Chit Chat Stocks - "The Depression...Of 1920?" From a History of Financial Markets

Episode Date: January 12, 2022

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Welcome into A History of Financial Markets. This is season two, episode four, and this is going to be covering the Great Depression of 1920. I know I call it the Great Depression and it's not the actual one, but this is a really, I mean, did you know, Ryan, that this one existed before we started researching? No, I had no idea. Yeah. So it's a pretty big depression, really tough time period. However, it only lasted about two years. So I think a lot of people forgot about it. And then afterwards, we got into the roaring 20s. So in these last bunch of episodes, we have three here. We're going to round out season two. We're going to cover this depression that happened in 1920 and 1921. The depression

was severe, and it looked like you could turn something into something that was like the Great Depression that happened a decade later. But it really only lasted 18 months, and the American economy and financial markets zoomed into the roaring 20s. However, by the depths of the depression, the Dow Jones industrial average, excuse me, was below where it was almost 20 years prior, making it a terrible period for investors during that time span. Can you imagine 20 years you're saving up as someone and the stock market's still lower? I mean, there was just so many things happening in that 20 years that was just negative for the world. Yeah. That's a sad feeling. I'm guessing that's a sad feeling because it feels like 20 years of saving gone. But I guess worth

keeping in mind that only like 1% of people were investors at this point. Yeah, true. It was really just rich people. It wasn't the individual investor hadn't come to be just because there wasn't really any way for them to do that. That number may have been taken up by this point. Yeah, true. In the 20s, that was when the individual investor was born. And I'm sure we're going to hit that next season. And the reason I bet it was is because the market started doing extremely well. So before we get into what the depression was, let's start by giving a few big facts about the depression before going into what sparked the depressive period. Then next episode, we're going to hit the impact of the depression, and then to round it out, we'll talk

about why the depression ended. So some fast facts for everyone. The 18-month depression was from January 1920 to July 1921. There was a 23.9% decline in nominal terms for GNP, which is basically the equivalent of GDP back then. There was an 8.7% decline in real terms. And I want to highlight that discrepancy because notice how that means there was a lot of deflation during that period. So prices went down around 24% nominally, but in real terms, it was 8.7%. So a lot of, I mean, most of it was deflationary, but the economy got a lot worse in real terms too. Producer prices fell by 40.8%, which is just absolutely devastating. Prices received by, so, okay, let me define producer prices.

That just means prices received by domestic producers for their output. So, think farmers, manufacturers, people making steel, stuff like that. Industrial production during the depression fell by 31.6%, and stock prices fell by 46.6%, and corporate profits fell by a whopping 92%. So that, I mean, that's some pretty bad news there. It was the 14th business cycle contraction since the panic year of 1812. So basically one, probably about more than one per decade going back then. And even after the Federal Reserve started, we're trying to hopefully not have it as bad and make things more centralized as we've talk about before, but what fact stands out to you the most from these fast facts here?

Corporate profits declining by 92%. It's insane to think about, but for reasons that we're going to get into here soon, it's not that crazy. I guess you would sort of expect that. Yeah. A lot of operating leverage in these businesses, which when it flips the other way, can be quite negative. A lot of it's manufacturing. You got GM, US Steel, stuff like that, where a lot of input costs, a lot of capital expenditures, if prices are going down, I mean, that can just really reverse that operating leverage that you've built up over the years. I think the fact that stands to me would be the producer prices falling by 40.8%. I mean, if you're a business that is selling stuff that's included in that index, I mean,

you're just absolutely crushed. And we'll go over the details here. It's logical to think that corporate profits fell by 92% when your prices dropped by 40%. Yeah. And you still had to pay wages and so forth and you still had costs and whatnot, but we'll get into that. Yep. Agreed. All right. Before we get into the real details, I know for anyone listening that knows about this period, you're thinking, all right, we skipped world war one. There's not that much. I think that impacts the United States domestically outside of the increase in spending. So we don't have a full episode to dedicate to this, but I want to give some interesting context because it kind of impacts or potentially

