Friday, August 28, 2015

Book Review #26: The Lords of Finance: Author: Liaquat Ahamed

Ambitious in scope, bold in execution, lyrical in prose and grand in its vision, the book 'Lords of Finance' tells the story of 4 Central Bankers, Montagu Morgan of Bank of England, Benjamin Strong of the Federal Reserve Bank of New York (New York Fed), Hjalmer Schacht of Reichsbank and Emile Moreau of Banque de France, who controlled and guided the financial destiny of the world during the tumultuous period of early 1900. This book covers the seminal events of the early 20th Century, World War I of 1918 followed by a brief period of global economic boom culminating in the great depression of 1929 and its aftermath leading to World War 2 and beyond.

In the introduction to the book, author Liaquat Ahamed, lays the base for the rest of the book. He starts of by discussing the terrible global consequences of the great depression - of global economic crisis, food wars, closed factories, high level of unemployment and sustained deflation. The global depression of 1929 lasted for almost 10 years and led to an entire lost generation. Another major impact of the depression was the rise of Xenophobia and the rise of Hitler and the Nazis in Germany, which would lead to terrible global tragedy (World War II) 10 years hence. Introduction also covers Gold Standard, where the value of the currency of each country was dependent on the quantity of gold possessed by the country. Since gold was hardly available world wide, Gold Standard led to restrictive credit flows and concomitant restriction on economic growth. Ebbs and flows in the availability of gold led to deflation and inflation in commodity prices.

Liaquat Ahamed wrote this book in 2008. As he was writing this, the world was experiencing similar economic depression as happened in 1929. Banks were imploding, unemployment was rising and global economy was entering into a recession. Central Bankers were trying their level best to bring order and control to global financial system, much like the protagonists of this book did at the beginning of the century. Nothing has changed except for technology. In that sense, the lessons of this book are still relevant today.

As a reviewer, what I like about this book is its structure. Liaquat Ahamed is a Finance Professional and his inherent need for order and flow reflects in this book. The book is divided into five parts, organized in chronological sequence. Part 1 titled 'The Unexpected Storm' covers the onset of World War 1 in 1914 and discusses the approach of each central bank to respond to the event. The efforts were un-coordinated and country specific. In this Part, the author introduces his protagonists detailing their career path. While the four central bankers are the key focus of the book, there are others - like Keynes and JP Morgan- who played a major part in the events that unfolded since.

Part 2 of the book, titled 'After the Deluge' covers the period from 1919 - 1923. The war had ended and the world was picking the pieces.

Part 3 of the book, titled 'Sowing a new wind' covers the period from 1923 till 1928. The global financial system had entered into a period of excess. Optimism abounded, the economies of the countries boomed and government, banks and investors started taking unwanted risks.

Of course, such excesses as was witnessed in the mid 1920's had to have their repercussions. This happened in the form of the ensuing depression from 1929 to 1933. The anatomy of this depression is captured in part 4 titled 'Reaping Another Whirlwind'

Part 5 of the book titled 'Aftermath' covers the period from 1933 to 1944 and discusses the hesitant steps the financial system was taking to come out of depression and stabilize the global economy. This initiative was thwarted when world entered into another world war in 1940.

If we human being have a flaw, it is our unbounded optimism despite historical evidence to the contrary. In the prologue, author talks about how, at the beginning of 1914, there was a certainty that a war, let alone a global war, was impossible. The world economy was inextricably linked through the flow of credit and the adoption of gold standard and any war would disturb this equilibrium and threaten the economies of all the players involved. Hence common sense suggested that the countries should not go to war !

Little did they know that a global war lasting four years was about to break out in a few months. Austria declared war on Serbia on 28 July, 1914. Initial opinion was that the war would last a maximum of six months. The economic impact of the war was felt within a few days across the world. There was run on the banks in Europe and stock exchanges across Europe were closed down. London stock exchange closed down next, first time in history. As central banks started printing currency, gold standard began to crumble. Dollar lost its value, and American businessmen who imported from Europe found themselves in payment crisis.

