X. GETTING WHAT YOU WISH FOR

Deflation has consequences beyond the glow of moral satisfaction it produces in its advocates. As Irving Fisher and Maynard Keynes had long since pointed out, deflation is the scourge of debtors, since the principal value of a loan doesn’t change when prices and wages fall. But nor is a serious deflation a boon for creditors, since past a certain point, debtors will simply default and bring the creditors down with them. The French-engineered price collapse in Europe did just that. Over the spring and summer of 1931, virtually all the major countries departed the gold standard. The primary axis of contamination ran from Austria to Germany to Great Britain.

The first victim was Austria’s largest bank, the Kreditanstalt, part of the Rothschild financial network, with a blue-ribbon business clientele. Like many Germanic banks, the Kreditanstalt took equity positions in its clients as well as lending to them. Given the financial disruptions in postwar Europe, the Austrian government had enlisted the bank’s aid in workouts of troubled lenders, most of them small. But in 1929, the Kreditanstalt had agreed to rescue its largest competitor out of bankruptcy, making its balance sheet bigger than that of all the rest of the Austrian joint stock banks combined. Worse, the bank’s portfolio was seriously mismatched, with long-dated troubled assets funded with volatile, short-term liabilities. As the loan portfolio continued to deteriorate, the government made secret cash infusions to keep the bank afloat, which must have been known within Vienna’s elite. But it was still a shock when in early May 1931 the officers admitted that they had run through almost all of the bank’s capital, and still were exposed on $100 million of short-term liabilities in favor of the US and European nationals. A run on the Kreditanstalt quickly turned into a run on Austrian banks. The government stepped in again with an equity infusion for the Kreditanstalt, and the Austrian National Bank (ANB) took over large swaths of its paper.⁸⁹

Austria was a country of only seven million people, and the Kreditanstalt was still relatively small potatoes. But the name and the connections drew the spotlight. The apparent takeover by the government and the ballooning short-term credits provided by the ANB looked like the first stage of a determined inflation. Most European banks were walking on a knife’s edge. Superficially, they were brimming with deposits, but an unusually high share of them, in the range of $3 billion, was hot money drawn by the continent’s high rates but ready to jump at the hint of danger. The ANB had begun the episode with a strong reserve position for a country its size. But once a run started, its reserves dropped by a third within just a few weeks. Seizing the chance to weaken a German ally, the French quietly encouraged their banks to repatriate their deposits in Austria.⁹⁰

Seeking protection, the ANB cobbled together a $15 million credit line from the Bank of England, the Federal Reserve, and the BIS, but it took three weeks, well into June. By that time, the run had intensified, and the ANB was in desperate need of another $20 million. France volunteered to provide it, subject to the condition that Germany and Austria drop plans of forming a customs union, which they had announced two months before. (In the nineteenth century such arrangements had been a step toward unifying Prussia and smaller German states. Versailles had strong provisions against German territorial additions.) Austria indignantly refused, and Norman provided the money from the Bank of England. But he conditioned the loan on a stand-still agreement sharply limiting depositors’ ability to move their money out of the country. In the eyes of traders, stand-stills were tantamount to leaving the gold standard. The Austrian government fell, and markets were distorted, although, technically, the Kreditanstalt did not fail.⁹¹

Stand-still agreements were like a virus—once used, they spread like swine flu. If Austria froze deposits, the offshore depositors were at greater risk of defaulting on their non-Austrian obligations. The Berlin stock market dropped steeply, and wild rumors swept through the German financial community. The Reichsbank lost $250 million of gold and foreign exchange in just three weeks. Later research suggests that it was the German depositors who were the first movers in pulling out their money, and there are multiple reports of wealthy Germans hauling suitcases of money over the Dutch and Swiss borders. The panic eased on June 24 when Hans Luther, a former finance minister who had replaced Schacht at the Reichsbank, put together a $100 million credit line from the Bank of England, the Federal Reserve, and the BIS.⁹²

