17,324 words/May 1987

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Fernand Braudel Institute of World Economics

Associated with the Fundação Armando Alvares Penteado

Avenida Angelica 580 • 01228 Higienópolis • São Paulo, Brazil

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17,324 words/May 1987

Depression Talk:

We never stop talking about it. But the folklore of the 1929 Crash

and the Depression has blurred the facts. What really happened?

The credit expansion bred by World War I led to the Great Depression.

What does this mean for today's credit expansion?

By Norman Gall

The Great Depression still haunts us as no other event in mankind's economic experience. Can something like the Wall Street Crash of 1929 happen again? Of course it can. Would such a crash trigger a worldwide depression like that of the 1930s? To deny this too confidently would be to repeat the overconfidence of 1929. But the world is different today. People say we have a safety net. Let's not overload that safety net.

Fear of another Crash and Depression may be the main safeguard against history repeating itself. Americans weren't afraid in 1929. "No nation ever faced a business decline more optimistically than America did this one," wrote historian Samuel Eliot Morrison.1But today fear has become a buzzword on Wall Street. At his 1933 inauguration President Franklin D. Roosevelt told the American people that "the only thing we have to fear is fear itself." In today's financial markets, however, the main thing to fear is the loss of fear. Fear is healthy, because it inspires caution and corrective action. Yet fear and confusion about the Great Depression still paralyze economic policy.

The Great Depression taught us the high cost of rigidity in the failure to scale down unrealistic claims. "Lenders were unwilling to adjust the debts due to them for the severe price level changes, and interest rates could not be said to have declined at all," says Barrie A. Wigmore, a Goldman Sachs partner, in his new book, The Crash and Its Aftermath, a richly detailed study of the financial system in the Depression. "Creditors accordingly had to bear debt burdens much greater in real terms than they bargained for. In the real estate, farm and commodities businesses, these debt burdens bankrupted the debtors. Thus, the financial system stuck to its practices as price levels changed, and the economy was required to adapt."2

Politicians and bureaucrats are caught in this kind of rigidity today, as a consequence of the biggest credit expansion of all time. They know many debts are unpayable, but they still are afraid to cut credit and liquidate bad debt for fear of starting another major crisis. "We eschew the sharp purge," the British economist Lionel Robbins wrote in 1934.3 "We prefer the lingering disease. Everywhere, in the money market, in the commodity markets and in the broad field of company finance and public indebtedness, the efforts of central banks and governments have been directed to propping up bad business positions." Choosing between the sharp purge and the lingering disease is harder because, after all these years, economists still disagree on the basic dynamics of the Depression and on what to do if such a calamity threatened again. This confusion is dangerous. If another earthquake were to occur, we might not be able to find the door.

1. What happened?

There's no disagreement over the statistical profile of the Depression. From 1929 to 1933, the U.S. gross national product [GNP] shrank by nearly half [46%] in current dollars and by 31% in constant dollars, discounting price declines of 22%. Nonfarm employment also fell by 22%. The number of unemployed multiplied eightfold, from 1.6 million in 1929 to 12.8 million in 1933, or from 3.2% to 25.2% of the civilian labor force. The business failure rate rose by half. Bankruptcy liabilities doubled by 1932. The prices of farm products fell by half and industrial raw materials by 23%.4 In early 1933 machine tool orders were 5% of their 1929 level.5 In the oil patches of Texas and Oklahoma, crude was selling for a nickel a barrel. The price of wheat in 1932 was 38 cents a bushel, less than one-third its 1926 level. Federal government revenues fell by half, covering only 41% of 1932 spending, creating a budget deficit of 4.7% of GNP, about the same size as the Reagan deficits of the 1980s.6 Big cities like New York, Chicago, Detroit and Philadelphia went broke. The financial problems of hundreds of state and municipal governments, plagued by tax shortfalls and collapsing real estate values, fed into local economic crises that led to 9,096 bank closings in 1930-33.7 In many places, factories and mines were shut down, towns abandoned, farms and homes sold for debt and economic activity of families and corporations geared toward subsistence and survival.

The Great Confusion about the Great Depression comes from our inability to deal with a man-made event that became too big for men to handle. So men have created a legendary figure, the Lender of Last Resort, to save them from the disaster they created. The failure of the Great Lender to save us from our mistakes runs through the writing of economists on the Depression. In their Monetary History of the United States, Milton Friedman and Anna J. Schwartz argue that the Depression was primarily an American collapse, needlessly deep and disastrous because of the failure of the Federal Reserve System to act effectively as a Lender of Last Resort to pump enough liquidity into banks in crisis. The other main view, developed by MIT's Charles P. Kindleberger, sees the Depression as basically an international phenomenon, involving the kind of financial crisis that tends to occur at peaks in the business cycle. On the 1931 financial collapse in Europe, deepening the U.S. Depression, Kindleberger argues that "if the runs on Austria, Germany and Britain had been halted by timely international help on a massive scale, the basic recuperative powers of competetive markets would have prevented the depression from going so long and deep."8

The legend of the Lender of Last Resort is being invoked to reassure us in today's credit expansion in the United States. The legend is rooted in the financial crises in 19th Century London, which were small by today's standards because the markets were regularly purged by smaller panics that prevented big financial distortions from getting out of hand. The idea was formulated in 1873 by Walter Bagehot, the great editor of The Economist, who wrote: "Theory suggests, and experience proves, that in a panic the holders of the ultimate [central bank] reserve (whether one or many) should lend to all that bring good securities quickly, freely and readily. By that policy they allay a panic; by every other policy they intensify it."9As a matter of fact, central banks and governments did do a lot of lending of last resort after 1929, but financial distortions, as well as disagreements among economists and central bankers, were too big for the lending to do much good. In 1928, Treasury Secretary Andrew W. Mellon voiced strong support for the idea as he was providing easy money to smooth the rise in stock prices. "We are no longer the victims of the business cycle," Mellon reassured his fans in the business community, who saw him as the greatest Treasury Secretary since Alexander Hamilton. "The Federal Reserve System is the antidote for money contraction and credit shortage."10

Other legends are increasing the Great Confusion. The Wall Street Journal, for example, regularly duns its readers with the falsehood that the 1930 Smoot-Hawley tariff caused the Depression to deepen throughout the world. Not only that, but Smoot-Hawley actually caused the Depression, even though the law was passed 14 months after the Crash. One Journal editorial (April 10, 1987) explained that "the 1929 stock market collapse represented efficient markets observing political developments and correctly anticipating the Smoot-Hawley tariff of 1930 --a plausible explanation of why the crash came before the tariff."

