Causes of the Great Depression Notes

We know what occurred, and it is staggering. GNP fell from $104 billion in 1929 to $56 billion in 1933; one out of every four in the labor force was without a job; residential construction fell by 90%; nine million savings accounts were lost due to bank closings; 85 thousand businesses closed. But knowing what occurred does not tell us why it occurred; and even today, experts disagree on the causes of the Great Depression. In sorting through these disagreements, we look first at American Agriculture. Agriculture The dilemma of the American farmer began long before the stock market crash of 1929.

His sad plight through much of the 1920s followed a more prosperous time in the preceding decade. The First World War generated a great demand for farm products. From 1915 to 1920, European countries imported much of their food, causing prices to rise, and US farmers’ cash receipts to double. After the war, European farmers resumed their output, decreasing the demand for imported foodstuffs. Farm products flooded the domestic market. A worldwide overproduction of wheat, cotton and other staples caused prices to drop. The retail price of agricultural goods fell 40% in 1920-21.

Technological improvements and the lack of crop limitations only made matters worse by further increasing output and oversupplying the market. Wheat prices declined from $1. 05 a bushel in 1929 to $. 39 in 1932, and cotton went from $. 17 a pound to $. 06. To compound the problem, the drought of the thirties struck, creating a dust bowl in much of the Midwest. Thirty million Americans made their living in the agricultural sector during the 1920s. Farmers became poverty stricken, as their produce could no longer command prices high enough to support their families.

Many of them struggled each year to earn enough money just to pay their taxes or the interest on their mortgage. As one fifth of the population’s purchasing power lagged, so did demand for manufactured consumer goods. Industrial Sector Generally speaking, the 1920s in America were a good time. Prior to the stock market crash, industrial production and profits were high and rising. Although many people were poor, more people were well off or rich than ever before. The main reason for this wealth was the increase in domestic production.

Between 1925 and 1929, the number of manufacturing establishments increased from 183,900 to 206,700. The value of their output rose from $60. 8 billion to $68 billion. The Federal Reserve Index of Industrial Production, which averaged only 67 in 1921, had risen to 126 by June 1929. In 1926, Henry Ford and his competitors produced 4,301,000 automobiles. Three years later, automobile production grew by a million cars. Business earnings increased rapidly. Profits of large corporations tripled between 1920 and 1929. While production rose steadily in industries such as manufacturing, ining, transportation and utilities, employment began decreasing due to rapid technological advancements. Technological displacement gripped the labor force as machines began to replace men on the assembly lines and in the mines. Consequently, output per man-hour rose tremendously. However, the gains from productivity were passed on to the consumers, not the workers. While the cost of living dropped 15% from 1920 to 1929, hourly wages also began to fall. The average workweek declined from 60 hours in 1900 to 44 in 1929.

Less hours and lower hourly wages resulted in a fall of the annual income of the American worker. Despite good economic figures on stock prices, earnings, and dividends, low wages left many middle- and low-income Americans on the edge of destitution. The US had a very lopsided distribution of purchasing power. In 1929, the top 1% of the population received 19% of total income; the top 5% received 33. 5% of the total income–figures that were higher by a half from their 1919 levels. Workers only earned an average yearly wage of $1,280 in 1929. The rich were getting richer and the poor were getting poorer.

Black people in the South and people in the southern Appalachians continued to live in poverty. Many of the workers’ savings accounts declined because installment purchases on automobiles and appliances allowed them to live beyond their means. Overproduction eventually plagued American business. Production of industrial goods had outrun consumer and investor demand. In 1929, America produced a quarter more commodities than it had the capacity to either consume or export; 40% of all factories operated at a loss. This loss, however, was disguised by the booming stock market.

The summer of 1929 was portentous. Industrial production began its inevitable decline. By October, the Federal Reserve index of industrial production was 117, compared to 126 four months earlier. Home building, which acts as a barometer for domestic production, had been falling for several years. The Stock Market Crash In the US stock market, buyers had a long heyday. In the early twenties stock prices were low and yields favorable. Corporate earnings were high and rising. Future prospects seemed promising. Trading began to increase drastically in 1928.

