The 1920s, often called the Roaring Twenties, witnessed an unprecedented surge in the New York Stock Exchange. Fueled by optimism and readily available credit, stock prices climbed to dizzying heights. The Dow Jones Industrial Average, a key indicator of market performance, spectacularly inflated sixfold, ascending from a modest 63 points in August 1921 to a staggering 381 by September 1929. Amidst this euphoria, the renowned economist Irving Fisher famously declared that stock prices had reached “what looks like a permanently high plateau,” a statement that would soon be proven dramatically wrong.
This remarkable boom, however, was unsustainable and ultimately culminated in a devastating collapse. “Black Monday,” October 28, 1929, marked the beginning of the market’s freefall, with the Dow plummeting nearly 13 percent. The following day, infamously known as “Black Tuesday,” witnessed an even steeper decline of almost 12 percent. By mid-November, the Dow had hemorrhaged nearly half its value. This downward spiral persisted relentlessly until the summer of 1932, when the Dow bottomed out at a mere 41.22, its nadir for the entire twentieth century – a staggering 89 percent below its peak. It would take over two decades for the Dow to recover to its pre-crash levels, finally reaching those heights again in November 1954.
This period of financial exuberance was underpinned by widespread optimism and burgeoning prosperity. American families experienced increased financial well-being, and new technologies like automobiles and telephones became increasingly accessible. Ordinary individuals, buoyed by this economic climate, began investing heavily in stocks and bonds. The proliferation of brokerage houses, investment trusts, and margin accounts made stock market participation accessible to the masses, even enabling purchases with borrowed funds. Investors could acquire corporate equities by putting down a mere fraction of the price, often as little as 10 percent, borrowing the remainder. The purchased stocks themselves served as collateral for these loans. This influx of borrowed capital flooded the equity markets, further propelling stock prices upwards in a speculative frenzy.
However, amidst the widespread enthusiasm, voices of caution emerged. The Federal Reserve, the central banking system of the United States, harbored significant reservations. Many governors of the Federal Reserve Banks, along with 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 articulated its concern, 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.”
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. Conversely, 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” as collateral. Section 14 extended these limitations to open market purchases.
These provisions reflected the prevailing “real bills doctrine,” a theory influential among the architects of the Federal Reserve Act in 1913 and prominent figures within the Federal Reserve System in 1929. This doctrine posited that a central bank should expand the money supply in response to increased production and commerce, and conversely, contract the supply of currency and credit during economic downturns.
Faced with mounting speculation, the Federal Reserve decided to intervene. The crucial question became how. Debate ensued within the Federal Reserve Board and among the leaders of the reserve banks. To curb the escalating tide of call loans, which were fueling the speculative boom, the Board favored a policy of direct action. They requested reserve banks to deny credit requests from member banks that were channeling funds to stock speculators. The Board also issued public warnings about the inherent dangers of excessive speculation.
George Harrison, the governor of the Federal Reserve Bank of New York, advocated for a different approach. He proposed raising the discount lending rate, the interest rate at which commercial banks borrow money from the Federal Reserve. This measure would directly increase the cost of borrowing for banks and indirectly raise interest rates across the board, impacting businesses and consumers alike. In 1929, New York repeatedly sought approval to raise its discount rate, but the Board initially denied these requests. However, in August, the Board finally conceded to New York’s proposal, and New York’s discount rate was increased to 6 percent.
This rate hike by the Federal Reserve inadvertently triggered a series of unintended consequences. Due to the prevailing international gold standard, the Fed’s actions compelled foreign central banks to raise their own interest rates to maintain the value of their currencies relative to gold and the US dollar. These synchronized tight-money policies precipitated economic recessions across the globe. International trade contracted, and the global economy experienced a significant slowdown.
Despite these measures, the speculative boom on Wall Street continued unabated. The Federal Reserve observed with growing apprehension as commercial banks persisted in lending to speculators, and other lenders further increased their investments in broker loans. In September 1929, the stock market exhibited increased volatility, marked by sudden plunges followed by rapid rebounds. Some prominent financial figures, including Charles E. Mitchell, the president of the National City Bank (now Citibank) and a director of the Federal Reserve Bank of New York, continued to publicly encourage investors to buy stocks. In a desperate attempt to restore market confidence in October, Mitchell and a coalition of bankers collectively purchased large blocks of shares at inflated prices. This effort, however, proved futile. Investors panicked and began selling their holdings en masse, triggering a catastrophic plunge in share prices.
Funds fleeing the stock market sought refuge in New York City’s commercial banks. These banks also found themselves holding substantial amounts of stock-market loans. This sudden influx of deposits and loan obligations placed immense strain on the banking system. As deposits surged, banks’ reserve requirements increased, while simultaneously, banks’ reserves dwindled as depositors withdrew cash, banks acquired distressed loans, and the clearing of checks (the primary method of depositing funds) experienced delays. These opposing forces left numerous banks temporarily deficient in reserves.
In response to this escalating crisis, the New York Fed swiftly intervened. It purchased government securities in the open market, streamlined lending through its discount window, and lowered the discount rate. It reassured commercial banks of its commitment to providing the necessary reserves. These actions collectively injected reserves into the banking system, eased the reserve constraints faced by New York City banks, and enabled financial institutions to remain operational and meet customer demands throughout the crisis. These measures also 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 interventions were met with controversy. The Board and several other reserve banks criticized New York for exceeding its authority. However, in retrospect, these actions are widely credited with containing the immediate crisis. While the stock market had crashed, the commercial banks at the epicenter of the storm remained solvent and operational.
Despite the New York Fed’s success in mitigating the banking crisis, the stock market crash of 1929 still inflicted significant damage on commerce and manufacturing. The crash instilled fear and uncertainty in investors and consumers alike. Individuals and families witnessed the erosion of their life savings, faced job insecurity, and grappled with anxieties about meeting their financial obligations. This widespread 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 decline in demand, leading to production cuts and workforce reductions. Unemployment surged, and the economic contraction that had begun in the summer of 1929 deepened significantly.
While the immediate impact of the 1929 crash subsided within a few months, and by the fall of 1930, signs of economic recovery seemed to emerge, problems within another segment of the financial system transformed what might have been a short-lived recession into the Great Depression, the most protracted and severe economic downturn in modern history.
The Wall Street Stock Market Crash of 1929 imparted at least two crucial lessons to economists and policymakers, including leaders within the Federal Reserve.
Firstly, central banks must exercise extreme caution when considering interventions in equity markets. Identifying and deflating asset bubbles is an inherently complex and challenging undertaking. Employing monetary policy to curb investor exuberance can have far-reaching, unintended, and undesirable consequences for the broader economy.
Secondly, when stock market crashes inevitably occur, their potential for broader economic damage can be contained by implementing the crisis management playbook effectively demonstrated by the Federal Reserve Bank of New York in the fall of 1929.
These issues have been the subject of extensive debate among economists and historians in the decades following the Great Depression. A consensus view solidified 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 numerous 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, scholars are re-evaluating these long-held conclusions. Economists are actively questioning whether central banks possess the capacity and mandate to preemptively address asset market bubbles, and to what extent concerns about financial stability should factor into monetary policy decisions. These ongoing discussions echo the debates that took place among the leaders of the Federal Reserve during the tumultuous 1920s, highlighting the enduring relevance of the lessons learned from the Wall Street stock market crash of 1929.
