The cable came in from London, and Benjamin Strong already knew what it would say before he read it.
The year was 1924 and Strong had quickly become the most powerful banker in America. But it wasn’t J.P. Morgan’s kind of power, where everything hinged on a private fortune.
No, Strong’s power was something newer. And something far greater.
Benjamin Strong had been tapped to run the Federal Reserve Bank of New York when it opened its doors in November of 1914. The public didn’t realize it yet because of how the Federal Reserve (the Fed) had been packaged and sold as a populist reformer’s institution… but Strong now sat at the one lever in the entire American financial system that could make money cheap or scarce across the whole country.
On the surface, it didn’t look like that was the case. Per the original structure, the public was led to believe that the Fed’s board of governors down in Washington would call the shots. But by 1924, everyone plugged into the American engine of high finance knew that the true lever of power resided in New York.
The man on the other end of the cable was Montagu Norman, Governor of the Bank of England. Strong had been expecting his telegram.
Norman was not merely a professional counterpart. He was Strong’s friend — a close, personal friend.
The two men made a habit of vacationing together – both at Bar Harbor in Maine and along the South of France. And they wrote to each other constantly, sometimes under assumed names to keep the correspondence private.
When Norman crossed the Atlantic, he stayed in Strong’s home as a guest. By some accounts, Norman had become something like Strong’s alter ego. The two men had come to see the world’s monetary order as a thing that the two of them, between them, could manage.
But in the spring of 1924, Norman needed a favor.
World War I had forced the combatant nations to suspend the gold standard so that they could print money to support the war effort. With the war over, Britain wanted to resume the gold standard to reassure the world that everything was back to normal. But there was a small problem…
Norman was pushing to restore the British pound to its old, pre-war exchange rate of $4.86 per pound sterling. In practical terms, this meant that one pound could be converted into $4.86 worth of gold, or vice versa.
For Britain, returning to the historical exchange rate was a matter of national pride as much as economics. The pound had been the anchor of the world’s financial system for a century, and Britain wanted that crown back.
However, Britain had inflated its money supply dramatically during World War I – so there were a lot more pounds in circulation than before the war. As such, the pound would not trade at the old parity of $4.86 on the open market. It would be overvalued relative to the US dollar at that level.
Norman knew that. And he knew that gold would rapidly flow out of London and into New York if Britain resumed the gold standard at the pound’s historical peg. That was guaranteed under the gold standard’s rules in which market actors could exchange national currencies for gold at the fixed parity.
So if Britain returned to the gold standard at the old peg, savvy investors would buy pounds, convert them to gold at the Bank of England, then ship that gold to New York and exchange it for dollars – because the same gold would buy more dollars in real terms since the pound was overvalued. In short, it would be profitable to move Britain’s gold across the Atlantic and cash it out in New York.
That’s why the head of the Bank of England needed a favor from his old friend.
In his telegram, Norman asked Strong to cut interest rates in America and hold them at artificially low levels below where rates were in London for an extended period of time. Doing so would devalue the US dollar relative to the pound, which would help offset the pound’s overvaluation at the old parity.
That, in turn, would reduce the incentive for gold to flow out of London. It might even cause gold to flow from New York to London to keep the pound propped up, the two friends knew.
The mechanism was straightforward.
When interest rates in New York sat below those in London, short-term capital naturally sought the higher return available in Britain. So investors sold dollars, bought pounds, and parked their money in London to earn the higher yield. That extra demand for pound sterling pushed the exchange rate upward and reduced the pressure that would otherwise have forced the Bank of England to pay out gold.
At the same time, the easier credit conditions in the United States tended to lift American prices relative to British ones, slowly narrowing the real overvaluation of the pound. This would buy Norman time for the markets to accept the old parity again and prevent a run on London’s gold.
Needless to say, Strong obliged his friend. He followed through with a series of rate cuts throughout the summer of 1924, reducing interest rates in New York by 1.5% so that the US dollar would be artificially weakened relative to the pound in an effort to prop it up.
Of course, Strong didn’t say that’s what he was doing.
