Download Economic Background to the Great Depression

Socials 11
Ms. Matthews
THE GREAT DEPRESSION: ECONOMIC BACKGROUND
Modern industrialized technology requires vast amounts of machinery, huge
factories, and stores of finished and unfinished materials, all of which make up a
particular kind of wealth called capital, or capital goods.
Such goods are devoted to the production of other goods. Since, in American
society, capital goods are primarily the private property of individuals, called capitalists,
the American economic system is called capitalism.
In modern capitalistic society, the vast amounts of money needed to finance the
purchase of capital goods are obtained largely through the selling of shares of stock in
corporation. The stock is sold to the public through an investment banker, whose
business is to help companies raise money. As long as the economy is healthy, as long as
businesses are operating profitably, and as long as people are confident about the future
of business, enough of them will willingly risk their savings in a variety of new or
established business ventures to keep this process going. If something happens to shatter
this confidence, people become afraid to risk their money and the economy is in trouble.
Never before or since has the country experienced anything so wrenching as what
started on “Black Tuesday”, the day of the great stock market crash of 1929. On that day,
stock prices plunged, and during the next three years most people had no money left for
investment. How did this happen? Let us begin to answer this question by examining
why the stock market crashed.
During the early 1920’s, stock prices were low, and the dividends, the money paid
to shareholders, were good. Then in May, 1924, stock prices began to rise, gong from an
average of $106 for twenty-five industrial stocks to an average of $116 by December
1926. In 1927, the rise accelerated. By the end of December, the average price of the
twenty-five industrial stocks was $245, a rise within one year equal to that of the previous
two-and-a-half years.
The rise in stock prices was partly due to events abroad. The United States had
been on the gold standard since 1879. In 1927, Great Britain and many other countries
returned to the gold standard. This meant that the value of most currencies was fixed in
terms of gold. In Britain, in 1927, prices were much higher than they had been at the
beginning of World War I. Logically, then, it should have taken more British pounds to
purchase an ounce of gold in 1927 than it had taken in 1914. But the British government
assigned the pound he same gold value it had in 1914.
Britain, in relation to the rest of the world, was now a very unattractive country in
which to buy. As a result, the British sold less abroad than they bought, paying out the
difference in gold. By 1927, the flow of gold from London was so great and Britain’s
gold reserves were depleting so rapidly that it seemed Britain would soon by unable to
pay its foreign creditors in gold and would be forced off the gold standard. With gold in
such short supply, it also appeared that businesses would be unable to get enough money
to operate and that the whole British economy might come to a standstill. The U.S.
government was concerned over Britain’s financial plight. To help ease Britain’s
problem, the U.S. Federal Reserve System agreed to lower American interest rates. The
intention was to encourage people to borrow money at low interest rates in New
York….and send it to the other world financial center, London, where it would earn a
high rate of interest.
The arrangement succeeded in encouraging a flow of gold from New York, where
there was a surplus, to London, where there was a need. But the arrangement also
encouraged banks that belonged to the Federal Reserve System to borrow from one of the
nine Federal Reserve Banks and then lend the money at attractively low interest rates to
the American people. People tend to borrow when they are optimistic about the
economy, when they believe that business will get better and better, that stock prices will
rise, and that a great deal of money can be made by borrowing a little.
To keep the money flowing the securities market allows what is called margin
purchasing. In the late 1920’s, for example, people could borrow up to 90 percent of the
purchase price of stocks. This meant that if a share of stock cost $100, a buyer would
need to spend only $10 of his own money. His broker lent him the remaining $90. The
broker charged the buyer perhaps 10 percent interest, having borrowed it at 7 percent
interest from a commercial bank which borrowed it from a Federal Reserve Bank at 5
percent.
As long as the market prices of stocks rose, everyone involved profited. If the
market value rose from, say, $100 to $150 a share, the purchaser could, by selling,
recover his $10, repay the $90 loan plus interest and broker’s fees, and make a profit of
about $45 – or 450 percent on his $10 investment. The prospect of such easy riches was
irresistible to many people. The real worth of the company whose stock they bought was
of no concern, nor was the value of its products, the size of its earnings, or the amount of
its dividends. Since the prospect for riches was so fantastic, brokers an commercial
banks found that speculators would willingly pay higher interest rates to be able to
borrow the dollars that would make them rich.
As interest rates rose, many corporations saw that they could make more money
by lending their surplus funds for speculation than they could make by expanding plants
and producing more goods. And from London, Paris, Warsaw, Bombay, Shanghai –
from all over the world – gold poured into New York in search of the high interest to be
earned from fuelling the stock market boom. By March, 1929, just as \Herbert Hoover
was taking office as President, there were people who wondered when the bubble would
burst. The government did nothing, largely because the Secretary of the Treasury Mellon
didn’t believe that the government should interfere in the workings of the economy…and
the governing board of the Federal Reserve System balanced nervously between feeling
that something ought to be done and fearing that whatever it might do might cause the
financial structure to topple.
In the 1920’s, the desire to get rich quick led people to look beyond the stocks of
the large, established companies, such as Westinghouse, General Electric, Du Pont, RCA
and General Motors. Many people bought the high-risk issues of new, unknown
companies, some of which had produced nothing and existed only to offer their stock for
sale to an unsuspecting public. By the end of the twenties, one-third of all such issues
were handled by the investment trusts. For a fee, they seemed to offer the small investor
the great benefits of expert management and diversification – the opportunity to spread
one’s few dollars among the stocks of several companies. In the late twenties, most
investment trusts issued their own stock – the value of which often bore little or no
relation to the assets of the trust.
