History Incognito:

The untold origins of the Roaring Twenties, the Crash, and the Great Depression

By Sean P. BreenMonday, April 10, 2006

Submitted in Partial Fulfillment of the Requirements for the Degree of Bachelor of Arts in the Department of History, Middlebury College

History Incognito – The untold origins of the Roaring Twenties, the Crash and

the Great Depression

This paper offers an answer to three important unanswered questions regarding the economic history of the 1920’s boom, the Crash of 1929 and the subsequent Great Depression. This paper supports its answers by creating new historical databases and subjecting the historical data to rigorous modern statistical analysis.

The three questions are: what caused the boom of the 1920’s, what caused the Crash of 1929 and what caused the ensuing Great Depression of 1930’s? The answer, which is detailed in the following pages, is that the antecedent cause for all three questions was the transformation of the United States into the world’s creditor as a result of World War One. This War and the reversal of the Unite States from a debtor nation to become the world’s only remaining banker, created a fragile world economy that demanded continued U.S. lending to support a level of international commerce that could allow repayment of War debts. The Mellon Treasury was masterful in managing the economic dislocation of the War Years and returning the U.S. economy to growth through a progressive and scientific reform of the U.S. tax structure and U.S. debt markets. This was the ‘cause’ of the 1920’s boom. The restructuring of lower peacetime tax rates and the lowering of tariffs promoted expanding trade with Europe that was essential if the European nations were to recover from the War and perform on the War debts owed to the U.S. Enabled by the Mellon treasury, the U.S. loaned money to Europe to buy U.S. products so that they could earn enough from the commerce to continue to perform on War debt and reparations that were in turn owed to the U.S. These policies were successful until the late 1920’s when declining agricultural prices, driven down by technological productive innovation, raised political temperament for agricultural tariffs. The politics of the agricultural tariff movement blossomed into a general tariff movement as all sectors of the economy sought to share in the political largesse. Unfortunately, the resulting Smoot-Hawley tariff destroyed the precarious basis under which the fragile international financial structure functioned. This was the ‘cause’ that resulted in the Crash of 1929. As international tariffs reduced international commerce the international financial system collapsed and the U.S. stock marked crashed. In reaction to the economic collapse U.S. policy retreated from the paradigm of low taxes and open markets to high taxes and closed markets which prevented recovery and so, ‘caused’ the Great Depression.

Sean P. Breen is a B.A. candidate in History at Middlebury College, in Middlebury Vermont. He gratefully acknowledges assistance of the College Library, History and Economic Faculty, which provided advice as well as strict deadlines contributing to the completion of this paper in April, 2006. He would like to further extend a special thanks to his advisors Travis Jacobs and Robert Prasch as well as Ed Breen, his father, and other members of the thesis committee for their support and encouragement. Finally, Sean is grateful to the late Jude Wanniski who laid the seeds that grew into this paper. Previous contributions by Milton Friedman, Anna Schwartz, Barry Eichengreen, Irving Fisher, Alan Meltzer, Robert Archibald, David Feldman, Eugene White, Claudia Goldin, Michal Bordo, Kevin Carey, Irwin Douglas, John Kenneth Galbraith, David Kennedy, Charles Kindleberger, Murray Rothbard, Peter Temin, and Jude Wanniski among many others were invaluable in composing this paper.

Contents :

INTRODUCTION 1

CHAPTER ONE: 9TAX POLICY: WORLD WAR ONE TO 1929 9

CHAPTER TWO: 28MONETARY POLICY, WORLD WAR ONE AND CHANGES IN THE PRICE LEVEL 28

CHAPTER 3: 53INTERNATIONAL FINANCE – WORLD WAR ONE AND THE INTERNATIONAL DEBTS IN THE 1920S 53

CHAPTER 4: 68FEDERAL RESERVE POLICY AFTER 1921 AND THE ERA OF PRICE STABILITY 68

CHAPTER 5: 84THE COOLIDGE BULL MARKET 84

CONCLUSION 148

APPENDIX A: 152

APPENDIX B: 154

APPENDIX C: 160

APPENDIX D: 166

BIBLIOGRAPHY 167DATA SOURCES: 167PRIMARY SOURCES (ORDER OF YEAR PUBLISHED): 167SECONDARY SOURCES (ALPHABETICAL ORDER): 173

Introduction

It is not possible to know for sure what direction economic and social history

would have taken if the First World War never occurred. Nonetheless, it is rational to

expect that the international economy would have developed in much of the same way

as it had during the fifty years that preceded the conflict. Within this construct, World

War I can be understood as a large exogenous shock. It was a shock that so upset the

underlying equilibrium of international development and growth, that the result was a

breakdown of the integrated international framework which characterized much of the

nineteenth century. Within this construct, the roots of the 1929 downturn in economic

activity and the collapse of the international economy can be traced directly to the

economic impact of the war. Conversely, if this construct is false, the initial shock of the

war and the resulting disturbance in economic development can be seen as only

temporary. Such that after a short adjustment period, economies reverted to their

previous trends without marked effects. In such case, the War had less of an impact on

the 1929 downturn and the subsequent depression.

Though the literature concerning the interwar period economy is vast, much of it

is of mediocre quality and some subjects still await serious analysis. Moreover, despite

the Great Depression’s reputation as the “holy grail” of economics, little consensus has

been reached over its fundamental origins. The same is true for the “Roaring Twenties”

and the period’s infamous ending with the “Great Crash” in October, 1929. The purpose

of this thesis is to create a picture of the American economy on the eve of Depression.

In doing so, an argument is formed both to explain the booming stock market throughout

the decade, and the source that precipitated its eventual collapse. In order to

-1-

understand fully the Crash and its relation to the ensuing Great Depression, a thorough

analysis of the previous decade is required.

An examination of the fiscal policy of the Harding administration, particularly the

fight in Congress over the proper tax system for a peace-time economy, and the actions

of the still emergent and amorphous Federal Reserve System is required to illuminate

the superstructures which supported the economy of the 1920s. More importantly, the

understanding of how these two factors compliment or fight each other is essential to

understanding the events of the decade, including the Crash.

The goal of this thesis is to help the reader understand both the precarious

position of the international financial system and the United States’ emergent role within

that system, as well as the forces within America that were pulling and pushing the

economy in different directions. Ultimately, considerable evidence is found supporting a

connection between the Mellon tax reform and a growing economy. Next, a micro-

oriented look at the stock market build-up, with particular attention to intangible capital,

demonstrated that the stock market, even at its peak in 1929, was performing rationally

and in line with fundamental valuations.

Finally, theories surrounding the stock market collapse are examined and a new

explanation is presented. The Smoot-Hawley Tariff, which passed congress in June,

1930, played a considerable role in changing investor expectations and consequently in

changing market valuations. This connection has been made before, notably by Jude

Wanniski, but a major addition is added here through econometric analysis which

dismisses criticism of the theory as simply “coincidental.”

What this paper strives to produce, is a coherent picture of the 1920s economy

and America’s role within the world financial system. Too many studies of the inter-war

period, and particularly those addressing the Great Crash in 1929, fall into a Weberian

“iron cage,” becoming lost in the details while ignoring the bigger picture. The economy

-2-

is a fluid machine. It is continually changing and reacting to future events. As

contemporary Joseph Schumpeter made famous: “Capitalism…is by nature a form or

method of economic change and not only never is, but never can be, stationary.”1 This

thesis attempts to allow for this “dynamic” nature of the economy by examining a longer

period and by identifying the key drivers of change. In doing so, main themes arise both

in the tremendous growth experienced during the bulk of the 1920s and the dramatic

disintegration that occurred during 1929 and 1930. Unlike authors who begin their

analysis in October, 1929, no assumptions about the economy are made here. Instead,

an historical picture is painted that makes nearly every existing explanation of the Great

Crash inadequate. The full history reveals a series of fiscal decisions that interacted

with a fragile monetary structure left as a result of World War One. For most of the

period, these fiscal decisions were positive, as tax reform began to “restore normalcy” in

the American economy and opened capital markets for increased investment and

growth. Beginning with the election of Herbert Hoover, however, in 1929, the political

platform changed. The direction of policy began to focus more on isolation and

protection rather than integration and open markets. This policy shift is exemplified by

the Smoot-Hawley debate in Congress that began in 1928 and continued through June

1930, when the bill was finally signed into law. Ample evidence has been gathered and

presented here to conclude that this shift in policy was a substantial cause of the decline

in market valuation that has become known as the “Crash of ’29.” The forces at work,

however, were no different than those that fueled the “Roaring Twenties,” or those that

accelerated the market downturn into the Great Depression of the 1930s. Certainly

monetary instability during the period played a significant part in these events, but the

initiation of both the period of growth, and the period of depression came from fiscal

1 Joseph Schumpeter, Capitalism, Socialism and Democracy (London: Allen & Udwin Publishing, 1943)

-3-

activities. There is no prior literature that examines the period as I propose to do herein.

This thesis is presented in six chapters.

Chapter One provides an in depth overview of American fiscal policy from before

World War One through to the end of 1929. This detailed examination of the tax reform

orchestrated by the Mellon Treasury has yet to be included in the modern literature

about the Depression and the Crash. Most authors view the 1920s as separate from the

1930s, with the Crash as a defining event that separates the two epochs. Instead,

readers should consider that this was one unified period during which a change occurred

in the way monetary and fiscal forces worked in steering the economy. The purpose in

this chapter is to establish a case to explain the root cause for the booming economy

and stock market. This explanation will later be supported by an extensive examination

of the stock market boom itself in Chapter Five.

Chapter Two concerns the complex period in American monetary history that

began with the establishment of the Federal Reserve System and continued through

World War I until 1922, when the American economy experienced severe price volatility.

The fledgling Fed, created in 1914, never had a chance to establish its institutional

independence before the onset of World War I. As a consequence, the Treasury

remained in control of America’s finances as the government attempted to fund the war.

Wholesale prices more than doubled by 1920 before a sudden and sharp recession

corresponded with a dramatic drop in prices. Nevertheless, in 1922, once prices again

stabilized, the PPI remained forty percent (40%) above its 1914 level. The existing

literature does not satisfactorily identify the drivers behind these price movements. The

traditional explanation blames the Federal Reserve’s conduct of monetary policy. In

particular, Monetarists attribute the post war inflation to the “artificially” low interest rates

induced by the Treasury to finance war debts immediately after the war. When the Fed

regained control over the discount rate in late 1919 and enacted a “tight” monetary

-4-

policy, prices fell. An alternate theory promoted primarily by Jude Wanniski, argues that

no “monetary” inflation occurred. Instead, the volatility of prices should be attributed to

changes in demand, as the economy moved from wartime to peacetime. When all the

data is examined, however, neither of these arguments seems wholly accurate. Instead,

it appears as if factors of both loose money, particularly during the 1919-1920 period,

and a drastic change in demand, both played a role in the resulting price volatility. As a

result of the drop in prices, the burden of international war debts were greatly increased

in real terms.

These first two chapters should be considered in tandem. Monetary and fiscal

policies act as the two main levers on the economy. Higher tax rates will, ceteris

paribus, decrease dollar demand, creating excess liquidity as too many existing dollars

begin to chase too few goods and services. Conversely, lower tax rates will stimulate

dollar demand and, unless more money is injected into the system, cause a shortage of

liquidity, as too few dollars chase too many goods and services. The former situation

instills inflationary pressures on the economy, while the later introduces deflationary

pressures. Similarly, lower discount rates encourage economic activity by reducing the

cost of financing, resulting in increased dollar liquidity. Higher discount rates, ceteris

paribus, have the opposite effect. During the period immediately following the war,

income tax rates were higher than ever before. At the same time, the Treasury

dominated the Federal Reserve and held the discount rate down. Thereafter, beginning

in late 1919, the Fed gained more independent control over monetary policy and began

to raise the discount rate. However, during the same time, the Revenue Bill of 1918

remained in effect and war-demand for production began to decrease. The net effect

was ambiguous, as money supply decreased (high discount rate) while money demand

also decreased (high taxes and higher cost of financing). Inflation remained rampant,

indicating that demand destruction took place more rapidly than supply depletion which

-5-

produced a net increase in liquidity. By mid-1920, however the Fed had raised the

discount rate to seven percent (7%), restricting dollar supply so much as to induce a

recession. This in turn resulted in too few dollars chasing too many goods and services.

Deflation set in and the economy fell into a sharp but brief recession until the Revenue

Bill of 1921, cut taxes, and boosted dollar demand. This indeed contributed to the

deflationary pressures on the economy, but did so by stimulating economic activity,

stopping the recession originally responsible for the falling prices.

Chapter Three discusses the precarious position of the international financial

system as a result of World War One. This chapter is essential for understanding the

real impact of the Smoot-Hawley Tariff on the world financial system in 1929 and 1930,

and the role of the tariff law in creating the drop in market prices. Beside the creation of

high income taxes, the most significant economic result of the War was a reshuffling of

the international financial order. The United States, historically a debtor nation

throughout its existence, became the world’s creditor. The Treaty of Versailles ultimately

made Germany responsible for paying off the World’s debts to America. In addition,

credit risk was not limited to governments but was securitized and sold excessively to

the American people, who began to discover and invest in capital markets for the first

time. Bond issuances from all over the world found markets in America. The table was

set for an international disaster if the debt payments failed to be met. Moreover, what

becomes increasingly clear is that the continued flow of these debt payments were

reliant on two factors: first, the extension of further credit, usually from the private sector

in the form of foreign direct investment (FDI), from the United States, or second, a

balancing trade surplus between the U.S. and foreign countries to match their credit

account deficit. Unfortunately, both these dependant factors were removed in 1928/29

due, in the first case, to American’s increasing interest in investing domestically brought

about by higher rates of return and lower risk, and in the second case, to the erection of

-6-

tariff barriers beginning with the Smoot-Hawley Tariff. The result was a collapse of the

world financial system.

Chapter Four provides an overview of monetary policy after 1922 through 1929

and the Crash. The goal here is to present an explanation of the relative price stability of

much of the 1920s and to dispute arguments that insist that the growing economy was

only a façade built on an inflationary boom. This chapter is also important in that it

deflects the argument that the Fed “burst” the stock market “bubble” by hiking interest

rates.

Chapter Five offers a micro analysis of the stock market just before the crash in

1929. In addition to a fundamental valuation of all United States businesses, the chapter

also analyses previous explanations for the stock market boom. None of the existing

literature presents a coherent argument for the flourishing market. All previous authors

cite business cycle facts and reiterate the effects of the boom, but there is a general

failure to find the origin. Of course, understanding the origin of a boom is of particular

interest in discerning its validity. In this chapter evidence is presented linking the Mellon

tax reforms along with the deregulation of business in the 1920s and the booming stock

market. The result is to show on the one hand, a valid foundation for the thriving

markets, and also to demonstrate on the other, that the capital markets themselves were

not overvalued (but were if anything undervalued) on the eve of the notorious stock

market crash in October, 1929.

Finally, Chapter Six concludes by addressing the Crash itself and the existing

theories that surround it. As with the boom, the quantity of literature is astounding, but

no explanation of the origin of the Crash can be found. The most common theories rely

almost completely on the formation of an “irrational bubble” which does not take into

consideration the factors discussed in Chapter Five. With this in mind, a new and often

overlooked explanation is examined: the uncertainty created by the debate around the

-7-

Smoot-Hawley tariff. This theory is not new, but was expressed repeatedly by

contemporary economists and bankers. Nevertheless, it only finds its way into the

modern literature in The Way the World Works by Jude Wanniski. This chapter adds to

Wanniski’s study by including regression analysis to identify and quantify the importance

of tariff news to stock market valuation. In addition, this chapter builds on Wanniski’s

research by including analysis of stock market volatility. An entire new data base was

created for this empirical testing.

-8-

Chapter One:

Tax Policy: World War One to 1929

At the end of World War I, taxes were high. The demand for revenue created by

America’s entry into the First World War elevated the rate of the three-year-old income

tax into otherwise impossible heights.2 The 16th Amendment, ratified in 1913, stated,

“The Congress shall have the power to lay and collect taxes on incomes, from whatever

source derived, without apportionment among the several States, and without regard to

any census or enumeration.”3 Congress then agreed to a one percent (1%) levy on net

personal income greater than $3,000 and a graduated surtax beginning at one percent

(1%) on income over $20,000, increasing to six percent (6%) on additional income over

$500,000 to create a top marginal rate of seven percent (7%). The corporate tax of one

percent (1%) was repealed. Congress then modified these initial ranges with The

Revenue Act of 1916, which raised personal income rates to two percent (2%) at the

entry level then progressively increased rates up to fifteen percent (15%) for the highest

income bracket. The fifteen percent (15%) rate, however, applied only to income over

$2 million.4 Nevertheless, b1917, the need to raise revenue quickly for the war became

imperative and a fundamental shift in tax policy occurred.

2 Technically, the income tax was not a new idea. Historically, its existence emerged under President Lincoln when he created the Commissioner of Internal Revenue to raise money to pay for the Civil War. It levied incomes between $600 - $10,000 at three percent (3%) and all incomes over $10,000 at 5%. The income tax, however, was never enforced due to public dismay. In the later half of the 19 th century ninety percent (90%) of all government revenues came from consumption taxes on liquor, beer, wine and tobacco. In 1872 the income tax was repealed. In 1894, the Wilson Tariff Act revived the income tax with the creation of the income tax division within the IRS. A year later, in 1895 the Supreme Court ruled the income tax unconstitutional. President Taft recommended to Congress in 1909 that a constitutional amendment be created empowering the government to tax incomes without allocating the burden along states according to level of population. Congress also levied a net tax on corporate income over $5,000. In 1913, Taft’s recommendation became the 16th Amendment when Wyoming ratified the proposal.3 U.S. Constitution, 16th Amendment. See: http://www.senate.gov/civics/constitution_item/constitution.htm#amdt_16_(1913). Visited on: 12.04.054 $2 million in 1916 is equivalent to approximately $36.5 million in 2005.

-9-

The War Revenue Act of 1917, signed into law on October 3 rd shortly after

declaring war, further increased the rates while simultaneously slashing exemptions.

Treasury Secretary William McAdoo presented Congress with specific estimates of the

costs of entering the World War One. In his budget, McAdoo initially estimated $3.5

billion in direct costs for the U.S. and $3.0 billion in loans to the Allies. According to his

plan, fifty percent (50%) of these costs would be raised through income taxation while

the rest would be raised through bond offerings. The resulting Bill, after a strong push

by Senator Robert LaFollete for more steeply progressive taxes on the wealthy,

exceeded any prior action of the federal government both in amount of revenue raised

and redistribution of wealth. It was truly revolutionary. The Act marks distinctly the shift

in American tax structure away from consumption levies (customs and excise taxes)

toward production levies (income taxes). Specifically, the Bill drastically cut exemptions

from $3,000 for single taxpayers and $4,000 for joint returns, to $1,000 and $2,000

respectively. All incomes above these levels were taxed at two percent (2%) and

surtaxes were added progressively, beginning with an additional two percent (2%)

(creating a marginal rate of 4%) on income over $3,000 ($4,000 for married couples)

until reaching a maximum of fifty percent (50%) (creating a marginal rate of 52%) on

incomes over $1 million. Corporate taxes were doubled from two percent (2%) to four

percent (4%) on income over $3,000 ($6,000 for partnerships). An additional graduated

corporate excise profits tax was also added, beginning at eight percent (8%) and

increasing to sixty percent (60%).5 Personal and professional service profits were

limited to an eight percent (8%) tax on income over $3,000. Finally, the inheritance tax

was increased beginning at 0.5% on estates over $50,000 and peaking at 10% on

estates over $10 million.6 The result of this significant tax increase and structural shift in 5 Profits were measured by return on investment (ROI) from 1911 – 1913 generally seven-to-nine percent (7-9%)6 John F. Witte, The Politics and Development of the Federal Income Tax, (Madison Wisconsin: 1985) pgs. 67-87. Also see: Historical Highlights of the IRS, Internal Revenue Service, US Treasury Department. See:

-10-

the tax scheme increased revenue from $0.8 billion in 1917 to $3.7 billion in 1918, a 463

percent (463%) increase. The income taxes and excise profits taxes accounted for

nearly ninety-percent (90%) of this increase.7

Nevertheless, as the War raged on President Wilson found himself again asking

Congress for additional revenue in the spring of 1918. The war was proving to be much

more expensive than McAdoo originally projected. On May 27th, Wilson presented his

argument to both Houses:

We are not only in the midst of the war, we are at the very peak and crisis of it. Hundreds of our men, carrying our hearts with them and our fortunes, are in the field, and our ships are crowded faster and faster to the ports of France and England with regiment after regiment…to join them until the enemy shall be beaten and brought to reckoning with mankind…If this is to be accomplished gentlemen, money must sustain it to the utmost. Our financial program must no more be left in doubt or suffered to lag more than our ordnance program or our ship program or our munitions program…These are not programs, indeed, but mere plans upon paper, unless there is to be an unquestionable supply of money.8

The following bill proposed by Secretary McAdoo in September of 1918 passed the

House unanimously, but met trouble in the Senate. Wilson argued that the American

people will “bear any burden and undergo any sacrifice” to win the war. “We need not

be afraid to tax them, if we lay taxes justly,” he continued in his speech to Congress,

“The noble use for which [American] wealth has been piled up [will bring Americans] to

see the dawn of a day of righteousness and justice and peace.”9

With the Armistice on November 11, 1918, however, and the end of the Great

War, circumstances changed dramatically. Wilson’s use of the War as justification for

the new Revenue Bill needed to be reconciled, and McAdoo presented a new set of

recommendations. Insurgent Republican’s, led by Senator LaFollette of Wisconsin,

pushed for more extreme rates on profits and the wealthy, calling for marginal rates of

http://www.irs.gov/irs/article/0,,id=101101,00.html. Visited on Dec. 3rd, 2005.7 Charles Gilbert, American Financing of World War I¸ (Westport Connecticut: 1970) 8 Taken from: Steven Weisman, The Great Tax Wars, (New York: 2002) p.3319 See Weisman, 332.

-11-

ninety percent (90%) on the top bracket.10 While the extremism of LaFollette was

defeated 55 to 6 in the Senate, the Revenue Bill of 1918 received approval in February,

1919, and drastically increased marginal rates yet again. The bottom tax bracket

doubled, from two percent (2%) to four percent (4%) on income up to $4,000.

Thereafter, the normal tax rate was twelve percent (12%) for the calendar year 1918 and

eight percent (8%) in following years. A surtax was then added to income in excess of

$5,000 on a progressive scale to a maximum of sixty-five percent (65%) up from the

1917 maximum of fifty percent (50%). The resulting top marginal rate was, therefore,

increased from the 1917 level of fifty-two percent (52%) to seventy-seven percent (77%)

for the calendar year 1918 and seventy-three (73%) for subsequent years. Moreover,

the top threshold was lowered from $2 million to $1 million, effectively further increasing

the top tax rate for those on the margin. With the Revenue Act of 1918, the United

States established the highest tax rates of any country in the world. Economist Edwin

Seligman announced: “This is the high water mark thus far reached in the history of

taxation. Never before, in the annals of civilization, has an attempt been made to take

as much as two thirds of a man’s income by taxation.”11

Although the Revenue Bill of 1917 had more drastic changes, the Revenue Bill of

1918 raised not only surtaxes on the wealthy, but significantly increased the “normal”

taxes and, consequently, affected a larger number of taxpayers. Also, and more

importantly, the Revenue Bill of 1918 came after the Great World War. Because of the

war the public largely accepted the 1917 bill. As the Wall Street Journal reported on

January 17, 1918: “We must win the war. All our useful activities must be subordinate to

10 The LaFollete insurgency also formed an opposition group later in 1929 against the protective Smoot-Hawley tariff and had also supported an income tax increase under the Theodore Roosevelt Administration. They continually supported increasingly progressive income taxation. They represented a rural middle-western constituency that paid little or no income tax because of high personal exemptions, but were not particularly poor.11 See Sidney Ratner, American Taxation: Its History as a Social Force in Democracy, (New York: 1942) pg. 376 and see Edwin Seligman, “Comparative Tax Burden,” Political Science Quarterly, Vol. 39, No. 1, (March, 1924) pg. 125 – 129;

-12-

this supreme object. To win the war men, money and munitions are required. Money –

a lot of it – must be raised by taxation.”12

Conversely, the 1918 Bill created a different consensus in American society, as

illustrated by the New York Times in an article dated February 8, 1919:

Manufacturers Say Pending Bill Will Bankrupt IndustryStephen C. Mason, President of the National Association of Manufacturers, issued a vigorous protest yesterday against the pending Revenue Bill. In Mr. Mason’s opinion: “the adoption and enforcement of the pending Revenue measure will intensify and make more general the present condition of industrial stagnation. It will contribute”, he said, “toward the longer duration of the existing period of business uncertainty and unemployment and most seriously hamper desired rapidity in our readjustment [in peacetime] and expansion of our industries [for rebuilding].

...in order to penalize the comparatively few ‘big business’ concerns, the framers of the bill are willing to jeopardize the existence and continued operation of those comparatively small manufacturing institutions which are likely to be made bankrupt and permanently put out of business under its enforcement.

Wage earners of the country have just as vital an interest in the far reaching effects [of the Revenue Bill]…because…it will result in serious impairment and immediate reduction of the ability of employers throughout the country to pay wages in accord with present standards of living.”13

With the end of fighting, Americans were no longer willing to pay such high tax rates.

Consequently, the populace, especially the small business world, was outraged by the

Revenue Bill of 1918, when they had been equally supportive of the high rates in the

1917 bill.

Clearly World War One shocked government finances, transformed the tax-code,

and moved America exponentially closer to its modern position in the world. The

legitimacy of the income tax, while confirmed by the ratification of the 16 th Amendment in

1913, was transformed into America’s major revenue producing agent. During the War,

the severity of the new income tax system was overlooked, but with the armistice the

circumstances were completely changed. As America shifted from war to peace, the

12 Wall Street Journal, “Income Tax Procedure 1918,” pg. 6 January 17, 1918. Taken from an excerpt of Robert Montgomery’s Income Tax Procedure 1918. Montgomery was the former president of the American Association of Public Accountants. 13 New York Times, “May Pass Bill by Monday Night,” pg. 6 February 8, 1919.

-13-

American people demanded an adjustment of the wartime tax scheme to one

appropriate for peacetime. When this transition failed to happen, the consequences

were immediate: a sweeping reversal of Democratic majorities in the Presidential and

Congressional elections of 1920 and 1918 occurred.14 The Harding campaign

understood this popular sentiment and captured the demand for change with its slogan

of a “return to normalcy.” Harding won in a landslide, capturing sixty (60%) of the

popular vote and seventy-six percent (76%) of the Electoral College.15 As a result, the

new Republican administration had a popular mandate to dismantle a tax scheme that

was considered abusive, by most in society.

Immediately following the armistice, McAdoo left the Wilson Cabinet and Wilson

appointed Carter Glass as Treasury Secretary. Glass continued very much in the

fashion of McAdoo. He issued $5 billion in Victory Bonds to help liquidate the expenses

of World War I. In doing so he ignored his under secretary, Russel C. Leffingwell’s

recommendation for tax reform, instead arguing to a receptive Congress that high tax

rates were necessary to pay off war debt. While McAdoo and Glass were steadfast in

their calls for heavy and steeply progressive tax structures, Glass’ understudy,

Leffingwell, began contemplating a permanent peacetime income tax system.16

Leffingwell began correspondence with a number of leading economists to discuss the

issue, including T.S. Adams, Irving Fisher, Frank Taussig, and Edwin Seligman.

Moreover, Glass pressured the Federal Reserve System to keep discount rates low to

14 There clearly were many issues that played into this political reversal, but it is the view of the author that the tax reform play a dominate role. While only one news article is given here as evidence of popular outcry against the tax bill, the authors opinion is based off of hundreds of articles from numerous news sources of the period.15 http://www.archives.gov/ “Electoral College Box Scores 1789 – 1996. Visited on 12.04.0516 The reader should acknowledge that Glass, nor his immediate predecessor David Houston, were completely blind to the need to reduce taxes. Secretary Glass told Congress: “The utmost brackets of the surtax have already passed the point of productivity,” and Secretary Houston argued: “It seems idle to speculate in the abstract as to whether or not a progressive income tax schedule rising to rates in excess of 70 percent is justifiable. We are confronted with a condition not a theory. The fact is that such rates cannot be successfully collected.”

-14-

ensure that the newly floated bonds traded near par value.17 In consequence, America

faced one of the sharpest depressions in history from 1920 through 1921. Money was

loose at the precise time that war production declined and post war taxation suffocated

growth. This left excess liquidity in the system and caused the price level to inflate.

Wholesale prices rose nearly forty-three percent (42.8%) between the end of the war in

1918 and 1920.18

After the election of Harding in 1920, Leffingwell left the Treasury to become a

partner at J.P. Morgan and Company, but he was replaced by his protégé, S. Parker

Gilbert, who became undersecretary to Harding’s Treasury Secretary, Andrew Mellon.

Gilbert and Leffingwell formed a group of tax reform supporters who touted “scientific”

taxation as a way to raise revenue fairly while limiting interference in the economy to a

minimum. The term “scientific” intended to emphasis that the reform proposals were

based on economic theory rather than political ideology. President Harding, in his

inaugural address, explained that America “can reduce abnormal expenditures, and

[America] will. [America] can strike at war taxation, and [America] must.”19 Harding

expanded on this statement a month later when he addressed a Special Session of

Congress on April 12, 1921:

The most substantial relief from the tax burden must come for the present from the readjustment of internal taxes, and the revision or repeal of those taxes which have become unproductive and are so artificial and burdensome as to defeat their own purpose. A prompt and thoroughgoing revision of the internal tax laws, made with due regard to the protection of the revenues, is, in my judgment, a requisite to the revival of business activity in this country.20

Harding clearly understood the relationship between business activity and taxation.

Beginning with the Revenue Bill of 1921, the Harding administration delivered a

17 See Chapter Three for a full description of this process and its consequences.18 Wholesale Price Index, Bureau of Labor Statistics. Adapted from Figure 1 in Mundell: A Reconsideration of the Twentieth Century, (Dec. 1999).19 Warren Harding, Inaugural Address, March 4th, 1921. Taken from http://www.bartleby.com/124/pres46.html. Visited on 12.04.0520 Harding, A Return to Normalcy, April 12 1921. See Congressional Record, 67 Cong., 1 Sess., pp. 169-173.

-15-

complete dismantling of the war time tax system and pulled the American economy from

the depths of the worse recession since the 1890s into a decade of prosperity. The

“Mellon Plan,” after the Treasury Secretary, adopted a tax reform scheme consistent

with the recommendations of Leffingwell and Gilbert. The “Mellon Plan” orchestrated by

Gilbert and publicized by Mellon, had the support of leading economists with the

common goal to design a nonpartisan permanent peacetime industrial capitalist

economy.

In a letter to Gilbert on November 1, 1920, Leffingwell observed “one very

unpleasant consequence of these heavy taxes is the constant pressure for exemption

from them.” 21 He related his experience at J.P. Morgan, working with clients who

supported a movement to exempt railway and public utilities from taxes because of

difficulty and cost to obtain the necessary capital due to competition with tax-free

municipal bonds. Leffingwell, however, dismissed the notion of exemption from taxes as

a proper policy, noting that it would be “fundamentally wrong, since, first, the

Government needed the revenue, and second, it was anti-social.”22 Instead, Leffingwell

encouraged a reduction in surtaxes. In March of 1921, Gilbert wrote to Secretary Mellon

explaining the need to reform:

The high surtax rates are not producing revenue. The rates are so high that large taxpayers are under constant pressure to reduce their taxable income. Among other things, the higher surtaxes are driving capital out of productive enterprise into tax exempt public securities which are largely unproductive. The investment capital required by industry and trade is being absorbed by unproductive public works.23

Gilbert identified the phenomenon that under the current tax structure, tax-exempt

securities, such as state and municipal bonds, offered higher after-tax return on

21 National Archives and Records Administration (NARA), Record Group 56, Correspondence of the Secretary of the Treasury, 1917-1932, Individual Files: Leffingwell. Even while Leffingwell had left the Treasury for J.P, Morgan, he remained in close contact with his former colleagues and frequently offered advice to Gilbert and Mellon.22 NARA, Individual Files: Leffingwell. 23 NARA, Record Group 56, Tax-General

-16-

investment than did taxable corporate securities.24 Contemporary economist T.S.

Adams confirmed this observation, arguing, “Such a possibility is enough to destroy the

long run potency of a sixty-five percent (65%) surtax.”25 On April 30, 1921 Mellon wrote

to Representative Joseph W. Fordney, chairman of the Ways and Means Committee,

recommending surtax reductions. President Harding called a Special Session of

Congress to consider tax reform. Economist T.S. Adams created the original draft for

the 1921 tax reform through correspondence with Gilbert and the House Ways and

Means Committee brought the bill to Congress. As presented to Congress, the bill

reduced the top marginal rate to thirty-three percent (33%), from seventy-three (73%) by

slashing the surtax rate from a maximum of sixty-five (65%) to a maximum of twenty-five

(25%). Base income tax rates remained the same. While the draft passed the House

easily, insurgent Senate leader LaFollette and Senator Kenyon of Iowa, a Republican

leader of the farm bloc, forged a bipartisan coalition with the Democrats to block the

reform. Secretary Mellon testified to the Senate Finance Committee explaining the case

against high surtaxes. Mellon argued that since the inception of wartime taxation in

1916, the number of tax returns with annual incomes over $300,000 declined fifty

percent (50%). Moreover, total reported income of these returns decreased more than

fifty percent (50%) while total reported income during the period showed an increase of

nearly three hundred percent (300%). Obviously tax-evasion was rampant. He

continued:

It is interesting to note that substantially as much revenue was realized from incomes over $300,000 under a 13% maximum in 1916 as was realized from the same class of taxpayers under a 65% rate in 1921. The high surtax rates are war taxes; and, as the war is over, such taxation should cease.26

24 For the sake of clarity, consider the extreme instance of an individual subject to the top marginal taxes of 73% in 1921. In order to match the return on investment of a municipal bond yielding 5% annually in the corporate market the investor would need to receive taxable returns of greater than 18% annually.25 T.S. Adams, “Fundamental Problems of Federal Income Taxation,” The Quarterly Journal of Economics, Vol. 35, No. 4, (Aug. 1921) pg. 531-3226 Andrew Mellon, Taxation: The Peoples Business, (New York: 1924). pg. 130-131.

-17-

Mellon explicitly understood the distinction between war economy and peace economy

and the amount of taxation each could support. During Congressional debate, Senator

Reed Smoot of Utah argued that the immediate reduction of surtaxes to a thirty-two

percent (32%) maximum for the fiscal year 1922 was “a mathematical calculation. The

reason is because thirty-two percent (32%) is the difference between the income from a

tax-exempt security and one that is taxable on the basis of today’s money markets.”27

The key here is to understand the “scientific” language behind the Mellon Plan. Despite

this bid, Mellon could not overcome the popular appeal to the notion, espoused by

Senator La Follette, that surtaxes could only be reduced at increased expense to

ordinary people. For example, Senator Kitchin, the ranking Democratic member of the

House Ways and Means Committee rebuffed the surtax reductions:

…even if millionaires and multimillionaires were putting their surplus income into state, county, and municipal bonds, are not the people of the states and counties and municipalities thereby benefited by getting a higher price for such bonds, and do not the proceeds from these state and municipal bonds go more directly for the benefit of the people than the taxes of the federal government?28

In the end, The Revenue Bill of 1921 lowered the maximum surtax to fifty percent (50%),

leaving a top marginal rate of fifty-eight percent (58%). In addition, the maximum

threshold was lowered to $200,000 from the 1918 level of incomes over $1 million.29

At first glance, the resulting Bill can appear to be more of a tax increase than a

tax decrease because, while the top surtax rate was reduced from sixty-five percent

(65%) to fifty percent (50%) the top threshold was lowered from $1 million to $200,000.

This is misleading, however. Surtaxes in both the 1918 and 1921 Bills increased at a

rate of one-percent (1%) for every additional $2,000 in income up to $90,000. The

graduation then became more progressive. In 1918, incomes between $200,000 and

$300,000 were subject to a sixty percent (60%) surtax, those between $300,000 and

27 Roy Blakey, “The Revenue Act of 1921” American Historical Review, Vol. 12. No. 1 (Mar. 1922) 81.28 Blakey, “The Revenue Act of 1921” 80-83.29 Congressional Record. The Revenue Act of 1921, Washington: 1923 (Seventy-Sixth Congress, Session I, Chpt. 136, 1921).

-18-

$500,000 a surtax of sixty-three percent (63%), $500,000 and $1 million sixty-four

percent (64%), and incomes over $1 million were subject to a top surtax rate of sixty-five

percent (65%) Under the new Bill, the top surtax was levied at fifty-percent (50%) on

incomes over $200,000 significantly reducing the $200,000 bracket by ten percent (10%)

and those brackets above it by larger amounts. More importantly, in 1918, the first

surtax of (1%) kicked in at incomes between $5,000 and $6,000, but in 1921 the bottom

threshold was raised to $6,000 and the minimum surtax rate of one-percent (1%) was

stretched through to incomes of up to $10,000. The effect of this was to lower all

surtaxes in all brackets up to $90,000 by two-percent (2%). Incomes between $90,000

and $100,000 were reduced by one-percent (1%) each, and those between $100,000

and $200,000 by four percent (4%) and seven percent (7%) respectively. The Bill,

therefore, while not to a great degree and no where close to the level called for the by

Mellon Plan, did marginally reduced tax rates.30

The Bill received moderate coverage in the press as senators made it explicit

that the tax reform would not end here. For example, on November 23rd, 1921, The New

York Times Reported:

TO PASS TAX BILL TODAY AND ADJOURN; Senate Agrees to Take the Final Vote by 5 o'Clock This Afternoon.

TEMPORARY, SAYS PENROSE He Asserts Measure Does Not Place Tax System on Stable or Scientific

Basis. BUT DOES LESSEN BURDENS

House Prepares for Adjournment by Passing Deficiency Bill Carrying $104,000,000. Reductions Made in Taxes.

Notice the “scientific” reference in the language of the Senators. Similarly, on

December 8th The Times printed:

MELLON CALLS FOR MORE CUTS IN TAXES; Tells Congress High Surtax Maximum Burdens the Masses and Reduces

Revenues.WANTS LOWER ESTATE LEVY

Suggests Small Tax on Specific Articles or Classes of Articles or Transactions.

30 Congressional Record, The Revenue Act of 1921.

-19-

STILL OPPOSES BONUS LAWSecretary's Annual Report Points to Economies Made and Need of

Continuing Reductions. Tax Revision Still Needed. Tax-Exempt Securities. Destruction of Incentive. Burden Falls on the People. Free Business Essential Sees Remedy in Lower Rates. Opposes Soldiers'

Bonus Law.

As promised, following the 1921 Bill, the Treasury continued to push for a twenty-

five percent (25%) maximum surtax and a top marginal rate of thirty-three percent

(33%). Gilbert began a rigorous consultancy with T.S. Adams and Price Waterhouse

accountants George O. May and Joseph Sterret that was focused on revising the

Revenue Act of 1921. On February 17, 1923 Gilbert urged Mellon to submit another bill

to revise the surtax rates. “If the revision is not made by the present Congress, there is

almost no possibility, with a more radical Congress and the Presidential election less

than a year off…”31 Gilbert understood that LaFollette’s insurgent coalition was

increasing its power to resist tax reduction due to their success in the 1922

Congressional elections. Throughout 1923, a tax revision committee fashioned a

complete revision of the 1921 Bill. The underlying message remained the same,

however: reduce surtax rates.

The new tax revision received support from economist T.S. Adams, whose

career had been dedicated to the development of the progressive income tax structure.

Nevertheless, he viewed the current level of surtaxes as unsustainable. Adams argued

along lines similar to those posed by Gilbert and Mellon:

The key to tax revision – and at once the simplest and most difficult tax problem before Congress – is the proper fixation of the upper surtax rates. It is charged that those rates are excessive, that they practically force wealthier taxpayers to avoid or evade the tax, that their yield is shrinking rapidly, and the current of free investment funds has been diverted away from railroad and industrial bonds to tax-free securities, with consequent recession of private enterprise and a corresponding fillip to municipal and state enterprise.32

31 NARA, Tax – General.32 Adams, pg. 529.

-20-

Adams wrote the House Ways and Means Chairman, Congressman William Green, to

argue that because of tax avoidance opportunities at both the individual and corporate

level, income tax-rate reduction was needed to save the progressive nature of the tax

structure and to continue economic recovery. The popular press closely covered the

tax bill’s progress. The New Times on November 12, 1923 headlined: “INCOME TAX

CUTS URGED BY MELLON. CALLS SURTAX A FAILURE.” The same day The Wall

Street Journal ran with “MELLON WANTS LOWER INCOME TAXES.” Business and

professional circles also supported the plan enthusiastically. On November 13, The New

York Times announced: “GLAD FOR SMALL INVESTORS: PHILADELPHIA BANKERS

SAY MELLON PLAN WILL PUT CAPITAL IN INDUSTRY,” and in a separate article:

“MELLON PLAN BOON TO INDUSTRY, FINANCERS ASSERT; TAX REDUCTIONS

THE GREATEST AID TO PROSPERITY CONGRESS COULD GIVE. WOULD

STIMULATE BUSINESS.” On Nov. 14 The Times reported: “PRESIDENT MITCHELL

OF NATIONAL CITY AND OTHERS HIGHLY PRAISE SECRETARY’S ABILITY. SEE

BIG BOOM IN BUSINESS.” On November 22, The Times expressed the Presidents

endorsement: “COOLIDGE WILL SEND LETTER PAVING WAY FOR MELLON PLAN.”