Recent research by leading economists show Smoot-Hawley having negligible effect on the Depression.11 But the financial distress in the United States hit the rest of the world very hard. The Depression was Great because it was a worldwide shrinkage of economic activity on a scale never before recorded in peacetime. While U.S. imports were only 4% of GNP in 1929, they were 16% of all other countries' exports.12 Many foreign nations suffered massive damage as U.S. imports fell in 1929-32 by half in volume and by two-thirds in current dollars and as U.S. foreign lending fell from $1.1 billion in 1930 to next to nothing two years later. In 1929 Britain still was the world's leading importer, even though it ran big trade deficits and its currency was supported by foreign [mainly U.S. and French] loans and bank deposits. By 1933 British imports were only 38% of their 1929 value as world trade shrank in the same proportion. U.S. import volumes never returned to 1929 levels until World War II began.13


Among industrial countries, the U.S. and Germany suffered most because they spawned the biggest credit expansions that were very vulnerable to economic contraction. Britain, France and Japan suffered less because Britain was stagnant throughout the 1920s, France was running a tight ship after a 1926 stabilization crisis and Japan was recovering from a 1927 banking panic that purged speculative fever enough for Japan to expand again in the 1930s. The Wall Street boom and crash of the 1920s had such a powerful impact on other economies because they cut savagely into a fragile worldwide debt and payments structure that was skewed and bloated as a consequence of World War I. Germany and the United States, despite the enormous differences between them, formed the axis of that structure and of the Depression that followed its collapse. The U.S. emerged from the war as the vital center of the world economy, while Germany not only was impoverished by the war but also was transformed into a snake pit of hatred and recrimination and a black hole that consumed other people's money.

By itself, the Depression was not a demographic catastrophe. But it was a key bridging episode between the two World Wars of 1914-45, which together cost 100 million lives and which, as time passes, are seen as one historical experience. "In the large sense the primary cause of the Great Depression was the war of 1914-18," President Herbert Hoover wrote in the opening paragraph of his memoir. "Without the war there would have been no depression of such dimensions. There might have been a normal cyclical recession; but, with the usual timing, even that readjustment probably would not have taken place at that paricular period, nor would it have been a `Great Depression.'"14

In the bleak landscape of the statistics, some distinctions have to be made. Despite great hardship of millions of people, death rates in the United States, as in the rest of the world, continued their decline through the Depression, although murders and suicides, which had been increasing since 1920, spurted upwards in 1929-33.15 Curiously, organized violence occurred only sporadically and on a small scale. The most serious outbursts of protest and repression were the March 1932 march of unemployed workers on the Ford Motor Co.'s giant River Rouge complex outside Detroit, when four demonstrators were killed by police, and the breakup in July 1932 of the "Bonus Army" veterans' encampment in Washington by the U.S. army after two men were killed by local police while dislodging protesters from a government building.16 These two incidents were the focus of worldwide publicity and propaganda, although they caused fewer casualties than many a two-car crash today. But they were key episodes in the political cornering of President Hoover, who was increasingly on the defensive as the Depression hit bottom in 1932-33.

Hoover protested that he never said: "Prosperity is just around the corner."17 But the words were pinned to his chest and used to ridicule him during the 1932 election campaign. However, he did say, over and over, with each bit of hopeful economic news, that the Depression had bottomed out and that things would get better. While he voiced optimism publicly, he told a White House meeting of business leaders on Nov. 21, 1929 that the crisis was worse than a mere stock market crash, that nobody could measure the depth of the disaster, that the Depression must last for some time.18 Many economists did detect a recovery underway in 1930 and 1931, led by sharp rises in consumer buying, machine tool orders and oil production, only to peter out amid spreading mortgage defaults and European financial crises that began in May 1931 with the failure of Austria's biggest bank, the Creditanstalt, and then went on to wreck Germany's debt-ridden financial structure and pushed England off the gold standard that September.

"The American people are going through another Valley Forge," Hoover said in May 1931, as the European financial crisis was deepening. "To each and every one of us it is an hour of unusual stress and trial."19 With 18 million people on relief, however, Hoover said a government survey found "neither hunger nor cold among the unemployed." About the men selling apples on street corners, he explained: "Some Oregon or Washington apple-growers' association shrewdly appraised the sympathy of the public for the unemployed. They set up a system of selling apples on the street corners in many cities, thus selling their crop and raising their prices. Many persons left their jobs for the more profitable one of selling apples."20

In The American Political Tradition, Richard Hofstadter explained: "What ruined Hoover's public career was not a sudden failure of personal capacity but the collapse of the world that produced him and shaped his philosophy."21 His view of human suffering and financial distress was different than that of most Americans. The son of Quaker pioneers in Iowa, Hoover saw his father, a blacksmith, die of heart trouble when he was six and his mother survive him by only four years, working to pay off his father's debts and speaking at religious meetings on the Iowa circuit. She managed to leave an inheritance of $2,000 [$28,000 in 1986 money] to her three children. After his mother's death Hoover lived with relatives in Oregon and graduated from Stanford in the depression year of 1895. Unable to find an engineering job, Hoover pushed ore cars at nights in a Nevada City mine for $2.50 a shift until an offer came to work in the gold mines of of western Australia.22

No President before or since Hoover has rooted his professional life so deeply outside the United States. He became very tough. From Australia he went to China, Japan, New Zealand, India, Zimbabwe, Egypt, Burma, Malaysia, Mexico, Peru, Sri Lanka, South Africa, Siberia and Italy. He became a millionaire and settled in London. When the Great War started in 1914, he was 40 and ready for public service. He organized voluntary famine relief for Belgium and then became President Woodrow Wilson's food czar, getting supplies to the hungry throughout Europe. He showed prodigious bureaucratic and political skill and became one of the most famous and admired of Americans. He went to Versailles with Wilson and, in The Economic Consequences of the Peace (1919), John Maynard Keynes said "Mr. Hoover was the only man who emerged from the ordeal of Paris with an enhanced reputation."23 In 1920 he was touted by both Republicans and Democrats as a possible presidential candidate. His future nemesis, Franklin Delano Roosevelt, wrote of Hoover: "He certainly is a wonder and I wish we could make him President of the United States. There could not be a better one."24 Hoover was dour and uneasy with politicians. He saw FDR as shallow and superficial. But Roosevelt had a common touch and a grasp of the main lines of problems and could wickedly taunt Hoover, as with his Alice in Wonderland-Humpty Dumpty story in the 1932 election campaign: IP3,3

"Will not the printing and selling of more stocks and bonds, the building of new plants and the increase of efficiency produce more goods than we can buy?"

