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Home Book Reviews Notes on The Great Crash of 1929 - John Kenneth Galbraith

Notes on The Great Crash of 1929 - John Kenneth Galbraith

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Speculative bubbles and subsequent crashes are a way of economic life; the sooner you accept this, the higher and more consistent your returns will be. Galbraith’s important observations of the great crash of 1929 are rather frightening, but also reassuring. We are aware of the consequences of a bubble, and in some instances there are even recognized preventatives of such a bubble, yet the recurring intense speculation that occurs among enthusiastic investors has been unchanged in the century following the Great Depression. As a result, savvy investors that observe these common bubble trends are able to profit by anticipating their inevitable burst. In The Great Crash of 1929, Galbraith analyzes the magnificent speculation of the 1920’s and its ensuing depression of the 1930’s. In walking the reader through this tumultuous ride, he highlights a number of prominent observations that still hold true today. The following are my notes fromThe Great Crash of 1929.

3 Causes of Speculation:

·         Mood: A pervasive sense of confidence, optimism, and conviction that ordinary people are meant to be rich, faith in good intentions, and benevolence of others.

·         Plentiful Savings: Speculation may rely on borrowed funds, but it must be nourished in part by those who participate… speculation is most likely to break out after a substantial period of prosperity.

·         Outbreak of speculation had not occurred in recent time: A speculation outbreak has a greater or less immunizing effect… an ensuing collapse automatically destroys mood needed for speculation.

Contributors of The Crash:

1.      Rediscount rate cut. The NY Federal Reserve bank cut the rediscount rate from 4 to 3.5%; the resulting funds made available were used to invest in common stock or help  finance the purchase of common stock by others

2.      Margin trading increased. Buying on margin, which is essentially borrowing money from your broker to purchase more stock than you’d normally be able to afford, dramatically increased. The volume of broker’s loans is a good index of speculation.

3.      Inaction. Regulators aware of the excess speculation were hesitant to take action and “pop” the bubble. They were making money out of it, wanted it to continue, and feared the social consequences of deliberately collapsing the bubble. The consequences of successful action seemed almost as terrible as the consequences of inaction, and they could be more horrible for those who took the action (some even went so far as to prop the market for their benefit).

4.      Classic instruments of control were useless.

a.      Open market operations: Usually the sale of government securities by the Federal Reserve Bank will get the money that is being used to loan to the public for stocks out of commercial banks. In the midst of this frenzy of speculation, however, there was not enough government securities to dry up the supply of funds feeding the market.

b.       Rediscount rate manipulation. A higher rediscount rate, which is the rate at which member commercial banks borrow from the Federal Reserve banks of their district, would have been distressing to everyone but the speculator. Only a drastic increase from 5% would have deferred commercial banks from borrowing, but this is difficult to pass when those in power, such as President Hoover and the Federal Reserve Board, veto even a slight increase to 6% in February 1929! (eventually the rate was raised to 6%, but not until late summer… after industrial and factory production both reached a peak in June).

5.      Investment trusts multiplied. Investment trusts, which arranged that people could own stock in old companies through the medium of new ones, satisfied the public demand for common stocks, which were believed to be high in price due to increasing scarcity. Corporate securities were then capable of being significantly higher than corporate assets in existence. A fascinating facet of the investment trust was the leverage that allowed a modest rise in stock price near the point of origin (security purchased by an IT) to translate into a major increase on the extreme periphery (the stock of an IT invested in an IT that invested in the original security… see pg. 59 for example). But, leverage, of course, works both ways.

5 Weaknesses Causing Depression:

1.      Bad distribution of income. The highly unequal income distribution meant that the economy was dependent on a high level of investment or a high level of luxury consumer spending or both.

2.      Bad corporate structure. America opened its hospitable arms to an exceptional number of promoters, imposters, and frauds. The most important corporate weakness was, without a doubt, the holding companies and investment trusts.

3.      Bad banking structure. The weakness was implicit in the large number of independent units. When one bank failed, the assets of others were frozen while depositors elsewhere had a pregnant warning to ask for their money – thus one failure led to other failures and these spread with a domino effect.

