Scrutiny of the 1929 Global Financial Crisis:

Causes, Features, Consequences and Remedy Tools

By

Amir N. R. Armanious

Lecturer of Economics and Finance, Cairo University

nasry_amir@yahoo.com

Abstract

The Worldwide economic downturn that began in 1929 and lasted almost until 1939
was the longest and most severe financial crisis that ever led to depression and
experienced by the developed countries. Although the depression originated in the
United States, it resulted in drastic declines in output, severe unemployment, and
acute deflation in almost every country of the globe. The defining characteristic of the
1929 financial crisis is the wholesale collapse of virtually every aspect of the
economy. For over four years, beginning in the summer of 1929, financial markets
and institutions, labor markets and international currency and goods markets all
virtually ceased to function. Throughout this, the government policymaking apparatus
seemed helpless. The study seeks the analysis of the main causes, features,
consequences and remedy tools of the 1929 global financial crisis. The study presents
a review and scrutiny of the 1929 financial crisis. It presents a discussion for the
reasons of the crisis in terms of roaring twenties, credit boom, low interest rate,
speculation, investment trust and margin trade. Furthermore, it represents a
descriptive analysis for the features and consequences of the 1929 crisis on the
financial sector and real economy as well as the remedy tools applied for the crisis.

Key Words

Financial Crisis, Great Depression, Banking Crisis, New Deal Policies,

Reconstruction Finance Corporation.

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Introduction

The Great Depression was the worst collapse in the history of world economy.
Throughout the 1930s, neither the free market nor the federal government was able to
get the country working again. The American people endured a full decade of almost
unbelievable economic misery. During 1930-33, the U.S. financial system
experienced conditions that were among the most difficult and chaotic in its history.
By March 1933, waves of bank failures culminated in the shutdown of the banking
system and a number of other intermediaries and markets. On the other side of the
ledger, exceptionally high rates of default and bankruptcy affected every class of
borrower except the federal government (Bernanke, 1983).

The great depression resulted from the excesses of the 1920s; excessive production of
commodities, excessive building, excessive financial speculation or an excessively
skewed distribution of income and wealth. None of these explanations has held up
very well over time. One explanation that has stood the test of time focuses on the
collapse of the U.S. banking system and the resulting contraction of the nation’s
money stock. Friedman and Schwartz (1963) made a strong case that a falling money
stock caused the sharp decline in output and prices in the economy.

The great depression was heralded by the crash of 1929. In the U.S., the effects were
harsh; industrial production declined by 47%, real GDP by 30% and unemployment
topped 20% (Galbraith, 2009). There was a stock market crash, a credit crunch, the
great depression was preceded by cheap credit, a property boom, increasing consumer
debt, and rising equity prices (Eichengreen and Mitchener, 2003).

In the 1930s, the industrialized economies fell into a deep crisis, because of the
continuous decrease of aggregate demand as well as output and the rise of
unemployment rate which was 3% in August 1929 reached 25% in U.S. and Germany
in 1933.

The fundamental cause of the 1929 economic crisis in the U.S. was a decline in
spending (aggregate demand), which led to a decline in production as manufacturers
and merchandisers noticed an unintended rise in inventories. The sources of the
contraction in spending in the U.S. varied over the course of the Depression, but they
cumulated into a monumental decline in aggregate demand. The U.S. decline was

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transmitted to the rest of the world largely through the gold standard. However, a
variety of other factors also influenced the downturn in various countries (Romer,
1992).

Friedman and Schwartz (1963) highlighted that monetary orthodoxy has associated
the Great Depression with restrictive monetary policies. From mid-1928 to August
1929, the Federal Reserve responded to the stock market boom with repeated interest
rate hikes and a slowdown in monetary growth. Monetary policy continued to be
restrictive during the depression, as the Federal Reserve interpreted bank failures such
as the Bank of the United States in late 1930 as the necessary recovery of an
unhealthy financial structure. Impulses from monetary policy did not come to be
expansionary until the New Deal, and when the swing finally occurred it apparently
came as a surprise to economic agents (Temin and Wigmore, 1990).

The 1929 stock market crash is the main feature of the Great Depression. The crash
destroyed considerable wealth. Perhaps even more important, the crash sparked
doubts about the health of the economy, which led consumers and firms to pull back
on their spending, especially on big-ticket items like cars and appliances. However, as
big as it was, the stock market crash alone did not cause the Great Depression.

There were multiple causes for the first downturn in 1929, including the structural
weaknesses and specific events that turned it into a major depression and the way in
which the downturn spread from country to country. In relation to the 1929 downturn,
historians emphasize structural factors like massive bank failures and the stock market
crash, while economists (such as Temin and Eichengreen) pointed to Britain's
decision to return to the Gold Standard at pre-World War I parities.

The Federal Reserve played a key role in nearly every policy failure in the function of
the central bank and the financial system during this period. There is nowadays a
broad consensus that 1) the collapse of the financial system could have been stopped
if the central bank had properly understood its function as the lender of last resort, 2)
deflation played an extremely important role deepening the Depression, 3) the gold
standard, as a method for supporting a fixed exchange rate system, was disastrous
(Cecchetti, 1997).

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I. Causes of The 1929 Financial Crisis

The 1929 financial crisis happened mainly due to speculations on land and stocks but
there were also many other contributing factors such as roaring twenties, public
budget surpluses, tax cuts, credit boom, low interest rate, investment trust, and margin
trade.

The boom is fed by an expansion of bank credit that enlarges the total money supply.
Banks typically can expand money, whether by the issue of bank’s notes under earlier
institutional arrangements or by lending in the form of addictions to bank deposits.
Such credit expansion was due to public budget surpluses, tax cuts, and Federal
Reserve monetary expansion after recession of 1920-21.

However, devaluation did not increase output directly. Rather, it allowed countries to
expand their money supplies without concern about gold movements and exchange
rates. Countries that took greater advantage of this freedom saw greater recovery. The
monetary expansion that began in the U.S. in early 1933 was particularly dramatic.
The U.S. money supply increased nearly 42 percent between 1933 and 1937. This
monetary expansion stemmed largely from a substantial gold inflow to the U.S.,
caused in part by the rising political tensions in Europe that eventually led to WWII
(Romer, 1992).

Worldwide monetary expansion stimulated spending by lowering interest rates and

making credit more widely available. It also created expectations of inflation, rather
than deflation, and so made potential borrowers more confident that their wages and
profits would be sufficient to cover their loan payments if they chose to borrow. One
sign that monetary expansion stimulated recovery in the United States by encouraging
borrowing was that consumer and business spending on interest sensitive items such
as cars, trucks, and machinery rose well before consumer spending on services.

I.1 Roaring Twenties

The Roaring Twenties used to describe the 1920s, principally in North America but
also in London, Paris and Berlin. The phrase was meant to emphasize the period's

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social, artistic, and cultural dynamism. The Roaring Twenties was an era of great
economic growth and widespread prosperity driven by government growth policies, a
boom in construction, and the rapid growth of consumer goods such as automobiles.
The North American economy, particularly the economy of the U.S., which had
successfully transitioned from a wartime economy to a peace time economy, boomed,
although there were sectors that were stagnant, especially farming and mining. The
U.S. augmented its standing as the richest country in the world, its industry aligned to
mass production and its society acculturated into consumerism. In Europe, the
economy did not start to flourish until 1924 (Streissguth, 2007).

I.2 Public Budget Surpluses

World War I brought large deficits that totaled $23 billion over the 1917–19 period.
The budget was then in surplus throughout the 1920s. Total budget surplus reached its
maximum in 1927 as it reached $1,155 million. However, the combination of the
Great Depression followed by World War II resulted in a long, unbroken string of
deficits that were historically unprecedented in magnitude. As a result, Federal debt
held by the public mushroomed from less than $3 billion in 1917 to $16 billion in
1930 and then to $242 billion by 1946. In relation to the size of the economy, debt
held by the public grew from 16% of GDP in 1930 to 109% in 1946 (Gordon, 2008).

Subsequent to the enactment of income tax legislation in 1913, these taxes grew
in importance as a Federal receipts source during the following decade. By 1930,
the Federal Government was relying on income taxes for 60% of its receipts,
while customs duties and excise taxes each accounted for 15% of the receipts
total (Gordon, 2008).

I.3 Tax Cuts

One of the main initiatives of both the Harding and Coolidge administrations was the
rolling back of income taxes on the wealthy which had been raised during World War
I. It was believed that a heavy tax burden on the rich would slow the economy, and

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actually reduce tax revenues. This tax cut was achieved under President Calvin
Coolidge's administration. Furthermore, Coolidge consistently blocked any attempts
at government intrusion into private business. Harding and Coolidge's managerial
approach sustained economic growth throughout most of the decade. The top tax rate
is lowered to 25 percent, the lowest top rate in the eight decades since World War I
(Murray, 1973).

I.4 Credit Boom

The literature on credit booms is concerned with both the growth of credit and its
effects. A significant expansion of the supply of credit is not sufficient by itself to
constitute a boom of the sort that was of concern to the Austrians or which nowadays
attracts the attention of economists like Borio and Lowe (2002). The critical aspect is
that the growth of credit should be associated with a rise in asset prices and
acceleration in rates of fixed investment relative to trend. It is this confluence of
factors that could comprise the distinction between credit boom and credit growth.
Whether credit booms and credit growth have significantly different implications for
the subsequent development of the economy is of course what determines whether
this distinction has substance.

Brunner and Meltzer (1976) emphasized that money and credit are not the same. Bank
money is not the only source of credit to households and corporate; firms can also
obtain credit through securities markets. This is only one of several reasons why the
two variable are not the same, albeit perhaps the most important one. During 1929
financial crisis, banks were more important as a source of credit as securities markets
in most countries have not gained the depth and liquidity they were to acquire
subsequently.

The credit boom in 1929 financial crisis stimulating investment both directly by
making external funding more freely available and reducing collateral constraints, and
indirectly, by raising Tobin's Q and the incentive to invest. Although those
movements are dominated by the collapse in the 1930s, as a result of which
fluctuations around trend in the second half of the 1920s hardly stand out, it is still
evident that a number of countries experienced surges in investment in the 1920s.

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There are a few exceptions worth noting. France experienced an investment boom in
the late 1920s, which extends through 1930, reflecting its relatively late postwar
stabilization in 1926, and the surge of investment initiated with the end of the post-
stabilization recession in 1927, sustained by the large amounts of financial capital that
flowed back to the country as the strong franc came to be seen as a safe haven (Patat
and Lutfalla, 1990).

There was a sharp rise in the importance of foreign exchange reserves relative to gold,
compared to the prewar era, imparting more elasticity to global supplies of money and
credit. During the boom period (1924-28) the share of foreign exchange in the total
reserves (gold plus FOREX) of the 24 central banks considered by Nurkse (1944) rose
from 27 to 42 percent, before falling back slightly to 37 percent in 1929. Then it
collapsed to 19 percent in 1931 and 8 percent in 1932. This lent procyclical elasticity
to money and credit under the hybrid interwar gold-exchange standard. It is one
reason why the elasticity of credit creation could have been higher than suggested by
models of the gold standard system.

