Outside of agriculture, which had been experiencing an economic depression since the end of World War I, the American economy during the 1920s was robust, vibrant and it seemed as though it would grow forever. The country had experienced an unprecedented industrial expansion starting with the Civil War and the demands for manufactured goods (and the technology to produce those goods on a grand scale) the war engendered. That expansion had continued through World War I and into the Roaring Twenties. So great was the faith in the American economy that as late as 1928 Herbert Hoover remarked in his acceptance speech at the Republican convention:
"We in America today are nearer to the final triumph over poverty than ever before in the history of any land. The poorhouse is vanishing from among us."
The Twenties roared because people had money to spend, a compulsion to buy and an enthusiastic but intemperate faith in the future. People had money to spend because the industrialist shared this unrestrained but ultimately insane belief that prosperity would not only last forever but that it would expand forever. Profits were, indeed, high and business, in anticipation of even greater rewards, reinvested in new factories creating new jobs and the new jobs created new spending. In the industrialized East, at least, the future could not have looked brighter. Nowhere would this mentality be more clearly displayed than in the stock market; almost nowhere would it eventually prove to be more destructive.
The tumultuous economy of the 1920s would find its antithesis in the dark years of the 1930s and hard lessons would be learned only to be forgotten in the 1990s. Even today there isn't a total consensus on what actually triggered the Great Depression but there is agreement that it resulted from the confluence of a number of events, the stock market crash ranking high on the list. If a single word had to be chosen to define the cause it would be speculation, in industry, in banking, in land, in the stock market. Another word that fits is regulation, more specifically, the lack of it and a third, excess. Discussing the contribution of all of these to the Great Depression and the legislation that followed would be well beyond the scope of this article so I'll limit it primarily to the stock market and to banking.
In the 1920s common wisdom held that the stock market anticipated the needs of making and selling goods and would correct itself as demand changed. It's that old favorite, laissez faire economics, and when mixed with a toxic dose of "trickle down" foolishness it becomes the bedrock of Republican dogma. Inexplicably, it's still common wisdom in some camps today despite having been proved to be just plain wrong at the end of the 1920s and again in 2007-2008. By 1927, what Herbert Hoover would call an "orgy of mad speculation" had taken control of the market. Everyone wanted in and the price, and therefore the perceived worth, of stock soared out of any proportion to the goods the stock represented. That this could happen wasn't entirely impossible to predict. As early as 1925 some were beginning to realize that mass production needed to be constantly fueled by mass consumption and that, in the absence of an rapidly expanding population or export market, growth at the rate then being realized couldn't be sustained. Unfortunately, neither of those existed at the time. Immigration had been severely curtailed by the Johnson Â-Reed Act (officially the Immigration Act of 1924), post World War I Europe was broke and Asia had not yet become a player in world trade.
With no regulation to restrain the market or those chasing the pot of gold they believed to be found there, a number of questionable, sometimes downright shady, unethical and crooked lending and investment practices arose. Leading the field in the "Questionable" and "Highly Destructive" categories was the practice of making "call loans," loans to be used specifically for the purchase of stock. These transactions were known as call loans because rather than being amortized, the lender could call for them to be repaid in full at any time. As is true with many things that become corrupted, call loans didn't start out being bad for America. They just started out flawed. The first problem with them was that since it was anticipated the loan would be repaid from the profit realized when the stock increased in value, actual collateralization of the loans was a pretty iffy thing. Some loans were secured at as little as ten percent of their purchase price with few being secured at more than fifty percent. Such was the faith in a concept that even a modicum of reflection should have called into question. The second problem was that without regulation there was no restraint on who could issue call loans.
It wasn't long before banks and brokerages were handing them to pretty much anybody who wanted one. Even large corporations started issuing call to be used only to purchase the corporation's stock, stock some were reissuing with staggering regularity The third problem was that, obviously, the lender was most likely to call the loan in early if the value of the stock fell to or below the amount loaned. As these loans proliferated a tremendous amount of unsecured debt was being accrued, unsecured debt that would eventually help bring down the stock market. When the bubble started to burst cash strapped banks began calling in loans only to find that investors had no cash and investors trying to sell learned that their stock had little or no value. The end to the good times didn't happen all at once; it happened in starts and stops and lurches but it did inevitable happen with a preordained certitude. There was just no avoiding it. Following a period of intermittent market instability in late October, the house of cards came crashing down with an ominous finality on "Black Thursday", October 24, 1929. If any of this sounds eerily familiar that's because it should. We would see the modern equivalent of it's rebirth in the late 1990s and the result of that rebirth in 2007-2008.
