The Great Crash 1929 (John Kenneth Galbraith)

John Kenneth Galbraith wrote a short, 200 page history of the 1929 Wall Street Crash whilst struggling with his seminal The Affluent Society, and it unexpectedly remained in print ever since. "Each time it has been about to pass from bookstores," he wrote, "another speculative episode – another bubble or the ensuing misfortune – has stirred interest in the history of this, the great modern case of boom and collapse, which led on to an unforgiving depression."

Galbraith gives an amusing account of the run up to and aftermath of the crash, clearly enjoying poking fun at the sages of that time, often quoting economists and politicians’ ‘scientific’ (but ultimately foolish) predictions. In the concluding chapter Galbraith gives his reasons for the crash itself, and more importantly for the persistence of the downturn during the great depression. The story itself is best told in the context of these reasons. It may be interesting here to compare these reasons and circumstances to the modern day situation, and that of the 2008 crisis. 

Conventional wisdom held that easy money was to blame for the speculation on Wall Street that ultimately led to the Great Crash of 1929. Galbraith calls this “formidable nonsense.” Many investors in the run up to the crash were buying shares ‘on the margin’, meaning that they would put down as little as 10% of the value of the shares they wished to purchase, borrowing the rest from banks or other financial institutions. They would then leave the shares in the possession of the bank as collateral. This, says Galbraith, is clearly an unspoken tool for encouraging speculation, and that the level of buying on the margin a good indicator of the level of speculation taking place in a market. 

The reason easy money cannot be blamed, is that historically interest rates being charged by banks were high during this period. If someone is buying on the market for the purposes of speculation, it is the rising price of the asset that matters, rather than long term dividends or economic prospects of the underlying company. If the shares are going to go up 500% in value, it makes no difference to the speculator if the bank is charging 3% or 10% annual interest on the loan. Conversely, from the perspective of the bank, they were able to charge 10% or at times 12% interest, whilst holding a liquid and seemingly safe asset in the form of the share certificate. This was such a good deal from the perspective of the lender, that both foreign banks and American companies got in on the arrangement, lending on the margin in ever increasing quantities. And so it went, that both sides of the bargain were able to convince themselves that they were getting an excellent deal. 

Why then, with stocks rising so rapidly would anyone lend on the margin rather than directly buying the shares themselves? The reason that would have been given at the time was that these banks and other institutions wouldn’t be so rash as to gamble with raw speculation. But any right-minded assessment of the situation would reveal that lenders were taking on systemic risk on a grand scale. For the leverage that allowed a speculator to see all the upside from 10% investment would work in both directions. And when leverage is widespread, it begins to take on the properties of a bubble. If for example, a share price in a risky stock were to fall significantly, banks would perform a ‘margin call’ on the borrower, demanding that they deposit more cash to make up for the now lower collateral on their loan. Many speculators, being leveraged with every penny they had, would have to sell other, seemingly safer shares in order to cash flow the margin call. And of course, when this happens on a wide enough scale prices in all assets fall, precipitating further margin calls and further price decreases. A risk that both lenders and borrowers were to fall victim to. 

It is worth noting that to raise interest rates under these conditions would have no direct effect, since the rate the borrowers were being charged would have to be stupendous to be a deterrent, and interest rates so high would cripple the economy first. This was especially so when much of the money fuelling the speculation was coming from abroad or from money raised on Wall Street, and so government rates weren’t as big of a factor as one might expect. That being said, Galbraith argues that the policy makers could burst the bubble at any point with a sharp enough statement, given the mentality of the herd and the determination of most people to get out of the bubble at the top. The problem was, that the bubble was easily burst but very difficult to gently deflate, and no one wanted to be responsible for ending the party.

If not easy money then, what were the conditions that helped create the crash? Two conditions identified are high levels of saving (and the consequent search for places to invest those savings), and a mood of optimism. What is interesting about the history of the stock market since 1929, is the amount of time it took to return to pre-crash levels, and how it was only in the 1980s that serious speculation returned in earnest. The time is significant because it is a product of the memories of those who were actually affected by the disaster. People who experienced the Wall Street Crash never returned to a speculative state of mind. One can apply this to the housing bubble of 2008, and many others alike - we make the mistakes we collectively forget about.

The depth of the Great Depression following 1929 was and still is, the worst in American history. Galbraith shows that there was significant weakness in the US economy before the crash itself, and in fact only about 1 million people were directly involved in the speculation - not a huge proportion of the population. Also, there had been downturns before, and none had been so severe; Galbraith identifies five factors that conspired to cause this severity.

Firstly, inequality was acute before the crash. Since aggregate demand stems from investment and consumption, a collapse in business confidence had to be offset by consumer spending. In a situation where the majority of wealth is in few hands, consumption cannot increase much, “the rich cannot consume large quantities of bread”. After a period of decreasing inequality up until around 1980, it grew again, reaching a peak in 2008. A key difference between 2008 and 1929, is that whilst the rich still took a large portion of income and wealth, the median income in 2008 was far higher than 1929. The average American in 2008 had a standard of living well above subsistence level, and so consumption could still be substantial despite inequality. Here absolute income trumps relative income. 

