J A N U A R Y 1 9 8 7
by John Kenneth Galbraith
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.
It was a grave problem, however, that in the event of failing earnings and values, leverage would work fully as powerfully in reverse. All income and value, and in practice more, would be absorbed by the outer debt and preferred shares; for the originating company there would remain literally -- very literally -- nothing. But of this in 1929 no one, or not many, thought; a rising market combined with the managerial and investment genius of the men who built these structures made any such concern seem irrelevant in the extreme.
Here the parallel: after fifty-seven years investment trusts, called closed-end funds, are now coming back into fashion, although still, I would judge, in a rather modest way as compared with 1929. The more exciting parallel is in the rediscovery of leverage. Leverage is again working its wonders. Not in utility pyramids: these in their full 1929 manifestation are forbidden by law. And the great investment houses, to be sure, still raise capital for new and expanding enterprises. But that is not where the present interest and excitement lie. These lie in the wave of corporate takeovers, mergers, and acquisitions and the leveraged buy-outs. And in the bank loans and bond issues, not excluding the junk bonds, that are arranged to finance these operations.
The common feature of all these activities is the creation of debt. In 1985 alone some $139 billion dollars' worth of mergers and acquisitions was financed, much of it with new borrowing. More, it would appear, was so financed last year. Some $100 billion in admittedly perilous junk bonds (rarely has a name been more of a warning) was issued to more than adequately trusting investors. This debt has a first claim on earnings; in its intractable way, it will absorb all earnings (and claim more) at some astringent time in the future.
That time will come. Greatly admired for the energy and ingenuity it now and recently has displayed, this development (the mergers and their resulting debt), to be adequately but not unduly blunt, will eventually be regarded as no less insane than the utility and railroad pyramiding and the investment-trust explosion of the 1920s.
Ever since the Compagnie d'Occident of John Law (which was formed to search for the highly exiguous gold deposits of Louisiana); since the wonderful exfoliation of enterprises of the South Sea Bubble; since the outbreak of investment enthusiasm in Britain in the 1820s (a company "to drain the Red Sea with a view to recovering the treasure abandoned by the Egyptians after the crossing of the Jews"); and on down to the 1929 investment trusts, the offshore funds and Bernard Cornfeld, and yet on to Penn Square and the Latin American loans -- nothing has been more remarkable than the susceptibility of the investing public to financial illusion and the like-mindedness of the most reputable of bankers, investment bankers, brokers, and free-lance financial geniuses. Nor is the reason far to seek. Nothing so gives the illusion of intelligence as personal association with large sums of money.
It is, alas, an illusion. The mergers, acquisitions, takeovers, leveraged buy- outs, their presumed contribution to economic success and market values, and the burden of debt that they incur are the current form of that illusion. They will one day -- again, no one can say when -- be so recognized. A fall in earnings will render the debt burden insupportable. A minor literature will marvel at the earlier retreat from reality, as is now the case with the Penn Square fiasco and the loans to Latin America.
THE third parallel between present and past, which will be vividly and also painfully revealed, concerns one of the great constants of capitalism. That is its tendency to single out for the most ostentatious punishment those on whom it once seemed to lavish its greatest gifts.
In the years before the 1929 crash the system accorded fortune and prestige to a greatly featured croup of men -- to Arthur W. Cutten, M. J. Meehan, Bernard E. ("Sell'em Ben") Smith, and Harry F. Sinclair, all market operators of major distinction; also to Charles E. Mitchell, the head of the National City Bank as it then was, and Albert Wiggin, the head of the Chase National Bank, both deeply involved in the market on their own behalf; to Ivar Kreuger, the Match King, international financier (and sometime forger of government bonds); and to Richard Whitney, soon to become president of the New York Stock Exchange and its most uncompromising public defender.
All suffered a fearful fall after the crash. Called before a congressional committee, Cutten, Meehan, and Sinclair all had grave lapses of memory. Mitchell and Wiggin, the great bankers, were both sacked; Mitchell went through long and tedious proceedings for alleged income-tax evasion, and the large pension Wiggin had thoughtfully arranged for himself was revoked. Ivar Kreuger went out one day in Paris, bought a gun, and shot himself. Harry Sinclair eventually went to jail, and so, for embezzlement, did Richard Whitney. Whitney's passage into Sing Sing, in dignified, dark-vested attire, wearing, it has been said, the Porcellian pig of his Harvard club, was one of the more widely circulated news portraits of the time.
