Or did it? As we have seen, the Federal Reserve can create large amounts of money simply by going into the open market and buying debt contracts. But, once it is in the mainstream of the economy, commercial banks can multiply that money by up to a factor of nine, and that is where the real inflationary action is. To protect that privilege is one of the reasons the banks formed this cartel in the first place. Nevertheless, the public still has the final say. If no one wants to borrow their money, the game is over.
That possibility is more theoretical than real. Although men may be hesitant to go into debt for legitimate business ventures in times of economic uncertainty, they can be lured by easy credit to take a long shot. Dreams of instant wealth are powerful motivaters.
Gaming casinos, poker parlors, race tracks, lottery windows, and other forms of tulipomania are convincing evidence that the lust for gambling is embedded in genetic code. The public has always been interested in free corn.
TULIPS IN THE STOCK MARKET
During the final phase of America's credit expansion of the 1920s, the rise in prices on the stock market was entirely speculative. Buyers did not care if their stocks were overpriced compared to the dividends they paid. Commonly traded issues were selling for 20 to 50 times their earnings; some traded at 100. Speculators acquired stock merely to hold for a while and then sell at a profit. It 1. See Charles Mackay, LL.D.,
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493
was the "Greater-Fool" strategy. No matter how high the price is today, there will be a greater fool tomorrow who will buy at an even higher price. For a while, that strategy seemed to work.
To make the game even more exciting, it was common for
investors to purchase their stocks on margin. That means the buyer puts up a small amount of money as a deposit (the margin) and borrows the rest from his stockbroker—who gets it from the bank, which gets it from the Fed. In the 1920s, the margin for small investors was as low as 10%. Although the average stock yielded a modest 3% annual dividend, speculators were willing to pay over 12% interest on their loans, meaning their stock had to appreciate about 9% per year just to break even.
These margin accounts are sometimes referred to as "call loans"
because the broker has the right to "call them in" on very short notice, often as short as twenty-four hours. If the broker calls the loan, the investor must produce the money immediately. If he cannot, the broker will obtain the money by selling the stock. In theory, the sale of the stock will be sufficient to cover the loan. But, in practice, about the only time brokers call their loans is when the market is tumbling. Under those conditions, the stock cannot be sold except at a loss: a total loss of the investor's margin; and a variable loss to the broker, depending on the severity of the price fall. To obtain even more leverage, investors sometimes use the stocks they already own as collateral for a margin loan on new stocks. Therefore, if they cannot cover a margin call on their new stocks, they will lose their old stocks as well.
In any event, such silly concerns were not in vogue in the 1920s.
From August of 1921 to September of 1929, the Dow-Jones industrial stock-price average went from 63.9 to 381.17, a rise of 597%.
Credit was abundant, loans were cheap, profits were big.
BANKS BECOME SPECULATORS
The commercial banks were the middlemen in this giddy game.
By the end of the decade, they were functioning more like speculators than banks. Instead of serving as dependable clearing houses for money, they also had become players in the market.
Loans to commercial enterprises for the production of goods and services—which normally are the backbone of sound banking practice—were losing ground to loans for speculating in the stock market and in urban real estate. Between 1921 and 1929, while 494
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commercial loans remained constant, total bank loans increased from $24,121 million to $35,711 million. Loans on securities and real estate rose nearly $8 billion. Thus, about 70% of the increase during this period was in speculative investments. And that money was created by the banks.
New York banks and trust companies had over $7 billion
loaned to brokers at the New York Stock Exchange for use in margin accounts. Before the war, there were 250 securities dealers.
By 1929, the number had grown to 6,500.
