The concept of what inflation is and is not has changed since the creation of the US Federal Reserve in 1913. Looking at Collier’s New Dictionary of the English Language, 1924 issue, we find the word “inflation” absent during the twilight era of the gold standard. However, Collier’s Dictionary 84 years ago did include the word “inflationist” as being “one in favor of an increased issue of paper money.” The chart below shows that since 1924, the “inflationists” had their way with the US money supply. Inflation in both financial assets and consumer goods has been a permanent factor in the dollar economy since 1913.
Currency in Circulation (CinC) is money plain and simple. CinC is paper money and coins used in everyday purchases of small items. However, when we purchase expensive items with a check, credit card, save money in a bank or money market account we are using interest bearing instruments of credit (debts) that are not money, plain and simple. Interest-bearing credits can grow many times the value of CinC and have great effect upon markets. A superb example of credit inflation moving a market both upwards and down would be NYSE margin debt moving the stock market from 1926 to 1933.
The chart above plots NYSE margin debt, the Dow Jones Industrial Average, US Currency in Circulation and the Broker’s Call-Money rate during the “Roaring 20ies” and the Great Depression.
Thanks to the then new Federal Reserve system, ample “liquidity” (credit) was made available to the banking system for loans to purchase stocks. From 1926 to 1929, banks found making loans to Wall Street attractive as the collateral supporting their loans were liquid blue chip stocks. From 1926 to 1929, not only banks found loans for stock speculation attractive. Margined investors could leverage their stock investments with 90% of the purchase borrowed from a bank. This created a situation where a mere 10% correction could wipeout the margined investor and force banks to sell stocks in a distressed market. Note the close correlation between margin debt and the DJIA from 1926 to 1933.
The rate at which these loans were made was an estimate of both creditor’s and debtor’s expectations for profit against a given risk. Creditors and debtors do not make loan agreements thinking they will lose money. Banks in 1926 were willing to extend credit for margined accounts at 4.0%. However as the DJIA marched toward October 1929, we see the banks raise their call rate as their perception of risks grew.
Margined investors were clueless of the risk they faced. The banking system fired warning shots across the margined accounts’ bow. In December of 1928 the call rate saw one shot of 10% and then another at 12%, the final warning of 16% was reported in the 29 April 1929 issue of Barron’s. The above chart shows the effectiveness of the warnings – none.
Historical accounts usually credit the Federal Reserve system for attempting to prick the stock market bubble in 1929. However the chart & table below shows the banking system continuing to inflate the market bubble even as stock valuations imploded under their own weight.
From the statistical section of Barron’s published 79 years ago, the following table provides a 15 week review from August to November of 1929.
- The banking system continued to expand credit until week 10, seven weeks after the market peaked in week 3.
- From week 3 to week 8 the market fell 9%. The 10% margined investors were wiped out. The banks became concerned. In an economy with only $3.9 billion in CinC, the banks found themselves with $6.80 billion in rapidly deflating collateral undermining the assets on their books. The banks acted with a 300 basis point cut in the call rate.
- The rate cut grants a one week a stay of execution in week 9. But in week 10 a further 100 basis point cut, and an additional $90 million credit injection were futile gestures as the forces of asset deflation gathered momentum ever downward.
- Week 11gives Barron’s no good news to report as the engine of bank credit went into full reverse and the stock market crashed. By week 15 margin debt will contract by 46% from their October 1929 highs. In the next three years the Dow Jones will ultimately drop -89% and margin debt would drop -95%.
In a single sentence, the 1921 to 1932 bull and bear market cycle can be described as follows. The Federal Reserve system provided banks with the means to transform the stock market into a towering edifice of debt that by 1929 became so grotesquely bloated that a normal 10% correction in September - October 1929 became a self-destruct mechanism to a margin debt load twice the valuation of US Currency then in Circulation. All else is commentary.
To fully appreciate the scale of devastation reckless credit creation brought upon the companies of the Dow Jones Industrials and their investors in 1929, consider the following chart displaying every Dow Jones bear market from 1885 to 2008.
It is doubtful that many in high office (people who manage monetary policy on a daily basis) would give my single sentence summary of the 1929 stock market crash much weight. Our current Chairman of the Federal Reserve is a noted expert on the causes of the Great Crash of 1929. This was most likely instrumental in his selection as Chairman Greenspan’s replacement. In 2002, in the context of the bear market of 2000-03, he shared his thoughts at the National Economist Club in Washington D.C. as how best to counter asset deflation in the stock market.
“…under a paper-money system, a determined government can always generate higher spending and hence positive inflation. Of course, the U.S. government is not going to print money and distribute it willy-nilly.”
- Ben S. Bernanke, Federal Reserve Board Governor, November 21, 2002
In reviewing my 123 Year History of the Dow Jones Industrials Bear Markets, as painful as the 2000-03 bear market was, historically it was rather ordinary for the Dow Jones. To know if in 2000 the general stock market faced an abyss similar to the 1929-32 event - that the DJIA declined only 34% thanks to “a determined government” and its “paper money system” -would require data not published in Barron’s. But to know with certainty that “a determined government” and its “paper money system” passed out vast amounts of money “willy-nilly” targeted at mortgages for 125% of inflated home valuations, often asking no money down, one only has to recall the incessant unsolicited daily phone calls and e-mailing offerings of only a few years ago.
From 2002 to 2007, the government and its Federal Reserve directed great tides of credit that “grotesquely bloated” the mortgage market. In 2008, the holders of these assets now want to sell, but is that possible? So now the holders of these ill-considered assets and I watch with interest on how well our monetary policy makers swim against the rip tide of debt of their own making.
Mark J. Lundeen
12 August 2008