As you know, I am taking a break from blogging to work on my book. If I was still blogging, here would be my views on some of the hot topics in the blogosphere:
1. A one size fits none monetary policy:
Are the problems in Europe caused by excessive borrowing, or the fact that a monetary policy appropriate for Germany may be inappropriate for Spain? Neither. Monetary policy in the Eurozone is far too tight for all members. As far as I know they are all seeing drops in NGDP. That’s the problem, everything else is symptoms. And there are no liquidity “traps” in Europe; everything the ECB is doing, they are doing intentionally. They don’t want inflation to be higher, which means, ipso facto, they don’t want NGDP to be higher.
2. Should we have a 2% inflation target?
No, we shouldn’t be targeting inflation at all. But if we must we should have either a 0% target, or a 4% target (as Blanchard recently suggested.) Zero percent is best if the Fed is willing to target the price level, and 4% if they plan on continuing to drive us into deep deflationary recessions every time interest rates get near zero. Obviously my preference is for sound policy and 0% inflation, or better yet, 3% NGDP growth. In my view 2% would only make sense if two things happened; we stopped taxing capital (making inflation less of a problem), and we got a sound, forward-looking monetary policy. Whatever we decide long term, we need a bit more inflation right now.
3. The exit strategy was implemented on October 8, 2008.
Everyone keeps saying we can prevent monetary policy from having an expansionary impact if we pay interest on reserves. It’s the Fed’s secret plan, it’s exit strategy. OK, but can someone remind me why this policy, which we are assured prevents reserves from having an expansionary effect, was implemented in October 2008. Just asking. (And don’t say “only a quarter point,” it was close to 1% for about nine weeks.)
4. Health insurance: The Goldilocks plan
The right-wing free market types say if we give poor people health insurance, they will spend too much on health care. OK, so give every poor person the amount needed to buy health insurance, and let them spend it as they choose. But now those do-gooder paternalists will say “we can’t do that, they’ll spend the money on booze and cigarettes, not check-ups for their kids.” Here’s my compromise, give them $5000/year, but force them to put it into an HSA. Have Medicare pick-up catastrophic expenses. When the choice is between fun stuff and healthcare (it is alleged, not my view BTW) the poor will spend too much on fun stuff and not enough on health care. When it’s between health care and rebating money to taxpayers, it is assumed that the poor (perhaps under pressure from medical providers) will overconsume. So why not HSAs, with any unspent money rolled over for retirement? There’s two equally boring goals, health care and retirement. No more battles between the id and superego. Both health care and retirement pensions appeal to the same boring part of the brain. So the poor will be able to make “rational” decisions along their indifference curves. In fact have everyone pay a 10% payroll tax into an HSA, and top off the amount from government funds for anyone who makes less than $50,000. Then get rid of health insurance companies. Please.
Here’s the second part of my essay on the slump of 1930. It describes policy news during 1929.
4.c Monetary Policy during 1928-29
In the previous section I argued that the post-October 1929 rise in the world gold reserve ratio provides an explanation for the onset of the Depression that is broadly consistent with the gold market approach to aggregate demand. However this increase seems to have begun after the stock market crash of October 1929; and well after the cyclical peak in output was reached in August 1929. How then could it have triggered the Depression? To answer this question we first need to take a closer look at the events leading up to the 1929 crash.
After the Fed switched to a tight money policy in mid-1928 the gold outflow from the U.S. reversed and the gold reserve ratio began to increase. In the absence of offsetting actions elsewhere, this increase was sizable enough to push the world toward deflation. Was this policy reversal then a “root cause” of the subsequent depression, or were the financial markets correct in essentially shrugging off the Fed’s tightening? One place to begin is with the stock market reaction to Fed policy announcements during the late 1920s.
On June 4th, 1928, the New York Times (NYT, p. 4) reported “Credit Curb Hinted by Reserve Board”. The market actually rose slightly on June 5th, but then over the following week the Dow plunged 7 percent. Policy news ought to be incorporated into securities prices almost immediately, and thus it is unclear whether the Fed announcement had any impact on the markets. The June 13th NYT attributed the previous week’s stock plunge to “Disappointment . . . at the turn of politics in Kansas City, with the evident elimination of President Coolidge and the substitution of Hoover as a candidate” and also to “Determination of the Federal Reserve . . . to liquidate broker’s loans”. This was the first of many stock market crashes that the press would at least partially attributed to Herbert Hoover.
