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The Roaring Twenties and the Great
Depression
Overview
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Economic Freedom
Real economy
Financial economy
Alleged causes of the Great
Depression
• More likely causes
• Implications for today
Why Do Economies Grow?
• Sufficient amounts of
economic freedom that
allows people to confidently
invest in:
• Human capital
• Physical capital
• Use of natural resources
• Technological advances
The Key Ingredients
• The key ingredients of
economic freedom are:
– Personal choice
– Voluntary exchange
coordinated by markets
– Freedom to enter and
compete in markets
– Protection of persons
and their property from
aggression by others
• Economic freedom is
present when individuals
are permitted to choose for
themselves and engage in
voluntary transactions as
long as they do not harm
the person or property of
others.
Will the Real Economy Please Stand Up?
• We make a distinction
between the real economy
and the financial economy.
• Real economy =
human capital + physical
capital + natural resources
+ technological change
• Financial economy = Banks
+ other financial
institutions
When Institutions Work Well
• When institutions work
well, the real economy and
the financial economy
support each other.
• Individuals earn income and
spend and save.
• Businesses accept the
income and produce goods
and services.
• Governments imposes taxes
and spends revenue on
public goods.
• If the financial economy can
not provide adequate loans
(liquidity), the real economy
suffers.
• If the real economy does
not produce the goods and
services consumers desire
or is mislead by poor
government rules, then
both sides suffer.
The Real Roaring Economy
• Consumers shifted spending
into purchases of durable
goods.
– Cars
– Houses
• Consumers purchased new
household goods
– Radios
– Washing machines
– Refrigerators
The Real Roaring Economy in 1929
• In the 1920s,
unemployment was often
5% or below.
• GDP was rising.
• Between 1920 and 1929
homeownership doubled.
• Most home-owning families
enjoyed amenities such as
electric lights and flush
toilets.
• 60% of all households had
cars, up from 26%.
• More teenagers were
attending high school.
Weaknesses in the Real Economy
• Even though farm incomes
rose from their lows in
1921, they never regained
the levels of 1919.
• The share of agriculture in
the new economy was
fading.
• Construction of new homes
peaked in 1926; most who
wanted a home had one;
reduced immigration also
contributed to reduced
demand for housing.
Speculators
• A speculator is an investor
willing to take higher than
average risks.
• They “bet” on short term
movements of prices of
stocks or commodities.
• Speculators look for stocks
selling for unusually low
prices.
• They buy the stock in hopes
of reselling for profit.
Speculators
Good Guys
• Speculators signal an
undervalued part of a
market and may raise stock
prices.
• When speculators buy, it
may attract other investors
to a hot new industry.
• When speculators sell, it
may be an early warning of
weakness.
Bad Guys
• Speculators might be wrong
so their actions distort real
values.
• Excessive guessing results in
bubbles which eventually
“pop.”
• Speculators may follow
flawed investment practices
- - “greater fool theory.”
Was Stock Speculation Excessive in the
1920s?
No
• Most speculation was based
on identifying new
productive ventures.
• Rising stock prices were a
correct signal of good
investment choices.
Well…Maybe
• Some speculation was
based on the “greater fool”
theory fueled by margin
buying.
• But how high were prices
pushed - - some say stocks
were only overvalued by
30%.
Why Did a Mild Recession in 1929 Become
the Great Depression
• In the 1920s,
– Unemployment was low.
– The standard of living
was rising.
– More people owned
cars.
– More people owned
homes.
– New labor saving devices
were abundant.
– More teenagers were
attending high school.
Why Did a Mild Recession in 1929
Become the Great Depression
• By 1933…
– One fourth of the labor
forces was
unemployed.
– Families were losing
their homes and many
were going hungry.
– Adolescents who
should be in school
were riding around the
country in freight cars,
looking for jobs.
Why Did a Mild Recession in 1929 Become
the Great Depression
• What happened?
• The United States possessed the same productive resources in
the 1930s as it had in the 1920s.
• Great factories and productive machinery were still present.
• Workers had the same skills and were willing to work just as
hard.
• How could life have become so miserable for so many in such
a short period of time?
1920s
• Prosperity of the 1920s
was based largely on
purchases of homes and
cars.
• Toward the end of the
decade sales began to
decline.
End of the 1920s
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Machinery workers stand.
Car sales people stand.
Auto workers stand.
Steel workers stand.
Construction workers
stand.
Furniture sellers stand.
Furniture workers stand.
Clothing sellers stand.
Restaurant workers stand.
Grocery workers stand.
The Business Cycle
1929
• Normally, people start
buying again as they are
attracted to bargain prices
and as automobiles wear
out and incomes improve.
Expansion Begins Again
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Machinery workers sit.
Car sales people sit.
Auto workers sit.
Steel workers sit.
Construction workers sit.
Furniture sellers sit.
Furniture workers sit.
Clothing sellers sit.
Restaurant and grocery
workers sit.
• Grocery workers sit.
What Are the Alleged Causes of the
Great Depression?
• The Stock Market Crash of October
29, 1929
• Excessive borrowing to purchase
stocks and consumer goods
• Excessive competition leading to low
prices
• Overproduction of goods and
services
• Low farm prices and low wages,
leading to an uneven distribution of
income
So, why did a mild recession in 1929 become
the Great Depression of the 1930s?
The Great Depression
Causes of the Great Depression
• Failed monetary policy
– Raising interest rates in the
beginning of a recession.
– Failing to act as a lender of last
resort.
• Failed fiscal policy
– Raising taxes in a recession.
