Economics and The Public Welfare

Chapter 26

The Stock Market Boom, 1927-1929

Summary of Stock Prices, 1922-1927. Stock prices had responded sharply to the Government security purchases of the Federal Reserve banks in 1922. The level had risen rapidly. With the reversal of Federal Reserve policy in 1923 we had a reactionary year in stock prices. The cheap money policy of 1924 was followed by a further very marked rise in stock prices which carried on through 1925. The spring of 1926 showed an important reaction, and by the end of the year prices were only moderately above the year end of 1925. The first half of 1927 showed a further rise to levels that were already definitely higher, and that suggested caution in conservative financial circles. With the renewal of the Federal Reserve cheap money policy late in the summer of 1927 a sharp acceleration of the upward movement of stock prices began. The following table tells this story.

Standard & Poor’s Industrials (Monthly)—1922-1927
January, 1922	50.2
October, 1922	64.6
June, 1923	57.5
December, 1923	60.7
June, 1924	59.3
December, 1924	70.4
December, 1925	90.7
May, 1926	83.6
December, 1926	95.2
June, 1927	103.4
December, 1927	122.4

New Money Created by Federal Reserve Policy Goes into Stocks. The new credit created by the renewal of cheap money by the Federal Reserve System following the Conference of Governors in 1927 went rapidly into security loans and bank investments in securities. There was a moderate seasonal increase in commercial loans during the autumn of 1927 which, however, was reversed at the year end, but the stock market continued to absorb the excess funds.

Intoxication Begins. At the beginning of the movement in the autumn, the stock market took the money somewhat languidly, tempted by the lower rates. But it took the money and it used it to put stocks rapidly higher. The rising prices themselves generated a psychological boom atmosphere.

Alarmed Reversal of Federal Reserve Policy. Alarmed, the Federal Reserve authorities reversed their policy in the winter of 1927-1928. They sold Government securities. They raised rediscount rates. The New York Federal Reserve Bank, which had reduced its rate to 3 1/2% in August of 1927, raised it to 4% in February, 1928, to 4 1/2% in May, and to 5% in July.

The Government security holdings for the Federal Reserve System were rapidly reduced, dropping from $617,000,000 at the year end, 1927, to $212,000,000 at the end of June, 1928.

Gold 1 also left the country in 1928, the gold monetary stock dropping from $4,379,000,000 at the end of December, 1927, to $4,109,000,000 by June, 1928.

The selling of Government securities and the loss of gold cut into member bank reserves. The banks were forced to rediscount heavily with the Federal Reserve banks. Total rediscounts with the twelve Federal Reserve banks had stood at $423,000,000 on February 1, 1928. The figure rose rapidly to $1,089,000,000 on July 11, 1928.

The increase in rediscounts would not have been as great as it was if the rediscount rate at the Federal Reserve banks had been above the market. But even so the banks were reluctant to rediscount, and did not rediscount enough to replenish their reserve balances completely. Member bank reserve balances stood at $2,405,000,000 on February 1, at $2,365,000,000 on July 11, and at $2,300,000,000 on July 25. With rediscounts above $500,000,000, enough banks were under pressure so that money rates stiffened, and with a decline of $100,000,000 in member bank reserves, the money market was definitely under pressure. As we have seen before 2 bank expansion virtually ceased around April 11, 1928.

Interest Rates Rise Sharply. Interest rates rose sharply with the reversal of Federal Reserve bank policy.

The call rate on stock exchange loans had been under 4% in October and November, 1927, and following year end firmness had dropped under 4% again in January, 1928. It rose to 5% in April, in June to more than 6%, in September to 7 1/2%, and in early December to 8 1/2%—at the year end to over 10%. The rate for bankers’ acceptances rose in 1928 from 3 1/4% at beginning of the year to 4 1/2% in the second half of the year, while open market commercial paper, which had stood at 4% at the beginning of 1928, went to over 5 1/2% in the second half of the year.

