To: Students of Supply-Side University
From: Jude Wanniski
Re: Why Wall Street crashed
Normally I would not have a lesson on Memorial Day weekend, but decided to at least make use of the space to run an article I wrote for The Wall Street Journal editorial page of October 28, 1977. In May of 1977, I had discovered the cause of the 1929 stock market crash, which to that point had been attributed to unknown causes that suddenly burst a speculative bubble. To this day, my thesis has been largely ignored by academic economists, who prefer the “bubble” thesis because the various demand-side schools have been built around the notion that the financial market can become “irrational” at times. If the market can have “irrational expectations,” then it becomes the task of government and the economists who advise government on how to manage the national economy.
The Keynesians do this by manipulating taxation and spending. The monetarists do this by manipulating the money supply. Even the present-day Austrian economists who decry the dominance of the state in managing our lives still hold to the view advanced by the late Murray Rothbard that the Federal Reserve inflated the supply of credit in the 1920’s, which led to the bubble and Crash. It has long been my hope that younger economists would, in accepting the logic of my thesis on what really happened, would be able to guide policymaking in the opposite direction. By this I mean gradually reducing the manipulative role of government by simplifying monetary and fiscal policies along classical, supply-side lines. The federal tax codes now contain more than 7 million words. There are more than 5000 different rates of tariff. And because so many demand-side economists blamed the Crash on the gold standard for preventing the Fed from inflating the economy out of the Depression, an acceptance of my thesis would help academics see the wisdom of giving the efficient market the gold venue instead of relying upon the judgments of a dozen men and women at the central bank on how much money to supply from one day to the next.
The complete version of my thesis is contained in Chapter Seven of my book, The Way the World Works, published in April 1978. Here is the newspaper version. The brief introduction was written by Robert L. Bartley, then the editor of the WSJ editorial page:
October 28, 1977
“The Crash of '29 -- A New View”
by Jude Wanniski
[The last week of October 1929 remains forever imprinted in the American memory. It was, of course, the week of the Great Crash, the stock market collapse that signaled the collapse of the world economy and the Great Depression of the 1930s. From an all-time high of 381 in early September 1929, the Dow Jones Industrial Average drifted down to a level of 326 on October 22, then, in a series of traumatic selling waves, to 230 in the course of the following six trading days.
The stock market's drop was far from over; it continued its sickening slide for nearly three more years, reaching an ultimate low of 41 in July 1932. But it was that last week of October 1929 that burned itself into the American consciousness. After a decade of unprecedented boom and prosperity, there suddenly was panic, fear, a yawning gap in the American fabric. The party was over. Why? The following interpretation by Jude Wanniski, Associate Editor of the Journal is adapted from his forthcoming book, The Way the World Works: How Economies Fail, and Succeed, to be published next spring by Basic Books.]
* * *
The most common explanation of the crash is that the market was overpriced, the victim of heedless speculators who had somehow lost their grip on reality in the mad rush for quick profits. But that explanation has never quite satisfied, either empirically or logically. There is no real sense in which the market can be "underpriced" or "overpriced." For every seller, there is always a buyer -- at a price. The stock market, particularly the New York Stock Exchange, was and is too massive for any group of individuals to manipulate. At any moment, it is fully priced.
Technically, what the market measures in the process of absorbing information and translating it into a valuation of the market shares is the capital stock of the U.S. The market places a value on each company listed on its exchange, based on its calculations of that company's future income.
Stock Market Anticipates
The accent should be on "future." The market does not reflect past events, it reflects the probabilities of future events. It anticipates. From studies of stock splits, we know that the price of individual shares starts moving up, relative to other shares, about 12 months before a split. By the time the split is announced, nothing further takes place. The market has already fully discounted the event. The most important information coming to the market is political news. Changes in underlying economic values tend to be glacial. But political news is volatile, because it can instantly and dramatically alter the future income of the companies whose stocks are listed on the exchange. On November 22, 1963, for example, the day President Kennedy was assassinated, the industrial average fell 22 points. On recognition that a successful presidential transition had been made, it recovered all the lost ground the following day and gained 11 more.
If one accepts this rational model of stock market behavior, it's logical to believe that the market at its 1929 peak was exactly where it should have been, and that the crash resulted from some stupendous error in a relatively few political minds. In particular, one would look first for an explanation in tax policies, the actions of government that most directly affect future income flows. Arthur B. Laffer of the University of Southern California has described the "wedge" of taxes between what workers produce with their efforts and the rewards they are allowed to keep. A change in the future wedge will be quickly reflected in stock markets. A 150-point slide in the Dow Jones industrials ended at noon on May 29, 1962 as news reached the market that the Kennedy administration would propose the tax cuts that spurred the economy in the 1960s. The industrials gained 50 points that afternoon.
Smoot-Hawley Tariff Act
Looking back at the history of 1929, there is no dramatic increase in the domestic tax wedge to explain the market collapse. But there is also an international wedge -- the tax on international transactions. And here there is a dramatic event, the gathering political momentum of what is now conceded to be the century's most disastrous piece of economic legislation. The Great Crash of 1929 anticipated the Smoot-Hawley Tariff Act of 1930. The calamitous declines of Monday, October 28, and Tuesday, October 29, followed immediately the collapse of the Senate coalition that had been the last barrier to the tariff.
To understand the crash, though, one must back up to review the boom years of the 1920s. The great Coolidge bull market got under way in earnest in 1924. The industrial average, which had taken four years to move from 90 to 106 in the first part of the 1920s, reached 134 at the end of 1924, 181 by the end of 1925 and, after a pause in 1926, 245 at the end of 1927.
These were not paper, "speculative" gains, for this was a period of phenomenal growth in the nations's capital stock. Between 1921 and 1929, GNP grew to $103.1 billion from $69.6 billion. And because prices were falling, real output increased even faster.
The boom coincided with sharp tax cuts. To pay for the First World War, income taxes had been boosted to a high of 77% on incomes over $1 million. An excess profits tax on business and a doubling of the normal corporate rate to 12% had also been imposed. In the 1920 elections, Warren Harding, pledging a return to normalcy and a reduction in taxes, won by the greatest landslide in American history up to that time. Harding's Treasury Secretary, Andrew Mellon, engineered a tax cut -- the top bracket was reduced to 56% in 1921 and then to 46% in 1922. Because this reduction in the domestic wedge was partly offset by the mild increase in tariffs the administration also pushed through, there was only mild expansion in the economy. But after Harding's death, Calvin Coolidge succeeded to the presidency, and he quickly embraced Secretary Mellon's arguments for even more drastic tax reductions.
As Coolidge aptly explained in a speech to the National Republican Club in February 1924: "An expanding prosperity requires that the largest possible amount of surplus income should be invested in productive enterprise under the direction of the best personal ability. This will not be done if the rewards of such action are very largely taken away by taxation."
As it gradually became clearer through 1924 that the Coolidge tax bill to reduce the top income-tax rate to 25% had sufficient support for passage, the stock market began its unprecedented climb. It's interesting that Great Britain, which did nothing to reduce the steep progressive income taxes introduced during World War I, experienced no boom at all during the 1920s. By contrast, Italy under Mussolini went from severe economic contraction to rapid expansion in 1923 as he cut the wartime personal tax rates back and also cut back tariffs and internal excises. And the French, under a center-right coalition formed by Poincare, ended a financial crisis in 1926 by slashing the general income-tax rates in half, to 30% from 60% at the top.
Wealth brings its own problems, however. In the U.S., in particular, farmers were being hurt by the falling farm prices that were doing so much to raise the standard of living for the rest of the country. The Republican Party in 1928 looked at this phenomenon as something to be corrected by governmental action, and decided to attempt to adjust the imbalance in wealth between farm and city by raising the protective tariff on foreign agricultural products.
The U.S. from its earliest days had imposed tariffs as a source of revenue and as a protection for fledgling industry. But it was one thing to impose tariffs when the U.S. was a small debtor nation (and much of the tariff revenue was used to pay off the public debt, which in turn meant a decrease in future domestic tax liabilities). It was quite another matter for the U.S. to impose tariffs when, as a result of World War I, it had grown into the most powerful creditor nation in the world.
As tragic as the marginal farmer's plight might be, no GOP argument, political or economic, could justify higher tariffs. By restricting foreigners' ability to sell their goods in the U.S., the Republicans were making it more difficult for foreigners to pay off their debts to the U.S. and import goods from us. Over time, tariffs would, in essence, have the same inhibiting impact on investment and commerce as an increase in taxes. Herbert Hoover signed the Smoot-Hawley Bill on June 16, 1930, but the stock market started anticipating the act as early as December 1928.
Double Blow to Market
The market was hit a double blow in the space of a few days. On December 5, after the market had closed, Coolidge announced there would be no further tax cut in the next budget. The industrial average dropped 11 points the next day. It fell another eight points the following day as word got out that the House Ways and Means Committee had scheduled hearings of 14 subcommittees to take up tariff testimony, and that the hearings would cover all commodities, not just agriculture.
There was plenty of opposition to higher tariffs, though, and the market soon continued its upward climb, reaching 300 by year's end and continuing to climb until March 23, 1929, when real trouble began. The tariff hearings were under way, Hoover had been inaugurated March 4 and on March 24, a Sunday, the world got bad news on page 2 of The New York Times: Senator Jack Watson, the Republican Senate leader, predicted in an interview that it would be difficult to limit tariff increases to agricultural products.