On every one of these days the market went up.

Private and academic circles also rallied around the cause. The Citizens’

National Committee, a nonpartisan organization formed in January of 1924 to educate

the public on “the basic facts and economic laws governing industrial activities,” became

a large promoter. The Committee consisted of leading economists Edwin Seligman,

Frank Taussig, Irving Fisher, and Roy G. Blakey, along with Saturday Evening Post

financial writer Albert W. Atwood; statistician and financial analyst Roger W. Babson,

investment banker Otto Kahn, former Harvard University President Charles W. Elliot,

and the Committee was chaired by lawyer and war hero, General John F. O’Ryan. The

committee thoroughly endorsed the Mellon Plan as “scientific taxation.” Such

-21-

endorsements were not limited to the academic and financial realms either. On January

1, 1924, The Times reported: “MELLON TAX APPEAL ON MENUES.” Later, O’Ryan

announced a National Tax Reduction Week beginning April 7, 1924 with planned media

events to involve the entire country. The New York Times reported that 327 movie

theaters flashed special messages about the Mellon plan across their screens

throughout the week. This tax reform was a popular revolution that came from all facets

and demographics of society. Finally, Mellon laid out the basic idea in his book,

Taxation: The Peoples Business, which can be recognized as a clear articulation of what

is today referred to as the “Laffer Curve”: 33

It seems difficult for some to understand that high rates of taxation do not necessarily mean large revenue to government, and that more revenue may often be obtained by lower rates. There was an old saying that a railroad freight rate should be “what the traffic will bear”; that is, the highest rate at which the largest quantity of freight would move. The same rule applies to all private business. If a price is fixed too high, sales drip off and with them profits; if a price is fixed too low, sales may increase, but profits decline.34

33 The Laffer Curve is named after Arthur Laffer, who in the winter of 1974 drew a curve for an aid to President Gerald Ford to show that there are always two tax rates that yield the same revenues. A tax rate of 100 percent (100%) yields zero revenue because all production ceases in the money economy. Similarly, a tax rate of zero percent (0%) yields no revenue because people keep 100 percent of what they produce. The two rates are differentiated in that the former minimizes production and the later maximizes it. There is only one tax rate for every economy that will maximize both production and revenue at once. Here the tax system is said to be in “equilibrium.” Tax rates above this “equilibrium rate” will yield less production in the economy and less revenue for government. Tax rates below the “equilibrium rate” will yield more production in the economy and less revenue for government. The fact that revenue increased as the Mellon tax cuts were implemented demonstrates that the US economy following the end of World War One was constrained by tax rates that were above the “equilibrium rate.” The Mellon tax reform brought America “down” the Laffer curve toward equilibrium. This concept is illustrated in the graph below:

34 Mellon, pg 16.

-22-

Taxation is the business of government. Mellon simply tried to maximize its “profits” in

the form of revenue. Nevertheless, despite overwhelming transparency and public

support, the Mellon plan again faced resistance in Congress, especially in the Senate.

As Gilbert feared, the insurgent Republican-Democratic alliance moved to block the bill,

resulting again, in a mixed victory for Mellon’s tax reform. On June 2, President

Coolidge, who had become President upon Harding’s death, singed the Revenue Bill of

1924 but announced:35

As I have said, the bill does not represent a sound permanent tax policy and in its passage has been subject to unfortunate influence which ought not to control fiscal questions…A correction of its defects may be left to the next Congress. I trust a bill less political and more truly economic may be passed at that time.36

The 1924 Bill reduced top surtax rates to forty percent (40%), and cut the top base

income tax rate to six percent (6%), leaving a top marginal rate of forty-six percent (46%)

down from fifty-eight percent (58%) under the 1921 bill. More importantly though,

bracket thresholds were raised. The top marginal rate threshold was raised to $500,000

from $200,000. In the lowest bracket, income tax rates were reduced from four percent

(4%) to two percent (2%) and a new income tax bracket with a rate of six percent (6%)

was created for incomes that exceeded $4000 but were less than $8000. While its

proponents considered this bill a step in the right direction, the Mellon plan was still far

from its 1920 goals. As economist Roy Blakey wrote: “The Federal Revenue act

approved June 2nd, 1924, is not a revolutionary measure; on the contrary, it is very

similar in general character to the Revenue act of 1921.”37

Coolidge, led by Mellon and Gilbert, seized the “loss” on tax reform as a

campaign issue and described the Republican Party platform on June 11, 1924, only

nine days after signing the Revenue Bill, as a commitment to “progressive tax reductions

35 Calvin Coolidge became President on August 3, 1923 following the death of President Harding.36 U.S. Treasury Department. 1925, Annual Report of the Secretary of the Treasury on the State of the Finances for the Fiscal Year ended June 30, 1924, Washington, C.C., GPO37 Roy Blakey, “The Revenue Act of 1924,” American Economic Review, Vol. 14, No. 3 (Sep. 1924) pg. 475.

-23-

through tax reform…to place our tax system on a sound, peacetime basis.” The

“scientific” language stressed as early as 1920 by Leffingwell and Gilbert and the need

for a “peacetime” tax system remained evident. These were not partisan issues. The

reaction was overwhelming. The 1924 election reaffirmed Republican control of the

White House and created strong Republican majorities in both the House and the

Senate. President Coolidge received 2.5 million more votes than the Democratic

challenger John Davis, or the Independent candidate, Insurgent Republican, LaFollette.

Republicans received a sixty seat majority in the House and a seventeen seat majority in

the Senate. More importantly, the election ended the progressive and insurgent

Republicans’ challenge to the Republican Platform and, particularly, the Mellon Tax

Plan.38

By 1925, public enthusiasm for the Mellon Plan supported the possibility of

greater surtax reduction than proposed in 1921. “Tax clubs” sprang up across the

country to promote the Mellon Plan. Tax reform suddenly became a grassroots

movement. In addition, a federal surplus, which began to build in 1920, reached almost

to the billion-dollar level in 1924. Slowly, tax cuts had pulled rates down from prohibitory

levels to produce a booming economy able to pay off the war debts. The United States

economy was moving “down” the Laffer Curve.

During March, 1925, Congress authorized a Special Session to facilitate the

revenue bill in the new Congress. The final success of the Mellon Plan was a forgone

conclusion by the time the Ways and Means Committee began hearings in October,

1925.39 The Revenue Bill of 1926 passed nearly unanimously in the House by a vote of

355 to 28, and in the Senate the very next day by a vote of 61 to 10. It was the signed

38 The author acknowledges that many other issues besides tax reform contributed to Coolidge’s and the Republican’s success in 1924, but taxes certainly played, an important, and in the eyes of the author, a central role.39 Roy Blakey, “The Revenue Acct of 1926”, American Economic Review, Vol. 16, No. 3 (Sept. 1926), pg. 407 – 408.

-24-

into law by President Coolidge on February 26, 1926 – a date that corresponds exactly

with, and so marks the beginning, of the Coolidge Bull Market. Over the weekend, the

Dow Jones Railroad Index jumped from 107 to 120, over a twelve percent increase

(12.15%). The maximum surtax rate was reduced to twenty percent (20%) on incomes

over $100,000 from the 1924 maximum of 40% on incomes in excess of $500,000.

Base income tax rates were reduced from the two percent-four percent-six percent (2%-

4%-6%) progressive schedule of 1924 to a one-and-one-half percent-three percent-five

percent (1½%-3%-5%) schedule. The new maximum marginal rate, therefore, was

twenty-five percent (25%), lower than what Mellon originally called for.40

Again, one could question the validity of this tax reduction as the top threshold

dropped considerably from $500,000 to $100,000. For this reason, some further detail is

necessary. In addition to the reduction in income rates, the bottom threshold for

surtaxes, which began at one-percent (1%), was raised from $6,000 to $10,000.

Moreover, as was the case in 1924, the new tax code reduced rates in every bracket

despite lowering thresholds on the top end.41

The last Revenue act of the decade came in 1928. The bill reduced the

corporate tax rate from thirteen-and-one-half percent (13½%) to twelve percent (12%)

but left personal rates unchanged.42 A 1929 resolution in response to the market

crashes in October lowered corporate rates one percent (1%) to eleven percent (11%)

40 Congressional Record. The Revenue Act of 1926, Washington: 1926 (Seventy-ninth Congress, Session I, Chpt. 26, 27). It is interesting that the 1926 Bill settled on a top rate of 25% on incomes over $100,000. One of the effects of the Laffer Curve is that under complicated progressive systems, such as those that exist today, it is difficult to actually collect more than twenty-two percent (22%) of GDP no matter what the tax rate is. Most flat tax schemes, such as those proposed by Hall & Robbins of Stanford or Steven Forbes, fall in around twenty percent (20%) if they keep mortgage deductions and fall off into the teens if they do not. Using a CPI Calculator provided by the Federal Reserve Bank of Minneapolis, $100,000 in 1926 is approximately $1.1 million today. This implies real rate of less than 25% on a generally flat tax basis for the majority of tax players, probably close to the rates proposed today by flat tax advocates in the United States and Europe trying to maximize revenue through a scientific taxation scheme of their own.41 Congressional Record, The Revenue Act of 1926.42 Congressional Record. The Revenue Act of 1928, Washington: 1928 (Seventieth Congress, Session I, Chpt. 842).

-25-

and stopped the market decline.43 More importantly, prior to the crash, the Republican

Party reversed its political position with regard to tax reform. Influenced by a perceived

imbalanced of wealth distribution between city and farm, the Republican nominee

Herbert Hoover ran on a platform of tariff protection:

The Republican Party believes that the home market, built up under the protective policy, belongs to the American farmer, and it pledges its support of legislation which will give this market to him to the full extent of his ability to supply it…It is inconceivable that American labor will ever consent to the abolition of protection, which would bring the American standard of living down to the level of that in Europe, or that the American farmer could survive if the enormous consuming power of the people in this country were curtailed and its market at home, if not destroyed, at least seriously impaired.44

A tariff tax by its nature is a tax on international commercial transactions in the same

way that income tax, surtax and excise tax are levies against domestic transactions.

Hoover campaigned on, what can be effectively, if indirectly, understood as an anti-

Mellon Plan platform.

With the election of Herbert Hoover, the United States new fiscal policy took hold

of the American Economy. Throughout the 1920s tax reform allowed the economy to

grow rapidly. Between 1922 and 1929, real gross domestic product (GDP) grew at an

annual rate of four-point-seven percent (4.7%) and unemployment dropped from six-

point-seven percent (6.7%) to three-point-two percent (3.2%).45 Nor was this growth

simply fixed on the high earners. Total income grew as more people became

prosperous in the growing economy. Between 1922 and 1928, the average income

reported on tax returns of those earning more than $100,000 increase fifteen percent

(15%), but the number of taxpayers within this bracket quadrupled. At the same time,

the number of taxpayers earning less that $10,000 fell. In the middle, the number of

taxpayers with incomes between $10,000 and $100,000 increase by eighty-four percent

43 On November 13, 1929, the day the resolution was announced by Mellon, the market stopped its decline at 198, as measured by the DJIA, and rallied the next day to 217 and then to 228 on November 15, gaining over fifteen percent (15.15%) in the two days. The DJIA finished the year at 239.44 Jude Wanniski, The Way The World Works, (New York: 1978) p. 127; also see Arthur Schlesinger, History of presidential elections, (New York: 1971), 3: 2624-40.45 U.S. Bureau of the Census, Series F1-5 and D85-86, pp. 135, 244

-26-

(84%). It is clear that by establishing a scientific peacetime tax system, the Mellon tax

reform revived the economy by restoring the incentives to work, save, and invest, and by

discouraging tax shelters. To understand fully the economy and the success of the

1920s, however, a thorough analysis of the monetary forces at work is needed.46

46 For a graphical description of the tax policy of the 1920s, see Appendix C.

-27-

Chapter Two:

Monetary Policy, World War One and Changes in the Price Level

Congress created the Federal Reserve in December, 1913, in direct response to

the multiple bank failures during the depression of 1907 but also in light of the tight

markets of the fall and in an effort to manage the gold standard. The establishment of a

central bank represented a compromise between opposing factions in the early twentieth

century. Opponents saw a central bank as open to political manipulation by the federal

government and vested interests of Wall Street. As a result, the system differed from

the older central banks in Europe. The United States established twelve regional banks,

each acting as a central bank in its own right, and a Federal Reserve Board, presiding in

Washington oversaw the system. The compromise between no central bank and a

single central bank was two fold: first it protected the system from being manipulated

due to over concentration and, second, it allowed the “central banks system” to meet the

varying credit needs of different parts of the country. The Federal Reserve primarily

sought to prevent financial panics, bank failures and speculation by adding elasticity to

the money supply and by acting as lender of last resort, to maintain the gold standard,

and to provide legitimate credit needs to both agriculture and business. Nevertheless,

despite all attempts to make the Reserves system apolitical, the outbreak of World War I

immediately put the system at the behest of the Treasury.47

From May 14, 1917, to April 21, 1919, the Treasury floated four Liberty Loans

and one Victory Loan to finance World War I and European recovery. All issues were at

47 A number of books address the history of the Fed’s formation in detail. Allan Meltzer’s A History of the Federal Reserve, (Chicago: University of Chicago Press, 2003) , Benjamin H. Beckhart, Federal Reserve System, (United States of America: American Institute of Banking, 1972), also see Thomas Humphrey’s article “Monetary Policy Frameworks and Indicators for Federal Reserve in the 1920s,” Economic Quarterly, Federal Reserve Bank of Richmond, Vol. 87, No. 1, 2001.

-28-

par in denominations as low as $50.48 Banks encouraged borrowing to buy these

government obligations which could be purchased through installments over a four

month period. In total, the bond issuances attracted over 66 million subscribers. As of

October 31, 1919, after all five loans had been floated successfully; total federal debt

amounted to $26.2 billion, including prewar bonds. This sum is well above McAdoo’s

original budget estimates of just over $6 billion with half to be financed through taxation.

The four Liberty Loans and one Victory Loan alone raised over $20 billion. In an effort to

keep costs down for the government, low interest payment became a priority for the

Secretary McAdoo, who stated in 1918:

The higher the rate on Government bonds, the greater the cost to the American people of carrying on the war and the greater will be the depreciation in all other forms of investment securities. We cannot regard without concern declines in the general value of fixed investments.49

The first Liberty Loan issuance sold at par with a coupon of 3.5 percent (3.5%) and

encouraged investment by offering exemptions from income taxes. In the following

issuances the coupon, which can be thought of as the cost of financing for the

government, slowly rose as some tax-exemptions were eliminated. The third bond sold

at par with a yield of 4.25 percent (4.25%), but the forth again required substantial tax

exemptions to be sold at par. The final Victory Loan offered a choice between tax-

exempt 3.75 percent (3.75%) and taxable 4.75 percent (4.75%) coupon payments.

Despite the advantages of the loans, they soon began to trade at a discount. When

bonds trade at a discount to par, their yields increase, rising the interest payment due by

the government to bond holders. In an effort to halt this rising cost of capital, the

Treasury created the War Finance Corporation to begin buying back bonds to support

the price and keep yields low.

48 Beckhart, p. 15849 Annual Report of the Secretary of the Treasury on the State of the Finances for the Fiscal Year Ended June 30, 1917 (Washington, D.C.: Government Printing Office, 1918) p. 4

-29-

The huge national deficit caused the Treasury to pressure the Fed toward

accommodative monetary policy. If the Fed tried to increase interest rates by raising the

discount rate, it would adversely affect the bond markets, causing yields to increase and

making it more expensive for the Treasury to pay off the government debt. Maintenance

of interest rates at artificially low levels had the effect of increasing liquidity in the

economy and caused the commercial banking system to finance much of the deficit.

The commercial banking system’s total share of war interest-bearing debt was $7 billion

or thirty percent (30%).50 Only World War II surpassed this proportion when the

commercial banking system supported forty percent (40%) of the deficit. The extension

of commercial credit to finance the war deficit was combined with a decrease in the

reserve requirement for Federal Reserve notes and deposit liabilities of member banks

and an embargo on gold exports to keep the price of gold from falling. The Federal

Reserve encouraged this increase in credit through loans to member banks. Discounted

bills totaled $1.8 billion by the end of 1917. Discount rates were continually adjusted in

relation to coupon rates on Liberty bonds to create preferential rates for loans against

war paper. This spread between the rate at which member banks could borrow from the

Fed and the rate at which they could purchase government war debt became known as

the “gentlemen’s agreement” and encouraged member banks to borrow in order to buy

war bonds. This “gentlemen’s agreement” effectively gave the Treasury control over the

Fed’s discount rate. The surge in member-bank borrowing from the Federal Reserve

caused short term rates to increase faster than long term rates and the yield curve

inverted. Most importantly, however, World War I destroyed the years of planning to

keep the Federal Reserve system free from government influence and, following the

armistice in 1918, the Fed became increasingly controlled by the Treasury.51

50 Sixth Annual Report of the Federal Reserve Board (Washington, D.C.: Government Printing Office, 1920), p. 115-117.51 Beckhart, p. 178-182

-30-

Perhaps the most visible change in the American economy as a result of the war

was a sharp increase in prices. Between 1913 and 1917, wholesale prices rose an

astounding sixty-eight percent (68.3%).52 By 1918, wholesale prices were even higher at

eighty-eighty percent (88%) above their 1913 levels. Nor did prices stop rising following

the armistice in November, 1918. Wholesale prices rose almost another twenty-two

percent (21.85%) before peaking in 1920 at 121.67 percent (121.67%) above their pre-

war levels. Consumer prices followed a similar pattern, as producers pushed rising

costs onto consumers. Before the United States entered the War in 1917, retail prices

had increased just over twenty-nine percent (29.29%) during the previous four years. By

the armistice, retail prices were fifty percent (50%) greater than before the war and by

1920 consumer prices reached a level twice as high (102%). Moreover, consumer

prices rose much more rapidly than producer prices following the armistice, some thirty-

two percent (32.45%) as compared with the still high twenty-two percent (21.85%) rise in

producer prices. In part this is due to the fact that producer prices “lead” consumer

prices. Producer prices rose much more quickly during the war as rising demand for raw

materials drove up costs. After the armistice, these costs were pushed onto the

consumer. The end result is one that corresponds well with the data. Producer prices

spike first, followed by rapid rises in consumer prices. Even more importantly, however,

the following year, 1921, both consumer and producer prices collapsed, dropping on a

year-over-year basis ten-and-a-half percent (-10.5%) and nearly thirty-seven percent (-

36.84%) respectively. The movement in consumer and producer price indexes (retail

and wholesale prices) is detailed table below:

52 Computed by the U.S. Bureau of Labor Statistics (Index converted to 1913 base)

-31-

Table 5Year CPI (1913 = 100) % Change YoY % change PPI (1913 = 100) % change YoY % change1913 100 100.01914 101.01 1.01% 1.01% 98.3 -1.67% -1.67%1915 102.02 2.02% 1.00% 100.0 0.00% 1.69%1916 110.10 10.10% 7.92% 122.5 22.50% 22.50%1917 129.29 29.29% 17.43% 168.3 68.33% 37.41%1918 152.53 52.53% 17.97% 188.3 88.33% 11.88%1919 174.75 74.75% 14.57% 199.2 99.17% 5.75%1920 202.02 102.02% 15.61% 221.7 121.67% 11.30%1921 180.81 80.81% -10.50% 140.0 40.00% -36.84%1922 169.70 69.70% -6.15% 139.2 39.17% -0.60%1923 172.73 72.73% 1.79% 144.2 44.17% 3.59%1924 172.73 72.73% 0.00% 140.8 40.83% -2.31%1925 176.77 76.77% 2.34% 148.3 48.33% 5.33%1926 178.79 78.79% 1.14% 143.3 43.33% -3.37%1927 175.76 75.76% -1.69% 137.5 37.50% -4.07%1928 172.73 72.73% -1.72% 139.2 39.17% 1.21%1929 172.73 72.73% 0.00% 136.7 36.67% -1.80%1930 168.69 68.69% -2.34% 124.2 24.17% -9.15%1931 153.54 53.54% -8.98% 105.0 5.00% -15.44%1932 138.38 38.38% -9.87% 93.3 -6.67% -11.11%1933 131.31 31.31% -5.11% 95.0 -5.00% 1.79%1934 135.35 35.35% 3.08% 107.5 7.50% 13.16%1935 138.38 38.38% 2.24% 115.0 15.00% 6.98%*Source: Bureau of Labor Statistics (www.bls.gov)

In the span of a single year, 1920-1921, wholesale prices to producers

decreased from 121.67 percent (121.67%) above their pre-war 1913 level to forty

percent (40.00%) above their prewar level, over an eighty-one percent (81.67%) decline

in wholesale prices with respect to their 1913 levels and nearly a forty percent (40%)

year-over-year deflation. The forces at work here are essential toward understanding

the following decade and the precarious position of international debts.

The traditional story, told by Milton Friedman and Anna Schwartz in their

magnum opus The Monetary History of the United States, is that the Fed’s

accommodative interest rate policy caused rapid borrowing by member banks, excess

liquidity of the dollar and, consequently, a monetary inflation caused by a surge in the

-32-

supply of money.53 This argument relies on changes in total money supply in

comparison to changes in GDP. The classic monetarist framework argues the Money

Supply multiplied by Money Velocity equals the Price Level times GDP growth

(MV=PY).54 Friedman assumes velocity is constant and consequently argued that

increases in the money supply immediately fed through to a rising price level.55 With this

methodology, the low interest rates that encouraged member bank borrowing to finance

the war debt increased the money supply and caused a monetary inflation. In a

sentence, Friedman blames the Fed. Much of this argument is based around the

formation of an “elastic currency” with the development of the Fed. Prior to the formation

of the Federal Reserve there existed four types of paper money:

1. Gold certificates - secured dollar for dollar by gold and held in the

Treasury and could only be increased/decreased with changes in the

volume of gold held in the Treasury.

2. Silver certificates, secured dollar for dollar by coined silver and the

amount was limited by law.

3. United States notes or “greenbacks” issued during the Civil War

originally secured by nothing other than the promise of the government

to pay but by 1914 about fifty percent (50%) were covered by gold.

The total in circulation was limited by law to no more than $346 million.

53 See Milton Friedman and Anna Schwartz, A Monetary History of the United States, (Princeton: Princeton University Press, 1963). 54 Where M=Money Supply; V=Money Velocity; P=Price Level; Y=GDP growth. See Humphrey, 2001 for a full description. 55 It is in this assumption that money velocity, which can easily be understood as money demand, remains constant that Friedman and his monetarist followers falter. The tax changes documented in Chapter On that created so much public outcry after the armistice certainly impacted the countries demand for money. As small businesses, the group most outraged by the Revenue Bill of 1918, were driven into bankruptcy, business transactions decreased and consequently the need for money declined. This fact, however, still supports the idea of a monetary inflation. With money supply rising (P increasing) and velocity decreasing (V decreasing) the inflationary effect would have been expounded. Similarly, the 1921 tax reform increased the demand for money (V increased) which helps explain the sudden decline in prices. Of course this analysis does not account for changes in international demand as Europe, which increasingly needed dollars, began rebuilding their countries following the war. These international considerations and the impact on velocity is covered later in the Chapter. The basic effect, however, is to increase the demand for dollars (V increased), hurting the Monetarists argument.

-33-

4. National bank notes issued by national banks and secured by

government bonds. The total amount in circulation was also limited,

only by the number of government bonds carrying a circulation

privilege.56

In 1914, before the war and the establishment of the Federal Reserve, the total paper

money in circulation was $2.56 billion, with gold certificates making up the largest

portion, about forty percent (40%) of the total supply.57 National bank notes were

second, near their maximum level, at twenty-eight percent (28%). It should be noted

that all paper was interchangeable, dollar for dollar, whether backed by metallic means

or government obligation. Moreover, the total circulation comprised of these for species

was fixed so that the supply of money could not be increased or decreased to respond to

seasonal demand changes or periods of emergency, such as war. The introduction of

the Federal Reserve Act and the creation of a fifth specie of paper money, the Federal

Reserve Note, provided a currency for emergencies and added flexibility into the

previously static system. The Federal Reserve Note is directly related to trade activity

and its issuance is intended to allow the supply of money to meet changes in short term

demand. By 1920 the total supply of paper money in circulation had risen to 4.84 billion,

nearly double the 1914 amount.58 Federal Reserve Notes, which by then made up

approximately seventy-three percent (73%) of all circulating paper, accounted for the

largest portion of this increase. Federal Reserve Notes were unique in that they could

be secured against short-term promissory notes or banker’s acceptances generated by

industrial, commercial, and agricultural transactions. This meant that, as W. Randolph

Burgess, deputy governor under Governor Benjamin Strong at the New York Fed,

explained in 1927: 56 W. Randolph Burgess, The Reserve Banks and the Money Market, (New York: Harper & Brothers Publishers, 1927), pg. 41-64: Chapter IV: “Changes in Currency.”57 Burgess, p. 4258 Burgess, p. 42.

-34-

…paper used as security represents agricultural products or other goods in the process of production, or in movement from producer to retailer, in process of export or import, or on the shelves of retailer of wholesaler awaiting sale….The acceptance of this kind of paper as collateral was essential in the war, and at present it offers the most convenient form for short-term member bank borrowing and usually represents business needs for funds as truly as paper having the form of a business obligation.59

This new form of currency created money supply “elasticity” in that it enabled currency

expansion to meet “any conceivable emergency.” Even in 1920, when the amount of

currency in circulation reached its maximum, the Reserve Banks could have issued

another $800 million in Federal Reserve Notes before the percentage gold reserve

minimum legally set for the system would have been met.60

Another way to examine total money supply, the process used by Friedman and

Schwartz, is through total deposits plus circulating currency (M1). The total deposit

increase from before the war through 1920 moved in line with the data already

presented. Deposits increased ninety-three percent (93%) from 1914 to 1920. During

the two years after the armistice, between 1918 and 1920, deposits increased

approximately twenty-seven percent (26.54%). This increase, in turn, was driven by a

sharp increase in total outstanding loans of approximately thirty-six percent (36.42%).

The increase in loans was made possible by the preferential treatment that the Federal

Reserve gave to commercial banks in its effort to assist the Treasury in reducing the

floating government debt.61 Contemporary economists of the period, as well as by

researchers such as Friedman, Schwartz, and Meltzer of the modern period, argued that

by keeping discount rates below market rates commercial banks had economic incentive

to borrow from the Fed and lend out through the commercial paper markets, thereby

increasing the money supply and driving up prices. This relationship between the

discount rate and the yield on commercial paper is demonstrated by the graph below:

59 Burgess, p. 4460 Burgess p. 4561 This treatment, dealt with earlier in the Chapter, became known as the “gentlemen’s agreement.”

-35-

The increase in the discount rate in November, 1919, pushed rates above the open

market rate, as measured by commercial paper, and marked the beginning of Federal

Reserve independence from the Treasury:

The disappearance of the Treasury from the long-term loan market and the rapid reduction of its requirements for short-term accommodation foreshadows the approach of the time when financial operations of the Government will cease to be the important factor in shaping the Reserve Bank policies which they have been, and the Federal Reserve Bank rates once more will be fixed solely “with a view of aiding commerce and business.”62

Prior to this point, the Fed was unable to increase the interest rate because of Treasury

opposition despite the strong preference of Governor Benjamin Strong and the Bank of

New York.63 There is considerable evidence of the dominating influence by the Treasury

over Federal Reserve Policy. The minutes from the September 4, 1919, meeting of the

Federal Reserve Board in Washington D.C. read:

The Governor made a statement reviewing the conditions under which the Federal Reserve System has been operating since the entrance of the United States into the world war, which conditions had made it impossible for the system

62 Federal Reserve Bulletin (Oct. 1919) p. 910.63 For a more detailed account of the debate between Benjamin Strong of the New York Federal Reserve Bank, Secretary McAdoo at the Treasury, and the Federal Reserve Board of Governors in Washington D.C., see Alan Meltzer’s The History of the Federal Reserve, part 1.

Interest Rates (1919-1922)

0123456789

Jan-

19

Apr-

19

Jul-1

9

Oct

-19

Jan-

20

Apr-

20

Jul-2

0

Oct

-20

Jan-

21

Apr-

21

Jul-2

1

Oct

-21

Jan-

22

Apr-

22

Jul-2

2

Oct

-22

Date

% Y

ield

Discount Rate

Weighted Avg. Open MarketRates

L/T Gov. Bond Rates

Commercial Paper Rates

The discount rate was raised above the rate on war bonds and long-term treasuries. This was the end of “preferential rates” by the Federal Reserve, supporting the Treasury.

Another notable point. The weighted average of all open market rates crossed below the discount rate. The Federal Reserve then began to cut the discount rate. Under the ideology of the Fed at this time, the rate movements needed to be initiated by the market. The debate over this policy is extensively covered by Alan Meltzer in A history of the Federal Reserve (2002). The policy has been blamed with causing the Fed to keep rates too high for too long and by extension the sharp recession of 1920-1921.

-36-

to function independently of the Treasury, particularly with respect to the determination of the discount rate…64

Moreover, Fed Board Chairman W.P.G Harding expanded on his statements before the

Joint Commission of Agriculture in 1921 following the collapse in prices65:

Senator Lenroot: …if the Board had adopted that policy [of raising the discount rate] a year before it did, would there have been less disturbance than we now have?

Governor Harding: That is quite probable, Senator.Senator Lenroot: Now, why was it not done?Governor Harding: For reasons relating to Government finance.66

The Fed found itself not only handcuffed because of the Treasury’s desire to cheaply

restructure the war debt, but also it understood that this handicap hurt the economy

through increased volatility in the price level. In order to be sustainable, this argument

relies on a clear connection between money supply and the discount rate, as well as a

clear relationship between the money supply and inflation.

64 Federal Reserve Board Minutes from meeting on Sept. 4 1919. Available at: http://fraser.stlouisfed.org/docs/MeltzerPDFs/min090419.pdf, visited on 1-March 200665 This collapse will be analyzed in the remainder of the chapter.66 Benjamin Beckhart, The Discount Policy of the Federal Reserve System, (New York: Henry Hold and Company, 1924) p. 465

-37-

This relationship is reflected in the graph above. Wholesale prices began to

appreciate in October of 1915. At the time, the war had begun and Federal Reserve

Notes had just been introduced into the system. The rate of price increase quickened in

mid-1916 before leveling off in 1917, but continued to rise again in 1918 through mid-

1920. This is consistent with supports the argument that the price increases were

caused by an increase in the supply of Federal Reserve Notes. The Federal Reserve

System conducted an accommodative “easy” money policy at the insistence of the

Treasury. Once the Federal Reserve regained its independency in November, 1919, it

began to hike rates and prices began to decline precipitously. The decline in prices did

not, however, response to the rate hikes at first. Nevertheless, in line with the

monetarists’ argument, the decline in prices occurred with a higher interest rate,

reflecting a sharp decline in the money supply. The data and the graphical analysis both

support this argument. Total bank deposits decreased from $41.84 billion in 1920 to

CPI and PPI Changes

0

50

100

150

200

250

Jan-

14

May

-14

Sep

-14

Jan-

15

May

-15

Sep

-15

Jan-

16

May

-16

Sep

-16

Jan-

17

May

-17

Sep

-17

Jan-

18

May

-18

Sep

-18

Jan-

19

May

-19

Sep

-19

Jan-

20

May

-20

Sep

-20

Jan-

21

May

-21

Sep

-21

Jan-

22

May

-22

Sep

-22

1913

= 1

00

012345678

Dis

coun

t Rat

e (%

)

CPI PPI Discount Rate

November 1919 the Fed begins to increase interest rates.

June 1920, Discount Rate Reaches its peak of 7%

May 1921, Fed Begins to cut the discount Rate

Sources: Bloomberg, Bureau of Labor Statistics (BLS), National Bureau of Economic Research (NBER)

-38-

$38.93 billion in 1921, or nearly seven percent (6.93%). Outstanding loans decreased

from $31.19 billion to $29.24 billion, a similar decline of about six percent (6.26%).67

The Fed has often been blamed for keeping rates too high for too long. As the

graph shows, the Fed kept the discount rate at seven percent (7%) for nearly a year

while prices began to decline almost immediately. The Report of the Joint Commission

of Agriculture Inquiry stated:

Notwithstanding the apprehensions of the Federal Reserve Board and Federal reserve banks regarding the possible results in a change in policy [as regards discount rates], the commission is of the opinion that a more liberal policy could have been adopted in the latter part of 1920 and the early part of 1921 and that the adoption of such a policy would have served to arrest in part the tide of deflation and to reduce the hardships and losses incident thereto.68

Gustav Cassel, the famous Swedish economist of the period, held similar beliefs. He

argued that the maintenance of the discount rate at seven percent (7%) for caused an

“aimless increase in the internal value of the dollar.”69 He argued that if rates had been

reduced sooner, the depression that began with the price declines in 1920-1921 could

have been abated. Instead, the rapid price decline put the country into a severe but brief

recession with unemployment jumping from just above seven percent (7.2%) in 1920 to

over twenty-three percent (23.1%) in 1921 and GDP plunging to negative 4.24 percent

(-4.24%). Even with the implementation of a pro-growth tax reform by the Mellon

Treasury and the discount rate cuts beginning in June of 1921, which together spurred a

business expansion and caused a jump in GDP growth to seven percent (7.01%) in

1922 and over thirteen percent (13.46%) in 1923, unemployment remained high at

eighteen percent (18%) in 1922, before dropping again to its 1920 level of about seven

percent (7.2%) in 1923.70 American GDP growth can be seen in the table below:

67 All Bank Statistics, United States, 1896-1955, (Board of Governors of the Federal Reserve System, April 1959) p. 3468 Cited in Beckhart, p. 400.69 Gustav Cassel, Money and Foreign Exchange After 1914, (London: Constable and Co, 1922) p 23670 Douglas, Paul H., and Director, Aaron, The Problem of Unemployment (Macmillan Company, New York, 1931), p. 28.

-39-

Gross Domestic Product (Millions of 1929 Dollars)Year GDP YoY % Change Year GDP YoY % Change Year GDP YoY % Change1919 $70,2711920 71,383 1.58% 1930 91,513 -10.85% 1940 112,961 8.17%1921 68,355 -4.24% 1931 84,300 -8.56% 1941 126,237 10.52%1922 73,150 7.01% 1932 70,682 -19.27% 1942 122,571 -2.99%1923 82,994 13.46% 1933 68,337 -3.43% 1943 121,918 -0.54%1924 85,222 2.68% 1934 74,609 8.41% 1944 126,633 3.72%1925 87,359 2.51% 1935 85,806 13.05%1926 93,438 6.96% 1936 95,798 10.43%1927 94,161 0.77% 1937 103,917 7.81%1928 95,715 1.65% 1938 96,670 -7.50%1929 101,444 5.99% 1939 103,736 6.81%

Average 3.84% Average -0.31% Average 3.78%

Total growth

(since 1919) 44.36%

Total growth

(since 1929 2.26%

Total growth

(since 1929 24.83%

Yet this “monetarist” explanation of the price level rise and fall is not the only

theory purporting to describe the transition to the post war economy. Jude Wanniski in

The Way the World Works, has emphasized that the United States never left the gold

standard and the value of the dollar, therefore, remained legally fixed at $20.67/ounce.71

Consequently, Wanniski argued that it is difficult to see how the value of the dollar

declined in a monetary inflation. Instead, he asserted that increased war demand drove

up the value of goods and services in what can be thought of as a war-demand driven

inflation. It was not that the dollar became less valuable while goods and services

remained steady, but that certain goods and services became more valuable, while the

dollar remained steady, fixed at $20.67/oz of gold. This is a subtle argument, but an

important one. Following the armistice this war demand collapsed and prices weakened.

This war-demand-explanation is also supported by the fact that both the consumer price

index and producer price index were rudimentary at the time and heavily weighted

71 This rate actually did deviate slightly from this rate as monetary policies changed. Data pulled from Bloomberg indicates that from 1920-32 the dollar-gold price did move between $20.58/oz to $21.32/oz. In addition, just before the devaluation to $35/oz, gold was trading at $26.33/oz., well above its legal parity. Moreover, it should be noted that from the period 1917 – 1919, the U.S. enacted a “gold embargo” that suspended outflows of gold. While not technically a departure from the gold-standard, it did protect the existing gold-dollar parity, while also allowing the money supply to expand.

-40-

toward basic commodity prices, those most susceptible to major swings in supply and

demand. In fact, regular publication of the national CPI did not occur until 1921 after the

price declines. The United States Bureau of Labor Statistics conducted surveys of

family expenditures in 92 industrials centers from 1917 to 1919. The various weights

used to construct the CPI reflected the relative importance of goods and services

purchased by consumers. The CPI was made up of the following components: Food,

clothing, rent, fuels, house furnishings, and miscellaneous other goods with food getting

the heaviest weighting. More importantly, all CPI data prior to 1921 was based on

estimated city averages back to 1913 using food prices only. This is important because

food prices are traditionally some of the most volatility and hence will tend to

overestimate measurements of aggregate price movements for the earlier period.72

One way to test Wanniski’s theory is to examine relative price changes for select

goods. In a monetary inflation, the price of all goods and services should appreciate

proportionally, or at least roughly proportionally, as the value of the dollar decreases.

Conversely, if the price rise is driven by changes in demand, individual prices should

move separately. A closer look at price changes reveals some surprising support for

Wanniski’s argument. The following table is useful:

72 Bureau of Labor Statistics, Handbook of Methods, chapter 17, found at: http://stats.bls.gov/opub/hom/homch17_d.htm#17a – visited on 2-March 2006

-41-

Changes in post-war commodity prices in 1919Commodity Change since 1913Farm Products 116%Foods 94%Cloths and Clothing 110%Fuel and Lighting 78%Metals and Metal Products 70%Building Materials 73%Chemicals and Drugs 69%House Furnishings 65%Farming Commodity Index 121%Industrial Commodity Index 85%Wholesale Index 99%Retail Index 75%

This table reflects that prices did not move uniformly as is expected under a monetary

inflation. In the aggregate, the wholesale price indexed measured prices at ninety-nine

percent (99%) higher than in 1913 while retail prices were seventy five percent (74.75%)

higher. Moreover, there is a marked difference between the increase in the industrial

commodities index (PPI for industry inputs only) and the farming commodity index.

Industrial commodities in 1919 were about seventy-seven percent (77.31%) higher than

before the war while farming commodities were an astounding 107.78 percent

(107.78%) higher. Nor did prices rise uniformly between 1919 and 1920, the year of

greatest inflation that, according to the Monetarist explanation, was caused by Fed-

induced artificially low interest rates. The greatest price increase was in building

materials, which was 193 percent (193%) higher than before the war. This fact is

important because in the four years 1914-1918, building materials appreciated only

seventy-three percent (73%). The dramatic rise in the 1919-1920 year, however, is not

surprising as the sudden need to rebuild postwar Europe drove demand for building

materials. Prices sky rocketed. Wanniski’s explanation does not seem out of line

considering the disparate increases of the different product sectors.

Similarly, the price declines in 1921 were not uniform or regular but varied

significantly between industries.

-42-

Changes in post-war commodity prices in 1922Commodity Change since 1913Farm Products 22%Foods 31%Cloths and Clothing 76%Fuel and Lighting 95%Metals and Metal Products 12%Building Materials 57%Chemicals and Drugs 24%House Furnishings 78%Farming Commodity Index 31%Industrial Commodity Index 46%Wholesale Index 39%Retail Index 69%

Farm prices, which had aggregated the highest before the war, were depressed the

most and remained only twenty two percent above their pre-war level. Moreover, this

decline in farm prices continued throughout the decade as economies of scale and new

technologies enabled more production in the farming sector. Notably, fuel and lighting

actually increased from seventy-eight percent (78%) above pre-war levels in 1919 to

ninety five percent (95%) in 1922. A similar situation arose in house furnishing prices.

These price rises are not in line with a sudden and terrific monetary deflation. In fact,

except for the producers of metal products and chemicals and drugs, the decline in

prices occurred most acutely in the agriculture industry undergoing tremendous

changes. As the Federal Reserve Bulletin explained, farm price volatility is not

surprising:

The reason for this situation is not hard to find. Foodstuffs are peculiarly subject to the vicissitudes of the market. A relatively slight surplus will result in a disproportionately sharp drop in prices. On the contrary, scarcity in relation to demand will bring about a sharp rise. It was natural, therefore, that during the war prices of foodstuffs should advance out of relation to many other prices…Following the war the great increase in foreign demand for American products, coupled with active domestic buying, gave an enormous impetus to the rise in agricultural prices.73

By 1920 agricultural exports began to subside.

73 Federal Reserve Bulletin, (Federal Reserve Board of Governors: Washington D.C., 1922), pp. 262-263

-43-

Finally, a closer look at aggregate price level change provides further evidence to

the war-demand-inflation hypothesis. As the table below demonstrates, price level

change began to decline substantially in 1917 and then stabilized between June, 1918,

and November, 1919, at a range between two and three percent inflation on a year-over-

year basis (2-3% YoY).

