The 1929 Wall Street crash triggered a banking crisis, but it didn’t cause the Great Depression. Bad policy did. (More)

Hall of Mirrors, Part III: The Worst 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. Thursday we began with the roots of the Great Depression. Yesterday we saw similarities, and differences, in the roots of the Great Recession. Today we 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.

“Without the buying of cream”

On Thursday we saw the roots of the 1929 Wall Street crash: housing and credit bubbles, stock market speculation, an increasingly international bond market, and more than a few doses of greed and outright fraud. Yet as the U.S. stock market was crumbling, actor and humorist Will Rogers saw little cause for worry:

All day just looking down on beautiful lands and prosperous towns, then you read all this sensational collapse on Wall Street. What does it mean? Nothing. Why, if the cows of this country failed to come up and get milked one night it would be more of a panic than if Morgan and Lamont had never held a meeting. Why, an old sow and a litter of pigs make more people a living than all the steel and General Motors stock combined. Why, the whole 120,000,000 of us are more dependent on the cackling of a hen than if the stock exchange was turned into a night club.

Just a year before, Rogers ran for president in a series of articles for Life magazine, with his Anti-Bunk Party. His letter to the New York Times dismissing the 1929 Wall Street crash would prove to be bunk, but many agreed with him at the time. The truth was hidden in conversations like a milkman’s response when a financier congratulated him for coming through Wall Street’s rocky October unscathed:

Unscathed nothing. Do you know that in the past three weeks I have had enough cancellations and reductions in cream order to reduce my business by over $400 a month? People still order the same amount of milk, but they have apparently decided they can get along without the buying of cream.

“Insured the soundness of the business situation”

Contrary to popular myth, and some widely-accepted scholarship, the Federal Reserve banks were not blind to the financial consequences of Wall Street’s cascading margin calls. George Harrison called an emergency meeting of his New York Federal Reserve Bank board at 3am on October 28th and, before the market opened on “Black Monday,” he announced that the New York Fed would buy $100 million in short term Treasury notes. That grew to $150 million over the coming days, as Harrison’s Fed bought commercial paper with cash to prevent a spike in interest rates. The New York Times praised the move, saying the New York Fed “insured the soundness of the business situation when the speculative markets went on the rocks.”

But other regional Fed presidents were furious that Harrison had acted on his own. They refused to lower the discount rate, and the New York Fed could not afford to do more on its own. Still, the real bills doctrine of keying the money supply to the “legitimate needs of trade” gave clear guidance for a credit crisis: inject liquidity to steady interest rates until the panic passed.

But the real bills doctrine offered no remedy for the milkman’s dilemma. The Fed’s mandate was to stabilize interest rates, not employment or commerce. If economic activity was slowing, the doctrine suggested, then the “legitimate needs of trade” were less and the Fed should take ‘excess’ money out of circulation. They did … and that contributed to the deflationary spiral.

“Diabolic loop”

The “diabolic loop” of collapsing demand hit Europe first. U.S. investors had been the primary source of capital in France and Germany. Now they pulled their money from European banks to cover margin calls on Wall Street. At the same time, U.S. businesses were buying fewer European goods, the spread of the milkman’s dilemma.

The double shock of capital flight and reduced exports devastated economies that were shackled to the gold standard. With the inflationary crisis of the early 1920s still fresh, German central bankers refused to inject money into the system. Rather than boosting government spending to close the demand gap, bankers and an inflation-skittish public demanded balanced budgets. The government cut salaries for public workers, and tightened eligibility for unemployment insurance, and cut benefits. Austerity strangled the economy still more, and would-be investors took still more money elsewhere. When Chancellor Heinrich BrĂ¼ning called new elections amidst rising public outrage, Hitler’s Nazi Party gained political respectability if not, yet, the government.

The spiral spread and fed on itself across Europe. Austria’s Creditanstalt bank held over 50% of the country’s assets, but that was not enough to cover its debts in a shrinking global economy. It was both too big to fail and too big to save, at least not without foreign investment. But French and English bankers demanded the Austrian government – with a budget of only 1.8 billion schillings – guarantee the bank’s entire $1.2 billion schilling portfolio. Investors saw through that absurd promise, and the Austrian economy froze … triggering yet more banking crises in Germany and elsewhere.

“Throwing good money after bad”

Back in the U.S., Dr. Eichengreen writes:

[B]alanced-budget doctrine and gold-standard ideology still carried the day. Andrew Mellon, who swore by the banker’s canon as faithfully as anyone, was by now President Hoover’s longest-serving cabinet member. Mellon continued to insist that by embracing fiscal and financial rectitude and limiting government intervention, confidence would be restored.

But the problem was not mere confidence. The economy was trapped in a deflationary spiral, with business failures boosting unemployment that reduced demand and led to more business failures. At the same time, banks whose cash was limited by the real bills doctrine could not lend. Without that lending, farmers could not plant, still-going firms could not expand, struggling firms could not survive downturns, and households could not spend.

President Hoover attempted to respond with a voluntary pool called the National Credit Corporation. Participating banks would contribute 2% of their deposits and qualify for assistance if they met a run. It was, or would have been, cooperative insurance. But bankers rejected the idea:

Weak banks, they observed, were in no position to contribute 2% of their assets to a common pool. Strong ones would be subsidizing their weaker brethren. In other words, the bankers understood the problem was not just one of liquidity; many distressed banks were insolvent. For the solvent to lend to their insolvent brethren would be throwing good money after bad.

Similar plans also failed. Only the Federal Reserve could inject money into the system, and it would need changes in law and a Congress willing to spend in order to do that. For those changes, the nation would need a new president.

Next Thursday we’ll see how the U.S. government did not repeat these mistakes in the fall of 2008. But the European Union did … and the U.S. government – in Dr. Eichengreen’s taut phrase – “succeeded just enough to fail.”


Happy Saturday!