By briefly analyzing the economic history of the early 20th century we can gain a better insight into the climate which led to such a devastating crash. A stock market crash can be thought of as a sharp and unanticipated decline in share prices. It is important to remember that the Federal Reserve's inception had only occurred as recently ago as 1913, a response to the requirement for easy credit creation caused by previous banking panics. The U.S. then experienced periods of economic prosperity triggered by increased foreign demand from WWI, especially for agricultural goods and armaments .
However as this external demand fell away during Europe's recovery and troops returned home, boosting unemployment, two brief recessions were experienced, in 1918-1919 and 1921. The second recession was particularly deep, but relatively short, probably correcting a bubble in land prices forming after WWI . The Fed's response of allowing the slump to run its course was relatively successful and may have influenced policy in the wake of 1929. What followed was a decade of huge productivity increases, triggered by more efficient utilization of energy, which in turn brought about the onset of mass production and a period of great technological advancement . “The Roaring Twenties,” as they were known, were a time of great optimism, helping to fuel a fierce bull market.
During the period of 1925 to 1929, the economy of the United States continued to inherit the prosperity of the previous period. U.S. manufacturing establishments increased by 26,000 while the total value of U.S. output increased by another $8 billion [ʇ] during that period .
By 1929, the investment trust industry sold approximately $3 billionʇ worth of shares (compared with the $40 millionʇ in 1927) to the public and their total assets were estimated to exceed $8 billion ʇ. High returns in call market loans attracted both foreign investors and firms making loans to the speculators. By early 1929, loans from these non-banking sources rivaled those from banking sources .In June 1929, the volume of margin trading was increasing at a rate of $400 millionʇ a month and by the end of that summer it exceeded $7 billionʇ as speculators kept on borrowing a comparable increment from the $260 millionʇ in January 1929 .
By Wednesday 23 October 1929, in the New York Stock Exchange, stock prices started to fall and 2.6 million shares were traded at rapidly declining prices in the last hour of trading . The Times Industrial Average lost all of its gains since the previous June, falling by 31 points, while an unprecedented volume of margin calls went out as the value of the stock held by investors had declined to a point where it was no longer sufficient collateral for the loan that had paid for it .
Thursday, October 24th 1929, began with a crash, the crash of Wall Street, known as Black Thursday. Leading Wall Street financiers tried to stop the collapse . New York financiers were not only holding back on margin calls and performing direct purchases, but also taking over loans from outsiders . Call money is loans secured almost exclusively by stocks and bonds . These call loans are repayable at the option of a lender or borrower within 24 hours notice; but if not “called” they may continue in force indefinitely . The DJIA, that is the weighted average of the most traded stocks, declined by 2% .
On Black Monday, 28th October and Black Tuesday, 29th October the DJIA dropped by 13% and 12% respectively. On Tuesday 16.4 million shares were tradedftn17">, the NYSE prices collapsed and the market lost $14 billion contributing to the total $30 billion loss by the end of the week. Prices fell almost perpendicularly and kept on falling as Fig.1 shows.
The bear market, characterized by pessimism and a lack of investor confidence was stabilized during October and November 1929. However, prices continued falling and the process did not stop until the bottom was reached of July 8th 1932 with a total 89% drop of DJIA. The NYSE declined from 216 to 34, treating 1929 as a base mark of 100.
Prices did not fully recover until 1954.
Canada and Belgium experienced the same exponential decline in stock prices as the USA. . The dampened sine waves show that the effect was not as pronounced in other countries.
The CAPM model, detailing all combinations of µ and β, should lie on the security market line helps us explain what actual stock prices were at the time of the crash. They were at a point like B in Fig.3 where the rates of return than the predicted by the CAPM model for the same level of systemic risk. Leading economists such as John Keynes and Irving Fisher believed that stocks were reasonably priced at that time.
At the time stock prices were heavily influenced by a powerful group of investors who were almost considered celebrities, in the way that people followed their actions. Investing in the stock market became part of popular culture. This is when ‘buying on the margin' became common practice and the ‘speculative mania' stage of the bubble began.
Buying on the margin involved borrowing money to buy stocks; only a 10% deposit was needed to buy a share. This easy credit creation suddenly meant individuals were in the same league as big investors. A common tactic of wealthy investors was to pool money to buy a certain stock and inflate its price. They would ensure there was good publicity on the stock and observing this, the general public would invest in hopes of large profits. However, once the stock reached a certain price, the large investors would stop buying and begin to sell to the unknowing public making massive profits i.e. taking advantage of asymmetric information. Eventually the large investors would have sold all their stocks and it is at this point at which the stock would collapse.