In November 1919, when the Fed first began to tighten money supply by

increasing the discount rate from 4.5 percent (4.5%) to 4.75 percent (4.75%), the

inflation rate actually began to climb significantly. This is counter-intuitive under the

Monetarist framework. The annual rate of inflation, as measured by the wholesale index

(PPI), rose from 2.5 percent (2.5%) in November, 1919, to a staggering 24.5% in April,

CPI and PPI Changes

-60.00%

-40.00%

-20.00%

0.00%

20.00%

40.00%

60.00%

Jan-

14

Jul-1

4

Jan-

15

Jul-1

5

Jan-

16

Jul-1

6

Jan-

17

Jul-1

7

Jan-

18

Jul-1

8

Jan-

19

Jul-1

9

Jan-

20

Jul-2

0

Jan-

21

Jul-2

1

Jan-

22

Jul-2

2

% C

hang

e

0

1

2

3

4

5

6

7

8

Dis

coun

t Rat

e (%

)

CP YoYIPPI YoYDiscount Rate12 per. Mov. Avg. (PPI YoY)12 per. Mov. Avg. (CP YoYI)

August 17th, 1917 The Wholesale Price inflation began to subside dramatically.

November 1919 the Fed begins to increase interest rates.

June 1920, both Retail and Wholesale Prices begin to fall dramatically.

June 1921, Retail and Wholesale Prices both bottom

Sources: Bloomberg, Bureau of Labor Statistics (BLS), National Bureau of Economic Research (NBER)

-44-

1920. During the same period, the discount rate went from 4.5 percent (4.5%) to six

percent (6%). This rise in the rate of inflation is interesting because prices had been

relatively stable for the previous year during which the Fed kept the discount rate low at

the insistence of the Treasury. According to the monetarist argument, prices should

have continued their increase as excess liquidity added to the system. Instead, inflation

only increased again when the Fed began to raise the discount rate, which in their

framework should extract liquidity. Not until the final rate hike of one full percentage

point from six percent (6%) to seven percent (7%) in May, 1920, did prices being to

decrease.74 This rate hike, on top of the post war slow down, also drove the national

economy into depression, consequently causing prices to plummet as demand was

destroyed. Viewing the period as a whole, it appears obvious that the rate of inflation

was initially driven up by increased demand from Europe created by the war. This war

demand peaked in 1917, just after the United States declared war against Germany, and

then began a continual decline until January 1922. It is important to note that the

economy was healthy in 1919, with inflation running at approximately 2.5 (2.5%)

annually, unemployment at 6.9 percent (6.9%), and GDP growing at an annual rate of

10.8 percent (10.8%) or 8.3 percent (8.3%) in real terms.75 Prices were admittedly

higher than their 1913 levels, but their rate of increase had slowed substantially. The

economy as a whole in 1919 was stable until the Fed began to hike rates.

Measures of industrial production cycles also corroborate a war-demand-

inflation-hypothesis. Industrial production peaked in 1917 and then steadily declined

74 In light of this data, an argument can be made that the Fed’s rate hikes were actually inflationary in the short term as transactions were pushed forward as businesses tried to get “ahead” of future rate hikes. Eventually, however, the rate hikes drove the economy into recession, destroying demand and in this way causing prices to decline. In this case the Fed’s inflation fighting policy was very inefficient indeed. It can be equated to “running a treadmill backward,” as it does indeed stem inflation, but only by wrecking the economy.75 GDP data from Miron, Jeffrey A. and Christina D. Romer. "A New Monthly Index of Industrial Production, 1884-1940." Journal of Economic History Vol. 50, no. 2 (1990): 321-37; inflation rate from data gathered by BLS, unemployment information taken from SOURCE: Douglas, Paul H., and Director, Aaron, The Problem of Unemployment (Macmillan Company, New York, 1931), p. 28.

-45-

thereafter, a pattern consistent with the increase in prices and eventual stabilization as

discussed above. Industrial production measures are generally used to describe

economic health and to indicate changes in aggregate demand. Industrial production

declined some thirty-one (31%) between 1918 and 1920. This decline reflected the shift

from a war economy to a peace economy. The rise and decline in prices can therefore

be explained by changes in world demand. The largest annual increase in industrial

production was a thirty-two percent (32%) surge in 1917, which marked the height of the

war and the precise peak of the annual rate of inflation. What is more, a thirty-two

percent (32%) year-over-year increase is huge and could certainly cause a large spike in

prices. Just as important, industrial production slowed by over twenty-one percent

(21.2%) in 1920, which undoubtedly contributed to the decline in prices. See graph and

table below:

Year Industrial production (1916 =100) % YoY1916 1001917 132 32.00%1918 139 5.30%1919 137 -1.44%1920 108 -21.17%Source: Miron and Romer (1990, table 2).

-46-

In addition, by looking at unemployment data and the annual change in GDP, it

becomes clear that the American economy began a significant slow down after 1919.

The graphs below are helpful:

According to GDP data, growth began to decline as early as 1919, well before

the prices began to decrease. Once growth turned negative in early 1921, however,

both unemployment and prices began to react negatively. Unemployment rose

dramatically as prices fell and the nation proceeded into a horrible recession. More

importantly, however, the official beginning of this recession is January 1920, well before

YoY % GDP growth

-40.00%

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

1919 1920 1921 1922 1923 1924 1925 1926 1927 1928 1929

GDP CPI PPI Average CPI/PPI change

Unemployment Rate

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

1919  1920  1921  1922  1923  1924  1925  1926  1928 1929

Sources: Bloomberg, Bureau of Labor Statistics (BLS), National Bureau of Economic Research (NBER) Douglas, Paul H., and Director, Aaron, The Problem of Unemployment (Macmillan Company, New York, 1931), p. 28.

-47-

the decline in prices which began six months later in June of 1920. These statistics

support the argument that declining demand instigated the collapse of prices and that at

least part of change in money supply was due to the resulting decrease in the demand

for dollars.

Despite all this data, which seems to support both the Monetarist theory of

inflation and the war-demand-inflation hypothesis, it is, nonetheless, difficult to gauge

what drove aggregate price movements. Was money supply out of control as Friedman

and Schwartz claim or was the increase in the money supply only the natural adjustment

to the increased level of business and higher demand created by the war? In economist

jargon, was money supply really endogenous? Did the dollar’s value fluctuate

dramatically relative to steady commodities prices causing prices to change or did the

dollar remain fixed, as the legal gold parity of $20.67/oz. of gold implies, while other

goods became more or less expensive relative to the dollar according to their own

supply and demand issues that caused prices to change?

This controversy is illuminated by considering the accepted definition of inflation

and deflation. Since the 1920s economists have defined inflation and deflation through

reference to price indexes of one sort or another. Under this definition, inflation is

defined as a rise in prices, while a deflation is defined as a decline in prices. In general,

these same price level definitions have been used thus far in this analysis. However, the

classical definition of inflation is a decline in the value of currency and that of deflation is

a rise in the value of currency. In 1817, David Ricardo addressed this very issue:

It has been my endeavor carefully to distinguish between a low value of money and a high value of corn, or any other commodity with which money may be compared. These have been generally considered as meaning the same thing; but it is evident that when corn rises from five to ten shillings a bushel, it may be owing either to a fall in the value of money or a rise in the value of corn…The effects resulting from a high price of corn when produced by a rise in the value of corn, and when caused by a fall in the value of money, are totally different.76

76 David Ricardo, Principles of Political Economy and Taxation, (New York: Prometheus Books, 1996) p. 101

-48-

The real question of importance, therefore, is: Did the value of gold decline or the value

of goods and services rise?77

Clearly, the answer is both. The surge in demand created by the war certainly

played a hand in causing prices to rise. At the same time, the suspension of the gold-

standard throughout most of Europe caused instability in the world monetary system.

The huge increase in the supply of money and the manipulation of the discount rate by

the Treasury through controlling the Federal Reserve also had an impact on prices. In

fact, it appears that the money supply increased in 1920 as world demand began to

decline. The two forces were likely working in tandem to create the volatility in prices

that defined the maladjustment of the post-war period. This confusion between money

supply and real economic demand can be inferred through the decline in industrial

production, matched by the increasing money supply. The relationship is shown below:

Industrial Prodcution

0

20

40

60

80

100

120

140

160

1916 1917 1918 1919 1920

1916

=100

$0.00

$5.00

$10.00

$15.00

$20.00

$25.00

$30.00

$35.00

$40.00

Billi

ons

of $

Industrial production (1916 =100) Stock of money, M2 (billions of dollars)

To estimate the importance of money supply in explaining the changing prices of

the period, regression analysis can be used.78 It appears that, ceteris paribus, the

77 The dollar was pegged to gold, so a change in the value of the dollar was only possible if the value of gold changed.78 See Appendix D for the data output.

-49-

growth in deposits during the twenty two years 1914 – 1935 can explain just over fifty

percent (50.4%) of the movement of wholesale prices and about fifty-five (55.4%) of the

movement in retail prices. These results are significant to a high degree (1% confidence

level) and have been corrected for normal time series problems.79 It should be

acknowledged that changes in money supply are not exogenous from changes in

demand, however. The entire idea behind the creation of the Federal Reserve System

was to make the dollar supply more elastic to adjust to changes in the demand for

money. World War I was a large shock to the world economy and it drastically changed

the demand for and flow of goods and services. Some of the increase in money supply

was in response to the changed world economy and wartime demand. Nonetheless, it is

useful to see what the money supply alone implied for prices. The table below shows

the annual year-over-year change in the CPI predicted by changes in the money supply.

Actual vs. Predicted Price Level ChangesDate CPIYoY CPIhat +/- DepositsYoY PPIYoY PPIhat +/-1914 1.01% 2.46% -1.45% 5.56% -1.67% 2.72% -4.38%1915 1.00% 1.27% -0.27% 3.87% 1.69% 0.78% 0.92%1916 7.92% 11.78% -3.86% 18.81% 22.50% 17.89% 4.61%1917 17.43% 9.38% 8.05% 15.40% 37.41% 13.98% 23.44%1918 17.97% 3.58% 14.39% 7.15% 11.88% 4.53% 7.35%1919 14.57% 9.02% 5.55% 14.88% 5.75% 13.39% -7.64%1920 15.61% 5.68% 9.92% 10.14% 11.30% 7.96% 3.34%1921 -10.50% -6.33% -4.17% -6.93% -36.84% -11.60% -25.25%1922 -6.15% 2.69% -8.84% 5.89% -0.60% 3.09% -3.68%1923 1.79% 3.92% -2.14% 7.64% 3.59% 5.09% -1.50%1924 0.00% 4.23% -4.23% 8.08% -2.31% 5.60% -7.91%1925 2.34% 4.91% -2.57% 9.05% 5.33% 6.71% -1.38%1926 1.14% 1.39% -0.25% 4.04% -3.37% 0.98% -4.35%1927 -1.69% 1.50% -3.20% 4.20% -4.07% 1.15% -5.22%1928 -1.72% 0.33% -2.06% 2.54% 1.21% -0.75% 1.96%1929 0.00% -1.29% 1.29% 0.23% -1.80% -3.40% 1.60%1930 -2.34% 1.08% -3.42% 3.60% -9.15% 0.46% -9.61%1931 -8.98% -5.04% -3.94% -5.10% -15.44% -9.49% -5.94%1932 -9.87% -15.84% 5.97% -20.45% -11.11% -27.08% 15.97%1933 -5.11% -7.45% 2.34% -8.53% 1.79% -13.42% 15.20%1934 3.08% 6.59% -3.51% 11.43% 13.16% 9.44% 3.72%1935 2.24% 5.85% -3.61% 10.38% 6.98% 8.23% -1.25%

79 Durbin Watson test for autoregressive problems turned up negative. In addition, it was found that total growth in deposits and price level are co-integrated, meaning they move together over time. This result was found using the dickey-fuller test for cointegration.

-50-

With the understanding that changes in the money supply will reflect some of the

changes in business activity noted above, we can still examine the impact on prices of

money supply alone. In reference to the above table, it becomes clear that retail prices

should have risen at a much lower rate during World War I, and through 1920.

Moreover, the decline in prices in 1921-1922 appears overstated. The 6.5 percent (-

6.5%) retail price decline in 1922 should actually have been a 2.7 percent (2.7%) rise in

prices according to changes in bank deposits. There is a similar result on the wholesale

side of the equation. Prices increased during, and immediately after the war, at a much

faster pace than is predicted by money supply growth alone. In addition, the rapid and

dramatic decline in prices is not effectively explained by tighter money policy. The highs

and lows of annual price changes cannot be explained by changes in the money supply

alone. Clearly other forces, such as declining world demand for American goods and

services in the early 1920s (perhaps driven by Germany’s reparation problems) played

an important role in influencing retail prices both up and down to extreme levels.80

Without regard for the multi variable causes of the price decline, the fact that wholesale

prices decreased by thirty-seven percent (-37.22%) and retail prices by sixteen percent

(16%) in two years, dramatically worsened the already problematic indebtedness of

Europe. Suddenly, the complicated allied debts needed to be paid back in dollars worth

much more than they were worth when they were borrowed. The world economy stood

at a precarious position.

80 The German reparations will be examined in detail in Chapter Three.

-51-

Chapter 3:

International Finance – World War One and the International Debts in the 1920s

The First World War completely changed the structure of the international world

order. It created a decisive transition from the old guard order of the post Napoleonic

era to the modern era of American dominance. From a political point of view, the war

ended civilization’s experiment with Monarchy as a form of National government

organization. Facades of the old regime still remained in Britain, Italy, and Japan, but in

reality the world’s long experience with monarchial forms of government had ended.

The three major European empires were in ruins: the Hohenzollern’s in Germany, the

Romanov’s in Russia, and the Habsburg’s in Austria-Hungry. Similarly in the Middle-

East, the Ottoman Empire had fallen. England too began losing its dominance to

America.

The most important economic fact born out of the Great War, however, and that

which is focused on for the purposes of this paper, was the scale of international war

debts. Prior to the War, the United States was a debtor nation, borrowing foreign money

throughout its history. This debtor position was balanced by European’s large holdings

of American assets: stocks, bonds and real estate. World War I caused European

nations to begin to liquidate their American assets by selling off their American bonds,

property holdings, and stock investments in order to raise revenue for the war. Before

the war, American bankers borrowed heavily and became indebted to British bankers to

the extent of approximately $500 million.81 As war became increasingly inevitable, the

81 Benjamin Haggot Beckhart, Federal Reserve System, (United States of America: American Institute of Banking, 1972), p. 135 “Funds were customarily borrowed in the spring to pay for the seasonal rise in imports and were repaid in the fall thanks to the seasonal outflow of cotton and wheat. This practice enabled American banks to sell sterling at its seasonal high and buy it at its seasonal low. It had the important secondary consequence of reducing seasonal fluctuations in sterling exchange.”

-52-

Bank of England on July 27th 1914, ceased to accept time bills of exchange. While this

policy protected the Bank of England from potential losses on bills contracted with

parties in hostile nations, it also meant American bankers could not replenish their

deposits by buying sterling bills as was the normal practice. As a consequence, the

British Pound became scarce, relative to demand, and its price rose from $4.8820 on

July 25th to 4.9200 and then to 5.5000 by August 1. The New York Times reported “The

price of foreign exchange, the practical suspension of business on the London Stock

Exchange, and the settlement day were named as being responsible for the inability to

do business with England.”82

Quickly gold began to flow to the United States as sterling crossed above the

“gold-export point.” Under normal circumstances gold flows would balance the system,

by driving the dollar and sterling toward equilibrium, but as was reported on the front

page of The New York Times: “KAISER CALLS RUSSIA TO HALT WITHIN 24 HOURS;

IF SHE REFUSES GERMANY, TOO, WILL MOBILIZE; ENGLAND AND FRANCE

READY, BUT HOPE FOR PEACE; AUSTRIANS DRIVE SERBIANS BACK FROM

BELGRADE,” the world was on the eve of a confrontation of enormous scale. 83 It

seemed as if all of Europe began to dump its holdings of American Securities in

preparation for war. On July 31, after approximately 1.3 million shares were sold on July

30 in a collapse not seen on the Exchange since the bank failures and panic of 1907, the

New York Stock Exchange was closed.84 The decision came after a meeting at J.P.

Morgan and Company that included Benjamin Strong Jr., then Vice President of Bankers

Trust who would go on to become governor of the Federal Reserve Bank of New York

following the war. The exchange did not reopen on an unrestricted basis until April 1,

82 The New York Times, July 25, 191483 The New York Times, June 30 1914. This confrontation was certainly not assumed in the contemporary mindset, but clearly circumstances were anything but “normal.”84 “Bankers Here Confer on War” New York Times, July 31st 1914, p. 1

-53-

1915,85 eight months later. By November, the premium on sterling had disappeared and

the pound was pegged to the dollar through J.P. Morgan & Co. at $4.76, based on the

new British gold-exchange point, where it remained until March 21, 1919, when the peg

was removed.

As the war got underway, the United States became the primary supplier of both

money and goods to the rest of the world. There was a dramatic, immediate and rapid

expansion of demand for foodstuffs, chemicals, explosives, and industrial products,

which led to an equally rapid increase in American production along with general prices.

Between 1913 and 1917, production, as measured by economist Wesley Clair Mitchell,

rose fourteen percent (14%). Exports rose 260 percent (260%) from $2.4 billion to $6.2

billion. Imports rose nearly 100 percent (100%) from $1.8 billion to $3.0 billion. Over the

three years ending June 1917, shipments of wheat increased by 680 percent (680%),

wheat flour by 200 percent (200%), meat by 240 percent (240%), sugar by an

astounding 3,380 percent (3380%) and zinc by 3,700 percent (3700%).86 The calendar

year 1915 marked the first time in history that exports outpaced imports in excess of

one-billion dollars. By 1916, exports exceeded imports by more than three-billion

dollars. The rising importance of net-exports is illustrated in the table below:

Table: Net Exports (in $ millions)Year Exports Imports Net1913 2.5 1.8 0.71914 2.1 1.8 0.31915 3.6 1.8 1.81916 5.5 2.4 3.1

Source: Lewis, C. America's Stake in International Investments, Brookings Institution, Washington D.C., 1938

85 “New York Stock Exchange Special Closings, 1885 – present” available at http://www.nyse.com/pdfs/closings.pdf or via www.nyse.com. Visited on March-25, 2006. The exchange was re-opened for bond trading with special price restrictions as early at November 28th 1914. A limited number of stocks were re-opened to trading, again under price restrictions, on December 12th and then all stocks were opened with price restrictions on December 15th.86 74 Cong. 2 sess., Munitions Industry, Hearings on S. res 206 before Senate Special Committee Investigating the Munitions Industry (1937), Part 26, p. 7934. The increases for individual commodities reflect both price increases and increased volume of exports.

-54-

This surging foreign and domestic demand for goods caused the fourteen percent (14%)

up-tick in production as the war progressed, but once production reached capacity,

prices were adjusted aggressively upward as has been discussed in Chapter 2.

At first the world paid for this surge of goods from the United States by canceling

the some $400 million in debts of American banks and businesses.87 As the War

escalated, however, Europeans sold bonds to Americans in order to finance the rising

costs. The Allies began to export gold, float loans and either sell holdings of American

assets or collateralize those assets for additional loans. During the first months of war

the State Department was reluctant to lend to the European belligerents. U.S. Secretary

State, William Jennings Bryan, stated in a letter to J.P. Morgan & Co., “in the judgment

of this government loans by American banks to any foreign nation which is at war are

inconsistent with the true spirit of neutrality.”88 Yet banks soon found a way to appease

the government and continue to extend loans to Allies. In October, 1914, National City

Bank extended a five-million dollar loan to Russia and a ten-million dollar loan to France

by accounting for the loans as credits extended in connection with legitimate trade. In

early 1915, J.P. Morgan & Co. made similar open “credit” issuances for the British and

French governments. By June, 1915, following Secretary Bryan’s resignation from the

State Department, the distinction between credits and loans was abandoned by the

American government and in October a $500 million “loan” was offered to the American

public by J.P. Morgan on behalf of the British and French governments. By April 5,

1917, as the US Congress was declaring war on Germany, the outstanding debt to

European belligerents from private American banks and businesses totaled $2.6715

87 “Yearbook of the United States Department of Agriculture,” 1915 (Washington D.C., Government Printing Office, 1916) p. 10.88 Munitions, Hearings, Part 30 pp. 9644-45; can also be found at http://www.lib.byu.edu/~rdh/wwi/1915/usloans.html , visited on 26th-Feb.-2006 At the time, Byran was heartily against entering the war and was battling with Wilson, who wanted to join the allies.

-55-

billion.89 Approximately eight-four percent (84%) of these foreign dollar loans were for

national governments, with the rest for provincial and municipal government as well as

corporations. Regardless of the issuer, however, the purpose of the loans was

consistent: to finance the expanding purchase of American goods. The distribution of

these credits can be seen below:

Table: Credit Extension before entrance into WWI (in $ millions)

Borrowers Short Term (<5years)Long Term (>5years)

France and Great Britian $2,101.6 N/ARussia and Italy $75.0 N/ACanada and Australia $135.1 $269.6Subtotal $2,311.7 $269.6Germany $7.5 N/AEuropean neutrals $7.0 $5.0South America $27.5 $28.3Other Latin Americas $6.7 -$3.5Other Countries $7.8 $3.9

Total $2,368.2 $303.3Source: Lewis, C. America's Stake in International Investments,

The United States gained over $1 billion in gold at $20.67/oz, giving America

approximately a third of the world’s reserves.90

Benjamin Strong, now head of the New York Federal Reserve Bank, summarized

the transition of financial power from London to New York in a speech given at the

London Clearing Banks dinner on March 10, 1916:

This War might entail tremendous sacrifices upon the English people, including the bankers, and if it involved the surrender of some of the world’s banking to New York, at least we believed that it would be surrendered upon fair terms, on fair competition, and that some of us felt that if this great sacrifice had to be made, England, which had established the standard of commercial honor and integrity throughout the world, would rather relinquish this great trust into the hands of those who spoke their own language and who believed in the same institutions, and had, I hoped, the same high ideals of honor and integrity.91

89 Lewis, C. America's Stake in International Investments, Brookings Institution, Washington D.C., 1938. Equivalent to approximately $45.287 billion in 2005.90 “Banking and Monetary Statistics 1914-1970” Section 14: Gold, (Board of Governors of the Federal Reserve System, April 1959) 91 Benjamin Strong, Diary, March, 10th, 1916, reporting speech at London Clearing Banks dinner, File 1000.2, Benjamin Strong Papers, Federal Reserve Bank of New York.

-56-

The war reversed the financial world order with New York, not London, at its center.

This fact was enforced when Congress declared war against Germany in April, 1917,

and the American government began to lend directly to the Allied nations. The United

States became, for the first time in its history, a net creditor rather than a net debtor

nation. Treasury Secretary McAdoo authorized the first “Liberty Loan Act” on April 24,

1917, allowing the Treasury to purchase foreign governmental obligations for countries

at war with Germany. The following day, McAdoo wrote a check to the British

government for $200 million. By the end of the year, $3.7 billion had been issued to the

Allies. The Liberty Loan Act limited the maximum amount of credit that could be

extended to foreign governments to $10 billion. By the end of 1922, after the last

government check was paid out on May 29 under a credit established much earlier, total

outstanding US government credit to the “rest of the world” was $9.387 billion.92 Of this

$9.387 billion in outstanding debt, $4.137 billion was extended to Britain, $2.933 billion

to France, and $1.648 billion to Italy. The total extent of the war debts was astounding.

Germany was easily the largest debtor with eleven creditors, while the U.S. was the

largest creditor with sixteen debtors. Britain and France had seventeen and ten debtors

apiece, while even the small net debtors, such as Czechoslovakia, Hungary, and

Bulgaria, were each under obligation to nine or ten creditors.93 When reconstruction

loans are included France’s combined public debt to the United States reached $3.5

billion. Total public credit extended by the United States at the end of the war, including

war reconstruction loans, was at least $12 billion.94 The entire world was interconnected

by this complex network of obligations and much of the risk had been sold to the

American people through the capital markets.

92 Combined Annual Reports of the World War Foreign Debt Commission, Fiscal Year 1922-26, Washington, Government print. office., 1927. Equivalent to $97.166 billion in 2005 dollars.93 H.G. Moulton and L. Pasvolsky, War Debts and World Prosperity (Washington D.C., The Brookings Institute: 1932) p. 5 94 Lewis, p. 368, 375; Derek H. Aldcroft, From Versailles to Wall Street, (Los Angeles: 1977) p. 78 – 80

-57-

In addition, debt came from the private sector to help recapitalize Europe, further

involving American businesses. Agricultural output was far below pre-war levels in

Europe and capital equipment and transportation systems had been run down or

destroyed. The continent in particular was in desperate need of food, raw materials and

manufactured goods, but had no foreign exchange with which to purchase them. On

January 12, 1920, The New York Times reported:

URGES PRIVATE LOANS TO HUNGRY EUROPE: ECONOMIC ASSOCIATION COMMITTEE SAYS CHAOS MUST BE AVERTED, EVEN FOR

SELFISH REASONS.

“Without food and raw materials,” says the committee’s report, “Europe may fall into chaos which may react upon us, industrially and perhaps politically. Europe

must have our goods and to get them she needs our credit.”

“But for purely selfish reasons we must lend. In order to balance our international debts and credits, the courses before are to curtail exports, increase

imports or to lend.”95

Members of the committee referred to in the article included Thomas W. Lamont of J.P.

Morgan & Co., David Friday of the University of Michigan, A. Barton Hepburn of the

Chase National Bank, F.W. Taussig of the Tariff Commission and of Harvard University,

and Elisha M. Friedman of the War Finance Corporation.96

Between 1919 and 1920, continental Europe imported $17.5 billion worth of

goods, while only exporting $5 billion. The majority of the financing came from loans for

reconstruction, of which at least eighty percent (80%) came from the United States. For

example, starting in 1919, Baldwin Locomotive Works sold $11.6 million worth of

engines to Belgium. Baldwin Locomotive and American Locomotive companies sold

engines to Poland, Rumania, Argentina, Mexico, China, and Columbia. By the end of

1922, Baldwin, American, and Standard Steel held over thirty million dollars worth of

foreign treasury notes. American Engineers and construction companies in the U.S.

also received large contracts from overseas, often doing work on credit because

95 The New York Times, January 12th, 1920, pg. 296 As an aside, A. Barton Hepburn graduated from Middlebury College in 1911.

-58-

Europeans did not have the dollars to pay. For example, in 1920 the American

International Corporation Stone & Webster group, along with Ulen Contracting Co,

received $2.253 million in Bolivian government notes for the construction of sanitation

works in La Paz and Cochabamba. These bonds were then publicly sold to the

American public in 1921. While not directly related to reconstruction in Europe, these

investments in South America and elsewhere reflect the increasingly international scope

of American financing. The world debt structure became increasingly entangled among

many different nations, but always included the United States government and, more

importantly, its people and businesses as its center. The same group also received a

seven billion dollar deal to build a railway 128 miles long paid for with eight percent (8%)

Bolivian government bonds. In China the Federal Telegraph Company was contracted

to build radio stations in 1921 and were paid with eight-percent (8%) Chinese

government securities worth $6.5 million.97 Besides dollar loans, three other forms of

foreign assets were acquired by Americans following the war. Quotas on treasury bills,

issued in dollars by the British and French governments were absorbed by New York

companies. Huge blocks of foreign currency loans and shares of foreign corporations

were brought to America for sale between 1920 and 1924. Unsold portions of loans

from Britain, Argentina, Australia, Brazil, Colombia, Dutch East Indies, Japan, Palestine,

Peru, and Rumania all found markets in the United States. Purchase of foreign stock by

Americans totaled no less than $67 million. Short term credits were also extended to

foreign governments and companies by American banks and businesses. Outstanding

credit amounted to between $600 million and $1 billion by the close of 1924.98

Before the war, in 1914, American investors held less than $1 billion in foreign

securities. By December 1924, private American holdings amounted to approximately

97 These numbers indicate fair value not market value.98 Lewis, p. 360 - 375

-59-

$4.6 billion, roughly 5.4 billion when including short-term credits. When combined with

the aggregate government holdings of foreign obligations of $11.9 billion, the real picture

of America’s risk exposure to the “rest of the world” becomes apparent. In only ten

years, the United State government and its citizens had acquired at least $17.3 billion

worth of foreign securities, an amount fifteen times as great as that accumulated during

the preceding 130 years. America’s position in the world financial network was

extraordinary. In affect, America was funding the purchases of its own goods abroad by

extending new credit lines so that the rest of the world could then meet the interest and

principle payments due from the previous American loans extended during the war. The

importance of a sound repayment system for inter-allied war debts was increasingly

essential to avoid world wide economic disaster.

On top of this, Britain, which was the single largest debtor to the United States

with a total $4.7 billion debt to the United States, was due an additional $11.1 billion from

the rest of Europe.99 It is important to realize that much of this Allied debt, especially in

the case of England, was in the form of worthless Tsarist bonds. The size and scope of

the Russian debt is unaccounted for, although in the case of Britain, it was carried for a

number of years on the official books as an unfunded obligation of more than one-billion

pounds sterling or $4.86 billion at an exchange rate of $4.86/pound. This number,

however, is likely understated. Beginning with the budget of 1918-19, the British

Chancellors of the Exchequer followed the practice of counting debts due from Allies at

one-half of their face values.100 In consequence, defaulted Russian debt may have been

in the order of $9 billion for Britain alone. According to a letter from British Secretary of

State for Foreign Affairs, Arthur J. Balfour, to the French ambassador in London,

Britain’s total loans to her Allies were more than double her borrowings from the United 99 Derek H. Aldcroft, From Versailles to Wall Street, (Los Angeles: 1977) p. 78 – 80; Jude Wanniski, The Way The World Works, (New York: 1978) pg. 117100 F.W. Hirst and J.E. Allen, British War Budgets, 1926, p. 204-205. Also see Moulton, War Debts and World Prosperity, p. 110.

-60-

States. This horribly entwined nature of the debts was disastrous with Britain and

France owing the majority of debt to the United States and with the “rest of the world”

owing just as much or more to Britain and France. In effect America’s exposure to credit

risk was leveraged like never before. Total inter-Allied war debts amounted to

approximately $26.5 billion, owed almost exclusively to the United States and Britain,

with France as the largest net debtor.101

To make matters worse, the Allies forced Germany to agree to approximately

$33 billion in reparations through the Treaty of Versailles.102 Article 231 of the Treaty of

Versailles, the “war guilt clause,” held Germany solely responsible for the “loss and

damages” suffered by the allied forces, including calculations for veterans’ pensions. In

essence, the Allies sought to have the Germans pay off their debts. From their

perspective, Germany had remained mostly unharmed from the war, which was fought

almost entirely on French soil. The sum of $33 billion was estimated to be seven

percent (7%) of prewar German GNP, not an obnoxious amount.103 Even those who

disagreed encouraged a quick ratification of the Treaty. Benjamin Strong, for example,

reasoned that the continuation of a technical state of war would cultivate persistent

uncertainty about European conditions among American businessmen and financiers.104

Such uncertainty would discourage private American investment, which Strong saw as

the only possible road to long term reconstruction. As was established above, the

American people did play a significant role in rebuilding Europe. The unreasonableness

of the German reparations was thought of as a temporary and acceptable “imperfection.”

Some of Germany’s negotiating economists also advised a quick acceptance of the

Treaty. Carl Melchior of M.M Warburg & Co argued,

101 Aldercroft, p. 79102 In 1921, the Reparations Comission announced the sum of German reparations, totaling $132 billion gold marks plus a variable payment equal to twenty-six percent (26%) of Germany’s exports.103 Wanniski, p. 128104 Benjamin Strong, for his part, opposed the Carthaginian peace, but supported instead a more moderate reparations agreement and a cancellation of the Allied debts.

-61-

We can get through the first two or three years with the aid of foreign loans. By the end of that time foreign nations will have realized that these large payments can only be made by huge German exports and these exports will ruin the trade in England and America so that creditors themselves will come to us to request modification.105

Regardless of Germany’s ability to pay, the principal beneficiaries of these

reparations were Britain and France. The United States did not claim a share.

Indirectly, however, America assumed most of the risk because of the extensive

indebtedness of Britain and France to the United States. Moreover, officially the United

States denied any connection between the reparations and the war debts. While it might

have simplified the process if America accepted payment directly from Germany, the

United States refused to entertain such an idea.106 As a result, both Britain and France

began payment of war debts on schedules lasting until 1984 and 1987 respectively. All

the strings of the international monetary system were attached and entwined. A house

of cards was slowly being built with American at the top with the longest way to fall.

Initially Germany did meet its obligations, but its ability to do so rapidly

deteriorated by the end of 1921. Germany had made an initial payment of $250 million

financed simply by printing reichsmarks and using them to buy foreign currency. This

was a pure monetary inflation. The market was flooded with money without any

increase in the underlying economy. The excess liquidity in the absence of any real

growth created a sharp rise in prices. The obligation to make cash payments led the

government to begin selling large blocks of paper marks to foreigners, exporting almost

entirely Germany’s foreign exchange and gold reserves depleting the base for its

currency. The German government simply printed money to pay off its debts, and

created the hyper-inflation of 1922-23. Total reichmark supply came to four-quintillion

(RM 4,000,000,000,000,000,000) before stabilizing at one-trillion paper marks to one

105 Viscount Edgar Vincent D’Abernon, An Ambassador of Peace, (London: 1929) Vol. 1, p. 194, Readers should also acknowledge the importance place on trade, particularly the ability to export for debtor nations, in paying off debts. This would come to be the source of anxiety about the American Smoot-Hawley tariff bill in 1929.106 Fearon, p. 82

-62-

gold mark. All internal debt was inflated away, but the international reparations

remained the same, as they were denominated in gold reichmarks.107

By January, 1923, the Reparations Commission realized that Germany was in

default. The Allies hand was forced and a new reparations scheme needed to be

established. A Reparations Commission created two committees of “non-political”

experts to examine possible solutions. The committee in charge of creating a new

payment schedule was headed by Chicago banker Charles C. Dawes. In April, 1924,

the Dawes committee presented the “Dawes Plan” to the Commission, which accepted it

and put it into action in September 1924. It reduced annual payments to one-billion

marks for the first year, rising to 2.5 billion marks per year over a period of four years. In

addition, the Reichsbank, Germany’s central bank, was reorganized under the

supervision of an “Agent General for Reparations.” This Agent was S. Parker Gilbert,

who was then undersecretary to Andrew Mellon in the US Treasury and the real

mastermind of the “scientific taxation” put into place throughout the 1920s in America.108

Finally, as a part of the plan, American banks underwrote an international loan of 800

million gold marks that was floated to help Germany readjust from hyperinflation and

rejoin the now U.S.-led gold standard. The plan restored confidence in the German

system and large amounts of capital began to flood the German market through foreign

direct investment (FDI), enabling reparation payments to run smoothly. With German

payments made in full between 1924 and 1925, Britain and France paid their debts to

the United States. The fragile system wavered but the Dawes plan kept it standing for

the time being. This “repayment,” however, was essentially financed, first by the

American banks through the Dawes loan, and then by the American people when the

loan was securitized and sold through the capital markets. The necessity of restoring

107 Wanniski, 129108 See Chapter One for a full account of the Mellon tax reform and Gilbert’s role therein.

-63-

Germany’s payments can be perceived in the words of Charles Evans Hughes,

Secretary of State, who told Poincaré regarding the Dawes Plan: “Here is the American

policy. If you turn this down, America is through.” Hughes went on to stress that the

Coolidge administration backed the plan so devoutly because the United States was

“vitally interested [in] economic recovery abroad.”109 The reasons for this “interest” are

obvious. A European economic failure would collapse the world financial system and

America would tumble from its position atop the delicate system.110

With the execution of the Dawes plan and the restoration of the German

currency, Americans became increasingly optimistic about foreign investment

opportunities on a whole. The higher yielding issuance of foreign obligations gained

favor on Wall Street. Loans for “productive purposes,” for highways, railways, public

utilizes, sanitation works, apartment houses, school, churches, etc., all flooded the

American market between 1925 and 1929. According to testimony before the Senate

Committee on Finance, there were twenty-nine representatives of American banks

bidding for loans to Columbia’s national government alone. Thirty-six were recorded

competing for a city of Budapest loan and fourteen for a loan issued by Belgrade.111 It

was not only banks that were investing abroad with increasing optimism. The big

American construction companies began to finance public works abroad. Ulen and Co.

financed and built public works throughout Greece in Athens and Piraeus. They also

built stockyards, tramways, gas and waterworks systems in Warsaw, Poland as well as

instigated projects in Turkey, Chile, and Colombia. Warren Bros. began building roads

in Argentina, Chile, Colombia, Cuba, and Guatemala. A loan was extended to the

Uruguayan city of Montevideo to extend a seacoast boulevard, develop beach front and

109 Houghton Diary, August 20, 1924, file 176-27, Houghton Papers.110 Fearon, p. 82; Aldcroft, p. 84-86; Wanniski pg. 129; Frank Costigliola, Awkward Dominion, (London: Cornell University Press, 1984) p. 114-116111 72 Cong. I session, Sale of Foreign Bonds or Securities in the United States, (1932), Hearings on S. res. 19 before Senate Committee on Finance, p. 1324.

-64-

widen streets. Loans such as these created a huge market for American goods and

services abroad and drove both U.S. and foreign economic growth. Road building

contracts created demand for steam shovels and grading machinery as well as for

cement and asphalt. Sanitation, gas and waterworks systems created demand for metal

piping and plumbing. Railway development called for steel production, engines and

cars. Foreign employment of American engineers increased. Lending helped spur on

other parts of the economy too, although less directly. Commodities of all kinds

boomed. This economic boom, however, was created by importing international risk and

selling it to the American people through the financial markets.

The public readily understood this aggressive foreign investment and perceived

its risks. Thomas W. Lamont of J.P. Morgan & Co. advised against “indiscriminate

lending and borrowing,” Which he perceived amongst his peers and competitors. On

October 13, 1927, Agent General for Reparations, Gilbert, issued a public warning

against further loans to Germany. Nevertheless, Americans continued to invest abroad,

particularly in Germany where investment in excess of repayments amounted to $379.2

million in 1927-1929.112 In total, Americans floated $5.1 billion of foreign dollar loans in

the United States by 1929. The yearly breakdown of net American foreign investment is

shown below, followed by a breakdown by country. In the 1920s, Germany, the nation

at the very heart of the international debt structure, became the largest international

borrower of American credit by a factor of more than two. This was the only way, bar a

large increase in German exports, that Germany could continue to pay its reparations to

England and France who in turn could then repay the United States.113

112 Lewis, p. 380113 Lewis, p. 393

-65-

Table 3 Table 4

YearForeign Investment

(in $millions)1925 $712.51926 $686.01927 $1,010.71928 $677.21929 -$101.01930 $537.01931 -$176.41932 -$284.31933 -$308.11934 -$539.21935 -$230.9

Source: Lewis, p. 393

Table 4

CountryForeign Investment

(in $millions)Germany $842.5Canada $370.8Italy $297.7Australia $217.6Chile $184.2Argentina $180.2Brazil $178.0Colombia $150.8Japan $148.2Poland $102.1

-66-

Chapter 4:

Federal Reserve Policy after 1921 and the Era of Price Stability

Price levels stabilized following the dramatic inflationary, then deflationary,

movements during and immediately following the war.114 By 1922, both wholesale and

retail prices had found a new level, and the Fed had lowed the discount rate back to 4.5

percent (4.5%), precisely where it was before the rate hikes began in November 1919.

The following two graphs help illustrate the price level for this period. The first shows

prices relative to their pre-war, 1913, level through the end of 1929. The second

demonstrates the annual rate at which prices changed following their post-war

adjustment.

114 These movements are covered in detail in Chapter Two.

-67-

CPI and PPI Changes

0

50

100

150

200

250Ja

n-14

Jan-

15

Jan-

16

Jan-

17

Jan-

18

Jan-

19

Jan-

20

Jan-

21

Jan-

22

Jan-

23

Jan-

24

Jan-

25

Jan-

26

Jan-

27

Jan-

28

Jan-

29

1913

= 1

00

012345678

Dis

coun

t Rat

e (%

)

CPI PPI Discount Rate

Sources: Bloomberg, Bureau of Labor Statistics (BLS), National Bureau of Economic Research (NBER)

January 1920, official beginning of economic contraction

July 1921, official end of economic contraction

May 1923 official beginning of economic contraction

July 1924, official end of economic contraction

October 1926 official beginning of economic contraction

November 1927, official end of economic contraction

August 1929, official beginning of economic contraction (Great Depression)

Sources: Bloomberg, Bureau of Labor Statistics (BLS), National Bureau of Economic Research (NBER)

CPI and PPI Changes

-60.00%

-40.00%

-20.00%

0.00%

20.00%

40.00%

60.00%

Jan-

14

Jul-1

4

Jan-

15

Jul-1

5

Jan-

16

Jul-1

6

Jan-

17

Jul-1

7

Jan-

18

Jul-1

8

Jan-

19

Jul-1

9

Jan-

20

Jul-2

0

Jan-

21

Jul-2

1

Jan-

22

Jul-2

2

% C

hang

e

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

Dis

coun

t Rat

e (%

)

CPI YoYIPPI YoYDiscount Rate12 per. Mov. Avg. (PPI YoY)12 per. Mov. Avg. (CPI YoYI)

-68-

These graphs illustrate a number of important points. First, the second graph

indicates that prices were relatively stable after the price declines during 1921-1922.

Wholesale prices oscillated between +/- 5 percent (5%) while retail prices were more

stable. On the whole, prices trended down slightly, with wholesale prices 5.2 percent

(5.2%) lower in 1929 than in 1923. Second, both graphs show that the Fed was relatively

active in moving the discount rate in response to economic activity. The Fed cut rates

after the beginning of a recession and raised them during the periods of strong growth.

