Winston Churchill’s Excellent Adventure in Monetary Policy
All people are most credulous when they are most happy; and when much money has just been made, when some people are really making it, when most people think they are making it, there is a happy opportunity for ingenious mendacity. Almost everything will be believed for a little while.
—Walter Bagehot362
In the early autumn of 1929, Winston Churchill conducted a leisurely private railcar tour of Canada. He arrived in New York on October 24, 1929, Black Thursday, the first calamitous stock market drop of many that fall, where he observed, “Under my window, a gentleman cast himself down fifteen stories and was dashed to pieces, causing a wild commotion and the arrival of the fire brigade.” The next day, a total stranger invited Churchill into the visitor’s gallery of the New York Stock Exchange, where he noted the following:
I expected to see pandemonium; but the spectacle that met my eyes was one of surprising calm and orderliness. [The brokers] are precluded by the strongest rules from running or raising their voices unduly. So there they were, walking to and fro like a slow-motion picture of a disturbed ant heap, offering each other enormous blocks of securities at a third of their old prices and half their present value, and for many minutes together finding no one strong enough to pick up the sure fortunes they were compelled to offer.363
He sailed for home shortly thereafter, oblivious to the connection between his financial ineptitude four years before and the momentous events that had just unfolded before his eyes. The crash, though, did catch Churchill’s eye in one regard. It devastated his speculative investment portfolio and plunged him into debt. His personal misfortune carried a silver lining for posterity: In order to repay his creditors, he fell back on his most reliable meal ticket, his pen. Over the ensuing decade he produced some of his finest books as well as many articles and even a screenplay.
To call Churchill’s political career before 1929 “checkered” would be an understatement. As first lord of the Admiralty during the First World War, he had vigorously supported the disastrous Gallipoli invasion, which resulted in thousands of casualties and his demotion. A decade later Prime Minister Stanley Baldwin, unaware of Churchill’s financial incompetence, appointed him chancellor of the exchequer, the British equivalent of Treasury secretary. (Churchill described his interactions with his exchequer mavens thusly: “If they were soldiers or generals, I would understand what they were talking about. As it is they all talk Persian.”)364
One name, Hyman Minsky, comes up most often when economists discuss financial bubbles. Minsky cut a curious figure in the economics profession from the 1950s to the 1980s—a long-haired iconoclast who believed that capitalism was fundamentally unstable: a modern, more grounded version of Karl Marx. Better than any other twentieth-century observer, he understood and described the pathophysiology of bubbles and busts which, he thought, required two necessary conditions: the easing of credit wrought by falling interest rates and the advent of exciting new technologies.
First, interest rates. Before the First World War, pound sterling notes were freely convertible into gold sovereign coins at £4.86 per ounce, and note holders had confidence that there was plenty of bullion on hand to meet any demand for it. Because the pound seemed solid, relatively few took advantage of this convertibility; of what use, after all, was a hunk of yellow metal? But England had run the printing presses to pay for its war effort, and the ballooning number of notes eroded this faith with a downward spiral in which the holders of paper currency became ever more likely to exchange it for gold.
Since following the war not nearly enough gold existed in Britain to cover paper currency, England had to suspend convertibility, lest the holders of the devalued notes drain away the nation’s bullion reserves. In 1925, Churchill disastrously resumed convertibility by returning the pound to the gold standard at the old £4.86 rate. The now overvalued pound made British goods more expensive and thereby decreased exports; in addition, the artificially high exchange rate also made foreign goods cheaper, thereby encouraging imports; by 1926, England saw its gold reserves fall by an alarming £80 million, 10 percent of its total amount.365
Ever since the birth of the United States, high American and British government officials have developed close personal friendships, and at this juncture one such relationship proved particularly unlucky: that between the world’s two most important central bankers, Federal Reserve Chairman Benjamin Strong and Bank of England Governor Montagu Norman.
The surest way to boost the value of the pound and to staunch the gold outflow was to lower American interest rates, which made sterling-denominated assets relatively more attractive. Strong did so in 1927 and thus bailed Norman out of his difficulties, but only temporarily. Lower interest rates in the United States, already in the midst of a vigorous economic boom, set alight a speculative fever that broke just as Churchill, nearing the end of his North American tour, alighted in New York.
By 1929, the developed world had grown used to periodic financial upheavals. Casual observers and historians alike often refer to these booms and busts as illnesses, and the medical model indeed provides a window into both the patient and the disease, whether for persons or societal events.
Physicians understand illness through three fundamental lenses: pathophysiology, the underlying biochemistry and physiology of the disease process; anatomy, the parts of the body affected; and the symptoms and signs, what the patient feels and what the doctor sees at the bedside.
We can understand bubbles and crashes in the same way. For example, their pathophysiology involves the vagaries of human psychology and the unstable supply of credit from a modern banking system. Their anatomy consists of the “four ps”: promoters, public, politicians, and press. Finally, their signs and symptoms include the contagious societal infatuation with nearly effortless wealth, the hubris of the promoters, and their veneration by the public.366
Recall that Hyman Minsky theorized that the blowing of a bubble required not only the sort of credit easing produced by Benjamin Strong’s 1927 lowering of interest rates, but also an exciting new advance in technology. Such a technological advance could be in the sciences or in engineering, such as the railroad in the nineteenth century; or in finance, such as the joint-stock company in the seventeenth and eighteenth centuries.367 Investors, excited about new technologies or financial products, begin to pour money into them, be they stocks, real estate, or some other instrument. Since these assets can also be used as collateral for loans, rising prices mean that speculators can borrow yet more to pour into these assets, thus raising prices even further and enabling them to borrow even more—a self-reinforcing “virtuous cycle,” but only on the way up. It’s thus no accident that manias, panics, and crashes became a permanent and recurring part of Western life around 1600 precisely because both “displacement” and elastic paper-based credit first appeared around that time.
