A History Lesson - Part 3 - Things Get Worse

More extracts from Professor Galbraith's classic work: The Great Crash 1929. A more accessible and witty summary of what happened in that year I have yet to read.

These extracts come from the chapter in his book entitled: 'Things Become More Serious'. I would urge anyone who is interested in such things, and who wishes to understand more of what is going on today, to invest in this modest volume.

A common feature of all these earlier troubles was that, having happened, they were over. The worst was reasonably recognizable as such. The singular feature of the great crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next day to have been only the beginning. Nothing could have been more ingeniously designed to maximize the suffering, and also to ensure that as few as possible escaped the common misfortune. The fortunate speculator who had funds to answer the first margin call presently got another and equally urgent one, and if he met that there would still be another. In the end all the money he had was extracted from him and lost. The man with the smart money, who was safely out of the market when the first crash came, naturally went back in to pick up bargains. (Not only were a recorded 12,894,650 shares sold on 24 October; precisely the same number were bought.) The bargains then suffered a ruinous fall. Even the man who waited out all of October and all of November, who saw the volume of trading return to normal and saw Wall Street become as placid as a produce market, and who then bought common stocks would see their value drop to a third or a fourth of the purchase price in the next twenty-four months. The Coolidge bull market was a remarkable phenomenon. The ruthlessness of its liquidation was, in its own way, equally remarkable.

Tuesday, 29 October, was the most devastating day in the history of the New York stock market, and it may have been the most devastating day in the history of markets. It combined all of the bad features of all of the bad days before. Volume was immensely greater than on Black Thursday; the drop in prices was almost as great as on Monday. Uncertainty and alarm were as great as on either.

Selling began as soon as the market opened and in huge volume. Great blocks of stock were offered for what they would bring; in the first half-hour sales were at a 33,000,000-a-day rate. The air holes, which the bankers were to close, opened wide. Repeatedly and in many issues there was a plethora of selling orders and no buyers at all.

Once again, of course, the ticker lagged - at the close it was two and a half hours behind. By then, 16,410,030 sales had been recorded on the New York Stock Exchange - some certainly went unrecorded - or more than three times the number that was once considered a fabulously big day. The Times industrial averages were down 43 points, cancelling all of the gains of the twelve wonderful months preceding.

But the worst thing that happened on this terrible day was to the investment trusts. Not only did they go down, but it became apparent that they could go practically to nothing. Goldman Sachs Trading Corporation had closed at 60 the night before. During the day it dropped to 35 and closed at that level, off by not far short of half. Blue Ridge, its offspring once removed, on which the magic of leverage was now working in reverse, did much worse. Early in September it had sold at 24. By 24 October it was down to 12, but it resisted rather well the misfortunes of that day and the day following. On the morning of 29 October it opened at 10 and promptly slipped to 3, giving up more than two-thirds of its value. It recovered later but other investment trusts did less well; their stock couldn't be sold at all.

The worst day on Wall Street came eventually to an end. Once again the lights blazed all night. Members of the Exchange, their employees, and the employees of the Stock Exchange by now were reaching the breaking point from strain and fatigue. In this condition they faced the task of recording and handling the greatest volume of transactions ever. All of this was without the previous certainty that things might get better. They might go on getting worse. In one house an employee fainted from exhaustion, was revived, and put back to work again.

In the first week the slaughter had been of the innocents. During this second week there is some evidence that it was the well-to-do and the wealthy who were being subjected to a levelling process comparable in magnitude and suddenness to that presided over a decade before by Lenin. The size of the blocks of stock which were offered suggested that big speculators were selling or being sold. Another indication came from the boardrooms. A week before they were crowded, now they were nearly empty. Those now in trouble had facilities for suffering in private.

The bankers met twice on the 29th - at noon and again in the evening. There was no suggestion that they were philosophical. This was hardly remarkable because, during the day, an appalling rumour had swept the Exchange. It was that the bankers' pool, so far from stabilizing the market, was actually selling stocks! The prestige of the bankers had in truth been falling even more rapidly than the market. After the evening session, Mr Lament met the press with the disenchanting task of denying that they had been liquidating securities - or participating in a bear raid. After explaining again, somewhat redundantly in view of the day's events, that it was not the purpose of the bankers to maintain a particular level of prices, he concluded: 'The group has continued and will continue in a cooperative way to support the market and has not been a seller of stocks.' In fact, as later intelligence revealed, Albert H. Wiggin of the Chase was personally short at the time to the tune of some millions. His cooperative support, which if successful would have cost him heavily, must have had an interesting element of ambivalence.

The rumour recurred that the 'organized support' was selling stocks, and Mr Lament, on meeting the press [again], added a minor footnote to this now completed story. He said he didn't know - the organized support was really not that well organized. The most plausible explanation is that everyone was feeling cheerful but the public. As before and later, the weekend had been a time of thought, and out of thought had come pessimism and a decision to sell. So, as on other Mondays, no matter how cheerful the superficial portents, the selling orders poured in in volume.

By now it was also evident that the investment trusts, once considered a buttress of the high plateau and a built-in defence against collapse, were really a profound source of weakness. The leverage, of which people only a fortnight before had spoken so knowledgeably and even affectionately, was now fully in reverse. With remarkable celerity it removed all of the value from the common stock of a trust. As before, the case of a typical trust, a small one, is worth contemplating. Let it be supposed that it had securities in the hands of the public which had a market value of $10,000,000 in early October. Of this, half was in common stock, half in bonds and preferred stock. These securities were fully covered by the current market value of the securities owned. In other words, the trust's portfolio contained securities with a market value also of $10,000,000.

A representative portfolio of securities owned by such a trust would, in the early days of November, have declined in value by perhaps half. (Values of many of these securities by later standards would still be handsome; on 4 November, the low for Tel and Tel was still 233, for General Electric it was 234, and for Steel 183.) The new portfolio value, $5,000,000, would be only enough to cover the prior claim on assets of the bonds and preferred stock. The common stock would have nothing behind it. Apart from expectations, which were by no means bright, it was now worthless.

This geometrical ruthlessness was not exceptional. On the contrary, it was everywhere at work on the stock of the leverage trusts. By early November, the stock of most of them had become virtually unsaleable. To make matters worse, many of them were traded on the Curb or the out-of-town exchanges where buyers were few and the markets thin.

