Wide Angle 39 - Lords of Finance - The Great Depression Explained - Part 1

Back to sermonizing people. Long weekend in the UK and I am at home doing not much, reading and sleeping. BTW, go watch Piranha 3D, it is awesome – not for the faint hearted of course. Today’s Wide Angle is about the Great Depression. Everyone has read about the current credit crunch and has read and re-read analyses. The Great Depression was the big daddy of them all – the world has been living through booms and busts through centuries but nothing has come close to the Great Depression in terms of scale (destroyed most of the big economies), impact (quarter of the American population became unemployed during the height of the depression) and duration (lasted almost 10 years). In my quest for finding out answers to why this happened, I read a book called “Lord of Finance: 1929 The Great Depression Explained and the Bankers Who Broke The World” by Liaquat Ahamed. Ahamed has been a successful investment manager on Wall Street. And is currently an advisor to several hedge fund groups.
The book is the story of four Central Bankers – Montagu Norman the Governor of the Bank of England, Hjalmar Schacht of the German Reichsbank, Benjamin Strong – the Chairman of the Federal Reserve Bank (Fed) of US and Emile Moreau – the head of the Banque de France. These four were the heads of the Central Banks of their respective countries between the end of the First World War and the beginning of the Great Depression around 1929. It was their actions taken in concert and individually that led to the Great Depression. While these four cannot be held totally responsible, the policies and principles that they stood for and propagated eventually led to the world going into Depression pretty much the way the bankers today caused the recession with the “toxic” investments. I am going to lay out in a simple manner what exactly happened back then that caused such a massive debacle in world finance. For ease of reading, I will break this up into parts since the topic is long and needs explaining.

Some Concepts to Start Off With:
Here are the main concepts that I thought I now understand and that results in financial problems in the world. Firstly, inflation – this simply means rise of prices because of more currency being becoming available in the market due to either lowering of interest rates or through printing of more money by the government. If interest rates are lowered, more people opt for loans since the interest is less, banks lend freely and hence money supply in the market increases. If money supply increases, the thing that cost X would cost X+Y because of more currency in the market.
Conversely, if inflation is too high either due to high prices (maybe because of shortages e.g. the prices of food grains) then the government increases the interest rates to reduce the money supply in the market thus reducing the prices of things (or so they aim for). This is called deflation. Deflation can result in less demand for goods (more demand – more price, less demand – less price) due to which industries cut production and unemployment may rise. Governments and central banks always have to balance the interest rate against prices and demands in order to make sure the economy is neither too overheated nor too slow. This is what is typically called credit policy which our RBI governor announces from time to time.
Another concept is of exchange rate of the currency. In simple terms, if your currency is valued lower than others, your prices will be cheaper in the world market and hence your exports will be more competitive. If your currency is higher in value, imports will be cheaper because you will pay less for the goods. Every government is free these days to determine its currency value i.e. internal and external considerations are applied to discreetly decide on the currency rate.
However, before the Great Depression, there were a handful of powerful economies in the world (US, France, England and Germany) with lot of small sized ones and they all adhered to something called the Gold Standard. This simply meant that the value of your currency was in direct correlation to the amount of gold that your country had. The higher your gold holdings, stronger would be your currency. Also, currency could be interchanged with gold, for example France could hold a million pounds in its accounts which were secured by gold in the vaults of England. Theoretically, France could pay the million pounds back to England and demand its gold in return which under the laws of the Gold Standard was an automatic assumption.
The Gold Standard was a matter of high principle for most of the bankers of that era because it tied down governments to a tangible asset i.e. gold thus limiting their powers of printing money at will and thus maintaining fiscal discipline. This also worked beautifully because through the nineteenth century and up to World War 1, the discovery and production of gold was able to keep pace with economic growth so the currencies could be pegged to gold. Before the war, US owned 50% of the world’s growth while Germany, England and France owned around half of it thus maintaining a delicate balance in the currency and trade world.

