The 1920s, often called the “Roaring Twenties,” witnessed an unprecedented surge in the New York Stock Exchange. Stock prices climbed to levels never seen before, fueled by optimism and new financial instruments. The Dow Jones Industrial Average, a key indicator of market health, experienced a sixfold increase, soaring from 63 points in August 1921 to a peak of 381 in September 1929. This incredible bull market led some, like economist Irving Fisher, to declare that stock prices had reached “what looks like a permanently high plateau.” However, this era of exuberance was abruptly halted by one of the most significant economic events in history: the stock market crash of 1929.
The boom culminated in a dramatic and devastating collapse. “Black Monday,” October 28, 1929, marked the beginning of the plunge, with the Dow Jones plummeting nearly 13 percent. The following day, “Black Tuesday,” saw an even steeper decline of almost 12 percent. By mid-November, the Dow had lost nearly half its value from its September peak. This was not a short-lived correction; the downward spiral continued relentlessly until the summer of 1932. At its nadir, the Dow closed at 41.22, a staggering 89 percent below its peak and the 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.
Chart 1: Dow Jones Industrial Average Index daily closing price, from January 2, 1920, to December 31, 1954. This chart visually represents the boom and bust cycle of the stock market in the 1920s and 1930s, peaking in 1929 and hitting its lowest point in 1932, before a long recovery. (Source: FRED, https://fred.stlouisfed.org (graph by: Sam Marshall, Federal Reserve Bank of Richmond))
The Roaring Twenties and Speculative Investments
The financial boom of the 1920s was deeply rooted in a widespread sense of optimism and prosperity. Families experienced increased wealth, and new technologies like automobiles and telephones became more accessible. This era saw ordinary individuals increasingly investing in stocks and bonds. The rise of brokerage houses, investment trusts, and margin accounts made it easier for the average person to participate in the stock market, often with borrowed money. Margin accounts allowed investors to purchase stocks by putting down only a small percentage of the price, typically just 10 percent, and borrowing the rest. The purchased stocks themselves served as collateral for these loans. This influx of borrowed funds into the equity markets fueled further price increases, creating a speculative bubble.
However, not everyone was caught up in the euphoria. The Federal Reserve, the central banking system of the United States, harbored skepticism about the escalating stock market speculation. Many governors of Federal Reserve Banks and a majority of the Federal Reserve Board believed that this speculative activity was diverting resources away from more productive sectors of the economy, such as commerce and industry. The Board explicitly stated that the Federal Reserve Act was not intended to support the use of Federal Reserve Bank resources for “the creation or extension of speculative credit.”
This stance was based on the interpretation of 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 loans. However, it specifically prohibited the acceptance of “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 restrictions to open market purchases.
These provisions reflected the “real bills” doctrine, a prevalent theory among the architects of the Federal Reserve Act in 1913 and influential figures within the Federal Reserve System in 1929. This theory posited that a central bank should expand the money supply when production and commerce grew and contract it during economic downturns.
The Federal Reserve’s Attempt to Curb Speculation
Faced with mounting speculation, the Federal Reserve decided to intervene. The crucial question was the best course of action. Debates arose within the Federal Reserve Board and among the leaders of the reserve banks. To control the flow of call loans, which were fueling market speculation, the Board favored a policy of direct action. They requested reserve banks to reject credit requests from member banks that were lending to stock market speculators. The Board also issued public warnings about the dangers of excessive speculation.
George Harrison, the governor of the Federal Reserve Bank of New York, advocated for a different approach. He preferred raising the discount lending rate, the interest rate at which commercial banks borrow money directly from the Federal Reserve. Increasing this rate would directly raise borrowing costs for banks and indirectly push up interest rates for all borrowers, including businesses and consumers. Throughout 1929, New York repeatedly requested to raise its discount rate, but the Board initially denied these requests. Finally, in August, the Board conceded to New York’s proposal, and New York’s discount rate was raised to 6 percent.
This increase in the Federal Reserve’s discount rate 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 own interest rates to protect their gold reserves and exchange rates. These tighter monetary policies contributed to economic recessions in economies around the world. International trade declined, and the global economy began to slow down.
