The high level of stock prices and the increasing use of leverage in the stock market were the two factors most frequently pointed to in early 1929 by those who saw disaster looming. These concerns penetrated the inner sanctum of the Federal Reserve Board. Unable to address the issue of high stock prices directly, or to influence the financial structure of the investment trusts, the central bank took action to arrest the growth in broker loans that made investing on margin possible.
On February 2, in a step that initiated one of the most curious chains of events in the history of the Federal Reserve System, the board sent a letter to member banks advising them not to borrow from the Federal Reserve “either for the purpose of making speculative loans or for the purpose of maintaining speculative loans.” There was no doubt that the term “speculative loans” referred to loans made to finance stocks bought on margin.
A storm of controversy ensued, not just between the Federal Reserve and its critics, but also between the Federal Reserve Board and one of its own regional branches–the Federal Reserve Bank of New York. The directors of the New York bank, which by virtue of its location was the most affected by the new policy, did not agree with the idea of attempting to restrict certain kinds of loans. Instead, they preferred to increase the discount rate for all loans as a means of checking speculative activity. They, in fact, did so on February 14, unilaterally increasing the New York bank’s discount rate from 5% to 6%. The Federal Reserve’s board of governors in Washington, facing political pressure from business borrowers who opposed general interest rate increases, stepped in to quash the New York rate increase. But this was only the beginning.
One of the most influential directors of the Federal Reserve Bank of New York was Charles E. Mitchell, chairman of the board of National City Bank, who was himself heavily involved in stock market speculation. Mitchell was a handsome, broad-shouldered extrovert with a booming voice and a flair for publicity; he was not about to knuckle under to what he thought was a misguided policy implemented by Washington bureaucrats. Although the Federal Reserve Bank of New York was forced to rescind its discount rate increase, Mitchell was to be heard from again.
The stock market initially sold off after the Federal Reserve letter was made public, but it soon righted itself. Departing President Calvin Coolidge, not noted for possessing particular insight on either the stock market or the economy, blithely remarked to reporters that the economy was “absolutely sound” and that stocks were “cheap at current prices.” For perhaps this or other reasons, stock prices rallied in early March. The Federal Reserve watched, waited, and did nothing.
Then in late March a flurry of activity was reported. The Federal Reserve’s board of governors met daily in Washington, in secret, even including a highly unusual Saturday session. Rumors abounded that the Fed would take some sort of decisive action to quell speculation. By Tuesday, March 26, the pressure of uncertainty was unbearable; stocks dropped in a near-freefall on record volume that would total over eight million shares.
Charles Mitchell stepped in to rescue the market. In spite of his position as a director of the Federal Reserve Bank of New York, ostensibly answering to the board of governors, Mitchell would not wait for the board to announce a decision. He instead took unilateral action, undercutting any attempt the Fed might make to control speculation. Mitchell announced that his National City Bank would provide money to the broker loan market to prevent the forced liquidation of stocks. He stated bluntly, “We feel that we have an obligation which is paramount to any Federal Reserve warning, or anything else, to avert any dangerous crisis in the money markets.”
The stock market promptly rallied on Mitchell’s statement. More important, the Federal Reserve’s board of governors did nothing to contradict him. Even so, the board came in for harsh criticism from proponents of the boom on Wall Street. One observer remarked that the Fed “should mind its own business.” Barron’s questioned whether the Fed “was adequately interpreting the times,” because of its apparent inability to recognize the obvious fact that high stock prices were amply justified by the dynamic, unprecedented growth taking place in the economy.
Professor Joseph S. Lawrence of Princeton went so far as to complain that Wall Street had been the target of “blatant bigotry and turbulent provincialism” and declared the Street to be “innocent.” He chastised the Federal Reserve, charging that the central bank had “aroused the enmity of an honest, intelligent and public-spirited community.” (Jesse Livermore and his fellow operators must have been surprised to realize that the “community” referred to by Lawrence included them.)
Charles Mitchell did not escape criticism, especially from those in Congress who had been denouncing speculation for years. Senator Carter Glass called for Mitchell’s resignation as a director of the Federal Reserve Bank of New York, denouncing his “contempt” for the board. When informed of Glass’s statement, Mitchell declined to comment. He later defended his action by arguing that since his National City Bank was not in debt to the Federal Reserve at the time, it was not restricted by the board’s directive against making speculative loans.
Whatever the case, Mitchell was widely perceived as having defied the Federal Reserve and won. The stock market roared ahead. The central bank’s inaction was now reassuring; when the Federal Reserve Board took no steps against Mitchell, it was clear to all that the central bank would do little to arrest the stock market boom.
To be continued…
Credits: Much of this article is extracted from B. Mark Smith’s Toward Rational Exuberance, 2004.