But whereas the U.S. economy, more dynamic and unhampered by a large internal debt, was quickly able to bounce back from the recession, Britain remained stuck. The number of unemployed would not fall below one million for the next twenty years. It soon became apparent that Britain had sustained terrible damage as an economic power during the war. Industries such as cotton, coal, and shipbuilding, in which it had once led the world, had failed to modernize and the traditional markets had been lost to competitors. Labor costs had risen as unions negotiated shorter working hours.
Norman now faced the uneasy prospect that the only way to follow the example set by his forerunners—his grandfather joined the Court the year of “resumption”—was by keeping unemployment high. But while before the war it might have been politically acceptable to create unemployment deliberately in order to support the currency, in the charged climate after the war—with Lloyd George promising the electorate “a land fit for heroes”—Norman would find himself constantly under pressure to find an alternative.
THE problem of resurrecting the gold standard went much deeper than selecting new exchange rates for the key currencies, for the war had brought about such a tectonic shift in the distribution of gold reserves that it seemed to threaten the very viability of a monetary system resting on gold.
Before the war, the four largest economies—the United States, Britain, Germany, and France—had operated their monetary systems with about $5 billion worth of gold among them. The amount of new gold mined during the war was small, and by 1923, monetary gold had increased only to $6 billion. Meanwhile, prices in the United States and the UK, even after the postwar deflation, were still 50 percent higher than before the war, which meant that in effect the real purchasing power of gold reserves had contracted by almost 25 percent.
FIGURE 2
In 1922, Norman worked with officials at the British Treasury to develop a plan whereby some of the European central banks would, as did many countries in the British Empire, hold pounds rather than gold as their reserve asset—in much the same way that many central banks hold dollars nowadays. He argued that substituting pounds for gold would allow the world to economize on the precious metal and thus reduce the risk of worldwide shortage. Few people failed to notice that by creating a captive source of demand for sterling, the plan would add to its privileged position in the constellation of currencies and greatly ease his job of returning the pound to gold. The plan never really did take off, except in a few minor Central European countries.
The bigger concern among bankers after the war was not so much that the world was short of gold, but that too much of the gold was concentrated in the United States. Before the war, there had been some parity among the major economic powers between the amount of gold in each banking system and the size of its economy. For example, the United States, with a GDP of $40 billion, accounted for about half the output of the four great economic powers and held about $2 billion in gold, a little less than half of the total gold of these four countries. The balance was only rough and ready—France held proportionately more and Britain less—but the system worked with remarkable smoothness.
By 1923, the United States had accumulated close to $4.5 billion of the $6 billion in gold reserves of the four major economic powers, far in excess of what it needed to sustain its economy. About $400 million circulated in the form of coins; the remainder consisted of ingots, small bars the size of a quart of milk, each weighing about twenty-five pounds, stored in the vaults of the Federal Reserve Banks and the Treasury. The largest hoard lay under
lower Manhattan, about $1.5 billion in the Treasury repository at the legendary intersection of Broad and Wall Streets, and at the New York Fed. The remainder was scattered among the eleven other Federal Reserve Banks across the country.20 By one estimate, excess gold reserves in the United States amounted to about a third of its holdings, roughly $1.5 billion.
While the U.S. monetary system was swamped by this enormous surplus, Europe, particularly Britain and Germany, suffered a chronic shortage. The three big European economies, which had operated before the war on $3 billion worth of gold, were left with barely half that. Faced with constant demands to pay out gold, European central banks had resorted to a complex of measures, the most important being to withdraw gold coins from circulation. All those solid talismans of turn-of-the-century middle-class prosperity had gradually disappeared from Europe’s pockets, to be replaced by shabby pieces of paper. By the mid-1920s, the United States was the only large country where one could still find gold coins.
The concentration of the world’s key precious metal in the United States had left the rest of the world with insufficient reserves to grease the machinery of trade. The world of the international gold standard had become like a poker table at which one player has accumulated all the chips, and the game simply cannot get back into play.
ONE MAN WHO had no difficulty liberating himself from the strictures of the gold standard was John Maynard Keynes. After the Peace Conference, he had gone back to teaching at Cambridge. But following the resounding success of The Economic Consequences of the Peace, he reduced his involvement with the university and became increasingly caught up on the grander stage of world affairs. He joined the board of an insurance company and became chairman of the weekly British magazine the Nation, for which he wrote regular pieces, as he did for the Manchester Guardian, articles that were syndicated around the world, including in the U.S. weekly the New Republic. And he began making his fortune as a currency speculator.