Impact of War:
Before the World War 1, London was the financial capital of the world and acted as the bank of the world. It borrowed, lent, insured to the world economies and industries and the pound was the prime currency of the world. The economies of the four main countries were intertwined deeply with German assets in the Bank of England and French holding English assets etc. Most of the bankers thought that a war was simply impossible since the world depended so much on each other. However, the World war did happen and for four years, the battles were bloody and costly in France and Belgium. America was the one who profited most from the war since till 1917 they were outside the war and thus able to act as suppliers to the warring nations. This trade gave America significant amount of gold (transferred from UK and France) and they also ended up giving debts to UK and France. The economies of France, Germany and Britain were hammered because of the war and the dollar became more pre-eminent because of the surplus gold that America now held.
Some figures to quote before we move on that will give a view of the situation – the economic impact of the War on the major countries was that German and French economies shrank by 30 percent while Britain’s shrank by 5 percent. Before the war, the GDP of America was $40 billion per annum and was roughly equivalent to that of Britain, France and Germany put together. After the war, it was more than 50 percent larger. The gold held by America increased from half of the world’s supply to more than 75% of the world’s stock.
Additionally, to finance the war effort, different countries adopted different methods. The simplest method was to raise taxes on the population that would pay the bill but that was impossible. None of the governments even tried this, they resorted to borrowing first, then they resorted to most common technique used by governments at war – inflation, they simply printed more money to pay for the war effort. The supply of money in England doubled by the end of the war, it tripled in France and quadrupled in Germany. All these countries ditched their link to gold and resorted to inflation. Britain was the most responsible of the countries and thus ended up borrowing mainly from banks and the US, they resorted to less printing of money. France was between UK and Germany, they spent $30 billion on the war, $15 billion was raised through selling bonds to the middle class savers (French were notoriously good savers), $10 billion came from UK and US and the rest through inflation. Germany was at the other end of the spectrum, it simply did not raise taxes nor could it borrow from rich allies, so they printed money. Prices quadrupled and they ended up losing the war which made them subject to reparations.

Case of German Reparations:
The situation at the end of the war was thus – France owed Britain some money and owed lot of money to US. Britain owed money to US. France was extremely insecure about gold hence they had simply removed their gold and stored it elsewhere and resorted to government bonds for financing. Britain had gone the straightway and in the transactions with America, lot of its gold had gone to America. The bankers i.e. Strong and Norman (UK Bank Head) became good friends and they began to collaborate to bring the world back to the gold standard. Norman was the voice respected in the financial world and he was a fervent believer in the gold standard and the pound’s pre eminence in the world. Both France and UK wanted Germany to pay reparations for the war since it was the loser, they expected to pay off America’s and internal loans by German money. The mood in Germany was completely against reparations – France was more belligerent since it had suffered many casualties. This question of reparations haunted the world of finance for the next two decades.
Around this time, John Maynard Keynes rose to prominence by writing his treatise “The Economic Consequences of Peace”. In this book he argued that Germany was in a bad shape and to ask them for reparations would only cause bad blood. Since America was the richer power, it could simply loan Germany the money which Germany could pay to France and UK as reparation which France and UK could use to repay America’s loans. This would ensure all were satisfied and America got their money back after circulating. However, the Americans did not agree to forego the Allies loans and France did not agree to let go of German reparations. The demands being made on Germany ranged from $50 billion (German GDP was $12 billion) to $100 billion. Finally, the Allies settled at a first payment of $5 billion before May 1921. The Germans were also treated badly at the peace talks (no chairs were given for them to sit). This led to anger in the German nation and it was this anger that eventually caused the Second World War.

Path back to the Gold Standard:
If the main countries had to return to the Gold Standard, they would have to do a lot of restructuring since the situation with the gold reserves had completely altered. Britain had much more currency in comparison to the gold they held so they could not have their currency rate at the same level as pre-war ($4.86 per pound as against the rate of $3.2 now). To move towards parity, they would either have to reduce the currency in circulation (deflation) or reduce the exchange rate of the pound (devaluation) to reflect its current gold reserves. England chose deflation since Norman wanted to maintain the pound as the primary currency of the world. This caused recession and the British economy went through pain (job losses) for the next few years (till 1923) but the currency circulation was back to normal.
France had significant gold reserves and more inflation which it brought under control by putting a lid on more currency printing. It ran a budget deficit but its army of middle class savers ensured that the country was in good fiscal shape. Its only problem was the debt to America which it hoped to pay for by German reparations. The French were also mentally reconciled to devaluating their currency once they went back to the Gold Standard.
It was here again that Keynes came back with a stinging pamphlet called “A Tract on Monetary Reform”. In this he argued that the gold standard was now a “barbarous relic” which should be now be discarded because of the skewed distribution of gold and governments should be in full control of the decision to peg their currency rates in accordance with the domestic fiscal situation. His views were met with derision and especially opposed by die hard Gold Bugs like Norman and Strong. Time was to prove him right.

So much for this week. Hope you found this interesting to come back next week for the next part of the story. It gets fascinating to say the least.