Never was there a time when more people wanted more money more urgently than in those days. The word that a man had 'got caught' by the markets was the signal for his creditors to descend on him like locusts. Many who were having trouble meeting their margin calls wanted to sell some stocks so they could hold the rest and thus salvage something from their misfortunes. But such people now found that their investment trust securities could not be sold for any appreciable sum and perhaps not at all. They were forced, as a result, to realize on their good securities. Standard stocks like Steel, General Motors, Tel and Tel were thus dumped on the market in abnormal volume, with the effect on prices that had already been fully revealed. The great investment trust boom had ended in a unique manifestation of Gresham's Law in which the bad stocks were driving out the good. The stabilizing effects of the huge cash resources of the investment trusts had also proved a mirage. In the early autumn the cash and liquid resources of the investment trusts were large. Many trusts had been attracted by the handsome returns in the call market. (The speculative circle had been closed. People who speculated in the stock of investment trusts were in effect investing in companies which provided the funds to finance their own speculation.) But now, as reverse leverage did its work, investment trust managements were much more concerned over the collapse in the value of their own stock than over the adverse movements in the stock list as a whole. The investment trusts had invested heavily in each other. As a result the fall in Blue Ridge hit Shenandoah, and the resulting collapse in Shenandoah was even more horrible for the Goldman Sachs Trading Corporation.

Under these circumstances, many of the trusts used their available cash in a desperate effort to support their own stock. However, there was a vast difference between buying one's stock now when the public wanted to sell and buying during the previous spring - as Goldman Sachs Trading Corporation had done - when the public wanted to buy and the resulting competition had sent prices higher and higher. Now the cash went out and the stock came in, and prices were either not perceptibly affected or not for long. What six months before had been a brilliant financial manoeuvre was now a form of fiscal self-immolation. In the last analysis, the purchase by a firm of its own stock is the exact opposite of the sale of stocks. It is by the sale of stock that firms ordinarily grow.

However, none of this was immediately apparent. If one has been a financial genius, faith in one's genius does not dissolve at once. To the battered but unbowed genius, support of the stock of one's own company still seemed a bold, imaginative, and effective course. Indeed, it seemed the only alternative to slow but certain death. So to the extent that their cash resources allowed, the managements of the trusts chose faster, though equally certain death. They bought their own worthless stock.

Men have been swindled by other men on many occasions. The autumn of 1929 was, perhaps, the first occasion when men succeeded on a large scale in swindling themselves.

A History Lesson - Part 2 - The Crash

More extracts from Professor Galbraith's classic work: The Great Crash 1929. A more accessible and witty summary of what happened in that year I have yet to read.

I hope the ghost of the Professor will forgive me for inserting the occasional Diogenerian comment here and there, especially as we currently seem to be living through a similar period in our history.

Most of these extracts come from the chapters in his book that are entitled: 'The Twilight of Illusion' and 'The Crash'. I would urge anyone who is interested in such things, and who wishes to understand more of what is going on today, to invest in this modest volume.

Without doubt, the most striking feature of the financial era which ended in the autumn of 1929 was the desire of people to buy securities and the effect of this on values. But the increase in the number of securities to buy was hardly less striking. And the ingenuity and zeal with which companies were devised in which securities might be sold was as remarkable as anything.

The most notable piece of speculative architecture of the late twenties, and the one by which, more than any other device, the public demand for common stocks was satisfied, was the investment trust or company. The investment trust did not promote new enterprises or enlarge old ones. It merely arranged that people could own stock in old companies through the medium of new ones. Even in the United States, in the twenties, there were limits to the amount of real capital which existing enterprises could use or new ones could be created to employ. The virtue of the investment trust was that it brought about an almost complete divorce of the volume of corporate securities outstanding from the volume of corporate assets in existence. The former could be twice, thrice, or any multiple of the latter. The volume of underwriting business and of securities available for trading on the exchanges all expanded accordingly. So did the securities to own, for the investment trusts sold more securities than they bought. The difference went into the call market, real estate, or the pockets of the promoters. It is hard to imagine an invention better suited to the time or one better designed to eliminate the anxiety about the possible shortage of common stocks.

Things like investment trusts are the holy grail to the financial markets. They don't want to be held back by trivial things like 'How much is the company worth?' or 'How many things have we got to sell to people?'. They want to be able to generate huge profits, out of all proportion to their own size. Imagine if a bank could only lend out the equivalent of how much gold it had in it's vaults? How is it meant to grow into a world beating company that can afford to pay it's executives huge bonuses?

The trouble with selling real things is that once you have sold them all, you have to spend money making or buying more of them. You are limited by your assets - what you have in stock. You are never going to get rich that way.

If you want to get rich, it is vital that you come up with some way - be it investment trusts, consolidated debt obligations, securities or derivatives - that enables you to separate your ability to generate money, from any aspect of reality. Reality is far too limiting. You are interested in unlimited growth. Things in the real world don't grow without limit.

The idea of the investment trust is an old one, although, oddly enough, it came late to the United States. Since the eighties in England and Scotland, investors, mostly smaller ones, had pooled their resources by buying stock in an investment company. The latter, in turn, invested the funds so secured. A typical trust held securities in from five hundred to a thousand operating companies. As a result, the man with a few pounds, or even a few hundred, was able to spread his risk far more widely than were he himself to invest. And the management of the trusts could be expected to have a far better knowledge of companies and prospects in Singapore, Madras, Capetown, and the Argentine, places to which British funds regularly found their way, than the widow in Bristol or the doctor in Glasgow. The smaller risk and better information well justified the modest compensation of those who managed the enterprise. Despite some early misadventures, the investment trusts soon became an established part of the British scene.

The managers of the British trusts normally enjoy the greatest of discretion in investing the funds placed at their disposal. At first the American promoters were wary of asking for such a vote of confidence. Many of the early trusts were [literally] trusts - the investor bought an interest in a specified assortment of securities which were then deposited with a trust company. At the least the promoters committed themselves to a rigorous set of rules on the kinds of securities to be purchased and the way they were to be held and managed. But as the twenties wore along, such niceties disappeared. The investment trust became, in fact, an investment corporation. It sold its securities to the public - sometimes just common stock, more often common and preferred stock, debenture and mortgage bonds - and the proceeds were then invested as the management saw fit. Any possible tendency of the common stockholder to interfere with the management was prevented by selling him non-voting stock or having him assign his voting rights to a management-controlled voting trust.

Brilliant! Use their money, but don't allow them to have any say over how it is used. Which is fine as long as the interest keeps rolling in, of course - no one cares too much. It's when it stops and people realise that their money isn't actually their money any more, that things get interesting.

Historians have told with wonder of one of the promotions at the time of the South Sea Bubble. It was 'For an Undertaking which shall in due time be revealed'. The stock is said to have sold exceedingly well. As promotions the investment trusts were, on the record, more wonderful. They were undertakings the nature of which was never to be revealed, and their stock also sold exceedingly well.

I'm sure that no one would be this stupid today! Fancy buying something without knowing or understanding what it was.

During 1928 an estimated 186 investment trusts were organized; by the early months of 1929 they were being promoted at the rate of approximately one each business day, and a total of 265 made their appearance during the course of the year. In 1927 the trusts sold to the public about $400,000,000 worth of securities; in 1929 they marketed an estimated three billions worth. This was at least a third of all the new capital issues in that year; by the autumn of 1929 the total assets of the investment trusts were estimated to exceed eight billions of dollars. They had increased approximately elevenfold since the beginning of I927.

