The 1920s, often dubbed the Roaring Twenties, witnessed an unprecedented surge in prosperity and optimism in the United States. This era of exuberance found its most dramatic expression in the booming New York Stock Exchange. Stock prices ascended to heights never before imagined, fueled by speculation and readily available credit. The Dow Jones Industrial Average, a key indicator of stock market performance, experienced a meteoric rise, increasing sixfold from a modest sixty-three points in August 1921 to a staggering 381 points by September 1929. This exponential growth led some prominent figures, like economist Irving Fisher, to famously declare that stock prices had reached “what looks like a permanently high plateau.” 1 This sentiment, however, proved to be tragically premature.
The euphoric boom culminated in a devastating collapse. The Wall Street Crash Of 1929 began on Black Monday, October 28, 1929, when the Dow Jones plummeted nearly 13 percent. The following day, infamously known as Black Tuesday, saw an even more precipitous drop of almost 12 percent. Within weeks, by mid-November, the Dow had lost nearly half of its peak value. This dramatic downturn was not a short-lived correction; instead, it marked the beginning of a prolonged slide that continued relentlessly until the summer of 1932. At its nadir in July 1932, the Dow closed at a mere 41.22, its lowest point of the twentieth century, representing a staggering 89 percent decline from its 1929 peak. The market would not recover to its pre-crash levels until November 1954, highlighting the profound and long-lasting impact of the Wall Street Crash of 1929.
The financial boom that preceded the Wall Street Crash of 1929 was deeply intertwined with the widespread optimism and economic prosperity of the era. American families experienced increased wealth, and new technologies like automobiles and telephones became increasingly accessible. This climate of prosperity extended to the stock market, where ordinary citizens began investing growing portions of their savings in stocks and bonds. The burgeoning financial industry played a crucial role in this expansion. Brokerage houses, investment trusts, and the proliferation of margin accounts made stock ownership accessible to a wider segment of the population. Margin accounts allowed investors to purchase stocks with borrowed funds, typically putting down only a small fraction of the total price, often as little as 10 percent. The purchased stocks themselves served as collateral for these loans. This influx of borrowed money into the equity markets significantly inflated stock prices, contributing to the speculative bubble.
However, amidst the widespread euphoria, voices of caution emerged. The Federal Reserve, the central banking system of the United States, harbored concerns about the excessive speculation in the stock market. Many governors of the Federal Reserve Banks and a majority of the Federal Reserve Board believed that the rampant stock market speculation was diverting capital away from productive sectors of the economy, such as commerce and industry. The Board articulated its stance, asserting 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 This view was rooted in the legal framework of the Federal Reserve Act itself.
The Federal Reserve Act of 1913, which established the central bank, contained provisions that reflected a specific economic philosophy known as the “real bills doctrine.” Section 13 of the Act authorized reserve banks to accept certain types of assets as collateral for loans to member banks. These eligible assets were primarily those that financed genuine agricultural, commercial, and industrial activities. Crucially, Section 13 explicitly prohibited the Federal Reserve from accepting as collateral “notes, drafts, or bills covering merely investments or issued or drawn for the purpose of carrying or trading in stocks, bonds or other investment securities, except bonds and notes of the Government of the United States” (Federal Reserve Act 1913). Section 14 extended these limitations to the Federal Reserve’s open market operations, further reinforcing the restrictions on supporting speculative activities.3
The real bills doctrine, influential among the architects of the Federal Reserve System, posited that a central bank should primarily focus on providing credit to facilitate the production and exchange of goods and services in the real economy. According to this theory, the money supply should expand when economic activity increased and contract during economic downturns. Applying this doctrine, the Federal Reserve viewed the stock market boom as speculative and detached from the real economy, raising concerns about the allocation of credit and potential financial instability.
Faced with mounting concerns about stock market speculation, the Federal Reserve decided to take action to curb what it perceived as excessive exuberance. However, the specific course of action sparked debate within the Federal Reserve System. The Federal Reserve Board favored a policy of direct action to rein in the flow of call loans, which were instrumental in fueling stock market speculation. The Board requested that reserve banks discourage member banks from extending credit to stock speculators.4 The Board also issued public warnings about the inherent risks of speculation, hoping to temper investor enthusiasm through moral suasion.