In public announcements and official explanations, he emphasized purely domestic reasons for the rate cuts. He talked about the mild business slowdown in 1924, continued heavy gold imports that were swelling bank reserves, the need to relieve pressure on member banks that were still heavily indebted to the Federal Reserve, and he emphasized the need to support American agriculture and commodity exporters with lower rates.
Only in private correspondence and in carefully worded internal memoranda did Strong acknowledge that he was working to help the pound sterling recover so that Britain could safely return to the gold standard. But he never elaborated on the fact that doing so required devaluing the dollar to support the pound.
Despite Strong’s efforts, the market proved more savvy than expected.
Britain did return to gold at $4.86 in April 1925 without an immediate collapse, but the underlying overvaluation never disappeared. British goods remained expensive on world markets, exports stayed weak, and unemployment hovered at painfully high levels. The Bank of England was forced to keep interest rates higher than it wanted just to defend the parity.
And while gold did not drain out of London in one catastrophic rush, it systematically leaked away in fits and starts whenever interest-rate differentials or other pressures turned against London.
By the summer of 1927 the strain had become acute again. Norman could not raise British interest rates further without risking domestic upheaval. At the same time, economic strength had been pulling capital into the United States to seek investment opportunities.
This prompted Strong to cut the Fed’s discount rate by another 50 basis points (0.5%) in 1927 to continue propping up the British pound. But that decision was much harder to justify.
It had become clear that US interest rates were already too low, and Strong’s “easy money” policies had fed a growing speculation in the American stock market. Share prices were climbing rapidly, brokers’ loans were expanding, and a number of officials (including inside the Federal Reserve) were already uneasy about the speculative fever on Wall Street.
Strong himself knew that his 1927 rate cut would pour more fuel on the fire. He privately likened it to giving the market “a little coup de whisky”.
This made then-Secretary of Commerce Herbert Hoover furious. To those paying attention, it had become clear that Strong’s actions were not primarily in service of the American economy.
Strong pressed on regardless.
To him, international cooperation among central bankers was more important than domestic political criticism. That, and he was a loyal friend to Montagu Norman.
As a result, two of the most important monetary policy decisions of the 1920s — the monetary easing of 1924 and 1927 — were shaped in large part by the desire to keep US interest rates low enough to support Britain’s return to, and maintenance of, the gold standard at an overvalued parity.
These moves were driven primarily by Strong at the New York Fed, in close private consultation with Norman. There was limited effective oversight from the Federal Reserve Board in Washington.
And it was all possible because a group of conspirators sold their central banking structure to America by positioning it as the “Federal Reserve” – implying that it would serve as a monetary reserve that would protect Americans from the periodic financial panics that had plagued them previously.
The Machine, Turned On
In the last several installments of this series, we traced how the Federal Reserve came to be — the blueprint Paul Warburg carried over from Europe, the secret gathering on Jekyll Island in 1910, and the three-piece legislative package of 1913 that installed a European-style central bank and an income tax in a country that didn’t want either.
When we left off, President Wilson had just signed the Federal Reserve Act two days before Christmas in 1913. That installed the machine… and it’s never been turned off since.
Now, if we go back to the beginning of this series, we’ll remember that Alexander Hamilton chartered the First Bank of the United States way back in 1791. That was a central bank… but it wasn’t one that we would recognize today.
Hamilton was adamant that the American financial system would run on sound money backed by specie (gold and silver), not money that could be created ex nihilo. He also believed very strongly in the principle of productive credit – the idea that bank credit should mostly be used to finance productive activity, not speculation or luxury spending.
Hamilton chartered the First Bank of the United States to be the vehicle that would ensure American credit would be funneled towards productive ventures – factories, infrastructure, farms, and the like.
And because the system ran on sound money, that credit was based on real savings. Thus, American credit wasn’t a tool of monetary policy – no such thing existed with the First Bank of the United States. Instead, it was a tool for driving productivity forward.
It’s certainly debatable how effective the national bank was at enshrining the principle of productive credit in the United States. It’s also debatable whether such an institution was needed.
What’s not debatable, however, is the fact that Hamilton’s central bank was markedly different from the system designed on Jekyll Island and based on European-style central banking. Indeed, the Federal Reserve was designed specifically to create an end-run around strict sound money requirements.
