The 1920s, often dubbed the “Roaring Twenties,” witnessed unprecedented exuberance in the New York Stock Exchange. Stock prices soared to dizzying heights, with the Dow Jones Industrial Average multiplying sixfold from 63 in August 1921 to a peak of 381 in September 1929. This dramatic climb led economist Irving Fisher to famously declare that stock prices had reached a “permanently high plateau.” However, this optimism was shattered by one of the most significant financial events in history: the stock market crash of 1929. Understanding why the stock market crashed in 1929 offers valuable insights into the dynamics of market booms and busts, and remains relevant for understanding potential stock market crashes today.
The Roaring Twenties Boom and the Setup for the Crash
The post-World War I era in the United States was characterized by economic prosperity and widespread optimism. Families experienced increased wealth, and new technologies like automobiles and telephones became increasingly common. This era of prosperity fueled a surge in stock market investment as ordinary individuals began pouring their savings into stocks and bonds. A burgeoning financial industry, featuring brokerage houses, investment trusts, and margin accounts, made stock ownership accessible to the masses. Margin accounts, in particular, played a crucial role in inflating the market bubble. These accounts allowed investors to purchase stocks by paying only a fraction of the price, typically 10 percent, and borrowing the rest. The purchased stocks themselves served as collateral for these loans. This influx of borrowed money into the stock market dramatically increased demand for equities, driving stock prices to unsustainable levels and creating a speculative frenzy.
The Federal Reserve’s Response and Unintended Consequences
Despite the widespread euphoria, some voices of caution emerged. The Federal Reserve, particularly its Board and several Reserve Bank governors, expressed concerns about excessive stock market speculation. They believed that resources were being diverted from productive sectors of the economy, such as commerce and industry, into speculative investments. This concern stemmed from the Federal Reserve Act, which was interpreted to restrict the use of Federal Reserve resources for speculative credit. The Act authorized reserve banks to accept assets related to agricultural, commercial, and industrial activities as collateral for loans but explicitly prohibited the acceptance of collateral related to investments in stocks and bonds, except for government securities. This reflected the “real bills doctrine,” a prevalent theory at the time, which advocated that central banks 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 to intervene. However, the optimal approach was debated. The Federal Reserve Board favored direct action, urging reserve banks to deny credit to member banks that were lending to stock speculators. They also issued public warnings about the dangers of speculation. In contrast, George Harrison, the governor of the Federal Reserve Bank of New York, advocated for raising the discount lending rate. This measure would directly increase the cost for banks to borrow from the Federal Reserve, indirectly raising interest rates across the economy, impacting businesses and consumers alike. Initially, the Board resisted New York’s repeated requests to raise the discount rate. However, in August 1929, they finally relented, and New York’s discount rate reached 6 percent.
This interest rate hike by the Federal Reserve had unforeseen and far-reaching consequences. Due to the 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. This synchronized tightening of monetary policy across the globe triggered a global economic slowdown, leading to a contraction in international commerce and a worldwide economic downturn.
Despite these warning signs and the global economic headwinds, the stock market boom in the U.S. continued. Commercial banks persisted in lending to speculators, and other lenders further increased their exposure to broker loans. In September 1929, the stock market began exhibiting increased volatility, with sharp declines followed by swift recoveries. Despite this instability, some prominent financial figures, including Charles E. Mitchell, 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 confidence in October, Mitchell and a group of bankers publicly purchased large blocks of shares at high prices. This effort proved futile. Investors panicked and began selling their holdings en masse, triggering a dramatic collapse in share prices.
Black Monday and Black Tuesday: The Crash
The culmination of the speculative bubble and the loss of investor confidence arrived swiftly. On Black Monday, October 28, 1929, the Dow Jones Industrial Average plummeted nearly 13 percent. The following day, Black Tuesday, witnessed an even steeper decline of almost 12 percent. By mid-November, the Dow had lost almost half of its peak value. This marked the beginning of a protracted market downturn that continued through the summer of 1932. The Dow eventually bottomed out at 41.22 in July 1932, a staggering 89 percent below its 1929 peak and its lowest point of the 20th century. It took over two decades for the Dow to recover to its pre-crash levels, finally reaching those heights again in November 1954.