But the Boom Went On. Here was a real restraining influence. The Federal Reserve authorities were using measures which, on the basis of their past experience, should have sufficed to stop the stock market boom, and did suffice to stop the expansion of bank credit. But the boom went on. There was a new factor in the situation. The public had taken the bit in its teeth. The rise in stock market prices and the lure of stock market profits had caught the public imagination. And the change in Federal Reserve policy, designed to restrict the supply of money, met with an overpowering increase in the demand for money. There was a momentary hesitance. The month of February, 1928, was reactionary in the securities markets. And then, despite restraint, the boom was resumed. Brokers’ loans had been taken languidly when interest rates were low in the autumn of 1927. But in 1928 and 1929 eager speculators, desiring brokers’ loans, took them at rapidly rising rates of interest and in greatly increasing volume, bidding eagerly and greedily for them.

Roy Young New Governor of Board. In the early spring of 1928 a visit to the office of the new Governor of the Federal Reserve Board, the Honorable Roy A. Young, just after three o’clock one day, found him standing before the news ticker in his office, laughing. Stocks had had a sharp rise that day, and the news ticker reported the fact. Asked what he was laughing at, he said, “I am laughing at myself sitting here and trying to keep a hundred and twenty-five million people from doing what they want to do.”

Governor Young is one of the ablest men ever to hold office in the Federal Reserve System, and one of the most upright. Before coming to the Governorship of the Federal Board he had been Governor of the Minneapolis Federal Reserve Bank. He had done an exceedingly fine job there. In the crisis of 1920-1921 he had taken the best possible care of small country banks, member banks of his institution. He had saved many country banks by taking paper which, though technically eligible for rediscount, was far from being certainly good—asking at the same time of the other eleven Federal Reserve banks that the Minneapolis Federal Reserve Bank should hold more than its share of the Government securities in the system, so that the income from the Government securities might offset losses from possible bad loans to the small banks. But his judgment in making these loans had been extraordinarily good, and the losses were far fewer than he had prudently provided for. He had won the respect of his fellow Governors in the system by letting them know this, and letting the share of the Minneapolis Federal Reserve Bank in the Government security holdings be reduced. He “played fair” with everybody.

Governor Young, like the Governors of the other interior Federal Reserve banks, had not been fully informed by Governor Benjamin Strong or Governor Crissinger as to the real purpose of the cheap money policy in 1927. It was not until after he became Governor of the Federal Reserve Board on October 4, 1927, that he began really to understand the situation. But he learned fast. He moved with vigor toward restraining the unsound tendencies, and the Federal Reserve System would have moved with much greater vigor had he been able to dominate its policies. He came in, however, after the mischief had been done.

Benjamin Strong Drops Out. Governor Benjamin Strong of the New York Federal Reserve Bank dropped out of the picture, through illness, by the end of 1927. He remained Governor till his death, October 16, 1928, but was too sick to accomplish anything. He was succeeded by George L. Harrison on November 22, 1928. Apologists for Governor Strong’s policies have said repeatedly that if he had remained on the scene and been able to dominate the scene as he did in 1927, he would have stopped the boom early in 1928. They have said that he would have had rediscount rates go to 6% immediately, and would have taken such decisive measures that things would have been thrown into reverse. They have offered this as an excuse for his policy. If it were true that he would have done these things, this still would not have constituted a defense for the 1927 policy. It would merely constitute a recognition of the unsoundness of that policy.

We have given here a general and nontechnical account of Federal Reserve policy and the money market in the autumn of 1927 and in the first half 3 of 1928. The Federal Reserve authorities made a real effort in the first half of that year to hold down the expansion of bank credit and to hold down the growth of brokers’ loans.

President Coolidge on Brokers’ Loans. They had very little help from the President of the United States, Calvin Coolidge. He was asked by newspapermen in early January, 1928, about brokers’ loans. He promised to give them an answer next day. Associated Press advices from Washington January 6, 1928, stated: “President Coolidge is of the opinion that the record-breaking increases in brokers’ loans held by Federal Reserve member banks is not large enough to cause any unfavorable comment.” 4 Bankers in New York were shocked by what he said. The information was that in the twenty-four hour interval he did not consult the Federal Reserve authorities, nor did he consult the Treasury with respect to the matter. One former newspaperman, whom he consulted, reported that he had told the President that he thought brokers’ loans were all right, and took credit for the President’s answer. Coolidge was still being one of the “Capeadores of Wall Street.” 5