impacts because there's not really any hard theories on this of what caused the inflation that comes right before this depression and then the deflation that comes during the 1920-1921 depression. So here's some facts here. To give some context for the depression of 1921, U.S. advanced $7.3 billion to allies during the war and then $2.2 billion after the war. Most foreign governments suspended the gold standard during World War I, however, not the U.S. so this brought a lot of uncertainty to the global system the gold standard was how things ran then without it things became decentralized more decentralized people were more on their own the us had to pick up some of the slack a bit and then the federal reserve's main activity during

world war one was to sell treasury bonds to finance everything um that you know very basic everyone i think knows about that but interestingly during that time member banks so these are the the banks, the big commercial banks or stuff like that, that are getting reserves from the Federal Reserve, as we talked about in previous episodes. Theoretically to lend. Yeah. So they borrow money from the Federal Reserve at a rate, but they can borrow during this time period at a preferential rate below the rate paid on treasury certificates. So when they borrowed and sat those reserves with treasuries in their accounts, borrowing became profitable. This was not the intention of the Fed, but it was an outcome of World War I.

Which diminishes the incentive to lend. The incentive for the member banks to do a next step and lend further to other people. But during this time period, there was so much need to finance the war that I don't think people are too upset. It's just kind of a weird quirk that I thought I'd talk about. But one thing I note here to compare it to the modern times is the Federal Reserve didn't make any open market purchases to help the treasury finance the war. Here's a quote from a book that highlighted all this. It said, quote, the system considered direct purchases to be inflationary. To avoid making open market purchases, it encouraged banks to offer

installment loans to non-bank purchasers on favorable items. Most commentators point out correctly, that it is no more inflationary for the Federal Reserve to buy the bonds. And when they refer to bonds here, they mean treasury bonds, to buy the bonds directly or in the open market than to lend money to the banks at below market rates so the banks can either purchase the bonds or finance the public's purchases. So that kind of compares to the QE type stuff. I know I may be getting the names wrong there, but the stuff that happened after the great financial crisis and the stuff that happened after the COVID crisis, where instead of like in 19 or whatever the year was for World War I, the banks were doing this financing. But in 21st century,

it was the Federal Reserve and it was essentially the same thing, but the Fed just kind of took out a step and said, well, we're not going to just let the banks buy all this stuff and make it a profit. We're going to do it ourselves. Does that make sense? Yeah. They kind of bypassed the member banks in this case. Do you want to talk about 1919 and sort of what led up to the panic of the 20s? Yeah. I don't know if I'd describe it as a panic. I think there was probably some panic, but depression. Depression. What caused it? I mean, there's always the question of what causes this stuff. So in 1919, yeah, we got to talk about the spark here. So in June 1917, a new rule allowed New York banks to lend 38.8% more versus every dollar

held in reserve. This means that lending capital capabilities were loosened up. And then the World War I armistice, I can't ever say that word, was on November 11th, 1918. So right around the start of the year 1919, the War Department canceled $2.5 billion in manufacturing contracts, which was worth up to 3.3% of gross national product at the time. So it's a pretty big chunk of gross national product. And you're thinking, the manufacturers of the stuff, whatever it is, they're just losing that demand overnight.

And that can go trickle down to all their workers and stuff like that. So in January 1919, commodity prices tumbled. However, the economy for the time being was saved by the post-war American consumer. So for example, at General Motors, revenue went from $270 million to $510 million from 1918 to 1919. So revenue almost doubled. Net income went from $15 million to $60 million. So Forex, which is amazing, operating leverage there, employee count doubled. I think that would cause anyone to be very bullish on GM's prospects. You have the post-war We're kind of, you know, we're not, we're stopping spending on the war financing and everyone's contributing to that, buying war bonds, stuff like that.

Now there's this pocket of money that people want to spend stuff on and they go over to automobiles, which is one of the big technology things of the day. In 1919, Woodrow Wilson went to war with grocers and retailers. I don't know if this could happen today. Maybe it would, but they accused them of hoarding inventory and thus further restricting supply, which caused prices of these goods to outpace overall inflation. Well, there was some pretty bad inflation at the time. Did we, I think we saw something very similar.

