The Great Crash, 1929 by John Kenneth Galbraith

The past does not repeat itself, but it rhymes - Mark Twain

Crises serve a useful purpose - Regulation is a poor substitute for good memory. People after a big crisis become fearful of excesses that regulation try hard to limit. Excesses might come in different forms after a few decades, for there is nothing more predictable as human desire to make money without effort. But memory serves the same purpose as SEC, in a far more effective way.

Refreshing memory was the main intention of the author when he wrote the book in 1950s. Half a century later, as a crises of comparable proportions looms, it is worth considering the aspects of the Great crash which rhymes slightly with the current one.

When people talk about the great crash, they say it merely precipitated the already weak economy. By most standards, the real economy had slowed down. The stock market crash merely made people realize what thin ice they were on when they were speculating high stock market values.

But that's underestimating the effect of stock market crash, argues Galbraith. During that time, the top 5% of the income earners controlled more than 30% of the wealth. Any crash which wiped out the wealth of these 5% was bound to affect the real economy. But how did it crash? Like most if not all crashes, the answer is Leverage.

In 1920s, Investment trusts, similar to Mutual funds today, operated on a holding companies model taking stakes in a host of operating companies (Montgomery Ward, American Telecom etc), and issuing securities to finance the acquisition. At the height of the boom, the market values of these holding companies sold at 2 or 3 times the market values of the operating companies they were holding! That's the first stage.

How do you act on this premium (ostensibly attributed to the financial genius of the managers of the trust in picking the right stocks and achieve diversification) ? The traditional way of issuing bonds, preferred stock etc achieves leverage to some extent (Assume a 100 Rs investment in stock portfolio financed by a 50% investment. A 1% rise in value to 101 results in a 2% rise in equity (50 becoming 51)) But that's not enough when you are a financial genius. The holding companies started spawning even more holding companies and so on and so on and the final link in the chain was the operating companies. The companies also held stakes in holding companies of other institutions (the author calls it financial intercourse) creating a structure which could bring the whole system down in times of crisis.

The second cog in the speculation wheel was the amount of broker loans (loans taken by brokers in the call market to finance purchases of stocks). Unlike the period of early 2000s, the money was by no means cheap. At 12%, it would've enticed the money lender in Mumbai. But such was the nature of speculation that the brokers were willing to finance stocks at that rate, and the world was willing to finance them.

In hindsight, the speculation had to come to an end. When the investment trusts did come under selling pressure, in a bizarre display of self delusion, the trusts started using the excess cash they had built up during good times to support their own stock. By the time they had realised the futility of trying to support the stock everyone wants to dump, they had burnt through all their cash and was left with nothing to pay up their debt. When they were forced on a firesale, for the first time in history, people realised that there need not be a buyer for every seller at any price. The market went on a free fall.

There were some auxiliary reasons why the recession became as severe as it did. In the present day current crisis, at least for a time being, the American economy was sustained by a surge in exports as the crisis, combined with high oil prices weakened the dollar against all major currencies. But 1920s America wasn't that fortunate. America, at that time was a creditor economy (lender and exporter to the world). In the balance of payments equation, the current account (Exports and imports) and capital account should by design balance. In those times, most of the economies of the world ran a huge current account deficit (imported more from US that they exported) The only way they balanced it was by borrowing more from the US. Most of the loans were made to Latin American countries which had domestic instability and credit risks (nothing changed till date). As credit became tight the loans came down sharply. The only way to keep the Balance of payments in balance was that the imports from US had to come down. This deepened the crisis.

The author agrees that the Economic knowledge at that time was poor in dealing in the crisis of that magnitude, and that some of the actions deepened rather than alleviate the crisis, (the rules which forced the Government to balance federal budgets and cut back spending during crisis, the Smoot Hawley Act that smacked protectionism, the Fed inaction leading to multiple Bank failure etc) which makes the Depression of 1930s unique in some ways. But his ideas behind the crisis, the basic human desire to make money without effort, to suspend disbelief when the going is good and even actively seek justification for the new found prosperity (Noted economist Irving Fisher made the infamous assertion 'the stock market had reached a permanently high plateau') remain true of every crisis.

P.S: There is an interesting observation. President Coolidge in his state Union address in 1928 said 'No congress has ever assembled, on surveying the state of the Union, has met with a more pleasing prospect than the current one...' Historians have chastised Coolidge for his false optimism that had prevented him from seeing the looming disaster. This, says Galbraith, is grossly unfair. Historians rejoice in crucifying the false prophet of the millennium. But they never dwell on the man who wrongly predicted Armageddon.

Could what be true of Coolidge be true of Greenspan? Was it wrong to let the good times last, especially the one which had lasted for more than a decade? (Even if he didn't do what William McChesney Martin, Jr., the longest serving Fed chairman (not Greenspan like many believe!) famously quipped 'the job of the Federal Reserve is to take away the punch bowl just as the party gets going'?)