Setting Great Depression Mythology Straight Part I: Prelude to Black Tuesday

During times of economic uncertainty, proponents of big government cite the New Deal as the model by which government should control the economy. Many misconceptions endure about the causes of the Great Depression as well as the fiscal, monetary and public policies that many people believe ended it. History teachers teach high school and college students that greedy investors and big business caused the stock market crash of 1929 and that President Roosevelt’s New Deal ended the greatest economic depression of the twentieth century. A consequence of such misguided education is that people assume that government intervention is necessary during economic downturns. Or, for those on the left, that the federal government should control the economy all the time.

An economic investigation of the Great Depression, however, reveals that the Federal Reserve and the federal government contributed to the casual factors of Black Tuesday and the economic downturn. The federal government’s unprecedented expansion and control of the economy following Black Tuesday prolonged economic recovery and kept unemployment high throughout the depression. Federal entities not only created the atmosphere in which investors accelerated investment but the United States’ monetary and foreign policies contracted the money supply and hurt businesses and banks in the private sector prior to Black Tuesday.

Leftists argue that only the free market, real estate speculators and Wall Street investors caused the stock market crash of 1929 and the subsequent depression.  As Gene Smiley illustrated in Rethinking the Great Depression, however, the stock market crash was precipitated by complex global events beginning with Germany’s post-World War I reparations to allied nations. Germany was forced to repay allied nations for war debt which led to hyperinflation its economy in 1922-23. The strongest currency at the time was the US dollar so the US lent money to Germany, other European countries and Central and South American countries. The US, in effect, became the foundation for the international economy.

Complicating matters further, the international community returned to a gold standard in 1925 but the supply of gold was too low to support the pre-WWI prices to which most countries wanted to return. The US dollar and Britain’s pound were the stabilizing currencies under the gold standard. Britain’s pound was overvalued, though, so US investors invested in British assets which stabilized the pound and the gold standard. Investment in British assets increased the money supply in the US and contributed to the economic boom of the second half of the 1920s. The system worked as long as countries maintained static exchange rates, did not experience deflation and the US was able to lend money to the international community.

The Great Depression was a global event that did not begin in the US. In 1927, the economy in Southeast Asia began to contract. Germany’s economy began a downturn that year as well and went into depression in 1928. Brazil suffered the same fate. In 1929, the economies of Poland, Argentina, Canada and the US contracted.  In 1927, the economic environment caused some countries to begin deflationary protectionist policies causing instability for the gold standard as they maintained or expanded their gold reserves.

To stem international gold flows, the Federal Reserve reduced the discount rate, which is the interest rate at which banks borrow short-term funds from the Federal Reserve, to 3.5 percent—which made money easier to obtain and subsequently increased investment in the stock market. Gold outflows from the US accelerated. In 1928, the inflated stock market and diminishing gold reserves prompted the Federal Reserve to incrementally increase the discount rate to six percent by August 1929. US interest rates increased and gold flowed back into the US. Gold also flowed into France at a high rate as it strengthened its gold reserves. Other countries increased interest rates as well to prevent their gold reserves from decreasing. The gold standard caused countries to pursue deflationary policies to stabilize prices and economies.

In the US, the Federal Reserve’s deflationary monetary policies decreased the money supply causing downturns in output, employment and income and increased pressure on banks. Although bank failures had persisted throughout the 1920s, the monetary contraction in 1929 accelerated runs on banks as demand for cash increased while the money supply decreased.

Banks operated under a fractional reserve system whereby they kept a fraction of their deposits and loaned the rest to generate income. When a massive number of depositors sought to withdraw their funds, many banks did not have enough gold and cash in their reserves to fulfill their obligations. When banks called in loans, borrowers did not have the resources to repay the loans. Banks also had difficulty selling loans. Therefore, banks that could not support massive withdrawals failed.

Most of the failed banks were in states that had unit banking regulations. Unit banking decreased competition as large banks were prevented from opening branches in small communities and small banks could not expand. Local banks were confined to small areas, typically a town, which prevented them from diversifying their loans and depositor sources. When a local economy contracted, the local bank failed leaving the community without a stable bank. Canada did not have a unit banking system and it did not experience a single bank failure during the depression.

As the banking system collapsed and the money supply decreased businesses could not afford to maintain production levels or retain employees. President Hoover believed that if businesses did not lay off employees and they maintained wages the economy would rebound. So, President Hoover’s response to the monetary contraction, the slumping economy and Black Tuesday was a plan that forced businesses to retain employees at their pre-monetary contraction wages or shut down. Businesses could not maintain their workforce so many of them shut down. President Hoover also began a series of federal spending programs intended to boost the economy, which will be discussed in next month’s A Line of Sight.

As one investigates the stock market crash of October 29, 1929, one realizes that the notion that only the free market system, big business and investors failed simply is not true. The Federal Reserve and the federal government contributed to Black Tuesday. The Federal Reserve reacted to the federal government’s role as the anchor of the international gold standard. In turn, the federal government’s fiscal and public policy responses made things a lot worse for the American public.