The parthenogenesis of an investment trust differed from that of an ordinary corporation. In nearly all cases it was sponsored by another company, and by 1929 a surprising number of different kinds of concerns were bringing the trusts into being. Investment banking houses, commercial banks, brokerage firms, securities dealers, and, most important, other investment trusts were busy giving birth to other trusts.

So a company that has no assets is able to borrow enough money to create other companies, none of which have any assets, and they in turn can borrow money to set up yet more companies, none of which have any assets, and so on, and on.

Yet, had these securities all been sold on the market, the proceeds would invariably have been less, and often much less, than the current value of the outstanding securities of the investment company. The latter, obviously, had some claim to value which went well beyond the assets behind them.

That premium was, in effect, the value an admiring community placed on professional financial knowledge, skill, and manipulative ability. To value a portfolio of stocks 'at the market' was to regard it only as inert property. But as the property of an investment trust it was much more, for the portfolio was then combined with the precious ingredient of financial genius. Such special ability could invoke a whole strategy for increasing the value of securities.

Consider by way of illustration, the case of an investment trust organised in 1920 with a capital of $150 million - a plausible size by then. Let it be assumed, further, that a third of the capital was realised from the sale of bonds, a third from preferred stock , and the rest from the sale of common stock. If this $150 million were invested, and if the securities so purchased showed a normal appreciation, the portfolio value would have increased by midsummer by about fifty percent. The assets would be worth $225 million. The bonds and preferred stock would still be worth only $100 million; their earnings would not have increased, and they could claim no greater share of the assets in the hypothetical event of a liquidation of the company. The remaining $125 million, therefore, would underlie the value of the common stock of the trust. The latter, in other words, would have increased in asset value from $50 million to $125 million, or by a hundred and fifty per cent, and as the result of an increase of only fifty per cent in the value of the assets of the trust as a whole.

This was the magic of leverage, but this was not all of it. Were the common stock of the trust, which had so miraculously increased in value, held by still another trust with similar leverage, the common stock of that trust would get an increase of between seven hundred and eight hundred per cent from the original fifty per cent advance. And so forth.

In 1929 the discovery of the wonders of the geometric series struck Wall Street with a force comparable to the invention of the wheel.

There was a rush to sponsor investment trusts which would sponsor investment trusts, which would, in turn, sponsor investment trusts. The miracle of leverage, moreover, made this a relatively costless operation to the ultimate man behind all of the trusts. Having launched one trust and retained a share of the common stock, the capital gains from leverage made it relatively easy to swing a second and larger one which enhanced the gains and made possible a third and still bigger trust.

Ah, leverage. I learned about this magic when I first read Galbraith's book. It seems to be inherent in the way that all financial markets work, at least nowadays. It is what caused the problems then, and it is what has caused many of the problems now. All the laws and regulations that were put in place after 1929, to stop it happening again, have been slowly removed and repealed.

The thing that immediately occurred to me, the first time I read Galbraith's book, was: 'Well that's ok when things are going well, but what happens when things are not going well?'

Galbraith addresses this very point later on in the chapter.

Leverage, it was later to develop, works both ways. Not all of the securities held by the Founders were of a kind calculated to rise indefinitely, much less to resist depression. Some years later the portfolio was found to have contained 5,000 shares of Kreuger and Toll, 20,000 shares of Kolo Products Corporation, an adventuresome new company which was to make soap out of banana oil, and $295,000 in the bonds of the Kingdom of Yugoslavia. As Kreuger and Toll moved down to its ultimate value of nothing, leverage was also at work - geometric series are equally dramatic in reverse. But this aspect of the mathematics of leverage was still unrevealed in early 1929, and notice must first be taken of the most dramatic of all the investment company promotions of that remarkable year, those of Goldman, Sachs.

That's the trouble with financial genius - good on calculating consolidated debt obligations, bad at remembering their school maths lessons.

In the two months after its formation, the new company sold some more stock to the public, and on 21 February it merged with another investment trust, the Financial and Industrial Securities Corporation. The assets of the resulting company were valued at $235 million, reflecting a gain of well over a hundred per cent in under three months. By 2 February, roughly three weeks before the merger, the stock for which the original investors had paid $104 was selling for $136.50. Five days later, on 7 February, it reached $222.50. At this latter figure it had a value approximately twice that of the current total worth of the securities, cash, and other assets owned by the Trading Corporation.

This remarkable premium was not the undiluted result of public enthusiasm for the financial genius of Goldman, Sachs. Goldman, Sachs had considerable enthusiasm for itself, and the Trading Corporation was buying heavily of its own securities. By 14 March it had bought 560,724 shares of its own stock for a total outlay of $57,021,936. This, in turn, had boomed their value. However, perhaps foreseeing the exiguous character of an investment company which had its investments all in its own common stock, the Trading Corporation stopped buying itself in March. Then it resold part of the stock to William Crapo Durant, who re-resold it to the public as opportunity allowed.

That's clever. I don't know if it's legal, but it's very clever.

The spring and early summer were relatively quiet for Goldman, Sachs, but it was a period of preparation. By 26 July it was ready. On that date the Trading Corporation, jointly with Harrison Williams, launched the Shenandoah Corporation, the first of two remarkable trusts. The initial securities issue by Shenandoah was $102,500,000 (there was an additional issue a couple of months later) and it was reported to have been oversubscribed some sevenfold. There were both preferred and common stock, for by now Goldman, Sachs knew the advantages of leverage. Of the five million shares of common stock in the initial offering, two million were taken by the Trading Corporation, and two million by Central States Electric Corporation on behalf of the co-sponsor, Harrison Williams. Williams was a member of the small board along with partners in Goldman, Sachs. Another board member was a prominent New York attorney whose lack of discrimination in this instance may perhaps be attributed to youthful optimism. It was Mr John Foster Dulles. The stock of Shenandoah was issued at $17.50. There was brisk trading on a 'when issued' basis. It opened at 30, reached a high of 36 and closed at 36, or 18.5 above the issue price.

Meanwhile Goldman, Sachs was already preparing its second tribute to the countryside of Thomas Jefferson, the prophet of small and simple enterprises. This was the even mightier Blue Ridge Corporation, which made its appearance on 20 August. Blue Ridge had a capital of $142,000,000, and nothing about it was more remarkable than the fact that it was sponsored by Shenandoah, its precursor by precisely twenty-five days. Blue Ridge had the same board of directors as Shenandoah, including the still optimistic Mr Dulles, and of its 7,250,000 shares of common stock (there was also a substantial issue of preferred) Shenandoah subscribed a total of 6,250,000. Goldman, Sachs by now was applying leverage with a vengeance.

This is all starting to sound a bit incestuous. I don't usually subscribe to the idea of a small clique of rich, powerful people running things behind the scenes, but I am starting to wonder - although this happened in 1929 - I'm sure it's different now.

Having issued more than a quarter of a billion dollars' worth of securities in less than a month - an operation that would not then have been unimpressive for the United States Treasury -activity at Goldman, Sachs subsided somewhat.