On July 10th the Fed raised the discount rate by one half percent, and the next day the market saw “its widest break since the war”, with the Dow falling 3.0 percent. Once again, it is not clear that we can attribute the crash to tight money. The July 12th NYT (p. 1) also indicated that the market actually opened “rather firm” and that the price break didn’t occur until late in the session. This is not to deny that Fed tightening might have had some impact on securities prices—one can find many instances of rumors about tight money coinciding with sharp stock price declines during late 1928 and early 1929. But these declines were merely brief interludes in a powerful bull market, with the Dow nearly doubling between June 1928 and September 1929. There is no evidence that investors thought that the Fed tightening in mid-1928 was likely to trigger a major depression. To understand why both the stock market, and the economy, performed so well during 1928-29 we need to examine the pivotal role played by the Bank of England during this period.
The June 2nd, 1928, NYT (p. 21) predicted “another large movement of gold from here to London.” Only a few days later, however, that perception began to change rapidly as interest rates rose in the U.S. on rumors of Fed tightening. By June 8th the NYT was suggesting (p. 32) that high money rates in New York might lead to a reversal in gold flows back toward the U.S. Britain would go on to lose 22.8 percent of its gold reserve during the period from June 1928 to October 1929. This is the price the Bank of England paid for delaying the onset of the Depression by one year with a highly expansionary monetary policy.
The famous bull market of 1928-29 was punctuated by a series of sharp price breaks followed by rapid recoveries. For instance, between December 5th and 8th, 1928, the Dow plunged 11.5 percent over worries about a discount rate increase. Then, between February 5th and 8th stocks plunged another 6.4 percent, and a February 8 NYT headline reported “RESERVE BOARD WARNING SENDS STOCKS TUMBLING; LONDON RAISES BANK RATE”. The article attributed the market decline to both a Fed warning that “drastic action might be taken unless the funds going into speculative channels were curtailed” and “the advance of the discount rate of the Bank of England from 4 1/2 per cent to 5 1/2 per cent.” The next day the NYT (p. 24) suggested (wrongly) that “The prospect of further gold shipments from London to New York has definitely been disposed of by the advance of the discount rate of the Bank of England”. The correction seemed to have ended on February 11th, when the Dow rose by nearly 3 percent. On the following day a front page NYT story attributed the rally to the fact that the Fed had failed to raise rates as had been anticipated. But just a few days later the market again fell sharply on renewed warnings of monetary tightening by the Fed.
 Five days earlier the NYT (p. 38) had predicted that Wall Street would be disappointed if Coolidge wasn’t drafted at the Republican convention.
In some respects, the world monetary situation in the late 1920s was similar to that of the late 1990s. There was great optimism about the prospects for the U.S. economy. Unfortunately, the sort of monetary policy that allowed for strong, non-inflationary growth in the U.S., tended to exert deflationary pressure on many weaker nations whose currencies were tied to the dollar. By March 1929, there were growing complaints that the Fed’s anti-speculation policy was hurting the European economies, particularly Britain. There was even concern that the Fed’s policy might eventually force Britain off the gold standard. Stocks again broke sharply during late March on “Fear of a drastic advance in the rediscount rates by the Federal Reserve”. As with the previous setbacks, stocks resumed their upward march once it became apparent that the Fed’s threats were not slowing the economy. The final two weeks of May saw the last mini-crash, once again attributed primarily to fear of a discount rate increase.
During the summer of 1929 concern over the monetary situation eased as the peak in the seasonal demand for credit passed and the Fed failed to boost the discount rate. The NYT even predicted (wrongly) that increased gold flows to the U.S. would eventually force the Fed to expand credit. On August 9th the summer bull market in stocks was temporarily derailed by the Fed’s decision (the previous evening) to boost its discount rate from 5% to 6%, as the Dow fell 4.0 percent in a slump the NYT called the “Most Severe Since 1911”. And this time stocks plunged right from the opening bell.
