Economists have long studied how the Great Depression spread and deepened, but there is surprisingly little consensus on why it began. (More)

Hall of Mirrors, Part I: The Best of Times

For the next two weeks, Morning Feature considers Barry Eichengreen’s Hall of Mirrors: The Great Depression, the Great Recession, and the Uses – and Misuses – of History. Today we begin with the roots of the Great Depression. Tomorrow we’ll see similarities, and differences, in the roots of the Great Recession. Saturday we’ll explore how governments in the U.S. and Europe initially responded, or didn’t respond, to the Great Depression. Next Thursday we’ll see why policy responses to the Great Recession were not as dramatic as those of the 1930s. Next Friday we’ll explore how mistaken policies extended and deepened the Great Recession. Next Saturday we’ll conclude with Dr. Eichengreen’s lessons and warnings for the future.

Barry Eichengreen is the Pardee Professor of Economics and Professor of Political Science at the University of California, Berkeley, where he has taught since 1987, and Pitt Professor of American History and Institutions, University of Cambridge, 2014-15. He is a Research Associate of the National Bureau of Economic Research (Cambridge, Massachusetts) and Research Fellow of the Centre for Economic Policy Research (London, England). He earned Masters degrees in Economics and History and his PhD in Economics at Yale University. Hall of Mirrors is his 21st book.

Charles Ponzi and New Age Economics

Dr. Eichengreen opens with the story of Charles Ponzi, best known for the gold coupon arbitrage scam that coined the term “Ponzi scheme.” Less known is that Ponzi was released from prison pending an appeal, and he fled to Florida to launch another pyramid scheme – the Charpon Land Corporation – selling tracts of swampland for ‘development.’ Yes, this is the origin of the phrase “I have some swampland in Florida to sell you.”

Ponzi found easy pickings in Florida, at least for awhile, because of a real estate boom. That was driven in part by the rise of the automobile and, with it, the creation of the suburban subdivision. It was also driven in part by state and local officials who were “developer-friendly” if not developers themselves. But as Dr. Eichengreen emphasizes, a key factor in the 1920s housing boom was the spread of new credit mechanisms. Banks and building and loan associations (B&Ls, the forerunner of S&Ls) spun off new institutions to offer mortgages. Rather than lending out of deposits and holding the loans, these companies offered investors mortgage-backed securities. Speculators drove up prices, and the result was a highly-leveraged bubble similar to that of the 2000s.

That bubble burst in 1926, and over 150 banks failed in Florida and southern Georgia. Local government revenues plummeted and many infrastructure projects were abandoned, spreading the pain to other workers. Yet that bubble did not cause the Great Depression, or at least not directly.

From Florida to Berlin, via Wall Street

Far from Florida, another bubble was developing on Wall Street. Like the housing bubble, the stock market bubble was fueled by low interest rates and a certainty among investors that the Roaring 20s would keep on roaring. After all, there were new technologies reshaping the economy: such as radio and the automobile. Surely their growth would spur more innovation and more growth.

Those low interest rates in the U.S. were due, in part, to pressure from Europe. The major combatants abandoned the gold standard in World War I, and a wave of inflation that climaxed in 1923 still scars the German psyche. Britain was still struggling to return to the gold standard in the mid-20s, and the Federal Reserve kept U.S. interest rates low while Britain kept rates high – despite a coal strike and gold runs by Germany and France – to encourage investors to recapitalize the Bank of England.

Political infighting in both Germany and France kept investors uncertain and their economies in turmoil. A wave of inflation in the mid-20s gutted French pensioners and other small savers, while the wealthy moved their money to other countries for better returns. Anchoring the Reichmark and Franc to gold halted the bleeding, but at Britain’s expense. In 1927, New York Federal Reserve President Benjamin Strong called a conference to coordinate an international response that would stabilize all three major European economies.

“Competing on an almost violent scale”

The result was yet another cut in U.S. interest rates that drove investors to look for higher yield. Dr. Eichengreen notes the rising trade of international bonds, with U.S. banks plying Latin American governments with food, wine, and “less licit pleasures.” Experienced bankers like Thomas Lamont warned that:

American bankers and firms competing on an almost violent scale for the purposes of obtaining loans in various foreign markets … tends to insecurity and unsound practice.

But such cautionary voices went largely unheeded, as younger, more aggressive competitors swarmed the market. Banks that once sold Liberty Bonds now spun off subsidiaries to sell foreign bonds, boosted by ads in Harpers and The Atlantic Monthly. U.S. investors provided 80% of the money borrowed by German public credit institutions from 1925 to 1928, and funded infrastructure projects from Austria to Belgium to the Congo. A worldwide credit bubble grew, despite warnings about “overspending and overborrowing … overstimulation and overexpansion.”

Meanwhile, U.S. stocks yielded 38% in 1927 and 44% in 1928, and brokers offered easy credit to would-be investors. Finally the Fed tried to turnoff the tap, raising interest rates in January and again in February of 1928. But the shadow banking system – insurance companies, corporate treasuries, investment trusts, and foreign banks – continued to fuel speculation. Instead the higher banking loan rates hurt businesses, and the U.S. economy began to slow. The same happened in Germany, as U.S. investors moved their money from bonds to skyrocketing stocks.

The bubble burst in London in September 20, 1929, with the arrest of Charles Hatry and his associates on fraud and forgery charges. A month later, on Black Thursday, October 24th, the New York Stock Exchange lost 11% of its value on the opening bell. Volume overwhelmed the ticker, and panicked brokers could not determine current prices. Wall Street bankers managed to stem the losses, but margin calls rolled in over the weekend. On Tuesday, October 29th, the bottom dropped out. The market had plunged $30 billion in two days. Failing loans rippled through the U.S. banking system, and the tightly-coupled international bond market soon spread the damage worldwide.

Tomorrow we’ll see a near echo in 2007-2008 … but the differences would prove to be as important as the similarities.

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Happy Thursday!