The world changed when Germany invaded Poland in September 1939. The event had consequences in financial markets as well and not only in Germany and the other belligerent countries. In neutral and warring countries alike, central banks and other public authorities addressed the sudden financial problems, most notably in foreign exchange and credit markets. In doing this, they acted decisively.
In Europe, the Second World War began when German troops invaded Poland on September 1, 1939. After their demands to halt the invasion were ignored, Britain and France declared war on Germany two days later. The Soviet Union invaded Poland from the east two weeks into the new war and the country was subsequently divided between the Germans and Soviets, barely a month after a non-aggression pact was signed between those two countries. Within a few weeks, Poland was defeated and German troops were freed up in the east, spelling danger for Western Europe.
In financial markets, the outbreak of war in September 1939 was most immediately felt in the bond and foreign exchange markets. The prices of German and Austrian government bonds plunged, as too did those of France and Belgium, though to a lesser degree. Switzerland was perhaps the most notable outlier; market prices for Swiss bonds rose after the invasion of Poland, just one piece of evidence that a historic flight of capital to safer countries was underway. As we will see, safer did not necessarily mean neutral.
Britain was not at all spared and the country imposed a minimum price on the trading of its public bonds but other countries of the British Empire saw their sovereign bonds fall, no matter how far from the events in Poland they were. British India was considered at war with Germany upon the British declaration and Australia, New Zealand, South Africa, and Canada all declared war by mid-month as well.
Some neutral countries, such as Belgium and those in Scandinavia, saw large declines in their bond markets as well, though others like Switzerland, the United States, and also for the time being, Italy and Japan, saw little movement or even appreciation. In general, the bonds of belligerent countries, no matter how large and powerful saw distress, while those of neutral countries were mixed but performed better overall. Polish bonds, needless to say, fell to distressed levels
Conditions were not far different in the foreign exchange markets. It was said that the US dollar, the Belgian franc, the Dutch guilder, and the Swiss franc were the only currencies for which there seemed to be any demand in the weeks after the war began. The stock markets offered a contrast though; even those in the warring countries saw surprisingly muted movements following the declarations of war. Markets seemed unsure how to react to the new state of affairs. War could mean new orders and government support but also higher taxes and supply shortages, whether due to import controls, rationing, or otherwise.
Across Europe, people hoarded currency, withdrew from bank accounts, and caused a contraction of credit. Borrowing costs rose. So too did commodity prices, both for foodstuffs and industrial materials. An index of commodity prices in US Dollars rose 20% in the week after the start of the invasion. Governments and central banks intervened in markets almost immediately. The British announced a bank holiday on September 4 and the London Stock Exchange was closed through September 7.
Britain and France
Besides the financial effects of the war already mentioned, short-term interest rates rose in the free economies of Europe. In Britain, money market rates rose from 1.35% in August to 2.72% in September and in France from 1.95% to 2.70%. In Britain at least, this would return below 2% by October as the Bank of England cut its interest rate back to 2% after an increase to 4% just a week before the invasion of Poland.
There was also capital flight from Europe, notably to the United States. This had the potential to amplify the credit contraction in belligerent countries. To lessen this, foreign exchange controls were implemented in Britain, France, and elsewhere. These measures limited the export of currency and gold and controlled currency exchange rates. So, whereas gold movement from Britain to America stood at $162 million in September 1939 (approximately 4.6 million ounces), this fell to just $10 million in October.
In France, the receipt of foreign currencies from abroad had to be declared and in Britain, foreign currency and gold had to be sold to the government at the official rate. In both countries, severe limits were placed on the ability to export capital abroad. Britain had briefly allowed the pound to float freely and it fell from 4.68 U.S. dollars to 4.00, before being controlled once more. This 15% fall was closely matched by the French franc. On September 6, there was a transfer of the Bank of England’s gold reserves into Britain’s Exchange Equalization Account, used to control exchange rates.
As with other countries, there was a pronounced increase in banknote issuance in Britain and France, likely to meet increased demands for physical cash. In the three weeks following August 23, the volume of Bank of England notes outstanding rose £45 million, or 9%, to £553 million. In France, note issuance by the Banque de France rose by 23 billion francs over a similar period, a 19% increase to 146 billion francs.
Upon its invasion of Poland, German sovereign bonds plunged in value. True, German bond prices had been falling through the 1930s. Hitler’s regime enacted a moratorium on reparations payments, signaling to some a reduced willingness to pay debts. Years of aggression in foreign affairs made war hardly an unlikely possibility, unnerving investors. Illustrating the point, Austrian bonds fell from a small premium to par value to below 40% of par value upon the Anschluss, or union with Germany, of 1938. The market judged Austria a far less creditworthy borrower in union with Germany than it was alone.