The responses of the Central Bank to the events impacting the country are inextricably linked to four factors. One is the savings culture of the country and the confidence that the citizens have on the stability of country's financial system. For example, both France and USA were able to raise money by selling government paper to its citizens to partly finance the war. This avenue was not open for Germany and the country was forced to print currency war leading to inflationary pressures.  Second aspect is the strength of the financial system and the financial prudence exhibited by the country. UK in the early 1900 was famous for its prudence which encouraged other countries to park their funds in UK. This ensured a steady flow of foreign capital to the country. Third aspect is the autonomy of the Central Bank. While Bank of England was relatively autonomous, Banque de France was an arm of the French Government. This meant that Banque de France had little autonomy in decision making and this weakened the financial system of the country. Final factor is the personality of the Central Banker and how they respond to crises that hit the country's financial system. Central bank is in the enviable position of having to maintain public confidence in the nation's banking system. For example,Montagu Norman, head of Bank of England, was very conservative banker and saw his responsibility as to keep London running as the credit capital of the world. Schacht of Germany was very hard working and ambitious, a trait he picked to contrast with his father who was not ambitious. Benjamin Strong of Federal Reserve Bank of New York was a crisis manager. Emile Moreau of France had grown in position by being close to the political class. While England was very conservative in spending during the war, France was very incompetent and ran up huge debt.

All the four countries were in some way prepared for the war since they had faced some form of Banking Crisis between 1907 to 1912 and had built up their Gold Reserves. However, the unexpected duration of the war (1914 - 1918) put strain on the finance of these countries and hence on the world economy at large.

By the time the war ended in 1918, the countries in Europe had already paid a heavy economic price. For one, the war had cost over 200 Billion Dollars which was almost 50 percent of their combined GDP. Second, the countries had taken recourse to debt financing (both domestic and international, mainly from US) and had mountain of debt to repay. Third, the countries resorted to printing currency to finance the war and the strong discipline of gold standard was violated.

It is fascinating to see how countries responded to these developments. Essentially, they had two options. One is monetary tightening to suck up excess currency from the system  bringing exchange rates in line with pre-war gold standard. This meant increasing the interest rates thereby squeezing the credit demand and sucking up currency from the system. UK under Norman resorted to this tactic. This led to about 6 years of economic contraction in UD, high levels of unemployment and lack of demand.  However, by 1922, the economy and prices had stabilized.

Second approach, adopted by Germany, was to accept the deviation from pre-war gold standard as the new normal by devaluing the currency.. Among all the countries in Europe, Germany was the most profligate in printing currency to finance an expected short war. However, as the war ended Germany was awash with paper currency. With the war having ended, the country was lacking goods to buy but with paper currency to spend. This led to unimaginable hyper-inflation in the country. German currency lost almost all its value.At the worst, the exchange rate was 11 trillion German Marks to a Dollar !!

Among all the countries US benefited the most from the war. Heavy demand of goods and services from war torn Europe kept the US Economy running. This also led to inflow of gold from Europe to US. At the end of the war, US had almost 80% of the gold in the world !. This had the impact of destabilizing the global gold standard significantly.

The key issue, that created further post war rift in Europe was reparations. Germany, being the instigator of war, was expected to pay back the costs to the victorious countries. Each victor had different demands. England demanded and atrocious sum of about 200 Billion Dollars, almost 5 times the pre-war GDP of Germany. France was more interested in segregating Germany to smaller countries with the aim of weakening the country.
These atrocious demands led to severe resentment in Germany and culminated in the disintegration of monarchy and the creation of German Republic.

There were saner voices which cautioned that demands for huge reparations would only weaken Germany  and thus the entire Europe. Once such voice was that of Montagu Norman, head of Bank of England. Another one was that of Keynes. It is gratifying to note that over the years, saner voices prevailed and the reparation demand came down to about 12 Billion Dollars, payable over an extended period of time.

The period from 1923-28 affected different countries in different ways. For Germany it was the elevation of Hjalmar Schacht to the position of the head of Reichsbank. The policies adopted by Schacht saw the gradual recovery of German currency and subsequent deluge of foreign funds into the country. The year of 1924 also brought in the Dawes plan that finally resolved the issue of German reparations. This period also saw the elevation of Moreau as the head of Banque De France. Initial part of the period saw French Frank tanking to almost 40 per dollar (from a pre-war rate of 5 per dollar) before smartly recovering to a managed rate of about 18 Franks per dollar.

The country worst affected during this period was Great Britain and this has got to do with the country aggressively moving towards pre-war Gold Standard levels. This decision led to increase in interest rate curtailing the money in circulation. Increase in rates also led to reduction in business activities leading to high level of unemployment and dissatisfaction in the country. At a time the economy needed stimulus and expansion, the country did exactly the opposite and paid a great price. It is worth pointing out that both Germany and France had anticipated this possibility and had resisted the return to the pre-war level gold standard.

Yet another reason for England taking this wrong decision was that Winston Churchill, who was not an economist, was the Chancellor of Exchequer during this period. Due to his lack of knowledge of Economy, he was forced to take decisions based on economic advice received from experts, even though in his gut he knew that  return to gold standard was a wrong decision.

