Yep, the 2020s feel like the 1920s

“History doesn’t repeat itself, but it often rhymes.”   – Mark Twain

It’s hard not to notice the similarities between the 1920s and 2020s economy.

Does that mean trouble is coming in 2029?   Maybe not exactly, but roughly? If so, the severity of the shock will depend on the Fed. 

A big difference between the 1920s and the 2020s is that now we have a Federal Reserve fully committed to intervene during a financial market crisis, as 2008, 2019 and 2020 clearly showed, and other central banks are following their lead.

Since little movement is afoot to reform the financial markets and their core plumbing, the repurchase market, it’ll be up to the Fed to soothe every panic.

No one knows …

• if that will encourage borrowers and lenders to take ruinous risks, believing they’ll be rescued
  
• how long the rescues will keep working
• how angry Americans will get when they see the Fed continue to pour trillions of dollars into Wall Street

But what does seem clear is this: The Fed has no choice.  By promoting instead of reforming the repurchase market since its first explosion in 1998, the Fed is trapped.

“It’s the Fed’s Hotel California problem,” said Mark Cabana, head of rates strategy at Bank of America, to CNN Business in March, in a reference to the Eagles’ 1977 hit song “Hotel California.”    “You can check out, but you can never leave.”

It’s not even clear that the Fed can raise rates to cool an overheating economy any more, since rising rates will cause repo collateral to lose value, spurring repo lenders to demand more collateral or repayment, and that can lead to fire sales and a repeat of 2008.

“Our current financial structure is designed to fail – and to be bailed out by dramatic central bank action,” wrote Carolyn Sissoko in 2020.

For many, it’s beyond strange that we seem to have voluntarily walked right back into The Roaring ‘20s, dismissing the lessons learned then and undoing the regulation in the 1930s that restrained financial panics for 50 years.

What are the similarities and what clues do they give us about where we might be going? Following is a short, admittedly oversimplified, history of some key trends in financial markets for the following periods:

• 1880-1907 and 1980-2007: Gilded Age or Great Moderation
• 1907 and 2007: Financial collapse
• 1907-1921 and 2007-2021: Inadequate reforms
• 1921-1929: The Roaring 20s
• 2021-2029: ?
• 1929: Stock market crash
• 2029: ?
• 1929-1940: Great Depression and regulation for the “forgotten man”

I’m especially indebted to scholars Gary Gorton, Morgan Ricks, Carolyn Sissoko, and Arthur Wilmarth Jr. for these insights.

(Editor’s Note: If you’re not a risk taker, one way to help protect yourself during this period, just in case, is to pay down your debt.)

1880-1907 and 1980-2007:  Gilded  Age or Great Moderation

In these times, Americans and their elected leaders put their faith in business instead of government, in free markets instead of taxes to finance people’s needs. These were periods of financial deregulation, rapid economic growth, great industrial/technological progress, globalization, mushrooming fortunes, growth of shadow banks to let money flow widely (shadow banks are financial firms that take deposits and make loans but aren’t banks), interconnected banks and shadow banks, repeated bank and stock market booms and crises. 

At the time, many saw the first period as the Second Industrial Revolution led by Captains of Industry after a terrible civil war, and they saw the second period as the Great Moderation after a terrible inflation. Today many think of The Gilded Age and robber barons, greed is good and homewreckers.

In the earlier period, the shadow bankers were trusts.  A hundred years later they were investment banks and eventually money market funds, hedge funds, insurance companies and more.

In the 19^th century bankers and shadow bankers did call loans, in the 20^th century they did repo loans. Both are callable collateralized loans that weave interconnections among financial institutions and can trigger swift system-wide collapse when panic hits and lenders suddenly call their loans.  

“To be clear, financial crises are always about short-term debt that debt holders no longer want,” wrote Yale professor Gary Gorton in Fighting Financial Crises.

In both periods, panics were often resolved by a consortia of bankers, goaded or orchestrated by government officials.  Too Big To Fail became a recognized problem, because the flow of resources to help Wall Street instead of Main Street encouraged risky finance and angered Main  Street. Familiar players in both centuries included JP Morgan Chase, Citigroup, and Lehman Brothers or their forerunners.

Among the crises were multiple banking panics in the early period, including the Panic of 1893, which was “one of the most severe financial crises in the history of the United States,” according to the Federal Reserve, and multiple financial crises in the more recent period, including the Latin American debt crisis and the collapse of the savings and loan industry in the 1980s, the stock market crash of 1987, the Asian financial crisis in 1997 and in 1998 the collapse of Long-Term Capital Management which was “the first systemic failure of a repo financier since the Great Depression,” according to scholar Daniela Gabor.        