 In the late 1920s it was European powers such as Britain that were under pressure from a strong dollar, in the late 1990s it was been developing nations such as Argentina.
 See the NYT, March 25, p. 42.
 NYT, 3/26/29, p.1.
 See the NYT 5/23/29, p. 38 and 5/28/29, p.1.
In fact, the Fed responded to the gold inflow with a contractionary policy during 1930. (See the NYT, 6/30/29, p. N7.)
In retrospect, the Fed’s decision to raise rates may have been a mistake. Only a few days earlier the NYThad reported that the Bank of England had seen its gold holdings fall £8,000,000 below the minimum level recommended by the CunliffeCommittee. They speculated that the Bank of England might be forced to raise its discount rate, an action that was seen as likely to depress the British economy anddisturb financial markets throughout the world. Ironically, the day before the Fed’s discount rate increase had sent U.S. stock prices tumbling, Wall Street had rallied on relief that the Bank of England had refrained from an increase in its discount rate.
Despite what we now know about its ultimate effects, it is hard to be too critical of the Fed’s action given that the markets seem to have made the same miscalculation. After dropping to 337.99 on August 9th, the Dow soared to its pre-war peak of 381.17 on September 3rd. The sharp price break on August 9th suggests that Wall Street was concerned about the discount rate increase, but the subsequent rally also suggests that it wasn’t seen as likely to trigger a severe slump. U.S/British policy coordination had been effective during the 1920s, and this may have lulled investors into believing that central bankers would again be able to cooperate enough to handle the monetary difficulties that might lie ahead.
Although the cyclical peak in output occurred in August 1929, it probably makes more sense to view October 1929 as the actual beginning of the Great Depression. Industrial production did decline slightly in August and September 1929 but this sort of modest drop in monthly output was not unusual, similar declines had occurred during May, June and September 1925, a year when no recession occurred. The NYT weekly business index suggests that output only began falling rapidly during the final week of October. And it wasn’t until November and December that we observe sharp declines in the monthly industrial production index. In addition, the fact that stock prices rose rapidly during the late summer of 1929 suggests that it is very unlikely that investors anticipated even a mild recession until at least late September. Almost all of the stock market crash occurred between late September and early November 1929. It is during this period that one would expect the market to have gradually become aware of any adverse shocks that might have triggered the Depression.
 NYT 8/9/29, p. 23.
 These perceptions changed rapidly after mid-September. The September 21st NYT (p.38) predicted a strong economy during the fall and winter. By October 17th, they noted (p. 38) that stocks had been following a business slowdown since mid-September. And by November 11th 1929, the NYT (p. 35) suggested that many were now forecasting a severe recession in the U.S.
In retrospect, the September 26th decision by the Bank of England to boost its bank rate from 5.5 percent to 6.5 percent appears to have been the decisive step which led to a reversal in Britain’s gold outflow, and thus helped trigger the dramatic increase in the world gold reserve ratio. But the market response to this action was not quite what one might have expected. To see why, we need to first consider exactly what type of information is conveyed by a change in central bank lending rates.
Although all indicators of monetary policy, including the money supply, exchange rates, and even the world gold reserve ratio, are susceptible to the identification problem, nominal interest rates are especially problematic. While an unanticipated increase in the central bank’s target interest rate can be viewed as being contractionary, on the day it is announced, over longer periods of time the nominal interest rate is an especially unreliable indicator of the stance of monetary policy. Whether a given discount rate will have an expansionary or contractionary impact depends on a complex set of economic factors including expectations of inflation and real economic growth.
Recent monetary theoryhas revived the Wickselliannotion that monetary authorities implement policy by moving their target rate above or below the ‘natural rate of interest.’ Because investors do not directly observe the natural rate, they have difficulty judging the current stance of monetary policy. Often it is only in retrospect (after discount rates changes have impacted other variables such as the gold reserve ratio), that investors are able to see whether a particularpolicy action has altered a country’s monetary policy. In addition, markets often seem undisturbed by discount rate increases that are consistent with a given central bank’s underlying operating procedures, but react very adversely to gold flows and/or other economic shocks which are expected to lead to undesirable changes in monetary policy. We will see this dynamic at work in the British policy changes of September 1929, and again in the Fed policy actions of October 1931.
