Beating the Bear - Lessons From the 1929 Crash Applied to Today's World

7/30/2019 Beating the Bear - Lessons From the 1929 Crash Applied to Today's World

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BEATING THE BEAR

Lessons from the 1929 CrashApplied to Todays World

Harold Bierman, Jr.


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Beating the Bear


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BEATING THE BEAR

Lessons from the 1929 CrashApplied to Todays World

Harold Bierman, Jr.


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Copyright 2010 by Harold Bierman, Jr.

All rights reserved. No part of this publication may be reproduced, stored in a retrievalsystem, or transmitted, in any form or by any means, electronic, mechanical,photocopying, recording, or otherwise, except for the inclusion of brief quotations in

a review, without prior permission in writing from the publisher.Library of Congress Cataloging-in-Publication Data

Bierman, Harold.Beating the bear : lessons from the 1929 crash applied to todays world / Harold

Bierman, Jr.p. cm.

Includes bibliographical references and index.ISBN 978-0-313-38214-7 (alk. paper) ISBN 978-0-313-38215-4 (ebook)

1. Stock Market Crash, 1929. 2. Global Financial Crisis, 20082009 3. Bearmarkets History. 4. Investments. I. Title.

HB37171929.B387 2010330.973'0916 dc22 2010014496

ISBN: 978-0-313-38214-7EISBN: 978-0-313-38215-4

14 13 12 11 10 1 2 3 4 5

This book is also available on the World Wide Web as an eBook.Visit www.abc-clio.com for details.

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ABC-CLIO, LLC130 Cremona Drive, P.O. Box 1911Santa Barbara, California 93116-1911

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I still think keeping that memory green a useful service,if only for the minority so saved.

John Kenneth Galbraith


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CONTENTS

Acknowledgments ix

Introduction xi

1. How High Is High? The Stock Markets in 1929 and 2008 1

2. The Events Prior to the 1929 and 2008 Crashes 9

3. Market Myths in 1929 and 20082009 19

4. The Feds Role in Good Times and Bad 29

5. Practice for the October Crash: The Week ofMarch 25, 1929 55

6. The 1929 Market in Depth: The Ups and Downsof the 1929 Stock Market 63

7. The Great Crash of 2008: The 20082009 Market in Depth 77

8. Stopping the Speculators: Margin Buying, Pools, Trusts,Short Selling, and the 1929 Crash 95

9. The Senate Hearings of 1931 Concerning 1929 109

10. Dispelling the Myths of 1929 11511. The U.S. Government Accuses . . . 141

12. The Prime Cause of the 1929 Crash: The PublicUtility Sector 153


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viii CONTENTS

13. Lessons to Be Learned 167

14. Post-Crash Investment Strategies:Beating the Bear Market 179

Notes 185

Bibliography 193

Index 199


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ACKNOWLEDGMENTS

Many people contributed to this project. Among those who were especiallyhelpful were: Betsy Ann Olive and Don Schedeker of Cornells Johnson

Graduate School of Managements library staff; Rosemary A. Lazenby ofthe archives division of the Federal Reserve Bank of New York; SeymourSmidt, Jerome Hass, and Maureen OHara, faculty colleagues at Cornellmade useful suggestions. Barb Drake typed untold revisions. Dick Con-way called my attention to the article that motivated my initial researchefforts.

Sections of this book were written during a study leave spent at theJudge Institute of Management, University of Cambridge. The leave and

the research were financed by the Arthur Andersen Foundation and Cor-nells Johnson Graduate School of Management. Richard Barker, SandraDawson, Gishan Dissanaike, Geoff Meeks, Christopher Pratt, and GeoffWittington all facilitated my visit and made it a very pleasant experience.At Cornell, Sheri Hastings kept my faxes flowing. Above all, I want tothank the people at the University of Cambridge Library, especially AnnToseland; Ann kept me supplied with film of the newspapers of 1929 to1950, and did not complain of my repetitive requests. While the others areunnamed by me (unfortunately), their helpfulness is well remembered.

I also want to thank Burton Malkiel, who offered a friendly intellectualchallenge that led to my initial interest in the events of 1929.


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INTRODUCTION

Senator Glass: Mr. Whitney, right on that point may I ask youa question: What percentage of the public is [sic] speculating in

stocks of the stock exchange understand the real intrinsic valueof the stocks in which they deal?

Hearings before the U.S. Senate Committee on Banking andCurrency on stock exchange practices

Admittedly, it is preposterous to suggest that stock speculationis like coin flipping. I know that there is more skill to stockspeculation. What I have never been able to determine is how

much more? Fred Schwed, Jr., Where Are the CustomersYachts?

The year 1929 stands out as the most significant year of the decade ofthe 1920s. In the minds of most people, the year 1929 marks the crashof the stock market, the beginning of the Great Depression, and the endof a 10-year period of prosperity that exceeded anything the United Stateshad ever known.

In 1955, John Kenneth Galbraith published his very readable and enjoy-able classic The Great Crash, 1929. A reader of that popular book mightwell conclude that it would be foolhardy for someone to retrace the samepath. And it would be; but I will follow a different path and arrive at adifferent set of conclusions.


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xii INTRODUCTION

What actually was the economic situation in 1929? How does it compareto the economic situation in 2008 2009? To better illuminate the currentdark financial picture, I take a fresh look at the Crash of 1929 and then

compare that period to the stock crash of 2008 2009. I challenge the factseveryone knowsand overturn previously held assumptions concerningthe catastrophic events that led to 10 years of economic depression. Like-wise, todays news is filled with stories about what is happening andwhy. While its still too soon to come to rock-solid conclusions about thefinancial market meltdown of 2008 2009, much of what has happenedcould have been foreseen and even avoided just as it could have beenin 1929. By accurately assessing the causes behind the 1929 stock marketcrash that led to the Great Depression, and the causes that led to the declineof 2008 2009, readers can better grasp the present market situation andmore wisely make financial decisions.

This book considers the economic situation in 1929 and the events lead-ing up to the stock price declines in October of that year. It concludes thatthe 1920s were a wondrous period of economic prosperity for the UnitedStates, and that in 1929 it was far from obvious that the stock market wasin trouble. But something very serious happened in 1929 to stock prices,and we should try to understand it.

There are many myths about 1929 that are incorrect. The myth thatis most relevant to this book is Stocks were obviously overpriced (theevidence suggests stocks were reasonably priced.)While stocks were notobviously overpriced in general, there was one sector of the market, publicutilities, that can be shown to have been overpriced.

This book is an attempt to refute unjustified myths and to define thecauses of the 1929 stock market crash. There were several factors thatcombined in October 1929 to bring about the crash.

It is important that the causes be properly understood, because the 1929stock market was not that much different from the market today or differentfrom what the market could be at any time in the future.

The 2008 2009 stock market crash was actually more severe than the1929 1930 crash, and it is equally important to understand that event.

During the 1920s, commerce in the United States attracted trulyoutstanding individuals who achieved successes of an international nature.The stories and achievements of such business people as Benjamin Strong,Owen D. Young, and Alfred P. Sloan are inspirational. What went wrong

and caused the stock market to crash in October 1929?What did happen in 1929? Herbert Hoover, the president of the United

States, saw increasing stock market prices as a speculative bubble manu-factured by the mistakes of the Federal Reserve Board: One of theseclouds was an American wave of optimism, born of continued progress


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INTRODUCTION xiii

over the decade, which the Federal Reserve Board transformed into thestock-exchange Mississipi Bubble.1 But the optimism was justified.The bubbledid not have to burst. The Federal Reserve Board did not

create the bubble, but it may have contributed to the destruction of stockmarket values.

During 1928, in hearings before the Senate Committee on Banking andCurrency, Senator Glass asked Whitney to reveal the percentage of inves-tors who were speculators and who understood the real intrinsic value ofthe stocks they bought. Whitney (and others) could not distinguish betweena speculator and an investor. Also, no one in 1929 knew how to determine,with any degree of confidence, the real intrinsic value of stocks (in fact,the determination of stock value still remains a challenge). Stock pickingrequires more skill than coin flipping, as Fred Schwed maintains, but itis not clear how much more skill we have to pick stocks or to determinewhen the market is too high (when it becomes necessary to make the selldecision) or too low (when it becomes necessary to make the buy deci-sion). Overconfidence on the part of investors who knowthat the marketis too high or too low is very dangerous, as the following conversationsuggests:

Investor: I am developing a feel for the market.Friend: Take an aspirin. You are probably just catching a cold.

Many financial decisions made today are heavily influenced by whatwe understand to have happened in the past. It is important that we tryto understand what the actual economic situation was in 1929 and whathappened to the stock market.