In 1919, it was a novel way of making money. Before 1914, currencies had been fixed, and opportunities to profit from the instability of exchange rates had been almost nonexistent. In the aftermath of the war, as exchange rates of the major currencies lurched up and down, it became possible to make large returns—and also lose equally large amounts—by betting on the direction of such moves. In the latter half of 1919, convinced that the inflationary consequences of the war would undermine the currencies of the main belligerents, Keynes went short on the French franc, the German Reichsmark, and the Italian lira, buying the currencies of countries that had sat out most of the war: the Norwegian and the Danish kroner, the U.S. dollar, and interestingly enough, the Indian rupee. He made $30,000 in the first few months. In early 1920, he set up a syndicate, with his brother, some of the Bloomsbury circle, and a financier friend from the City of London. By the end of April 1920, they had made a further $80,000. Then suddenly, in the space of four weeks, a spasm of optimism about Germany briefly drove the declining European currencies back up, wiping out their entire capital. Keynes found himself on the verge of bankruptcy and had to be bailed out by his tolerant father. Nevertheless, propped up by his indulgent family and by a loan from the coolly acute financier Sir Ernest Cassel, he persevered in his speculations—built for the most part around the view that the German and Central European currencies were headed for disaster. By the end of 1922, he had amassed a modest nest egg of close to $120,000.
But by far the most important development in his life was that he had fallen in love—this time with a woman, Lydia Lopokova, a married Russian émigrée ballerina, no less. The daughter of a Russian father, an usher at the Imperial Alexandrinsky Theater, and a Scottish-German mother, Lydia came from a family of dancers—her two brothers and a sister had also gone to the Imperial Ballet School in St. Petersburg. When Maynard met her in 1918, she was traveling with the Diaghilev Ballet, having spent seven years in the United States as a cabaret artist, model, and vaudeville performer, and was married to the business manager of the company, Randolfo Barrochi. After her marriage broke down, she disappeared into Russia, then in the thick of civil war, with a mysterious White Russian general, but reappeared in Keynes’s life at the end of 1921.
Though they would not get married until 1925 when her divorce finally came through, they began living together in 1923. They made an unlikely couple—he a brilliant and all too cerebral intellectual with a genius for exposition, she an unpredictable artist with a risqué past, a flighty and vivacious chatterbox with an equal skill for stumbling into the most memorable malapropisms. She once complained that she “disliked being in the country in August, because my legs get so bitten by barristers.” On another occasion, after visiting an aviary, she remarked on her hostess’s “ovary.” And though the rest of Bloomsbury looked down on her, Keynes was to remain completely enchanted with her for the rest of his life.
In December 1923, Keynes published a short monograph, A Tract on Monetary Reform, much of which had already appeared as a series of articles in the Manchester Guardian during 1922 and early 1923—his first systematic attempt to unravel the sources and consequences of the chronic monetary instability that plagued the postwar world. Like his earlier book, A Tract was a strange hybrid, this time a half-theoretical treatise—with sections on “The Theory of Purchasing Power Parity” and “The Forward Market in Exchanges” and half pamphlet for the laity. It was, however, very different in tone from The Economic Consequences. That had been an angry, passionate work, written in the heat of debate and controversy. This one had a lighter touch, a “tentative almost diffident tone,” as if the author himself were searching for the answer to the quest for monetary stability.
Before the war, however much he had enjoyed challenging conventional nostrums about morality, conduct, and society, in economics Keynes had fully embraced the liberal orthodoxy that dominated his still nascent profession. He believed in free trade, in the unfettered mobility of capital, and in the virtues of the gold standard.
There were times when, like so many other economists, he might speculate whether gold was the right foundation for money. But those had been largely theoretical ruminations; and ultimately, when it came down to it, there seemed no other practical basis so tried and tested upon which to organize the world’s currencies. Asked at the height of the 1914 crisis to brief the chancellor of the exchequer as to whether the pound should remain tied to gold, he had come down very strongly in favor of maintaining the link: “London’s position as a monetary center depends very directly on complete confidence in London’s unwavering readiness” to meet its obligations in gold and would be severely damaged if “at the first sign of emergency” that commitment was suspended.
Even during the first years after the war, he was still advocating a return to gold. But the shift in the world’s economic landscape was beginning to give him doubts. He still believed that the prime goal of central bank policy should be to keep prices broadly stable. But whereas before the war he had thought that the best way to achieve this was to ensure that currencies such as the pound be fully convertible to gold at a fixed value, he had now come to believe that there was no reason why linking money supply and credit to gold should necessarily result in stable prices.
The gold standard had only worked in the late nineteenth century because new mining discoveries had fortuitously kept pace with economic growth. There was no guarantee that this accident of history would continue. Moreover, while the original rationale for a gold standard—the commitment that paper money could be converted into something unequivocally tangible—might have been necessary to instill confidence at some point in history, this was no longer the case. Attitudes toward paper money had evolved and it was not necessary to allow the supply of precious metals to regulate the creation of credit in a sophisticated modern economy. Central banks were perfectly capable of managing their countries’ monetary affairs rationally and responsibly, he argued, without any need to shackle themselves to this “barbarous relic.”
