The Lords of Finance

by Jörgen Eriksson on September 15, 2012

euro crises“When history books trace the evolution of the euro crisis, September 2012 will mark the beginning of a new chapter.”

– The Economist, September 15, 2012

“We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand.”

– John Maynard Keynes, 1932

In recent days we have seen decisive moves from The central banks of both the European Union and United States in tackling the recession. These bold steps inspired me to write this blog, which aims to explain the new situation but also to make a retrospective journey in time by reviewing a book on how the central banks acted (and failed to act) in the 1920s and thus caused the great depression of the 1930s.

Therefore, this blog is about money. In a modern economy, the role of money is to be a medium of exchange and a standard of value. The amount of money we have access to is the measure we use to judge how prosperous we are. The question is, just what value should money have?

Game change

On September 12th Germany’s constitutional court backed the European Stability Mechanism (ESM), the euro zone’s permanent rescue fund, removing the last big hurdle to its launch. The same day, the European Commission laid out a blueprint for joint European banking supervision by the European Central Bank (ECB), the first step to a banking union.

A few days earlier the ECB announced that, under certain conditions, it would buy unlimited amounts of the bonds of troubled euro-zone countries. This is a huge step for the ECB and with this decision, the bank aims to cut the borrowing costs of debt-burdened Eurozone members by buying their bonds and thus lowering interest rate levels in the crises ridden economies.

The hope is that the ECB’s pledge, by itself, will push euro-zone debt markets into a positive cycle, one where yields on sovereign debt in peripheral economies fall as investors lower the probability of the euro’s collapse, and as yields fall those countries’ debt dynamics and economic prospects improve.

doberman pinscherThe caveat is that any national government that wants the ECB’s active help to fight off financial speculators must first agree to embark on a program of tough macroeconomic policy measures, and then must follow through.

This means that the ECB will now become the enforcer of fiscal policy in EU countries in crisis, and thus have both responsibility for monetary policy, banking supervision and fiscal policy compliance.

In a Europe with indecisive governments having difficulties to show accountability, this is a major game change. It will mean that the governing council of the ECB and its president (currently Mario Draghi) will be the most powerful decision maker in the European Union.

Also this week, the Federal Reserve in United States announced another round of quantitative easing. What was new was the Fed’s promise of unlimited volumes and the targeting of mortgage-backed securities. The trigger was slowing growth. For the third consecutive year, the US economy remains stalled.

The Fed has a dual mandate to maintain stable prices and full employment and as there is no sign of inflation on the horizon, the Fed’s message that the asset purchase programme and the pledge on zero-bound interest rates until the US economy was well into recovery should be well received.

This means that both the ECB and the Fed will take strong action to keep low interest rates and ample supply of money. Milton Friedman would be happy, and todays governments will be less under pressure to launch new Keynesian initiatives in the financial policy.

This will also mean that we will see adjustments in the relative value of the dollar and of the euro. To what extent we cannot yet know. What we do know is the mechanism that increasing money supply fosters currency devaluation, and thus increases domestic export industry competitiveness and over time increasing costs for consumers (inflation).

The Bankers Who Broke the World

The action of our modern central bankers is promising for renewed economic growth and yet again shows that we live in times when the governors central banks take a more central role in policymaking.

Politically elected governments are on retreat and cannot spend any more to take us out of crises or recession, as we have written about in a number of blogs on this site. Instead the technocrat leaders of the central banks take on responsibility and governs their institutions towards providing macro economic stability.

Back in the 1920s, the situation was different. In his book The Great Slump of 1930, John Maynard Keynes wrote:

“We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand.”

The “delicate machine” Keynes referred to was of course the global economy. a series of policy errors by the world’s four most important central banks, the Federal Reserve, the Bank of England, the German Reichsbank and the Banque de France, had led to the near collapse of the capitalist economies. Industrial production had fallen 30 percent in the United States, 25 percent in Germany and 20 percent in Britain.

Lords of FinanceThree years ago, the book Lords of Finance was published, written by Liaquat Ahamed, a former official at the World Bank. He wrote the book during a year spent on Cap Ferrat, not far from where I live. I found the book last winter at Gatwick Airport in London and it is a really good read. It won the Pulitzer Prize for History in 2009.

The book narrates the events preceding the Black Tuesday stock market crash of 1929 and the disastrous response of the world’s major central banks. It follows the life and actions of the then chiefs of the central banks: Benjamin Strong Jr. of the New York Federal Reserve, Montagu Norman of the Bank of England, Émile Moreau of the Banque de France, and Hjalmar Schacht of the German Reichsbank.

The main theme of the book is the role played by the central bankers’ insistence to adhere to the gold standard of currency value even in the face of total catastrophe.

The first and biggest set of errors leading to the depression came already after the Paris peace conference at the end of the first world war. The conference allotted the fighting powers, still devastated by war with an unimaginable burden of international debt. Germany owed enormous sums in reparations to France and Britain, France was in hock to Britain and the US, and Britain in its turn also had huge debts to America. These capital imbalances were a fault line in the world’s financial system, and when the pressure became too intense, they cracked.

The central bankers recognized the political blunders of the peace process and did what they could to deal with the consequences. But more than anyone else, they were responsible for the second fundamental error of economic policy, the decision to return to the gold standard, at the wrong time and the wrong rate.

Modern Time coverAhamed has said he got the idea for the book when he read a 1999 Time magazine cover story headlined “The Committee to Save the World” about Alan Greenspan (then the Federal Reserve chairman), Robert Rubin (Bill Clinton’s Treasury Secretary) and Lawrence Summers (Rubin’s number 2).

Ahamed realized that in the 1920s, the four top central bankers had acquired a similar mystique and fame; they were sometimes described as “the most exclusive club in the world.” and he decided to tell the story of “the descent from the roaring boom of the ’20s into the Great Depression” by “looking over the shoulders” of these four men.

The central bankers were enigmatic figures in the 1920s, not least because they preferred to operate in secret. According to the book, the cloak was peculiarly attractive to Sir Montagu Norman, governor of the Bank of England (pictured below, right), who adopted a false identity when he travelled, though this sometimes attracted attention rather than deflecting it. Asked for his reasons for promoting a policy, Norman replied: “I don’t have reasons. I have instincts.”

Benjamin Strong, Norman’s principal collaborator, ran the Federal Reserve Bank of New York, which was responsible for America’s international financial relationships. In the mid-1920s, Strong decided the American economy was sufficiently prosperous that he could widen his brief to promote economic stability. Liaquat Ahamed suggests that Strong more than anyone else invented the modern central banker.

Time Magazine coverNorman and Strong were committed to the gold standard. Emile Moreau, the governor of the Banque de France, was an obsessive hoarder of gold and tended to act only in his nation’s own interest.

The arrogant Hjalmar Schacht who headed the Reichsbank, had, by a remarkable feat ended Germany’s hyperinflation in 1923, but he was unable to persuade his fellow central bankers to forget reparations, even though they all appreciated that heavy post-war payments were “bleeding Germany white”.

The quartet, united by a belief that they knew best, had persuaded the great powers to leave the fate of their economies to the workings of the gold standard. This was “a barbarous relic” in the view of John Maynard Keynes. They had the power, in a legendary phrase, to “crucify mankind upon a cross of gold”, and so they did.

The problem was that there was not enough gold available to finance world trade. Stocks were concentrated in America and France, and countries like Britain where it was scarce had to borrow heavily, and to adjust interest rates and government spending at the expense of employment in order to replenish gold reserves.

The Aftermath

Politicians were left to clean up the mess left by the central bankers. One of them was Adolf Hitler, who instigated a series of measures to combat German unemployment by abandoning the gold standard and investing in infrastructure by printing money. As Germany by then was an economy with regulated prices, inflation was avoided in the short run, but if the war had not come when it did then the Germany economy would have imploded sooner or later, just as the  economy of the Soviet Union did.

General theoryIn United States, President Roosevelt launched the new deal by borrowing and starting government programmes. In Britain, prospects brightened as soon as the gold standard was dropped in 1931. The French, less troubled, remained loyal to gold until 1936.

Due to the failures of the central bankers of the 1920s, the pendulum of policy stroke far over to the other side of economics, and for the following 50 years (until Reaganomics), the Keynesian view of how the economy could be stabilized and grown gained the strongest position, and as a logical consequence we have todays problems with huge national debts.

Maybe the science of economics have learned something since the 1920s and maybe todays central bankers are wiser? The events of the last week are promising.

About Jörgen Eriksson :