Lords of Finance: 1929, the Great Depression, and the Bankers Who Broke the World (46 page)

Nevertheless, such was his power that Harrison embraced the idea. He did, however, warn Norman that since Strong had died, things had changed within the Fed. The conflict between the Board and the New York Fed had become even greater than in the past. There was now general agreement that the United States was faced with a stock market bubble. But the system was deeply divided about how to respond. While the reserve banks wanted to raise rates, it was now the Board that was resisting, and it had become more aggressive about getting its way. Harrison himself had just emerged from a collision with the Board over issues of jurisdiction, Chairman Young warning him that he and the other Board members did not “any longer intend to be
⁴⁹⁵
a rubber stamp.” Harrison urged Norman
⁴⁹⁶
to visit Washington—which he had till now ignored—and begin building a relationship with the Board if he wanted to continue to influence U.S. credit policy.

On February 5, Harrison, fortified by his discussions with Norman, himself went down to Washington and proposed exactly the Norman strategy to Young. He rejected the idea that his old chief, Strong, had been advocating in his last few months—that the Fed should passively sit by and “let the situation go along until it corrects itself.” Instead, he now pressed for “sharp incisive action,” a rise in rates of 1 percent. He had come to the conclusion, as he would put in later, that it would be better “to have the stock market fall
⁴⁹⁷
out of the tenth story, instead of the twentieth later on.” Once the speculative fever
⁴⁹⁸
had been broken, rates could be brought down again. The next day, Norman also turned up in Washington, bearing the same message. Members of the Board could not help but remark on the almost sinister influence that he seemed to exert over the New York Fed, originally upon Strong and now upon Harrison. One governor would later comment that Harrison “lived and breathed
⁴⁹⁹
for Norman.”

While Harrison and Norman were pressing for rate hikes, the Board continued its campaign for direct action. On February 2, it issued a directive to all its member banks that they should not borrow from the Fed “for the purpose of making speculative loans or for the purpose of maintaining speculative loans.” Four days later, it made the directive public. The Dow
fell 20 points over the next three days, but quickly recovered and by the end of the week was back at the highs. The market’s attitude was best summarized by an editorial in the Hearst newspapers. “If buying and selling stocks
⁵⁰⁰
is wrong, the Government should close the Stock Exchange. If not, the Federal Reserve Board should mind its own business.”

Norman left for home in the middle of February shaken by his trip. In the old days, during his visits to the United States, there had been an easy camaraderie and his friend Strong had always exercised a calming influence over him. This time he returned to Britain as anxious as when he had set out. It had been “the hardest time in America
⁵⁰¹
that he had ever had,” he reported to his colleagues. He had found the American central bankers paralyzed by indecision; there was “no leader”; within the Federal Reserve System, they were “at odds with one another, drifting and not knowing what to do.” In a circular letter sent to several heads of European central banks, he wrote that he had set off in the hope of getting a clearer view of what was going on in the United States only to return with “an even deeper feeling
⁵⁰²
of confusion and obscurity.”

Meanwhile, back in the United States the struggle between the Board and the New York Fed was intensifying. On February 11, the directors of the New York Fed voted unanimously to raise rates by 1 percent to 6 percent. Harrison called Young in Washington to inform him of the decision, acknowledging the Board’s right to override it. Young asked for time to consider the initiative, but Harrison insisted on a definitive answer that day. After three hours of calls back and forth in which Young unsuccessfully tried to persuade Harrison not to force a showdown, he eventually called to say that the Board had voted to disallow the hike. Over the next three months
⁵⁰³
, the directors in New York voted ten times to raise rates and each time were overridden by Washington.

The Fed was now paralyzed by this standoff between its two principal arms. The Board kept insisting that the right way to deflate the bubble was through “direct action”: credit controls, particularly of brokers’ loans. New York was equally insistent that such a policy could not work, that it was
impossible to control the application of credit once it left the doors of the Federal Reserve. Meanwhile, the pace of speculation was accelerating.