As late as September 19th, the Dow had declined only slightly from its previous peak. A 2.1 percent stock price break on the 20th was attributed to fears of an imminent decision by the Bank of England to raise its discount rate.
This point has been emphasized by monetarists such as Friedman and Schwartz, and Meltzer (2003.) Also see Hawtrey (1947, p. 120.)
See Woodford (2003.)
 NYT, 9/21/29, p. 25.
Just four days later there were reports of “Unprecedented withdrawal of gold from the Bank of England”, and another 1.8 percent decline in the market was linked to expectations that the Bank would raise the discount rate on the 26th as a way of averting a financial crisis. The actual increase was somewhat anticlimactic, and there was no adverse impact on U.S. stock prices. But the next day stocks fell by another 3.1 percent, a decline attributed to concerns that the discount rate increase would fail to provide the needed boost to sterling.
Unfortunately, there is no “smoking gun” linking monetary policy to the October stock market crash. One possibility is that during the month of October the market gradually became aware of the fact that discount rates in the U.S and Britain were set at levels that would soon lead to a dramatic increase in the world gold reserve ratio. For instance, as late as October 19th the NYT(p. 26) was continuing to report that “experts” doubted that gold flows from the U.S. to Britain were likely to resume before yearend andthat the Bank of England would be forced to take further steps to attract gold. In fact, although Britain’s contractionary monetary policy appeared to lack credibility, the bank rate increase to 6.5 percent would prove to be so effective that a reduction in the bank rate occurred a mere twelve days after the NYTprediction. What changed, of course, was the economic environment. The U.S. stock market crash so reduced the demand for credit that existing discount rates throughout the world, and even somewhat lower rates, now represented highly contractionary policies capable of dramatically increasing the world gold reserve ratio. As output began to fall sharply in late 1929 and into 1930, the natural rate of interest fell even further, and discount rate reductions in the U.S. and elsewhere were not large enough to prevent a sharp rise in the world gold reserve ratio.
By October 28th the NYT (p. 34) was reporting that London expected to receive gold imports from the United States and South America, and on November 1st the NYT (p. 24) predicted that “We have already seen the end of the crumbling-away of the Bank of England’s gold reserve.” This shift in British policy need not have a major impact if other countries had simultaneously shifted to a more expansionary policy. In practice, “other countries” meant primarily the U.S. and France, which between them held over one-half of the world’s monetary gold stock. However because of the French Monetary Law, investors had little reason to believe that France would reduce its demand for gold. Prior to October 1929, France had been receiving much of its gold from England. After England tightened its monetary policy the French had to go elsewhere for gold. On October 29, the NYT (p. 52) reported that France had just received its first shipment of gold from the United States since the Armistice.
 NYT, 9/25/29, p. 1.
Glasner(1989, p. 123) also suggests that excessive demand for monetary gold by the major central banks contributed to the Depression, andblames the October crash on investor disappointment that the Fed didn’t reverse course in late 1929. This is similar to my own view, although because Glasnerdoes not look at world gold reserve ratios, he is unable to provide an explanation for the timing of the crash. He credits Earl Thompson with the basic idea.
At the time of the crash the U.S. monetary gold stock was well in excess of legal requirements and thus the Fed could have easily accommodated the Bank of England, as it had during 1927. Had it done so, the world gold reserve ratio would have only increased by 3 or 4 percent, and the economy would have held up much better during 1930. On October 31 the Federal Reserve Bank of New York, in coordination with the Bank of England, did cut its discount rate to reassure the markets. The same day the Dow rose by 5.8 percent. Statements by Fed officials, however, gave the market little reason to believe that any significant accommodation was forthcoming. The Fed was particularly anxious to avoid a repeat of its expansionary policy during 1927, which was perceived as resulting in a large gold outflow and excessive stock market speculation.
4.d Other Contributing Factors in the 1929 Crash
In addition to the highly uncertain monetary situation, there were several political developments that may have played a supporting role in the stock market crash. On the evening of October 25, 1929, Attorney General William Mitchell gave a speech advocating much more aggressive enforcement of antitrust laws. Bittlingmayer(1996) showed that throughout the early 1900s, both the stock market and the overall economy reacted adversely to aggressive enforcement of antitrust laws, and tended to do well when enforcement was lax (as under President Coolidge.) Although stocks did not fall on October 26th, Bittlingmayer (p. 399) suggested that the speech’s “contents or fundamental message could have reached Wall Street a day or two earlier, in the middle of the week-long October 1929 stock market decline that started on October 23.”
