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7

The Causes of the Crisis of 1920

The Quantity Theory of Money Stops Analysis of Causes. With the turn in the tide of commodity prices in the spring of 1919 there came into vogue a ready-made explanation which gave great comfort and confidence to the speculators and to the business community as the boom of 1919-20 proceeded. It was the explanation afforded by the quantity theory of money. Money in circulation and bank credit in the United States were enormously expanded as compared with the prewar situation. Commodity prices were enormously higher. But the prices, according to this theory, were higher because of the expansion of money and credit, and the prices were consequently safe, and adequately explained. Professor Irving Fisher was the leading advocate of this view in the United States. The formula of the quantity theorists is a monotonous “tit-tat-toe”—money, credit, prices. With this explanation the problem was solved and further research and further investigation were unnecessary, and consequently stopped—for those who believed in this theory. It is one of the great vices of the quantity theory of money that it tends to check investigation of underlying factors in a business situation.¹

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The quantity theory of money is invalid.² It was clear as early as May 1919 that the boom was thoroughly unsound, that the commodity prices prevailing were dangerously high and very precarious, and that the longer the boom lasted, the more violent the reaction would be.³ The basic cause of the boom was in the factors which we have previously considered, notably, the one-sided export trade to Europe first financed by the government, and, second, the going on the basis of unfunded private credits. We cannot accept a predominantly monetary general theory either for the level of commodity prices or for the movements of the business cycle.

Money and credit have their place in the explanation of both of these problems, but they are only a part of the explanation and often are a very minor part. The role of bank credit in particular is very frequently secondary and passive. Bank credit usually adapts itself to the underlying factors, rather than forcing the pace. Very notable exceptions, as we shall see, appeared in the period 1922-29, and in the period 1897-1903. The monetary forces provide the primary explanation of our Civil War prices, when our currency was the irredeemable greenback. Monetary forces may well dominate our price situation following World War II. The inflowing gold and the resultant ease with which the expansion of bank credit could go on were contributory factors of great importance in the rise of commodity prices in 1916 and the first part of 1917.

Money and Credit as Factors in the 1919-20 Boom. The factor of money and bank credit was not the dominating factor in the postwar boom, 1919-20, despite the fact stated above, that bank loans and investments in the United States expanded 25.4 percent between April 11, 1919, and April 9, 1920. This expansion was, on the whole, a reflex rather than a cause of the other phenomena. We were losing gold from April 1919 through April 1920. Our gold stock stood at $2,890,000,000 in April 1919 and at $2,554,000,000 in April 1920, a decline of $336,000,000, or 12 percent. Interest rates rose steadily and to very great heights. Open market commercial paper which had sold at 5.5 percent at the beginning of 1919 sold at a 7 percent rate in early 1920, reaching a peak of over 8 percent in the third quarter of 1920. Prime customers’ loans at the great city banks did not rise as high as this, but they rose steadily, and 7 percent was a very common rate for strong corporations before the boom was over.

Federal Reserve Rediscount Rates Below the Market. It must be recognized, however, that the handling of the Federal Reserve rediscount rate permitted the expansion to move faster and to go further than would otherwise have been the case. That rate was held at 4 percent through the greater part of 1919 despite the rising rates of interest in the money market.

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The explanation appears to be that the Federal Reserve authorities did not wish to raise their rate until the government had got over the peak of its borrowings. That peak was reached, however, in August 1919, whereas the rise in the Federal Reserve rate was delayed until November 1919. The New York Federal Reserve Bank suddenly found itself with a reserve deficiency and was thus obliged under the law to raise its rate. The rate went to 4.75 percent on November 4, 1919, to 6 percent on January 23, 1920, and to 7 percent on June 4, 1920. The other Federal Reserve banks followed New York in these moves, though only three of them went to 7 percent in June. It is thus true that down to January 23, 1920, it was definitely profitable for a member bank to rediscount at a Federal Reserve bank and relend to its customers. Too many of them did this, and too many of them found themselves heavily indebted to the Federal Reserve banks when the crisis came. The head of one great trust company, early in January 1920, put this question to an economist: “How much longer is it safe for me to go on borrowing at the Federal Reserve bank to relend at a profit?” He was shocked and startled when the economist replied that he had already gone much too far, that he had borrowed twice his reserves, and that it was essential for him to pull up. He did pull up and let some profitable business go to some other institutions, and took good care of his customers when the crisis came in autumn 1920.

