The 1920s, often dubbed the “Roaring Twenties,” echoed with exuberance, particularly within the bustling New York Stock Exchange. This era witnessed an unprecedented surge in stock prices, propelling the Dow Jones Industrial Average from a modest 63 in August 1921 to a staggering 381 by September 1929 – a sixfold increase. At the zenith of this financial boom, even renowned economist Irving Fisher boldly declared that stock prices had reached a “permanently high plateau.” 1 This optimistic outlook, however, was soon to be dramatically shattered by one of history’s most significant financial events: the Wall Street crash.
This spectacular boom met an abrupt and devastating end with a series of Wall Street Crashes. “Black Monday,” October 28, 1929, marked the initial shockwave, as the Dow plummeted nearly 13 percent. The following day, infamously known as “Black Tuesday,” witnessed a further market collapse of almost 12 percent. By mid-November, the Dow had hemorrhaged nearly half of its peak value. This downward spiral persisted relentlessly until the summer of 1932, when the Dow hit its nadir for the 20th century, closing at 41.22 – a staggering 89 percent below its pre-crash peak. It would take until November 1954 for the Dow to finally recover to its pre-crash levels, highlighting the profound and long-lasting impact of the Wall Street crashes.
The preceding financial boom was fueled by a pervasive sense of optimism and widespread economic prosperity. Families enjoyed rising incomes, and new technologies like automobiles and telephones became increasingly accessible. Ordinary individuals began investing growing portions of their savings in the stock market, enticed by the promise of quick riches. The burgeoning financial industry, populated by brokerage houses, investment trusts, and the advent of margin accounts, made stock ownership accessible to the masses. Margin accounts allowed investors to purchase stocks with borrowed funds, typically putting down only 10 percent of the price and borrowing the remainder. The purchased stocks themselves served as collateral for these loans. This influx of borrowed money into the equity markets further inflated stock prices, creating a speculative bubble.
However, not everyone was caught up in the euphoria. Skeptics, including voices within the Federal Reserve, raised concerns. Many governors of Federal Reserve Banks and a majority of the Federal Reserve Board believed that excessive stock market speculation was diverting crucial resources away from productive sectors of the economy, such as commerce and industry. The Board asserted that the Federal Reserve Act was not intended to facilitate the use of Federal Reserve resources for “speculative credit” (Chandler 1971, 56).2
This stance was rooted in the Federal Reserve Act itself. Section 13 of the Act authorized reserve banks to accept assets financing agricultural, commercial, and industrial activities as collateral for discount loans. Crucially, it explicitly prohibited accepting “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 of the act extended these limitations to open market purchases.3 These provisions reflected the “real bills doctrine,” a prevailing theory among the architects of the Federal Reserve Act in 1913 and influential figures within the Federal Reserve System in 1929. This doctrine posited that the central bank should expand the money supply in response to increased production and commerce and contract it during economic downturns.
Faced with mounting speculation, the Federal Reserve decided intervention was necessary. The critical question became how to intervene. Debate ensued within the Federal Reserve Board and among reserve bank leaders. To curb the escalating tide of call loans fueling market exuberance, the Board favored direct action. They urged reserve banks to reject credit requests from member banks that were channeling funds into stock market speculation.4 The Board also issued public warnings about the inherent risks of excessive speculation.
However, George Harrison, the governor of the Federal Reserve Bank of New York, advocated for a different approach: raising the discount lending rate. This strategy would directly increase the cost for banks to borrow from the Federal Reserve, indirectly raising interest rates for all borrowers, including businesses and consumers. In 1929, New York repeatedly requested discount rate hikes, but the Board initially resisted. Finally, in August, the Board conceded to New York’s plan, and the New York discount rate climbed to 6 percent.5
This interest rate hike by the Federal Reserve had unforeseen international repercussions. Due to the prevailing international gold standard, the Fed’s actions compelled foreign central banks to raise their own interest rates to maintain their gold reserves and exchange rates. These synchronized tight-money policies inadvertently pushed economies worldwide into recession. International trade contracted, and the global economy experienced a significant slowdown (Eichengreen 1992; Friedman and Schwartz 1963; Temin 1993).