Various factions within the Federal Reserve coarsely debated Federal Reserve

policy throughout the 1920s. The resulting strategy was the result of a monetary

learning process, while two separate theories struggled for dominance. With the

collapse of the international gold standard in World War I, two divergent views emerged

within the Fed concerning the appropriate role of monetary policy. New York Fed

Governor, Benjamin Strong, who increasingly became the “face of the Fed” in the 1920s,

argued for price stability and the use of open market operations. Until Strong’s death in

1928, open market operations offset gold inflows and stabilized the level of bank

reserves. An opposing view, taken by the Federal Reserve Board under the influence of

Adolph C. Miller and economist W.W. Stewart, supported the “real-bills” doctrine which

advocated discount rate changes rather than open market operations. This doctrine

argued that changes in the discount rate should be determined on a discretionary basis.

This “soft” rule for monetary policy held that credit should be extended or withheld based

on the extent of “unsound” credit within the banking system. That is, so long as money

was being extended into “real” business activity as opposed to “speculative” activity, the

discount rate need not to be changed.115

Under the guidance of economist Irving Fisher of Yale University, an active group

of private individuals, including economist John Commons, began to form “Stable Money

115 Fearon 76-85; Alan Meltzer, The History of the Federal Reserve, Vol. 1 (London: 2003) Chapt. 4

-69-

Associations” in order to lobby for price level stability.116 Fisher was one of the first

economists of what is now called the “monetarist” school. During the same time, in

Congress, a number of politicians representing agricultural states began to focus on

price level stability as well. During this period American farmers suffered from lower

and lower prices. In 1926, the advocates of stable money, led by Representative James

Strong of Kansas, introduced a bill that required the Federal Reserve to make price

stability its principal goal. Hearings were held during 1926-27 and in 1928. John

Commons and Irving Fisher argued in support of the “Strong Bill,” as it came to be

called, pointing to Governor’s Strong success in stabilizing the price level by stabilizing

bank reserves after 1922.117 The bill sought to establish the price level policy of the New

York Federal Reserve under Benjamin Strong throughout the entire system.

Governor’s Strong’s policy of open market operations and price stability was

formed through a process of trial and error. The impact of open market operations on

the money supply was discovered accidentally following the 1921 recession. Prior to

1922 Federal Reserve banks executed open market operations in an uncoordinated

manner through the independent action of individual Federal Reserve officials, who

regarded the Reserve System banks more as a source of revenue than as a monetary

tool for regulating reserves and controlling the money supply. The sharp decline in

member-bank barrowing from 2.8 billion immediately after the war to $1 billion in 1922

occurred as a result of the sharp recession of 1921.118 Higher interest rates during the

recession attracted an inflow of gold stock as foreigners liquidated their borrowings,

increasing gold reserves by $800 million. The simultaneous slowdown in business

116 Fisher, Irving, “Discussion by Professor Irving Fisher.” The Annals of The American Academy of Political and Social Science, (January 1934), pp. 150-151117 Readers should realize the “Strong” bill was named such because of Rep. James Strong who proposed the bill, not Fed Governor Benjamin Strong who supported it.118 Beckhart, 1972

-70-

activity caused a rapid decline in circulating money totaling approximately $1.1 billion.119

As borrowing decreased and the economy slipped further into recession, the discount

rate was allowed to come down from its high of seven percent (7%) in May 1921. It

continued to be cut throughout the remainder of 1921 until the rate reached four percent

(4%) in July 1922.120 The combination of a decline in borrowing and rates began to

erode the earnings of the Reserve banks. Net earnings in 1922 were 61% lower than in

1921.121 The banks that suffered the worse were those in metropolitan areas,

particularly the New York City and Chicago Reserve banks. Strong described the

situation during the Strong Bill hearings before Congress in 1926:

…in the latter part of 1921 and early 1922, the member banks had liquidated so large a portion of their discounts [borrowings] at the reserve banks that there was some concern felt by some of the Federal reserve banks as to their earnings…I think I should state very frankly to the committee that many directors, of many of the reserve banks, strongly held the feeling that a part of their duty was to earn enough to pay expenses…122

In response to these circumstances, Strong initiated a policy at the New York

Fed began of purchasing government obligations. Other reserve banks acted similarly,

but all purchases were done individually and according to each bank’s own initiative.

Significantly, a need for income, not business activity, motivated these purchases.123

The Treasury complained about these actions because of the effect on interest rates,

which made it difficult for the Treasury to determine the appropriate coupon for the

issuance of new debt. During the period, Federal Reserve holdings increased 85.1

119 Banking and Monetary Statistics (Washington, D.C.: Board of Governors of the Federal Reserve System, November 1943), p. 369; and Federal Reserve Bulletin, 1923 – cited liquidation of foreign borrowings as cause of gold stock increase.120 NBER, SERIES: 13009, can be found at: http://www.nber.org/databases/macrohistory/contents/chapter13.html?tools=printit visited in 4th March 2006.121 Ninth Annual Report of the Federal Reserve Board Covering Operations for the Year 1922 (Washington, D.C.: Government Printing office, 1923) pp. 18-25122 Stabilization, pt. 1. Formal title of hearings before the Committee on Banking and Currency, House of Representatives, 69th Cong. 1st Sess., Washington, D/C: Government Printing Office, March, and April 1926, pg. 309123 Operation of the National and Federal Reserve Banking System, Hearings before a Subcommittee of the Committee on Banking and Currency. U.S. Senate, 71st Cong., 3rd sess. Pursuant to S. Res. 71 Appendix, Part 6. Federal Reserve Questionnaires (Washington D.C.: Government Printing Office, 1931) pp. 799 – 811.

-71-

percent (85.1%), with the majority of the increase coming in short term Treasury

Securities.124 Strong again commented in 1926:

So that in that period [1921] the reserve banks, being autonomous and having the power to invest money, were making considerable investments in the market, buying bills and buying Government securities. It was found that in that actual execution of the orders, and in the effect upon the price of Government securities in the market, there seemed to be some cause for complaint in the Treasury.125

In response, Strong formed a committee (OMIC) of regional Fed governors to coordinate

purchases of government bonds. He explained:

…So, in May of 1922, at a meeting of the governors of the reserve banks, it was decided to get some sort of supervision of the way this was done, so as to satisfy the Treasury and equally so as to have more orderly procedure. A small committee was appointed to deal with the matter…126

Carl Snyder, a statistician and economist under Governor Strong at the Federal Reserve

Bank of New York from 1920 to 1935, attributed Strong’s monetary policy to Strong’s

experience in 1921 and 1922. Snyder argued that Strong believed that it was the open

market purchases of government obligations in 1921, albeit done arbitrarily at the time

and for reasons of financing only, that actually brought the economy out of recession:

Towards the end of 1921 several Reserve Banks found themselves facing a deficit…So to acquire some earning assets, they began considerable purchases of government securities. Within six months the fall in prices had stopped, business began to recover and confidence returned. A…result which did not escape the attention of careful observers, and most noticeable of Governor Strong.127

Synder goes on to attribute Strong’s reaction to the economic slowdown in 1924

to his experience in 1921. Synder stated “in 1924, not as a means of meeting expenses

but as a deliberate policy” Governor Strong advocated a lowering of the discount rate

and heavy buying of government securities.128 The OMIC used short term market rates

and discount window borrowing activity to estimate whether money supply met money

124 U.S. Monetary Policy and Financial Markets, chapter 2: “The Federal Reserve and U.S. Monetary Policy: a short history,” Federal Reserve Bank of New York, p. 22. Total holdings of treasury securities increased form $234.1 million to $433.4 million..125 Stabilization, pt. 1, pg. 309 126 Stabilization, pt. 1, pg. 309.127 Carl Synder, Capitalism the Creator. (New York: the Macmillan Co, 1940) pg. 226128 Snyder, p. 277.

-72-

demand. The large open market purchase beginning in December, 1923, and

continuing through September, 1924, represented the first joint investment strategy of all

the Federal Reserve Banks directed solely towards influencing economic conditions.

The result, when paired with the news of tax reform in the 1924 budget, was only a

shallow recession, as the economy quickly recovered. These actions can be seen in the

first graph at the beginning of this chapter,. Note that the discount rate was lowered in a

series of rate cuts from 4.5 percent (4.5%) in April, 1924, to three percent (3%) in

August. Total Federal Reserve holdings increased 304.3 percent (304.3%), the vast

majority of which came through the purchasing of treasury securities.129 The economy

began to recover in July, 1924. The connection between open market operations and

the discount rate for the remainder of the decade is outlined in the table below. The Fed

continued to purchase securities during economic slowdowns, accompanied by cuts in

the discount rate, and the Fed continued its practice to sell securities during economic

expansions.

129 U.S. Monetary Policy and Financial Markets, p. 22, source: Federal Reserve Bank of New York. Holdings of treasury securities increased from $133.6 million to $540.2 million.

-73-

Table 1Open-Market Operations, 1922-1929 Production and Price Indexes

Period

Operation: Purchases (in

$mlns)

Operations: Sales (in $mlns)

NewYork Federal Reserve Discount

RateJan. 1922 - May 1922 $365 1-Jan-1922 4.50%

22-Jun-1922 4.00%June 1922-July 1923 $494 23-Feb-23 4.50%

1-May-24 4.00%Dec. 1923 - Sept. 1924 $469 12-Jun-24 3.50%

8-Aug-24 3.00%27-Feb-25 3.50%

Nov. 1924 - March 1925 $212 8-Jan-26 4.00%23-Apr-26 3.50%

April-1926 $63 13-Aug-26 4.00%August 1926 - Sept. 1926 $37 5-Aug-27 3.50%May 1927 - Nov. 1927 $288 3-Feb-28 4.00%Jan. 1928 - Aug. 1928 $497 18-May-28 4.50%

13-Jul-28 5.00%Aug. 1928 - Dec. 1928 $358Jan. 1929 - July 1929 $480July 1929 - Oct. 1929 $269 9-Aug-29 6.00%

Source: The timing of policy operation except those for 1928 and 1929 are taken from Operations of the National and Federal Rerserve Banking

Systems. Subcommittee on Banking and Currency. U.S. Senate. 71st Cong. 3d Sess. 1931 (Washington, D.C.: Government Printing Office) p.

803. The data given are monthly average of daily data, except for April 1926 which are end of the month data.

It should also be noted, that during all these periods of recovery (1921, 1924,

1927), dramatic reform of the tax system was being signed into law by Congress.

These tax reforms increased the demand for money. The Fed, in turn, responded to the

demand by purchasing government securities and lowering of the discount rate to

increase the money supply in order to avoid changes in the price level. Money demand

is often forgotten in the historical account of this economic period, despite the fact that

the Federal Reserve System was established to respond to these very changes in dollar

demand. Certainly both the tax reforms (Chapter 1) and the actions of the Fed worked

in tandem to help resurrect the economy which began to pick up substantially after the

-74-

1921 recession. The economy boomed beginning as early as 1924 and continued to

expand until the beginning of the Great Depression in June 1930.130

The official beginning of the 1923-24 contraction occurred in May, 1923. Shortly

thereafter, Governor Strong began to notice the slow down as he observed mounting

“pressure for loan liquidation,” by which he meant that businesses were going

bankrupt.131 Strong aimed to create “a somewhat lower level of interest rates in this

country at a time when prices were falling generally.” He believed that this policy would

promote the flow of funds to foreign markets and further the resumption of gold

payments to Britain. Part of this crisis can be attributed to the Fordney-McCumber Tariff

which was signed into law on September 19, 1922, to replace the Emergency Tariff Act

of 1921. The tariff raised rates to approximately where they were prior to the rate

reductions that were achieved in the 1913 Underwood Tariff. While this increase was

not as onerous as what was to come at the end of the twenties, the increase in tariff

rates did make it more difficult for Europeans to meet their reparation and debt

repayment obligations. For this reason the tariff increase marked a step in the wrong

direction. Strong observed this fact, noting that the increased tariff barriers made it

difficult for the European nations to conduct the necessary trade to pay off their debts.

With the barrier to trade established, the only way to avoid recession in the US and to

sustain the repayments of the European Allies was through lowering domestic interest

rates and encouraging an outflow of American capital abroad. In effect, the United

States had to lend more money overseas so the rest of the world could continue to buy

American goods and services, receiving American dollars to pay off debts while at the 130 The “Great Crash” of the stock market in October 1929 is often cited as the beginning of the Great Depression. Marking the beginning of the depression to October 1929, however, is problematic. The economy was still growing strongly in late 1929 despite a mild slow down in industrial production and other indicators of economic health. The stock market also rallied off its lows of 198 in November when the Treasury announced a one percent (1%) corporate income tax cut. By year end the market was in the low 200s and rallied all the way up to 298 before declining again in June. After June, 1930 both the economy and the market continued to spiral down. The, albeit brief, recovery following the crash makes this later date a more proper end for the “booming twenties.”131 Stabilization, pt. 1, 1926, p.336)

-75-

same time keeping the American economy afloat. As a result of the open market

purchase and the subsequent lowering of the discount rate the pressure for loan

liquidation was relaxed, a market was created for the flotation of foreign and domestic

security issuances, sterling rose in the exchange markets and business recovered. The

increasingly fragile international financial web was sustained for the time being.

The year 1927 is often pointed to as one of the most crucial to understanding the

proceeding “bubble” in the stock market and the crash in late 1929. GDP growth slowed

from nearly seven percent (6.9%) on an annual basis in 1926 to less than one percent

(0.77%) in the fiscal year 1927. The official beginning of the slow down is October 1926.

As in 1924, the Fed moved to purchase securities and lower rates to assist business

recovery. Federal Reserve security holdings increased almost seventy-eight percent

(77.9%) from $695.8 million to $868.9 million.132 In addition, as Bankers’ Acceptances

actually declined during the period, the increase in Fed holdings came completely from

purchases of government securities, which amounted to a total of $288 million from May

through November, 1927 (see earlier chart). It has been argued by Allan Meltzer in The

History of the Federal Reserve and Benjamin Beckhart in The Federal Reserve System

that the open market operations between May 11th and November 16th created a rapid

increase in money supply and a reduction in the gold stock.133 This had the effect, it is

argued, of reducing both short-term and long-term interest rates and resulted in

increased speculative lending through security loans and investments by member-

banks. In particular, they point to the growing importance of time deposits and the

corresponding credit expansion into more long-term lending, which increased the

velocity of money in the economy The result was a growing irrational bubble in the stock

market, which, according to this argument, “burst” when the Fed reversed policy and

132 U.S. Monetary Policy and Financial Markets, p. 22, source: Federal Reserve Bank of New York133 See chapter three in Metlzer’s A History of the Federal Reserve (Chicago: University of Chicago Press, 2002, pg. 65-135.

-76-

raised the interest rate, stemming the speculative lending. Friedman and Schwartz

similarly have argued that the Fed was in a precarious position. On the one hand,

setting lower rates to help faltering businesses, and on the other trying to discourage

speculation on the stock market. In other words, they argue that while the stock market

was inflating, the economy was not, stating: “Federal Reserve policy was not restrictive

enough to halt the bull market yet too restructure to foster vigorous business

expansion.”134

While this view of the stock market and the economy may or may not have been

the case, as will be addressed in Chapter Five, these commentators also point to

international factors as the primary motive behind the rate cuts. Instead of trying to help

businesses recover in the United States, Strong pressured the Fed to lower discount

rates to help his friends at the European central banks. Under this view, discount rates

were made “artificially” low in 1927. In particular, appeals came from the Bank of

England, which was attempting to reestablish the gold standard at the pre-war parity,

and the Bank of France, which was attempting to rejoin the gold standard in 1927. By

lowering rates and expanding the money supply in the United States, sterling

strengthened as gold flowed out of the United States and into France and England.

Moreover, Governor Strong robustly supported the reestablishment of the international

gold standard, stating in 1926:

I really have a feeling in my own mind that the prosperity of our country is so wrapped up in general world prosperity that…the best that we can do for our people is to try in a any way that we can to maintain these markets on which our prosperity so largely depends…I earnestly believe that the greatest service that the Federal reserve system is capable of performing to-day in this matter is to hasten…monetary reform in the countries that have suffered from the war.135

This quotation also illustrates the point made in Chapter Three about U.S. credit risk.

American prosperity increasingly relied on European economic success and the ability to

134 Friedman and Schwartz, Chpt.9: “The Great Contraction.”135 Stabilization, pt. 1, 1926, p. 518

-77-

pay off debts. The importance of these international factors is also clearly documented

in the papers during this period. The front page of The New York Times reports on

March 4 1927:

BANK OF ENGLAND HEAD SEES REICHBANK CHIEF; BERLIN DENIES VISIT CONCERNS THE STABILIZATION OF THE FRENCH CURRENCY.

Then on the front page of the June 15, 1927 edition:

OLD WORLD BANKERS TO SEE STRONG HERE; NORMAN, SCHLACHT AND RIST OF BANK OF FRANCE COMING FOR CONFERENCE.

PROBABLY EARLY IN JULY PROBLEMS OF STABILIZATION OF FOREIGN FINANCIAL AFFAIRS TO BE DISCUSSED.

Then again on page one of June 29, 1927:

OLD-WORLD BANKERS BEGIN PARLEYS HERE: GOVERNORS OF BANK OF ENGLAND AND REICHSCBANK ARRIVE AND JOIN FRENCH OFFICIAL.

TAKEN TO FEDERAL RESERVE. CONVERSATIONS WITH STRONG TO INCLUDE MONEY RATES AND GOLD SHIPMENTS. STRICT SECRECY OVER ALL. QUARTER OF VISITORS NOT REVEALED – NORMAN AND

SCHACHT CLOSE COMPANIONS ON VOYAGE.

Meetings took place from July 1 through July 8 when France pledged to formally rejoin

the gold standard the following month.136

statements made by the Federal Reserve banks in replies to a questionnaire

transmitted by the United States Senate in early 1931 indicate the 1927 open market

purchases were driven by seven factors: First, to assist European countries in the

purchase of American agricultural products; second, to strengthen the foreign

exchanges; third, to preserve the gold standard in Europe; fourth, to facilitate flotation of

foreign bonds in the American market; fifth, to stimulate a business recovery; sixth, to

initiate discount rate reductions; and finally, to check the decline in commodity prices.

Clearly international factors played the dominant role. Moreover, the same

questionnaire provides the observed consequences: foreign exchange rates improved;

floatation of foreign bonds were encouraged; gold export movement was induced; the

gold standard was maintained abroad; domestic production improved; interest rates

136 See The New York Times, pg. 1 July 8th 1927

-78-

declined; wholesale prices stabilized; and finally, the banks noted a “stimulation of

speculative activity.”137

The following activity of the Federal Reserve also draws attention to Friedman

and Schwartz’s argument. Both in 1928 and 1929 open-market holdings were reduced

in the first half of the year and then increased in the second. From January 1928

through August the Fed sold $497 million worth of open market securities. Then from

August through December, the Reserve banks bought back $358 million of securities on

the open market. With the turn of the New Year, the Fed began to liquidate its holdings

again, selling $480 million worth of securities from January 1929 through July. Then, as

if like clockwork; the Fed bought back $269 million in securities beginning in July ending

in October when the market “crashed.” This chaotic, even schizophrenic, credit policy at

the Fed is what led Friedman and Schwartz to their somewhat contorted conclusions

about stock market inflation in light of economic deflation.138 It also indicates the

conflicting views that existed within the Fed about the appropriate policy action.

The view that open market operations should be used as a countercyclical tool to

control monetary conditions gained favor as the 1920s progressed, but debate for pro-

cyclical policies based on the demand for credit for commercial activity, such as the real

bills doctrine, continued. In addition, even those that argued that open market

operations and discount rate changes should be used to moderate business cycles in a

counter-cyclical fashion feared such policy might impart an inflationary bias to the Fed.

On the one side was Governor Strong in New York, working with Montagu Norman of

the Bank of England and Charles Rist of the Bank of France to reestablish the worldwide

gold standard and promoting open market operations within the US to keep prices

stable. On the other was Adolph Miller of the Fed Board of Governors who promoted the

137 Hearings before the Subcommittee of the Committee on Banking and Currency, United States, Seventy-first Congress, Third Session, Pursuant to S. Res 71, Part VI, pp. 795-96.138 Friedman and Schwartz, Chpt.9: “The Great Contraction.”

-79-

“real bills doctrine.” In the 1928 Strong Bill hearings, Miller criticized the validity of the

assumption that credit changes could impact business activity rather than vice versa:

One of those assumptions is that changes in the level of prices are caused by changes in the volume of credit and currency; the other is that changes in volume of credit and currency are caused by the Federal reserve policy. Neither of those assumptions is true of the facts or the realities. They are both in some degree figments-figments of scholastic invention-that have never found any very substantial foundation in economic reality, and less to-day in the United States than in other times.…undertaking to regulate the flow of Federal Reserve credit by the price index is a good deal like trying to regulate the weather by the barometer. The barometer does not make the weather; it indicates what is in process.The total money in circulation is determined by the community. The Federal Reserve System has no appreciable control over that and no disposition to interfere with it.139

Under the real bills doctrine the changes in monetary policy needed to be initiated by the

public, with the Fed acting indirectly through changes in the discount rate. Open market

operations required direct action by the Fed, and so undesirable under this doctrine.

Instead, reserve control through the discount window put the initiative in the hands of

public businesses. Miller saw the open market purchases in 1927 as excessive and

misguided, arguing that the increased credit made possible through the purchases was

beyond the needs of trade and so put to speculative purposes.140 Instead, in 1928 Miller

urged for the discount rate to become the primary policy variable for the Fed.

Consequently, the discount rate was raised from 3.5 percent (3.5%) to four percent (4%)

in January 1928, following Governor Strong’s open market purchases. Beginning in

May, the Fed hiked the discount rate a quarter point per month, moving it to five percent

(5%) by August 1928 where it remained until August, 1929. In August, as the market

continued to boom, the Federal Reserve raised the discount rate three-quarters of a

point to 5.75 percent (5.75%) and then another quarter point to 6 percent (6%) in

September, one month before the notorious Crash. This “push and shove” between

139 Stabilization, pt. 2 1928, pp. 1009, 348, 180140 Stabilization, pt. 2, 1928, pp. 172 – 174. Miller argued: “…the low money rates that resulted form the Federal Reserve policy, in light of subsequent developments, appear to have been particularly effective in stimulating the absorption of credit in stock speculation.

-80-

Governor Strong at the New York Fed and Adolph Miller at the Board of Governors in

Washington helps explain the oscillating policy between open market purchases and

sales.141

Throughout the 1920s, Governor Strong had dominated the Board, but by late

1927 the power struggle with the Board was heating up again. At the same time the

reserve system was debating policy, it was struggling to meet its multiple goals

simultaneously – stabilizing European currencies, curbing the use of speculative credit,

and stimulating business to offset the declines of 1924 and 1927. These competitive

and often inconsistent agendas combined with confusion over policy and the power

struggle within the Fed contributed to an unsound and hesitant environment.

The Strong Bill hearings in the spring of 1928 marked the last public appearance

for Governor Benjamin Strong. The Board of Governors disapproved of the bill and, as

Irving Fisher wrote in 1934, “Governor Strong felt bound by their action.”142 In the fall of

1928, amongst the open market purchases, Governor Strong died and the Strong bill

failed to pass through Congress. This greatly shifted the balance of power toward the

Board and the consequences of Strong’s death have been a matter of speculation ever

since. As Irving Fisher wrote in 1935, “I myself believe very strongly that this depression

was almost wholly preventable and that it would have been prevented if Governor Strong

had lived.”143 This same argument was later made by Friedman and Schwartz.144

Regardless of this counterfactual proposition, just prior to the stock market crash of

October 1929 and the following Great Depression, the face of the Federal Reserve died

and this tipped the scale of power toward the Board of Governors. This power shift

occurred at a time when the Fed struggled with a rapidly rising stock market, an

141 For a full account of the dynamics between Strong and Miller See Allan Meltzer’s The History of the Federal Reserve (2002).142 Fisher, (1934) p. 171143 Irving Fisher, Stable Money: A History of the Movement (New York: Adelphi Company, 1934) p. 517.144 See Freidman and Schwartz, pages 255-264 and chapt.9: “The Great Contraction”

-81-

economy emerging from the contraction of 1927 and a newly functional worldwide gold

standard. The resulting policy was hardly coherent.

-82-

Chapter 5:

The Coolidge Bull Market

By 1926, the American economy was booming. Beginning in 1924, as Mellon

and Coolidge unveiled another round of tax reforms and the Fed succeeded in

maintaining a fairly consistent price level, business began to expand rapidly. More

importantly, it was becoming increasingly clear in 1926 that Mellon would realize his aim

of a twenty-five percent (25%) top marginal tax rate (Chapter 1) and the great Coolidge

bull market began.145 The physical output of industry in 1926 exceeded that in any other

previous year.146 This terrific production was paired with low unemployment and a

declining price level, something so exceptional it has yet to be reproduced since.

Monthly, seasonally adjusted industrial production levels are illustrated in the below

graph:

145 It should be noted that there are many other factors that contributed to the Coolidge bull market besides fiscal policy. It is the opinion of this author, however, that the tax reform allowed for other factors to take shape.146 Manufacturing production reached 108 with 1923-1925 equaling 100. Index was compiled from original data from Federal Reserve Board Bulletin, August 1940

-83-

From 1920 through 1924 the New York Times index of industrial share prices

hardly from 90 to 106, but by December 1924 it reached 134. At the end of 1925 it had

climbed to 181 where is paused throughout 1926 before tracking upward to 245 in 1927.

The New York Times industrials average peaked on September 19th 1929 at 469, over

quadruple its level at the open of 1924. The Dow Jones Industrial Average (DJIA)

preformed similarly. Opening the century at 68, the DJIA traded between 50 and 100

points through the first fifth of the century. From 1920 to the beginning of 1924 the DJIA

actually declined from 108 to 96, or a drop of nearly twelve percent (12%). Over the

period, the market traded as low as 63.9 on August 25, 1921 as market prices collapsed

with the sharp recession and decline in the general price level covered in Chapter Two,

before rebounding in 1922 and 1923. By year end 1925 the DJIA stood at 151, an

increase of over fifty percent (50%) in two years. It too paused at this plateau in 1926

Industrial Production

0

2

4

6

8

10

Jan-

19

Jan-

20

Jan-

21

Jan-

22

Jan-

23

Jan-

24

Jan-

25

Jan-

26

Jan-

27

Jan-

28

Jan-

29

Jan-

30

Jan-

31

Jan-

32

Jan-

33

Jan-

34

Jan-

35

Date

Beginning of irrational “bubble” in the stock market for many historians in an attempt to explain the “Crash” in October. The fact remains, however, that Industrial Production began to grow at an unprecedented pace at this precise moment. The stock market growth was based on fundamental market activity.

Source: Bureau of Economic Analysis; (www.bea.gov)

-84-

ending the year at 157 before rallying to 200 by the end of 1927. The DJIA peaked on

September 3, 1929 at 381.17, nearly four times their 1924 level. The below graph

details the yearly changes in the DJIA from 1922 through 1929:

As the graph shows, growth throughout the twenties, especially after 1924, was steady

and significant. After declining slightly in 1923, the market as measured by the DJIA

appreciated over twenty-five percent in 1924 (26.16%) and 1925 (25.37%). It paused in

1926, moving up only four points (4.05%) from 151 to 157 and then surged forward in

1927 and 1928 moving 27.67 percent (27.67%) and 49.48 percent (49.48%)

respectively. The bull market continued through the first three quarters of 1929 before

the legendary crash brought valuations down, causing the market to lose one-third of its

worth in the period of week.

Controversy still abounds over what caused the stock market boom, whether a

bubble emerged in 1928-29 and what precisely caused of the stock market to crash.

Despite the vast literature on this topic, no clear explanation has emerged let along a

Beginning of the stock boom, May – 14th 1924 with DJIA at 88.77

Market Peak – September 3rd 1929 with DJIA at 381.17

Sources: Bloomberg

-85-

consensus among economists or historians. The most famous account of the crash,

John Kenneth Galbraith’s The Great Crash 1929, does not attempt to explain the stock

market boom at all. Galbraith simply supposed a bubble emerged in the market during

the rapid economic growth of the 1920s, but he makes no reference to what may have

caused the rapid growth in the underlying economy. He then emphasized the irrational

“mania” of the public, arguing “the vested interest of euphoria [led] men and women,

individuals and institutions to believe that all will be better, that they are meant to be

richer and to dismiss as intellectually deficient what is in conflict with that conviction.”147

The fuel behind this “euphoria,” according to Galbraith, was excess speculative liquidity

evident through brokers’ loans. In The World in Depression, 1929-1939, Charles

Kindleberger is equally vague about what caused of the boom. In writing about the

American market, Kindleberger only proclaims, “…the boom was built around the

automobile, not only the manufacture of vehicles, but tires and other components, roads,

gasoline stations, oil refineries…”148 Kindleberger offers no explanation, however, as to

what might have caused the automobile boom. Nor does he offer more explanation for

what caused the crash. Like Galbraith, Kindleberger focuses on the precarious position

of the irrational investor, believing a bubble existed and that this bubble inevitably had to

“pop.149”

There remain a number of important questions to be answered concerning not

only the crash in 1929, but the boom before it. There seems a tendency to blame the

depression of the 1930s on the happiness and exuberance of the 1920s. The 1920s

have been continually characterized as an extravagant self-indulgent period of

unchecked excesses which led to the crash of 1929 and the following depression. In

147 John Kenneth Galbriath, The Great Crash, (Cambridge MA: The Riverside Press, 1954) pp. xii-xiii 148 Charles P. Kindleberger, The World in Depression: 1929-1939, (London: University of California Press, 1973) p. 44149 See Galbriath’s The Great Crash, 1929 and Kindleberger’s The World in Depression, 1929-1939, esp. chapters 1-3.

-86-

order to test this conventional understanding, considerable attention will be given both to

the causes behind the aggregate boom in the economy and to the stock market itself to

determine if prices were justified before the crash.

Popular criticisms of the 1920s have resounded ever since the Crash of 1929

and the onset of depression. One argument is that wages remained low in the

“prosperous decade” despite the large gains in productivity. Irving Bernstein, in The

Lean Years: A History of the American Worker, 1920 – 1933, and Frank Stricker, in

Affluence for whom? – Another Look at Prosperity and the Working Classes in the

1920s,” present the 1920s as a period of sluggish or even declining wages for the

American worker. This was simply not the case, however. Wage rates did decline

significantly, but the entirety of the wage decline came in the 1920 – 1921 depression

when consumer prices fell 10.5 percent (-10.5%) and producer prices fell by 36.8

percent (-36.8%). During the same period, unskilled manufacturing wages fell by

twenty-two percent (22%) and skilled manufacturing wages by twenty percent (20%).150

While this decline is substantial, it should not be used to manipulate the rest of the

decade. From 1922 through 1929, both unskilled and skilled manufacturing wages had

substantial increases of twenty percent (20%).151 Moreover, using data estimated by

Keynesian economist Lawrence Klein in his book titled The Keynesian Revolution

published in 1947, wage growth looks even more impressive. Klein’s data for all private

wage bills indicates a drop of only 11.5 percent (-11.5%) in the 1920-1921 period and

then substantial growth of forty-one percent (41%) from 1922 through 1929. The wage

level of 1929 would not be reached again for another decade.152

150 Paul David and Peter Solar, “A Bicentenary Contribution to Research the History of the Cost of Living in America,” In Economic History, pg. 1-80 in Vol. 2, (Greenwich: JAI Press) Table B1, pg. 59.151 Historical Statistics of the United States, Colonial Times to 1970, 2 vols (Washington DC, 1975) series D839-44)152 Lawrence Klein, The Keynesian Revolution, (New York: MacMillan Company: 1947). This is the Klein Model I data set, available from http://pages.stern.nyu.edu/~wgreene/Text/tables/tablelist5.htm visited on February 15th, 2006.

-87-

Another popular argument blaming the Twenties for the economic pain of the

Thirties is that of excess profits. Using the incorrect assumption of falling wages, the

argument concludes a “shift to profits” must have occurred. This “shift,” it is argued,

moved most of the income growth to high income groups with lower “propensities to

save.” The result was supposed to be more savings than could profitably be applied to

real business activity. This helps the “bubble” theorist such as Galbraith and others who

argue surplus savings flowed directly into the stock market speculation as a form of easy

money. In particular, supporters of this argument point to wealthy individuals and

corporations who would offer idle savings to brokerage firms to lend out on margin.153

Again, however, the data does not support this argument. Before tax corporate profits

average 8.2 percent (8.2%) in 1920 through 1929 as compared with 9.7 percent (9.7%)

in the pervious decade of 14.1 percent (14.1%) in the 1940s.154 More importantly, the

share of GDP going to employee compensation averaged over sixty percent (60%) in the

1920s as compared with fifty-fifty five percent (55%) in the first fifth of the century.155

Others point to the “farmer depression” of the 1920s. Proponents of this theory

highlight “sharply lower prices” for farmers, while arguing that goods in general were

rising in price. Again facts are to the contrary. Putting aside the 1920-21 price decline,

farm commodities actually increased in price on an annual basis five out of the eight

years 1922 to 1929 and were nearly twenty percent (18.4%) higher in 1929 than in 1921.

The CPI, on the other hand, was actually 4.5 percent (4.5%) lower in 1929 than in 1921

and only rose on an annual basis in three of the eight years. Moreover, net income of

farm operators on a per capita (per farm) basis rose 4.6 percent (4.6%) in 1928 and 2.3

153 Irving Fisher, The Stock Market Crash and After, (New York: The Macmillan Company, 1930) pp.. 44-48.154 After tax corporate profits, 1929 and later: www.bea.doc.gov/dn1.htm, NIPA Table 1.14; for period before 1929 see Ellen McGrattan and Edward Prescott, “The Stock Market Crash of 1929: Irving Fisher was right!” NBER Working Paper 8622, December 2001 and Reynolds, (1979).155 Reynolds, 1979 While economic circumstances were notably different during the separate decades and consequently a direct comparison is impossible, the data still does not support any upward “shift” in profits. Whether an argument can be made for shifts in the opposite direction is less clear.

-88-

percent (2.3%) in 1929. Finally, the “parity cost” of farm costs to prices rose in every

year of the bull market and at ninety-two (92) in 1929, was higher than in any year

before 1954.156 Agricultural prices did decline when the decade is measured as a whole,

but this is a manipulation of the data. As with wages, agricultural prices grew when the

1920-1921 depression is accounted for.

Two monetarist schools also disagree over the period. Murray Rothbard argues

in America’s Great Depression that the boom was only a product of inflation. Rothbard

has a broad definition of “money” and estimated the money supply increased by 68.1

percent (68.1%).157 Rothbard counters the fact that the CPI declined by 4.5 percent (-

4.5%) and the PPI by 11.3 percent (-11.3%) by arguing prices should have declined

more because of the increases in productivity.158 This is a tough argument to make.

Conversely, Friedman and Schwartz on have a much more limited view of “money” and

go to lengths to separate the stock market activity from business expansion, arguing:

“Far from being an inflationary decade, the twenties were the reverse.”159 They point out

that “The cyclical expansion from 1927 to 1929 is one of the very few…during which

prices were…lower at the three months centered on the peak than on the three months

…on the initial trough.” Moreover, they point out “The stock of money…fell slightly

during most of the expansion – a phenomenon not matched in any prior or subsequent

cyclical expansion.” As a result, Friedman and Schwartz conclude that “Federal Reserve

policy was not restrictive enough to halt the bull market, yet too restrictive to foster

vigorous business expansion.”160 Taking the opposite extreme from Rothbard, they

156 Bureau of Labor Statistics, Handbook of Methods, chapter 17, found at: http://stats.bls.gov/opub/hom/homch17_d.htm#17a – visited on 2-March 2006 and Reynolds (1979)157 Rothbard used a measurement similar to M2, which includes time-deposits.158 Murray Rothbard, America’s Great Depression, esp. part 2, entitled “The inflationary Boom, 1921-29.” Similar arguments are presented by conservative historian Paul Johnson in Modern Times, chpt. 7.159 Friedman and Schwartz use M1 which includes on demand deposits.160 Friedman and Schwartz, pp. 298-99

-89-

believe the Federal Reserve policy actually restrained the economy and argue for the

lack of a boom.161

Nevertheless, it is difficult to deny that the period 1922 through 1929 was an episode of

exceptional economic growth and not a period of inflation. GDP expanded from 68.4

billion in 1921 to 101.4 billion in 1929 and averaged an annual growth rate of 5.13

percent (5.13%) over the entire period. At the same time, prices declined meaning real

growth was even greater. Industrial Production (seasonally adjusted) increased from 4.4

in 1921 to 8.5 in 1929, a jump of over ninety-one percent (91.3%). Life expectancy at

birth rose by 5.6 years. There were more applications for patents in 1929 than in any

other year until 1965.162 Productivity also expanded rapidly. Output per man hour of

U.S. production increased 66.5 percent (66.5%) from 44.6 to 74.3.163 It does not seem

as if any of the “theories” arguing that the 1920s exuberance laid the foundation for the

1930s depression hold any merit. The 1920s was a period of extreme creativity and

economic revolutions. Whole new industries, such as the manufacture of radios,

developed. Production of autos, crude oil, and electricity nearly doubled from 1920-

1929. Consequently, it is clear that despite a plethora of criticisms, the 1920s was built

around genuine economic growth and prosperity. One question remains, however: what

about the stock market?

In August of 1929, just a month before the market began its perpetual decline,

Charles Dice, Ohio State University economist, argued that the current stock market was

justified by economic fundamentals. On October 22, 1929, The New York Times printed

the headline: “FISHER SAYS PRICES OF STOCKS ARE LOW – QUOTATIONS HAVE

161 See Rothbard’s America’s Great Depression and Friedman and Schwartz’s A Monetary History of the United States, 1867-1860.162 Alan Reynolds, “What do we know about the Great Crash?” National Review, Nov. 9th 1979, pg. 1416 – 1421.163 Federal Reserve Board - available at: http://www.federalreserve.gov/releases/G17/ visited on March 7, 2006

-90-

NOT CAUGHT UP WITH REAL VALUES AS YET”164 The article covers Fisher’s speech

to the New York Credit Men’s Association, where Fisher commented on the short-term

market sell off from Friday October 18th through Monday October 21st when the DJIA

dropped from a close of 341.86 on Thursday to 320.91 on Monday, a lost of over 9.5

percent (-9.5%). Fisher argued the two day break in the market was a “readjustment” to

“trade” and that any predictions of overvaluation were unfounded, arguing:

Let us take the month of August, 1929, when the price level of stocks had reached its record top of 200. The price level was 145 in August of the preceding year. Yet, August, 1929, common stocks, as computed by the Standard Statistics Company, were selling at thirteen-times the total earnings, as compared with fourteen times the total earnings in August of the preceding year…In other words, while the index of prices of representative stocks has risen very rapidly during the past year, it has risen more slowly than the rate of total earnings.165

Fisher clearly believed the market was based on a sound economic reality. The next

day the market plunged 6.3 percent (6.3%) from 326.51 to 305.85 and the Great Crash

had begun.

Even following the crash, in December 1929, Fisher continued to argued that “the

market went up principally because of sound, justified expectations of earnings, and only

partly because of unreasoning and unintelligent mania for buying.” In his book The

Stock Market Crash and After, published in 1930, Irving Fisher exclaims that in hindsight

it is easy to see a picture of the market as portending or predicting the disaster that

came: “In the rapidly mounting aggregate of margin accounts the unsoundness of the

situation is revealed.” He points to the Federal Reserve Board’s warning of an inflated

stock market beginning in March 1929 and the resulting “shutting off of stock market

credit that at once precipitated a near panic.” The panic Fisher cites was avoided

through the efforts of Charles Mitchell, Chairman of the National City Bank of New York,

who made $100,000,000 available to the market at high rates. Fisher notes that “From

164 The New York Times, “Fisher Says Stocks are Low” October 22, 1929 pg. 24.165 The New York Times, “Fisher Says Stocks are Low” October 22, 1929 pg. 24.

-91-

[this picture] many have hastily concluded that the new plateau of stock prices was

wholly unwarranted and merely the result of insane speculation.”166

There is, however, as Fisher stressed, another side of the story. To begin with,

Mitchell’s actions in March, 1929, which were so criticized by Senator Carter Glass and

others following the crash, were not unwarranted. William C. Durant, founder of General

Motor’s Corp., was outraged by the Federal Reserve actions in the beginning of 1929.

Durant polled 500 industrialists across twenty cities concerning the Fed’s policy. In

response Durant received 463 replies from companies, with only twelve supporting the

Federal Reserve. Durant called the Fed’s actions a “battle” against the businesses of

the country. Calling the board an “autocratic group” Durant argued that the Federal

Reserves’ decision to hike the discount rate twenty basis points on March 27, 1929

created a situation where “a Stock Exchange panic was in the making.” Durant called

Mitchell’s actions in response a “patriotic offer,” And demanded a lowering of the

discount rate to three percent (3%). Durant also supported Mitchell’s calls for the

abolishment of the capital gains tax to free up investors capital.167 The capital gains tax

enticed investors to circumvent selling stock in efforts to avoid a taxable event. Instead,

investors borrowed to buy new stocks through margin accounts. As will be shown, this

leverage played a considerable part in the October Crash. The liquidation that would

result in abolishing the capital gains tax, Mitchell argued, would wipe out any “artificiality”

in stock prices, free up capital for investors by decreasing the demand for broker loans

and allow the Fed to focus on supporting business interests.168

166 Irving Fisher, The Stock Market Crash and After, (New York: The Macmillan Company, 1930) pp. xx-xxi.167 The New York Times, “W.C. Durant Demand Reserve Board Keep Hands Off Business,” April 15th, 1929. p. 1.168 The New York Times, “Wall Street Differs On Mitchell Plan: Proposal to Abolish Tax on Profits From Stock Sales Widely Discussed,” April 20th, 1929. p. 9.

