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The Great Depression - Why It Lasted 18 Years

The Great Gatsby showed the 1920's as a carefree time, a time of wealth and decadance, and vacuum cleaners.

This doesn't tell the whole story though. That narrative was short-lived and the other-side of the 20's is much darker. One where the economy collapsed, millions lost their jobs and the aftermath left 1 in 4 people unemployed.

But the government could have done more to prevent The Great Depression. We're going to look at the causes and the mistakes made. How the gold standard prolonged the recovery and why prohibition contributed to the collapse.

10 years before, the US was at war and the whole country united to support troops on front line. It led to domestic shortages but everyone was happy to play their part. Even if it meant higher prices.

But then the war ended, and prices didn't go down. The public wanted pay-rises inline with the higher cost of living. There were meetings between union leaders and company execs, but negotiations went nowhere. Workers snapped. And by 1920, nearly 4000 separate strikes had taken place with around 4,500,000 people involved.

Despite the conflict, the labor market did pick up towards the end of the year and the roaring 20's were a time of huge optimism. Innovation was at an all time high. Machines increased output on farms, mines and in factories. It was the age of mass production. Household chores were easier too, as washing machines and hoovers became mainstream.

At the same time, the federal government was operating at a surplus and paying off debt. The country was flying.

But post war inflation was high. $100 in 1920 was worth less than 90, in real terms, a year later. Inflation was destroying public confidence in the dollar as savings were being eroded.

The lure of high returns on the stock market was ever more tempting.

Between 1921 and 1929, the cost of borrowing remained around 4-6% while yearly returns on the Dow Jones returns could be as high as 50.

Borrowing at 5% to make 50% enticed many to take out loans for stock market investments. And it was not only professional investors pouring money in, it was families too.

Everyone wanted to get involved. People were remortgaging houses, using savings and hunting down any spare cash they could find.

New brokerage houses made it easier too. Especially for those with minimal funds. They introduced margin investing to the masses. A buyer would put down 10% and the other 90 would come from the broker.

Investing on margin can lead to huge gains but the swing can go both ways. If that happens, losses can exceed your initial investment. Many first time investors do not realise this.

You have less control of this type of investment too. Brokers can force you to sell by issuing a margin call. If the value of your investments drops too low and you can’t prop it up with more funds you will be forced into a sale, regardless of the current market price.

Despite the risks, money started flooding in and stock prices shot up. Valuations exceeded any realistic expectation of future profit. And before long the cracks began to show. Key market indicators like house building and steel production were down. But stock prices continued to rise.

The bubble burst on October 29th 1929, a date which has become known as Black Friday. Confidence ran out, prices crashed and demand dried up. Investors were stuck holding portfolios worth a fraction of what they were the day before.

Huge numbers of margin calls were issued as brokers tried to recover the money they had lent out. But this further increased supply and only added to the problem. Over the next three years, the Dow Jones dropped by 80%.

Banks were in trouble too. They had a similar problem to the brokers. A lot of their clients were penniless from the crash and left unable to repay loans too. But the banks had one more issue. Many believed their bank might collapse so decided to take their money out. These withdrawals were so widespread that a lot banks ran out of money.

The government decided to let them fail with a survival-of-the-fittest mentality. But this strategy hit small banks hard. Over the next 4 years, more than 10,000 banks collapsed. And with every closure, many families would lose their life savings.

Protectionism

The government did try to step in, in some cases though. In 1930, they tried to shelter businesses from foreign competition. The Smoot-Hawley Tariffs introduced massive levies on imported goods. If imports were more expensive, more people would buy from domestic businesses, right?

Before the act passed, prominent economists warned the government on the potential repercussions. They didn't listen and as soon as the act passed, retaliatory tariffs were placed on US goods by many of the worlds largest economies.

International trade stagnated and Smoot and Hawley's ideas became so unpopular that they both lost their seats in next election cycle.

Roosevelt replaced the protectionist policies with the 1934 Reciprocal Trade agreements act. It reduced tariffs to fair levels and stimulated foreign trade.

Oversupply

Oversupply played a huge role too and it affected many industries.

Farmers had purchased more land when food prices and demand was high. This additional land combined with improved machinery led to huge harvests. Supply was abundant and it began to drive prices down. The problem wasn't helped by Prohibition either. With alcohol banned, the prices for the wheat and barley used to create it, fell to record lows. A lot of farmers who had bought additional land during the boom were forced into foreclosure or selling it off at a loss.

Agriculture was not the only industry affected through oversupply. Other industries had invested in new equipment that allowed them to mass produce too.

Industries like car manufacturing had a lot of production capacity but consumers could no longer afford them. Many companies found out they were not profitable when operating at lower volume. It led to products being sold at a loss to recover some money for payroll or loan repayments.

The was compounded by the federal reserve increasing interest rates to try and curb the amount of speculative investments being made. This did slow down the number of risky investments but it also curbed sensible investments too. It also deterred companies from taking loans to invest in their own growth or cover payroll.

Oversupply and limiting lending meant growth stalled. Mass layoffs in the early 1930's led to a peak unemployment rate of 25% in 1933.

Gold Standard

The gold standard played a role too. The value of the dollar in the early 20th century was linked to the price of gold. The central bank legally had to hold 40% of its issued currency in gold. This rule limited the production of new currency.

And when panic set in, everyone began buying and hoarding gold. The central bank's supply diminished and their issuance problems deepened.

The government attempted to combat the gold shortage with Executive order 6102. It required all citizens to trade in their gold at an exchange rate of 20.67 dollars per troy ounce. If you didn't comply, you could be imprisoned for up to 10 years or fined up to $10,000 ($200,000 in today's money!). It became illegal to own gold!

And this wasn't the end of the government's gold drive. In 1934 the Gold Reserve Act ordered Federal banks to offer up their gold to the Treasury. They received gold certificates in return, which allowed them to continue lending.

A separate clause in the Gold Reserve Act changed the price of gold from 20 to 35 dollars per troy ounce. This price increase, led to a huge influx of gold from abroad. Finally, the government had enough reserves to inject money into the economy.

So when did the depression end?

It is easy to look at the surge in jobs caused by the second world war and say that's when the depression ended. But there was no guarantee that the economy wouldn't just nosedive after. It would only be if the economy was stable without war that you can say it is really out of the depression.

The Keynesian view was that a drop in troop needs and government spending would sink the economy straight after.

Instead the government lowered taxes and removed pricing restrictions. This created huge incentives for private enterprise and after a short recession, companies were able to drive the economy forward.

Household spending grew and private investment increased despite a decrease in government spending.

For these reasons 1947 is when The Great Depression ended. It is when the economy started growing with little need for government intervention.

The depression lasted 18 difficult years and it has defined economic policy ever since. The lessons learned have helped manage more recent crises, and it is the only positive from an otherwise miserable period.


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