It did not help that the Fed seemed incapable of even exerting its control over leading bankers, let alone over the crowd psychology of investors. At the end of March, it was announced that total broker loans had increased to almost $7 billion, and the market swooned. The fear that some drastic action from the Fed to curtail the amount of credit going into the stock market was imminent drove the rate on brokers’ loans to over 20 percent. Instead, Charlie Mitchell of National City Bank, himself a director of the New York Fed, defied the Board by calling a press conference and announcing that his bank would pump an extra $25 million into brokers’ loans to support the stock market. After that, what little credibility the Fed possessed was irretrievably lost.

It is too easy to mock the Fed for entangling itself in a bureaucratic turf feud and fiddling while Rome was burning. Both parties to the debate were in fact right. The Board was undoubtedly correct that with the demand for money on Wall Street so strong, call money averaging over 10 percent, sometimes spiking as high as 20 percent, and speculators counting on gains of 25 percent a year and more, a hike in the Fed’s discount rate from 5 percent to 6 percent or even 7 percent at this stage of the game was going to have almost no effect. To be sure of pricking the bubble would have required raising interest rates higher, perhaps to 10 or 15 percent, which would have caused massive cutbacks in business investment and would have plunged the economy into depression.

But the New York Fed also happened to be right. All the jawboning about reducing credit for speculators proved to be pointless. It did in fact succeed in curbing the amount of money going into brokers’ loans from banks—between early 1928, when the Board first declared war on brokers’ loans, and October 1929, banks cut their loans to brokers from $2.6 billion to $1.9 billion. Meanwhile, other sources of credit—U.S. corporations with excess cash, British stockbrokers, European bankers flush with liquidity, even some Oriental potentates—more than made up for the decline by
increasing their funding of brokers’ loans from $1.8 billion to $6.6 billion. It was these players, all of them outside the Fed’s control, who were by far the most important factor supporting leveraged positions in the stock market.

Even Adolph Miller
⁵⁰⁴
, the most vocal opponent of speculation in general and brokers’ loans in particular, could not resist the temptation to earn 12 percent on his own savings. In 1928, Fed officials discovered that he had invested $300,000 of his own money in the call market through a New York banker, personally helping to feed the very speculation that he so vociferously opposed at the Board.

One is led to the inescapable but unsatisfying conclusion that the bull market of 1929 was so violent and intense and driven by passions so strong that the Fed could do nothing about it. Every official had tried to talk it down. The president was against it, Congress too; even the normally reticent secretary of the treasury had spoken out. But it was remarkable how difficult it was to kill it. All that the Fed could do, it seemed, was to step aside and let the frenzy burn itself out. By trying to stand up to the market and then failing, it simply made itself look as impotent as everybody else.

PERHAPS THE MOST
perverse consequence of the bubble was that by the strange mechanics of international money, it helped to tip Germany over the edge into recession. For five years, hordes of American bankers had descended on Berlin to press loans upon German companies and municipalities. However much Schacht had tried to wean his country from this dependence on foreign capital, there was little he was able to do about it. Over the five years between 1924 and 1928, Germany borrowed some $600 million a year, of which half went to reparations, the remainder to sustain the rebound in consumption after the years of austerity.

In fact, Germany’s appetite for foreign exchange was so great that even the deluge of long-term loans from U.S. bankers was not enough, and it was forced to supplement this with short-term borrowings in international markets closer to home. Out of the total of $3 billion for which German
institutions signed up in those years, a little less than $2 billion came in the form of stable long-term loans. But more than $1 billion was “hot money,” short-term deposits attracted to German banks by high interest rates—7 percent in Berlin compared to 5 percent in New York—and subject to being pulled at any time. In late 1928, as the U.S. stock market kept climbing and call money rates on Wall Street skyrocketed, American bankers mesmerized by the phenomenal returns at home suddenly stopped coming to Berlin.