However, George Harrison, the Governor of the Federal Reserve Bank of New York, advocated for a different approach. He favored raising the discount rate, the interest rate at which commercial banks could borrow money directly from the Federal Reserve. Increasing the discount rate would directly raise the cost of borrowing for banks and indirectly push up interest rates across the economy, affecting businesses and consumers alike. In 1929, the Federal Reserve Bank of New York repeatedly requested permission from the Federal Reserve Board to raise its discount rate. Initially, the Board resisted these requests. However, in August 1929, the Board finally conceded to New York’s proposal, and the New York discount rate was raised to 6 percent.5
The Federal Reserve’s decision to raise interest rates, while intended to curb domestic speculation, had unintended and far-reaching international consequences due to the prevailing international gold standard. Under the gold standard, exchange rates between currencies were fixed, and capital flowed relatively freely across borders. The Fed’s tight-money policy in the United States put upward pressure on interest rates globally. To maintain their exchange rates and prevent capital outflows, foreign central banks were compelled to raise their own interest rates in response. This synchronized tightening of monetary policy across the globe tipped several economies into recession. International trade contracted, and the global economy experienced a significant slowdown (Eichengreen 1992; Friedman and Schwartz 1963; Temin 1993).
Despite the Federal Reserve’s actions and the emerging global economic headwinds, the stock market boom in the United States continued, at least initially. The Federal Reserve watched with growing apprehension as commercial banks persisted in lending to speculators, and non-bank lenders further increased their investments in brokers’ loans. In September 1929, the stock market began to exhibit increased volatility, characterized by sudden declines followed by rapid recoveries. Despite these warning signs, some prominent financial figures continued to publicly encourage investors to buy stocks. Notably, Charles E. Mitchell, the president of the National City Bank (now Citibank) and a director of the Federal Reserve Bank of New York, remained optimistic and promoted continued investment in equities.6 In a desperate attempt to restore investor confidence amidst growing market jitters in October, Mitchell and a coalition of influential bankers pooled resources to publicly purchase large blocks of shares at inflated prices. This intervention, however, proved futile. Investor panic intensified, and a massive wave of selling ensued. Stock prices plummeted, marking the definitive onset of the Wall Street Crash of 1929.
As investors frantically sold off their stock holdings, funds fled the stock market and flowed into New York City’s commercial banks. These banks, however, were already heavily exposed to the stock market downturn, holding millions of dollars in stock-market loans. The sudden surge in deposits, coupled with the deteriorating quality of their loan portfolios, placed immense strain on the banks. As deposits increased, banks’ reserve requirements, the fraction of deposits they were legally obligated to hold in reserve, also rose. Simultaneously, banks’ reserves were depleted as depositors withdrew cash, banks absorbed losses on defaulted stock market loans, and the clearing of checks (the primary method of depositing funds) experienced delays due to the financial turmoil. These conflicting pressures created a situation where many banks found themselves temporarily short of required reserves.
In response to the escalating financial crisis and the liquidity strains on banks, the Federal Reserve Bank of New York swiftly intervened. It engaged in open market operations, purchasing government securities to inject liquidity into the banking system. It also expedited lending through its discount window, making it easier for banks to borrow reserves, and lowered the discount rate to reduce borrowing costs. Crucially, the New York Fed publicly assured commercial banks that it would provide the necessary reserves to meet their liquidity needs. These actions collectively increased the overall reserves in the banking system, alleviated the reserve constraints faced by New York City banks, and enabled financial institutions to remain operational and meet customer demands during the height of the crisis. Furthermore, these interventions effectively prevented short-term interest rates from spiking to disruptive levels, a common occurrence during financial panics.
At the time, the New York Fed’s actions were not universally applauded. The Federal Reserve Board and several other reserve banks voiced concerns that New York had exceeded its delegated authority. However, in retrospect, these actions are widely credited with containing the immediate fallout of the Wall Street Crash of 1929 in the short run. While the stock market had indeed collapsed, the commercial banking system, particularly in the epicenter of the crisis, remained functional (Friedman and Schwartz 1963).