"No, shouted Humpty Dumpty. "The more we produce, the more we buy."

"What if we produce a surplus?"

"Oh, then we can sell it to foreign consumers."

"How can the foreigners pay for it?"

"Why, we will lend them the money."25

As head of European food relief, Hoover showed great concern for human suffering abroad. Why would he show less concern for the suffering of his own people? Hoover's defensive statements about people not going cold and hungry may have been exaggerations by a wounded and cornered politician, or a cynical concealment of the truth, but they deserve further investigation, especially since they touch upon the Great Confusion about the Great Depression. From 1929 to 1933, consumer spending fell by 18% in constant dollars. But 1929 was a year of exceptional growth [6.2%], driven by the stock market boom. When average consumption for 1930-33 is compared with 1925-28, the fall is much less, only 2.8%. On the other hand, gross fixed business investment, beginning its fall earlier after reaching an all-time peak in 1927, was 38% below the 1925-28 average in 1930-33.26 Hence Hoover's great concern for keeping the bond market alive and functioning.

The performance of stocks in 1929-33 show how business experience varied. There was a general collapse of asset values, but profits and losses differed enormously among both companies and industries. In the pit of the Depression stocks were traded on Wall Street at 12% of their 1929 peaks. But those peaks were absurd, with stock prices averaging 420% of book value and 30 times earnings, double the price-earnings ratio [P/E] on Wall Street today.27 Hit hardest by the collapse in asset values and the shrinkage of business were the capital-intensive industries already declining, like railroads and steel, or those with a fragile financial structure, like utility holding companies, movies and investment trusts. The boom industries of the 1920s, like oil, farm equipment and autos, also got a bad beating. But big industrial companies survived intact, with few bankruptcies.

"Good management made a big difference in the face of adversity," observes "Inland Steel stood out in a lousy industry by reporting only one year of losses, while Bethlehem Steel, U.S. Steel and Youngstown Sheet & Tube lost money from 1931 to 1933." Wigmore adds that "IBM was already a glamour stock," earning 16.5% on equity and paying a $6 dividend thoughout the Depression. While nearly all movie companies went broke, Loew's earned profits and paid dividends throughout. Differing from the speculative investment trusts, Lehman Corp. played its game carefully, keeping one-third of its portfolio liquid and paying dividends throughout, even though it was formed at the peak of the bull market, while none of the other funds maintained a dividend or could keep its stock above 5% of 1929 value. Surprisingly, the chemical industry did well. Apart from the gold miners, Monsanto was the only major company whose stock traded in 1933 above its 1929 price. But Dow Chemical, National Biscuit and Owens-Illinois Glass were selling right at 1929 levels.28

The statistical profile of moderately reduced consumption is supported by the strong Depression performance of companies geared to people's day-to-day buying. Although their stock prices fell steeply, Standard Brands earned 29% on equity in 1933; General Foods 18% and National Biscuit 12%, while the average earnings for big food industry companies was 11.5%.29 Big operating utilities earned 6.6% on equity in 1932, even though their stock was trading at only 16% of their 1929 high at their lowest prices. Utility revenues were above 1929, their profits only 17% below and were floating new bond issues. In 1929-33 Coca Cola averaged a 23% return on equity, raised its dividend from $4 in 1929 to $8 in 1931 and saw its stock price fall by only 44%, or half the general market decline. Cigarette consumption fell by only 7% in 1929-33. Retail prices held steady while the farmers' selling price of tobacco fell by 50%. Cigarette companies were the best Depression investment after gold mining stocks. Shrinking world trade did not prevent U.S. cigarette exports from reaching record levels in 1930-31, absorbing one-third of production, allowing the companies even to raise their export prices by 20% in 1930 and 9% in 1931.30

The Great Depression was essentially a collapse of inflated asset values that damaged payments systems and wrecked many kinds of economic activity. Most politicians and economists of the day believed that the inflation of these asset values was a consequence of World War I. The most important inflated assets were Wall Street stocks, German war reparations obligations and the British pound. The overvaluing of all these assets was sustained by credit from the U.S. financial system. At some point, this overvaluation had to be adjusted. The great Joseph Schumpeter wrote that calculations based on these assets were "swamped by the torrents of a process of readjustment corresponding in magnitude to the extent of the industrial revolution of the preceeding 30 years. People, for the most part, stood their ground firmly. But that ground itself was about to give way."31

In his monumental study of Business Cycles (1939), Schumpeter argued that in the major industrial countries, including the U.S., "depressions were actually impending or in progress in 1914 and...public expenditures turned them into prosperity first and created untenable situations afterward."32 He added: "The huge machine for credit creation set up by the Federal Reserve Act as amended during the war period was left intact, and war expansion of the credit structure was supported and to some extent camouflaged by the broadening of its gold basis."33 [NOTE TO JWM: SEE PRE-1914 DIP IN SCHUMPETER'S INDUSTRIAL PRODUCTION CHART (p796) FOR 1897-1929]; THIS DIP IS CONFIRMED BY RECENT RESEARCH; ANOTHER CHART (p800) SHOWS HOW FLAT U.S. INDUSTRIAL PRODUCTION WAS IN 1919-29.]

