War had not yet been declared on July 27, but the Wall Street Journal described the mayhem: “Conditions which have not been witnessed before by some of the oldest operators prevailed in the foreign exchange market on Monday. A well-nigh complete state of demoralization characterized the market, and where rates were quoted they uctuated with a violence that deterred operators from transacting in the majority of instances. … Sterling was driven to the unprecedented level of $4.92.”*
How abnormal was an exchange rate of $4.92? Daily records collected by the U.S. National Monetary Commission in 1910 show that since 1889 the British pound never once rose above $4.90,124 con rming the Journal’s description of $4.92 as “unprecedented.” During the rst half of 1914 sterling reached a peak of $4.8900, only to wither under the weight of gold exports.
The exchange rate of $4.92 turned Max May’s arbitrage into a money machine. Instead of making $54 selling 42,477 British pounds to the clothing manufacturer, he would have made $1,690.125 Max could have bought a deluxe Paige 36 automobile ($1,275 with electric lights and starting system) on that trade alone.126 He would have made about $14 million on his London foreign exchange business during 1913 if the exchange rate had remained at
$4.92 all year, producing a 43 percent return without risk on the Guaranty Trust Company’s capital (and without using any of the rm’s capital).† Max should have been selling pounds at $4.92 and shipping gold to London until they made him president of the company. Was Max asleep at the wheel of his new car or did something, or someone, prevent him from locking in the arbitrage?
On Sunday, July 26, the day before sterling reached $4.92, the New York Times headline announced a break in diplomatic relations between Serbia and
Austria-Hungary: “Austrian Minister Recalled as Reply to Ultimatum Rejected.”127 Emperor Franz Joseph also instituted martial law throughout Austria-Hungary. Austria’s declaration of war on Tuesday, July 28, was almost a formality, but most people still did not expect the con ict to ensnare the Great Powers. The New York Times headline announcing Austria’s rejection of the Serbian reply to the Ultimatum also included the following:
“Britain to Work for Peace: Hope Entertained That Trouble Can Be Adjusted by Means of Mediation.”128
Did the U.S. Treasury turn the diplomatic confrontation into an excuse to curtail the availability of gold at $20.6718 per ounce? Perhaps the Treasury adapted the advice that John Maynard Keynes would give the British government: “To maintain specie payments … while making it extremely di cult for the ordinary man to get gold. [For example] Gold should only be available at the head o ce of the Bank of England.”129 Cutting o the gold supply at the U.S. Treasury would kill Max May’s arbitrage like a stake through the heart, allowing the price of sterling to rise unchecked.
The U.S. Treasury had changed the arbitrage game before. On March 18, 1891, Lazard Frères applied for $500,000 in gold bars for shipment to Germany. The Treasury Department forced the bankers to settle for gold coin at the subtreasury by ruling temporarily that “no more bars should be issued for export.”130 Bars dominate coin for shipments abroad because coins su er from abrasion in everyday use and bars do not. In Europe, the U.S. coins were weighed for their precise gold content and exchanged for foreign currency accordingly, while normal wear and tear did not infringe on their domestic value. For similar reasons, exporters prefer high-denomination U.S. gold coins like double eagles ($20), to eagles ($10) and half eagles ($5).
When Lazard Frères came to collect the $500,000 gold coin, Assistant Treasurer Roberts added further insult by ruling that the coin “would be paid out in proportion to the amount of the various coins on hand … $285,000 in double eagles, $145,000 in eagles, and $70,000 in half eagles.” Roberts assured the public: “There is no di culty on the part of the Treasury in meeting any calls for gold coin that are likely to arise … [but] the fair and proper method is to pay all comers a fair share of all denominations of gold coin.”131
During the entire week of July 27, 1914, the U.S. Treasury never wavered in its commitment to exchange gold for dollars at $20.6718. The Treasury cannot be blamed for preventing arbitrageurs from responding to the jump in the British pound to “unprecedented levels” on July 27. The Wall Street Journal noted: “In some quarters it has seemed somewhat anomalous that sterling should maintain its high level in the face of an unprecedented export of gold.”132 What deterred Max May’s arbitrage?
The withdrawal of $2.5 million gold bars on July 27, for shipment to France two days later aboard La Savoie, depleted the New York subtreasury’s
inventory of gold bars. The last bars were withdrawn by Lazard Frères. Max May had to accept gold coin from the subtreasury for export on the Carmania on the July 29.133 And Assistant Treasurer Roberts’s 1891 decree regarding the distribution of coins remained in force in July 1914. But the presence of eagles and half eagles in Max’s consignment of gold did not interfere with his arbitrage.
Coin abrasion added only about .07 percent to arbitrage costs, implying a gold export point of $4.8835 rather than $4.88.134 According to Max May, “At the quoted [foreign exchange] gures gold could be exported to any part of the globe at a pro t.”135 The exchange rate responded to the extensive gold shipments by declining from $4.92 on July 27 to $4.915 on both July 28 and July 29. But why didn’t arbitrage activity drive the exchange rate all the way back to $4.8835?