The young professionals now engaged in much-admired and no less publicized trading, merger takeover, buy-back, and other deals, as they are called, will one day, we can be sadly sure, suffer a broadly similar fate. Some will go to jail; some are already on the way, for vending, buying, and using inside information. Given the exceptionally oblique line between legitimate and much-praised financial knowledge and wrongfully obtained and much-condemned inside information, more are known to be at risk. But for most the more mundane prospect is unemployment and professional obloquy, and for some, personal insolvency. Expensive apartments will become available on the upper East Side of Manhattan; there will be property transfers in the Hamptons. David Stockman, said by the press to have a car sent out for him to Connecticut each morning by his employer, may end up taking the train.
S. C. Gwynne, a young onetime banker, tells in his excellent book Selling Money of his services in the late seventies and early eighties to the international division of Cleveland Trust, now AmeriTrust, a relatively conservative player on the world scene. He journeyed from Manila to Algiers and Riyadh in search of loans. It was a time of admiring reference to the recycling of funds on deposit from the OPEC countries to the capital-hungry lands. And he tells us that
by December 31, 1982, more than $200 million in loans would be in trouble in Mexico, Brazil, Venezuela, Poland, and the Philippines.... By 1984, thirteen of the seventeen officers who had staffed the [international] division in 1980 would be gone, and Ben Bailey, [the] deputy manager, and most of the members of the senior credit committee that approved the foreign loans would take early retirements.The end for those in the present play will come when either recession or a tight- money crunch to arrest inflation makes the debt load they have so confidently created no longer tolerable. Then there will be threats of default and bankruptcy, a drastic contraction in operations, no bonuses, a trimming of pay and payrolls, and numerous very, very early retirements. And from many who did not themselves foresee the result, there will be a heavy-handed condemnation of the failure to see that this would be the result. For those who engage in trading operations at the investment houses the day of reckoning could be when the market goes down seemingly without limit. Then will be rediscovered the oldest rule of Wall Street: financial genius is before the fall.
THE final parallel with 1929 is a more general one; it has broadly to do with tax reduction and investment incentives. In the Coolidge years, as noted, Andrew Mellon reduced taxes on the affluent. The declared purpose was to stimulate the economy; more precise reference to saving, investment, and economic growth was for the future. The unannounced purpose was, as ever, to lessen the tax bite on the most bitten. By the summer of 1929 the economy was, nonetheless, stagnant -- even in slight recession. (To this, rather than to the built-in inevitabilities of speculation, some economists looking for deeper substance later attributed the crash.) There is every likelihood that a very large part of the enhanced personal revenues from the tax reduction simply went into the stock market, rather than into real capital formation or even improved consumer demand.
So again now. Funds have been flowing into the stock market to be absorbed by the deals aforementioned or the cost of making them. Some, perhaps much, of this money -- no one, to be sure, knows how much -- is from the supply-side tax reductions. Real capital spending is currently flat, even declining -- a depressing fact.
From the mergers, acquisitions, and buy-backs, it is now reasonably well agreed, comes no increase at all in industrial competence. The young men who serve in the great investment houses render no service to investment decisions, product innovation, production, automation, or labor relations in the companies whose securities they shuffle. They have no real concern with such matters. They do float some issues for new ventures or expanded operations; one concedes this while noting again how dismal is the present showing on real capital investment. Mostly their operations absorb savings into an inherently sterile activity.
History may not repeat itself, but some of its lessons are inescapable. One is that in the world of high and confident finance little is ever really new. The controlling fact is not the tendency to brilliant invention; the controlling fact is the shortness of the public memory, especially when it contends with a euphoric desire to forget.
Copyright © 1987 by John Kenneth Galbraith. All rights reserved.
The Atlantic Monthly; January, 1987; The 1929 Parallel; Volume 259, No. 1; pages 62-66.