Through

Time
 
1. US Financial Markets in the Early Twentieth Century

2. Federal Reserve in the Early Days

3. Financial Markets During World War II

4. Postwar Boom: Home Mortgages, Consumerism, and European Unification

5. Effects of Stagflation and the Reagan/Thatcher Revolution of Financial markets

6. Savings and Loans and Junk Bonds

 US Financial Markets in the Early Twen
Century
1.1a The Early 20th Century

 The 1st decade of the 20th century saw many dramatic transformations in
the financial markets of US

 During the 2nd half of the 19th century, the US business sector was dominated
by the creation and expansion of trusts

 Trusts are horizontally integrated ownership structures that dominated key

industries, including railroads, oil, steel, and banking.

 In this structure, firms that produce similar goods are combined

 This is often done within the same industry and creates what we today call
monopolies.
 US Financial Markets in the Early Twen
Century
1.1a The Early 20th Century

 Trusts, then, was the name given to agreements that created these monopolies.

 Leaders of these trusts include almost mythical figures: J. Pierpont Morgan,

John D. Rockefeller, Andrew Carnegie

 The 1st decade of the 20th century saw American businesses being transformed
as corporations moved away from the trust-dominated markets of the late
19th century and toward a structure featuring professional managers and stock-
holders.

 The movement toward professional managers was fostered in great part by the
spread of Fredecrick Taylor’s idea of “scientific management”, which is sometimes
simply called Taylorism.
 US Financial Markets in the Early Twen
Century
1.1a The Early 20th Century

 Taylor argued for the use of time and motion studies of production processes to
find the one best way to produce goods.

 An important part of Taylorism was to make managers responsible for the

organization of the firm and the production process

 As a result of Taylorism, the level of output of US manufacturing firms increased

significantly, demand for the number of workers also increased.

 The size of the US economy increased significantly during the decade. Increased
corporate profits and the sharing of these profits with stockholders sent the stock
markets to new highs.
 US Financial Markets in the Early Twen
Century
1.1a The Early 20th Century

 The increasing stock prices also resulted in increased speculation in stock

markets.

 Quick fortunes were made as speculators borrowed large sums from commercial
banks, trust companies, and brokerage houses to place wild financial bets on
rising stocks

 These speculators also were sowing the seeds of the worst economic event of
the decade: the Panic of 1907.
 US Financial Markets in the Early Twen
Century
1.1b The Panic of 1907

 Americans had been leery of big banks that stretched nationwide.

 This fear of “big banks” continued well into the 20th century. As a result, during
the National Banking Era (1863 – 1913) the United States did not have a central
bank or much in the way of national banking laws.

 Almost all the commercial banks were “local” and regulated on a state level.

 The Panic of 1907 was triggered by wild speculation in the stock market;
excessively loose lending by banks and trusts, a need to divert cash to San
Francisco for rebuilding after the 1906 earthquake; and a lack of effective
oversight of financial markets
 US Financial Markets in the Early Twen
Century
1.1b The Panic of 1907
The People, the Money, and the Crisis

 Morgan helped to create the world’s first billion – dollar company, the United
States Steel Corporation, by underwriting and selling its stock.

 Morgan wanted to create a massive firm that would concentrate on professional

management, research and development and the latest engineering advancements
in steel making.

 But as Panic of 1907 unfolded, Morgan realized that something had to be done
to calm the financial markets. He understood that if he did not do something
to stop the panic, the entire US economy would be at risk
 US Financial Markets in the Early Twen
Century
1.1b The Panic of 1907
Heinze: How People Can Trigger Financial Collapses

 In the autumn of 1907 Heinze had spent $50 million of his own money in a scheme
to corner the market of United Copper Company stock.

• When someone tries to “corner a market”, they buy up as much of an asset

needed to control the price. Once the market is “cornered”, whoever controls
that asset can demand extremely high prices and thus attain huge profits.

• On October 18, when it became known that the Knickerbocker Trust – at the time
the 3rd largest bank in New York – was a business associate of Heinze, there was
a run on Knickerbocker. That same day the National Bank of Commerce announced
it would no longer acts as a clearing house for Knickkerbocker.
 US Financial Markets in the Early Twen
Century
1.1b The Panic of 1907
Heinze: How People Can Trigger Financial Collapses

 And without a clearinghouse , no one would accept checks drawn on Knickerbocker.

• To make matters even worse, many of the banks in New York were running out of gold.

 Due to earthquake and massive fires at San Francisco, vaults in SF remain intact .
With the inability to open the vault doors, the banks were not able to access their gold to
meet depositors’ need.

