Before You Begin

If you don’t know the background of this complicated story, you might want to first read a shorter version that introduces some of the key factors explaining the Crash and the Depression. See,

Introduction to the Stock Market Crash of 1929 and the Beginning of the Great Depression

Before reading this essay, I strongly recommend you see the PBS video on YouTube. Type in Stock Market Crash 1929. Look for US – The Crash of 1929 (PBS), ALLHISTORIES – PLAYLIST. 

Documentary broken into 6 parts to show commercials. Or buy the video on Amazon Prime. Great documentary with wonderful photos, videos, and scenes from movies of the 1920s and the crash. Shows what a crazy time it was.

The video is also a great introduction to Andrew Ross Sorkin, 1929:  Inside the Greatest Crash in Wall Street History – and How It Shattered a Nation. This book concentrates on the roles played by a small number of key men; the video also focuses on these men and their social environment.

The following quote that introduces this essay is from Mr. Sorkin’s book.

The stock market is a mirror whose function it is to provide an image of the underlying or fundamental situation. Cause and effect run from the economy to the stock market, never the reverse. An unstable economy can be disturbed by all kinds of incidents that on the surface appear extraneous.

    Jesse Livermore

    Famous stock market speculator 

INTRODUCTION

The usual reason given for the Great Depression – the stock market crash in October 1929 and the later collapse of the banking system – does not tell the whole story. Available economic data (there were no national income accounts in 1929) indicate that a recession had already begun before the stock market crash. The crash of October and November of 1929 was a catalyst that made the recession worse, but the partial stock market recovery in early 1930 did not end the recession. Industrial production continued to fall quickly and unemployment rose rapidly in 1930. As the economy sunk lower into depression and unemployment reached catastrophic heights, continuing farm and businesses failures over the next two years wiped out thousands of small rural banks and threatened total financial collapse in early 1933.  

For a fuller explanation, we have to go back to the 1920s to see additional reasons for the stock market crash of 1929 and the rapid decline in output at the beginning of the Great Depression. We have to look at the international financial situation and how it contributed to America’s depression, including the attempt after World War I to reestablish the pre-war gold standard.

Economic Growth in the 1920s:  Industrial Production and the Real Economy

There was a spectacular increase in industrial production starting in the 1870s and continuing into the 1920s. The 1920s were a decade of economic growth and development. The large increase in manufacturing output in this decade was driven by innovation in new and greatly expanding industries and companies.

The structure of the economy changed in the 1920s, with consequences for the stock market and financial markets in general. Industrial production, especially of large corporations, were a larger and more important part of the total economy. In contrast, agriculture stagnated in the 1920s. In 1920, agriculture accounted for 18% of Gross Domestic Product (GDP, a measure of total output); by 1929, agriculture’s share had fallen to 12%. 

The foundations of the new economic structure were corporations building large-scale manufacturing plants with electricity replacing steam as the power source, new steel machinery, lower transportation and information costs, increased productivity (output per worker), and lower unit cost.

The drivers of economic growth were the new and developing technologies.

• consumer durables, especially autos, electrical appliances, and radios. 
• electricity utilities.
• mass communication (phones) and entertainment (radios, phonographs, movies). 
• mass-produced consumer nondurables such cosmetics, toiletries, processed food, and cigarettes.

Steel was the basis for the new auto industry, modern machinery, and skyscrapers. The amount of railroad track increased eight times from 1870. Thousands of miles of paved roads were built in the 1920s. The telephone system became ubiquitous and transcontinental with an increase in transmission bandwidth.

The 1920s was a decade of economic growth and development but it was uneven. It began with a severe deflationary (prices going down) recession as the economy adjusted from the World War I wartime economy to a peacetime economy. Economic growth began in 1922. The stock market grew rapidly in 1922 and 1923, and kept growing until late in 1929. But in 1927 and 1928, the economy hardly grew at all. Growth for the two years was about 1% per year. One reason for the 1927 stagnation was the bursting of the Florida land boom bubble (in video). This bubble showed large numbers were willing to speculate on something they knew nothing about but thought they would get rich quick. (See Marx Brothers movie Cocoanuts. Groucho was wiped out by the market crash. The movie, ironically, was released in 1929.)

Another reason was the total shutdown of Ford in 1927. Henry Ford finally scrapped the Model T and retooled his plants to produce an entirely new auto. He laid off 60,000 workers. There were spillover effects on other major industries such as steel, tires, and glass. Full production was not reached until 1929.

But strong economic growth returned in 1929. The annual growth rate was 6%. Industrial output grew faster. This strong growth was led by increased production of autos, radios, electrical appliances, and new consumer goods.  

The economic expansion of 1921-1929 was based on the development of new technologies like radio and the expansion and sales of consumer durables like autos. The urban and regional buildout of the electric grid (and lower rates) led to demand for new electrical appliances and large productivity gains in mass production. Car ownership increased from about 7 million in 1919 to 27 million in 1929, on average about one car per household. This created demand for complementary products and services such as steel alloys, refined oil products, gas stations and mechanics, paved roads, and motels. 

