Economics and The Public Welfare

Chapter 29

The “New Era,” and the Precautions of the Commercial Banks in New York

The New York Times stock market average for twenty-five rails and twenty-five industrials reached a low of 58.35 on June 21, 1921, and the closing price for 1921 was 68.50. For 1923 the closing price was 84.15. With the great upswing created by the cheap money policy of 1924, this rose to 106.92 by the year end 1924, to 137.46 by the year end 1925, and to 139.53 by the year end 1926. The year end figures of 1926 looked pretty high, but had many reasonable defenders who would point to substantial corporate profits for their justification. But 1927-1928 and 1929 made these 1926 figures look conservative indeed. The stock market moved without impressive reactions to the fantastic high of 311 in September of 1929.

Spéculative Slogans and Theories. Every era of speculation brings forth a crop of theories designed to justify the speculation, and speculative slogans are easily seized upon. The term “new era” was the slogan for the 1927-1929 period. We were in a new era in which old economic laws were suspended.1

Cassel and Fisher. We were troubled also in 1928-1929 by the weird doctrine of Professor Gustav Cassel of Sweden (who had many American followers as well as wide vogue in Europe) that it was the business of central banks to maintain a fixed commodity price level, and that central banks must not concern themselves with the stock market and must not tighten credit to restrain stock market excesses because that would reduce commodity prices. Professor Cassel even maintained that not enough credit was being supplied by the Federal Reserve System because there had been a decline in commodity prices between 1925 and 1927. Professor Cassel, moreover, maintained the remarkable doctrine that an increase in stock exchange loans does not raise rates of interest or withdraw money from other uses.2

We were told, moreover, by Professor Irving Fisher that we were on a “higher plateau” of stock exchange prices.3 This was strongly reminiscent of Professor Fisher’s defense of the commodity price level of 1919-1920.

Industrial Consolidations for Stock Market Purposes. The new era of 1924-1929, like the earlier new era of 1896-1903, was characterized by a great consolidation movement. The alleged “inevitable tendency toward monopoly” in American business has been largely confined to these two “new eras.” It has not been due to technological or industrial reasons, but rather has been due to the ease with which new securities can be issued when money is excessive and stocks are rising—which makes it easy and profitable to organize holding companies and buy out competing concerns. There have been, in fact, only two great periods of consolidation in our history, the three-year period 1899-1902, and the five-year period 1924-1929. Both were periods of cheap money and excited stock markets.4 There were, in fact, a great many consolidations in the years 1924-1929.

Bank Consolidations in an Era of Speculation. The movement ran far beyond industrial consolidations. Bank consolidation moved rapidly and branch banking was expanded with great rapidity, particularly in California. In certain States where branch banking was not permitted, or was permitted only within narrow limits, the consolidation movement took the form of bank holding companies, the stocks of which rose to fantastic levels and which pulled up bank stocks with them as they were exchanged for bank stocks. One of the most conspicuous and dangerous of these developments was in Detroit. Minneapolis was also a center, and the movement was found in other parts of the country. In New York City itself the development was chiefly in outright consolidations with an interchange of stocks, and without the necessity for elaborate public security offerings.5

Bank consolidations, carefully considered, are often wholesome and beneficial, but the activities of promoters in throwing together a great many banks, as an incident to an excited stock market, were clearly unwholesome and dangerous.