Writing in Foreign Affairs magazine in 1932, the Harvard economic historian Edwin F. Gay observed: "The war fervor, aided and inflamed by energetic organization, placed government bonds in the hands of millions of people who never before had possessed instruments of credit. They were not thereby educated in the use of credit; they simply received a new vision of its possibilities. The basis was thus laid for the vast and credulous postwar market for credit which culminated in the portentous speculation of 1928 and 1929. Credit on the great scale is a modern invention, an instrument of immense power, comparable with the prime movers in the physical field. But the engineers of credit know far less about the limitations and control of their new organ than the engineers of steam and electricity know about theirs."34

In 1917, the U.S. entered World War I. Even before entering the war, U.S. investors lent $3 billion abroad, mostly to the belligerents, beginning the transformation of the U.S. from the world's biggest debtor [$3.8 billion in 1914] into the leading net creditor [$12.5 billion] by 1919 and holder of the world's biggest gold stock.35 When the guns of August opened fire in 1914, few people thought the war could last more than a few months, simply because the belligerents lacked the gold to finance fighting for much longer.36 What they didn't count on was the credit expansion unleashed by the war, which was as momentous as the war itself.

American investors stepped into the breach. In 1916 Citibank asked the Federal Reserve for permission to open 11 branches throughout the Russian Empire, from Warsaw to Vladivostok, and negotiated a $50 million bond issue for the Czarist government. Less than a month after Citibank assured the New York Fed that it would be unthinkable for a Russian government to repudiate its debts, the unthinkable happened. The Bolsheviks seized power, repudiated the Czar's debts and declared banking a state monopoly. Citibank's losses [$33 million] were more than 40% of its capital.37

According to prevailing theories of war finance, the Great War was to be paid for mainly with reparations exacted by the winners from the losers. But the war lasted too long. The direct cost of the war to all belligerents was $260 billion, nearly seven times U.S. GNP in 1914, only 20% of which was financed by taxation.38 The rest was paid for by borrowing, inflation and selling foreign securities, mainly in New York. By 1915 Germany's conservative Finance Minister warned: "How this debt is cast off will be the biggest problem since the beginning of the world."39 Under the peace treaty, Germany was saddled with an estimated $40 billion reparations debt, including a 26% export tax over 42 years.40

Foreign loans paid for nearly all the reparations and much more. To finance German reparations payments, the allies agreed in 1924 to lend Germany $200 million, of which $110 million were bonds sold in New York and oversubscribed 10 times. The plan's author, the Chicago banker Charles P. Dawes, won the Nobel peace prize. Schumpeter called what followed "the Dawes prosperity." "More than anything else," writes MIT's Charles P. Kindleberger in The World in Depression, 1929-1939,41 "this was the spark that ignited foreign lending from New York, first to Germany and shortly thereafter to Latin America and much of the rest of Europe." The $6.25 billion borrowed by Germany in 1924-30 offset $2 billion in reparations payments, financed lavish public works and a big trade deficit and still enabled the Reichsbank to gain $550 million in gold reserves.42 Like petrodollars in the 1970s, German reparations were recycled. Like U.S. bank loans to the Third World in the 1970s, these foreign bonds carried low interest relative to risk but high bankers' front-end fees.43

The first issue of Forbes [Sept. 15, 1917] ran a prophetic article headlined: "Revolutionizing Security Selling: Nation-Wide Activities and Plans of National City Company Mark New Development in Merchandising Investments. Remarkable Career of Its President, Charles E. Mitchell." At 40, Mitchell was a "financial human dynamo" and the rising star of Wall Street, "square of shoulder and lithe of limb" with "commanding, clean-cut features, eyes that penetrate," who in four years, by mounting a nationwide organization to sell war bonds, was to make National City Co. the world's biggest securities distributor before becoming head of the whole Citibank empire [1921].44 A salesman rather than a banker by training, Mitchell told B.C. Forbes: "The principal duty of the head of a large organization in the formative, developing stage is to pump, pump, pump energy into every fiber of it, to train thoroughly every member of it and to infuse into every employee white-heat enthusiam."

Under the impact of this white-heat enthusiasm, beginning with the wartime Liberty Bond drives, American nonfarm households accumulated financial assets at an astonishing rate, growing from $72 billion in 1912 to $290 billion in 1929. Their holdings of U.S. government securities grew from only $397 million in 1912 to $10.8 billion in 1922. Then families sold half their U.S. bonds to buy stocks as they expanded their total securities holdings from $87 billion to $262 billion over the next seven years [1922-29].45 Never before in the world economy had households accumulated assets on this scale. Since then, only the Japanese households have done so, providing liquidity to their own and foreign financial markets as the U.S. did in the 1920s.

Under Mitchell, Citibank was the first big bank to use mass marketing and a nationwide organization to sell stocks and bonds. According to Citibank's official history: "What General Motors was doing for the automobile and Proctor & Gamble for household products, National City now did for financial services. In fact, National City became a financial department store." Although Citibank considered closing its whole foreign branch system after taking crippling losses in Russia [1917] and Cuba [1921], under Mitchell's leadership it underwrote or sold 36% of the $10.3 billion in foreign bonds floated in the U.S. in the 1920s, as well as 19% of all domestic corporate issues.46

Other big banks formed their own securities marketing subsidiaries, often rooted in wartime efforts to sell Liberty bonds. "The great harm came when they began to put their own names on issues and, above all, when they established retail selling organizations with enterprising, high-pressure salesmen selling securities to individuals in the name of a great bank," observed Benjamin M. Anderson, then chief economist of the Chase National Bank. "The pressure on the head office to provide securities was immense. If first-rate securities were not available, the temptation was great to provide them with something to sell anyway. This was a factor of real importance in the deterioration of the quality of new securities offered to the public in the period of 1924-29."47 Naturally, the banks flogged their own stock through their securities subsidiaries, providing easy credit to customers and employees. Among the most overvalued stocks in the market were Citibank, trading at 120 times 1929 earnings and 1,300% of book value, and Chase, with P/E of 62, or 438% over book. By 1932 Chase stock fell to 7% and Citibank to 4% of their 1929 prices.48

These wonderful assets would have collapsed sooner if men of all nations had not shown strong faith in central banks. "Never before did central banks possess so much power and exercise so much influence as they did in the 1920s," observed the Hungarian economist Melchior Palyi in The Twilight of Gold 1914-1936.49 "That was the general consensus at the time, and still is, relying on appearance rather than realities. True, they had never been so deeply engaged in international affairs, even beyond their competence."