Radio (RCA) and others went from selling hobby kits in 1919 to sales of $60 million in 1922 to sales of $426 million in 1929. (Figures on car and radio sales are from digital history.uh.edu, “The Consumer Economy and Mass Entertainment.”)

Auto production was an important part of the industrial economy in the years leading up to the stock market crash. The auto industry produced approximately 4 million cars in 1926, fell to 3.1 million in 1927 because of the Ford shutdown, recovered in 1928, and reached a record 5.4 million in 1929. 

Sales of these products was greatly enhanced by a large increase in consumer credit. General Motors started its own credit operation in 1919. Sears quickly followed by offering installment plans on appliances and other products. (Singer Sewing Machine Company started an installment payment plan in the 1800s.) Hundreds of new consumer credit companies were started in the 1920s. 

New industries were created or greatly expanded in new types of passive entertainment (movies and phonographs) and mass consumption products like packaged food, cigarettes, toiletries, and cosmetics. Marketing and advertising encouraged consumption.

Economic growth and industrial production helped to create and expand a new middle class including managers, engineers, accountants, and lawyers. So did the expansion of the financial sector. This middle class had rising income and savings. They provided many of the new speculators in stocks in the 1920s.

Industrial Corporations and Stock Markets

Starting in the late 1800s, new and rapidly-growing industrial corporations needed large amounts of investment and expansion capital, far more than what they could generate from internal cash flow. Capital was needed to take advantage of scalability (economies of scale).

The stock market, and the financial sector in general, had become increasingly important to the American economy during the 60 years leading up to the crash of 1929. In the 1920s, the financial sector doubled as a percent of the national economy. Its growth paralleled the financial requirements of new and growing companies. New, capital-intensive, large, and growing corporations needed investment capital far in excess of what company founders and rich backers could provide. The solution was the creation of the publicly financed, limited liability corporation. The canals starting in the 1820s, the railroads starting in the 1830s and then the industrial corporations starting in the 1870s issued stocks and bonds to the public to finance their capital requirements. In an expanding economy, investors could expect to collect dividends and watch their stocks appreciate in price.  

Equity capital (stock) had the advantage over bonds that the corporation was not obligated to buy back the securities. Or pay a fixed amount of interest. But investors were “locked-in.” This might have limited the attraction of equity investment except that investors in public companies could exit by selling their stock to others in “secondary” markets like the New York Stock Exchange (NYSE).

So large companies and stock exchanges were connected, complementary, and grew together.

The Stock Market Crash of 1929

In the 1920s, the “stock market” meant the New York Stock Exchange. This is where the shares of most large companies were bought and sold. 

The New York Stock Exchange was a private company, owned by its members. Until the 1920s, most stock traders were full-time professionals. There were no rules or laws. Traders lied, cheated, and deceived among themselves. In the 1920s, they could now also do this to naïve small investors. They viewed small investors as sheep to be shorn.

In 1929, there were 1,334 companies whose stock was traded on the New York Stock Exchange. This was a tiny percent of all the farms and businesses in America. But these were most of America’s largest companies. They accounted for much of the economic growth in the 1920s.

Many of the companies on the NYSE dominated their industries and markets. They had exhibited large increases in sales and profits over time, which led to high expectations for rapid future growth in company sales and profits.

The impression that “everyone” was playing the stock market is an exaggeration. By 1929, fewer than one out of ten families had money in the market. They were about half of all families with financial assets. Stocks, like consumer durables, were often bought on credit, or “margin,” by some of the speculators. About half of small investors bought on margin. Typically, the investors put up 10 – 20% of the value of the stock and borrowed the other 80 – 90% from the broker. The stock was collateral for the loan. The broker, in turn, borrowed the money from banks and other institutions with spare cash. Brokers’ loans (also known as “call money” because they were overnight loans and could be “called” in one day) increased  about $1 billion in 1920 to $4.4 billion in early 1928 to $8.5 billion in October 1929. 

About 80% of the brokers loans came from sources outside the banking system, including overseas, so Fed pressure on member banks not to make call loans had little effect. The loans seemed safe as long as the stock collateral increased in value. Interest rates were higher than alternative short-term loans.

Small investors leveraged their bets even more by using margin to buy stock in new investment trusts. Investment trusts were similar to today’s mutual funds except they were also leveraged – selling both shares to investors and floating bonds. Then leveraged investment trusts bought shares in other leveraged investment trusts. Alas, leverage also worked on the downside; owners of shares in investment trusts were wiped out even when the shares of the underlying companies still had some value.

The speculative bubble, when stock prices rose much faster than earnings and earnings per share, began in March 1928. As measured by the Dow Jones Industrial Average, stock prices doubled and reached an all-time high the day after Labor Day,  September 3, 1929. The Dow Jones index went from 200 to 390. The total value of stocks had gone from $25 billion to over $50 billion, in an economy of $100 billion.

By 1929, investors had high expectations about the percent increase in stock prices. Based on the yearly increases from the beginning of 1928 to September 29, conservative investors who paid cash and bought a diversified portfolio of stock like the Dow Jones index, expected returns of 50%/year. If they bought stock on 20% margin, they expected to make over 200% a year; on 10% margin, over 400% a year.

Investors who bought leveraged investment instruments like investment trusts with margin expected an even higher yearly return.

Speculators bet on companies like Radio (RCA). RCA was up 500% since beginning of 1928.

There were also short-term bets based on rumors about big pools of capital going into a stock. Often a big speculative pool started buying a stock. They paid for a lot of publicity, including bribing financial journalists to hype their stock. As more small speculators piled in, the pool started selling. Small investors were left holding a bag of stocks with rapidly falling prices. (See video)

While corporate profits were going up, stock prices were going up even faster. This led to record high stock price/earnings per share (P/E) ratios. This was viewed as an indication of rising confidence that the market would continue to go up. But the market’s P/E ratio would have to continue to rise if the market continued to go up at 50% a year.

The Dow Jones index reached its high on September 3, 1929. The market slowly declined for a few weeks and then crashed at the end of October. The market was down nearly 13% on Monday, October 28. The climax, in massive volume, was the next day, October 29 (Black Tuesday), when the market fell 12%. The total drop from its September high to the end of October was 40%.

By the end of November 1929, the stock market had fallen 50% and had wiped out all of the speculative gains since early 1928. In early 1930, it reversed direction and regained 40% of its 1929 losses. Volume was high. But in April commodity prices started to fall again. Industrial production continued to decline all through 1930. Unemployment rose quickly. The market turned down again. By late 1930, the stock market had fallen below its November 1929 lows.

The entry of large “pools” of outside speculative capital and small investors into the stock market was one reason for the bubble. This was something new; until the 1920s, stock market participation was an insider’s game of professional speculators. But now insiders and investment managers of outside capital could manipulate stock prices at the expense of small investors.

Partners of the largest investment banks, market analysts, government officials, congressional committee hearings, and Fed officials had private doubts or warned the public of the dangers of the “over-priced” market. But their messages were drowned out by reassuring and optimistic statements of market boosters like Charlie Mitchell of National City Bank who had done much to encourage margin buying by new small investors. Negative comments were ignored by speculators caught up in the frenzy. Instead, they listened to advisors like the foremost astrologer of the day, who predicted the market would go up forever. Presumably to the stars (see video).

The stock market crash of October 1929 did not come as a surprise to everyone. Some of the biggest speculators like Jesse Livormore and investment bankers like some of the partners at J.P. Morgan sold their positions before the crash. Livormore shorted the market (bet it would go down); when he came home on the worse day of the crash, he told his wife he had made more money that day than any other day in over 20 years of speculating. 

Before World War I, about a half a million shares were traded on a typical day. In 1928 and 1929, volume was rising rapidly, averaging about five million shares a day. On October 29, volume hit an all-time high of 16 million shares. Stock prices were on average six times higher than earlier in the 1920s, so that the combination of more speculators, and more of them acting like short-term traders, led to a huge increase in the dollar value of the stock market.

Investors’ and large speculators’ margin of 10%-20% was wiped out in just two days, October 28 and October 29. Margin calls for more cash went out; if not provided immediately, the broker tried to sell the underlying stock, increasing supply. Banks and other providers called their loans. All this led to a cascade of hitting stop-loss orders and more margin calls.  In the fall of 1929, about $2 billion of brokers’ loans were pulled out or wiped out.

Large investment pools, like the one controlled by Billy Durant (who put together General Motors and then drove it into bankruptcy), speculated on margin and also lost heavily in the stock market crash. When stock prices fell, they doubled down – buying more stock – only to see their losses increase. Durant personally lost $18 million. One of the richest men in America (on paper) in 1929, he never recovered and finally declared personal bankruptcy in 1936. Jesse Livermore, probably the most successful individual speculator in the 1920s, made a series of bad bets in the 1930s and committed suicide in 1940. 

The large, sharp decline in the stock market had an immediately negative impact on aggregate (total) demand, especially demand for consumer durables usually bought on credit and luxury goods and services. Expectations of rising personal wealth and a higher standard of living from rising stock prices were shattered.

After the bubble burst, the New York Fed reacted quickly. In the six months after the crash, the New York Fed injected $500 million of liquidity into the banking system. It cut its rediscount (loan) rate to banks from 6.0% to 2.5%. New York banks, in response, took over $1 billion in brokers’ loans. No major New York bank failed. The market rallied in the first half of 1930. It appeared the crash had been contained. It wasn’t.

It was not because of:

• the weaknesses in the American economy, especially the farm sector.
• the fragile international financial system, based on the gold standard, constructed after World War I.
• the fragmented American banking system watched over by passive regional Fed banks.
• the rising importance of the financial sector, and how it interacted with the real economy.

The Farm Economy

The period from the mid-1890s to 1918 has been called the “Golden Age of American Agriculture.” Expansion into new areas, rising demand from American and European urban areas and industry, rising prices, and World War I (large food exports to England) all led to prosperity for the farming sector. 