In 2008, the stock market again crashed. The 20082009 crash wasactually more severe than the 19291930 crash. We should look to the

events of 1929 in order to better understand the events of 20082009. Thefirst lesson for an investor is that even in a normal year, the stock marketcan fall 50 percent in a matter of months. The investor who does notrecognize that fact is vulnerable to unnecessarily large losses. The stockmarket is volatile and always will be. Diversify!


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Chapter 1

HOW HIGH IS HIGH? THE STOCK

MARKETS IN 1929 AND 2008

However, contemporary and historical accounts have failed tofind even a smoking gun, let alone a culprit.

Rappoport and White (1993, p. 570)

On Black Thursday, October 24, 1929, the stock market (New York StockExchange) fell 34 points, a 9 percent drop for the day. The trading volumewas approximately three times the normal daily volume for the first ninemonths of the year. There was a selling panic. But the series of eventsleading to the crash actually started before that date.

THE STOCK MARKET 19221932Table 1.1 shows the average of the highs and lows of the Dow Jones

Industrial Stock Index for 1922 to 1932.Using the information of Table 1.1, from 1922 to 1929 stocks rose in

value by 218.7 percent. This is equivalent to an 18 percent annual growthrate in value for the seven years. From the low of 245.6 in 1928 to the highof 386 in 1929, there was a 57 percent growth; but using the 290.0 mea-sure for 1929, the increase for 1929 was only 15 percent. From 1929 to

1932, stocks lost 73 percent of their value (different indices measuredat different times would give different measures of the increases anddecreases). The price increases were large but not beyond comprehen-sion, given the real prosperity taking place in the United States. The pricedecreases from 1929 to 1932 were consistent with the fact that by 1932,


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2 BEATING THE BEAR

there was a worldwide depression, and stock price expectations were notoptimistic.

If we take the 386 high of September 1929 and the 1929 year-end value of248.48, the market lost 36 percent of its value during that four-month period.John Kenneth Galbraith apparently would have had no difficulty forecastingthe crash: On the first of January of 1929, as a matter of probability, it wasmost likely that the boom would end before the year was out(1961, p. 29).Paul A. Samuelson, on the other hand, admits that playing as I often do theexperiment of studying price profiles with their dates concealed, I discoveredthat I would have been caught by the 1929 debacle(1979, p. 9).

Most of us, if we held stock in September 1929, would not have sold earlyin October. In fact, if I had liquidity, I would have purchased stocks after themajor break on Black Thursday, October 24. For the next 10 years, I wouldhave been sorry, since Black Thursday was not the end of the decline.

The 1929 stock market, for many reasons, was like a large boulder ontop of a hill. Given enough pushes to get it started, the boulder would roll

down the hill, accelerating as it went. We want to consider why the marketwas in such a sensitive position and what factors acted to start its down-ward fall. We will find that there were many contributing factors leadingup to the crash. Each of them is small taken individually, but together theyhelped create the right situation for the debacle.

Table 1.1Dow-Jones Industrials Index,* Average ofthe Highs and Lows

Index

1922 91.0

1923 95.6

1924 104.4

1925 137.2

1926 150.9

1927 177.6

1928 245.6

1929 290.0

1930 225.8

1931 134.1

1932 79.4

*1922 1929 measures are from the Stock MarketStudy, U.S. Senate, 1955, pp. 40, 49, 110, and 111.1930 1932 average of the lows and highs for theyears, Wigmore, 1985, pp. 63739.


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HOW HIGH IS HIGH? 3

Observers were not pleased with the severity of the crash. Thus JohnMaynard Keynes (Moggridge 1981, p. 1, and 1992, p. 480), in a letterto his wife, Lydia (October 25, 1929), wrote, Wall Street didhave a go

yesterday . . . The biggest crash ever recorded . . . I have been in a thor-oughly financial and disgusting state of mind all day.Before the eventsplayed out, many others would share Keyness despondency.

There is evidence that the stone on the hill is an apt description of themarket in 1929. In a recent study, Rappoport and White (1994) treat brokersloans as options written by the lender and bought by the borrowers. Theyconclude ( p. 271), The sharp rise in implied volatility coincident withthe stock-market boom suggests the fear of a crash.This conclusion, thatthere was fear of a market crash, is easily acceptable given the statementsand positions of the Federal Reserve Board and the U.S. Senate, to bedescribed later.

One position is that the stock market was too high; thus a crash wasinevitable. Reasons will be given to justify the level of prices. I concludethat the market was not too high in 1929.

There are two basic but nave and incorrect methods of provingthat thestock market was too high in SeptemberOctober 1929, using only stockprices. One is to compare the stock market prices for some prior period,

say 1925, with those of September 1929. The stock price increases for thistime period are impressive. Balke and Gordon (1986) show a 155 percentincrease (the third-quarter 1929 stock prices are 2.55 times as large as the1925 prices). During the first nine months of 1929, the increase was 15 per-cent. The market did go up dramatically from 1925 to October 1929.

The second popular method of provingthat the market was too highis to compare the September 1929 prices with those in November 1929 or,more impressively, with prices in 1932. In 1932, prices were 32 percent of

the year-end 1929 prices. They went down. Malkiel (1996, p. 50) uses thefollowing stock prices (Table 1.2) to illustrate the excessive heights thatstocks reached in September 1929.

Obviously, either the September prices are too high, the Novemberprices are too low, or the world changed. But comparing stock pricesmerely shows that changes took place. There is a plausible explanation forthe high prices of September 3, 1929.

In evaluating the P/ Es of firms in 1929, it is useful to estimate the costs ofcapital. Long-term debt was yielding approximately 5 percent and preferred

stock 6 percent. Dividend yield on the average stock was 3.19 percent inAugust, and the dividend payout rate was 0.64. For comparison, U.S. Trea-suries in August of 1929 yielded 3.7 percent.

With a retention rate of b = 0.36 and a return on new investment ofr = 0.14, the expected growth rate is g = rb = 0.14(.36) = 0.05. Assume that


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4 BEATING THE BEAR

the cost of equity is approximately 8.2 percent. With these assumptionsand facts, a P/ E of 20 is justified for the average firm.

With a growth rate of 0.06, a P/ E of 29 would be justified.Adding growth from the use of debt and from issuing new equity

capital, a larger P/ E than 20 would be justified. There is a wide rangeof calculations of actual average P/ Es for 1929. One estimate in Bier-man (1991, p. 59, based on statistics from Moodys) is an averageP/ E of 16.3, which is low compared with the 20 computed above.Wigmore (1985, p. 572) found a P/ E of 29.8 using the high stock pricesand 12.4 using the low prices of 1929. These P/ Es are based on the data

of 135 companies. Irving Fisher estimated the P/ E ratio to be 13 forthe market as of August 1929 (Commercial and Financial Chronicle,October 26, 1929)

The use of different companies and data from different times resultsin different measures of the P/ E ratio in 1929, but the range of estimatesseems to be from 12.4 to 29.8, with 16.3 being a reasonable estimate.

Let us consider (Table 1.3) the price earnings ratios of the same sixcompanies that were included by Malkiel, using the high and low prices of1929 (numbers from Wigmore, 1985, pp. 34 87).

Using the low 1929 prices for all the stocks, we have very reasonableP/ E ratios ranging from 7 to 18. If anything, given the low cost of equityand high expected growth rate, these P/ Es are too low. Using the highprices in the numerators, the ratios are somewhat high, especially RCA,with an indicated P/ E of 73.

Table 1.2Selected Stock Prices in 1929

High Price

September 3, 1929

Low Price

November 12, 1929

American Telephone &Telegraph

304 19714

Bethlehem Steel 140 7814

General Electric 39314 16818

Montgomery Ward 13778 4914

National Cash Register 12712 59

Radio Corporation of

America

101 28

P

E

b

k g=

( )

=

=

1 0 64

0 082 0 0520

.

. .


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HOW HIGH IS HIGH? 5

Table 1.3Price Earning Ratios for the Corporations of Table 1.2

Using the High Price

for 1929

Using the Low Price

for 1929

American Telephone &Telegraph

20 13

Bethlehem Steel 13 7

General Electric 43 18

Montgomery Ward 60 16

National Cash Register 28 11

Radio Corporation

of America (RCA)

73 17

The Wall Street Journal on October 9, 1929 (p. 17), had an article withthe heading Rails Sell 11.9 Times Earnings.This multiple was before theOctober 24 crash, but it reflected the stock price decreases of September andthe first week of October. The P/E measure was for 27 dividend-paying rail-roads. During October, the Dow Jones railroad index dropped from 173 to159, a drop of only 8.1 percent. Railroads were not a bubble on October 1.

