There’s less than 10 days to go until our 250th national birthday celebration on July 4, so I’m running out of time. This is my continuing overview from the New To Las Vegas world headquarters of the entire financial history of the United States. In my judgment, this can be summarized in just three words: boom, bubble, bust. I recently described in Part 1, which you can read by clicking here, my perspective of the first century of American independence. Part 2, which you can read by clicking here, covered the next half-century to 1926. This is Part 3, getting us up to our 200th birthday in 1976.
By the time of the bicentennial, the U.S. had experienced 33 boom-bubble-and-bust cycles consuming, with recoveries, about two-thirds of its then-200 years of existence, one cycle every three years. For better or for worse, financial volatility was firmly baked into our culture.
But first, my definitions again. A boom is a period of rapid economic expansion accompanied by rising asset prices (stocks, bonds, real estate, crops, metals, businesses or whatever) and higher profits. A bubble is a unsustainable rapidly accelerating increase in asset prices, often driven by speculators using borrowed money from expansive credit policies in what amounts to a euphoria. A bust is the sudden decline of asset prices and overall economic activity, often precipitated by a single event causing mass realization, panic selling (which pushes prices even lower), job losses, recession and a great sense of investor revulsion.
As it turned out, by 1926 the U.S. was in a boom, not withstanding the Recession of 1926 that had started because one man–Henry Ford–shut down all his car factories for retooling from the Model T to the Model A. The bigger story in the Roaring 20s was the stock market. During the decade to 1929, stock prices rose by 500%. But the prices weren’t going up just because companies were more profitable, although some were. Rather, they went up because of the expansion and availability of easy credit.
Behind all of this partying was–ta da!–the Federal Reserve. Until it was far too late, the Fed fueled the credit expansion by keeping interest rates low, lowering what percent of their net worths banks couldn’t lend out and buying back government bonds like crazy to pump huge amounts of cash into the banking system. The boom soon turned into a bubble.
Sure, there were plenty of warnings. In January 2929, the financial editor of The New York Times predicted a crash by year’s end. Investment banker Paul Warburg, one of the forces behind creation of the Fed, warned stocks were too high. Herbert Hoover, the new president, asked newspaper publishers to editorialize against speculation.
At a time when the average stock’s price-earnings ratio (share price as a multiple of earnings per share) was about 10, investors using borrowed money bid up stocks a lot more. RCA, the premier tech company of the era, sold for 72 times earnings. General Motors at 73, Westinghouse Electric at 57.
Margin loans, as they were called, allowed investors to put down as little as 10% of the cost of stocks they bought, using the shares as collateral. The loans generally came from banks, either directly to investors, or to brokerages that in turn made loans at a mark-up) to investors.
So if a stock doubled in, say, three years (as many did for a time), an investor who had put down only 10% would have a return on his out-of-pocket cost of an amazing 2,900%. (I’ll spare you the math). This could then be used to buy more stocks. This feeling of financial euphoria spread throughout the land, even though only a small percentage of the population actually owned stocks.
But here was the rub. If the stock dropped by just 10%, the highly leveraged stock investor had no equity left. Moreover, his lender would issue a margin call demanding cash to maintain the 10% margin, or else the shares would be sold, often at a loss and often creating a downward cycle.
Which is exactly what happened starting on three startling trading days–Black Thursday, Black Monday and Black Tuesday–in late October 1929 when panicked investors desperately tried to unload their holdings and panicked lenders made margin calls to protect declining collateral. This kicked off the Great Depression. By the middle of November, stocks lost nearly 40% of their value. By July 1932, stocks were down 89%. When everyone’s selling, no one’s buying. Huge numbers of leveraged investors, leveraged banks and leveraged companies were wiped out. Unemployment rose to nearly 25%. The governor of the Bank of England, who helped to oversee word markets, had a nervous breakdown and took an indefinite leave of absence.
The Fed did almost everything it could to make things worse. It contracted the money supply by 30% rather than inject liquidity into the system. It sat around as thousands of commercial banks failed, depositors (and investors) wiped out in an era of no federal deposit insurance. It lowered and raised interest rates at exactly the wrong time. It adhered to old-fashioned notions of protecting the value of gold, and considered only short-term loans to businesses as adequate collateral.