By that time, Lamont had begun lobbying President Hoover to declare a moratorium on war debts and reparations. While Hoover was vetting Lamont’s proposal with his cabinet, the conservative German chancellor, Heinrich Brüning, trying to gain control of the Reich’s budget deficits, announced a major austerity package, including new taxes and substantial benefits cuts. In the same announcement, he complained bitterly about the Young plan and “the intolerable reparation obligations” and “tributary payments” being exacted from Germany. Henry Stimson, Hoover’s secretary of state, took umbrage at Brüning’s tone, warning that it would trigger capital flight from Germany and undercut Hoover’s still secret moratorium.⁹³

Two weeks later, after extensive consultations with the Congress, and with Germany hemorrhaging gold, Hoover announced that the United States would forego a year’s principal and interest on $245 million of war debts, provided the Allies suspended $385 million in reparations. Incredibly, as it seemed to outsiders, the administration teams putting together the package had diligently consulted everyone except the French, by far the largest reparations creditor. But it was not an oversight; Hoover feared that the French would block his proposal, so he and Stimson chose to surprise them. The entire French nation was outraged. Treasury secretary Mellon was in France on a vacation and was hurriedly dispatched to Paris to patch things up, which he did, after three weeks and some minor technical adjustments, a delay that was costly.⁹⁴

By the time the moratorium was officially announced, a major German textile conglomerate had failed, exposing the Danat Bank, one of Germany’s largest. An immediate panicked run on the Danat forced Luther to run through his entire credit line by July 4. Luther somehow kept the Reichsbank afloat, although in violation of its gold and exchange reserve requirements. On July 8, Luther told the other major central banks that he needed a new credit line of at least $500 million, and ideally $1 billion, to stop the rot. The bankers were skeptical. Their information suggested that it was German nationals, not foreign depositors, who were causing the run. There was also a loose consensus that the sums Luther was looking for needed approval from their respective governments. That was impossible: French aid would come only with stringent political conditions; the British wanted all reparations and similar conditions dropped; the Americans were willing to countenance a one year moratorium, after which the agreed payment schedules would once again be enforced. At a London meeting of July 20–23, the bankers and government representatives agreed only to organize a study group. Like Austria, Germany did not officially go off the gold standard, but maintained a pretext of functioning by freezing all international accounts—in effect, living off other people’s money, as they had been doing for some time.⁹⁵

By mid-1931 Great Britain’s Labour government had been in power for two years, and was tearing itself apart. The prime minister, Ramsay MacDonald, and his chancellor, Snowden, were diligently following the hard path required to wrench the country’s finances into conformity with its overvalued pound. For their pains, they had seen industrial output decline by about a fifth and the unemployment rate double to about 22 percent. Arthur Henderson, the foreign minister and a leading figure in the TUC, accused the government of punishing ordinary workers to satisfy the whims of its overpaid financial industry. Great Britain was clearly in trouble. Its short-term liabilities were at least $2 billion, supported by only a fourth or fifth that amount in gold reserves. It had succeeded in reducing imports, but had cut its exports even more. It had cut its overseas capital investment, but had seen its invisibles trade and earnings from overseas investments fall even more—precisely vindicating Keynes’s sarcasm in Consequences of Mr. Churchill that “so far as the maintenance of the gold standard is concerned, it is a matter of indifference whether we have £100,000,000 worth of foreign investment or £100,000,000 worth of unemployment.”⁹⁶

The July attacks on the Danat bank quickly spread to the pound. Sterling fell beneath the gold export point, and within two weeks, Great Britain had lost a quarter of its gold and foreign exchange reserves, at a time when the German stand-stills had barred access to $300 million of British deposits. Financial authorities in France, Belgium, Switzerland, Holland, and Sweden all pulled assets out of London. It didn’t help that the government released the final version of the parliamentary Macmillan Report, an analysis of the country’s fiscal situation, for it had the first revelations of the country’s immense overhang of short-term liabilities. Rumors flew. The government responded with platitudes. Norman collapsed, and left for a months-long recuperation in Canada. Parliament adjourned.⁹⁷

Harrison and Clément Moret, Moreau’s successor at the Bank of France, assembled a credit line of $250 million in July, each putting up half. Its effect was diminished by haggling over the process for disbursing funds. At about the same time, Snowden announced the current year’s budget deficit would be well over $600 million—the biggest since 1920—and would be even larger the next year.⁹⁸