New, Strange Counter Forces Offset Federal Reserve Restraints. When the Federal Reserve authorities tried to withdraw funds from the money market, the market found new and strange sources from which to draw funds. So much new money had been created in the period from 1922 to early 1928 that the problem of reabsorbing it and getting it under control was a very difficult one. When a bathtub in the upper part of the house has been overflowing for five minutes, it is not difficult to turn off the water and mop up. But when the bathtub has been overflowing for several years, the walls and the spaces between ceilings and floors have become full of water, and a great deal of work is required to get the house dry. Long after the faucet is turned off, water still comes pouring in from the walls and from the ceilings. It was so in 1928 and 1929. At a price, the speculator could get all the money that he wanted.

Brokers’ Loans “For Account of Others.” One major source from which additional money came was in the so-called brokers’ loans “for account of others.” New York banks had long been accustomed to making loans to the stock market for their own account and for the account of out-of-town banks, with occasional loans made for the account of other customers. These loans for “others” had never, prior to 1927, been large in volume. It would happen in the old days in time of monetary tension when the call rate got very high that a few foresighted men—Russell Sage was one—who had withdrawn from the stock market and who had their holdings in cash, would make loans to brokers against stock and bond collateral when the rate got to 10% and 12%. This was ordinarily a useful service, which helped to relax a tight call loan market at a time of tension or crisis. It had never before been a baleful influence in the situation. In normal times not enough people would have surplus cash to do very much of this. But in 1928 and 1929 this factor rose to undreamed-of volume—not in a time of crisis, but in a boom.

Relax Money Market by Reducing Bank Deposits But Not Bank Reserves. The effect upon the money market of a bank’s making a loan for a customer’s account was definitely to relax the money market. A typical case, and a case which makes the point most clearly, would be the following. A New York bank, instructed by a customer to debit his account and lend a million dollars for his “account and risk” to the stock market, would turn over to the customer a broker’s loan which the bank had already made, with the result that the bank’s balance sheet would go down on both sides. Deposits would be down a million dollars and loans would be down a million dollars. The bank’s cash reserves, however, would remain unchanged. And the ratio of the bank’s reserves to the bank’s remaining deposits would thus be improved. The bank would be in a stronger position to make another loan. The tendency of this operation would be to ease the money market and to make interest rates lower than they would otherwise have been.

A more complex operation with the same result would be as follows. The bank would debit its customer’s account a million dollars and would offer a million dollars at the money desk of the stock exchange, which a broker would borrow. The bank would give the broker a cashier’s check and the bank would receive from the broker his note with acceptable diversified collateral. The note would be in the custody of the bank, but would not be entered in the bank’s own loans. It would belong to the customer. The cashier’s check would be a demand liability of the bank in the general category of deposits, so that the bank’s figures would not yet be reduced on either side of the balance sheet. But the bank, knowing that next day it would have an additional million dollars to meet as the cashier’s check for a million dollars came in against it at the clearing house, would itself call a loan which it had made for its own account to some other broker. When this other broker had paid off his loan and the bank had met its cashier’s check at the clearing house, the bank’s position would be the same as in the first illustration. Its deposits and loans would each be down a million dollars. New repercussions, however, would set in as the broker whose loan was called undertook to replace his money by borrowing somewhere else, but it is not profitable to follow this transaction in detail for present purposes.6

The evidence is clear that, taking the banking system of New York City as a whole, net demand deposits dropped as brokers’ loans “for account of others” rose. Between May 2 and October 10 of 1928 the following five closely related developments took place: (1) a decline in brokers’ loans made by New York banks for their own account of $462,000,000; (2) an increase in loans for account of others of $642,000,000 according to the figures reported by the member banks to the Federal Reserve banks, or of $846,000,000 when the additional loans reported by the New York Stock Exchange are included; (3) a decline in net demand deposits for the member banks of the Federal Reserve System of $749,000,000, of which $590,000,000 was in New York City alone; (4) a decline in the legal reserves of the member banks of the Federal Reserve System of $129,000,000; and (5) a sharp tightening of interest rates, though not nearly so great a tightening as would have taken place with this decline in reserves had the net demand deposits not gone down. The reader will find the evidence on this point abundantly presented in “Brokers’ Loans and Bank Credit.” 7

