The Great Depression

The Great Depression

The Great Depression is one of the most widely studied and critiqued financial meltdowns in economic history. What began with the stock market crash of October 1929 turned into a severe worldwide economic depression that led to a decade of high unemployment, widespread poverty, and significant disruptions in both domestic and global financial systems. The depression was widespread hitting sectors from agriculture and manufacturing to banking and trade. Millions were plunged into economic hardship and poverty altering the course of thousands of families, often for the worse. Governments struggled to tame the downturn which led to significant changes in economic policies and theories. The Great Depression also lingered well past its time and is cited as one of the reasons that led to extremist movements and influenced the trajectory of World War II. In this edition of the Narwhal Blog Post, we continue our series of economic downturns with the Great Depression to understand the causes, impacts, and responses to the Great Depression.

In 2002, Ben Bernanke said the following: “Regarding the Great Depression, … we did it. We’re very sorry. … We won’t do it again.”[1]. A true failure on all levels, what began as a stock market crash soon turned into a monstrosity that provides valuable lessons for the future. The Depression lasted a decade consisting of a series of events beginning with the stock market crash of 1929. But to begin, we’re going to look a bit further back in time to set the stage for what led to the greatest economic meltdown in U.S. history.

The roaring twenties were loud and the stock market during the 20’s roared even louder. Share prices in major U.S. indexes rose to unprecedented heights with the Dow Jones Industrial Average increasing from 63 points in August of 1921 to 381 in September 1929[2]. The financial boom occurred during a time when World War I had concluded, and optimism was at fever pitch. Technological innovations such as the automobile and telephone drastically changed the lives of people who began to invest larger sums of money in stocks and bonds. A new wave of margin investing took hold and ordinary men and women began to use borrowed money to invest into the markets causing stock prices to soar.

The Federal Reserve began to be spooked by this speculative buying and soon the New York branch of the Federal Reserve raised their discount rate to 6%. The Fed’s action forced foreign central banks to raise their own rates and this tight-money policy pushed foreign economies into recessions resulting in a slowdown in the international economy. Although stock prices continue to rise this was on the back of further speculation and sure enough, volatility began to ensue. Confidence in the financial markets began to waver and efforts by bankers ultimately failed as the market began to crash. Men and women lost their life savings, demand collapsed, and unemployment began to rise. The contraction that began in the summer of 1929 continued and panic spread as the markets crashed in October of that year. On Black Monday (October 28, 1929), the stock market Dow Jones fell 13% and on the following day Black Tuesday, the Dow Jones fell almost 12%.

In 1930, the dynamics of the banking industry were quite different than what they are today. There were roughly 8,000 commercial banks belonging to the Federal Reserve System but about 16,000 were not under the Federal Reserve System. These 16,000 banks operated in an environment like the time before the advent of the Federal Reserve which was founded in 1913. At the time many banks counted checks in the process of collection as “cash reserves”. The checks were counted on both banks, the one in which the check was deposited and the one from where it was drawn. In reality, the cash was only in one bank at any given time. These “reserves” grew exponentially peaking before the financial crisis in 1930. These errors were spotlighted by the collapse of Caldwell & Company. Caldwell was a large financial services conglomerate and after bad investments in securities, its banking subsidiaries began to close their doors in the Southeast leading to a widespread panic across the country. As panic spread across the country, banking runs ensued resulting in hundreds of small banks shutting down. Most of these banks never recovered and opened back up. The panic began to ease in December of that year, but fears continued to simmer.

In New York, a failed merger attempt for the Bank of United States (4th largest bank in New York City) resulted in it ceasing operations as well. This event like the collapse of Caldwell caused mass panic across the nation once again resulting in more bank runs. The banking crisis eventually paved the way for deflation as it led to bankers accumulating reserves and the public to hoard its remaining cash sinking demand for goods and services. Between 1930 and 1932, the nation saw four periods of extended banking panics resulting in bank customers simultaneously attempting to withdraw their cash. By 1933, roughly 20% of the banks that existed in 1930 had collapsed leading to newly minted United States President Franklin D Roosevelt to initiate a four-day “bank holiday” to stabilize the banking industry. Due to the failures of many banks, consequentially there was a reduction in consumer spending and investment as there was a smaller number of banks able to lend money. Additionally, as the public began to hoard cash, the money supply began to become scarcer.

The weakening demand for goods and services, brought by cash hoarding and lack of investment/lending pressured many businesses throughout the country. Industrial production in the United States fell north of 40% as demand neared its trough. The wholesale price index fell 33% and due to the weak demand, many businesses engaged in layoffs to mitigate cost as profits were shrinking. It is widely accepted that during the depression, unemployment exceeded 20% at its peak (see figure below).

[1] https://www.federalreservehist...

[2] https://www.federalreservehist...

Today, there is a debate amongst economists regarding the gold standard’s effect on the Great Depression. Some economists believe the tightening of the money supply led the by the Federal Reserve was in part due to the preservation of the Gold Standard. Under the gold standard, each country set the value of its currency to gold and its monetary actions thus were to defend the “set price”. Whether the gold standard played a role in limiting monetary policy domestically, there is little doubt the gold standard played a vital role in turning the depression into a global issue.

To better understand the effects of gold turning the depression global, we must understand how the gold standard worked. The gold standard was a monetary system where the value of a country’s currency was directly linked to gold. Countries essentially agreed to settle international trade using gold, hence the title “gold standard”. Nations that carried a trade surplus saw increases in their gold reverse and nations who faced deficits in trade, faced declining gold reserves.

Dominoes began to fall, with the British for example returning to the gold standard after WWI, but given the aftermath of WWI, the pound was overvalued leading to further trade deficits and gold outflows in the late 20’s and early 30’s. The Bank of England raised interest rates to curb the outflows reducing British consumer spending and increasing the unemployment rate. Once the U.S. economy began to contract, the inflow of gold into the United States began to expand dramatically as deflation in the United States made American goods attractive to foreigners. Domestically, the deflation led to lower income American families spending less on imported goods. To counteract the inflow of gold into the United States, central banks across the globe increased their interest rates. In order to maintain the gold standard, there was a large-scale global monetary contraction that began to resemble the dire economic situation in the United States.

As the depression turned global, a wave of currency devaluations and monetary expansion began stimulating economies. Devaluation allowed countries to expand monetary supply for example in the United States, during the period of monetary expansion in early 1933 increased about 42% during a 4-year span. The monetary expansion was helped by the significant gold inflows during the 30’s partially led by investors flooding gold into the United States, as Europe began bracing for WWII. The expansion brought forth inflation instead of deflation, giving borrowers confidence their wages would rise. This began to ease consumer fears and borrowing began to pick up. Although many give credit to President Roosevelt’s New Deal having helped the consumer, it did little to help expand the overall economy. The debate about the New Deal’s impact on the economic recovery is still widely debated today.

The Great Depression stands as one of the most pivotal moments in American history. Today, central bankers still draw lessons from this era. For instance, Ben Bernanke, as Chairman of the Federal Reserve, applied insights from his research on the Great Depression to implement a policy of stimulus that differed significantly from the early, more restrictive approaches of that time. This shift in policy helped contain the Financial Crisis. Moreover, the actions of tightening monetary policy, which are now seen as mistakes during the Great Depression, underscore the era's critical lessons. Some argue that the Great Depression also contributed to the rise of extremism and fascism in Europe, which was a leading cause of World War II. In summary, while the Great Depression remains a dark chapter in history, it was also a crucial period from which vital lessons were learned—lessons that continue to inform efforts to prevent a recession from spiraling into a depression.