THE GREAT DEPRESSION

The great depression is the period known to us right after the oct 29th stock market crash of 1929 almost
until the end of WW2. It is the worst economic phase in the 19th century according to economists and
here is a brief summary about what really happened.

(I will talk about it briefly first, but since there are many things about economics the depression can
actually teach us- I will cover them separately after the summary)

The US experienced a huge boom in the stock market in the 1920s, wherein there was almost a growth
of 20% each year in the 5-6 years leading up to the 1929 crash. On September 3rd 1929, the DJIA- Dow
Jones Industrial average- was at 381- Margin trading (financial invention at that time), excess liquidity,
led to a lot of people heavily investing in the markets without their own funds and there was an overall
boom in confidence. However in 1929, fueled by a huge over valuation and also events in the UK market
(The Hatry case fraud), panicky investors liquidated their holdings on “black Thursday”- 24th October
1929. On Friday efforts to buy in helped the markets to rally a little but it was not enough- on Monday
and Tuesday- 28th and 29th October respectively, the markets crashed around 12% on both days,
cumulatively a 25% crash over the 2 days- the steepest so far in the history of the markets.

What followed was massive unemployment, starvation, Goof-ups by the fed, protectionist measures by
the Herbert Hoover administration, and a bottoming of the market in 1932 to 41. (From 381, to 41, in a
span of 4 years)- and this level of 381 was not to be seen till 1954 now.

Here is a glimpse of the market:

CAUSES

You must have all heard the term “asset bubble” and over valuation. Whenever the stocks are
representing a value which is too high (even after considering the future earning of those
companies), there is a bubble- and when this happens at an aggregate stock market level, it is
almost a market bubble.

This is what happened in the 1920s. reasons? A growing economy, increasing exports to Europe
(Europe was just recovering from WW1), spread of automobiles through out the country which gave
rise to more jobs and hence incomes, and most importantly easy money since people were trading
on HUGE margins (1:3). People were not basing decisions on the fundamentals of stocks, rather
they were basing it on the expectation that prices would increase- and they wanted to be a part of
the game. It had almost become a hobby. And since lot of companies were able to raise cash easily
from the stock markets, they invested into higher production capacities owing to a boost in the
optimism across the economy. But by 1929, this had reached unsustainable levels. Companies
were sitting on lot of excess inventory and were forced to sell their products at a loss- share prices
staggered and panic had set in- and the crash is what it resulted into.

WHAT HAPPENED AFTER THE CRASH?

• Unemployment rose to 25% (3% in 1929, 25%in 1933)

• Wages fell 42%
• Prices of items fell 10 % a year each year from 1929 to 1933
• Drought set in many places in USA
• By 1931-32, Europe was also heavily impacted
• The DJIA reached 41 dollars on 8 July 1932
WHAT STEPS WERE TAKEN POST THE CRASH AND ONCE THE DEPRESSION HAD BEGUN?

The role of the federal reserve

The fed was introduced in 1913. For over 8 years of its initial existence, it barely interfered. However
after WW1, it did introduce quite a few policies aiding monetary expansion and thereby injecting a
lot of liquidity (more than needed) into the economy. In a sense, by keeping reserve requirements
low, and interest rates low, it stimulated the economic rise of the 1920s leading to the overall crash.
However right after the crash, the FED resorted to becoming extremely restrictive and plugging out
(much needed) liquidity from the economy, choking essential hope for a quicker recovery.

The Fed’s reaction can be perhaps understood maybe since it did not want to rescue irresponsible
banks who were finding it hard to give back customers their fixed deposits

BANKS usually keep 10% reserves incase customers ask for their money- it assumes naturally that
everyone is not going to ask for their money at the same time- but when the market crashed in
1929- people ran amock and asked for their money back.

Anyway- The point to be noted here was the the Fed was a bit useless.

What did Herbert Hoover do, the then prime minister, as response to the crisis?

Contrary to criticism that he did not do anything,

• He increased federal spending by 42% into public development programs like the reconstruction
finance corporation
• He raised taxes
• Smoot-Hawley tariff act- extreme protectionist measures- it imposed massive duties on several
products hence restricting and completely minimizing international trade- which drastically
affected the economy- by 1934- trade declined by 66%

What did Franklin D Roosevelt do once he took over in 1933?

• The new deal: loosely based on Keynesian economics, He invested massively into public
spending programs- many infrastructure projects were undertaken which fueled
employment
• He abolished the GOLD STANDARD system- by doing so he was able to inject money into the
economy (The gold standard is a very interesting concept- and will be covered separately)
 • Farmers were paid to STOP production to avoid a drop in agricultural prices
• He instituted the glass- Steagall act- which separated investment banks from retail banks so
as to protect the people’s deposits

However, the measures- while they helped to instill confidence, were viewed as too less to actual
spark a recovery. Economists also say that, just like Herbert hoover, even Roosevelt tried to do too
much in too little time instead of the economy taking its course to recover.

It was also during this time that SEVERAL states in the USA were struggling with drought and famine, and
this highly exacerbated the situation.

So what finally gave in? How did the economy actually recover?

While some credit can be given to FDR’s new deal and other allied policies, many people credit WW2 as
having helped recover from recession.

By 1939, The WW2 was about to set in. Many economists credit the world war to have had a massive
positive impact on the economy and some say it was even the reason how the great depression
subsided- although it does seem like a broken window fallacy

As per Investopedia, The broken window fallacy is as below:

In Bastiat's tale, a boy breaks a window. The townspeople looking on decide that the boy has actually
done the community a service because his father will have to pay the town's glazier to replace the broken
pane. The glazier will then spend the extra money on something else, jump-starting the local economy.
The onlookers come to believe that breaking windows stimulates the economy.

