Labor spokesmen endorsed this policy of European borrowing in the U.S. private sector instead of selling more products to the United States. Matthew Wohl, vice-president of the American Federation of Labor, recognized that the U.S. Government was only “going through the motions of collecting these debts. Europe is going to pay with one hand and borrow back with the other, and go on using the capital just the same . . . it is better for us that it shall be so, instead of actually receiving payment in goods that would interrupt our own industries. I think it is a safe guess that fifty years from now the United States will have more loans and investments abroad than it has today, including these debts, and this will mean that we will not have received actual payment of these debts. They will only have changed their forms.”11
The transformation of intergovernmental debts to private debts took the form of a triangular flow of payments. Funds flowed from the United States to Germany, from Germany back to the European Allies, and from these back to the United States. During 1924–31, U.S. private investors lent $1.2 billion to German municipalities and industries, and other countries lent an additional $1.1 billion.12 The Reichsbank used these dollars to pay reparations to the Allied Powers. Some went directly to Britain, others to France to be used by France to pay Britain on its wartime loans. Britain and the other European Allies then paid the funds to the U.S. Government to service their war debt. Intergovernmental claims thus became partially supplanted by and integrated with private investment capital. Europe’s debt repayments tended to inflate the American credit base, making accessible to U.S. investors still more funds to lend to Germany and other European countries.
This circular flow of payments was maintained precariously, but with no realistic hope of its functioning perpetually. The assets required to underwrite the debt simply did not exist. As Keynes wryly described the situation: “the European Allies, having stripped Germany of her last vestige of working capital, in opposition to the arguments and appeals of the American financial representatives at Paris . . . then turn to the United States for funds to rehabilitate the victim in sufficient measure to allow the spoliation to recommence in a year or two.”13 For Germany and the Allies, wrote another economist, the “only incentive to agree to pay is the opportunity to get new private loans not otherwise obtainable.” The U.S. stake “from the beginning was represented by the sum we could persuade our debtors to pay us, while not permitting our demands to rise so high as to prevent settlement and delay the restoration of international trade and commerce. We had nicely to appraise the relative values of old debts and new business.”14
During 1928–29 the circular flow of payments between the United States and Europe began to break down, first by a slowing down in U.S. private purchases of foreign bonds when investments increased domestically in response to the stock market boom; then by the market collapse which erased lendable assets; and finally by the Great Depression, itself the product of the impossibility of pyramiding debt to infinity. The first great swelling of intergovernmental claims came to an end in bankruptcy on a world scale.
First came the problems associated with sterling, toward whose stability the British Government sacrificed the nation’s living standards in a deflationary process in 1926. On the one hand, a higher value for sterling meant that a given number of British pounds would exchange for a greater number of dollars and thus pay off a larger value of dollar-denominated debt. On the other, this worked to price British exports out of world markets, reducing Britain’s ability to earn dollars and other foreign exchange. Internal deflation thus was accompanied by loss of export markets, high interest rates which deterred investment, and a wave of strikes culminating in the General Strike of 1926.
Meanwhile, the attempt by the U.S. Government to help foreign governments maintain their Inter-Ally debt service set in motion responses that prevented this process from continuing. After 1926 the Federal Reserve System helped Britain hold the pound sterling at its (overvalued) prewar level by promoting low interest rates in the United States via a policy of monetary ease. As long as British interest rates exceeded those of the United States, Britain was able to borrow the funds needed to sustain its Inter-Ally debt transfer. Thus “American support for the pound sterling in 1927 implied low rates of interest in New York in order to avert big movements of capital from London to New York . . . but presently America herself was in need of high rates as her own price system began to be perilously inflated (this fact was obscured by the existence of a stable price level, maintained in spite of tremendously diminished costs).”15
The United States could not raise its interest rates without depriving Britain of the ability to borrow the money (mainly from U.S. lenders) to pay its war debt. “As long as America lends freely to the world, and thus gives the nations greater buying power than otherwise they would have,” George Paish wrote in 1927, “Great Britain will be able to continue to buy from America and to sell to other nations. But should anything occur to cause American investors and bankers to stop their loans to foreign countries, Great Britain’s position would become most precarious. . . . If a time should come when [Britain’s] credit is exhausted and she is forced to reduce her purchases to the limit of her selling power, less her reparation and interest payments, then the full consequences of the impoverishment of the German people will be experienced by other nations.”16 The U.S. financial sector thus became responsible not only for its own prosperity, but also for that of its debtors including, indirectly, Germany. The government could collect on its Inter-Ally debts only so long as its own investment bankers and other investors would provide the funds. To be sure, the longer this process continued, the longer it seemed that it could go on forever. Economists even began to speak of a new era of world prosperity rather than examine the shaky foundations on which the world’s growing debt pyramid rested.
U.S. interest rates were held down in part by the inflationary money creation facilitated by the Treasury’s receipt of foreign debt payments. As is normal in such situations, the credit inflation made its first appearance in the money and capital markets: the price of stocks and bonds was bid up considerably before commodity prices began to rise. By 1928 nearly 30 per cent of bank assets were devoted to broker loans to finance stock market speculation (requiring only 20 per cent down payment, with favored customers putting up as little as 10 per cent of the price of their stocks). “As rates on call loans ran above other market rates by wide margins, funds were drawn into the New York stock market from all over the country and from financial centers abroad,” much of it in the form of short-term funds. This became a major factor curtailing new American loans to Europe – and to Germany in particular – loans without which U.S. export trade could not be financed. And without exports there could be no American prosperity, at least not without a sharp economic readjustment. Stocks and bonds soared even as earning power was threatened by the situation developing. “An extraordinary volume of new issues of common stock was floated toward the end of the boom – $2.1 billion in 1928 and $5.l billion in 1929, as compared with a total of $3.3 billion in 1921–27 and the later postwar peak of $4.5 billion ($2.65 billion ‘net change’) in 1961.”17
America’s speculative prosperity undercut world equilibrium as “investors turned from foreign bonds to American stocks since that was where the greatest gains were to be made. The rise in stocks brought European funds into the American market. The cessation of lending drew gold to balance the accounts. The combined effect was to force a contraction of credit in the outer world which undermined gold prices. A year later international prices fell so rapidly that they impaired the position of the debtors. This in turn forced a further contraction of credit and set prices and credits spinning in a vicious spiral of deflation. The depression which had begun in the far corners of the world in 1928 reached the United States and Europe in 1929–30.”18
Private funds flowed increasingly from foreign stock markets to the U.S. market. This explains why Europe’s stock markets peaked before the U.S. market. “Abroad, stock markets had peaked in Berlin in the spring of 1927, in London and Brussels in April and May 1928, in Tokyo in midsummer 1928, in Switzerland in September 1928, and in Paris