It may not have come directly from the president during Thanksgiving this year. Oh, right. Right. I forgot. I forgot about that. Yes. Yes. I agree. I don't, they didn't, maybe the actions weren't taken, but there is definitely some accusations in the similar, in the similar light. Attorney General Alexander Palmer reactivated wartime corps of food price administrators. So, I mean, they really went to war with the food companies here. He organized federal raiding parties. On August 16th, 1919, Palmer's team seized millions of eggs in Detroit and Nashville and 200,000 pounds of sugar in Canton, Ohio. The reason they did this is because there

was rapid inflation happening worldwide. There was 21% happening in Australia, 20% in Britain, 43% in France, which is a bit, that's almost hyperinflation at that point. And then 9.7% in Japan. And this was, I wouldn't call it, well, I think I would call it unprecedented for that time period because for context between 1860 and 1891, wholesale prices actually fell 58% while currency in circulation rose by 344%. So I don't know if this is, you know, all this stuff is kind of, it's gray area stuff. Nothing's black and white.

But I think to me, that kind of proves that when people talk about how inflation is just a rise in, you know, the amount of currency in circulation, I think that's a notch that that's in the, whatever. That's kind of evidence that that thought is wrong. There's more to it than just the currency. against the the purchasing power yeah i mean there's more than just the amount of currency out there i think it's it's about people's the psychology yeah what's cost yeah i mean

i mean at this point just in general i guess to move on with this story inflation was not something people are used to and then another fact that comes into the play here is in the summer of 1919 socialism fervor was at its peak uh you know russia the revolution had just gone down, they called this the red summer. And Woodrow Wilson was actually quoted as saying, quote, I'm perfectly sure that the state has got to control everything that everybody needs and uses. So there was a lot of leanings towards socialism. As you can see, the government was kind of able to take over some of the grocery store stuff there. And that's just one example of what things that were happening. And to give some context on the US inflation in July of that

year the cost of living was up 15 percent and in late 1919 when touring to promote the league of nations which is i think a lot of people don't know what that is but it's basically what they were trying to do a united nations um that fell apart um as you know world war ii happened stuff like that but it was the pre-united nations that didn't really take it didn't happen uh but when he was trying to promote it because woodrow wilson was the person that was trying to get this together with people worldwide he actually had a stroke so this led the government to hit a standstill by the start of 1920. a lot of things happened that summer what are the consequences do you think if wilson doesn't get the stroke like or what are the consequences of him getting it it seemed like

a lot of variables are in play yeah i after reading your notes i took a little time to read up on wilson and he was very much he believed that he's a big government guy yeah like a democratic system was a way of the past and that it was time for the government to control everything i think you kind of highlighted that with your quote um i don't know i think that may have slowed growth especially for the coming decade that followed yeah well yeah that i think that's one takeaway I think another one is that the league of nations could have happened because he was the one that was trying to get it together. And I wonder what the fallout of that is.

If all the countries never really got connected together, if some of the angst of, you know, 1930s stuff like that fashion, if it would have, it would have, would have been as bad, probably still would have been.

Um, but it's hard to tell that stroke though, is, is a kind of a crazy, like if I don't know, stroke of luck. Oh, well,

it's hard. It's, it's hard to tell. It's hard to tell. I would not call it that it's just, I'd say when that happened, it kind of changed up a lot of variables or something like there's a lot of different outcomes or how these things could have gone. All right. And now we're about to hit an ad break,

but to give a reference for anything in the financial world, the Dow Jones peaked in November, 1919, right around when Wilson had the stroke here at $119 and 62 cents. That's probably just a coincidence. Did Wilson recover from that stroke? He, uh, I don't want to call it a stroke of luck. it here oh yeah don't um i'm pretty sure he may have died from that but or he didn't go to office let's look uh let's look when he died forget we said that yeah don't let's look when he died uh

1924 nope he did not die from the stroke so but he was out of office right around then um all right let's hit the ad break all right welcome back we've given a hopefully a little context here we talked about world war one spending we talked about some fast facts about the depression and And then we talked about kind of the cultural background, the historical background, and the political background of the United States during this time period. But we really haven't determined what caused the economy to spiral. But let's look at one of the big influences in National City Bank. Now, there's always some big bank.