All central bankers joined hands in a nostalgic revival of the prewar gold standard, even though gold as money had come to mean less and less, despite huge increases in gold production, as paper money and demand deposits generated 95% of world money expansion from 1873 to 1913, while gold shrank from 28% to 10% of all money.50 Before 1914, the international gold payments system was run from London, the main lending center. After the war, England nostalgically restored the pound to its prewar value, $4.86, an overvaluation that it could not sustain, forcing it to live on other people's money. When Britain returned to the gold standard in 1925, it got a $200 million gold credit line from the New York Fed and another $100 million from J.P. Morgan & Co.51 Thus Americans, as the main providers of liquidity to the world, lent Britain the money to sustain the pound in the same way that the Japanese in the 1980s lent to Americans to sustain an overvalued dollar.

With an overvalued currency, Britain was expected to raise interest rates to prevent foreign deposits from leaving London. But higher interest rates would worsen the problems, mainly investment and unemployment, of an already depressed economy. The stability of the pound depended on higher interest rates in London than in New York. So the British decided that it would be nicer for the Americans to inflate their currency by lowering interest rates than for the British to raise their own. Montagu Norman, governor of the Bank of England, was such a great friend of Benjamin Strong, president of the New York Fed and the dominant figure in the infant Federal Reserve system, that Hoover scornfully called Strong "a mental annex to Europe" and charged that the British "invented the idea that the U.S. should expand credit and maintain lower interest rates" so Britain wouldn't have to raise its own interest rates to sustain an overvalued pound.52 Also see Eichengreen, "International coordination," p149.

This strategy crystalized at a secret meeting of the central bank governors of Britain, France, Germany and the U.S. at the Long Island estate of Treasury Undersecretary Ogden Mills in July 1927. Charles Rist, representing the Bank of France at the meeting, said later that "the decision to lower the discount rate was taken directly in a conversation between Montagu Norman and Benjamin Strong, by themselves. All the rest of us had to do was to approve it later. Once more in this case English monetary policy was decisive for the rest of the world." Over the next few weeks, interest rates were cut amid bitter controversy among the Federal Reserve banks and large-scale buying of government securities began.53

Stocks surged when the Fed launched its cheap money policy in late 1927, then crashed 18 months after the Fed switched to tight money in early 1928, when fears of unrestrained speculation prevailed. Higher discount rates failed to control speculation as banks rushed to borrow from the Fed at 5% to lend to brokers at higher rates.54 U.S. foreign lending slowed as tight money, together with Fed restrictions on bank credit to brokers, brought a huge flow of gold and money to the U.S. as foreigners were lured by the bull market and high interest rates for call money to finance stock speculation. "The tide of investment funds turned definitely from Europe to the United States, whereas in the preceding years it had been from the United States to Europe," recalled Anderson. "Our stock prices were mounting so rapidly that they were an irresistible magnet for a speculatively inclined world. Orders to buy New York stocks came from Asia and Africa. The high interest rates in New York, moreover, were a magnet for loose funds. Banks in Cairo and Morocco, to say nothing of European banks, were sending funds to New York to be loaned on call at the high rates prevailing."55

There also were domestic reasons for the cheap money. Contrary to cliches about the Roaring Twenties, performance of the U.S. economy was patchy and slowing down toward the end of the decade. Measured from the pit of the 1920-21 recession, real growth was a roaring 6.4% yearly to its 1929 peak. But taken from the previous peak in 1918, it was the same as the 2.7% of 1976-86, while factory employment failed to grow at all in 1918-29. Economic growth spurted in the early 1920s, but GNP was flat in 1926-28. Real estate and automobile markets were showing signs of saturation. In 1927 the president of Studebaker, noting that two-thirds of cars were sold on credit and that $1.5 billion in unpaid installment notes were outstanding for the industry, asked: "What would occur should there be another 1893?"56 Factory payrolls were shrinking, unemployment was rising sharply and freight-car loadings and railway receipts were falling off. Mellon said interest rates would remain low, seeing "no evidence of overspeculation" in the stock market, which seemed "to be going along in a very orderly fashion.57

Mellon's claim to greatness in his 11 years as Treasury Secretary, serving longer than any other man, was that he ran budget surpluses and cut government spending and debt. But in other respects the Pittsburgh banker was an enigma to his fellow men. In his biography of Calvin Coolidge, William Allen White said "Mellon was President Coolidge's bad angel."58 His influence was seen in Coolidge's statements reassuring the market on the enormous growth of brokers' loans, which doubled in 1928-29, saying prosperity was "absolutely sound" and stocks were "cheap at current prices."59 While Hoover warned against stock speculation throughout the 1920s, Mellon greased the wheels of the cheap money policy. In the style of the New Economics of the 1960s, both men saw the U.S. entering a New Era of permanent prosperity, immune to depression.

Mellon's attitude changed quickly after the Crash. The change reflected the stark choices, then and now, of officials during financial crisis. Either you provide money, creating it if necessary, or you let the system purge itself through the collapse of unsound debtors and creditors. "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate," Mellon told Hoover shortly after the Crash. "It will purge the rottenness from the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the pieces."60

Mellon told Hoover what he remembered as a boy during the 1873 depression, when tens of thousands of farms had been foreclosed; when railroads fell into receivership; when banks failed; when men went jobless and mobs roamed the streets. The 1873 depression was deep and painful, Mellon said, but within a year the economy started recovering on its own. Schumpeter, however, called 1874-78 "years of almost unrelieved gloom," with some aspects of depression "quite as dark in 1873 to 1877 as they were in 1929 to 1933." Some 400 banks and more than 47,000 businesses failed, including many railroads, in what Dun's annual report called "a depression unparalleled in extent, character and duration."61 After fevered speculation in land and railroad shares ended in the bankruptcies of Jay Cooke and the Northern Pacific, a wave of panic selling forced the New York Stock Exchange to close for 10 days. The U.S. Treasury immediately started pumping cash into the money market. President Ulysses S. Grant and his Treasury Secretary went to New York to hear bankers plea for a massive printing of greenbacks to bail them out.62 New railroad construction fell by two-thirds in two years.63 Prices of wheat, cotton, rails and pig iron spiralled downward.64 While data were sketchy, Schumpeter said stories of 3 million "tramps" in the winter or 1873-74 "indicate that relative unemployment was actually worse than it was during the recent world crisis."65 Hoover replied to Mellon that in the 1870s much suffering might have been prevented; the economy was simpler then and many unemployed could return to farms to live with relatives.66

