A presentation I gave to an investment group on what caused the Great Depression.

1. J E E M A N G H A N I
Causes of the Great Depression

2. What was the Great Depression?
 A deflation in asset and
commodity prices
 Dramatic drops in demand
and credit
 Contraction of the money
supply
 Disruption of trade
 Widespread poverty and
unemployment
 Generally agreed that it
started in 1929
 Lasted until 1942

3. First things first
 To understand why things
collapsed in 1929, you have to
understand the 1920s.
 And in order to understand the
1920s, you have to go back to
the aftermath of World War
One.

4. World War One
 During the war, European countries had to finance
the expensive war.
 Most of the countries, including Germany, France,
and England abandoned the gold standard.
 They also borrowed hefty sums of money from
America.

5. Paying back their debts
 The Versailles Treaty forced Germany to repay the full cost of the war to Great
Britain and France.
 (The original bill was 269 billion marks to be paid off by 1984. The allies reduced it
to 132 billion marks. Full repayment of all debts will be finished in 2010)
 In turn, G.B. and France would pay their debts to the USA.
 None of these countries had the wealth to pay back their debts. Thus, the US let
them borrow money to rebuild their industrial infrastructure, thereby increasing
their debts.
 To help fuel this pipeline of repayments, the US helped to fuel a credit expansion in
Germany, which made the repayment of debts to the US reliant on the US.

6. American Tariffs
 During WW1, American farmers enjoyed very healthy
exports of food.
 After WW1, they suffered under over-expansion and
many farmers struggled to stay solvent.
 European countries were trying to pay their debts by
flooding the American market with their cheaper
products.
 As a result, the Fordney-McCumber Tariff was
passed, putting 38% tariffs on all imported goods.
 This actually encouraged Americans to buy American
goods, creating a fairly health economy.
 However, this prolonged European recovery.

7. 1922-1925
 America was in the growth phase of the economic
cycle.
 America was enjoying steady but unspectacular
growth as Americans bought American products.
 The DJIA went from 78.91 to 120.51 during these 6
years.

8. Returning to the Gold Standard
 Great Britain’s pound was the reserve currency of
the world at the time. To return prestige to the
pound, they wanted to return to the Gold Standard
at pre-WWI convertibility.
 Gold reserves had been flowing out from England
and into the US. Thus, there were too many pounds
for each unit of gold, causing deflation as the excess
pounds were being destroyed by the lack of backing.
 Increasing their already high interest rates would
have decreased their corporate investment
environment and increased their high
unemployment.

9. Returning to the Gold Standard,
continued
 Montagu Norman, head of the Bank of England, had
an especially good relationship with Benjamin
Strong, the head of the Federal Reserve.
 In late 1924, Strong lowered US interest rates in
order to make US rates of return less attractive,
while GB increased their rates.
 Gold started to flow into Great Britian, strengthening
the pound.

10. Fuel to the Fire
 American interest rates
dropped from 4.5% in 1924 to
3% in 1925 during a strong
economic cycle.
 This encouraged more trading
in the stock and commodities
markets.
 This encouraged the growth
of corporations and bankers
extending credit to borrowers.

11. Fuel to the Fire, cont’d
 The “Roaring Twenties”
went into overdrive as
people who normally
couldn’t afford cars,
radios and electricity,
were now getting loans to
buy.
 Corporate profits
continued to jump, as did
the GDP.
 Optimism was unbridled
as most people believed
that the good times would
never end.

12. Debt is a good thing?
 With credit being so cheap, corporations and
bankers borrowed money and lent them out to the
populace to finance a high standard of living.
 The rate of production and expansion increased
rapidly to meet the growing demand, which was
fueled mainly by debt.
 Banks took part in speculative investments in the
stock market with their depositor’s money.
 Small investors “leapt giddily into the stock market
in large numbers” with a margin requirement of 10%
in the mid 1920s.

13. 1927
 Great Britain was encountering
more economic problems in
returning to the gold standard.
 The Fed had increased rates in
1926 back to 4%, but cut them in
late 1927 to 3.5% to help Great
Britain.
 This set off the final frenzy of
stock trading.
 The DJIA went from 156.41 to
200.7 in 1927.

