In J.K. Galbraith’s entertaining 1954 account of the stock-market collapse of 1929 The Great Crash (re-released by Penguin in paperback last year), the celebrated economist took delight in recording the madness of crowds, responding to the lure of easy wealth. Galbraith observed that, unlike military historians, the economic historian is expected to use past experience to foretell the future. What similarities would he find in today’s financial markets?
In Galbraith’s telling, Florida real estate in the mid-1920s provided a foretaste of the stock-market boom that would follow later in the decade. Booms need “the indispensable element of substance”. For Florida, air-conditioning and improved transport revealed its climate advantage.
Florida illustrated a further key component of the boom: financial leverage. Developers sold blocks on 10 per cent deposit. In a rising market, profits could be realised before the full payment fell due, encouraging further purchases.
Once the boom got underway, it was hard to distinguish substance from the ephemeral. Wealth was created not from conventional physical investment, but by the transformation of worthless swampland into potential building blocks, with values based not on usage, but on expectations of future higher values.
Around 1925 the Florida land-boom expired, but new speculative opportunities opened up as equity prices began the ascent that peaked in 1929.
Margin trading and brokers’ loans provided leverage. Further institutional support was given by leveraged investment trusts. Galbraith describes these as:
the most notable piece of speculative architecture of the late twenties … The virtue of the investment company is that it bought about an almost complete divorce of the volume of corporate securities outstanding from the volume of corporate assets in existence.
Modern-day investment funds are common enough, although none of them offers the degree of leverage provided back then by Goldman Sachs’ Shenandoah and Blue Ridge trusts. One timeless commonality is the belief that fund managers have special insights into future markets, not available to ordinary investors.
Galbraith described these 1920s investment companies as “more wonderous than the South Seas Company” in that “they were undertakings the nature of which was never to be revealed”. Perhaps present-day “special-purpose acquisition companies” (SPACs) – “blank-cheque” companies – match them in lack of transparency.
Companies bought their own shares to boost prices, predating today’s equity buy-backs.
Beginning in 1928, additional market support came from optimistic commentary: the “process of reassurance … (which) eventually achieved the status of a profession” … “For effective incantation, knowledge is neither necessary nor assumed.” Today, as then, optimistic seers get more airplay than spoilsports predicting an end to the good times.
“Organised support” was mobilised when the boom faltered in 1929. Financiers made coordinated efforts to shore up the market, although there was more show than substance.
In today’s world, “organised support” has been replaced by the “Greenspan put” – the US Federal Reserve’s readiness to prop-up sharply falling financial markets, pioneered by the chairman Alan Greenspan in 1987, repeated by his successors Ben Bernanke in 2008 and by Jerome Powell in 2018 and 2020. This has proved more substantive than in 1929, but at some cost. Each time the market has been saved, this was taken as endorsement of the speculation.
As prices fell in 1929, balance sheets were cross-infected, with prime stocks sold at fire-sale prices because non-prime stocks in the same portfolio were illiquid. This phenomenon re-emerged in 2008 and in March 2020.
Since the 1920s, technology has created new products, with new markets – Uber, Airbnb, Facebook and many others – with the same problems of assessing long-term value of Florida real estate. What is the substance behind crypto-currencies such as Bitcoin or non-fungible tokens (a digital representation of an asset such as a painting)?
Warren Buffet’s observation that “we only know who is bathing naked when the tide goes out” is a restatement of Galbraith’s argument that bad corporate and banking structures in 1929 only looked obvious with hindsight.
Innovation has greatly expanded financial markets, but separating value from puffery is just as hard as in the years preceding the Great Crash. Does additional liquidity add to market depth, or just fund speculation? Does super-fast algorithmic trading provide better price discovery, or just give opportunity for “front-running”? Do derivatives broaden markets or facilitate gambling?
And the critical policy question: will the “Greenspan put”, justified by the Covid crisis in March 2020, be used again to protect those who have gambled that interest rates will stay low forever?
What was monetary policy doing during the 1920s equities boom? The US Fed lowered its key rate – the discount rate – in 1927 and expanded its quantitative easing-like bond buying “with the mathematical consequence of leaving the banks and individuals who had sold them with money to spare”. The rationale was to help the UK after its disastrous return to the gold-standard in 1925. One of the Fed Board members Galbraith quotes later described this as “one of the most costly errors committed by it or any other banking system in the last 75 years”.
The motivation for today’s rock-bottom global interest rates is different, but the effect on asset prices is much the same.
Better fiscal policy seems assured today. No Treasury Secretary would repeat then incumbent Andrew Mellon’s unfortunate call to “liquidate labour, liquidate stocks, liquidate the farmers”. Galbraith noted a “determination to do much that is wrong” with fiscal policy in the 1930s, but a “failure to do enough” was apparent after 2010.
Galbraith argued that while the linkage between the stock-market crash and the Depression was causal, other factors such as poor corporate governance and weak banking rules played a part.
Warren Buffet’s observation that “we only know who is bathing naked when the tide goes out” is a restatement of Galbraith’s argument that bad corporate and banking structures in 1929 only looked obvious with hindsight. This was demonstrated again in 2008. Today the banking system is far stronger, but stricter regulation has meant that risks have gravitated to non-banks.
The Shiller cyclically-adjusted Price/Earnings ratio for US stocks is currently twice its historical average and well above its peak before the 1929 crash. It is just short of the peak which foreshadowed the 1999 tech-wreck. Does history rhyme?