Cairncross (1953) and Ford (1962) suggested that changes in money and credit
conditions occurring in response to investment fluctuations were an important source
of global business cycle fluctuations under the pre-1914 gold standard. Portraits of the
consequences do not suggest that credit booms were less pronounced in the gold-
standard years than under subsequent monetary regimes.

Although the deflation of the 1930s was unusually protracted, there had been a similar
episode as recently as 1921-22 which had not led to mass insolvency. The Great
Depression was not only due to the extent of the deflation, but also to the large and
broad-based expansion of inside debt in the 1920s. Persons (1930) reported that
outstanding corporate bonds and notes increased from $26.1 billion in 1920 to $47.1
billion in 1928, and that non-federal public securities grew from $11.8 billion to $33.6
billion over the same period. (This may be compared with a 1929 national income of
$86.8 billion) Perhaps more significantly, during the 1920s, small borrowers, such as
households and unincorporated businesses, greatly increased their debts. The value of
urban real estate mortgages outstanding increased from $11 billion in 1920 to $27
billion in 1929, while the growth of consumer installment debt reflected the
introduction of major consumer durables to the mass market.

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The fall in bank loans outstanding was partly offset by the relative expansion of
alternative forms of credit. In the area of consumer finance, retail merchants, service
creditors, and nonbank lending agencies improved their position relative to banks and
primarily bank-supported instalment finance companies (Nugent, 1939). Small firms
during this period significantly reduced their traditional reliance on banks in favour of
trade credit (Merwin, 1942). But in a world with transactions costs and the need to
discriminate among borrowers, these shifts in the venue of credit intermediation must
have at least temporarily reduced the efficiency of the credit allocation process,
thereby raising the effective cost of credit to potential borrowers.

I.5 Low Interest Rate

The run up to the 1929 Equity Market Crash was characterized by easy monetary
policy. The FED cut rates in 1927, and borrowing was cheap until the spring of 1928,
when it became only a little more expensive. Low interest rates made borrowing
attractive, so both corporate and financial leverage increased.

Cheap money alone is not enough to create a boom (Galbraith, 2009). In addition,
there is both a ready supply of money for investment and a broad sense of confidence.
The early and mid-1920s were a period of growth and stability. Equity prices were
rising, and the market became more than just the talk of a small number of financial
experts. Many ordinary people wanted a piece of the action.

Frederiksen (1931) mentioned “we see money accumulating at the centres, with
difficulty of finding safe investment for it; interest rates dropping down lower than
ever before; money available in great plenty for things that are obviously safe, but not
available at all for things that are in fact safe, and which under normal conditions
would be entirely safe but which are now viewed with suspicion by lenders”. The idea
that the low yields on Treasury or blue-chip corporation liabilities during this time
signalled a general state of easy money is mistaken as money was easy for a few safe
borrowers, but difficult for everyone else.

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I.6 Speculation

After a period of time, increased demand presses against the capacity to produce
goods or the supply of existing financial assets. Prices increase, giving rise to new
profit opportunities and attracting still further firms and investors. Positive feedback
develops, as new investment leads to increases in income that stimulate further
investment and further income increases. Speculation for price increases is added to
investment for production and sale. If this process builds up, the result is often,
though not inevitably overtrading.

Excessive gearing arises from cash requirements that are low relative both to the
prevailing price of a good or asset and to possible changes in its price. It means
buying on margin, or by installments, under circumstances in which one can sell the
asset and transfer with it the obligation to make future payments. As firms or
households see others making profits from speculative purchases and resales, they
tend to follow "Monkey see, monkey do”. Therefore in 1929 financial crisis there
were low price of stocks in the early 1920s, easy credit, buying on the margin, by
August 1929, brokers were routinely lending small investors more than 2/3 of the face
value of the stocks they were buying, and over $8.5 billion was out on loan, more than
the entire amount of currency circulating in the U.S. (Kindleberger, 2005).

I.6.1 Property Boom till 1925

Florida in the mid 1920s - like Florida in the early 2000s - enjoyed steeply rising
property prices. Increasing numbers of people were moving to the state, and
speculative development boomed to exploit them. By 1926, the supply of new
property outpaced the supply of new buyers, and prices started to level out. Then, in
the autumn of that year, two hurricanes devastated coastal areas. Investors realized
that Florida was not paradise. Prices fell, speculative developments and leveraged
investors failed. Mortgage defaults rose dramatically. This in turn caused severe
distress to mortgage banks (Murphy, 2009).

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The Florida boom and bust did not kick off the Great Depression. However, it was a
warning that speculative bubbles could develop in the U.S. economy of the 1920s, and
that the bust, when it happened, could be both unexpected and severe.

Another aspect of the financial crisis was the pervasiveness of debtor insolvency.
Given that debt contracts were written in nominal terms, the protracted fall in prices
and money incomes greatly increased debt burdens. According to Clark (1933), the
ratio of debt service to national income went from 9 percent in 1929 to 19.8 percent in
1932-33. The resulting high rates of default caused problems for both borrowers and
lenders. The debt crisis touched all sectors. About half of all residential properties
were mortgaged at the beginning of the Great Depression; according to the Financial
Survey of Urban Housing (Hart, 1937).

In the early 1920s, intense real estate speculation (particularly in Florida and at the
fringes of major urban areas) failure due to over supply and lack of demand and
resulted in major loan defaults. This started a cascade of bank failures in 1928 and
1929 leading up to the October 1929 stock market crash.

Because of the long spell of low food prices, farmers were in more difficulty than
homeowners. At the beginning of 1933, owners of 45 percent of all U.S. farms,
holding 52 percent of the value of farm mortgage debt, were delinquent in payments
(Hart, 1937). State and local governments tried to provide relief for the unemployed,
also had problems paying their debts. As of March 1934, the governments of 37 of the
310 cities with populations over 30,000 and of three states had defaulted on
obligations (Hart, 1937).

One way for banks to adjust to a higher CCI is to increase the rate that they charge
borrowers. This may be counterproductive, however, if higher interest charges
increase the risk of default. The more usual response is for banks just not to make
loans to some people that they might have lent to in better times. This was certainly
the pattern in the 1930s. For example, it was reported that the extraordinary rate of
default on residential mortgages forced banks and life insurance companies to
practically stop making mortgage loans, except for renewals (Hart, 1937). This
situation prohibited many borrowers, even with good projects, from getting funds,
while lenders rushed to compete for existing high-grade assets.

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Home mortgage lending was another important area of credit activity. In this sphere,
private lenders were even more cautious after 1933 than in business lending. They had
a reason for conservatism; while business failures fell quite a bit during the recovery,
real estate defaults and foreclosures continued high through 1935. Some traditional
mortgage lenders nearly left the market: life insurance companies, which made $525
million in mortgage loans in 1929, made $10 million in new loans in 1933 and $16
million in 1934. During this period, mortgage loans that were made by private
institutions went only to the very best potential borrowers. Evidence for this is the
sharp drop in default rates of loans made in the early 1930s as compared to loans
made in earlier years (Behrens, 1952); this decline was too large to be explained by
the improvement in business conditions alone.

The home mortgage market functioned in the years immediately following 1933,
mainly because the direct involvement of the federal government. Besides
establishing some important new institutions (such as the FSLIC and the system of
federally chartered savings and loans), the government readjusted existing debts,
made investments in the shares of thrift institutions, and substituted for intractable
private institutions in the provision of direct credit. In 1934, the government
sponsored Home Owners' Loan Corporation made 71 percent of all mortgage loans
extended (Murphy, 2009).

I.6.2 Stocks 1928-29

It has been amply documented, initially by Friedman and Schwartz (1963) and
recently by Hamilton (1983) and others, that Federal Reserve policy became
substantially tighter in the fall of 1928, almost immediately following the death of
Benjamin Strong, the President of the Federal Reserve Bank of New York. Strong
controlled Federal Reserve policy, as the Federal Reserve Board was not as powerful
as it is nowadays, while Adolph Miller of the Federal Reserve Board was able to take
control of policy. Miller believed that speculation was causing share prices to be too
high, and that this was damaging the economy. Together with Herbert Hoover, who
had just been elected President, Miller set out to bring down the stock market.

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The initial decline in output in the U.S in the summer of 1929 is widely believed to
have stemmed from tight U.S. monetary policy aimed at limiting stock market
speculation. The 1920s had been a prosperous decade, but not an exceptional boom
period; wholesale goods prices had remained nearly constant throughout the decade
and there had been mild recessions in both 1924 and 1927. The one obvious area of
excess was the stock market. Stock prices had risen more than fourfold from the low
in 1921 to the peak reached in 1929. In 1928-29, the Federal Reserve had raised
interest rates in hopes of slowing the rapid rise in stock prices. These higher interest
rates depressed interest-sensitive spending in areas such as construction and
automobile purchases, which in turn reduced production. Romer (1992) believed that
a boom in housing construction in the mid-1920s led to an excess supply of housing
and a particularly large drop in construction in 1928-29.

The crash followed a speculative boom that had taken hold in the late 1920s, which
had led hundreds of thousands of Americans to invest heavily in the stock market, a
significant number even borrowing money to buy more stocks. By August 1929,
brokers were routinely lending small investors more than two thirds of the face value
of the stocks they were buying. Over $8.5 billion was out on loan, more than the
entire amount of currency circulating in the U.S. at the time (Financial Times, 2008).

The rising share prices encouraged more people to invest; people hoped the share
prices would raise further. Speculation thus fueled further rises and created an
economic bubble. The average price to earnings (P/E) ratio of S&P composite stocks
was 32.6 in September 1929, clearly above historical norms. Most economists view
this event as the most dramatic in modern economic history. Between May 1928 and
September 1929, the average prices of stocks rose 40 percent. Trading mushroomed
from 2-3 million shares per day to over 5 million. The boom is largely artificial
(Murphy, 2009).

I.7 Investment Trust

Investment trusts were launched; at first, these vehicles offered retail investors the
chance to make a diversified equity investment. Thus, rather than buying shares in
twenty or thirty companies - roughly the minimum at the time thought necessary to

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have some measure of diversification - the investor could buy shares in one
investment trust, and the trust would in turn invest in a collection of different shares
(Speaker, 1928).

A series of events revealed the fragility of the banking system which had evolved
since the foundation of the Federal Reserve. During the 1920s, financial markets
changed rapidly. Entrepreneurs invented new financial instruments and forms of
consumer credit. Individuals began investing in the equity markets to a hitherto
unimagined extent. Markets became more tightly integrated across space and time.
Financial conglomerates grew to take advantage of these opportunities. These new
organizations included banking chains and groups and also organizations that spanned
commercial and investment banking, insurance, real estate, equity trading, and
brokerage services. These organizations enabled corporations and individuals to
access the rapidly modernizing financial system.

