On 24 October 1929, Winston Churchill looked down from the visitors’ gallery of the New York Stock Exchange at the dumbfounded crowd that had gathered below as panic and fear engulfed the market. The former UK chancellor of the exchequer had put Britain back on the gold standard in 1925 at the pre-war exchange rate, the consequences of which some argue spurred on the devastating Wall Street Crash.
After years of misguided optimism, that crash brought the US back to reality with a horrible jolt. It had widespread consequences, setting the scene for the Great Depression of the 1930s and a global economic slump. The greatest sell-off of shares in US market history meant that dreams of lucre ultimately ended in penury. Given its historical significance, every crash since has been compared to it.
John Kenneth Galbraith outlines, and then attacks, the received wisdom on what caused the crash in his classic 1954 work The Great Crash 1929. A common argument of the time pinned the blame on the Federal Reserve for creating the conditions in which investor speculation could run rampant. As gold flowed out of the UK and Europe into the US, central bankers went to New York in 1927 to plead for a softer monetary policy. Bank of England governor Montagu Norman, Reichsbank governor Hjalmar Schacht and Bank of France deputy governor Charles Rist had some success on their transatlantic journey. The New York Fed cut its rediscount rate and started buying up government bonds. The other US reserve banks pursued the same agenda.
This meant that, on one view of things, credit was eased at exactly the wrong moment. The Fed's reaction to the gold flow situation opened the floodgates for catastrophe. Galbraith quotes New York Fed board member Adolph C Miller, who called the body's move "one of the most costly errors committed by it or any other banking system in the last 75 years!". He also cites London School of Economics professor Lionel Robbins, who argued that "from that date [of the Fed's policy move], according to all the evidence, the situation got completely out of control".
But Galbraith finds the roots of the crash elsewhere. On his reading, the crash was fundamentally caused by the madness of crowds rather than credit conditions. In his words, “far more important than rate of interest and the supply of credit is the mood. Speculation on a large scale requires a pervasive sense of confidence and optimism and conviction that ordinary people were meant to be rich”.
The issue was investor speculation, not monetary policy. Galbraith points out that interest rates were actually relatively tight in the late 1920s. The New York Fed changed tack, increasing the rediscount rate in 1928 and selling off government securities, although "credit growth continued to outpace US economic growth, broker loans continued soaring and the stock market continued its near vertical assent" as financial historian Edward Chancellor puts it in The Price of Time. The investing environment was one in which it seemed impossible not to become rich by putting money into stocks such as United Corporation and Steel. The stock market dominated the social consciousness, with record trading volumes built upon leverage and trading on margin. The psychological mood created a culture that led to what Galbraith calls the “great speculative orgy”.
Individual and corporate investors, along with journalists and politicians, were living in a dreamworld in which the market was only heading in one direction. Brokers became sages, listened to at New York cocktail parties in hushed tones. The dream of making easy untold riches in the market was a fantasy, of course, but all sorts of people bought into the myth. Economist Irving Fisher famously argued that “stock prices have reached what looks like a permanently high plateau”, before he lost a fortune in the crash.
The role of investment trusts
An important part of the story that Galbraith covers is the growth of investment trusts in the US. The country was slow to embrace this new financial product, but once it did so it was with wild abandon. Investors didn't know what they were getting into, but no one seemed to mind and dubious practices abounded. Financial engineering, through leverage and cross-shareholdings, led to a flurry of trusts hitting the market and ultimately to disaster. Goldman Sachs, which had created the interconnected Goldman Sachs Trading Corporation, Shenandoah Corporation and Blue Ridge Corporation, was almost ruined by the crash.
There were emerging signs of a misplaced optimism earlier in the decade which weren't heeded. Galbraith highlights the real estate boom in Florida in the mid-1920s as a harbinger of the American people creating "a world of speculative make-believe". More and more land – from bogs to swamps – was subdivided and sold for a 10 per cent deposit. Speculators piled in, with a feeling in the air that all deserved riches and that the good times would not end. A couple of 1926 hurricanes burst the Floridian bubble, but this was not enough to burst the wider speculative mindset that led to such chaos in 1929 and beyond.
Are we in a new age of speculation?
As well as being of great interest in terms of economic and social history, Galbraith’s analysis of investor psychology and the conditions in which economy-wide weaknesses led to disaster have enduring and relevant lessons for us today. Fast forward almost a century from the events of 1929, and similarities in the current market mean that the question has to be asked if we are in a new age of speculation rather than informed investing. US stocks are sitting in an historically expensive position. The cyclically adjusted price-to-earnings (CAPE) ratio of the US market is 34 times, well ahead of the long-run average and above the 29 times when Churchill peered down on the stunned masses on Wall Street in 1929.
There are obvious examples of speculation in the market today, with investors making trading decisions that are in no way based on underlying fundamentals. Look at crypto, or the fresh surge in meme stock GameStop (US:GME) following a social media post. Modern forms of financial engineering are evident, with the Spac (special purpose acquisition company) bubble a painful example.
But the bigger psychological risk for investors at the moment is with artificial intelligence (AI) stocks. Rapid developments in AI have led to a sense amongst many in the market that share prices are only going in one direction for the foreseeable future. ChatGPT and chips have unsurprisingly enraptured investors. But while AI is clearly a revolutionary technology in the same way as the internet, this doesn't mean that investors can afford to be blasé about market risks and splay capital around indiscriminately.
Like with the Floridian real estate mess and the new investment trusts that Galbraith highlights, and crypto and Spacs, there isn't a clear understanding in many cases of what is being invested in. This exacerbates risk when there is an historic concentration of returns at the top of the market, with Magnificent Seven stocks such as Nvidia (US:NVDA) and Meta (US:META) driving S&P 500 growth. Deutsche Bank research shows that the US market is now just about as concentrated as it was in 1929 and is more reliant on certain companies than at the time of the dot-com bubble peak in 2000.
Jeremy Grantham, co-founder and chief investment strategist at asset management company GMO, argues that "many such revolutions are in the end often as transformative as those early investors could see and sometimes even more so – but only after a substantial period of disappointment during which the initial bubble bursts". But he adds a caveat in relation to AI that "a new bubble within a bubble like this, even one limited to a handful of stocks, is totally unprecedented, so looking at history books may have its limits".
There are also economy-wide issues we need to consider on top of issues of investor psychology when it comes to speculative risks. Galbraith highlights five weaknesses in the US economy that left it particularly exposed to the 1929 crash. These are a very unequal distribution of income, a weak corporate environment, a poor banking structure, the US as creditor in the aftermath of the First World War, and the failure of economic models and policymaking.
While solid progress has undoubtedly been made on some of these fronts, it can hardly be said that systemic risks have been extinguished. Like in 1920s Florida, we have a housing bubble with a lot of highly leveraged individuals. Financial institutions hardly covered themselves in glory in the financial crisis of 2008-09. Central banks have received significant criticism for their response to recent inflation.
One thing that perhaps is different to 1929 is the idea of "too big to fail". While big players in the US market in 1929, both individual and corporate, tried and failed to shore things up, in the aftermath of the great financial crisis and the Covid-19 pandemic there is a well-justified idea that governments simply won't allow stock markets to go to the wall. This provides perverse incentives and has only exacerbated the speculative mindset.
Reading Galbraith's work on the Wall Street Crash provides some fascinating insights into a historical moment of widespread financial delusion. But it should also raise concerns that we haven’t progressed as much as we might like to think. Financial speculation is still very much around us, only in different guises, and investors need to be suspicious if the market and culture gets into a position of "boundless hope and optimism".