On October 22 theJournal ( p. 3) reported Utilities Sell at 24 TimesNet.The net was for the 12 months ending June 30, and the multiplewas for 20 representative companies (6 were below 20 times earnings).At the end of July, they had been selling for 35 times earnings. A daylater, the Journal ( p. 1) reported that aviation issues were selling at12 times net after their market value was reduced 56 percent (the P/ Ehad been 23). The earnings used were the estimated 1929 earnings. Theabove P/Es were all before Black Thursday.

THE REAL ECONOMY

The 1920s were a period of real growth and prosperity. Real incomerose 10.5 percent per year from 1921 to 1923 and 3.4 percent from1923 to 1929. The gross national product (GNP) increased in real termsfrom 296.22 in 1928 to 315.69 in 1929 (Balke and Gordon, 1986, p. 782).The year 1929 was the best year ever for the U.S. economy. The FederalReserve Bulletin showed production at 119 in July; in August it increased

to 121, and in September to 123. In October, it dropped to 120, but thislevel of production was still higher than Julys level.

There was a widespread feeling that real business activity was in goodshape. For example, consider the following from the Economist, Octo-ber 5, 1929 ( p. 616): Meanwhile, business news continues rather good,


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6 BEATING THE BEAR

with exceptionally high rate of production during the summer months. . . .Excellent autumn and holiday trade is anticipated.

During the period 19191929, total factory productivity increased at an

annual rate of 5.3 percent for the manufacturing sector. This was twice therate for the entire period studied (the last year studied was 1953 [Kend-rick, 1961]). Farming, mining, transportation, communications, and publicutilities all did well. Across all industries the period 19191929 was theperiod of most productivity improvement. The Federal Reserve Bulletin(1930, p. 494) showed total industrial production at 83 in 1919 and 118 in1929 (the maximum was 125 in May and June). This was an annual growthrate of 3.6 percent.

There were warning signs, not necessarily observed in October 1929,that real economic activity was slowing. Steel output in September was416,000 tons below August, and automobile production decline[d]82,000 cars practically to level of 1928.These observations were fromthe New York Times, December 31, 1929 (p. 30). They were not likelyto be widely known in October. Balancing these belated negative reportswere two front-page headlines in October from the Wall Street Journal(October 2): Steel Activity in Sharp Riseand (October 7) Motor OutputAbove Normal.The majority of the economic news reports in October

were very favorable.On October 4, the Wall Street Journal (p. 1) had a major headline: Best

September in Typewriters.The article went on to say that sales of type-writers were regarded as a reliable index of business activity. TheJournaleditor concluded that there was little chance of a recession.

All of the following measures for September October 1929 were abovethe 1923 1926 index measure of 100:

Total productionManufacture

Building contracts awarded

Factory employment

Factory payrolls

Freight car loadings

Commodity prices were less than 100 and the prices of farm products were

at 105.The business news during the summer and fall of 1929 was very good.

On May 24, theMagazine of Wall Streetcarried an article describing theexpansion possibilities for electricity in rural areas. The October 1, 1929,issue of Forbes described record-breaking rail earnings. The June 15


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HOW HIGH IS HIGH? 7

issue of theMagazine of Wall Streetstated, Business so far this year hasastonished even the perennial optimists.

When the stock market price break came on Thursday, October 24,

the Economist (p. 805) observed, The final collapse of the Wall StreetBoom . . . has confounded optimists and pessimists alike.And animportant point that is frequently ignored (p. 824): The share boomof 192629 originated in a period of industrial prosperity which hasnever been surpassed in the worlds history.Thus the business newsimmediately prior to October 24 was extremely positive (except for theregulatory news applicable to the utility sector). As theEconomiststates,it was a period of industrial prosperity that had never been surpassed. Ofcourse, stock prices went up. They went up not because of speculatorsbut primarily because of economic facts. If this had not been true, thespeculators would have sold the market (or more exactly its components)short and put an end to the boom long before October 24, 1929.

Cecchetti (1992, p. 576) writes, We will never know exactly whatcaused the stock market to fall by nearly 30 percent in late October 1929.He is correct, but there is more to be learned. He also states, First, therewas no reason to believe a priori that stock prices were too high beforethe crash.He identifies (p. 574) as causes the Federal Reserve behavior,

together with the public statements of numerous government officials.The research conducted for this book allows us to agree with and expandon these thoughts.


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Chapter 2

THE EVENTS PRIOR TO THE

1929 AND 2008 CRASHES

However, if the attitude of the Federal Reserve officials canbe properly construed from statements of its friends, there are

those who are just as apprehensive that the market may go up asthe average small investor is afraid that it might go down.

The Magazine of Wall Street, May 18, 1929

From 1925 to the first three quarters of 1929, the stock market increaseddramatically. Table 2.1 shows an index of all common stock prices and thechanges in value from 1925 to 1929.

The fact that common stocks increased in value by 120 percent in four

years (19251929) implies a compound annual growth rate of 0.218.Although this is a large rate of appreciation, it is not obvious proof of anorgy of speculation.

The decade of the 1920s was extremely prosperous in real terms, andthe stock market, with its rising prices, reflected this prosperity as wellas the expectation that the prosperity would continue. But Congress andthe Federal Reserve Board worried about the speculation taking place inNew York. The hearings held by the Senate Committee on Banking andCurrency on broker loans in February and March 1928 and the hearings

on stabilization held by the House Committee on Banking and Currencyin March, April, and May 1928 are very helpful in understanding thesubsequent actions of the Federal Reserve Board in 1929.

The Senate committee was concerned because total loans secured bystocks and bonds of the member banks of the New York federal reserve


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Table 2.1Common Stock Prices, 19251929

Year

Index of

All Common Stock(1941 42 = 10) Growth Rate

Cumulative Changefrom 1925

1925, first quarter 11.01

1926, first quarter 12.94 0.18 0.175

1927, first quarter 13.94 0.08 0.266

1928, first quarter 17.49 0.25 0.589

1929, first quarter 24.24 0.39 1.202

1929, second quarter 24.43 0.01 1.219

1929, third quarter 28.12 0.15 1.554

1929, fourth quarter 21.90 0.22 0.989

Source: N. S. Balke and R. J. Gordon, Historical Data,in The American Business Cycle (Chicago:University of Chicago Press, 1986), p. 802.

district on January 11, 1928, exceeded $3.8 billion, and the largest partof this sum is used for speculation in the New York Stock Exchange.1

The desire to control the speculation taking place in the New York StockExchange (NYSE) was primary. The senators did not define speculation,but they knew it was evil and had to be controlled.

Senator Robert LaFollette of Wisconsin led off the 1928 hearings byquoting H. Parker Willis, an ex-secretary of the Federal Reserve Board:it remains a fact that our reserve system has excited no real remedialinfluence upon the great American evil of stock-exchange gambling.2

Roy Young, the newly appointed governor of the Federal Reserve Board

(he had been the governor of the Minneapolis Reserve Bank), defended thereserve system and pointed out that the increase in broker loans betweenJanuary 6, 1926, and February 29, 1928, came about entirely in the ad-vances that were made by corporations and individualsand was not theresult of actions taken by the Federal Reserve or by New York banks.3

Young asked the rhetorical question: Is this volume of credit that isgoing to the stock market denying commerce and industry credit?4 Heconcluded that he could find no evidence of credit being denied to com-merce or productive industry.5 Young concluded by stating, Now, I am

not prepared to say whether the brokersloans are too high or too low.I do not think anybody else can say so. I am satisfied they are safely andconservatively made.6

Senator Carter Glass responded by asking, Would you not modify thatand say they are safely made?7


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THE EVENTS PRIOR TO THE 1929 AND 2008 CRASHES 11

Young did not object to the elimination of the word conservatively.He stated, Yes, I am; however, speaking from the Federal Reserve Bankstandpoint, I do not think the Federal Reserve should say whether they

are too high or too low. Now if there is a further expansion of this bro-kersloan account and it gets to the place where it is dangerous andborders on unwarranted speculation, I have enough confidence in theAmerican banking fraternity to believe they can correct that situationthemselves.8

This positive statement is important, since it separated Young from theother members of the board. The five other members of the board con-cluded that there was excessive speculation and the board had to takeaction.

Edmund Platt, vice-governor of the Federal Reserve Board ( Platt was anex-newspaper editor from Poughkeepsie, New York), also testified that hedid not know that the market was too high.9

Mr. Platt: It looks as if it was an inflation in the price of securities. On theother hand, I do not believe anybody can positively and definitely say that asecurity like United States Steel, for instance, should not sell on a 5 percentbasis. . . . With all the saving of capital that Professor Sprague has told youabout and everything, maybe there is so much capital seeking investment that

securities that appear to be reasonably sound, with a future prospect perhapsought to sell on a 5 percent or even a 4 percent basis. I do not see howanybody can tell positively.

