Your new book contradicts a lot of the received wisdom about the stock market crash of 1929 and the financial reforms that proceeded from it. What are some of the biggest misconceptions?
Economists continue to debate the causes of the economic downturn that began in 1929 and the contemporaneous stock market crash. Much of the debate centers on monetary policy. Interestingly, there was also a substantial real estate boom and bust in the 1920s not too different from what we saw in the years leading up to the recent financial crisis.
However, fraud and market manipulation in the stock market were almost certainly not a significant cause, notwithstanding the popular view that these were rampant on the major stock exchanges. Congressional investigations concluded that traders routinely engaged in “pump and dump” schemes that drove up prices through massive purchases and then dumped the stock on unwitting investors, at which point the price collapsed. It was a powerful argument in favor of federal regulation of the exchanges that the president and Congress used to justify the passage of federal securities laws.
My colleagues and I examined the so-called “stock pools” which were said to be manipulative schemes. It turns out that once a pool formed, the price of the target stock increased, but it didn’t subsequently collapse. In fact, the data supports precisely the argument that pool operators made—they identified undervalued stocks and bought them. It is possible they sometimes traded on inside information, but they were not engaged in market manipulation, which was a central rationale for the New Deal regulatory regime.
And you’ve re-examined that, as well.
The Securities Act of 1933 was supposed to crack down on deceptive sales practices by major investment banks. One challenge to that story is that the largest investment banks were generally in favor of the Securities Act, although they opposed its liability provisions. Their support was entirely rational – after a decade of losing market share, the largest investment banks began to regain it after the Securities Act went into effect.
There is a straightforward explanation for this result. In the decade prior to the Act, the investment banking industry became much more competitive. The most important players used a traditional method of underwriting based on a painstaking book-building process and a strict separation between large wholesale houses and smaller, regional retail houses. New entrants, however, were using faster methods that integrated the wholesale and retail steps and relied on greater pre-offering marketing. The Securities Act, by banning pre-offering marketing and imposing a waiting period, effectively eliminated the smaller houses’ competitive advantage, to the benefit of the major wholesale investment banks.
We can fortunately identify the amounts underwritten by all the active investment banks before and after the Securities Act using data gathered in part by the financial press and in part by the parties in U.S. v. Morgan – an antitrust case against the investment banking industry in which S&C represented the investment banks. The data shows that the major houses gained substantial market share after 1933.
But if the information is available, why does myth become accepted as history?
Financial history is like military history – the winners get to write it. The engineers of the New Deal, who served in the Roosevelt administration or Congress at that time, wrote the first draft of that history. They of course portrayed themselves as heroes who saved the markets and the economy. To do that, they needed a story about a Wild West of unregulated stock markets that led to widespread fraud and market manipulation and ultimately to the Great Depression. Yet there’s almost no evidence that any of that is actually true.
In order to understand how markets evolve, it’s important to examine primary evidence about actual events and participants, and understand them as real, flawed, self-interested people trying to influence government processes for their own benefit.
What inspired you to study the Great Crash?
Back in high school – I think it was my freshman year – my classmates and I were introduced to the miraculous research technology known as microfilm. As part of our training, we were given microfilm of old newspapers and told to research an important historical event and write a paper about it. I decided to write about the 1929 crash – I was already developing an interest in financial markets.
I expected to see a screaming headline, “Market Crashes!” But, to my surprise, the reaction was more muted and almost matter-of-fact: “The market suffered heavy losses early and then picked up toward day’s end.” The next day things were a little better. The day after that, another bad day. On the whole, the press paid more attention to the heavy trading volumes and attendant logistical problems than to the price declines themselves. There was no sense at all that this was a major world-historical event.
Some years later, I read an article by a historian who examined death records during the months around the crash and found that the number of suicides in New York City stayed relatively constant during that period, despite the popular image of ruined investors jumping to their deaths.