On March 12, 1928, volume on the stock exchange reached 3,875,910 shares, an all-time high. On June 12, volume cracked five million shares for the first time. On November 16, a further wave of buying hit the market. An unbelievable 6. 6 million shares were traded. Over the whole year of 1928, 920 million shares were traded on the New York Stock Exchange, dwarfing the previous record of 576 million shares in 1927. The stock market behaved erratically as it heated up. It would rise by great leaps, fall, and then rise even higher. Yet investors still made money.

During the three summer months of 1929, the New York Times Industrials gained more than the entire previous year, which had been a year of unprecedented rise. In those three months alone, an investor who bought 100 shares of Westinghouse would have doubled his money. October 24, 1929, also known as Black Thursday, is the first of the days identified with the panic of 1929. Over 12 million shares changed hands, many at low prices. Often there were no buyers, and only after drastic declines in prices could anyone be induced to bid. By 11:00 am, the market had fallen into a mad, wild scramble to sell.

The ticker was lagging far behind the declining values, and uncertainty caused many to panic. Brokers demanded more margin from speculators, and when they were unable to produce, sold them out–dumping even more shares on this vastly over-sold market. Monday, October 28, was another terrible day on Wall Street. Volume was heavy and losses more severe. The Times Industrials were down 49 points; Westinghouse 34 points; and Steel 18 points. The most devastating day in the history of the New York stock market occurred on Tuesday, October 29. Volume was great, as was the decline in prices.

In many cases, a plethora of selling orders had no buyers at all. Great blocks of stock were offered for what they would bring. The stock of White Sewing Machine Company, which traded as high as $48, ended the day at $1. The Times Industrial Averages were down 43 points. An unprecedented 16,410,000 shares traded. In a single day, the increase in stock values of the entire previous year was erased. In all, $30 billion of wealth vanished. Millions of investors, who watched their capital gains soar and thought themselves to be well off, realized they were poor.

The crash did not occur because the market suddenly became aware that a serious depression was in the making. Hardly anyone foresaw the downturn in production and employment. Rather, the stock market crashed because the bubble burst: the early days of declining prices slapped investors with a cold wake-up call. Those who knew that the previous market frenzy was unsustainable sold their shares; a snowball effect ensued; many, many others–previously happy buyers–suddenly turned into snarling sellers. The stock market usually mirrors fundamental economic conditions.

Cause and effect flows from the economy to the stock market, never the reverse. In 1929 the economy was suffering, a fact that was violently reflected on Wall Street. Speculation and Buying on Margin Americans in the twenties learned that they could get rich quick with a minimum of effort. A new term entered the lexicon of the middle class: buying on margin. Margin is the percent of the purchase price of a stock that the buyer has to pay in cash; he can borrow the rest. A typical margin during the late 1920s was 10%; a buyer could put up $100 and buy $1000 worth of stock.

Of course, the buyer had to leave his shares with the broker as security. But as long as stock prices were rising, as long as market prices covered the borrowed 90%, the buyer was in no jeopardy. But let prices fall, and the situation could turn mean. The broker would call the buyer and demand more margin. If the buyer could not produce more margin, the broker would sell the shares to cover the loan on the shares. The interest rate on these brokers’ loans was almost always higher than dividends on the stock. Investors viewed this as inconsequential. If stock prices were soaring, interest costs were a small price to pay.

A savvy buyer could leverage his money by a huge amount; a little cash controlled a lot of stock. At first, New York banks were supplying the capital to brokers for margin loans. At the beginning of 1928, this liquid and seemingly secure investment for non-risk capital brought a 5% interest rate. As demand for brokers’ loans increased, the rate of interest also increased, and eventually hit 12%. In March of 1929, the rate for call money reached its high of 20%. As speculation grew, many banks around the country and the world became lenders in New York.

Gold from Montreal, London, and Hong Kong converged on New York, all of it to help Americans hold common stock on margin. One of the paradoxes of speculation in securities is that the loans that underwrite speculation are among the safest of all investments. A cash margin and stocks that, under normal circumstances, are instantly marketable protect them. The money can, in theory, be retrieved on demand. Corporations discovered this fact, and some decided that financing speculation was a more profitable use for working capital than additional production.

Many firms began to lend their surplus money to Wall Street. During 1929, Standard Oil of New Jersey contributed a daily average of $69 million to the call market; Electric Bond and Share averaged over $100 million. A few firms even sold their securities and loaned the proceeds. New York banks took this profitable opportunity a step further. They borrowed money from the Federal Reserve for 5% and re-lent it on the call market for 12%. Numbers tell the tale. In the early 1920s, brokers’ loans were in the range of a billion to a billion and a half per year.