Today, technological displacement can take many forms. The dizzying pace of scientific advance seems a permanent feature of modern life: a mere twenty years ago, people would have blinked in disbelief at being told that worldwide personal video communication would become ubiquitous and nearly free. As recently as the 1940s, common bacterial diseases such as cholera, typhoid, bacterial pneumonia, and meningitis routinely struck down people in their prime, with no respect for wealth or social class. In developed nations, these scourges became vanishingly rare events after the advent of antibiotics such as penicillin.
By contrast, before 1600, the lack of progress was not just accepted, but assumed. Until the advent of the printing press, many a technological advance was lost simply because the manual reproduction of its documentation was so laborious and expensive that not enough copies survived down the generations. Furthermore, the rarity of literacy meant that artisans often failed to record their techniques, which consequently disappeared with them. The Romans, for example, invented concrete, but its use effectively died with the Empire; not until 1756 did John Smeaton rediscover the secret of Portland cement.
Gutenberg’s invention of mass-produced moveable type around 1450 removed this particular roadblock to technological advance, but others remained; per-capita GDP hardly grew at all before 1600 in the West, and not until much later in the East.
In 1620, philosopher Francis Bacon published his Novum Organum Scientiarium (“new instrument of science”; in English, The New Organon). Before Bacon, “natural philosophers,” as scientists were then called, developed their models via the Aristotelian, “deductive” method that proceeded from axioms—unquestioned principles that formed the basis of all further reasoning. In this system, observable facts were almost an afterthought.
The New Organon was itself a form of displacement, and its genius was twofold. First, it recognized that the old Aristotelian system of deductive reasoning stifled human progress; and second, it proposed a viable alternative: an “inductive” process that meticulously gathered empirical data, which could then be matched against theory—the essence of the modern scientific method. Within a few generations, Bacon’s intellectual children—Hooke, Boyle, and Newton, to name but a few—established the Royal Society for the Promotion of Natural Knowledge (now known simply as the Royal Society). This spawned similar groups throughout Europe, and with them followed a prodigious acceleration of scientific discovery.368
The seventeenth century midwifed not only the scientific method, but also a second societal revolution: the appearance of elastic currency. Most Americans labor under the misconception that money consists of green pieces of paper decreed by the government to be “legal tender for all debts, public and private,” or, in years past, stamped round disks of gold and silver. But in the ancient world, almost anything could be money: a fixed measure of wheat, oil, or, as time passed, silver. Only in the middle of the seventh century b.c. did the Lydians in Asia Minor stamp out the first coins made of electrum, a mixture of gold and silver.
Today, we live in a very different world. In the United States, only one-tenth of money consists of circulating notes and coins; keystroke entries in government and bank computers create the rest of it. For example, a bank doesn’t issue a mortgage in the form of a gym bag filled with green linen with pictures of Alexander Hamilton, Ben Franklin, and assorted dead presidents; rather, it sends a packet of electrons to the title company. And those checks and electrons are most certainly not backed by a corresponding amount of notes and coins, let alone gold, silver, or cattle.
This credit system is today known as “fractional reserve banking” and has become ever more elastic in the centuries following its creation by seventeenth-century goldsmiths. If early banks issued certificates much above a reserve ratio of 2:1, they risked a run by depositors demanding their money back. With the development of banking consortiums and government-run central banks, this ratio grew to around 10:1 for commercial banks, and much higher, on occasion, for investment banks. How high the reserve ratio climbs depends upon how much consumers and investors want to borrow, how willing banks are to lend, and, with increasing frequency, how much leverage government regulators will allow.369 A rubber band provides an apt metaphor for the stretching of the reserve ratio: enshrined in the 1913 legislation that established the Federal Reserve Bank is the mandate to “Furnish an Elastic Currency.”370
The housing market of the early 2000s provides a perfect example of Hyman Minsky’s paradigm. Before 2000, the housing market was reasonably sedate, stable, and dull. Banks extended mortgages to only the safest borrowers: those with superb credit histories, steady incomes, and little other debt, and who needed to borrow much less than the market value of their homes. Consequently, they almost always paid off these mortgages on schedule, default rates were low, and the banks made a modest profit.
Bank managers began to notice, however, that competing institutions with looser loan requirements serviced more borrowers and thus made more money; eventually, nearly everyone followed suit. Around the same time, another phenomenon gained steam: Banks began to sell their mortgages to Wall Street firms that assembled them into increasingly dodgy packages such as collateralized debt obligations (CDOs). This so-called securitization of the loans transferred the risk of homeowner mortgage default from the originating banks, which were in a good position to know the initial borrowers, to gullible institutions and governments around the world, who did not know them from Adam.