4.      Dubious state of foreign balance. The reduction of American exports [due to foreigners defaulting on American loans] was not vast in relation to total output of the American economy, but it contributed to the general distress.

5.      Poor state of economic intelligence. Insistence upon a balanced budget meant government outlays could not be increased to expand purchasing power… and an out-of-balance budget meant an increase in taxes and/or a reduction in spending. In fear of “going off” the gold standard and rising inflation, the US effectively added to its gold reserves which led to a violent deflation.

Changes as a result of the depression:

            The Crash led to strict laws being created in the Securities Act of 1933 and the Securities Exchange Act of 1934, such as full disclosure on new security issues and adjustments to margin requirements. The Securities and Exchange Commission (SEC) was established to regulate the NYSE and other exchanges.

            The extreme weaknesses of 1929 have substantially strengthened: the distribution of income is no longer lopsided; investment trusts have dispersed; the US now spends far more than it sells/receives; and bank deposits are now federally insured.

 

Galbraith’s Additional Prescience:

·                It is that very specific and personal misfortune awaits those who presume to believe that the future is revealed to them.

·                The chance for recurrence of a speculative orgy remains great. The government preventatives and controls are ready. In the hands of a determined government their efficacy cannot be doubted. There are, however, a hundred reasons why a government will determine not to use them.

·                But during any future boom some newly discovered virtuosity of the free enterprise system will be cited… Among the first to accept these rationalizations will be some of those responsible for invoking controls. They will say firmly that controls are not needed.

·                But now, as throughout history, financial capacity and political perspicacity are inversely correlated. Long-run salvation by men of business has never been highly regarded if it means disturbance of orderly life and convenience in the present.

False Theories:

a.      False: Speculative orgy was due to credit being easy and people were impelled to borrow money to buy common stocks on margin. (Money, by ordinary tests, was tight and interest rates astringent in the late twenties. Credit has been easy in the past and no speculation occurred)

b.      False: Life is governed by an inevitable rhythm and after a certain time prosperity will destroy itself and depression will correct itself.

c.       False: High production of the 20’s outran the wants of the people and the depression was needed so people’s wants could catch up with their capacity to produce. (Given the income to spend, evidence showed a capacity for a further increase in spending)

d.      False: The economy was subject to such physical pressure and strain as a result of its past level of performance that a depression was bound to come.

One Last Note:

One of the most frightening aspects of the late 1920’s was the pervasive optimism coupled with the negative view of contrarians. Official optimists were many and articulate, but the few that expressed concern did so with fear and trepidation as they were referred to as “destructionists” [of America] by some. So convincing were these idealists that even some adamant pessimists were converted; The Harvard Economic Society, which had been predicting a recession since early 1929, finally gave up and confessed error after the setback had not appeared by summer.

There were, of course, a small handful of contrarians that stuck to their guns in 1929. The New York Times, under the guidance of Alexander Dana Noyes, was the “greatest force for sobriety” because a “regular reader could not doubt that a day of reckoning was expected.” In March 1929, Paul Warburg of the International Acceptance Bank called for a stronger Federal Reserve policy and argued that if the present orgy of “unrestrained speculation” were not brought promptly to a halt there would be a disastrous collapse that would “bring about a general depression involving the entire country [not just speculators].” Good call, Paul.

Notable Quotes:

·                The striking thing about the stock market speculation of 1929 was not the massiveness of the participation. Rather it was the way it became central to the culture.

·                In these matters, as often in our culture, it is far, far better to be wrong in a respectable way than to be right for the wrong reasons.

·                The stock market is but a mirror which… provides an image of the underlying or fundamental economic situation.

·                Crime, or even misbehavior, is the act of an individual, not the predisposition of a class.

·                When people are least sure they are often most dogmatic… we compensate for our inability to foretell the consequences by asserting positively just what the consequences will be.

·                Had the economy been fundamentally sound in 1929 the effect of the great stock market crash might have been small.

Last Updated on Wednesday, 18 August 2010 14:37