In addition to the usual seasonal loans, farmers went deeper in debt to expand acreage (the average size farm increased) and buy large amounts of new equipment, including tractors, to increase productivity and lower unit cost. They also bought new cars (mostly Model T Fords) with borrowed money. During this period, thousands of new banks were started in rural areas to finance this expansion.

Agriculture was still a major part of the economy. In 1920, the farm population was 30% of the total U.S. population.  Almost 50% of Americans lived on the farm or in towns with fewer than 2.500 people, many of them in rural areas dependent on agriculture.

The farm economy went into recession during the price deflation after World War I and remained stagnant during the 1920s. Farm prices fell in half after World War I and then slowly declined as American farmers lost their European markets. European demand fell because of the violence, chaos, and disruption caused by the war. 

Attempts by the Hoover Administration to stabilize farm prices through purchasing surpluses failed. In 1930, the market price of wheat fell in half.  Further large decreases after 1930 in farm prices and the “Dust Bowl” collapsed the agricultural sector, farmers defaulted on loans at a rate of 1,000 a day, resulting in the bankruptcy of thousands of small, rural banks. 

Eight rural states set up deposit insurance programs before and during the 1920s. All failed by 1929. Depositors (savers) were ruined along with the banks since there was no federal deposit insurance before 1933.

Large industrial corporations created and dominated markets. The raising of large amounts of financial capital fueled buying the more efficient capital equipment and industrial expansion. Large industrial companies employed factory workers, office workers and new types of professionals like engineers, chemists, accountants, and managers. Combined with the stagnation of the rural sector, America became an urban, industrialized society.

Investors in corporate stock did not always understand why stock prices were rising. Mass production processors and assemblers had high fixed costs in capital equipment. Some of it was financed with debt, creating financial leverage. Companies had to run at a high percent of rated capacity to make a profit. A small increase in sales (output) resulted in a leveraged increase in profit. Stock prices rose with rising profits; expectations of future increases in profits led to higher stock price to earnings (P/E) ratios, also increasing stock prices. This worked in reverse, starting in late 1929. Decreases in sales led to leveraged decreases in profits. Stock prices fell. Expectations of further decreases in profits lowered P/E ratios causing even lower stock prices.

Real incomes rose in the 1920s. But, like today, income and especially wealth was concentrated.

One estimate is that about one-third of all income was going to the top 5%. Sales of luxury goods and services soared. In contrast, farm families experienced a fall in total real income. 

Demand for many consumer durables was partly paid for with a large increase in consumer debt called installment loans (buy now, pay later). As an expanding urban middle class and working class financed their rising standards of living partly through increased borrowing, household debt rose faster than income. By 1929, about 60% of cars and 75% of all radios were bought on credit. (A top-of-the-line radio cost as much as the average cost of a car!) Total consumer debt doubled in just four years, going from $1.4 billion in 1925 to $3.0 billion in 1929. Hundreds of new banks and finance companies were started to provide consumer credit.

Home ownership financed by new forms of mortgage debt rose rapidly. Mortgage debt rose over eight times from 1920 to 1929. Hundreds of new “saving” banks were started to supply mortgages. 

Household balance sheets were leveraged with consumer debt and mortgages backed by illiquid assets as collateral that quickly lost market value starting in the fall of 1929. Even as savings were being wiped out, families still had to make installment and mortgage payments.

By October 1929, the economy was already in recession. Railroad car loadings and steel production had been falling since summer. The Fed’s Index of Industrial Production was also declining. Auto inventories were rising. But a general recession wasn’t recognized and declared until late in 1929. These numbers had little influence on analysts or investors.

1930

The recession was sudden and severe. Industrial production fell about 5% in October and another 5% in November. The contraction continued into 1930; industrial production fell another 30%. Unemployment doubled, from about 1.5 million (3% of the workforce) in the summer of 1929 to about 3 million (6%) in the spring of 1930, and then rose to about 5 million (10%) at the end of 1930. At least 25% of American families – a higher percent of non-farm families – were hit by unemployment sometime before the end of 1930. About half of the Great Depression’s total decrease in industrial production and about half of the increase in unemployment had already occurred by late 1930. Families experiencing unemployment couldn’t meet loan payments. (Most urban families were one-income families. Also, there wasn’t unemployment benefits like today.)

In 1930, farmers were hit with lower prices, the Dust Bowl (huge dust clouds), loss of deposits in local failed banks, and inability to make loan payments on equipment. Farmers started to lose their farms; banks foreclosed on about 100,000 farms in 1930. (See the movie and/or read the book about this – The Grapes of Wrath.) The Dust Bowl continued until 1940, helping to wipe out many more farmers (see PBS video on the Dust Bowl; the dust clouds are unbelievable).

Demand for consumer durables was especially hard hit. Car sales were 5.4 million in 1929, falling about one-third to 3.4 million in 1930. (At the bottom of the depression, auto production would fall by 90%.) Sales went from $3.5 billion in 1929 to $0.8 billion in 1932. Repossessed and used cars glutted the market. (Good for my grandfather; he bought a used truck in the 1930s for $30 to start a small business. The seller had to teach him how to drive.)

