Causes of the great depression

A presentation I gave to an investment group on what caused the Great Depression.

1. Jee Manghani Causes of the Great Depression

2. What was the Great Depression? A deflation in asset and commodity prices Dramatic drops in demand and credit Contraction of the money supply Disruption of trade Widespread poverty and unemployment Generally agreed that it started in 1929 Lasted until 1942

3. First things first To understand why things collapsed in 1929, you have to understand the 1920s. And in order to understand the 1920s, you have to go back to the aftermath of World War One.

4. World War One During the war, European countries had to finance the expensive war. Most of the countries, including Germany, France, and England abandoned the gold standard. They also borrowed hefty sums of money from America.

5. Paying back their debts The Versailles Treaty forced Germany to repay the full cost of the war to Great Britain and France. (The original bill was 269 billion marks to be paid off by 1984. The allies reduced it to 132 billion marks. Full repayment of all debts will be finished in 2010) In turn, G.B. and France would pay their debts to the USA. None of these countries had the wealth to pay back their debts. Thus, the US let them borrow money to rebuild their industrial infrastructure, thereby increasing their debts. To help fuel this pipeline of repayments, the US helped to fuel a credit expansion in Germany, which made the repayment of debts to the US reliant on the US.

6. American Tariffs During WW1, American farmers enjoyed very healthy exports of food. After WW1, they suffered under over-expansion and many farmers struggled to stay solvent. European countries were trying to pay their debts by flooding the American market with their cheaper products. As a result, the Fordney-McCumber Tariff was passed, putting 38% tariffs on all imported goods. This actually encouraged Americans to buy American goods, creating a fairly health economy . However, this prolonged European recovery.

7. 1922-1925 America was in the growth phase of the economic cycle. America was enjoying steady but unspectacular growth as Americans bought American products. The DJIA went from 78.91 to 120.51 during these 6 years.

8. Returning to the Gold Standard Great Britain’s pound was the reserve currency of the world at the time. To return prestige to the pound, they wanted to return to the Gold Standard at pre-WWI convertibility. Gold reserves had been flowing out from England and into the US. Thus, there were too many pounds for each unit of gold, causing deflation as the excess pounds were being destroyed by the lack of backing. Increasing their already high interest rates would have decreased their corporate investment environment and increased their high unemployment.

9. Returning to the Gold Standard, continued Montagu Norman, head of the Bank of England, had an especially good relationship with Benjamin Strong, the head of the Federal Reserve. In late 1924, Strong lowered US interest rates in order to make US rates of return less attractive, while GB increased their rates. Gold started to flow into Great Britian , strengthening the pound.

10. Fuel to the Fire American interest rates dropped from 4.5% in 1924 to 3% in 1925 during a strong economic cycle. This encouraged more trading in the stock and commodities markets. This encouraged the growth of corporations and bankers extending credit to borrowers.

11. Fuel to the Fire, cont’d The “Roaring Twenties” went into overdrive as people who normally couldn’t afford cars, radios and electricity, were now getting loans to buy. Corporate profits continued to jump, as did the GDP. Optimism was unbridled as most people believed that the good times would never end.

12. Debt is a good thing? With credit being so cheap, corporations and bankers borrowed money and lent them out to the populace to finance a high standard of living. The rate of production and expansion increased rapidly to meet the growing demand, which was fueled mainly by debt. Banks took part in speculative investments in the stock market with their depositor’s money. Small investors “leapt giddily into the stock market in large numbers” with a margin requirement of 10% in the mid 1920s.

13. 1927 Great Britain was encountering more economic problems in returning to the gold standard. The Fed had increased rates in 1926 back to 4%, but cut them in late 1927 to 3.5% to help Great Britain. This set off the final frenzy of stock trading. The DJIA went from 156.41 to 200.7 in 1927.

14. 1928 In 1928, greater numbers of people jumped into the stock market as everything could only “go up”. The DJIA went from 200.7 to 300. The Federal Reserve was concerned about the mania on the market and raised interest rates fairly promptly after dropping them in 1927. By the summer of 1928, they were at 5%. Margin requirements were raised from 10% to 50% of the loan, although this was loosely followed.

15. 1929 By February, cracks were beginning to show in the economy. Inventories were piling up, leading to concern about consumer sentiment. Common sentiment was that the nation had reached a “permanent plateau of prosperity”. The DJIA continued to climb from 300 to a high of 381 September 3rd. The average P/E of the S&P was 32.6.

16. The Federal Reserve Moves Interest rates stay steady at 5% for most of 1929. In August, they raise it to 5.78%, and in September, to 6%.

17. Babson Break September 5 th , 1929, economist Roger Babson gave a speech saying that “ Sooner or later a crash is coming, and it may be terrific“. That day, the market fell 3% and the “smart money” realized fear was starting to creep into the markets. They started selling their positions. That day was to be known as the “Babson Break”, as it marked the start of the high volatility in the markets.

18. Black Thursday The decline from the Babson Break to Oct. 24 was 20%, after a series of rallies and drops. October 23, the market fell 6.3% in one day to 305.85, with a volume of 6 million shares, leading to panic the next day. October 24 was known as Black Thursday where a record 12.9 million shares were traded. However, the market dropped only 2% to 299.47 on that chaotic day. Around 1:30pm, the market was down from 312 to 277, as the NYSE Vice President, Richard Whitney came onto the floor and loudly bid for shares, causing a rally. The DOW ended up down only 2%. Friday, October 25 largely traded flat and many people thought that the worst was over.