-92-

Moreover, as Fisher points out, every stock price represents a discounted value

of the future dividends and earnings of that stock. For the rise in the stock market to be

rational, therefore, it could only occur for four reasons:

(1) Because the earnings are continually plowed-back into business instead of being

declared in dividends, this plowing-back resulting in an accumulation at

compound interest, so to speak;

(2) Because the expected earnings will increase on account of technical progress

within industry;

(3) Because less risk is believed to attached to those earnings than formally;

(4) Because the “basis” by which the discount is made has been lowered.169

Fisher demonstrated that all four of these forces were at work and, fundamentally, the

market was justified.

Rather than simply take Fisher’s word for this fact, however, as he has been

continually criticized for his proclamations both before and after the crash in light of the

events of late 1929. A detailed analysis of the actual market is necessary as Fisher’s

analysis has been discredited, if not ignored, when the market went from a high of

381.17 in September 1929 to 41.22 on July 8th 1932, its lowest value of the twentieth

century..

The Undervalued Stock Market: A Fundamental Analysis

Strong growth in company profits drove the market in the late 1920s. Both Dice

and Fisher pointed to growing earnings and dividends provided by new technologies,

better management techniques, and mergers that consolidated industries and gained

economies of scale and scope for corporations. This rising in corporate earnings and

169 Fisher, 1930, p. xxii

-93-

earnings potential as resulting in the stock market boom. In a speech on October 22,

1922 the day prior to the first big sell off that marked the beginning of the crash, Fisher

explained:

During the past six years there have been pronounced changes in the tempo of production and trade, due to the vast increment of scientific research and application of inventions. Virtually every line of manufacturing witnessed daily technical development that results in a greater total of products, at reduced costs, greater profits, and lower prices to consumers. These gains are continuing into the future.170

More recently, Gerald Sirkin (1975) used average price-to-earnings (P/E) multiples

during the boom to argue stocks were, if anything, undervalued. During the period 1925-

29, the average P/E ratio was 20.4, as measured by Sirkin. Based off a historical normal

P/E for the DJIA of 15, earnings would need to grow at nine percent (9%) for another 10

years to justify the 20.4 P/E of the boom period. Average growth during the 1925-29

period was in fact slightly higher than nine percent (9%), making the market valuation

appear justified. Sirkin also argued that the market valuation for the period, compared

with post-World War Two yields and stock returns, implied growth rates for dividends

that were quite conservative and in fact below post-World War II growth rates. That is,

investors rewarded growth less in the 1925-1929 period than they did after World War

Two.171

A different approach to using dividend data to judge the valuation of companies

prior to the crash in 1929 is to use data on productive capital stocks and tax rates to

estimate the fundamental value of all U.S. public companies. In fact, a model that

values the assets of a company is advantageous to one that uses expected discounted

dividends, as Sirkin’s did, because it does not rely on assumptions of investor

expectations. Ellen McGrattan and Edward Prescott conservatively estimate the

fundamental value of all corporations before the crash as twenty times (20X) after tax

170 The New York Times, “Fisher Says Stocks are Low” October 22, 1929 pg. 24.171 Gerald, Sirkin, “The Stock Market of 1929, Revisited: A Note” Business History Review, Summer 1975, Vol. 44, pp. 381-386.

-94-

corporate earnings, which for 1929 is 1.8 times (1.8X) GDP.172 Actual market value was

between 1.57 times (1.57X) and 1.24 times (1.24X) GDP, indicating Fisher was right.

No bubble existed and, if anything, the market was undervalued on the eve of the crash.

McGrattan and Prescott assume real interest rates were high (above 5%) and market

participants were extremely risk adverse to generate these ratio.

If a more reasonable real interest rate is assumed and the level of risk aversion

lowered, fundamental values for U.S. corporations is actually estimated to be higher than

twenty times (20X) earnings.173 The real rate of interest is based on open market rates

and the expected rate of inflation. On a gold standard, as the U.S. was on in 1929,

expectations of inflation should be near zero. Romer (1989) estimates an annual

inflation rate of slightly below zero at -0.29 percent (-0.29%) for the period 1925-1929.174

Therefore, only slight adjustments need to be made to open market rates to determine

the real rate of interest. The Fed discount rate during this period ranged between 3.5

percent (3.5%) in early 1927 to six percent (6%) late in 1929, but for the majority of the

period was between four percent (4%) and five percent (5%). Short-term U.S. treasury

securities ranged between 3.5 percent (3.5%) and just below five percent (5%), while

Long-term U.S. treasuries remained below four percent (4%) for the entire period.

Commercial paper rates ranged mostly between four percent and 4.5 percent (4%-4.5%)

until the Fed increased discount rates significantly. Commercial paper reaching five

percent (5%) in the middle of 1928, 5.5 percent (5.5%) by 1929 and just over six percent

172 See Ellen McGrattan and Edward Prescott “The Stock Market Crash of 1929: Irving Fisher was Right!” Working Paper 8622, National Bureau of Economic Research (NBER), December 2001173 McGattan and Prescott use the following valuation model, which assumes a stable tax policy:V=(1-tpers)(K’t + (1-tcorp)K’i) Where K’t is the end of period resource cost of tangible capital, K’I is the end of period resource cost of intangible capital, tpers is the personal income tax rate including stock dividends, and tcorp is the tax rate on corporate profits. Other models used to measures bubbles use discounted value of expected future stock dividends to value companies. This model is preferred because it makes no assumptions about market participants’ expectations.174 Christina Romer “The prewar Business Cycle reconsidered: New estimates of Gross National Product, 1869 – 1908.” Journal of Political Economy, Vol. 97, p. 1-37. Also see Romer, “The Great Crash and the Onset of the Great Depression,” NBER Working Paper, June 1988.

-95-

(6%) at the peak of the market just prior to the crash in October. These high rates,

however, were only temporary, lasting less than a few months. Corporate bonds yields

are perhaps the most relevant for measuring assets in the corporate sector. According

to the Federal Reserve’s Banking and Monetary Statistics, the basic nominal yield on

corporate bonds with maturities of two years is around five percent (5%) for 1929.

Corporate bonds with longer maturities have coupons closer to 4.4 percent (4.4%). Only

in the very short term are yields as high as 5.6 percent (5.6%).175

Taking all this into account, 5.75 percent (5.75%) is a conservative upper bound

for real interest rates. Using this real rate of interest, total value of all corporations is

around 1.78 times GDP or 20 times corporate earnings. A more realistic real rate of

interest of five percent (5%) yields a total value of 2.75 times GDP, indicating that even

at its peak, the market was fundamentally undervalued in 1929.

The actual 1929 market value can be estimated using a number of methods.

Irving Fisher estimated the August 1929 price-to-earnings ratio to be 13.176 McGrattan

and Prescott took three different approaches. The first used estimates based off a

detailed study of 135 industrial corporations provided by Laurence Sloan and Associates

(1936) at the Standard Statistics Company. McGrattan and Prescott viewed this

estimate as the most representative for the total market. The second method used the

S&P Composite index made up of fifty industrial companies, twenty railroads, and twenty

utilities. Finally, an estimate is made using the total market capitalization of all 846

companies on the New York Stock Exchange (NYSE). These estimates and others are

outlined in the table below:177

175 Short-term, Long-term, and Corporate interest rates from Federal Reserve Board of Governors, Flow of Funds Accounts of the United States (Washington D.C.: Federal Reserve Board, 1943), Table 115: Federal Reserve Bank Discount Rates on Eligible Paper; Table 120: Short-term Open Market Rates in New York City; Table 122: yields on short term U.S. government securities; Table 125 Bond Yields; Intermediate-term U.S. Bonds yields from Ibbotson Associates Stocks, Bonds, and Inflation 2000 Yearbook (Chicago: Ibbotson Associates, Inc., 2000), Table A-13176 The New York Times, “Fisher Says Stocks are Low” October 22, 1929 pg. 24.177 Market Value of All Listed Companies – Survey of Current Business Annual Supplement, various issues starting 1932 (U.S. Commerce 1929 – 2000), Flow of Funds Accounts of the Unites States (Federal Reserve

-96-

Estimates of Market Value of All U.S. Corporations on August 30, 1929 Based On Information for Subsets of Corporations

Data Source**Company Coverage

Market Value ($ billions) Price/Earnings

Estimated Total Market Value/GDP

Sloan & Associates 1936 135 Industirals 30.80 17.5 1.54CRSP & Moody's Industrial Manual 40 S&P Industrials 26.20 18.4 1.62CRSP & Moody's Industrial Manual 90 S&P Composit 43.30 19.0 1.57Irving Fisher 1930 45 Industrials 14.1 1.24NYSE & Flow of Funds Accounts 846 listed on NYSE 89.70 14.1 1.24Jovanovic and Rousseau 2001 All Corporations 130.6* 1.25*

*End of year estimate was divided by 0.7 because prices fell 30 percent (30%) between August and December1.67

Source: Prescott and McGrattan (2001)**CRSP = Center for Research on Security Prices and NYSE = New York Stock Exchange

As the table shows, all the estimates are below nineteen times (19X) after tax corporate

earnings, or 1.67 times GDP. With no evidence of high real rates of interest, given the

market rates of 1929, a conservative fair value for all U.S. companies is at least twenty

times (20X) after tax earnings, or 1.8 times (1.8X) GDP. Because this “fair value” for

U.S. companies is greater than the existing market value in just before the Crash the

market was undervalued. This result uses the highest estimate for the actual market

valuation of U.S. companies in August, 1929, while also using the lowest fundamental

valuation. In other words, it is the most conservative analysis possible and there still

exists no evidence in support of a bubble. As McGattan and Prescott write: “A

fundamental valuation any lower is not justified by observation on profits, capital stock,

tax rates, growth rates, and interest rates.”178 As a result, this data supports Fisher’s

argument that stocks were in fact undervalued in August 1929 and that no bubble

existed. The table below shows different fundamental valuations using different real

rates of interest.179

Board 1945-2000), Javanovic and Rousseau (2001), www.econ.nyu.edu/user/jovanovi - visited on 3/8/2006.178 McGrattan and Prescott, (2001)179 Data used in calculation, such as after-tax profits, GNP for 1929 and later, domestic tangible corporate capital – all available at www.bea.gov (NIPA Table 1.14, 1.9, 7, 9) – visited on 03/09/2006

-97-

Estimates of Intangible Capital and the Fundamental Value of U.S. Corporations in August 1929 for Various Real Interest Rates

Estimates of

Real Interest Rate (%) Fundamental Value/GNPMarket

Overvaluation (%)*Market

Overvaluation (%)***

5.00 2.75 -39.27 -44.00%5.25 2.33 -28.33 -33.91%5.50 2.01 -16.92 -23.38%5.75 1.78 -6.18 -13.48%6.00 1.59 5.03 -3.14%6.25 1.43 16.78 7.69%6.50 1.32 26.52 16.67%6.75 1.21 38.02 27.27%6.93 1.14 46.49 35.09%

*Assumes a market value of 1.67 times GNP 1.67 1.54

***Assumes a market value of 1.54 times GNP

Source: Prescott and McGrattan (2001)

**Highlighted region is conservative estimate for real rates. Real rates were likely closer to 5 percent for the period 1925-1929

Most of the work done regarding the stock market of 1920s incorrectly assumes

that markets can be overvalued but not undervalued. Authors have consciously or

subconsciously believed that asset prices were either overvalued relative to

fundamentals or justified vis-à-vis fundamentals in 1929. Nevertheless, as McGrattan

and Prescott demonstrate the use of modern theory and historical data support Fisher’s

original claims that the market was undervalued even at their peak. Fisher’s claims have

been washed aside by Galbraith and the slew of “bubble” theorists including Eugene

White (1990, 1993) because they viewed the crash as clear and indisputable evidence

that Fisher was wrong. These authors have presented no evidence that the market was

overvalued, but have simply started with the presumption that a bubble existed and

pointed to circumstantial evidence to make their points.

-98-

Conversely, another recent article by Tim Nicholas (2004) also finds that

companies were undervalued prior to the crash in 1929.180 Nicholas’ work is important

because it brings concrete validity to McGrattan and Prescott theoretical valuations. In

their valuation, McGrattan and Prescott estimate intangible capital indirectly, using

equilibrium relations from a growth model.181 Their efforts are notable because they

represent the first attempt to systematically estimate intangible capital during the 1920s

bull market, and effective because they use conservative estimates indicating that

unless intangible capital were zero, stocks were undervalued in August of 1929.

Nicholas adds further support to this argument by introducing a robust measure of

intangible capital based on patenting activity of firms during the 1920s. In particular he

uses citations to patents in the current data set of patents granted between 1976 and

2002 to reduce the “signal to noise” ratio that is often associated with using patents as

measures of innovation. Patents citations during the late 1920s were particularly high

compared to other historical periods. Nicholas demonstrates that in light of the rapid

innovation of the 1920s, as measured by patent citations, the booming stock market

valuations were justified. Moreover, he illustrated that investors were aware of the value

of intangibles during the boom. Nicholas finds cited patents have a substantial amount

of explanatory power in market value regressions, indicating that investors placed a 180 Tim Nicholas, “Stock Market Swings and the Value of innovation, 1908-1929,” (April, 2004),. LSE Working Paper. 181 Intangible Capital is needed in McGrattan and Prescott’s valuation model, but because it is not recorded by the BEA, it is more difficult to compute. McGrattan and Prescott construct a lower bound for Intangible Capital (K’i – in their model) through the following method:A relation between after-tax NIPA profits and corporate capital stocks can be used to infer Intangible Capital (K’i):∏ = iKt + (I – g)(1-tcorp)KiWhere ∏ is after-tax NIPA profits, i is the real interest rate, and g is the growth rate of real output.McGrattan and Prescott assume that (1) the after-tax rate of return for tangible capital is equal to the rate of return for intangible capital and all other types of capital. This makes sense if firms are operating in the best interest of their owners. (2) that tax policy is unchanging so that steady state analysis is appropriate. This assumption too is supported by the corporate tax environment of the late 1920s. Average taxes on profits and dividends from 1925 – 1929 was 12.45 percent (12.45%). The maximum annual rate was reached in 1927 at 12.95 percent (12.95%) and the lowest annual rate was for the fiscal year 1929 at 11.75 percent (11.75%). McGrattan and Prescott use Romer (1989) estimates of real GNP growth as a estimate for the growth rate of 3.63 percent (3.64%). The difficulty comes in measuring the real interest rate (i), which was covered earlier. Higher levels of real interest imply low values for intangible capital and vice versa.

-99-

premium on firms that invested heavily in innovation. What is more, while most studies

of the stock market boom have concentrated on short time intervals, such as Rappoport

and White who focus on the period from 1928 through October 1929, Nicholas’ uses

over twenty years of data prior to the Crash to track firm-level innovation over several

major movements of financial markets. His results are robust for the entirety of the

period as well as for shorter sub-periods.

Nicholas makes clear that intangible capital growth during the 1920s was

significant, that investors realized such growth and that investors integrated this

innovation into their market pricing decisions. Between 1920 and 1929 the United States

Patent and Trademark Office (USPTO) granted the 121 firms included in Nicholas’ study

19,948 patents, of which 4,215 were subsequently cited in patent grants during the

1976-2002 period. These patent citations represent inter-generational flow of knowledge

and so indicate that the 1920s was a major period of technological progress. Evidence

is also provided by the companies themselves. For example, J.I. Case Threshing

Machine Company, the Wisconsin agricultural machinery manufacturer, reported $1.4

million worth of patents between 1922 and 1928, explicitly indicating the value of patents

and intangible capital. American Bosch Magneto Corporations, which manufactured

devices for internal combustion engines, valued its patents at between $584,176 and

$633,356 from 1924 through 1926, a amount equivalent to one-third (33%) of its total

assets.182 Nor does evidence of innovation in the 1920s need to be limited to patent

citations as Nicholas does in order to test the theory empirically. From a purely

historical prospective the 1920s represented a period of rapid technological change.183

182 See Moody’s Manual of Industrials for company balance sheets183 Tim Nicholas, “Why Schumpeter was Right: Innovation, Market Power, and Creative Destruction in 1920s America” The Journal of Economic History, Vol. 63, No. 4 (December 2003) p. 1023 – 1058) Also see Claudia Goldin, “The Human Capital Century and American Leadership: Fruits of the Past.” Journal of Economic History, (June 2001) Vol. 61, pp. 263-291 and Paul David, “The Dynamo and the Computer: An Historical Perspective on the Modern Productivity Paradox” American Economic Review Papers and Proceedings, (May 1990) Vol. 80, pp. 355-361

-100-

The 1920s was a period of “Schumpeterian competition,” where new

technologies brought about competition that “strikes not only at the margins of the profits

and outputs of existing firms, but at their foundation and very lives.”184 Waves of

“creative destruction” drove the 1920s economy, which saw the electrification of

America, the popularization of movies, the mass production of the radio, the first

transatlantic flight, and the Model T. The first rocket was invented in early 1926 and the

first color movies began in early 1928.

Beginning in the great merger wave between 1897 through 1904, firms began to

build up separate research and development laboratories. For example, when General

Electric and Westinghouse in 1896 agreed to pool their patents they were criticized for

creating a virtual duopoly. Heavy investment, however, in research and development

made GE and Westinghouse the leaders of productivity-enhancing electrification for the

next few decades. In effect, innovation became increasingly firm oriented rather

focusing primarily around than individual inventor-entrepreneur.185 This became

especially evident in the 1926-1929 period, which saw a sharp rise in the number of firm

patents in comparison to total patents. Firm patents were driven by early investments in

research and development (R&D) departments earlier in the century. R&D departments

increased nearly eighty percent (80%) from 1918 through 1929 with the most rapid rate

of growth occurring in the later part of the decade. Over the same period, total patents

increased approximately only twenty percent (20%), indicating the growth of firm driven

innovation of the Schumpeterian type. Over the same period186 During the 1920s,

prices for electrical capital goods declined substantially, driven by the innovation of GE

184 Joseph Schumpeter, Capitalism, Socialism and Democracy (New York: Harper Brothers Publishing, 1950) p. 84185 See Naomi Lamoreaux, The Great Merger Movement in American Business 1895-1904 (Cambridge: Cambridge University Press, 1988).186 Nicholas (2004), p. 11, also see David Mowery, “The Boundaries of the U.S. Firm in Research and Development,” in Coordination and Information: Historical Perspectives on the Organization of Enterprise, ed. Naomi Lamoreaux and Daniel Raff, (Chicago: University of Chicago Press, 1995) p. 147 - 182

-101-

and others, encouraging the electrification of the mass production economy. By 1920 at

least fifty-three percent (53%) of mechanical power was provided for by electricity, rising

to nearly eighty percent (78%) by 1930.187 In consequence, productivity picked up and

with it the demand for skilled, literate, and educated labor. Larger generating unit and

higher voltage transmission lines came online, reducing the cost of electric power at the

same time the expanding economy and growing population was providing an ever larger

market for the new technology. In turn, utility companies made up one of the strongest

industries during the boom. Both operating public utilities and public utility holding

companies performed well during the bull market. By 1929, utilities were worth

approximately $5.1 billion. Galbraith and others pointed to this sector as one of

especially egregious speculation, but this ignores the tremendous growth through

innovation and the rising importance to the economy of the new technologies these utility

companies provided. Consolidated Gas Co. was the most widely held stock by

investment trusts.188

Innovation existed in other sectors as well. As White (1990) pointed out, General

Motors became attractive to investors because it upgraded faster than Ford to the

changing technological environment. In addition, the chemical industry, which is heavily

oriented toward innovation, went through major expansion in the 1920s. Industry profits

were $157 million in 1929 on sales of $4 billion.189 None of the leading chemical

companies held any debt and the overall industry averaged a 17.8 percent (17.8%)

return on equity. E.I. Du Pont de Nemours and Co. led the sector, with business

primarily in explosives, plastics, paints, rayon, cellophane, dyes, and ethyl alcohol.

Beginning in 1917, Du Pont also held about 10 million shares of General Motors

(22.9%). Average return on equity for Du Pont during the boom was 22.2 percent

187 David (1990)188 Wigmore, p. 38 – Investment Trusts in the 1920s were the equivalent of Mutual Funds today.189 Wigmore, p. 54.

-102-

(22.2%). In contrast to the Du Pont behemoth, Commercial Solvents, a small firm with a

$13 million market cap, was highly innovative and produced mostly butyl alcohol and

other solvents through the “Weizmann Process,” which it developed and held exclusive

rights to. Commercial Solvents averaged an annual return on equity of 31.9 percent

(31.9%) from 1925 through 1929. The market rewarded Commercial Solvents Co. much

more than that of Du Pont or Commercial Solvents’ equally sized competitors such as

Monsanto Chemical or Dow Chemical Co., which generated ROE averages of about

13.3 percent (13.3%) and 17.5 percent (17.5%) respectively.190

Moreover, Nicholas’ showed empirically in a separate paper that the threat of

creative destruction loomed continually in the product markets of the 1920s and financial

markets handsomely rewarded innovators with large payoffs.191 Nicholas illustrated that

both competition and market power, treated as separate aspects of market structure,

functioned concurrently. This dichotomy is the foundation of Schumpeterian innovation

through creative destruction. Access to capital through the financial markets likely

mediated the positive correlation between market power and innovation during the

1920s. This fact further points to Schumpeter’s observation, writing in the 1930s, that

financial institutions and the ability to raise capital are essential catalysts to creative

destruction and growth. Following the successful issuances of the Liberty and Victory

Bonds during World War One, the public became more responsive to different types of

securities issued by corporations.192 Companies increasingly used the capital markets in

the 1920s as a source of financing rather than the commercial paper market.

Perhaps as a result of the threats of creative destruction, the 1920s and

especially the stock market boom from 1925-1929 was associated with a period of

intense mergers and acquisitions. The 1920s began relatively tough on anti-trust policy,

190 Wigmore, p. 54191 See Nicholas (2003)192 William Peach, The Security Affiliates of National Banks, John Hopkins, 1942

-103-

with both President Wilson and President Harding pursuing traditional enforcement, of

the sort established under Theodore Roosevelt, against cartels, mergers and vertical

restraints.

The Federal Trade Commission (FTC) filed 121 restraint of trade cases in 1919,

as compared with only sixty-four in 1918 and twenty in 1917 before the armistice.193

Nine merger cases were also filed against public companies. Moreover, Harding’s

attorney general, Harry Daugherty, gained trust busting authority in a series of rulings

giving the Antitrust Division more strength against trade associations. Daugherty began

to treat many trade associations as cartels. After Harding’s death in 1923, however,

Daugherty was indicted in the Teapot Dome Scandal.194 Coolidge replaced Daugherty

with Harlan Stone, who worked closely with Herbert Hoover, then Secretary of

Commerce, to create safe havens for trade associations.195

In 1925, when Coolidge selected William Donovan as antitrust chief and William

Humphrey as FTC commissioner, anti-trust enforcement changed drastically.196

Donovan focused on price-fixing, but allowed advance clearance of mergers.

Humphrey’s appointment to the FTC created a majority of pro-business Republicans in

control of the FTC. Humphrey publicly pledged a more open merger market, advocating

informal settlements over formal court cases. He described the new policy as

“cooperation and stipulation,” which gives “opportunity for an industry to do away with 193 Richard Posner, “A Statistical Study of Antitrust Enforcement,” Journal of Law and Economics, Vol. 14, (October 1970) p. 365-419194 The Tea Pot Dome Scandal was over oil reserves in Wyoming restricted for the use of the Navy. In 1922, the reserves were under jurisdiction of Edwin Denby, Secretary of the Navy. Senator Albert Fall was publicly opposed to the restrictions on the oil reserves and, in mid-1922 was able to gain control over the oil fields. Fall then illegally leased the rights to the oil to Harry Sinclair of Mammoth Oil. On April 14, 1922 the Wall Street Journal broke the story. On April 15th, Senator La Follette headed the Senate Committee on Public lanes to investigate the matter. The investigation led to a series of civil and criminal charges throughout the 1920s. In 1927 the Supreme Court found the oil leases to have been illegal and the reserves were delivered back to the navy.195 George Bittlingmayer, “The Stock Market and Early Antitrust Enforcement” Journal of Law and Finance, (1993) Vol. 36, p. 1-32 196 Following his stint as Antitrust chief, William Donovan successfully defended Appalachian Coal in APPALACHIAN COAL vs. UNITED STATES where the “per se” law against price fixing was overturned. The “cartel” was allowed to continue in operation. See http://www.justia.us/us/288/344/case.html for details, visited on 03/09/2006

-104-

any fraudulent or unfair practice” and “to regulate itself, to clear its own house…to

achieve decency instead of having the government thrust decency upon it.”197 For the

period 1919 through 1925 the average number of restraint of trade cases brought by the

FTC was 46 per year, the average number of complaints was 146, and the combined

number of annual merger cases brought by the FTC and DOJ was 5. Conversely, the

averages for the period 1926 through 1929 are significantly lower. The average number

of restraint of trade ceases declined seventy nine percent (-79%) to 9.75, the number of

complaints decreased fifty-four percent (-54%) to sixty-five, and the number of average

annual merger cases declined by thirty-five percent (-35%) to 3.2.198 Below are graphs

displaying the annual number of antitrust cases brought by the FTC and DOJ during the

1920s199:

Measures of Antitrust Enforcement, 1919-1929

0

50

100

150

200

250

1919 1920 1921 1922 1923 1924 1925 1926 1927 1928 1929

Year

Num

ber o

f Cas

es

FTC Restraint of Trade Cases FTC Restraint of Trade Complaints

197 Taken from Fisher, (1930) p. 111198 FTC Restrain of Trade Cases from Posner (1970) pp. 366 and 369); FTC Complaints Issued from FTC Annual Report (1935) p. 82-83; DOJ Merger Cases compiled from Commerce Clearing House, The Federal Antitrust Laws (1952); FTC Merger Cases compiled from Commerce Clearing House.199 Ibid.

-105-

FTC and DOJ Merger Cases, 1919-1929

0

2

4

6

8

10

1919 1920 1921 1922 1923 1924 1925 1926 1927 1928 1929

Year

Num

ber o

f Cas

es

This decline in antitrust enforcement fueled a merger boom during the 1922-1929

period. As Irving Fisher wrote: “One who reads the headlines sees that there is a ‘Race

for Mergers in Steel’; ‘Large Mergers on Way in Utilities’; that there are mergers

moves…of various kinds in nation-wide links, expected for economical reasons…”200

Moreover, Fisher, who dedicated an entire chapter in his book The Stock Market Crash

and After to the ‘Age of Mergers,’ claims that “the continued increase in the number of

mergers and consolidations in the trade association field is presaged by the steady

growth of combinations in trade and industry.”201 Clearly mergers had much to do with

the increase in the stock price during the 1920s. Moreover, Fisher compliments the

merger movement calling the mergers “generally…inevitable” because of the ability to

lower production costs. He goes on to note a change in public opinion:

Only a short time ago there was great prejudice against big business of every kind, particularly when it was obtained by combination. But suddenly the pent-up pressure toward larger business unites, in spite of public prejudice and opposition of politicians, has broken free in a wonderful period of expansion.202

Fisher goes on to identify an important point concerning merger activity. As the market

is continually pricing the future value of corporations, mergers and anticipated mergers

will discount future growth into the current stock price. In the short run, this can lead to

200 Fisher, (1930) p. 101201 Fisher (1930). p. 102202 Fisher (1930) p. 105

-106-

abnormal price-to-earning ratios and other standard tools of valuation. In sum, the

merger boom played a vital role in the stock market boom and in the economy. As

Fisher argued, “The big examples of mass production today, as instanced by Henry

Ford, General Motors, Westinghouse and General Electric, the great railways…the big

banks and so on, have reduced costs to the consumer by reducing costs in general.”

The effect of mergers was cost reduction, which led to lower corporate costs, lower

consumer cost, great profits and larger market shares. The stock market responded

accordingly.203

Finally, the stimulus of all these market forces was the movement “down the

Laffer Curve” through the extensive tax reform orchestrated by Secretary of Treasury

Andrew Mellon covered in Chapter One. From 1920 through 1930, the Mellon tax

reforms managed to cut the national debt to $16.9 billion from $24.3 billion and stimulate

business, inciting a booming economy and a bull market. The accumulation of intangible

capital and the large merger boom help explain the rise in stock market prices.

Nevertheless, these explanations are also only products of the general economic

success of the period in the United States. This economic success was founded on a

sound fiscal platform put into place throughout the decade.

John Maynard Keynes, presiding in Cambridge, England, had trouble explaining

the “booming 1920s” in America. From his theoretical framework, tax cuts could only

“stimulate” the economy if tax relief was concentrated in the lower tiers of the income

distribution, where the “propensity to spend” was higher than in the upper echelons.204

As Jude Wanniski points out in The Way The World Works, part of Keynes trouble was

that fact that his vantage point was England, and the British economy did not boom in

203 See Fisher (1930) p,. 101-118 for a full discussion.204 This idea became even stronger in the early 1930s when Richard Kahn presented the consumption multiplier relation. Nevertheless, the views are evident in Keynes’ original writings. See: John Maynard Keynes, The general theory of employment, interest and money, (New York: Harcourt, Brace and Howe, 1936)

-107-

the 1920s. It should be noted that amongst other mistakes, notably returning to the gold

standard at the overvalued pre-war parity, Britain also left the highly progressive income

taxes in place from the war.

The tax reform outlined in Chapter One clearly impacted business activity and

stimulated the bull market of 1924 through 1929. The sampling of The New York Times

headlines in the following paragraphs makes this fact explicitly clear.

Amongst secretary Mellon’s second battle with congress for tax reform that

eventually resulted in cutting the top marginal income tax rate from fifty-eight percent

(58%) to forty-six percent (46%), The New York Times reported on a speech by the

Chairman of United States Steel Company entitled: “PROSPERITY AND TAX

REFORM.” In the speech given to the League for Political Education, Chairman Gary

argued for a clear connection between the quest for tax reduction and a revival of trade.

The New York Times reported that as “Chairman of the largest steel corporation in the

world [he] was qualified by his position to indicate the influence of the one consideration

on the other.” The Times further pointed out that the Chairman needed to include such

considerations in his own business calculations. Chairman Gary placed the blame for a

slowing economy in 1923-1924 “unhesitatingly” on the existing Federal tax code, which

were: “so heavy as to drive the wealthy investor out of the ordinary industrial

investments, where the high surtax would practically cut his 5 or 6 per cent return down

to 3, and into the 4 per cent tax-free bonds of States or municipalities.”205 Similarly, The

Times reported on March 19, 1924: “SEES MUCH GOOD IN TAX PUBLICITY; C.F.

Noyes Believes That It Will Bring About Revision of "Iniquitous" System. SAYS

EVASION IS RIFE.”206

205 The New York Times, December 2nd, 1923 – p. E6 “Prosperity and Tax Reform”

206 The New York Times, March 19th, 1924 “FINANCIAL MARKETS” pg. 27.

-108-

Wall Street also responded to the tax cuts, explicitly connecting Mellon’s tax

reform and the initiation of the bull market. In November of 1924, The New York Times

reported:

NATION-WIDE BUYING TAXES WALL STREET AND PRICES SOAR; Heaviest Trading on New York Stock Exchange

of Any Saturday Since 1906. 1,388,105 SHARES IN 2 HOURS

Country's Response to Coolidge and Baldwin Victories and Setback to Radicalism.

EXCITEMENT ON EXCHANGES Ralls Lead In Seething Market –

Business Outlook and Tax Cut Prospect Help. NATION-WIDE BUYING TAXES WALL STREET

The article described the inflow of new investors from all across the country following

Coolidge’s re-election and the enactment of the new Budget of 1924. Brokers reported

business increasing some 300 percent (300%) following the election on November 3. In

citing the causes of the “Bull Market” The Times reports:

Wall Street sums up the development which have brought about this bull market as follows: The re-election of President Coolidge, the veering away

from radicalism in the United States and in Great Britain, the assurance that the railroads will be free from adverse legislation…the knowledge that drastic

tax readjustment will be the next step of Administration at Washington…207

There was a similar reaction in the Markets following the tax reform in 1926 and 1928.

On October 20, 1925, while Mellon was battling for his third tax cut that would bring top

marginal rates down twenty five percent (25%), The New York Times reported:

TOPICS IN WALL STREET. A Day of Wildly Confused Stock Market Movements; Trading Large.

The financial district, when if found time yesterday afternoon to talk of anything but stocks, was greatly encouraged by the outline by Secretary Mellon of his policies on taxation. It was generally

believe in Wall Street that the tax reform will be bound to be adopted in the next session of Congress, with resultant stimulus to business. Great prosperity to corporations all along the line

was predicted as a result of the reduction in Federal imposts, and the bankers also expressed the hope that the various States would emulate the Federal Government in its program of economy

and tax reductions.208

207 The New York Times Nov 9, 1924. “NATION WIDE BUYING TAXES WALL STREET AND PRICES SOAR” p. 1

208 The New York Times Oct 20, 1925. “TOPICS IN WALL STREET” p. 31

-109-

On December 9, 1927, The Times ran with:

TAX CUT REVISED; PUT AT $232,735,000; Committee Reports Bill to House

With Figures Verified by Treasury Experts. CORPORATE RELIEF LARGER

Cut Will Run to $176,000,000 and Apply on Income Received in 1927.

The reduction in the corporation tax from 13 ½ to 11 ½ percent, the bill provides, shall become operative on March 15th, 1928 on income of 1927. All

other cuts in taxes become effective thirty days after the approval of the measure by the president.209

Evidence is clear and abundant.210 The fiscal reforms driven by secretary Mellon

under the Harding and Coolidge presidencies created an environment in which the

American economy could thrive. At the same time, the Federal Reserve was able to

establish a relatively stable price level following the depression in 1921-1922. Europe

was demanding huge amounts of American goods and the United States economy

began to respond. Business innovation was high and productivity increased throughout

the decade. As taxes continued to come down the “Laffer curve,” revenue continued to

increase for government and the “booming” twenties were fully underway.211 In addition,

in response to an attractive fiscal and legal environment, businesses began to expand

and a major merger boom began to drive the economy beginning in 1925/26.

Productivity continued to increase as mergers created economies of scale and scope

and allowed corporations to reach new markets. Moreover, there is ample evidence that

even immediately prior to the stock market crash in 1929, the market was fairly priced

according to company fundamentals. Described as such, the causes and the scope of

the boom are not so surprising. In fact, the lack of previous explanations surrounding

the boom, both in the economy and the stock market, in much of the traditional literature

is startling.

209 Special to The New York Times.., “TAX CUT REVISED” Dec 9, 1927. p. 3 210 This is only a sampling of the articles in The New York Times alone. Interested readers could find many more similar articles both in The New York Times as well as the other major newspapers and journals of the period.211 See appendix C for a graphical representation of the impact of the tax-reform.

-110-

The only other country to bring tax rates down in the 1920s was Italy, which also

enjoyed a booming economy following the war. In the years following the war, Italy

found itself in severe economic retrenchment. In 1922, Benito Mussolini took control

over the Italian government. Under Mussolini, Alberto de Stefani, the Italian Minister of

Finance, reformed the fiscal structure, slashing both tariffs and the progressive income

tax policies established during the War.

France took similar action when Henri Poincare took office in August, 1926.

Following the war, France imposed a steeply progressive income tax called “l'impôt des

poires,” literally, “the tax of pears.” Wanniski describes this tax as a “suckers tax” that

was effectively only paid by those who could not escape it. As the decade progressed,

the government became more adept at enforcing tax codes and the French economy

began to contract amongst high inflation, which pushed more people into the higher tax

brackets. Total government revenues were only slightly higher for the period 1920

through 1925 than in they were in 1913, when there no income tax existed. The

financial crisis ended in 1926 when the Poincare cabinet rose to power and announced a

new tax reform on August 3, 1926. The top income tax rate was slashed from sixty

percent (60%) to thirty percent (30%). The inheritance tax and estate tax rates were

also reduced and made less progressive. The tax on securities, the capital gains tax,

was decreased by nearly forty percent (40%); the “carnet de coupons” was also

abolished.212 Following the tax reform, the franc stabilized and actually strengthened

against the dollar as the economy recovered. By 1927, the tax cuts had generated an

increase in revenues of nearly twenty-three percent (22.9%) from 5.4 billion to 7 billion

prewar francs. After Poincare took office in July, 1926 through the end of the year, the

franc rapidly strengthened on the foreign-exchange market from two cents to four cents

212 The “carnet de coupons” was established to check tax evasion on income tax due from sale of securities.

-111-

on the dollar, a 100 percent (100%) gain.213 Commenting on this stabilization and

strengthening of the franc, The New York Times printed: “the advance of the franc…has

now got a further favorable influence from the French Senate’s passage of all the tax-

reform bills.”214

The connection between tax reform, namely tax reduction during the 1920s from

excessively high progressive world income taxes, and economic success was not only

economically valid, but also readily understood by the public during this period. It is only

the historians and economists since that have failed to recognize, or acknowledge, the

connection. What remains to be seen, however, is what changed so drastically in

October 1929 to cause a sudden and remarkable fall in market valuation? Moreover,

were these the same forces that propelled the nation, and the world, into the most

severe and chronic depression in modern history?

213 Robert Murray Haig, The Public Finances of Post-War France (New York: Columbia University Press, 1929) p. 163. Information for this entire paragraph can be attributed to this source.214 The New York Times, December 2nd, 1923 pg. E6 “Prosperity and Tax Reform”

-112-

Chapter Six:

The Stock Market Crash and the Smoot-Hawley Tariff – Evidence of a Catalyst

Gain through freeing imports from taxation does not depend on other countries doing the same. For other countries to tax our exports to them is an injury to us and an obstacle to trade. For us to tax their exports to us is not a correction of that injury; it is just a separate additional obstacle of trade….If one country has good harbors while all the rest have bad ones, it will not realize the advantages of good harbors so fully as if all the rest had good ones also. But it will realize some advantages; it will be better off than if it, too, sank rocks all round its coasts.215

After rising four-fold from January 1924 to September 1929, the DJIA dropped a

third of its value in the third week of October 1929, crashing from 306 to 230 from

October 23 through October 29. In the years following the “Crash” the marked lost

ninety percent (90%) of its peak September 1929 value of 381 in an irregular decline to

41 on July 8, 1932, marking its lowest point for the DJIA in the twentieth century. In

returning to the original question – what caused the stock market crash and subsequent

depression of 1929, where the causes one and the same, and why was the depression

so severe, wide in scope, and lengthy? – It is helpful to give an overview of the existing

theories.

With regard to the crash, Galbraith, Kindleberger, Friedman and Schwartz, and

others, focus on the inevitability of collapse in prices rather than attempt to explain the

causes for the rapid decline in stock market valuation during that infamous week of

October 1929. The traditional story is that bubbles pop because they must. This

absence of any trigger for Galbraith’s “speculative mania” or for the subsequent “crash”

leave students of the 1920s and 1930s with much to be desired.216 Eugene White

215Sir William Beveridge, Tariffs: The Case Examined, (London: Longmans, Green & Co, 1932) pgs. 109-110.216 These authors often rely on the argument that expectation are “herd” events and that they need not have clear “turning points.” Whether this is a valid point or not will be left for another discussion, but even irrationality must have a source. A herd of animals may stampede irrationally, but there is always one

-113-

addressed some of these issues in a number of articles in the early 1990s, but fails

himself to come to conclusive results.217 Inevitably, he defaults back to the “bubble”

explanation. While not attempting himself to estimate the fundamental value of stocks

before the crash, White posits that the necessary conditions for a bubble were already

present. Citing work by Oliver Blanchard and Mark Watson (1982), White argues

fundamentals were becoming difficult to access in the late boom environment,

mentioning major changes in industry as evidence of this opaqueness.218

White’s second point concerns investors themselves. He argues the “overall

sophistication of investors was weakened” as more people entered the market. White

points to women as an identifiable new group that brokers began to cater toward.219 Yet

this too is unsatisfactory. To attribute the crash to “stupid investors” does not give the

market of the 1920s the respect it deserves. Nor is it easy to believe such as story

considering the sophistication of investment bankers of the time. For example, during

the first days of the Crash, bankers assembled at J.P. Morgan & Company’s office at the

corner of Wall and Broad streets across from the NYSE. The “Bankers’ Pool,” as the

group became known, consisted of Thomas Lamont CEO of J.P. Morgan & Co., his

partner and heir, George Whitney, along with head of Chase National Bank, Albert

Wiggin, Chairman of the Guaranty Trust Co, William Potter, president of Bankers Trust,

animal that notices a threat and starts to run, enticing the others. It is in this animal that the irrational panic begins. It is in what this animal understood as a threat that can be attributed as the origin of the stampede. There is always a source and the stock market is no different. Moreover, it is the opinion of this author that ample evidence has been presented that stock prices were valued rationally and so something must have turned investors’ expectations.217 See White, “The Stock Market Boom and Crash of 1929 Revisited” The Journal of Economic Perspectives, Vo. 4, No. 2 (Spring 1990) 67-83 and “Was There a Bubble?” The Journal of Economic History, Vol. 53, no. 3 (September 1993).218 See Oliver Blanchard and Mark Watson’s “Bubbles, Rational Expectations, and Financial Markets,” In Paul Watchel’s Crises in the Economic Financial Structure. (Lexington: D.C. Heath and Co, 1982) pp. 295-316. In particular White references the shift in dominance toward the modern General Motors Corp. and away from the proprietary Ford Motor Co as specific evidence for the increasing importance of technology. It should be noted that General Motors was increasing its dividend throughout the period, a clear and transparent bull signal for investors. White also cites RCA, Radio Manufacturers of America, as further evidence. RCA did not pay a dividend, but sales were growing 50 percent (50%) a year throughout the decade and there was a plethora of information concerning the extent and use of radio’s in America.219 Evidence surrounding the role of women in the stock market can be found in Frances McMullen “Women and the Ticker Tape – A Year after the Crash,” The Women’s Journal, 1987, No. 60, pp. 1-40.