Investment Trusts, 1928-1929. Another development of the period was the rapid multiplication and rapid growth of investment trusts. The investment trust idea is good in itself, and investment trusts in England and Scotland had had a long and honorable history. Investment trust management in the United States following 1932 has been, on the whole, highly creditable. But the mushroom growth of institutions of this kind in a financial atmosphere such as obtained in 1928-1929 was bound to bring a great deal of grief and humiliation. In the best of times the problem of investing funds prudently and wisely is difficult, and calls for exceptional experience, exceptional prudence, and exceptional brains. Investment trusts organized in 1928, and above all in 1929, if they used their stockholders’ funds at all in investments other than Government bonds, were foredoomed to incur heavy losses. Very many of the investment trusts organized during this period did make the best stock investments that could have been made, but the best were not good enough. In some conspicuous cases, however, their policies were not conservative, even by 1929 standards. The most conspicuous was doubtless the Goldman Sachs Trading Corporation which, with its two subsidiaries, Shenandoah and Blue Ridge, went through the sky like a blazing meteor for a time.6

We had the curious phenomenon that some of the investment trusts were buying shares of other investment trusts, as illustrating the difficulties of investment policy. This curious type of transaction became a definite pathology in certain cases in 1929, when the stocks of investment trust “A” rose because investment trust “B” was buying its shares, while the stock of the investment trust “B” rose because the investment trust “A” was buying its shares. This is an easy way to put stock prices up in an uncritical market, and it gives a brave semblance of success and prosperity for a limited time.

The most fortunate of the great investment trusts was probably the Lehman Corporation, which was organized so late in 1929 that its management was definitely afraid of the stock market, and was able to come into the crash with its capital all in cash.

Investment Banks Lost Perspective. The speculators lost their heads. To too great an extent, the investment bankers did. American investment banking had had a long and honorable record. Investment banks had been for decades intermediaries between the railroads and the industrial corporations, on the one hand, and the investing public, on the other. They had underwritten billions of dollars worth of securities, which had placed billions of dollars from the American investing public into sound and profitable uses in building up the railroads and industries of the country. They had been critical of the credits they extended. They had insisted upon sound policies on the part of the corporations for which they were obtaining investors’ funds. They had been concerned about their reputations. They tried hard not to put out unsound issues, if only because they wished to be able to sell other issues in later years to the same investors. They had done their work well. But with the great flood of cheap money, and with insatiable demand for stocks and bonds, their perspective and their credit standard began to relax as early as 1925. And with the renewal of cheap money in 1927 perspective was badly lost and credit standards suffered a great deal.

Commercial Bankers in New York City Kept Perspective, in General. The commercial bankers in New York City, on the other hand, did not as commercial bankers lose their heads. Many country bankers, with excess funds even at crop-moving time, did load up with real estate mortgages and high yield bonds. But the great banks tried to keep liquid. There was one conspicuous mushroom bank in New York City, the Bank of United States, which departed to an incredible degree from sound commercial bank practices, with the result that the bank later crashed and certain of its officials went to prison. But in general the commercial banks in New York were alert to the dangers and were afraid of the boom.

Charles E. Mitchell’s Alleged Defiance of Federal Reserve Warning. There was one conspicuous exception among the heads of the great banks of New York in Charles E. Mitchell, head of the National City Bank. Mitchell was a conspicuous bull leader throughout the boom.

On March 26, 1929, the call loan rate had risen to 20% and threatened to go higher. Several of the New York City banks, including the National City Bank, had thereupon rediscounted at the Federal Reserve Bank to get additional funds to lend on call in order to prevent a strangulation rate. None of the other banks said anything about it. But Mr. Mitchell gave out the following statement: “So far as this institution is concerned, we feel that we have an obligation which is paramount to any Federal Reserve warning, or anything else, to avert, so far as lies in our power, any dangerous crisis in the money market. . . .” 7 This was an unfortunate utterance which made Mr. Mitchell a great deal of trouble later, particularly as it angered Senator Carter Glass of Virginia and led him to remorseless investigation of Mr. Mitchell’s activities as a whole. It was, moreover, a misleading statement. There had been no defiance of the Federal Reserve authorities. On the contrary, the New York City banks acted in harmony with the Federal Reserve System. The facts were the following: the Governor of the New York Federal Reserve Bank phoned the Governor of the Federal Reserve Board to report to him what had happened. When the call loan rate went to 20%, several of the banks of the city called up the Governor of the Federal Reserve Bank to inquire if it were the wish of the Federal Reserve Bank that they should rediscount—not to make a low call rate, but to prevent the rate from going to a very high figure—as the Federal Reserve Bank had requested them to do at the preceding year end. The Governor of the New York Federal Reserve Bank reported that he had told the New York bankers that they were closer to the money market than he was, and that if in their judgment it was the best thing to do, the Federal Reserve Bank was at their service. Thereupon several of the New York banks did rediscount and did make additional loans on call to the Stock Exchange houses. The Governor inquired if the Federal Reserve Board approved of what he had done. The Governor of the Federal Reserve Board immediately called a meeting of the Board and reported what the Governor of the New York Federal Reserve Bank had told him. The Board sat less than five minutes and approved what the New York Federal Reserve Bank had done. There was no defiance of the Federal Reserve authorities. But Mr. Mitchell’s utterance was unfortunate as suggesting to the public that the great New York banks were behind the boom, when most of them were gravely concerned about it, and when most of them in the action they took that day were concerned merely with preventing a money market crisis.

