Friday, September 24, 2010

Galbraith on the Crash of 1929

From looking at my previous posts, the reader might think that I have a preoccupation with the Great Depression. This is not really so. The fact is that during and shortly after the Depression, a flurry of good economic work was done on both the Micro and Macro level. That such a catastrophic economic collapse could take place under a regime that was much more along the lines of what the classical economists would refer to as "business friendly", opened the door to some fundamental changes in economic theory. By my estimates, it took about forty years to forget a lot of what economists learned from the Crash of 1929 and the subsequent
Depression. I think it is still an open question as to whether contemporary economists have the capacity to respond to our current difficulties as creatively.

But I digress. The point of this post is to present a play by play of the Great Crashof 1929 according to the famous Institutional Economist John Kenneth Galbraith. From his book, we learn a great deal about the psychology behind booms and busts. We are also privy to a laborious account of how institutions in the United States responded to the collapse. I think this is a good addendum to the post on Milton Friedman, as it acts as a sort of prequal. Now, to the book!

Vision and Boundless Hope and Optimism

Galbraith opens up his book with a section on the Roaring Twenties, a time familiar to most students of United States History. In hindsight, it seems obvious that the spectacular growth of the twenties was too good to be true. Still, the issue is raised as to how some of the more obviously unsound or unprofitable practices were allowed to continue for so long, with little or no notice by voracious speculators.

The first point that Galbraith raises is that mass delusion of this sort usually does not take place on such a large scale, and it requires some considerable time to build up. Essentially, at some point in the early twenties, enough people became convinced that they could get reasonably rich fairly quickly, because modern financial genius had changed the rules of making money. Convinced that they could benefit from rising prices, individuals and firms became more willing to take on debt, and lenders (also noting the rising prices) became more lax in their standards. And, as more people and more money poured into financial markets, prices rose. Rational Investors, Galbraith notes, might recognize the transience of this kind of price increase. But, he points out that many well respected businessmen and political figures "talked up" the market, leaving investors assured that greater forces were protecting their fortunes.

Something Should be Done?

By 1929, Galbraith asserts, some learned individuals in business and policy recognized that a correction in financial markets was imminent. Easing the pain of this correction was the responsibility of:

  1. The President of the United States
  2. The Secretary of the Treasury
  3. The Federal Reserve Board
  4. The Governor and Directors of the New York Fed.
However, none of the people wanted (or perhaps even knew how) to rock the boat. The President and the Secretary of the Treasury didn't have the expertise to understand what was going on, and the factions in charge of the Federal Reserve system were overall opposed to direct intervention in the market. To their credit, Galbraith argues that their attempts to use Open Market Operations or Discount Rate hikes wouldn't have frazzled speculators, and only would have harmed sounder business transactions. After a failed attempt at "moral suasion", or essentially trying to warn speculators to slow down, he asserts that the Fed chose the course of letting the bust play out.

In Goldman Sachs We Trust

In this section, Galbraith discusses the role that investment corporations and banks (like Goldman Sachs) played in fueling the speculative bubble. It has already been noted that investors were given the added comfort of assuming that powerful forces were working to keep the market moving in their favor. One such source of comfort came from investing in large scale funds headed by financial "experts". These "experts" used the power of increasing the leverage of their funds to take advantage of rising prices. On paper, modest price increases to a hugely leveraged company appear to be vast increases in wealth. But Galbraith notes that a slight decrease in price to the same leveraged firm can just as easily wipe them out. This is what ended up happening.

The Twilight of Illusion

When reading the title of this section, one cannot help but think of Nietzsche's "Twilight of the Idols", and the similarity of the message leads me to believe that this is intentional. It begins by noting two of the more familiar aspects of a runaway bubble in financial markets:

  1. Prices rose daily, almost never falling.
  2. The volume of trading was consistently heavy.
Galbraith then goes on to talk about another element in the psychology of the boom. The first, we have already noted, was a faith that some greater forces were at work to keep the market tilted in the favor of the investor. Another element to support the boom was the spread of supposed market "experts". Sailing past reality for a boom essentially means that the money being poured into the market comes from taking on debt in an effort to profit from price increases that are solely based on increases in demand prompted by other people taking on similar debt. While this can only last while the expectations and utility functions of borrowers and lenders stand in a particular relation to one another, it is still the case that prices will rise. People who know people that benefit from this, or who benefit from it themselves, are only too eager to attribute the gains to their own genius. They make idols of themselves or others, and imbue them with similar powers to the other great forces at work in their favor. Galbraith thinks this lasted until around September 3, 1929 when these previous relationships began to reverse themselves.

