By Patrick N. Allitt, Emory University
Economists and economic historians continue to debate the causes that led to the Great Depression. It’s really one of the great mysteries of American history. Why exactly did the Great Depression start? What was its connection to the Wall Street crash? Why did it persist so long? There are lots of answers to these questions, none of which is completely comprehensive or conclusive.
A Vicious Cycle
The downward spiral of the Depression tended to be self-perpetuating. It was a vicious circle. The more wage cuts and the more layoffs took place, the spending power shrunk even further. The demand shrank, which, in turn, made the incentives for manufacturers to make things less and made recovery that much more difficult.
Let us take a look at one of the reasons for this crash: the stock market.
This is a transcript from the video series A History of the United States, 2nd Edition.
Watch it now, on Wondrium.
Margin Trading in the Stock Market
In the late 1920s, stock market prices began to exceed real values, and various financial practices, which then were legal, encouraged reckless speculation. One of them was the creation of investment trusts. Another was called “buying on margin,” margin trading. A speculator who wanted to buy shares only had to come up with one-tenth of the asking price in order to buy them.
The broker would then keep the shares as collateral, and sell them to raise the money if the buyer was unable to meet demands made upon him.
The margin trading worked fine if the buyer of shares had gone into the market, not with the intention of holding on to these shares (so that from year to year he would be paid a dividend from the work of the company that was represented) instead he had bought them with the intention of selling them quickly as a speculation.
The value rose. He sold them, and he paid off the rest of the purchase price after the profits he had made. As long as the market was going up, margin trading worked fine.
The Temptation of Borrowing Money
The dividend rates paid by even the healthiest American corporations were rarely more than one or two or three percent per year. If you had to borrow money to buy the shares in the first place at eight or 10 or one percent, which was common by the late 1920s, you had very strong incentives to buy shares as a speculation rather than to hold on to them for the relatively low long-term dividends they would pay.
The Federal Reserve, which had been founded back in 1914 to manipulate the vagaries of the currency, encouraged an expansion of credit. They could have done much more to restrain speculation by making it more difficult to borrow money, but they didn’t. The Federal Reserve itself joined in, to some extent, with the effect that the stock market boom, the speculation boom, swelled.
More and more people get tempted in, with these stock booms, and respectable people were doing it. They thought they were being foolish for being contended with a one or two percent per year gain, when all around them, people were making a 50 or 60 percent gain. They felt that they were not making the most of their money. Perhaps they were being irresponsible to not to get into the market.
The End of the Swollen Boom
The Wall Street crash in the fall of 1929 ended the fantasy. There had been stock market crashes prior to the one in 1929. In each of those cases, the federal government’s policy had been to do nothing, but simply to let economic reality return. The strongest companies would survive because their shares were genuinely meritorious, and the weakest ones would go to the wall. There’d be a sort of shakeout of the economy, and economic realities would return.
A lot of experts and senior government officials, hoped that the Federal Reserve had done away with the irregularities of the business cycle. Anyone who had studied economic history knew that a boom and bust cycle was a familiar part of American capitalism, and that as more and more people were drawn into the market economy, these fluctuations tended to be more exaggerated. They hoped that they now had sufficient mechanisms to prevent a crash from recurring. It was a groundless confidence.
The Shocking Fall of the Stock Market
Actual economic growth in America stopped in about June of 1929. Stock prices stayed high for a while, but then began to fall very quickly on October 21. Disastrously, on October 24, 11 prominent financiers committed suicide because they’d been ruined. Even worse on October 29, 12 million shares were traded in a market where usually less than one million per day were sold. A massive volume for the times.
There are many misleading stories that every Tom, Dick, and Harry was investing in the late 1920s. The truth is, only about one percent of the entire American population was actually in the market, and that too it was the most influential one percent of the whole American population. They were the richest people in the USA whose opinions tended to have public consequences.
It was the disastrous losses of these rich people in those couple of weeks that had massive consequences for the whole economy, and for nearly everybody else in America.
Common Questions about the the Wall Street Crash and the Great Depression
The Federal Reserve encouraged an expansion of credit. They could have tried to restrain speculation by making it more difficult to borrow money, but they didn’t.
The people of America believed that the Federal Reserve had controlled the irregularities of the business cycle. They hoped that they now had sufficient mechanisms to prevent a crash.
The stock market in the USA had crashed many times before 1929. In each of those cases, the federal government’s policy had been to do nothing, but simply to let economic reality return.