This corrosion of lending standards spread throughout the banking system, and defaults began to creep up. At first, the value of the underlying collateral, in this case, the homes, rose, and the banks and holders of the mortgage securities sustained few net losses, since defaulting properties could be seized and resold at a profit. Beginning around 2007, the increasing forced sales of homes depressed their prices, and the banks and securities holders started to lose money; eventually some went bankrupt and/or got federal bailouts. In the end, everyone tightened lending standards. This shutoff in lending from banks further decreased house prices and forced homeowners to walk away from their mortgages.
This sequence played out not just in the United States but globally. For the first five years of the housing bubble, roughly 2002–2007, the major mortgage qualification seemed to be possession of a pulse; after the collapse, banks counted a loan applicant’s gold fillings. Similarly, consumers, investors, and prospective homeowners became much more interested in paying down debt than in acquiring it, so the supply of credit, and with it the money supply, fell.
Minsky, who died in 1996, had taught that this cycle is the inevitable result of an elastic currency in which banks, both the government central one (the Federal Reserve) and private ones, can expand and contract the supply of money. Further, he understood that this monetary expansion and contraction occurs in just about all areas of the market economy, not just in housing, but in corporate management and in the stock and bond markets as well.
Minsky’s famous “instability hypothesis” states that in a safe and stable financial environment, money inevitably migrates away from safe borrowers and toward increasingly risky ones. Eventually, things get out of hand, resulting in a blowup of the sort described above, which makes lenders and investors more prudent, and the cycle begins anew, a process that seems to play out, very roughly, once per decade. In short, stability begets instability, and instability begets stability, with lenders periodically cycling the economic system through fear and greed.371 Of course, without intermittently greedy borrowers, greedy lenders would lack customers.
Minsky must have intuitively understood that two more conditions, in addition to “displacement” and credit easing, had to be met, though he didn’t explicitly spell them out: amnesia for the previous boom and bust, and the abandonment of customary and prudent objective methods of valuing investments.
Amnesia is implicit in the instability hypothesis. In the aftermath of a financial crisis, with the memory of painful losses still fresh, bankers and investors shy away from risk; the former will make only the safest of loans, while the latter are loath to purchase stock shares. As markets slowly recover and the unpleasant memories fade, participants become more open to risk and the instability cycle begins anew.
The abandonment of hardheaded financial calculations in favor of compelling narratives is the last factor that precipitates financial manias. When human beings are confronted with difficult or impossible analytical tasks, such as valuing a company that has never produced a profit, let alone a dividend, they default back to simpler methods of analysis; psychologists apply the term “heuristics” to such mental shortcuts.
Over the past several decades, psychologists have expanded our understanding of how humans apply heuristics when confronted with challenging or impossible problems; this work is directly applicable to finance, and particularly to understanding manias. In the 1940s, a Hungarian-born psychologist named George Katona began to study the intersection of economics and the human mind at the University of Michigan, where he pioneered psychological measurements relating to the economy. Among other accomplishments, he developed the now widely used Index of Consumer Sentiment, and the university became a hotbed of psychological research.
Another area pioneered at the University of Michigan was research into decision-making, which caught the attention of a particularly brilliant Israeli researcher named Amos Tversky.372 (His acquaintances liked to joke about the Tversky Intelligence Test: “The faster you realized that Tversky was smarter than you were, the smarter you were.”)373 The Michigan researchers had assumed, as do many economists even today, that humans were skilled intuitive statisticians; that just as we effortlessly acquire the rules of grammar and syntax, so do we also for statistics and probability.
Initially, this seemed reasonable to Tversky, but when he debated the question with a fellow academician at the Hebrew University of Jerusalem, Daniel Kahneman, he found himself persuaded otherwise. Around 1970, the two embarked on a remarkable series of experiments that revolutionized the way both economists and psychologists regard decision-making. It turned out, not only human beings in general had lousy statistical intuition, but so did even their fellow psychologists, who should have mastered it.374 In a classic study, they presented subjects with the following vignette:
Steve is very shy and withdrawn, invariably helpful, but with little interest in people, or in the world of reality. A meek and tidy soul, he has a need for order and structure, and a passion for detail.
Kahneman and Tversky then asked subjects if Steve was most likely a farmer, salesman, airline pilot, librarian, or physician. Most people chose librarian, since the above description best fits the librarian stereotype. Nevertheless, farmers outnumber librarians by a factor of twenty, and since there are plenty of shy farmers, Steve is more likely to be one of them than he is to be a librarian.375
The two proceeded to uncover a wide range of systematic analytic errors made by even the smartest people: the blindness to baseline frequencies (not recognizing, for example, that there are far more farmers than librarians), not realizing that large samples are more reliable than small ones, underestimating how easily humans perceive nonexistent patterns in random data, and not grasping that particularly good or bad task performance usually reverts toward normal on successive attempts, to name but a few.376 The two came away from their work deeply disappointed with the sad state of human rationality:
What is perhaps surprising is the failure of people to infer from lifelong experience such fundamental statistical rules as regression toward the mean, or the effect of sample size on sampling variability. Although everyone is exposed, in the normal course of life, to numerous examples from which these rules could have been induced, very few people discover the principles of sampling and regression on their own.377
Their exercises revealed that humans are by nature cognitively lazy. Rather than stop to rigorously analyze which of the five listed professions Shy Steve was most likely to practice, it’s far easier to default back to the following shortcut: Steve fits the stereotype of a librarian—end of story.378
The relevance of Kahneman and Tversky’s findings to financial bubbles is obvious. Rather than attempt the nearly impossible estimation of the value of a stock with high projected future earnings—the South Sea Company in 1720, RCA in 1928, Pets.com in 1999, or Tesla today—investors default back to this simple heuristic: “South Sea/RCA/Pets.com/Tesla is a great company that’s going to change the world, and it’s worth paying almost any price for it.”