14. 1928
 In 1928, greater numbers of people
jumped into the stock market as
everything could only “go up”.
 The DJIA went from 200.7 to 300.
 The Federal Reserve was concerned
about the mania on the market and
raised interest rates fairly promptly
after dropping them in 1927.
 By the summer of 1928, they were at
5%.
 Margin requirements were raised
from 10% to 50% of the loan,
although this was loosely followed.

15. 1929
 By February, cracks were beginning
to show in the economy.
 Inventories were piling up, leading
to concern about consumer
sentiment.
 Common sentiment was that the
nation had reached a “permanent
plateau of prosperity”.
 The DJIA continued to climb from
300 to a high of 381 September 3rd.
 The average P/E of the S&P was
32.6.

16. The Federal Reserve Moves
 Interest rates stay steady at 5% for most of 1929.
 In August, they raise it to 5.78%, and in September,
to 6%.

17. Babson Break
 September 5th, 1929, economist Roger Babson gave a
speech saying that “Sooner or later a crash is
coming, and it may be terrific“.
 That day, the market fell 3% and the “smart money”
realized fear was starting to creep into the markets.
They started selling their positions.
 That day was to be known as the “Babson Break”, as
it marked the start of the high volatility in the
markets.

18. Black Thursday
 The decline from the Babson Break to Oct. 24 was 20%, after a
series of rallies and drops.
 October 23, the market fell 6.3% in one day to 305.85, with a
volume of 6 million shares, leading to panic the next day.
 October 24 was known as Black Thursday where a record
12.9 million shares were traded. However, the market
dropped only 2% to 299.47 on that chaotic day.
 Around 1:30pm, the market was down from 312 to 277, as the
NYSE Vice President, Richard Whitney came onto the floor
and loudly bid for shares, causing a rally. The DOW ended up
down only 2%.
 Friday, October 25 largely traded flat and many people
thought that the worst was over.

19. Smoot-Hawley Tariff Act
 Weekend reporting on the stock market dropped
caused a lot of alarm and concern as investors
digested the news.
 More destructive, however was the news on the
Smoot-Hawley Tariff Act on the same weekend.
 With the drop in economic output during 1929,
Congress and Hoover were considering increasing
tariffs on imports from 40% to 60%, to encourage
Americans to prefer American goods.
 Most economists predicted that retaliatory tariffs
would be raised by other countries, seriously
damaging American exports, and frowned on this
bill.
 1,000 prominent economists sent a plea to the
government to refrain from passing the bill.
 The weekend between Black Thursday and Black
Tuesday, word leaked the Hoover would not veto
Smoot-Hawley.

20. Black Monday and Tuesday
 Monday, October 28, based on
the declines since September
and the news of Smoot-Hawley,
more investors got out of the
market.
 A record loss of 13% on the
DOW for that day, falling to
260.64.
 October 1929, 16.4 million
shares were traded as the
market fell another 12% to 230.

21. Hoover Steps In
 Hoover rejected Treasury Secretary Andrew Mellon’s
“leave it alone” approach.
 In November, amid billions in losses for the average
person, Hoover meets with business leaders.
 In the summit, he encouraged businesses to keep
wages steady to keep consumer spending at elevated
levels.
 However, the debts of many Americans had
devastated their own finances.
 Many Americans lost a lot of money in the market
and curtailed their own spending by over 10%.

22. Consumers are Tapped Out
 Consumers also couldn’t not repay their debts, and
their assets were repossessed.
 Ramped up over-production, dropping consumer
demand along with repossessed collateral led to
excessive inventories.
 Businesses could not keep their payrolls at the level
Hoover requested while their revenues and the
prices of their products were dropping.