Now, bear in mind that I'm only showing you a very small part of a very large picture here. A number of other events were also taking place at about the time I'm describing (and continuing into the early 1930s), events that would also help bring America to it's economic knees and define life for a great many Americans during the Depression years. The Bank Panic in 1930 and the dust storms that fell upon already struggling farmers and devastated the Midwest between 1930 and 1936, to name just two, each played their role and each to one degree or another affected the others.
After the excesses of the 1920s and the damage done in part by irresponsible banking and investment practices it was clear that new rules were need to protect the middle class. Some of those new rules came in the form of the Glass-Steagall Act (G-SA) named for its authors, Senator Carter Glass (D-Va.) and Congressman Henry Steagall (D-Ala.). When we speak of Glass-Steagall we're usually thinking of the second Glass-Steagall legislation. The first (officially known as the Banking Act of 1933) was a sort of emergency legislation limited to expanding the powers of the Federal Reserve and was intended to control runaway deflation. The second GSA established the Federal Deposit Insurance Corporation and imposed a number of restrictions on banking practices. Both were intended to protect the middle class investors and savers from the excesses and abuses of the 1920s that had cost so many their job, their savings, their dignity, their future.
The GSA imposed four new restraints on a financial industry that had proven itself incapable of restraining itself. First, commercial banks were prohibited from engaging in investment activities. That is to say, commercial banks could no longer risk monies given to them as savings in investment schemes in which the investor's money (rather than the banker's) was lost if the scheme failed. Secondly, investment banks could no longer also act a commercial banks, the flip side of the first provision. Next, no Federal Reserve member bank could affiliate itself with any bank primarily involved in investment activities and finally, no individual could serve in an official capacity for a commercial bank and an investment bank at the same time. Each of these restraints responded to a specific abuse prevalent in the 1920s. In 1956, Congress passed the Bank Holding Company Act (BHC) to stop an end run by bankers in which they sought to circumvent GSA by establishing holding companies they then used to allow the parent bank to own both investment and commercial banks. The fight to stop bankers from engaging in practices that are profitable for themselves but not good for the country is an ongoing battle and it has to be fought over and over again.
The attack on Glass-Steagall started slowly. In the 1960s banks began employing lobbyist to argue the case for banks being allowed back into the bond market. Lobbying against GSA became a career specialty and a very lucrative endeavor but not much was really accomplished until the mid 1980s when the assault was greatly ramped up. In 1986, the Federal Reserve Board, popularly known as just the Fed, the entity with regulatory power over banking practices, seized on wording in GSA, the phrase "engaged principally," and decided that it meant banks could get into the securities business a little bit, up to five percent of their gross income. The first chink in the armor had just appeared. Throughout 1987 the Fed chipped away at GSA with a ruling in favor of banker here, another one there. In January 1989, with Alan Greenspan having been in charge of the Fed for a couple of years, it was decided that ten percent of gross income met the less than "engaged principally" limitation. A bigger chink could be seen. In December 1996, The " engaged principally" limitation was raised to twenty-five percent and the provisions GSA prohibiting commercial banks from engaging in investment activities becomes essentially toothless. By the fall of 1997 the remaining protections separating commercial banking are mostly gone. In a supreme irony, one argument advanced in support of repealing the GSA was that it wasn't needed anymore since the Securities and Exchange Commission had become so strong and effective. This was, of course, the same SEC that soon installed a revolving door to facilitate the exchange of personnel between itself and Wall Street.
Again, the events I just described weren't happening in a separate universe, independent of all other events. At the same time that G-SA was being pillaged by the Alan Greenspan and the Fed, Congress, responding to intense lobbying by banking interests, was trying to repeal it outright. Now, enter stage right, Phil Graham and a Republican party that believed (and still does believe) that it had found legitimacy and an intellectual voice in Ayn Rand and Objectivism, a generally selfish and soulless pseudo-philosophy with particular appeal to the "me firsters." Would America be a better place if Rand had stayed in Russia, or better yet never learned to read and write? Who can say? Still, it does seem to be a good bet. For some twenty years Republicans had been trying to repeal Glass-Steagall. Twelve times legislation was introduced and eleven times it failed. In Graham they found the water carrier who would finally get the job done. With the passage of the Graham-Leach-Bliley act (officially the Financial Services Modernization Act of 1999) in November of that year the job was done, Glass-Steagall was at last officially dead.