The Source of Brokers’ Loans “For Account of Others.” In no previous period of our history had there been any great volume of outside funds available for lending in this way, but here in 1928 and 1929 we find the rising interest rates calling in incredible sums, which rose to over 5 1/2 billion 8 dollars at the peak of 1929. Where did this money come from? What was its origin and source? The answer is to be found in the volume of bank credit which had previously been created and which, unneeded for ordinary purposes, had remained idle in bank deposits.

Business corporations, putting out new stocks at high prices, had accumulated funds far in excess of their needs and were holding them idle as deposits with their banks. The money had come to them from the stock market on a 2% or 3% stock yield basis, and when the stock market in turn was ready to pay 7%, 8%, and 10% for their money, they loaned it back to the stock market. It came originally, not from investors’ savings, but from bank expansion, as we have seen.

Foreigners, overborrowing in the United States, had accumulated vast sums of idle money, which they carried in bank deposits, as well as in other highly liquid forms. When the call loan rate went high enough, they put this money into call loans. See table p. 192.

Well-to-do investors, who had sold securities at high prices and withdrawn from the market, had idle cash on a great scale which they expected to use again in buying securities when the prices once more suited them, but which, meanwhile, they were glad to lend at 7% to 10% to the stock market speculators on well-secured loans, carefully watched as to adequacy of margin and diversity of collateral by the skillful loan clerks of the great banks. The water poured out of the walls, pulled by the suction pump of rising interest rates.

New Bank Stock Issues Ease Money Market. Another very substantial factor in reducing the pressure on the bank reserves and making possible a greater expansion of credit than would otherwise have taken place was in the fact that the banks themselves, on a great scale, took advantage of the rising prices of stocks to issue new bank stocks at high prices. The effect of this on the banking system as a whole was a decline in deposits on the liability side of the bank’s balance sheet, and a rise in capital and surplus on the liability side of the bank’s balance sheet. There was a substitution of capital liabilities to stockholders for liabilities to depositors. Individual banks issuing new stock might get in additional cash, if their subscribers were not confined to their own depositors. But the banking system as a whole could not get any new cash from a new stock issue, except in the rare case where the new stock was paid for with hoarded currency. The issue of new bank stocks in 1928 and 1929 was very substantial in the aggregate. Between June 30, 1927, and December 31, 1929, the capital of the member banks of the Federal Reserve System increased from $2,274,000,000 to $2,757,000,000, while their surplus increased from $2,030,000,000 to $2,865,000,000. The aggregate increase in capital and surplus was $1,318,000,000, or 30.6%. Not all of this increase, of course, came from new stock issues. Part was profits turned back to surplus. But the greater part came from new bank stock issues. It will be observed in the figures that the increase in surplus in this process was greater than the increase in capital. The reason is very simple. A bank whose stock had a par of $100, but was selling in the market at $700, would offer its stockholders the right to subscribe for a new issue at $500. This was a valuable right. The stockholder might exercise the right or he might sell it. But in any case, the right was too valuable to remain unexercised. The bank would get $500 for the new share. In the subsequent adjustment of the bank’s books, however, capital would be credited with $100 per share, and surplus would be credited with $400 per share. Surplus would increase in this case four times as much as capital. The sale of new bank stocks on this scale during this period held down the rise in demand deposits very substantially, held down the reserve requirements of the banks, and operated to lessen tension in the money market.

