THE GREAT CRASH

By John Kenneth Galbraith

In the quarter century from 1983 though 2008, Americans witnessed three stock market crashes: 1987, 1990 and 2000. The first of those crashes represented the sharpest one-day drop in the history of the New York Stock Exchange. Comparisons to 1929 obviously suggested themselves. But when no recession materialized — and the market quickly reversed itself — the investors of the 1980s took a very different lesson from their grandparents: a crash is a time to buy.

In 1990 and 2000, stock market declines were followed by recessions, but mild and brief recessions. Again the markets recovered in impressively short order — and again the 1929 comparison receded into historical remoteness.

But now, Depression economics again demands attention. The world this year suffered the first global economic contraction since World War II. The recession that started in the summer of 2008 looks also to be the harshest since 1945. The crash in asset values that originated in the US housing market has spread to just about anything and everything — stocks very much included. It seemed time to read a book I’d been hearing about all my life: John Kenneth Galbraith’s The Great Crash.

Galbraith’s reputation as a theoretical economist has declined greatly over the past half-century. Despite the efforts of admirers like biographer Richard Parker, that reputation seems unlikely to revive. Galbraith devoted his attention to a subject that seems as vanished as the gold standard: the management of the big-unit, mass production American economy of the mid-20th century. That economy has vanished as utterly as plantation agriculture or the gold standard, and with it much of the relevance of Galbraith’s analytic work.

As a narrative economic historian, however, Galbraith has rarely been rivaled, never exceeded. Long after dust covers over The New Industrial State (1967), The Great Crash will remain the most vivid and grimly entertaining account of the financial disaster that announced the Great Depression.

Galbraith begins with a simple logical proposition: You cannot understand the crash unless you first understand the preceding boom. By the summer of 1928, the expansion of the Harding-Coolidge years was perceptibly faltering. Yet at precisely that moment, the US stock market hurtled off into the wild blue yonder. Stocks that had traded at an already dizzying 20-1 price-earnings multiple in mid-1928 rocketed to a 32-1 multiple at the market peak in September 1929.

The mystery to be explained is not that this bull market ended. The mystery is: why did it happen in the first place?

Galbraith’s answer is both simple and ideologically challenging: the 1928-29 bull was a purely speculative event, utterly irrational, an example of the kind of mania to which human beings are prone.

One by one he knocks aside explanations that tried to offer some kind of rational basis for the Hoover market. The Federal Reserve cut interest rates in 1927 in an effort to weaken the dollar against European currencies. At the time, that 1-point cut was famously described as “un petit coup de whisky” for the New York market. Did it trigger the runup? Galbraith argues no, on three grounds.

1) Even after the cut, interest rates remained relatively high: 5% at a time of zero inflation.

2) Low interest rates alone do not in themselves trigger speculative bubbles. Rates at the Fed are much lower today than they were in 1928 — but who is speculating in the summer of 2009?

3) For the many who traded on margin in the 1920s, interest rates were never low. Brokers’ loans carried interest rates of 10%, sometimes 12%. People paid those rates because they expected to score gains of 100% or more on their stock trades.

Galbraith makes this case explicitly. His story makes the case implicitly — and more powerfully. Here are the investment trusts of the 1920s, that created the appearance of value by buying up each other’s shares; the ultra-leveraged utility companies that depended on hypothetical future earnings growth to pay massive existing debts; the glamour companies of the era, General Motors and Radio Corporation of America, continuing to soar even after the stock market generally has begun to tumble.

The literary classic at the core of the book is the day-by-day telling of the terrible last week of October 1928. Galbraith at his best is a great literary stylist, ironic, witty, highly alert to human folly, but not unsympathetic to it. (As he notes, disdain for the errors of the previous generation only invites retaliation upon the present generation from the next.) The Galbraith style grew prolix and unpleasantly self-satisfied in the maestro’s later years, but in the early 1950s and on this subject he wrote in his very sharpest and most elegant manner, dispensing witticisms as off-handedly as a retired robber baron distributing dimes to newsboys.