Kahneman, Tversky, and other researchers also found that one of the most powerful heuristics is the human susceptibility to salience, our overemphasis of dramatic events. As an extreme example, a defining U.S. event of the past half century, the 9/11 attacks, killed nearly three thousand individuals. Even the death of a single individual in a terrorist attack will make headlines, yet individual deaths as a result of ordinary gun violence, opioids, or car accidents pass largely unnoticed in the media, despite the fact that more than thirty thousand lives are lost in each of these three categories annually in the United States.379 An American is far less likely to die from a terrorist attack than from a lightning strike, yet the United States devotes far more resources to antiterrorism efforts than to preventing the hundred thousand or so total deaths from guns, cars, and narcotics. (In a similar vein, any tourist who contemplates a visit to Israel is likely to be asked by a friend or family member if she isn’t worried about terrorism, despite the fact that since 2005 the average Israeli is roughly twenty times more likely to die in a road accident.)380
Kahneman and Tversky refer to the above salience fallacies as the “availability heuristic.” Salience has another dimension, which is temporal; you’re more likely to buy insurance for an earthquake or flood immediately following one. Naturally enough, they refer to this as the “recency heuristic.”
Humans, in short, are prisoners of salience, and this applies to financial manias in several different ways. The dramatic novelty of a new technology, such as the ability to fly around the planet at hundreds of miles per hour or to instantaneously bring entertainment or current world events into the home, is salient in the extreme—until the novelty wears off.
The recency heuristic also distorts investors’ perception of long-term reality: If stock prices have been rising for the past several years, they will come to believe that equity levels will continue to do so forever; as prices climb, shares become more attractive, which drives prices up even more. This becomes a self-perpetuating “virtuous cycle” that can drive stocks into the stratosphere. The reverse, of course, happens during long bear markets.
Like most economists, Minsky didn’t bother much with psychology, but he clearly understood the all-too-human preference for narratives over quantitative reasoning. We all like a good story; in the grip of a bubble, when faced with an unpleasant or difficult calculation, a compelling narrative provides easy escape from the eye-crossing effort of rigorous analysis. It’s not too much of an oversimplification to consider the narratives as the pathogen that spreads the bubble disease throughout a society.
Understanding how bubbles pop requires extending the elastic money metaphor only a bit. Imagine a rubber band an inch in diameter and several hundred feet long. Around the rubber band cluster hundreds of observers, most of whom are just milling about. Several dozen of them, though, are engaged in stretching it out. Further imagine that the rubber band’s increasing length imparts wealth to the pullers; as it gets longer, it attracts more idle crowd members. Their more naïve members believe that the rubber band will be stretched out forever, but a large number know that sooner or later it will contract violently. The latter group is programmed to let go at the first sign of contraction and is confident that they will know when to do so; that is, they are primed to release it.
Eventually, a few let go, which increases the strain on those remaining. Then, those primed to let go do so in a rush, and soon enough, the band snaps back not just to its natural length, but curls into a tight coil. Eventually, a few smart observers find it easy to lengthen the crumpled coil out again, and the cycle begins anew.
By the 1920s, all four of Hyman Minsky’s conditions were well established.
After the First World War, five technological advances rocked peoples’ lives. The internal combustion engine, invented in the late nineteenth century, came first, and facilitated two more: the Wright brothers’ invention of heavier-than-air flight and the spread of the motorcar, which freed people to travel long distances at will. By 1925, more than one-third of American families owned an automobile.381
The fourth was radio. In 1895, Guglielmo Marconi transmitted a Morse code letter s over a few kilometers of Italian countryside, but for the succeeding two decades the expensive new technology was reserved for the private transmission of sensitive and valuable information, and even in the United States, radio was reserved primarily for one domain: maritime communication, since the telegraph proved far more reliable and less expensive over land, as well as between continents via undersea cables.
In 1915, a Marconi employee named David Sarnoff wrote the famous “Radio Music Box Memo,” which proposed opening the medium up to the public “to bring music into the house by wireless.” It took some doing for Sarnoff to get Marconi to throw open to the public his profitable private medium, but in 1919, Marconi and General Electric incorporated Radio Corporation of America (RCA), and by 1920, the first two radio stations, KDKA in Pittsburgh and WWJ in Detroit, began operations. For the first time in history, concerts, sporting events, and breaking news could be broadcast live; without question, radio ranked with the invention and spread of the telegraph and the internet in the way that it transformed everyday life.
Bringing the news, George Burns and Gracie Allen, or the 1921 heavyweight championship fight between Jack Dempsey and Georges Carpentier into the nation’s living rooms astounded even more than the arrival of the world wide web in the early 1990s. RCA became the darling of investors, and by the late 1920s, when someone uttered the word “radio,” he or she was almost as likely to be referring to the stock’s nickname as to the medium or the hardware.