• Failed international trade policy
– Raising trade barriers
Lightening Review of the Fed
Conducting Monetary Policy
The Federal Reserve System has 3 traditional tools to
control inflation:
1. Sets reserve requirements for banks.
– Raise reserve requirement = reduce money supply
– Lower reserve requirement = increase money supply
Conducting Monetary Policy
2.
Sets the discount rate for members who borrow money
from the Fed.
– Banks can borrow funds to keep up their required
reserves is by taking a loan from the Fed Reserve at the
discount window.
– The discount rate is usually higher than the federal funds
rate.
– Raise discount rate = reduce money supply
– Lower discount rate = increase money supply
Conducting Monetary Policy
3.
Manages the Federal Open Market Committee (FOMC).
– The FOMC sets a target rate for the Federal Funds rate.
This is the rate for loans made from bank to bank.
– This is almost always what the media is referring to when
it says the Federal Reserve "changing interest rates".
– To increase the money supply, the Fed instructs the
Open Market Desk at the New York Fed to buy bonds to
try and hit the target rate.
– To decrease the money supply, the Fed instructs the
Open Market Desk at the New York Fed to sell bonds.
Interest Rates
• The world financial system that
emerged after World War I was
based upon the gold standard.
• The United was a safe haven for
gold.
• The United States and Great
Britain guaranteed that they
would exchange their currencies
for gold at a fixed rate ($20.67)
for an ounce of gold.
• Other major countries agreed to
exchange their currencies for
gold, dollars, or pounds.
Gold Standard and Interest Rates
• In 1927, several countries,
most notably Germany and
Austria, experienced serious
bank runs.
• To stabilize their currencies,
they exchanged their dollars
and pounds for gold.
• The United States
experienced a serious
outflow of gold.
• To encourage foreign
investors to buy American
investments and encourage
an inflow of gold, the
Federal Reserve raised
interest rates in 1929.
Interest Rates
• The Federal Reserve lowered
interest rates after a time, but in
1930 and 1931, when the
American economy had already
taken a downturn, more bank
runs occurred in many countries,
and again gold flowed out of the
United States.
• To keep gold in the United
States, the Federal Reserve
Banks again raised interest rates.
• Thus, the Fed kept interest rates
high in what was becoming a
deepening recession.
• Call it failed monetary policy,
Part I. It gets worse…
Smoot-Hawley Tariff
• In 1930 Congress approved
the Smoot-Hawley Tariff.
• It raised rates from 20% to
34% on agricultural
products.
• Tariffs were raised on 887
items.
• The number of items listed
as dutiable commodities
increased to 3,281.
Smoot-Hawley Tariff
• American farmers lost
nearly one third of their
markets.
• Farm prices plummeted.
• Thousands of farmers went
bankrupt.
• Rural banks failed in record
numbers.
• Trade partners such as
Germany (Weimar Republic)
were also hurt.
Banks Fail
Banks Fail
• http://www.youtube.com/watch?v=qu2uJWSZ
kck
Number of U.S. Banks Closing Temporarily
or Permanently, 1920-1933
Year
Number of Bank Closings
1920
168
1921
505
1922
367
1923
646
1924
775
1925
618
1926
976
1927
669
1928
499
1929
659
1930
1352
1931
2294
1932
1456
1933
4004
Money in Circulation
Year
Money in
Circulation*
1929
$26.2
1930
$25.1
1931
$23.5
1932
$20.2
1933
$19.2
*Currency plus bank deposits, in billions of dollars.
“We Did It.”
• The Fed failed to act as the
lender of last resort.
• Call it failed monetary policy,
Part II.
• In 2002, at Milton Friedman’s
90th birthday
• Ben Bernanke, then Federal
Reserve Board Governor, said:
“ I would like to say to Milton
and Anna: Regarding the
Great Depression, you were
right, we did it. We’re very
sorry. But thanks to you, we
won’t do it again.”
Failed Fiscal Policy: Revenue Act of 1932
• By 1932, federal revenues
had declined and spending
had increased.
• In 1932, Congress approved
and Hoover signed the
Revenue Act.
• It doubled the income tax.
– The lowest bracket went from
1.25% to 4%.
– The top bracket ($100,000)
went from 24% to 63%.
• Exemptions were lowered.
• Corporate and estate
taxes were raised.
• New gift, gasoline, and
auto taxes were imposed.
Causes of the Great Depression
• Failed monetary policy
– Raising interest rates in the
beginning of a recession.
– Failing to act as a lender of last
resort.
• Failed international trade policy
– Raising trade barriers
• Failed fiscal policy
– Raising taxes in a recession.
And We Have the Lessons Learned From the
Great Depression
Carefully consider those governmental policies
which distort incentives and create unintended
consequences with negative results:
Monetary
contraction of the
Great Depression
Era
Trade restrictions
(Smoot-Hawley
Tariff Act of 1930)
Tax increases
(Revenue Tax Act
of 1932)
Constant changes
in monetary and
fiscal policy
generates
uncertainty and
delays private
sector recovery.
Questions
The Fed
• The Federal Reserve System was created in 1913.
• The Fed has 4 parts
– Board of Governors (Washington D.C.)
– Federal Open Market Committee (FOMC)
– Reserve Banks (12 members)
– Member Banks
Why Did the Fed Fail to Act?
1.
2.
3.
The Board of Governors
believed that many banks
were unsound.
They wished to protect
the value of the dollar by
keeping interest rates
high.
They wished to protect
the nation against
inflation which they
thought was the main
problem.