Investors tune in daily to economic news and forecasts to hopefully glean a tidbit of information that will give them a clue to the future direction of the stock market. One source of information that investors clamor for is the Federal Reserve and its current chairman Dr. Ben Bernanke. Dr. Bernanke is arguably one of the most powerful men in our country. His testimony at Congressional hearings will sometimes move markets. Precedent for such power comes with the position and dates back to the founding of the Federal Reserve and its first leader, Benjamin Strong.
Benjamin Strong was considered by many at the time to be an easy money advocate. However, he was very concerned by the booming stock market of the 1920s and was beginning to take the necessary monetary steps to put a stop to rampant speculation when he died in 1928. Had he lived to continue his work, the Crash of 1929 might have been prevented.
America’s economy suffered a short depression in 1920-1922 and then took off on a tear. Then Treasury Secretary Andrew Mellon pushed for lower income tax rates and plowed government surpluses into paying off the national debt. Government expenditures fell, but personal income and the gross national product soared in the 1920s. Per capita income rose by a third while inflation was nonexistent.
The boom was fueled by the emerging technology of the time…the automobile. Ancillary industries sprang up…oil, rubber, glass, steel…all financed by the booming stock market.
Stock prices soared along with the economy. From 1922 to 1929 the Dow Jones Industrial Average quadrupled. Worker productivity, thanks to the use of electricity increased 40%, according to author John Gordon in The Great Game.
Credit played an important role in this expansion. Up to then, credit was a privilege reserved for the wealthy. General Motors, Macy’s and other retailers began offering credit to their customers, making the good life available to the middle class. And, it became an easy stretch to expand credit to the stock market by borrowing from a broker to buy securities on margin.
With 90% financing available, the masses flocked to the rising stock market in the quest for easy money that came from buying stocks with low down payments and selling at rapidly rising prices for a profit. This practice was a lot like what was happening in our real estate market 5 years ago. “Flippers” bought real property with small down payments with the goal of “flipping” (reselling) the property for a quick profit.
Benjamin Strong was named the first governor of the Federal Reserve Bank of New York in 1914 and dominated the Federal Reserve System during its formative years. Strong was an internationalist and saw the central bank playing a substantial international role. Strong advocated monetary policies that assisted our European Allies in rebuilding after World War I.
He wanted U.S. interest rates low to keep European capital from flowing out of Europe and into the U.S. Low interest rates only fed the stock market speculation. Alan Greenspan, Federal Reserve Chairman during the real estate bubble, did the same thing by keeping interest rates low in order to recover from the recession of 2000-2001. Low interest rates encouraged banks in the 1920s to lend more on margin for stock purchases where they got rates as high as 20% toward the end of the summer of 1929. With a similar motive, banks increased their sub-prime mortgage lending in the last decade to improve their profits.
Chairman Strong tried to put a halt to the speculation by raising the discount rate (three times in 1928) up to 5%, which was considered high at the time. He also took steps to restrict the money supply. His goal was to avoid a crash on Wall Street while aiding, if possible, the recovery in Europe.
Unfortunately he died of tuberculosis late in 1928, leaving the Fed without a strong leader. As a result no further steps were taken by the Fed to halt the stock market speculation.
In 2005, Fed Chairman Alan Greenspan, stopped short of saying the American economy had created a housing bubble when he testified before the Joint Economic Committee. Referring to the current housing market, Chairman Greenspan said “There do appear to be, at a minimum, signs of froth in some local markets.” He then added, “The apparent froth in housing markets may have spilled over into the mortgage markets.” Shortly after his testimony, the Federal Reserve boosted their target for the federal funds rate a quarter-percentage point to 3.75 percent, the highest level in more than four years. The rate increase was the 11th straight since June 2004. Following the announcement the Fed issued a statement saying that more “measured” rate increases were likely in the coming months.
Alan Greenspan may have seen the same problems brewing in the real estate market as Benjamin Strong did in the stock market. Both Chairmen tried to slow things down by raising interest rates but neither was successful. Chairman Bernanke recently said he intends to keep interest rates low until 2014. Some economists have speculated that a prolonged period of low interest rates will ignite bubbles like we saw in the 1920s and again in the 2000s. We need to be ever vigilant for bubbles. We may not be able to stop them from happening but we can choose not to participate. It’s easy to get caught up in the euphoria of the moment. Don’t be fooled by the lure of quick profits.
- “Those who fail to learn from history are doomed to repeat it.” —Sir Winston Churchill
- The Federal Reserve lowers interest rates to stimulate the economy and raise interest rates to slow the economy down.
- The crowd is usually wrong. They overpay believing prices will continue rising and sell at deep discounts thinking prices will go even lower.