I think most of the time, there's always a big bank that is doing something that may be a bit risky that can help exacerbate things like this. So a big theme of almost any panic and depression seems to be unsustainable lending practices. and this one was no different. So in the second half of 1919, National City Bank's loans expanded by 30%. Remember, it's pretty inflationary time. So people are trying to keep up with that. At the time, the Fed was lending out at 4.75%, and the bank would lend out at about 5.6%. So that's not the reverse kind of thing with the treasuries that happened before. Standard practice.

Standard practice. Yeah. National City Bank aggressively lent in Cuba on the theme of rising sugar prices. Exposure to Cuba was $79 million or 80% of the bank's existing capital. However, things got pretty hairy when the price of sugar, which is the popular crop in Cuba, went from 4 cents to 22 cents a pound. Sorry, that's not when things get hairy. That is why they started doing this. I mean, the price of that just was skyrocketing and people probably thought, wow, this is the new, I mean, we got to get in on this. Everyone's probably, there's a lot of momentum building up, stuff like that. This caused a huge influx in demand for sugar production and investors in sugar production needed credit. So Citibank provided

them that with 22 branches opened in Cuba in 1919. The bet on sugar was that prices would continue to stay high or rise, which is always, as I think a lot of people know, I mean, those are famous last words. However, the government intervention and other things we'll introduce, we're going to say otherwise with these continually rising and rising prices. Yeah. All right. So now let's get into what sparked the depression. Now we have, I want people to keep the National City Bank in the back of their minds because we're going to talk about them more. And as you can tell, the huge concentration of sugar, the rising prices, as we mentioned before, I think we kind of maybe spoil what's going to happen when deflation

eventually comes. You can probably put two and two together. Things don't go great for National and others that are banking on these commodity prices. But on November 3rd, 1919, the Federal Reserve raised rates from 4% to 4.75%. I don't know the technical reason on this, but it was probably to fight inflation. I'm not sure if it was really in their strategy at the time, but either way, they decided to raise rates from 4% to 4.75%. And then on November 11th, money markets in New York instantly tightened and overnight loans were 30%. Oh, that's basically just payday loans? Yeah. Yeah. You have questions on that. I think typically overnight loans are something like,

okay, it's a bit out of my realm of expertise. There's probably people listening to this that know about this more than me, but I believe it is when a bank needs liquidity overnight or a big financial institution needs liquidity overnight. Typically you get lending and it's super cheap. Um, but if there's a, if there's a, yeah, like the rate of that skyrocketed to 30%. Um, and I think it was on loaning for money market funds to possibly again, really just think about it like this. There was a liquidity constraint there and the rates were skyrocketing and that makes it pretty unsustainable if you have to do overnight loans at 30 at a 30% rate.

And then in November, 1919, the Dow, because of this, lost 12.8% of its value. So things kind of were reversing. And then on January 23rd, 1920, the Fed decided to raise rates again to 6%. And I don't know if it was directly to fight inflation. I believe it was. I don't have any notes on that. But during the first five months of 1920, inflation was at a 17.5% rate. So, I mean, what do you think during the time? Do you think, like, you can understand how people would be pretty panicked about runaway inflation during this time period, right?

Yeah, it's interesting that it feels like we have more levers to control it today or a better handle on it. It seems like the Fed was kind of just chasing at this point. yeah yeah um it's hard to tell yeah and you can always result i think in the past you know like you can look like oh if they did this it would have been better but it's so hard to do it during the time period yeah and you have to remember that during this time period the president is incapacitated uh is that the right term i think it is uh at this time with the stroke i don't know if i'm saying that correctly but he has the stroke and he can't do anything who filled in just the vice president or was there i think there wasn't there wasn't a new uh president i don't think uh But what's weird is that I remember reading in the book

that his wife was like the only one that would communicate with him. So it's a bit strange where she was like controlling who was going to talk to him and stuff like that is a bit strange for the guy. That's, you know, the leader of a giant country like this. But yeah, in the White House, you know, things are kind of shaky. They push off control. Do you know or was he still? I forget. I forget.

I would have to look that up. But either way, like I mean, think about that. if that happens at any time in history, that adds a, you know, a total wrench into everything that's going on. Right. Yeah. I mean, anytime a president gets incapacitated, uh, people start, you know, that adds a lot of stress to a lot of people, but if we go back to inflation, inflation was killing city dwellers. So they actually donned country overalls as a symbol of pain.

