The Great Depression
We have just talked about the general course of speculation and its relation to depression. Speculation was also the catalyst for the Great Depression, but this time it was a little bit different. The difference was, millions of people were speculating, on the stock market. The stock market had become almost a form of national lottery. Before the crash, the number of shares traded daily went from two to three million to over five million, and on extremely active days over 10 million stocks would be traded. There was an amazing amount of activity for that time.
Much of this trading was done with borrowed money. Brokerage firms and banks offered generous terms to people who wanted to borrow money to play the stock market. In some cases, bank employees themselves would play the market with the bank's money.
Because of this activity - the jump in the number of shares traded - stock prices rose continuously for more than a year. Soon the prices paid for these stocks had no relation to their value; it was simply the speculative nature of the market which was increasing their prices.
Eventually, of course, any speculative bubble has to burst; an artificial expansion can go on only so long. The speculators push up prices as high as possible, and try to anticipate when they have reached their highest so they can sell off just before the bubble burst. Once the general mood changes, once enough speculators decide that prices won't rise anymore, then there is the start of a collapse. This happened in October of 1929. The speculative bubble burst.
When the 1929 bubble burst, stock prices collapsed, and it became apparent that many of the people playing the stock market had done so not with their own money, but with money borrowed from banks and brokerages. As collateral for these loans, the banks and brokerages accepted stock. However, the amount assigned for collateral was the inflated value of the stock. When the prices dropped, this collateral often became practically worthless. As a result, these banks failed.
The failure of a number of large banks created a run on banks across the country as people attempted to withdraw their savings. Banks, obviously, make money by loaning money, and so keep only a small percentage of deposits on hand. When the run began, most banks lacked sufficient cash reserves to satisfy their depositors, and so were forced to close their doors. Further, the general decline in prices pushed many banks into insolvency. They had loaned out money at the inflated pre-crash prices, and after the deflation the collateral was worth less. Even prudent banks which had only made loans backed by solid collateral went under, because of the drastic contraction of the economy. Over 9,000 banks went under or closed down during the Depression.
There are three factors. There is the weakness in demand which was the result of the transitional nature of the economy, the possibility of fluctuation in demand which was part of industrialism, and the collapse of the stock market and then our banking system. The three combined to cause a massive drop in demand. Few people had any money to buy anything. The drop in demand was followed by a drop in supply. Our gross national product shrank 25%. Farm incomes, already low, dropped even further. Businesses were both afraid to invest money in capital goods and unable to find money, so investment dropped. The whole of our economy contracted.
The banking failure had another effect as well; it caused a crisis of confidence in our economic system. Bluntly put, many people in this country no longer trusted the institutions of capitalism, and weren't even sure that the present economic system would survive. This was a time in which there was a great deal of uncertainty as to what the future held. Banks couldn't be trusted, the stock market couldn't be trusted. Millions of people had lost their life savings, and the obvious culprits were the people who had abused the system by speculating on the stock market.
The classical economists were unable to explain either the Depression or why the economy did not rebound. This opened the door for the New Economists. They felt that they had a pretty good awareness of the causes of the Depression; they recognized the softness of demand due to the transitional nature of the economy.
They based their explanations of the Depression on two theories, the over savings theory and the under investment theory. Both are concerned with the lack of money in circulation, and hence the weakness in demand. The over savings theory suggests that too much money was being saved, and so it was being taken out of the economy instead of being used for consumption. The under investment theory suggested that the money being saved was not being injected back into the economy by way of investment; the possibilities for investment did not keep up with the supply of money. Essentially these are two different parts to the same theory. Too much money is in the banks and not in circulation, so supply and demand do not balance; there is a shortage in demand.
Both of these are a reflection of the transitional stage of the economy, beyond agrarianism but not yet to mature industrialism. This country by that time had a small upper class consisting of industrialists and old money families, a small middle class consisting of professionals, managers and some skilled workers, and a lower class comprising almost two thirds of the population, consisting of farmers and unskilled industrial workers. There is a tendency to think of America as always having had a large middle class, but this is not true; our large middle class really didn't develop until the late forties and fifties. In a situation such as that which existed in the twenties, there was a vast disparity in income and savings. The lower class had to spend almost all, if not all of its earnings just to survive. The upper class, on the other hand, was accumulating great sums of money during this time, and was able to save a comparatively large percentage of its money. In aggregate terms, the amount of money being saved was not disproportionately large. In a mature economy, this money would be recirculated into the economy in the form of investment. However in this partially developed industrial economy, there were a limited number of investment opportunities. There was only a very limited consumer segment, and so there were not enough investment opportunities to justify borrowing the money from the banks. As a result, money was not invested in productive activities. There were simply not enough industries, nor large enough markets, to justify a level of investment which would recirculate a large percentage of the money being saved.
So the theories of the New Economists recognized and explained the problems this transitional phase posed. Unfortunately, they didn't look at this as the heart of the problem. Instead they believed it was because the government had not taken responsibility for planning the economy. They believed that supply and demand had not balanced because the government had not balanced them.
Essentially, the economists were completely rejecting the equilibrium theory of classical economics. They assumed that supply and demand would not have a tendency to meet equilibrium, achieve a balance, at or near full employment. This is something that happens time and again. Someone, or a group of people, comes up with a new awareness that increases understanding. But instead of seeing the new awareness as an extension of what we already know, increasing the present body of knowledge, the discoverer tends to look at what they have found as a completely new view, one which invalidates the old view, proves it wrong. This was the case with the New Economists. What they recognized really was an advance in our comprehension of how the economy works; it showed a weakness in the classical theory, and offered an explanation which better described reality. But this didn't mean the classical theory was wrong; it was just incomplete. The New Economists rejected the classical theory altogether; they assumed that supply and demand would not tend to reach an equilibrium at or near full employment, but would tend to be somewhat disassociated, creating fluctuations in the economy. This was their justification for having government play a leading role in the economy. Supply and demand could not be counted on to balance, so it was the government's responsibility to insure that they did.
This was the role for government they suggested to Roosevelt, making sure that supply and demand would be equal. Essentially, this was a two fold suggestion. One part involved putting more money into the hands of consumers to strengthen demand. But they saw this weakness in demand as an effect of the central cause: there was not a rationally planned economy. The economy was being left to chance in the hope that supply and demand would balance, taking advantage of the information accumulated by economists. The New Economists felt they had learned enough to allow the government to apply scientific management to the economy as a whole. By determining the level of production needed and its cost, the government would be able to insure that the economy was always in balance. They would maintain full employment, achieve maximum productivity, and remove the fluctuations from the economy. Not only would there not be another depression, there would no longer be any business cycles.
They called their suggested role "national planning." A nationally planned society would remove the competition from our economy. Our economic resources would then be used to benefit everybody, and the U.S. would only produce what was needed. Part of this plan would allow businesses to get bigger. Businesses could become less competitive, easier for the government to control and also less likely to suffer from market fluctuations. Government would take over planning and regimentation, telling each company what to produce and at what price to produce it. Because there was no effort wasted on competition, and companies were so much larger and more "efficient", only that which was wanted would be produced, and so, everybody's needs would be better satisfied. People would eventually realize that it was due to government control.
Next: Roosevelt's Response