 Thus the New York banks saw an opportunity: lend their gold to SF banks and charge them
a high interest rate.

 The NY banks had lent out all their gold, and when depositors wanted to withdraw their
gold as well as their cash, the banks were in dire straits.
 US Financial Markets in the Early Twen
Century
1.1b The Panic of 1907
Old Man Morgan: How One Person Can End a Financial Collapse

 October 21 – Morgan assembled a committee of four trusted bankers to audit the financial
records of Knickerbocker to determine whether it should be saved and to
check what else would need to be done to save the financial system from
collapse.

 October 22 – Morgan was considering stepping in and saving the Knickerbocker.

 October 23 – Morgan would not aid Knickerbocker Trust, stating a lack of capital and poor
management

Morgan also announced The Trust Company of America would be aided

Cortelyou (Treasury Secretary) promised that the US government would

deposit $25 million into the New York City banks that Morgan deemed worth
saving
 US Financial Markets in the Early Twen
Century
1.1b The Panic of 1907
Old Man Morgan: How One Person Can End a Financial Collapse

 October 23 – Morgan also was able to convince John D. Rockefeller to deposit $10 million
of his own money into New York City banks

 October 24 – The Trust Company of America was able to withstand a bank run

 October 25 – Morgan went to the NY Clearing House and essentially ordered them to use
certificates, which were a type of temporary loan, as cash.

 The next week, the City of New York issued bonds worth the $30 million it needed to stay
solvent.

 Morgan pledged his support in selling the city’s bonds – but only if the city agreed to appoint
a committee of bankers to oversee the city’s accounting practices.
 US Financial Markets in the Early Twen
Century
1.1b The Panic of 1907
Old Man Morgan: How One Person Can End a Financial Collapse

 As the crisis seemingly came to an end, Morgan understood that more needed to be done
to stabilize the trust companies.

 Because the trust companies were not technically commercial banks, they did not have
to abide by the more strict rules to which commercial banks had to adhere.

 Morgan eventually took to locking the bankers in his library until they agreed to aid the
trust companies.

 The announcement of the bank’s plan to aid the trusts was enough to stabilize the financial
markets, and by early November 1907, the panic had passed.
 US Financial Markets in the Early Twen
Century

LESSONS LEARNED

As the dust cleared from the Panic of 1907, the lessons to be learned
from the experience became clear. The US banking system had become
so large and so important to the rest of the economy that it needed a
“lender of last resort” during a time of crisis. In addition, to avoid financial
crises, the United States needed a single currency used nationwide instead
of thousands of different bank notes. Simply put, the United States needed
a central bank.
 US Financial Markets in the Early Twen
Century
1.2a Early Structure of Federal Reserve

 In creating the Federal Reserve, Congress wanted something that would serve
as a “lender of last resort” to the banking system, but because this entity would
be there for the benefit of banks, Congress did not want US taxpayers to pay
for it.

 In creating the Federal Reserve Congress created a quasi-government agency

- something created by the federal government but not really part of the govern –
ment.

 Congress required that commercial banks buy the shares of the new central
bank to give the Federal Reserve the capital it needed to begin operations.
 US Financial Markets in the Early Twen
Century
1.2a Early Structure of Federal Reserve

 Many in the northeastern financial markets wanted a central bank based on the
model of European central banks, which were designed to ensure adherence to
the gold standard.

 President Wilson agreed to a system of 12 regional banks under the control of

local bankers and a Federal Reserve Board in Washington, DC, that would be
responsible for the system as a whole.

 In the early days of the Federal Reserve, there was no clear division of power,
and as a result the district banks often set their own interest rates and lending
policies
 US Financial Markets in the Early Twen
Century
1.2a Early Structure of Federal Reserve

 In 1914 Strong had been appointed the first president of Federal Reserve Bank of
New York. Of the 12 Federal Reserve banks, the New York Federal Reserve
quickly established itself as the most important.

 Strong envisioned a central bank along the lines of the Bank of England, with
the American central bank headquartered in the center of the nation’s financial
market: New York

 Many scholars argue that Strong’s death in October 1928 led to a return of
conflict and power struggles within the Federal Reserves. Strong’s successor
at the New York Federal Reserve, George Harrison was a weak leader and did
not have nearly the intellectual capability of Strong.
 US Financial Markets in the Early Twen
Century
The Failed Rescue Attempt: This Isn’t 1907

 Lamont, Mitchell, and other bankers had created a pool of funds that would be
used to attempt to stabilize the market

 Share prices remained stable that Friday and Saturday (October 25 and 26, 1929)

 October 28 stock prices fell significantly.