Thus, on 1 August the papers announced the formation of Anglo-American Shares, Inc., a company which, with a soigné touch not often seen in a Delaware corporation, had among its directors the Marquess of Carisbrooke, G.C.B., G.C.V.O., and Colonel the Master of Sempill, A.F.C., otherwise identified as the President of the Royal Aeronautical Society, London.

American Insuranstocks Corporation was launched the same day, though boasting no more glamorous a director than William Gibbs McAdoo. On succeeding days came Gude Winmill Trading Corporation, National Republic Investment Trust, Insull Utility Investments, Inc., International Carriers, Ltd, Tri-Continental Allied Corporation, and Solvay American Investment Corporation.

On 13 August the papers also announced that an Assistant U.S. Attorney had visited the offices of the Cosmopolitan Fiscal Corporation and also an investment service called the Financial Counsellor. In both cases the principals were absent. The offices of the Financial Counsellor were equipped with a peephole like a speakeasy.

Do you know, I'm starting to wonder if these were real companies. I think they were just making them up as they went along.

More investment trust securities were offered in September of 1929 even than in August - the total was above $600 million. However, the nearly simultaneous promotion of Shenandoah and Blue Ridge was to stand as the pinnacle of new era finance. It is difficult not to marvel at the imagination which was implicit in this gargantuan insanity. If there must be madness something may be said for having it on a heroic scale.

I'm shocked that a respected economist like Professor Galbraith should describe this behaviour as gargantuan insanity. Clearly he does not understand the complexities of the financial markets, and how they can provide continuous growth and ever-increasing wealth. Forever.

More than the prices of common stocks were rising. So, at an appalling rate, was the volume of speculation.

Brokers' loans during the summer increased at a rate of about $400,000,000 a month. By the end of the summer, the total exceeded seven billions. Of that more than half was being supplied by corporations and individuals, at home and abroad, who were taking advantage of the excellent rate of return which New York was providing on money. Only rarely did the rate on call loans during that summer get as low as six per cent. The normal range was seven to twelve. On one ocasion the rate touched fifteen. Since, as earlier observed, these loans provided all but total safety, liquidity, and ease of administration, the interest would not have seemed unattractive to a usurious moneylender in Bombay. To a few alarmed observers it seemed as though Wall Street were by way of devouring all the money of the entire world. However, in accordance with the cultural practice, as the summer passed, the sound and responsible spokesmen decried not the increase in brokers' loans, but those who insisted on attaching significance to this trend. There was a sharp criticism of the prophets of doom.

There were two sources of intelligence on brokers' loans. One was the monthly tabulation of the New York Stock Exchange, which in general is used here. The other was the slightly less complete return of the Federal Reserve System which was published weekly. Each Friday this report showed a large increase in loans; each Friday it was firmly stated that it didn't mean a thing, and anyone who suggested otherwise was administered a stern rebuke. It seems probable that only a minority of the people in the market related the volume of the brokers' loans to the volume of purchases on margin and thence to the amount of speculation. Accordingly, an expression of concern over these loans was easily attacked as a gratuitous effort to undermine confidence. Thus, in Barren's on 8 July, Sheldon Sinclair Wells explained that those who worried about brokers' loans, and about the influx of funds from corporations, simply did not know what was going on. The call market had become a great new investment outlet for corporate reserves, he argued. The critics did not appreciate this change.

The bankers were also a source of encouragement to those who wished to believe in the permanence of the boom. A great many of them abandoned their historic role as the guardians of the nation's fiscal pessimism and enjoyed a brief respite of optimism. They had reasons for doing so. In the years preceding, a considerable number of the commercial banks, including the largest of the New York houses, had organized securities affiliates. These affiliates sold stocks and bonds to the public, and this business had become important. It was a business that compelled a rosy view of the future. In addition, individual bankers, perhaps taking a cue from the heads of the National City and Chase in New York, were speculating vigorously on their own behalf. They were unlikely to say, much less advocate, anything that would jar the market..

However, there were exceptions. One was Paul M. Warburg of the International Acceptance Bank, whose predictions must be accorded the same prominence as the forecasts of Irving Fisher. They were remarkably prescient. In March 1929, he called for a stronger Federal Reserve policy and argued that if the present orgy of 'unrestrained speculation' were not brought promptly to a halt there would ultimately be a disastrous collapse. This, he suggested, would be unfortunate not alone for the speculators. It would 'bring about a general depression involving the entire country'.

He was clearly a troublemaker - best to ignore him.

Only Wall Street spokesmen who took the most charitable view of Warburg contented themselves with describing him as obsolete. One said he was 'sandbagging American prosperity'. Others hinted that he had a motive - presumably a short position. As the market went up and up, his warnings were recalled only with contempt.

The most notable sceptics were provided by the press. They were a great minority to be sure. Most magazines and most newspapers in 1929 reported the upward sweep of the market with admiration and awe and without alarm. They viewed both the present and the future with exuberance. Moreover, by 1929 numerous journalists were sternly resisting the more subtle blandishments and flattery to which they have been thought susceptible.

Thank goodness - at least they could rely on the gentlemen of the press for fair and objective reporting.

Instead they were demanding cold cash for news favourable to the market. A financial columnist of the Daily News, who signed himself 'The Trader', received some $19,000 in 1929 and early 1930 from a free-lance operator named John J. Levenson. 'The Trader' repeatedly spoke well of stocks in which Mr Levenson was interested. Mr Levenson later insisted, howeyer, that this was a coincidence and the payment reflected his more or less habitual generosity.

Main Street had always had one citizen who could speak knowingly about buying or selling stocks. Now he became an oracle. In New York, on the edge of any gathering of significantly interesting people there had long been a literate broker or investment counsellor who was abreast of current plans for pools, syndicates, and mergers, and was aware of attractive possibilities. He helpfully advised his friends on investments, and pressed, he would always tell what he knew of the market and much that he didn't. Now these men, even in the company of artists, playwrights, poets, and beautiful concubines, suddenly shone forth. Their words, more or less literally, became golden. Their audience listened not with the casual heed of people who are collecting quotable epigrams, but with the truly rapt attention of those who expect to make money by what they hear.

That much of what was repeated about the market - then as now - bore no relation to reality is important, but not remarkable. Between human beings there is a type of intercourse which proceeds not from knowledge, or even from lack of knowledge, but from failure to know what isn't known. This was true of much of the discourse on the market. At luncheon in downtown Scranton, the knowledgeable physician spoke of the impending split-up in the stock of Western Utility Investors and the effect on prices. Neither the doctor nor his listeners knew why there should be a split-up, why it should increase values, or even why Western Utility Investors should have any value. But neither the doctor nor his audience knew that he did not know. Wisdom, itself, is often an abstraction associated not with fact or reality but with the man who asserts it and the manner of its assertion.