I think a lot of people laugh about the, these days because it's kind of reversed. People hate the, you know, the coastal people that were the rising prices and stuff like that. But in April, a switch flipped and deflation actually swung hard. So under the influence of inflation, stores had made multiple orders at a time and they were expanding out, all right, we need to catch up. We need to catch up with inflation. We need to buy as much stuff as possible. But I don't know if it was random, them, but maybe it was sort of a tipping point and it reversed and it yo-yoed demand and the economy. So then everything starts going into deflation when demand dries up and they have so

much supply. So Adolph C. Miller on the Federal Reserve Board said, where there has been inflation, there must follow deflation as a necessary condition to the restoration of economic health. I don't know if I agree with that. I think he might just be anchoring to some prices because not sure deflation is ever good but i don't know what are your thoughts on that well my question was my question for you is what seems to be worse based on some of the historical events we've looked at hyperinflation or deflation i'd say probably hyperinflation because that's like it just i think that's ended some civilizations yeah yeah it's ended yeah i mean i think there's more examples of that being just terrible like deflation yeah terminal yeah that's a good that's

that's a good word to use, terminal. Deflation's bad, and as we'll get into, it really sucks for businesses and people, and deflationary spouse can be tough. But it feels like it's fixable, and it's not like something where a runaway train, as we'll get into more in here. But I definitely say both are bad. I would not want to be in a heavy deflation or a heavy inflationary country. All right. We're almost to the end here. In late spring 1920, manufacturers couldn't borrow at say high rates, but raise cash by dumping war bonds that they bought. So the fourth, for example, here, the fourth Liberty four and a quarter, which is basically the rate you're getting on there, that was for the year 1938, which is when it ends, plunged to 82 cents on

the dollar from 94 cents on the dollars. And prices peaked in May for the US in 1920. In April 16th, 1920, the price of a pound of cotton fetched 43 cents, 43.25 cents. In March 2021, oh, wow. 1921. It fetched 12 cents. I mean, that is just such a bad, like think if you're a business owner and that happens to you. I mean, that is just absolutely, yeah, it's absolutely devastating. for the business owners. Yeah. All right, you have anything else to wrap things up? I don't know, what are some of the problems

that you think come with sharp deflation? I think the key one is that wages stay steadier than what, they can't really rapidly adapt with prices. And people might say, well, that's good at some point because consumers can do better for a short time period. But remember when I talked about how, you know, there was that consumer bump during this, That, you know, it's good for a short period of time, but once businesses starts faltering, that one leg of the stool just can't survive. And then most, you know, people are employed by businesses that can spiral out of control where I'm not having price stability really screws with everything. And you get people panicking.

I have a paragraph here to read about the cycle. If you're wondering what the cycle is that feeds back on itself during deflationary periods, this encapsulates it. It says, at the beginning of a deflationary period, there is a temporary lull when consumers' income remains steady while prices decline. Eventually, these falling prices begin to have an impact on the health of companies. Logically, I think people can tie that together. And then in response to falling revenue, companies are forced to cut, pay, and lay off workers. This results in increased unemployment, incomes declining, and consumer confidence decreasing. When incomes decline and confidence is lowered, consumers decrease their spending. This creates another situation where companies are pushed to cut their prices in order to sell their products. So they're just continually lowering revenue, which as a business, you obviously can't operate under forever, perpetually diminishing revenue.

Yeah. So that's kind of the cycle that happens in deflationary periods. There has to be a floor, obviously. Yeah. And that's why people in financial media, economists, stuff like that. I mean, that's why people talk about the worries about deflationary shocks so much. They haven't happened that much in the United States, but it could be so impactful that people probably think it's worth talking about because the fear of that is probably very high. All right. Well, let's go wrap things up for this episode. We'll leave this episode with the economy ready to turn into a downward spiral. You're going to have to listen to the next episode to hear about how this stuff resolves. But in the next few ones, we're going to talk about the horrors of the depression. We're going to talk about what happened to cause the economy to recover. And we're going to talk about some amazing investment opportunities that occurred at the bottom. I will make an argument that 1921 may have been the best time to buy

stocks ever if you had the chance. But we'll save that for another time period or the last episode. All right. That's going to do it. Thank you all for listening. We'll see you next time.