Ninety-three years ago on October 24, 1929, the U.S. stock markets went on a sharp decline that eventually fell by 89% of the all-time high of 381.17 reached on September 3 of that year. On July 8, 1932, the bleeding finally stopped as the Dow Jones Industrial Average bottomed out at $41.22, and didn’t reach the all-time high again until November, 1954. Comparing that to current times, it would mean that the DJIA would fall from about 35,000 today to a low of about 3,815 by December, 2024, and not return to the original high until 2046. The resulting financial turmoil contributed to the severity of the Great Depression that lasted off and on again for nearly a decade until 1939 when World War II began. The million-dollar question is: What went wrong?
The Prior Decade: During the decade after the end of World War I in 1918, the United States economy took a major upswing. Being one of the few industrialized economies in the world that did not suffer significantly as a consequence of the war, Americans enjoyed an era of prosperity unlike any seen before. The resulting wealth led to vast excess and great amounts of speculation—not only in stocks, but also in land values and commodities. In Florida, a land speculation boom occurred in 1925 whereby investors in places like New York would buy land in Florida in a spot they never heard of nor ever even seen, and then sell it to a greater fool few months later for a huge profit.
As stock prices kept climbing, it seemed to many that the markets had nowhere else to go but up, and the speculation continued. Thanks to a margin requirement of only 10%, investors could buy into stock positions with just 10% of the purchase price down, and use the securities themselves as collateral. This margin process brought a massive amount of borrowed money into securities markets forcing prices high above the value of the stocks being purchased. Further, commercial banks that accepted deposits and made loans to individuals and businesses also owned stocks buying them with depositors’ money. It was during this wild era of speculation that Ponzi schemes and other tricks to get rich quick evolved lending the appearance of prosperity to potential investors when there was no real value in the potential investment.
Black Thursday: The decline of stock prices began in September, 1929, after the all time high on September 3. But the pullback did not raise many eyebrows until October 24, when the DJIA fell 11%. This slide only amounted to a correction (a decline of 10%), but Wall Street financiers and other large stake holders bought the dip, and the DJIA went back up the next day. But the charm of constantly providing winners was broken, and the DJIA fell by 13.7% on the following Monday, and then another 11.7% on Tuesday. Even this was only a bearish decline (a decline of 20%) that had happened before and has happened since, but the damage had been done. The great groundswell of stock market speculation and euphoria dried up leaving many families with their life savings gone, and businesses in financial ruin.
Banking Liquidity Crisis: The Federal Reserve had been formed in 1911 to help stabilize banking and financial transactions in this country. But in 1929, only about a third of all banks were members of the Federal Reserve system. These banks were able to get loans and carry on, but many banks not in the system ran out of money and closed, unable in many cases to return deposits to their banking customers. As businesses suffered during the ensuing depression, many were unable to pay back loans they already had, and were unable to get new loans to stay in business. This led to businesses closing and laying off employees who then didn’t have enough money to buy essentials, thereby decreasing the demand for goods and services and pushing more businesses into bankruptcy. This vicious cycle constituted the main thrust of the Great Depression.
Before the crash took place, the Federal Reserve was restricted by law from accepting securities as collateral for loans to banks from the Fed’s discount window. The theory then evolved that the Fed as a central bank should increase the supply of money when the economy prospered and decrease it when economic activity contracted. As speculation reached a fever pitch, the Fed decided to deny loan requests from member banks that made a practice of loaning money to stock speculators. There was a major push by some Fed board members to raise rates on the funds loaned to member banks. After much debate those rates made it up as high as 6%. This prompted foreign central banks to likewise raise rates to their member banks precipitating a large slowdown in foreign trade, and helped push those economies deeper into recession. When the crash hit in the fall of 1929, only the New York Federal Reserve Bank acted in a manner that resulted in positive steps to end the crisis. Amongst other things, the New York Fed purchased government bonds on the open market, lowered discount loan rates, and expedited lending through the discount window. They further relaxed the reserve requirement for their member banks. These actions helped keep short-term rates in check and kept many banks in business, but they only applied to those governed by the New York Federal Reserve and not the remainder of the country.
Federal Fiscal Policy: In the early 1930’s the Hoover Administration acknowledged the need for action to shore up the economy, but the actions taken, however well intended, often did the opposite. Hoover was a zealous believer in the balanced budget—a very noble pillar to any administration, but not when a large economy is crumbling. At one point he decided to raise the top tax rates in the country to 63% in order to keep the budget balanced, possibly inhibiting the resurgence of entrepreneurship. He further believed the government should take a hands-off stance when it came to business, and failed to provide much serious regulation towards remedying the crisis. He did, however, take a number of steps to help the poor particularly with organized food distributions. Even a visit from famed British economist John Maynard Keynes failed to inspire him to undertake a system of deficit financing of more programs to put workers back on the job. Hoover received a tremendous amount of criticism for his approach to handling the recession, and was handily defeated by Roosevelt in the 1932 national election for president.
Conclusions: The 1929 Stock Market Crash was not directly responsible for the ensuing depression. The depression had begun months earlier with outputs declining in a number of sectors pointing to a retreat of GDP. Most of the problems leading up to the crash were mitigated over time with regulation and legislation, and the great fervor of speculation has not hit the same level since 1929. More is known today in academia and widely accepted as useful policy than what was available in the early 1930’s. Take a look at the actions by the N.Y. Federal Reserve in the early 1930’s for its member banks and one can draw many similarities to what the Fed did for the entire country during the 2007/8 financial crisis. We can only hope that the great temptation of politicians to turn the economy loose when it is already overheated will be met with more reasonableness and restraint in the future.
Sources: Wikipedia, Wall Street Crash of 1929.
Federal Reserve History, Stock Market Crash of 1929. By Gary Richardson, Alejandro Komai, Michael Gou, and Daniel Park.
The Balance, Stock Market Crash of 1929, Facts, Causes, and Impact, by Kimberly Amadeo.