All of this made me wonder: How much of what we know about the Great Crash and the Depression and the New Deal isn’t quite right? I filed that question in the back of my mind for many years, until I had the opportunity to examine it more closely as an academic.
Is this sort of misinformation common?
It’s incredibly common and longstanding. You see it going back to the first statute in the English-speaking world focused on stock markets—a statute that Parliament enacted to regulate the stock market in 1697! In 1696, Parliament undertook a monetary reform that had the effect of making many coins in circulation invalid for payment of taxes. The government made a complete mess of the transition to the new coinage, creating a panic that caused a run on the new (at that point) Bank of England. Parliament then decided the best way to avoid blame was to pin it on stock speculators, and, with much fanfare, it announced a new statute to regulate the stock market. It was a transparent diversion from the real problem.
People feel a need to tell morality stories about painful events, even when the stories are not justified by the facts. I have tried to look at these events with a fresh eye and to lay out the facts more accurately.
Your work suggests that we’re continuing to “waste our crises.” How can we stop doing that?
Regulators ought to focus more on basic blocking and tackling, looking out for serious frauds and making sure that financial firms are adequately capitalized, and stop spending so much time trying to prevent the last crisis. In general, the next crisis won’t look like the last one. Even if it does, complex regulations do not appear to make that much difference.
For instance, the real estate cycle was a contributor to the Great Depression of the 1930s and the Great Recession that started in 2007. Yet it is extremely doubtful that either the New Deal regulations or Dodd-Frank, which targeted politically unpopular practices in the financial sector, will prevent the next leveraged real estate bubble or lessen its impact on the economy.
We’d do well to remember that there is a straightforward set of longstanding legal rules – the basic rules of contract, fraud and misrepresentation – that have been around for a long time. These rules have proved remarkably good at solving complex problems. So even though there is a strong instinct to legislate new rules after every crisis, the basic rules do the most work over the long haul.
That’s how I see the English common law system: It’s an extraordinary accomplishment that helped England and the United States, in turn, to become the premier commercial and financial power in the world. We ignore that fact at our peril.
How did your experience at S&C inform the work you are doing now, and have you stayed in touch with your S&C colleagues?
I came away from my experience at the Firm with detailed knowledge of the plumbing of the financial system that has been helpful to me in thinking through how that system is regulated and whether that regulation makes sense or not. And I do keep in touch. It is incredibly valuable to know that when I’m trying to think through an issue in securities law, I can talk to people like Bill Williams, and in banking law, people like Rodge Cohen.
About Paul G. Mahoney: Paul is a David and Mary Harrison Distinguished Professor at the University of Virginia School of Law and served as dean from 2008-16. His teaching and research areas are securities regulation, law and economic development, corporate finance, financial derivatives and contracts. He has published widely in law reviews and peer-reviewed finance and law and economics journals. His book, Wasting a Crisis: Why Securities Regulation Fails, was published by the University of Chicago Press in 2015.
Paul joined the Law School faculty in 1990 after practicing in S&C’s London and New York offices and clerking for Judge Ralph K. Winter, Jr. of the U.S. Court of Appeals for the Second Circuit and Justice Thurgood Marshall of the U.S. Supreme Court. He served as academic associate dean at the Law School from 1999 to 2004 and has held the Albert C. BeVier Research Chair and the Brokaw Chair in Corporate Law. He has been a visiting professor at the University of Chicago Law School, the University of Southern California Law School and the University of Toronto Faculty of Law. He has also worked on legal reform projects in Kazakhstan, Kyrgyzstan, Mongolia and Nepal.
Paul is a member of the Council on Foreign Relations and a fellow of the American Academy of Arts and Sciences. He served as an associate editor of the Journal of Economic Perspectives from 2004 to 2007 and as a director of the American Law and Economics Association from 2002 to 2004. He is a past recipient of the All-University Outstanding Teacher Award and the Law School's Traynor Award for excellence in faculty scholarship.