Despite the Federal Reserve’s attempts to cool down the market, the financial boom continued. The Federal Reserve watched with growing concern as commercial banks persisted in lending to speculators, and other lenders increased their investments in broker loans. In September 1929, the stock market became increasingly volatile, experiencing sudden drops followed by rapid recoveries. Some financial leaders, 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 encourage investors to buy stocks. In October, Mitchell and a group of bankers attempted to restore investor confidence by publicly purchasing large blocks of shares at inflated prices. This effort, however, proved futile. Investors began selling their holdings in a panic, and stock prices plummeted.
A large crowd gathers outside the New York Stock Exchange in the aftermath of the 1929 stock market crash, illustrating the public reaction to the financial turmoil. (Photo: Bettmann/Bettmann/Getty Images)
The Immediate Aftermath and Containment Efforts
As the stock market crashed, funds rapidly flowed out of equities and into New York City’s commercial banks. These banks also found themselves holding millions of dollars in stock-market-related loans. The sudden surge in deposits and the existing loan portfolios placed immense strain on the banks. As deposits increased, so did banks’ reserve requirements, the fraction of deposits banks are legally required to hold as reserves. Simultaneously, banks’ reserves were decreasing as depositors withdrew cash, banks purchased loans, and the check clearing process (the primary method of depositing funds) was slow. These opposing forces created temporary reserve shortages for many banks.
The New York Fed acted swiftly to alleviate the pressure. It initiated open market purchases of government securities, increased lending through its discount window, and lowered the discount rate. It reassured commercial banks that it would provide the necessary reserves. These actions increased the total reserves within the banking system, eased the reserve constraints faced by New York City banks, and allowed financial institutions to remain operational and meet their customers’ demands during the crisis. Crucially, these measures prevented short-term interest rates from spiking to disruptive levels, a common occurrence during financial crises.
At the time, the New York Fed’s actions were met with controversy. The Federal Reserve Board and several reserve banks argued that New York had overstepped its authority. However, in retrospect, these actions are seen as crucial in containing the immediate crisis. While the stock market had collapsed, the commercial banks at the epicenter of the storm remained solvent.
Long-Term Economic Impact and Lessons Learned
Despite the New York Fed’s success in stabilizing the banking system in the short term, the stock market crash had a significant negative impact on the broader economy, particularly commerce and manufacturing. The crash instilled fear and uncertainty in investors and consumers alike. Many individuals lost their life savings, worried about job security, and struggled to meet their financial obligations. This pervasive fear and uncertainty led to a sharp decrease in spending on major purchases, such as automobiles, which were often bought on credit. Companies like Ford Motors experienced a decline in demand, leading to production cuts and worker layoffs. Unemployment rose, and the economic contraction that had begun in the summer of 1929 deepened considerably.
While the crash of 1929 significantly curtailed economic activity, its initial impact appeared to be fading within a few months. By the fall of 1930, economic recovery seemed possible. However, problems in another part of the financial system, the banking sector more broadly, transformed what might have been a short recession into the Great Depression, the most severe and prolonged economic downturn in modern history.
The stock market crash of 1929 provided economists, including leaders within the Federal Reserve, with crucial lessons that remain relevant today.
Firstly, central banks should exercise caution when reacting to movements in equity markets. Identifying and deflating financial bubbles is an inherently complex task. Using monetary policy tools to curb investor enthusiasm can have broad, unintended, and potentially detrimental consequences for the wider economy.
Secondly, when stock market crashes do occur, the damage can be mitigated by implementing the crisis response playbook developed by the Federal Reserve Bank of New York in the fall of 1929 – providing liquidity to the banking system to prevent wider financial contagion.
Economists and historians have continued to debate these lessons in the decades following the Great Depression. A consensus view 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 on these events are widely cited by economists, including prominent figures within the Federal Reserve Board of Governors like Ben Bernanke, Donald Kohn, and Frederic Mishkin.
However, in the wake of the financial crisis of 2008, scholars are re-examining these established conclusions. Economists are actively debating whether central banks can, and indeed should, attempt to prevent asset market bubbles, and how concerns about financial stability should influence monetary policy decisions. These ongoing discussions echo the debates that took place among the leaders of the Federal Reserve in the 1920s, highlighting the enduring relevance of the lessons learned from the stock market crash of 1929 for understanding and responding to financial market dynamics today.
