FRBSF Economic Letter
99-10; March 26, 1999
 Economic
Letter Index
Monetary Policy and the Great Crash of 1929: A Bursting Bubble
or Collapsing Fundamentals?
In recent years, a number of economists have expressed concern that the
stock market is overvalued. Some have compared the situation with the
1920s, warning that the market may be headed for a similar collapse. Indeed,
some suggest that lax monetary policy contributed to the Great Crash and
have argued that current monetary policy is also dangerously lax. For
example, an April 1998 Economist article stated:
In the late 1920s, the Fed was also reluctant to raise interest rates
in response to soaring share prices, leaving rampant bank lending to
push prices higher still. When the Fed did belatedly act, the bubble
burst with a vengeance.
To avoid the same mistake, The Economist suggested that it would
be better for the Fed to take deliberate, preemptive steps to deflate
the bubble in share prices. It warned that the bubble could harm the economy
if it were to burst suddenly, reducing the value of collateral assets
and bringing on a recession. The article went on to say that "the longer
that asset prices continue to be pumped up by easy money, the more inflated
the bubble will become and the more painful the economic after-effects
when it bursts,'' and it concluded that "the Fed needs to raise interest
rates."
In this Economic Letter, I argue that The Economist
has misinterpreted the lessons of the Great Crash. A closer examination
of the events of the late 1920s suggests it is mistaken on at least four
points. First, stock prices were not obviously overvalued at the end of
1927. Second, starting in 1928 the Fed shifted toward increasingly tight
monetary policy, motivated in large part by a concern about speculation
in the stock market. Third, tight monetary policy probably did contribute
to a fall in share prices in 1929. And fourth, the depth of the contraction
in economic activity probably had less to do with the magnitude of the
crash and more to do with the fact that the Fed continued a tight money
policy after the crash. Hence, rather than illustrating the dangers of
standing on the sidelines, the events of 1928-1930 actually provide a
case study of the risks associated with a deliberate attempt to puncture
a speculative bubble.
Monetary Policy 1927-1930
In 1927, there was a mild recession in the United States. In addition,
Britain was threatened by a balance of payments crisis whose proximate
cause was a demand by France to convert a large quantity of sterling reserves
into gold. Thus, both domestic and international conditions inclined the
Fed to shift toward easing. The resulting fall in interest rates helped
damp the decline in domestic economic activity and facilitated an outflow
of gold toward Britain and France.
Should the Fed have refrained from easing in 1927 because of concerns
that the stock market might be overvalued? Measures of conventional valuation
suggest the answer is no, for there was no obvious sign of an emerging
bubble at that time. For example, Figure
1 illustrates the price-dividend ratio on the value-weighted New York
Stock Exchange (NYSE) portfolio. At the end of 1927, the price-dividend
ratio was around 23, which is actually a bit below its long-run average
of 25. Although share prices had risen rapidly in the 1920s, so had dividends.
Given that the price-dividend ratio was slightly below average, the Fed
would have had little reason to refrain from easing in a recession year
or to decline assistance to a gold standard partner in maintaining balance
of payments equilibrium.
In any case, equity prices began to accelerate in January 1928, and they
rose by 39% for the year. Dividend payments also grew rapidly that year,
and the price-dividend ratio increased by 27%.
Motivated by a concern about speculation in the stock market, the Fed
responded aggressively. Between January and July 1928 the Fed raised the
discount rate from 3.5% to 5%. Because nominal prices were falling, the
latter translated into a real discount rate of 6%, which is quite high
in a year following a recession. At the same time, the Fed engaged in
extensive open market operations to drain reserves from the banking system.
Hamilton (1987) reports that it sold more than three-quarters of its total
stock of government securities: "in terms of the magnitudes consciously
controlled by the Federal Reserve, it would have been difficult to design
a more contractionary policy."
Furthermore, as Eichengreen (1992) has emphasized, monetary policy was
tight not only in the U.S. but also throughout much of the rest of the
world. By that time, roughly three dozen countries had returned to the
gold standard, and when the Fed tightened, many countries faced a dilemma:
Unless their central banks also tightened, lending from the U.S. would
be disrupted and their balance of payments would move toward a deficit.
In that case, they would either have to devalue or abandon the gold standard
altogether. The former option was unattractive for countries with dollar-denominated
debts, and the latter was virtually out of the question at the time, especially
for countries where restoration of the gold standard had been painful
and difficult.
The alternative was to conform with the Fed. By shifting toward more
contractionary monetary policies, other gold standard countries could
ensure that domestic interest rates would rise in parallel with those
in the U.S. and would be able to maintain balance of payments equilibrium.
This explains, for example, why the Bank of England shifted toward tighter
policy in 1928, three years after Britain had entered a slump. It also
explains why countries still rebuilding from WWI would adopt contractionary
policies.
The implication is that monetary policy was far more restrictive than
a purely domestic perspective might suggest. In 1928 there was a synchronized,
global contraction of monetary policy, which occurred primarily because
the Fed was concerned about stock prices. These actions had predictable
effects on economic activity. By the second quarter of 1929 it was apparent
that economic activity was slowing. The U.S. economy peaked in August
and fell into a recession in September.
