The 1920s was a time of unprecedented growth and investment in the American stock market. So how did such prosperity end up precipitating the incredible instability and general lack of confidence that ended up as the Great Depression?
And even more importantly, is history threatening to repeat itself, as described in the Barron's article by Randall Forsyth, Party Like It's 1937?
Let's take a look back to see what happened in the years leading up to the Great Depression, and see if we can use any of those lessons as we try to avoid a depression of our own.
After nearly a decade of growth and heavy investment in the stock market, largely by inexperienced investors buying stock with borrowed money, the market collapsed on October 29, 1929. Also called Black Tuesday, this is the day often cited as the beginning of the Great Depression. So what really happened?
First let's look at how the investment growth of the 1920s was made possible. Here's the short story: The Federal Reserve loaned money to banks. In turn, banks loaned money to brokerage firms, who then loaned money to investors and speculators. During the 1920s, brokerage firms were routinely giving $9 in loans for every $1 put up by the investor.
The end result was that more money was in stocks than in actual currency circulation. By 1929, stock growth had diminished and uncertainty in the market was growing.
In the week in which Black Tuesday occurred, the frenzied investment of the 1920s reached its end, and novice investors who had seen their stock prices grow for years suddenly saw them plummet. The bottom fell out, and panic selling ensued as investors tried to get what money they could out of the market by dumping stocks indiscriminately.
The cycle of loans reversed, starting a cycle of defaults. As the market collapsed and stocks were dumped, brokerage firms were forced to call in their loans. Investors defaulted on these loans when their portfolio of stocks declined in value, and liquidating the undervalued portfolios only contributed to continued downward pressure on prices. Brokerage firms then defaulted on bank loans because they couldn’t recall any capital, and banks, with insufficient reserves to cover their loans and deposits, began to close as depositors started withdrawing their cash.
This brings us to back to the Federal Reserve and the next major contributor to the Great Depression.
Throughout the 1920s, it was the Federal Reserve’s policy to increase the currency supply, keeping interest rates low in order to stimulate the economy. When the market crashed, however, that policy was abruptly reversed.
Rather than increasing the currency supply by lending money to the banks to cover their deposits, the currency supply was decreased by nearly one-third. This precluded any chance of recovery for the banks that were being emptied via continuous bank runs.
The stock market crash may have been inevitable given the overspeculation and rapid expansion of the 1920s, but it was the bank closures that were disastrous, as it essentially evaporated billions of dollars in loaned money, wiping out the savings of people who weren’t even invested in the stock market.
The decrease in currency supply and the closures of banks led to deflation -- the devaluation of a wide set of assets. For example, due to deflation of 20%, a home purchased for $1,000 in 1928 was worth only $800 in 1929. Because most people owed money on the assets they owned, and the loans didn't deflate along with the assets, the deflation had two devastating effects. First, with diminishing returns on assets and a decreased value of goods, businesses, especially manufacturing, had no incentive to produce goods. The halt in manufacturing squashed any chance of economic growth.
Second, because debtors had to pay off loans on assets that were now valued at less than their purchase price, the more a debtor paid, the more they lost financial ground.
The Second Leg Down
The decrease in the currency supply, debt deflation and bank closures turned a significant recession into a deep depression. But the longevity of the depression was further affected by two dramatic pieces of legislation.
First was passage of the Smoot-Hawley Act, a measure pushed by President Hoover that put a tariff on foreign imports. Hoover believed that workers' wages needed to remain high as the recession set in. In order to keep wages high the cost of domestic goods needed to remain high as well, so that manufacturers would continue producing.
The Smoot-Hawley Act was intended to discourage the import of foreign goods and stimulate production and consumption of domestic goods. Other countries quickly retaliated, however, and set tariffs of their own on U.S. imports, effectively freezing international trade and wiping out domestic exports.
The other significant piece of legislation was President Roosevelt’s contentious "New Deal." The program was a government-centered economic stimulus plan intended to increase industry and public works and decrease unemployment.
Though many of the New Deal programs were successful -- some still exist today -- many contend the program took economic recovery out of the hands of the normal recession/recovery cycle and artificially manipulated wage rates and production without much success.
Unemployment remained high when companies could not afford the regulated wage rates. Domestic consumption failed to increase because prices remained high -- often resulting in black market trade rings. The assumption that government spending would stimulate the economy worked best in some of the notable public works projects that improved infrastructure and generated jobs, but not so well when it came to workers putting wages back into the economy through spending.
In the end, it took World War II to stimulate economic growth, as the government needed mass quantities of goods at low prices and left regulation to the free market.
The Great Depression was the outcome of a series of factors. The crash of the stock market was likely unavoidable and an ensuing recession should have just been part of a typical recession/growth cycle.
But the unprecedented bank closures, a reduction in currency supply and severe debt deflation turned the recession into a depression that continued through the 1930s. Recessions and market collapses occur, but the Great Depression was such an imbedded, total economic collapse that singular causes cannot be found.
Instead, we must look at the initial triggers of the event -- and the ensuing response -- in order to understand how the unforeseeable is seen in hindsight.
More recently, we've managed to stave off a large-scale series of bank closures, though you'd be surprised at the number of banks that continue to fail each month. But just as in 1936, when the U.S. enacted strict monetary policies thought to relieve the economic crisis, we're at a belt-tightening crossroads of our own. And only by looking at our past mistakes can we hope to improve our response when history does, indeed, repeat itself.
[Learn more in the InvestingAnswers feature: U.S. Spenders vs. U.K. Savers: Who's Headed to Prosperity?]
[Photo: Great Depression statue at the FDR Memorial site in Washington, D.C. Courtesy of Tony.]
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Cached on May 18, 2012, 3:39 pm