 October 29 things got so bad that many stocks found absolutely zero buyers,
White Sewing Machine Company, whose stock had sold for $48 a share a few
months earlier, had seen its price fall to only $11 on Monday. But on Black
Tuesday it fell to only $1 per share because a stock market messenger boy made
that offer and there were no others.
 US Financial Markets in the Early Twen
Century
A Misapplied Doctrine

 Under the Burgess Riefler doctrine, commercial banks could borrow from the
Federal Reserve only in times of need and not to earn profit by re-lending the
funds.

 Under the doctrine the Federal Reserve could induce banks to borrow and repay
loans by other means.

 The level of bank borrowing in New York and Chicago and the level of short-term
nominal interest rates would indicate whether there was a shortage or an
abundance of liquidity in the market.
 US Financial Markets in the Early Twen
Century
A Misapplied Doctrine

 To stop the financial bleeding, firms slashed prices in an attempt to generate any
sales they could. But all of this price slashing combined to trigger deflation as
the overall price fell and continued to fall.

 With growing uncertainty, falling prices, and decreasing sales volume, firms were
in no mood to go to banks to borrow money in order to buy inventory or inputs.

 Because firms were not borrowing money from commercial banks, the banks had
very few loans that they could bring to the Federal Reserve to use as collateral
for discount window loans.
1.3 Financial Markets During World War II US Financial Markets in the Early Twen
Century
1.3a Preparing for War

 In 1941 Congress passed and President Roosevelt signed the Lend – Lease
Act, which allowed the administration to provide military and economic assistance
to any country the president viewed as “vital to the defense of the United States”.

 In August of 1939 the US exported $250 million worth of goods and services, but
by August 1941 – thanks to the Lend – Lease program – exports hits $460 million.

• The federal government had to take control of the means of production and
convert them for the war effort.

 This meant that the government had to take control both of the labor market, which
it did through the military draft as well as wage and price controls, and of the
capital markets to finance the war effort.
1.3 Financial Markets During World War II US Financial Markets in the Early Twen
Century
1.3b Funding the War Effort

 To figure out how to finance the war effort, economists turned to Keynes. Keynes
argued that to pay for the war the government should run budget deficits funded
by borrowing from the public and the financial system.

 The US government followed Keynes ‘s playbook. From 1940 – 1946 federal

government spending increased sixfold, with 75% of it being for military expendi-
tures. This represented a massive increase in government spending.

 Of this increase in government spending, 40% was paid through higher taxes.
Even with the increase in tax rates, the level of government debt increased from
48.2 billion to 271 billion.
1.3 Financial Markets During World War II US Financial Markets in the Early Twen
Century
1.3b Funding the War Effort

 To sell this much debt, the federal government had to sell a lot of government bonds.

 Starting December of 1942 the federal government organized several “bond

drives”.

 This was bond drives often made use of Hollywood and radio stars travelling across
the country and encouraging Americans to be patriotic and “buy bonds”.
1.3 Financial Markets During World War II US Financial Markets in the Early Twen
Century
1.3c Controlling Inflation During the War

 Not only were the war bonds used to fund the government’s purchases, they also
were key in keeping down inflation. As consumer goods became scarce because
they were being diverted for the war effort, there were fears that prices would
increase dramatically.

 War bonds – debt issued by the federal government to fund the spending on wars.
Done in the US most recently during WWI and WWII

 Another important tool in restricting consumption, and thus inflation, was

government rationing. If you wanted to buy goods you could not – even if you had
the money to pay for it – because these goods were rationed.
1.3 Financial Markets During World War II US Financial Markets in the Early Twen
Century
1.3c Controlling Inflation During the War

 Government rationing – limitations, implemented by a government, on the amount

of goods a person can purchase; it the past put in place because of wartime
shortages of many goods.

 Another policy used to control were the wage and price controls.

 Wages and price controls – Also called incomes policy, an economic policy where
governments place legal liits on the amount of wage and price increases.
 1.4 Postwar Boom: Home Mortgages, US Financial Markets in the Early Twen
Consumerism, and European Unification Century
1.4a. Financial Markets Help Fund the “American Dream”

 The US financial markets greatly expanded their lending to families to buy homes

 1940 – 43% owned their homes. In 1960 – it was close to 62%

 The forefront of the expanding home mortgage market were the depository
institutions known as the Savings & Loans.

 Savings & Loan – A depository institution that focuses on taking deposits of house
holds and individuals. Most loans are consumer loans including home mortgages.
1.4 Postwar Boom: Home Mortgages, US Financial Markets in the Early Twen
Consumerism, and European Unification
Century
1.4b. Push for European Economic and Financial Integration

 Unfortunately, it took much longer for the European economies to recover after the
war. They tried to create an economic setup similar to the US.

