Before the 1920s
Before the 1920s, many 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 (before 1913).
The Roaring ’20s
Except for a recession in the early 1920s, this decade experienced economic prosperity and low unemployment. Vast growing innovations 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 and assembly line innovations, 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 a person who purchased $5,000 worth of stocks could have borrowed $4,500 while putting in only $500 of his or her own money. When the market crashed many stocks lost at least half of their value. The person in the example above owned $2,500 worth of stocks while owing the bank $4,500 and losing his or her 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 banks in financial hardship.
The above set of circumstances is very similar to the recent housing crisis of 2008. However, instead of borrowing (too much) money to participate in the appreciation of houses and real estate during the 1990s and beyond, people borrowed (too much) money to purchase stocks during the 1920s.
After the stock market crash of 1929, even people without stock market investments felt the pain because overall economic confidence eroded and businesses were reluctant to invest and hire. Bankruptcies ensued and loans couldn’t be paid back. As banks failed, many people lost their life’s savings because many banks did not offer deposit insurance. Problems on Wall Street turned into problems on “Main Street” and unemployment skyrocketed to 25%.
Governments around the world, influenced by John Maynard Keynes, attempted to correct the failing economy by increasing their involvement in the areas of fiscal and monetary policy, labor laws, and protectionism, and by increasing taxes, interest rates, and the national debt.
Some economists believe that the Great Depression was caused by the free market and that more government involvement in the economy could have avoided 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 before the Great Depression (creation of the Federal Reserve in 1913, many labor laws, creation of anti-trust laws, increases in tariffs and quotas on foreign goods, higher taxes, etc.) increased business costs and harmed the economy. Businesses were able to shoulder these costs during many of productive years of the 1920s. However, when the economy slowed after the stock market crash, the costs were too much to handle for many businesses. In addition, the easy lending policies by the Federal Reserve in the 1920s is said to have created the borrowing bubble in the stock market that, after it burst, affected main street (jobs, unemployment) in an adverse way. According to Milton Friedman, once the stock market crash lead to a recession, the United States government made things worse by raising taxes and interest rates (the Fed allowed the money supply to contract considerably), and passing economically harmful protectionist laws. 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: