AP, from msnbc.com

I posted a paper I wrote for one of my classes a while back up on the blog. It got some hits; how anyone managed to find it is beyond me. I’m posting the second paper I wrote for the same class now. I liked the first one while I was writing it at least as much, if not better, but I got a better grade on this one. So here goes.

The stock market boom and crash of 1929 is a fairly good embodiment of the concept of “too much of a good thing.” A thriving economy being helped to thrive by a successful securities market – this sounds good. The majority of the 1920s had this thriving economy – in fact, in his book The Great Crash – 1929, Galbraith says output per industrial worker increased by over 40 percent during this decade. However, some believed the situation was better than it really was. It is this attitude that Galbraith isolated as underscoring the problems that eventually led to the crash – the rampant speculation, the desire to obtain something specifically to see its monetary value increase. This attitude was first seen on a grand scale during a mid-1920s real estate boom in Florida that saw rapidly increasing prices for essentially artificial reasons. This mindset found its way into the stock market, and soon enough there were huge companies with soaring stock prices that were not even paying out one cent of dividends to shareholders. At the time, the shareholders didn’t mind – their shares were increasing in value, after all. But what happens when too much of a good thing ends? The answer, evident in 1929 as well as today in China (hopefully not to the same extent), is that when such irrational exuberance is displayed, it doesn’t matter until too late.

The Florida real estate boom took place slightly before the stock market completely lost control. Galbraith argued that the reason of substance for this boom, Florida’s mild, more livable winter weather, was overrun by the less rational, thought-out obsession with getting rich without doing much work. As prices rose, more people got in on the boom. As more people got in, the whole process became more frenzied, and few people thought about much but rising prices. The price of even the most unlivable land was bound to increase, with such demand for property in the state. People bought even tracts of land “close” to areas they were really 60 miles away from, or tracts that were “close” to nonexistent areas (Galbraith’s example is the “city” of Nettie). When the boom had exhausted all potential buyers, though, prices stopped shooting upwards. Two 1926 hurricanes didn’t help matters, either. Despite claims of people desperate to believe otherwise, the boom was over. The market crashed. There was really no other way for it to end – people neglected trivial matters such as the quality of land or its location, and instead focused solely on its price. This had disastrous consequences, and surely investors would learn a valuable lesson. One problem: they did not.

The stock market boom that occurred later in the same decade of the Florida boom was spurred on by the same type of reckless speculation on a grand scale. People wanted rising prices, and they got them. Incredible numbers of people wanted to get in on it – the number of shares traded in 1928 represented an increase of over 340 million from the previous year. The Federal Reserve conducted open market sales in 1928 in an attempt to contract the money supply, but it didn’t help. Plus, that was about the only thing the Fed did. Even so, the fact that it made any effort at all was enough to anger some, such as Princeton’s Joseph Stagg Lawrence, who was indignant at the fact that anyone would dare question the activities on Wall Street. It was this attitude that in part led to the massive speculation crush, but not the only factor. Perhaps most important was the ability to trade on margin. Under this scenario, a speculator obtains a loan from a banker and buys a security – which is left, along with some cash, with the banker to protect the original loan. However, the speculator reaps all price gains, despite leaving the security with the lender – the strongest incentive imaginable to care about nothing but stock price. In addition, there were investment trusts using leverage. Leveraging involved the purchasing of common stock through bonds and preferred stock. The bonds and preferred stock both had a fixed value, so any increase in the value of the portfolio was entirely attributable to increase in the value of the common stock, meaning return on common stock was higher than overall return on the portfolio. This was true in magnified terms of any trust company holding the common stock of another; the gains functioned as a geometric series. This led to some amazing increases in value of common stocks held by investment trusts – and later, losses just as spectacular, since, as Galbraith almost gleefully points out, a geometric series operates in the same fashion when values decrease. However, no thought was given to this at the time. Attention was paid only to drastically increasing stock prices, such as Radio Corporation of America going from 85 to 505 from the beginning of 1928 to early September 1929. Speculators neglected the fact that Radio had never paid a dividend. Certainly, this was no indication of the “sound” business climate Americans desperately wanted to believe existed. Perhaps the rampant optimism of the time is best captured by writer Will Payne, who contrasted gambling and investing by saying that a gambler makes money only because someone else loses, whereas in investing everyone makes money. By November 13, 1929, when the stock market price index was 224, down from 452 on September 3, and spectacular cases of embezzlement ($3,592,000 in one case) were beginning to be revealed, Payne had likely changed his tune.

Such drastic tune-changing will hopefully be avoided in China currently. Their economy has been sizzling for some time – GDP growth of at least 9% per year, with some speculation that the real number may be around 12%. These numbers, though impressive in their own right, pale next to the amount of investment, which is growing at the rate of 50% per year. Such investment could not happen without loans from banks – those are growing by 25% annually. This is too much activity. The ever-increasing investment is ever more inefficient – $4.50 is needed to produce an extra $1 of output. This figure has already increased from $3 a few years ago, and would increase further, but unlike stateside in 1929, action is actually being taken. In a recent development, China is freezing commercial bank loans for the rest of the year. This, they hope, will cool off the overheating economy, which many figure is due eventually for a hard fall. Certainly, action this drastic was not taken in the late 1920s in the United States. Whether China’s attempt to succeed where others have failed (including China itself, where a similar bubble burst 13 years ago) works or not, something is being done.

History has a tendency to repeat itself. The great stock market crash of 1929 was not the last (see 1987), and the prospect of an overinflated bubble in China is not the first (see 1994). However, responses can change. The Federal Reserve has taken a beating over the years for tight monetary policy following the 1929 crash, therefore worsening the economic slowdown. With such strong historical documentation and criticism, this situation is unlikely to repeat itself for the time being. And now, in China, a policy is being enacted to curtail overzealous investors. However, these situations arising again at all shows that perhaps people just need to be better educated about past events. Would the problems of China exist if investors just thought more about, say, Florida real estate speculators in the mid-1920s? Then again, the problem may lie in a more complicated area – human nature. People want to latch on to the latest fad because it will make them rich, or maybe popular. And when people want to do something, they can go to great lengths to convince themselves it’s a good idea, even when substantial evidence says it is not. Certainly this problem was rampant in the late 1920s, as people throughout the United States ridiculed anyone with the temerity to suggest that a problem was even possible. Human nature led people to overinvest in stocks in the 1920s, and it has led people to overinvest in China in the 2000s. Investment funds can be cut off through economic policy; human nature cannot. One can only hope that smart policies can correct for human nature where previously it has failed.