Aftermath and Initial Recovery
As the stock market crashed, funds rapidly exited the equity market and flowed into New York City’s commercial banks. These banks also found themselves holding substantial amounts of stock-market related loans. This sudden influx of deposits, coupled with the loan obligations, put significant strain on the banking system. As deposits increased, banks’ reserve requirements also rose, while simultaneously, their reserves were dwindling as depositors withdrew cash, banks acquired loans, and check clearing processes were slow. This created a precarious situation where many banks faced temporary reserve shortages.
In response to this banking crisis, the New York Federal Reserve Bank intervened decisively. It engaged in open market purchases of government securities, facilitated lending through its discount window, and lowered the discount rate. The New York Fed assured commercial banks that it would provide the necessary reserves to meet their needs. These actions injected liquidity into the banking system, eased reserve constraints on New York City banks, and enabled financial institutions to remain operational and meet customer demands during the crisis. Furthermore, these measures prevented short-term interest rates from spiking to disruptive levels, a common occurrence during financial crises.
While controversial at the time, with some members of the Federal Reserve Board questioning New York’s authority, these actions are now recognized as crucial in containing the immediate financial crisis. Although the stock market had collapsed, the commercial banking system at the epicenter of the crisis remained functional.
From Recession to Depression: The Lingering Impact
Despite the New York Fed’s success in stabilizing the banks, the stock market crash had a significant detrimental impact on the broader economy. The crash instilled fear and uncertainty among investors and consumers alike. Individuals who had lost their life savings became apprehensive about their financial futures, job security, and ability to meet their financial obligations. This pervasive fear led to a sharp decrease in consumer spending, particularly on big-ticket items like automobiles that were often purchased on credit. Companies, such as Ford Motors, experienced a decline in demand, leading to production cuts and worker layoffs. Unemployment surged, exacerbating the economic contraction that had already begun in the summer of 1929.
While the initial impact of the 1929 crash on economic activity began to wane within a few months, and by the fall of 1930, signs of economic recovery seemed possible, problems in another part of the financial system transformed what might have been a short-lived recession into the Great Depression, the most severe and prolonged economic downturn in modern history.
Lessons Learned from the 1929 Crash
The stock market crash of 1929 provided economists and policymakers, including leaders within the Federal Reserve, with crucial lessons about financial markets and economic management. Two key lessons emerged from this period.
Firstly, central banks should exercise caution when intervening in equity markets. Identifying and deflating asset bubbles is a complex and challenging task. Using monetary policy to curb investor enthusiasm can have broad, unintended, and potentially negative consequences, as demonstrated by the global economic downturn triggered by the Federal Reserve’s interest rate hikes in 1929.
Secondly, when stock market crashes do occur, their damage can be mitigated by following the crisis management playbook developed by the Federal Reserve Bank of New York in the fall of 1929. Providing liquidity to the banking system and ensuring its stability is crucial to preventing a financial crisis from spilling over into the broader economy.
These lessons were debated and refined in the decades following the Great Depression, culminating in the consensus view articulated in Milton Friedman and Anna Schwartz’s seminal work, A Monetary History of the United States (1963). Their conclusions regarding these events have been widely cited by economists and policymakers, including prominent members of the Federal Reserve Board of Governors.
The financial crisis of 2008 has prompted renewed discussions and a re-evaluation of these long-held conclusions. Economists are actively debating whether central banks can and should proactively prevent asset market bubbles and how concerns about financial stability should be integrated into monetary policy decisions. These contemporary discussions echo the debates among Federal Reserve leaders in the 1920s, highlighting the enduring relevance of the lessons learned from the stock market crash of 1929 for navigating the complexities of modern financial markets and understanding why stock markets crash.
