THE FEDERAL RESERVE, created in 1913, began to function in the early days of the First World War. But it did not come into its own until after peace was reestablished. It then almost immediately made its first serious policy mistake.
As always when huge deficits have to be financed, the First World War caused a serious inflation and the Consumer Price Index nearly doubled between 1915 and 1920. The Federal Reserve had kept interest rates low during the war to facilitate the government’s borrowing needs, and maintained those rates until November 1919. Then it moved the rediscount rate—then its major means for influencing interest rates—in a series of abrupt steps from 4 percent to 7 percent over the next eight months.
The economy, in fact, had already been moving toward recession with the end of vast military orders and the revival of European agriculture. The Federal Reserve’s actions turned a decline into a near disaster. The money supply contracted by 9 percent, while unemployment shot up from 4 to 12 percent. GNP declined by nearly 10 percent. At least the Federal Reserve’s overcorrection broke the back of the wartime inflation, and wholesale prices declined by nearly 40 percent between 1920 and 1921, one of the sharpest price declines in American history.
Fortunately, the depression of 1920–21 proved to be short-lived. New opportunities abounded in the 1920s and produced a decade of immense prosperity. The new economic engines behind that renewed prosperity were the automobile and electricity.
THE LATE-NINETEENTH-CENTURY ECONOMY—dominated by steel, petroleum, and railroads—had been the era of heavy industry. The 1920s would see the emergence of a much more consumer-oriented economy, a trend that only accelerated for most of the rest of the century. But the seeds of the new economy, as always, had been created in the old.
The automobile was not an American invention (although a clever patent attorney from Rochester, New York, named George B. Seldon, who never actually built one, managed to get a patent for “an improved road engine,” powered by “a liquid-hydrocarbon engine of the compression type” in 1879, even before the word automobile entered the English language). Most of the necessary technology was developed in Europe. A German named Nickolaus Otto had built the first practical internal combustion engine in 1876, and Wilhelm Maybach, also German, invented the carburetor in 1893. The carburetor was the last piece of the puzzle needed to build a practical horseless carriage, and tinkerers and entrepreneurs by the hundreds in both Europe and America began to manufacture automobiles in backyards and blacksmith shops. In 1900 four thousand automobiles were manufactured in the United States, by dozens of different firms and individuals.
A classically Darwinian competition ensued, just as in a natural ecosystem when a new body plan evolves or a new territory is reached. Whenever a major new technology becomes practical, there is always a large number of people and firms who will try to exploit it for profit. Most quickly fall by the wayside as they fail to compete successfully. Then, as the industry matures, the need for economies of scale and the huge capital needs often required to realize them cause the industry to consolidate into a few firms of great size. This was certainly true of the automobile. In 1903 alone, fifty-seven automobile companies came into existence in the United States, and twenty-seven went bankrupt. Today there are no more than two dozen automobile companies, all of them necessarily multibillion-dollar corporations, in the world.
One of the American companies that opened for business in 1903 was the Ford Motor Company. Its principal owner (sole owner after 1915), Henry Ford, wanted to produce a new kind of car, a car for the masses rather than the rich, the market for automobiles up to that point. If the automobile was invented in Europe, the mass-produced automobile, sold at a price the middle class could afford, was a purely American idea, an idea that transformed the American and world economies.
More than any single other economic development, the mass-produced automobile made the twentieth century very different from the nineteenth. Less than thirty years after the Ford Motor Company was founded, the British novelist Aldous Huxley wrote the science fiction classic Brave New World. In it he depicted a future world industrialized to the point where even human beings are produced in baby factories. And that world reckoned time not from the birth of Christ, but from the birth of Henry Ford.
The son of a farmer in Dearborn, Michigan, Henry Ford attended public schools there until going to work at the age of sixteen as an apprentice in a machine shop. Neither well educated nor well read, he early exhibited a marked talent for and fascination with mechanics, and he began tinkering with internal combustion engines in the early 1890s. In 1896 he built his first automobile in a carriage house behind where he was living. In the next few years he built several racing automobiles, which broke speed records, and, with the help of several backers, opened the Ford Motor Company in 1903.
