Bill Totten's Weblog

Sunday, July 11, 2010

Heroes and Zeroes

When central bankers rescued, then ruined, the world.

In the nineteen-twenties, the great central bankers were considered heroes. Then they led the world into economic catastrophe.

by John Lanchester

The New Yorker (February 02 2009)

As a child, I was frightened of ATMs. Specifically, I was frightened of the first ATM I ever saw, the one outside the imposing headquarters of the Hongkong and Shanghai Bank, at One Queen's Road Central, Hong Kong. This would have been around 1970, when I was eight. My father, being an employee of the bank, was an early adopter of the ATM, which stood just to one side of the building's iconic bronze lions, but every time I saw him use it I panicked. What if the machine got its sums wrong and took all our money? What if the machine took someone else's money by mistake, and my father went to prison? What if the machine said it was giving him only ten dollars but actually took much more out of his account - some unimaginably large sum, like fifty or a hundred dollars? The freedom with which the machine coughed up its cash, and the invitation to go straight out and spend it, seemed horribly reckless. The flow of money, from our account out through the machine and then into the world, just seemed too easy. My dad would stand there grimly tapping in his PIN number while I hung onto his arm and begged him to stop.

My scaredy-cat eight-year-old self was on to something. The sheer frictionlessness with which money moves around the world is frightening; it can induce a kind of vertigo. This can happen when you are reading the financial news and suddenly feel that you have no grip on what the numbers actually mean - what those millions and billions and trillions actually represent, how to get hold of them in your mind. (Try the following thought experiment, suggested by the mathematician John Allen Paulos, in his book Innumeracy [1990]: Without doing the calculation, guess how long a million seconds is. Now try to guess the same for a billion seconds. Ready? A million seconds is less than twelve days; a billion is almost thirty-two years.) Or it can happen when you look at a bank statement and contemplate the terrible potency of those strings of digits, their ability to dictate everything from what you eat to where you live - the abstract numerals whose consequences are the least abstract thing in the world. Or it can happen when the global flow of capital suddenly hits you personally - when your apparently thriving employer goes out of business owing to a problem with credit, or your mortgage payments jump unpayably upward - and you think, Just what is this money stuff, anyway? I can see its effects - I can thumb a banknote, flip a coin - but what is it, actually? What do these abstract numbers stand for? What is the thing that's being represented? Wouldn't it be reassuring if it was more like a physical thing, and less like an idea? Wouldn't the global financial system be less vertiginous, less bizarre, if your money actually stood for something?

The answer to that question is no, and we know this because the system was in effect for years and - to borrow a phrase from the subtitle of Liaquat Ahamed's new book, Lords of Finance (Penguin Press, 2009) - it "broke the world". The system was the gold standard, and it involved the world's major currencies being pegged against gold in a way that was, in theory, redeemable: that is, you could go to the bank and exchange your currency for a specified amount of gold. In the United States, it was 23.22 grains of gold to the dollar; in the United Kingdom, it was 113 grains to the pound sterling. (A grain is based on the notional weight of a grain of wheat: 1/7,000 of a pound.) By fixing currencies to gold, the gold standard also fixed them to each other. In addition, the central banks, which had a monopoly on printing and distributing money, were obliged by law to keep the amount of money in circulation linked to the amount of gold in their reserves. This was not just a local issue but a planetary one. Even the most vertigo-prone of us, those who are least comfortable with the abstractness of modern money, can begin to spot a problem here: what if the world needs more money? What if all the gold is in the wrong place, or there isn't enough of it?

These turn out to be good questions. Liaquat Ahamed's book stretches from the beginning of the First World War to the setting up of the Bretton Woods system to regulate the global flows of capital, at the end of the Second. At the time his story begins, Ahamed estimates that the entire global supply of gold can be stored in a two-story town house. Most of it is to be found in the vaults of the world's central banks, doing the passive work of propping up the respective national currencies. The men in charge of the gold are the heads of those central banks, and it is they who are the central figures of Ahamed's book.

That might make the story sound dry - but it isn't, not at all. The central banks turn out to be unexpectedly rickety institutions. Most of them had an odd semi-private, semi-public status, as privately owned companies with a legal monopoly on printing money. The oldest of the four central banks that Ahamed writes about, the Bank of England, was founded in 1694 to help pay for the latest installment of the European wars, and it was set up by a group of Protestant merchants, several of them French Huguenot refugees, who made the following offer: the government would get a loan of 1.2 million pounds in perpetuity, at an interest rate of eight per cent. In return, the bank would be allowed to issue 1.2 million pounds in banknotes, and have the exclusive right to be the government's banker. So the setting up of the central bank was a mutually beneficial deal to create a monopoly - with the faint but perceptible smell of a conspiracy against the public. This trend was to continue. America's first modern central bank was established in 1913, in the teeth of strong populist suspicion of bankers. The men who conceived it were worried about the perception that they were forming a cabal, and so did what you naturally do when you're worried about that: they travelled by private train, under pseudonyms, to a top-secret meeting at a private island off the coast of Georgia.