Some curious coincidences:

•  1884 and 1984: Widely watched rescue of a seriously Too Big To Fail bank (Metropolitan and Continental Illinois)
• 1901 and 2001: Stock market crash, driven by railroad and dot-com speculation, and followed by booms in stocks and housing
• 1905 and 2005: Call and repo lenders widen their protected status in bankruptcy court

1907 and 2007:  Financial collapse

In these years, the financial markets collapsed.  Call loans and repo loans were among the short-term debt that lenders suddenly no longer wanted because they lost faith in the stock securities (1907) and mortgage securities (2007) they held as collateral.  The crash of this debt quickly spread throughout the vastly interconnected financial markets.

“Panics, to repeat, are widespread redemptions of short-term debt, period,” wrote Morgan Ricks in The Money Problem.

When the crises peaked in 1907 and 2008, 20^th century bankers and the 21^st century Fed launched massive interventions.  In both centuries JP Morgan, the man and the bank, played critical roles in the run-up to the collapse and in the intervention.

“The parallels between the crises in 1907 and 2008 are striking,” wrote the Federal Reserve in its history of the panic of 1907.  “The trust companies in 1907 were like the shadow banks in the financial crisis of 2007-09 .… Both the trusts and the shadow banks faced runs by their depositors and had to withdraw lending in short-term credit markets.”

Some curious coincidences:

• 1907 and 2008: Mercantile National and Bear Stearns were rescued
• 1907 and 2008: Then Knickerbocker Trust and Lehman Brothers were allowed to close, creating chaos

1907-1921 and 2007-2021:  Inadequate reforms

Congress immediately launched investigations and designed reforms that would later prove to be inadequate, creating the Federal Reserve in 1913 and toughening up on banks with the Dodd-Frank Act in 2010, but in both cases failing to adequately regulate shadow banks.

Congress’ Pujo Committee (1913) and Financial Crisis Inquiry Commission (2011) reported causes of the two financial crises, and while their reports were influential they did not result in effective congressional action to control interconnected banks and shadow banks or to corral shadow banking. 

Financial markets fought to recover, and within a few years the market-driven booms resumed in the U.S. and globally. Too Big To Fail banks got bigger. Giant financial conglomerates with affiliates that did both commercial banking (take deposits and make loans) and investment banking (underwrite and trade securities) – so-called “universal” banks – dominated financial markets in the U.S. and abroad. Key conglomerates were Citigroup and JP Morgan Chase, whose bank ancestors set up the first nonbank securities affiliates 1908-1917 and who led the return to universal banking a century later.

Some curious coincidences:

• 1918 and 2020:  Brutal pandemics fail to deter powerful financial markets
• 1920 and 2020:  Deep recessions followed by recovery

1921-1929:   The Roaring 20s

In this period the financial sector expanded dramatically, creating a period of easy money.  Universal and global banking thrived. Consumer demand soared. Individual and business debt exploded. Ordinary people stormed Wall Street. Stock and housing markets boomed, with stocks caught up in “an extraordinary, unprecedented expansion and … a speculative euphoria.“

The Federal Reserve lent liberally to banks for several years, creating the illusion that financial panics were a thing of the past. Low interest rates encouraged debt and drove investors to reach for yield and risk.

Soaring short-term call loans with securities as collateral were set-ups for fire sales if the value of the securities should fall. These were mainly loans from nonbanks like insurance companies, corporations and rich people to brokers who needed money to lend to clients, who put up stocks as collateral for their short-term loans from the brokers. 

“Nonbank lenders in the call loan market effectively functioned as the ‘shadow banks’ of the late 1920s,” wrote Arthur Wilmarth Jr. in Taming the Megabanks.

2021-2029: ?

1929:  Stock market crash

The stock market collapsed in October. Call loans fell by half. Foreign investors retreated. The Fed waffled. Stock and bond markets rallied briefly in early 1930, but consumer and investor support was gone and the Great Depression had begun.

2029:   ?

1929-1940: Great Depression and regulation for the “forgotten man”

A series of banking crises 1930-1933 cemented the Great Depression. The stock market hit bottom in 1932. The Hoover administration’s emergency loans to Wall Street incited anger on Main Street.  