AFTER 1930 – A QUICK SUMMARYAs the Great Depression got worse, stock prices kept going down, about 5,000 more banks went under wiping out depositors, unemployment rose to catastrophic heights, families couldn’t meet loan payments and lost their houses and cars.Eventually, almost half of all mortgages were in default.When the worse was over, real GDP fell by about 25% and nominal GDP went from about $100 billion in 1929 to about $50 billion in 1932. In 1929, corporations made total profits of about $10 billion; in 1932, they lost about $3 billion. Business investment disappeared.The depression and consequent disappearance of corporate profits (earnings) had consequences for stock prices. Using valuation metrics like price/earnings (P/E) ratios, there was no support level, no bottom, for stock prices. The other support for stock prices – dividends – also fell drastically as profits disappeared. Trading volume fell, from an average around 10 million shares per day in October 1929 to around a half a million shares per day in 1932.By 1932, market indexes had fallen 80-90% from October 1929.The negative reinforcing feedback effects between the real economy and the financial sector created the Great Depression. Again, the size of the total economy was about $100 billion in 1929. Between 1929 and 1932, stocks (and stockholders) lost about $30-$40 billion in value. Total bank credit fell $20 billion.

WAGES AND PRICES

Wages and prices acted differently at the beginning of the Great Depression compared to earlier recessions. The Consumer Price Index (CPI) went down only 2.6% in 1930. Nominal (current dollar or money) wages in the large industrial corporations, and other large companies, stayed virtually constant in 1930. Industrial prices also did not decline. Instead, large manufacturing firms laid off employees and cut production, watching sales and profits plummet. Investment stopped, hurting the capital goods sector. The question all this raises is:  Why didn’t large companies quickly cut wage and prices, as in prior recessions?In a series of conferences in November and December 1929, President Herbert Hoover urged the leaders of the largest companies not to cut wages. Many corporate presidents agreed, including the presidents of General Motors, Ford, General Electric, Westinghouse, Standard Oil, U.S. Steel, Du Pont, Firestone, and Goodrich. The idea was that by not cutting the wages, and therefore income, of their workers, they were helping to limit the fall in overall (aggregate) demand. Keeping wages and thus prices high probably contributed to the large decreases in demand for consumer durables. As demand and output fell, these companies laid off workers, contributing to the rapid increase in unemployment. It was only in late 1930 and 1931 that large companies began cutting wages.In 1933, President Franklin Roosevelt had Congress pass the National Recovery Act (NRA), an economy-wide, mandatory version of President Hoover’s voluntary program.

FINANCING ECONOMIC GROWTH AND DEVELOPMENT IN THE 1920SThe financial sector as a whole was a growing part of the economy in the 1920s. Finance doubled as a share of GDP with most of the growth coming in the second half.The raising of large amounts of financial capital fueled the economic expansion, not just on the supply side but also on the demand side.An expanding urban middle class financed its rising standard of living partly through increased borrowing; household debt rose faster than income. In addition, mortgage debt rose rapidly. Household balance sheets were leveraged with debt backed by illiquid assets that quickly lost market value starting in the fall of 1929.The purchase of consumer durables such as autos, radios (some cost as much as cars), furniture, and some electrical appliances was usually financed with debt, often with money borrowed at the new consumer finance companies. Miss one payment and the product was repossessed. One of the largest banks that specialized in car loans, controlled by Henry Ford’s son Edsel, went under. 

THE AMERICAN BANKING SYSTEM AND THE FED

At the beginning of 1929, the United States had 25,000 banks. Most, about two-thirds, were outside the Federal Reserve System (the Fed). States and the federal government had passed laws to protect local banks from competition from larger banks by limiting the geographical reach of banks. The small rural banks depended on the health of the local farm economy. It should have been an alarm bell as thousands went under in the decade before the crash.Between 1929 and 1933, the U.S. banking system – unregulated, fragmented, without deposit insurance – went through waves of bankruptcies as farmers, businesses, and consumers defaulted. In the two years 1929 and 1930, about 10% in of the total number of banks failed. About a third of all banks would disappear during the Great Depression. Depositors lost their savings. Farmers and processors could not repay loans and small, local banks went under. Solvent farmers could not get credit to produce. Urban and suburban banks started to go bankrupt as consumers, local businesses, and homeowners defaulted on loans. At the depth of the depression, half of all mortgages were in default.

Why did not the Fed save the banking system from collapse?  One of the Fed’s powers was to be the “lender of last resort” to member banks. Banks in a liquidity squeeze could borrow at the rediscount window at the Fed banks. This was limited since one-third of banks were members of the Federal Reserve System. But they were the larger banks; smaller banks typically held part of their reserves at larger banks. As the economic crisis deepened, small, local banks began asking for their deposits at the larger banks. This reduced reserves at the larger banks which were not balanced by new liquidity from the Fed.