Hoover rejected Mellon's advice to do nothing and, instead, began applying to government policy the techniques of business management that had been gaining strength since the 1873 depression by which, according to Harvard business historian Alfred D. Chandler Jr., "the visible hand of management replaced the invisible hand of market mechanisms in administering and coordinating day-to-day production and distribution."67 Beginning with 1873, development of the management techniques of big business accelerated during periods of depression. The decades after 1873 saw the application to a broad range of industries the principles of nationwide business organization pioneered by the railroads. In the 1920-21 depression, involving as steep a two-year fall in output as 1930-31, big companies in major industries --such as General Motors, Ford, Armour, General Electric, Sears Roebuck, Dupont and U.S Rubber-- found themselves in an inventory crisis that forced them to reorganize their operations and develop ways of more carefully forecasting demand, output and flows of materials. After the 1929 Crash, many diversified into new products: GE and Westinghouse into home appliances, radio and X-ray equipment; GM into diesel locomotives, tractors and airplanes; Dupont into paints, dyes, film and fibers. However, while big business learned to calibrate supply and demand, the Great Depression showed it had no way of preventing collapse of the mass market.68

Recognition of this paved the way for modern economic management on a national scale.

The facts of the 1873 depression place the Great Depression of the 1930s in broader perspective. According to William H. McNeill, the eminent University of Chicago historian, both crises produced radical economic modernization. "The principal key to the surge in wealth that occurred in the first three decades of the 20th Century probably lay in new forms of economic management and control invented in the aftermath of the 1873 crash," McNeill argues. The crisis, and its pressures to reduce costs, accelerated development of big business, staffed by professional managers, that "soon dominated the manufacture and sale of such commodities as steel, chemicals, sewing machines, automobiles and the like....Thus, as long as most of the population farmed, and could revert to a quasi-subsistence mode of life in times of credit collapse, corporate management of large-scale industrial production could and did avert most of the cost of the business cycle for themselves, while improving ordinary citizens' lives by cheapening many old products and creating new consumer goods. It was a great achievement, and transformed industrial society profoundly between the 1880s and the 1930s."

Between the two depressions, people moved into towns and cities very fast. The U.S. population shifted from 25% urban in 1870 to 56% in 1930, reaching 75% today.69

By 1930, the shrinking farm sector no longer could harbor the unemployed of the growing cities, containing millions of immigrants and their children with no ties to rural areas. So another radical change came. Profits and losses were socialized with more government regulation and transfer payments. "The national scale of economic management that emerged from the Depression of the 1930s and World War II seems very like the enlarged corporate scale of management that emerged from the crash of 1873 and the depressed decades that followed," McNeill observes. "New concepts --GNP for example-- and new statistical measuring rods were developed to allow skills that had been developed for the management of big corporations to direct the economic activity of entire nations."70

After 1945, these lessons were applied worldwide to develop what the British economist Angus Maddison calls the "managed liberalism" that bred the Golden Age of heightened growth, trade and economic stability lasting from 1950 to 1973. Hoover was a pioneer of this change. Throughout the 1920s, he preached government countercyclical policies and mobilization of private energies to reduce economic pain and raise efficiency, using new lines of statistical and business cycle research that found their way into official pep talks and exhortations. "The ideas embodied in the New Deal legislation were a compilation of those which had come to maturity under Hoover's aegis," wrote Rexford G. Tugwell, a key Roosevelt adviser.71 "The Hundred Days was the breaking of a dam rather than the conjuring out of nowhere of a river."

When the 1929 Crash came, Hoover was ready with a plan. He quickly went into action with a three-prong program to sustain demand and keep the economy moving: (1) more public works spending at all levels of government; (2) low interest rates to ease business investment and home-building (3) keeping wages high to prevent a collapse of consumer purchasing power. Within weeks of the Crash, Hoover launched into the most forceful government effort to curb economic crisis ever seen in modern times. He got Congress to enact a tax cut, got business and labor leaders to hold the line on prices, wages and capital spending and got the Fed to ease credit by lowering interest rates from 4% to 1.75%, the lowest on record.72 As the Depression deepened, he organized the Reconstruction Finance Corporation [RFC], whose loans did much to save the financial system.

Why then did Hoover fail?

Nobody was prepared for a calamity on this scale. In facing the calamity, it may be that Hoover didn't go far enough in his economic nationalism. While he and Roosevelt agreed on a high wage policy and a tariff wall to protect U.S. wages from cheaper foreign labor, Hoover allowed his commitment to the gold standard and a strong dollar to suck the U.S. into the collapse of the weird international debt and payments structure spawned by World War I. Roosevelt had no such commitments. Within his commitments to gold and the dollar, Hoover managed ably, until 1931, what inevitably had to be a severe depression following the worldwide inflation of assets in 1914-29. But in 1931 the whole house of cards blew away.

The house of cards was floating on a broth of short-term loans. The Creditanstalt, the Rothschilds' Vienna bank and Austria's biggest, failed after the French pulled their loans in protest against a planned customs union between Germany and Austria. Half the Creditanstalt's $145 million deposits were foreign.73 By the time the Creditanstalt closed in July, the panic had spread to Germany, which lost one-third of gold and foreign exchange reserves in two months, forcing its whole banking system to shut down. The Bank for International Settlements found that $10 billion of short-term debt was floating around the world, with $5 billion in Central Europe, a much bigger share then of total international assets than the $212 billion in developing country short-term debt discovered at the time of the Mexico default in 1982.74 But faith among bankers is robust and always comes back. Citibank, a leader during the 1920s in short-term lending to Germany, which generated one-third of its foreign business and 43% of its foreign profits before the loans went bluey, announced confidently in its 1981 annual report, published a few months before the Mexico default, "country risk from foreign currency lending is reduced as te length of the obligation decreases, since shorter maturities permit adjustment in exposure as balance of payments or political conditions change."75

Fed officials at first told Hoover that U.S. banks made only $500 million of these short-term loans but Hoover, checking further, found that the real amount "probably exceeded $1.7 billion," enough to destabilize some large U.S. banks, blaming this on "artificially low interest rates and expanded credit in the United States from mid-1927 to mid-1929 at the urging of European bankers. Some of our bankers had been yielding to sheer greed for the 6% or 7% interest offered by banks in the European panic area."76 Likewise, London bankers had borrowed short-term in French francs at 2% and relent the funds, changed into reichmarks, to German industry and local governments at 8% in loans totaling $3.6 billion, more than five times the gold reserve of the Bank of England. Collapse of the German financial system, spreading panic throughout Eastern Europe, thus shifted enormous pressure onto the gold standard and the British banking system. In July 1931 Britain lost 19% of its gold reserves. Its Foreign Secretary told the French Premier that Britain might have to stop paying private debts if Germany did. Massive withdrawals of foreign deposits from London grew until Britain left the gold standard in September. That event shook the world and shifted the pressure to the United States.

