The Great Depression and Monetary Policy

The Stock Market Crash

It is a well known fact that the economy was booming in the 1920s. There was a high level of optimism that made economists believe that the United States Federal Reserve would be able to stabilize its economy. The Federal Reserve worried about extremely high and unstable level of the stock market, “It seemed better to the Federal Reserve in 1928 and 1929 to try to “cool off” the market by making borrowing money for stock speculation difficult and costly by raising interest rates. They accepted the risk that the increase in interest rates might bring on the recession that they hoped could be avoided if the market could be “cooled off”: all policy options seemed to have possible unfavorable consequences.” (http://econ161.berkeley.edu/TCEH/Slouch_Crash14.html) Sure enough on October 24 1929, also known as “Black Thursday,” a record of 12,894,650 shares were traded. Only five days later another catastrophic downturn of 16,410,000 shares were bought and sold.

Most people believe that the majority of Americans at the time owned stock, but in actuality less than 2% of population at the time of the crash held ownership in stock. So the question arises, why did the stock market crash have such an impact on the American people?

Effect on the American People

The crash undoubtedly generated uncertainty regarding future income. The uncertainty is said to be the reason why consumers and producers forwent purchases of durable goods. In agreement with the Keynesian mechanism, this decline in spending results in a drop of income.

GDP (A common measurement of national income) = C + I + G + (X – M)

According to Christina Romer, “there is indeed a statistically significant negative relationship between consumer spending on durables and stock market variability” (598)

According to this table one can see the negative affect the variability in the stock market has on consumer spending. Also the decline in purchases of durable goods is very evident. Purchases of perishable goods (food) rose immediately following the crash whereas purchases of durable goods plummeted and by Jan of 1930 automobile registrations were 24% lower than they were before the crash. Romer offers a very logical explanation for the decline of consumer purchases, “Consider a consumer deciding whether to buy a durable good that is available in varying levels of quality. When future income is temporarily uncertain and durables purchases are irreversible for long periods of time, there is a trade-off between purchasing the durable and waiting.” Therefore, if the consumer decides to make the purchase they may have bought the good at a quality level too luxurious or too modest for their future income level.

Business analysts conveyed their forecasts and thoughts about the future of the economy. In her article Romer takes a close look at the forecasts of five economists. She proves that there was obvious uncertainty among these forecasters. A forecaster from the Standard Traded stated, “With the opening of the new year, there is a wide conflict of opinion as to what is in store for the industry and commerce during the early part of 1930,” another forecaster stated, “Opinions may differ as to whether or not the stock market collapse… need necessarily by followed by a serious business recession.” The exposure to the forecaster’s conflicting opinions may have been a cause of the uncertainty among consumer and producers. Perhaps a reason for the conflicting predictions was due to Hoover’s response to the crash, “to promulgate optimistic forecasts and to encourage other to do so as well.” It is likely that several of the analysts participated in this positive propaganda. Other causes of the nationwide uncertainty were the “suspense and indecision created by the final outcome of the new rates included in the Hawley-Smoot tariff bill” and the “alarm about the continuing weakness in prominent commodity markets.”

Early Reaction to the Depression

Herbert Hoover, President of the United States from 1928 to 1932, believed that there should be little government intervention in the economic activity of the country. He felt that the Depression would be a temporary period and that the country would soon return to prosperity. Hoover did little to prevent or discourage the Stock Market crash of 1929. Due to his aversion to government regulation of business, Hoover also did not stop abusive business practices after the crash or institute much-needed financial reforms. Hoping for “Voluntary Cooperation” from businesses, Hoover felt that the economy would eventually stabilize on its own, but few businesses were willing to take risks during the Depression.

Secretary of the Treasury Andrew Mellon advised President Hoover to instate shock therapy, which called for the liquidation of all labor, stocks, farming, real estate, and other assets. Mellon wanted to reorganize the entire economy and hoped that the Depression would make people more hardworking with better morals who would work diligently to reconstruct the economy. Mellon and other supporters of liquidation feared that increasing the money supply would only lead to more speculation in the stock market and in the overall economy without creating any increase in output.

In 1932 Congress passes laws that allowed the government to begin helping businesses. One of these laws created the Reconstruction Finance Corporation which loaned money to banks and businesses to prevent them from going bankrupt. Although Hoover had hoped that state and local governments would provide the unemployed with jobs, towards the end of his presidency he began supporting public works programs that created more jobs.

Monetary Policy

Keynesian Theory

In the early 1930’s, economist John Maynard Keynes began constructing theories that advocated more government intervention as a way of getting out of the Depression. He theorized that the government should run high deficits during a depression in order to stimulate the growth of the economy. During the Depression the private sector was too hesitant to invest, so the government must heavily invest, for example in large public works programs, in order to create jobs and increase economic activity. As investment increases, aggregate demand will increase. As aggregate demand increases output will increase, eventually bringing the country back to equilibrium.