Senator Glass: Do you think that bets are always made with reference to thesoundness of the security?

Mr. Platt: Not always; but I think that is pretty generally true with relation tothe higher grade ones such securities, for instance, as the investment trustsall buy. There is another thing injected into the situation. We have had a tre-mendous growth in investment trusts lately by which the smaller investor can

put in a thousand dollars and have his investment scattered among such stockas American Telephone and Telegraph, United States Steel, etc. His thousanddollars are spread among the whole lot of them so there is not very much riskof loss in the long run.

Platt failed to realize that investment trusts could not protect the inves-tor from changes in the level of the stock market. He also did not realizethat some of the trusts were using large amounts of borrowed funds toleverage the returns on equity investment and thus had large amounts of

risk.Glass then establishedthe presence of gambling in the market.

Senator Glass: I have in mind just a single security right now among many othersthat occupy a similar position. It was quoted in last January at 10814. Therehas been no change in the management of the corporation, there has been no


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12 BEATING THE BEAR

approximate increase or diminution in the supply and sale of the product. Thesame security is selling on the market, or was yesterday, at 69.

Mr. Platt: It was selling at 108?

Senator Glass: It was selling at 108 in January. It was selling on the marketyesterday at 69. Now, what is that but gambling?10

Glass seemed to suggest that buying a stock that decreased in value wasgambling. Platt was correct about not much risk of loss in the long run,if long runis defined to be in excess of 20 years. In the short run, the riskprospects are much different.

Charles Hamlin of the board (a lawyer from Boston) declined theinvitation to testify, but E. H. Cunningham of the Federal Reserve Board

(an ex-Iowa farmer) did offer some comments. He made clear that hewas against the use of credit for speculative purposes: I do feel, how-ever, that the rapid increase of the past three years in the use of creditfor speculative purposes is a tendency in the wrong direction. Creditused for such purposes is a part of the credit availability of the country,and in the event that the credit supply should become or limited, theamount invested in stock loans will naturally have the effect of limit-ing credit availability, and might possibly, if some measure of control is

not provided, reach such proportions as to seriously embarrass the creditrequirements of business and commerce.11 The inability of the board todistinguish between credit being used to finance security purchases andcredit used to finance the purchase of real goods and services was to costthe country dearly.

In March, April, and May of 1928, the House Committee on Bankingand Currency held hearings on stabilization. These hearings were relativeto the consideration of an act that would amend the Federal Reserve Act of1913 to have the federal reserve system promote the stability of commerce

and a more stable purchasing power for the dollar.The first person to testify was Adolph Miller of the Federal Reserve

Board, a former economics professor. He quoted extensively from TheBehavior of Prices by Frederick C. Mills. There followed an interestingexchange between Miller and Otis Wingo, a congressman from Arkansas:

Mr. Miller: Well, I have had this book in my hands only a couple of days, soI cannot tell you all that is contained in the volume.

Mr. Wingo: I think you will find when you read it clear through that he says thatthe behavior of prices is largely like the behavior of individuals. That is histheme.12

Wingo later asked a series of questions that anticipated perfectly themisguided actions of the board in 1929.


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Mr. Wingo: Isnt this the major question that governs your board in deciding suchquestions? Dont you consider what your policies should be in regard to meet-ing the needs of legitimate business in the country, and not the effect on thestock market? If the needs of legitimate business require easy money, then youwill meet that need and not be scared off because perchance there is an atten-dant evil that there may be a lot of speculation in the stock market?

Mr. Miller: How do you propose to reconcile those two purposes? We have asecurities market in this country that generally is ready to take advantage ofeasy and cheap credit.

Mr. Wingo: I dont think you caught my point. My point is this. The factor thatshould control in fixing the rediscount rates and in determining whether or notyou will put more money in the market or take money out is not what is goingon in the stock market that is not the prime consideration but what are the

necessities of legitimate business?Mr. Miller: Yes.

Mr. Wingo: And the fact that in meeting the necessities of legitimate business youhappen to stimulate a little bit the amount of speculation in the stock marketshould not deter you from meeting the major needs of business?13

Miller kept responding and Wingo kept pointing out to Miller that Youstill dont get my question.14 If Miller had understood Wingo, the courseof history might well have been changed. Wingo was intelligent and

knowledgeable. He was even a fine pragmatic teacher (as evidenced byhis questions). Unfortunately, Miller and four other members of the boarddid not understand the difference between the stock market and the realeconomy. Wingo finally declared: That is, you cannot always determinewhen a brokers loan or a stock loan is one for speculative purposes.15Miller did not speak directly to that statement but he did finally state, I am of the opinion that for the purposes of good administration in thefederal reserve system a tight control over the diverting of its credit into

any kind of speculative loans is necessary.

16

When one of the congressmen asked As a matter of practical banking,you would know where the money went to, wouldnt you?17 Millerresponded It is not always easy to know it. But it can be sensed.18Remember, Miller was the intellectual leader of the board in 1929 and themost forceful of its members. The board was in deep trouble.

Hamlin, who declined to testify in earlier hearings, testified at thishearing and revealed that he thought the board had a right to act whenspeculation so threatens business, threatens to curtail, perhaps, business

credits that may be demanded.But he also stated I should always bereluctant to act.19

Young, governor of the Federal Reserve Board, also testified, but histestimony can be summarized by his statement that stability is a big ques-tion and a big problem. It is one that I am not capable of talking about


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14 BEATING THE BEAR

definitely at this time.20 Miller thereby became the de facto leader of theboard.

No one can support or contradict conclusively the conclusions resulting

from what if statements. But we should ask, what if a healthy Otis Wingoof Arkansas had been the governor of the Federal Reserve Board in 1929?His questions during the hearings indicated a knowledge of economicsand finance exceeding that of all members of the board. Unfortunately, thecards were not dealt that way, and Adolph Miller was the guiding forcebehind the actions of the board in 1929.

Wingo deserves more than a few words of praise. He was admitted tothe bar in 1900 and practiced law in Sevier County, Arkansas. He waselected to Congress nine times and served in Congress from 1913 untilhis death in 1930. He was one of the prime authors of the Federal ReserveAct. When he died on October 21, 1930, he was replaced in Congressby his wife, Effiegene Loeke Wingo, who then ran for Congress, waselected, and served in Congress from 1930 to 1933. She did not offerherself as a candidate for renomination in 1932 but proceeded on to otheractivities.

A contemporary offered the following description of Wingo: A man ofcommanding appearance, self-confident, fearless, and aggressive, Mr. Wingo

was a natural leader. His ideals were high, his emotions deep, and in allrelations he was loyal, kind and considerate.21 Despite the fact that he wassuffering from ill health during the hearings, his questions were unusual intheir consistent fairness, insightfulness, and intelligence. It is a tragedy thatMiller did not listen more carefully to the congressman from Arkansas. Thecongressman did well. We are in his debt. He effectively dispelled the myththat credit given to brokers kept credit from being given to the real economy.Unfortunately, Miller did not learn the lesson.

We cannot be sure of cause and effect in 1929. But we can be sure thatMiller did not understand the lesson being taught by Wingo in 1928. In1929 the Federal Reserve Board, with Miller as the intellectual leader,tried by several significant actions to stop stock market speculation. ByAugust it had succeeded. We will not be able to conclude that the boardcaused the stock market price declines in the fall of 1929, but there is evi-dence that the stock market price increases (arising from speculation) werea major concern of the board, which took actions to stop them.

On Sunday, October 13, 1929, the Times ( p. 7) reported that Professor

C. A. Dice of Ohio State, an economist, had declared, Stock Prices WillStay at High Level for Years to Come.He gave the following justifica-tions ( p. 7): the great economic developments in wealth, in efficiency ofproduction and transportation, in cheapness and adequacy of distribution,in invention and engineering and in public good-will and confidence.


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He concluded The day of the small investor is here.Dice was an advo-cate for the new era.

Consider the following information regarding performance of U.S.

corporations, which was readily available in 1929:

1. In the first nine months of 1929, a total of 1,436 firms announcedincreased dividends (Forbes, October 15, 1925, p. 95). In 1928, only955 announced an increase.

2. In the first nine months, cash dividends were $3.1 billion, up from$2.4 billion in 1928 (a 29 percent increase).

3. In September 1929, dividends were $399 million compared with $278 mil-

lion in 1928, an increase of 44percent.4. The dividend payout was 64percent in September 1929, compared with75 percent for September 1928, reflecting increased earnings.

5. Earnings compiled for 650 firms showed a 24.4 percent increaseversus 1928 for the first six months (National City Bank of New York

Newsletter, August 1929). The earnings for the third quarter for638 firms were 14.1 percent larger than for 1928. For the first ninemonths of 1929, the earnings of the 638 firms had increased 20.3 per-cent compared with 1928 (November 1929, p. 154). The March 1930

issue showed that for 1,509 firms, annual earnings had increased by13.5 percent for 1929 compared with 1928.