23. DJIA Struggles for its Former Glory
 Bottom feeders came back into the market after the
crash.
 Even though the over-rosy optimism was shattered, the
general sentiment was that the market would self-
correct.
 The DOW nearly hits 300 in May of 1930, a 50% gain.
 It was quite possible for quick recovery…

24. DJIA Struggles for its Former Glory
 5. "Stock prices have reached
what looks like a permanently
high plateau.” – Irving Fisher,
10/17/29
 7. "Hysteria has now disappeared
from Wall Street."
- The Times of London,
November 2, 1929
 9. "[1930 will be] a splendid
employment year."
- U.S. Dept. of Labor, New
Year's Forecast, December 1929
 15. "While the crash only took
place six months ago, I am
convinced we have now passed
through the worst” - Hoover,
5/1/1930
Google: “Pompous Prognosticators”

25. Smoot-Hawley Passes!
 June 17, 1930, the excessive tariffs pass
Hoover’s desk with a signature.
 Investors knew this would hurt the
already struggling businesses as world
trade would plummet.
 The DOW falls that month to from 275 to
226

26. America Stops Investing Overseas
 The engine that kept the world economy humming stopped as deficits in
the US budget needed to be amended.
 Germany was hung out to dry, as American investment disappeared.
 Imports into America dropped precipitously with the new tariffs, and
other economies start to struggle.
 Over the coming months, many countries by passing their own tariffs on
American imports. World trade slows.

27. American Business Start Layoffs
 Combined with weak domestic demand and the
retaliatory foreign tariffs, American businesses start
laying off.

28. US Budget Deficits
 In 1930 and 1931, Hoover:
 1) Increased subsidies to farmers
 2) Created unemployment assistance.
 3) Increased public works spending.
 4) Created a series of organizations to help distressed
Americans.
 The increased spending caused deficits, and Hoover
agreed to the largest tax increase in American history.
 The top income earners saw their taxes jump from 25%
to 63%.

29. Monetary Contraction
 During this time, fractional reserve banking was working
in reverse as defaults increased.
 Credit was being destroyed faster than anyone thought.
 The tax increases inhibited investment as the risk
outweighed post-tax rewards.
 The Fed dropped rates from 6% in Oct. ‘29 to 1.5% in mid
1931.

30. Bank Reserves
 Bank reserves were distressed due to defaulted loans.
 Banks also lost depositor cash by speculative trading.
 Dropping rates kept them solvent for some time,
even though bank failures were climbing.
Number of Bank Failures
1929 – 659
1930 – 1352
1931 – 1456

31. The Fed raises rates
 Concerns in 1931 about the dropping value of the
dollar and inflation prompts the Fed to raise rates
from 1.5% to over 3%.

32. Bank Failures
 The increase in rates cause bank balance sheets to
worsen.
 Americans, having no insurance on their deposits, rush
to withdraw at the same time.
 Banks usually carried 10-20% of deposits at any time.
With the increased Fed funds rates, banks are unable
to survive.
Number of Bank Failures
1929 – 659
1930 – 1352
1931 – 1456
1932 – 2,294
1933 - 5190

33. The Perfect Storm
 Defaulting consumer debt, plummeting world trade,
consumer fear, failing banks, and destroyed savings all
combined to monetary contraction and deflation.
 Deflation caused falling wages, making it harder for them
to service their debt, causing more defaults and more
monetary contraction.

34. Schools of Thought
 Early theories – Overproduction and under-consumption.
Money should be pumped into consumer pockets. Hoover
and Roosevelt ascribed to this, however, most consumers
put their money into repaying debts.
 Keynesian – Government should run deficits in times of
trouble. The tax and fed rate increases caused the most
problems.
 Moneterists – The fall in the money supply caused the
Depression. The Fed should have increased liquidity, but
didn’t reach far enough.
 Gold Standard – Pegging the currency rigidly to a fixed
amount of gold tied the hands of the Fed.
 Austrian School – The credit bubble in the 1920s led to
unsustainable boom in asset prices and capital goods.

35. Depression lasted until 1942
 Despite some amount of recovery during FDR’s
administration, a 2nd severe recession occurred after
his first term.
 The New Deal intended to help the average man at
the expense of business, leading to high levels of
unemployment.
 America didn’t pull out of the Depression until the
over-supply of labor became soldiers and the need
for productivity jumped for the war effort.