Concern over the worsening political situation in Europe, andespecially Germany, may have also played a modest role in the crash. Although in retrospect the interwaryears are often seen as a period of almost unending political crises, in the late 1920s there was a brief window of optimism about the prospects for both continued prosperity (the so-called “New Era”), and international cooperation. At the time, even the conservative business press tended to view developments such as the League of Nations, the World Court, and the Kellogg-Briand Pact (which outlawed war) as effective devices for reducing hostilities. There was also a perception that progress was being made at the London Naval Disarmament Conference, at the Hague Conference on war reparations, and in the talks aimed at creating the Bank of International Settlements (BIS).
On the economic front, the Young Plan (which rescheduled war debts and reparations), and the BIS were viewed as being particularly important. Supporters of the BIS argued that the bank could play an important role in coordinating monetary policy among the major central banks. The Economist(7/6/30, p. 6) suggested that the BIS might be able to “stabilize the value of gold” and also noted that Wall Street was hopeful that the U.S. government would support the BIS. After the BIS began operating in 1930, it did try to encourage central bank policy coordination. In order for the BIS to play an important role, however, it was seen as essential that there be cooperation on the question of reparations and war debts, especially between Germany and France. Because German Foreign Minister Stresemann and French Premier Briand were highly respected internationalists who had played a key role in the rapproachment between France and Germany during the late 1920s, there was optimism that a solution could be reached.
Stocks stabilized during the first half of October, with the only sharp price break occurring on October 3rd. Early on the morning of the October 3rd there occurred an event which can be seen in retrospect as signaling the end of the cooperative spirit of the late 1920s, and the beginning of the much more contentious 1930s. The Economistcalled the death of German Foreign Minister Stresemann a “calamity . . . overhanging Europe for months, years” and the NYT termed it a “political catastrophe”. Carr reported that “Almost at the same moment a panic occurred on the New York Stock Exchange.”  Carr probably exaggerated the importance of this event on U.S. stock prices, Stresemann’s death occurred before the market even opened. In retrospect, however, it seems just as clear that such a market reaction would have been appropriate. The ominous fears of the Economist concerning the impact of Stresemann’s death seem mild when compared with subsequent events. Events in Germany began deteriorating almost immediately and by mid-1931 turmoil in Germany had become the single most important influence on the U.S. stock market.
The most severe phase of the 1929 crash began on October 16th, when the Dow fell by 3.2 percent. Coincidentally, this was the same day that the German nationalists began a petition drive to stop the Young Plan. If the nationalists could register at least 10 percent of the electorate within two weeks, then a plebiscite would have to have been held on the proposal. Even if this were to occur, it was considered highly unlikely that the effort would be ultimately successful since rejection of the Young Plan would require 50 percent of all eligible voters. Nevertheless, the petition drive was viewed as an irritant to the delicate negotiations underway at the time. In commenting on the petition drive, the October 26th Economist (p. 752) lamented the passing of Dr. Stresemann whom they regarded as having been a key factor in restraining nationalist sentiment.
 See the Economist (10/5/29, p. 610) and the NYT (10/3/29, p. 1).
 See Carr (1947, p. 129). The NYTdid attribute the weak opening of the Berlin bourseto Stresemann’s death, and also suggested that it may have depressed French stock prices. But the London market was mixed on the 3rd and it seems unlikely that this event could, by itself, have pushed the Dow lower by 4.3 percent.
The same issue of the Economist(p. 766) described the collapse of the Briand government, which occurred on the evening of October 22, as a “bolt from the blue” andsuggested that it had occurred at the worst possible moment because of “the delicate situation withthe German plebiscite the Saar Conference and the evacuation.” The NYT noted that there was concern that the collapse could undermine German support for the Young Plan, and thus delay its adoption. On October 23rd the Dow dropped 6.3 percent, although the financial press could not find any reason for the decline.
