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Where Did All the Money Go? Part IV: Those Who Cannot Remember the Past George H

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Where Did All the Money Go? Part IV: Those Who Cannot Remember the Past George H Where Did All The Money Go? Part IV: Those Who Cannot Remember the Past George H. Blackford (2011) (Revised 1/18/12) The 1920s began with a mild recession in 1920-1921 followed by a speculative bubble in the real estate market. The real estate bubble burst in 1926 and was superseded by a speculative bubble in the stock market. There was a mild economic downturn in 1927, a brief recovery that same year, and another mild downturn in the summer of 1929. Then the stock market bubble that began in 1926 came to a dramatic climax in the fall of 1929. (Galbraith Friedman Meltzer) The Crash of 1929 began October 24—a day that became known as Black Thursday— when stock prices dropped dramatically in the morning and recovered somewhat in the afternoon. While prices rallied the following day, there were two more black days to come: October 28, Black Monday, when the Dow Jones Industrial Average fell 12.8% and October 29, Black Tuesday, when the Dow fell an additional 11.7%. Overall, the stock market fell by 80% from its high in 1929 to its low in 1932 as the Dow lost almost 90% of its value. As stock prices fell in the fall of 1929, the mild recession that had begun in the summer became severe, and a banking crisis began in 1930 that reached its climax in 1933 when some 4,000 banks and 1,700 savings and loans went under in that year alone. By the time the crisis came to an end some 10,000 banks had gone out of business along with 129,000 other businesses, and we were in the depths of the Great Depression. The Great Depression of the 1930s From 1929 through 1933, unemployment went from 1.6 million to 12.8 million as the unemployment rate jumped from 3.2% of the labor force to 24.9%. The economy experienced a major deflation as consumer prices fell by 25% and wholesale prices by 30%. The total value of goods and services produced in the United States fell by 46% 2 while the level of production fell by over 30%. Just as happened in 2008, the financial crisis in the United States spread throughout the rest of the world, and the entire world faced an economic catastrophe of epic proportions. The depression lasted more than ten years. There were still 8.1 million people unemployed in 1940, and the unemployment rate did not fall below 14% until 1941. It wasn't until 1943—when the economy was fully mobilized for World War II—that the unemployment rate finally fell to its 1929 level, and by then the United States had increased the size of its military by over 8.5 million soldiers. In other words, we did not solve the unemployment problem created by the Great Depression until we were fully mobilized for World War II and had drafted a number of people into the military comparable to the number who were unemployed in 1940. (Figure 1) Figure 1: Rate of Unemployment, 1929-2010. Source: Economic Report of the President, 2011. ( B35PDF-XLS 1967 B20PDF) What Went Wrong It was clear to most people at the time that the cause of the problem was rampant speculation in the stock market financed by expanding debt. In fact, the debt created by the financial system during the 1920s had grown to unreasonable levels in all areas, not just in the stock market. This debt was unsustainable, and the stock market crash was 3 just the trigger that set in motion a set of forces that, in the face of this debt, brought down the entire economic system. (Fisher) When the stock market crashed, the value of stocks that provided the collateral for speculative loans fell. This led to a panic in the financial sector as financial institutions tried to cut their losses by recalling existing loans and refusing to make new loans, not just loans collateralized by stocks but all loans. The financial system simply froze, and credit became unavailable. This forced debtors whose loans were called or who could not refinance their loans when they came due to sell the collateral underlying their debts as well as other assets in order to meet their obligations. These forced sales of collateral and other assets, in turn, caused asset prices to fall throughout the financial system, and debtors began to default as the value of their assets fell below the value of the loans they had to repay. (Fisher) As the panic grew, businesses that were unable to finance their inventories and payrolls for lack of credit were forced to cut back their operations and layoffs began. At the same time, households that were unable to finance the purchase of such things as new homes, automobiles, and other durable goods for lack of credit were forced to cut back their expenditures. As output, employment, and business and household expenditures fell, income fell as well. The rise in uncertainty and the heightened sense of fear and pessimism toward the future exacerbated the situation. The result was a vicious spiral downward as falling output and employment led to falling income and expenditures which, in turn, led to falling output and employment. (Keynes) All of this should sound familiar, given our experience during the current crisis, since this is exactly what happened in the mortgage market following the bursting of the housing bubble in 2007 and the financial sector grinding to a halt in September of 2008. Debt in the American economy had grown to unsustainable levels by 2007, and when the housing market crashed, the value of the real estate that provided the collateral for real estate loans fell. This led to a panic in the financial sector as financial institutions tried to cut their losses by recalling existing loans and refusing to make new loans, not just loans collateralized by real estate but all loans. The financial system simply froze, 4 and credit became unavailable. This led to the same kind of forced selling of collateral and other assets that, in turn, caused asset prices to fall that we saw following the stock market crash in 1929. It also initiated the same kind of vicious downward spiral in output and employment in 2008 and 2009 that the economy experienced in 1930 through 1933 with falling output and employment leading to falling income and expenditures which, in turn, led to falling output and employment. (FCIC WSFC) There were some fundamental differences, however. Following the stock market crash in 1929, a run on the banking system began that led to the banking crisis in 1930 as people began taking money out of the banks in an attempt to protect their savings by hoarding cash. At the same time, the Federal Reserve was both unwilling and unable to react appropriately to the deteriorating situation. This, in turn, caused the money supply to fall by 25% from 1929 to 1933 which, combined with the fall in output and employment, caused wages and prices to fall as well. The resulting deflation caused the debt that had been accumulated during the 1920s to become an overwhelming burden since this debt now had to be repaid in the face of falling wages, prices, and incomes. To make things worse, wages and prices fell more rapidly than the debt could be liquidated which caused the real burden of the debt to increase even as the total debt fell. (Fisher) In short, because of the unsustainable level of debt that had accumulated during the 1920s and the inability and unwillingness of the Federal Reserve to act, as debtors found themselves unable to meet their contractual obligations the contract system within the financial system broke down; widespread bankruptcy followed, and the financial system simply imploded. It was this implosion of the financial system—brought on by an unsustainable level of debt combined with falling output, income, money supply, wages, and prices—that brought down the rest of the economy and created the Great Depression of the 1930s. (Fisher Keynes Friedman Meltzer) The Fall and Rise of Ideology The vast majority of our political leaders entered the 1930s with an abiding faith in the nineteenth century ideology of free market capitalism. They were convinced that 5 markets were self correcting, attempts at government intervention would do more harm than good, and that if the economy was just left to its own devices competition in free markets would allow wages and prices to adjust to bring the economic system back to full employment. Some even believed the economic system would be made better by the experience of a depression in that depressions weeded out economically inefficient firms and, thereby, made the economy more productive. The experience of the 1930s provided a shocking dose of reality. With total output falling by 30%, the unemployment rate increasing to 25%, tens of thousands of business going bankrupt, and human misery increasing at an accelerating rate, it was impossible for economists to explain just how the economic system was going to be made better by all of this or why the government should not be allowed to intervene to do something about it. There had to be something wrong with an ideological theory that proclaimed it was a good thing for society to be going through what it was going through at the time. The only explanation the theory could offer for the dismal unemployment statistics was that wages were not falling fast enough to bring the system back to full employment. But by 1933, wages had already fallen by 22% in manufacturing, 26% in mining, and 53% in agriculture.
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