By the end of 1927, the amount reached nearly $3. 5 billion. Loans increased $400,000,000 a month during the summer of 1929, and by the end of the summer, totaled over $7 billion, with more than half being supplied by corporations and individuals. But in the fall of 1929, the free lunch of rising stock prices became the unaffordable lunch of the crash. With the waves of declining prices came the inevitable margin calls. Customers who had already put what little cash they had into the market could not produce the additional cash demanded in the margin call.

Brokers called the loans and liquidated the stocks. Investment Trusts Another favorite investment vehicle of the twenties was the investment trust. These were professionally managed companies formed solely for the purpose of investing the funds of their shareholders in common stock. By purchasing shares of an investment trust, a small investor could reduce his risk, since the trust’s funds were invested in a diversified portfolio. Investment banking houses, commercial banks, brokerage firms, securities dealers and most important, other investment firms created new trusts.

The only property of the investment trust was the common and preferred stocks, debentures, mortgages, bonds and cash that it owned. Investment trusts did not promote new enterprises or enlarge existing ones. They merely allowed investors to own existing stock through the medium of new companies. Investment trusts were able to produce significant returns for their investors because they operated with substantial leverage. Many stockholders of trusts purchased their shares on margin. The investment trust, in turn, also purchased stocks for their portfolios on margin.

This escalated a very small amount of equity into a highly leveraged speculative venture: the same investor who could control $1000 of stock with his $100 could now control $10,000 as both he and the trust could borrow at the ten-to-one rate. But the process need not end there: one trust could own another which could own another, so that the $100 could theoretically control a million dollars worth of stock. Investment trusts became the rage of Wall Street. The trusts marketed themselves very well to speculators. They stressed the diversity of their portfolio, their efficiencies and their knowledge of the market.

By the beginning of 1927, 160 trusts were in existence and another 140 were formed during the year. In 1928, 186 were organized, and by the following year they were being promoted at the rate of one each business day. In 1927 trusts sold to the public about $400 million worth of their shares. In 1929 they sold $3 billion. By the autumn of 1929, the total assets of the trusts were $8 billion. They increased eleven fold in just two years. They were so popular that many new trusts were oversubscribed in less than two hours after they offered their initial shares for sale.

The stock market crash exploited the weakness of investment trusts. Investors soon discovered the devastation of reverse leverage. As stock prices fell across the board, investment trusts’ portfolios plummeted. Many trusts used their available cash in a desperate, but unsuccessful attempt to support their own stock. Any assets they had left were allocated to bond and preferred stock holders. Common stock had nothing behind it. By November, the stock of most investment trusts had become virtually worthless. United Founders and American Founders, trusts that sold for $70 and $117 in September, eventually fell to 50 cents.

The entire system came crashing down as the value of the collateral securities plummeted. One of the surprises of the stock market crash is the relatively small number of Americans that were hurt by it. This was simply due to the relatively small portion of the population that participated in the stock market in the first place. According to a Senate committee investigation aimed at discovering the amount of speculation that occurred during 1929, only a million and a half people, out of a total population of approximately 120 million, had an active association with the stock market.

The number of active speculators at the peak in 1929 was probably a million or less. The Federal Reserve Board: Government Inaction The severity of the stock market crash and the duration of the Great Depression can somewhat be attributed to the absence of concerted monetary and fiscal policies. Hands-off government and laissez-faire were the watchword of the country’s leaders. Macroeconomic policies as we know them were nonexistent. As the stock market was booming in the late twenties, authorities were well aware of the large amount of speculation and margin purchases. Yet they did nothing.

President Coolidge neither knew nor cared what was going on in the stock market. A few days before leaving office in 1929, he said everything was sound and stocks were cheap at current prices. He believed that keeping speculation under control was the responsibility of the Federal Reserve Board. Meanwhile, the Secretary of the Treasury, Andrew Mellon, was also an advocate of inaction. In February of 1929, the Federal Reserve Board wrote tentative letters to their district banks and the public stating that they would not interfere with loans to support speculation as long as Federal Reserve credit was not involved.

