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Why did the USA fall into depression in 1929?

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Why did the USA fall into depression in 1929?

This huge topic is really two topics.  

The first question is the easier question to answer:

  • Why was there a Great Crash on the American Stock Market in 1929?


The second is much harder:

  • Why was there a Great Depression in the 1930s?


Many textbooks just assume that the Great Crash led on to the Great Depression, but this is far from proved, and most economists state that the Great Crash did NOT cause the Great Depression.

Background knowledge

Companies sell shares as a way of raising money, and they attract buyers by giving them a share (hence the name) of the profit at the end of each year (this is called the 'dividend').   In America in 1929 about 1.5 million people owned shares.

If a firm is doing well, the value of its shares rise, and people can sell them for more than they bought them.   When there is a 'bull' market (when share prices are generally rising) people buy shares solely hoping to make a profit.   These people are called 'speculators' and in 1929 about 600,000 of the 1.5 million shareholders were active speculators.


A 'bear market' is one where prices are falling.   Speculators fuel a bull market by gambling on future price rises, but they can turn a bear market into a crash by desperately trying to get rid of their shares before they fall any further. 


1.  Why was there a Great Crash in 1929?

Historians are fairly much agreed why the Wall Street Crash of 1929 happened.

1.  Wall Street over-heated:

●   Between 1924-29 the value of shares rose 5 times.  

●   Share prices rose way beyond what the firms they were shares were worth; only speculation kept up the over-inflated prices.

2.  Speculation:

●   Many people became speculators - 600,000 by 1929.

●   Many people were buying shares 'on the margin' (borrowing 90% of the share value to buy the shares, hoping to pay back the loan with the profit they made on the sale).   American speculators borrowed $9bn for speculating in 1929.

●   Some firms which were not sound investments floated shares (e.g. one was set up to develop a South American mine which did not exist), but people still bought them, because they expected to make a profit in the bull market.

3.  Corruption - the Senate Committee set up to investigate the Great Crash found that there was a corruption and 'insider-trading' between the banks and the brokers.

4.  Panic:

●   There were losses of confidence in March and September (when the economist Roger Babson forecast a crash), but the banks papered over the cracks by mass-buying of shares to help the market.  

●   On Thursday 24th October 1929, nearly 13 million shares were sold in a panic, and prices crashed.  

●   The banks tried to shore up the market again, but on Monday there were heavy selling; the banks realised it was hopeless and stopped buying shares.

●   Speculators panicked at the thought of being stuck with huge loans and worthless shares.   On Tuesday 29th October the market slumped again, when 16 million shares were sold.



Source A

The rich man's chauffer drove with his ears laid back to catch the news of an impending move in Bethlehem Steel; he held 50 shares himself.   The window-cleaner at the banker's office paused to watch the ticker, for he was thinking of converting his savings into a few shares of Simmons ... a broker's valet who made nearly a quarter of a million on the market, a trained nurse who cleaned up $30,000 following the tips given her by grateful patients; and the Wyoming cattleman, 30 miles from the nearest railroad, who bought or sold 1,000 shares a day.

Frederick Lewis Allen, Only Yesterday (1931)

Allen gives the impression of a public 'drunk' with share-buying.   In fact, this was far from the truth.


2.  Why was there a Great Depression in the 1930s?

Many textbooks simply link the Great Crash and the Great Depression together - what caused the Great Crash is assumed to have caused the Great Depression which followed it.


Actually there was no reason why a stock market crash need have caused the Depression, so economists have tried to find reasons why the Crash slid into Depression.   Their explanations are VERY complicated and theoretical, but some of their main ideas (MUCH simplified) are:

1.  Explanations at the time

a.  Basically, at the time, people hadn’t a clue what had caused the depression.   Herbert Hoover argued that it was the European financial collapse of 1931 that turned it into the Depression; (so it was Europe’s fault, not America’s).  

b.  The explanation of British economist John Maynard Keynes in 1936, who wrote General Theory of Employment, Interest, and Money, was that the cause was a DROP IN SPENDING, caused by people saving too much.   This was certainly what Roosevelt believed, and his answer was simply to pump money into the US economy; increased spending, however, did not cure the Depression.


2.  Great Crash

a.  You will often hear it said that the Great Crash didn’t cause the Great Depression.   There were only 1.5 million shareholders, and only 600,000 speculators – so why should their misfortune cause a Depression in a country of 123 million?

b.  However, you will remember that much of the bull market had been financed by loans – in 1929 brokers’ loans amounted to $8.5 billion.   Much of this money had been advanced by the banks, and by the big companies (in 1929, 200 companies controlled half of US industry).   So when the speculators crashed, many banks went bankrupt, and half of US businesses was damaged, so the whole US economy suffered.


3.  The Fed

a.  (‘The Fed’ was the US Federal Reserve – the American ‘Bank of England’.)  

     In the 1940s, Milton Friedman came up with a theory about the cause called ‘monetarism’ – he believed that price changes were caused by a reduction of money in the economy.   He therefore blamed the US Federal Reserve which in 1931 raised interest rates – which, he claimed, led to a reduction in the money supply.   His famous saying was that ‘the Fed put the Great in the Great Depression’.  

b.  This was made worse, Friedman added, when the banks began to go bankrupt after 1931, and because the amount of money in the economy was linked to the Gold Standard (meaning that the government would only issue as much money as it could redeem in gold).  


4.  Tariffs

a.  In 1930, fearing for the US economy, the government passed the Smoot-Hawley Tariff – a new, even heavier tariff law.  

b.  Sixty countries passed retaliatory tariffs in response and world trade slumped.   This damaged US industry, especially agriculture.


5.  Maldistribution of wealth

a.  Nowadays, historians think that a major cause of the depression was the inequality of wealth in America.   There were some extremely rich people, and huge numbers of extremely poor people – the top 5% owned a third of the wealth, while 40 per cent of the population were living in poverty.  

b.  It wasn’t that there was too little money, but it wasn’t in the hands of the people who would spend it.   Consequently, Americans produced too much and bought too little, and prices plummeted.


6.  Weaknesses in the economy

     You will remember that Agriculture, and the Coal, Iron and Textiles industries were all experiencing problems in the 1920s.   When the Depression started, they were not strong enough to cope, and collapsed quickly.
7.  Cycle of Depression

     As more banks and companies failed, and people were put out of work, they had less to spend, and so more companies went bankrupt and made their workers unemployed etc.   Once the Depression had taken hold, it simply spiralled down worse and worse.

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