It was the combination of the drying up of foreign credit due to high interest rates induced by the U.S. stock bubble and the residual lack of confidence among German businessmen following Schacht’s ill-fated strike against the stock market in 1927 that drove Germany into recession in early 1929. Moreover, as long-term American loans stopped, Germany was forced to rely more and more on hot money, some raised from London, but much from French banks, then flush with all the excess gold that had been sucked into their country. Germany therefore found itself slipping into recession just as its foreign position was becoming increasingly vulnerable. A British Treasury official, recalling how much money France had pumped into Russia before the war, could not help remarking with cynical detachment, “The French have always had
⁵⁰⁵
a sure instinct for investing in bankrupt countries.”

The collapse in foreign loans and the recession could not have come at a worse time for Germany. Under the Dawes Plan schedule
⁵⁰⁶
, Germany was to have fully recovered by now, and was due to ramp up its reparations payments in 1929 to the full $625 million a year, about 5 percent of its GDP. This would not have been an intolerable burden by historical standards. But Schacht, for that matter most of the German leadership, had always been resolute that with its new constitution still fragile, its body politic still divided, its people still bitter over the defeat, and its middle classes decimated by the ravages of the inflation years, Germany simply could not pay this amount.

As 1929 and the scheduled rise in payments approached, Schacht was of two minds about what to do. He often spoke about simply waiting for
the economic crash that so many financial experts were predicting. It was a common view in Britain, held, for example, by Frederick Leith-Ross, the top Treasury official responsible for reparations, that the world was headed for a massive payments crisis in which several European countries would default on their debts, setting the stage for a general restructuring of all international commitments arising from the war. Europe could then wipe the slate clean of both reparations and war debts and start over again. Occasionally, Schacht even talked almost too glibly about provoking such an upheaval himself.

The alternative was to reopen negotiations before the jury-rigged payments system broke down. During the Long Island central bankers’ meeting of 1927, Schacht had made enough of a stir about Germany’s foreign debt problem as to convince Strong and Norman that something had to be done soon, to the point that Strong in turn pressed Agent-General Seymour Parker Gilbert to strike a deal before the whole thing blew up in their faces.

Gilbert, effectively Allied economic proconsul for Germany for the last four years, was even then all of thirty-six years old. A precocious genius, he had graduated from Rutgers at the age of nineteen, from Harvard Law School at twenty-two, had become one of the four assistant secretaries at the U.S. Treasury at the age of twenty-five, and been promoted to undersecretary, the second most powerful official in the department at the age of twenty-eight. In 1924, at the tender age of thirty-two he had been appointed agent-general for reparations, responsible for managing Germany’s payments, and most important, for deciding how much it could afford to transfer into dollars every year. In the hands of this tall, shy, boyish, sandy-haired young man from New Jersey lay the immediate fate of the world’s third largest economy.

There was little doubt that they were very capable hands. Reserved, bookish, and taciturn, Gilbert was uncomfortable around people, speaking “with a mixture of awkwardness
⁵⁰⁷
and arrogance, mumbling the words so that one could hardly understand his English.” But his intellectual power and capacity for work were legendary. At the Treasury, he had usually been
at his desk till two or three o’clock in the morning, seven days a week. Living in Berlin for five years, he did not socialize, never learned German, did “nothing but work
⁵⁰⁸
without interruption,” according to the German finance minister, Heinrich Kohler. “No theater, no concert, no other cultural events intruded into his life . . .”

That so young an American should have such enormous sway over the life of their country was greatly resented by most Germans. Government officials
⁵⁰⁹
also suspected the staff in his office of being espionage agents, sent to report on Germany’s attempts to cheat on the limitations imposed on its armed forces by the Versailles Treaty. In February 1928, a right-wing group staged a mock coronation attended by ten thousand people in which Gilbert’s effigy was crowned “the new German Kaiser
⁵¹⁰
who rules with a top hat for a crown and a coupon clipper for scepter.” Schacht, always attuned to the locus of power, was one of the few German officials to befriend Gilbert.