As money became tighter, The National City Bank announced it would loan money as necessary to prevent liquidation (margin calls) of the market. In fact, the bank borrowed money from the Federal Reserve Bank of New York to do so, exactly what the Board had warned against doing. The Fed was obviously less interested in checking speculation than in detaching itself from the responsibility for the speculation. The Federal Reserve Board in the late twenties was impotent. Their two instruments of control, open market operations and the manipulation of the rediscount rate, were practically useless.

By the end of 1928, the Fed had run out of securities to sell. At the beginning on 1928, Fed security holdings were $617 million. By the end of the year they amounted to only $228 million. The other instrument, the rediscount rate, is the rate at which member commercial banks borrow from their district Reserve Bank. In January 1929, the rediscount rate at the New York Federal Reserve Bank was only 5%. With brokers’ loans at a rate of 6-12%, only a drastic increase in the rediscount rate would prevent banks from lending money to speculators. On February 14, the New York Federal Reserve Bank suggested raising the rate to check speculation.

The Federal Reserve Board in Washington and President Hoover thought this would harm business borrowers and did not raise the rate until later that summer. It was only raised to 6%, which merely weakened the market for a single day. From the end of March 1929 on, the market had nothing to fear from authority. The Fed took no action. They had no control over margin requirements and could not curb money from non-bank sources from entering the call market. President Hoover thought that primary responsibility for regulating the stock market rested with the Governor of New York, Franklin D.

Roosevelt. Roosevelt, however, also followed a laissez-faire policy as far as the stock market was concerned. The threat of any government reaction or retribution had completely disappeared Smoot-Hawley Tariff During the 1930s many countries fought rising unemployment by setting tariffs at unprecedented heights, subsidizing exports and restricting the quantity of imports. The United States led the way as President Hoover signed the Smoot-Hawley Tariff Bill in 1930. The bill established the highest tariff rates in American history, increasing the rates over 50% on average.

The bill covered many goods that were in no sense competitive with domestic products. In fact, a number of them were not produced at all in the US. On the other hand, some articles were placed on a free list, which did not have tariffs imposed on them. These products included broken bells, sheep dip, dried blood, bones, ice, ivory tusks and lava. When the infamous Smoot-Hawley tariff surfaced, more than a thousand prominent economists petitioned President Hoover to veto the bill. Industrial and financial leaders from around the world also protested.

They realized the tariff would make it impossible for the US to develop the export trade necessary to stem the tide of the depression. Auto executives, who relied heavily on foreign exports, were furious. Henry Ford personally told Hoover the measure was an “economic stupidity. ” General Motors’ Alfred Sloan Jr. pointed out, “We cannot sell unless we buy. ” But Congress passed it anyway, and President Hoover, claiming reluctance, signed it. Their argument was simple but misguided: Raising tariffs will keep production at home and increase government revenues.

This short-sighted bill inflicted great damage on international commerce, which was already suffering from the gathering worldwide depression. Probably no other piece of legislation in history has ever aroused so much anger and international ill will as the Smoot-Hawley Tariff. Many foreign countries raised their tariffs very soon after the enactment of the bill. Several European nations, including Italy and France, launched boycotts of American goods and retaliated with their own tariff walls. The snowball effect of raising tariffs and implementing trade restrictions caused world trade to decline by one-third between 1929 and 1932.

While the volume of US imports fell during 1930-1933 more than any other major industrial country, the volume of US exports also fell by the greatest amount. In 1932, the volume of US exports was only 53% of 1929, while that of the UK was 63%; France, 59%; Germany, 59%; and Japan, 94%. The bitter irony of this bill is that it actually contributed to the contraction of US income and employment–exactly what it intended to prevent. Bank Failures The year 1929 devastated banks. In the first six months, 346 banks failed around the country with aggregate deposits of nearly $115 million.

A large number of independent banks existed. When one bank failed, depositors rushed to others to ask for their money. This resulted in a domino effect. One failure led to other failures. For much of the 1920s, banks in agricultural areas suffered as farmers could not repay their loans. In 1929, those who lent to the stock market joined the list as stocks that collateralized loans became worth less than the loans. As the depression proceeded, bank failures quickly became an epidemic. In October of 1930, the US financial situation deteriorated drastically. Confidence in the banking system faded.