Street Loans, Daily Reporting Banks, New York City (In millions of dollars)
Date	Total	For own account	For correspondents *
June 25, 1924	1,478	869	609
June 24, 1925	2,237	1,063	1,175

Brokers’ Loans, Weekly Reporting Banks, New York City (In millions of dollars)
Date	Total	For own account	For out-of-town banks *	For others
Jan. 6, 1926	3,141	1,338	1,239	564
Aug. 31, 1927	3,184	1,046	1,223	915
Dec. 28, 1927	3,718	1,374	1,338	1,006
Mar. 28, 1928	3,825	1,121	1,427	1,278
Aug. 29, 1928	4,235	793	1,535	1,907
Dec. 26, 1928	5,091	1,109	1,660	2,322
Mar. 20, 1929	5,793	1,091	1,768	2,934
Aug. 21, 1929	6,085	926	1,787	3,372
Oct. 9, 1929	6,713	973	1,799	3,941
Oct. 23, 1929	6,634	1,077	1,733	3,823
Oct. 30, 1929	5,538	2,069	1,005	2,464
Nov. 27, 1929	3,450	831	638	1,982
Dec. 31, 1929	3,424	1,167	709	1,548
June 4, 1930	4,101	1,911	995	1,195
Dec. 31, 1930	1,926	1,321	235	370
Dec. 30, 1931	591	544	41	6
July 27, 1932	331	306	17	8

* Figures prior to 1926 are for daily reporting banks. Those beginning with 1926 are for weekly reporting member banks. The difference between the two series on January 6, 1926, is moderate. The daily reporting member banks report $2,908,000,000 and the weekly reporting banks report $3,141,000,000, a difference of $233,000,000. See Banking and Monetary Statistics, Board of Governors, Federal Reserve System, 1933, pp. 496-499. The figures for June 25, 1924, and for June 24, 1925, lump the loans made for out-of-town banks and for others in one figure under the general caption of “for correspondents.” Figures beginning with 1926 separate “out-of-town banks” and “others.”

High Interest Rates Pull Money in Circulation into Bank Reserves. A third factor which operated to interfere with the Federal Reserve System’s policy of restraint was a decline in money in circulation of 110 million dollars (daily average) which took place in 1928 as compared with 1927. This made a corresponding addition to member bank reserves. The cause was the very high rates of interest, which meant that individual banks would find inducement to reduce their vault cash, and that merchants would carry slightly less till money. The figure for money in circulation included the vault cash of member banks, which, since the Federal Reserve System had come in, did not count as legal reserves for member banks of the Federal Reserve System.

Substitution of Acceptance Credits for Straight Loans Lessens Pressure. A fourth factor lessening tension in the 1928-1929 money market was the substitution of acceptance credits for straight “line of credit” commercial loans, on a very substantial scale, by the banks.9 When banks make straight loans to customers there is a corresponding increase in bank deposits, and in reserve requirements. But when a customer takes an acceptance credit from a bank, he gets merely the bank’s assumption of responsibility for the debt when it is due, and the bank does not give him a deposit credit. The money his creditor gets is obtained through selling the bank acceptance in the open market.

Because Federal Reserve Banks Chief Market for Acceptances. In the well-established acceptance market of London, acceptances are bought by very many people, but especially by banks, or by discount houses which borrow from banks to carry the acceptances. In the American acceptance market, however, as it existed in 1928-1929, the Federal Reserve System had itself become the primary market for acceptances. The Federal Reserve banks had made a “baby” of the acceptance market, had fostered it, had made acceptance rates artificially low in an effort to build it up, and therefore had succeeded in making a parasite of it.

The market for acceptances was the Federal Reserve banks primarily, and certain foreign banks which bought acceptances, often with Federal Reserve bank guaranty.

Federal Reserve Acceptance Buying Breaks Rate on Brokers’ Loans, Late 1928. The rise of the acceptance rate in 1928 forced the Federal Reserve banks either to abandon their baby or to buy far more acceptances than they wished to buy. They bought the acceptances, which meant increased Federal Reserve credit to the money market and additions to member bank reserves. Acceptance credits thus eased the money market, where straight bank loans would have tightened it. The New York Federal Reserve Bank made a protest about this. But their acceptance policy pulled down the acceptance rate from 4.63% in August, 1928, to 4.50% for the rest of the year; and the call loan renewal rate, which had averaged 7.26% in September, dropped to 6.98% in October, and to 6.67% in November.

Enormous Volume of New Securities—Domestic and Foreign. Through 1928 and 1929 to the October crash, the volume of new securities grew at an enormous pace, as shown by our table on page 178.