The company was moderately successful at first. Then in 1908 Ford introduced the Model T. It was designed to be both rugged, to handle the often ghastly roads then in existence (there were fewer than two hundred miles of paved roads in the entire country in 1900, outside of cities) and cheap to manufacture. Its initial price was $850, a fraction of what most automobiles then cost, and its running expenses were equally modest, by some estimates only a penny a mile. It was an immediate hit with the public, which bought 10,607 Model Ts that year.
Henry Ford, having developed a product that he regarded as perfect, then bent every effort to finding ways to manufacture it more and more cheaply and thus bring it within reach of an ever larger segment of the population. In 1913 he fully introduced the assembly line at a new plant, built for the purpose, at Highland Park, Michigan. (Ford had visited a meat-packing plant and realized that if animals could be disassembled as they moved along a line, automobiles could be assembled in the same way, with huge savings in labor.)
That year it took only ninety-three minutes to assemble a Model T. In 1916 the price had dropped to only $360, and Ford sold 730,041 of them. By the 1920s, despite the inflation caused by the First World War, the price tag of a Model T was only $265, and Ford was still finding ways to lower labor costs by an average of 7.4 percent a year.
The result of Henry Ford’s relentless drive to lower costs in manufacturing the Model T was one of the most astonishing economic success stories in world history. Over the nineteen years that the Ford Motor Company produced the Model T, it manufactured fifteen million of them. By the end of the model run, the company had more than $700 million in undistributed profits. In 1920 Ford was producing half the cars built in the world. The runaway success of the Model T helped mightily to cause the entire automobile industry to take off. From 4,000 cars in 1900, the country produced 187,000 in 1910. By 1920 some 1.9 million cars rolled off assembly lines, and 8.1 million vehicles were in registration. By 1929 production was up to 4.5 million cars, and 23.1 million had been registered. The five-thousand-year reign of the horse as the prime mover of humankind was over.
It would be difficult to overestimate the impact of the automobile on the American economy by the 1920s. The automobile industry not only employed hundreds of thousands of workers itself, but greatly stimulated other industries. In the 1920s automobiles were using 20 percent of the steel produced in this country (and almost all of the sheet steel), 80 percent of the rubber, and 75 percent of the plate glass.
By the 1920s the automobile industry had become the largest in the American economy. The seemingly insatiable national appetite for cars produced a decade of great industrial prosperity. GNP increased by 59 percent between 1921 and 1929, reaching $103.1 billion. Meanwhile, GNP per capita rose by 42 percent, and personal income by more than 38 percent.
The automobile also greatly increased road building and paving, which became a major component of the construction industry and greatly stimulated quarrying and cement manufacture. From hardly any paved roads in 1900, by 1920 there were 369,000 miles, and by 1929 there were 662,000 miles. Just as the old turnpikes built in the late eighteenth century had stimulated commerce along them, the new roads did likewise. Gasoline had originally been sold at general stores and blacksmith shops, which, adapting to a changing market, had mostly become garages by the end of the 1920s. In 1905 the first purpose-built gas station opened in St. Louis. A quarter century later there were tens of thousands of them, most of them franchisees of the major oil companies. And gasoline replaced rapidly fading kerosene as the most important petroleum distillate, giving the petroleum industry a new, and larger, niche in the marketplace.
The fact that automobiles moved so much faster than a horse and carriage required a change in advertising. Seen at a speed of thirty or forty miles an hour, a sign had to be grasped instantly or it wouldn’t be grasped at all. Corporate logos became important for the first time, and the wordy style of nineteenth-century advertising disappeared, even in other venues, such as newspaper ads, as short and punchy became perceived to be “modern.”
And the automobile began to change the country’s demographics. The shift from a predominantly rural population to an urban one had been going on almost since the dawn of the Republic and had reached the tipping point in the census of 1920, which was the first to record more urban dwellers than rural ones. But the automobile allowed the emergence of a whole new demographic region: the suburbs.
A nineteenth-century demographic map of a typical American city would have resembled a daddy longlegs, with a dense urban core and long, thin strings of population along the railroad and trolley tracks. In between the tracks was deep country, for once a person disembarked from the train, he was again reduced to the speed of a horse. With the coming of the automobile, however, people could live miles from the railroad tracks and still be able to reach the city easily. More and more people began living in the country and working in the city.