I.8 Margin Trade

The investment trust started to use leverage: they borrowed, so that they could invest
in more shares. They also bought shares in other leveraged investment trusts, increas-
ing leverage further.

Further, buying on margin became commonplace. Investors would use their stock as
collateral for a loan, allowing them to buy three, four or sometimes even more times
the notional they had to invest. Total margin lending rose as the market did,
increasing roughly five fold from the early 1920s to 1928. As prices raced ahead more
investors were drawn into the market, and the volumes of shares traded increased fast
(Curley, 2008).

The share price rises of the 1920s were spectacular. The Dow Jones Industrial
Average was at 158.75 at the start of 1926, but it had more than doubled, to 381.17,
by late 1929 (www.djindexes.com). There was a general sense that the ordinary
person could get rich quickly by investing in stocks.

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During the Crash of 1929 preceding the Great Depression, margin requirements were
only 10%. When the market fell, brokers called in these loans, which could not be
paid back. Banks began to fail as debtors defaulted on debt and depositors attempted
to withdraw their deposits all together, triggering multiple bank runs. Government
guarantees and Federal Reserve banking regulations to prevent such panics were
ineffective or not used (Curley, 2008).

I.9 Financial Institutions and Corporate Leverage

Economic historians believed that substantial increases in farm debt in the 1920s,
together with U.S. policies that encouraged small, undiversified banks, created an
environment where such panics could ignite and spread. The heavy farm debt
stemmed in part from the response to the high prices of agricultural goods during
World War I. American farmers borrowed heavily to purchase and improve land in
order to increase production. The decline in farm commodity prices following the war
made it difficult for farmers to keep up with their loan payments.

I.10 Fraud

In the dying days of the Hoover administration, Republicans reluctantly agreed to two
initiatives which would later become crucial. The first were hearings under the
auspices of the Senate Banking and Currency Committee to investigate the 1929
Crash. These are sometimes known as the Pecora Hearings after the most effective
Chief Counsel to the committee, Ferdinand Pecora. What they uncovered shattered
the moral authority of the financial community. There were three main strands to the
bad behavior uncovered by these hearings (Murphy, 2009):

o Crony capitalism and insider trading; Shares had been offered to friends at
well below market prices, company officers had awarded themselves low or
no interest loans, and insider information had frequently been used for profit.

o Fraud or quasi-fraudulent lack of disclosure; There were examples of simple

fraud, falsified accounts for instance, but also more subtle deceptions. For

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 instance bonds were sold as high quality debt even though the sponsor had
reason to believe the issuer would default. This deceit was presumably enacted
so that the underwriter could collect their fees.

o Antisocial behavior; It was revealed that JP Morgan, one of the richest

financiers in America, paid no tax in 1930, 1931 or 1932, perfectly legally.
With millions starving, disclosures like this did nothing to enhance the
prestige of finance.

In November and December 1930, these new and supposedly superior institutions
showed signs of weakness. Correspondent networks (such as Caldwell’s) collapsed.
Banking chains (such as A.B. Banks) failed. Banking groups (such as
BancoKentucky) also failed. Three prominent conglomerates (Caldwell in Middle
America, the Bank of the United States in New York, and the Guaranty Building and
Loan Association in California) failed. Their demise resulted in three of the largest
bankruptcies in U.S. to that date. Scandals swirled around each bankruptcy.
Defalcation undermined each institution. False financial reports deceived investors
and depositors, who lost large sums as a result. For months, newspapers throughout
the nation reported the scandals at length and in depth on their front pages. The news
must have altered depositors’ beliefs about the safety, stability, and efficacy of the
system. The public reacted by withdrawing funds, increasing holdings of currency,
and switching savings to safer, older, and more transparent institutions.

I.11 Wealth and Income Imbalance

Foster and Catchings (1923) popularized a theory that influenced many policy
makers. It held the economy produced more than it consumed, because the consumers
did not have enough income. Thus the unequal distribution of wealth throughout the
1920s caused the Great Depression. Wages increased at a rate lower than productivity
increases. Most of the benefit of the increased productivity went into profits, which
went into the stock market bubble rather than into consumer purchases.

As long as corporations had continued to expand their capital facilities (their factories,
warehouses, heavy equipment, and other investments), the economy had flourished.

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Under pressure from the Coolidge administration and from business, the Federal
Reserve Board kept the discount rate low, encouraging high and excessive
investment. However, by the end of the 1920s, capital investments had created more
plant space than could be profitably used, and factories were producing more than
consumers could purchase.

The root cause of the Great Depression was a global overinvestment in heavy industry
capacity compared to wages and earnings from independent businesses, such as
farms. The solution was the government must pump money into consumers' pockets.
That is, it must redistribute purchasing power, maintain the industrial base, but
reinflate prices and wages to force as much of the inflationary increase in purchasing
power into consumer spending. The economy was overbuilt, and new factories were
not needed. Foster and Catchings (1923) recommended federal and state governments
start large construction projects, a program followed by Hoover and Roosevelt.

Franklin D. Roosevelt elected in 1932 and inaugurated March 4, 1933, blamed the
excesses of big business for causing an unstable bubble-like economy. Democrats
believed the problem was that business had too much money, and the New Deal was
intended as a remedy, by empowering labor unions and farmers and by raising taxes
on corporate profits. In addition, excess price and entry competition, integrated
banking, and the sheer size of corporations were viewed as contributing factors.
Regulation of the economy was a favorite remedy to this problem.

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II. Features of The 1929 Financial Crisis

Speculation for profit leads away from normal, rational behavior to what has been
described as manias or bubbles. As distress persists, speculators realize, gradually or
suddenly, that the market can not go higher. It is time to withdraw. The race out of
real or long-term financial assets and into money may turn into a panic. The distress
in 1929 financial crisis resulted in economic downturn in spring/summer 1929,
reduced profit expectations, and Black Friday.

In 1931, the expectations that the international financial system would collapse
became self-fulfilling. A general attempt to convert currencies into gold drove one
currency after another off the gold-exchange standard. Restrictions on the movement
of capital or gold were widely imposed. By 1932, only the United States and few
countries remained on gold.

The experience of different countries and the mix of depressive forces each faced
varied significantly. For example, Britain, suffering from an overvalued pound, had
high unemployment throughout the 1920s; after leaving gold in 1931, it was one of
the first countries to recover. The biggest problems of food and raw materials
exporters were falling prices and the drying up of overseas markets. Thus there is no
need not look to the domestic financial system as an important cause in every case
(Bernanke, 2004a).

The significance of pigou effect or real balance effect during the 1929 financial crisis
was clear according to the monetary approach. Assuming that the behaviors are not
altered a stable money stock or a stock decreasing at a lower rate than the price level
should encourage the consumption through a wealth effect since the real money
balances will be increased. In some countries, like U.S. the money stock decreased as
much as the price level. In those countries the pigou effect did not appear since the
money stock contraction offset the real effect of the deflation. In some others, where
the average speed of the deflation is higher than the speed of the M1 contraction, the
pigou effect must have worked. But it should not be powerful enough to compensate
the devastating effects of the deflation occurring through the other channels (Bénassy,
2007).

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The return of the private financial system to normal conditions after March 1933 was
not rapid; and that the financial recovery would have been more difficult without
extensive government intervention and assistance. A moderate estimate is that the
U.S. financial system operated under handicap for about five years from the beginning
of 1931 to the end of 1935, a period which covers most of the time between the
recessions of 1929-30 and 1937-38 (Bernanke, 1983).

As the fall of the gold standard parallelled domestic bank failures, the domestic in-
solvency problem had an international analogue as well. Largely due to fixed
exchange rates, the deflation of prices was worldwide. Countries with large nominal
debts, notably agricultural exporters such as Canada, became unable to pay. Foreign
bond values in the United States were extremely depressed.

II.1 Monetary Contraction

The Federal Reserve did little to try to stem the banking panics. Friedman and.
Schwartz (1963), in the classic study ”A Monetary History of the United States”,
argued that the death of Benjamin Strong, the governor of the Federal Reserve Bank
of New York, was an important source of this inaction. Strong had been a forceful
leader who understood the ability of the central bank to limit panics. Strong's death
left a power vacuum at the Federal Reserve and allowed leaders with less sensible
views to block effective intervention.

The panics caused a dramatic rise in the amount of currency people wished to hold
relative to their bank deposits. This rise in the currency to deposit ratio was a key
reason why the money supply in the United States declined 31 percent between 1929
and 1933 (Romer, 1992). In addition to allowing the panics to reduce the U.S. money
supply, the Federal Reserve also deliberately contracted the money supply and raised
interest rates in September 1931, when Britain was forced off the gold standard and
investors feared that the U.S. would devalue as well according to the following table.

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 Table 1
Money Supply and National Income by Type, 1929-33

Money Non-
National Employee Farm Net Corporate
Supply farm Rent
Year Income Compensation Income Interest Profits
(M1- Income (%)
(Billion$) (%) (%) (%) (%)
Billion$) (%)

1929 26.4 84.7 60.3 7.2 9.8 5.8 5.6 11.3

1930 24.6 73.5 63.8 5.9 9.4 5.7 6.7 8.6

1931 21.9 58.3 68.3 5.8 8.9 5.8 8.4 2.7

1932 20.4 42.0 74.1 5.0 7.4 6.4 11.0 -3.8

1933 19.8 39.4 75.1 6.4 7.4 5.1 10.4 -3.8

Source: Hanke (2008).

Romer (1992) believed that such declines in the money supply caused by Federal
Reserve decisions had a severe contractionary effect on output. A simple picture
provides perhaps the clearest evidence of the key role monetary collapse played in the
Great Depression in the United States. Figure 1 shows the money supply and real
output over the period 1900 to 1940. In ordinary times, such as the 1920s, both the
money supply and output tend to grow steadily. But, in the early 1930s, both drop
sharply. The decline in the money supply depressed spending in a number of ways.
Perhaps most importantly, because of actual price declines and the rapid decline in the
money supply, consumers and business people came to expect deflation that is they
expected wages and prices to be lower in the future.

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 Figure 1
Money and Output in U.S.

Source: Romer (1992).

As a result, even though nominal interest rates were very low, people did not want to
borrow because they feared that future wages and profits would be inadequate to
cover the loan payments. In turn, this hesitancy led to severe reductions in both
consumer spending and business investment spending. The panics surely exacerbated
the decline in spending by generating pessimism and a loss of confidence.
Furthermore, the failure of so many banks disrupted lending, thereby reducing the
funds available to finance investment.

Monetarists including Friedman and Bernanke argued that the Great Depression was
mainly caused by monetary contraction, the consequence of poor policymaking by the
American Federal Reserve System and continued crisis in the banking system. In this
view, the Federal Reserve, by not acting, allowed the money supply as measured by
the M2 to shrink by one-third from 1929 to 1933, thereby transforming a normal
recession into the Great Depression. Friedman argued that the downward turn in the
economy, starting with the stock market crash, would have been just another
recession.

