by Bobby Akart
The Great Depression was the most severe economic depression ever experienced in modern times. It was considered the world's most famous case of deflation. The aftermath, the depression, was so intense, that the economic policy of the last one hundred years has been designed to prevent deflation at all costs. Between 1929 and 1932, worldwide GDP fell by fifteen percent. Personal income, tax revenues, profits and prices plunged by fifty percent.
The crash of the New York Stock Exchange on October 29, 1929, signaled the start of the Great Depression, the worst economic crisis in U.S. history. This period would last until 1941 when the United States began preparations to enter World War II.
When the stock market began to spiral downward, many looked on in disbelief. However, others recognized that the plummeting prices were a confirmation of severe economic problems long in the making. The stock market crash of 1929, usually cited as the beginning of the Great Depression, was preceded by the Roaring Twenties, a period when the American public discovered the stock market and dove in head first.
For much of the 1920s, the United States seemed prosperous. Many Americans were employed, and goods such as automobiles, appliances, and furniture flowed out of factories. Economic growth picked up as new technologies like the car, household appliances, and other consumer-oriented goods led to a vibrant consumer culture.
It also began the advent of consumer debt. More than half of automobiles in America were sold on credit by the end of the twenties, during which consumer debt more than doubled. At the peak of prosperity in 1927, the United States enjoyed the highest standard of living in the history of the world.
An undercurrent of unhealthy factors ran through the American economy—including the growth of income inequality. After the decade of the roaring twenties, the income of the top one percent had increased by seventy-five percent while the incomes for the remainder of Americans had only risen by nine percent.
The Dow Jones Industrial Average (DJIA) doubled, stock values raced upward, and the future looked promising. On an everyday level, the car, radio, and motion pictures were stirring up high hopes, and Henry Ford had shaken up America by offering great pay for shorter hours, forcing other industries to follow his lead. Also, America was feeling its power. World War I provided the United States with global trading ties and almost every major European nation became a debtor to Washington.
With the value of stocks skyrocketing, reports of people making fortunes lured people into investing heavily in the market. At the same time, the Federal Reserve Bank was very accommodating with an easy-credit policy. It expanded the money supply and lowered interest rates. In this loan-friendly environment, brokers, amateur investors, and even banks were leveraging everything on margin to get more of the action. The buying glut caused prices to break away from the fundamentals and sent them soaring. By 1928, signs that such prosperity was not sustainable began to appear.
On June 12, 1928, the New York Stock Exchange (NYSE) saw five million shares trade hands during a seemingly random drop across the board. This market hiccup was fleeting, and the bull market picked up again, but with perhaps a slight sense of unease over how quickly the market could go down. The Fed noticed and set about reversing the loose monetary policies that had added momentum to the bull market by increasing interest rates and announcing a ban on loans for margin trades in February of 1929. In most runaway markets, this should have been enough to cool the economy down, but investors were leveraged to the hilt and their greed and desperation kept the market on an upward trajectory.
In the summer of '29, many banks also tried to tamp down speculative investing by raising the discount rate on loans to brokers, many of whom were trading with huge outstanding debts. This hike effectively halted the bull market. The Dow slumped for weeks before rallying briefly in early September to reach a pre-crash high of 381.17. Markets entered into a relatively quiet period until reality set in late October.
October 24 and 25, Black Thursday and Black Friday, heralded the beginning of the chaos to follow. The DJIA plunged eleven percent at the open in very heavy volume on Black Thursday. The NYSE watched as thirteen million shares traded hands in furious bouts of panic selling. Intervention by wealthy industrialists, bankers, and investors—primarily the buying up of huge blocks of plummeting shares—halted the slide briefly.
The crash resumed on Black Friday, and into the following Monday, as more investors rushed to get out of the market while Wall Street continued to artificially prop up prices. The Dow dropped thirteen percent despite Wall Street's best efforts and, the following day, the situation worsened. On Tuesday, more than sixteen million shares were traded in panic selling that lasted the whole day. The market lost $14 billion.
The crash was severe, but the aftershocks were proved more damaging. If everyone had been investing with money they could afford to lose, the crash wouldn't rank among the most severe market corrections. However, with everyone, including banks, trading on margin, the bloodletting on Wall Street meant millions of dollars in bad loans. The banks holding the bad loans could call in the collateral, but in the market slide, even that meant losing money.
Soon enough, banks began to fail. The shock to the overall banking system was so severe that the U.S. economy spiraled into a recession, which deepened into a depression. As the economy soured, the markets continued to fall. On the worst day of the crash, the DJIA lost thirteen percent, but throughout the following years of the Great Depression, it shed eighty-nine percent of its pre-crash high.
The crash wiped out many people's investments and the public was understandably shaken. When bank failures erased the savings of those who weren't even invested in the stock market, the American public was devastated. Historians argue that although the stock market crash was unavoidable, the bank failures could have been prevented with better regulation.
