In the spring and summer of 1929, the U.S. economy was riding high on the decade-long winning spree called the Roaring Twenties, but the Fed was raising interest rates to slow a booming market and an increasingly vocal minority of economists and bankers were beginning to wonder how long the party could possibly last.
In 1929, popular prognosticators like the Yale economist Irving Fisher swore that if a correction came, it would look like a harmless slump, while others predicted a jagged cliff. But nobody, absolutely nobody, could have foreseen the stock-market slaughter that happened in late October.
On two straight days, dubbed Black Monday and Black Tuesday, the stock market crashed by 25 percent, and by mid-November, it had lost half its value. When the market collapse finally hit rock bottom in 1932, the Dow Jones Industrial Average had withered away by a staggering 90 percent.
Hindsight is 20/20, but there were signals back in the summer of 1929 that trouble lay ahead.
What Goes Up...
Gary Richardson, an economics professor at the University of California Irvine and a former historian for the Federal Reserve, has researched the Fed’s role in the 1929 crash and the ensuing Great Depression. He says that the first warning sign of a looming market correction was a general consensus that the blistering pace at which stock prices were rising in the late 1920s was unsustainable.
“People could see in 1928 and 1929 that if stock prices kept going up at the current rate, in a few decades they’d be astronomic,” says Richardson. The question was less about whether the meteoric stock market rise was going to end, but how it would end.
The global financial industry is now highly sophisticated with some of the best minds and the most powerful computers dedicated to predicting future market movements. In 1929, the field of quantitative forecasting was in its infancy. Each leading economic forecaster devised his own stock market indexes in an attempt to capture market trends.
Economist Roger Babson was one of the most prominent prophets of doom, concluding that stock prices were wildly inflated compared to the prospect of future dividends. In September 1929, Babson told a National Business Conference in Massachusetts that “sooner or later a crash is coming which will take in the leading stocks and cause a decline from 60 to 80 points in the Dow-Jones barometer… Some day the time is coming when the market will begin to slide off, sellers will exceed buyers and paper profits will begin to disappear. Then there will immediately be a stampede to save what paper profits then exist.”
Others, like the Yale economist Fisher, brushed off fears of a reversal, concluding that stock prices were on par with soaring corporate profits. In response to Babson’s dark predictions, Fisher famously told a crowd of stock brokers that stock prices had reached “what looks like a permanently high plateau.” That was on October 15, 1929, less than two weeks before Black Monday.
Fed Tried to Put on the Brakes
Richardson says that Americans displayed a uniquely bad tendency for creating boom/bust markets long before the stock market crash of 1929. It stemmed from a commercial banking system in which money tended to pool in a handful of economic centers like New York City and Chicago. When a market got hot, whether it was railroad bonds or equity stocks, these banks would loan money to brokers so that investors could buy shares at steep margins. Investors would put down 10 percent of the share price and borrow the rest, using the stock or bond itself as collateral.
Buying on margin lets investors buy more stock with less money, but it’s inherently risky since the broker can issue a margin call at any time to collect on the loan. And if the share price has gone down, the investor will have to pay back the full loan balance plus some change. One of the reasons Congress created the Federal Reserve in 1914 was to stem this kind of credit-fueled market speculation.
Starting in 1928, the Fed launched a very public campaign to slow down runaway stock prices by cutting off easy credit to investors, Richardson says. It started with a technique called “moral suasion,” similar to Alan Greenspan’s warning in 1996 that “irrational exuberance” was artificially pushing up stock prices. Back in 1929, the message was “Stop loaning money to investors,” says Richardson. “This is creating a problem.”
Banks didn’t get the message, so the Fed resorted to “direct action,” which operated more like a direct threat. In a letter to every commercial U.S. bank under the Fed’s purview, the central bank said that if you continue to lend to brokers and investors, we’re going to cut off access to the Fed’s discount window. No more credit for you.
But that didn’t work either.
In a last-ditch effort to undercut the spike in stock prices, the Fed decided to raise interest rates in August 1929. If investors missed the first two signs that the Fed wanted to slam the breaks on the stock market, this one should have been abundantly clear.
“The Fed made a string of public announcements: ‘We’re doing this to slow the growth of stock prices,’” says Richardson. “Investors are very aware that the Fed is trying to bring down stock prices using all the tools at its disposal.”
Interest Rate Hike’s Bad Timing
Unfortunately, the timing of the interest rate hike couldn’t have been worse. Little did the Fed know that the U.S. economy would reach its peak in August 1929. Tightening the credit market was supposed to shrink stock prices by maybe 10 percent, says Richardson, but definitely not 90 percent.
Today, even mainstream news outlets run stories on wonky financial terms like the inverted treasury yield curve, which is supposed to be a strong predictor of a coming recession. Back in 1929, there were fewer such indicators available to investors, but still enough to get a read on whether the economy was expanding or contracting. Monthly figures were published, for example, about leading indicators like new housing permits and manufacturing orders.
“In 1929, it was clear that there had been this big boom but that the economy was starting to cool down,” says Richardson. “Just like today, there was a lot of discussion in the press about whether the economy had reached a peak or not. That all got resolved very quickly with the crash and its aftermath.”
‘No big decline has ever been fully predicted.’
While newbie middle-class investors seeking easy riches absolutely fueled the 1929 stock market boom and bust, plenty of very sophisticated investors also missed the coming crash. And even those who were savvy enough to foretell a market slide couldn’t have imagined the carnage to come.
“No big decline has ever been fully predicted,” says Richardson. “If there was any reasonable prediction that home prices would collapse in 2008, then people would have stopped buying homes. If any reasonable person had foreseen anything like the 90-percent collapse in equity prices from 1929 to 1934, the market would have not gone up. There’s lots of really smart people who bet wrong on the market all the time.”