Senator Couzens: Did Goldman, Sachs and Company organize the Goldman Sachs Trading Corportation?
Mr. Sachs: Yes, sir.
Senator Couzens: And it sold its stock to the public?
Mr. Sachs: A portion of it. The firms invested originally in ten per cent of the entire issue for the sum of ten million dollars.
Senator Couzens: And the other ninety per cent was sold to the public?
Mr. Sachs: Yes, sir.
Senator Couzens: And what is the price of the stock now?
Mr. Sachs: Approximately one and three quarters.
—from the Senate Hearings of Stock Exchange Practices, 1932
In March of 1929 Paul M. Warburg, a founding parent of the Federal Reserve System and an immensely prestigious banker in his time, called attention to the current orgy, as he said, of "unrestrained speculation" in the stock market and added that were it not brought to an end, there would be a disastrous collapse. His warning was badly received. It was made clear that he did not appreciate the new era in economic well-being that the market was so admirably reflecting; he was said by one exceptionally articulate critic to be "sandbagging American prosperity." Less eloquent commentators voiced the thought that he was probably short in the market.
There was a decidedly more sympathetic response somewhat later that year to the still remembered observation of Professor Irving Fisher, of Yale, one of the most diversely innovative scholars of his time. Fisher said, "Stock prices have reached what looks like a permanently high plateau." Fisher was, in fact, long in the market and by some estimates lost between eight and ten million dollars in the almost immediately ensuing crash.
There is here a lesson about the larger constant as regards financial aberration and its consequences. There is a compelling vested interest in euphoria, even, or perhaps especially, when it verges, as in 1929, on insanity. Anyone who speaks or writes on current tendencies in financial markets should feel duly warned. There are, however, some controlling rules in these matters, which are ignored at no slight cost. Among those suffering most will be those who regard all current warnings with the greatest contempt.
The first rule—and our first parallel with 1929—has to do with the stock market itself and, as it may somewhat formally be called, the dynamics of speculation.
Any long-continued increase in stock prices, such as preceded the 1929 crash and such as we experienced at least until last September, brings a change in the purposes of the participants in the market. Initially the motivating force is from institutions and individuals who buy securities (and bid up prices) because of some underlying circumstance, actual or imagined, that is judged to affect values: The economy as a whole is improving. Inflation as a threat is pending or perhaps receding. The tax prospect seems favorable. Or, mercifully, a business-oriented Administration has come to power in Washington. Most of all, in a time when common-stock dividends are largely a fixed dole to stockholders, interest rates are thought likely to decline. This calls for a compensating increase in the value of stocks if they are to earn only the new going return. On such matters virtually all comment concerning the market, informed and often otherwise, centers.
But as a stock-market boom continues (the same can be true as regards a boom in real estate or even art), there is increasing participation by institutions and people who are attracted by the thought that they can take an upward ride with the prices and get out before the eventual fall. This participation, needless to say, drives up prices. And the prices so achieved no longer have any relation to underlying circumstance. Justifying causes for the increases will, also needless to say, be cited by the sadly vulnerable financial analysts and commentators and, alas, the often vulnerable business press. This will persuade yet other innocents to come in for the loss that awaits all so persuaded.
For the loss will come. The market at this stage is inherently unstable. At some point something—no one can ever know when or quite what—will trigger a decision by some to get out. The initial fall will persuade others that the time has come, and then yet others, and then the greater fall will come. Once the purely speculative component has been built into the structure, the eventual result is, to repeat, inevitable.
There will previously have been moments of unease from which there was recovery. These are symptoms of the eventual collapse. In 1928 and through the winter, spring, and summer of 1929 the stock market divorced itself from all underlying reality in the manner just cited. Justification was, of course, asserted: the unique and enduring quality of Coolidge and Hoover prosperity; the infinitely benign effects of the supply-side tax reductions of Secretary of the Treasury Andrew W. Mellon, who was held to be the greatest in that office since Alexander Hamilton; the high-tech future of RCA, the speculative favorite of the time, which so far had not paid a dividend.
But mostly speculators, amateur and otherwise, were getting on for the ride. In the spring of 1929 came the initial indication of instability—a very sharp break in the market. Prices recovered, and in the summer months they rocketed up. There was another bad break in September and further uneasy movements. Then, at the end of October, came the compelling rush to get out and therewith the crash. No one knows what precipitated it. No one ever will. A few—Bernard Baruch and, it has long been said, Joseph P. Kennedy—got out first. Most went down with the mob; to an extraordinary degree, this is a game in which there are mainly losers.