The Fed, politicians and investors had not learned from history. Twenty-two years earlier, the panic of 1907 offered a similar scenario, as panic selling sent the NYSE spiraling downward and led to a run on bank deposits. With no central bank in place (the Federal Reserve was founded in 1913) to inject cash into the market, it fell upon investment banker J.P. Morgan to organize Wall Street's elite. Morgan rallied people who had cash to spare and moved that capital to banks lacking funds. The panic led the government to create the Federal Reserve, in part to cut its reliance on financial figures like Morgan in the future.
Famed economist Milton Friedman studied the Great Depression and created a poignant analysis of the events leading up to the 1929 stock market crash. He lays the blame for the crash squarely on the shoulders of the Federal Reserve.
During the crash of 1929, the Fed took the course of action of cutting the money supply by nearly a third, thus choking off hopes of a recovery. Consequently, many banks suffering liquidity problems failed. The Fed's harsh reaction, puzzling to most economists, may have occurred because it wished to send Wall Street a message by refusing to bail out careless banks. In their mind, a bailout of reckless banks would only encourage more fiscal irresponsibility in the future.
Ironically, by increasing the money supply and keeping interest rates low during the twenties, the Fed instigated a rapid expansion that preceded the collapse. In some ways, it set up the market bubble leading to the crash and then kicked the economy when it was down. Although some economists, such as Friedman, have correctly suggested that the Fed's mismanagement of the economic situation significantly contributed to the Great Depression. Proper monetary policy, or even abstention, they argue, would probably have resulted in a minor recession.
Following the crash, economists claimed that the Federal Reserve was making a huge mistake by keeping money too tight. Editorials from 1930 and 1931 had headlines like No Wampum and More Juice, Please. Here is an excerpt from one impassioned plea for easier money issued on Aug. 6, 1930: "The Federal Reserve system, instead of continuing a helpful release of credit to counteract the creeping paralysis of deflation, has done nothing."
Freidman demonstrated that the expectations of deflation among well-informed observers were indeed driven by the Fed's monetary contraction, not outside factors. This appears to show that the Fed was to blame and that Friedman was correct. If this result holds up in other narrative sources, it will provide important confirmation of the monetary explanation of the Depression.
As further evidence of Friedman's analysis, business magazine editors weighed in during the height of the Depression. "The deflationists are in the saddle," Business Week editors wrote in October 1930. "Our idle gold hoard piles up without increasing the means of payment by credit expansion because of paralysis of banking policy, thus prolonging price deflation."
Unfortunately, the Fed—and other central banks—didn't listen.
And this, from Sept. 9, 1931, refers to signs of economic weakness: "They are symptoms of a sudden, mysterious, universal shrinkage and shortage of the money and credit medium by which everything is exchanged and the supply of which rests solely in the hands of the world's banking institutions."
By 1933, President Roosevelt rode into office by characterizing a do-nothing attitude on the part of the government and the Fed. In truth, however, his predecessor, Herbert Hoover, had done far too much to try to halt the recession following the crash. One of Hoover's main concerns was that workers' wages would be cut following the economic downturn. To ensure artificially high wages among all businesses, he reasoned, prices needed to stay high so companies would continue producing. To keep prices high, consumers with the money would need to pay more. The public had been burned badly in the crash, and most did not have the resources to overpay for products.
This bleak reality forced Hoover to use legislation, the government's trump card, to try to prop up wages. Congress tried to restrict the flow of foreign goods by passing the Smoot-Hawley Tariff Act. Because foreign nations weren't willing to buy over-priced American goods any more than Americans were, Hoover decided to choke out cheap imports. The Smoot-Hawley Act started out as a way to protect agriculture but swelled into a multi-industry tariff. Other nations retaliated with their own tariffs, essentially cutting off international trade. Not surprisingly, the economic conditions worsened worldwide and the U.S. economy sunk from a recession into a depression.
Although Roosevelt promised change when he came into office, he continued Hoover's economic intervention, only on a bigger scale. He created the New Deal with the best intentions, but like Hoover's wage controls, it backfired. With previous recession/depression cycles, the U.S. suffered one to three years of low wages and unemployment before the dropping prices led to a recovery. Responding to this historical trend of a few hard years followed by a recovery, American industrialist, and philanthropist J.D. Rockefeller remarked, "These are days when many are discouraged. In the 93 years of my life, depressions have come and gone. Prosperity has always returned and will again." By attempting to recover immediately without swallowing the bitter pill of two hard years, Hoover and Roosevelt may have prolonged the pain.
The New Deal set lofty goals to maintain public works, full employment, and healthy wages through price, wage, and even production controls. The New Deal was loosely based on Keynesian economics, specifically on the idea that government works can stimulate the economy. Occasionally these projects were ideal, but there were just as many cases of mismanagement, political back-scratching and general waste that accompanies government-run initiatives.
