A History of Financial Crises by Bilginsoy Cihan

Author:Bilginsoy, Cihan [Cihan Bilginsoy]
Language: eng
Format: epub, pdf
ISBN: 9781317703792
Publisher: Taylor & Francis Ltd

Prelude to the crash: 1928–9

Figure 10.3 Dow Jones Industrial Average, 1928–9 (daily).

Source: S&P Dow Jones Indices.

Historical accounts date 1928 as the start of the speculative fever in earnest. Figure 10.3 reports that the daily Dow Jones Industrial Average (DJIA) grew by 33 percent over the year, while earnings per share rose by 23 percent. The initial bull run that started in March raised the stock index by 15 percent before leveling off in June and turning into a brief bear market with very heavy trading. The second bull run started in September and gained momentum in November after Hoover was elected president.

Monetary policy was not expansionary in 1928. The FRBNY tightened monetary conditions by raising the discount rate between February and July 1928 from 3.5 percent to 5 percent. The long-term bond rate climbed higher, from 3.3 percent to 3.6 percent, over the course of the year. However, higher interest rates did not slow down the expansion of call loans, and speculation continued feverishly. Call rates rose from 5 percent to as high as 10 percent over the year, and the spread between the discount rate and the call rate remained advantageous for lenders (White 1990). Call-loan volume rose from $4.4b at the end of 1927 to $4.9b in mid 1928, and was $6.4b at the end of 1928. Moreover, US corporations and foreign banks flooded the credit market with their surplus cash to take advantage of the high-yield, high-liquidity debt. Their share in call loans rose from 41 percent to 60 percent (Kindleberger 1973: 113). The fact that the debt was backed by liquid stocks and the belief that stock prices would continue their upward trajectory likely offered further comfort to lenders.

The evidence indicates that the Fed was not behind the credit expansion, and borrowing increased despite the cost of loans turning against margin borrowers. Moreover, in addition to higher call rates, margin requirements on call loans started rising after October 1928 (Smiley and Keehn 1988). The continuation of credit growth under these circumstances suggests that the driver of credit expansion was the rising demand for loans. Borrowers appear to have been highly optimistic, anticipating high returns on their stock investments. Bank and, increasingly, non-bank sources of credit were merely accommodating the demand.

There was widespread apprehension among policymakers regarding excessive speculation. Strong, the most innovative and influential central banker of the time, attempted to raise the discount rate in the summer of 1928 to 6 percent to curb speculation but was rebuffed by the FRB. The FRB was also concerned with speculation but preferred to use the qualitative measures of coercion, pressure, and persuasion to have banks reduce their call loans. The FRB did not favor a higher discount rate because it could adversely affect “productive” users of credit and economic performance.

During the first six months of 1929 stock prices were turbulent. The market gained 5 percent, while earnings per share increased by 7 percent. The uncertainty over whether the FRB and FRNBY would intervene through qualitative or quantitative measures attracted much attention.

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