The fifth transformative technology involved the rapid expansion of the electrical utility companies that increasingly lit the nation’s homes and powered its factories. Although J. P. Morgan and his colleagues had incorporated General Electric more than a generation before, GE and its competitors needed decades to fully electrify the nation.
All five of these “displacements”—the internal combustion engine, airplane, automobile, radio, and widely available electrical power—stimulated the Roaring Twenties economy, as did Henry Ford’s mass-production techniques and the influence of Frederick Winslow Taylor, a mechanical engineer who, beginning in the late nineteenth century, led the “efficiency movement” that turned the stopwatch into a driver of worker productivity and corporate earnings. Between 1922 and 1927, the output of American workers increased by 3.5 percent per year, which delighted company shareholders; the response of company employees was less enthusiastic.382 Such was his influence that “Taylorism” entered the English vocabulary; ironically, Lenin and Stalin were fans, whereas in the United States, the term was not always a compliment, particularly within the rapidly growing union movement.
The second Minsky criterion during the 1920s was the easing of credit in the United States. Minsky knew that displacements could be financial as well as technological, and the 1920s produced a bumper crop of “advances” in leverage: brokers’ loans, investment trusts, and holding companies. All of these provided new and powerful sources of funds that could be borrowed and then deployed to flood the stock market, and which appeared to an increasing number of Americans as nothing so much as a wealth-spewing fountain. As put by economist John Kenneth Galbraith, “The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable form.”383
Before the twentieth century, the primary form of stock market leverage was the low initial subscription amount for shares, followed by mandatory calls for further capital. Greed-fevered participants assumed they could meet those calls by selling their partially owned but appreciating shares; a lucky few did, most did not, and many were ruined.
The speculators of the 1920s, by contrast, had fully purchased their shares, but with borrowed money, sometimes as much as 90 percent of the shares’ value. Consider, for example, the investor who had paid for shares of stock worth $1,000 with $100 of his own money on top of a $900 “brokers’ loan.” If the shares increased in value by 10 percent, they were now worth $1,100, leaving him with $200 after paying back the loan, thus doubling his original $100 investment. Alas, if the value of the investment fell by 10 percent to $900, the creditor demanded more funds to protect his $900 loan with a “margin call” to the plunger, and if the funds were not forthcoming, the loan’s terms allowed the creditor to sell out the position in order to protect his $900 loan. Brokers’ loans did not come cheap; as stock prices rose, so did the demand for the loans, which by 1929 had raised their rates to as high as 15 percent annual interest which served to gradually tighten the screws on those who purchased shares with them.
While all but the most optimistic plungers at least dimly perceived the risks of equity speculation, the brokers’ loans themselves seemed perfectly safe to the banks, which could access funds from the Federal Reserve at 5 percent and loan out to speculators at double or triple that rate, a simple and spectacularly profitable operation. The primary function of financial capitalism is to efficiently funnel money from those with an excess of it to those who need it. Bubbles distort that flow and so corrode a nation’s economy; the 1920s provided a spectacular example of this distortion when not a few large corporations diverted the capital needed to maintain and grow their businesses to the margin-loan market.384
The high brokers’ loan rates focus a bright light on just how hard it is, even today, for the Federal Reserve to safely puncture an established bubble. In 1929, the Fed could theoretically have staunched the flow of brokers’ loans, but since banks and corporations benefited from double-digit loan rates, the Federal Reserve would have had to raise interest rates almost this high, which would have been economically disastrous. Nor would raising the brokers’ loan rates themselves, if such a thing could be mandated by the government, have had much effect on the enthusiastic speculators, whose net worth, at least on paper, was giddily increasing at a much higher clip as yesterday’s price rise drove tomorrow’s in a self-sustaining cycle. The Fed found itself in the position of a skateboard rider barreling out of control down a hill, for whom there are only two options: intentionally crashing into a tree or continuing forward in a deep crouch and crashing later at higher speed. It chose the latter course. (The initial crash in October 1929 did in fact dampen the demand for brokers’ loans, whose rate fell to 7 percent.)
During the 1920s, the financial mania also infected the by-then well-established institution of investment trusts. During the late eighteenth century, a Dutch merchant named Abraham van Ketwich created what may have been the first mutual fund, a publicly available collection of shares in businesses from all over Europe and in New World Plantations: Eendragt Maakt Magt (Unity Creates Strength).385 Over the following century the investment trust concept spread throughout Europe, particularly to Scotland, and in 1893, to the United States with the formation of the Personal Property Trust in Boston. These conservatively run funds generally traded as stocks that could be bought and sold on demand. A few of those created during the 1920s have survived to the present day: General American Investors, Tri-Continental, Adams Express, and Central Securities.
The story of another trust, the Goldman Sachs Trading Corporation, did not end as happily. The brokerage firm that created the Trading Corporation, Goldman, Sachs & Co., did not get into the investment trust business until late in the game when it sponsored the Trading Corporation in December 1928. The Trading Corporation’s first steps were timid; it owned all of its stocks and bonds outright—that is, without leverage; further, the parent brokerage firm, Goldman, Sachs & Co., retained ownership of 90 percent of the Trading Corporation’s shares, selling only 10 percent of them to the public. In today’s terms, the Trading Corporation could be thought of as a simple mutual fund set up by Vanguard or Fidelity, which then owned almost all of the shares.
