The American Crisis of 1929 and Its Causes

The prelude to the crisis

On many occasions, financial system actors wanted to set up a central bank. The risk of a bank run was often the reason given. In 1913, a conglomerate of 12 banks finally managed to obtain permission from the US Congress to establish the Federal Reserve, the only institution authorized to print money and set a basic interest rate for banks which she lends. If the US government today needs money, it will have to borrow it from the Fed. The primary mission of the Fed was to prevent a collapse of the banking system in case of panic and to channel the necessary capital if all the depositors of a bank wanted to withdraw their savings.

Some even said that this 'giant step' would avoid the credit crises and recessions that had manifested here and there during the previous century. Not only did the recessions not go away, but the Federal Reserve failed miserably to its original mission and let thousands of banks go bankrupt between 1930 and 1932; what was only a severe recession in 1930 turned into a gigantic depression.

There was a real danger in concentrating all power in the hands of a small group of bankers or a cartel. The United States still adhered, at least in theory, to the gold standard but interest rate changes were not necessarily dictated by the market but by political actors. The Fed had and still has ambivalent relations with the US government. It exerts an influence on this one not only by releasing the necessary funds to finance its debt but also because in a democracy, the politicians who need money to finance their campaigns can hardly put down a powerful cartel of banks who are in contact with big companies. On the other hand, the government can always withdraw from the Fed the privileges that were once granted to it.

After the first world war, the world had changed fundamentally. Germany was ruined and many European countries, especially England, had financed the war effort by exporting their gold reserves to the United States. Despite this bloodletting, despite the adoption of a fiat currency by several belligerents, England had accumulated a mountain of debts to the United States. The presence of a considerable reserve of capital makes it possible, of course, to finance viable projects, but it sometimes allows the appearance of speculative bubbles. The relatively low interest rates allowed American households to go into debt at a faster rate. The purchase of radios, home appliances and new inventions could now be done on credit. Americans were bathed in a climate of optimism that nothing seemed to shake. But in London, we grumbled.

The pound was traded only for a fraction of its 1914 value in dollars. Once the financial capital of the world, London was now living in the shadows of Wall Street. The nostalgia of that blessed time when England adhered to the gold standard won the political and financial world. England was looking for a way to re-adhere to the old system. But London set itself a goal too ambitious; she wanted to join this system with the same exchange rate as in 1914. ‘How easy it would be to repay the US creditor with a hard pound!’ England wanted butter and buttery money.

The step was finally taken in April 1925; England re-adhered to the gold standard. But in order to be able to adhere to the system of the gold standard with the objective which England had given herself, to convert, if necessary, four pounds sterling for an ounce of gold, it was necessary to drain gold from foreign countries; France and the United States alone had three quarters of the world's gold reserves. Interest rates were therefore significantly increased at the instigation of Sir Montagu Norman, Governor of the Bank of England. The recession that followed was catastrophic. 1.2 million Britons were unemployed, but Norman, who scorned the industrial sector and swore by the financial sector, stayed the course. But the pound was now so overvalued that exports of English products, which had become more expensive, fell massively. British industry and its outdated machinery could not compete with US industry given the exchange rate set by London.

The lack of wage flexibility in England was also a factor. Higher interest rates had drained capital, but the trade deficit led to an even greater exodus of what was left of English gold to America. Norman's plan had failed. If England had remained attached to the gold standard in 1914, a small trade deficit would have been gradually settled by a feedback effect, but the brutal rebalancing desired by London could not be achieved without the British workers working for a mouthful of bread. In physical or material terms, the re-anchoring to the gold standard was Norman's attempt to liquidate in one fell swoop a substantial portion of the wartime promises made to the US creditor, to increase the power the purchase of speculators wishing to invest in the United States, to lower the price of imported American goods by putting the weight of this improvement on the shoulders of manufacturing companies and workers who depended on them.

Norman now realized that popular discontent would no longer allow him to retain Churchill's support. So Norman opted for a plan B. Rather than keeping the interest rate high in England, it would be better to ask his American counterpart to lower his interest rate so that capital would return to London.. If Benjamin Strong, who headed the Federal Reserve in the United States, adopted an aggressive policy of easy credit, there is no doubt that British exports would benefit in one way or another. Strong bonds of friendship united the two men. Before the creation of the Fed, such collusion would have been impossible but the United States no longer had a decentralized banking system. After Norman's visit to the United States at the end of July 1927, the Federal Reserve began trading on the market to increase credit and the interest rate was lowered in August. From June to August the Fed injected more than 500 million dollars and it was only a beginning; in 18 months the flow of banks to the accounts of individuals increased from $ 53.6 to $ 82 billion.

