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February 6, 2012

“Lords Of Finance”

by Anne Paddock
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In 2010, “The Lords of Finance” by Liaquat Ahamed, a professional investment manager was awarded the Pulitzer Prize for History. A non-fiction account of “the bankers that broke the world,” this 505 page book takes a complicated topic – macro and microeconomics – and makes it easily understandable.The book begins with an annotated biography of the four major bankers overseeing the largest economies in the world at the beginning of the 20th century:

  1. Benjamin Strong, Jr., United States:   Federal Reserve Bank of New York
  2. Montagu Norman, England:   Bank of England
  3. Hjalmar Schacht ,Germany:   Reichsbank
  4. Emile Moreau, France:   Banque de France

Once the reader has a basic understanding of the players, the author delves into the international banking industry and how the system operated. Of primary importance is understanding that central banks were not organized as they are today with an overall governing entity. At the time, banks adhered to what is referred to as the “gold standard” which tied a currency to a specific quantity of gold. As the author so clearly points out, there was universal faith in gold as the foundation of the international monetary system but with a limited supply and all players subscribing to the same rules, the world economy could not continue operating on a gold standard.

Enter WW I – a war that everyone thought would last for months but in reality continued on for more than four years. Wars are costly endeavors according to Ahamed and none more so than the first world war with both England and France greatly relying on large-scale borrowing from the United States to finance the fight against Germany. At the end of the war, Germany was punished in many ways but the most damaging was by far the demand for war reparations they could ill afford to pay.

The author points out the European allies tried to link the high war reparations to their war debts and deeply resented the United States for rejecting the association and instead insisting debt owed to the Americans is separate from war reparations owed to the European allies. In order to make the war reparations, Germany resorted to printing money which caused outrageous inflation and transformed the class structure of Germany. Those with hard assets saw their value soar while inflation wiped away the debts. Those that had their investments in bank deposits or in government bonds watched their assets become essentially worthless.

France and Britain also experienced severe inflation after the first world war because they too opted to print money to pay their war debts. To restore the balance between the value of the gold reserves and the total money supply, each country had to decide whether they would choose deflation or devaluation. Deflation would mean contracting the amount of currency in circulation whereas devaluation requires reducing the value of the currency. Germany and France took the route of devaluation while England and the US chose deflation. Because each economy had so many moving parts, the author points out there was no clear path to keeping prices stable and the economy growing while making debt payments or reparations.

With Germany owing $12 billion (equivalent to $2.4 trillion in todays dollars) in reparations to the Allies and the Allies owing nearly as much to the US – and both parties having difficulty paying – the bankers came up with a plan called the “Dawes Plan” which primarily involved lending Germany money with the intent to grow the economy and thus making the reparation payments more feasible. Ahamed quotes the leading economist of the times John Maynard Keynes saying the Dawes Plan is “a great circular flow of paper across the Atlantic: The United States lends money to Germany, Germany transfers its equivalent to the Allies, the Allies pay it back to the United States government. Nothing real passes..” What the Dawes Plan did do, according to the author is allow the economies to continue operating for a few more years until replaced by the “Young Plan” which called for Germany to make lower reparations but over 58 years thereby “saddling two generations” of Germans. This plan of course, failed miserably.

In the 1920’s, the Federal Reserve was relatively new and the author spends considerable time explaining how this bank came about, the structure, and the problems they faced: the biggest being interest rates and when to react. It’s no secret that raising interest rates contracts growth because money is more expensive to borrow while lowering rates stimulates the economy by making money easier to borrow and thus invest in the economy; the bankers just didn’t respond fast enough.

The management of interest rates, especially in the United States was a key issue in the 1920’s according to the author because America faced tremendous pressure from Europe to keep rates low but this action led to widespread speculation and eventually the crash of the stock market, bank failures, high unemployment and the Depression.Interest rates, wages, government budgets, lending practices, saving habits, markets, employment, population, and monetary policy – all of these pieces are spokes on a wheel that need to work in conjunction to keep prices stable and an economy growing. Ahamed shows the reader that there is no one right prescription to make an economy work especially when the world is a global economy. What becomes so clear in the book is that what is good for one country is not necessarily good for another with the author citing the US abandonment of the gold standard in 1933 and the devastating effects this action had on France’s economy. In humor, Ahamed quotes Will Rogers in saying “that it was obviously the best thing to do if both Britain and France were against it.”

The Lords of Finance” is a historical account of the days when central bankers controlled credit and currency without undue pressure from politicians and even though this all changed in the early 1930’s when Hitler came to power in Germany and Roosevelt to office in the US, the author deftly points out that some things never change:

“Financial crises would generally begin innocently enough with a surge of healthy optimism among investors. Over time, reinforced by cavalier attitudes to risk among bankers, this optimism would transform itself into overconfidence, even into a mania. The accompanying boom would go on for much longer than anyone expected. Then would come a sudden shock – a bankruptcy, a surprisingly large loss, a financial scandal involving fraud. Whatever the event, it would provoke a sudden and dramatic shift in sentiment. Panic would ensue. “

Sounds like the past decade to me.

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