The automobile also affected the rural areas as much as the urban and suburban ones. For one thing, it ended the suffocating isolation of the typical American farm. European farmers usually lived in villages and walked out to the fields (often owned by someone else) to work. But American farmers mostly lived on their own land often a mile or more from the nearest neighbor and several miles from the nearest town. Visiting was difficult and time-consuming.
The automobile allowed the rural consumer to shop farther afield. Before the automobile, what wasn’t available at the local general store had to be ordered from catalogs, such as those put out by Sears, Roebuck and Montgomery Ward. But the inexpensive automobile began to change that. The cozy monopolies of the local mercantile and bank were broken when their clients could drive to a larger town and do their business there, taking advantage of the better prices that are always to be found in larger markets. Commerce in the smallest towns began to decline and has been declining ever since.
Because the local banks were usually stand-alone operations dependent on their local economy, many of them began to decline when their customers began to go elsewhere. There were an astonishing number of them, peaking at 29,798 in 1921, almost all of them one-branch outfits with assets under a million dollars, and which were not members of the Federal Reserve. The number of bank failures in the United States in the 1920s, despite the general prosperity, began to increase. By the end of the decade, more than six hundred rural banks a year were failing, often taking the savings of their customers with them.
The automobile also put a far greater stress on the country’s rural economy as a whole. In 1900 one-third of the nation’s farmland was devoted to fodder crops to feed the vast number of horses and mules that powered the local-transportation and agricultural industries. By 1929 most of that herd was gone, replaced by automobiles, and much of the land that had grown such crops as hay and oats had been switched over to crops for human consumption, causing food supplies to rise much faster than demand and prices to decline sharply. The result was hard times for many farmers, who never saw prices recover from the fall-off in European orders after the First World War. The depression in American agriculture, largely unnoticed by the urban-based media at the time, would slowly, inexorably both deepen and widen.
ELECTRICITY HAD BEEN AN UTTER MYSTERY in the seventeenth century and a parlor trick in the eighteenth as people like Benjamin Franklin began to explore its nature. Although the early nineteenth century would gain a deeper understanding (in 1831 the great British physicist Michael Faraday proved the identity of electricity and magnetism) and produce the first practical use of electricity, the telegraph, it was only at the end of the century that electricity began to impact seriously on everyday life. No one played a greater role in that than Thomas Edison, who proved to be to Yankee ingenuity what Shakespeare had been to drama.
Thomas Edison is today remembered for his almost endless stream of inventions that helped turn the nineteenth century into the twentieth. Every schoolchild knows that Edison invented, or made substantial contributions to, the phonograph, the stock ticker, the telephone (along with important mechanical improvements to Bell’s original machine, Edison also coined the word hello), movies, and, of course, electric light.
But two of Edison’s greatest inventions are seldom mentioned because, by their nature, they couldn’t be patented. One was perhaps his greatest invention of all, the industrial research laboratory. Edison established his own laboratory in Menlo Park, New Jersey, in 1876, and it was there that he created the phonograph (1877), the electric light (1879), and hundreds of other inventions. It was, in essence, an invention factory where engineers, chemists, and mechanics turned new technological possibilities into practical—and, most important, commercially viable—products.
When General Electric was formed in 1892 by J. P. Morgan from the Edison General Electric Company and its major competitor, Thomson-Houston Electric Company, the new company almost immediately established a laboratory of its own at its headquarters in Schenectady, New York. It quickly became the model for a number of other corporate research labs that in the twentieth century would turn out an unending stream of inventions and practical applications of new technology. The list of the fruits of Edison’s seminal idea to industrialize the process of invention—to industrialize Yankee ingenuity—is nearly endless: cellophane, nylon, synthetic rubber, transistors, Teflon, and the microprocessor being but a few of the more important. In 2003 IBM alone would take out more than thirty-four hundred patents.
Edison’s other unsung invention was the electric power system by which his lightbulb could be lit. Once the lightbulb was a working invention, he set about to build a generating plant and lay electric lines in a one-square-mile area of the Manhattan business district. In 1880 he secured from the city the right to “lay tubes, wires, conductors and insulation, and to erect lamp-posts within the lines of the streets and avenues, parks and public places of the City of New York, for conveying and using electricity or electrical currents for purposes of illumination.”