The bull market was destroyed in three terrible days, Monday October 24, Thursday October 28 and Monday October 31. The 24th suffered the steepest plunge, the 28th the most chaotic trading, although with the market ending net positive. The 31st was the very worst day of all: as chaotic as the Thursday and nearly as plunging as the Monday. That day many stocks found no buyers at all.

Galbraith debunks the myth that the crash was followed by a spate of suicides, especially of the leaping out of windows sort. (They seem to have been inspired by a trick of the eye: As crowds gathered around the stock exchange on the 28th, somebody spotted a workman preparing to descend a skyscraper to wash the windows. The rumor spread that the man was readying himself to leap.)

What did follow the crash was a spate of revelations of embezzlement. Galbraith is credited with the aphorism: “Recessions catch what the auditors miss.” Some anonymous editor has redacted the remark out of a somewhat wordier presentation here, but it’s the thought that counts. In Galbraith’s telling, the brokers come out rather well from the 1929 crash. The bad practices exposed by 1929 occurred in corporate America. Galbraith quotes Walter Bagehot’s observation that people are most credulous when most happy, and in the happy 1920s, unscrupulous business operators used that credulity to conceal all kinds of schemes against investors and the larger public. Galbraith narrates the story of a bank in Flint, Michigan, where all the top officers were helping themselves to company money. They accidentally discovered each other’s thefts and decided to work together. They pooled their misappropriated funds and shorted the market on the eve of its most euphoric spurt. Panicked, they reversed themselves and went long — only to be hit by the October crash.

What also followed the crash of course was the Great Depression. Unlike most economists then and since, Galbraith argues that the crash represented much more than a signal of the impending downturn: he argues that it was an important causal factor.

In the first place, the crash destroyed enormous amounts of wealth. The 1920s expansion had been led by business investment — and this sudden evanescence of asset values abruptly called a halt to further investment plans.

Second, the stock market boom had depended heavily on leverage in the form of brokers’ loans to buy stocks on margin. When stock prices tumbled, brokers called those loans, forcing the sale of the stock — which drove the price down more, triggering more margin calls, and down through a vicious cycle. The crash destroyed the value of the heavily leveraged investment trusts, the hedge funds of their day. That in turn prompted a round of bank loan calls. The crash, Galbraith contents, commenced a massive, unexpected and rapid forced deleveraging that paralyzed economic activity.

Perhaps at some other time — 1987 say — the broader economy could have sustained such an event without untoward effect. Not in 1929. Galbraith argues that the economy of the 1920s was unsound in five important ways: (1) business was too indebted, (2) the banking system was too fractured, (3) wealth was too concentrated (making spending too vulnerable to a shock to the financial health of the most affluent), (4) economic understanding too primitive to enable policymakers to respond effectively, and (5) American tariffs had locked European exporters out of the US market at a time when Europeans had huge dollar debts to service — creating a need for dollars that was met by excessive international lending.

Note that four out of Galbraith’s five causes are domestic. Galbraith’s life and work coincided perfectly with what might be called the isolationist phase of American economic life. Before 1914, the United States was tightly integrated into the global financial system. It borrowed massively from Europe, and especially Britain, to develop its industries and resources — and then ran a huge export surplus to pay the interest on that debt. Since 1980, the United States has again become conscious of its place in a larger world economy. In between — and most especially in the years of Galbraith’s maximum professional success, 1950-1970 — the economic activity of the rest of the world felt far off, the American economy a world unto itself. Only — it wasn’t. The mid-century economy on which Galbraith founded his theories was a passing phenomenon, a product of the wars and crises of a terrible moment in human history.

The Great Depression was a global event, and its history has to be a global history. If you want a short explanation for the Great Depression, “the New York stock market crash” cannot be it. The short explanation for the Great Depression is, “the failure to restore a functioning world economy after the First World War.” Galbraith’s narrative of that terrible month on Wall Street 80 years ago remains definitive and fascinating. The intellectual context in which Galbraith set his magnificent narrative, however, is partial and defective. The man who coined the phrase “conventional wisdom” himself was himself not only a creator of one moment’s wisdom, but also its prisoner. The global view would have to await a very different era — superbly represented by a book that I’ll be discussing in this space shortly, Liaquat Ahamed’s Lords of Finance.