Economics and The Public Welfare

Chapter 24

The Consequences of the Cheap Money Policy in the United States Down to the Summer of 1927

Eleven and a Half Billion Dollars Unneeded Expansion of Bank Credit in Five Years. Bank credit expansion had moved far in the United States between June 30, 1922, and June 30, 1927. For the commercial banks of the United States, State and national banks, and trust companies, there had been an expansion between these dates—both in deposits on the liability side of the balance sheet, and in loans and investments on the asset side of the balance sheet—of not less than $11,500,000,000. This expansion of bank credit was not needed by commerce, and commerce did not take it. Commercial loans were, in fact, decreasing after 1924. The figure for “all other loans and discounts” includes the commercial loans, but it also includes installment finance paper. Even so, the figure for “all other loans” was slightly smaller on June 30, 1927, than on the same date in 1921, 1923, and 1926 (all member banks).

Went Into Real Estate Mortgages. Unneeded by commerce, the rapidly expanding bank credit went into capital uses and speculative uses. It went into real estate mortgage loans on a great scale. For the member banks of the Federal Reserve System, real estate mortgage loans stood at $460,000,000 in 1918. This figure had risen to approximately $3,000,000,000 by the middle of 1927, an ominous increase in illiquid assets.

And Installment Finance Paper. There was, moreover, a great increase in installment finance paper, and by 1927 installment finance paper had become a source of a great deal of concern to the banking community. The terms and conditions were relaxing. Maturities were stretching from twelve to eighteen months, and finance companies were multiplying. It must be said that, in the final day of reckoning, installment finance paper made very little trouble; but this is because the bankers grew alarmed about it in 1926, and insisted on some radical reforms, which included the strengthening of the capital structure of the finance companies and the shortening of maturities. The bank credit men did a good job on this, and the major finance companies cooperated well.

And Security Loans and Bond Investments. The most startling increase, however, in the assets of the banks was in bank investments in bonds and in collateral loans against stocks and bonds.

All Reporting Member Banks (In billions of dollars)
	Total demand, time and U. S. Government deposits	Investments in securities		Loans against securities	Loans against securities plus investments in securities	All other loans and discounts
End of June		U. S. Government	Other
1922	14.70	2.060	2.158	3.909	8.127	7.115
1923	15.40	2.555	1.968	4.157	8.680	7.748
1924	16.27	2.306	2.260	4.310	8.876	7.939
1925	18.13	2.611	2.655	5.289	10.555	8.085
1926	18.90	2.577	2.785	5.693	11.055	8.541
1927	19.72	2.591	3.067	6.220	11.878	8.628

Declining Liquidity of Banks. The changing character of bank assets had, as a necessary concomitant, a great decline in the percentage of paper eligible for rediscount with the Federal Reserve banks in the assets of the banks, as shown by the table on page 176.

The figures in the table are for National banks only. Comparable figures for all the banks of the Federal Reserve System, for all these dates, are not available, but for the single date June 30, 1926, the Federal Reserve authorities made the following statement:

“Of the total loans and investments of all member banks on June 30th, 1926, 16 per cent was eligible for rediscount at the reserve banks, and this proportion was 18 per cent for national banks and about 12 per cent for nonnational member banks.” 1

The significance of these figures at the time seemed ominous. The great crisis of 1920-1921 was primarily a crisis in commerce and industry, and in the course of the crisis customers who needed loans were able to supply the banks with paper which was available for rediscount at Federal Reserve banks. This circumstance made it far easier for the banks to extend additional accommodation and ease the strain of readjustment. The next crisis, however, seemed more likely to come in installment finance, in real estate, and, above all, in stocks and bonds. And none of these could supply paper eligible for rediscount at the Federal Reserve banks. It was, therefore, of first importance that the banks, in getting ready for a major trouble, should concern themselves with improving their liquidity, increasing as far as possible the percentage of paper which would be eligible at the Federal Reserve banks, and, also as far as possible, increasing their holdings of Government securities which the Federal Reserve banks could lawfully lend against.

National Banks—Paper Eligible for Rediscount * (Figures as of June 30)
		Percentage of eligible paper to total loans and discounts	Percentage of eligible paper plus U. S. securities to total loans, discounts, and investments
United States	1923	30.16	37.05
	1925	26.93	32.33
	1926	26.06	30.98
New York City	1923	25.49	38.62
	1925	21.03	31.97
	1926	19.71	30.32
Chicago	1923	36.47	40.50
	1925	30.11	33.50
	1926	27.33	31.38
Boston	1923	32.53	35.61
	1925	12.50	17.26
	1926	21.00	27.05
Reserve cities (excluding New York and Chicago)	1923	31.43	39.18
	1925	26.55	33.53
	1926	26.16	32.49
All reserve cities	1923	30.11	39.11
	1925	25.16	33.01
	1926	24.20	31.69
All country banks	1923	30.21	35.07
	1925	28.91	31.63
	1926	28.16	30.27
Country banks in New York State	1923	31.07	31.59
	1925	30.39	26.95
	1926	27.70	24.22

* Chase Economic Bulletin, Apr. 8, 1927, p. 19.