The great New York banks in general were very reluctant to borrow from the Federal Reserve bank when the system was first inaugurated. Banks in general were disposed to feel that it was a sign of weakness if they rediscounted with the Federal Reserve banks, though banks in the Dallas district, where there is an immense pressure in the cotton-moving season, very early learned to do so. But it was not until the coming of war finance or shortly before this that the great New York banks rediscounted. They did so at the request of the Federal Reserve bank, which wished them to give an example to the other banks in the country.⁴ However, the great banks got used to it during the war, and in the postwar boom they overdid it.

The Federal Reserve System should have held to the orthodox rule of keeping the rediscount rate above the rate to prime borrowing customers at the great city banks.⁵

Discounts at the Federal Reserve banks increased from the beginning of 1919 to the middle of 1920 about $750 million. Offsetting this in its effect on member bank reserves was the loss of gold of $336 million mentioned

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above, and the increase of money in circulation, which amounted to $534 million between May 1919 and May 1920. The net result of these conflicting forces was a steady increase in pressure on the money market, with rapidly rising interest rates. On balance the monetary factor was a restraining influence through the whole of 1920, and it was not the primary influence in causing the boom in 1919.

It may be observed here that following the postwar boom and crisis, the great city banks resumed their tradition that they did not rediscount except in unusual circumstances, even though it was profitable to do so. They were very reluctant to show bills payable to the Federal Reserve bank in their published balance sheets. This tradition held very strongly until 1928. When the Federal Reserve banks in 1928 began to tighten the money market by selling government securities, the member banks in New York began to rediscount again, not for the purpose of increasing their reserves or increasing their loans, but for the purpose of maintaining their reserves. Their loans and deposits did, in fact, go down in 1928, as we shall see later when we study the brokers’ loan episode. But the Federal Reserve System ought not to rely upon such a tradition on the part of the banks. They ought to keep their rediscount rates above the market.

The Equilibrium Theory. The general body of economic theory which guides the interpretations given to the more than three decades of the economic history covered in the present volume, and which finds its verification in that history, is based on the notion of economic equilibrium.⁶ This concept includes many elements. It includes the equilibrium of the industries among themselves. It includes the price and cost equilibrium. It includes the relation of international debts to the volume of international

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trade. It includes the position of the money market. It includes, not merely the quantity of money and credit, but also the quality of money and credit. It includes consideration of wages, rentals, and taxes, as well as interest, in the costs of production. It centers on the question of whether economic forces are working away from balance or toward balance. It is a flexible conception which puts emphasis at different times upon different factors of the situation, depending on which ones are doing unusual things.⁷

The Growing Economic Unbalance. The situation in 1920 was shot through with abnormalities, stresses and strains. The movement was in almost every case away from equilibrium.

1. Our export balance. The most striking abnormality from the standpoint of ordinary economic laws was that the United States, a creditor country, should have an enormous export balance. The world as a whole was heavily indebted to us, and under normal conditions this would have involved an excess of imports to the United States as foreign countries paid their debts to us with goods.

2. Gold movements. The second great abnormality of 1919-20 was that despite our tremendous export balance of trade we were losing gold heavily. The extent of this is indicated in the foregoing tables, and the reasons for it have been stated. We had an export balance with Europe only, and we could not draw on Europe for payments to the non-European world to pay for our import surplus from them.

3. Prices and gold. The net result of our foreign commerce during 1919-20 was that we lost both goods and gold. The loss of goods raised prices and encouraged speculation. The loss of gold tightened the money market.

4. Government expenditure. In the two years following the Armistice the government spent practically as much money as it had spent during the war itself. A large part of this was in liquidating canceled war contracts and in meeting other unavoidable expenses of postwar readjustment. But part of this governmental expenditure was for financing the shipment of goods to Europe, while the continuance of government shipbuilding after the Armistice created a surplus of unneeded ships at the same time that it led to shortages in other lines where the labor and resources could have been advantageously employed.

5. Industrial efficiency. One of the most striking abnormalities was to be found in the fact that the return of nearly four million men from the army and navy to industry in 1919 was accompanied by an actual decline in the physical volume of goods produced in 1919 as compared with 1918.