Edison built the world’s first power plant on Pearl Street and installed six of the largest dynamos yet built, weighing thirty tons each. Working at night so as not to make New York City’s traffic any worse than it already was, he dug trenches for his electric mains, which totaled fifteen miles in length, and sent out crews to wire up houses and stores whose owners were willing to sign up for the new service.
As with any new technology, Edison had to devise solutions on the fly to endless problems that had not been thought of until they arose. One problem was that if there was a leakage of current under the pavement, horses would conduct it through their shoes and panic. Many of Edison’s on-the-fly solutions were patentable, and he applied for no fewer than 102 patents in 1882, the most in any one year, as he was building his system.
Finally, at 3 PM on September 4, 1882, Edison, standing in J. P. Morgan’s office, closed the circuit, and 106 lamps came on in the offices of Drexel, Morgan and Company. More came on at the New York Times, which had also signed up as an Edison customer, and in shops along Fulton Street. They didn’t make much impression in daylight. But by that evening it was obvious that something important had happened. The next day the New York Herald reported that “in stores and business places throughout the lower quarters of the city there was a strange glow last night. The dim flicker of gas, often subdued and debilitated by grim and uncleanly globes, was supplanted by a steady glare, bright and mellow, which illuminated interiors and shone through windows fixed and unwavering.”
In the next few years electricity spread through the business districts and fashionable residential areas of the country’s cities, but it remained expensive, and most people continued to get along with gaslight or, beyond the reach of urban gasworks, kerosene. It would be Thomas Edison’s former secretary, Samuel Insull, who would prove to be the Henry Ford of electricity and make the new technology affordable for the average person and permanently change the American economy thereby.
Insull was born in 1859 in London, to a lower-middle-class family, and he went to work at an auction house at the age of fourteen while continuing to study at night. At eighteen he went to work for Edison’s British representative, who was so impressed with his energy and organizational abilities that in 1881 he sent him to the United States to be Edison’s personal secretary. Soon he was indispensable to Edison, who was not nearly as good a businessman as he fancied himself to be.
Edison put Insull in charge of the Edison General Electric Company, which had been struggling, and Insull quickly turned it around. To obtain a measure of independence from Edison, he moved the company to Schenectady, explaining that “we never made a dollar until we got the factory a hundred and eighty miles away from Mr. Edison.” In a few years he increased business so much that the labor force rose from two hundred to six thousand, and the company became highly profitable.
When the company merged to form General Electric, however, Insull, although being paid the then-princely sum of $36,000 a year, decided to move on. He was more interested in building a power grid than in manufacturing electrical equipment, and he accepted the top job at one of Chicago’s electricity-generating companies, Chicago Edison (it had been named in honor of Edison, but he had no financial stake in the company). It had only five thousand customers when Insull arrived in 1892. And it was one of thirty companies then generating electricity in that city.
One severe restraint on the number of customers for electricity was the cost, then about 1 cent an hour to light a single bulb (which produced only about one-fifth as much light as a modern lightbulb of the same wattage). A factory worker at that time was lucky to earn $750 a year, so electric light was a luxury few could afford.
There were two problems that made the cost of electricity so high. One was that electricity was a very capital-intensive business. This meant that economies of scale were crucial. But in the early days of electricity, generators were relatively small. Thus, large users, such as department stores and factories, were often better off building their own generating capacity than buying the electricity from a utility. With only small customers, the price per kilowatt-hour was necessarily high.
Insull moved to do something about this. He built the world’s largest generating plant on Harrison Street in Chicago and installed a new design of generators that used only half as much coal as the previous type. He also began buying up the competition to enlarge his market. By 1898 his company owned all the generating capacity in his distribution area and had doubled the size of the Harrison Street plant. But when he began to supply power to Chicago’s streetcars and elevated railways, he needed still more power.
Insull decided to gamble on a radical new technology. Steam-powered generating equipment up to this time had used reciprocating engines, where pistons pounded up and down, turning a crank shaft to produce the power. They were noisy and, at maximum output, vibrated alarmingly. They needed constant maintenance. On a trip to England Insull had seen a speedboat that was powered by a new type of steam engine invented by Charles Parsons, called a turbine. Instead of piston rods pounding up and down, the turbine spun smoothly, turned by steam acting on blades of propellors, at much higher speed, producing far more power per unit of fuel and needing less maintenance.