In later years, a Senate committee investigating the securities markets undertook to ascertain the number of people who were involved in securities speculation in 1929. The member firms of twenty-nine exchanges in that year reported themselves as having accounts with a total of 1,548,707 customers. (Of these, 1,371,920 were customers of member firms of the New York Stock Exchange.) Thus only one and a half million people, out of a population of approximately 120 million and of between 29 and 30 million families, had an active association of any sort with the stock market. And not all of these were speculators. Brokerage firms estimated for the Senate committee that only about 600,000 of the accounts just mentioned were for margin trading, as compared with roughly 950,000 in which trading was for cash.

The striking thing about the stock market speculation of 1929 was not the massiveness of the participation. Rather it was the way it became central to the culture.

By the end of the summer of 1929, brokers' bulletins and letters no longer contented themselves with saying what stocks would rise that day and by how much. They went on to say that at 2 p.m. Radio or General Motors would be 'taken in hand'. The conviction that the market had become the personal instrument of mysterious but omnipotent men was never stronger. And, indeed, this was a period of exceedingly active pool and syndicate operations - in short, of manipulation.

During 1929 more than a hundred issues on the New York Stock Exchange were subject to manipulative operations, in which members of the Exchange or their partners had participated. The nature of these operations varied somewhat but, in a typical operation, a number of traders pooled their resources to boom a particular stock. They appointed a pool manager, promised not to double-cross each other by private operations, and the pool manager then took a position in the stock which might also include shares contributed by the participants. This buying would increase prices and attract the interest of people watching the tape across the country. The interest of the latter would then be further stimulated by active selling and buying, all of which gave the impression that something big was afloat. Tipsheets and market commentators would tell of exciting developments in the offing. If all went well, the public would come in to buy, and prices would rise on their own. The pool manager would then sell out, pay himself a percentage of the profits, and divide the rest with his investors.

While it lasted, there was never a more agreeable way of making money.

Of course, no party can go on forever. In the end, you always have to pay the piper.

On 3 September, by common consent, the great bull market of the nineteen-twenties came to an end. Economics, as always, vouchsafes us few dramatic turning points. Its events are invariably fuzzy or even indeterminate. On some days that followed - a few only - some averages were actually higher. However, never again did the market manifest its old confidence. The later peaks were not peaks but brief interruptions of a downward trend.

There were some who said, cause and effect run from the economy to the stock market, never the reverse. In 1929 the economy was headed for trouble. Eventually, that trouble was reflected in Wall Street.

In 1929 there were good, or at least strategic, reasons for this view, and it is easy to understand why it has become high doctrine. In Wall Street, as elsewhere in 1929, few people wanted a bad depression. In Wall Street, as elsewhere, there is deep faith in the power of incantation. When the market fell many Wall Street citizens immediately sensed the real danger, which was that income and employment - prosperity in general - would be adversely affected. This had to be prevented.

Preventive incantation required that as many important people as possible repeat as firmly as they could that it wouldn't happen. This they did. They explained how the stock market was merely the froth and that the real substance of economic life rested in production, employment, and spending, all of which would remain unaffected. No one knew for sure that this was so. As an instrument of economic policy, incantation does not permit of minor doubts or scruples.

No one seemed to want to admit that the tail had started to wag the dog. That far from the stock market being the speculative froth on top of the solid, sound and, above all, real economy, the sheer amount of speculation was instead capable of overturning and possibly sinking the real economy. A bit like someone in a tree sawing off the very branch they are sitting on.

I'm not sure how that affects us now, here in dear old Blighty, because for many years we haven't really had much production, so most of our wealth seems to be of the more 'frothy' kind anyway.

In the later years of depression it was important to continue emphasizing the unimportance of the stock market. The depression was an exceptionally disagreeable experience. Wall Street has not always been a cherished symbol in our national life. In some of the devout regions of the nation, those who speculate in stocks - the even more opprobrious term gamblers is used - are not counted the greatest moral adornments of our society. Any explanation of the depression which attributed importance to the market collapse would accordingly have been taken very seriously, and it would have meant serious trouble for Wall Street.

Wall Street, no doubt, would have survived, but there would have been scars. We should be clear that no deliberate conspiracy existed to minimize the consequences of the Wall Street crash for the economy. Rather, it merely appeared to everyone with an instinct for conservative survival that Wall Street had better be kept out of it. It was vulnerable.

Professor Galbraith shows himself to have a truely Diogenerian turn of phrase.

It is in the nature of a speculative boom that almost anything can collapse it. Any serious shock to confidence can cause sales by those speculators who have always hoped to get out before the final collapse, but after all possible gains from rising prices have been reaped. Their pessimism will infect those simpler souls who had thought the market might go up forever but who will now change their minds and sell. Soon there will be margin calls, and still others will be forced to sell. So the bubble breaks.

Along with the downturn of the indexes Wall Street has always attributed importance to two other events in the pricking of the bubble. In England on 20 September 1929 the enterprises of Clarence Hatry suddenly collapsed. Hatry was one of those curiously un-English figures with whom the English periodically find themselves unable to cope. Although his earlier financial history had been anything but reassuring, Hatry in the twenties had built up an industrial and financial empire of truly impressive proportions. The nucleus, all the more remarkably, was a line of coin-in-the-slot vending and automatic photograph machines. From these unprepossessing enterprises he had marched on into investment trusts and high finance. His expansion owed much to the issuance of unauthorized stock, the increase of assets by the forging of stock certificates, and other equally informal financing. In the lore of 1929, the unmasking of Hatry in London is supposed to have struck a sharp blow to confidence in New York.

A bit like Northern Rock asking for help from the Bank of England.

Ranking with Hatry in this lore was the refusal on 11 October of the Massachusetts Department of Public Utilities to allow Boston Edison to split its stocks four to one. As the company argued, such split-ups were much in fashion. To avoid going along was to risk being considered back in the corporate gaslight era. The refusal was unprecedented. Moreover, the Department added insult to injury by announcing an investigation of the company's rates and by suggesting that the present value of the stock, 'due to the action of speculators', had reached a level where 'no one, in our judgement ... on the basis of its earnings, would find it to his advantage to buy it'.

Confidence did not disintegrate at once. As noted, through September and into October, although the trend of the market was generally down, good days came with the bad. Volume was high. On the New York Stock Exchange sales were nearly always above four million, and frequently above five. In September new issues appeared in even greater volume than in August, and they regularly commanded a premium over the offering price. On 20 September the Times noted that the stock of the recently launched Lehman Corporation which had been offered at $104 had sold the day before at $136. (In the case of this well-managed investment trust the public enthusiasm was not entirely misguided.) During September brokers' loans increased by nearly $670 million, by far the largest increase of any month to date. This showed that speculative zeal had not diminished.

Ah, Lehmans - whatever happened to them?

