Before the 1920s
During the latter part of the 19th century and very early 20th century, various industrialized countries around the world enjoyed mostly free market economies. Government involvement was limited to essential functions, such as the provision of a legal system, national defense, the provision of infrastructure (roads, highways, railways, etc.), education, and police and fire protection. Regulations, even though they were on the rise, were relatively modest and tax rates were low (the United States did not have an income tax before 1913).
The Roaring ’20s
Except for a modest recession in the early 1920s, this decade experienced economic prosperity and low unemployment. Important innovations (radio, television, automobiles, assembly lines, washing machines, airplanes, electric razors, instant cameras, refrigerators, etc.) and technologies helped propel the economies of industrialized countries. Business profits and stock prices reached record highs. Andrew Bernstein in his book, The Capitalist Manifesto points out that, due to new technologies, business profits rose by 387% between 1921 and 1929 (Bernstein A., 2005, P. 377). Industrial production more than doubled, and stock prices of U.S.-traded firms rose by 385% during this same time. Bernstein claims that contrary to common belief, stock prices increased in line with economic conditions. However, politicians and Federal Reserve officials made announcements that they would pressure banks to restrict loans to investors buying stock on margin (Bernstein A., 2005, P. 378). Bernstein continues: “Starting in February of 1928 and continuing throughout 1929, the Fed continued to raise the interest rate for the borrowings of member banks …. The Fed fixated on ways to curb otherwise perfectly legitimate stock gains.” So Bernstein concludes that no stock market correction was necessary in 1929 and stock prices did not need to fall so drastically.
Events Leading up to the Great Depression
But falling stock prices by themselves don’t necessarily need to harm the general economy. The main reason why Wall Street affected “Main Street” (the non-financial economy) so much in 1929 is that so many people had borrowed money to purchase stocks. The Federal Reserve of the United States was created in 1913. Despite being on the gold standard, the Fed increased the money supply considerably during most of the years in this decade. This supplied funds that allowed people to borrow money (for example, to purchase stocks).
Some people borrowed 90% (the legal limit at the time) of the funds needed to purchase their stocks. So people who purchased $5,000 worth of stocks could borrow $4,500 while putting in only $500 of their own money. When the market crashed many stocks lost at least half of their value. In the example above people who owned $2,500 worth of stocks after the crash owed the bank $4,500 while losing their own equity of $500. Many people had to sell all of their stock holdings (further depressing stock prices) and still could not pay back their loans. This put many people and many banks in financial hardship and led to a chain effect of banks and eventually regular businesses going bankrupt.
The above set of circumstances is very similar to the recent housing crisis of 2008/2009. However, instead of borrowing money to take advantage of the appreciation of stocks, people invested in houses and real estate during the 1990s and early 2000s. Irresponsible borrowing and irresponsible lending was the key cause of both of these serious downturns. If people had invested in these assets (stocks during the 1920s and real estate before 2008) without excessive borrowing, then any drop in the prices of these assets would have had no chain effect on the economy. When people buy stocks with their own money, and the price of the stocks goes down, most people will hold on to their stocks in the knowledge that prices will rebound. Banks are unaffected as little to no money was borrowed, and no one goes bankrupt.
After the stock market crash of 1929, even people without stock market investments felt the pain because the multitude of bankruptcies caused overall economic confidence to erode and regular businesses (construction companies, car companies, etc.) to fail. In addition, because of bank failures, many people lost their life’s savings because most banks did not offer deposit insurance. The official unemployment rate skyrocketed to 25% in the United States, thousands became homeless and hundreds committed suicide.
Government actions made things even worse when politicians passed productivity stifling labor laws, enacted protectionism (imposition of import tariffs and quotas) and increased taxes. In addition, the Federal Reserve in the United States increased interest rates and allowed the money supply to contract to dangerously low levels.
Some economists believe that the Great Depression was caused by the free market and that more government involvement in the economy was necessary to avoid the severe economic downfall of the 1930s. Classical and neo-classical economists, on the other hand, believe that the increase in government involvement in the economy in the 1920s and immediately after the stock market crash harmed the economy significantly. The easy lending policies by the Federal Reserve in the 1920s is said to have created and enabled the borrowing bubble in the stock market that, after it burst, affected main street (jobs, unemployment) in an adverse way. According to Andrew Bernstein: “Today it is certain that the growing preponderance of professional economists agree on two broad points: it was government intervention in some form – not the free market – that initiated the crash and, similarly it was statism that exacerbated the depression, causing it to last for an agonizing decade, even into the 1940s.” (Bernstein A., 2005, P. 379).
See: Bernstein, A. (2005). The Capitalist Manifesto. Lanham, Maryland: University Press of America, Inc., and Milton Friedman in https://www.youtube.com/watch?v=ObiIp8TKaLs.
For a video explanation of the causes and consequences of the Great Depression of the 1930s, please watch: