The Roaring Twenties and the Great Depression

Overview

• 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

• 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

• 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=qu2uJWSZkck

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. The Board of Governors believed that many banks were unsound.

2. They wished to protect the value of the dollar by keeping interest rates high.

3. They wished to protect the nation against inflation which they thought was the main problem.