In late October it appeared unlikely that the German petition would be successful, and thus it is unlikely to have been a significant contributor to the October crash. An October 29th NYTheadline prematurely called the “Anti-Young Plan Vote a Nationalist Rout”, andthen a six days later had to backtrack with a report that the nationalists had surprised everyone by collecting the 4 million signatures necessary to force a referendum on the Young Plan. At the same time, the Briand government in France was replaced by a more hawkish regime headed by Tardieu. The weak opening on the German Boerse on Monday, November 4th, was attributed to both the German referendum, and to the gains made by reactionaries in France. And the U.S. market, which had been widely expected to open higher, instead plunged by 5.8 percent.
If European political troubles contributed in any way to the October crash, the most likely mechanism would have involved a change in expectations regarding international monetary cooperation. An October 29 NYT headline stated that “Europe is disturbed by American Action on Occupation Debt.” The reports that the U.S. would take a unilateral approach to German war debts created concern that “German nationalists can make further use of [the] American action as showing that Washington thinks little of the Young Plan or the International Bank.” And an October 28th NYT headline noted that the “Young Plan [is] endangered by deadlock over BIS.”
 The Oct 30th NYT declared that uncertainty regarding the political situation in France had depressed stock prices in Paris.
Although these European disturbances occurred at roughly the same time as the October crash, there is little evidence linking specific news stories with important stock market movements. In addition, these events received less coverage in the U.S. press during late October than did the fight over the Smoot-Hawley tariff bill. A number of economistshave suggested that the Smoot-Hawley tariff contributed to the Great Depression, and Wanniski (1978) even argued that it triggered the October stock market crash. The tariff may have had an impact, but probably not for the reasons suggested in previous accounts. Indeed the mechanism by which Smoot-Hawley impacted the market appears to have changed over time, and thus it will be useful to separate the impact of the tariff fight of 1929, from the impact of its enactment in 1930.
Wanniski argued that the tariff began affecting the market in December 1928 when word got out that the Republicans planned hearings on a bill that would include more than the agricultural protection promised in Hoover’s presidential campaign. He also noted that stocks dropped sharply on March 25 and the morning or March 26, 1929, on news that pressure was building for tariff protection on many industrial goods. Wanniski missed several other news stories that support his interpretation. The March 5th NYT (p. 40) observed that stocks fell sharply “during yesterday’s inauguration”, but could find no explanation. The only significant economic news contained in the speech, however, was Hoover’s announcement that he planned to call a special session of Congress for tariff legislation. And the May 8th NYT (p. 30) reported that the proposed tariff increases reported out of the House Ways and Means Committee on the previous day “go far beyond what the President had led the country to expect.” The CFC called the proposals “a great shock to the community.” The Dow dropped 1.3 percent on May 7th.
The first big tariff fight occurred in the U.S. Senate during late October and early November of 1929. One of the key votes cited by Wanniski was a procedural vote on the afternoon of October 23rd over the issue of the tariff rate on calcium carbide. A split on this issue within the coalition of Democrats and progressive Republicans that had opposed higher industrial tariffs was treated as a major news story in the October 24th NYT. The Dow fell 6.3 percent on October 23rd, with most of the decline occurring in the last hour of trading, following the Senate vote.
 See Meltzer (1976), Gordon and Wilcox (1981), and Saint-Etienne (1984.)
Despite the preceding evidence, there is a serious problem with Wanniski’s account of how Smoot-Hawley contributed to the October 1929 stock market crash. After the October 23rd vote, the anti-tariff coalition grew progressively stronger, just as the crash entered its most severe phase. The November 1st NYT (p. 1) reported “Republicans Admit Coalition Control.” By November 10th, the protectionist Republicans had been completely routed and there were predictions that the coalition might force reductions in tariffs on manufactured goods. Contemporaneous observers also believed the news favored the low tariff bloc. Bankers Trust director Fred Kent argued that a contributing factor in the crash was the success of the coalition in blocking the tariff. Even if one does not accept Kent’s analysis of the market reaction, it is hard to reconcile Wanniski’s view with the widespread contemporaneous interpretation that in the weeks following October 23rd the protectionist wing of the Republican Party had suffered a major setback.