The question now, in the winter of 1987, is whether the stock market is or has been repeating its history. There was, early last year, a period of very sharply appreciating prices following an earlier, slower ascent. Then, on September 11 and the days following, came a severe slump, the worst in any recent period. So far (as this is written) there has been no significant recovery. As to the further prospect, no one knows, despite the extreme willingness to say otherwise on the part of many who do not know. What is certain, however, is that once again there existed a speculative dynamic—of people and institutions drawn by the market rise to the thought that it would go up more, that they could ride the rise and get out in time. Perhaps last September signaled the end; perhaps it was an episode in a continuing speculative rise with a worse drop yet to come. What we do know is that speculative episodes never come gently to an end. The wise, though for most the improbable, course is to assume the worst.
Another stock-market collapse would, however—one judges—be less traumatic in its larger effect than was the one in October of 1929. The Great Crash had a shattering effect on investment and consumer spending and eventually on production and employment, leading to the collapse of banks and business firms. Now there are safety nets, as they are called. Unemployment compensation, pensions, farm-income support, and much else would have a general cushioning effect, along with government fiscal support to the economy. There is insurance of bank deposits and the further certainty that any large corporation, if in danger, would be bailed out. Modern socialism, as I've elsewhere said, is when the corporate jets come down on National and Dulles airports.
A second, rather stronger parallel with 1929 is the present commitment to seemingly imaginative, currently lucrative, and eventually disastrous innovation in financial structures. Here the similarity is striking and involves the same elements as before. In the months and years prior to the 1929 crash there was a wondrous proliferation of holding companies and investment trusts. The common feature of both the holding companies and the trusts was that they conducted no practical operations; they existed to hold stock in other companies, and these companies frequently existed to hold stock in yet other companies. Pyramiding, it was called. The investment trust and the utility pyramid were the greatly admired marvels of the time. Samuel Insull brought together the utility companies of the Midwest in one vast holding- company complex, which he did not understand. Similarly, the Van Sweringen brothers built their vast railroad pyramid. But equally admired were the investment trusts, the formations of Goldman, Sachs and Company and the United Founders Corporation, and—an exceptionally glowing example of the entrepreneurial spirit—those of Harrison Williams, who assembled a combined holding-company and investment-trust system that was thought to have a market value by the summer of 1929 of around a billion dollars. There were scores of others.
The pyramids of Insull and the Varr Sweringens were a half dozen or more companies deep. The stock of the operating utility or railroad was held by a holding company. This company then sold bonds and preferred stock and common stock to the public, retaining for itself enough of the common stock for control. The exercise was then repeated—a new company, more bonds and stock to the public, control still retained in a majority or minority holding of the stock of the new creation. And so forth up the line, until an insignificant investment in the common stock of the final company controlled the whole structure.
The investment trusts were similar, except that their ultimate function was not to operate a railroad or a utility but only to hold securities. In December of 1928 Goldman, Sachs and Company created the Goldman Sachs Trading Corporation. It sold securities to the public but retained enough common stock for control. The following July the trading corporation, in association with Harrison Williams, launched the Shenandoah Corporation. Securities were similarly sold to the public; a controlling interest remained with the trading corporation. Then Shenandoah, in the last days of the boom, created the Blue Ridge Corporation. Again preferred stock and common were sold to the public; the controlling wedge of common stock remained now with Shenandoah. Shenandoah, as before, was controlled by the trading corporation, and the trading corporation by Goldman Sachs. The stated purpose of these superior machinations was to bring the financial genius of the time to bear on investment in common stocks and to share the ensuing rewards with the public.
No institutions ever excited more admiration. The creators of the investment trusts were men of conceded as well as self-admitted genius, and were believed to have a strong instinct for the public interest. John J. Raskob, the chairman of the Democratic National Committee in those days, thought an investment trust might be created in which the toiling masses would invest from their weekly earnings. He outlined the proposal in a Ladies' Home Journal article titled "Everybody Ought to Be Rich."
In all these operations debt was incurred to purchase common stock that, in turn, provided full voting control. The debt was passive as to control; so was the preferred stock, which conferred no voting rights. The minority interests in the common stock sold to the public had no effect of power either. The remaining, retained investment in common stock exercised full authority over the whole structure. This was leverage. A marvelous thing. Leverage also meant that any increase in the earnings of the ultimate companies would flow back with geometric force to the originating company. That was because along the way the debt and preferred stock in the intermediate companies held by the public extracted only their fixed contractual share; any increase in revenue and value flowed through to the ultimate and controlling investment in common stock.