This decision is all the more surprising since, Kaynes, who had vociferously opposed the return to pre-war gold standard fearing exactly this outcome, was a friend and confidante of Churchill. That the land of Keynes acted against his recommendations while other countries followed the same is perhaps the greatest irony of it all.

Meanwhile in the US, economy was expanding and the stock market was on a roll. The Dow went from about 70 in 1923 to about 160 in 1927 leading to fears of a stock market bubble. However, it corrected by about 10% in 1927 and was range bound in that level for much of 1927.  There were clamours for Central Bank to intervene in Stock Market which Strong actively resisted. He did not want the additional responsibility of managing the stock markets to affect his focus on price stability and economic growth. This period also saw the beginning of speculative excesses in the US that will turn to Irrational Exuberance (Bubble) leading to the crash and the great depression a year later. The fag end of this period also saw the passing away of Benjamin Strong, the head of US Fed.

The bubble in US stock market started in the summer of 1927. By early 1928, Dow was trading at 200, a 30 percent jump in just six months. Through the year 1928, Dow continued rising creating concern in the policy makers. George Harrison, who succeeded Benjamin Strong in New York Fed wanted to raise the interest rates. However there was difference of opinion between the N Y Fed and the Federal Reserve Board on how to handle the bubble. Fed wanted to raise interest rates while Board was in favor of direct intervention into the financial markets by asking banks to stop providing loans to brokers. Fed recommended ten times to raise rates and board vetoed it all the ten times.

Dow touched a peak of 381 on 3 September 1929. By July of that year, signs of impending crash was apparent to experts. Most of the professional investors sold off their positions by July and had made money in the market. That left retail investors ('Boot Blacks, House Servants and Clerks'), many of them women, carrying the can as the market started collapsing.

The curious aspect of the bubble was as follows. The president of US, Mr.Hoover was warning about excessive speculation, the Congress - both House and Senate - were for legal intervention to control speculative markets, NY Fed and other Fed Banks wanted to increase the discount rate to control money supply to burst the bubble and the Federal Reserve Board wanted to control the credit flow to the stock market (direct intervention) to apply brakes on excessive speculation....Despite all these efforts, the bubble persisted, immune to the efforts of the policy makers.

The flow of money to US Markets negatively impacted the economies of European countries, especially Germany and England. Both countries were tied to the gold standard and so the gold flowing out of their countries into the US Markets, thereby weakening their economies and driving Germany into recession, second time in a decade.

By August, saner voices began shouting about an impending market crash leading to a crash landing of the economy.

The period also bring to sharp focus on the personality clashes of  the Central Bankers. The key player in this drama was Morgan. He was very friendly with Strong and took a personal liking for Schacht. However, he disapproved Emile Moreau, a feeling which was reciprocated, and at various points his personal dislike of the French hampered effective resolution of issues. Moreau on the other hand disapproved of British attempts to return to pre-war gold standard and felt that Britain was trying to elevate the pound sterling at the cost of French Franc.

Finally, this period also saw the Central Banks coming out of the shackles of war and asserting their independence from the Bureaucracy. For some like Morgan and Schacht it was easier than for Moreau, but all of them managed to handle the challenge quite effectively.

British went out of gold standard in 1928. British pound was devalued and the economy entered a growth path. However, France, which was holding about 100 million in pound sterling lost heavily due to this devaluation. Bubble in the US dried up the flow of foreign credit to Germany and pushed the country to recession.

From a peak of 381 in early September, Dow had fallen to 250 by November of that year, a fall of 40% in a span of two months. Initially experts viewed the fall as good and that this will not affect the 'Main Street'. However as the year 1930 started, the economy entered into a deep correction as public had stopped spending. Fed tried to pump prime the economy to no avail.

In the year 1930, global economy collapsed. Industrial output was down, unemployment increased and prices started falling leading to deflation. Gold started flowing to relatively stronger economies like US and France. Countries like Argentina, Australia and Brazil left gold standard and let their currencies devalue (Same thing is happening now. China has devalued Yuan, Brazilian currency has devalued by about 30% in 2015).

Even while economy was collapsing, the Banking System in the US remained stable till the end of 1930. In late 1930, there was a run on Bank of United States (BUS) which collapsed. Anxious of the safety of their deposits, investors across the country started withdrawing their deposits from the banking system. People were keeping their money everywhere but in banks. Banks in turn started calling back their loans to ensure capital adequacy. The effect of this, along with US and France accumulating Gold was to reduce the credit flow to the system, just  as the economy was rebounding.