However, the Federal Reserve allowed some large public bank failures – particularly
that of the New York Bank of the United States – which produced panic and
widespread runs on local banks, and the Federal Reserve sat idly by while banks

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collapsed. If the Fed had provided emergency lending to these key banks, or simply
bought government bonds on the open market to provide liquidity and increase the
quantity of money after the key banks fell, all the rest of the banks would not have
fallen after the large ones did, and the money supply would not have fallen as far and
as fast as it did. With significantly less money to go around, businessmen could not
get new loans and could not even get their old loans renewed, forcing many to stop
investing. This interpretation blames the Federal Reserve for inaction, specially the
New York branch (Griffin, 2002).

One reason why the Federal Reserve did not act to limit the decline of the money
supply was regulation. At that time the amount of credit the Federal Reserve could
issue was limited by laws which required partial gold backing of that credit. By the
late 1920s the Federal Reserve had almost hit the limit of allowable credit that could
be backed by the gold in its possession. This credit was in the form of Federal
Reserve demand notes. Since a promise of gold is not as good as gold in the hand,
during the bank panics a portion of those demand notes were redeemed for Federal
Reserve gold. Since the Federal Reserve had hit its limit on allowable credit, any
reduction in gold in its vaults had to be accompanied by a greater reduction in credit.
On April 5, 1933 President Roosevelt signed Executive Order 6102 making the
private ownership of gold certificates, coins and bullion illegal, reducing the pressure
on Federal Reserve gold.

Friedman and Schwartz (1963) monetary hypothesis stated that the wrong policies of
Fed caused a continuous decrease of the money stock. Fed is accused for at least three
mistakes. It tightened its monetary policy by increasing interest rates before the
depression began. Not only this behavior led the stock market to the crash, but it also
contributed to the initial deflation. When the price decreases became continuous and
while nominal interest rates were falling, the Fed did virtually nothing, since it
considered this as sign of easy money. It is very doubtful that the Fed’s managers
were aware of the fact that the real interest rates were becoming very high because of
the deflation; thus, the monetary policy was tighter than they thought (Parker, 2004).

The second mistake was Fed’s total inaptitude to prevent the banking panics and
failures, or at least, to decrease their intensity. In fact, the original mission of Fed was
to operate as the lender of last resort. The absence of deposit insurance caused the

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panics to spread to sound financial institutions, and not only those in effective
bankruptcy. When the banking panics came in waves and the financial system was
collapsing, being the lender of last resort was a responsibility that the Federal Reserve
either could not or would not assume (Parker, 2004).

The Fed’s third mistake was the misuse of the Gold Standard. The central banks in
France and U.S., two gold surplus countries, did not lend the money supply to grow
along with the gold flows. In other words, they sterilized the extra gold. This behavior
contributed to the contraction of the money stocks in other countries and fuelled the
propagation of the deflation at the international level (Eichengreen, 1992).

The mixture of tight money and banking panics as well as failures provoked the
decrease of money stocks in every country, touched by the depression. This decrease
in money stocks created deflation prone economies but it also had an adverse effect
on the aggregate demand. The bank failures caused capital/ wealth losses for their
stakeholders. Moreover, if the deflation is even partially anticipated and the decrease
of the money stock is quite high, the opportunity cost of holding money becomes
negative, causing decline in consumption and investment. In essence, the economy is
de-capitalized (Cecchetti, 1997). The economies where the money stock decreased
rapidly faced this real money effect.

Post-holiday credit problems, small businesses, which suffered disproportionately

during the contraction, had continuing difficulties with credit during recovery.
Kimmel (1939) carried out a survey of credit availability during 1933-38 as a
companion to the National Industrial Conference Board's 1932 survey. Kimmel’s
conclusions were generally optimistic. However, Kimmel’s survey results showed
that, of responding manufacturing firms normally dependent on banks, refusal or
restriction of bank credit was reported by 30.2 percent of very small firms
(capitalization less than $50,000); 14.3 percent of small firms ($50,001-$500,000);
10.3 percent of medium firms ($500,001-$1,000,000); and 3.2 percent of the largest
companies (capital over $1 million). The corresponding results from the 1932
National Industrial Conference Board survey were 41.3, 22.2, 12.5, and 9.7 percent.

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II.2 Liquidity Crisis

Since, banks hold only a fraction of the value of their customers’ deposits in the form
of reserves; a sudden unexpected attempt to convert deposits into cash can leave
banks short of reserves. Ordinarily, banks can borrow extra reserves from other banks
or from the Federal Reserve. However, borrowing from other banks becomes
extremely expensive or even impossible when depositors make demands on all banks.
During the Great Depression, many banks could not or would not borrow from the
Federal Reserve because they either lacked acceptable collateral or did not belong to
the Federal Reserve System.

Good borrowers may find it more difficult or costly to obtain credit when there is
extensive insolvency. The debt crisis should be added to the banking crises as a
potential source of disruption of the credit system. Bank failures, caused by economic
decline, no government deposit insurance, depositor’s bank runs, and excess reserves
to guard against runs and money supply all fell notably.

Bank failures snowballed as desperate bankers called in loans which the borrowers
did not have time or money to repay. With future profits looking poor, capital
investment and construction slowed or completely ceased. In the face of bad loans and
worsening future prospects, the surviving banks became even more conservative in
their lending. Banks built up their capital reserves and made fewer loans, which
intensified deflationary pressures. A vicious cycle developed and the downward spiral
accelerated.

As of 1930, a series of banking panics rocked the U.S. financial system. As depositors
pulled funds out of banks, banks lost reserves and had to contract their loans and
deposits, which reduced the nation’s money stock. The monetary contraction, as well
as the financial chaos associated with the failure of large numbers of banks, caused
the economy to collapse.

The financial crisis of 1930-33 affected the macroeconomics by reducing the quality
of certain financial services, primarily credit intermediation. The basic argument is to
be made in two steps. First, it must be shown that the disruption of the financial sector
by the banking and debt crises raised the real cost of intermediation between lenders

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and certain classes of borrowers. Second, the link between higher intermediation costs
and the decline in aggregate output must be established (Bernanke, 1983).

The banking crises and the associated scrambles for liquidity exerted a deflationary
force on bank credit. In 1932 a National Industrial Conference Board (NICB) survey
of credit conditions reported that during 1930, the shrinkage of commercial loans
reflected business recession. The period from 1931 and till the first half of 1932,
represents with no doubt the pressure exercised by banks on customers for repayment
of loans and refusal to grant new loans (Bernanke, 2004b).

II.2.1 Credit Squeeze

The financial crises (debtor bankruptcies as well as the failures of banks and other
lenders) may have affected output slump. The basic premise is that, because markets
for financial claims are incomplete, intermediation between some classes of
borrowers and lenders requires nontrivial market-making and information-gathering
services. The disruptions of 1930-33 reduced the effectiveness of the financial sector
as a whole in performing these services. As the real costs of intermediation increased,
some borrowers (especially households, farmers, and small firms) found credit to be
expensive and difficult to obtain. The effects of this credit squeeze on aggregate
demand helped convert the severe but not unprecedented downturn of 1929-30 into a
protracted depression.

Terminal suspensions disrupted financial intermediation and increased the costs of

credit intermediation to a greater extent than temporary suspensions. Temporary
suspensions were symptoms of liquidity crises and banking panics caused by sudden
swings in depositors’ moods. The transmission mechanism of the monetary and non-
monetary effects of financial panics and the ways in which Federal Reserve action (or
inaction) contributed to the collapse of the economy (Sauert, 2010).

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II.2.2 Credit Crunch

Difficulties of the banks worsened the general economic contraction; first, by

reducing the wealth of bank shareholders; second, and much more important, by
leading to a rapid fall in the supply of money. Lower capital and less easy and cheap
funding, uncertain counterparty credit quality, and the desire to be seen to be reducing
risk all create a credit crunch (Mankiw, 1991).

Credit crunch occurred during the Great Depression. Mortgages became very hard to
get and very expensive when they could be obtained. Many home owners struggled
with payments on existing mortgages making even those lenders with enough capital
and funding reluctant to take on new risk. Foreclosures were causing misery across
the country, by 1933 there were a thousand homes being repossessed everyday.
Distress like this had all sorts of knock-on effects. For instance, the building industry
suffered as very few new houses were being built.

The liquidity crunch began in the fall of 1930 and lasted through the spring of 1931.
Friedman and Schwartz (1963) mentioned that the liquidity crisis grew like a
snowball rolling down a hill. The initial credit crunch forced some banks out of
business. Fear of further failures induced depositors to withdraw additional funds,
which forced banks to sell more assets, which drove asset prices even lower, which
forced more banks to fail, which confirmed depositors’ fears in a continuing cycle of
self-fulfilling pessimism. The snowball stopped only when Roosevelt declared a
national banking holiday in the winter of 1933 and restored confidence in the safety
and soundness of the financial system.

When the extent of debt-deflation is severe enough, which was the case in the 1930s;
it threatens banks health as well. Actual and potential loan losses rising from debt-
deflation damage bank capital and efficiency in several ways: 1) At the beginning,
deposit withdrawals forces banks to dump their assets on the market, an asset price
deflation inevitably follows which raises the problem of solvency. 2) Depositors
escape and withdrawals deprive banks of funds for lending. 3) The unanticipated
increase in the number of the debtor bankruptcies leads to a decline in the nominal
value of the banks’ assets, while nominal values of liabilities do not change. At the
end, insolvency becomes a big problem in the banking system. 4) The risk of bank

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runs induces banks to increase the liquidity of their assets, so that they can reduce the
volume of lending; this is the well known mechanism of credit crunch (Federal
Reserve Bank of Richmond, 1974).

Parker (2004) mentioned financial panics, debtor and business bankruptcies resulted
in an increase in the real cost of credit intermediation. As the cost of the credit
intermediation increased, sources of credit for many borrowers (especially
households, farmers and small firms) became expensive or even unobtainable at any
price. This tightening of credit put downward pressure on aggregate demand and
helped turn the recession of 1929-30 into the Great Depression. There is also another
research that studied 24 countries during the Great Depression and showed that the
degree of suffering from banking crises has a large and highly statistically significant
effect on the industrial output (Bernanke, 1995).

The observations about the contraction of bank credit were; First, the class of
borrowers most affected by credit reductions were households, farmers,
unincorporated businesses, and small corporations; this group had the highest direct or
indirect reliance on bank credit. Second, the contraction of bank credit was twice as
large as that of other major countries, even those which experienced comparable
output declines (Klebaner, 1974).

The American Banker of 1932, reported "The chief criticism of our present system
appears to be that in good times credit is expanded to great extremes... but, when the
pinch of hard times is first being felt, credit is suddenly and drastically restricted by
the banks... At the present time, loans are only being made when the banks have a
very wide margin of security and every effort is being made to collect outstanding
loans. All our banks are reaching out in an endeavour to liquefy their assets...".

