The View From 1776

An exceptionally clear and insightful analysis of the precipitating and sustaining causes of the twelve-year-long Great Depression is to be found in Banking and the Business Cycle: A Study of the Great Depression in the United States. Published in 1937, this book provides a wealth of statistics and quotations from Federal Reserve officials, bankers, and economists of that era.  It can be obtained from the Ludwig von Mises Institute via its website.

At the end of World War I, when the Federal Reserve System was only five years old, the Fed decided to prevent prices across the economy from falling back to the levels prevailing before the war.  To do so, the Fed pumped so much money into the economy via the banks that total bank lendable deposits more than doubled in the six years from 1914 to 1920.  To make the perspective clearer, the Fed pumped more lendable funds into the banking system in six years than had been created in the prior 131 years since the ratification of the Constitution.

With lendable funds far in excess of the needs of business to finance inventories, receivables, and other normal day-to-day business activities, banks began to do the same sorts of things that they were to do 80 years later in the housing and subprime mortgage bubble.  They used low cost, easy money to invest in assets that were outside the normal range of traditional, prudent banking.  While business financing needs remained fairly steady in the 1920s, banks began to employ the excess lendable funds created by the Fed to purchase corporate bonds, ramp up stock market call loans which facilitated issuance of new stock issues, and to finance real estate expansion.  They also began to finance the new category of consumer installment loans, the 1920s version of credit cards.

These asset categories were relatively illiquid, compared to self-liquidating loans on inventories and receivables, which normally turned over in 90 to 180 days.  Just as in the recent decade, when banks became increasingly illiquid with ballooning amounts of high-risk assets, banks, by 1929, were in poor shape to weather the wave of defaults on real estate, stock market call loans, and corporate bonds.

These increased investments in bonds, stock market call loans, and real estate had exactly the same effect on business activity as did the expansion of credit that led to our current financial meltdown.  With massive amounts of money available at low interest rates via the bond and stock markets, businesses investment to increase output capacity surged throughout the 1920s, as did real estate development.  In other words, just as the Fed’s creation of fiat money made possible the dot.com bubble and burst, as well as the current over-expansion of home-building and over-investment in subprime mortgages and collateralized debt obligations, so too did it create the conditions for the 1929 stock market crash.

When the Fed finally took steps in 1928 and 1929 to rein in the money supply, it was too late.  The sharp increase in interest rates accruing from the Fed’s reduction in the money supply increased business operating costs and made too many cheap-money, long-term business investments no longer profitable.  As stock market call loans terms and conditions tightened, stock prices began to decline, precipitating margin calls and dumping of stocks on the market.  Black Tuesday, October 29, 1929, was the culmination.  The Dow Jones Industrials index dropped more than 22%, and the Depression was underway.

Unfortunately, the lesson of the 1920s and of more recent periods has not been learned by the Fed or the Treasury.  Read Charles Gasparino’s op-ed article in the Wall Street Journal for a useful overview of the Fed’s continuing to feed our addiction for easy money with ever more easy money, along with government guarantees, directives, and bailouts.