It is not difficult to see why the market was using high expectationsof earnings growth. With reasonable (for the time period) estimates ofgrowth, most of the industrial stock prices for September 1929 can bejustified with a dividend growth valuation model.

It is important that we more fully understand the causes of the 1929

stock market crash and correct some of the widely held misconceptions.If stock prices were too high because of speculative buying and the crashwas inevitable, then the lesson to be preached is simple, if not easilyexecuted. One should not invest in stocks if stock prices are too high. Theconventional wisdom is that speculation was the cause of stock pricesbeing too high. Thus Malkiel (1996) writes ( p. 51) about a speculativeboom: Perhaps the best summary of the debacle was given by Variety,the show-business weekly, which headlined the story, Wall Street Laysan Egg.The speculative boom was dead and billions of dollars of share

values as well as the dreams of millions were wiped out.Laying the blame for the boomon speculators was even more com-

mon in 1929. Thus, immediately upon learning of the crash of October 24,Keynes wrote in the New York Evening Post (October 25, 1929): Theextraordinary speculation on Wall Street in past months has driven up


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16 BEATING THE BEAR

the rate of interest to an unprecedented level(Moggridge, 1981, p. 2 ofvol. xx). And theEconomist, when stock prices reached their low for theyear, repeated the theme that the U.S. stock market had been too high

(November 2, 1929, p. 806): There is warrant for hoping that the defla-tion of the exaggerated balloon of American stock values will be for thegood of the world.

The key phrases in the above quotations are exaggerated balloon ofAmerican stock valuesand extraordinary speculation on Wall Street.The common viewpoint was that the U.S. stock market was too high.

But if the conventional view of history is not correct and if U.S. stockswere not universally too high, then what did cause the great crash? Thestock market index hit a high of 386 in September 1929; by November,it had dropped to 230, a drop of 40 percent. By the time the crash wascompleted in 1932 and thanks to the oncoming of the real economicdepression stocks had lost in excess of 70 percent of their value. Theresults of the crash were devastating to individuals and to nations. Thecrash helped bring on the depression of the thirties and the depressionhelped to extend the period of low stock prices, thus provingthat theprices had been too high. This book reviews a small set of possible causesof the crash and reaches specific conclusions that might cast some light

on this important event. The lessons for investors and students of historyare important. Although I cannot prove that I know the exact specificcauses of the crash, I present some reasonable evidence supporting myhypotheses.

A CATALOGUE OF EIGHT CAUSES

Consider the eight suspectsthat may or may not have caused the crash.

The identified possible causes include the following:1. The stock market was too high in September 1929 (values did not

justify the prices) because of excessive speculation, making the crashinevitable.

2. There was a real downturn in business activity.

3. Actions of the Federal Reserve Board excessively restricted growth ofthe money supply.

4. On both sides of the Atlantic, a message was being sounded by both the

media and important governmental figures that the U.S. stock marketwas too high; hence there was a waragainst the speculators.

5. There was excessive buying on margin and excessive buying of invest-ment trusts; relative returns and costs of buying on margin are relevantto evaluating margin buying.


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6. There was excessive leverage when the debt of operating utilities, hold-ing companies, investment trusts, and margin buying are all considered.

7. There was a setback in the public utility market arising from an adverse

decision for utilities in Massachusetts combined with an aggressivelypriced utility market segment.

8. The market overreacted.

We will choose number 7 as the triggering event. The leverage (num-ber 6) and the repetitive statements that the market was too high werealso major factors.

THE 20082009 MARKET CRASHWhen real estate prices started to go down in 2007 and homeowners

found that their mortgages were larger than the value of their houses,many borrowers stopped making their mortgage payments. The mortgagedefaults spread to the default on collateralized mortgage obligations heldby financial institutions financed with over $30 of debt for each dollarof equity. This led to a string of financial institutions having more debtsthan assets, resulting in a drastic restriction of credit available to industry.

The stocks of the financial sector were battered; then, as business activityslowed, other stocks tumbled. With falling operating results, the lowerstock prices observed in the fall of 2008 were soon justified, given thelower operating earnings.

The problems in the financial sector led to an inability of these firms tolend. The drying up of credit led to a decrease in business activity, whichled, in turn, to a worldwide recession in 2008 2009.

In 1929, the stock market crash led to a decrease in business activity in

1930 1932.In 2008, financial events (house prices decreased in value, subprimemortgages defaulted, and business activity decreased) triggered stockprice decreases, which were rapidly validated by poor income measuresin the fourth quarter of 2008. The stock price decline in 2008 was moresevere than that in 1929.

Alan Greenspan wrote in The Wall Street Journal (March 11, 2009) that: There are at least two broad and competing explanations of the origins ofthis crisis. The first is that the easy moneypolicies of the Federal Reserve

produced the U.S. housing bubble that is at the core of todays financialmess. The second, and far more credible, explanation agrees that it wasindeed lower interest rates that spawned the speculative euphoria. How-ever, the interest rate that mattered was not the federal-funds rate, but therate on long-term, fixed-rate mortgages.


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18 BEATING THE BEAR

The long-term fixed rate was more relevant, since it is the rate thatshould be used to value long-lived real estate.

Thus we have low long-term interest rates fueling a vigorous real

estate market. Wall Street encouraged the real estate boom by packagingthe mortgages so that even segments with the worst credit were givena triple-A rating. In addition, the buyers of risky components seemedto be able to divest themselves of the risk by engaging in credit defaultswaps.

All seemed to be going well until 2008, when real estate prices stoppedgoing up and borrowers lost the incentive to pay on mortgages that werelarger than the value of the real estate.

Credit default swaps (CDSs) grew from a market of a few billion dollarsin 2001 to $60 trillion in 2007. Banks bought subprime mortgages andthen engaged in swaps, where they paid the risk taker in good years, butthe banks were paid if the borrower did not pay the mortgage in a timelyfashion. Since the bank unloaded its risk to the swap counterparty, it couldbuy additional risky mortgages.

Unfortunately, the risk still existed. If the counterparty who promised topay in case of mortgage default accepted too many swaps in a bad year, itwould be unable to pay. The banks that had purchased protection would

(and did) find that the losses were not effectively hedged.Why were credit default swaps a reasonable strategy for the banks

buying the subprime mortgages? The mortgage originators were lendingmoney to real estate buyers with a low probability of being able to maketheir mortgage payments and with little incentive to pay if the value of thereal estate was less than the value of the mortgage obligation.

In a letter to the editor (The New York Times, May 10, 2009), Ian Jarvismakes the point that if a real estate investor would have walked down

Main Street just once pretending to be a homebuyer and spent one dayhaving liarsloans thrust at him, he would have met the real estate agentsselling overpriced merchandise to underinformed dreamers and heard theagentspitch Investors like you, sir, are making a fortune.If he haddone his homework, Mr. ________ might not have played the part he didin devastating our economy.


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Chapter 3

MARKET MYTHS

IN 1929 AND 20082009

WHO KILLED COCK ROBIN? Are the Prophets of DisasterNow Satisfied?

The Magazine of Wall Street, November 16, 1929

There is a great deal wrong with our understanding of the 1929 stockmarket crash. Even the name is inexact. The largest losses to the market didnot come in October 1929 or the winter of 1930 but rather in the followingtwo years. In the calendar year 1929, the market lost only 11.9 percent ofits value, after having gained 37.9 percent in the previous year. In Decem-ber 1929, many expert economists, including John Maynard Keynes and

Irving Fisher, felt that the financial crisis had ended, and by April 1930the Dow Jones Industrial Average had recovered a large percentage of theOctober losses. By contrast, from September 2008 to March 2009, thestock market lost in excess of 50 percent of its value.

Our misconceptions about the events of the fall of 1929 have been fedby the easy generalizations of authors more interested in being dramati-cally clever than in analyzing the facts. We will show that there are goodreasons for thinking that the stock market was not obviously overvalued in1929 and that it was sensible to hold stocks in the fall of 1929 and to buy

stocks in December 1929 (admittedly this investment strategy would havebeen terribly wrong).

We want to consider two basic questions in this book: Was the stockmarket unreasonably high in October 1929? Was a crash inevitable? We willpresent explanations for the initial decline in stock market value which are


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20 BEATING THE BEAR

not dependent upon an assumption of overvaluation. But we will not fullyexplain why the market turned down in the fall of 1929. Changes in marketpsychology are not perfectly explained by reference to specific events.