-114-

Seward Prosser, and Charles Mitchell president of National City Bank. The group

immediately devoted $125 million or the equivalent of $1.54 billion in 2006 toward

supporting stocks, giving orders to Richard Whitney and Warren Nash, President and

Treasurer of the NYSE, to execute. The idea was to place large buy orders well above

market prices to halt the sell off and restore stability to the market. For example, by

noon on “Black Thursday,” October 24, 1929, a bid for 25,000 shares at $205 (over $5

million) was placed by Whitney for U.S. Steel using the bankers’ capital, while the stock

was trading at $195. Similar bid were placed in other blue chips stocks. This was a

tactic used by J.P. Morgan himself to help stabilize the markets during the 1907 panics.

It is difficult to believe that such experienced and developed investors with such huge

amounts of capital were overwhelmed by White’s new group of “unsophisticated”

investors.220

In another article, White and Rappoport present more evidence to support the

Galbraith “bubble” theory, citing widening spreads between interest rates on broker

loans (call and time loans collateralized by stocks and bonds) and other money market

rates (banker acceptances’ and commercial paper). They argue this spreading gap

indicated that “lenders…thought stock prices might collapse during the term of a loan

and jeopardize the collateral.”221 Moreover, White and Rappoport contend that these

“high premia in the brokers’ loan market therefore contain information about lenders’

perceptions of a bubble in the stock market.””222 Yet, as Tung Liu, Gary Santoni and

Courtenay Stone (1995) showed, similar or in fact larger credit spreads formed between

broker’s loans and other market rates in the late 1919 and 1920 period, when stocks

220 Barrie A. Wigmore The Crash and Its Aftermath, (London: Greenwood Press, 1985). During the 1907 bank crisis, J.P. Morgan organized a team of bankers and trust managers to redirect money between banks and secure international credit lines to halt the run on the banks and give the system liquidity. Moreover, the group eagerly created markets to keep the exchange open by buying the plunging stocks of healthy corporations. Stability in the market was created and panic subsided with only minimal macroeconomic effects. 221 White and Rappaport (1993) p. 570222 White and Rappaport (1993) p. 550.

-115-

were actually declining.223 Moreover, econometric tests provide no evidence of

parameter instability or structural breaks in credit spreads during the 1928-1929 boom.

Finally, these “interest rate premia” cited by White and Rappoport as evidence of a

“bubble,” disappeared in the weeks prior to the crash. This disappearance should not

occur if White and Rappaport are correct. Instead, it appears that the run up in broker

loan rates was due to a credit squeeze caused by the Federal Reserve, which used

moral suasion and other techniques to discourage such loans. As the supply was

restricted, simple supply of brokers’ loans and demand economics explain the higher

rates on call and time loans in comparison to banker acceptances’ and commercial

paper.224

Finally, unable to find a cause for the crash even after assuming the existence of

a bubble, White simply argued that traders’ revised their future expectations of cash flow

as evidence emerged of economic slow down. Specifically, White pointed to a drop in

Industrial Producing in July 1929. The evidence of oncoming recession combined with

rising interest rates, White argued, caused a modification in valuations and a collapse of

the “bubble.” Putting aside the fact that White first attributed the booming stock market

to “irrational exuberance,” but then proceeded to attribute the collapse to a rational

readjustment of expectations to economic conditions, White left a number of

fundamental questions unanswered. For example, why this collapse came in the last

week of October when the slowdown began in July, and why the market rallied through

the first half of 1930 to a high of 297, nearly where the DJIA stood before the crash,

White does not address. Nor does he address the fact that, according to information

provided by the Federal Reserve index, industrial production actually increased by 1.38

percent (1.38%) on a seasonally adjusted basis (2% not adjusted) in July and only

223 Tung Liu, Gary Santoni, Courtenay Stone “In Search of Stock Market Bubbles: A Comment on Rappoport and White,” The Journal of Economic History, Vol. 55, No. 3 (Sept. 1995) p. 647 - 654224 See Liu, Santoni, and Stone (1995) p. 647-654 for a full description of this argument.

-116-

began to fall in August. Moreover, this fall was of a mere one percent (1%) on a month-

over-month basis, hardly enough to cause a severe revision in expectations. Even more

important, this industrial production data only became available to traders during the

week following the crash in October, when the figures were published.225 White’s theory

is simply not supported by the data. Even if investors somehow reacted off non-

published information, the decline in output was gradual and the timing does not support

a link to the crash. As a result, it is not plausible that such a rapid and vast revaluation

of the market occurred as a result of a typical cyclical slow down in the economy,

especially considering the slowdown was not even visible to contemporaries at the time

of the Crash. There is little evidence to support White’s argument for a revision in

expectations due to a foreseen recession as the driving factor in the crash.

Galbraith sums up his explanation for the Crash in a single paragraph:

It was simply that a roaring boom was in progress in the stock market and, like all booms, it had to end. On the first of January of 1929, as a simple matter of probability, it was most likely that the boom would end before the year was out, with a diminishing change that it would end in any given year thereafter. When prices stopped rising – when the supply of people who were buying for an increase was exhausted – then the ownership on margin would become meaningless and everyone would want to sell. The market wouldn’t level out; it would fall precipitately.226

This account is more of a non-explanation that anything else. As with Galbraith above,

Kindleberger also believed that what goes up must come down. To him, however, the

crash was not a “superficial phenomenon” or a “trigger.” Kindleberger argued the crash

was endogenous to the Great Depression, by viewing it as part of the deflationary

mechanism. Yet Kindleberger failed to offer a reason for the “deflationary mechanism”

itself. Instead he fell back on Friedman and Schwartz’s argument, which credits a

225 See Federal Reserve Board Index for Industrial Production - available at: http://www.federalreserve.gov/releases/G17/ visited on March 8th, 2006. Alternatively, an argument could be made, but was not by White, that investors anticipated November’s much larger decline in output of five percent (5%) on a seasonally adjusted basis and nine percent (9%) not adjusted. This would be more inline with statistical evidence demonstrating that stock prices lead output. Nevertheless, the decline in output was likely a result or, not a cause of, the crash. 226 Galbriath (1955) pg. 29

-117-

liquidity squeeze caused by the Fed’s decision to hike the discount rate from five percent

(5%) to six percent (6%) in August 1929 as causing the crash and eventually created the

subsequent liquidity panic and bank runs of the 1930s. This theory, however, is not

wholly believable. Even if money was tight immediately prior to the crash, the Fed had

taken similar action in 1926, 1924, and 1921. The only other time the Fed’s actions can

be said to have caused a collapse was 1921, when commodity prices plunged sixty

percent (60%) in only a few months. Assets prices also fell sharply, dropping from a

high of 119 in late November 1919 to a low of sixty-six in December, 1920, a decline of

over forty-four percent (44.2%). Why did this collapse not lead to similar bank failures

and depression? Moreover, the rise in the discount rate did not have a significant impact

in the loan market. Broker loans peaked on a weekly basis for the week of October 9,

1929 at $3.94 billion and only fell to $3.82 billion on October 23, the first day of the

crash. Previous declines of larger scale did not lead to any catastrophic sell offs,

indicating the “squeeze” by the Fed was not the cause of the crash. Moreover, by

looking at the period of the boom before the crash and the period after, brokers’ loans

appear to reacted to the markets, but not to drive them.227

Others historians and economists point to similar financial factors such as a

sharp increase in the supply of new stocks, the Hatrey empire financial collapse in

England, or the October 11, 1929, decision of the Massachusetts Department of Public

Utilities to deny a stock split. These theories, however, are equally lacking in power,

circumstances or timing.

Fred I. Kent, of Bankers Trust put forward the argument that the issuance of new

securities overwhelmed the market. Stock issuances were increasing continually

throughout the Coolidge bull market. In addition, the new flow of issuances while large

in nominal terms was miniscule in comparison with the aggregate stock of equities. At

227 Liu, Santoni, Stone (1994) p. 654 & White, (1990) pg. 80.

-118-

the end of August 1929 the NYSE had a market capitalization of $89.7 billion. A dilution

because of new stock issuances might have had an impact in the decline, but could not

have been the cause the sudden break in prices.

The Hatrey collapse in London was mentioned by Galbraith as an important

shock to the market both in London and in New York. Yet the timing was wrong. The

Hatrey collapse occurred on September 20, 1929. Moreover, in order to show causality,

prices in London should fall before prices in New York. As White (1990) demonstrated,

this was not the case. The London market only lost 2.8 percent (2.8%) by October 18th,

before the New York Crash, and most of the sell off was in the Anglo-American

securities of railway stocks. The decline in both markets following the crash was simply

London reacting to the collapse in New York, not the other way around.228

Finally, the notion that the crash was triggered by a refusal to allow a Boston

Edison stock split on October 11 fails to stand up under scrutiny. The timing was again

wrong. The crash did not occur for nearly another two weeks. This fact alone cannot

refute the theory entirely, but the market also gave no indication of anticipating the

crash, as would be expected under this presumption. The day of the announcement by

the Massachusetts Department of Public Utilities, the market failed to react. The DJIA

lost 0.05 percent (-0.05%) on Friday October 11 and only half a percent (0.5%) on the

following Monday. The absence of a market reaction that might portend the later violent

sell off greatly discredits the theory. The Boston Edison regulatory decision must be

considered irrelevant to the crash.

This lack of a satisfactory explanation surrounding the crash is troubling. Bull

markets do not crash for no reason. Even speculative “bubbles,” which has been shown

to be unlikely in 1929, need to be “popped.” In the conventional literature, however, no

convincing theory adequately tells the story. The most lasting legacy of fear from the

228 White, 1990, p. 79.

-119-

Great Crash has been the failure to explain it. One more theory does remain, however.

Jude Wanniski in The Way The World Works presented a new theory surrounding the

crash; one that accepts the booming market as legitimate and looks to explain the

severe reduction in future valuations in real terms. Specifically, Wanniski points to the

Smoot-Hawley Tariff of 1930 as the “trigger” for the stock market crash.

Consider the following course of events:

(1) The New York Times ran with eight articles on December 5, 1928 documenting the

lobbying of different groups for higher duties in the new tariff and the growing resentment

of Europe to such discussions. Five more articles ran the following day, December 6.

On December 7, The Times reported that the House Ways and Means Committee had

scheduled hearings of fourteen subcommittees to take up tariff testimony in the New

Year and the hearings would cover all commodities, not just agriculture. The market

reacted immediately dropping from 290 to 279 on Thursday December 6 then to 271 on

Friday and to 263 on Monday, December 10. In the three day period, the DJIA lost

nearly ten percent (-9.2%) of its value, its largest four day sell-off since before the war!

(2) News then died down around the tariff and Coolidge actually spoke out against the

idea arguing tariff revision would be of little benefit to American farmers. The DJIA

traded up to 300 by December 31, 1928 and continued upward in 1929 until March 23,

when it stood at 310. On Sunday, march 24, page two of The New York Times read:

WATSON PREDICTS TARIFF DIFFICULTIESAFTER CONFERENCE WITH HOOVER, SENATE LEADER

SAYS INDUSTRIES SEEK WIDE REVISIONHE WILL ASK CEMENT RISE

OTHER LEGISLATORS WILL BACK OWN INDUSTRIESLONGWORTH SUPPORTS PRESIDENT ON LIMIT

-120-

The article clearly stated that Congress will not tolerate a limited tariff revision, but will

fight for a complete overhaul of the existing tariff to push rates up across the board. The

DJIA dropped to 297, a decline of 4.1 percent (-4.1%) making it the worse day on Wall

Street since October 10, 1927 when the market dropped from 197 to 189 or 4.3 percent

(4.3%). The New York Times reported that “only twice in the history of the Exchange

have there been broader breaks.”229

The following day, Tuesday March 26th, The Times printed:

GIVE HOOVER TARIFF DATADAVENPORT AND TREADWAY TELL HIM OF

TEXTILE INDUSTRY’S NEEDS

In the article, it was clear that a substantial hike in textile tariff schedules was being

pushed with little resistance in the Ways and Means Committee. This was further bad

news for the already volatile market. The market crashed on record trading volume.

8,246,740 shares changed hands, approximately 19 percent (19%) higher than any

trading day over the history of the exchange. The New York Times reported “The day’s

trading reflected forced liquidation of the most drastic sort, and the inability or

disinclination of traders…to further carry stocks whose quotations were rapidly melting

away.”230 The “crash” was adverted by a group of institutional buyers including a number

of prominent banks that stood in to stem the panic. The DJIA finished at 296, only one

point off the day before but the trading was much more volatile with the low for the day at

281. Before bankers aided the market with concentrated support, the market sold off

twenty-three percent (23%) of its value in two days, a decline nearly equivalent to that of

the “Great Crash” that would come in October.

229 The New York Times, March 25th 1929, “STOCKS PRICES BREAK HEAVILY AS MONEY SOARS TO 14 PER CENT” p. 1230 The New York Times, March 27th, 1929, “FINANCIAL MARKETS” p. 40

-121-

(3) The market then recovered, advancing to 300 where it remained through May.

President Hoover called the first Special Extra Session of Congress since 1922 to

discuss the tariff bill. He stressed revision in farm duties only. The New York Times

headlined the story on front page on April 17th 1929:

HOOVER FOR FARM BOARD AS EXPERIMENT AND 'LIMITED' REVISION OF THE TARIFF; SHARP DIVISIONS RISE IN BOTH PARTIES

In response, the market traded up two percent (2%) to 309. Meanwhile, opposition to

the tariff began to form in the Senate. A coalition of thirty-nine Democrats and fifteen

“progressive” Republicans joined forces against the “Old Guard” Republicans led by

chairman of the Senate Finance Committee and champion of the tariff bill, Senator Reed

Smoot of Utah. It appeared as if the coalition would win and the tariff would be rebuked

entirely in the Senate or, if passed, limited to agricultural products. The DJIA moved to

347 by the end of July and then to 380 by August 30. The DJIA reached 381 on

September 3, 1929, a level it would not attained again for another quarter of a century

on November 23, 1954.

4) On September 4, Congress came back to Washington from the summer recess and

the redrafted bill was presented to the Senate. The decline from 381 on September 3

began immediately, but was orderly and consistent. By Friday October 11, the DJIA was

at 352. Loans over the past two weeks had declined by $120 million as foreigners pulled

money out of America putting stress on margin accounts.231 This foreign selling was to

be expected in a world concerned over the tariff bill. The Fed had tightened rates in

August, so the current squeeze could not be attributed directly to its one percentage rate

hike to six percent (6%).

231 Friedman and Schwartz, p. 307-308

-122-

5) On October 21, the Senate rejected 64 to 10 a movement by Senator Thomas of

Oklahoma to limit the bill to increases in agriculture only. The market reacted violently.

The New York Times reported “wild and erratic movements” as traders complained of

“absence in Europe of a leading broker whose optimism” could serve to stem the slide.

6) During the debate on October 21, Senator LaFollette of Wisconsin argued the

progressive Republican bloc had voted against limiting the tariff reform to agricultural

duties with hopes of reducing rates on industrial products. On October 22, the

progressive bloc, along with the Democrats, forced a cut in the chemical rates in a test

vote, 45 to 33. The market moved up sharply, gaining six points or almost two percent

(2%) to 326.

7) Late in the afternoon on October 23, The Commercial and Financial Chronicle noted:

“A weakening of the Democratic-Progressive Coalition,” as the sixteen members of the

anti-tariff coalition switched sides and voted to double the tariff on calcium carbide from

Canada. Stocks buckled in the last hour of trading. The DJIA dropped to 305, losing

over six percent (6.3%). The “Great Crash” began.

8) The following day, October 24 or Black Thursday, The New York Times covered both

stories on the front page:

COALITION BREAKS PRICES IN STOCK CRASHOVER CARBIDE RATE HEAVY LIQUIDATION

TOTAL DROP OF BILLIONS CRASH IN FINAL HOUR

The crash that began in the final hour of trading on Wednesday, once the news of the

senate vote hit the markets, continued on Thursday. As Galbraith described, “The panic

-123-

did not last all day. It was a phenomenon of the morning hours.”232 The DJIA reached

as low as 272.32 or 11 percent (11%) off their opening of 305. The New York Times

called it “The widest break in the history of the stock market since the war…”233 The DJIA

closed at 299, down only two percent (2%). In almost identical fashion to the earlier

March crash, Bankers had pooled together to place large orders to support stocks,

including a 25,000-share bid for US Steel at ten dollars ($10) over the market price.

Volume was enormous as 12,894,650 shares exchanged hands, more the four million

more than the previous record set during the March panics.

9) By the afternoon on Black Thursday, the anti-tariff coalition had reassembled and

pushed through further cuts in chemical rates and put crude chicle on the free list.234

The DJIA gained almost two points to 301 as The New York Times reported “STOCKS

GAIN AS MARKET IS STEADIED.”235

10) On Monday, October 28, a delegation of senators appealed to Hoover for help in

pushing through the tariff bill. The front page of The New York Times read:

LEADERS INSISTBILL WILL PASS

SMOOT AND BORAHCONTRADICT REED

WHO TOLD PHILADELPHIANSBILL WAS DEAD

Suddenly both the anti-tariff coalition and the old guard Republicans promised the bill

would pass. The DJIA dropped a record thirty-eight points or eleven percent (11%),

closing a shade over 260 for a total loss of more than $14 billion in what The New York

Times called a “Nation-Wide Stampede to Unload,” as an “unexpected torrent of

232 Galbraith, pg. 104233 The New York Times, October 25th 1929, “TOPICS IN WALL STREET” pg. 43.234 Chicle is a type of tree.235 The New York Times, October 26th 1929, “STOCKS GAIN AS MARKET IS STEADIED” pg. 1

-124-

liquidation again rock[ed] market.” What is more, The Times reported “Selling by

Europeans and “Mob Psychology” as big factors in the break. The Commercial and

Financial Chronicle headlined news about broker loans reporting: “Recall of Foreign

Money Grown Heavier – All Europe Withdrawing Capital.” Again, this mad selling by

Europeans was consistent with the tariff hypothesis.

11) The following day, Black Tuesday, the selling continued and the press proceeded to

print assurance that the tariff would pass. The DJIA dropped another thirty points to

230. Volume reached another new high, smashing the previous mark with 16,410,030

shares trading hands.

12) On Wednesday, October 30 the front page of The New York Times reported, “THE

COALITION FIGHTING MOVE TO KILL TARIFF.” The DJIA rallied twenty-eight points

or over twelve percent (12.3%) to 258.

13) The Market moved erratically downward, but at a much calmer pace until the DJIA

reached 198 on November 14. On this day, The Chronicle reported that a demoralized

Senator Smoot, “virtually surrendered the tariff bill to the Coalition of Progressives and

Democrats,” and President Hoover announced a one percent (1%) tax cut on person

and corporate income rates. The DJIA finished the day at 217, up almost ten percent

(10%).

14) In the following days, the Senate postponed action on the bill until the spring

session. Talk of a filibuster covered the press. It looked like a stalemate. The market

traded continually upward reaching 241 on November 20, and then 254 where it roughly

remained, closing the year at 248. By February 18, 1930, the DJIA reached 270 and by

-125-

April 17 had reached 294, only eleven points or 3.4 percent (3.4%) from its pre-crash

level of 305. The DJIA would did not reach 294 again until 1954.

15) Also on April 17, the Tariff Conference Committee finished consideration of the

rates agreed on by the House and Senate in March and reported to Congress. The

Market began a continued downward march. Both the House and the Senate approved

the Tariff in March, while debate lingered regarding if Hoover would veto. A tariff defeat

was looking increasingly unlikely. From April 17, to the beginning of May, the DJIA

steadily declined until settling around 265 where it continued to trade within a small

range.

16) June opened and the DJIA was at 275. A plethora of economists and businessmen

warned Congress and the President not to pass the bill. 1,028 economists petitioned

against the bill. On June 3rd Dr. Theodore Grayson, Dean of the Wharton School of

Finance, was quoted in The New York Times as saying “the present method of making

tariffs is ‘suicidal as well as ridiculous.’”236 On June 10 the general sales manager for

General Motors gave a speech against the tariff stating:

America has become a creditor nation for the first time, and it is elemental in economic history that a creditor nation, particularly one which happens also to be one of the world’s greatest producing nations, must, if it hopes to preserve its prosperity, do more than buy foreign services and send its tourists abroad – it must buy foreign goods…237

Over the period, stocks declined over eight percent (8.2%), dropping to 249 the day after

the General Motor’s speech.

236 The New York Times, June 3rd, 1930, “CALLS TARIFF WALL SUICIDE FOR TRADE” pg. 6237 The New York Times, June 10th, 1930 “URGE TARIFF CUT TO AID WORLD AMITY” pg. 2

-126-

17) On June 12, the market awaited Senator Reed’s decision on the tariff. At the time,

the Senate was split 50-50 with Reed’s decision understood as the deciding factor. The

New York Times reports:

TOPICS IN WALL STREET

Because of the impression that Senator Reed’s attitude might easily be the deciding factor in the fight over the tariff legislation, Wall Street

waited yesterday with intense interest for his speech in the Senate. It was about 2:30 o’clock when the financial news ticker flashed the word that the Pennsylvania Senator would vote for the Smoot-Hawley Tariff.

Brokerage houses in their afternoon circulars devoted much space to the tariff bill’s prospects…The average price of fifty representative

stocks showed a net decline of 89 cents on the day. The erratic price swings reflected the shifting moods of the [traders].238

STOCKS BREAK AND RALLY THROUGHOUT DAYTRADERS LAY DECLINES TO REED TARIFF STAND

… For the last half our of trading the downward trend of prices was slow but steady. Of reasons given for the decline the most popular

one with traders was that Senators Reed’s statement that he intended to vote for the tariff bill as it now stands spread abroad a feeling that

the new measure would be passed.”239

18) In the afternoon on June 13, the Senate finally adopted the conference agreements

and the tariff bill was virtually assured. The DJIA finished up two points to 249, but

turnover was almost non-existent with only 2,221,900 shares traded, less than half the

average daily volume. The market was literally waiting to hear what the Senate would

do and news only broke after the market closed. The New York Times covers trader’s

sentiment:

TOPICS IN WALL STREET

Trading on the Stock Exchange was sharply curtailed yesterday, but prices were higher as professional selling subsided. The total turnover was only 2,221,900 shares and the shrinkage was ascribed to the waiting attitude

assumed by the market community on the eve of the vote in the Senate on the tariff bill. News of that body’s approval of the conference report was not received until shortly after the close of the market….With the bear party

temporarily inactive, the market was able to make considerable headway on the up side.

238 The New York Times, June 13th, 1930, “TOPICS IN WALL STREET.” Pg. 40239 The New York Times, June 13th, 1930, “STOCKS BREAK AND RALLY THROUGHOUT DAY: TRADERS LAY DECLINE TO REED TARIFF STAND.”

-127-

The following day all the market reacted to the previous day’s news from the Senate.

The House also passed the bill. The New York Times Reports:

STOCKS PRICES SAG ON PASSAGE OF TARIFFVIEWED AS WALL STREET’S DISAPPROVAL OF BILL

The market pointed downward soon after the opening and remained heavy until the close, final quotations disclosing net losses of from 2 to 7 points in many of the active issues. Among the stocks which led the decline were

United States Steel, Standard of New Jersey, Westinghouse Electric, Worthington Pump, American Water Works, Baltimore & Ohio Calumet and Arizona, Anaconda Copper, J.I. Case, United States Freight, Consolidated Gas, Eastman Kodak, International Telephone and Telegraph and Radio

Corporations.

Brokerage houses in their week-end circulars devoted much space to the tariff legislation, most of them expressing the view that its effect had been

discounted, so far as the stock market was concerned.

It is important to note that all stocks broke and that the “normal” market ,movers

continued despite trader’s actions being explicitly driven by the tariff. This aggregate

market move has been a source of criticism of opponents to the tariff hypothesis who

believe news on the tariff should only impact businesses controlled by the export and

import market. Nonetheless, the precarious position of the international financial system

left all U.S. businesses and citizens directly at risk and consequently impacted by the

bill’s passage. In addition the stock market, the grain market and other commodities

collapsed in Chicago, with wheat at an eight year low of 99 cents. Dissatisfaction with

the tariff bill was explicitly stated in The New York Times in multiple articles as the

primary cause of the general market sell off. Also, market gossip noted the long held

short position of many bear investors, indicating they had been playing this position on

the tariff for some time, perhaps since the debate picked up the previous March, 1929.

The DJIA closed the short two hour Saturday session down five points or just over two

percent (-2%) to 244.

-128-

19) Uncertainty still surrounded whether Hoover would sign the bill. Then, on Sunday,

the front page of The New York Times read: “HOOVER SAYS HE WILL SIGN TARIFF

BILL,” arresting any ambiguity. On Monday the market absorbed the news. The New

York Times made the connection clear:

DEMOCRATS TURN TARIFF FIRE ON HOOVERAS SENATE SENDS BILL TO WHITE HOUSE;BREAK IN STOCK AND COMMODITY PRICES

Selling Swamps ExchangeLeading Issues Tumble as

Wall Street Assails the New TariffCotton and Wheat Down

Former Touches the Lowest inThree Years With Grain Sagging in Chicago

Many Margin Wiped OutMuch Liquidation Due to Brokers Calling

In Vain for Further Deposit

In what The Times called the “markets formal reaction to the tariff” over eight million

shares changed hands, or four times that on Friday when the street waited in

anticipation of the Senate decision. Active issues declined seven to nineteen points and

included many of the strongest names, with Industrials and Railways declining roughly

equal amounts. Commodity prices also broke, with Wheat dropping 3½ cents to 95½

cents, or twelve cents below its level of a weak earlier, a decline of eleven percent (-

11%). The DJIA broke fourteen points or six percent (-6%) to close the day at 230,

precisely where it stood at the close of Black Tuesday, the last day of the “Great Crash”

of the previous October. The accuracy and continuity in pricing the tariff is astounding.

20) The next day, the markets in London, Paris and Germany all sold off with Anglo-

American and international shares leading the decline. The Times reported:

MARKETS IN LONDON, PARIS AND BERLIN FRENCH STOCKS DELINE; MANY BREAK SHARPLY, WHILE TRADING IS

DULL – SELLING MOVEMENT HALTED ON GERMAN BOERSE.

A liquidation continued all day as a result of increasing nervousness over European as well as American markets. Virtually no buying was anywhere in

evidence until the afternoon.

PRICES DECLINE IN PARIS

-129-

There was considerable talk in financial circles of the passage of the new American tariff bill, which some quarters is credited with causing the Wall

Street recession. Little optimism is expressed here as regards the prospects for the immediate future.

BERLIN RECOVERS AFTER LOSSES

The Wall Street break in prices had a depressing influence on today’s session of the Boerse.

In light of this congruence, this story in quite attractive. News on the tariff

correlate nearly perfectly with activity on the stock market. More importantly, the stock

market behavior, in its timing, volume, volatility, and price level is consistent. Every

major market event corresponds to the tariff. The largest three day break since World

War One corresponded with news that the tariff would be extended to all industries in

December 1928. The beginning of the battle for industrial rate increases in Congress,

lacking a coherent anti-tariff bloc at the time, corresponded with the near panic in March,

1929. The apparent certainty behind the passage of the tariff in late October matched

perfectly with the famous stock market crash. Finally, the passage of the bill in June

brought prices down dramatically and to the exact same level as in late October, 1929.

The same can be said for market rises. Every dramatic rise in the stock market

corresponds to a move by the anti-tariff coalition to block the tariff all together or to hold

rate increases to agricultural products only. Similarly, market volume jumped

considerably, often to new highs, whenever there was prominent news concerning the

tariff. Lack of news during the key periods of the debate are also related to abnormally

low volume on the major exchanges.

The tariff theory explaining the crash rests upon the notion that the stock market

measures the future value of corporations. The market, in this sense, is an instrument

for measuring the capital stock of a country. It absorbs information and translates this

information into a valuation of the shares on the market. As Wanniski explained, “The

-130-

market is the most accurately programmed computer on the planet, the closest

expression of the mind of the electorate itself. It places a value on each company within

it, based on its calculation of that company’s future income stream.”240 The most

important day-to-day information absorbed by the market is political. Only political news,

according to Wanniski, can explain a vast, universal, change in market valuation. Only a

political shock, in other wards, can instantly affect the entire market and dramatically

alter the market’s expected future income streams. In this instance, mounting evidence

supports the case for the Smoot-Hawley tariff as just such a shock.

Wanniski’s assumptions are based on a plethora of financial literature. The

“discounted-cash-flow” valuation system used by nearly every analyst and commentator

on Wall Street as well as within every major corporation in the world is based off this

very idea. In the world of finance, what is important is the future, not the past or present.

Moreover, the importance of political news is also well documented. George

Bittlingmayer demonstrated the overriding importance of political news on the market in

Output, Stock Volatility, and Political Uncertainty in a Natural Experiment: Germany

1880-1940.241 Bittlingmayer illustrated that political uncertainty created increased

volatility in the stock market and reduced output in the economy. Moreover, he finds that

despite increases in market volatility commonly being associated with output declines,

political events are actually more clearly the source of such volatility as well as often the

source of such contractions in output. Bittlingmayer’s findings are also supported by and

support the theory of irreversible choice under uncertainty. Ben Bernanke (1983) argued

that irreversibility of investment decisions implies that firms must make timing decisions

240 Wanniski, 1978, p. 124241 George Bittingmayer, “Output, Stock Volatility, and Political Uncertainty in a Natural Experiment: Germany, 1880-1940” Journal of Finance, Vol. LIII, No. 6, December 1998, p. 2243.

-131-

based off the trade on between the greater potential upside from early investment

decisions against the security gained from waiting for more information.242

Using the investment framework outlined by Bernanke and others, Robert

Archibald and David Feldman (1998) demonstrated that the political uncertainty

surrounding the Smoot-Hawley tariff played an important role in shaping investment

decisions.243 These results further support Wanniski’s theory and help show how the

tariff pushed the economy into depression by stemming output. Archibald and Feldman

find that uncertainty surrounding the Smoot-Hawley tariff did in fact slow investment

spending by businesses. Uncertainty took the form of both the domestic passage of the

bill by Congress and then the possibility of a counter-reaction by the rest of the world. In

particular they find that during 1929 investment was significantly negatively effected by

the uncertainly surround the bill. Archibald and Feldman summed up their findings by

arguing: “our results suggest that Smoot-Hawley played an important role in the

recession that later became the Great Depression.”

Yet, in general, the tariff theory has not received serious attention from the

academic world. Eugene White dismissed the idea rather quickly. He argued the tariff

could only be a key factor in the crash if the major export industries were particularly

depressed during the crash. These industries, he argued, should have reacted

differently than the aggregate market because they were the most directly impacted by

the decreased foreign demand caused by the tariff and foreign tariff retaliation. The

opposite would have been true, according to White, for nontradeables and import-

competing industries who may have actually benefited from the tariff. White then

242 Ben Bernanke, “Irreversibility, uncertainty, and cyclical investment” Quarterly Journal of Economics, No. 85, 1983, pg. 85-106. Robert Pindyck (1991), in “Irreversibility, uncertainty, and investment” likened the concept to a financial call option. Since Pindyck, MIT professor Steward Myers has coined a similar valuation model “real options” which uses Black-Scholes like inputs for financial options pricing to value companies.243 Robert Archibald & David Feldman, “Investment during the Great Depression: Uncertainty and the Role of the Smoot-Hawley Tariff,” Southern Economic Journal, Vol. 64, No. 4 (Apr. 1998) p. 857 – 879.

-132-

identified industries as “exporters,” “importer-competing” or “nondurables” and found that

the stocks of all groups declined approximately the same percentage at the time when

the tariff was assured. He then concluded that “thus no evidence [exists] to support the

view that the Smoot-Hawley tariff significantly contributed to the crash.”244 Barry

Eichengreen also questioned the theory by citing the fact that exports only represented

four-to-five percent (4-5%) of GDP at the time and therefore could not possibly have

caused such a large drop in market valuation.245 Others economist and historians there

was little record of trader gossip linking the tariff with the crash.

All these criticisms, however, are unfounded. To begin with the last criticism first,

traders and commentators did link the crash with the tariff. This is especially evident

during the market decline in 1930 where the New York Times continually cited traders

who attributed the violent market sell offs to the tariff. Less has been written about the

Crash of 1929, but it can hardly be said that there was no gossip. In the ten days

between October 21, 1929 and October 31, The New York Times alone published 171

stories concerning the tariff bill. This plethora of news, averaging seventeen articles a

day with multiple headlines frequently covering the front page, hardly could have

escaped traders’ radar. In addition, Irving Fisher, the prominent financial economist of

the day, made the connection in his book The Stock Market Crash and after. Similarly,

immediately after the October crash, Fred I. Kent, President of Banker’s Trust, outright

accused the uncertainty around the tariff bill as the primary causing of the crash. Nor

was Kent alone when he argued: “As soon as dealers in securities who were constantly

on watch for indications as to business changes, realized this feeling of uneasiness [on

account of the tariff bill] was spreading throughout industry, they began selling stocks.”246

244 White, (1990), pg. 79.245 Barry Eichengreen, “The Origins and Nature of the Great Slump Revisited,” The Economic History Review, (May, 1992). Vol. 45, No. 2

246 Fisher (1930), p. 48

-133-

Kent made similar remarks on November 11, in a speech before 400 bankers. The

connection between the tariff bill and stock market activity was well established by

contemporaries of the period. The same can be seen in The Commercial and Financial

Chronicle, the leading investment journal of the day, which extensively covered the news

of the tariff. In 1922, no such news coverage was given to the Fordney-McCumber tariff.

Clearly the financial community was aware and active with regard to the tariff and

criticisms based on a “lack of trader gossip” are unfounded.

The other main sources of criticism can be treated together. The blindness and

vastness of the market reaction can only be understood in light of the uniqueness of the

post war economy. World War One was a tremendous shock to the world financial

system and completely changed both the monetary and fiscal environments by derailing

the Gold Standard and introducing the income tax. Even more importantly, it placed the

world on unstable financial footing in the form of huge international war debts. These

debts are what made the world economy, as well as the American stock market, so

susceptible to collapse. The fiscal activity focused on in this theory simply put pressure

on the economy to support (tax reform) or break (tariff bill) this precarious international

financial situation.

Throughout the 1920s, Secretary of Treasury Mellon and Presidents Harding and

Coolidge embarked on a vast reformation of the American domestic tax system. As

Chapter One and Chapter Five made clear, the stock market responded positively to this

tax reform. The bull market corresponded almost perfectly to the systematic reduction in

tax rates from seventy-three percent (73%) during the war, to fifty-three percent (53%) in

1921, to forty-six percent (46%) in 1924 when the market began its rise, and then to

twenty-five percent (25%) in 1926 when the market truly began its steep upward climb.

In addition, the corporate tax cut in 1928, with new rates effective on 1927 earnings, also

corresponded beautifully with the booming bull market of the 1927-29 period.

-134-

In late 1928, however, the country changed course dramatically. The election of

President Hoover in November 1928 brought a new type of taxation into the economy –

a tax on international transactions. Hoover ran on a protectionist platform, stating:

The Republican Party believes that the home market, built up under the protective policy, belongs to the American farmer, and it pledges its support of legislation which will give this market to him to the full extent of his ability to supply it….It is inconceivable that American labor will ever consent to the abolition of protection, which would bring the American standard of living down to the level of that in Europe, or that the American farmer could survive if the enormous consuming power of the people in his country were curtailed and its market at home, if not destroyed, at least seriously impaired.247

A tariff on agricultural goods, however, was not the major concern. Farmers

were in dire straights in much of the country simply because mass production and

technological innovation had created greater economies of scale and allowed farmers to

bring more to market. This increase in supply was paired with a decrease in demand

from Europe with the revival of European production after the War. The threat, however,

came in the form of a protective tariff which spread rate increases to other industries,

halting international trade and creating problems in the international banking system.

Besides the enormous war debts of $11.9 billion, some of which had been paid off, the

rest of the world borrowed an additional $12.5 to 14.5 billion from private American

sources between 1919 and 1929, according to estimates by the Department of

Commerce.248 In order for Europe to pay off these debts, it needed to trade with the

United States. The rest of the world ran a “trade deficit” with America, buying more

goods and services from the United States than it sold. At the same time, the America

ran a “capital-accounts deficit” with the rest of the world, as is illustrated in its huge

creditor position. The only way for the United States citizens, who were particularly

247 Wanniski, p. 127248 Special to The New York Times. May 5, 1930 “1,028 Economists Ask Hoover To Veto Pending Tariff Bill:Professors in 179 Colleges and Other Leaders Assail Rise in Rates as Harmful to Country and Sure to Bring Reprisals. Economists of All Sections Oppose Tariff Bill” This article cites information from the Department of Commerce.

-135-

exposed, to continue to get paid back was through continued world trade. Either the rest

of the world needed to sell their goods and services on the American market to take in

dollars for which they could pay off debts, or America needed to continue to extend

credit in dollars to the rest of the world to allow them to meet their debt payments.

Investment abroad by Americans had already begun to decline in 1928/29 period. This

slow down in FDI corresponded with a slowdown in the world economy beginning in

1928. Then, in 1929, the government threatened to choke off the possibility of trade and

the only chance for investors to get paid back began to disappear.

More importantly, this concept was well understood at the time. The World

Economic Conference of 1927 held in Geneva stressed the importance of free

international trade to support the continuance of debt payments and the maintenance of

peace. The Conference was called under the general theme of consolidating the

economic recovery to ensure its continuance: “the whole work of the Conference was

dominated by…resolutions on international trade…inspired by the ideal of the rational

distribution of work between nations.”249 International trade was deemed essential in

maintaining world peace and avoiding another war of international scale. The

Conference made the case as follows:

We are concerned not only with the prosperity but with the peace of the world. It is our unanimous conviction that the maintenance of world peace depends largely upon the principles on which the economic policies of nations are formed and executed, that the Governments and people of all countries should constantly take counsel together as to this aspect of the economic problem; and that we should look forward to the establishment of a recognized body of principles designed to eliminate the economic difficulties which cause friction and misunderstanding. Economic conflicts and divergence of economic interest are perhaps the most serious and most permanent of all dangers which are likely to threaten peace of the world….No task is more urgent or more vital than that of securing agreement on certain principles of policy which are necessary in the interests of future peace. (Bond mine)250

249 J.P. Day, An Introduction to World Economic History Since the Great War, (London: Macmillan and Co, 1939) pg. 75.250 Taken from Day, p. 76

-136-

The Conference went on to conclude that “for these reasons…the time has come to put

a stop to the growth of Customs tariffs.”251

In addition, The New York Times ran a series of articles following the election of

Hoover regarding the impact of a new tariff. On November 1, 1928, The Times printed:

“TARIFFS AND DEBTS,” in which it stated:

It is much to be hoped that an adjustment of all these tariff disputes may be reached. Neither country could face a tariff war with equanimity. The United States would suffer more from it than would France. This is not simply because she buys from us more than she sells, but because the whole question of the French war debt to our Treasury is involved in the question of French exports. Already the French press is complaining that America, while demanding full payment of the French debt, is more and more shutting her doors against French goods…252

Another article published on July 7, 1929, titled: EUROPE LOOKS HARD AT OUR

TARIFF WALL,” stressed the fear felt by the rest of the world concerning the enactment

of a new, higher tariff wall by the United States. The article quoted a German writer

confused by the American actions. He called it a “curious irony” that simultaneously with

the Young plan for payment of reparations and debts, America began considering an

increase in tariff rates, which would handicap the rest of the world in making debt

payments. “One can not continue to sell where one does not buy…and a creditor should

not reduce his debtor’s capacity to pay.” The French understood the same argument. A

Parisian business man quoted in the article explained: “In agreeing to pay our debt in

America we ought at least to be assured that our export trade, necessary to pay the

debt, will receive fair treatment.”253

World economists spoke out against the tariff as well. The month before the

Smoot-Hawley bill was signed into law, 1,028 economists, including Irving Fisher of

251 Taken from Day, p. 78252 The New York Times, Nov 1, 1928. “TARIFFS AND DEBTS” p. 28 253 Harold Callender,The New York Times, Jul 7, 1929. “EUROPE LOOKS HARD AT OUR TARIFF WALL; Nations Across the Sea Weigh Means to Meet the New Threat of Competition Involved in Higher Schedules--The Various Objections Put Forth by Manufacturers and Commercial Organizations Some of European Complaints. The Most Unhealthy Aspect. Causes of Europe's Fears. British Anxieties. Bitter French Protests. European Rapprochement. "Invisible Payments." America's Prohibitions. “p. 110

-137-

Yale, Frank Taussig of Harvard, Frank Fetter of Princeton, Wesley Mitchell of Columbia,

and J. Laurence Laughlin of the University of Chicago among many others, petitioned

Hoover in protest of the bill. The New York Times front page ran the story:

1,028 Economists Ask Hoover To Veto Pending Tariff Bill:

Professors in 179 Colleges and Other Leaders Assail Rise in Rates as Harmful to Country and Sure to Bring Reprisals. Economists of All Sections Oppose Tariff

Bill

The text of the [economists] statement is: …Many of our citizens have invested their money in foreign enterprises. The Department of Commerce has estimated that such investments, entirely aside from the war debts, amounted to between $12,555,000,000 and $14,555,000,000 on Jan. 1, 1929. These investors, too, would suffer if restrictive duties were to be increased, since such actions would make it still more difficult for their foreign debtors to pay them the interest due

them.

