1929 Parallels
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Posted: 09/25/07
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1929 Parallels
By Thomas E. Brewton
Central banks are not so wise or powerful as most people assume them
to be.
The over expansion of credit fueled by the Federal Reserve between
1922 and 1927 had many parallels to the "irrational exuberance" of
financial markets since the beginning of the Clinton administrations.
In the Wall Street Journal's September 21 edition, reporter Brian
Blackstone writes:
"Federal Reserve governor Kevin Warsh on Friday cautioned against
assuming that the Fed will prop up asset prices or protect individual
financial institutions..."
In "Economics and the Public Welfare," a book that cannot be too
highly recommended, Benjamin M. Anderson described a similar
situation confronting the Federal Reserve in 1926.
Mr. Anderson's assessment is authoritative, because he was chief
economist for the Chase National Bank, then one of the world's
largest, from 1920 to 1937. During that period he was in close
contact with major bankers in the United States and central bankers
around the world, as well as being closely involved with Chase's
large corporate clients.
In contrast to the 1922-27 period, "The great crisis of 1920-21," he
wrote, "was primarily a crisis of commerce and industry, and in the
course of the crisis customers who needed loans were able to supply
the banks with paper which was eligible for rediscount at Federal
Reserve banks."
Eligible paper then was based on self-liquidating, short-term
transactions, representing sales of products to creditworthy
customers who could be expected to pay for the goods, usually within
90 days.
As the Great Crash of 1929 approached, Mr. Anderson observed, "The
next crisis, however, seemed more likely to come in installment
finance, in real estate, and, above all, in stocks and bonds. And
none of these could supply paper eligible for rediscount at the
Federal Reserve Banks."
Today, as in 1927-29, financial institutions are clogged with
illiquid, long-term assets, this time subprime mortgage loans and
complex derivative securities that are several generations removed
from any underlying merchandise transactions.
Continuing the quotation from Federal Reserve governor Kevin Warsh:
"Recent problems in financial markets were caused by "complacency" in
valuing assets, and not solely by problems in the subprime mortgage
sector, Mr. Warsh also said...
Mr. Warsh traced the market's complacency to the perception that
economic conditions were so "benign" and financial markets "robust"
that investors "tended to act with confidence greater than warranted
by the fundamentals."
Again Mr. Anderson's analysis of the 1922-27 period provides
disquieting parallels:
"Bank credit expansion had moved far in the United States between
June 30, 1922, and June 30, 1927...Unneeded by commerce, the rapidly
expanding bank credit went into capital uses and speculative uses.
It went into real estate mortgage loans on a great scale...There was,
moreover, a great increase in installment finance paper...The terms
and conditions were relaxing. Maturities were stretching from twelve
to eighteen months, and finance companies were multiplying...The most
startling increase, however, in the assets of the banks was in bank
investments in bonds and in commercial loans against stocks and bonds...
Stock prices were already high in the summer of 1927...There was a
growing belief that stocks, though high, were going much higher.
There was an increasing readiness to use cheap money in stock
speculation...Moving concomitantly with the bank expansion and the
rising stock prices was a great increase in new security issues."
Today's parallels are the gross expansion of subprime mortgage loans
and so-called home equity, second mortgage, home loans, along with
rampant growth of take-overs by private equity funds, based largely
upon the abundant availability of cheap loans.
One difference between today's situation and the 1920s over
expansion, both fueled by the Federal Reserve's excessive expansion
of the money supply, is that in the 1920s our banks were lending
heavily to overseas banks to provide credit for our booming exports
of farm products and machinery to rebuild Europe after the First
World War. By 1927, blocked by our high tariffs, foreign exporters
could no longer sell enough product to the United States to generate
sufficient dollars to repay their loans from American banks and
investors.
Today, the Federal Reserve finances burgeoning imports from overseas
via inflationary expansion of the money supply. Central banks
everywhere are awash in dollar-based assets. Many of them are
beginning to diversify their foreign exchange reserves into other
currencies and into new classes of assets. OPEC countries are making
noises about no longer being willing to price oil exports in dollars,
because our currency is depreciating so rapidly against the Euro,
Japanese Yen, and other major currencies.
Mr. Anderson's concluding observation on the Federal Reserve's over-
expansion of the money supply from 1922 to 1927 was:
"We could prolong it for a time by further bank expansion and further
cheap money policies, but only at the cost of creating a desperately
difficult situation at a later time."
Thomas E. Brewton is a staff writer for the New Media Alliance, Inc.
The New Media Alliance is a non-profit (501c3) national coalition of
writers, journalists and grass-roots media outlets.
His weblog is THE VIEW FROM 1776
http://www.thomasbrewton.com/
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