Illiquidity disturbed banks throughout the depression. Heavy withdrawals played a

primary or contributed a role in nearly half of all suspensions. Asset problems also
disturbed banks throughout the Great Depression. Slow, doubtful, or worthless assets
played a primary or contributed a role in over half of all suspensions. The initial
banking panic in the fall of 1930 – with its cluster of temporary bank suspensions,
bank runs, and collapsing correspondent networks – appeared to have been a credit
crunch inspired by the collapse of financial conglomerates and propagated by the

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public’s flight from deposits to currency. During later surges in banking crises, the
suspension of depository institutions appears to have been driven less by sudden
swings in depositors’ fears for the safety of banks and more by declines in the values
of banks’ portfolios.

Hardy and Viner (1935) conducted a credit survey in the Seventh Federal Reserve
District in 1934-35. Based on intensive coverage of 2600 individual cases, they found
a genuine unsatisfied demand for credit by solvent borrowers, many of whom could
make economically sound use of working capital. The total amount of this unsatisfied
demand for credit is a significant factor, among many others, in retarding business
recovery. So far as small business is concerned, the difficulty in getting bank credit
has increased more, as compared to a few years back, than has the difficulty of getting
trade credit (Stoddard, 1940).

Another credit survey for the 1933-38 periods was done by the Small Business
Review Committee for the U.S. Department of Commerce. This study surveyed 6,000
firms with average employees from 21 to 150 employees. A special sample of 600
companies was selected based on their high ratings according to a standard
commercial rating agency. Even within the elite sample, 45 percent of the firms
reported difficulty in securing funds for working capital purposes during this period;
and 75 percent could not obtain capital or long-term loan requirements through
regular markets (Bernanke, 2004a).

II.3 Debt Deflation

The Debt-deflation concept has been introduced into the economic literature by Ben
Bernanke (1983) but the original idea goes back to Fisher (1933). The concept
designates a combined effect of the financial variables like nominal debt, price level,
nominal incomes and interest rates on the aggregate demand, and also on the supply
side, through the bank panics impact on the ability of the banking system to
efficiently allocate credits. This effect operates through the balance sheets of the main
economic agents, namely, households, firms and banks. The deflation alters the real
values in both sides of a balance sheet, the real values of the assets as well as the

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liabilities, provoking dramatic changes in the behaviors of the borrowers as well as in
those of the lenders.

The debt-deflation process operation requires rigid debt contracts. Indeed, this was the
case in the 1920s when nominal contracts did not include clauses related to the price
level changes (Bernanke, 1995). The debt-deflation process requires over
indebtedness to be operational. Following the second industrial revolution, the 1920s
was the period when mass consumption of the consumer durables increased greatly
particularly in the U.S. A large number of households were borrowing long-term
loans to buy refrigerators, radios, and especially cars. There was also a boom in
housing. Many households took long-term mortgages. When the deflation began in
1930, the real and relative burden of the debt stock started to rapidly increase in the
U.S. and worldwide, since the current nominal incomes were falling at the same time.
This fall prevented the real income to compensate the increase of the real value of the
debt stock. During this period borrowers suffered from big losses of net worth.
Obviously, these circumstances affected the demand of the consumer durables and the
housing adversely. Moreover, a higher risk of physical assets loss (the incapacity to
reimburse even one installment was enough for the start of the legal procedures of
repossession) put pressure on the spending for other consumption goods.

Also, the Great Depression demonstrated the importance of price stability. Deflation
was an important cause of falling incomes and financial distress, as households and
firms found it increasingly difficult to repay debts. Because debt contracts always
specify repayment of a fixed-dollar sum, deflation increases the real cost of a given
nominal debt. Thus, deflation often leads to increases in loan defaults and
bankruptcies, which in turn raise the number of bank failures and produces further
declines in income, output and employment. Price stability is nowadays widely
accepted as the paramount goal for monetary policy because fluctuations in the price
level - either deflation or inflation - cause financial instability and hinder economic
growth (Wheelock, 2010).

The debt-deflation mechanism worked for the firms too. The majority of the firms
were always net borrowers. With the start of the deflation the real burden of their debt
stock also started to increase. Moreover, their real incomes, as well as the real value
of their assets (shares, bonds and fixed capital) were decreasing with the deflation.

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Friedman and Schwartz (1963) estimated firm’s capital losses to be 85 billion dollars,
while stock market losses were limited to 15 billion. These shocks had a direct impact
on investment.

The debt-deflation mechanism should be considered as a first wave effect. In 1929

nobody was capable to anticipate the deflation. The highest price decrease occurred
everywhere in 1930, so the impact of the debt-deflation effect was extremely severe
for the first year. If the majority of decision makers thought that the deflation would
end very soon, then the same effect would have continued in the following years. But
most probably, the majority of the economic agents began to anticipate further price
decreases. In this case, the propensity to postpone investments, particularly the
purchases of consumer durables, increased tremendously since their prices were
expected to fall further. Of course, the postponement could not be too long. Indeed,
the decision to postpone a purchase results from a change in the inter-temporal
optimization of the consumer and therefore it is limited in time. But this behavior
must have constituted a second real shock on demand, forcing the depression to
deepen (Bernanke, 1995).

The liquidation of debt could not keep up with the fall of prices which it caused. The
mass effect of the rush to liquidate increased the value of each dollar owed, relative to
the value of declining asset holdings. The effort of individuals to lessen their burden
of debt effectively increased it. Paradoxically, the more the debtors paid, the more
they owed. This self-aggravating process turned a 1930 recession into a 1933 great
depression.

It is instructive to consider the experience of a country that had a debt crisis without a
banking crisis. Canada entered the Great Depression with a large external debt, much
of it payable in foreign currencies. The combination of deflation and the devaluation
of the Canadian dollar led to many defaults. Internally, debt problems in agriculture
and in mortgage markets were as severe as in the United States, while major
industries (notably pulp and paper) experienced many bankruptcies (Safarian, 1959).
Although Canadian bankers did not face serious danger of runs, they shifted away
from loans to safer assets. This shift toward safety and liquidity, though less
pronounced than in the U.S. case, drew criticism from all facets of Canadian society.

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II.4 The Real Interest Rate

A modern economy could not function without money, and economies tend to break
down when the quantity or value of money changes suddenly or dramatically. Print
too much money, and its value declines, that is prices rise (inflation). On the other
hand, shrink the money stock and the value of money rises that is prices fall
(deflation).

In modern economies, bank deposits comprise the lion’s share of the money stock.
Bank deposits are created when banks make loans, and deposits contract when
customers repay loans. The amount of loans, that banks can make, and hence the
quantity of deposits that are created, is determined both by regulations on the amount
of reserves that banks must hold against their deposits as well as the business
judgment of bankers (Wheelock, 2010).

In the 1930s, the United States adopted the gold standard, meaning that the U.S.
government would exchange dollars for gold at a fixed price. Commercial banks, as
well as Federal Reserve banks, held a portion of their reserves in the form of gold
coin and bullion, as required by law. An increase in gold reserves, which might come
from domestic mining or inflows of gold from abroad, would enable banks to increase
their lending and, as a result, would inflate money stock. On the other hand, a
decrease in reserves would contract money stock. For example, large withdrawals of
cash or gold from banks could reduce bank reserves to the point that banks would
have to contract their outstanding loans, which would further reduce deposits and
shrink the money stock (Wheelock, 2010).

A damaging effect of deflation has been the great increase in real interest rates.
Nominal interest rates, by nature, cannot go under the 0 percent, as it has been made
clear by the Japanese deflation. It is widely accepted that nominal interest rates have a
lower bound; 1-2 percent for the treasury bonds, 3-4 percent for the banking loans can
make sense. In these circumstances a 10 percent decrease in the price level means an
ex-post real interest rate of, at least, 11 percent, and most probably higher. The real
interest rate increase can be considered as a windfall income for bond holders on one
hand, and an unanticipated cost increase for borrowers on the other hand. The

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additional income is expected to encourage consumption, and in case of cost increase,
back to the debt-deflation mechanism (Cecchetti, 1992).

Hence, the operational mechanism of the real interest rate effect depends closely on
the ability of the decision makers to anticipate deflation. Cecchetti (1992) estimated
ex-ante real interest rate in U.S. for three and six month’s loans. Cecchetti concluded,
“beginning in late 1930, and possibly as early as late 1929, deflation could have been
anticipated at horizons of 3-6 months”; so, the real interest rate during the entire
depression period was extremely high, in early 1932 the peak exceeded 20 percent.
So, while nominal interest rates were low, real interest rates were extremely high. The
clear cause of high real interest rates was the extraordinarily tight monetary policy
(Cecchetti, 1997).

II.5 The Gold Standard

The gold standard of the interwar period is more correctly referred to as a gold
exchange standard, and its primary purpose was to establish and maintain a system of
fixed exchange rates. While central banks were required to hold reserves to back their
monetary base, those reserves could be part of monetary gold and part of foreign
exchange. Furthermore, requirements generally stated that, central bank need only
hold 30% to 40% of the value of the monetary base as backing. The real problem
comes with the fact that countries losing gold (because they were running current
account deficits) had no choice but to contract their money stocks. But countries
gaining reserves could choose whether to sterilize the inflows, leaving their money
stocks unchanged, or allow their monetary base and money stock to grow (Moffett et
al., 2008).

The Depression and the policy response also changed the world economy in crucial
ways. The Great Depression hastened, if not caused, the end of the international gold
standard. Although a system of fixed currency exchange rates was reinstated after
World War II under the Bretton Woods system, the world economies never embraced
that system with the assurance and dedication they had brought to the gold standard.
By 1973, fixed exchange rates were abandoned in favor of floating rates.

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The most persuasive case for the causal role of the gold standard comes from
Bernanke and James (1991) and Bernanke (1995). They showed that the depth of the
Depression depended critically on when a country left the gold standard. Those
countries that left earliest, such as Great Britain (1931), had shallower contractions
than the U.S. (1933) and France (1936).

The earliness with which a country left the gold standard reliably predicted its
economic recovery. For example, Great Britain and Scandinavia, which left the gold
standard in 1931, recovered earlier than Italy and the U.S. that remained on the gold
standard well into 1932 or 1933, while a few countries in the so-called gold bloc, led
by France and including Poland, Belgium and Switzerland, stayed on the standard
until 1935-36. Countries such as China, which had a silver standard, almost avoided
the depression entirely. The connection between leaving the gold standard as a strong
predictor of the country’s depression severity and the time needed for its recovery has
been shown to be consistent for dozens of countries, including developing countries.
This partly explains why the occurrence and length of depression differed between
national economies.