The European financial crisis of 1931 moved the Great Depression in the United States into a new phase. Until then, the U.S. Depression was fruit of domestic forces. From late 1931 until Roosevelt declared a bank holiday and took the U.S. off gold in 1933, U.S. financial liquidity was under steadfy pressure from the collapse of Europe's payments system. According to Wigmore:77 "The international trade and currency collapse of 1931 dealt a wide-ranging blow to the U.S. economy which exceeded the impact of either the Crash or the Bank Holiday of 1933."

Up to September 1931, the economy had been stable at a low level, but in September it began to collapse. GNP fell so fast that for 1931 as a whole it was down 7.7%. Industry's losses cost another 3 million jobs. Banks began to fail at record rates in a chain reaction as foreigners began taking away large amounts of gold. In 1929 the U.S. had 40% of the world's gold reserves and France about 16%. The U.S. gold stock actually grew by 14% until September 1931, when Britain went off gold. In 1929-32 France's gold reserves doubled. During the Europe's financial crisis of 1931-32, its countries staying on gold --France, Switzerland, Belgium and the Netherlands increased their stocks by 73%, mainly by withdrawing deposits from London and then from the U.S.78 This started a massive drain of funds from the U.S. banking system, which by law maintained a 40% gold backing for money in circulation.

The drain was swift and powerful. By February 7, 1932 Treasury Secretary Mills told Hoover that the U.S. was within two weeks of being forced off the gold standard. To stop the drain of money from the financial system, Congress within 20 days passed the first Glass-Steagall Act enabling the Fed both to use government securities to back the currency and to increase liquidity by buying more of them from banks.79

When the decision was announced, the Dow rose by 20% in three days.80

Within three months, the Fed doubled its holdings of government securities.81 The gold drain stopped until early 1933, amid rumors that President-elect Roosevelt was going to take the U.S. off gold. Roosevelt refused to deny these rumors. In three days ending March 3 the New York Fed lost nearly half its gold and was left with only $381 million against foreign deposits of $600 million, forcing it to press for a New York State bank holiday.82 By then, the whole system was reeling from bank panics leading to bank holidays in several states.

Politically and socially, the climax of the Depression came in Detroit, between the "massacre" at Ford's River Rouge plant in March 1932 and the Detroit banking crisis and Michigan bank holiday that preceded Roosevelt's inauguration a year later. Of all major cities, Detroit was hit hardest by the Depression, with unemployment estimated at 45%. Capital-intensive and cyclical sensitive to cycles, the auto industry was hit quickly and savagely by the Depression. By 1930 sales fell by 40%, employment by 25% and their stocks to only 21% of their 1929 highs. It hit bottom around the time of the November 1932 election, when production fell to 10% of its 1929 peak.83

Detroit's Depression troubles were boom-and-bust troubles. Between 1900 and 1930, Detroit's population grew by 550% to 1.6 million. To finance all that growth, its overextended banks lent heavily to real estate. The city borrowed heavily to build infrastructure. By 1930 both were in trouble. By 1931 the city was unable to sell its bonds and earmarked one-third of its taxes for debt service. By February 1933 it stopped interest payments as delinquencies on taxes rose to 80%. It tried issuing scrip instead of paychecks to city employees, but the scrip was turned down at local stores. Then the city tried something like the ploys of Argentina, Brazil and Mexico in the 1980s when they no longer could service their huge foreign debts. It arbitrarily cut interest payments to 3% and then wrung from its creditors a 30-year stretchout and refunding of its $400 million debt. After that, the price of Detroit bonds rose quickly from $45 to $70.84

This was one of the wondrous workings of the capitalist system, which thereby remained intact.

Detroit's bank crisis, which led to Roosevelt's March 1933 nationwide bank holiday, was a breakdown of the political process rather than the financial system. The crisis focused on the Guardian Detroit Union Group, which took shape in 1929 with Ford backing and owned banks in 16 Michigan cities. By 1932, 40% of the capital of the group's capital was sunk in real estate it took over from defaulted loans, while real estate prices had fallen by 40%. An RFC examiner said the group could get only $20 million by liquidating its $88 million in real estate loans.85 Much was made of the fact that before the 1929 Crash, as its stock price rose from $120 to $300 in a few months, Guardian lent its depositors' money to its own officers and employees to buy Guardian stock, using the stock as collateral. But that amounted to only $1.5 million by March 1933.

When the banks in the Guardian Detroit group closed in March 1933, they were so engulfed by political maneuvers that it never became clear whether the bank should have been closed or the big bank holiday really was necessary.86

Unlike the panics that developed later in other states, there never was a run on the Detroit banks, even though Father Charles Coughlin, the Detroit priest with a nationwide following, was denouncing "banksters" on his Sunday radio programs and urging depositors to withdraw their money. More important than the issue of solvency of the banks was the bad blood not only between Hoover and Roosevelt but also between Henry Ford, Hoover's friend, and Senator James S. Couzens, Ford's enemy and a member of the Senate Banking Committee, who as a founding partner of the Ford Motor Co. a generation earlier was the genius behind the marketing of the Model T. In their history of the Ford Motor Co., Allan Nevins and Frank E. Hill said: "Either Ford or Couzens could have met the crisis, or the two jointly could have done so. The clash of personalities blocked action."87 The RFC wanted to lend heavily to the Detroit banks, but Couzens said he would "denounce from the housetops" any loan without absolute security.88 "Why should the RFC bail out Ford?" he told an interviewer.89 At the last minute, Ford refused an offer from Couzens to go half-and-half in putting up collateral for the RFC loan. Two hours later, at 10pm on Feb. 13, 1933, Governor William A. Comstock closed all Michigan banks for eight days, immediately leading to panics in Cleveland and Indianapolis.90 By then Treasury Secretary Mills was pressing the RFC to lend to all banks in trouble.

