A History Lesson - Part 1

The Great Crash 1929
John Kenneth Galbraith

978-0-14-013609-8

This is a book that made a profound impact on me when I read it as a student, more than two decades ago. I wanted to understand the world of stocks and shares, and in order to understand a system, I have always found that one learns more by studying it when it is at its most atypical.

If, to be considered a Diogenerian, one must view the world with, what some might call, a cynical gaze, then this book is, in no small way, responsible for my being able to be so considered.

If you wish to understand something of the current economic crisis, I can think of no guide who is more clear, more witty and more readable than Professor Galbraith. It is with this in mind that I humbly present these extracts from his classic study.

Galbraith starts off by explaining why he spent the Summer of 1954 writing his book.

A good knowledge of what happened in 1929 remains our best safeguard against the recurrence of the more unhappy events of those days. Since 1929 we have enacted numerous laws designed to make securities speculation more honest and, it is hoped, more readily restrained. None of these is a perfect safeguard. The signal feature of the mass escape from reality that occurred in 1929 and before - and which has characterized every previous speculative outburst from the South Sea Bubble to the Florida land boom - was that it carried Authority with it. Governments were either bemused as were the speculators or they deemed it unwise to be sane at a time when sanity exposed one to ridicule, condemnation for spoiling the game, or the threat of severe political retribution.

Until the beginning of 1928, even a man of conservative mind could believe that the prices of common stock were catching up with the increase in corporation earnings, [...] and the certainty that the Administration, then firmly in power in Washington, would take no more than necessary of any earnings in taxes.

Early in 1928, [however,] the nature of the boom changed. The mass escape into make-believe, so much a part of the true speculative orgy, started in earnest. It was still necessary to reassure those who required some tie, however tenuous, to reality. And, as will be seen presently, this process of reassurance ... eventually achieved the status of a profession. However, the time had come, as in all periods of speculation, when men sought not to be persuaded of the reality of things but to find excuses for escaping into the new world of fantasy.

During the same month reassurance came from still higher authority. Andrew W. Mellon [the Secretary to the Treasury] said, 'There is no cause for worry. The high tide of prosperity will continue.'

Mr Mellon did not know. Neither did any of the other public figures who then, as since, made similar statements. These are not forecasts; it is not to be supposed that the men who make them are privileged to look further into the future than the rest. Mr Mellon was participating in a ritual which, in our society, is thought to be of great value for influencing the course of the business cycle. By affirming solemnly that prosperity will continue, it is believed, one can help insure that prosperity will in fact continue. Especially among businessmen the faith in the efficiency of such incantation is very great.

You see, being a cynic, I've always been bothered by this notion that house prices always go up. People would keep telling me that, even after I pointed out to them that I could remember two occasions in my lifetime (not counting the present one) when they had gone down, quite dramatically. Of course, what I didn't understand, until I read Galbraith, was that, for these clever people in the money markets of the world, the last thing that they want to do is actually own something.

As noted, at some point in the growth of a boom all aspects of property ownership become irrelevant except the prospect for an early rise in price.

It follows that the only reward to ownership in which the boomtime owner has an interest is the increase in values. Could the right to the increased value be somehow divorced from the other and now unimportant fruits of possession and also from as many as possible of the burdens of ownership, this would be much welcomed by the speculator. Such an arrangement would enable him to concentrate on speculation which, after all, is the business of a speculator.

Such is the genius of capitalism that where a real demand exists it does not go long unfilled. In all great speculative orgies devices have appeared to enable the speculator so to concentrate on his business. In the Florida boom the trading was in 'binders'. Not the land itself but the right to buy the land at a stated price was traded. This right to buy - which was obtained by a down payment of ten per cent of the purchase price - could be sold. It thus conferred on the speculators the full benefit of the increase in values. After the value of the lot had risen he could resell the binder for what he had paid plus the full amount of the increase in price.

The worst of the burdens of ownership, whether of land or any other asset, is the need to put up the cash represented by the purchase price. The use of the binder cut this burden by ninety per cent - or it multiplied tenfold the amount of acreage from which the speculator could harvest an increase in value. The buyer happily gave up the other advantages of ownership. These included the current income of which, invariably, there was none and the prospect of permanent use in which he had not the slightest interest.