One of the most heartbreaking results of the New Deal was the destruction of excess crops to justify the artificially high prices, despite the need for cheap food. In fact, many of the agencies created by the New Deal broke up black markets selling cheap goods. This forced factory workers to stop working and halted the production that was needed for recovery. Even unemployment remained high because companies couldn't afford to keep large payrolls at the rates set by the government.
Eventually, the economic recovery came in the form of World War II. Some argue that the war ended the Great Depression. The global conflict did open up international trading channels and reversed price and wage controls. Suddenly, the government wanted lots of things made inexpensively and pushed wages and prices below market levels. When the war finished, the trade routes remained open and the post-war era went from recovery to a bull run in a few short years.
The Great Depression was the result of an unlucky combination of factors—a non-committal Fed, protectionist tariffs and a Keynesian, government-centered recovery plan. It could have been shortened or even avoided by a change in any one of these.
Despite some serious downturns and corrections since the crash of 1929, it still reigns as the most dreadful market event in history. This is partially because of the severity of the event, but mostly because the entire economy buckled and then broke under the strain, starting America on the way to the Great Depression.
Another general factor that contributed to the Depression was the get rich quick mentality that developed during the 1920s. Many Americans believed their fortune was just around the corner. This belief was fueled by the mass production of consumer goods, unsubstantiated advertising in magazines and newspapers, and exotic silent movies telling tales of riches and success. With this get rich quick attitude, many Americans began to recklessly spend what little money they had. Hoping to look like glamorous movie stars, they bought a vast array of beauty products.
On a larger scale, many Americans purchased, sight unseen, parcels of land in Florida and southern California. When some investors went to visit the lots that had been purchased, they found swamps or desert. Realizing they had made a poor investment, many turned to the roaring stock market to overcome their losses. Focused on their own individual situations, these people did not recognize that their actions would soon combine with a number of other factors to produce the Great Depression.
Historians recognize a number of causes for the Great Depression, including the following:
(1) Chronic agricultural overproduction and low prices for farm products
(2) Excessive production of consumer goods by manufacturing industries
(3) Concentration of wealth in the hands of a few
(4) The structure of American business and industry itself, which included several large holding companies
(5) Investors' speculation, greed through orchestrated optimism
(6) The lack of action by the Federal Reserve System
(7) An unsound banking system
Here are three different perspectives on the cause of the Great Depression from three different economists.
Keynesian
Keynes saw the causes of the Great Depression as based upon over-production, and a lack of commensurate demand. In 1936, when he published The General Theory of Employment, Interest, and Money, he focused on this factor. His solutions were two-fold. First, through Federal Reserve monetary policy, reduce interest rates. Second, through US government fiscal policy, increase federal spending in the form of infrastructure investment.
Smith and Friedman
Their view would lay the blame on the Federal Reserve and the fall in the money supply. US investors were holding money and consuming less. This caused a contraction in employment and production since prices were not flexible enough to adjust. Friedman was quoted as saying, "The Great Depression, like most other periods of severe unemployment, was produced by government mismanagement rather than by any inherent instability of the private economy."
In most contexts, the term "crash" is used for market downturns that are sudden and harsh. The Great Crash of 1929, however, is used to refer to more than three years of economic misery. While the crash of 1981 almost doubled the single-day loss of Black Tuesday and several subsequent crises have shed more market value, the crash of 1929 encompasses the many crashes, slides and general misery that followed during the Depression years. With any luck, it will remain both the first and last crash to earn the title of "great."
Hayek
Libertarian economists would also lay blam
e at the feet of the Federal Reserve. The extraordinary rise in credit, fueled by the Fed's easy credit policies, led to an unsustainable credit-driven boom.
Could it happen again?
History repeats itself, but never in exactly the same way. To apply the lessons of the past, one must understand the differences to present circumstances. Let's use the military context by way of example.
During the American Revolution, the British came prepared to fight a successful war, but against a typical European army. Their formations, which gave them devastating firepower, and their red coats, designed to emphasize their strength in numbers, proved the exact opposite of the tactics needed to fight the guerrilla war planned by the colonists.
Before World War I, generals still saw the cavalry as the pride of their armies because of their mobility. Of course, the horse soldiers proved worse than useless in the trenches.
Following the end of World War I, in anticipation of a future German attack, the French built the impenetrable Maginot Line—a series of concrete fortifications, obstacles and weapon installations that France constructed on its borders with Switzerland, Germany and Luxembourg during the 1930s. History repeated itself and the attack came, but not in the way the French expected. Their preparations were useless because the Germans didn't attempt to penetrate it. They simply went around it, and France was defeated.
The military doesn't prepare for the last war out of perversity or stupidity, but rather because past experience guides them. The majority of military leaders don't know how to interpret that experience. They are correct in preparing for another war but wrong in relying upon what worked in the last one.