That conservatism soon fell by the wayside. A few months later, the Trading Corporation was merged with another Goldman creation, the Financial and Industrial Securities Corporation, and so bubbly was the market that, a few days after the February 1929 merger, the newly configured Goldman Sachs Trading Corporation was priced at twice the value of the securities it held; in effect, selling dollar bills to the public for two dollars.
Most companies would have been happy with such a showing, but Goldman then had the Trading Corporation buy up its own shares, which boosted its value yet further. At this point, Goldman, Sachs & Co. began unloading the shares it held in the Trading Corporation to the general public at hugely inflated prices. Next, in rapid succession, the Trading Corporation itself sponsored a new trust, the Shenandoah Corporation, which, piling absurdity upon absurdity, sponsored yet a third trust layer, the Blue Ridge Corporation. As put by Galbraith:
The virtue of the trust was that it brought about an almost complete divorce of the volume of corporate securities outstanding from the volume of corporate assets in existence. The former could be twice, thrice, or any multiple of the latter.386
Within the remarkable Goldman Sachs edifice Shenandoah and Blue Ridge each issued both common and “convertible preference” shares, the latter being essentially the same as a bond, with an obligation to pay 6 percent in interest to its owners. The two trusts had, in effect, written themselves brokers’ loans with their convertible preference shares, magnifying the price changes of the common shares according to the “multiple” described by Galbraith.
By ordinary standards, the leverage was not that great: only about one-third of Shenandoah’s shares and slightly less than half of Blue Ridge’s were the bond-like convertible preference shares. But the multiplication of these two leverages, and of the ownership structure, of which Trading Corporation sat on top, destabilized things disastrously. Shenandoah controlled Blue Ridge, and so got paid only after Blue Ridge’s convertible preference owners got their 6 percent interest payments, and the Trading Corporation got paid only after Shenandoah’s convertible preference holders got their interest payments, and so the price changes multiplied as they wound their way up the pyramid to the Trading Corporation, which by this point had also taken on its own debt. Shenandoah, for example, paid exactly one paltry dividend to its common shareholders before suspending payment in December 1929 for good.
Goldman had designed its fleet of trusts for calm winds and glassy seas, and as long as prices rose, the sailing was smooth. But almost immediately after the three trusts were formed, the skies turned foul, and the funds sank in reverse order of their creation: Blue Ridge first, then Shenandoah, then finally the Trading Corporation.
The effects of the leveraged structure were devastating. By year-end 1929, for example, the Dow Jones Industrial average had recovered somewhat from the October crash, and had suffered a decline of “only” 35 percent from its September peak. The three trusts, by contrast, fell by around 75 percent. By the low point of the market in mid-1932, the Dow had fallen 89 percent, the trusts by 99 percent. The total losses borne by the public in the three Goldman Sachs trusts alone totaled approximately $300 million. During just August and September of 1929, American corporations issued more than a billion dollars’ worth of similar investment trusts, a staggering amount for the era, most of which was lost by 1932.387 The Great Depression was by this point fully established and would grind on until the Second World War, which functioned as a massive public works project that brought the economy back to life.388
By 1929, the third factor, amnesia for the last bubble, was also solidly established. The preceding generation did see two market declines. The first, the Panic of 1907, was a rather curious affair. Its triggering event was indeed a failed stock speculation, but on a very small scale, a disastrously unsuccessful attempt by two brothers, copper mining magnates named Otto and Augustus Heinze, to execute an arcane maneuver known as a short squeeze of the shares of their company, United Copper.389
Augustus also owned a small Montana bank, the State Savings Bank of Butte, which went under with the failed short squeeze. Andrew Jackson’s euthanasia of the Second Bank of the United States in 1837 had left the nation without a “lender of last resort” to supply sorely needed capital when private lending dried up. Banks lend to each other, and the failure of one can spread domino-like; absent a central bank to ride to the rescue, a mild recession can turn into a full-fledged panic and depression. This is precisely what occurred during the financial crisis of the late 1830s, one of the worst in United States history.
In 1907, the failure of Heinze’s bank took out ever larger banks and eventually depressed stock prices by about 40 percent, and the panic stopped only when J. P. Morgan “drew a line,” above which were banks that were, in his estimation, solvent and thus worthy of support, and below which were banks that were allowed to fail. By historical coincidence, Morgan was born in 1837, the year of the death of the nation’s last central bank, and he died in 1913, with the passage of the Federal Reserve Act, which reestablished it. For much of that seventy-six-year lifetime, he effectively was the country’s central banker, and on one occasion in 1893, when an economic depression drained the U.S. Treasury’s gold reserve, he orchestrated its rescue.
The second market decline before 1929 occurred at the end of the First World War. The conflict had buoyed U.S. stock prices, but this speculation soon gave way to despair as farm prices fell; during the year following the market peak in the summer of 1919, stocks gradually fell by about one-third, though part of that was ameliorated by the generous dividends that stocks yielded in that period.390 As market declines went, this was relatively mild.
Before the First World War, only wealthy Americans owned stock shares, so neither the Panic of 1907 nor the market decline of 1919 made much of a lasting impression on the general public. By 1929 a new investing public, attracted by the wonders of the internal combustion engine, aircraft, automobile, radio, and electrical power, thus had no memory of prior bubbles.