The machinery by which Wall Street separates the opportunity to speculate from the unwanted returns and burdens of ownership is ingenious, precise, and almost beautiful. Banks supply funds to brokers, brokers to customers, and the collateral goes back to banks in a smooth and all but automatic flow.

It's marvellous, isn't it. And such is the genius of the markets that it is only a small step to apply this idea - separation of the opportunity to speculate, from the unwanted burdens of ownership - not only to physical assets such as land or buildings, but to the stocks and shares themselves!

People were swarming to buy stocks on margin - in other words, to have the increase in price without the cost of ownership.

One of the paradoxes of speculation in securities is that the loans that underwrite it are among the safest of all investments. They are protected by stocks which under all ordinary circumstances are instantly saleable, and by a cash margin as well. The money ... can be retrieved on demand. At the beginning of 1928 this admirably liquid and exceptionally secure outlet for non-risk capital was paying around five percent. The rate rose steadily through 1928, and during the last week of the year it reached twelve per cent. This was still with complete safety.

In Montreal, London, Shanghai, and Hong Kong there was talk of these rates. A great river of gold began to converge on Wall Street.

Corporations also found these rates attractive. At twelve per cent Wall Street might even provide a more profitable use for the working capital of a company than additional production. A few firms made this decision: instead of trying to produce goods with its manifold headaches and inconveniences, they confined themselves to financing speculation. Many more companies started lending their surplus funds on Wall Street.

Thank heavens for the regulators, who stop abuses of the system. Otherwise you might get someone setting up a hedge fund which turns out to be no more than a glorified pyramid scheme, which eventually collapses leaving debts of 50 billion.

All this being so, the position of the people who had at least nominal responsibility for what was going on was a complex one. One of the oldest puzzles of politics is who is to regulate the regulators. But an equally baffling problem, which has never received the attention it deserves, is who is to make wise those who are required to have wisdom.

Some of those in positions of authority wanted the boom to continue. They were making money out of it, and they may have had an intimation of the personal disaster which awaited them when the boom came to an end. But there were also some who saw, however dimly, that a wild speculation was in progress and that something should be done. For these people, however, every proposal to act raised the same intractable problem. The consequences of successful action seemed almost as terrible as the consequences of inaction, and they could be more horrible for those who took the action.

A bubble can be easily punctured. But to incise it with a needle so that it subsides gradually is a task of no small delicacy. The real choice was between an immediate and deliberately engineered collapse and a more serious disaster later on. Someone would certainly be blamed for the ultimate collapse when it came. There was no question whatever as to who would be blamed should the boom be deliberately deflated. The Federal Reserve Authorities. One may doubt if at any time in early 1929 the problem was ever framed in terms of quite such stark alternatives. But however disguised or evaded, these were the choices which haunted every serious conference on what to do about the market.

The men who had responsibility for these ineluctable choices were the President of the United States, the Secretary of the Treasury, the Federal Reserve Board in Washington, and the Governor of the Federal Reserve Bank of New York.

President Coolidge neither knew nor cared what was going on. A few days before leaving office in 1929, he cheerily observed that things were 'absolutely sound' and that stocks were 'cheap at current prices'.

So unlike our own Tony Blair, or even George W Bush.

These men do not issue orders; at most they suggest. Chiefly they move interest rates, buy or sell securities and, in doing so, nudge the economy here and restrain it there. Because the meanings of their actions are not understood by the great majority of the people, they can reasonably be assumed to have superior wisdom. Their actions will on occasion be criticized. More often they will be scrutinized for hidden meanings.

Such is the mystique of central banking. Such was the awe-inspiring role in 1929 of the Federal Reserve Board in Washington, the policy-making body which guided and directed the twelve Federal Reserve Banks. However, there was a jarring difficulty. The Federal Reserve Board in those times was a body of startling incompetence.