The Crash

Galbraith begins this section by pointing to the peculiar relationship that businessmen and politicians tend to have with the meaning of movements in the stock market. One such view is that the stock market is a slightly delayed indicator of the situation prevailing in the economy as a whole (in this case, the crash just reflected a reality check). An opposing view is that the stock market is, in fact, the canary in the coal mine (where the crash actually told us where the market was going). Still others think that the stock market confounds both of these views all the time, and is thus a poor measure of any economic "fundamentals". A final view is that the stock market does, in real time, represent the actual state of the economy. Furthermore, each of these views seems to have its own day in following the business cycle. During a boom, many people believe the stock market has it right. During the bust, the foreboding and the correction camps fight it out. Near the bottom, it is usually the sense of disillusionment that dominates. Then, back to the foreboding and correction camps on the way up, until people decide again that the market is "right".

Things Become More Serious

Galbraith opens this section up with a marvelous quote describing what followed the crash of 1929: "The singular feature of the great crash of 1929 was that the worse continued to worsen. What looked one day like the end proved on the next day to have been only the beginning. Nothing could have been more ingeniously designed to maximize the suffering, and also to insure that as few as possible escaped the common misfortune." (Galbraith 180). Indeed, one of the features that distinguishes our Great Recession from the Great Depression is that there are notable sections of our population who seemed to be missing out on the misery, or actually profiting from it.

During the period following the crash, investors and speculators seemed to realize in great numbers that not only were they wrong in believing that the price of their holdings could only go up, they were wrong in believing that they had the slightest idea what the prices of their holdings actually were. Panicking investors, banks, and other financial entities tried to dump their assets only to find that there was no one to dump them on. Attempts at organized support, by asserting that corrections had been made and the market was now sound, failed at every turn, taking public confidence to new lows each time.

Aftermath I and II

In this section, Galbraith turns his attention to some of the socio-political phenomena that followed the crash, discussing how they related to modern society in general.

1. The tales of mass suicides by wealthy businessmen was more rumor than anything else, but it says something about the effect of the crash on the country's imagination.

2. There seems to be a cycle of embezzlement that is related to the business cycle. During booms people are freer and less careful with their money, so the supply of embezzlement or "bezzle" increases. When a crash comes, and people start to look to their funds, people uncover the previous fraud, and the supply of bezzle shrinks. This was particularly evident in the boom and bust of the Great Depression.

3. A classic political method designed to restore confidence is the "no business" meeting. Here, officials meet with no real agenda, besides portraying an image of action and control to the public.

4. In the great congressional circus that sought to get at the cause of the crash and the depression, many of the former captains and titans of industry found themselves suddenly unable to recall any particular transactions that they engaged in prior to the crash.

Cause and Consequence

In an effort to help understand the causes and consequences of the Crash and the following Great Depression, Galbraith first takes note of five weaknesses in the American Economy around 1929.

1. An unequal distribution of income that was quite large by historical standards.

2. Inadequate oversight of corporate investment practices.

3. A fundamentally unsound banking system.

4. Predatory trade practices i.e. high tariffs meant to encourage positive trade balances.

5. Poor economic knowledge on the part of policy advisors.

All of these factors could have conspired together to make what would have been an ordinary market correction into something worse. The unequal distribution of income might mean that the sudden collapse in demand due to uncertainty from the crash battered businesses harder than usual. Many of these businesses were already battered by their own speculation in the market. Furthermore, as both individuals and businesses tried to hold more cash for security, they helped bring about a collapse of the banking system (which could not handle such a large demand for currency). During all this time, policy advisors wrongly advocated austerity measures (balanced budgets etc). The result of this: a decade or so of misery.

Too Long to Read Summary:

Galbraith's book "The Great Crash", discusses the stock market crash of 1929 and its connection to the Great Depression. He argues that individuals and firms got carried away with economic growth in the roaring twenties, and started taking on risks they did not fully understand. For years, it seemed validated by rising prices. When it became evident that something had to give, most institutions and political figures were hampered by doctrines of austerity or fear of causing a violent correction. When prices reached a point that too many individuals wanted to take their profits, the market collapsed. Prices went from certainly increasing to unknown. Overleveraged firms and individuals quickly became insolvent. Attempts by politicians and businessmen to support the market by declaring the correction completed, failed at every turn. The general destruction of perceived wealth helped destroy projections of demand by businesses, and preference for liquidity lead to collapses of the banking system and credit markets. This resulted in a decade or so of misery.