The 1920s, often called the Roaring Twenties, were a period of unprecedented economic boom in the United States, with the New York Stock Exchange at the heart of this exuberance. Share prices soared to remarkable levels, becoming a symbol of the era’s widespread prosperity. The Dow Jones Industrial Average, a key indicator of stock market performance, surged sixfold from 63 in August 1921 to a peak of 381 in September 1929. This exponential growth led to optimistic pronouncements, famously exemplified by economist Irving Fisher’s statement that stock prices had reached “what looks like a permanently high plateau.”
However, this extraordinary bull market was not sustainable. The boom culminated in a devastating crash, initiating a period of economic hardship known as the Great Depression. “Black Monday,” October 28, 1929, marked the beginning of the collapse, with the Dow plummeting nearly 13 percent. The following day, “Black Tuesday,” saw another dramatic drop of almost 12 percent. By mid-November 1929, the Dow had lost almost half its value. The downward spiral continued relentlessly until the summer of 1932, when the Dow reached its nadir at 41.22, a staggering 89 percent below its peak and the lowest point of the 20th century. It took until November 1954 for the Dow to recover to its pre-crash heights, highlighting the profound and long-lasting impact of the 1929 stock market crash.
The Roaring Twenties Boom: A Foundation for the Fall
The financial boom of the 1920s was deeply rooted in a pervasive sense of optimism and progress. American families experienced increased prosperity, fueled by the rise of new technologies like automobiles and telephones, which transformed daily life. This era of confidence extended to the financial markets, as ordinary citizens increasingly invested in stocks and bonds. A burgeoning financial industry, comprised of brokerage houses, investment trusts, and margin accounts, made stock market participation accessible to the masses. Margin accounts, in particular, played a crucial role in inflating the market. 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 equity markets dramatically drove up stock prices, creating a speculative bubble.
Seeds of Doubt: Skepticism and the Federal Reserve’s Response
Despite the widespread euphoria, some institutions harbored concerns about the escalating stock market speculation. Among the skeptics was the Federal Reserve System. Many governors of the Federal Reserve Banks and a majority of the Federal Reserve Board believed that excessive speculation was diverting resources from more productive sectors of the economy, such as commerce and industry. The Board articulated its stance, asserting that the Federal Reserve Act was not intended to facilitate the use of Federal Reserve resources for speculative credit expansion.
This viewpoint was grounded in the Federal Reserve Act of 1913. Section 13 of the Act authorized reserve banks to accept assets financing agricultural, commercial, and industrial activities as collateral for discount loans. However, 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.” Section 14 extended these limitations to open market purchases.
These provisions reflected the “real bills doctrine,” a prevalent theory among the architects of the Federal Reserve Act and influential figures within the Federal Reserve System in 1929. This theory posited that a central bank should expand the money supply in response to increased production and commerce and contract it during economic downturns.
Faced with mounting stock market speculation, the Federal Reserve decided to intervene. However, the optimal course of action was a subject of intense debate within the Federal Reserve Board and among the leaders of the reserve banks. To curb the flow of call loans fueling speculation, the Board favored “direct action,” urging reserve banks to reject credit requests from member banks that were lending to stock speculators. The Board also issued public warnings about the risks of speculation.
In contrast, George Harrison, the governor of the Federal Reserve Bank of New York, advocated for raising the discount lending rate. This approach would directly increase the cost for banks to borrow from the Federal Reserve, indirectly raising interest rates across the economy for businesses and consumers alike. The Federal Reserve Bank of New York repeatedly requested to raise its discount rate in 1929, but the Board initially denied these requests. Finally, in August 1929, the Board conceded to New York’s plan, and the discount rate was raised to 6 percent.
This decision to raise interest rates had unforeseen international repercussions. Due to the international gold standard in place at the time, the Fed’s actions compelled foreign central banks to raise their interest rates in response. These tighter monetary policies contributed to economic slowdowns and recessions in economies worldwide, leading to a contraction in international commerce and a global economic downturn.