Great Britain burned through the $250 million in less than a month. Snowden produced a new, rigorously austere budget, which split the Labour party and brought down the government. But the king asked MacDonald to stay on as prime minister and organize a national government comprising mostly Conservatives and Liberals. Snowden was also retained as chancellor. Harrison worked diligently with the Bank of France and came up with a $400 million rescue package, half from a private flotation by a Morgan-led banking consortium, while the French supplied its share 50:50 from a private flotation and a public offering.⁹⁹

At the end of the day, the British commitment to gold may have been undone by a Yertle the Turtle event. As all Dr. Seuss fans know, Yertle was forced to hold up a huge tower of turtles, but when he burped, the whole construct collapsed. On September 15, the Admiralty announced that five hundred sailors at the Royal Navy base at Invergordon, Scotland, had refused to man their ships after learning of Snowden’s pay cuts. The men had held an orderly meeting in a field, and later they “could be seen dancing on the decks of one battleship, and from all the ships came sounds of men singing and shouting.” Their grievance was twofold. Men who had enlisted in the early years of the war received “permanent pay” of a $1-per-day equivalent, while newer men received a lower rate. The chancellor had not only broken the “permanent pay” pledge, but had made much steeper percentage cuts in the lower pay scales than for top officers. The nation was shocked, although the Admiralty had the good sense to announce an investigation into the men’s complaints. In parliament, Winston Churchill cursed the gold standard, and Viscount John Sion, a senior and respected Liberal, called for the adoption of a tariff—a particularly radical notion in dogmatically free trade England. In his history of the period’s central banking, Stephen V. O. Clarke writes “[T]here can be little doubt that the so-called mutiny… precipitated the final onslaught against sterling.”¹⁰⁰

By September 16, almost half of the new $400 million line had been committed to the defense, but with little visible effect on the markets. By September 19, the Bank of England’s gold and foreign exchange exceeded its most pressing liabilities by only $20 million. By that point, the defense of sterling had consumed $1 billion over the space of two months, completely overshadowing Snowden’s first balanced budget. Sir Ernest Harvey, the bank’s deputy governor, who was acting for Norman, called Harrison in New York on the 19th to warn him that England was planning to go off the gold standard on Monday, the 21st. Harrison proposed alternatives, but Harvey had no interest. Harrison’s memorandum records: “I said it seems a great pity to let it go and asked whether there was anything we could do within reason. Harvey replied that he thought we had already done a great deal and that he saw nothing else which we could do to help, that there was no alternative left.”¹⁰¹

The blow to global confidence from the British departure was palpable. American bank failures rose by 86 percent in the second half of 1931, and defaults on foreign dollar bonds increased seventeenfold. The decline in industrial output accelerated, and industrial country unemployment reached new highs. World exports fell by about a third in 1932. Overall volumes were just two-fifths of those in 1929.¹⁰²

France enjoyed a much easier Depression than the rest of Europe until about 1932, when their beggar-my-neighbor policies caught up with them. First of all, the deep decline in European production and purchasing power destroyed their export markets—specialty foods and wines, perfumes, and tourism. European prices mostly fell to the range of those in France, destroying the special advantage of the undervalued franc. And since the commodity gold price was no longer a constraint on most of France’s trading partners, franc prices could be readily undersold. French unemployment spiked in 1932 to 15 percent, and industrial production dropped by 25 percent. From that point to the run-up to the war, the French economy simply stagnated.¹⁰³

Germany and the United States are generally conceded to have endured the most serious depressions. In Germany, where unemployment rose to the 40 percent level, ragged crowds of former workers and their families were reduced to beggary. The destabilization paved the way for the rise of Hitler, who imposed a command economy focused on military production and financed by a radical suppression of consumer demand. By the mid-1930s, Germans were virtually fully employed living at a spartan but sustainable level. Most were happy to make the trade. Reparations had been repudiated, and Hitler was driving to a near autarkic economy.¹⁰⁴

At a 1932 conference in Lausanne, Switzerland, Great Britain, Germany, and France agreed to suspend reparations, provided that the United States would suspend collection of its war debts—which Congress refused. The following year, Hitler repudiated the entire Versailles framework.

In 1933, in the United States, a new president, Franklin D. Roosevelt, attempted to inaugurate what his publicists called a “New Deal.”