Despite the New York Fed’s success in mitigating the immediate banking crisis, the Wall Street Crash of 1929 still inflicted significant damage on the broader economy, particularly on commerce and manufacturing. The crash triggered a wave of fear and uncertainty among investors and consumers alike. Individuals and families witnessed the evaporation of their life savings, faced job insecurity, and worried about their ability to meet financial obligations. This pervasive fear and uncertainty led to a sharp contraction in consumer spending, especially on big-ticket items like automobiles that were often purchased on credit. Industries, such as Ford Motors, experienced a dramatic decline in demand, forcing them to curtail production and lay off workers. Unemployment surged, and the economic downturn that had begun earlier in 1929 deepened significantly (Romer 1990; Calomiris 1993).7
While the Wall Street Crash of 1929 undeniably triggered a sharp economic contraction, its initial impact appeared to be fading within a few months. By the fall of 1930, there were tentative signs suggesting an imminent economic recovery. However, problems in another segment of the financial system, the banking sector outside of New York City, soon emerged, transforming what might have been a relatively short and sharp recession into the Great Depression, the most severe and prolonged economic depression in modern history.
The Wall Street Crash of 1929 and the subsequent Great Depression yielded profound lessons for economists and policymakers, including those at the Federal Reserve.8 Two key lessons emerged with particular clarity.
First, central banks must exercise caution when considering interventions in response to developments in equity markets. Identifying and effectively deflating asset bubbles is an exceedingly complex task. Utilizing monetary policy tools to curb investor exuberance carries the risk of unintended, broad, and potentially detrimental consequences for the wider economy.9 The experience of 1929, where the Fed’s interest rate hikes contributed to a global recession, underscored this danger.
Second, when stock market crashes do occur, their immediate damage can be contained by implementing the crisis response playbook effectively employed by the Federal Reserve Bank of New York in the fall of 1929. Providing liquidity to the banking system and acting as a lender of last resort can prevent a financial panic from spiraling out of control and triggering a broader economic collapse.
These lessons have been the subject of extensive debate among economists and historians in the decades following the Great Depression. A broad consensus emerged around the time of the publication of Milton Friedman and Anna Schwartz’s seminal work, A Monetary History of the United States, in 1963. Their conclusions regarding these events are widely cited by economists, including prominent members of the Federal Reserve Board of Governors such as Ben Bernanke, Donald Kohn, and Frederic Mishkin.
However, the financial crisis of 2008 and its aftermath have prompted scholars to re-examine these long-held conclusions. Economists are actively debating whether central banks possess the ability and whether they should attempt to proactively prevent asset market bubbles. Furthermore, the question of how concerns about financial stability should influence the conduct of monetary policy remains a central topic of discussion. These contemporary debates echo the very discussions and dilemmas faced by the leaders of the Federal Reserve in the lead-up to and aftermath of the Wall Street Crash of 1929, highlighting the enduring relevance of this historical event for understanding modern financial challenges.
Footnotes
[1] Fisher (1929) quoted in Galbraith (1955), 89.
[2] Chandler, Lester V. 1971. The Economics of Money and Banking. 5th ed. New York: Harper & Row.
[3] Federal Reserve Act. 1913. Section 13 and 14.
[4] Friedman, Milton, and Anna Jacobson Schwartz. 1963. A Monetary History of the United States, 1867-1960. Princeton, NJ: Princeton University Press.
[5] Wheelock, David C. 2010. The Federal Reserve, History. Federal Reserve System.
[6] Galbraith, John Kenneth. 1955. The Great Crash, 1929. Boston: Houghton Mifflin.
[7] Calomiris, Charles W. 1993. “Financial Factors in the Great Depression.” Journal of Economic Perspectives 7 (2): 61–85.
[8] Bernanke, Ben S. 2004. “Panel Discussion: What Have We Learned Since the Great Depression?” American Economic Review, Papers and Proceedings 94 (2): 343–47.
[9] Mishkin, Frederic S. 2011. “Monetary Policy Strategy: Lessons from the Crisis.” National Bureau of Economic Research Working Paper 16755.