Through all this, the eleven regional Fed banks outside of New York and the governing board in Washington did virtually nothing. Controlled by local bankers and manufacturers, they did not believe it was their responsibility to save the banking system. Their governing boards limited the types of collateral they were willing to accept from borrowing banks at the discount window. They did not actively encourage local banks to apply for funds. The exception was the sixth regional located in Atlanta. They faced the first regional banking crisis and successfully contained it.  

This attitude of letting the economy and its banks to go to hell was shared by Andrew Mellon, Hoover’s Secretary of the Treasury, who believed a major recession was good for the health of the economy. (He was too busy adding to his fabulous art collection by secretly and illegally buying art from the Soviet Union, which needed hard currency to finance its spying operations. These paintings, taken from the Hermitage, are now in the National Gallery collection in Washington. The spies later stole America’s atomic bomb secrets.)

By the spring of 1933, the American banking system was near total collapse. Over half the states had declared a “bank holiday,” closing all the banks in their states to see which ones could be saved. This meant that depositors could not withdraw their savings. The new Roosevelt Administration’s first act in March 1933 was to declare a national bank holiday. Roosevelt’s second act was to take the United States off the gold standard. 

INTERNATIONAL ASPECTSIn the 1920s, New York had become the center of the global financial system. This was a consequence of World War I and its aftermath. During the war, England and France partly financed their war effort with substantial borrowing from New York banks. England and France could not borrow from the American government because Wilson was afraid isolationists could help defeat him for reelection in 1916. During the 1920s, Germany borrowed large sums from New York banks to restart its economy and pay war reparations to England and France.Central bankers and large investment banks spent the 1920s trying to rebuild the global financial system shattered by World War I. They saw the pre-war gold standard as a control mechanism to overcome the economic dislocation and instability caused by the war. The key, as they saw it, was to fix the value of national currencies in gold and thus, to each other. By 1929, almost all currencies, including the dollar, were on the gold standard. (In a bit of bad timing, Japan went on the gold standard in January 1930.)The gold standard depended critically on the pound sterling and London before the war, and the dollar and New York after the war. The New York Fed chairman (Benjamin Strong) worked closely with the chairman of the Bank of England (Montagu Norman) and other central bankers to coordinate policy, primarily changes in interest rates to influence currency and gold flows. Central banks and investment banks, mostly American, would also loan money to foreign governments to ease pressure on their currency. But America’s commitment to reforming the global financial system was limited. There were three major problems:1) Entente (Allies) war debts and German reparations. The Entente countries, including England and France, had borrowed over $10 billion in America to help finance the war. After the war, the Allies imposed reparations on Germany, payable mostly to England and France. These two countries relied on payments from Germany to meet the interest and principal payments on their debt to the United States. But the German economy had a hard time recovering from the war and taxing its people to raise reparation funds. Instead, Germany depended on borrowing from private banks in New York. Some of the funds would then go to London and Paris, to be cycled back to New York. Towards the end of the 1920s, more of the loans were short-term (“hot money”) rather than the usual long-term credits. The system functioned as long as American bankers were willing to lend to Germany, that is, to roll over rather than call short-term loans. 

2) England went back on the gold standard in 1925 at the pre-war parity. It overvalued the pound compared to other currencies. English exports were priced out of global markets; imports were relatively cheap. As a consequence, the English economy had a hard time recovering from the war, experiencing deflationary stagnation. England ran a trade surplus before the war but a trade deficit after the war. Defending sterling’s price in gold meant high interest rates to attract foreign funds, low economic growth, deflation (with pressure on wages), and high unemployment rates.

The New York Fed often changed American interest rates to accommodate the Bank of England’s attempts to deal with England’s economic and financial problems.

3) Central bankers would change interest rates to influence cross-country capital and gold movements. But changes in interest rates also affected domestic economies. Interest rates in New York were actually lowered at the beginning of the stock market boom to encourage money flows to England. But lowered rates also reduced the cost of call money and brokers’ loans to speculators, fueling the stock market bubble.Gold was also “high-powered” money, a part of the banking system’s reserves. An influx of gold allowed a country’s banking system to created money by creating new loans. Throughout the 1920s there was a net inflow of gold into the United States. American banks could increase the amount of loans to American consumers, stock market speculators, farmers, and corporations.

Just when it seemed the global financial system was stabilizing, it started to unwind. Germany went into recession in 1928. The head of Germany’s central bank threatened to stop paying reparations. Money flowed out of Germany. American bankers stopped expanding short-term loans to Germany. The American government refused to reduce Allied war debts; England and France could not reduce debt payments to private American banks. By 1929, Germany had reduced paying war reparations and the crucial cycle of American loans to Germany, German reparation payments to England and France, and their war debt payments to American banks began to unravel. American banks were now sitting on billions of dollars of bad loans. A delegation of American bankers went to Europe to renegotiate the repayment timetable of German reparations.
A slowdown in economic growth in the industrialized countries led to a large decrease in global commodity prices (inelastic demand). Countries that depended on commodity exports went into recession and were the first countries to leave the gold standard.