…The higher duties proposed in our pending legislation…invite other nations to compete with us in raising further barriers to trade. A tariff war does not furnish

good soil for the growth of world peace.

It is clear that not only did the entire world understand that a tariff war would bring down

the international banking system at the expense of American creditors, but also that

such actions would threaten world peace. Both, in retrospect, seem to be eerily

prophetic statements.

Following the passage of the tariff in June, country after country took retaliatory

actions, enacting their own tariffs. The much feared tariff war had come to fruition. This

tariff war brought a complete slow down in world trade and the stock market continued to

sink. While obviously detrimental to the import and export industries, the tariff bill’s real

horror was the realization that Americans would never be paid back what they were

owed by the rest of the world. With at least $12.5 billion in privately invested funds

extended abroad, the tariff greatly increasing the chance of default. This sudden change

in credit risk caused a vast re-valuation on Wall Street. Of course other factors

contributed, but as the international financial system collapsed, output declined and the

world sank into depression.

-138-

Finally, the size and speed of the market sell offs cannot be wholly attributed to

the Tariff. The capital gains tax helped to make the crash a panic. As the stock market

rose, seemingly continuously, from 1926 through 1929, investors were hesitant to close

their positions for fear of creating a taxable event. Throughout the period investors

criticized the Capital gains tax. President Mitchell of National City Bank and President

Kent of Bankers Trust were two of the loudest voices against the tax. Mitchell wrote in

January 1929, “If one could check up on the people leaning on borrowed money for the

carrying of securities, it would be found that there are an overwhelming number of

holder, who, because of this tax, do not sell.”254 Others too called for an abolition of the

capital gains tax. Irving Fisher wrote in 1930, “the capital gains tax operated to prevent

outright selling and buying of stocks…[and] stimulated holders to enlarge their margin

accounts because their own funds were locked up in held securities.”255 For years

investors held unrealized gains, refusing to take profits through liquidation, but instead

bought new stock on margin using borrowed money. As the capital gains tax kept

decreasing throughout the decade as Mellon slashed income taxes from seventy-three

percent (73%) to twenty-five percent (25%) investors had further reason to hold their

stocks. The expectation of future tax reductions made selling increasingly irrational for

the contemporary investor. The resultant rapid build up of margin accounts in 1929 put

the market in a bad technical position, and made it vulnerable to a crash when news of

the tariff hit the wires. The capital gains tax was not the trigger, but effectively

leveraged the market and so helped the readjustment due to the tariff be increasingly

severe and uncontrollable. Panic set in as more and more margin calls forced more

and more selling on the market. As Irving Fisher wrote: “…revenue from the sale of

capital assets including stocks, bonds and real estate, amounted to less than 10 percent

254 Fisher, 1930, p. 39255 Fisher, 1930, p. 38.

-139-

(10%) of total…incomes. In any event the government would have had little to lose and

much to save,” by abolishing the capital gains tax.256

Econometric Support: A Regression Analysis

It is important to examine the period 1928-1930 as a whole. The crash of

October 1929 should not be separated from the earlier panics in March 1929 or later

panics in June 1930. Nor should the “crash” be analyzed separately and without context

of the bull market that preceded it. Obviously it is impossible to say with certainty what

caused the stock market to move up or down on any certain day, but the evidence

surrounding a correlation between the market of 1929 and the Smoot Hawley tariff is

compelling. The historical importance and degree of this connection has already been

outlined in this thesis and by Jude Wanniski and Alan Reynolds before.257 In order to

better understand the connection, however, some econometric analysis is useful.

Econometric tools helps illustrate and quantify the significance of the Smoot Hawley tariff

in a way hitherto unexamined. From January 1, 1928 through July 31, 1930, the words

“Smoot” and “Tariff” appear together in 464 articles. These articles were used for

econometric analysis. In addition, however, articles appeared in 240 of the 647 trading

days of the period under examination. Because Senator Smoot was the champion of the

Bill in the Senate, articles that include his name were generally the largest and most

important articles surrounding the bill on a given day. That said, news of the tariff

dominated the period. In fact, 7,799 articles were written in The New York Times alone

from January 1, 1928, through July 31, 1930.258 During the period of the crash, from

256 Fisher, 1930, pg. 40.257 See Wanniski (1978) and Reynolds (1979).258 A compilation of this full data set would be a great addition to this preliminary study. Due to time and energy limits, however, the small data set of 464 articles was used. This data set is available from the author upon request. As a point of comparison, the North American Free Trade Agreement (NAFTA) and the World Trade Organization (WTO) debates in the 1990s received substantially less press. From 1991

-140-

October 20, through Oct, 31, 126 articles appeared. In the ten days March 20 through

March 30, during the first market panics of 1929, sixty-two (62) articles appeared in The

New York Times. Similarly, during the panics of June 1930, which traders directly

attributed to news on the tariff, The New York Times printed 169 stories from June 9

through 18. Over each these periods, articles covered the front page, headlining next to

reports about the market panics of the day before. This saturation of tariff news is

important and impossible to miss.

In order to gauge the importance of this news to traders, the news stories can be

broken into three groups: “good” stories that indicate the bill will be killed or limited to

agricultural industries only, “bad” stories that indicate the bill will be passed and include

rate hikes in all industries, and “ambiguous” stories that are not clearly positive or

negative.259 When done, a number of supporting facts become evident. First of all,

news about the tariff had important effects on daily market returns.260

“Bad” news regarding the tariff is related to large market sell offs, especially

during the period of the October crash. At the same time, the inverse is true regarding

“good” news about the tariff. This is a substantial finding. Average market returns on

days with “good” tariff news is 1.15 percent (1.15%) or over 205 percent (205.6%) above

that of the average daily return for all trading days in the study. Similarly, average

returns for days with “bad” tariff news is negative 1.53 percent (-1.53%) or a decline of

over 507 percent (-507.35%) of the average daily return. The results become

even more dramatic during the periods immediately surrounding the crash in October

1929 and July 1930. This fact, that “good” tariff news is clearly and substantially

through 1994, NAFTA received only 722 articles in The New York Times, while WTO received 677. For all of the 1990s, there is only 2,306 articles regarding NAFTA and 1,132 articles concerning the WTO. Even combined, and over a period of ten years, the WTO and NAFTA debates received substantially less press than the Smoot-Hawley’s 7,799 articles in less than three years. 259 The reader should be aware that the following information uses only those stories in which the words “tariff” and “smoot” appeared. A data base including this breakdown and the news story headlines is available from the author upon request.260 For the purpose of this paper, market returns are estimated using the daily return of the Dow Jones Industrial Average.

-141-

associated with positive market returns and “bad” tariff news with negative returns, add

explicit empirical support to the historical correlation observed and documented

surrounding the stock market crash and the tariff. The below table highlights the

profound impact news about the tariff had on market returns.

Returns Summary

January 1928 through July 1930 Average Return Impact % IncreaseTariff News -0.13% -0.51% -134.49%Bad Tariff News -1.53% -1.91% -507.35%Good Tariff News 1.15% 0.77% 205.60%Period Average: 0.38%August 1929 through December 1929Tariff News -0.20% -0.57% -151.99%Bad Tariff News -2.58% -2.95% -784.03%Good Tariff News 1.95% 1.58% 419.08%January 1930 through January 1930Tariff News -0.13% -0.51% -135.82%Bad Tariff News -1.44% -1.82% -482.94%Good Tariff News 0.85% 0.48% 126.57%

In addition, regression analysis indicates that news about the tariff is statistically

important to daily market returns. This examination allows a degree of causation to be

attributed to the tariff, disputing the criticism that the connection between tariff news and

market conditions being completely coincidental. For the entire period under analysis

“bad” tariff news brought a 1.7 percent (-1.7%) decrease in market valuation, while

“good” news brings a one percent (1%) increase in market value.261 Moreover, nearly

fifteen percent (15%) of market returns can be explained by tariff news alone. These

findings become more robust when specific periods are examined individually. News on

the tariff becomes even more explanatory. For the period of the October crash, news on

the tariff can explain twenty-three percent (23%) of market returns and for the period of

the July 1930 crash, the tariff can explain twenty-seven percent (27%).262

261 These results were found using the DJIA.262 The results are robust even when corrected for problems of autocorrelation and heteroskedasticity. Using the ARCH function in stata to correct for these potential problems, the results remain the same with a WaldChi-Squared statistic of 224.97 indicating the regression is highly significant.

-142-

During the period of the Crash, from August, 1929 through December, 1929,

“bad” news caused a drop in market valuation by 2.3 percent (-2.3%), while good news

caused an increase of 2.2 percent (2.2%). Similar results are found for the period of the

June, 1930 crash. During this time frame, from January 1, 1930 through July 31,, 1930,

“bad” tariff news alone can explain nearly a quarter of daily market returns, causing a

drop in the DJIA of 1.7 percent (-1.7%) to 1.9 percent (-1.9%) on average. These are

large moves in daily market valuation. For the entire period, average daily returns are

less than a tenth of a percent (0.06%). Tariff news clearly contributed significantly to

changes in daily market returns, adding support to the argument that the tariff

substantially helped trigger the market panics of March, 1929, October, 1929 and July,

1930.263

The second important observation arising from the data is the impact on short

term volatility.264 The table below summarizes these findings:

Volatility SummaryAverage Volatility

Tariff News 28.28%Bad Tariff News 32.79%Good Tariff News 28.01%No Tariff News 19.99%Period Average 23.26%

With Respct to No Tariff News % IncreaseGood News Impact + 8.02% + 41.50% Bad New Impact + 12.80% + 64.06% Tariff News Impact + 8.29% + 40.14%

As can be seen in the table, “bad” news about the tariff significantly increased market

volatility. Specifically, “bad” tariff news caused a more than sixty-four percent (64.04%)

increase in volatility. Furthermore, even if the subjectivity of separating articles into

“good” and “bad” groups is removed, aggregate tariff news alone brings over a forty

263 See Appendix A for results.264 Short term, ten-day historical volatility was used in this analysis.

-143-

percent (40.14%) volatility premium. A more volatile market is generally considered a

more bearish market. In many ways, volatility is equated with risk. Therefore, this

finding indicates that news about the tariff, directly or indirectly, made traders more

nervous about the inherent risk of stocks. Market valuations became more uncertain as

the tariff appeared more likely to pass.

Regression analysis again demonstrates that the results even more compelling.

The analysis indicates that while “good” news is not statistically important to stock

volatility, “bad” news is very significant.265 The finding makes sense and is consistent

with the existing literature because trading reactions to negative tariff news was

exaggerated by other factors, such as margin calls, which increased selling and caused

volatility to spike even further. Furthermore, when removing any subjectivity from the

examination, the impact of any “tariff news” signifies that the tariff was an important

cause of market volatility.

As was the case with daily returns, more insight can be gained by examining the

impact of the tariff on market volatility for specific time periods. While news surrounding

the tariff can only explain approximately eight percent (8%) of market volatility for the

entire period January 1, 1928 through July 31, 1930, the explanatory power increases

substantially around the period of the October, 1929 crash and the July, 1930 crash.

For the period surrounding the “Great Crash” tariff news can explain fifty-six percent

(56%) of changes in short term volatility. “Bad” news again is found to be significant

while good news is not. On average, a day with “bad” tariff news saw a 13.4 percent

(13.4%) jump in volatility for this period. Also the results are the same when the

subjectivity of the analysis is eliminated by analyzing the impact of “tariff news” in

general without grouping the news further into good and bad categories. On average,

days with any tariff news of any kind saw volatility fourteen percentage points (14%)

265 See Appendix B for data output.

-144-

higher than on days without tariff news. The results for the period surrounding the crash

in June 1930 are even more robust. For this period, tariff news can explain nearly

seventy percent (69.3%) of the variation in market volatility.

By objectively demonstrating the connection between tariff news and the

increase in market volatility surrounding the 1929-1930 stock market, these findings

contribute to existing literature. A gap in the current literature exists in the largely

unexplained decline in consumer spending during the period. In 1990, Christina Romer

illustrated that stock market variability can explain the decline in aggregate demand, as

uncertainty halted consumer expenditure. Romer writes that “the negative effects of

stock market variability is more than strong enough to account for the entire decline in

real consumer spending on durables that occurred in late 1929 and 1930.”266 Romer,

however, did not attempt to hypothesis what caused the increase in market volatility in

the first place. The large significance of tariff news in explaining volatility during this

same period substantially adds to Romer’s findings by identifying exactly what triggered

market volatility. The tariff bill, therefore, indirectly precipitated the decline in consumer

spending. In such, a new path is uncovered over which the Smoot Hawley tariff was

transmitted to the aggregate economy.

From this investigation, both historical and econometric, it is clear that the

Smoot-Hawley tariff played a substantial part in the stock market collapse of the 1928-

1930 period. In the modern literature, the stock market boom and crash of the 1920s

remains largely unexplained. Most authors have not even attempted to explain the

boom, but instead have focused, unsuccessfully, on proving the existence of a “bubble.”

Nor have authors succeeded in explaining what triggered the “bursting” of the bubble

with any plausibility. The most shocking aspect of the modern literature is really the lack

of any explanation. Instead authors merely assert that the stock market collapsed

266 Romer, “The Great Crash and the Onset of the Great Depression,” NBER Working Paper, June 1988.

-145-

simply because it rose. By understanding the impact of fiscal activity on the market a

new interpretation of the Crash and the depression is possible. Instead of the failure of

markets, the failure becomes that of government. It is only in light of this entire process

of the post-war period that the micro events surrounding the “Great” Crash of 1929 can

be understood. An analysis of the stock market cannot be done in a vacuum. The

forces at work in the 1920s boom did not change in October 1929 or in the post crash

period of 1930 through the ensuing years of depression. Only by viewing the period,

including the crash, in this larger context can the causes be understood. The enormous

economic shock of World War One transformed the international economic and political

relationships that existed previously. The international debt and banking structure

completely reversed and in many ways was left in shambles with the United States and

Germany as opposing pressure points. The world was left with excessively high tax

rates following the war. As the United States reduced rates throughout the 1920s, the

economy and then the stock market reacted brilliantly. The change in policy in late 1928

with the introduction of protectionist policies caused a period of uncertainty and

eventually disaster. The passage of the tariff corresponded perfectly with the panics on

Wall Street and helps explain the decline in consumer expenditure stimulated by

excessively volatile capital markets. The basis of this thesis was originally presented by

Jude Wanniski in The Way the World Works, but has remained largely ignored by the

modern literature. The addition of econometric analysis in support of the tariff theory

adds new validity, and hopefully new attention, to the explanation.

-146-

Conclusion

The date, October, 1929 is undoubtedly an historical landmark. Like September

11, 2001 and December, 1941, October, 1929 has remained fixed in the minds of most

Americans. The date and the Crash that took place that day have become part of our

modern culture. However, to most scholars and certainly most Americans, the crash of

1929 is also a great mystery. Now, more than seventy years later, Americans still worry

during every bull market, whether the tragedy is about to be repeated. Like the World

Trade Center attacks on September 11, 2001 or the dropping of the first atomic bomb in

1945, historians and economists alike have used the stock market crash as a symbol for

the end of one era and the beginning of another. This is understandable. At the

beginning of the year, economic activity was still thriving. By the end of 1929, however,

the stock market had collapsed and the world was lurching into an increasingly serious

recession. As a result of this thinking, however, scholars have struggled to come up with

convincing answers to what caused the crash and what, if any, role it played in bringing

on the following depression. As David Kennedy observed, “The disagreeable truth…is

that the most responsible students of the events of 1929 have been unable to

demonstrate an appreciable cause-and-effect linkage between the Great Crash and the

Depression.”267

By approaching the problem from a wider historical prospective, this thesis

presents a new integrated explanation for these unanswered questions. The events that

drove the economic boom and the large stock market appreciation in the 1920s also

drove the events in 1929 and 1930 that sent the economy and the stock market spiraling

267 David M. Kennedy, Freedom from Fear: The American People in Depression and War, 1929-1945, (New York, 1999) p. 39

-147-

downward. History, like the economy, cannot be judged by examining instantaneous

and static moments. Only be accounting for the fluidity of history can an understanding

be reached.

World War One brought such an enormous shock to the international financial

system that it left the world in a precarious position. Even while economic conditions

were good, as they were for almost the entirety of the 1920s, America was continually at

risk of collapse had the European reconstruction failed at any time. The huge creditor

position of the United States vested U.S. interest entirely with that of the world economy.

Isolation was financially impossible after World War One. As demonstrated in the

preceding chapters, those economies (with particular attention to the United States) that

brought tax rates down toward peacetime equilibrium saw tremendous economic growth

and prosperity along with rising tax revenues. These measures propped up the fragile

international financial system. At the same time, the Fed struggled to find a functional

monetary policy as Europe scrambled to rejoin the now-US led Gold Standard. Barriers

to trade were lowered and the American economy became increasingly open as the tax

wedge was eliminated. The economy boomed and the stock market flourished.

However,, a reverse policy of protection, including increasingly high barriers to

trade, began, in late 1928, to move the economy toward a more closed posture. The

vehicle of this policy reversal was the debate over the Smoot-Hawley tariff, which

passed Congress in June 1930 and was signed into law the same month. These actions

put the opposite pressure on the world financial system, breaking down world trade and

bursting the credit imbalance that existed as a result of World War One. The stock

market and the economy collapsed as international finances were forced into default.

While it cannot be covered properly in the scope of this thesis, the same forces

continued to work as America fell into the worst and most prolonged depression of its

short history. By the beginning of 1931, the economy seemed to have reached a point

-148-

of economic equilibrium, having discounted the higher international wedge created by

the tariff bill. This equilibrium, however, was lower than that of the pre-tariff period and

the slowdown in economic activity had created a budget deficit for Hoover of more than

$1 billion in only eighteen months.268 Hoover and Ogden Mills, who had replaced Mellon

as Secretary of Treasury, proposed an increase in income-tax rates to close the deficit.

The top marginal personal income tax was pushed up from the twenty-five percent

(25%) rate established by Mellon in 1926 to sixty-three percent (63%). Just as

importantly, the lowest bracket saw a rate increase of four-hundred percent (400%),

increasing from a rate of one percent (1%) to a rate of four percent (4%). Corporate

rates were also raised in the bill. To make matters worse, the bill, which passed the

Senate and was signed by Hoover in June, 1932, was made retroactive to January 1,

1932.269

Having already widened the international wedge with the tariff bill, Hoover now

put the domestic wedge back to its 1921 position, effectively undoing the “scientific

taxation” orchestrated by the Mellon plan that Harding and Coolidge had worked to put

into place. As a result, money flowed out of the stock market as business activity was

further depressed. The bill passed on June 6, 1932 and the market dropped eight

percent (-8%) in two days of trading. After only a month, the market lost over sixteen

percent (-16.4%) of its value, reaching its lowest point of the twentieth century on July 8,

1932 of 41.22.

Franklin Roosevelt then ran on a platform that “condemned” the Smoot-Hawley

tariff and pledged “reciprocal tariff agreements with other nations, and called for an

international economic conference designed to restore international trade and facilitate

exchange.”270 Before his inauguration, in February, 1933, Roosevelt named Cordell Hull 268 Wanniski, pg. 152269 Wanniski, pg. 152.270 “The Democratic Party Platform of 1932,” taken from The American Presidency Project at UC Santa Barbara website. Available at: http://www.presidency.ucsb.edu/showplatforms.php?platindex=D1932;

-149-

as Secretary of State. Hull was a former Senator from Tennessee who had devoted

much of his attention in the preceding years to repealing the tariff bill. He attributed

America’s economic problems to international causes. On April 9, 1933, The New York

Times printed: “ROOSEVELT SCRAPS POLICY OF ECONOMIC NATIONALISM TO

ASSIST WORLD PARLEY.” The article described how Hull attributed the “World Slump

to 12 years of isolation.” The new administration had invited eleven nations to consider

a revival of trade through agreements to lower tariffs. In response the stock market

surged nearly seventy percent (70%) from 59 on April 8, 1933 to finish the year at 100.

Increasingly, however, President Roosevelt turned away from the international platform

he campaigned on. Instead, he began to focus on internal remedies, such as national

planning and the infamous New Deal. Consequently, the economy would continue to

flounder for much of the remaining decade and would not truly come out of economic

stagnation until after World War Two.

visited on April 9, 2006.

-150-

APPENDIX A:

Results for entire period: January 1st, 1928 through July 31st, 1930:

. regress returns TariffNews Goodnews BadNews Source | SS df MS Number of obs = 644 -------------+------------------------------ F( 3, 640) = 36.44 Model | .032925694 3 .010975231 Prob > F = 0.0000 Residual | .192734893 640 .000301148 R-squared = 0.1459 -------------+------------------------------ Adj R-squared = 0.1419 Total | .225660588 643 .00035095 Root MSE = .01735 ------------------------------------------------------------------------------ returns | Coef. Std. Err. t P>|t| [95% Conf. Interval] -------------+---------------------------------------------------------------- TariffNews | .0004909 .0022747 0.22 0.829 -.0039758 .0049576 Goodnews | .0096464 .0028463 3.39 0.001 .0040573 .0152356 BadNews | -.0171963 .0027883 -6.17 0.000 -.0226716 -.0117209 _cons | .0013685 .0008634 1.59 0.113 -.0003269 .0030639 ------------------------------------------------------------------------------

Results for August 1st, 1929 through December 31st, 1929:

. regress returns goodnews3 badnews3 Source | SS df MS Number of obs = 102 -------------+------------------------------ F( 2, 99) = 14.53 Model | .028728597 2 .014364299 Prob > F = 0.0000 Residual | .097841648 99 .000988299 R-squared = 0.2270 -------------+------------------------------ Adj R-squared = 0.2114 Total | .126570245 101 .001253171 Root MSE = .03144 ------------------------------------------------------------------------------ returns | Coef. Std. Err. t P>|t| [95% Conf. Interval] -------------+---------------------------------------------------------------- goodnews3 | .0223085 .0075353 2.96 0.004 .0073567 .0372602 badnews3 | -.0229887 .0075353 -3.05 0.003 -.0379404 -.008037 _cons | -.0027652 .0046352 -0.60 0.552 -.0119624 .006432 ------------------------------------------------------------------------------

-151-

Results for January 1st, 1929 through July 31st, 1930.

. regress returns goodnews4 badnews4 Source | SS df MS Number of obs = 146 -------------+------------------------------ F( 2, 143) = 25.85 Model | .010746427 2 .005373214 Prob > F = 0.0000 Residual | .029722279 143 .000207848 R-squared = 0.2655 -------------+------------------------------ Adj R-squared = 0.2553 Total | .040468707 145 .000279095 Root MSE = .01442 ------------------------------------------------------------------------------ returns | Coef. Std. Err. t P>|t| [95% Conf. Interval] -------------+---------------------------------------------------------------- goodnews4 | .0062286 .0029162 2.14 0.034 .0004642 .0119931 badnews4 | -.0167194 .0029162 -5.73 0.000 -.0224839 -.010955 _cons | .0023017 .0016991 1.35 0.178 -.0010568 .0056602 ------------------------------------------------------------------------------

-152-

APPENDIX B:

Results for entire period: January 1st 1928 through July 31st, 1930:

. regress Vol10day TariffNews Goodnews BadNews djia Source | SS df MS Number of obs = 645 -------------+------------------------------ F( 4, 640) = 14.11 Model | 1.77822576 4 .44455644 Prob > F = 0.0000 Residual | 20.1651203 640 .031508 R-squared = 0.0810 -------------+------------------------------ Adj R-squared = 0.0753 Total | 21.943346 644 .034073519 Root MSE = .1775 ------------------------------------------------------------------------------ Vol10day | Coef. Std. Err. t P>|t| [95% Conf. Interval] -------------+---------------------------------------------------------------- TariffNews | .0637542 .0239878 2.66 0.008 .0166499 .1108586 Goodnews | .0339946 .029117 1.17 0.243 -.0231819 .0911711 BadNews | .0763634 .0286006 2.67 0.008 .0202012 .1325257 djia | -.0004857 .0001496 -3.25 0.001 -.0007794 -.0001919 _cons | .3237481 .0391644 8.27 0.000 .2468418 .4006543 ------------------------------------------------------------------------------

. arch Vol10day TariffNews Goodnews BadNews djia Time-series regression Sample: 1 to 645 Number of obs = 645 Wald chi2(4) = 59.91 Log likelihood = 202.3426 Prob > chi2 = 0.0000 ------------------------------------------------------------------------------ | OPG Vol10day | Coef. Std. Err. z P>|z| [95% Conf. Interval] -------------+---------------------------------------------------------------- Vol10day | TariffNews | .0637542 .021933 2.91 0.004 .0207662 .1067422 Goodnews | .0339946 .0223984 1.52 0.129 -.0099054 .0778946 BadNews | .0763634 .0212212 3.60 0.000 .0347706 .1179562 djia | -.0004857 .0002236 -2.17 0.030 -.0009239 -.0000474 _cons | .3237481 .0580788 5.57 0.000 .2099157 .4375804 -------------+---------------------------------------------------------------- SIGMA2 | _cons | .0312638 .0011712 26.69 0.000 .0289682 .0335593 ------------------------------------------------------------------------------

-153-

Results for entire period: August 1st 1929 through December 31st, 1929:

. regress Vol10day tariffnews3 djia Source | SS df MS Number of obs = 102 -------------+------------------------------ F( 2, 99) = 63.01 Model | 6.47520992 2 3.23760496 Prob > F = 0.0000 Residual | 5.08688122 99 .051382639 R-squared = 0.5600 -------------+------------------------------ Adj R-squared = 0.5511 Total | 11.5620911 101 .11447615 Root MSE = .22668 ------------------------------------------------------------------------------ Vol10day | Coef. Std. Err. t P>|t| [95% Conf. Interval] -------------+---------------------------------------------------------------- tariffnews3 | .1396821 .0534341 2.61 0.010 .0336571 .245707 djia | -.0044602 .0003974 -11.22 0.000 -.0052487 -.0036718 _cons | 1.72372 .1226986 14.05 0.000 1.48026 1.967181 ------------------------------------------------------------------------------ . regress Vol10day goodnews3 badnews3 djia Source | SS df MS Number of obs = 102 -------------+------------------------------ F( 3, 98) = 41.19 Model | 6.44807 3 2.14935667 Prob > F = 0.0000 Residual | 5.11402114 98 .052183889 R-squared = 0.5577 -------------+------------------------------ Adj R-squared = 0.5442 Total | 11.5620911 101 .11447615 Root MSE = .22844 ------------------------------------------------------------------------------ Vol10day | Coef. Std. Err. t P>|t| [95% Conf. Interval] -------------+---------------------------------------------------------------- goodnews3 | .0812368 .0549909 1.48 0.143 -.0278907 .1903644 badnews3 | .1338718 .0552912 2.42 0.017 .0241482 .2435954 djia | -.0043791 .0003952 -11.08 0.000 -.0051634 -.0035947 _cons | 1.745059 .1232366 14.16 0.000 1.5005 1.989618 ------------------------------------------------------------------------------

-154-

. arch Vol10day tariffnews3 djia Time-series regression Sample: 397 to 498 Number of obs = 102 Wald chi2(2) = 71.77 Log likelihood = 8.181972 Prob > chi2 = 0.0000 ------------------------------------------------------------------------------ | OPG Vol10day | Coef. Std. Err. z P>|z| [95% Conf. Interval] -------------+---------------------------------------------------------------- Vol10day | tariffnews3 | .1396821 .0515102 2.71 0.007 .0387238 .2406403 djia | -.0044602 .0005486 -8.13 0.000 -.0055355 -.003385 _cons | 1.72372 .1459529 11.81 0.000 1.437658 2.009783 -------------+---------------------------------------------------------------- SIGMA2 | _cons | .0498714 .0069165 7.21 0.000 .0363153 .0634275 ------------------------------------------------------------------------------ . arch Vol10day goodnews3 badnews3 djia Time-series regression Sample: 397 to 498 Number of obs = 102 Wald chi2(3) = 64.34 Log likelihood = 7.910597 Prob > chi2 = 0.0000 ------------------------------------------------------------------------------ | OPG Vol10day | Coef. Std. Err. z P>|z| [95% Conf. Interval] -------------+---------------------------------------------------------------- Vol10day | goodnews3 | .0812368 .053501 1.52 0.129 -.0236232 .1860969 badnews3 | .1338718 .0586034 2.28 0.022 .0190113 .2487324 djia | -.0043791 .0005505 -7.95 0.000 -.0054581 -.0033001 _cons | 1.745059 .1428938 12.21 0.000 1.464992 2.025125 -------------+---------------------------------------------------------------- SIGMA2 | _cons | .0501375 .0076128 6.59 0.000 .0352167 .0650582 ------------------------------------------------------------------------------

-155-

Results for entire period: January 1st 1930 through July 31st, 1930:

-156-

. regress Vol10day tariffnews4 djia Source | SS df MS Number of obs = 146 -------------+------------------------------ F( 2, 143) = 153.70 Model | 1.64996706 2 .824983532 Prob > F = 0.0000 Residual | .767537088 143 .005367392 R-squared = 0.6825 -------------+------------------------------ Adj R-squared = 0.6781 Total | 2.41750415 145 .016672442 Root MSE = .07326 ------------------------------------------------------------------------------ Vol10day | Coef. Std. Err. t P>|t| [95% Conf. Interval] -------------+---------------------------------------------------------------- tariffnews4 | .0250012 .0126968 1.97 0.051 -.0000964 .0500988 djia | -.005036 .0002874 -17.52 0.000 -.0056042 -.0044678 _cons | 1.526885 .075025 20.35 0.000 1.378584 1.675187 ------------------------------------------------------------------------------ . regress Vol10day goodnews4 badnews4 djia Source | SS df MS Number of obs = 146 -------------+------------------------------ F( 3, 142) = 106.84 Model | 1.67527471 3 .558424904 Prob > F = 0.0000 Residual | .742229439 142 .005226968 R-squared = 0.6930 -------------+------------------------------ Adj R-squared = 0.6865 Total | 2.41750415 145 .016672442 Root MSE = .0723 ------------------------------------------------------------------------------ Vol10day | Coef. Std. Err. t P>|t| [95% Conf. Interval] -------------+---------------------------------------------------------------- goodnews4 | .0414431 .0150386 2.76 0.007 .0117147 .0711715 badnews4 | .0274246 .0148512 1.85 0.067 -.0019335 .0567827 djia | -.0051037 .0003011 -16.95 0.000 -.0056989 -.0045085 _cons | 1.543173 .0787266 19.60 0.000 1.387545 1.6988 ------------------------------------------------------------------------------

-157-

. arch Vol10day tariffnews4 djia Time-series regression Sample: 500 to 645 Number of obs = 146 Wald chi2(2) = 283.83 Log likelihood = 175.9518 Prob > chi2 = 0.0000 ------------------------------------------------------------------------------ | OPG Vol10day | Coef. Std. Err. z P>|z| [95% Conf. Interval] -------------+---------------------------------------------------------------- Vol10day | tariffnews4 | .0250012 .0126138 1.98 0.047 .0002786 .0497239 djia | -.005036 .0002989 -16.85 0.000 -.0056219 -.0044501 _cons | 1.526885 .0740144 20.63 0.000 1.38182 1.671951 -------------+---------------------------------------------------------------- SIGMA2 | _cons | .0052571 .0005833 9.01 0.000 .0041138 .0064004 ------------------------------------------------------------------------------ . arch Vol10day goodnews4 badnews4 djia Time-series regression Sample: 500 to 645 Number of obs = 146 Wald chi2(3) = 311.52 Log likelihood = 178.3993 Prob > chi2 = 0.0000 ------------------------------------------------------------------------------ | OPG Vol10day | Coef. Std. Err. z P>|z| [95% Conf. Interval] -------------+---------------------------------------------------------------- Vol10day | goodnews4 | .0414431 .0148735 2.79 0.005 .0122915 .0705947 badnews4 | .0274246 .0145081 1.89 0.059 -.0010107 .0558599 djia | -.0051037 .0003003 -17.00 0.000 -.0056923 -.0045151 _cons | 1.543173 .0746989 20.66 0.000 1.396766 1.68958 -------------+---------------------------------------------------------------- SIGMA2 | _cons | .0050838 .0005691 8.93 0.000 .0039683 .0061992 ------------------------------------------------------------------------------

-158-

APPENDIX C:

A Look at the Mellon Tax Reform

Before and After: Federal Government Receipts (in $ billions)

Fiscal Year Revenue

YoY % Change

Inflatoin Adjusted Revenue

YoY % Change

1920 $6.6 6.61921* $5.6 -15.2% 6.2 -6.1%1922 $4.0 -28.6% 4.8 -22.6%1923 $3.9 -2.5% 4.5 -6.3%

1924* $3.9 0.0% 4.5 0.0%Average -11.6% -8.7%

1925 $3.6 -7.7% 4.2 -6.7%1926** $3.8 5.6% 4.3 2.4%

1927 $4.0 5.3% 4.6 7.0%1928 $3.9 -2.5% 4.5 -2.2%

Average 0.2% 0.1%

*Small tax cuts did occur in these years** Major tax cut and completion of Mellon tax plan outlined in 1920-1921Source: Fiscal year U.S. Budge Data

5-Years Before primary Tax Cut

4-Years After primary Tax Cut

Federal Revenue Growth

-14.0%

-12.0%

-10.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

Before After

-159-

Real GDP Growth

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

Before After

Unemployment Rate

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

Before After

-160-

-161-

Precentage Share of Total Income Taxes Paid by Income Class: 1920,

1925, and 1920Income Class 1920 1925 1929Under $5,000 15.4% 1.9% 0.4%$5,000 - $10,000 9.1% 2.6% 0.9%$10,000 - $25,000 16.0% 10.1% 5.2%$25,000 - $100,000 29.6% 36.6% 27.4%Over $100,000 29.9% 48.8% 62.2%

Source: Internal Revenue Service

-162-

-163-

IMPACT OF SMOOT-HAWLEY TARIFF:

Source: U.S. Bureau of the Census, Historical Statistics of the United States, Colonial Times to 1970, Washington, D.C.: USGPO, 1975, Series 212.

-164-

APPENDIX D:

Regression of year-over-year changes in the CPI index and the PPI index with respect to year-over-year changes in the total amount of demand deposits:

. regress CPIYoY DepositsYoY Source | SS df MS Number of obs = 22 -------------+----------------------------- F( 1, 20) = 24.84 Model | .081074053 1 .081074053 Prob > F = 0.0001 Residual | .065279702 20 .003263985 R-squared = 0.5540 -------------+----------------------------- Adj R-squared = 0.5317 Total | .146353755 21 .006969226 Root MSE = .05713 ------------------------------------------------------------------------------ CPIYoY | Coef. Std. Err. t P>|t| [95% Conf. Interval] -------------+--------------------------------------------------------------- DepositsYoY | .7035407 .1411635 4.98 0.000 .4090788 .9980025 _cons | -.0145222 .0138238 -1.05 0.306 -.0433581 .0143137 ------------------------------------------------------------------------------ . regerss PPIYoY DepositsYoY unrecognized command: regerss r(199); . regress PPIYoY DepositsYoY Source | SS df MS Number of obs = 22 -------------+----------------------------- F( 1, 20) = 20.32 Model | .214775694 1 .214775694 Prob > F = 0.0002 Residual | .21135013 20 .010567506 R-squared = 0.5040 -------------+----------------------------- Adj R-squared = 0.4792 Total | .426125824 21 .020291706 Root MSE = .1028 ------------------------------------------------------------------------------ PPIYoY | Coef. Std. Err. t P>|t| [95% Conf. Interval] -------------+--------------------------------------------------------------- DepositsYoY | 1.145093 .2540005 4.51 0.000 .6152575 1.674929 _cons | -.0365532 .0248736 -1.47 0.157 -.0884386 .0153323 ------------------------------------------------------------------------------

-165-

Bibliography

Data Sources :

U.S. Bureau of the Census. Series F1-5 and D85-86.

Chapter Two: The Federal Reserve and U.S. Monetary Policy: a short history. U.S. Monetary Policy and Financial Markets.

Data, Bloomberg LLC.

Data, Bureau of Economic Analysis (BEA).

Data, National Bureau of Economic Research (NBER).

Governors, F. R. B. o. Banking and Monetary Statistics 1914-1970. Washington D.C., Federal Reserve System.

An essential data source for banking information.

NYSE New York Stock Exchange Special Closings, 1885 - present. New York, New York Stock Exchange (NYSE).

Available at http://www.nyse.com/pdfs/closings.pdf or via www.nyse.com

Statistics, B. o. L. Handbook of Methods. Washington D.C., Bureau of Labor Statistics - US

Government: chapter 17.Can found at: http://stats.bls.gov/opub/hom/homch17_d.htm#17a

Important in understanding the construction of the CPI in the 1920s.

System, B. o. G. o. t. F. R. "Banking and Monetary Statistics 1914-1970."

Primary Sources (order of year published):

(1916). Yearbook of the United States Department of Agriculture. Washington D.C, United States Department of Agriculture.

Strong, B. (March, 10th, 1916). Diary-Benjamin Strong Papers. L. C. B. dinner. New York, Federal Reserve Bank of New York.

Primary documents -- personal correspondence of Benjamin Strong.

(1918). Annual Report of the Secretary of the Treasury on the State of the Finances for the Fiscal Year Ended June 30, 1917. Washington, D.C, Government Printing Office.

Montgomery, R. (1918). "Income Tax Procedure 1918."

-166-

Source was used through the Wall Street Journal. Montgomery was the former president of the American Association of Public Accountants. His analysis of the Revenue Bill of 1918 was useful in that he offered a contemporary criticism.

(1920). "Individual Files: Leffingwell." National Archives and Records Administration (NARA): Correspondence of the Secretary of the Treasury 1917-1932 Record Group 56.

Even while Leffingwell had left the Treasury for J.P, Morgan, he remained in close contact with his former colleagues and frequently offered advice to Gilbert and Mellon. This source was invaluable to understanding Leffingwell's continued relationship with the Treasury and position in designing the "Mellon" tax plan.

(1920). Sixth Annual Report of the Federal Reserve Board. Washington, D.C, Government Printing Office.

Keynes, J. M. (1920). The Economic Consequences of Peace. New York, Harcourt, Brace and Howe.

Keynes was fundamental opposed to the Treaty of Versailles. This essay laid out his case and brought Keynes into the limelight as a prominent economist of his day. Keynes recognized the precarious position of the international financial structure and forecasted it inevitable instability and ultimate collapse.

Taussig, F. W. (1920). Free Trade, the Tariff and Reciprocity. New York, Macmillan Company.

Head of the Harvard Economic Department and a leading international economist himself during much of the period, Taussig laid out the fundamental danger surrounding tariffs. More importantly he examined the political pressures that can manipulate bills and create uneconomical results.

(1921). "The Revenue Act of 1921." Congressional Record: Seventy-Sixth Congress Session I(Chpt. 136).

The actual Revenue Bill of 1921. Very useful in determining how drastic it changed tax rates on the margin.

Taussig, F. W. (1921). Selected Readings in International Trade and Tariff Problems. Boston, Ginn and Company.

Cassel, G. (1922). Money and Foreign Exchange After 1914. London, Constable and Co.

Governors, F. R. B. o. (1922). Federal Reserve Bulletin. Washington D.C., Federal Reserve Board of Governors.

Keynes, J. M. (1922). A revision of the Treaty, being a sequel to The economic consequences of the peace,. New York, Harcourt, Brace and Howe.

(1923). Ninth Annual Report of the Federal Reserve Board Covering Operations for the Year 1922. Washington D.C., Federal Reserve Board.

-167-

Moulton, H. M., Constantine (1923). Germany's Capacity to Pay. New York, McGraw-Hill Book Company Inc.

A contemporary study of the German reparations problem

Seligman, E. (March, 1924). "Comparative Tax Burden." Political Science Quarterly Vol. 39(No. 1): 125 - 129.

A terrific primary source written by one of the authors/correspondents to Gilbert and Mellon in the Treasury. Seligman effectively helped Gilbert and Mellon orchestrate the tax reform throughout the 1920s. This article details the comparative tax burdens post war countries. It examines the United States, France, Germany, and England in detail.

Beckhart, B. (1924). The Discount Policy of the Federal Reserve System. New York, Henry Hold and Company.

An important primary source documenting the Fed policy in the immediate post war period. Beckharts analysis helped me in understanding the complex make-up of different monetary tools (such as the introduction of the Federal Reserve Note). Beckhart also documented a plethora of Congressional debates surrounding Fed policy, offering some incite as to how Congress was viewing the Fed's policy and what the reaction was by the nation following the price declines in 1920-21.

Mellon, A. (1924). Taxation: The Peoples Business. New York, Macmillan.

A important source. Secretary Mellon's own argument surrounding the much needed tax reform that would eventually become known as the "Mellon Plan." The book was used to popularize the plan in the 1924 campaign to adopt the tax reform. Very quotable, but also full of facts. Let's the reader "into" the Treasury's mindset during the 1920 tax debates.

(1925). "Annual Report of the Secretary of the Treasury on the State of the Finances for the Fiscal Year ended June 30, 1924." U.S. Treasury Department.

Moulton, H. L., Cleona (1925). The French Debt Problem. New York, The Macmillan Company.

(1926). "The Revenue Act of 1926." Congressional Record: Seventy-ninth Congress Session I(Chpt. 26-27).