The objective of this book is not to determine whether the fall in stockprices triggered the Great Depression of the 1930s but to describe moreaccurately the stock market crash of 19291932 so that we can better under-stand the present stock market situation and better predict the future.

It is normal practice to describe the 1929 stock market prior to Octoberas a bubble or speculative orgy. Throughout economic history many eventshave been defined as bubbles. Historically, the existence of price bubbles(large price increases followed by large price decreases) in financial mar-kets has been explained, in part, by the assumption of irrationality on thepart of traders. For example, C. R. Kindleberger explains bubbles in thefollowing way: speculation for profit leads away from normal, rationalbehavior to what have been described as manias or bubbles. The wordmania emphasizes the irrationality; bubble foreshadows the bursting.1 In2008, the real estate bubble burst. How do we now there was a bubble in2008? Prices went down in 2008 and 2009.2

One empirical investigation of the existence of a price bubble wasperformed by R. R. Flood and R. M. Garber.3 They were unable to reject

the hypothesis that bubbles were absent from the German hyperinflationof the 1920s. Since their research dealt with rates of changes associatedwith an overall price level, they are appropriately circumspect in makingclaims about more specialized asset markets: The professions folkloreon the existence of bubbles emphasizes such markets, for example, theTulip Bubble, the South Sea Bubble, the Mississippi Bubble, the crash of1929. However, no one has verified that a bubble of the type defined in thecurrent rational-expectations literature has ever existed.4

Many of the so-called bubbles are actually interesting economic venturesthat failed or well-managed scams that were vigorously sold by expert conartists. The famous South Sea Bubblewas a combination of the abovetwo factors.

The South Sea Bubble (17111721) occurred in England. It started out asa legitimate business enterprise (the South Sea Company with a charter formonopoly of trade with Latin American countries) but ended up being thehigh-pressured selling of nearly worthless securities. The South Sea Com-panys first ship to approach Latin America was driven off by the Spaniards

in 1717. In 1718, England was at war with Spain and the companys originalcharter lost its value. Faced with the loss of its reason for existence, thecompany then proceeded to repackage the debt securities of the Englishgovernment. The firms stock tremendously increased in value as new capi-tal was used to pay old capital and more government debt securities were


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MARKET MYTHS IN 1929 AND 20082009 21

purchased. Before concluding that only fools get taken in by such bubbles,consider the fact that Isaac Newton in a single month sold his 7,000 ofSouth Sea Company stock at a profit of 100 percent; several months later,

however, he lost 20,000 after making further investments in the company.5It has been said of John Blunt, a director of the South Sea Company and

the prime promoter of its securities from 1717 to 1721, that he continuedto live his life with a prayer-book in his right hand and a prospectus in hisleft, never letting his right hand know what his left hand was doing.6

The 1929 stock market situation was intrinsically different from the classicexamples of bubbles, including the South Sea Bubble. The 1929 stockmarket crash was more the result of the misjudgments and bad decisionsof good people than the evil actions of a few profiteers. There were solidreasons for buying stock in October 1929, but the market sentiment soonshifted from optimism to pessimism, and the negative psychology of themarket became more important than the underlying economic facts.

BEFORE 1929

It is important to understand some of the most significant events thatled to the 1929 stock market decline. In 1920, Warren G. Harding was

elected president of the United States, and in 1924, Calvin Coolidgewas elected. These two presidents do not rank high in performance, andtheir appointees left something to be desired. At the beginning of 1929,the Federal Reserve Board consisted of Harding Coolidge appointeesor reappointees (three members of the board Edmund Platt, CharlesS. Hamlin, and Adolph C. Miller had originally been appointed byWilson). Unfortunately, these appointees were not the most talented or bestprepared for controlling the U.S. banking system. The Federal ReserveBoard in January 1929 consisted of the following six members (omitting

the two ex-officio members: Secretary of the Treasury A. W. Mellon andComptroller of the Currency J. W. Pole):

Roy A. Young, Governor. Young had been governor of the MinneapolisReserve Bank before joining the board.

Edmund Platt, Vice-Governor. Platt was an ex-newspaper editor andex-congressman from Poughkeepsie, New York.

Adolph C. Miller. Miller had been a professor of economics at Harvard, theUniversity of Chicago, and Cornell.

Charles S. Hamlin. Hamlin was a Boston lawyer who had been an assistantsecretary of the treasury with Cleveland and Wilson. He was the firstgovernor of the Federal Reserve Board.

George R. James. James was a Memphis merchant.Edward H. Cunningham. Cunningham was an Iowa farmer.


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22 BEATING THE BEAR

Young, Hamlin, and Miller had relevant experience or academicqualifications, but the other members of the board required on-the-jobtraining. Neither Young nor Hamlin were very insightful or forceful and

did not supply the leadership needed by the board, although Young actu-ally opposed many of the boards actions in the first six months of 1929.Miller was by far the most decisive member of the board and becamethe de facto intellectual leader. Although he had an academic background,his style was that of an autocrat. Hamlin kept a diary that is an impor-tant source of our understanding of what happened in the meetings of theFederal Reserve Board.

Benjamin Strong, the most respected (internationally) of U.S. bankers,was the head of the New York Federal Reserve Bank from 1914 until thefall of 1928. In 1925, when direct pressure on banks to control speculationwas recommended by the board as a strategy, Governor Strong disagreed,pointing out that direct pressure could not succeed in New York unlessthe Federal Reserve Bank refused to discount for banks carrying specula-tive loans, and that it would mean rationing of credit, which would bedisastrous.7

Although he died in 1928, Strongs influence extended to 1929. From1921 to August 1928, the real financial genius and power in the United

States was Benjamin Strong, governor of the New York Federal ReserveBank. Lester V. Chandler has written the definitive biography of Strong.8Strong was an acknowledged leader of international finance and truly agiant in U.S. banking. Most important, Strongs intellect and personality(including a great sense of humor) led to New York being the power centerof U.S. banking from 1921 to 1928. This frustrated several members of theFederal Reserve Board, especially Young and Miller.

In the summer of 1927, the United States was on the verge of a reces-

sion. Productivity had dipped down and significant economic signs werenegative. In addition, Europe was losing gold to the United States andEuropean bankers feared an international disaster.

Strong led a move to reduce the discount rate and increase the reservebanksholdings of U.S. securities. This easy money policy succeeded andthe recession was avoided. Later Miller would blame the resurgence ofstock speculation in 1928 on Strongs easy money policy of 1927. Millerwas very influential in leading the board to avoid this mistakein 1929.

STOCK SPECULATION

Throughout the 1920s, New York banks had financed broker loans. Thespeculationbeing financed by the New York banks became increas-ingly distasteful to members of the Federal Reserve Board. The board


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advocated direct pressureon New York banks to limit borrowing bymember banks from the Fed, which was then used to finance broker loans.Strong disagreed with the Federal Reserve Board. He successfully argued

that penalizing banks that carried speculative loans would be a disastrouspolicy. In October 1928, Strong died after a long illness. After his death,the dispute between the board and the New York Reserve Bank acceler-ated, with the board advocating restricting broker loans and the New YorkBank wanting to increase the rediscount rate.

The Federal Reserve Bulletin of February 1929 made it clear that thefederal reserve banks would take steps to decrease the flow of credit tospeculators.The bulletin stated that the Fed means to restrain the use,either directly or indirectly, of Federal reserve credit facilities in aid of thegrowth of speculative credit.

By early 1929, the board had sent out a clear signal that it believed therewas excessive speculation in stock, and that it wanted the banks to decreasetheir broker loans. Over the next several months, there evolved a seriesof explicit conflicts between the board (wanting to control speculation bydirect pressure) and the New York City Reserve Bank (wanting to avoidan arbitrary tightening of credit with the banks deciding who wouldget credit). Beginning in February 1929, the Reserve Bank of New York

wanted to increase the rediscount rate from 5 to 6 percent. The FederalReserve Board refused the repeated requests until August 1929.

A commercial bank that had made a loan, wanting to expand its ability tomake more loans, would send the loan to the reserve bank in its district andreceive in return federal reserve notes or the accounting entry equivalent.The rate paid by the commercial bank to the federal reserve bank is calledthe rediscount rate; it represents a cost to the bank and defines the rate itmust charge. (This bank loan rate must be larger than the rediscount rate.)