What were the effects on the stock market? At the beginning of 1929,
it seemed that the contractionary measures taken in 1928 were working.
The NYSE price-dividend ratio reached a local peak in January and then
fell gradually through the first half of the year. Thus, it appeared that
stock prices had stabilized. Furthermore, shares still were not obviously
overvalued. The local peak was reached at 30.5, which is roughly 20% above
the long-term average. Dividends had grown rapidly through 1928, and investors
projecting similar growth rates forward may have been willing to settle
for dividend yields somewhat below the long-run average.
Monetary policy was on hold during the first half of 1929, and some economists
have argued that inaction in this period was responsible for the events
that followed. But three observations are relevant here. First, as mentioned
above, price-dividend ratios had stabilized and were falling gradually.
To a contemporary observer, it would have appeared that the actions of
1928 were having the intended effects. Second, it was becoming increasingly
apparent that general economic activity was slowing, and many other countries
already had entered recessions. And third, while monetary policy was not
becoming tighter, it was still quite tight. Short-term real interest rates
were still around 6%, and there was no growth in the monetary base.
Price-dividend ratios continued to fall until July 1929, but then prices
began to take off. In August, the Fed raised the discount rate by another
percentage point to 6%. The stock market peaked in the first week of September.
It is worth noting that at its peak the price-dividend ratio was 32.8,
which is well below values reached in the 1960s or 1990s. Share prices
declined in a more or less orderly fashion until the end of October, but
then the market crashed. From its peak, the price-dividend ratio fell
roughly 30%, to a level roughly similar to that prevailing at the beginning
of 1928, when the Fed began to tighten.
In the immediate aftermath of the crash, the New York Fed took prompt
and decisive action to ease credit conditions. When investors attempted
to liquidate their equity holdings, many lenders also called their loans
to securities brokers. With the encouragement of officials at the New
York Fed, many of these brokers' loans were taken over by New York banks,
who were allowed to borrow freely at the discount window for this purpose.
The New York Fed also bought government securities on its own account
in order to inject reserves into the banking system. In this way, they
were able to contain an incipient liquidity crisis and prevent the crash
from spreading to money markets.
But this respite from tight money proved to be temporary. After the liquidity
crisis had been contained, monetary policy once again resumed a contractionary
stance. Throughout 1930, officials at the New York Fed repeatedly proposed
that the System buy government securities on the open market, but they
were systematically rebuffed. The reasons other members of the Federal
Reserve gave for opposing monetary expansion are instructive. Several
felt that much of the investment undertaken in the previous expansion
was fundamentally unsound and that the economy could not recover until
it was scrapped. Others felt that a monetary expansion would only ignite
another round of speculative activity, perhaps even in the stock market.
In any event, monetary policy remained contractionary; the monetary aggregates
fell by 2% to 4%, and long- term real interest rates increased.
By maintaining a contractionary stance throughout 1930, after a recession
had already begun, the Fed contributed to a further decline in economic
activity and share prices. By the end of the year, the price-dividend
ratio had fallen to 16.6, or roughly 34% below the long-run average. By
then, there was a consensus that speculative activity had been eliminated!
Were the Fed's actions stabilizing or
destabilizing?
If one grants that a speculative bubble existed at the beginning of 1928,
when the Fed began to tighten, then stocks must have still been overvalued
in the aftermath of the crash. After all, price-dividend ratios were about
the same in the dark days of November 1929 as at the beginning of 1928,
and fundamentals must surely have taken a turn for the worse. If equities
were still overvalued, it follows that a further dose of contractionary
monetary policy was needed to purge speculative elements from the market.
Perhaps this is what motivated the famous advice of Treasury Secretary
Andrew Mellon to President Herbert Hoover, to "liquidate labor, liquidate
stocks, liquidate the farmers, liquidate real estate." To argue that the
actions of 1928-1930 were stabilizing, one must adopt the liquidationist
position.
On the other hand, if one interprets the Great Crash as a bursting bubble,
so that shares were more or less properly valued in the aftermath, then
it follows that they were probably also not far from their fundamental
values at the start of 1928, when the Fed began to tighten. Again, prices
and price-dividend ratios were about the same after the crash, and fundamentals
had surely become less favorable. According to this interpretation, the
Fed's initial actions may have been destabilizing, and the actions of
1930 certainly were.
Conclusion
In retrospect, it seems that the lesson of the Great Crash is more about
the difficulty of identifying speculative bubbles and the risks associated
with aggressive actions conditioned on noisy observations. In the critical
years 1928 to 1930, the Fed did not stand on the sidelines and allow asset
prices to soar unabated. On the contrary, its policy represented a striking
example of The Economist's recommendation: a deliberate, preemptive
strike against an (apparent) bubble. The Fed succeeded in putting a halt
to the rapid increase in share prices, but in doing so it may have contributed
one of the main impulses for the Great Depression.
Timothy Cogley
Senior Economist
References
Economist. 1998. "America's Bubble Economy" (April 18).
Eichengreen, Barry. 1992. Golden Fetters: The Gold Standard and the
Great Depression, 1919-1939. Oxford: Oxford University Press.
Hamilton, James D. 1987. "Monetary Factors in the Great Depression."
Journal of Monetary Economics 19, pp. 145-169.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
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Research Department
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