The fourth bubble prerequisite was the abandonment of conservative, traditional methods of stock valuation. The United States funded the First World War partly through the issue of billions of dollars of Liberty Bonds, yielding between 3.5 and 4.5 percent, and in the process introduced the average American into the securities markets. Liberty Bonds served as the public’s investment “training wheels,” and provided a safe and modest rate of return.
Government bonds can be thought of as a baseline, or what financial economists call the “risk-free rate” for safe assets. For centuries, investors bought stocks solely for their dividends, and since they were risky, in order to attract buyers, the dividend yield of stocks had to be higher than those provided by safe government securities. George Hudson, for example, had to promise the buyers of his railways shares dividends far higher than the 3 to 4 percent yields of British government bonds. Like their British counterparts, rational American investors did not require, nor did they expect, to benefit from share price increases, but they did desire to collect a dull but steady dividend flow higher than that offered by safe bonds; before the First World War, U.S. stock yields averaged around 5 percent.391 By the 1920s, it was generally accepted that stocks should sell for approximately ten times their annual profits, so as to easily cover that payout.
Today, investors, wisely or not, take long-run rises in company profits and share price for granted and so tolerate much lower dividend payouts, but before the twentieth century, sustained share price increases were a rarity, seen only with the most successful companies. Even in the most favorable cases, the price increases were tiny. For example, the two most successful early English joint-stock companies were the Bank of England and the East India Company, and even this cherry-picked pair saw share price appreciation averaging only 0.7 and 0.6 percent per year, respectively, between 1709 and 1823.392
How, then, could even the most accomplished investors value RCA, which by the time of the 1929 crash had not yet produced any dividends, and, in the event, would not do so until 1937?393 By the late 1920s, while investors obviously thought that the company had stellar prospects, they did not have the tools to estimate an appropriate price to pay for the company’s expected future profits. Not for another decade would financial economists like Irving Fisher, John Burr Williams, and Benjamin Graham work out the complex mathematics of calculating the intrinsic value of a stock or bond, particularly one with highly speculative future prospects. Even today, this technique, the so-called discounted dividend model, which estimates the value of all future dividends and “discounts” them back to the present, challenges the average investor, and in any case, is of such limited accuracy that even professionals more often than not run afoul of it.394
In the bubbling technological environment of the 1920s with the development of radio, automobiles, and airplanes, it was easy for the public to believe that the old rules of security valuation didn’t apply anymore. As supposedly put by a great twentieth-century investor, John Templeton, “The four most expensive words in the English language are ‘This time it’s different.’”395
Writing about that time, Benjamin Graham observed:
If a public-utility stock was selling at 35 times its maximum recorded earnings, instead of the 10 times its average earnings, which was the preboom standard, the conclusion to be drawn was not that the stock was now too high but merely that the standard of value had been raised. . . . Hence, all upper limits disappeared, not upon the price at which a stock could sell, but even upon the price at which it would deserve to sell. . . . An alluring corollary of this principle was that making money in the stock market was now the easiest thing in the world.396
By 1929, the full panoply of Kahneman and Tversky heuristics, especially the salience of the era’s new technologies, the recency of ballooning security prices, and the availability of credit-fueled prosperity, had overwhelmed the rational analysis of security prices.
The economist Max Winkler put it most simply. Alluding to the newly described discounted dividend model, Winkler archly observed in the crash’s aftermath that the 1920s stock market discounted not only the future but the hereafter as well.397
362. Bagehot, 158.
363. Martin Gilbert, Winston S. Churchill (Boston: Houghton Mifflin Company, 1977), V:333–351, quote 350.
364. Liaquat Ahamed, Lords of Finance (New York: Penguin, 2009), 231.
365. H. Clark Johnson, Gold, France, and the Great Depression, 1919-1932 (New Haven, CT: Yale University Press, 1997), 141; converted at $4.86/pound sterling, see also Federal Reserve Bulletin, April 1926, 270–271.
366. Benjamin M. Blau et al., “Gambling Preferences, Options Markets, and Volatility,” Journal of Quantitative and Financial Analysis Vol. 51, No. 2 (April 2016): 515–540.
367. Hyman Minksy, “The financial-instability hypothesis: capitalist processes and the behavior of the economy,” in Charles P. Kindleberger and Jean-Pierre Laffargue, Eds., Financial crises (Cambridge, UK: Cambridge University Press, 1982), 13–39.
368. William J. Bernstein, The Birth of Plenty, 101–106.
369. For a marvelously lucid description of this system, see Frederick Lewis Allen, The Lords of Creation (Chicago: Quadrangle Paperbacks, 1966), 305–306.
370. https://fraser.stlouisfed.org/theme/?_escaped_fragment_=32#!32, accessed March 30, 2016.
371. Minsky, 13–39.
372. Floris Heukelom, “Measurement and Decision Making at the University of Michigan in the 1950s and 1960s,” Nijmegen Center for Economics, Institute for Management Research, Radboud University, Nijmegen, 2009, http://www.ru.nl/publish/pages/516298/nice_09102.pdf, accessed July 18, 2016.