In the middle of all this, Hoover signed the Smoot-Hawley Tariff Act, which raised U.S. tariffs on 20,000 imported goods to near-record levels. This pretty much guaranteed the impact of the bust would run for a lot longer.
It was the bust to end all BB&B scenarios, and with ups and downs lasting until 1940, near the start of World War II (although stock prices didn’t get back to their 1929 peak levels until 1954, a long 25-year-long climb). The debacle was so gigantic there were boom, bubble and bust recessions within boom, bubble and bust recessions. The Recession of 1937 proceeded this way. The massive amount of New Deal federal spending after Franklin D. Roosevelt became president in 1933, caused a massive boom, although not in stocks. People and companies started borrowing again. But in 1937 the FDR administration, thinking things were back to normal (supporting my thesis that government officials across the centuries really like booms) started cutting back on federal subsidies in an effort to balance the federal budget while raising taxes. The Fed required banks to lend less. Oopsie! The Recession of 1937 lasted about a year until Roosevelt completely reversed course, launched a new round of big-dollar relief, public works and, with war nearing, defense spending projects.
Ah, war. As so often seen in American history, World War II was a tremendous economic stimulus. A boom. It became a bubble that burst when the war ended in 1945 (that damn peace again), cutting government spending and leaving some speculators and companies overleveraged. The result was the Recession of 1945. But it only lasted less than a year, thanks to pent-up consumer demand. However, that same demand factor led to the Recession of 1949. That started when satiated consumers stopped buying goods on time, partly because the Fed raised interest rates, and companies were left with large inventories also funded with borrow money.The recession lasted less than a year and ended when the Fed eased monetary conditions and consumers started borrowing and spending again.
Ah, war again. The U.S. found itself again in conflict with the Korean War from 1950 to 1953, started when North Korea backed by its ally, China, invaded South Korea, backed by its ally, the U.S. Once again, wartime spending stimulated the economy, especially for defense companies–the boom. The end of the war prompted a bust called the Recession of 1953. But it passed within a year.
For our next two BB&B episodes, the equally brief Recession of 1958 and Recession of 1961, the precipitating event pricking the bubble came from the Fed itself. The agency raised interest rates to stall economic expansions deemed to be too hot.
Ah, war yet again. The 1960s saw a nearly decade-long economic expansion that came to be dominated by U.S. spending for the Vietnam War. Coupled with President Lyndon B. Jonson’s “Great Society” programs, large amount of federal spending coursed through the economy. That was the boom. Stocks soared. That was the bubble. The bust came from a decision of the Fed to stem high inflation by raising interest rates from 5% to 9%. Result: the Recession of 1969. It lasted about a year.
Hopes and memories seem to go in inverse relationships. Investors enthusiastically borrowed money to buy shares of the “Nifty Fifty,” a group of large-cap stocks considered a sure thing. The Fed kept interest rates low to encourage employment–then raised them–then lowered them–then raised them. The easy credit created a housing explosion. The boom quickly turned into a bubble that deflated almost as quickly, thanks to rising prices and the OPEC oil embargo, an effort by petroleum-producing countries to combine their efforts to artificially jack up prices. The resulting gas shortages had motorists waiting in lines for hours. Voilà, the Recession of 1973. It lasted for two years and probably helped drive Watergate-scarred Richard Nixon from the White House in 1974. Doing its part, the Nifty Fifty plunged 40% from their peak (and over time would under-perform the broader market by 75%!). A new word gained attention–stagflation, the simultaneous occurrence of slow economic growth, high unemployment and rapidly rising prices.
“Two centuries later, as we celebrate our bicentennial year of independence, the great American adventure continues,” President Gerald Ford proclaimed on the morning of July 4, 1976. This can only be described as a judicious, carefully worded sentence. Ford did not have a reputation as the brightest bulb on the front porch, but his words proved prescient in light of the next 50 years. Stay tuned.