There had been a great deal of concern about this trend among thoughtful bankers. Mr. Breckinridge Jones, President of the Mississippi Valley Trust Company of St. Louis, and a member of the Federal Advisory Council, was particularly active in urging the matter both upon the Federal Reserve authorities and upon individual banks. The Boston bankers, too, had been alarmed at the sharp decline in their own percentage in 1925, as shown by the table above, and had already taken steps to improve their position, as shown by the figures for 1926.

Rapid Rise in Stock Prices. Along with the growing holdings of securities by banks and the growth in collateral loans against securities had come a great rise in the stock market. The monthly average of Standard & Poor’s industrial common stocks index, which had stood at 44.4 in June of 1921 and at 59.4 in June of 1922, had risen to 103.4 by June of 1927. Their railroad common stocks index, which stood at 156 in June of 1921 and at 189.2 in June of 1922, had risen to 316.2 by June of 1927. The public utility common stocks index, standing at 66.6 in June of 1921 and at 82 in June of 1922, had risen to 135.1 by June of 1927.

Stock prices were already high in the summer of 1927. There was an unhealthy tone. There was a growing belief that stocks, though high, were going much higher. There was an increasing readiness to use cheap money in stock speculation. The situation was still manageable. The intoxication was manifest, not so much in violent behavior as in slightly heightened color and increasing loquacity. The delirium was yet to come. It was waiting for another great dose of the intoxicant.

Great Increase in Security Issues. Moving concomitantly with the bank expansion and the rising stock prices was a great increase in new security issues. The following table is based on the annual securities summaries of the Commercial & Financial Chronicle.

Public Issues of Securities in United States (Refunding Excluded) (Millions of dollars)
1922	4,304
1923	4,304
1924	5,593
1925	6,220
1926	6,344
1927	7,791
1928	8,114
1929	10,195

Growth of Foreign Security Issues. As part and parcel of this issue of new securities, and of strategic importance in connection with it, was the growth of foreign securities placed in the United States. This was significant (a) in getting out the exports of farm products, and (b) in building up the foreign holdings of deposits in American banks, which facilitated the growth of the gold exchange standard as distinguished from the gold standard discussed in an earlier chapter.

Our position in 1927 was thus an unwholesome and a precarious one. We were busy and active, we were making money, there was little unemployment. But we were going ahead despite a fundamental disequilibrium, namely, the weakness of the farmers and the producers of raw materials in the absence of satisfactory export trade. We were temporarily providing them with the export trade by increasing the volume of foreign loans, but we had tariffs so high that export trade would suffer immediately if the foreign loans ceased, and we were making the foreign loans primarily because we were expanding bank credit. The table on page 179 shows the relation between exports, imports, export balance, and foreign loans.

It is to be observed in connection with this financing of the export trade by means of foreign loans that an ever increasing volume of foreign loans was necessary if we were to maintain a given volume of exports and a given export balance. Each year that the foreign loans went on meant that an increasing part of next year’s foreign loans must be used in paying interest on preceding loans, leaving a smaller percentage available for financing exports. The principle of compound interest was against this policy.

Spending Capital Gains. The continuance of the bank expansion for the purpose of making foreign loans was, moreover, bringing about ominously unhealthy conditions in our domestic life, as shown above. Our bank assets were growing illiquid. Speculation in real estate and securities was growing rapidly, and a very considerable part of the supposed income of the people which was sustaining our retail and other markets was coming, not from wages and salaries, rents and royalties, interest and dividends, but rather from capital gains on stocks, bonds, and real estate, which men were treating as ordinary income and spending in increasing degree in luxurious consumption. The time for us to pull up was already overdue. The necessity for reducing our tariffs, so that Europe could send an adequate backflow of manufactured goods to us, was growing at an ominous rate. The dangers of the course we had been pursuing since 1922 were increasingly grave. We could prolong it for a time by further bank expansion and by further cheap money policies, but only at the cost of creating a desperately difficult situation at a later time.2

American Exports, Imports, and Foreign Loans (000,000 omitted)
	Exports	Imports	Excess of exports	New foreign security issues
1922	3.832	3,113	719	630
1923	4,168	3,792	376	267
1924	4,591	3,610	981	1,047
1925	4,910	4,227	683	1,078
1926	4,808	4,431	377	1,145
1927	4,865	4,185	680	1,562
1928	5,128	4,091	1,037	1,319
1929	5,241	4,399	842	759
1930	3,843	3,061	782	1,010
1931	2,424	2,091	333	255
1932*	1,189	1,015	174	0

* First nine months.

• 1This point will be discussed at length in Chap. 34.
• 2I have not been able to find that this article was ever published. However, the reader will find much of it in two books by Veblen: Imperial Germany and the Industrial Revolution, New York, 1915; and The Nature of Peace and the Terms of Its Perpetuation, New York, 1917.