Allen, F. W. H. J. E. (1926). British War Budgets. Oxford, Oxford University Press.

Hoover, H. (1926). The Future of Our Foreign Trade. Washington D.C, GPO.

Burgess, W. R. (1927). The Reserve Banks and the Money Market. New York, Harper & Brothers Publishers.

-168-

Another invaluable primary source for understanding the monetary policy of the 1920s. Burgess was particularly important because he worked directly under Benjamin Strong at the New York Fed. Strong was undoubtedly the most important figure in monetary policy throughout the period until his death in 1928. Burgess's first hand account of Fed policy is, therefore, an important source for discussing monetary policy in the 1920s.

Burgess, W. R. (1927). The Reserve Bank and the Money Market. New York, Harper & Brothers Publishing.

Valuable primary source for understanding monetary policy in the 1920s. Burgess worked closely with Benjamin Strong at the New York Fed. Strong actually wrote the introduction to this book.

Glass, C. (1927). An Adventure in Constructive Finance. New York, Doubleday, Page and Company.

A valuable examination of monetary policy by a former Secretary of Treasury and Senator Carter Glass.

Taussig, F. W. (1927). International Trade. New York, Macmillan Company.

Another important study by the leading international economist of his day. Taussig makes clear that international trade is of up most importance to the stability of the system after World War One.

(1928). "The Revenue Act of 1928." Congressional Record: Seventieth Congress Session I(Chpt. 842).

(1928-1932). Numerous Articles - See Footnotes. The New York Times. New York.Invaluable resource of information.

(1928-1932). Numerous Articles. The Wall Street Journal. New York.

(1929). Hearings before the Subcommittee of the Committee on Banking and Currency. Subcommittee of the Committee on Banking and Currency. Washington D.C., Government Printing Office.

D'Abernon, V. E. V. (1929). An Ambassador of Peace. London, Hodder and Stoughton.

Haig, R. M. (1929). The Public Finances of Post-War France. New York, Columbia University Press.

(1929-1930). Numerous Articles. The Commercial and Financial Chronicle. New York.

A valuable resource as this was the prominent news source for Wall Street traders.

Fisher, I. (1930). The Stock Market Crash and After. New York, The Macmillan Company.

-169-

A useful primary source from the dominant name in economics during the 1920s. Fisher offers an extensive analysis of the primary causes and implications of the Stock Market Crash in October 1929. He builds the case that prices were mostly based on fundamental economic activity and so should not depreciate much more. He has been discredited by historians ever since, but his points are still important to understand.

Keynes, J. M. (1930). A treatise on money. New York, Harcourt, Brace and Howe.

Written just after or during the Crash in America and published in 1930. A precursor to "The General Theory of Employment" and essential to truly understanding Keynes' theory and his theoretical development.

Douglas, P. H. D., Aaron (1931). The Problem of Unemployment. New York, Macmillan Company.

Important source analyzing the source/extent of unemployment, especially between sectors/classes in the 1920s. Was particularly useful in examining the agricultural/farming sector and understanding the criticism of the Twenties as being a decade of "excess" that inevitably led to the opposite reaction in the Great Depression.

Nations, S. o. t. L. o. (1931). The Course and Phases of the World Economic Depression. Geneva, League of Nations and World Peace Foundation.

(1932). Sale of Foreign Bonds or Securities in the United States. Senate Committee on Finance. Washington D.C., United States Congress.

Beckhart, B. (1932). The New York Money Market. New York, Columbia University Press.

Beveridge, S. W. (1932). Tariffs: The Case Examined. London, Longmans, Green & Co.

Moulton, H. (1932). War Debts and World Prosperity. Washington D.C., The Brookings Institute.

Important source directly connecting international economic trouble and the war debts.

Pasvolsky, H. G. M. L. (1932). War Debts and World Prosperity. Washington D.C., The Brookings Institute.

A valuable resource in understanding the credit risks of the United States and their profound impact on the world economy in the early 1930s.

Commerce, U. S. D. o. (1933). Economic Analysis of Foreign Trade of the United States in Relation to the Tariff. Washington D.C, U.S. Department of Commerce, GPO.

Fisher, I. (1934). Stable Money: A History of the Movement. New York, Adelphi Company.

-170-

Jones, J. (1934). Tariff Retaliation: Repercussions of the Hawley-Smoot Bill. Philadelphia, University of Pennsylvania Press.

The best case of the view that there was extensive foreign retaliation against Smoot-Hawley. Some have criticized Jones' argument as generally overstated but it offers a glimpse into the contemporary mind set of Americans.

Schattschneider, E. E. (1935). Politics, Pressures and the Tariff. New York, Prentice-Hall.

Offered a classic account of the political process that resulted in the Smoot-Hawley tariff. Much of this information could be gained through an examination of the news sources, as is provided in this thesis. Nonetheless, Schattschneider's analysis is valuable.

Joint Committee, C. E. I. C. o. C. (1936). International Economic Reconstruction. Paris, Carnegie Endowment & International Chamber of Congress.

Keynes, J. M. (1936). The general theory of employment, interest and money. New York, Harcourt, Brace and Howe.

Keynes' most famous work, in which he laid out his fundamental theory and attempted to refute says law and the classical economics of this period.

Lewis, C. (1936). The Recovery Problem in the United States. Washington D.C., The Brookings Institution.

Invaluable source in understanding the international financial structure of the world following the First World War. Helps outline the interconnectivity of the economy in this period and is full of useful statistical data.

(1937). Munitions Industry. Senate Special Committee Investigating the Munitions Industry. Washington D.C.: Part 26, p. 7934.

Important in finding/understanding export and import statistics used in thesis.

Lewis, C. (1938). America's Stake in International Investments. Washington D.C., Brookings Institution.

Essential in understanding the precarious position of the international finances following the war. A primary source full of detailed information and data summaries.

Day, J. P. (1939). "An Introduction to World Economic History Since the Great War." London Macmillan and Co.

Useful in understanding economic reasoning behind need to open up trade in late 1920s. Covered major economic conferences around the world as well as the Depression in detail.

-171-

Synder, C. (1940). Capitalism the Creator. New York, the Macmillan Co.

Valuable in understanding the development of Open Market Operations at the Federal Reserve Bank of New York under Benjamin Strong in the 1920s.

Secondary Sources (alphabetical order):

(2001). Survey of Current Business Annual Supplement. Washington D.C., U.S. Commerce 1929 - 2000.

(2005). Historical Highlights of the IRS, Internal Revenue Service, US Treasury Department.

(Feb. 1930). "Review of the Year 1929." The Review of Economic Statistics Vol. 12(No. 1): 1-14.

A useful source, full of important statistical data. Also gives incite into the contemporary outlook for the coming years.

(January 17, 1918). Income Tax Procedure 1918. Wall Street Journal. New York: 6.

(March and April 1926). Stabilization. Committee on Banking and Currency. Washington D.C., Government Printing Office.

(Sept. 4 1919). Federal Reserve Board Minutes. Federal Reserve Board Meeting, Washington D.C.

Available at: http://fraser.stlouisfed.org/docs/MeltzerPDFs/min090419.pdf

Adams, T. S. (Aug. 1921). "Fundamental Problems of Federal Income Taxation." The Quarterly Journal of Economics Vol. 35(No. 4): pg. 531-32.

An invaluable source. T.S. Adam's was the most important tax economist of the 1920s period. He actively participated with the Treasury through the post war period and can be thought of as a primary architect of the "Mellon" tax reform. This source presents the argument for why the tax system needed to be reformed following World War I.

Aldcroft, D. (1978). The European Economy, 1914-1970. New York, St Martin's Press.

Aldcroft, D. (1997). Studies in the Interwar European Economy. Aldershot, England, Ashgate.

Aldcroft, D. H. (1977). From Versailles to Wall Street. Los Angeles, University of California Press.

A valuable source in connecting the War Debts created by the Treaty of Versailles (among other things) and the stock market crash and depression in 1929 and after.

-172-

Anderson, K. L. F. (April 1934). World Economic Survey 1931-1932. Geneva, League of Nations.

Anderson, K. L. F. (Oct. 1935). World Economic Survey 1934-35. Geneva, League of Nations.

Archibald, R. B. F., David H., (April 1998). "Investment during the Great Depression: Uncertainty and the Role of the Smoot-Hawley Tariff." Southern Economic Journal Vol. 64(No. 4).

A very important article in which the authors make the case that uncertainty surrounding the Smoot-Hawley bill caused a depression in investment in 1929. Archibald and Feldman use econometric techniques and modern day investment theory to demonstrate their results.

Associates, I. (2000). Stocks, Bonds, and Inflation 2000 Yearbook. Chicago, Ibbotson Associates, Inc.

Balderston, T. (2004). "Reflections on the Great Depression." International Journal of Social Economics 31(7/8): 732-733.

The book Reflections on the Great Depression, by Randall E Parker, is reviewed.

Beckhart, B. H. (1972). Federal Reserve System. United States of America, American Institute of Banking.

Essential to understanding the Federal Reserve System in the 1920s. Not as detailed as Meltzer's history of the Fed, but more sweeping and easier to see the "big picture." Particularly useful in comparing different period due to the way the book is organized. It also covers the international perspective of the world debt system following World War One.

Bernanke, B. (1983). "Irreversibility, uncertainty, and cyclical investment." Quarterly Journal of Economics(No. 85).

Bernanke, B. S. (2004). Essays on the Great Depression. Princeton, NJ, Princeton University Press.

A compilation of all Bernanke's essay's on the Great Depression. An invaluable source, although extremely economic in nature.

Bittingmayer, G. (Dec. 1998). "Output, Stock Volatility, and Political Uncertainty in a Natural Experiment: Germany, 1880-1940." Journal of Finance Vol. 53.

Bittlingmayer, G. (1993). "The Stock Market and Early Antitrust Enforcement." Journal of Law and Finance Vol. 36.

Bittlingmayer, G. (Jan. 2002). "The 1920's Boom, The Great Crash and After." Working Paper - University of Kansas.

-173-

Blakey, R. (Mar. 1922). "The Revenue Act of 1921." American Historical Review Vol. 12(No. 1).

This is a published document covering the precise tax rate changes by bracket. It includes the entire progressive surtax structure. Important in analyzing the true impact of the Revenue Bill of 1921

Blakey, R. (Sep. 1924). "The Revenue Act of 1924." American Economic Review Vol. 14(No. 3): pg. 475.

Blakey, R. (Sep. 1926). "The Revenue Act of 1926." American Economic Review Vol. 16(No. 3): pg. 407 - 408.

Board, F. R. (1945-2000). Flow of Funds Accounts of the Unites States. Washington D.C., Federal Reserve Board.

Bordo, M. G., Claudia & White, Eugene (1998). The Defining Moment: The Great Depression and The American Economy in the Twentieth Century. Chicago, University of Chicago Press.

Brownlee, W. E. (1996). Federal Taxation in America: A short history. Cambridge, England, Cambridge University Press.

An important source in documenting and understanding the progression of taxation from consumer levies (sales and tariff taxes) to production taxes (income and profit taxes). A good overview. Not too in-depth, but this is a virtue in many ways. Very useful.

Brunner, K., Ed. (1981). The Great Depression Revisited. Boston, Martinus Nijhoff Publishing.

A compilation of essays surveying different understandings of the Great Depression and illustrating the lack of consensus regarding the origins and causes of the decline.

Callahan, C. M. M., Judith A. & O'Brien, Anthony Patrick (Sept. 1994). "Who Voted for Smoot-Hawley." The Journal of Economic History Vol. 54(No. 3).

Again, this sources helped outline the progression of the Smoot-Hawley Tariff in Congress and the process of voting that took place. Less directly important for my thesis, but an interesting approach to the political side of the debate.

Calomiris, C. W. and J. R. Mason (2003). "Fundamentals, Panics, and Bank Distress During the Depression." American Economic Review 93(5): 1615-1647.

We assemble bank-level and other data for Fed member banks to model determinants of bank failure. Fundamentals explain bank failure risk well. The first two Friedman-Schwartz crises are not associated with positive unexplained residual failure risk, or increased importance of bank illiquidity for forecasting failure. The third Friedman-Schwartz crisis is more ambiguous, but increased residual failure risk is small in the aggregate. The final crisis (early 1933) saw a

-174-

large unexplained increase in bank failure risk. Local contagion and illiquidity may have played a role in pre-1933 bank failures, even though those effects were not large in their aggregate impact. [PUBLICATION ABSTRACT]

Carey, K. (Sept. 1999). "Investigating a Debt Channel for the Smoot-Hawley Tariffs: Evidence from the Sovereign Bond Market." The Journal of Economic History Vol. 59(No. 3).

Cary examined the change in price of certain sovereign bonds over several weeks in 1930 that corresponded with the progress in the Smoot-Hawley Tariff. He argued that If market was anticipating increased defaults due to the Tariffs, it will be visible in the cross-country patterns of bond prices. Cary shows there is a significant correlation, but that the overall effect is relatively small.

Carlstrom, C. T. and T. S. Fuerst (2001). "Perils of price deflations: An analysis of the Great Depression." Federal Reserve Bank of Cleveland. Economic Commentary: 1-3.

In the last 2 decades, central banks within the industrialized world have been successful at lowering inflation rates. Now that inflation rates are near zero, periodic deflations are much more plausible. Some think that a policy of price stability requires that the monetary authority walk a tight rope between the danger of letting inflation reignite and the threat of allowing possible deflation. Some of the potential perils of price deflations are reviewed. How price deflation contributed to the worst economic calamity of the twentieth century - the Great Depression - is examined. Economic theory suggests that deflations potentially pose 3 main dangers: 1. Because nominal interest rates cannot fall below zero percent, deflations can increase real interest rates. 2. If employers are unable to reduce nominal wages, price deflations will increase the real wage, which tends to discourage employment growth. 3. Price deflations can lead to large redistributions of wealth from borrowers to lenders.

Costigliola, F. (1984). Awkward Dominion. London, Cornell University Press.

Crucini, M. J., & Kahn, James (1996). "Tariffs and Aggregate Economic Activity: Lessons from the Great Depression." Journal of Monetary Economics Vol. 38(No. 3).

Crucini and Kahn combined stochastic growth and a computable general equilibrium model to argue that the macroeconomic impact of the Smoot-Hawley Tariff has been universally understated. They find that Tariffs could have increased US output by 2% between 1929-1932. View's tariffs as taxes on intermediate inputs, distorting labor supply and capital accumulation. This article does not take the collapse of the international financial structure as an endogenous event, related to the tariff war, as I have proposed in this thesis.

David, P. (May 1990). "The Dynamo and the Computer: An Historical Perspective on the Modern Productivity Paradox." American Economic Review Papers and Proceedings Vol. 80.

Dornbusch, R. F., Stanley (1986). The Open Economy: Implications of Monetary and Fiscal Policy. American Business Cycle: Continuity and Change. Chicago, University of Chicago Press. Vol. 25.

-175-

Dornbusch and Fischer discuss the potential macroeconomic impact of the Smoot-Hawley Tariff.

Douglas, I. K., Randall S. (1996). "Log-Rolling and Economic Interests in the Passage of the Smoot-Hawley Tariff." Carnegie-Rochester Series on Public Policy Vol. 4.

Eichengreen, B. (1989). "The Political Economy of the Smoot-Hawley Tariff." Research in Economic History Vol. 12.

Eichengreen's understanding of the Smoot-Hawley bill, which he dismissed as being a primary cause of the Depression.

Eichengreen, B. (2004). "Viewpoint: Understanding the Great Depression." Canadian Journal of Economics 37(1): 1-25.

If there is a feature of modern scholarship on the Great Depression that distinguishes it from its antecedents, it is the tendency of recent contributions to frame that event as a global phenomenon (see e.g. Eichengreen, 1992; Johnson 1998; Bernake, 2000; and James 2001). Whether this new research has produced a scholarly consensus is another matter. In this paper, it is asked whether it is possible to arrive at such a consensus by synthesizing the old and the new literatures. It is suggested that the opposition between the 'old' and 'new; (or 'US-centric' and 'global') views of the Great Depression may ultimately prove artificial.

Eichengreen, B. (May, 1992). "The Origins and Nature of the Great Slump Revisited." The Economic History Review Vol. 45(No. 2).

A good overview of the existing theories - especially focusing on Fearson's article "The origins and nature of the Great Slump, 1929-1932." Eichengreen argues that while Fearson demonstrated the lack of consensus over the central issues of the Great Depression, today (written in 1992) a consensus has emerged. Eichengreen takes us through a number of competing arguments (structural changes of post war production, labor market operational changes, and others) and then focus' on the failure of the international monetary system as today's consensus.

Eichengreen, B. T., Peter (2000). "The Gold Standard and the Depression." Contemporary European History Vol. 9(No. 2): 183-207.

Evans, P. and I. T. E. W. Hasan (2004). "Monetary Explanations of the Great Depression: A Selective Survey of Empirical Evidence." Economic Review - Federal Reserve Bank of Atlanta 89(3): 1-23.

Seventy years after the Great Depression, economists still debate the causes of this economic catastrophe. Two leading explanations are distinguished by whether or not the Federal Reserve's monetary policies are perceived as being chiefly responsible for propagating and magnifying the initial contraction into a depression. This article surveys recent modeling efforts and empirical work that examine aggregate explanations for the Great Depression from both the extensive literature using vector auto regression techniques and the more recent

-176-

literature using dynamic stochastic general equilibrium modeling. Neither of these approaches has yielded a consensus about the causes of the depression. Data alone are insufficient to distinguish the precise role of monetary policy during that period. The modeling strategies impose restrictions that help isolate the meaningful economic interactions in the data. In each literature, the ways in which the respective models identify monetary policy can differ substantially, and these differences are why monetary policy shocks may or may not explain much of the output contraction. Also, these modeling approaches vary in their ability to capture important institutional features of the banking and financial system.

Fackler, J. S. and R. E. Parker (2005). "Was Debt Deflation Operative During the Great Depression?" Economic Inquiry 43(1): 67-78.

This study demonstrates three facts consistent with the debt deflation/credit view explanation of the Great Depression. First, private medium- and long-term nominal debt during the 1920s exhibited a combination of a high initial value relative to income and a rapid growth rate that is unparalleled in a consistent data set covering more than half a century. Second, the debt issued during the 1920s occurred in a stable price regime. Third, near the onset of the Depression, the price process switched to one of deflation. Taken together, the evidence suggests that debt deflation was operative during the Depression. For the debt deflation/credit view to explain part of the path of output during the Depression, large unanticipated rises in real debt should be observed. This can occur due to rises in nominal long-term outstanding debt and/or due to unanticipated deflation. The argument is that each occurred at the onset of the Depression, with rapid rises in nominal debt during a period of price stability followed by a switch to a deflationary price process.

Fainsod, M. (1941). Government and the American Economy. New York, W.W. Norton & Company, Inc.

Fearon, P. (1987). War Prosperity and Depression: The US Economy 1917-1945. Kansas, University Press of Kansas.

Peter Fearon surveyed the depression of the 1930s first in The origins and nature of the Great Slump, 1929-1932, and then in more detail in War, Prosperity & Depression: The U.S. Economy 1917-1945. In this survey, Fearon revived literature that treated the depression as a consequence of the instabilities of the development of the previous decades. Half of his account is devoted to World War I and the 1920s. He focused on the structural changes of the interwar economy away from staple trades (iron and steel, coal, textiles, shipbuilding) and toward the 'new industries' (chemicals, electrical, engineering, motor vehicles.) Fearon noted the inability of Britain to adapt to these structural changes in contrast to the flexibility of the United States as the driving force for economic success during the decade in the face of Britain's relative underperformance.

Federico, G. (2005). "Not Guilty? Agriculture in the 1920s and the Great Depression." Journal of Economic History 65(4): 949-976.

Agricultural distress in the 1920s is routinely quoted among the causes of the Great Depression. This article challenges the conventional wisdom. World

-177-

agriculture was not plagued by overproduction and falling terms of trade. The indebtedness of American farmers, a legacy of the boom years 1918-1921, did jeopardize the rural banks, but the relation between their crises, the banking panic of 1930, and the Great Depression is tenuous at best. [PUBLICATION ABSTRACT]

Ferderer, J. P., & Zalewski, David A., (Dec. 1994). "Uncertainty as a Propagating Force in the Great Depression." The Journal of Economic History Vol. 54(No. 4).

Ferderer, J. P. Z., David A (Sept. 1999). "To Raise the Golden Anchor? Financial Crises and Uncertainty during the Great Depression." The Journal of Economic History Vol. 59(No. 3).

Field, A. J. (2003). "The most technologically progressive decade of the century." American Economic Review 93(4): 1399-1413.

The years 1929-1941 were in the aggregate, the most technologically progressive of any comparable period in US economic history. This hypothesis entails two primary claims: 1. that during this period businesses and government contractors implemented or adopted on a more widespread basis a wide range of new technologies and practices, resulting in the highest rate of measured peacetime peak-to-peak multifactor productivity growth in the century, and 2. that the Depression years produced advances that replenished and expanded the larder of unexploited or only partially exploited techniques, thus providing the basis for much of the labor and multifactor productivity improvement of the 1950's and 1960's. The 1929-1948 period is critical in understanding the long-term trajectory of technological change in the US, both because of its direct effect on growth during the period and because of its lagged effect on multifactor productivity advance in the 1950s which when coupled with renewed capital deepening, produced a golden age of labor productivity growth and living standard improvement.

Fisher, I. (Jan. 1934). "Discussion by Professor Irving Fisher." The Annals of The American Academy of Political and Social Science.

Friedman, M. S., Ann (1965.). The Monetary History of the United States, 1967-1960. Princeton, Princeton University Press.

The entire book is valuable for its wealth of statistical information, but of most interest was the Chapter on the Depression entitled "The Great Contraction." Friedman and Schwartz argued that while the stock market boomed throughout the 1920s, the economy did not. They asserted that the "Federal Reserve policy was not restrictive enough to halt the bull market, yet too restrictive to foster vigorous business expansion." I find this argument troubling as GNP grew from $69.9 billion to $103.1 billion during the period and the CPI Index dropped from 53.6 - 51.3, making the growth in national output even faster (54%) in real terms.

Galbraith, J. K. (1955). The Great Crash, 1929. Boston, Houghton Mifflin.

In many ways, this book is still the "bible" for students of the 1929 stock market Crash. Galbraith founded, or at least popularly publicized the bubble theory for

-178-

the stock market and for the Crash of 1929. He made no attempt, however, to explain the causes of the stock market boom or the trigger for the Crash.

Gerald, S. (Summer 1975). "The Stock Market of 1929, Revisited: A Note." Business History Review Vol. 44.

Gilbert, C. (1970). American Financing of World War I. Westport Connecticut, Greenwood Publishing.

Goldin, C. (June 2001). "The Human Capital Century and American Leadership: Fruits of the Past." Journal of Economic History Vol. 61.

Gordon, R. J. and M. Friedman (1974). Milton Friedman's monetary framework : a debate with his critics. Chicago, University of Chicago Press.

Harding, W. (April 12 1921). "A Return to Normalcy." Congressional Record 67 Cong(1 Sess.): pp. 169-173.

Harding, W. (March 4, 1921). "Inaugural Address."

See: http://www.bartleby.com/124/pres46.html

Hetzel, R. (1985). "The Rules verse Discretion Debate over Monetary Policy in the 1920s." Federal Reserve Bank of Richmond.

Hetzel, R. (Winter 2002). "German Monetary History in the First Half of the Century." Economic Quarterly - Federal Reserve Bank of Richmond.

Higgs, R. (1987). Crisis and Leviathan: Critical Episodes in the Growth of American Government. Oxford, Oxford University Press.

Himmelberg, R. F., Ed. (1968). The Great Depression and American Capitalism. Boston, D.C. Heath and Company.

Hoover, H. (1952). The Memoirs of Herbert Hoover: The Cabinet and the Presidency, 1920 - 1933. New York, Macmillan Company.

Lays out the Republican Party platforms for the era and gives a first hand (but probably not completely truthful) account of the Hoover administration. Chapter 41, on the tariff bill, is particularly useful.

Humphrey, T. M. (2001). "Monetary policy frameworks and indicators for the Federal Reserve in the 1920s." Economic Quarterly - Federal Reserve Bank of Richmond 87(1): 65-92.

The 1920s saw the Fed reject a state-of-the-art quantity theory framework for a flawed real bills one. The quantity theory framework featured the money stock, price level, and real interest rates as policy guides. By contrast, the real bills framework featured nominal interest rates, volume of discount window borrowing, and type of commercial paper eligible for discount. When the start of the Great Depression put these rival sets of indicators to the test, the quantity theory set

-179-

correctly signaled that monetary policy was sharply contractionary, while the real bills set incorrectly signaled that money and credit conditions were sufficiently easy and needed no correction. This experience shows that policy guides originating in a theoretically flawed framework can lead the policymaker astray.

Irwin, D. A. (May, 1998). "The Smoot-Hawley Tariff: A Quantitative Assessment." The Review of Economics and Statistics Vol. 80(No. 2).

Irwin finds that the Smoot-Hawley tariff both negatively and significantly disrupted the macroeconomy of the early Depression. Irwin is refuting Eichengreen's analysis, which found the tariff actually helped the US economy during the Depression (especially the later years of the Depression). Irwin finds that up to 40% of the decline in imports can be accounted for by the Smoot-Hawley Tariff.

Kennedy, D. M. (1999). Freedom From Fear: the American People in Depression and War, 1929 - 1945. New York, Oxford University Press.

A good overview of the period that addressed the political, economic, and social impacts of the Crash and the Depression.

Kindleberger, C. P. (1973). The World in Depression, 1929 - 1939. London, Allen Lane.

Argued primary effects of Tariffs was to redirect aggregate demand from foreign trade to home products, so that while losses occur due to decreased trade, gains also occur due to increased aggregate demand. He was somewhat ambiguous on the net impact. I am not sure I entirely accept this claim.Also argues that foreign trade was such a small percentage of US aggregate demand that any impact is ill-founded. Nevertheless, Kindleberger offers a good overview of the depression and focuses on the impact of the entire world economy and the interconnectivity of countries due to the war debts.

Klein, L. (1947). The Keynesian Revolution. New York, MacMillan Company.

Klein, M. (2001). Rainbow's End. Oxford, Oxford University Press.

Lamoreaux, N. (1988). The Great Merger Movement in American Business 1895-1904. Cambridge, Cambridge University Press.

Leffingwell, R. (Jun. 1931). "Causes of the Depression." Proceedings of the Academy of Political Science Vol. 14(No. 3).

Leffingwell was a partner at J.P. Morgan and Company as well as one of the architects of the Mellon Tax reform. His short article noted the Tariff as a contributing cause to the Depression.

Lewis, N. (July 2001). "The Role of Money and Gold in the Great Contraction of the 1930s." Polyconomics, Inc.

A new argument surrounding the importance of the Gold Standard. Lewis argued against Eichengreen and others that the failure of the Gold Standard was

-180-

in the revaluations in the early and mid-1930s that upset existing the international monetary framework.

Lewis, W. A. (1950). Economic Survey 1919-1939. Philadelphia, The Blakiston Company.

McDonald, J. O. B., Anthondy Patrick & Callahan, Colleen (1997). "Trade Wars: Canada's Reaction to the Smoot-Hawley Tariff." Journal of Economic History Vol. 57(No. 4).

McMullen, F. (1987). "Women and the Ticker Tape - A Year after the Crash." The Women's Journal(No. 60).

Melling, A. B. P., Ed. (2004). America in the 1920. Mountfield TN, Helm Information.

Meltzer, A. (1976). "Monetary and Other Explanations of the Start of the Great Depression." Journal of Monetary Economics Vol. 2.

Meltzer emphasized the importance of Smoot-Hawley in explaining the Great Depression. Much of this monetary points are extended upon in his book "The History of the Federal Reserve."

Meltzer, A. (2003). A History of the Federal Reserve. Chicago, University of Chicago Press.

A very important work and one that covers the Federal Reserve System's actions in extreme detail. Meltzer covers day-to-day debate over monetary policy between different Federal Reserve Banks as well as between Governor Strong at the New York Bank and Adolph Miller at the Board of Governors. Meltzer's book is perhaps a too critical of the Fed in causing the recession of 1921 and in not stopping the deflation and bank runs during the Depression. Metlzer's work offers a complete documentary of the Feds actions throughout the period, and a detailed account of the personalities at work. In particular, Meltzer focuses on Benjamin Strong of the New York Fed and is sympathetic of Milton Friedman and Anna Schwartz's claim that had Strong lived through 1928, the Great Depression could have been avoided.

Meltzer, A. H. (2001). "Money and monetary policy: An essay in honor of Darryl Francis." Review - Federal Reserve Bank of St. Louis 83(4): 23-31.

The 1960s and 1970s were the Keynesian decades in US economic policy. Keynesian policy views were mainstream views in the academic profession. The primary role of fiscal policy in economic stabilization was a distinguishing characteristic of Keynesian policy. At the height of the controversy in the late 1960s and early 1970s, Darryl Francis was the principal, and usually the only, spokesman who challenged this orthodoxy at meetings of the Federal Open Market Committee. Federal Reserve history suggests that neglect of money growth is a major mistake. The Federal Reserve would have avoided mistakes such as the Great Depression and the Great Inflation if it had used money growth as an indicator of the thrust of monetary policy.

-181-

Mintz, I. (1959). Trade Balances during Business Cycles: U.S. and Britain since 1880. New York, National Bureau of Economic Research (NBER).

Mintz, I. (1961). American Exports During the Business Cycle, 1879-1958. New York, Natoinal Bureau of Economic Research (NBER).

Miron, J. A. R., Christina D. (1990). "A New Monthly Index of Industrial Production, 1884-1940." Journal of Economic History Vol. 50(no. 2): 321-37.

Useful for its estimations of GDP and other macro variables in the 1920s.

Mises, L. v. (1949). Human Action. New York, Regnery.

A full economic theory in itself. "Human Action" was useful in understanding the difference between a monetary inflation/deflation and demand/supply driven inflation/deflation. He also has a full theory around incentives which include taxation.

Mowery, D. (1995). The Boundaries of the U.S. Firm in Research and Development. Coordination and Information: Historical Perspectives on the Organization of Enterprise. N. L. a. D. Raff. Chicago, University of Chicago Press.

Mundell, R. (Dec. 1999). "A Reconsideration of the Twentieth Century." The Nobel Foundation, Stockholm, Sweden.

This article is a revised version of the lecture Robert A. Mundell delivered in Stockholm, Sweden, December 10, 1999, when he received the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel.The underlying theme of the speech was the role of the United States in what has been aptly called the "American century." Mundell brought out the role of the monetary factor as a determinant of political events. Specifically, he argued that many of the political changes in the century have been caused by little-understood perturbations in the international monetary system, while these in turn have been a consequence of the rise of the United States and mistakes of its financial arm, the Federal Reserve System. In particular, the first section "Mismanagement of the Gold Standard" was most useful

Murnane, M. S. (2004). "Selling Scientific Taxation: The Treasury Department's Campaign for Tax Reform in the 1920s." American Bar Foundation.

Valuable in understanding the debate and forces that brought the Mellon Plan to fruition.

Nicholas, T. (2004). "Stock Market Swings and the Value of Innovation." LSE Working Paper.

This article investigated whether the run-up in stock market valuation during the 1920s was related to the accumulation of intangible capital by firms. Valuable in testing the results of Prescott and McGattan who found that stocks were undervalued in late 1929, before the crash.

-182-

Nicholas, T. (Dec. 2003). "Why Schumpeter was Right: Innovation, Market Power, and Creative Destruction in 1920s America." The Journal of Economic History Vol. 63(No. 4).

Pastor, R. (1980). Congress and the Politics of United States Foreign Economic Policy, 1929 - 1976. Berkeley Calif, University of California Press.

Takes the view that party politics was of supreme importance in passage of the tariff.

Peach, W. (1942). The Security Affiliates of National Banks. John Hopkins, John Hopkins University.

Pierce, P., Ed. (1982). The Dow Jones Averages 1885-1980. Homewood, Illinois, Dow Jones-Irwin.

Pindyck, R. (1991). "Irreversibility, uncertainty, and investment." Journal of Economic Literature.

Posner, R. (October 1970). "A Statistical Study of Antitrust Enforcement." Journal of Law and Economics Vol. 14.

Prescott, E. M. E. (Dec. 2001). "The Stock Market Crash of 1929: Irving Fisher was right!"" NBER Working Paper 8622.

An important article that demonstrated the stock market was in fact undervalued on the eve of the Crash, just as Fisher had broadcasted.

Rappaport, E. W. P. (1993). "Was the Crash Expected?" The American Economic Review Vol. 84(No. 1).

Ratner, S. (1942). American Taxation: Its History as a Social Force in Democracy. New York.

Reynolds, A. (Nov. 9th 1979). "What do we know about the Great Crash?" National Review.

Although trained at the Chicago Monetarist School under Milton Friedman, Reynolds argued in line with Wanniski that the Smoot-Hawley bill played a dominant role in the October 1929 Stock Market Crash. Used "The Commercial and Financial Chronicle" to test the theory.

Ricardo, D. (1996). Principles of Political Economy and Taxation. New York, Prometheus Books.

Roberts, P. (Spring 2000). "Benjamin Strong, the Federal Reserve, and Limits to Interwar American Nationalism." Economic Quarterly - Federal Reserve Bank of Richmond.

Romer, C. (1969). "The prewar Business Cycle reconsidered: New estimates of Gross National Product, 1869 - 1908." Journal of Political Economy Vol. 97.

-183-

Romer, C. (June 1988). "The Great Crash and the Onset of the Great Depression." NBER Working Paper.

Rothbard, M. (1975). America's Great Depression. Kansas City, Sheed and Ward, Inc.

Rothbard, M. (2002). A History of Money and Banking in the United States: The Colonial Era to World War II. Auburn Alabama, Ludwig von Mises Institute.

Rothbard, M. G., Garet (1980). "The Great Depression and New Deal Monetary Policy." San Francisco Cato Institute.

Santoni, G. (Nov. 1987). "The Great Bull Markets 1924-1929 and 1982-1987: Speculative Bubbles or Economic Fundamentals." Federal Reserve Bank of St. Louis Review Vol. 69.

Schlesinger, A. (1971). History of presidential elections. New York.

Schumpeter, J. (1950). Capitalism, Socialism and Democracy. New York, Harper Brothers Publishing.

Schwartz, A. J. (2001). "Essays on the Great Depression." Cato Journal 20(3): 493-495.

Essays on the Great Depression, by Ben S. Bernanke, is reviewed.

Schwartz, M. F. a. A. (1963). A Monetary History of the United States. Princeton, Princeton University Press.

Perhaps the most famous book on the period. Milton Friedman and Anna Schwartz offer a tremendous amount of data focusing primarily on the money stock and monetary policy of the United States in explaining changes in price level and even the Depression. This is the definitive "monetarist" explanation for the period. Much of what Friedman and Schwartz have said has been since discredited. My own analysis of their theory also found many flows. Nevertheless, it remains the starting point for any anlysis of the economy during the 1920s/1930s and is especially important for understanding monetary factors. Even if its conclusions can be criticized, the work is invaluable for its data collection, all of which is provided in extensive appendixes.

Siegler, M. V. (2005). "International growth and volatility in historical perspective." Applied Economics Letters 12(2): 67-71.

This paper studies the relationship between the volatility and growth of real GDP using a newly constructed panel data set from twelve countries over the 1870 to 1929 period. In addition, many other variables are examined that are related to economic growth. The goal has been to uncover robust empirical regularities on this issue for the period prior to the Great Depression - a period which has been relatively neglected in previous empirical work. The main finding is that there is a robust negative partial correlation between volatility and growth, after controlling for other factors. This result is consistent with recent empirical evidence on the post-World War II period. [PUBLICATION ABSTRACT]

-184-

Siegler, M. V. and K. A. Van Gaasbeck (2005). "From the Great Depression to the Great Inflation: Path Dependence and monetary policy." Journal of Economics & Business 57(5): 375-387.

There is substantial narrative evidence that the shadow of the Great Depression may have influenced the conduct of U.S. monetary policy during the 1970s. In this paper, we estimate central bank reaction functions for the United States and 12 other countries over the 1970s to examine the relationship between the magnitude of the Great Depression and the response of central banks to output gaps and inflation during the Great Inflation. The main finding is that countries which suffered the most during the 1930s had monetary policy reaction functions that responded substantially more aggressively to output gaps during the 1970s. [PUBLICATION ABSTRACT]

Silverman, D. (1982). Reconstructing Europe after the Great War. Cambridge, Harvard University Press.

Stevens, M. (1989). Sudden Death. New York, Penguin Books.

System, B. o. G. o. t. F. R. (1959). All Bank Statistics, United States, 1896-1955. Washington D.C., Federal Reserve Board of Governors.

Essential data source for many of the graphs/regressional studies in the thesis.

Thompson, N. (2004). "The End of Globalization, Lessons from the Great Depression." Labor History 45(4): 554-555.

The End of Globalization, Lessons from the Great Depression by Harold James is reviewed.

Tung Liu, G. S., & Courtenay Stone (Sept. 1995). "In Search of Stock Market Bubbles: A Comment on Rappoport and White." The Journal of Economic History Vol. 55(No. 3).

Wanniski, J. (1978). The Way The World Works. New York, Basic Books.

The work that inspired this Thesis. Wanniski was the first to propose the importance of the tariff in the modern literature as the central cause behind the crash and the main factor (along with poor tax policy) in pushing the United States into depression. He thoroughly documents the tariff through the news during the period of the October stock market crash. In addition, Wanniski argues that Secretary Mellon's tax plan helped bring the economy out of recession in 1921 and laid the foundation from which the "booming twenties" where able to grow. His book also outlines his understanding for the functioning of the political and economic dynamics within the world. He would call himself (and his theory) a "supply-side" political economic theorist.

Wanniski, J. (2005). Re: Gold Fetters. B. Eichengreen, non-published Wanniski archives.

Valuable private correspondence between Jude Wanniski and Barry Eichengreen concerning the Crash of 1929, the Depression and the organs of both. Not

-185-

published information but available from Polyconomics (www.polyconomics.com) upon request.

Wanniski, J. (2005). Origins of the Great Depression. B. Bernanke, non-published Wanniski archives.

Important, non-published and private correspondence between Jude Wanniski and Ben Bernanke discussing the origins and sources of the Crash of 1929 and the Great Depression. Also useful because it compares situations to modem day phenomenon. This is on the eve of Bernanke becoming Fed Chairman in 2006.

Wanniski, J. (2005). Re: Eichengreen Response. B. Bernanke, non-published; Wanniski Archives.

Correspondence between Wanniski and Bernanke regarding Eichengreen's thoughts on the origins of the Depression.

Wanniski, J. (January 8th, 2005). "The Crash of 1929." Supply Side University - Memo on the Margin.

Wanniski, J. (June 17th, 2005). "75th Anniversary of Smoot-Hawley Tariff Act." Supply Side University - Memo on the Margin.

Watson's, O. B. M. (1982). Bubbles, Rational Expectations, and Financial Markets. Crises in the Economic Financial Structure. P. Watchel. Lexington: D.C, Heath and Co.

Weidenbaum, M. L. (1990). Business, Government and the Public. Englewood Cliffs, NJ, Prentice Hall.

Weisman, S. (2002). The Great Tax Wars: Lincoln to Wilson, The Fierce Battles Over Money and Power that Transformed the Nation. New York, Simon & Schuster.

An invaluable book for the first chapter. Extensively covers the tax debates in the United States since the Civil War. Weisman is somewhat sympathetic to the Mellon tax reform of the inter-war years. Like Witte's "The Politics and Development of the Federal Income Tax" it was lacking in specific detail regarding the bills most important to my thesis. For this detailed information I used the actual bills themselves.

West, R. C. (1977). Baning Reform and the Federal Reserve 1863-1923. Ithaca, Cornell University Press.

Wheelock, D. C. (Jun. 1989). "The Strategy and Consistency of Federal Reserve Monetary Policy, 1919-1933." The Journal of Economic History Vol. 49(No. 2).

White, E. (1990). When the Ticker Ran Late: The Stock Market Boom and Crash in 1929. Crises and Panics: The Lessons of History. Homewood, Dow Jones Company.

White, E. (Sept. 1993). "Was There a Bubble?" The Journal of Economic History Vol. 53(No. 3).

-186-

White, E. (Spring 1990). "The Stock Market Boom and Crash of 1929 Revisited." The Journal of Economic Perspectives Vo. 4(No. 2).

Important article that attempts to demonstrate a bubble existed in 1929. Major contribution to research.

Wigmore, B. A. (1985). The Crash and Its Aftermath. London, Greenwood Press.

Valuable in understanding the different sectors in the stock market on the eve of the Crash as well as how they reacted both during and after the crash. Wigmore detailed the individual stocks admirably. A valuable resource.

Wilkins, M. (2004). The History of Foreign Investment in the United States, 1914-1945. Cambridge, Harvard University Press.

Wilson, J. J., Charles (Apr. 1987). "A Comparison of Annual Common Stock Returns: 1871-1925 with 1926-85." The Journal of Business Vol. 60(No. 2).

Witte, J. F. (1985). The Politics and Development of the Federal Income Tax. Madison, Wisconsin, University of Wisconsin Press.

An overview of the development of the Federal Income Tax beginning with the Civil War. The first section covers tax theory while the later sections delve into the history. A useful work to get a sense of the political reaction/debate over different Revenue Bills but not completely inclusive regarding the specifics of all tax changes. The work is important because it promotes a method for studying public policy that integrates political theory, political practice, and policy analysis (definitively for tax policy).

-187-