Speculative bubble on Wall Street

But the easy credit policy used by Benjamin Strong did not yield the desired results. Soon a large portion of the credit generated resulted in Wall Street and the brokers largely used the leverage of a margin call system and the stock market exploded. The Dow Jones index nearly doubled in two years. The system was very simple and was based on the principle of a pyramidal chain. If an American or an Englishman had $ 1,000, he could borrow $ 10,000 to 'invest' on the stock exchange. If the price of a $ 10 share climbed to $ 12, our investor would have made $ 200 with his initial bet. But with $ 10,000, he was making $ 2,000 less profit from low interest charges. He could sell for $ 2,000 worth of shares, borrow $ 20,000 more, and start over. Or, calling himself a financial genius, try to dazzle his friends by talking about the wonderful move he made, which did not fail to bring other 'customers' in the circuit. If, on the other hand, the client bought $ 10,000 worth of $ 10 shares and covered $ 1,000 of them with his own money and the price fell below $ 9, he had to sell immediately. But what did our man have to fear after all, the more there was a demand for these actions and the more their price climbed....

Of course, there is a flaw in the reasoning. Banks can not infinitely finance such a chain and when shareholders discover that price caps they start selling, which causes prices to fall until a panic brings the collapse of this pyramid. In fact, in October 1929 investors were so panicked that even selling at one-tenth of the purchase price some could not find a buyer. Many had no choice; once the margin or down payment was no longer covered it was automatic selling, sometimes at a ridiculous price for lack of buyers. Many banks, heavily involved in this speculative fever, were on the brink of bankruptcy. Often 'creative accounting' (say falsification of balance sheets) allowed some of them to survive one, two or three years but their existence was only one thread; hundreds, then thousands of banks went bankrupt between 1930 and 1932. Bank panics multiplied. To respond to those who were scrambling to get their savings back, the banks had no choice but to demand immediate repayment from their borrowers, forcing many companies (who had never played the stock market) to bankruptcy.

At the beginning of 1929 the members of the Federal Reserve began to worry seriously about the turn of things on Wall Street. The price of the shares was no longer related to dividends paid to shareholders. The more the speculative pyramid grew, the more its sudden deflation could cause a shock wave that would push the economy into a prolonged recession. The Federal Reserve, however, was reluctant to raise interest rates for fear of triggering panic and preferred to use persuasion to bank executives whose speculation activities seemed 'excessive.' But nothing helped.

The situation was not very great for Montagu Norman either. Lower interest rates in the United States were supposed to help the UK to replenish its gold reserves, but once again things were not going as planned. Soaring stock prices on Wall Street were such that not only did Americans not place their gold in English banks, but many English investors pulled their money from English banks to place on Wall Street.

On February 6, the Governor of the Bank of England arrived in Washington to talk to Andrew Mellon, the Treasury Secretary. Shortly after Montagu Norman's visit, the Federal Reserve abruptly changed its policy. However, if President Herbert Hoover was unhappy about Wall Street speculation, he feared that a rise in interest rates would hurt the manufacturing sector too much. He pushed Andrew Mellon, the secretary of the Treasury, to make a statement to the press. Not to trigger panic Mellon used hackneyed language. On March 15, he declared:

'The current situation on the financial markets gives prudent investors the opportunity to buy government bonds, and vouchers are cheaper than shares.'

He added that he was in full agreement with the Federal Reserve regarding the restrictions on credit for speculative purposes. Roy Young, the new governor of the Fed, made similar statements the next day. The nerves of some speculators bent and the stock market had some jolts. But the distrust of Charles E Mitchell, president of the National City Bank, heavily involved in the financing of speculators using the margin call system, reassured the stock markets; the Dow Jones continued its flight.

The Crash of 1929

In August 1929, the Federal Reserve finally decided to increase its base rate to 6%. Stock markets were increasingly nervous as a recession began. In the weeks that followed, the less adventurous investors sold and their number exceeded the number of new speculators for the first time. The first major crash took place on 24 October, and the intervention of some banks and several large manufacturers to support the prices delayed the deadline. On October 28, the Dow Jones plunged again strongly, leaving many speculators with a margin to open. On October 29, panic was total and no intervention of the banks could stop the fall.

Some decline in auto sales was already beginning to be felt before the crash. The popularity of the stock market was such that many people delayed the purchase of durable goods in order to offer a significant margin and borrow to buy shares. Speculative bubbles have always existed and are associated with a sudden abundance of money, whether it is money saved or money obtained through an extension of credit. Some of the money is used for the purchase of consumer goods but another part is directed towards financing operations in order to obtain a return on capital. The massive influx of funds in a very specific sector (stock exchange, land, etc.) creates pockets of high yield and sooner or later these investments take a pyramidal shape; greed helping speculative fever contaminates an increasing share of the population until the final collapse. But speculative bubbles and their bursting are a calamity for the economy because they do not only involve the transfer of wealth from one group of people to another. There is a huge physical and material waste that is engendered, a bad allocation of capital that negatively affects the country's wealth.

Take the example of a person who wanted to study to become an agronomist; if there is an artificial boom in real estate following a speculative bubble this person may decide to borrow to take a real estate agent course while other individuals borrow to create training schools in this area. The person can work 1, 2 years in this sector but when deflating the bubble she loses her job. She is already in debt and thinks twice before borrowing again to become an agronomist; in the best case this person has lost two years of his life. Those who have borrowed to create a school in the field are going bankrupt too. A speculative bubble distorts the judgment of a multitude of actors and leads them to waste their time or money, which has a domino effect on the entire economy. Before the bursting of this bubble, the 'new rich', believing that they have a comfortable cushion, offer luxury goods and create an artificial demand in another sector which leads an entrepreneur to borrow to take advantage of In the end the economy must return to a balance where everyone knows roughly how many hours he has to work in a certain trade to exchange his hours of work for other hours of work or goods. consumption, but this return to normal is painful; there are many losers.

