The bull market of the 1920s was one of the earliest booms that could properly be described as a technology bubble. There were earlier cases where investors got excited about specific technologies; British investors were briefly enthralled with bicycle stocks in the 1890s. But typically, big movements of capital in the past were driven by some mix of technology deployment and regulatory favor: railroads were intimately tied to government policy, as were canals before that, and the South Sea Bubble was driven by some clever financial engineering done by what was basically a government-owned entity.¹

In the 20s, investors were optimistic about electrification and autos, which meant that in addition to having lots of consumer applications to bet on (lights, appliances, radios, cars) and a general groundswell in productivity-enhancing growth: electrification made factories more efficient, and drove a capex cycle as new factories got built and new equipment got installed. Trucks as last-mile delivery were complements to railroads' and ships' cheaper long-distance bulk shipping. Meanwhile, internal combustion engines for agricultural equipment and widespread ammonia fertilizer were adding food supply and freeing up a lot of labor supply, so those new factories could find plenty of workers—in the 1920 census, for the first time, the US had a larger urban than rural population. (The internal combustion engine also destroyed some demand for agricultural outputs—horses need lots of calories!)

There were political and geopolitical elements to this boom: Europe had recently destroyed itself, which meant that the US had both a lot of physical capital and a lot of financial capital. Republicans were in control of the House, Senate, and Presidency over this period, and one of them, Calvin Coolidge, had first achieved national prominence as governor of Massachusetts, when he spoke out against a police strike. ("There is no right to strike against the public safety by anybody, anywhere, any time.") So, investors did not have to be worried that returns from this investment would be captured by labor.

So, for investors who cared about revenue, costs, capital expenditures, and other concrete measures of company performance, it was a good time. But, as the cycle went on, it was an even better time for people who liked financial engineering. Closed-end funds got popular in this period; they'd lever up to buy hot stocks, and then trade at a premium to their net asset value. And some of the stocks they bought were holding companies that themselves borrowed against their stakes in subsidiaries and minority investments. The Van Sweringen Brothers, for example, bought control of the Nickel Plate railroad with 17:1 leverage.

But that's just a classic story of leveraged excess, with the usual mechanism behind it: lenders got a little sloppy, but that sloppiness meant more purchasing power for consumers and higher asset prices for investors, which kept defaults low.

The really interesting part was when companies started to cut out the middleman, and lend their cash on the "call money" market, i.e. for margin loans. They could get between 6% and 9% interest, and these were short-term loans, which gave them a kind of temporal seniority: they probably wouldn't be first in line if a borrower were completely wiped out and declared bankruptcy, but they could be first out the door by yanking their loans when asset prices declined. Meanwhile, though the returns on this money were lower than for most companies' core businesses, they were much more predictable. And, critically, the interest rate on call money exceeded the earnings yield on many companies' shares. So, a company that earned $1/share and traded at $25 could have paid out a dollar as a dividend, but if they retained it, and their business were otherwise unchanged, a year later their earnings might be $1.08 and their stock would be worth $27. But the buyer of that stock was, increasingly, financing it with margin loans, so they were paying 8% interest to buy something with a 4% earnings yield that achieved that yield partly by lending to them at 8%!

The immediate cost of all that circularity was just a little paperwork; money moved around, but nobody was better or worse off, at least for the moment. But it meant that a sufficiently fast drop in the stock market would actually make companies' earnings drop, immediately, and that a decline in speculation would also impair those earnings. Meanwhile, if call money was easier money than investing in the company's operations, the economic fundamentals underpinning the boom were also going to get weaker. This circularity made the system brittle in many ways.

It's surprisingly hard to come up with a precise cause for the Great Depression, because there were so many factors at once. For all those credit issues, the stock market just wasn't as economically central as it would later become, and the crash alone didn't cause an economic downturn—in retrospect, the recession actually predated the crash by a few months, starting in August 1929. There had been a few brief recessions earlier in the 1920s, but investors who'd bought the dip did well. And there was plenty of optimism in the immediate aftermath of the crash (partly because nobody who counted as an expert could afford to say that stocks were still expensive). The Smoot-Hawley tariffs in 1930 and the collapse of Bank of United States² in 1931 are also contenders for depression catalysts. Downturns are rarely monocausal, and typically market crashes don't have a distinct fundamental cause at all, or at least not one that can explain more than a small fraction of the decline. That's just how credit cycles work: for a while, everyone's better off, and it's optimal for them to be so; credit expansion is a channel for the economy to convert an increase in productive capacity into an immediate increase in consumption and investment (which can lead to more productive capacity long term). But credit growth tends to make things look a little too good, and when it's part of the feedback loop it encourages perverse decisions. An omniscient economic planner would have begged big companies not to lend money to speculators, but the closest thing we have to an omniscient planner is price signals, and while they're pretty good, they're never perfect.

It's too bad for market history that the crash of 1929 was such a spectacular episode of wealth destruction, because the 20s were a very interesting time, and of course some of the tricks invented then have been rediscovered since. The Diff has written about a few related phenomena:

• We've considered the quantitative and qualitative stories of easy money ($), in a piece that alludes to call money's role in the 20s.

• We've also looked at the South Sea Bubble in more detail ($).

• One of the useful functions of financial engineering is separating out different kinds of risk, which we see today in AI ($).

• Electrication is a useful analogy for cloud computing ($).

• We've looked at the 2010s as a version of the Great Depression with slightly higher growth ($).

Join the discussion!

1  If you read high-level stories about the South Sea Bubble, the story just doesn't hold together. It doesn't make sense that investors were paying so much for what they knew to be so little. The critical detail many narratives miss is that the way the South Sea Company issued stock was that buyers put a small amount down and then required full payment later. This made it an asymmetric trade, where the company implicitly gave a lot of leverage to traders, who obliged by buying the shares, and who expected it to keep doing so and manufacture another set of bidders. This obviously couldn't go on forever, but in any given month there wasn't a reason for the bubble to pop.

2  Yes, they picked the name as a marketing ploy to convince their depositors, many of whom were recent immigrants, that they were a full-faith-and-credit sort of shop. And yes, if you didn't pay much attention to business news and then saw a headline that "Bank of United States" was in trouble, it would be reasonable for you to get spooked.