An increase in the rediscount rate translates immediately into an increasein the rate the banks charge their customers.The U.S. Senate reacted immediately to the boards public condemna-

tion of the banks practices of fueling the speculative boom; it adoptedthe following resolution in support of the board:

Whereas in press dispatches recently, the Federal Reserve Board hascomplained that money is being drawn from the channels of business andused for speculative purposes, and that some of said speculation is illegiti-mate and harmful:

Therefore, be itResolved, That the Federal Reserve Board is hereby requested to give to

the Senate any information and suggestions that it feels would be helpful insecuring legislation necessary to correct the evil complained of and preventillegitimate and harmful speculation.9


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24 BEATING THE BEAR

The mood was firmly established that the levels of 1929 stock marketprices were the result of unthinking, evil speculation. The investing com-munity was bombarded with statements from both financial experts and

policy makers at the highest levels that there was excessive speculation,resulting in stock prices that were too high. Even Trowbridge Callaway,president of the Investment Bankers Association of America, spoke ofthe orgy of speculation which clouded the countrys vision.10

M. Friedman and A. J. Schwartz describe the situation at the end of the1920s as follows: The bull market brought the objective of promotingbusiness activity into conflict with the desire to restrain stock market spec-ulation. The conflict resolved in 1928 and 1929 by adoption of a monetarypolicy, not restrictive enough to halt the bull market yet too restrictive tofoster vigorous business expansion.11

The Feds restrictive credit policy on speculative loans started to affectbroker loan rates early in 1929. Broker call loan rates were 6.94 percentin January 1929, but they were reported by the Fed to have increased to14.40 percent by the end of March 1929.12 Rates on commercial paperhad also increased, although not as much (from 514 to 6 percent). Thedifference between the rates on broker loans and rates charged for othercommercial activities was dramatic.

Although the Fed expressed concern regarding excessive speculation instocks, the real economy as measured by published statistics was funda-mentally sound. But it is important to remember that while the Fed wasimplicitly fighting speculation and price increases in the stock market,there was a deflation in the prices of goods and services. As described byFriedman and Schwartz, The stock of money, too, failed to rise and evenfell slightly during most of the expansion a phenomenon not matched inany prior or subsequent cyclical expansion. Far from being an inflationary

decade, the twenties were the reverse.

13

By March 1929, the tight money policy of the Federal Reserve Boardwas successful in increasing the price of credit. The normal credit demands(income tax payments, quarterly payments of dividends and interest, andspring agricultural requirements) resulted in a withdrawal of funds fromthe New York call loan market; call rates were reported by National CityBank to reach a maximum of 20 percent.14 There was a drop in stockprices, but the New York City banks provided funds for broker loans andthe stock price decrease was very small.

The rates on call loans fluctuated violently in April and May. In Mayalone the call loan rates ranged from 6 to 15 percent.15The National CityBank of New York Newsletterreported that there was a growing reluctanceof the banks to extend their loans on collateral ineligible for rediscount atthe Reserve Banks.16


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The July 15, 1929, issue ofForbes reported (quoting R. W. McNeel) thatthe policy of the Federal Reserve Board was destroying the confidence ofinvestors and that a continuation of the policy would undoubtedly stop the

free flow of capital into American industry.There was a growing feeling among business writers that the Fed did not

want the market to go up further. The war against the New York speculatorshad begun.

MYTHS AND FABLES

A myth exists only in imagination. We know, using historical data, thatstocks actually decreased in value in the fourth quarter of 1929. But other

things that we knowabout 1929 are less clearly based on fact. There areseven great myths about 1929:

1. Stocks were obviously overpriced (the evidence suggests stocks werereasonably priced).

2. The crash was inevitable. ( It was just as likely to observers at the timethat stocks would go up as down.)

3. The Great Crash occurred in October 1929. (Most of the losses took

place in 1930 1932.)4. Speculators deserved to be taught a lesson. ( It was very difficult todistinguish good investors from bad speculators.)

5. Dishonest manipulation drove stock prices up. ( There is evidence ofsome bothersome but not significant manipulation; there is no evidencethat the level of the market was materially affected by these actions.)

6. Credit given to brokers kept credit from being given to the real economy(this would be true only if Federal Reserve actions rationed the totalcredit; it certainly does not have to be valid.)

7. The high level of stock market prices jeopardized the nations prosperity.( It was not stock prices but the action of the Federal Reserve to bringdown stock prices that jeopardized prosperity.)

Gerald Sirkin also takes the position that descriptions of 1929 as a periodof speculative orgyare misleading. He concludes that some showedsigns of over-indulgence. But, by the usual standards for such things, theconclusions would have to be: not much of an orgy.17

The following fable is typical of the stories told about promoters andspeculators in 1929:

Consider the story of the oil promoter who appeared before Saint Peterand presented his credentials for admission to Paradise. He was informedby Saint Peter that the quota for promoters was filled and no more of


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26 BEATING THE BEAR

his profession could enter for the time being at least. Not dismayed, thepromoter queried, As I understand it then, the only condition under whichI can gain admission is that a vacancy be created?Precisely,replied

Peter. A faint smile appeared on the candidates face; it was apparentthat he could meet that situation. He asked for the privilege of makingan announcement to his former colleagues. Directed to the celestialmicrophone he delivered himself of a brief message. Fellow promoters,oil has been discovered on Jupiter!The words were no sooner spokenthan several thousand of the tribe stormed out through the gates. Peter,somewhat surprised by the exodus, turned to the candidate, Well, I guessyou may come in now.The reply: Saint Peter, Ive changed my mind . . .Im going too. . . . There may be some truth in that report.18

HAWLEYSMOOT ACT (1930)

In 1930, the Hawley Smoot Act was passed, fixing the average rate ofduties at about 41 percent.19 Given that the first major stock market declineoccurred in October 1929 and the act passed in 1930, it is difficult to con-clude that this act was a major contributing factor to the October stockprice declines (there had been considerable hope that the president wouldveto the bill), but it probably did contribute to the subsequent stock price

declines and the Great Depression.One hypothesis is that the stock market was not excessively high in 1929

but that there were effective efforts by the Federal Reserve Board, Con-gress, and the president of the United States to bring the stock marketspeculators to their knees. The constant attack on the New York specu-lators and the overpricedstock market created a situation where anynegative news or a combination of relatively minor events could generatea psychological reaction that would lead to a market decline.

Who killed cock robin?remains a valid question. It was not the NewYork speculators.From reading articles and books, everyone knows that in 1929, bathroom

attendants and bellhops were speculating in stocks. But no one knows howmany people lacking the necessary qualifications (whatever they were)were in the market (speculating or possibly even investing). F. L. Allenwrites: Unquestionably there were far more people speculating than everbefore; unquestionably there were great numbers of clerks, stenographers,janitors, chauffeurs, and waiters in the market. Yet probably not much

more than one person in a hundred in the American population was playingstocks on margin.20

Most of us are in favor of broad-based ownership of U.S. industry. Butin 1929 the ownership of stock by nonprofessionals was looked at as a badact, called speculation.


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THE GREAT MYTH OF 2009

The great myth of 2009 is the administrations stimulus plan passed inMarch 2009. Rather than a pure stimulus plan, it was a grab bag of theprojects Democratic congressmen and senators had wanted to implementfor the previous eight years and were not able to obtain because of theeight years of President George W. Bush and a Republican Congress.

I do not mean to imply that all the projected spending under the stimulusbill is bad. But much of it cannot be justified as part of a stimulus plan.Hardly anyone knows what spending has been approved for specific proj-ects, since few persons have read the stimulus bill as passed. I know CornellUniversity gets a chunk for projects, few of which were high priority for the

United States.Does this mean that the $800 billion of stimulus spending will not

stimulate the economy? This is not the issue. The correct question iswhether, with a month of careful evaluation, a better set of projects andstrategies to create jobs and increase economic activity could not havebeen approved. Consider the $250 grant each recipient of Social Securityreceived in the spring of 2009. That $250 was not subject to federal incometaxes and the amount did not depend on the income or wealth of the recipi-ent. If husband and wife both received Social Security, the family wouldhave received $500 in total. Not exactly a carefully targeted award.


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Chapter 4

THE FEDS ROLE IN GOOD

TIMES AND BAD

At home high wages and little unemployment have promotedindustrial peace and excepting the issues of prohibition, farm

relief, the crime wave and the policies of the Federal ReserveBoard there is little to disturb the even tenor of our commercialways.

Joseph Stagg Lawrence, Wall Street and Washington

By the beginning of 1929, both the Federal Reserve Bank of New Yorkand the Federal Reserve Board believed that speculation in stocks wasexcessive and had to be controlled. The New York bank thought the best

method to control credit was to increase its rediscount rate. The board didnot want to increase interest rates but rather to take direct action.Thisreferred to the utilization of publicity to make the boards position knownand then moral persuasion (threats?) to convince banks that they shouldgo along with the boards desire to restrict stock market speculation. Inthe first half of 1929, this meant that the banks should divert credit fromloans financing stocks to loans to be used for normal business activity.Although the difference in the desired course of action could be describedas an intellectual one, there were other more important factors that contrib-

uted to the lack of cooperation: The close of the period was marked byopen conflict between the Federal Reserve Board and the Federal ReserveBanks over the technique for controlling stock market speculation. Thiswas the crucial engagement in a struggle for power within the system thathad always been potential and that was to lead in the course of the next few


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30 BEATING THE BEAR

years to a near-complete shift of power from the Banks in general and theNew York Bank in particular to the Board.1

To understand the hostility of the Federal Reserve Board toward the

Federal Reserve Bank of New York, one has to go back to the years1914 1928, when Benjamin Strong was governor of the Federal Re-serve Bank of New York. By 1921, Strong was the dominant U.S.central banker of this era. From 1921 to 1928, Washington was a sideshow compared with New York when it came to issues of national andinternational finance.