Over 9,000 out of 24,700 banks in existence at the beginning of 1930 had failed by the end of 1933. In an attempt to ease fears, President Roosevelt declared a “banking holiday” on March 6, 1933, which completely shutdown all banks. But the damage had been done. The bank failures intensified deflation directly through the destruction of deposit money and reduced lending. From August 1929 to March 1933, the stock of money declined by 33%. The Money Hypothesis Advocates of the money hypothesis believe the collapse of the banking system was the primary cause of the depression.

These economists claim the collapse converted a normal, short-lived recession into a major depression. As banks failed, the money supply contracted, and the Fed did nothing to reverse the trend. Milton Friedman and Anna Schwartz support this hypothesis. They show a correlation between the stock of money and level of income, and claim that the fall in the supply of money was caused by the bank failures. This, in turn, caused the income contraction. The Money Hypothesis can be illustrated using The Quantity Theory of Money: MV=PQ, where M is the money supply, V is the velocity of money, P is price level and Q is real GDP.

This equation states that the money value of nominal GDP (calculated by P times Q) equals the product of the stock of money times velocity of money. There is an obvious link between the stock of money, M, and the nominal value of a nation’s output. Monetarists believe the fall of M caused the Depression. The Spending Hypothesis Advocates of the spending hypothesis claim that a fall in autonomous aggregate spending (demand) caused the depression. John Maynard Keynes created the framework of this argument.

Aggregate spending is composed of consumption (C), investment (I), government purchases (G) and the difference between exports and imports (X-M). Aggregate demand = C+I+G+(X-M). The components of I are business investment in plant and equipment, residential construction and inventory investment. Responding to this demand, firms produce the domestic product. A decline in any component of demand can reduce domestic product, and consequently domestic income. At the beginning of the Depression, a decline in construction and the stock market crash caused a decrease in investment (I) and consumption (C).

Construction, a substantial component of investment, fell because the housing stock exceeded the demand for housing after 1925. The stock market crash did not, in and of itself, cause widespread poverty. It did cause consumption to fall somewhat. But more importantly, it exposed huge pyramids of investment trusts and brought down flimsy structures of credit. Banks and financial institutions became insolvent. The collapse of the banking system and the overly timid monetary policy permitted the money stock to shrink by one-third. It was this shrinkage which struck consumption and investment.

Bank failures caused falls in consumption as families lost their savings. A fall in exports as a result of the Smoot-Hawley trade wars hurt the US. All these depressing factors caused consumption to fall further as more workers became unemployed. To make things worse, adverse expectations of the future pushed consumption even lower. Expectations of profit play a crucial role in the rate of capital formation. The stock market crash, the bank failures, the weakness of the agricultural sector and the falling consumer expenditures all led to low profit expectations.

These grim expectations dampened investment spending. Real investment in the US fell from healthy numbers in the late 1920s to a negative number in 1932, as American business did not invest enough to replace depreciating machines. So the fall in aggregate spending began on the farm, then spread to housing, then to investment, then to consumption and finally to exports. Together they produced a tremendous decrease in real income. We were to learn later from Keynes that any fall in spending causes production and income to fall by a greater amount – what he called the multiplier effect.

Conclusion One cannot pinpoint a single cause or event that brought on the Great Depression. Instead, an extraordinary series of negative events occurred in sequence. These events struck an economy with fundamental weaknesses in agriculture, banking and finance, and in income distribution. Most important was the fundamental weakness in the level of economic knowledge. The worsening income distribution during the 1920s played a crucial role in the depression. As the poor became poorer, millions of Americans had no savings. Even the smallest financial malady would cause an economic epidemic.

Living paycheck to paycheck, the great majority of Americans could not weather this economic storm. But even more important, these events and economic weaknesses hit an economy guided largely by misinformation or outright ignorance. At bottom, the Great Depression resulted from this ignorance. The wise men of the day simply did not understand the world of economics as well as they thought they did. The strong economic ideas of the day– for example, that restricting imports cures recessions–were dead wrong. The Fed was useless. The Congress was a vast ocean of misguided policy.

And the President would have been much more comfortable in an earlier, simpler age when saying do nothing over and over made good public policy. Also not to be excused, the economics profession did not understand the depression. Economists of the day had largely ignored the study of economics in the aggregate–what we today call macroeconomics–preferring to spend their time trying to fathom the world of prices, markets, and values. And so when calamity hit, the country did not know what to do. Unfortunately, it took a decade of pain on the part of a huge portion of the population before the puzzle was solved.