Despite these monetary policy adjustments, the financial boom in the U.S. stock market continued. 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 began to exhibit signs of instability, with erratic fluctuations, characterized by sudden drops followed by swift recoveries. Despite the volatility, 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, publicly encouraged investors to continue purchasing stocks.
Black Tuesday and the Cascade of Panic
In a final attempt to restore confidence in October 1929, Mitchell and a coalition of influential bankers collectively purchased large blocks of shares at inflated prices. This effort proved futile. Instead of reassuring investors, it triggered a wave of panic selling. Investors began to liquidate their holdings en masse, causing share prices to plummet dramatically.
As the stock market crashed, funds rushed out of equities and into New York City’s commercial banks. These banks also found themselves holding substantial amounts of stock-market loans. The sudden surge in deposits and loan activity placed immense strain on the banking system. Increased deposits raised banks’ reserve requirements, while withdrawals by depositors and the purchase of loans depleted reserves. The slow check clearing process further exacerbated the reserve shortages, leaving many banks temporarily unable to meet their reserve obligations.
To alleviate this financial strain, the New York Fed took decisive action. It engaged in open market purchases of government securities, facilitated lending through its discount window, and lowered the discount rate. The New York Fed reassured commercial banks that it would provide the necessary reserves. These measures successfully increased reserves within the banking system, easing the reserve constraints faced by New York City banks. This intervention enabled financial institutions to remain operational and meet customer demands during the crisis. Furthermore, these actions prevented short-term interest rates from spiking to disruptive levels, a common occurrence during financial crises.
While controversial at the time, with the Board and some reserve banks criticizing New York’s actions as exceeding its authority, hindsight suggests that these interventions were crucial in containing the immediate crisis. The stock market had collapsed, but the commercial banks at the epicenter of the storm remained solvent, preventing a complete financial system meltdown.
The Aftermath: From Crash to Depression
Despite the New York Fed’s success in stabilizing the banking system, the stock market crash had a significant detrimental impact on the broader economy. The crash instilled fear and uncertainty among investors and consumers alike. Many individuals lost their life savings, faced job insecurity, and worried about their ability to meet financial obligations. This pervasive fear and uncertainty led to a sharp decline in consumer spending, particularly on big-ticket items like automobiles that were often purchased on credit. Companies, such as Ford Motors, experienced a drop in demand, forcing them to reduce production and lay off workers. Unemployment surged, deepening the economic contraction that had begun in the summer of 1929.
While the immediate impact of the 1929 crash diminished within a few months, and signs of economic recovery emerged by the fall of 1930, problems within another segment of the financial system transformed what might have been a short 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 critical lessons. Firstly, central banks should exercise caution when responding to developments in equity markets. Identifying and deflating financial bubbles is a complex task, and using monetary policy to curb investor enthusiasm can have broad, unintended, and undesirable consequences for the wider economy.
Secondly, when stock market crashes do occur, the proactive measures implemented by the Federal Reserve Bank of New York in the fall of 1929 offer a valuable playbook for containing the immediate fallout.
These lessons and the events of 1929 have been subject to extensive debate among economists and historians in the decades following the Great Depression. The publication of Milton Friedman and Anna Schwartz’s seminal work, A Monetary History of the United States, in 1963, helped solidify a consensus view on these events, influencing prominent economists and Federal Reserve officials like Ben Bernanke, Donald Kohn, and Frederic Mishkin.
However, the financial crisis of 2008 has prompted scholars to re-evaluate these long-held conclusions. Economists are currently revisiting questions about whether central banks can and should proactively prevent asset market bubbles and how concerns about financial stability should factor into monetary policy decisions. These contemporary discussions echo the debates that took place among the leaders of the Federal Reserve during the volatile 1920s, highlighting the enduring relevance of the 1929 stock market crash and its lessons for modern economic policy.
In conclusion, the 1929 stock market crash was a multifaceted event, triggered by a combination of speculative excesses during the Roaring Twenties, underlying vulnerabilities in the financial system, and arguably, the unintended consequences of monetary policy decisions. While the New York Fed’s response mitigated the immediate banking crisis, the crash nonetheless marked a turning point, contributing to the onset of the Great Depression and leaving behind crucial lessons that continue to inform economic thinking today.