In April 1933 Presidential candidate Franklin Roosevelt delivered his “forgotten man” speech, saying,

“These unhappy times call for the building of plans that … put their faith once more in the forgotten man at the bottom of the economic pyramid. …  The two billion dollar fund which President Hoover and the Congress have put at the disposal of the big banks, the railroads and the corporations of the nation is not for him.”

In July 1932 Congress passed what became Section 13(3) of the 1913 Federal Reserve Act, allowing the Fed to lend to troubled nonbanks but only in an emergency and with very limited collateral. This prevented the Fed from being the Lender of Last Resort to investment banks and other nonbanks until Congress eased the provision in 1991.

In January 1933 Ferdinand Pecora, counsel to the U.S. Senate Committee on Banking and Currency, launched an investigation into banking and stock-market practices that within weeks destroyed the reputations of the nation’s leading banks and financiers, especially the reputations of the forerunners to today’s Citi, JP Morgan Chase and Continental Illinois. Hearings continued to dominate headlines until June 1934.

In June 1933 Congress tackled banking by passing The Glass-Steagall Act after two years of hearings.  It has these key provisions:  (1) securities firms and other financial nonbanks cannot accept deposits, which are described as any money that is subject to immediate repayment, (2) a new Federal Deposit Insurance Corp. financed by banks will guarantee that depositors can get their deposits back in a crisis, (3) banks cannot underwrite or trade in securities, (4) banks can’t affiliate with securities firms, (5) interest that banks pay on deposits is limited, and (6) bank branching is limited.

Editor’s Note:  In the ensuing years, only the last three provisions have been openly undone, but #1 has been evaded because courts and regulators have decided that repo, money market mutual funds and other callable loans are not “deposits.”

In June 1934 Congress tackled the securities markets by enacting the Securities Exchange Act of 1934. It created the U.S. Securities and Exchange Commission with a mission of “protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation.”

Push-back from financiers was intense, and in 1939, in a preface to his book Wall Street Under Oath, The  Story of Our Modern Money Changers, Ferdinand Pecora warned:

“Under the surface of the governmental regulation of the securities market, the same forces that produced the riotous speculative excesses of the ‘wild bull market’ of 1929 still give evidences of their existence and influence. Though repressed for the present, it cannot be doubted that, given a suitable opportunity, they would spring back into pernicious activity.

“Frequently we are told that this regulation has been throttling the country’s prosperity.  Bitterly hostile was Wall Street to the enactment of the regulatory legislation. It now looks forward to the day when it shall, as it hopes, reassume the reins of its former power.

“That its leaders are eminently fitted to guide our nation, and that they would make a much better job of it than any other body of men, Wall Street does not for a moment doubt. Indeed, if you now hearken to the oracles of The Street, you will hear now and then that the money-changers have been much maligned. You will be told that a whole group of high-minded men, innocent of social or economic wrongdoing, were expelled from the temple because of the excesses of a few. You will be assured that they had nothing to do with the misfortunes that overtook the country in 1929-1933; that they were simply scapegoats, sacrificed on the altar of unreasoning public opinion to satisfy the wrath of a howling mob blindly seeking victims.

“These disingenuous protestations are, in the crisp legal phrase, ‘without merit.’ The case against the money-changers does not rest upon hearsay or surmise. It is based upon a mass of evidence, given publicly and under oath before the Banking and Currency Committee of the United States Senate in 1933-1934, by The Street’s mightiest and best-informed men. Their testimony is recorded in twelve thousand printed pages. It covers all the ramifications and phases of Wall Street’s manifold operations.

“The public, however, is sometimes forgetful.  As its memory of the unhappy market collapse of 1929 becomes blurred, it may lend at least one ear to the persuasive voices of The Street subtly pleading for a return to the ‘good old times.’  Forgotten, perhaps, by some are the shattering revelations of the Senate Committee’s investigation; forgotten the practices and ethics that The Street followed and defended when its own sway was undisputed in those good old days.

“After five short years, we may now need to be reminded what Wall Street was like before Uncle Sam stationed a policeman at its corner, lest, in time to come, some attempt be made to abolish that post.

“It is in the hope of rendering this service, especially for the lay reader unfamiliar with the terminology and conduct of The Street, that the author has endeavored, in the following  pages, to summarize the essential story of that investigation – an inquiry which cast a vivid light upon the uninhabited mores and methods of  Wall Street.”

Ferdinand Pecora
New York City
February, 1939