The Roaring Twenties roared louder and longer on the New York Stock Exchange. share prices rose to unprecedented heights. The Dow Jones Industrial Average increased sixfold, from sixty-three in August 1921 to 381 in September 1929. After prices peaked, economist Irving Fisher proclaimed, “stock prices have reached ‘ what looks like a permanently high plateau. 1
The epic boom ended in a catastrophic boom. On Black Monday, October 28, 1929, the Dow was down nearly 13 percent. the next day, black tuesday, the market fell almost 12 percent. By mid-November, the Dow had lost nearly half its value. The slide continued through the summer of 1932, when the Dow closed at 41.22, its lowest value of the 20th century, 89 percent below its peak. the dow did not return to its pre-crash levels until november 1954.
The financial boom occurred during an era of optimism. Families prospered. Automobiles, telephones, and other new technologies proliferated. Ordinary men and women invested growing sums in stocks and bonds. A new industry of brokerage houses, investment trusts, and margin accounts enabled ordinary people to purchase corporate equities with borrowed funds. Purchasers put down a fraction of the price, typically 10 percent, and borrowed the rest. The stocks that they bought served as collateral for the loan. Borrowed money poured into equity markets, and stock prices soared.
However, there were skeptics. among them was the Federal Reserve. Governors of many Federal Reserve Banks and most of the Federal Reserve Board believed that speculation in the stock market diverted resources from productive uses, such as commerce and industry. The board stated that the “Federal Reserve Act does not… contemplate the use of the resources of the Federal Reserve Banks for the creation or extension of speculative credit” (Chandler 1971, 56).2
The opinion of the board arose from the text of the law. Article 13 authorized reserve banks to accept as collateral for discount loans assets that financed agricultural, commercial, and industrial activities, but prohibited them from accepting as collateral “notes, money orders, or drafts that cover mere investments or issued or drawn for the purpose of to carry or deal in stocks, bonds, or other investment securities, except bonds and notes of the government of the United States” (Federal Reserve Act of 1913).
section 14 of the act extended those powers and prohibitions to open market purchases.3
These provisions reflected the real currency theory, which had many adherents between the authors of the Federal Reserve Act in 1913 and the leaders of the Federal Reserve System in 1929. This theory stated that the central bank should issue money when production and trade expanded, and the supply of currency and credit contracted when economic activity contracted.
the federal reserve decided to act. the question was how. The Federal Reserve Board and the leaders of the Reserve Banks debated this issue. To stem the tide of demand loans, which was fueling the financial euphoria, the board favored a policy of direct action. The board asked reserve banks to deny credit applications from member banks that lent funds to stock speculators.4 The board also warned the public about the dangers of speculation.
new york federal reserve bank governor george harrison favored a different approach. she wanted to increase the discount loan rate. This action would directly increase the rate banks pay to borrow Federal Reserve funds and indirectly increase the rates paid by all borrowers, including businesses and consumers. In 1929, New York repeatedly requested to increase its discount rate; the board denied several of the requests. in august, the board finally agreed to the new york action plan, and the new york discount rate reached 6 percent.5
the increase in the federal reserve rate had unintended consequences. Due to the international gold standard, the Fed’s actions forced foreign central banks to raise their own interest rates. tight monetary policies pushed economies around the world into recession. international trade contracted and the international economy slowed (eichengreen 1992; friedman and schwartz 1963; temin 1993).
However, the financial boom continued. the Federal Reserve watched anxiously. commercial banks continued to lend money to speculators, and other lenders poured ever larger sums into loans to brokers. in September 1929, stock prices swung, with sudden declines and rapid recoveries. Some financial leaders continued to encourage investors to buy stocks, including Charles E. Mitchell, president of the National City Bank (now Citibank) and a director of the Federal Reserve Bank of New York.6 In October, Mitchell and a coalition of bankers attempted to restore confidence by buying blocks of stock at high public prices. the effort failed. investors began to sell madly. stock prices plummeted.
Funds that fled the stock market flowed into New York City’s commercial banks. These banks also assumed millions of dollars in stock-market loans. The sudden surges strained banks. As deposits increased, banks’ reserve requirements rose; but banks’ reserves fell as depositors withdrew cash, banks purchased loans, and checks (the principal method of depositing funds) cleared slowly. The counterpoised flows left many banks temporarily short of reserves.
To ease the tension, the New York Feed sprung into action. it bought government securities on the open market, accelerated lending through its discount window, and lowered the discount rate. he assured the commercial banks that he would provide them with the reserves they needed. These actions increased total reserves in the banking system, relaxed the reserve constraint facing banks in New York City, and allowed financial institutions to remain open to operate and meet customer demands during the crisis. The stocks also prevented short-term interest rates from rising to disruptive levels, which often happened during financial crises.
At the time, the New York Fed’s actions were controversial. The board and several reserve banks complained that New York was exceeding their authority. in hindsight, however, these actions helped contain the crisis in the short term. the stock market crashed, but commercial banks near the center of the storm remained in business (friedman and schwartz 1963).
while new york stocks protected commercial banks, the stock market crash still hurt trade and manufacturing. the drop spooked investors and consumers. Men and women lost their life savings, feared for their jobs, and worried if they could pay their bills. fear and uncertainty reduced purchases of expensive items, such as cars, that people bought on credit. Companies, such as Ford Motors, saw demand decline, so they cut production and laid off workers. unemployment increased and the contraction that had begun in the summer of 1929 deepened (Romer 1990; Calomiris 1993).7
While the crash of 1929 reduced economic activity, its impact faded within a few months, and by the fall of 1930 economic recovery seemed imminent. then problems elsewhere in the financial system turned what could have been a short, sharp recession into our nation’s longest, deepest depression.
From the stock market crash of 1929, economists, including the leaders of the Federal Reserve, learned at least two lessons.8
First, central banks, like the Federal Reserve, need to be careful when acting in response to equity markets. detecting and deflating financial bubbles is difficult. the use of monetary policy to restrain investor exuberance can have widespread, unintended and undesirable consequences.9
second, when stock market crashes occur, their damage can be contained by following the playbook developed by the federal reserve bank of new york in the fall of 1929.
Economists and historians debated these issues in the decades following the Great Depression. Consensus coalesced around the time of the publication of Milton Friedman and Anna Schwartz’s Monetary History of the United States in 1963. Their conclusions on these events are cited by many economists, including members of the Federal Reserve Board of Governors. like ben bernanke, donald kohn and frederic mishkin.
In reaction to the 2008 financial crisis, scholars may be reconsidering these conclusions. Economists have been questioning whether central banks can and should prevent asset market bubbles and how concerns about financial stability should influence monetary policy. These widespread discussions date back to debates on this topic among Federal Reserve leaders during the 1920s.