The idea of an “elastic currency” was at the heart of the design. The term refers to credit that could be created out of nothing, with some constraints at first, whenever the men at the controls decided the financial system needed extra liquidity.
What’s more, the system hammered out on Jekyll Island had little interest in the principle of productive credit. In fact, its elastic currency created the exact opposite effect – as we’ll see in just a few minutes.
So when the Federal Reserve machine turned on and the new elastic currency began flowing, the only question was: where would it go?
Hamilton had an answer for where bank credit should go — toward productive activity. But the Federal Reserve’s answer was: wherever the men closest to the money spigots want it to go.
In the 1920s, the men standing closest to the money spigots were not factory owners in Ohio or wheat farmers in Kansas. They were financiers in New York… and so the new money poured into Wall Street.
The Cheap Money Decade
Throughout the 1920s, under Benjamin Strong’s steady hand, American money stayed cheap. That is to say, interest rates were kept relatively low and credit remained readily available for much of the decade.
These easy money policies supported a rapid expansion of business and consumer spending, but they also made it easy for large amounts of credit to flow into financial speculation, particularly on Wall Street.
To be fair, the historical record suggests that Strong genuinely believed in what he was doing. He was one of the men who met on Jekyll Island to get the central bank started. And he genuinely believed that the Fed should cooperate with the central banks of Europe. He was, by most accounts, smart, principled, and sincere.
So this doesn’t appear to be a man intent on sabotaging the American economy. But Strong’s apparent sincerity doesn’t make up for what happened next…
By cutting rates and engaging in easy money policies, Strong set the Cantillon Effect in motion. And the New York financiers who got their hands on America’s new elastic currency first used their good fortunes to engage in rampant speculation in the US stock market. Apparently they were not familiar with Hamilton’s principle of productive credit, either.
I suspect many of us have heard the term Roaring ‘20s before. And perhaps we’ve heard of the great bull market on Wall Street — the seemingly endless rise in stock prices that came to symbolize the decade’s exuberance and excess.
The problem is, the excesses of the Roaring ’20s were not the result of a purely organic productivity boom, as Hamilton expected his American System to create. To the contrary, it was the result of the Fed’s cheap money meeting the machinery of Wall Street.
The Dow Jones Industrial Average closed at 108.76 on the first day of trading in 1920. At its peak in September 1929, the Dow hit 381.17. That represents a gain of roughly 250%, or 3.5x. That was a mind-blowing investment gain at that time.
Central to this hollow boom was the instrument of margin.
Margin allowed speculators to buy stock on borrowed money. Under the loose rules of the day, one could buy a stock by putting down as little as ten percent of its price and borrowing the other ninety percent.
So if you put down $1,000, you could control $10,000 worth of shares. With that degree of leverage, you would double your money if the stock rose a mere 10%.
The mathematics were intoxicating on the way up. And since much of the liquidity rushing into the US stock market was cheap money from the Fed anyway, no one seemed to think much of it.
The fuel for all this borrowing was tracked in a figure called brokers’ loans — the money lent to investors to buy stocks on margin. In 1926, brokers’ loans stood at roughly $3.5 billion. By the summer of 1929, they had swollen to around $8.5 billion.
That is where the Fed’s cheap money ultimately ended up – not in Hamilton’s factories, but on the ticker tape, leveraging ordinary Americans into a market that had lost all connection to the earnings of the underlying companies.
Margin doesn’t just work in one direction, however. And that’s how the Roaring ‘20s came to an end…
The Man at the Controls Steps Off
Benjamin Strong died on October 16, 1928… just about one year, almost to the week, before the bottom fell out.
With Strong gone, it left a power vacuum at the New York Fed. Those left to fill in were indecisive and unable to agree with one another on anything.
Then the party ended.
On October 28, 1929, Black Monday, the US stock market collapsed. The Dow that had hit a record above 381 in September began a descent that would not end until July 8, 1932, when the index closed at 41.22 — off nearly 90% from the peak.
That’s what the downside of buying on margin looks like.
The speculator buying on margin who put down 10% to control ten times his money made a fortune on the way up. On the way down, a 10% drop wiped him out completely.