Strong believed that credit should not be restricted solely to prevent ofstock speculation and feared the consequences of the credit restrictionpolicy:

I think the conclusion is inescapable that any policy directed solely toforcing liquidation in the stock loan account and concurrently in the pricesof securities will be found to have a widespread and somewhat similar effectin other directions, mostly to the detriment of the healthy prosperity of thiscountry.

Some of our critics damn us vigorously and constantly for not tackling thestock speculations. I am wondering what will be the consequences of such apolicy if it is undertaken and who will assume the responsibility for it.2

When the fall in stock prices came, no one claimed responsibility.In 1927, business activity was relatively flat and the Federal Reserve

Board, at the urging of Strong, decided on an easy money policy. AdolphMiller, a very influential member of the board, blamed this policy forthe bad events of 1929 and subsequent years and stated that Strong wasits originator: The policy . . . was originated by the New York FederalReserve Bank, or more particularly by its distinguished Governor, the

late Benjamin Strong. Brilliant of mind, engaging of personality, fertileof resource, strong of will, ambitious of spirit, he had extraordinary skillin impressing his views and purposes on his associates in the FederalReserve System.3

Miller felt that the federal reserve system during 1927 and 1928 hadfollowed policies of easy credit with disastrous results. Stock priceswent up in 1927, 1928, and the first nine months of 1929. It was notuntil February 2, 1929, that the Federal Reserve Board acted in a man-ner Miller approved. He blamed the Federal Reserve Bank of New York

for not supplying the necessary leadership: But it is abundantly clearthat acceptance by the Board of aggressive easing action proposed by theNew York Federal Reserve Bank in 1927 and of complete abandonmentof restraining action in the second half of 1928 proves that the Board,under the established tradition, was first too quick to fall in with a daring


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THE FEDS ROLE IN GOOD TIMES AND BAD 31

and dangerous proposal and later too slow to assume the leadership whichwas needed and was lacking at a most critical time. . . . And New Yorksleadership proved to be unequal to the situation.4

Adolph Casper Miller had been a member of the Federal Reserve Boardfrom its beginning. For 24 years before joining the Department of theInterior and then the Federal Reserve Board, he had taught economics atHarvard, Cornell, the University of Chicago, and the University of Califor-nia. William Hard described Miller as the brains of the Board.5 As earlyas 1925 in a speech to the Boston Commercial Club, Miller declared waron speculation: It is clear therefore that no bank has a proper status as anapplicant for reserve-bank accommodation which is supplying credit forspeculative purposes.6 This radical view of banking and the function ofthe Federal Reserve was held in check by Benjamin Strong. With Strongsdeath in October 1928 and the election of Herbert Hoover in November1928, Miller was able to impose his philosophy on the board and on thecountry.

Miller lived on S Street in Washington; Herbert Hoover lived on thesame block. Hoover and Miller became fast friends and undoubtedlyHoovers economic policies were heavily influenced by his friend (orMiller was influenced by Hoover).7 When Hoover moved into the White

House in 1929, Miller was finally in a position of tremendous influence.Miller was never able to shift his focus from the speculation taking place

on the New York Stock Exchange to the real economy. The fact that themonetary policies of 1927 advocated by Strong helped to avoid a recessionand resulted in the prosperous years of 1928 and 1929 did not enter histhinking. His obsessive goal was to put an end to speculation. Finally, inFebruary 1929, he convinced the Federal Reserve Board that direct actionwas appropriate: In this period of optimism gone wild and cupidity gone

drunk . . . the Federal Reserve Board was growing more and more anx-ious at the course of developments. Ultimately its anxiety reached a pointwhere it felt that it must itself assume the responsibility of intervening inthe dangerously expanded and expanding speculative situation menacingthe welfare of the country. This it did early in February, 1929.8

Before 1929 Strong and President Coolidge stood between Miller andcontrol of the Federal Reserve. The persuasive power and leadershipcapabilities of Strong are further illustrated by a story told by Chan-dler concerning the Kansas City Reserve Bank. Governor Bailey of that

bank was addressing the Reserve Bank Governors Conference:

Hardly had he begun to speak when one of his colleagues shouted: Tell usGovernor, why your Federal Reserve Bank led off in the reduction of thediscount rate?


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32 BEATING THE BEAR

I dont mind telling you,said the Governor, I did it because BenStrong wanted me to.

At this remark there was much laughter. When Governor Bailey resumed,

he said with some show of feeling:Im not afraid to follow the lead, in financial matters, of such men asBen Strong and Andrew Mellon.9

In October 1928 Strong died. On November 23, 1928, George Harrisonwas appointed as governor of the Federal Reserve Bank of New York.However, Strongs death left the system with no center of enterprising andacceptable leadership. The Federal Reserve Board was determined that theNew York Bank should no longer play that role.10 The election of Hooveralso ensured that the restrictive credit policies of the Federal Reserve Boardwould be supported by the White House starting in March 1929.

Harrison was the son of a U.S. Army career officer. He graduated fromYale in 1910 and from the Harvard Law School in 1913. He served fora year as legal secretary to Justice Oliver Wendell Holmes of the U.S.Supreme Court. At the formation of the federal reserve system, he wasappointed assistant general counsel of the Federal Reserve Board. After atour of duty with the American Red Cross in France during World War I,he served as general counsel of the Federal Reserve Board. In 1920 he

became a deputy governor of the Federal Reserve Bank of New York andaccompanied Governor Strong on his last trip to Europe in the summer of1928. Harrison was a very intelligent and competent leader with a highsense of morality, but he was not an effective political strategist. He wouldhave trouble with the Federal Reserve Board.

The Federal Reserve Board waited until the beginning of 1929 to flingdown the gauntlet and challenge the New York bank. Hoover had beenelected president of the United States and had already spoken out against

speculation. With Hoover about to be inaugurated, the board acted.On January 3, 1929, Harrison called Governor Young of the FederalReserve Board to advise him that the New York directors had increased theminimum buying rate for bankersbills (a bill in this context is a bankersacceptance). The rate increase was to be effective the next morning. Thiswas the normal procedure followed by reserve banks for changing theminimum buying rate for bills. The banks voted to change the rate andthen informed the board of their actions.

That evening a telegram was received by Harrison from the board

indicating that the board was not prepared to approve of the increase.Harrison was shocked by the telegram. Young had been governor of theFederal Reserve Board for well over a year and should have understoodthe accepted process for changing the bill rate. In three telephone callsthat afternoon Young had not indicated that the board was displeased with


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THE FEDS ROLE IN GOOD TIMES AND BAD 33

New Yorks raising the bill rate. In fact, a week previously Harrison hadtold Young that the bill rate might be raised. Young had not indicated thathe disapproved or that the Reserve Board would have to approve such

an increase. Harrison did not realize that Young was only nominally incharge of the Federal Reserve Board. Adolph Miller wielded the effectivepower, and he strongly disapproved of a rate increase.

Harrison tried to call Young at his home and finally made connection atseven oclock that evening. He told Young that he was sorry that there wasany misunderstanding as to procedure and that the New York bank hadfollowed the same procedure it had followed for many years in the pastwithout any question or disapproval by the board. But Young was verymuch put outand said that he did not intend any longer to be a rubberstamp.Harrison added that he seemed very much out of temper thisabout a man described by contemporaries as jovial.Young was frustratedby the fact that the New York Federal Reserve Bank raised the bill rate andthat an activist majority of his board would not accept the increase. He wasin the middle.

C. S. Hamlin reports in his diary that Young was furious at not havingbeen consulted by New York for his approval and that he wanted to orderthe rate suspended. Platt said that would seem like a slap in the face; that

Governor Young said that was what he wanted.Young thought Harrisonhad not treated him courteously. Pent up emotions were being released.Harrison received the blasts that were intended for Benjamin Strong butwere never delivered.

Hamlin writes that the board tried unsuccessfully to find a regulationthat showed New York had acted illegally. Miller thought a new regulationwas needed that henceforth all acceptance rates must be appr

Documents

Beating the Bear - Lessons From the 1929 Crash Applied to Today's World