Other signs indicated that the gods of the New Era were still in their temples. In its 12 October issue, The Saturday Evening Post had a lead story by Isaac F. Marcosson on Ivar Kreuger. This was a scoop, for Kreuger had previously been inaccessible to journalists. 'Kreuger,' Marcosson observed, 'like Hoover, is an engineer. He has consistently applied engineer precision to the welding of his far-flung industry.' And this was not the only resemblance. 'Like Hoover,' the author added, 'Kreuger rules through pure reason.'

In the interview Kreuger was remarkably candid on one point. He told Mr Marcosson: 'Whatever success I have had may perhaps be attributable to three things: one is silence, the second is more silence, while the third is still more silence.' This was so. Two and a half years later Kreuger committed suicide in his Paris apartment, and shortly thereafter it was discovered that his aversion to divulging information, especially if accurate, had kept even his most intimate acquaintances in ignorance of the greatest fraud in history. His American underwriters, the eminently respectable firm of Lee, Higginson and Company of Boston, had heard nothing and knew nothing. One of the members of the firm, Donald Durant, was a member of the board of directors of the Kreuger enterprises. He had never attended a directors' meeting, and it is certain that he would have been no wiser had he done so.

Well, the greatest fraud in history until Bernard Madoff hit the headlines.

On Sunday the market was front-page news - the Times headline read, 'Stocks driven down as wave of selling engulfs the market', and the financial editor next day reported for perhaps the tenth time that the end had come. (He had learned, however, to hedge. 'For the time at any rate', he said, 'Wall Street seemed to see the reality of things.') No immediate explanation of the break was forthcoming. The Federal Reserve had long been quiet. Babson had said nothing new. Hatry and the Massachusetts Department of Public Utilities were from a week to a month in the past. They became explanations only later.

The papers that Sunday carried three comments which were to become familiar in the days that followed. After Saturday's trading, it was noted, quite a few margin calls went out. This meant that the value of stock which the recipients held on margin had declined to the point where it was no longer sufficient collateral for the loan that had paid for it. The speculator was being asked for more cash.

The other two observations were more reassuring. The papers agreed, and this was also the informed view on Wall Street, that the worst was over. And it was predicted that on the following day the market would begin to receive organized support. Weakness, should it appear, would be tolerated no longer.

Never was there a phrase with more magic than 'organized support'. Almost immediately it was on every tongue and in every news story about the market. Organized support meant that powerful people would organize to keep prices of stocks at a reasonable level. Opinions differed as to who would organize this support. Some had in mind the big operators like Cutten, Durant, and Raskob. They, of all people, couldn't afford a collapse. Some thought of the bankers - Charles Mitchell had acted once before, and certainly if things got bad he would act again. Some had in mind the investment trusts. They held huge portfolios of common stocks, and obviously they could not afford to have them become cheap. Also, they had cash. So if stocks did become cheap the investment trusts would be in the market picking up bargains. This would mean that the bargains wouldn't last. With so many people wanting to avoid a further fall, a further fall would clearly be avoided.

In the ensuing weeks the Sabbath pause had a marked tendency to breed uneasiness and doubts and pessimism and a decision to get out on Monday. This, it seems certain, was what happened on Sunday, 20 October.

Monday, 21 October, was a very poor day. Sales totalled 6,091,870, the third greatest volume in history, and some tens of thousands who were watching the market throughout the country made a disturbing discovery. There was no way of telling what was happening.

Previously on big days of the bull market the ticker had often fallen behind, and one didn't discover until well after the market closed how much richer he had become. But the experience with a falling market had been much more limited. Not since March had the ticker fallen seriously behind on declining values. Many now learned for the first time that they could be ruined, totally and forever, and not even know it. And if they were not ruined there was a strong tendency to imagine it. From the opening on the 21st the ticker lagged, and by noon it was an hour late. Not till an hour and forty minutes after the close of the market did it record the last transaction. Every ten minutes prices of selected bonds were printed on the bond ticker, but the wide divergence between these and the prices on the tape only added to the uneasiness - and to the growing conviction that it might be best to sell.

Of course that could never happen today, with modern technology. Provided that the computer's don't crash. Or a particularly virulent computer virus infests the computer networks used by the financial centres. Or a ship's anchor slices through an undersea cable. Or the country becomes the victim of a cyberattack from a hostile nation.

On Tuesday, Charles M. Mitchell dropped anchor in New York with the observation that 'the decline had gone too far'. (Time and sundry congressional and court proceedings were to show that Mr Mitchell had strong personal reasons for feeling that way.) He added that conditions were 'fundamentally sound', said again that too much attention had been paid to the large volume of brokers' loans, and concluded that the situation was one which would correct itself if left alone.

However, another jarring suggestion came from Babson. He recommended selling stocks and buying gold.

That afternoon and evening thousands of speculators decided to get out while - as they mistakenly supposed - the getting was good. Other thousands were told they had no choice but to get out unless they posted more collateral, for as the day's business came to an end an unprecedented volume of margin calls went out.

Thursday, 24 October, is the first of the days which history - such as it is on the subject - identifies with the panic of 1929. Measured by disorder, fright, and confusion, it deserves to be so regarded. That day 12,894,650 shares changed hands, many of them at prices which shattered the dreams and the hopes of those who had owned them. Of all the mysteries of the Stock Exchange there is none so impenetrable as why there should be a buyer for everyone who seeks to sell. 24 October 1929, showed that what is mysterious is not inevitable. Often there were no buyers, and only after wide vertical declines could anyone be induced to bid.

The panic did not last all day. It was a phenomenon of the morning hours. The market opening itself was unspectacular, and for a while prices were firm. Volume, however, was very large, and soon prices began to sag. Once again the ticker dropped behind. Prices fell further and faster, and the ticker lagged more and more. By eleven o'clock the market had degenerated into a wild, mad scramble to sell. In the crowded boardrooms across the country the ticker told of a frightful collapse. But the selected quotations coming in over the bond ticker also showed that current values were far below the ancient history of the tape. The uncertainty led more and more people to try to sell. Others, no longer able to respond to margin calls, were sold out.

By eleven-thirty the market had surrendered to blind, relentless fear. This, indeed, was panic.

Outside the Exchange in Broad Street a weird roar could be heard. A crowd gathered. Police Commissioner Grover Whalen became aware that something was happening and dispatched a special police detail to Wall Street to ensure the peace. More people came and waited, though apparently no one knew for what. A workman appeared atop one of the high buildings to accomplish some repairs, and the multitude assumed he was a would-be suicide and waited impatiently for him to jump.

In New York at least the panic was over by noon. At noon the organised support appeared.

A bit like our Government pumping £37 billion into our banking system. They are about to do it again, presumably because it worked so well the first time. Get banks lending. Get people spending. Get back to normal.

Or maybe we are starting to get a glimpse of just how little real money we have really got, and see just how successful - or unsuccessful - some companies, including banks, really are. That is, when you take away the make-believe money that the financial markets seem to work with.

