Andrew Sorkin’s new book, 1929: The Greatest Crash in Wall Street History sheds light on how financial markets work.
Economists argue over how exactly the Great Depression of the early 1930s occurred. We are pretty much agreed on what happened in New Zealand – our ability to borrow internationally became very limited while the terms of trade (the price of our – almost solely pastoral – exports relative to the price of imports) fell sharply. The external shocks were caused by the international downturn. It is the precise mechanisms which made that world depression so deep that are contested.
It is common to date the Great Depression from October 1929 when the price of shares (or ‘stocks’ in the American vernacular) on the New York Stock Exchange (commonly called ‘Wall Street’) crashed; they fell on average by almost 90 percent in the next three years. In the first week, share prices fell by (roughly) a quarter (25 percent).
Wall Street was already the greatest financial centre in the world and there is no doubt that the crash contributed to the Great Depression. However, it is argued that the world economy was weakening before October 1929 and certainly some policy responses intensified the downturn. Among the most serious was the Smoot–Hawley Tariff Act, which was intended to shield American industries from foreign competition; it set tariffs at levels so high that they make Trump look like a tariff moderate.
We can also look at the Wall Street crash outside the context of the Great Depression, to enable us to understand better how financial markets work. This is not about the intricacies, which have become much more complicated in the last century, but how financiers operating in them behave, which probably hasn’t changed that much. We can be very grateful to journalist and historian Andrew Sorkin for his 1929: The Greatest Crash in Wall Street History—and How It Shattered a Nation which could be taken as a prequel to his earlier book about the 2008 financial crash: Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System—and Themselves.
The new book tells the 1929 story by tracing the stories of various people involved ranging from Presidents Hoover (who Sorkin treats kindly) and Roosevelt to the shoeshine boys outside the dealing house (Joseph Kennedy, John’s father, decided it was time to sell when the boys were offering share tips); even Winston Churchill makes an appearance, losing a small fortune.
There are many men in the story. (Wives are mentioned plus one astrologer/fortune teller who predicted that ‘stocks might climb to heaven’ a few weeks before the 1929 crash and who lost money shortly after). There is such a kaleidoscope of them that Sorkin provides nine pages of ‘the cast of characters’.
The book gives particular prominence to Charles Mitchell, who was the president of National City Bank, sometimes described as the ‘world’s largest bank’. (It exists today as a part of Citibank.) ‘Sunshine Charley’ aggressively encouraged his bank’s customers and employees to buy securities, including shares in the bank, even on credit. The NCB was also taking over other financial institutions to enlarge its market power.
Mitchell was in the process of merging National City with another bank when Wall Street crashed. The deal was that the other bank’s shareholders could swap their shares for cash, or for National City shares. Before the crash, when share prices were high, they preferred the share swap, but when the share price of both banks plunged they went for cash. National City did not have the cash they demanded. In order to protect NCB, Mitchell did some financial manipulations which, not incidentally, put his own fortune at risk. But they did not work and he ended up broke. He had been fabulously rich. As well as a town house he had a rural estate: 108-acres including a 25-room mansion, an elaborate stone boathouse, a ten-room guest cottage, a nine-room groom's cottage, and multiple garages and stables.
What strikes one about Sorkin’s account is that while Mitchell was frequently treated as a villain – even the chief villain – in the Crash, he was not an evil man. He got into a financial mess because he was trying to protect the institution he loved and those who were involved with it. It is true that he was criminally charged with tax evasion. The jury found him not guilty, but a civil lawsuit had him paying $US2m (say $US50m today) to Inland Revenue. (We may take it that his views were not as tender towards the US government as they were to his bank, employers and customers.)
Few of the people portrayed in the book were wicked. They were rich, they were greedy, they were arrogant, they were poorly informed on issues outside their narrow expertise (but still wanted to interfere there), and they would willingly outwit another businessman in a deal; many were religiously devout. But most were not genuinely evil; Sorkin reports a few; some got deserved comeuppances such as poverty and jail (some of the suicides involved honourable, but depressed, men). More generally, many financiers lost their fortunes; not all – Joseph Kennedy made his by ‘shorting the market’. *
Much the same applies today. There are some genuinely wicked financiers but most are so-so, rather like the rest of us. It’s worth underlining this point because when financial markets crash again, many involved will be labelled villains. While we should not feel sorry for them when they lose their fortunes and we should not try to bail them out, the attitude misses the point that there is a fundamental problem with financial markets.
It was Karl Marx who pointed this out. (Marx is considered one of the great classical economists, whatever you may think of other aspects of his thinking or that of his followers.) He observed that once money was merely a medium of exchange used to convert one commodity into another. Commercialisation changed that. Money became a store of wealth and you entered into a transaction where you purchased a commodity to increase your wealth.
Symbolically, transactions changed from C➙M➙C1 (the commodity is exchanged for another commodity with money intermediating) to M➙C➙M+ (the commodity is used to increase one’s money holdings).
The next step is to use a financial instrument – a piece of paper which is a contract about exchanging in the future – instead of a commodity. The deal becomes M➙FP➙M+.
Magically, one makes money by dealing in the intangibles of finance. We have moved a long way from the C➙M➙C1 world or even the M➙C➙M+ one. That world involving commodities worked because the other side of the transaction (actually, there could be many sides) wanted to exchange commodities too, so that both sides thought themselves better off after the transaction (providing they did not make mistakes).
In the M➙FP➙M+ world the holder of the financial paper thinks they are better off because they are going to flip it on too, increasing their stock of money. It is a speculative Ponzi scheme, relying on someone wanting to hold financial paper of intangible worth which they will convert into cash if they can pass on the baby (or is it the bomb?).
In the 1920s the mechanism was compounded by encouraging Americans to borrow to fund their speculation. In a C➙M➙C1 or M➙C➙M+ world it is a means of coordinating decisions through time. In a M➙FP➙M+ world borrowing works fine until it doesn’t and the Ponzi speculation crashes. So be it, except innocent people suffer as well as some of those who have been speculating.
Sorkin nicely illustrates the story; it is especially detailed in his account of Mitchell. You can read his book as a gripping history. But it is also a parable which may help you understand what is currently going on and what will happen when the next bust comes.
* Explanation: When shorting the market (or short selling), an investor borrows shares they do not own, sells them at the current high price, intending to buy them back later at a lower price when the share price falls and pocket the difference. This is the opposite way around from the normal speculation of buying shares, selling them when their price rises and pocketing that difference.