The pressure on the banking system continued through the year 1931. Many banks across the country declared Bankruptcy. Board could have intervened to prevent this catastrophe. However, the feeling was that this will rid the economy of inefficient banks and economy will rebound stronger. Governors of states across the country started declaring Bank Holidays to stop the run on the banks.

Harrison of Fed and other experts felt that such kind of piecemeal approach will not work and requested President Hoover to call a Bank Holiday across the country. By now it was clear that there was overhang of pessimism in the county and Hoover would lose the General Elections which were to take place by end of 1932. Hoover did not want his last decision as President to close the Banks across the country.

A single statistic puts the entire US recession in perspective. Dow Jones Index, which closed the day of 3 September 1929 at 381, stood at 40 on 8 July 1932, a fall of 90% in less than two years !!!

It was in this situation that Franklin Delano Roosevelt (FDR) sworn in as President of the United States.

The first decision that FDR did was to declare a national Bank Holiday for 10 days. As paper money became scarce, people resorted to innovative arrangements, including Barter, to carry on financial transactions (churches accepted IOUs from parishioners, for example). FDR used this window to delink from Gold Standard and devalue US Dollar. Over the next two years, the devaluation of US Currency continued, by end of which the currency had devalued by almost 40 percent. Devaluation of Dollar coupled with other policy measures initiated by the government turned around the economy.

During FDR's first term from 1932-36, US Industrial Production doubled and economy expanded by 40 percent...

Meanwhile Germany moved from one economic crisis to another leaving most of its adult population unemployed. This led to a lot of upheavals and led to Hitler taking over as the Chancellor of the Country in 1933. These chain of events finally led to World War 2.

The decade of 30's was also the time when Keynes star started shining. The events in the past decade had proven right in most of his opinions. From the mid of 30's he played a key role in the Bretton Woods conference organized to regulate the international monetary order post World War 2. Keynes understood that one of the key reasons for the crisis of the past two decades was that each country was taking its own decisions, with out any global co-ordination. The need for the hour was an international organization that can co-ordinate the activities of various central banks. This organization, which was named IMF, could also lend money to countries to help them tide over temporary crises. IMF founded in Bretton Woods in 1945, continues to play its key role even today.

What were the mistakes committed in the 1920s that led to the Global Recession? How could  the bankers have handled it differently. Author sites two reasons. One is the illogical adherence to the Gold Standard. This unnecessarily strengthened the country currencies and impacted the economic recovery. Second mistake was insisting that Germany pay reparations for World War 1. Author points out that while Europe started with a demand of 32 Billion from Germany, all that they could get over almost 13 years was 4 Billion !. However, demand on reparations took away the focus from the more urgent task of Economic Recovery.

Lessons of this book are still relevant. The world is still experiencing the impact of the great recession that started in 2008. Just like the previous recessions, this one also started with reckless banking practices and countries had to bail out their financial sector.Last recession proved that the only way for countries to come out of recession is monetary expansion. Keep the interest rates low and devalue the currency to spur economy.

Fortunately the policy makers seem to have learned a lesson. Almost all the countries resorted to economic stimulus  in 2008 to jump start their economies.

Will that work? Was the stimulus sufficient? Could something have been done differently?

Only time will tell. Perhaps it will take another Liaquat Ahamed, writing in 2108, to tell us whether we are taking the right steps now in 2015.

The key takeaway from this book is that uncontrolled financial sector will quickly deteriorate and crash taking the global economy with it. It is very important that each country put in tight controls over its Financial Sector so that we do not repeat the past mistakes.

Remember that 'Those who forget history are condemned to repeat it'.


  1. Dear Sir, This is the first time I have come to your blog. I really enjoyed this review of Lords of Finance - you have covered each of the four bankers in great details, and this gives a very good idea of what to expect in the book.

    I read a lot and shall definitely read this book.

    Recently started reading "Barons of Banking" by Bakhtiar K. Dadabhoy, which is about 6 prominent personalities from an Indian banking standpoint. It is quite enjoyable actually. You may read it if you haven't done so yet.


    PS: Also firmly believe that the blessings of Goddess Saraswati, Goddess Lakshmi and Lord Ganesha is essential for any endeavor.

    1. Hello Subhodeep, Thanks for your detailed comment on this review. As you mention, this review is very exhaustive but I tried to summarize the key lessons from the book in my review. I am grateful that you took the time to read the review and then comment on the same.
      I will definitely read the book 'Barons of Finance' as mentioned in your post and review the same.
      Currently I am reading 'Getting rich your own way' by Brian Tracy. I have already published the review in my blog. I am rereading the same to write a more detailed post about the book.
      I also visited your blog 'MKERJ'. It is very good aesthetically. Very pleasing to the eye. I will read some of the posts later and comment on the same.


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