The New York Federal Reserve Bank, under Governor Strong's leadership, may not have been sufficiently perturbed by the speculation. Nor was it after Governor Strong died in October 1928 and was replaced by George L. Harrison. A reason, no doubt, was the reassurance provided by people in high places who were themselves speculating heavily. One such was Charles E. Mitchell, the Chairman of the Board of the National City Bank, who on 1 January 1929 became a class A director of the Federal Reserve Bank of New York. The end of the boom would mean the end of Mitchell. He was not a man to expedite his own demise.

Actually, not even new legislation, or the threat of it, was needed. In 1929, a robust denunciation of speculators and speculation by someone in high authority and a warning that the market was too high would almost certainly have broken the spell. It would have brought some people back from the world of make-believe. Those who were planning to stay in the market as long as possible but still get out (or go short) in time would have got out or gone short. Their occupational nervousness could readily have been translated into an acute desire to sell. Once the selling started, some more vigorously voiced pessimism could easily have kept it going.

The very effectiveness of such a measure was the problem. Of all the weapons in the Federal Reserve arsenal, words were the most unpredictable in their consequences. Their effect might be sudden and terrible. Moreover, these consequences could be attributed with the greatest of precision to the person or persons who uttered the words. Retribution would follow. To the more cautious of the Federal Reserve officials in the early part of 1929 silence seemed literally golden.

Then toward the end of the month disquieting news reached Wall Street. The Federal Reserve Board was meeting daily in Washington. It issued no statements. Newspapermen pressed the members after the sessions and were met with what then, as now, was known as tight-lipped silence. There was not a hint as to what the meetings were about, although everyone knew they concerned the market. The meetings continued day after day, and there was also an unprecedented Saturday session.

Soon it was too much. On Monday, 25 March, the first market day following the unseemly Saturday meeting, the tension became unbearable. Although, or rather because, Washington was still silent, people began to sell. Speculative favourites - Commercial Solvents, Wright Aero, American Railway Express - dropped 10 or 12 points or more; the Times industrial average was off 9.5 points for the day. More important, some banks decided that, in the event of a Federal Reserve crackdown, virtue might have a reward above revenue. They began curtailing their loans in the call market, and the rate on brokers' loans went to fourteen per cent.

On the next day, Tuesday, 26 March, everything was much worse. The Federal Reserve Board was still maintaining its by now demoralizing silence. A wave of fear swept the market. More people decided to sell, and they sold in astonishing volume. An amazing 8,246,740 shares changed hands on the New York Stock Exchange, far above every previous record. Prices seemed to drop vertically.

To avoid confusion, I should say at this point that this was not, in fact, the Great Crash. This was simply a minor dip in the apparently ever-rising tide of prosperity. What was soon to come would make this look like the calm before the storm.

26 March 1929 could have been the end. Money could have remained tight. The authorities might have remained firm in their intention to keep it so. The panic might have continued. Each fall in prices would have forced a new echelon of speculators to sell, and so forced prices down still more. It did not happen, and if any man can be credited with this, the credit belongs to Charles E. Mitchell. The Federal Reserve authorities were ambivalent, but Mitchell was not. He was for the boom. Moreover, his prestige as head of one of the two largest and most influential commercial banks, his reputation as an aggressive and highly successful investment banker, and his position as a director of the New York Federal Reserve Bank meant that he spoke with at least as much authority as anyone in Washington. During the day, as money tightened, rates rose, and the market fell, Mitchell decided to take a hand. He told the press, 'We feel that we have an obligation which is paramount to any Federal Reserve warning, or anything else, to avert any dangerous crisis in the money market.' The National City, he said, would loan money as necessary to prevent liquidation. It would also (and did) borrow money from the New York Federal Reserve Bank to do what the Federal Reserve Bank had warned against doing. Disguised only slightly by the prose form of finance, Mitchell issued the Wall Street counterpart of Mayor Hague's famous manifesto, *I am the law in Jersey City.*

I'm sure that no on in a position of power would behave in this way today! Pumping huge sums of borrowed money into the system to prevent collapse. How silly can you get!