Senators, he noted, were being deluged by industries in their own districts for similar treatment. On Monday, the stock market broke heavily again. There was more bad news on Tuesday, March 26. New York and New England's elected officials called on Hoover for tariff increases on rayon, cotton and related materials. Stocks crashed on record volume (8,246,740 shares), though a late rally stemmed the tide.
Interestingly, though The New York Times and other papers closely followed the tariff hearings -- and the stock market's activity, of course -- the two weren't linked. A typical headline in the Times was March 26's "Stock Prices Break Heavily as Money Soars to 14%." The front-page story blamed the sell-off primarily on a tightening of credit; there was no mention of tariff matters, though a separate story on tariffs appeared on page 19. The reference to "money" going to 14% referred only to spot loans to individuals who had bought shares on margin and were having to raise fresh funds to cover their accounts. Long-term rates didn't rise. The Times and others would insist on linking money rates and stock prices right through the October crash.
Opposition to the tariff binge began to materialize in the Senate, and it appeared that a combination of progressive Republicans and Democrats would prevail against the Old Guard Republican protectionists. A procedural vote before the summer recess seemed to confirm this, and the stock market, reassured, resumed its climb, reaching 381 on September 3. The Dow Jones industrials wouldn't see that level again for more than a quarter of a century.
The decline over the next several weeks was orderly; by October 10, the market had drifted down to 352. On October 22, the market even gained six points on news that anti-tariff forces had won a test vote to cut chemical tariff rates. But on October 23, an hour before the market closes, disaster strikes: The market declines a stunning 21 points after news is out that the anti-tariff coalition has broken apart on the question of carbide rates. The carbide rates themselves are relatively unimportant; the vulnerability of the anti-tariff forces is the key. Yet the remarkable coincidence again goes unremarked in the next day's newspapers.
Morning Panic, Afternoon Rally
On Thursday, October 24, the anti-tariff forces suffer another setback; casein tariffs are raised 87%. John Kenneth Galbraith, in his book, The Great Crash -- 1929, describes the day on Wall Street: "The panic did not last all day. It was a phenomenon of the morning hours....For a while prices were firm. Volume, however, was very large, and soon prices began to sag. Once again the ticker dropped behind. Prices fell farther and faster, and the ticker lagged more and more. By eleven o'clock the market had degenerated into a wild, mad scramble to sell. In the crowded boardrooms across the country the ticker told of a frightful collapse....By eleven-thirty the market had surrendered to blind, relentless fear. This, indeed, was panic."
By afternoon, however, the anti-tariff forces had reassembled and pushed through amendments cutting other chemical rates. The stock market rallied and closed with only a 6½-point drop. The following Monday morning's Times provides the hardest news yet that the anti-tariff coalition had broken and the pro-tariff coalition was in control.
Not only did Senator Smoot predict the bill would survive. So did Senator Borah, until then leader of the anti-tariff forces, saying he thought "it is going to be made into a good bill." Worse yet, Democratic leader Simmons said the Democrats would do nothing to kill the bill, that the Republicans would have to take full responsibility. In the day's trading, the DJI dropped 38 points in what the Times called a "Nation-wide Stampede to Unload."
The following day, Black Tuesday, the industrials fall 30 points more, to 230, as all the reports coming out of Washington seem to be aimed at assuring the stock market that the tariff bill will not be killed. Senate Majority Leader Watson even complains that Democratic delays might be charged with responsibility for the crash in stocks!
Recovery on Tax Cut
On November 13, the market hits its low for the year, 198. A surprise 1% tax cut announced by Mellon shores up the market -- it recovers to 263 by the end of December. But the Senate resumes work on the tariffs in the spring despite vigorous protests from U.S. trading partners; there is still hope that Hoover might veto the bill.
On June 13, the Senate approves by two votes the measure to increase tariffs on more than 1,000 items and sends the bill to Hoover. On this news, the stock market breaks 14 points to 230, precisely where it was on the bottom on Black Tuesday, October 29. Hoover signs the bill and stocks tumble again. The market slide does not end until Franklin Roosevelt, a tariff foe, is nominated by the Democrats in 1932.
Most one-term Presidents only have time for one truly disastrous decision. Herbert Hoover squeezed in two. Having crimped international trade, he proceeded in 1932 to squeeze the domestic economy directly by pushing through Congress a measure to boost the income-tax rate back to 63% from 25% and piling on business taxes too. His aim was to reduce the budget deficit of the preceding 18 months, caused by the gathering slowdown. With ample help from the Democrats, Congress approved the tax increase. Under Roosevelt, economic management was only slightly improved, for even as he and his party chipped away at Smoot-Hawley, they again and again added to internal taxation during the following eight years, and the depression lengthened into war.