As it looks as though a recession may be looming on the horizon, many investors are concerned about the depth and duration of a potential economic pullback. No two recessions are exactly alike, but it’s worthwhile nonetheless to take a look at what got our economy into the worst one ever in our history.
Vulnerabilities: After World War I, the economies of the industrialized world shifted away from war production back into the consumption sector as consumers became large buyers of not only food and clothing, but also durable goods such as automobiles and home appliances. Then a boom era ensued in the 1920’s, and countries became major exporters competing with each other.
Financial Speculation: The boom era enabled a number of businessmen to get rich quick, and that emboldened many more potential entrepreneurs to engage in speculation ranging from swampland in Florida, to nonexistent oil deposits, to the stock markets. Stock market speculation became more rampant as investors would borrow as much as 90% of the total stock purchase, pledging the stock itself as collateral. The various stock exchanges became hugely overbought and ripe for the bubble to burst. Brokerages were making vast amounts of money charging commissions for these transactions, but perhaps not fully cognizant that if they held the investor’s stock on margin, they could also be in trouble if the bubble burst. Many banks became extended by backing up the brokerage houses with loans enabling them to maintain the vicious pace of margin trading.
Federal Reserve Mistakes: Formed in 1913, the Federal Reserve System was not information-equipped the way it is today. Recessions and bank panics had occurred previously, but few people familiar with how an economy worked could imagine what a massive depression could do. For the eight years between 1921 and 1929 the Fed increased the supply of money to the economy by sixty-seven percent, helping keep interest rates low and keeping money in the hands of speculators. The Fed’s governors understood that the rampant speculation in the stock markets needed to be cooled down, but what tools would be most useful. In 1928, the Fed started to act by beginning a campaign to eliminate the easy and seemingly automatic credit that fueled the flames. The campaign didn’t stop the banks from reckless lending, so the Fed stepped it up by declaring that banks must stop loaning money to investors since it was causing a problem. As this wasn’t working either, the Fed stepped it up further in 1929 by sending a letter directly to every bank’s president that operated under the Fed’s purview that if the lending to investors didn’t stop, the bank would be shut out from the Fed’s discount window. Again, not much happened. Finally, the Fed decided to raise interest rates to cool down the speculation, and did so in August of 1929. This might have worked earlier on in the decade, but the result wound up shutting out the brokers and investors all at once, and the stock markets collapsed.
Stocks Crashed: On October 28, 1929, the major U.S. stock markets crashed losing 13% of the aggregate stock value in just one day. The destruction raced on for a month or so when about half of the aggregate stock value was lost. There were brief bear market rallies during the next several months until it bottomed out in 1932 with as much as 89% of the entire equity value of all stocks wiped out. The stock market crash was more symptomatic than causative of the burgeoning depression, as the indices continued to go up and down over the next few years according to their nature. But as investors were wiped out and banks overextended, the sources of capital needed to pull the economy back around were nearly depleted. As banks began to fail, it appeared that all credit might collapse. Before the crash occurred, investor consensus recognized that the very fast pace of the stock market’s rise would likely not be sustainable. Still some economists predicted that if there was a pullback, it would be short and sweet.
The Gold Standard: At the time of the Great Depression, most industrialized countries adhered to the Gold Standard, that meant that paper currency was tied directly to the value of a maintained gold reserve. During World War I, many European countries had to temporarily abandon the gold standard to finance their own war efforts. When interest rates were raised in the U.S. in 1929, it became difficult for these European countries to pay back their loans to the U.S. compounding the mounting liquidity crisis. Most European countries abandoned the Gold Standard in the early 1930’s, but the U.S. did not end it until the Gold Reserve Act of 1934 was passed by Congress and signed by President Roosevelt. At that point, gold came largely out of the hands of private individuals and was consolidated into the Bullion Depository at Fort Knox in Kentucky.
Fiscal Policy Shortfalls: The Hoover Administration believed that even as the recession pressed on, it was the Federal Government’s best maneuver to achieve a balanced budget. The idea was that this act of leadership would point the way to fiscal responsibility for businesses and industry, and help reduce the rampant speculation. However, these policies did not push the economy out of its retreat. It wasn’t until after Roosevelt was elected that the principles put forth by British economist John Maynard Keynes were adopted in that demand was needed to end the recessionary spiral; and that in the absence of private sector capital, the government needed to step up and provide the requisite demand. The best method for the government to respond to the need for capital would be via deficit financing, or ending the balancing of budgets. Even with the willing efforts of the new Roosevelt administration, the economy’s GDP did not reach pre depression levels until 1939.
The Smoot-Hawley Act: Passed in 1930 and signed into law by President Hoover, the Smoot-Hawley Act raised tariffs by 16% in a move to protect American businesses from foreign competition. The result was a trade war as other countries responded by passing their own tariffs. The act was not originally created to be a depression fighter as it was being debated in Congress before the depression began. But it was delayed in the Senate and became law also at a very bad time after the stock market crashed and banks began to fail. The corresponding retaliatory tariffs from other economies stymied exports and therefore contributed to the depression’s severity.
Conclusion: The Great Depression of 1929 was not caused specifically by the stock market crash beginning on October 28, 1929, as outputs had been falling for over six months beforehand. The most important factor to remember is that the severity of the Great Depression was caused by a long series of missteps, errors, bad policy decisions, and delays in remedial action by the government and government agencies. It all formed together to create a perfect storm of economic collapse. There is always concern whenever a recession looms large, but owing to the study and analysis of the causative factors of the Great Depression, it becomes more likely that future recessions will be dealt with using the right remedies in a timely manner.
Sources: history.com, great-depression-causes.
Wikipedia, Causes of the Great Depression, John Maynard Keynes.