The Great Depression

The US economy did not immediately plunge into deep depression. A recession was felt, but in the early summer of 1930 a surge of activity led many to believe the recession was coming to an end. On June 19, William Green, President of theAmerican Federation of Labor, informed President Hoover and the press that the employment situation was starting to improve. But two almost simultaneous events would kill the recovery; A severe drought in the agricultural states in August and the dumping of Soviet wheat on the world market. The collectivization of land in Ukraine by Stalin met with great resistance and today it is known that much of the 'leap forward' of Soviet industry was financed by the massive confiscation of wheat crops in Ukraine. Millions of peasants hostile to the regime died, but the massive sale of wheat further depreciated the price and bankrupted not only several American farmers but also their banks, already weakened by the crash of 1929 and the losses they had wiped.

The growing bankruptcy of hundreds of banks caused a record number of depositors to come forward to withdraw their savings rather than lose everything. To satisfy this wave of withdrawals, banks had to recall their loans to support the demand for cash. Tens of thousands of businesses that depended on credit for their survival were pushed into bankruptcy. The culmination of the year 1930 was reached on December 12 when a bank in the state of New York, Bank of the United States, declared bankruptcy. 400,000 depositors lost their savings. A growing number of Americans were withdrawing their savings to put them in a woolen sock, which put even more pressure on an already weakened system. It was later learned that certain accounting practices of this bank bordered on fraud.

Nevertheless, such a spiral is rarely irreversible. The bankruptcy of a growing number of companies makes available to the companies that survive a human and material capital especially that can be obtained for a mouthful of bread. The resultant lowering of production costs leads to a recovery after reaching a break-even point. The Federal Reserve Board published figures for the industrial production index; from January to February 1931, it had fallen from 83 to 86 (on a base of 100 for 1929) and 87 for March 1931. The employment situation had stopped deteriorating even though unemployment remained chronic.

Another shock, however, shocked the American economy in the spring of 1931; the collapse of the European economies. Germany and Austria were in a very bad position because of the reparations imposed by the Versailles Treaty. The counter-coup of the crash of 1929 had caused a rise in unemployment and a growing political instability in these countries. The economy of Great Britain was in free fall; Norman's clumsy attempts to anchor the pound on the gold standard at a grotesque exchange rate had led to disaster.

To cope with their own liquidity problems, several European countries had no choice but to hastily repatriate the gold reserves they had placed in the United States when they bought vouchers. The US Federal Reserve tried to stop this exodus, but the ensuing monetary contraction drove the economy further into the depression. France also wanted to exchange its reserves of English books for gold but despite its attempts England, breathless, failed. The United Kingdom broke away from the gold standard.

Roosevelt and the New Deal

In 1932, 25% of workers in the United States were unemployed. A stubborn legend has it that Roosevelt, his New Deal and his Keynesian deficits ended the crisis; It did not happen. Massive loans to finance the construction of roads or bridges created jobs, but such programs often served to place political friends at the head of organizations for which they had no jurisdiction. Especially Roosevelt set in motion foolish policies that made the crisis last. While in Germany, Sweden, Japan, Great Britain and several European countries unemployment fell quickly to return to normal levels well before 1936, it was, in the United States, still 17% in 1936 and almost 14.3% in 1937, nearly four times its 1928 level. When Roosevelt, alarmed by the dramatic growth of the US deficit and the impossibility of maintaining this exponential growth, began to limit State spending at the end of 1937 the US economy plunged into recession and the unemployment rate reached 19% the following year. Keynesian theory predicted, however, that by substituting itself for private enterprise, the state could act as a catalyst and create a dynamic that would be self-sufficient after a certain period of time.

In Roosevelt's logic, it was not the depression that caused prices to fall, but the fall in prices that caused the depression. A battery of laws were passed to hinder the game of supply and demand. Six million pigs were slaughtered and thrown away, stocks of wheat, cotton and maize were destroyed to firm up prices, and farmers were helped by the state to avoid producing benefits. Meanwhile millions of Americans who did not eat their fill had to settle for soup kitchens and a diet of survival. A New York cleaner was even thrown in jail because he offered to press trousers for 35 cents instead of the minimum 40 cents prescribed by law.

Roosevelt was a big fan of trade unionism because it was putting upward pressure on corporate wages. But as the margin of profit of the employers did not increase, they only engaged in the drop. In 1937, the number of strike days throughout the country rose from 14 to 28 million compared to the previous year.

In fact the United States did not emerge from the crisis until 1940. The huge demand from Europe to fuel the war industry brought unemployment down to its 1928 level. Many of the policies associated with the New Deal were suppressed the same year; it was no longer a question of limiting the production or of directly or indirectly favoring strikes at the moment when the nation engaged more and more behind its British ally in the alliance game that preceded Pearl Harbor.