The institution they envisioned became the Federal Reserve, and it was a compromise from the start. The bankers wanted a single central bank, but opposition in Congress watered the plan down so that it created twelve autonomous regional institutions overseen by a board of governors appointed by the President. Benjamin Strong, the first head of the New York Federal Reserve Bank - which, it was soon clear, would be the most important of the twelve branches - had been at the island meeting, and supported a single central bank. Strong argued, in Ahamed's words, that the Federal Reserve's "decentralized structure would simply perpetuate the fragmentation and diffusion of authority that had so bedeviled American banking and would only lead to conflict and confusion".

Strong was right about that; he was right about many things, and, of the four central bankers in Ahamed's book, he is the one who seemed to have the most flexibility of mind - though he could also be forceful to the point of brutishness. He died in 1928, just before the end of the bull run and the subsequent crash; if he had lived, Ahamed thinks, the United States might have done a much better job of managing its way through the subsequent economic turmoil.

The three other men lived through that turmoil, and didn't do a great job of trying to alleviate it. It may not have helped that they all had personalities that teetered on the verge of self-caricature. The oddest of them was Montagu Norman, the governor of the Bank of England, which at the time of the First World War was, thanks to its age and its place at the center of the British Empire, the most powerful financial institution in the world. Norman was a clever man, and a world-class flake - a bohemian who cultivated a voluptuous Vandyke beard, preferred the company of artists and designers to that of his colleagues, and usually dressed in a floppy hat and a cloak. He was a neurotic, an obsessive about secrecy, a manic-depressive, and a sometime Theosophist, who once told a colleague that he could walk through walls. If he were a children's entertainer, you would decide not to employ him after checking out the photo on his Web site. He travelled under the pseudonym Professor Clarence Skinner, as part of his policy of maximum shiftiness; when asked by a British government select committee what his reasons were for a particular decision, he tapped his nose three times and said, "I don't have reasons. I have instincts." Try that one on Henry Waxman.

The climax of Norman's career was in 1925, when he prevailed on Winston Churchill, then Chancellor of the Exchequer, to return Britain to the gold standard - the fixed rate having been abandoned during the war. Churchill was no financial guru. He recalled how his father, Randolph, who had also been Chancellor, talked about struggling with decimal points: "I never could make out what those damned dots meant". In later years, Churchill saw the return to the gold standard as "the biggest blunder" of his life: "I had no special comprehension of the currency problem and therefore fell into the hands of the experts, as I never did later where military matters were concerned". He often ranted about "that man Skinner". In the short run, though, Norman got the credit for the restoration of the international financial system. He was a heroic success, before he was a heroic failure - a trajectory common to all four of Ahamed's subjects.

The second temporary hero of inter-war finance was Horace Greeley Hjalmar Schacht. (His father gave him his first two names, which he didn't use, in honor of the founding editor of the New York Tribune.) Schacht was the German central banker who took the credit for rescuing the German currency from the hyperinflation that overtook it after the First World War. By the early nineteen-twenties, the German economy, damaged by defeat, had become crippled by the attempt to pay the reparations demanded by the victorious European Allies and simultaneously develop a social-welfare state. The government printed as much money as it could, and inflation was running out of control. In 1914, the German mark had stood at 4.2 to the dollar; by 1922, it was 190 to the dollar; by the end of that year, it was 7,600. By November 1923, a dollar was worth 630 billion marks, a loaf of bread cost 140 billion marks, and Germany was disintegrating under the strain. Schacht was appointed currency commissioner, and took charge of the project to issue a new currency, the Rentenmark, whose value was underpinned not by gold but by land. (For a short period, Germany had two legal currencies.) The Rentenmark held its value, helped by such drastic measures as the firing of a quarter of the government's workforce. Schacht became a national hero. He seems to have been a spectacularly unpleasant man, whose physical rigidity, starched collars, and stiff gait offer a precise parallel to his prickly, arrogant personality - a man who embodied to full effect negative stereotypes of the petty bureaucrat and the banker. He struck a contemporary as "a compound of a Prussian reserve officer and a budding Prussian judge who is trying to copy the officer". In later life, he worked with the Nazis, though he never joined the Party, and eventually became so disillusioned with Hitler that he was involved in conspiracies to overthrow him. Schacht was tried with leading members of the regime at Nuremberg (where John Dos Passos described him as looking "like an angry walrus"), and was acquitted. After several more trials, and a solitary conviction that was overturned on appeal, he lived in freedom until his death, in 1970, at the age of ninety-three.

