October 27, 2008
Have we learned enough from the Crash of 1929?
Posted by Mike Guttentag

This is an opportune moment to reflect on any lessons that can be gleaned from the regulatory responses to the Crash of 1929 and the Great Depression.  In his editorial in yesterday’s New York Times N. Gregory Mankiw asks “have we learned what caused the Depression of the 1930s? Most important, have we learned enough to avoid doing the same thing again?” To answer this question Mankiw examines the adequacy of the macro-economic policies adopted to address the economic downturn experienced following the Crash of 1929.  In this post I’d like to use a micro-economic perspective to address questions similar to those Mankiw asks, but about the Crash of 1929: Have we learned what caused the Crash of 1929? Most important, have we learned enough to avoid doing the same thing again?

The Crash of 1929 (and the ensuing economic downturn) led to the adoption of the two major pieces of legislation that shape securities regulation to this day.  The Securities Act of 1933 federalized the regulation of new securities offerings, and adopted a philosophy of “full and fair” disclosure as the cornerstone of federal securities regulation.  The Securities and Exchange Act of 1934 established the SEC to regulate financial markets and oversee securities exchanges.  There is still little agreement as to whether the benefits provided by either of these Acts offsets their costs, in part because only limited evidence exists on the overall efficacy of either of these Acts. The question I pose here is more specific: did the Securities Act of 1933 and the Securities and Exchange Act of 1934 implement measures that were effective in reducing the likelihood of future market crashes? 

Neither disclosure nor enforcement (the main pillars of the ’33 and ’34 Acts) directly address the types of investment strategies that I suggested in previous posts create fertile ground for market crashes.  In those posts I explained how certain investment strategies can destabilize markets.  The purchase of stock using borrowed funds, also known as buying stock on margin, is an example of a practice, which, if sufficiently widespread, can be destabilizing.  Disclosure would not provide an effective preventative measure against this type of investment strategy, as it is not a lack of information which leads an investor to buy stock on margin.  Similarly, enforcement does not provide an effective preventative measure, as an investor using borrowed funds to purchase stock on margin is not committing an act of fraud.  Thus, disclosure and enforcement, the central elements of the ’33 and ’34 Act, are ineffective in addressing the types of investment practices, such as the widespread purchasing of stock on margin and the purchase of portfolio insurance, which likely played a significant role in the crashes of 1929 and 1987, respectively.

However, the Securities and Exchange Act of 1934 did include one provision, which my previous posts suggest was pivotal to reducing the likelihood of future market crashes: mandatory margin requirements.  The ’34 Act established a rule which limited the extent to which borrowed funds could be used to purchase equities.  The original limit set for a margin loan was 55% of the value of equities (initial loan to value ratios as high as 90% were common in the late 1920s). However, there were exceptions to the 55% rule, and the ’34 Act also granted the FED the power to amend these margin requirements when it deemed it appropriate to do so.  Albeit a blunt instrument and subject to future modification, the margin requirements of the’34 Act limited the extent to which securities could be purchased with borrowed funds, substantially restricting a practice which can contribute to destabilizing price dynamics.

At the time of the enactment of the Securities and Exchange Act of 1934, the decision to restrict margin lending practices was hotly debated.  On the one side, the representatives of Wall Street argued that imposing margin requirements would lead to additional selling into an already weakened market and then unduly limit the demand for equities in the future.  On the other side, the New Dealers believed that the cascading sales of securities when highly leveraged purchasers were forced to sell equities were a key driver of the Crash (a view John Kenneth Galbraith would later endorse).   Since their enactment, the margin requirements of the 1934 Act have received relatively little academic attention, despite the fact that the restrictions on margin lending might well have provided one of the most effective anti-crash measures that the 1933 and 1934 Acts contain.   Legislators at the time might not have been able to explain the effects of purchasing stock on margin in terms of upward sloping aggregate demand curves, Giffen goods, and disparate equilibrium prices, but their intuitions were sound.

In subsequent posts I will consider regulatory responses that may be appropriate to address our current financial markets.  For now, we should note that, in at least one important respect, the U.S. Congress in 1934 got it right.  The challenge for new legislation lies in determining how to restrict, without unduly limiting the efficacy of markets, investment strategies (like purchasing securities on margin and portfolio insurance) from reappearing in disruptive new forms and destabilizing the markets in the future.

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