Though the
Tract was a technical monograph, the Cambridge undergraduate in Keynes could not resist lacing the book with the playful sarcasms that had made The Economic Consequences such a success. He flippantly dedicated the book, “humbly and without permission, to the Governors and the Court of the Bank of England,” knowing very well that the members of that august body would disagree with almost everything he had to say. He poked fun at the self-importance of those “conservative bankers” who “regard it as more consonant with their cloth, and also as economizing on thought, to shift public discussion of financial topics off the logical on to an alleged moral plane, which means a realm of thought where vested interest can be triumphant over the common good without further debate.” And he peppered it with the sort of bons mots—the most famous being “in the long run we are all dead”—that made him so scintillating a conversationalist.
But more than anything else it was Keynes’s ability to strip away the surface of monetary phenomena and reveal some of its deeper realities and its connections to the society at large that has made the Tract such an enduring classic. For example, by tracing through the consequences of rising prices on different classes in a stylized picture of the economy—what economists today might call a model—he showed that inflation was much more than simply prices going up, but also a subtle mechanism for transferring wealth between social groups—from savers, creditors, and wage earners to the government, debtors, and businessmen. He thus highlighted the fact that the postwar inflation in countries such as France and Germany was not just the result of an error in monetary policy. Rather, it was a symptom of the fundamental disagreement that had wracked European society since the war about how to share the accumulated financial burden of that terrible conflict.
In contrast to The Economic Consequences, the new book had almost no practical impact. At a time when the currencies of Central Europe had completely collapsed and the franc was perilously close to the edge, few people could be convinced to entrust the management of national moneys and currency values to the discretion of treasury mandarins, politicians, or central bankers. There were too many examples to point to—Germany, Austria, Hungary, admittedly some of them pathologically extreme—of what could happen when the discipline of gold was removed. But the experience of the next decade would, in the words of one of Keynes’s biographers, win for the Tract “the allegiance of half the world.”
NORMAN’S RESPONSE To the Tract was predictably to dismiss it as the froth of a clever dilettante. As he wrote to Strong, “For the moment Mr. Keynes seems to have rather outdone himself, a fact that perhaps comes from his trying to combine the position of financial mentor to this and other countries with that of a high-class speculator.”
What separated Norman from Keynes had less to do with economics and more to do with philosophy and worldview. For Norman, the gold standard was not simply a convenient mechanism for regulating the money supply, the efficiency of which was an empirical question. He thought about it in much more existential terms. It was one of the pillars of a free society, like property rights or habeas corpus, which had evolved in the Western liberal world to limit the power of government—in this case its power to debase money. Without such a discipline to protect them, central banks would inevitably come under constant pressure to help finance their governments in much the same way that they had done during the war with all the inflationary consequences that were still all too apparent. The link with gold was the only sure defense against such a downward spiral in the value of money.
His reaction to the Tract was colored by his personal dealings with Keynes. After the war, Norman, agreeing with much of Keynes’s argument on reparations, had consulted him at the height of the German hyperinflation. But Keynes’s vocal opposition to the war-debt settlement with the United States, which Norman had been responsible for engineering, created a rift. Norman, acutely sensitive to public criticism, harbored grudges for a long time—“the most vindictive man I have ever known,” according to one close friend. Thereafter, though their social circles overlapped somewhat and though Keynes, for all his youthful iconoclasm, was already widely recognized as the most brilliant monetary economist of his generation, Norman studiously ignored him professionally, and refused ever to invite him to advise the Bank.
Strong’s reactions were on the surface similar to Norman’s. He had never met Keynes, but given his puritan background, he would have vehemently disapproved of the Bloomsbury irreverence and mockery of authority. When The Economic Consequences came out, he had written of Keynes, “He is a brilliant but, I fear, somewhat erratic chap, with great power for good and, unfortunately . . . some capacity for harm.” Many in his circle had taken offense at Keynes’s merciless lampooning of Woodrow Wilson at the Peace Conference. He echoed this again in his reaction to the Tract. “Keynes’ little book arrived safely and I am just now reading it,” he wrote to Norman on January 4, 1924, from the Arizona desert. “I have a great respect for his ability and the freshness and versatility of his mind, but I am much afraid of some of his more erratic ideas, which impressed me as being the product of a vivid imagination without very much practical experience.”
The hidden irony was that every one of Keynes’s main recommendations—that the link between gold balances and the creation of credit be severed, that the automatic mechanism of the gold standard be replaced with a system of managed money, that credit policy be geared toward domestic price stability—corresponded precisely to the policies Strong had instituted in the United States.
During the war, the flow of gold into the United States had pushed up prices by 60 percent. When the fighting ended, but turmoil in Europe continued and the gold still kept arriving, Strong decided that it was time to abandon the conventional rules of the gold standard and insulate the U.S. economy from the flood of bullion. The system was being swamped by so much excess gold that to have followed the traditional dictates of the gold standard would have led to a massive expansion of domestic credit, which inevitably would have led to very high rates of inflation—Strong calculated that it would cause prices to double. It made no sense to him for the United States to import, in effect, the inflationary policies of Europe and destabilize its own monetary system just because the Old World had been hit by political and financial disaster. The Fed therefore began to short-circuit the effects of additional gold on the money supply by contracting the amount of credit that it supplied to banks, thus offsetting any liquidity from gold inflows.