The U.S. economy went into recession and the stock market crashed. One consequence was that American banks started calling in German loans, deepening the German recession. There was a large and sudden increase in German unemployment. This contributed to the rise of Hitler and the Nazi Party, which received only 2.6% of the vote in 1928 but over 35% in 1930. The Nazi Party was the largest right-wing party, making it almost inevitable that Hitler would become Chancellor as conservatives tried to form an effective government to counter rising left-wing support. In office in January 1933, Hitler quickly renounced all reparations payments.


By 1931, the English government realized that England would not get out of long-term stagnation without eliminating the deflationary effects of the gold standard. England and 20 trading partners left the gold standard. The English pound sterling depreciated (went down in value) against the dollar, making America’s recovery more difficult.

THE GOLD STANDARD AND DOMESTIC POLICY

The Hoover Administration’s and the Fed’s commitment to the gold standard limited domestic policy options. Budget deficits, lower interest rates, or increasing the money supply through Fed lending to banks would have tempted foreign central banks and depositors to withdraw gold. This was one reason the Fed did not use gold as part of the monetary base to expand credit through its discount window. Another reason:  the Fed might lose gold and contracted credit would also happen if Americans used dollars to buy gold. This was legal until President Roosevelt took America off the gold standard in early 1933. 

The worsening recession and the gold standard led to deflation. Deflation led to the higher real cost of debt to borrowers, and then defaults as incomes and asset prices fell. The banking system weakened. Banks failures rose dramatically in 1931 and 1932. Seeing the deep recession and the weak financial sector, foreigners began pulling gold out in 1932. The Fed raised interest rates to keep the gold in the U.S. The Hoover Administration raised taxes to reduce deficits and signal “fiscal responsibility.” Again, by early 1933, the entire U.S. banking system was approaching total collapse.

THE SMOOT-HAWLEY ACT OF 1930

At the beginning of the Great Depression, Congress passed the Smoot-Hawley tariff bill of 1930 to protect farmers. Of course, everyone in Congress added their favorite worthy group of constituents who wanted protection. Tariffs went up to 60%. 1,000 economists, a rather conservative bunch in 1930, warned of the negative consequences of the bill.

The main target was Canada, America’s largest trading partner. The more anti-American party won the next Canadian election. 

Anti-American boycotts of American products started in Europe. American exports to Europe and Japan fell.

England walled off its Dominion countries and colonies from American imports; France and Holland did the same with their colonies. Since imports and exports were a small percent of the American economy, about 5% in total, the Smoot-Hawley tariff bill was probably not a major cause of the Great Depression. Both imports and exports fell by about $1 billion, so the Act had little net macroeconomic effect. But, on the margin, it probably contributed somewhat to the length and depth of the Great Depression. 

Tariffs and other barriers to trade reenforced America’s isolationism. To keep America out of the looming European war (on England’s and France’s side), a strong America First movement arose. Some of its members, including Charles Lindbergh and a future president of Yale, were pro-Hitler. The organization effectively disbanded in December, 1941.

A LONGER VIEW OF THE STOCK MARKET CRASH OF 1929

By the end of 1929, the Dow Jones Index was back to the beginning of 1928. It was only 17% lower than the beginning of 1929 – a year of above-average gains followed by larger losses. So any investor who bought stock for cash at the beginning of 1928 or earlier, was about even. Anyone bought stock at the beginning of 1929 was even by the end of the first quarter of 1930, before the market turned down again. Only speculators who bought stock on margin were wiped out. This included many large speculators. Of course, anyone who held their stock until the end of 1932 lost almost of the value anyway. And anyone who bought on “dips” between 1929 and 1932 lost money.

It is likely that many families who still had stock after 1929 were later forced to sell because of some combination of unemployment, lose of savings in a collapsed bank, and to meet installments on borrowings for consumption and maybe a mortgage on their home.

Anyone who bought at the top in September 1929 and held onto their shares had to wait until 1954 to break even.

Since 2000, there has been three market contractions of similar magnitude to October 1929. The last two could have led to a prolong depression. But they didn’t. The difference is that the federal government stepped in with massive fiscal stimulus and support for failing companies.

SUMMARYIt is a mistake to see the stock market as separate from the rest of the economy. It was part of the financial sector, which greatly expanded in the 1920s and became a more important part of the economy. The financial sector helped finance the economic growth and new products of the 1920s, especially demand for the new consumer durables. Gains from the stock market helped to finance the flamboyant life-style of a small percentage of consumers, symbolized when wealthy Americans on luxury trans-Atlantic steamers could radio their brokers in New York with stock orders. The boom in buying consumer durables and housing was made possible by the expansion of consumer loans and home mortgages. Increases in consumption and consumer loans were tied together. In contrast, small local banks were tied to the stagnant, leveraged agricultural sector. Although the bottom of the Great Depression came over three years after the start, over half the fall in output and real income occurred in the first year, by the end of 1930. This was a large and rapid decline. The stock market crash was a catalyst; it accelerated the decline in income, wealth and the demand for goods and services through feedback effects between the financial sector and the real economy.The stock market crash of 1929 was not the only reason for the depression. Many of the systemic risks were due to global and domestic problems caused by the First World War and its aftermath. There were continuous feedback effects between the real sector and the financial sector. What changed was the size and importance of the American financial sector – as an international lender, as a raiser of capital, as a provider of household credit, as a seller of financial instruments. 