There is another way that the tariff dispute could have affected the markets. The tariff fight was unquestionably the major news story during the October crash (after the crash itself) and NYT headlines indicated that the Senate battle had created a serious split in the Republican Party. An October 26th NYTheadline reported that Kahn had been appointed chair of the Republican election committee as a slap at Republican members of the anti-tariff coalition. Only days later, however, an angry reaction from the anti-tariff Republicans forced Kahn to decline the position. An October 30th NYT headline stated that an outraged Joseph Grundy (the principal lobbyist for eastern manufacturers) had suggested that small (i.e. agricultural) states should be denied equal representation in the Senate.
In November the situation grew even worse for the Republicans. The November 1st NYT reported “It is a long time since such utter confusion prevailed in Congress as was revealed today.” On November 10th the NYT reported that even Smoot’s total capitulation to the coalition, which included an offer to let the coalition write its own bill, had been rejected. And on the next day the NYT headline read “Republican Revolt Seen, Following Senate Split and Chaos in Leadership . . . Call Party Disorganized.” The same issue (p. 1) argued that the public was upset with the apparent inability of the Republicans to govern and (correctly) predicted major Democratic gains in the next Congress. This view was reinforced by recent Democratic gains in certain state and local contests. It was the sort of crisis that could have brought down a parliamentary government.
Roger Babson called the Senate’s actions on the tariff the “most important” factor in the crash.
 NYT, 11/12/29, p. 3.
 See the CFC(11/23/29, p. 3257). Babson was respected on Wall Street because of his September 1929 forecast of a stock market crash. Interestingly, although in November he blamed the crash on the tariff fight, his earlier forecast was based on the Fed’s “tight money” policy. He may simply have been lucky, however, as many of his other predictions were much less accurate.
By explicitly blaming both sides of the tariff issue, Babsonsuggested that the problem had more to do withthe spectacle of government ineptitude than with the specifics of the legislation. In general, however, observers were much less likely to connect the October crash to the tariff bill than would be the case during the June 1930 market plunge.
The attractiveness of the ‘political paralysis’ explanation is enhanced by the fact that these events would not necessarily have had a deflationary impact on the economy. Although there was a significant decrease in commodity prices during late October and early November 1929 (see figure 4.1), the drop was certainly too small to account for the severity of the crash. And the fact that the crash was more severe in the United States than in Europe also points to the likelihood that there were some specific American factors involved.
Additional support for the hypothesis that political turmoil contributed to the October crash comes from its dramatic denouement. The November 12th and 13th issues of the NYT reported that there was no explanation for the continual slide in the stock market. The next issue, however, was very different in tone. The income tax cut announced by the Hoover Administration on the evening of the 13th was treated as the major news story. Equal importance was given to the promise of cooperation from House and Senate leaders. The news led to widespread speculation that the market had hit bottom and would rally on the following day (the 14th.)
The following day the NYT was even more optimistic. The 9.4 percent increase in the Dow was one of its sharpest gains ever. Front page articles were entitled “Congress to Rush Tax Cut,” “Leaders are Enthusiastic,” and “Officials Confident Will Suffer No Severe Depression Now.” The financial page (p. 38) noted “There has not been a day in many weeks in which such an aggregation of good news descended on Wall Street.” One of those pieces of “good news”, the final approval for the BIS, was not entirely unexpected. Nevertheless, the NYTargued that the French signature was “significant” because it showed that “the Tardieu Cabinet is as conciliatory as its predecessor.” The Fed also contributed to the government’s effort by cutting the discount rate.
While the plethora of good news makes it difficult to attribute market gains to any one factor, the tax cut was treated as the major news story of the day. And although its effect on the market was undoubtedly partly due to an anticipation of its expansionary impact, the NYT (p. 26) also suggested a political interpretation; “What will make an unquestionably good impression [to Wall Street] in the Treasury’s present move is the promptness with which Congressmen dismissed political differences in their ready assent to the government’s proposal.”
 A comparable example might be the adverse stock market reaction to the disarray in the Republican Party during the summer of 1990 after President Bush abandoned his no new taxes pledge.
4.e What do We Know About the 1929 Stock Market Crash?