Despite these broader economic headwinds, the financial boom in the US stock market continued unabated for a time. The Federal Reserve watched with growing apprehension. Commercial banks persisted in lending to speculators, and other lenders amplified their investments in broker loans. In September 1929, the stock market began to exhibit increased volatility, characterized by sudden drops followed by rapid recoveries. Despite these warning signs, some financial leaders, including Charles E. Mitchell, president of the National City Bank (now Citibank) and a director of the Federal Reserve Bank of New York,6 continued to publicly encourage investors to buy stocks, attempting to maintain market confidence. In October, Mitchell and a group of bankers even attempted to artificially prop up prices by publicly purchasing large blocks of shares at inflated prices. This desperate effort ultimately failed to stem the tide. Investors began selling their holdings en masse, triggering a massive sell-off and sending share prices into a precipitous decline – the Wall Street crashes were fully underway.
Funds fleeing the collapsing stock market flowed into New York City’s commercial banks. These banks also found themselves burdened with millions of dollars in outstanding stock market loans. This sudden influx and shift in liabilities put immense strain on the banking system. As deposits surged, banks’ reserve requirements increased. Simultaneously, banks’ reserves dwindled as depositors withdrew cash, banks acquired loan portfolios, and the check clearing process (the primary method of deposit) lagged. This conflicting dynamic left numerous banks temporarily short of required reserves.
To alleviate the escalating financial pressure, the New York Fed swiftly intervened. It purchased government securities in the open market, expedited lending through its discount window, and reduced the discount rate. Crucially, it reassured commercial banks of its commitment to providing the necessary reserves. These actions collectively injected reserves into the banking system, easing the reserve constraints faced by New York City banks and enabling financial institutions to remain operational and meet customer demands during the height of the crisis. These interventions also successfully 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 met with controversy. The Federal Reserve Board and several other reserve banks voiced concerns that New York had overstepped its authority. However, in retrospect, these actions are widely credited with containing the immediate crisis. While the stock market had crashed dramatically, the commercial banking system at the epicenter of the turmoil remained functional (Friedman and Schwartz 1963).
Despite the New York Fed’s success in stabilizing the banks, the Wall Street crash still inflicted significant damage on the broader economy, particularly commerce and manufacturing. The crashes instilled fear and uncertainty in investors and consumers alike. Individuals and families suffered devastating losses of their life savings, became fearful for their job security, and worried about their ability to meet financial obligations. This pervasive fear and uncertainty led to a sharp reduction in purchases of big-ticket items, such as automobiles, which were often financed with credit. Companies like Ford Motors experienced a steep decline in demand, leading to production cuts and worker layoffs. Unemployment surged, and the economic contraction that had begun in the summer of 1929 deepened considerably (Romer 1990; Calomiris 1993).7
While the Wall Street crash of 1929 triggered a significant economic downturn, its initial impact appeared to be waning within months. By the fall of 1930, signs of economic recovery were emerging. However, problems within another segment of the financial system transformed what might have been a short, sharp recession into the Great Depression, the most prolonged and severe economic crisis in modern history.
The Wall Street crashes of 1929 offered profound lessons for economists and policymakers, including leaders within the Federal Reserve.8
Firstly, central banks must exercise extreme caution when responding to movements in equity markets. Identifying and deflating speculative financial bubbles is an inherently complex and challenging task. Utilizing monetary policy to curb investor exuberance can have far-reaching, unintended, and undesirable consequences on the broader economy.9
Secondly, when stock market crashes do occur, the damage can be mitigated by adopting the crisis management strategies successfully employed by the Federal Reserve Bank of New York in the autumn of 1929, focusing on maintaining liquidity and stability within the banking system.
Economists and historians have extensively debated these critical issues in the decades following the Great Depression. A general 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, in the wake of the financial crisis of 2008, the Great Recession, scholars are actively re-evaluating these long-held conclusions. Economists are now intensely debating whether central banks possess the capacity and responsibility to proactively prevent asset market bubbles, and how concerns about broader financial stability should be integrated into monetary policy frameworks. These contemporary discussions echo the very debates that preoccupied the leaders of the Federal Reserve during the tumultuous years of the 1920s, highlighting the enduring relevance of the lessons learned from the Wall Street crashes.
Footnotes
1 Fisher (1929)
2 Chandler (1971)
3 Federal Reserve Act (1913)
4 Board Meeting Minutes (1929)
5 Harrison Papers (1929)
6 Mitchell Testimony (1930)
7 Romer (1990); Calomiris (1993)
8 Bernanke (2004)
9 Kohn (2009)
