[Excerpt from: Foundations of Modern Economics by Lauren A. Whitmore (2004) — Oxford Academic Press, p. 487]
The American stock-market crash of 1929 provides one of the clearest historical examples of the relationship between asset prices, credit and economic confidence. It is important, however, not to understand the crash simply as a sudden disappearance of wealth. The more significant problem was that the financial system had become highly dependent upon continued increases in asset prices.
Black Tuesday is often remembered as though it were a single event: a spectacular collapse of share prices on the New York Stock Exchange which somehow transformed prosperity into depression almost overnight.
The crash was the visible explosion of a financial system that had spent much of the 1920s becoming increasingly dependent upon rising asset prices. By 1929, shares were not merely being purchased by wealthy investors. They were being purchased by clerks, shopkeepers, professionals and ordinary families who had come to believe that the stock market offered a relatively easy route to prosperity.
American investors were also increasingly purchasing shares using borrowed money. This practice, known as buying on margin, allowed an investor to control a much larger quantity of stock than his own savings would otherwise permit. The arrangement was highly profitable while prices were rising. It was considerably less forgiving when prices moved in the opposite direction.
The system was deceptively simple. An investor might purchase $10,000 worth of stock while providing only $2,000 of his own money. The remaining $8,000 was borrowed, usually against the shares themselves. If the stock rose to $12,000, the investor had apparently made $2,000 on an investment of only $2,000.
The return was therefore enormous.
The danger was equally enormous.
If the shares fell to $8,000, the investor's entire original stake had disappeared. If they fell below that figure, he did not merely possess an investment worth less than he had paid for it. He owed money.
This was the mechanism by which an apparently modest decline in the stock market could become a personal catastrophe. A twenty per cent fall in an unleveraged investment was unpleasant. A twenty per cent fall in a highly leveraged investment could be ruinous.
Consider the ordinary investor who purchased $10,000 of shares with $2,000 of his own money and $8,000 borrowed from a broker. If the market rose by twenty per cent, his shares became worth $12,000. After repaying the loan, he possessed $4,000. He had doubled his money. But if the market fell by twenty percent; those same shares became worth only $8,000. The entire $2,000 of his original capital had vanished.
And the broker still wanted his $8,000.
This was the fundamental misunderstanding of the late 1920s. The public had begun to regard a rise in the stock market as though it represented the creation of wealth. In reality, much of the apparent wealth existed only as a valuation.
So long as prices continued rising, the distinction was difficult to see. When prices stopped rising, it became impossible to ignore.
By the summer of 1929, the American economy was already showing signs of strain. Industrial production had begun to weaken. Construction was slowing. Automobile sales were no longer expanding at the extraordinary rate of the preceding years. Agricultural producers had been suffering from low prices for years, while consumer credit had expanded rapidly.
Yet the stock market continued upward. That created a dangerous psychological relationship because shares were rising and that meant investors believed the economy remained fundamentally strong.
Because investors believed the economy remained fundamentally strong, they continued purchasing shares. Because they continued purchasing shares, prices continued rising. The rise in prices was then interpreted as proof that the original belief had been correct.
It was a circle.
And like many circles in financial history, it could continue indefinitely only so long as nobody attempted to leave it.
By September, the first serious cracks appeared.
Prices became increasingly volatile. Several heavily traded shares began falling sharply. Investors who had purchased on margin received demands from their brokers for additional funds.
These demands were known as margin calls. A margin call was not a polite request to reconsider one's investment. It was a demand for money. If the investor could not provide it, the broker could sell the shares.
This created a second circle.
Falling prices produced margin calls.
Margin calls forced investors to sell.
Forced selling pushed prices lower.
Lower prices produced more margin calls.
More margin calls produced more selling.
On Thursday, the 24th of October, that mechanism began operating on a massive scale.
The volume of shares offered for sale overwhelmed the ability of buyers to absorb them. Prices fell violently. Panic spread through the financial district. Some companies' valuations would fall upwards of 90%.
Bankers attempted to restore confidence by purchasing large quantities of leading stocks, and for a brief period their intervention appeared successful.
It was not. The underlying problem had not been solved. Confidence had merely been postponed. The following week proved their efforts had been pointless.
On Monday, the 28th, the market suffered another extraordinary decline. The next day, the 29th, became known as Black Tuesday.
Millions of shares changed hands. Prices collapsed. Fortunes disappeared. But the most important losses were not necessarily those recorded by the wealthiest investors. The stock market was connected to the wider economy through credit. A wealthy investor could lose ten million dollars and remain wealthy. A shopkeeper who had borrowed $5,000 to speculate could lose his business. A bank holding loans against securities could suddenly discover that its collateral was worth far less than the amount it had lent. A company whose shares had fallen might find it impossible to raise new capital. And a family that had depended upon a bank that subsequently failed could discover that the money they believed they possessed was no longer available to them.
The crash therefore did not destroy the American economy in four days.
It damaged something almost as important.
Confidence.
Banks became more cautious. Businesses became more cautious. Consumers became more cautious. Investors became more cautious. And caution, when multiplied across an entire economy, can become contraction.
A businessman who feared falling sales postponed the construction of a new factory.
The contractor who lost the order dismissed workers.
