bankers. There were too many examples to point to—Germany, Austria, Hungary, admittedly some of them pathologically extreme—of what could happen when the discipline of gold was removed. But the experience of the next decade would, in the words of one of Keynes’s biographers, win for the
Tract
“the allegiance of
²⁴³
half the world.”

NORMAN
’
S RESPONSE TO
the
Tract
was predictably to dismiss it as the froth of a clever dilettante. As he wrote to Strong, “For the moment
²⁴⁴
Mr. Keynes seems to have rather outdone himself, a fact that perhaps comes
from his trying to combine the position of financial mentor to this and other countries with that of a high-class speculator.”

What separated Norman from Keynes had less to do with economics and more to do with philosophy and worldview. For Norman, the gold standard was not simply a convenient mechanism for regulating the money supply, the efficiency of which was an empirical question. He thought about it in much more existential terms. It was one of the pillars of a free society, like property rights or habeas corpus, which had evolved in the Western liberal world to limit the power of government—in this case its power to debase money. Without such a discipline to protect them, central banks would inevitably come under constant pressure to help finance their governments in much the same way that they had done during the war with all the inflationary consequences that were still all too apparent. The link with gold was the only sure defense against such a downward spiral in the value of money.

His reaction to the
Tract
was colored by his personal dealings with Keynes. After the war, Norman, agreeing with much of Keynes’s argument on reparations, had consulted him at the height of the German hyperinflation. But Keynes’s vocal opposition to the war-debt settlement with the United States, which Norman had been responsible for engineering, created a rift. Norman, acutely sensitive to public criticism, harbored grudges for a long time—“the most vindictive man
²⁴⁵
I have ever known,” according to one close friend. Thereafter, though their social circles overlapped somewhat and though Keynes, for all his youthful iconoclasm, was already widely recognized as the most brilliant monetary economist of his generation, Norman studiously ignored him professionally, and refused ever to invite him to advise the Bank.

Strong’s reactions were on the surface similar to Norman’s. He had never met Keynes, but given his puritan background, he would have vehemently disapproved of the Bloomsbury irreverence and mockery of authority. When
The Economic Consequences
came out, he had written of Keynes, “He is a brilliant
²⁴⁶
but, I fear, somewhat erratic chap, with great power for good and, unfortunately . . . some capacity for harm.” Many in his circle
had taken offense at Keynes’s merciless lampooning of Woodrow Wilson at the Peace Conference. He echoed this again in his reaction to the
Tract
. “Keynes’ little book
²⁴⁷
arrived safely and I am just now reading it,” he wrote to Norman on January 4, 1924, from the Arizona desert. “I have a great respect for his ability and the freshness and versatility of his mind, but I am much afraid of some of his more erratic ideas, which impressed me as being the product of a vivid imagination without very much practical experience.”

The hidden irony was that every one of Keynes’s main recommendations—that the link between gold balances and the creation of credit be severed, that the automatic mechanism of the gold standard be replaced with a system of managed money, that credit policy be geared toward domestic price stability—corresponded precisely to the policies Strong had instituted in the United States.

During the war, the flow of gold into the United States had pushed up prices by 60 percent. When the fighting ended, but turmoil in Europe continued and the gold still kept arriving, Strong decided that it was time to abandon the conventional rules of the gold standard and insulate the U.S. economy from the flood of bullion. The system was being swamped by so much excess gold that to have followed the traditional dictates of the gold standard would have led to a massive expansion of domestic credit, which inevitably would have led to very high rates of inflation—Strong calculated that it would cause prices to double. It made no sense to him for the United States to import, in effect, the inflationary policies of Europe and destabilize its own monetary system just because the Old World had been hit by political and financial disaster. The Fed therefore began to short-circuit the effects of additional gold on the money supply by contracting the amount of credit that it supplied to banks, thus offsetting any liquidity from gold inflows.

Having jettisoned
²⁴⁸
the simple operating procedures of the gold standard, which linked credit creation solely to gold reserves, Strong began to improvise an alternative set of principles to guide monetary policy. The Fed’s primary goal should be, he believed, to try to stabilize domestic
prices. But he thought that it should also respond to fluctuations in business activity—in other words, the Fed should try to fine-tune the economy by opening the spigot of credit when commercial conditions were weakening and closing it as the economy strengthened.

This new set of principles, somewhat cobbled together on the fly, represented a quiet, indeed carefully unheralded, revolution in monetary policy. Until then central bankers had seen their primary task as protecting the currency and confined their responsibilities to ensuring that the gold standard was given free rein, only stepping in at times of crisis or panic. The credit policy of every industrial country had been driven by one factor alone: gold reserves. The United States was, however, now so flush with gold that the solidity of its currency was assured. Led by Strong, the Fed had undertaken a totally new responsibility—that of promoting internal economic stability.

It was Strong more than anyone else who invented the modern central banker. When we watch Ben Bernanke or, before him, Alan Greenspan or Jean-Claude Trichet or Mervyn King describe how they are seeking to strike the right balance between economic growth and price stability, it is the ghost of Benjamin Strong who hovers above him. It all sounds quite prosaically obvious now, but in 1922 it was a radical departure from more than two hundred years of central banking history.

Strong’s policy of offsetting the impact of gold inflows on domestic credit conditions meant that as bullion came into the United States, it was, in effect, withdrawn from circulation. It was as if all this treasure that had been so painfully mined from the depths of the earth was being reburied.

Strong’s policy contained a fundamental contradiction. On the one hand, he advocated a worldwide return to the international gold standard. On the other, he was doing things that not only undermined the doctrine he claimed most to believe in, but also, by preventing the gold from being recycled to Europe, he was making it all the more difficult for Europe to contemplate rejoining America on the gold standard. It was a dilemma he was never able to resolve.

European bankers argued that the massive bullion imbalance between
their countries and the United States was a fundamental problem for the world and pressed for some mechanism to recycle some of this gold. “I do not intend
²⁴⁹
another quarter to pass,” wrote Norman to Strong in January 1924, “without seeing you face to face, and asking you how in the name of heaven the Federal Reserve System and the United States Treasury are going to use their gold reserves.”

KEYNES WAS THE
first to recognize and articulate that, for all the public rhetoric about reinstating the gold standard, the new arrangements were in fact very different from the hallowed and automatic prewar mechanism. As he put it in the
Tract,
“A dollar standard
²⁵⁰
was set up on the pedestal of the Golden Calf. For the past two years, the US has pretended to maintain a gold standard. In fact it has established a dollar standard.”