Percy Chubb, of Chubb & Sons, marine underwriters, implicated wartime insurance in blunting the downward pressure of arbitrageurs on the exchange rate: “[I have] never known a time when the [insurance] rate on gold was as high as at present.”136 Gold sailing on July 28 aboard the Kronprinzessin Cecilie paid $600 per $1 million for insurance compared with the normal $500.137 When the Carmania left port on July 29 insurance costs tripled to $1,500 per
$1 million.138 But those numbers merely rippled the surface compared with the tidal wave about to hit. On Thursday July 30, the New York Times reported that “marine underwriters were loath to assume new risks, but the rate was … $10,000 per million.”139
Soaring insurance costs infringed on Max May’s gold arbitrage. The 1 percent rate (equal to $10,000 divided by $1,000,000) pushed the gold export point up to nearly $4.93.140 But within a day the price of sterling left even this bloated barrier behind.
On Thursday, July 30, sterling soared to $4.98, 5¢ above the new gold export point. The Wall Street Journal noted: “To describe the conditions in the foreign exchange market in the past few days as being unparalleled is portraying the truth, but hardly conveys a proper notion of the real state of a airs. As a matter of fact, the most experienced operator would never have dreamed that any combination of circumstances could have arisen to drive … sterling to $4.98.”141 The Journal explained the source of the spiraling demand for the British currency: “Huge amounts of American securities were sold here for foreign account by direct cable, which created an extra demand for [sterling] remittance just at the juncture when a supply was least to be had.”142 European investors wanted sterling rather than dollars and evidently were willing to sacrifice an extra nickel to get British pounds.
What was wrong with dollars?
Nothing under ordinary circumstances, but wartime uncertainties drove investors to safety. In 1914 the British pound was the safest currency in the world. Most countries held their international reserves in gold or sterling.143
The dollar’s credibility su ered from periodic bank suspensions in the United States, most recently in 1907. The Panic of 1907 had damaged the reputation of American nance.* Sterling rose relative to the dollar because it was a safe-haven currency.
None of this made Max May’s arbitrage any less pro table, however. He could sell pounds to anyone wanting to pay $4.98, take the proceeds to buy gold from the U.S. Treasury, and ship the gold to the Bank of England, where he could get the pounds just sold. Max would earn $4.98 minus $4.93 (the mint parity exchange rate for pounds plus shipping costs at wartime insurance rates) per pound. The arbitrage was more pro table than ever and should have pushed the sterling exchange rate back toward the $4.93 gold export point—except for one detail.
Max needed ships to transfer the gold across the Atlantic. Although fty ocean liners were scheduled to leave New York harbor during the week of July 27, not all ships were equally helpful for Max May. Less than twenty were destined for Europe, and fewer actually sailed as scheduled. A further reduction in available shipping space occurred because “no insurance could be obtained for German vessels”144 and “underwriters were unwilling to insure more than about $10,000,000 going in one bottom.”145 As the New York Times observed, “With cancellations of sailings and the most prohibitive insurance rates on such ships as are still running it has become almost impossible to ship gold to Europe.”146
A number of cautious arbitrageurs refused to ship gold with the merchant eets of likely combatants. The Wall Street Journal said: “Some international houses, which have abstained from making shipments either because of their inability to secure insurance against war risks or their refusal to accept the prevailing rates of such insurance, may ship by the St. Louis, which is an American vessel and, therefore, not subject to seizure in the event of war between the [European] Powers.”147
The caution made sense, especially after the German ship, Kronprinzessin Cecilie, which had sailed to Europe with part of the recordbreaking gold exports that began on July 27, returned to American soil the following week, unable to deliver its cargo.* Foreign exchange dealers puzzled over what to do with the gold. According to the Journal, “The banks have already sold [foreign] exchange against the gold and unless the metal goes forward with another ship they will be that much ‘short’ of exchange.”148 Dealers needed their gold to reach England so they could purchase the sterling they had promised to their customers.
Turmoil in the foreign exchange market precipitated a meeting among the major dealers to confront the escalating crisis. The foreign exchange bankers created a committee to meet every day while the strain lasted “to enforce for all the brokers any regulations it may decide are necessary.”149 When the Wall Street Journal asked Max May, a member of the committee, about the gold
that had been brought back to America by the Kronprinzessin Cecilie, his response was “that gold will stay here and will be deposited in the sub- Treasury to the credit of the banks that had made the shipment. Now that foreign exchange transactions are to be placed on a war basis the shipment of gold abroad is out of the question.”150
To sum up: During the week of July 27, before Germany, Britain, Russia, and France declared war, Max May and other foreign exchange bankers took as much gold from the U.S. Treasury as they possibly could. But ships and insurance constrained Max and his fellow nanciers as e ectively as a longshoreman’s wildcat strike. The price of sterling rose above even the bloated gold export point because Max & Company could not do the arbitrage as often as they wished. On Friday July 31, sterling reached one more unprecedented level—$6.00—causing an unnamed foreign exchange dealer to throw up his hands and scream: “It’s just criminal, that’s all.”151
Figure 2.1, showing the exchange rate between the British pound and the U.S. dollar for 1914, illustrates the dimensions of the crisis.† The narrow movements in the price of sterling during the rst half of the year re ect the arbitrage operations of foreign exchange dealers. The panic that erupted at the end of July drove the value of the British pound to levels not witnessed in more than a genetation. During the rst week of August, foreign exchange prices literally disappeared from view, with only a few transactions taking place privately.* Quotations reappeared the following week but uctuated with uncommon violence until the end of the year.
Figure 2.1. Sterling Exchange Rate, 1914.
Data Source: Wall Street Journal.
The declaration of war among the Great Powers during the week of August 2, 1914, turned thoughts of gold shipments into a fantasy from Oz.
The dealers could not arrange exports until the Bank of England conspired to lend a helping hand. How much damage did the bankers do before the war temporarily halted exports?