There was, however, one battle left for the bankers to fight and, while not a Glass-Steagall issue, it's relevant to the deregulation discussion. I'm referring here to derivatives. Now we've been told ever since derivatives became a household word that they are far too complicated for the uninitiated public to understand. Well, yes and no. Understanding the formulas used to create and trade them does require an advanced knowledge of the arcane language of business but the concept is pretty simple. A derivative is a financial instrument with no intrinsic value. Rather, it's value is tied to something that does have intrinsic value. A Credit Default Swap (CDS) is a derivative because it's an somewhat like an insurance policy taken out on a loan and typically it's value is tied to whether the loan is repaid. CDSs are potentially harmful to America's financial health because, unlike traditional insurance policies, they are not limited to the principals in the loan. Anyone can take them out on most any loan making them vulnerable to all sorts of nefarious scheming. As practiced by some banks during the runup to the Crash the concept is analogous to taking out a life insurance policy on a neighbor without his knowledge. Now you stand to gain if the neighbor dies and if you're in a position to influence that outcome that neighbor is pretty much screwed.
Debris From a Bank Hit be a meteorological Tornado-- not so different from damage caused by Economic Hurricanes.
Flickr image By Jon Person
Thanks to deregulation in one case and the absence of regulation in the other, banks were able to purchase large blocks of mortgages, divide them into tiers (some likely to paid off, others not so likely), make one profit by selling the packages and another by betting on the lower tier to fail, even though they no longer had a proprietary interest in the loans. There are a number of other reasons why unregulated CDSs can be a threat to America's economy but most significant is that they are another source of unsecured debt. They can, on the other hand, be terribly profitable, particularly if you are in a position to rig the game.
Regulation of derivatives falls within the purview of the Commodity Futures Trading Commission (CFTC) and during the mid 1990s the CFTC was led by an intelligent, capable and forceful woman named Brooksley Born. In the mid 1990s Ms. Born recognized the particular peril CDSs represented and set about writing regulations to reel them in. She was at once opposed by the triumvirate of Alan Greenspan, Larry Summers and Robert Ruben. In a nut shell, Ms. Born was shouted down, the CDSs market continued to grow unchecked until it played it's part in the crash of 2008 and Greenspan and Summers would be joined by Tim Geithner and go on to become players in the Obama administration.
For an outstanding report on the Born, et. al. battle go the PBS Frontline documentary, The Warning, here:
It must be kept in mind that I've only focused on one facet of a very broad, systemic problem. Glass-Steagall protected us from some, but not all, excesses by a financial system in which excess had become endemic and greed had become a virtue. Without regulations bankers were able to grant loans they knew could never be repaid, bundle those loans into packages and sell them for a profit and then bet they would fail and profit again when they did. Without regulation bankers could issue loans (and other financial instruments) amounting to billions of dollars more than they could cover. Without regulation banks would grow so big they could not be allowed to fail because the consequence of their failure would be catastrophic. We've been told that the Dodd-Frank bill (officially the Wall Street Reform and Consumer Regulation Act) addresses many of the problems originally rectified by Glass-Steagall but it doesn't. The all important and imminently sensible Volcker Rule has been diluted to the point that is fundamentally ineffective and the SEC has foot dragged, stonewalled and otherwise delayed either writing or implementing most of the rules necessary to make the law work.
George Santayana warned that if we don't remember the past we're doomed to repeat it. Sadly, as humans we aren't very good at remembering the past. As it was once described to me, we seem to have only a generational memory and, thus, are doomed to make the same institutional mistakes every twenty years or so. I suppose it took longer to forget the lessons of the 1930s because we had to take time out to fight World War II and because we were busy after the war enjoying unparalleled prosperity. We were reaping the rewards that responsible banking and investing, industry that recognized the value of a well-educated and healthy workforce and equitable taxation affords the middle class. Those were very good times and they're being taken from us by a government owned by corporations and big-monied interests, a Republican party that doesn't care a lick about you or me, politicians of all stripes who are more committed to getting re-elected than governing effectively and ultimately by our own ennui and indifference.
Significant reference sources for this article can be found in:
Griftopia: Bubble Machines, Vampire Squids, and the Long Con That Is Breaking America by Matt Taibbi
The Big Short: Inside the Doomsday Machine by Michael Lewis
Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System--and Themselves by Andrew Ross Sorkin
Franklin D. Roosevelt and the New Deal: 1932-1940 by William Edward Leuchtenburg
Freedom From Fear: the American People in Depression and War, 1929-1945 by David Kennedy
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