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Professor E. E. Day⁸ gave figures showing an increase in agriculture of 3.3 percent, a decline in mining of 18.3 percent, and a decline of manufacturing of 8.8 percent, with a decline in production generally of 5.5 percent. Professor Walter Stewart⁹ estimated the decline in the physical volume of production of 1919 as compared with 1918 at four percent. There was a great decline in the efficiency of labor in 1919 and 1920 accompanied by a rapid rise in wages. This usually comes toward the end of a boom. In a boom certain “marginal” or inefficient labor is employed which would have difficulty in finding employment in dull times, and is taken on often at full wage rates. A great deal of overtime work is engaged in, and overtime rates increase labor costs. Moreover, overtime beyond forty-eight hours a week, over a series of weeks, leads to a weariness on the part of labor. Shop discipline is increasingly difficult in boom times. The turnover of labor, moreover, is very rapid in such a period. Labor costs per unit of output were mounting rapidly.

6. Managerial efficiency. Toward the close of a boom managerial efficiency always goes down. Managers are harassed by rush orders, by a high labor turnover, by difficulties in getting materials in on time, and by a multiplicity of details which do not press them so hard in dull times. Moreover, profits look large and managers have less incentive for close economies. They find it easy to add increased expenses to selling prices. They are, moreover, easily persuaded by enterprising promoters with “ideas to sell,” to incur extravagant overhead expenses for advertising and other items from which the return may be doubtful. They cease to watch small economies.

7. Raw materials. Ordinarily prices of raw materials rise faster than prices of finished products in a boom time. Imported raw materials did not rise as fast following the latter part of 1919 as did the prices of finished products, but raw materials in the cases where foreign competition was absent rose very rapidly, and this was particularly true of building materials. In some cases local monopolies were able to push building prices to outrageous levels.

8. Money and interest rates. The year following April 1919 saw a steady rise in money rates and in long-time interest rates on investments, with a resultant sharp increase in the interest element in the cost of production. Businesses which had maturing bond issues were especially hard hit by this development, and there was a great increase in the volume of short time notes in this period, as businesses were unwilling to tie themselves up with long-time contracts to pay existing interest rates. Gold was leaving the

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country and undermining bank reserves at the same time that bank loans were expanding, as we have seen, at a rapid rate.

9. Rentals. In all growing cities, in view of the shortage of housing, rents rose rapidly during 1919 and most of 1920. As business leases expired during this period, new leases had to be taken on at much higher rentals, leading again to marked increases in costs of business production.

10. The railroad situation. The war had subjected our railroad system to a very great strain. Traffic was dislocated and equipment had got into bad condition. Railway wages were high and the efficiency of railroad labor was low. The postwar boom caught the railroads in such a position that it was not easy for them to bear the strain. More traffic was offered than they could handle, and railroad congestion grew at many points. This was one of the worst elements of the industrial disequilibrium. It led to interferences with production and marketing, created a coal shortage, increased factory costs, and led, moreover, to the tying up of goods in transit with a consequent freezing of bank credits and commercial credits based on goods in movement. Freight cars and bank loans were direct competitors. This situation was in evidence in 1919 and became acutely critical in the early part of 1920.

Railroad congestion was complicated by the fact that railroad rates were lower than they should have been. The railroads were not paying their way and the United States Treasury was standing the loss. This meant that more traffic was offered to the railroads than would have been the case had the rates been high enough to enable the railroads to pay their way. Economic abnormalities arise whenever costs and prices get out of proper relation to one another. This is the case almost equally where prices are lower than costs or where prices are higher than costs.

11. Rising costs, and vanishing profits. From many causes, then, costs of production rose with startling rapidity during the second half of 1919 and the first part of 1920. As costs rose businesses which were unable to advance their prices faced declining and vanishing profits. With the decline in profits in a sufficiently important minority of businesses, a boom must come to an end. The businesses facing losses contract their operations to cut their losses. If they fail to do this voluntarily, their creditors force their hands. Credits are based on earning power. As earning power diminishes creditors grow nervous and begin to press for collection, liquidation is forced, and reaction and crisis come.

The heart of the business movement is not money, is not credit, is not commodity prices. The heart of the business situation is the outlook for profits. The heart of the credit situation is the quality of credit and the quality of credit rests on the outlook for profits.

12. Industries. Especially hard hit were those industries where prices were fixed by law or custom or necessity, but where costs nonetheless rose. Typical of these were gold mining, railroading, public utilities, and the

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like. The years 1919 and 1920 saw difficulties multiplying rapidly for all of these industries.

13. Competition. Very commonly in boom times competition functions imperfectly or disappears, and this was strikingly true in 1919-20. The legislation of the Wilson administration in 1913, in the Clayton Act, and administrative policy down to our entrance into the war in 1917 had made substantial progress in restoring competition to American business. During our own participation in the war, however, the government, for war purposes, temporarily reversed this policy and encouraged businessmen in most industries to get together, to pool their resources, and to pool their business secrets.