Given the key roles of monetary contraction and the gold standard in causing the
Great Depression, it is not surprising that currency devaluations and monetary
expansion became the leading sources of recovery throughout the world. There is a
notable correlation between the time countries abandoned the gold standard (or
devalued their currencies substantially) and a renewed growth in their output. Britain,
which was forced off the gold standard in September 1931, recovered relatively early,
while the United States, which did not effectively devalue its currency until 1933,
recovered substantially later. Similarly, the Latin American countries of Argentina
and Brazil, which began to devalue in 1929, had relatively mild downturns and were
largely recovered by 1935. In contrast, the Gold Bloc countries of Belgium and
France, which were particularly devoted to the gold standard and slow to devalue, still
had industrial production in 1935 well below its 1929 level. Numerous researchers
contributed to the understanding gold standard, beginning with Choudhri and Kochin
(1980), followed by Hamilton (1983), Temin (1989) and Bernanke (1995). But it is
Eichengreen (1992) who is responsible for consolidating the Knowledge
improvement.

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Under the gold standard, imbalances in trade or asset flows gave rise to international
gold flows. For example, in the mid-1920s intense international demand for American
assets such as stocks and bonds brought large inflows of gold to the United States.
Likewise, a decision by France after World War I to return to the gold standard with
an undervalued franc led to trade surpluses and substantial gold inflows (balance of
trade). But both of these countries sterilized the inflows, forcing the world money
stock to decline substantially and rapidly. Beginning in 1928, the Federal Reserve's
contractionary policy is of the utmost importance in understanding the nature of the
Depression which resulted in the transmission of the American decline to the rest of
the world (Romer, 1992).

Romer (1992) believed that the Federal Reserve allowed or caused huge declines in
the American money supply partly to preserve the gold standard. Under the gold
standard, each country set a value of its currency in terms of gold and took monetary
actions to defend the fixed price. It is possible that the Federal Reserve had expanded
greatly in response to banking panics; foreigners could have lost confidence in the
United States’ commitment to the gold standard. This might have led to large gold
outflows and the United States could have been forced to devalue. Likewise, had the
Federal Reserve not tightened in the fall of 1931, it is possible that there would have
been a speculative attack on the dollar and the United States would have been forced
to abandon the gold standard along with Great Britain.

Once the U.S. economy began to contract severely, the tendency for gold to flow out
of other countries and toward the United States intensified. This took place because
deflation in the United States made American goods particularly desirable to
foreigners, while low income reduced American demand for foreign products. To
counteract the resulting tendency toward an American trade surplus and foreign gold
outflows, central banks throughout the world raised interest rates. Maintaining the
international gold standard, in essence, required a massive monetary contraction
throughout the world to match the one occurring in the United States. The result was a
decline in output and prices all over the world, thus nearly matching the downturn in
the United States.

In principle, the gold standard did not provide an elastic currency at the global level,
which should have worked to limit the amplitude of the credit boom. For the world as

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a whole, supplies of money and credit should have been tied down by supplies of
monetary gold that were inelastic in the short run. Higher interest rates tend to
dampen investment and render borrowing by stock-market speculators. The
implication was that credit booms should have been less pronounced under the gold
standard, this was the conclusion of Mises and Hayek.

II.6 International Lending

International financial markets suffered as well during the Great Depression, with the
gradual break down of the fixed-exchange rate system administered through the gold
exchange standard. Foreign lending to Germany and Latin America had expanded
greatly in the mid-1920s. U.S. lending abroad fell in 1928 and 1929 as a result of high
interest rates and the booming stock market in the United States. This reduction in
foreign lending may have led to further credit contractions and declines in output in
borrower countries. In Germany, which experienced extremely rapid inflation
(hyperinflation) in the early 1920s, monetary authorities may have hesitated to
undertake expansionary policy to counteract the economic slowdown because they
worried it might re-ignite inflation. The effects of reduced foreign lending may
explain why the economies of Germany, Argentina, and Brazil turned down before
the Great Depression began in the United States (Wheelock, 2010).

II.7 Smoot Hawley Tariff Act of 1930

President Herbert Hoover started numerous programs, all of which failed to reverse
the downturn. On June, 17, 1930 Congress approved the Smoot-Hawley Tariff Act
which raised tariffs on thousands of imported items. The intent of the Act was to
encourage the purchase of U.S. made products by increasing the cost of imported
goods, while raising revenue for the federal government and protecting farmers.
However, other nations increased tariffs on U.S. made goods in retaliation, reducing
international trade, and worsening the Depression. Protectionist trade policies resulted
in the collapse of international trade. The 1930 enactment of the Smoot-Hawley tariff
in the United States and the worldwide rise in protectionist trade policies created

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further complications. The Smoot-Hawley tariff was meant to boost farm incomes by
reducing foreign competition in agricultural products. But other countries followed
suit, both in retaliation as well as in attempt to force a correction of trade imbalances.
Protectionist policies may have contributed to the extreme decline in the world price
of raw materials, which caused severe balance of payments (BOP) problems for
primary commodity producing countries in Africa, Asia, and Latin America and led to
contractionary policies.

The sharp decline in international trade after 1930 helped to worsen the depression,
especially for countries significantly dependent on foreign trade. The American
Smoot-Hawley Tariff Act blamed for worsening the depression by seriously reducing
international trade and causing retaliatory tariffs in other countries. While foreign
trade was a small part of overall economic activity in the United States and was
concentrated in a few businesses like farming, it constituted a much larger part in
many other countries. The average ad valorem rate of duties on dutiable imports for
1921-25 was 25.9% but under the new tariff it jumped to 50% in 1931-35
(Kindleberger, 1986).

U.S. exports declined from about $5.2 billion in 1929 to $1.7 billion in 1933; but
prices also fell, so the physical volume of exports only fell by half. The Hardest hit
was farm commodities such as wheat, cotton, tobacco, and lumber. Accordingly, the
collapse of farm exports caused many U.S. farmers to default on their loans, leading
to the bank runs of small rural banks that characterized the early years of the Great
Depression (Kindleberger, 1986).

A commonly held view is that the tariff wars of the 1930s bore significant
responsibility for the wholesale collapse of economic activity. Meltzer (1976) has
argued that the Smoot-Hawley tariff was of paramount importance in deepening the
world-wide depression. Crucini (1994) noted that most import duties were specific,
not ad valorem. This means that they were stated in fixed dollar amounts per unit of
import. As a result, the main fluctuations in the real value of the tariffs came not with
legislated changes in the tariff rates themselves, but with movements in the aggregate
price level. Therefore, it is the deflation during the 1930s that is the villain, raising
tariffs by much more than even the Smoot-Hawley tariff.

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III. Consequences of The 1929 Financial Crisis

Revulsion and discredit may go so far as to lead to panic, with people crowding to get
through the door before it slams shut. The panic feeds on itself, as did the speculation,
as a result of the 1929 financial crisis; the first banking crash happened on November
1930 as well as 9,765 bank failures in the period from 1929-33 (Bernanke, 2004a).

The sources of banking collapse are best understood in historical context. The first
point to be made is that bank failures were hardly originality at the time of the
depression. The U.S. system, made up as it was primarily of small, independent
banks, had always been particularly vulnerable. Countries with only a few large
banks, such as Britain, France, and Canada, never had banking difficulties matching
the U.S. scale. The dominance of small banks in the United States was due in large to
a regulatory environment which reflected popular fears of large banks and trusts; there
were numerous laws restricting branch banking at both the state and national level.
Competition between the state and national banking systems for member banks also
tended to keep the legal barriers to entry in banking very low (Klebaner, 1974). In
such an environment, a significant number of failures was to be expected and
probably was even desirable. Failures due to natural causes such as the agricultural
depression of the 1920s upon which many small, rural banks foundered were
common.

Friedman and Schwartz (1963) pointed out that, before the establishment of the
Federal Reserve in 1913, panics were usually contained by the practice of suspending
convertibility of bank deposits into currency. This practice, typically initiated by loose
organizations of urban banks called clearinghouses, moderated the dangers of runs
by making hasty liquidation unnecessary. In conjunction with the suspension of
convertibility practice, the use of demand deposits created relatively little instability.

Friedman and Schwartz (1963) pointed that with the advent of the Federal Reserve
this roughly stable institutional arrangement was upset. Although the Federal Reserve
introduced no specific injunctions against the suspension of convertibility, the
clearing-houses apparently felt that the existence of the new institution relieved them
of the responsibility of fighting runs. Unfortunately, the Federal Reserve turned out to
be unable or unwilling to assume this responsibility.

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The most obvious economic impact of the Great Depression was human suffering. In
a short period of time world output and standards of living dropped sharply. As much
as one fourth of the labor force in industrialized countries was unable to find work in
the early 1930s. While conditions began to improve by the mid-1930s, total recovery
was not accomplished until the end of the decade.

III.1 Loss of Confidence

The money stock fell during the Great Depression primarily because of banking
panics. Banking systems rely on depositors’ confidence that they will be able to
access their funds in banks whenever they need them. If that confidence is shaken,
perhaps by the failure of an important bank or large commercial firm, people will rush
to withdraw their deposits to avoid losing their funds if their own bank fails.

The problems faced by the U.S. financial system between October 1930 and March
1933 have been described by Chandler (1970, 1971) and Friedman and Schwartz
(1963). The two major components of the financial collapse were the loss of
confidence in financial institutions, primarily commercial banks, and the widespread
insolvency of debtors and their joint relation to aggregate fluctuations.

The banking problems of 1930-33 disrupted the credit allocation process by creating
large, unplanned changes in credit flow channels. Fear of runs led to large
withdrawals of deposits, precautionary increases in reserve-deposit ratios, and an
increased desire by banks for very liquid or re-discountable assets. These factors, plus
the actual failures, forced a contraction of banking system's role in the intermediation
of credit. Some of the slack was taken up by the growing importance of alternative
credit channels. However, the rapid switch away from the banks (given the banks'
accumulated expertise, information, and customer relationships) no doubt impaired
financial efficiency and raised the CCI (Bernanke, 2004a).

The yield differential reflected changing perceptions of default risk, as well as the
close relationship of the differential and the banking crises (Friedman and Schwartz,
1963). Bank crises depressed the prices of lower-quality investments as the fear of
runs drove banks into assets that could be used as reserves or for rediscounting.

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Illiquidity played a role in the surge in bank suspensions in June of 1931 (Friedman
and Schwartz, 1963). In that month, runs occurred on banks in Illinois. Examiners
reported that heavy withdrawals were the primary cause of almost all of these
suspensions. Frozen assets and limited cash reserves contributed in many closures, but
none of the banks possessed portfolios which had deteriorated near the point of
insolvency.

III.2 Herd Mentality

According to Friedman and Schwartz (1963), the crisis began when a fear contagion
spread among depositors. The contagion began in agricultural areas and accelerated
after the failure of the Bank of the United States, which was the largest commercial
bank ever to have failed up to that time in U.S. history, and whose distinctive name
led many at home and abroad to regard it somehow as an official bank (Friedman and
Schwartz, 1963). The panic spread more rapidly than it would have under the pre-
Federal Reserve banking system, because the existence of the Federal Reserve
prevented banks from restricting the conversion of deposits into currency, which
would have cut the vicious circle set in train by the search for liquidity. Such a
restriction would almost certainly have prevented the subsequent waves of bank
failures that were destined to come in 1931, 1932, and 1933, just as restriction in 1893
and 1907 had quickly ended bank suspension arising primarily from lack of liquidity.