Mitchell's words were like magic. By the end of trading on the 26th money rates had eased, and the market had rallied. The Federal Reserve remained silent, but now its silence was reassuring. It meant that it conceded Mitchell's mastery. The next day the National City regularized its commitment to the boom: it announced that it would insure reasonable interest rates by putting $25 million into the call market - $5 million when the rate was sixteen per cent, and $5 million additional for each percentage point.

Of course, Wall Street doesn't like regulators interfering with it's running, even if it is to their benefit. To try and illustrate this, let's say, hypothetically, that our banks have been forced to accept a bailout package from the Government because they are in danger of going bankrupt. It couldn't possibly happen, of course, but I am speaking hypothetically. Would they be grateful? Or would they complain that the Government wanted too much control over the way that they are run? Would they still refuse to lend money, displaying what some might call a lack of gratitude? Surely only the most cynical would wonder if all of the taxpayer's money that had been pumped into the banks had actually been wasted? Perhaps the only lesson that we can draw is that, seemingly, men who are used to power don't like being told what to do - even if they are being told to get into a lifeboat.

The Federal Reserve was criticized [for interfering in the running of the markets] even more than Mitchell - even though it could hardly have done less than it did. Arthur Brisbane said judiciously: 'If buying and selling stocks is wrong the government should close the Stock Exchange. If not, the Federal Reserve should mind its own business.' In a leading article in Barron's, a Mr Seth Axley was less even-handed:' For the Federal Reserve Board to deny investors the means of recognizing economies which are now proved, skill which is now learned, and inventions which are almost unbelievable seems to justify doubt whether it is adequately interpreting the times.' Since the principal action which the Federal Reserve had taken against investors had been to hold meetings and maintain silence, this was doubtless a trifle harsh.

After the defeat by Mitchell in March, the Federal Reserve retired from the field. There continued to be some slight anxiety [from Wall Street that they might still try to regulate the market]. In April, William Crapo Durant is supposed to have paid a secret night visit to the White House to warn President Hoover that if the Board were not called off it would precipate a terrible crash. The President was noncommittal, and Durant is said to have reduced his holdings before leaving on a trip to Europe. In June from Princeton Mr Lawrence said that the Board was still 'doing its utmost to cast the proverbial monkey wrench into the machinery of prosperity'. He warned the Board that it had 'aroused the enmity of an honest, intelligent, and public-spirited community'. (Some hardened Wall Streeters may have been surprised when they realized that this meant them.) But the Board, in fact, had decided to leave that honest, intelligent, and public-spirited community strictly to its own devices.

If there is one thing that Wall Street demands from it's regulators, it is that they should not try to regulate - only appear to do so. After all, what's a 50 billion hedge fund between friends?

Governor Young said subsequently, that 'while the hysteria might be somewhat restrained', it would have to run its course, and the Reserve Banks could only brace themselves for the 'inevitable collapse'. More accurately, the Federal Reserve authorities had decided not to be responsible for the collapse.

In August the Board finally agreed to an increase in the rediscount rate to six per cent. The market weakened only for a day. Any conceivable consequence of the action was nullified by a simultaneous easing of the buying rate on acceptances.

In fact, from the end of March on, the market had nothing further to fear from authority. President Hoover did ask Henry M. Robinson, a Los Angeles banker, to proceed as his emissary to New York and talk to the bankers there about the boom. According to Mr Hoover, Robinson was assured that things were sound. Richard Whitney, the Vice-President of the Exchange, was also summoned to the White House and told that something should be done about speculation. Nothing was done, and Mr Hoover was able to find some solace in the thought that primary responsibility for regulating the Stock Exchange rested with the Governor of New York, Franklin D. Roosevelt.

Roosevelt, too, was following a laissez-faire policy, at least on the matter of the stock market.

For now, free at last from all threat of government reaction or retribution, the market sailed off into the wild blue yonder. Especially after 1 June all hesitation disappeared. Never before or since have so many become so wondrously, so effortlessly, and so quickly rich. Perhaps Messrs Hoover and Mellon and the Federal Reserve were right in keeping their hands off. Perhaps it was worth being poor for a long time to be so rich for just a little while.

Coming soon: The Twilight of Illusion - The Crash.

Followed by: Things Become More Serious - The Aftermath