Foreign securities during this same period increased very rapidly in 1927 and remained high in 1928, but dropped off sharply in 1929, as shown by the following table:

Foreign Securities Publicly Placed in United States (Refunding Excluded)* (Millions of dollars)
1922	631
1923	267
1924	997
1925	1,086
1926	1,145
1927	1,561
1928	1,319
1929	758

* Chase Economic Bulletin, Mar. 14, 1930, p. 8.

Notice the extraordinary bulge for the two years 1927 and 1928. But these calendar year figures do not tell the story adequately. In the twelve-month period from June 30, 1927, to June 30, 1928, we took approximately $1,800,000,000 worth of new securities. These are the Commercial & Financial Chronicle’s figures for publicly placed issues. They do not include investments privately made, or funds placed by American businesses in their own plants abroad, or purchases made by Americans in European stock markets.

Fantastic Rise in Stock Prices, 1928-1929. These new issues were in response to the rapidly rising prices of securities. The stock market rose by leaps and bounds, as shown by the following tables:

Dow-Jones Industrials
Date	High	Low	Close
November 15, 1922	........	........	95.11
January 10, 1924	........	........	97.23
November 10, 1924	........	........	105.91
November 15, 1927	........	........	195.37
February 15, 1928	........	........	197.59
November 15, 1928	271.63	266.48	269.42
August 29, 1929	378.76	370.79	376.18

Standard & Poor’s Common Stocks (Monthly) (Average of closing prices one day each week)
Date	Industrials	Rails	Public utilities
June, 1921	44.4	156.0	66.6
June, 1927	103.4	316.2	135.1
January, 1928	124.1	332.4	151.3
December, 1928	161.1	357.9	202.6
June, 1929	172.5	384.1	272.2
September, 1929	195.2	446.0	375.1

The reader will notice that as our own stock market rose progressively to fantastic heights in 1929, the volume of foreign issues fell off rapidly. We ceased to be interested in anything except stocks that would rise five or ten points in a week. We ceased to be interested in bonds.

Early in 1942 a Swiss banker in New York said that he could not understand his American friends. They had thought that he was very foolish in 1929 because he was not willing to borrow money at 8% in order to buy stocks yielding 2%, and in early 1942 they thought he was very foolish because he wanted to borrow money at 2% to buy stocks yielding 8%.

• 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.
• 3See my book The Effects of the War on Money, Credit and Banking in France and the United States, published by the Carnegie Endowment for International Peace, Oxford University Press, New York, 1919. For London, see the interesting articles by Mr. J. M. Keynes in the British Economic Journal in late 1914.
• 4O. M. W. Sprague: “Crisis of 1914 in the United States,” American Economic Review, September, 1915; H. G. S. Noble: “The New York Stock Exchange in the Crisis of 1914,” Garden City, N. Y., Country Life Press, 1915. These two papers are classics of permanent value.
• 5The figures of all the State and National banks and trust companies appear only once a year in the Comptroller’s report as of approximately June 30. For dates other than June 30, it is necessary to make estimates. During the war period these estimates are made on the basis of variation in the National Bank figures.
• 6War Industries Board Price Bulletin No. 3, Government Control Over Prices, by Paul Willard Garrett, assisted by Isador Lubin and Stella Stewart, Washington, Government Printing Office, 1920, p. 550.
• 7Mr. Herbert Hoover, in particular, did a superb job in bringing the grain and milling interests into the service of the country. I shall later find occasion to criticize his policies as President, but I wish to pay high tribute to his work in feeding the Belgians before we entered the war, to his work in food control at home during the war, to his postwar work in feeding stricken countries, and to his work under President Truman along similar lines after World War II.
• 8See my “Value and Price Theory in Relation to Price-fixing and War Finance,” an address before the American Economic Association, printed in papers and proceedings, American Economic Review Supplement, March, 1918. Reprinted in the Economic Bulletin issued by the Capital Research Company of Los Angeles, Vol. II, No. 2, Dec. 6, 1940, and reprinted in the hearings of the Senate Committee on Banking and Currency on the Price Control Bill Dec. 16, 1941. See also my testimony of Dec. 16, 1941, before this Committee.
• 9“An Index Number of Production,” American Economic Association, Dec., 1920, published in Papers and Proceedings the following March.