It is proper to add that Mr. Mitchell’s own bank, as a bank, did not, in its lending policy, follow his bullish enthusiasm. The vice-presidents and managing staff of the bank took the same conservative measures that the other great New York banks were taking in getting ready for the stock market crash. And the National City Bank performed very well indeed when the stock market crash came.

Special New York Clearing House Committee, 1928. The great commercial banks of New York were in general troubled by the renewal of cheap money in 1927. By the summer of 1928, the Clearing House was troubled. A committee of the Clearing House was organized, some thirteen months before the grand smash, to provide for a system of weekly reports by every bank in the Clearing House to the Clearing House, showing in detail the extent of its liquidity and the extent of its illiquid assets. No more searching questionnaire was ever provided for bankers than those which the New York Clearing House banks had answered every week, from the time this committee completed its work until the time when the great crash came. The questionnaire put every bank in the Clearing House on notice, and it had a very real influence in bringing about house-cleaning where housecleaning was needed.

Increased Margin Requirements and Reduced Loan Values—Diversification of Collateral. The banks, too, inaugurated the policy of increasingly rigorous requirements in connection with stock market loans. They were concerned particularly with the quality of the loans. Additional margins were required on loans, and, far more important, loan values were increasingly marked down. The commercial banks discounted a very substantial part of the fantastic prices of the stocks that had had the biggest speculative rises when it came to lending money against them. There was increasing rigor with respect to the diversification of collateral in every broker’s loan, and increasing concern regarding the marketability of every security taken into brokers’ loan envelopes. In the matter of customers’ loans against securities, the banks were less rigorous. But there was a great deal of discussion of cases where strong customers had large loans against particular types of securities, and increasing pressure was put on such customers either to reduce their loans or to diversify their collateral.

We distinguish brokers’ loans and customer’s loans against securities, but it is proper to make a further distinction between “strict brokers’ loans” and loans to broker customers. Strict brokers’ loans, those made through the money brokers at the “Money Desk” of the Stock Exchange, were the loans where the standards were most rigorous. Sometimes brokers who had long been good customers of a bank borrowed part of their money as customers rather than as brokers, and the full rigors were not applied always to loans of this kind. The great bulk of the brokers’ loans, however, were strict brokers’ loans.

Stock Exchange Houses Follow Commercial Bank Practices in Rigid Loan Standards. The stock exchange brokerage houses, likewise—whatever might be their individual positions with respect to the stock market, and whatever might be their expectations with respect to the market prices—none the less, as brokers, behaved with increasing conservatism as the market went higher. Partly because of pressure from the banks and partly because of the instinctive conservatism of financial men, they, too, required higher and higher margins from their customers, and they, too, took stocks held by their customers into their loan envelopes at increasing discounts from the prevailing high prices. For the brokers as well as for the banks loan values were far below market values. When the crash came both the commercial banks and the stock exchange brokers were ready for it.

• 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.