III.3 Global Contagion

Banking crises may arise through individual bank failure or through shocks all over
banks. Individual bank failure may spread through contagion associated with
asymmetric information. Counterparty exposure also propagates contagion when a
bank’s failure causes defaults on its inter-bank liabilities; the counterparty’s position
may deteriorate sufficiently to propagate further through interbank relations.

Friedman and Schwartz (1963) advocated that bank failures resulted from
unwarranted panic and that failing banks were in large measure illiquid rather than

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insolvent. Friedman and Schwartz attached great importance to the banking crisis of
late 1930, which they attribute to a “contagion of fear” that resulted from the failure
of a large New York bank, the Bank of United States, which they regard as itself a
victim of panic.

James (1938) highlighted the role of interbank cooperation in mitigating the costs of
the banking crisis. The limited duration and costs of contagion may have reflected the
cooperative intervention by the Chicago clearing house, which used its illiquid assets
to protect at least one solvent bank from unwarranted attack until the runs by
uninformed depositors subsided. The failure experience during the panic of 1932
could have been less severe if there were cooperation.

Concerning causes of the banking crises, some scholars concluded that banks failed
because the economy contracted, loan default rates rose, asset values declined,
deteriorating fundamentals forced banks into insolvency, and continuing process of
liquidation that began during the 1920s (Temin, 1976; Calomiris and Mason, 2003;
White, 1984). Other scholars concluded that a fear contagion, a flight to cash
holdings, and withdrawals all together drained deposits from banks and pushed
financial markets towards collapse. Illiquidity of assets and Federal Reserve inaction
exacerbated the credit crunch (Friedman and Schwartz, 1963; Wicker, 1996).

III.4 Financial Sector Downturn

The 1929 stock market crash and the Great Depression was the biggest financial crisis
of the 20th century. The panic of October 1929 has come to serve as a symbol of the
economic contraction that gripped the world during the next decade. The falls in share
prices on October 24 and 29, 1929 were practically instantaneous in all financial
markets, except Japan. The Wall Street Crash had a major impact on the U.S. and
world economy. Wheelock (1991) highlighted that abuse by utility holding companies
contributed to the Wall Street Crash of 1929 and the Depression that followed.
Wheelock (1991) blamed the crash on commercial banks that were too eager to put
deposits at risk on the stock market.

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After the experience of the 1929 crash, stock markets around the world instituted
measures to temporarily suspend trading in the event of rapid declines, claiming that
they would prevent such panic sales. The one-day crash of Black Monday, October
19, 1987, however, was even more severe than the crash of 1929, when the Dow
Jones Industrial Average fell a full 22.6%. The markets quickly recovered, posting the
largest one-day increase since 1933 only two days later Wheelock (1991).

Most Fed officials felt that money and credit were plentiful. Short-term market
interest rates fell sharply after the stock market crash of 1929 and remained at
extremely low levels throughout the 1930s as in figure 2. Wheelock (1991) declared
that the decline in short-term rates implied monetary ease. Long term interest rates
declined less sharply and yields on risky bonds, such as Baa-rated bonds, rose during
the first three years of the Depression. Nevertheless, the exceptionally low yields on
short term securities suggested to many observers an abundance of liquidity.

Figure 2
Interest Rates (1920-1935)

Source: Calomiris (1989).

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Relatively few banks came to the Fed’s discount window to borrow reserves, many
banks built up substantial excess reserves as the depression progressed as in figure 3.
For most observers, it appeared that there was little demand for credit and since most
policymakers saw their mission as one of accommodating credit demand, few
believed that more vigorous expansionary actions were necessary.

Figure 3
Borrowed and Excess Reserves of Federal Reserve Member Banks

Source: Calomiris (1989).

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III.4.1 Stock Market Crash

The Roaring Twenties, the decade that led up to the crash, was a time of wealth and
despite the caution of the dangers of speculation; many believed that the market could
sustain high price levels. Shortly before the crash, Fisher (1933) proclaimed that stock
prices have reached what looks like a permanently high plateau. The optimism and
financial gains of the great bull market were shattered on Black Thursday October 24,
1929, when share prices on the NYSE collapsed. Stock prices fell on that day and
continued to fall, at an unprecedented rate, for a full month.

The Wall Street Crash of 1929 was a part of the new theories of boom and bust.
According to Joseph Schumpeter and Nikolai Kondratieff the crash was merely a
historical event in the continuing process known as economic cycles. The impact of
the crash was merely to increase the speed at which the cycle proceeded to its next
level.

The October 1929 crash came during a period of declining real estate values in the
United States, which peaked in 1925, near the beginning of a chain of events that led
to the Great Depression, a period of economic decline in the industrialized nations.

When the crash came, the falls were enormous. The Dow Jones fell by more than ten
percent two days in a row, October 24th and 25th 1929 as in figure 4. Many investors
could not meet margin calls, and were forced to sell. The value of the leveraged
investment trusts fell fast and many were forced to liquidate to avoid defaulting on
their debt. Those that did not move quickly enough endangered those that had lent
them money. The market continued in a pattern of small recoveries followed by larger
falls throughout the early 1930s, as the figure illustrates. For a few years at least,
Americans had learnt that getting rich quickly through investing in capital markets
was by no means an assured strategy Wheelock (1991).

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 Figure 4

Dow Jones Industrial Average (1928-33)

Source: Dow Jones Industrial Average (www.djindexes.com).

By the fall of 1929, U.S. stock prices had reached levels that could not be justified by
reasonable anticipations of future earnings. As a result, when a variety of minor
events led to gradual price declines in October 1929, investors lost confidence and the
stock market bubble burst. Panic selling began on Black Thursday, October 24, 1929.
Many stocks had been purchased on margin that is using loans secured by only a
small fraction of the stocks’ value. As a result, the price declines forced some
investors to liquidate their holdings, thus exacerbating the fall in prices. Between their
peak in September 1929 and their low in November 1929, U.S. stock prices
(measured using the Cowles Index) declined 33 percent. Because the decline was so
dramatic, this event is often referred to as the Great Crash of 1929.

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 Figure 5
U.S. Stock Prices 1926-39

Source: Dieffenbach (2008).

III.4.2 Banking Panics

The nature of the banking crisis changed over time. Before October 1930, the pattern
of failures resembled the pattern that prevailed during the 1920s. Small, rural banks
with large loan losses failed at a steady rate. In November 1930, the collapse of
correspondent networks triggered banking panics. Runs rose in number and severity
after prominent financial conglomerates in New York and Los Angeles closed amid
scandals covered prominently by the national press. More than a third of banks which
closed their doors to depositors soon resumed normal operations. Following Britain’s
departure from the gold standard in September 1931, the depression deepened. Asset
values declined. Insolvency loomed as the largest threat facing depository institutions.
During the financial crisis in winter of 1933, almost all of the banks that failed were
liquidated at a substantial loss (Richardson, 2006).

There is a large empirical literature on historical banking crises. Sprague (1910)

highlighted the classic study of crises in the US during the National Banking Era

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(1864-1914). It was commissioned by the National Monetary Commission, after the
severe crisis of 1907, as part of an investigation on the desirability of establishing a
central bank in the U.S.

Friedman and Schwartz (1963) have written a comprehensive monetary history of the
U.S. from 1867-1960. Among other things, they argued that banking panics can have
severe effects on the real economy. In the banking panics of the early 1930s, bank
distress developed quickly and had a large effect on output. Friedman and Schwartz
(1963) argued that crises were panic-based and offer as evidence the absence of
downturns in relevant macroeconomic variables prior to the crises.

Friedman and Schwartz (1963) attached great importance to four banking crises in the
early 1930s in advancing their view that bank failures were the result of panics. They
suggested these crises were important shocks to the real economy and were significant
factors in causing the Great Depression. The four crises were: (i) the crisis in late
1930 following the failure of the Bank of the United States, (ii) the crisis from March
to August 1931, (iii) the crisis following Britain’s departure from the Gold Standard,
which lasted from September 21, 1931 until the end of the year and (iv) the crisis that
lasted from the end of 1932 until the bank holiday declared when President Roosevelt
came to office in early 1933.

The initial government response to the Great Crash was complacent and ineffectual.
Many influential bankers at the time thought that the financial system would mend
itself. There were attempts to balance the Federal Budget, and frequent exhortations
on the virtues of thrift and self-reliance. Monetary policy was tight. This, together
with falling economic activity, caused distress to companies. Default rates on loans
and corporate bonds rose rapidly.

A banking crisis developed in Michigan in the dog days between the Hoover and
Roosevelt administrations. This quickly spread to neighboring states, and the
Reconstruction Finance Corporation (RFC) seemed powerless to help. Banks did not
want to use it. Confidence in the banking system evaporated. Depositors feared for the
safety of their money, and many rushed to get their cash out of banks. A nationwide
bank run began. By Roosevelt's inauguration day, March 4th, all the states had either
declared a bank holiday or restricted the withdrawal of deposits. Roosevelt extended

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this holiday period until March 13th. The closing of banks provided a short pause, but
quick action was needed to prevent widespread bank failures once the system
reopened.

Bank failures led to the loss of billions of dollars in assets. Outstanding debts became
heavier, because prices and incomes fell by 20–50% but the debts remained at the
same dollar amount. After the panic of 1929, and during the first 10 months of 1930,
744 U.S. banks failed. (In all, 9,000 banks failed during the 1930s). By April 1933,
around $7 billion in deposits had been frozen in failed banks or those left unlicensed
after the March Bank Holiday (Friedman and Schwartz, 1971).

Calomiris and Mason (2003) undertook a detailed study of the four crises. They
develop an econometric model of bank failures using a broad range of data on
fundamentals at the local, national and regional level. They estimated a stable model
that is able to predict bank failures in terms of fundamentals during the first three
crises, suggesting that panics did not play a significant role. The model breaks down
in the fourth crisis, however, suggesting that panics may have played a role there.
Overall, their conclusions are in sharp contrast to those of Friedman and Schwartz.

Like the banking crises, the debt crisis of the 1930s was not qualitatively a new
phenomenon; but it represented a break from the past in terms of its severity and
pervasiveness. Friedman and Schwartz (1963) and others noted the close connection
of the stages of the financial crisis (specially the bank failures) with changes in real
output.

Overall, between the Great Crash and the Banking Holiday in March 1933, both
illiquidity and insolvency were substantial sources of bank distress. Nearly three
fourths of banks that closed their doors due to financial difficulties were insolvent.
Slightly more than one quarter were solvent, and without outside financial assistance,
reopened for business, or repaid all their depositors and creditors, or merged at face
value with other institutions. Frozen and devalued assets were a primary cause of
approximately one half and a contributing cause of another one quarter of all bank
suspensions. Heavy withdrawals were a primary cause of slightly under one half and a
contributing cause of another one sixth of all bank suspensions (Richardson, 2006).