One of the most famous investment trusts was Goldman Sachs Trading
Corporation, founded in December, 1928, at which time its stock sold at $104 a share.
By February 2, 1929,the price had risen to $136.50, and on February 7 it was at $222.50.
At this time the total market value of all Goldman Sachs stock was about twice that of all
the real assets owned by Goldman Sachs. One reason the price was so high was that
Goldman Sachs was buying up its own stock, forcing up the price and building a
speculative balloon of its own. But such manipulation was common during the late
twenties.
On September 3, 1929, the great bull market reached its highest point, with the
average price of twenty-five industrial stocks at $452. On Thursday, Oct. 24, a number
of stock owners – perhaps feeling that the market was due for a drop – decided to sell.
By 11:30, the panic was on. Prices plunged, and the rumour spread that stocks were
selling for nothing. At noon, a group of leading New York bankers met in the offices of
J.P. Morgan and Company and decided to buy over $200 million worth of stocks in an
effort to shore up the market. In New York, they succeeded in restoring a measure of
optimism. Nevertheless, at the day’s end, $3billion had been stripped from the market
value of stocks listed on the New York Stock Exchange. Most of this loss was borne by
small investors, most of whom were wiped out.
To many people, the worst seemed over. In New York and in many other cities,
exchanges closed until Monday to give clerks time to catch up on the paper work
resulting from the record sales. On Monday morning, New York newspapers carried ads
by brokerage houses urging people to pick up bargains. But when the market opened,
there was a huge backlog of sell orders from people across the country, and throughout
the day the prices fell. In addition, banks and corporations had started calling in loans
they had made to brokers, and brokers, in an effort to repay the loans, were forced to send
out margin call after margin call – telling stockholders to put up more money or lose their
stocks.
Tuesday October 29 was the worst day in market history. On the New York
Stock Exchange, 16.5 million shares were sold as dumping forced prices lower, and
lower prices brought more dumping. Many well-to-do investors were stripped of cash in
an effort to stave off disaster, and many professional speculators, with no cash to spare,
were ruined.
How did all this come to be followed by a serious business depression? A
popular scapegoat at the time was the so-called business cycle, which apparently rose and
fell for its own mysterious reasons. Another common explanation was that the economy
needed a rest after the hectic activity of the twenties. There were a host of other
explanations, all partly true and all insufficient in themselves: the problems of farmers,
the revolution in transportation, dishonest activities by banks and investment trusts, tariff
policies. Believers in the iron law of supply and demand argued that the supply of goods
had outstripped demand. But there was no evidence that the needs and wants of the
majority of Americans had been satisfied.
During the twenties, most Americans did not earn enough to buy the new
consumer goods being produced. For example, between 1919 and 1929, industrial output
rose 43 percent, substantially increasing profits, but wages were raised only slightly.
This uneven distribution of income was one of the major ailments of the 1920’s
economy. One-third of all income went to only one-twentieth of the population.
Anything that shut off the spending of this tiny minority was felt immediately throughout
the economy. And, when the crash stripped them of cash, they quit spending. By
November 1929, department store sales were dropping and industrial production was
plunging.
This drop in production soon exposed another weakness in the economy – the
holding company. A holding company was nothing more than a financial arrangement
whereby a small group of people, with a relatively small amount of money, could control
a large number of companies producing for public consumption. To create its vast
empire, a holding company bought enough stock in each of the operating companies to
give it control. The money was obtained by borrowing, which meant that interest had to
paid periodically and the loans themselves had to be repaid as they fell due. As long as
the holding company received an income in the form of dividends from its operating
companies, it could meet its obligations.
But if this income was shut off, the holding company would be forced into
bankruptcy and the business empire it controlled would fall apart. So when consumer
buying, industrial output, and the earnings of operating companies fell, a vicious circle
set in for the entire economy. To keep dividends flowing, the holding company stopped
its operating companies from spending on new plants and equipment and slashed their
other expenses, including wages. Each cut in capital spending removed that much money
– that much purchasing power – from the economy and brought further drops in
consumer spending, industrial output, corporate earnings, and capital spending.
The second and most disastrous phase of the Depression was ushered in by the
collapse of Europe’s financial structure. For several years, Germany and Austria had
been borrowing heavily to pay World War I debts. France, which had financed many of
the loans, demanded payment in March 1931. Germany and Austria appealed to the U.S.
and Britain for help….but meanwhile Austria’s largest bank failed. In June, President
Hoover proposed a year’s moratorium on all debts between governments, including
reparations payments. Britain and Germany quickly agreed, but France waited. As each
country tried to stave off bankruptcy for itself, turmoil ensued. Within six months, the
entire international monetary system had collapsed, trade between nations was at a
standstill, and Europe was hit by a severe depression.
The repercussions in the U.S. were immediate and devastating. Before the crisis,
Europeans had large sums on deposit in American banks. Now, they demanded
repayment. The American banks were forced to call in loans to meet European demands.
This sudden credit squeeze set off a wave of fear, and Americans began hoarding cash
and gold. To get back as much money as they could, Europeans began selling their
American stocks, which caused another slump in the stock market. By the late summer
of 1932, it seemed that American capitalism might not be able to survive the financial
crisis. While many people at the time regarded Franklin D. Roosevelt’s policies as
socialistic, the prevailing opinion in retrospect is that capitalism in the United States may
well owe its survival to the New Deal.