Insull thought the steam turbine was ideally suited to producing electricity, but had to cajole General Electric into producing engines of the size he wanted, far larger than had ever been built. And his own board was so nervous that Insull had to personally guarantee the company against loss if the new turbine-powered plant he planned on Fisk Street didn’t work. When the plant was ready to go on line for the first time, the engineer told Insull to step away in case something went wrong and the turbine blew up. “Well,” Insull replied, “if it blows up, I blow up with it anyway. I’ll stay.”
It didn’t blow up, of course. It revolutionized the electricity-generating business, greatly lowering costs per kilowatt-hour. The steam turbine immediately became the standard means of producing electricity, which it remains to this day.
The biggest problem with lowering the cost of electricity, however, is the fact that electricity, almost uniquely among major commodities, cannot be stored. Instead, it must be produced at the instant of demand. Thus generating capacity must be large enough to meet peak demand, even though that means there will be very expensive excess capacity 95 percent of the time, the expenses of which must be pro-rated.
Again on a trip to England, Samuel Insull found a partial solution to the problem. The first electric meters had merely measured how much current was used between readings, as most house meters still do. (Thomas Edison had devised a meter wherein a small amount of the current being used melted zinc, which dripped onto a plate below. The meter reader would weigh the plate to determine how much electricity had been used.) But in the resort town of Brighton, on England’s south coast, Insull talked to a man who had invented a meter that not only kept track of how much was used, but, crucially, when it was used.
Electricity usage over the course of a day varies widely but predictably, peaking in the hours between 4 P.M. and 8 P.M. and reaching its lowest point between 2 A.M. and 5 A.M. Insull realized that any electricity he could persuade users to use at slack times was, in effect, found money, whatever he charged for it, while getting customers to shift away from peak periods lowered his capital costs by reducing the capacity he had to build and maintain.
In the first year the new meter was in use in Chicago, electric rates fell by 32 percent, while demand began to soar. It came first to stores, factories, and advertising, but by 1910 one household in six in Chicago was electrified and the percent climbed steeply thereafter. By the 1920s the gaslight business was nearing extinction.
The ever increasing use of electricity in the United States is one of the wonders of the twentieth century. In 1902 the United States used 6 billion kilowatt-hours of electricity, about 79 kilowatt-hours per person. In 1929 it was 118 billion, and 960 kilowatt-hours per person, well over ten times as much per capita. Today usage is a staggering 3.9 trillion kilowatt-hours, more than 13,500 per person, more than 170 times as much electricity as was used per person in 1902.
This astonishing rise in the use of electricity came about not only because more and more people were switching over to electric light, but also because more and more tasks were being powered by electricity rather than by other means. This affected the American economy in many ways. For one thing, it changed the very shape of factories. Steam engines are very inefficient in terms of the amount of energy in the fuel that is converted into work-doing energy. And the smaller they are, the more inefficient. So nineteenth-century factories were tall, with as large a steam engine as possible in the basement. The engine powered a shaft running up the side of the building, from which horizontal shafts on each floor took power. It was important that these shafts be as short as possible.
But small electric motors are just as efficient as large ones (more so in some ways), so it made sense, once the price of electricity dropped sufficiently, to power each machine separately by electricity, eliminating the need for shafts to transmit power. (An electric motor is exactly the same mechanism as an electric generator, only working backward. The first uses electricity to produce power, the latter uses power to produce electricity.) Once freed from the need to connect machinery to the shaft from the steam engine, factories began to spread out horizontally on one level.
The rapidly widening use of electricity also caused productivity to soar in the 1920s, increasing output per worker by 21.8 percent in that decade. This helped to push manufacturing output up by more than 90 percent. Although electricity and the small electric motor had been around for two decades, the full effects of their use on industrial productivity came only in this decade. This is always the case with new technology because of what economists call the installed base problem. The old technology is already in place and paid for. Therefore it makes no economic sense to replace it until it wears out. The Erie Canal, rendered obsolescent by the railroads in the 1850s, was still carrying freight as late as 1970. Today the personal computer is the main engine behind the extraordinary gains in productivity in recent years although the personal computer has been around for nearly a quarter of a century.