The second factor is corporate structure. Serious businesses from the non-financial world had been engineered to reap the rewards of Wall Street, in the form of Holding Companies and Investment Trusts. An Investment Trust would issue shares in itself, and invest the money in the stock market, often being absurdly more valuable than the totality of it’s portfolio. In addition, they would issue bonds, and spend that money on shares, increasing the leverage of the initial capital. Banks like Goldman Sachs would create an investment trust, which would then create another investment trust a few months later. This extreme leverage would eventually work in reverse. Holding Companies would buy up large sections of a given industry, paid for by issuing bonds and shares. The danger here was that the profits from the real companies funded the interest on these bonds. As a result money that otherwise might have been invested in the future of the companies was used for interest, and so the real companies underlying the mountain of speculation and leverage were weakened by the financial wizards. In the case of investment trusts, a fall in any set of shares naturally led to a fall in the shares of the trusts, further increasing the systemic risk of the edifice. When one looks back at the 2008 financial crisis, the corporate structure was again very weak systemically, albeit in a different way. This time the leverage came from the collateralised debt of residential property, but the interconnectedness came from a globalised financial system bigger by far than any country. The toxic CDOs were held by pension and insurance funds, and the interconnectedness was on a far greater scale. Whilst there wasn’t the characteristic wild speculation of individuals, there was a collective holding of risk similar to the lenders on the margin described above. I often think when reading of financial crises, that in any period that there is a large scale “risk-free” return that is significantly above the level of interest, that that in itself is good enough evidence of impending trouble. 

Thirdly, the banking sector of the United States in 1929 was structurally weak. It consisted of thousands of banks, each so small as to be unable to withstand a run. The obvious problem being that runs on banks are self-fulfilling prophecies, and so a single failed bank will precipitate further failures, as depositors panic and withdraw their money (in the first 6 months of 1929, 346 banks failed in America). Galbraith argues that depositor insurance was a revolution in terms of ending the domino effect of bank failure. Today we have no such problem, as banks are few and large, and depositors insured; consequently bank runs are rare. What is interesting to consider here, are the second order consequences of insuring against systemic risk in banking. One lesson from 1929 is that the damage of failed banks to an economy is so great that it cannot be allowed to happen. It can be argued that many of the problems relating to financial crises since then have come as a result of bankers themselves being aware of this fact (the consequences of Lehman only reinforced this notion). It is an essay itself, but the consequences of moral hazard caused by government backstops from bank failures are surely the bigger threat today than failures themselves. 

Fourth, the state of the balance of payments. In 1929 all the major powers were on the gold standard, meaning their currencies were pegged in value to gold - theoretically meaning stability of prices between trading nations. Under this system, if the trade balance needed to adjust to a new reality, currencies couldn’t, so prices had to. Instead of a currency devaluation, prices in a country would have fall across the board - something which in practice was devastating to an economy, and usually to the politicians in charge at the time. Added to this masochistic system was a widespread contention that a country should export more than it imports (patently not everyone could do this simultaneously), and that it is of benefit to domestic industries to protect them from foreign competition using tariffs. Apart from the overall lower trade that results from such a policy, it forces the hand of whichever nation is trading in deficit. The United States had massive outstanding loans to Germany and South America in 1929, which had to be paid back in dollars. Since the U.S. had a trade surplus with these countries, dollars were in short supply, and since the dollar couldn’t appreciate against those currencies (because of the gold standard), this was a problem for Germany and the South American nations. The best solution would be to export more goods to the U.S., but Hoover’s massive tariffs on imports made this impossible - leaving the only solution as default and / or a reduction in the purchase of U.S. goods. This was not a major cause of the downturn (as the volume of trade wasn’t huge), but it didn’t help in a moment of economic weakness.The overall reduction in world trade in this period made everyone poorer, even before the calculations are made on the cost of deteriorating international relations. In 2008 trade was as open as ever, but it is worth reviewing the consequences of the 1930s protectionism when considering current escalating US-China trade relations.

Finally, Galbraith ascribes the severity of the aftermath of 1929 to ‘low economic intelligence’. As he acknowledges, to regard any period of time as being especially ignorant is to invite future generations to mock the undoubted gaps in our own knowledge; nonetheless says Galbraith, “those who offered economic council in the late 20s and early 30s were almost uniquely perverse”. The policy response to the crash and general downturn is where we certainly can contrast with 2008 with some reassurance. 1929 was dominated by the classical view that economies were self-correcting, and even that downturns were a form of penury to be paid for the good times. Keynes’ General Theory wasn’t published until 1936 (and at least in part was inspired by the policy failures after 1929), and balancing the budget was almost universally considered the best course of action. This seriously harmed those suffering from the depression. Refusing to partake in a massive, government-funded public works programme in order to stimulate demand is one thing, but the Hoover government response actually went further than this. In any downturn tax receipts will automatically fall, and government spending on unemployment benefit increase. Even so, the budget was balanced, incredibly, with taxes being increased during this time. In addition, the gold standard meant that there was no currency devaluation and no reduction of interest rates. The fear of inflation, during a period of the greatest deflation in America’s history, kept the economy in a harmful straightjacket for years until Roosevelt’s New Deal and ultimately World War II reversed these policies. Contrast this with 2008, and especially the response to Covid-19. Immediately increasing the money supply through slashed interest rates and quantitative easing avoided anything like the experience of the great depression (although it has been argued that these stimulus’ were withdrawn too quickly, hence the stodgy recovery), and government deficits are considered par for the course in such moments. 

One could argue that the learning from the 2008 crisis informed the economic response to Covid-19, and that our knowledge in dealing with economic crises has improved dramatically not just since 1929, but even since 2008. Whether one is a Keynesian or sides with Galbraith’s great rival Milton Friedman’s assessment of The Great Depression (book review to follow), our response today satisfies both causes of inadequate demand. On the other hand, the persistence of financial crises shows that we are far from immune to the speculative urge, or the innate human responses to feelings of greed and fear. The Great Crash 1929 should remain in print as long as our desire for a free lunch persists.