Below is the Random Walk Model which states the best predictor of tomorrow's price (Pt+1) is today's price (Pt) plus an error term (εt).
Pt+1 = Pt+ εt
We now know stock prices can never be predicted; they are as likely to go up as they are to go down. So even if people expect prices to rise as they have done so previously, this can't last forever. This could be considered weak form efficiency as information consists of only past and current prices.
At the time of the bubble, information was publicly available and so the financial market could be considered to be semi-strong efficient. A more accurate model to explain this would be the Martingale Model:
E[Pt+1 | Ωt ] = Pt
The expectation of next period's price (Pt+1) conditional on information available today (Ωt) equals today's price (Pt). For example, if people expect prices to rise because of what they've heard in the news, they'll buy that particular stock to earn profit. As the information is public, everyone buys the stock and in doing so, the increased demand will cause today's price to rise. This is how the investors made their money off the public.
Furthermore the Federal Reserve (Fed), who knew the economic boom based on a foundation of borrowing was dangerous, did not warn the public and took a laissez-faire attitude. Borrowing was a relatively new concept for the public and so with no warning from the Fed, they continued to borrow. Although the Fed had the power to stop this, the market was now dependant on borrowed money. Many small investors had financed speculation by buying on the margin so when stock prices began to fall below 10%, many margin calls was made. Soaring interest rates meant people were further in debt. This caused mass selling further exaggerating falling prices; the bubble had finally burst.
At the beginning of the Great Crash of 1929, the global macro economy was also experiencing a downturn. The United States had not realised that the central problem of the crash was based on the collective pessimism of the stock market. U.S administration did not focus on the stock market and the collapsing of the banking system even though more than five thousand banks had failed at that time.
In the meantime, instead of stimulating the economy by increasing government expenditure, they implemented some ineffective or controversial policies such as the infamous Smoot-Hawley Tariff Act, which imposed a high tariff on 20,000 imports. This reduced international trade (refer to Fig.4) and induced similar retaliatory policies from other countries.
The contracting spiral of world trade from January 1929 to March 1933(Fig.4) shows total imports of 75 countries expressed in terms of US gold dollars (millions).
The U.S.' total export value fell by half. The U.S. unemployment rate had reached 23.6% by 1932, and it peaked in early 1933 at 25%. Additionally, a drought persisted in agricultural land; 50% of workers in the agricultural sector had become unemployed.
Conversely, Japan was the first country to boost the economy by implementing large fiscal stimulus policies and by devaluating their currency. This may be why Japan was the first country to step out from the crash. The Japanese government took a Keynesian approach, increasing government expenditure in the hope of pushing up aggregate demand along with output and lowering the unemployment rate. Econometric studies indicate these measures were effective. More importantly, the injection of funds from the Japanese Government stabilised the fluctuation of the stock market and rebuilt the investment atmosphere in the 1930s which consolidated investors' confidence in future. Thus, Japan's industrial production doubled during the 1930s. It led Japan out from the recession and the stock market became active again by 1933.
In addition, the devaluation of the Yen had increased the competitiveness of Japan's exports. As the Yen had been devalued, Japanese products became less expensive for foreigners. The devaluation of the currency had an immediate effect. It also improved the trade balance.
After the successful results displayed by Japan in the 1930s, Keynesian economics was largely accepted and widely implemented. The Roosevelt administration imposed The First New Deal and Second New Deal which sought to stimulate demand and provide work and relief for the impoverished. This was achieved through increased government spending and financial reforms. In 1929, federal expenditures constituted only 3% of GDP. National debt as a proportion of GNP rose under Hoover from 20% to 40%. Roosevelt kept it at 40% until World War II began, which helped to lead the economy out from recession in 1937.
There are many parallels to be drawn with the excesses in investor optimism which helped to fuel such a boom; attitudes of present day figures envisioning the 90's as “The Great Moderation.”, bear eerie resemblance to Irving Fisher's famous “Permanently high plateau.” What is unclear is as to why such a large slump occurred. Economic fundamentals were consistently high in the 20's and such technological advances could conceivably have justified optimism. Some contemporary commentators have pointed to a possible “self fulfilling prophecy,” where the announcement of some bad news led to a spiralling over-reaction. Additionally, the increased participation of inexperienced investors could have exacerbated such panic.
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