373. Malcolm Gladwell, David and Goliath (New York: Little, Brown and Company, 2013), 103.
374. Daniel Kahneman, Thinking, Fast and Slow (New York: Farrar, Straus and Giroux, 2013), 4–7.
375. Amos Tversky and Daniel Kahneman, “Judgment under Uncertainty: Heuristics and Biases,” Science Vol. 185, No. 4157 (September 27, 1974), 1124.
376. A classic example of the phenomenon of “reversion to the mean” is provided by Daniel Kahneman’s experience with Israeli flight instructors who mistakenly believed that praise/scolding for good/bad performance was effective, when in fact relative performance was mostly due to chance. Thus, the instructor’s yelling had nothing to do with the “improvement” in the pilot’s prior performance, which was merely randomly poor and had subsequently “reverted to the mean.” See Daniel Kahneman, Thinking Fast and Slow, 175.
377. Ibid., 1130.
378. “Judgment under Uncertainty” (vide supra) is Kahneman and Tversky’s most widely quoted work. Also see, by the same authors, “Availability: A Heuristic for Judging Frequency and Probability,” Cognitive Psychology Vol. 5 (1973): 207–232; “Belief in the Law of Small Numbers,” Psychological Bulletin Vol. 76, No. 2 (1971): 105–110; “Subjective Probability: A Judgment of Representativeness,” Cognitive Psychology Vol. 3 (1972): 430–454; “On the Psychology of Prediction,” Psychological Review Vol. 80, No. 4 (July 1973): 237–251; “On the study of statistical intuitions,” Cognition Vol. 11 (1982): 123–141; and “Intuitive Prediction: Biases and Corrective Procedures,” Advances in Decision Technology, Defense Advanced Research Projects Agency, 1977.
379. For firearms deaths, see https://www.cdc.gov/nchs/fastats/injury.htm; for motor vehicle deaths, see https://www.cdc.gov/vitalsigns/motor-vehicle-safety/; and for opioid addiction, see https://www.cdc.gov/drugoverdose/.
380. Between 2005 and 2019, terrorists have killed 250 Israelis, about fifteen per year, whereas in 2018, 315 were killed in road accidents; see https://www.jewishvirtuallibrary.org/comprehensive-listing-of-terrorism-victims-in-israel and https://www.timesofisrael.com/cautious-optimism-as-annual-road-deaths-drop-for-the-first-time-in-5-years/.
381. In 1925, there were twenty million automobiles in the United States out of a population of 116 million; see http://www.allcountries.org/uscensus/1027_motor_vehicle_registrations.html, accessed July 18, 2016.
382. Allen, The Lords of Creation, 235–236.
383. John Kenneth Galbraith, A Short History of Financial Euphoria (Knoxville, TN: Whittle Direct Books, 1990), 16.
384. Galbraith, The Great Crash 1929 (Boston: Houghton Mifflin Company, 1988), 22.
385. K. Geert Rouwenhorst, “The Origins of Mutual Funds,” in The Origins of Value, William N. Goetzmann and K. Geert Rouwenhorst, Eds. (Oxford: Oxford University Press, 2005), 249.
386. Galbraith, The Great Crash 1929, 47.
387. Amalgamated from Galbraith, The Great Crash 1929, 60–63; and J. Bradford De Long and Andrei Schleifer, “The Stock Market Bubble of 1929: Evidence from Closed-end Mutual Funds,” The Journal of Economic History Vol. 51, No. 3 (September 1991): 678.
388. Galbraith, The Great Crash 1929, 58–62; and Barrie Wigmore, The Crash and Its Aftermath (Westport, CT: Greenwood Press, 1985), 40, 45, 248–250.
389. A short seller borrows shares from an existing owner, then sells them to a third person with the expectation that the short seller can later buy them back to repay their lender at a lower price. A short squeeze attempts to profit from the knowledge that the shares will eventually need to be repurchased by the short seller; the squeezer buys up enough of them to inflate their price and so force the short seller to close out his trade at great profit to the squeezer, and great loss to the short seller.
390. From Robert Shiller database, see http://www.econ.yale.edu/~shiller/data/ie_data.xls, accessed July 17, 2016.
391. Robert Shiller database, ibid.
392. Neal, The Rise of Financial Capitalism, 232–257. Even these numbers may overstate the degree of price rise, since 1709 was near the end of the debilitating War of the Spanish Succession, and so represented a low starting point upon which to build further price increases.
393. “Radio Declares Dividend,” Ellensburg Daily Record, November 5, 1937.
394. The canonical form of the technique was laid down in John Burr Williams, The Theory of Investment Value (Cambridge: Harvard University Press, 1938). See also Irving Fisher, The Theory of Interest (New York: The Macmillan Company, 1930); and Benjamin Graham and David Dodd, Security Analysis (New York: Whittlesey House, 1934).
395. This sentence is one of the most repeated in finance, contributing the title, for example, to a classic in international economics, Carmen M. Reinhart and Kenneth S. Rogoff, This Time Is Different (Princeton NJ: Princeton University Press, 2009). It is mainly attributed to Templeton, but sometimes to David Dodd, Benjamin Graham’s coauthor. I am unable to find a definitive source for this quote.
396. Graham and Dodd, 310.
397. Paraphrased in Frederick Lewis Allen, Only Yesterday (New York: Perennial Classics, 2000), 265. I am unable to locate a primary source.