The continuous feedback effects also help explain why the depression lasted so long and was so deep. Waves of bank failures, loss of savings and assets, lack of the Fed’s responsibility as “lender of last resort” all contributed to lengthening the depression and making the recovery difficult

Many of the government recovery programs of the Hoover Administration and the early Roosevelt Administration were substitutes for a financial sector that had ceased to function.  

The American economy in the 1920s became not only larger but also more complex. There were more “fault lines.” Recent studies of “complex adaptive systems” indicate they can go from seemingly stable to unstable very quickly. New potential fault lines were added in the 1920s – stock market speculation,  agricultural stagnation and debt, consumer durables bought with loans, and America’s involvement in international finance. 

The structure (including rules and lack of rules) of the financial sector when the crisis hit was important. The banking structure and much of the rest of the financial markets had not adjusted to the economic changes of the 1920s. Fragmented domestic banking, the gold standard, lack of information and analysis, absence of oversight, and widespread manipulation and fraud all contributed to a financial sector that was ill-prepared to handle the stresses beginning in 1929. Changing the rules – increasing the confidence of depositors, borrowers and investors – was an important part of the New Deal.The depression was made worse by the antiquated mentalities of those in power. They were faced with the instabilities and dislocations of an international financial system radically changed by World War I. Their response was to revert back to the rigidity and deflationary pressure of the gold standard. American officials and the three Republican presidents in the 1920srefused to decrease Allied war debt, a necessary condition to stabilize the international financial system. In America, an increasingly industrialized, mass consumption economy fueled by financial capital and consumer debt depended on a fragmented banking system of small, local banks designed for a decentralized agrarian economy. Fed and government officials strongly believed in market competition and laissez-faire, which was ill-suited to an economy dominated by large, mass production corporations and a greatly expanded financial sector.

CONCLUSION

The real economy was growing rapidly, probably around 6% in 1929. This growth rate was unsustainable. Part of it was because of pent-up demand for autos; many consumers had waited for Ford to get back to full production. There was a big increase in the purchase of autos and other consumer durables during this period. A high percent of consumer durables were bought on credit.Rising domestic optimism was behind the big increases in both output and the stock market. Employment levels were high. This optimism is hard to quantify but it was pervasive outside of some rural districts. (See video)Recessions start with an unexpected shock. They are often outside of economic models used at the time of the shock. In 1929, the stock market decline was mostly independent of the real economy recession. In 1930, stock market recovered 40% in first quarter, indicating investors believed the decline was a “correction” and stock prices were cheap. But the real economy continued its rapid deterioration. When recognized, investors realized their optimism was misplaced and the stock market turned down again. The recession of 1930 does not show up in financial figures except for the stock market and more than the usual number of small banks failing. As the buying of consumer durables and other mass-produced consumer products declined, profits fell. Investment in manufacturing declined, as the reason for increasing capacity disappeared. The government did not make up any of the loss of income in 1930 through welfare programs or fiscal deficits. (Even during the 1930s, Roosevelt’s budget deficits were much smaller than the decline in private incomes and corporate investment. A misguided policy to balance the budget in 1937 led to a severe recession that wiped much of the output and employment gains of the prior four years.)The structure of the economy had fundamentally changed since the last depression that occurred in the 1890s. New economic and financial fault lines appeared in both rural and industrial America. The situation was made more dangerous as the global economy struggled to recover from World War I and its chaotic aftermath. Only the New York Fed and large New York banks worried about international instability and its possible consequences. Eventualy, all Americans would become aware of the consequences of post-WWI overseas problems, the stock market crash of 1929, and the beginning of the Great Depression in 1930. On December 7, 1941.

======================================================The best introduction to the 1920s and the stock market crash is Frederick Lewis Allen, Only Yesterday; An Informal History of the 1920’s. This is a wonderful popular history of the 1920s and the crash. It shows how the economic, social, and psychological changes in the 1920s contributed to the speculative frenzy in the stock market. Allen lived through it all. You can skip some of the chapters the first time through; for example, skip Chapters III, VI, IX, And X.If all of this seems complicated and confusing (it is), you might want to see a summary:

Introduction to the Stock Market Crash of 1929 and the Start of the Great Depression

For a look at the similarities and differences between the stock market falls in 1929 and 2020 (written in 2021), see

The Stock Market:  Party Like It’s 1929! For a (hopefully humorous) explanation of the 2007-08 financial crisis, seeExplaining Derivatives – An Analogy
AMERICAN ECONOMIC HISTORY
The Beginning of the Industrial Revolution in America
How America Industrialized and Became Wealth
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