More important, small electric motors began to power an ever-increasing number of household appliances in the 1920s, refrigerators, electric irons, vacuum cleaners, hair dryers, washing machines, radios, and phonographs among them. These began replacing servants in large numbers, and the servants moved on to more wealth-creating jobs. Many servants had gone to work in factories to take jobs left by soldiers in the First World War and had not returned. With the new appliances, the need for servants began its long decline. And households that had never had help became much easier to keep clean and supplied with clean clothes. As in the early nineteenth century, the middle class became able to live in a lifestyle that had once been reserved for the rich.
These wondrous new machines, of course, cost money, especially automobiles, in sums that were often beyond the ready means of the average family. In the early twentieth century few households had bank accounts and even fewer had established means of borrowing money. Bankers, who catered to business and the rich, were usually not interested in customers of modest means, although there were notable exceptions, such as A. P. Giannini, who built San Francisco’s Bank of America into the largest bank in the country.
So the manufacturers of the new devices began to offer credit terms of so much down and so much a month for what economists call “durable goods,” those with a useful life of more than three years. This greatly increased the potential number of buyers, of course, and the larger market brought down prices, further enlarging the market. Thus the country’s rapidly increasing number of people with significant disposable income (income over and above what is needed for necessities) came to be a major influence in the American economy in the 1920s.
This was a profoundly democratizing development as huge industrial concerns came more and more to cater to the needs and desires (and also, of course, to foster these needs and desires) of the average citizen. “Why flounder around waiting for good business?” Henry Ford asked, explaining his business philosophy of pursuing the mass market. “Get costs down by better management. Get the prices down to the buying power.”
But there was more to this new mass market than just cheap prices, and some companies were better at understanding it than others. Henry Ford, obsessed with the idea that the Model T was perfect, refused to change the design after 1908, concentrating instead on making it cheaper and cheaper. He even refused to add an electric starter after they became available in 1912, because of the weight of the battery. The starter became standard on other cars almost immediately because it was far safer to use than hand cranking (the crank could, and not infrequently did, break the arm of an unlucky user). It also allowed many people, such as women and the elderly, to use automobiles unassisted. Nor would Ford provide credit or even paint his cars any color other than black (which dried faster than other colors and thus, once again, lowered costs).
By the mid 1920s the Model T was out of date both technologically and commercially, but Ford refused to change. His once unassailable position as the world’s largest producer of automobiles began to fade as his chief American competition, General Motors, outcompeted him for the attention of the American consumer. Ford’s business model regarded the automobile as transportation and nothing but. The cheaper, therefore, the better. But Alfred P. Sloan and his remarkable associates at GM realized that the automobile had become much more than just transportation; it had become a part of how Americans saw themselves and others. It had become both a status symbol and a means of expressing personality, not unlike clothes.
General Motors set up the General Motors Acceptance Corporation to finance purchases of its products, making it possible for customers to move up market. And it provided instead of just one model, a whole series of models and brand names, from Chevrolet to Cadillac, providing what has now been called in business school for generations a “mass-class” business model.
In 1927, shortly after the fifteen millionth Model T rolled off the once revolutionary assembly line, Henry Ford, facing acres of unsold cars, had no choice but to shut down for eighteen months while he retooled his plants to produce an up-to-date car, the Model A. By the time the Ford Motor Company was back in business, General Motors had become the largest automobile company on earth, as it remains to this day.
The lesson was clear: not even the sole owner of a multibillion-dollar industrial concern and one of the half dozen richest men in the world could defy the power of the new American marketplace for long. The consumer was now in control of the American economy.
BUT IF CONSUMERS were in control, they could not lead, and the American economy was not well led in the 1920s. One might say it was not led at all. By the end of the First World War the United States had become financially as well as economically the strongest country in the world. It was now the world’s greatest creditor nation, and its share of the world’s manufacturing increased from 36 percent in 1914 to 42 percent by the end of the 1920s. It was the world’s largest exporter and the second largest importer (after Britain), and the greatest supplier of capital to other countries.