Bastiat points out that further analysis exposes the fallacy. By forcing his father to pay for a window, the
boy has reduced his father's disposable income. His father will not be able to purchase new shoes or
some other luxury good. Thus, the broken window might help the glazier, but at the same time, it robs
other industries and reduces the amount spent on other goods.

Bastiat also noted that the townspeople should have regarded the broken window as a loss of some of
the town's real value.

Moreover, replacing something that has already been purchased represents a maintenance cost, not a
purchase of new goods, and maintenance doesn't stimulate production.

In short, Bastiat suggests that destruction doesn't pay in an economic sense.

There are many theories which suggest that it was due to WW2 that unemployment drastically fell,
thereby leading to a recovery, coupled with increase in war spending. Proponents of the broken window
fallacy and critics of Keynesian economics, however suggest that post the war the government actually
reduced taxes and spending, hence giving money in the hands of the public which fueled consumption.

However, how it actually happened still remains a mystery- for most people. Here’s our view:
The war might have actually helped bring down unemployment since lot of people actually did get
pulled off into the war itself, and not to mention into all the war-time related factories. This might have
helped the economy garner some momentum. But we also feel it was strongly because the natural
course of the economic cycle was allowed to take course- and that post the war, there was actually
more money in the hands of people who which boosted consumption in an optimistic post war scenario.
Additionally, the USA was recovering from the draught and the famine that had engulfed it in a pretty
miserable situation in the mid 1930s.

Many countries had also detached themselves from the GOLD standard in the 1930s- which helped
them to recover faster. One article I read actually states that the recovery of countries was strongly tied
to when they gave up the gold standard. (Britain’s economy actually recovered faster since it was one of
the first which gave it up in 1931- when it had run out of gold reserves owing to its over valued
currencies) France, USA, Switzerland etc came out of subsequently.

I did want to take out some time to write about how the GOLD STANDARD actually played a pretty big
role in transmitting the effects of this depression through out the world : you see, if the economies at
that were on a free floating mechanism, the impact could have been minimized and it may have not
been as severe as it actually was. But unfortunately in a gold standard- economies are heavily inter
linked.

So- what exactly is the GOLD standard and how does it actually work? And why was the gold standard
playing a role with the transmission of the depression?

The Gold standard is a fixed exchange rate system which pegs the value of a currency with certain
amount of gold. Eg. 1 dollar = 1.5 ounces of gold. This enables an economy to trade with other
economies in a fairly consistent manner. Suppose, the pound= 2 ounces of gold. Now if USA wanted to
trade with Britain, lets say the USA wanted to import a basket costing 8 pounds, and the british wanted
to import a basket from USA costing 12 dollars; Here is how the situation would play out. USA would
need to hand over 16 ounces of gold to Britain, and Britain would hand over 18 ounces of gold to USA. In
essence, Britain would run a deficit of gold since its import >export in terms of gold. And hence if this
sustained, Britain would actually run out of gold reserves over time.

Hence, it would need to intervene either by adjusting its interest rates ( it can lower interest rates-
leading to increase in money supply and reduced prices, and thereby boosting exports- therefore
restoring equilibrium) It can also wait for the economy to readjust itself ( if there is a gold deficit, money
supply will come down and hence exports will eventually become cheaper and boost the economy)

Here, we evaluate the interconnectedness economies have due to gold standard by the below graph:
In the context of the great depression and the World wars, Here is what we need to note. The gold
standard worked just fine- until WW1. It was temporarily suspended then since the countries had to
pump in money into the economy to sustain momentum. Since the GS allows you to print only a
LIMITED amount of money (that which can be backed by a particular ratio of gold reserves), economies
gave up the GS since they did not want this restriction and wanted to be freely available to pump
money. Excessive pumping of money led to differing levels of inflation in countries. Thus, when the war
was over and the Govt actually wanted to reinstate the gold standard, it did so but now the exchange
rates did not reflect the actual worth of currencies. Due to this, issues started to arise. For example, The
britains currency was over valued and Frances currency was undervalued. Hence France ran a BOP
surplus, and Britain, a deficit. Soon Britain had to give up the GS because it no longer had enough gold
reserves to sustain the deficit. It gave up the GS in 1931. Similarly, USA wanted to pump in more money
in 1933 into the economy, hence decided to give up the GS, and in doing so actually pegged the US
dollar at a higher currency to the gold (i.e- it devalued the dollar, with the objective of making its
exports more competitive)

WHAT CAN WE LEARN FROM THE GREAT DEPRESSION?

• A LOT is at stake when financial institutions are left loosely inspected

• Assets which form a bubble eventually WILL collapse
• Financial innovations like margin trading- need to be exercised with utmost caution
• Keynesian economics- the usefulness of the same definitely has been questioned and the great
depression is a big reminder that aimlessly pumping money into the economy may not help
• While war will simulate- it need not be looked upon as a savior of the economy
• There is a huge interconnectedness between the different countries- back then more so because
of the fixed exchange rate system, but now more so because of the globalized nature of our
economy and reliance on trade
• Some times, it may take more than 20 years for an economy to regain back to the same stock
levels, as was the case with the great depression
Links and resources used for reference

• Investopedia.com
• Thebalance.com
• Wikipedia.com
• Coursera.org
• Gold.org