Emile Moreau, the fourth lord of finance, was another hard banker to love, a blunt version of the classic French haut fonctionnaire, preoccupied with questions of national status. As head of the Banque de France, he had the greatest success of any European central banker in the years after the First World War. His masterstroke was to hold the value of the franc to a low level. Germany was crippled by war reparations and inflation, and Britain had gone back to the gold standard at too high a level. For the British, the postwar years saw a textbook deflationary trap. Prices were falling, but interest rates were kept high to protect the pound, which in turn made exports too expensive. The result was rocketing unemployment and a general strike. In contrast, Moreau, by keeping the franc cheap, presided over a boom in exports. All those foreigners buying inexpensive French goods meant that France was sucking up money. The Fed, thanks to the American wartime boom, had most of the world's gold; the Banque de France now had much of the rest. The analogy would be a poker game in which two players have won nearly all the chips, and no one else can play. Montagu Norman was one of the people who foresaw disaster but were unable to prevent it. He wrote to Moreau that "unless drastic measures are taken to save it, the capitalist system throughout the civilised world will be wrecked within a year".

It's easy to be reminded, by all this, of more recent events. It's also easy to see history through the eyes of the present, and make people look stupid for not knowing what we know. Liaquat Ahamed has the imagination not to do that. While he makes clear the ways in which his protagonists were wrong, he doesn't judge them anachronistically. He shows just how hard it is to be right when one is confronted with new facts and unfamiliar developments. He was inspired to write the book by a 1999 issue of Time with the cover line "The Committee to Save the World", featuring a photograph of Alan Greenspan, Robert Rubin, and Lawrence Summers. The occasion for the piece was the 1997 to 1998 meltdown in developing markets, and the ensuing collapse of Long-Term Capital Management, which, by some estimates, risked blowing a trillion-dollar hole in the world economic system. Ahamed was an investment manager during this period, and his book is informed by an awareness of how unprecedented events look at the time they are being lived through - an awareness that helps to make his book seem timely today.

Would a book about the men in charge of today's global financial system be called "The Committee to Save the World"? Or "The Bankers Who Broke the World"? It's too early to say, though it's not too early to ask - and one should bear in mind that the consensus opinion on these things tends to fluctuate. You may well have been taught in school the same thing I was taught, that the New Deal brought an end to the Great Depression; but, of a hundred economists surveyed in the mid-nineties, nearly half agreed with the proposition "Taken as a whole, government policies of the New Deal served to lengthen and deepen the Great Depression". The present calamity will probably be the subject of debate for as long as the crash and the Depression have been, and will provide equally rich material. Consider Ben Bernanke and Henry Paulson: the slouchy Jewish academic who, thank God, made a special study of the causes of the Great Depression; and the aerobicized Christian Scientist former head of Goldman Sachs. The scenario resembles a movie pitch: Danny DeVito and Arnold Schwarzenegger - and they're twins! As for Calvin Coolidge, the President who, in Ahamed's words, "elevated inaction to a point of principle": not hard to think of a latter-day parallel for him. And then there's the cast of differingly motivated, ideologically disparate foreigners, each trying to build his or her own national life raft: Gordon Brown, Angela Merkel, Nicolas Sarkozy. Perhaps most fascinating of all is the man who was at the center of that Committee to Save the World and who got most of the credit for the boom before it turned into a bust: Alan Greenspan.

The crucial questions in history often turn out to involve things that people at the time simply did not understand. Sometimes these things were too complicated to be resolved, and sometimes they were so glaringly obvious that they were hidden in plain sight. Sometimes they were both at the same time: horribly complex, horribly obvious. In the buildup to the 1929 crash and the subsequent depression, the linked issues of reparations and the gold standard were at once unfixably complicated and so much at the heart of the system that they were hard to see plainly. The equivalent issue at the heart of the current financial meltdown is that of risk. For reasons to do with a lack of historical awareness, overconfidence, and faulty mathematical modelling, the entire global financial system was built on mistaken calculations about probability.

Greenspan, who more than anyone else was central to this system, told the House Committee on Oversight and Government Reform on October 23rd that the crisis was prompted by "a once-in-a-century credit tsunami", which had arisen from the collapse of a "whole intellectual edifice". "Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity - myself especially - are in a state of shocked disbelief", he said. This failure of self-interest to provide self-regulation was, he said, "a flaw in the model that I perceived as the critical functioning structure that defines how the world works". It's worth dwelling on that phrase: "the critical functioning structure that defines how the world works". That's a hell of a big thing to find a flaw in. Here's another way of describing that flaw: the people in power thought they knew more than they did. The bankers evidently knew too much math and not enough history - or maybe they didn't know enough of either.

Montagu Norman, that odd, lonely man who was once the most powerful central banker in the world, came to feel that his life had been largely futile. Reflecting on his work and that of his friend Ben Strong, of the New York Fed, he wrote, "As I look back, it now seems that, with all the thought and work and good intentions ... nothing that I did, and very little that old Ben did, internationally produced any good effect - or indeed any effect at all except that we collected money from a lot of poor devils and gave it over to the four winds".

Bill Totten


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