And here is the quiet cruelty of the Cantillon Effect playing out in full…
The men who stood closest to the money — the ones who got the cheap credit first – many of them got out ahead of the crash… because they had already made their money.
But those Americans who got lured into the boom in its late stages by all the exciting headlines and the prospects of finally striking it rich – they were the ones left holding the bag. Indeed, the Dow Jones would not recover to its 1929 peak of 381.17 until November 1954 — a quarter of a century later.
Hamilton Was Right… So Was Jefferson
With the benefit of hindsight, it’s easy to see that the Roaring ‘20s was an artificial boom driven not by pure productivity gains, but aided by cheap credit emanating from the Fed. The great Austrian economists would flesh out the Austrian Theory of the Business Cycle to explain this dynamic in more detail.
And now that we understand the visions and systems present at America’s founding, it’s easy to see that the financial system we’ve lived under since 1913 would not be remotely recognizable by America’s founders.
Alexander Hamilton had argued that a great nation needs the capacity to mobilize credit. He believed very strongly that a country without a national financial engine would remain weak, dependent, and poor.
On that point, history has largely vindicated him – at least to an extent. The nations that industrialized and grew powerful were, by and large, the ones that learned to marshal credit toward production to grow their industrial base.
One could argue whether or not Hamilton’s American System was directly responsible for that success, but Hamilton’s belief that industrialization was essential to economic growth and raising standards of living isn’t in question.
As we know, Thomas Jefferson had taken issue with Hamilton’s views right from the beginning… and he’s also been vindicated.
Jefferson and Hamilton were largely aligned on what they wanted for America. They wanted it to be a land of individual liberty and economic independence. They disagreed on the best path forward to bring those ideals about, however.
Where Hamilton saw a national banking system as a tool to direct credit towards productive activity, Jefferson argued that a national banking system would, over time, be captured by the financial interests it was meant to serve. Jefferson went so far as to say “banking institutions are more dangerous to our liberties than standing armies”.
Jefferson had witnessed the corruption embedded in Europe first-hand, and he knew that much of it stemmed from the fact that a class of political and financial elite had captured the financial system and turned it toward serving their own interests. He feared that the engine Hamilton wanted to build would inevitably be seized and turned to private benefit in just the same way.
While there were periodic instances of corruption prior, the first two decades of the Federal Reserve’s operation proved Jefferson right on the money.
The institution that was packaged and sold as a public reserve for national stability was, in practice, born as a captured entity.
The original blueprint came directly from a man with deep connections to the most powerful banking houses in Europe and the United States. And, once implemented, the head of the New York Fed began coordinating monetary policy with the Bank of England right from the jump.
It was both Hamilton and Jefferson’s greatest fears come to life.
Hamilton was very clear that he wanted America to break free from economic dependency on Britain, and he believed the fledgling republic needed an engine to drive productivity and industrialization for that to happen.
Hamilton laid the foundations for such an engine in America’s infancy. Then various other men took the torch and helped build out Hamilton’s American System in the 19th century.
Meanwhile, Jefferson just wanted America to be what he called an Empire of Liberty, and he wanted to make sure that the tools used by the financial elites of Europe never touched American soil. And when it became clear that Hamilton was set on implementing a centralized financial system, Jefferson warned that corruption would inevitably follow.
Both men were right.
This is the great irony of the American System’s history. It does appear to have helped the United States (and others) industrialize quickly and become economically independent. And it did indeed help the United States to break free from economic dependence on Britain.
However, the system was prone to corruption… and that corruption eventually led to outright capture.
Hamilton wanted America to have a central bank to serve as an engine for driving production. What Paul Warburg’s blueprint delivered with the Federal Reserve was an engine built for extraction — one that could inflate asset bubbles and transfer a nation’s wealth toward the men nearest the money centers.
Worse still, the creature from Jekyll Island immediately engaged in coordinated monetary policy with Britain, the nemesis of the American founders. We’re taught today that Britain is one of America’s greatest allies, but the historical record suggests that the exact opposite is true.
And as we’ll see in the next installment of the series, corruption, once embedded, tends to metastasize. The machinery of extraction virtually guarantees it.
More to come…
-Joe Withrow