At twelve o'clock reporters learned that a meeting [of the chief executives of the major banks] was convened at 23 Wall Street at the offices of JP Morgan and Company. A decision was quickly reached to pool resources to support the market. Prices firmed at once and started to rise.

Then at one thirty Richard Whitney appeared on the trading floor and went to the post where steel was traded. [...] He bid 205 for 10,000 shares. This was the price of the last sale, and the current bids were several points lower.

This was it. The bankers, obviously, had moved in. The effect was electric. Fear vanished and gave way to concern lest the new advance be missed. Prices boomed upwards.

On Friday and Saturday trading continued heavy - just under six million on Friday and over two million at the short session on Saturday. Prices, on the whole, were steady - the averages were a trifle up on Friday but slid off on Saturday. It was thought that the bankers were able to dispose of most of the securities they had acquired while shoring up the market on Thursday. Not only were things better, but everyone was clear as to who had made them so. The bankers had shown both their courage and their power, and the people applauded warmly and generously. The financial community, the Times said, now felt 'secure in the knowledge that the most powerful banks in the country stood ready to prevent a recurrence [of panic]'. As a result it had 'relaxed its anxiety'.

Almost everyone believed that the heavenly knuckle-rapping was over and that speculation could be now resumed in earnest. The papers were full of the prospects for next week's market.

Stocks, it was agreed, were again cheap and accordingly there would be a heavy rush to buy. Numerous stories from the brokerage houses, some of them possibly inspired, told of a fabulous volume of buying orders which was piling up in anticipation of the opening of the market. In a concerted advertising campaign in Monday's papers, stock market firms urged the wisdom of picking up these bargains promptly. 'We believe', said one house, 'that the investor who purchases securities at this time with the discrimination that is always a condition of prudent investing, may do so with utmost confidence.

On Monday the real disaster began.

Coming soon: Things become more serious - The Aftermath

So It Was, So Shall It Ever Be

I've just come across this article from the Telegraph:

Definitive proof that the Bank of England saw the financial crisis coming

All the warning signs were there but nobody did anything....

Do you know, that reminds me of something that I have recently read in a book .... now what was it called again.....

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

Get the Abbey Habit

It's a relief to know that most reputable Building Societies are protecting their director's salaries ... er .. I mean, shareholder's interests ... by ensuring that their flexible mortgage products aren't quite as flexible as they seemed to be.

If you own such a mortgage, I would strongly suggest that you do not watch this video, as it will lead to a lack of confidence, and possibly panic, which, I am sure you will agree, we all wish to avoid in these uncertain times.

I'm sure you won't let me down.