At the beginning of this chapter I suggested that in order to understand the October crash, one needed to explain why it would have been sensible for investors to be highly optimistic in September 1929, and somewhat pessimistic in November 1929. Is there an explanation for such a dramatic change in sentiment? We know that between 1922 and 1929 the U.S experienced strong economic growth accompanied by stable prices, as well as budget and trade surpluses. Government was widely viewed as being competent and pro-business. Of course the international situation was never really completely satisfactory during the interwar years, but 1929 saw distinct signs of progress. In September 1929 there really were good reasons to anticipate a “New Era”.
If we were to list some of the underlying causes of not just the downturn in late 1929, but also the Depression itself, the list might include the simultaneous adoption of tight money in the major economies, international political discord and lack of policy coordination, ineffectual leadership from President Hoover, and widespread banking panics. It is rather striking that three of these four problems suddenly appeared on the horizon in October and early November 1929. Nevertheless, it is unlikely that a ‘Great Depression’ was anticipated by investors in the months after the October crash. The Dow fluctuated between 200 and 260 during the first six months after the crash, levels comparable to those of highly prosperous 1928, or for that matter, the early 1950s. By contrast, during the summer of 1932 the Dow would fall into the low 40s. In order to explain the crash it is only necessary to show how investors moved from the giddy optimism of mid-1929 to a much more circumspect mood during the last three months of the year.
The decision by the Bank of England to raise interest rates in September 1929 may have triggered a dramatic tightening in world monetary policy, but we only know this in retrospect. Contemporaneous observers find it difficult to ascertain even the current stance of monetary policy. And what matters to most to investors is not so much what a central bank or a group of central banks is doing at a point in time, but rather the policy they are expected to adopt over an extended period of time. This makes it almost impossible to establish a clear link between monetary policy and the 1929 crash.
If moves toward a tighter monetary policy did contribute to the crash, one might also have expected a decline in commodity prices. A significant decline did occur in October, however a major stock market crash might reduce commodity prices even in the absence of tight money, and so this correlation doesn’t really provide independent confirmation that tight money triggered the stock market crash. All we can actually say is that if markets did begin to perceive a worldwide move toward higher gold reserve ratios after October 1929, then that perception was accurate.
A tightening of monetary policy that leads to a decline in equity prices anda slowdown in the economy is also likely to reduce the natural rate of interest. Unless central bankers understand this and reduce the discount rate sufficiently, policy will become steadily more contractionary over time. And this doesn’t even account for the deflationary effects of banking panics. At the most fundamental level, the “New Era” optimism was predicated on confidence in government policy, especially monetary policy. If markets had expected the macroeconomic environment of the 1920s to continue into the 1930s, that belief was presumably predicated on the assumption that Fed policy would continue on the path set by Governor Strong. The instability of domestic monetary policy would be even worse in the absence of international policy coordination. In particular, if the world’s central banks began competing for the limited supply of monetary gold then it would become even more difficult for any individual central bank to stabilize domestic prices. France was accumulating gold throughout the late 1920s and early 1930s. Once investors became convinced that Britain and the U.S had raised interest rates enough so that their gold reserve ratios would also started increasing, it is likely that expectations turned sharply bearish, and this could explain why prices and output began falling rapidly.
When viewed in isolation, the political events of late 1929 don’t seem all that significant. But the fact that the turning point in monetary policy occurred in the midst of a tumultuous period in both domestic and international political affairs would have naturally led to doubts about whether a “New Era” had actually arrived. Investors may have begun to (correctly) perceive that governments would not be up to the task of effectively responding to the weaknesses of the international monetary system. Further support for this view comes from the fact that several of the subsequent “crashes” during the early 1930s were clearly linked to bearish economic or political news, especially to news stories that first appeared in the October 1929. The first such example is the June 1930 stock market crash.
The is some dispute as to whether the Fed’s underlying policy regime policy actually changed after the death of Governor Strong. Meltzer (2003) argues that it did not. Yet several prominent contemporaneous observers, including Irving Fisher and R.G Hawtrey, argued that Strong’s death left the System without leadership, and that this contributed to the Fed’s passivity during the early 1930s. While either interpretation is plausible, Strong’s activist policy bent and forceful personality were certainly needed in the early 1930s