But Woodrow Wilson was outmaneuvered at the Versailles Peace Conference and a draconian, merciless peace was imposed on Germany, requiring it to pay vast war reparations to the victors (but not the United States, which demanded no reparations). The peace treaty assured that Germany, intrinsically the greatest power in Europe, would be economically prostrate for the foreseeable future. Britain, France, and Italy, meanwhile, were saddled with huge war debts to the United States, which they had scant means to pay and the United States had scant interest in forgiving. “They hired the money, didn’t they?” Calvin Coolidge asked.
Woodrow Wilson’s stubborn refusal to make necessary political compromises prevented the United States from joining the League of Nations and effectively leading the international system. Instead American diplomacy largely pursued a quixotic foreign policy with such treaties as the Washington Naval Treaty, which limited the size and number of battleships and total naval tonnage, and the Kellogg-Briand Pact, which outlawed war as an instrument of national policy (both Germany and Japan signed it).
Further, the United States was determined to maintain a high tariff to protect American producers and to have a favorable balance of trade. Meanwhile the Federal Reserve returned to a policy of low interest rates while European central banks maintained high ones to protect the value of their currencies. The result was a largely unnoticed (at the time) cycle. American investment banks aggressively pushed highly profitable loans and underwritings in Europe. Europe used the proceeds to finance imports from the United States, and Germany used them to fund reparations to the Allied Powers. The Allied Powers then used the reparations to repay their war loans to the United States.
Thus the exported American capital quickly returned to the United States and provided the wherewithal for more loans to Europe. As long as the cycle continued, everything was fine. But, of course, it didn’t continue. The result would be a worldwide economic disaster.
In 1928 American investment bankers began increasingly to turn to a market even more lucrative than European loans, the call money market on Wall Street. Call money was the term for the funds used to finance stocks held on margin. At that time a speculator could buy stocks on as little as 10 percent margin, borrowing the rest from the broker. As long as the stock, which served as collateral for the loan, was headed upward, all was fine, and the speculator could increase his capital very quickly. But if the stock price declined, he had to put up more money or he would be sold out, often wiping him out.
The call money market was very lucrative in the late 1920s as Wall Street had entered one of its periodic booms, such as had occurred in the 1830s, the 1850s, and the 1870s. Once it recovered from the short-lived depression of 1920–21, Wall Street, as it always does, had reflected the growing American economy and had reached heights that had seemed impossible only a few years earlier. But in fact Wall Street, at least as measured by the Dow-Jones Industrial Average, increased far faster than the American economy. While the GNP increased by 59 percent in the 1920s, the Dow-Jones went up by 400 percent.
In 1928 the Federal Reserve acted to slow down the economy and thus, it hoped, the boom on Wall Street, which was showing signs of getting out of hand. By the fall of 1928, the New York Federal Reserve, headed by Benjamin Strong, had raised its discount rate to 5 percent from 3.5 percent and had begun clamping down on the money supply. The other eleven Federal Reserve banks had done the same. “The problem now,” Strong explained, “is to shape our policy as to avoid a calamitous break in the stock market…and at the same time accomplish if possible the recovery of Europe.”
Benjamin Strong, former president of Bankers Trust, had been governor of the New York Federal Reserve bank since it began in 1914, and he was the unquestioned leader of the system. The other banks and the board in Washington almost always did what he suggested. But Strong suffered from tuberculosis, and in the fall of 1928 he died after an operation on his lungs. The Federal Reserve was now effectively leaderless.
By the spring of 1929 the economy, reacting to the Federal Reserve’s policy, had cooled noticeably. Wall Street, however, appeared not to have. Although usually a leading indicator of the economy, declining and rising before the economy does, the market, as measured by the Dow-Jones Industrial Average and the New York Times Index, continued to rise while the economy began to move into recession. But the wider market, including thousands of secondary stocks and those not included in the most widely watched averages, had begun to decline along with the economy.
Such is the economic power of human psychology, however, that neither the market nor the public noticed, and all attention was focused on the most widely held stocks. The market was caught up in a bubble, and bubbles are always recognized by the public only in retrospect.
Call money rates continued to climb as the action became more frantic on the Street, but speculators are notably indifferent to the cost of borrowing money in a rising market. Banks and even industrial corporations flocked to lend money to brokerage firms at 12 percent, while the brokers lent it in turn to their customers at 20 percent. Bethlehem Steel had $150 million in the call money market by the end of summer 1929. Chrysler had $60 million.