19. Smoot-Hawley Tariff Act Weekend reporting on the stock market dropped caused a lot of alarm and concern as investors digested the news. More destructive, however was the news on the Smoot-Hawley Tariff Act on the same weekend. With the drop in economic output during 1929, Congress and Hoover were considering increasing tariffs on imports from 40% to 60%, to encourage Americans to prefer American goods. Most economists predicted that retaliatory tariffs would be raised by other countries, seriously damaging American exports, and frowned on this bill. 1,000 prominent economists sent a plea to the government to refrain from passing the bill. The weekend between Black Thursday and Black Tuesday, word leaked the Hoover would not veto Smoot-Hawley.

20. Black Monday and Tuesday Monday, October 28, based on the declines since September and the news of Smoot-Hawley, more investors got out of the market. A record loss of 13% on the DOW for that day, falling to 260.64. October 1929, 16.4 million shares were traded as the market fell another 12% to 230.

21. Hoover Steps In Hoover rejected Treasury Secretary Andrew Mellon’s “leave it alone” approach. In November, amid billions in losses for the average person, Hoover meets with business leaders. In the summit, he encouraged businesses to keep wages steady to keep consumer spending at elevated levels. However, the debts of many Americans had devastated their own finances. Many Americans lost a lot of money in the market and curtailed their own spending by over 10 %.

22. Consumers are Tapped Out Consumers also couldn’t not repay their debts, and their assets were repossessed. Ramped up over-production, dropping consumer demand along with repossessed collateral led to excessive inventories. Businesses could not keep their payrolls at the level Hoover requested while their revenues and the prices of their products were dropping.

23. DJIA Struggles for its Former Glory Bottom feeders came back into the market after the crash. Even though the over-rosy optimism was shattered, the general sentiment was that the market would self-correct. The DOW nearly hits 300 in May of 1930, a 50% gain. It was quite possible for quick recovery…

24. DJIA Struggles for its Former Glory 5. "Stock prices have reached what looks like a permanently high plateau .” – Irving Fisher, 10/17/29 7. "Hysteria has now disappeared from Wall Street." - The Times of London, November 2, 1929 9. "[1930 will be] a splendid employment year." - U.S. Dept. of Labor, New Year's Forecast, December 1929 15. "While the crash only took place six months ago, I am convinced we have now passed through the worst” - Hoover, 5/1/1930 Google: “Pompous Prognosticators”

25. Smoot-Hawley Passes! June 17, 1930, the excessive tariffs pass Hoover’s desk with a signature. Investors knew this would hurt the already struggling businesses as world trade would plummet. The DOW falls that month to from 275 to 226

26. America Stops Investing Overseas The engine that kept the world economy humming stopped as deficits in the US budget needed to be amended. Germany was hung out to dry, as American investment disappeared. Imports into America dropped precipitously with the new tariffs, and other economies start to struggle. Over the coming months, many countries by passing their own tariffs on American imports. World trade slows.

27. American Business Start Layoffs Combined with weak domestic demand and the retaliatory foreign tariffs, American businesses start laying off.

28. US Budget Deficits In 1930 and 1931, Hoover: 1) Increased subsidies to farmers 2) Created unemployment assistance . 3) Increased public works spending. 4) Created a series of organizations to help distressed Americans. The increased spending caused deficits, and Hoover agreed to the largest tax increase in American history. The top income earners saw their taxes jump from 25% to 63%.

29. Monetary Contraction During this time, fractional reserve banking was working in reverse as defaults increased. Credit was being destroyed faster than anyone thought. The tax increases inhibited investment as the risk outweighed post-tax rewards. The Fed dropped rates from 6% in Oct. ‘29 to 1.5% in mid 1931.

30. Bank Reserves Bank reserves were distressed due to defaulted loans. Banks also lost depositor cash by speculative trading. Dropping rates kept them solvent for some time, even though bank failures were climbing. Number of Bank Failures 1929 – 659 1930 – 1352 1931 – 1456

31. The Fed raises rates Concerns in 1931 about the dropping value of the dollar and inflation prompts the Fed to raise rates from 1.5% to over 3%.

32. Bank Failures The increase in rates cause bank balance sheets to worsen. Americans, having no insurance on their deposits, rush to withdraw at the same time. Banks usually carried 10-20% of deposits at any time. With the increased Fed funds rates, banks are unable to survive. Number of Bank Failures 1929 – 659 1930 – 1352 1931 – 1456 1932 – 2,294 1933 - 5190

33. The Perfect Storm Defaulting consumer debt, plummeting world trade, consumer fear, failing banks, and destroyed savings all combined to monetary contraction and deflation. Deflation caused falling wages, making it harder for them to service their debt, causing more defaults and more monetary contraction.

34. Schools of Thought Early theories – Overproduction and under-consumption. Money should be pumped into consumer pockets. Hoover and Roosevelt ascribed to this, however, most consumers put their money into repaying debts. Keynesian – Government should run deficits in times of trouble. The tax and fed rate increases caused the most problems. Moneterists – The fall in the money supply caused the Depression. The Fed should have increased liquidity, but didn’t reach far enough. Gold Standard – Pegging the currency rigidly to a fixed amount of gold tied the hands of the Fed. Austrian School – The credit bubble in the 1920s led to unsustainable boom in asset prices and capital goods.

35. Depression lasted until 1942 Despite some amount of recovery during FDR’s administration, a 2 nd severe recession occurred after his first term. The New Deal intended to help the average man at the expense of business, leading to high levels of unemployment. America didn’t pull out of the Depression until the over-supply of labor became soldiers and the need for productivity jumped for the war effort.