The View From 1776

A great many economic conditions, as well as the structure of the financial markets, are different from those of the 1920s.  Not all of the differences, however, are reassuring.

Recent news reports tell us that banks’ reserves against risky loans such as sub-prime mortgages are at low points.  Money is pouring into hedge funds and private equity groups.  The massive prevalence of derivative securities in portfolios of pension funds, insurance companies, and commercial banks is worrisome.  In 1998, the cratering of Greenwich’s Long Term Capital Management, because of unanticipated consequences of its derivatives investments, threatened to sink the international financial markets.

The first broad parallel to the 1920s is the excessive creation of bank credit by the Federal Reserve.  For details on the events of the 1920s, the best sources are Benjamin M. Anderson’s Economics and the Public Welfare and Murray Rothbard’s America’s Great Depression.

With the elimination of the gold standard in 1933 and the expansion of Federal programs financed by the Fed’s perennial unlimited creation of fiat currency, we have since then suffered from an excessive money supply and the resulting distortions of inflation, today on a much greater scale than in the 1920s.

From 1922 to 1928, the Federal Reserve created an immoderate growth in commercial bank reserves, via open-market purchases of Treasury securities.  The purpose was to provide bank funds for floating loans in the New York market to European governments to finance their imports of American farm products and machinery and equipment to rebuild cities and industries destroyed in World War I.  The results domestically were similar to the dot.com boom of the 1990s, when companies with no operating history could rake in a couple of billion dollars of equity capital on the promise of sales.

In both eras, there was an over-expansion of investment in plant and equipment, increasing production capacities far in excess of stable domestic demand.  The 1990s, for example, produced enough fiber optic cable installations to serve the market ten times over.  In the 1920s, machinery manufacturers invested heavily in new production facilities and farmers went heavily into debt to buy land and farm equipment for the European export market.

The Fed’s over-expansion of credit by 1927 led to a speculative surge of purchases in the stock market.  Banks, particularly those outside New York City, also began to invest in real estate mortgage loans and installment-sales paper, both highly illiquid.  This meant that when the crunch came, most banks around the country would find themselves in a squeeze attempting to liquidate loans against farms, manufacturing plants, real estate, and long-term consumer loans.  When liquidity was needed in 1928 and 1929 for banks to finance legitimate business needs, it was in short supply.

Alarmed by the rise of unsound bank loans, the Fed abruptly reversed direction and squeezed the money supply after 1927.  Farmers and equipment manufacturers suffered when European governments were suddenly no longer able to float loans in New York to finance continued imports from the United States.  Between 1928 and 1929, the dollar amount of foreign government loans floated in New York dropped roughly 50 percent.

Deteriorating business and farm conditions that followed efforts to reduce production to the level of domestic demand alone, coupled with the rise in bank loans on mortgages, long term bonds, and consumer installment paper, set the stage for the celebrated stock market crash of 1929.

Today, need we say, the financial community is sliding along the same sort of path, with the explosion of second-mortgage home-equity loans and a tidal wave of credit card debt to anyone who can sign his name to a piece of paper, along with burgeoning acquisitions of derivative securities.

The second broad parallel between today and the 1920s is the rise of protectionist sentiment. 

In 1930 the Fed increased its volume of open market purchases of Treasury securities in order to provide banks with more lendable funds.  But the damage was already great enough to lead to an economic recession of some degree of severity.  The coup de grace was administered by Congress’s passage of the Smoot-Hawley tariff act in 1930, ill-advisedly intended to raise import prices and encourage exports.

Instead, the act plunged the whole Western world into recession, as one nation after the other countered by raising its own tariffs against American exports.  European nations could no longer repay the loans floated in New York during the 1920s, because they could no longer earn foreign exchange by exporting their products to the United States.  There needed to be two-way trade if the financial markets were to function.

Today, of course, there is a rising level of protectionist sentiment, loudly voiced by pundits and politicians on both sides of the political aisle.  The new Congress, dominated by liberal-socialists, may be expected to lend sympathetic ears to labor union pleas for measures to keep out imports in order to increase domestic jobs and swell union membership rolls.  Such measures are likely again to be self-defeating.

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