German government bonds had fallen 17% during the March 1939 invasion of Czechoslovakia. They fell by 39% after the invasion of Poland; Austrian bonds fell by 46%. Clearly, investors did not think Germany would win the war, at least ‘win’ in any way that investors could find comfort in. Payments even on private debts to creditors of ‘enemy nationality’, or those who acquired their claims from such persons following September 1st, were suspended. Indeed, foreign exchange controls in Germany were already tight long before the war so the new measures were hardly surprising; they were amplifications, and not deviations, from pre-war conditions there.
Foreign exchange aside, in the short run, the war did not mean that greater demands were placed on the central bank by the government. The German state raised taxes and remained able to borrow on the local credit markets. So, the Reichsbank spent the year facilitating the incorporation of new territories into the Third Reich and provided relief to the private economy, focusing on firms suffering from the suspension of foreign trade with enemy countries.
Over 1939 alone, banknote issuance by the Reichsbank, net of those notes held in reserve and not released into circulation, rose by RM (reichsmarks) 3.6 billion. The stock of outstanding currency thus rose 43.5% from RM 8.2 billion to RM 11.8 billion in just one year, much of this in the weeks leading up to the invasion of Poland and too a lesser extent in the succeeding weeks.
In the United States, the outbreak of war in Europe had the most muted effect. One result was a strengthening in the economy as industrial orders from abroad, Germany excluded, rose in anticipation of future disruption. As in much of Europe, though to a smaller degree, bond prices did fall upon the outbreak of war but prices then rose substantially, in part because of the interventions of the central bank.
Like Switzerland, the country was seen as a safe haven. Gold was transited from Europe to America. More so than in Europe, stock prices in America rose upon the start of the Second World War. Thus, it was hardly a time of panic. Unlike at the start of the First World War, the exchanges remained open and rather than experience a run, banks saw deposits and reserves increase.
On September 1, the Federal Reserve announced that “in view of current developments in the international situation, the Federal Reserve banks are prepared at this time to make advances to member and nonmember banks on Government obligations at par at the rates prevailing for member banks”. The healthy state of the banks rendered this aid unnecessary.
To provide support to the credit markets, after having allowed some of its holdings of government bonds to mature without replacement in the summer, government securities held by the Federal Reserve rose 16.5% in September alone to $2.8 billion. These purchases injected fresh funds into the banking system.
It may be worth looking at a neutral country in Europe. Sweden was a neutral country like America but, unlike America, was not separated from events in Poland by a sea quite so large. In 1939, the Swedish Riksbank’s gold reserves were transferred from Britain to America and on August 28, the Swedish krona was pegged to the dollar rather than to the pound in order to link the currency to a fellow neutral country. Other Scandinavian countries followed suit in fixing their currencies to the dollar.
Like other European countries and unlike the United States, the Swedes implemented new foreign exchange controls. Nonetheless, in contrast to the currencies of Britain and France, the krona was more stable, falling only 2% against the dollar between August 24 and September 22. Unsurprisingly given the broad trend, the Riksbank also increased banknote circulation, likely to make up for currency hoarding and the accompanying contraction of credit, from 1.03 billion kronor to 1.47 billion between July 1939 and May the following year.
The events in Europe in September 1939 were certainly distressing though not for financial reasons. Nevertheless, the actions of investors and the public contributed to significant movements in foreign exchange and credit that needed addressing. In multiple countries, central banks and other authorities sought to cushion the impact of the swings in markets on the economy. Governments stemmed the evaporation of credit by preventing large capital outflows. In any case, unlike in diplomacy, there was not an immediate crisis in finance. Public authorities were decisive in their interventions. Unfortunately, this was not their first such disaster in the 20th century.
More from the Tontine Coffee-House
Learn about the ‘Allied military currency’ used by the Allies on campaigns abroad during the Second World War. Also, read about the role of the war in turning art into a store of value. Lastly, consider subscribing to this blog’s newsletter here.
1. The Commercial & Financial Chronicle, vol. 149, no. 3872, 9 Sept. 1939, William B. Dana Co.
2. The Commercial & Financial Chronicle, vol. 149, no. 3873, 16 Sept. 1939, William B. Dana Co.
3. The Commercial & Financial Chronicle, vol. 149, no. 3874, 23 Sept. 1939, William B. Dana Co.
4. Federal Reserve Bulletin October 1939, vol. 25, no. 10, Board of Governors of the Federal Reserve System.
5. Federal Reserve Bulletin December 1939, vol. 25, no. 12, Board of Governors of the Federal Reserve System.
6. Federal Reserve Bulletin September 1940, vol. 26, no. 9, Board of Governors of the Federal Reserve System.
7. Frey, Bruno S., and Marcel Kucher. “History as Reflected in Capital Markets: The Case of World War II.” The Journal of Economic History, vol. 60, no. 2, June 2000, pp. 468–496.
8. Wetterberg, Gunnar. “From the First War to the Second.” Money and Power – the History of Sveriges Riksbank, Atlantis, pp. 255–320.