Banks began borrowing money from the Federal Reserve through the discount window at 5 percent and lending it to brokers. The Federal Reserve could have stopped this any time it wanted to, and there is little doubt that Benjamin Strong would have done exactly that. But, leaderless, the bank used only what it called “moral suasion” to urge the commercial banks to end the practice. It didn’t work. When a bank can borrow at 5 percent and lend at 12, making a 7 percent return on someone else’s money, it is going to do so.
By the summer of 1929 Wall Street and its millions of customers were deeply out of touch with the underlying economy, visions of riches dancing in their heads. Broker’s boardrooms were full of people watching prices, and even normally sensible and knowledgeable people were caught up in the frenzy. Irving Fisher, a nationally known professor of economics at Yale, who had made a fortune by inventing the Rolodex, opined that “stock prices have reached what looks like a permanently high plateau.” The Saturday Evening Post printed a poem that summer that caught the mood of the country.
Oh, hush thee, my babe, granny’s bought some more shares
Daddy’s gone out to play with bulls and the bears,
Mother’s buying on tips, and she simply can’t lose,
And baby shall have some expensive new shoes!
On September 3, the day after Labor Day, the New York Stock Exchange closed with the Dow at 381.17, a new all-time high. On September 5 a stock market analyst of no great note named Roger Babson addressed a luncheon group in Wellesley, Massachusetts. The frequent predictions of trouble ahead from this perennial pessimist had been ignored by a market that wanted only optimistic forecasts. On this day he didn’t say anything different, merely noting that “I repeat what I said at this time last year and the year before, that sooner or later a crash is coming.”
It was a slow news day, and the Dow-Jones Financial News Service put Babson’s unexceptionable remark on the news ticker at 2 PM. The effect was extraordinary. In the last hour of trading, prices plunged (U.S. Steel fell 9 points, AT&T 6) and volume that final hour was a fantastic two million shares. Known as the “Babson break,” it was like a slap across the face of a hysteric, and the mood of Wall Street changed abruptly from “the sky’s the limit” to “every man for himself.”
Over the next six weeks the market trended downward, with occasional plunges followed by more modest recoveries. Then, on October 23, a wave of selling swept the market on the second highest volume on record. A mountain of margin calls went out that night, and sell orders by the thousands piled up at brokerage houses across the country. The next day, Thursday, October 24, soon known as Black Thursday, was the most frantic in the history of the New York Stock Exchange up to that time, as stocks plunged, generating more margin calls, which caused more stock to be sold at any price, as the averages spiraled downward. Meanwhile, short sellers added to the downward pressure on stocks in bear raids.
A group of the Street’s leading bankers met at J. P. Morgan and Company, across Broad Street from the exchange, to decide what to do. They raised a fund of $20 million to steady the market and entrusted it to Richard Whitney, acting president of the exchange. At 1:30 Whitney went to the post where U.S. Steel was traded and asked the price. He was told that the last trade had been at 205 but that it had fallen several points since with no takers. “I bid 205 for 10,000 Steel,” Whitney shouted dramatically. He then went to other posts, buying other blue chip stocks in large amounts.
The effect was everything the bankers had hoped for. Short sellers ran for cover and the market steadied. At the end of the day, U.S. Steel closed up slightly. But the volume had been an utterly unprecedented thirteen million shares.
The rally continued on Friday, with modest profit taking at the Saturday morning session. On Monday selling resumed as rumors flew around the Street about major speculators having killed themselves and new bear pools being formed. The next day, Tuesday, October 29—Black Tuesday—there was no stopping the market. It plunged from the opening bell and kept plunging nearly continuously all day. Volume reached sixteen million shares, a record that would stand for forty years, and the ticker ran more than four hours late, not tapping out the last price until nearly eight o’clock that night. Someone calculated that the nation’s tickers that day had used up fifteen thousand miles of ticker tape. The Dow-Jones average at the end of the day’s carnage stood at 23 percent below where it had closed on Saturday, and nearly 40 percent below its high of early September.
No one could know it at the time, of course, but the greatest economic calamity in the nation’s history had begun.