 To make western Europe more economically united, trade barriers between the
member nations were lifted. Capital was allowed to flow relatively unencumbered
between the western Europe countries.
1.5. Effects of Stagflation and the Reagan / US Financial Markets in the Early Twen
Thatcher Revolution on Financial Markets
Century
1.5a. The Rise of Stagflation

 By the late 1960s, a new problem started to emerge: growing unemployment, along
with increasing rates of inflation. The economy was stagnating and at the same
time suffering from inflation. A new term entered: Stagflation

 Stagflation – a time when the economy suffers from high rates of inflation and
economic stagnation, often a high and / or increasing unemployment
rate.

 At first many economist thought of the time, they thought that inflation most often
came about because of the increasing labor cost due to falling unemployment rates
but during 1966 the inflation rate picked up and continued to increase until 1969,

 It was clear that stagflation was not going away.

1.5. Effects of Stagflation and the Reagan /
Thatcher Revolution on Financial Markets

1.5b. Paul Volcker

US Financial Markets in the Early Twen
Century

 Paul Volcker, the president of the Federal Reserve bank of New York was
appointed by Jimmy Carter as the new Federal Reserve Chairman.

 He immediately determined that to control inflation the Federal Reserve should no

longer worry about keeping interest rates low; instead it should concentrate on
growth rate of the money supply.

 He believed that reducing the growth rate of the money supply, however, US
interest rates, which were already very high, would increase to even higher levels.

 As the economy continued to weaken, Volcker came under growing pressure to

change the course.

 Carter’s loss in the presidential election in 1980 was one of the “costs” of
Volcker policies.
1.5. Effects of Stagflation and the Reagan /
Thatcher Revolution on Financial Markets

1.5c. Reagan and Thatcher

US Financial Markets in the Early Twen
Century

 Reagan’s represented a major change in economic policy.

 Reagan’s and Thatcher’s elections (in 1979 Thatcher had been elected as PM)
represented a movement toward a more deregulated economy, especially in
financial markets, with lower taxes and lower inflation.

 They did not focus on short – term fluctuations in the economy; instead, they
focused on loner – term issues: growing the economy, controlling inflation, and
creating economic opportunities.

 Volcker and the Federal Reserve continued to tighten monetary policy even though
it would mean a long, deep recession.

 The recession of 1981 – 82 was the worst economic slowdown since the Great
Depression.
1.5. Effects of Stagflation and the Reagan /
Thatcher Revolution on Financial Markets

1.5c. Reagan and Thatcher

US Financial Markets in the Early Twen
Century

 Once the economy started to demonstrate that inflation had finally been brought
under control, Volcker and the Federal Reserve started to ease their monetary
grip on the economy.

 As interest rates were allowed to fall, the economy started to grow and expand
without inflation. Volcker had done it: He had slayed the inflation dragon.

 Reagan reappointed Volcker to another four year term as Federal Reserve Chair.
 1.6. Savings and loan and Junk Bonds
US Financial Markets in the Early Twen
1.6a. The Savings and Loan Crisis Century

 As market interest rates increased with the rise in inflation, the Savings and Loan
started to lose deposits to money market mutual funds, which could pay higher
rates of interest.

 The interest rates the Savings and Loan could pay were capped by a law called
Regulation Q

 Regulation Q – the interest rate on bank deposit accounts ceiling in effect from
1933 to 2011

 In 1980 Congress passed the DIDMCA – (Depository Institution Deregulation and

Monetary Control Act) the act sought to increase the amount of competition in
financial markets while also granting the Federal Reserve additional regulatory
oversight.
 1.6. Savings and loan and Junk Bonds
US Financial Markets in the Early Twen
1.6a. The Savings and Loan Crisis Century

 In less than two years the Savings and Loan went back to Congress to ask for
even more help. This time Congress responded by passing the Garn-St.
Germain Act.

 Garn – St. Germain Act of 1982 - an act designed to reduce the amount of
regulation over the Savings & Loan or
Thrift Industry.

 Both DIDMCA and the Garn – St. Germain Act were considered methods of
financial market “deregulations”, meaning the removal of government regulations.
 1.6. Savings and loan and Junk Bonds
US Financial Markets in the Early Twen
1.6b. Leveraged Buyouts and Junk Bonds Century

 Another of the outcomes from the push for deregulation of markets during the
1980s was the leveraged buyout (LBO)

 Leverage buyout (LBO) – the acquisition of a public or private company where the
buyout is financed mostly by debt (leverage)
 US Financial Markets in the Early Twen
Century

End of Chapter 1