The dismissed workers reduced their spending.
The shopkeeper consequently sold less.
The shopkeeper reduced his own orders.
The manufacturer then produced less.
Workers were dismissed again.
The process was self-reinforcing.
The crash had become an economic contraction.
The banking system made the contraction considerably worse.
Banks throughout the United States had spent the prosperous years of the 1920s making loans against securities, businesses and consumer purchases. When economic conditions deteriorated, borrowers struggled to repay them.
Some banks failed. Their customers lost access to deposits. Depositors, understandably frightened by the failures, withdrew money from other banks. Those withdrawals placed even healthy banks under pressure.
A bank did not need to be insolvent to fail.
It merely needed too many customers demanding their money at the same time.
By 1930 and 1931, the financial crisis had therefore escaped Wall Street.
It was now reaching Main Street. Factories closed. Wages fell. Unemployment rose.
Farmers, already struggling with depressed agricultural prices, were hit particularly hard. Mortgages that had appeared manageable during better years became impossible to service.
The American crisis also became an international crisis.
The United States was the world's largest creditor nation. American banks and investors had supplied enormous quantities of capital to Europe during the 1920s, particularly to Germany.
When American banks began calling in loans, European borrowers discovered that the money on which their economies depended could no longer be taken for granted.
German banks came under increasing pressure.
European industrial production weakened.
International trade contracted.
Countries responded by attempting to protect their domestic industries through tariffs and other restrictions. The result was an extraordinary decline in world trade. The Great Depression was therefore not simply the consequence of a stock market crash.
Had the financial system been less leveraged, had banks been stronger, had governments responded more aggressively, and had international trade remained open, the stock market collapse might have produced a severe recession rather than the deepest economic crisis in human history.
Instead, each weakness amplified the others. Falling share prices damaged banks. Bank failures reduced lending. Reduced lending damaged businesses. Business failures created unemployment. Unemployment reduced consumption. Reduced consumption damaged businesses further.
The international financial system then transmitted the contraction across the Atlantic. The world economy entered a downward spiral. The initial response of the American government was restrained.
President Calvin Coolidge had left office in March 1929, and Herbert Hoover inherited an economy whose underlying weaknesses had not yet become apparent on their full scale.
The Hoover administration initially believed that confidence could be restored through cooperation between government and business rather than through massive direct intervention.
This was not entirely unreasonable.
There was little precedent for an economic collapse of the scale that was developing.
The federal government possessed neither the institutional machinery nor the political consensus that would later characterise New Deal America.
Hoover therefore appealed to businesses to maintain wages where possible, encouraged private charity, supported voluntary cooperation between employers and workers, and sought to prevent unnecessary layoffs.
The philosophy was straightforward.
If businesses remained confident, employment would remain stable.
If employment remained stable, consumption would remain stable.
If consumption remained stable, the downturn would eventually correct itself.
The problem was that businesses could not be persuaded indefinitely to behave as though the economy were healthy when their customers were disappearing. By 1930, voluntary cooperation was proving insufficient. The government began moving towards more direct measures.
Public works were expanded.
Federal lending institutions were established.
The Reconstruction Finance Corporation, created in 1932, provided loans to banks and other financial institutions in an attempt to prevent further collapse.
But these measures arrived after the crisis had already become deeply entrenched.
There was another problem. The federal government was attempting to fight a collapsing economy while simultaneously maintaining confidence in the currency and public finances.
The result was hesitation.
Measures were introduced.
Then limited.
Then expanded.
Then reconsidered.
Meanwhile, unemployment continued rising.
The Smoot-Hawley Tariff of 1930 provided another example of how an intervention intended to protect the American economy could produce consequences beyond its immediate purpose. Higher tariffs were intended to shield American producers from foreign competition. Instead, other countries responded with restrictions of their own.
International trade suffered further.
The world economy became increasingly divided into protected national markets at precisely the moment when it most needed international demand.
By 1932, the United States was no longer experiencing a financial panic. It was experiencing an economic depression.
A panic can end when confidence returns. A depression creates the conditions under which confidence becomes difficult to recover. A man who has lost his savings cannot simply be told that prices will rise again. A factory that has closed cannot immediately reopen because interest rates have fallen. A bank whose depositors have lost faith cannot restore that faith through an announcement. And a family without work cannot increase its consumption merely because economists predict that recovery is approaching.
This was the central tragedy of the early Depression.
Every individual decision could be rational.
Every household attempted to spend less.
Every bank attempted to lend less.
Every businessman attempted to invest less.
Every investor attempted to preserve his remaining capital.
Yet when millions of people made those decisions simultaneously, the collective result was disastrous. The entire basis of capitalist economics makes it necessary for capital to move and suddenly everyone was not moving.
The American economy had entered a trap. The stock market had not created all of the weaknesses that produced the Great Depression, but it had exposed them.
The twenty per cent fall that ruined one investor was therefore only the smallest unit of a much larger disaster. Multiply that investor by millions, connect him to banks, businesses, workers and foreign governments, and the mathematics of the crash changed entirely.
The Great Depression was born not from one mistake, but from the interaction of many.
That was what made it so difficult to stop.
By the time governments fully understood what was happening, the crisis was no longer confined to Wall Street.
It was everywhere.