Later that week the RFC was ready to lend $135 million to Detroit's two biggest banks, but the loan was cancelled after Roosevelt summoned Mills to New York for an emergency meeting. Within two weeks, currency in circulation increased by one-fourth as depositors took their money from banks.91 After refusing to advise Hoover on a course of action, the Fed pressured Hoover to declare a bank holiday on the morning of Roosevelt's inauguration. Hoover said a bank holiday was unnecessary, agreeing only to suspend gold trading and restrict withdrawals if both the Fed and the President-elect publicly supported the action.92

"Roosevelt did not need to close the banks --all he needed to do, until bank depositors got over the panic, was to restrict bank payments to necessary business and limit foreign exchange likewise," Hoover wrote years later.93 "The whole panic was simply an induced hysteria among bank depositors. We had successfully fought off four far greater crises during the three preceding years. We had no panic after the stock market collapsed in October 1929. We had no panic when the financial crash of Europe culminated in the British collapse in September 1931, nor when we were nearly forced off the gold standard in February 1932, nor at the bottom of the depression in June 1932, when our structure was greatly weakened by Congressional obstruction and foreign pressures. At any of these periods panic could have risen."

Hoover's point was that the country held together. Life and the political process went on. The Great Depression was a calamity but not a catastrophe. The Oxford English Dictionary says calamity is rooted in the idea of damage to crops and means "grievous affliction or adversity," while catastrophe means "overturning, an event producing the subversion of the order or system of things, a sudden disaster, widespread, very fatal." In other words, calamity is an experience that can be lived with and overcome, while catastrophe is final. In this sense, our financial system was shaken and damaged but remained intact.

As with the stock market and financial assets generally, there was an inflation in the number of banks during and after World War I. Most of the new banks started in rural and suburban areas during prosperous times. By 1933 only 14,523 banks remained, against 30,419 in 1921. If we exclude the 4,000 banks that closed in 1933, when the New Deal purposely weeded out unviable banks after the panics and holidays of February-March, fewer banks failed in 1929-32 [4,548] than in 1922-28 [5,755].94

Throughout the 1920s, many people said the country had too many banks. "No community can possibly provide adequate resources, competent officers and experienced directors for one bank for every 750 of its inhabitants, as in North Dakota, or to 1,400 as in Iowa," said a report of the National Bureau for Economic Research [NBER] a few months before the 1929 Crash.95 The bulk of the bank failures were precisely in small towns in scantly populated states.96 In 1931, the worst for bank failures before 1933, three-fourths of the 2,293 closings were small banks not belonging to the Federal Reserve System, involving less than 2% of all U.S. bank deposits. In 1986, 145 banks failed, more than in any year since 1933, and so far this year the failure rate is greater. There bank closings are concentrated in the same western and southern states where most banks failed in the 1920s and 1930s. Oklahoma's governor says the Federal Deposit Insurance Corporation is now his state's biggest banker. But this by itself doesn't mean the whole system is in trouble. The 9,096 bank failures in 1930-33 wiped out irretrievably only 0.81% of the country's bank deposits.97 Of the failed banks, 80% had less than $25,000 in capital.98

Like the rest of the Great Depression, the banking crisis is divided into the periods before and after the 1931 financial collapse in Europe, which made things much worse. According to Rutgers banking historian Eugene White, the bank failures of the early depression years were basically an extension of the nearly 10,000 closings, mergers and absorptions of the 1920s, adding that "the importance of the bank crisis of l930 in the history of the Great Depression appears to be somewhat inflated," even though the two most famous failures took place in November-December 1930.99 First came Caldwell & Co., a Nashville bond house and holding company that controlled banks, insurance and industrial companies, investment trusts and newspapers with assets totaling $500 million, whole collapse on Nov. 14, 1930 led to a two-week panic closing 120 banks in Tennessee, Arkansas, Kentucky and North Carolina.100 Four weeks later New York City's Bank of the United States closed with $286 million in 440,000 accounts, mostly small savings and thrift deposits of Jewish immigrants.101 Both crashes came from the financial razzle-dazzle of little guys becoming big bankers during a credit expansion in the same style as seen in the 1980s in Argentina, Brazil and Chile and at Oklahoma City's Penn Square bank, among others. In 1930 the most notorious and politically sensitive bust was Bank of the United States, whose troubles surfaced while Roosevelt was running for reelection as governor of New York. When Robert Moses investigated and warned of flagrant abuses at the bank, FDR scuttled Moses's report and named a new panel that included the director-legal counsel of Bank of the United States! After the bank failed, FDR clamored for action by the Republican legislature: "The people of the State not only expect it, but they have a right to demand it. The time to act is now."102

The surprising thing in all this panic and clamor is that the financial system held together. Not only were the deposits in failed banks a small share of all the country's deposits, but the scale of defaults throughout the system were amazingly small in proportion to the collapse of economic activity. The main areas of wreckage were in the $50 billion in mortgages and in state and municipal bonds. One sample showed 41% of urban mortgages bought by insurance companies in 1925-29 in default before 1934.103 One-third of commercial buildings in Chicago were in default on their mortgages, as were many of the big new hotels and apartment buildings in Manhattan. All over the country, the tax base of cities collapsed just as their welfare burdens mushroomed. With $2.1 billion in bonds, New York City was the biggest debtor, bailed out by its banks in tussle very much like its crisis of the 1970s. Nevertheless, of the other $14.2 billion in municipals outstanding in 1933, only $1.2 billion [TK] worth had been in default during the Depression. There were no defaults among operating utilities, although some holding companies like the Insull empire in the Midwest went under, and industrial bond defaults were very rare.104 The damage would have been much greater if Hoover had not set aside his private enterprise credo to create the RFC, the most powerful instrument of state capitalism in U.S. history, to save the financial system from the effects of the 1931 debt and payments collapse in Europe. In less than eight months in 1932, the RFC lent $1.3 billion [$13 billion in today's money] to 5,520 financial institutions. By March 1933 it lent another $365 million to 62 railroads to prevent mass default on their bonds.105 Without these RFC loans, half of all rail bonds might have gone into default.106

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