That Sinking Feeling

Around the Club, there has been little talk of The Crunch. Because of the Club ethos, no-one will admit to personal loss from market speculation. But last week, HM the Queen, until the previous week the wealthiest woman in Europe, set tongues a-wagging by asking, How could this happen? She herself had lost around £25 million - money she was going to use to fix up the Palace bedrooms one day. Why did no-one say anything, asked the dear lady - warn the others of the fact the Crunch had been predicted? The answer she was given is that each was relying on the others to provide such warnings. It’s part of a system of delegated and distributed responsibility that was set up in the wake of the South Sea Bubble scandal, when government set up the so-called Sinking Fund to ensure future stability and manage the national debt.
... It was indeed for that very reason, the management of national debt, that the government of the day were drawn into the Bubble. The South Sea Company was really a bank masquerading as a stock company, set up in 1711 by Harley, the Earl of Oxford, who was the Lord Treasurer and prime minister in the new Tory government, to underwrite a national debt which had grown to £30 million since the Act of Union, when Scotland’s debts had been added. An Act of Parliament awarded the South Sea Company a trade monopoly with South America, in exchange for a £7 million loan.
The official prospect presented to investors, of lucrative trading rights to Spanish slave colonies in South America (over which in reality England had no control), was a shell game talked up by insiders to lure the greedy. It was so successful that even servants began investing, borrowing money to finance the share purchase, and as the share price rose, acquiring luxury goods such as fine carriages and livery. Others sunk their entire family fortunes into the scheme. Nearly a hundred other “joint stock” companies started up, some with even less realistic aims – to buy up the Irish Bogs, manufacture square cannon balls, and so on. Speculators included the Royal family, and King George I outlawed brokers selling shares in rival offerings.
Inevitably, what goes up on the market must come down, but even the discoverer of the Law Of Gravity, Sir Isaac Newton, didn’t see that coming, and reportedly lost £20,000. He later explained 'that he could not calculate the madness of people'. “The Madness of Crowds” would become a popular phrase to explain such collective delusions. MP Robert Walpole decried "the dangerous practice of stockjobbing’ which would decoy the unwary to their ruin, ‘for a prospect of imaginary wealth.’
The dangers of jobbing stock salesman manipulating the market had already been demonstrated across the Channel the previous century, when Holland had been caught up in buying and selling shares in tulip growing enterprises. The facts that it took 7 years to grow a prize tulip from seed, and that supply soon outstripped demand, did not halt the tulip bulb futures trading mania until the price of a tulip had reached 5,000 guilders. But the Dutch economy survived the bursting of the Tulip Bulb bubble because the Amsterdam Stock Exchange had declined to trade in tulip futures. Walpole also warned the Company directors would become masters of the government, controlling the legislative process.
His warning was in vain, for over 460 MPs and 112 Peers invested. The main private backer, Blunt, Chairman of the Sword Blade Company (which had diversified into official managing forfeited estates), also publicly spoke out against greed and corruption. But behind the scenes he set up a £1 million fund to convert government debt into company stock and drive up share prices, plus a slush fund of £500,000 to bribe government officials. (He was elevated to the Lords within the month.)
European and American interests were also involved, with a Scotsman pulling the strings. Scotland had been forced to subjugate itself to England under the Act Of Union 1707 due to its facing bankruptcy over the Darien Scheme. Promoted by the Scots co-founder of the Bank Of England, the scheme had been backed by the new Bank Of Scotland, which invested a fifth of the nation’s fortune. It was meant to open up trade with China and Japan by setting up a colony on the isthmus of Panama, where a canal would be dug.
The idea was ships from China and Japan would arrive on the Pacific side to trade, offering finest Cathay silks, etc. in exchange for Scots staples. In the event, there were no ships from Cathay and the colonists couldn’t even interest the local Indians in their baubles and bibles. Though guided by a former castaway (a surgeon on one of Dampier’s vessels who had been marooned for 4 years among the local Indians on the isthmus), the colonists were largely young aristocrats with unrealistic expectations. All their ships but one sank, and over 2,000 colonists perished on land. Scotland had to petition England to pay off its national debt to stabilise their paper currency.
A Scots economist, the so-called “father of finance,” John Law, set up a similar French operation, the Mississippi Scheme. Law was a Scots banker who helped broker the 1707 Act Of Union bail-out, but had fled to France after escaping prison following a duel over a woman. He was the exponent of two economic theories, 'The Scarcity Theory Of Value', and the 'Real Bills Doctrine'. He is credited with the notion each country should have a national bank which could issue its own paper money.
He proposed what he termed a Land bank (which wits of the time called a Sand Bank, suggesting it would sink the ship of state), whereby currency was issued according to crown land-holdings, rather than gold and silver hoards. This appealed to a nearly-bankrupt France, which had exhausted most of its coinage in a series of wars, and Law was appointed Controller-General of Finance by the French regent. Law and his brother set up Law & Co, a bank in all but name, which was awarded exclusive trading rights to the French colonies in the Indies.
To expand this empire, Law set up the Mississippi Scheme to exploit a trading monopoly with the French interests in the Mississippi basin lands. Inspired by the tales of Conquistador gold, the Mississippi stock offer was at first a runaway success. Law and associates talked up the colonies’s potential wealth, leading to massive speculation. Shares rose to over 10,000 livres apiece, and became almost a negotiable currency in themselves. To maintain public confidence, an army of over five thousand beggars was conscripted, equipped with miners’ picks and shovels and marched through the Paris streets towards the ports, supposedly bound for the gold mines of Louisiana – though it was observed most just sold their gear in taverns and returned to begging.
In 1720 Law’s scheme, like all pyramid schemes, became over-inflated. The company was re-organised as the Banque Royale, a mechanism to ease the French exchequer by issuing its own currency. But the Regent could not grasp why he should not keep on issuing paper notes far beyond any tangible assets. To prevent a run on the bank, he had to pass laws to stop people trying to cash in their paper notes for coins. It became illegal to own more than a modest amount of coin, jewellery, precious stones, or even plate, and bounties were paid for servants to turn in their masters for hoarding. Anyone suspected had their homes raided and their assets seized, even for being seen with a single louis d'or coin. Everyday trade collapsed as there was no coin for small purchases. Those with assets remaining who tried to flee were arrested at the border, stripped of any coin or plate, and imprisoned as speculators. Anyone who did escape abroad was sentenced to death in absentia.
Law’s carriage was stoned by the mob, and he fled to England while his brother was put in the Bastille for malversation. (Law would end his life in exile in Venice, where he squandered his personal fortune on his lifelong addiction, gambling, dying impoverished.) The Regent’s attempt to blame Law for his own recklessness did not solve the matter, and many others were charged by a commission of enquiry with malversation. The inflated paper currency was publicly burned, and the Paris treasury issued a new paper currency of modest denomination which was redeemable against gold, silver, or copper coin, leading to a crush in which 15 people died trapped in the bank doors.
The initial success of Law’s scheme had helped inspire England’s Bubble, but the French collapse did not prompt English official action at home. In mid-1720, South Sea Company stocks began to slide from their peak price of £1000 a share. The Sword Blade Company, who acted as chief cashiers of the Company, stopped paying out, and it became known that Sir John Blunt and others had sold out. Other bankers also closed up shop. The ruin of thousands of people followed, beginning with the working class speculators who had bought on credit. Middle-class investors were next, their life savings gone in a week.
Finally even the wealthy suffered, from bankers to bishops. Angry crowds gathered at Westminster, till the Riot Act was proclaimed. The King, George I, lost over £50,000, and his German mistresses, a Countess and a Duchess who had promoted the scheme, were booed in public. There were suicides almost daily as financial ruin spread throughout the country. The Bank of England was called upon to help by subscribing to company bonds, but declined. The South Sea Bubble had burst.
Company directors were spat at in the street and threatened. The treasurer fled in disguise to Calais, and an extradition warrant was issued for his person, but he escaped Belgian custody. A parliamentary ‘Committee of Secrecy’ was formed to investigate, and informed the House they had “discovered a train of the deepest villany and fraud that Hell had ever contrived to ruin a nation.” The Commons ordered the doors locked, and 5 MPs were placed in the custody of Black Rod, including Sir John Blunt. Blunt testified that he couldn’t remember details.
An Act was passed to prevent directors fleeing or sending assets abroad, and to seize the papers of what Tatler co-founder Sir Richard Steele called these "cyphering cits", whose arrogance led to their downfall. The Committee of Secrecy reported the company books, where they were not entirely missing, had pages torn out, contained many fictitious entries, blanks and erasures.
All the directors were arrested and their estates seized to finance a compensatory fund. Blunt alone had £178,000 seized. The Chancellor of the Exchequer was impeached for corruption and put in the Tower for a time. The Secretary of State died after bursting a blood vessel in the Lords defending himself against corruption charges. The Postmaster General died suddenly, poison being suspected. The official Parliamentary History concluded that the Company had amazed all Europe, "but whose foundation, being fraud, illusion, credulity, and infatuation, fell to the ground as soon as the artful management of its directors was discovered."
Walpole, the new Chancellor, divided assignment of the debt between the Bank of England, the Treasury, and the South Sea Company (now effectively nationalised), along with something aptly known as the Sinking Fund. This was a reserve of savings out of the annual Budget to stabilize the currency. Legislation then had to be passed (by Pitt) to stop successive Ministers raiding the fund, and it was decades before The South Sea Company and the Sinking Fund could be safely abandoned, for other economic crises continued to appear, as part of the natural boom-and-bust cycle of capital investment.
... Today of course, things are quite different. Money can be moved electronically, added or subtracted in an instant, with no need for coins or even paper. Plastic is the new gold standard. Collateral such as real estate can be re-mortgaged, the debts repackaged, sold and re-sold abroad. To maintain confidence in the stock market, the Chancellor will quickly intervene to save any bank that gets itself into a mess through mismanagement, no matter how huge the public cost and scandal. The Prevention Of Terrorism Act can be used to seize foreign assets, where there is a perceived danger to British interests.
As to the lessons of the past, many would conclude there is nothing to be learned – or rather, nothing that will be learned.

What Was The Derivatives Market, Daddy?

As I have mentioned in previous entries, it is important, in these times of financial crisis, that we don't give in to gloom and despondency.

An article has come to my attention that starts with the following paragraph:

While it may look superficially similar to the recent implosions of such investment giants as Fannie Mae, Freddie Mac and Lehman, the takeover and bailout of AIG is quite different, and means that the market is entering the next and even more dangerous phase. What is driving the fall of AIG – and potential government losses that may far, far exceed the $85 billion bailout announced late on September 16th - is not mortgages or real estate (directly), but fears that AIG’s huge, global credit-default swap positions will unravel. The $62 trillion dollar credit derivatives market is 50 times the size of the subprime mortgage derivatives market, and is indeed larger than the entire global economy.

I feel that the last sentence is unnecessarily inflamatory, and I would urge everyone to make sure that they do not read the article

http://www.financialsense.com/fsu/editorials/amerman/2008/0917.html

under any circumstances, as it provides a clear explanation of the derivatives market, and so could create panic and despondency amongst the general populace.

And whatever you do, don't let your wives, children or servants read it either. These things are far to complex for them to understand, and there is no need to worry them unnecessarily.

I know you won't let me down.