As a temporary war policy this was necessary and desirable. It was accompanied by price fixing, by rationing of materials and supplies, and by other restraints of an authoritative character which took the place of free competition in regulating prices and production. The end of the war saw the rapid disappearance of price fixing and authoritative controls, but did not see an adequate restoration of competition. One may add that never since the early years of the Wilson administration has there been any consistent effort to enforce antitrust legislation. Of course the whole theory of the NRA was contrary to the spirit of the antitrust laws and, indeed, the antitrust laws were suspended by the National Industrial Recovery Act.

14. Speculation. The great strain in commodity markets and the shortage of goods created by the abnormal growth of our export balance led to rapidly rising prices of commodities. This rise in commodity prices led to and was greatly accentuated by an appalling speculation in commodity prices. This speculation created shortages where shortages would not otherwise have existed. The year 1919 saw also a stock market boom of disquieting proportions, culminating in November. Speculation in farmlands and other real estate went dangerously far in many sections, while there was a great deal of exceedingly ill-informed and dangerous speculation in foreign exchange as well.

15. Conditions abroad. Our great export trade was based, not on revival in Europe, but on the failure of Europe to revive. Industrial revival in complicated modern industry must rest on sound currency and sound public finance. Public finance of the belligerents of continental Europe grew steadily worse. Monetary depreciation in Europe moved rapidly. Europe was buying goods in enormous quantity on credit from every part of the world, and building up throughout the world a fictitious prosperity similar to that which we had in the United States. Reaction and collapse were inevitable. The collapse came first in Japan with a violent break in silk prices early in 1920. Troubles came in India. Collapse came in Cuba as sugar plunged from 22.56¢ a pound in May 1920 to 3.63¢ in December.

16. The Unbalance Among the Industries. Leaving aside the disorder in credits and finance brought about by European troubles, there was a

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fundamental disturbance in the equilibrium of the world’s industries due to the great reduction in Europe’s output of manufactures. The normal functioning of industry and commerce rests upon a proper balancing of various industries. Manufactures, foods, and raw materials must be produced in proper proportion.

We saw such a disequilibrium in the United States in 1893-96—it was not our only problem, for fears regarding our standard of value were very acute then, as a result of the Sherman Silver Act of 1890 and the strong agitation for bimetallism. The production of raw materials and foods due to the rapid exploitation of the Mississippi Valley had outrun the development of manufactures. As a consequence the prices of raw materials and foods fell very low, and the buying power of the producers was cut so much that they could not give full employment even to the relatively scarce manufacturing capacity of the country.

The world as a whole faced a similar problem in 1920. Europe had been the great manufacturing center, drawing in foods and raw materials from all over the world, working up the raw materials, and sending out finished manufactures in payment. The most unmistakable revival in continental Europe following 1918 was in agriculture rather than in manufacturing. City industry calls for good money. Agriculture has far fewer financial problems. There had been a drastic change in our exports and imports from prewar conditions as a consequence of this fact. Before the war only thirty percent or our exports were manufactures ready for consumption. This percentage rose very high during the war, and even as late as November 1920 we were still sending out virtually forty-two percent of our exports in the form of manufactures ready for consumption. Raw materials constituted thirty-four percent of our prewar exports. They averaged only twenty percent of our exports during 1919 and 1920. On the other hand, on the import side there had been a marked diminution during and since the war in the proportion of manufactured goods imported, with a very substantial increase in the proportion of raw materials brought in. We had been trying to take over Europe’s job of supplying the world, including Europe, with manufactured goods, and of buying from the world its surplus raw materials. Our manufacturing capacity was not adequate to carry this work, and the result was so great a collapse in the price of raw materials, with a resultant decline in the purchasing power of the producers of raw materials, that our own factories could not keep active at prevailing prices.

There were many false theories accepted during this extraordinary postwar boom. One of the most remarkable was the theory offered in 1919 that there was a worldwide scarcity of raw materials. This was presented as an argument for extensive American investments in Siberia, South America, and other outlying regions, and served as a foundation for the fantastic commodity speculation in which the world engaged. But the fact

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was that the war had been fought chiefly in manufacturing countries and that, barring Russia, the sources of raw materials had been stimulated, rather than depressed, during the war.

Raw materials broke first and broke violently, and then all prices yielded.