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The next blow to aggregate demand occurred in the fall of 1930, when the first of four
waves of banking panics gripped the United States. A banking panic arises when
many depositors lose confidence in the solvency of banks and simultaneously demand
their deposits to be paid to them in cash. Banks, which typically hold only a fraction
of deposits as cash reserves, must liquidate loans in order to raise the required cash.
This process of hasty liquidation can cause even a previously solvent bank to fail. The
United States experienced widespread banking panics in the fall of 1930, the spring of
1931, the fall of 1931, and the fall of 1932. The final wave of panics continued
through the winter of 1933 and culminated with the national bank holiday declared by
President Franklin Roosevelt on March 6, 1933. The bank holiday closed all banks,
permitting them to reopen only after being deemed solvent by government inspectors.
The panics took a severe toll on the American banking system. By 1933, one-fifth of
existing banks had failed (Romer, 1992).

The banking system collapse is caused by the debt-deflation according to Fisher

(1933) and more recently formalized by Bernanke and Gertler (1989 and 1990); the
theory is that the 30% cumulative deflation of 1930-32 was primarily responsible for
the depth of the Depression. Since unanticipated deflation increases the real burden of
nominal debt, it caused debtors to default on loans, which led to bank failures and the
collapse of the financial system. Bernanke and Gertler (1989 and 1990) examined a
formal model in which deflation lowers borrower net worth, thereby increasing
leverage and the desire of entrepreneurs to take on risk. This raises the probability of
bankruptcy, lowers the level of investment, and causes a reduction in both aggregate
supply and aggregate demand.

According to Temin (1976) and White (1984), the first banking crisis was caused by
worsening fundamental factors, rather than contagion among banks. Temin (1976)
argued that the Stock Market Crash, the Dust Bowl, and the ensuing financial,
agricultural, and industrial depressions reduced the value of bank’s investments and
raised suspension rates. White (1984) argued that bank failures during 1930 did not
mark a departure from previous experience. Both real and monetary factors played a
part. Poorly performing assets and restrictive monetary policy were both contributing
factors. The former pushed banks towards insolvency. The latter raised banks’ costs
by forcing them to seek costly sources of funds such as bills payable, acceptances, and

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rediscounts. Since banks failed for those reasons throughout the 1920s and since
national bank failures can be predicted a year in advance with some accuracy, the
banking failures during the fall of 1930 appear to be an accentuation of prior trends,
rather than a turning point in the propagation of the Great Depression.

The bank failures were coincidence in timing with adverse developments in the
macroeconomic. Friedman and Schwartz (1963) highlighted an apparent attempt of
recovery from the 1929-30 recession was stalled at the time of the first banking crisis
(November-December 1930); the incipient recovery degenerated into a new slump
during the mid-1931 panics; and both the economy and the financial system reached
their respective low points at the time of the bank holiday of March 1933. Only with
the New Deal's rehabilitation of the financial system in 1933-35 did the economy
begin its slow emergence from the Great Depression.

Banking panics by their nature are largely irrational, inexplicable events, but some of
the factors contributing to the problem can be explained. During the Bank Holiday of
March 1933, Roosevelt closed all banks for more than one week, then bank examiners
closed unsound banks, 18,000 commercial banks in total, 5,000 banks did not reopen
at the end of the holiday in addition to 2,000 banks that never reopened as indicated in
the following table, which restored confidence as deposits insured.

Table 2
U.S. Bank Failures
Year Bank Failures
1929 659
1930 1352
1931 2294
1932 1456
1933 4004
1934 61
1935 32
1936 72
1937 84
1938 81
1939 72
1940 48
1941 17
Source: Dieffenbach (2008).

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The percentage of bank failures layers showed the ripple effect of the financial crisis,
beginning in Florida in 1928 and spreading throughout the country over the next five
years. The layers indicate the percentage of bank failures for a given year based on the
existing (remaining) number of banks in that county that year (not the total number
that existed prior to the crash) thus showing a cumulative effect (Murphy, 2009).

The total collapse of the financial intermediation system was signaled by the fact that
from the beginning of 1930 to the bank holiday of 1933, there were a shocking 9096
commercial bank suspensions. The 1350 commercial banks in 1930 alone were more
than double the 659 commercial banks in 1929 (Cecchetti, 1997).

The percentages of operating banks which failed in each year from 1930 to 1933
inclusive were 5.6%, 10.5%, 7.8%, and 12.9%; because of failures and mergers, the
number of banks operating at the end of 1933 was only just above half the number
that existed in 1929. Surviving banks experienced heavy losses (Bernanke, 2004a).

The failure of the system of financial intermediation culminating into the bank
holiday of 1934 strongly suggested that there was something inherently wrong with
the organization of the banking system prior to the Depression. There is the fact that
banks entered the Depression with what, by modern standards, were little amounts of
equity. Looking at book value bank balance sheets, at the end of 1929, bank capital
was 14% of assets (Cecchetti, 1997).

Besides the simple lack of economic viability of some marginal banks, the U.S.
system historically suffered as well from a more damaging source of bank failures
(financial panics). The fact that liabilities of banks were principally in the form of
fixed-price, callable debt (demand deposits), while many assets were highly illiquid,
created the possibility of the perverse expectational equilibrium known as a run on the
banks. In a run, fear that a bank may fail induces depositors to withdraw their money,
which in turn forces liquidation of the bank's assets. The need to liquidate hastily, or
to dump assets on the market when other banks are also liquidating, may generate
losses that actually do cause the bank to fail. Thus the expectation of failure, by the
mechanism of the run, tends to become self-confirming (Kraner, 2010).

The banking situation calmed in early 1932, and nonbank failures peaked shortly
thereafter. A new recovery attempt began in August, but failed within a few months.

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In March 1933, the bottom was reached for both the financial system and the
economy as a whole. Measures taken after the banking holiday; ended the bank runs
and greatly reduced the burden of debt. Simultaneously aggregate output began a
recovery that was sustained until 1937.

The Federal Reserve attributed most bank suspensions to one of five common causes.
The first was slow, doubtful, or worthless paper. The term worthless paper indicated
an asset with little or no value. The term doubtful paper meant an asset unlikely to
yield book value. The term slow paper meant an asset likely to yield full value in
time, but whose repayment lagged or which could not be converted to full cash value
at short notice. The second common cause of suspension was heavy withdrawals, the
typical example being a bank run. The third was a banking correspondent failure.
Correspondents were banks with ongoing relationships facilitated by deposits of
funds. A typical example is a county bank (the client) which kept its reserve deposits
within and cleared its checks through a national bank in a reserve city (the
correspondent). The fourth common cause was mismanagement. The fifth was
defalcation, a monetary deficiency in the accounts of a bank due to fraud or breach of
trust.

Figure 6 displays patterns of terminal and temporary suspensions from January 1929
to March 1933. The rates of both types of suspensions remained near pre-depression
levels until November 1930, when rates rose to levels unseen since the turn of the
century. The rise in temporary suspensions was particularly pronounced. Few
temporary suspensions occurred during typical weeks; many weeks witnessed none.
Almost all temporary suspensions occurred during waves of bank failures such as the
banking crisis of fall 1930, when more than 40% of all institutions which closed their
doors to depositors soon reopened for business. The percentage fell as the depression
progressed. Less than 20% of banks which closed their doors during the fall of 1931
later reopened. Only a small fraction of banks which suspended operations during
1932 and 1933 reopened, and most of those that did manage to resume operations did
so after receiving flow of cash from stockholders, depositors, and other sources
(Richardson, 2006).

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 Figure 6
Terminal and Temporary Bank Suspensions, January 1929 through March 1933

Source: National Archives and Record Administration (www.archives.gov).

As Wicker (1980, 1996) argued, the collapse of the Caldwell conglomerate triggered
the initial banking panic in the fall of 1930. Correspondent networks propagated the
panic during the initial weeks, when almost all of the banks which suspended
operations were financially or geographically connected to the Caldwell
conglomerate. Bank runs radiated outward from these focal events. Heavy
withdrawals became the principal form of bank distress and forced hundreds of banks
to suspend operations. Yet, as Friedman and Schwartz (1963) argued, the failure of
the Bank of the United States accentuated depositors’ fears and reinvigorated the
panic. Friedman, Schwartz, and Wicker argued that the crisis was a departure from
previous trends, a unique event that may have altered the course of the contraction.
So, the archival evidence supports a synthesis of their views while revealing
additional aspects of the event. Several smaller correspondent chains, with no
connection to Caldwell, imploded in Caldwell’s wake. The failure of the Guaranty
Building and Loan Association added fuel to the fire. Nearly half of the institutions
that suspended operations as a consequence of these events rapidly reopened for
business.

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The causes of bank suspensions fit the descriptions of events offered by Temin (1976)
and Calomiris and Mason (1997, 2003). Declining asset values were the principal
cause of bank suspensions. Most banks which closed their doors did so permanently,
all were insolvent. The few which reopened did so only after receiving outside
financial assistance.

Friedman and Schwartz (1963) believed that banking panics had monetary effect.
Panics eroded depositors’ confidence, induced further withdrawals, forced banks to
liquidate assets at deep discounts, lowered asset prices, encouraged banks to hold
excess reserves, and reduced the money multiplier. This vicious cycle reduced the
money supply and turned what would have been a typical recession into a disastrous
contraction. Bernanke (1982) pointed that bank panics influenced economic activity
by disrupting financial intermediation. Bank failures increased the cost of credit
intermediation, dislocated the financing of small and medium firms, disrupted current
production, and shortened investment spending. This financial acceleration lowered
the economy deeper into depression.

Personal and firm bankruptcies rose to unprecedented highs. In 1932-33, aggregate

corporate profits in the United States were negative. Some 9,000 banks, with $6.8
billion of deposits, failed in the period 1930-33 as in figure 7. Since some suspended
banks eventually reopened and deposits were recovered, these figures overstate the
extent of the banking distress (Calomiris, 1989). Nevertheless, bank failures were
numerous and their effects severe, even compared with the 1920s, when failures were
high by modern standards.

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 Figure 7
Bank Suspensions (1920-35)

Source: Calomiris (1989).

III.4.3 Insurance Companies

Most financial institutions (even semi-public ones, like the Joint Stock Land Banks)
came under pressure in the 1930s. Some, such as the insurance companies and the
mutual savings banks, managed to maintain something close to normal operations.
Others like the building and loans (which, despite their ability to restrict withdrawals
by depositors, failed in significant numbers) were greatly hampered in their attempts
to carry on their business (O'Hara and Easley, 1979). The significance of the banking
difficulties derived both from their magnitude as well as the central role commercial
banks played in the financial system (Goldsmith, 1958).

According to Wicker (1980, 1996), the collapse of Caldwell and Company triggered
the crisis. Caldwell controlled one of the largest banking chains in the South, with

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assets over $200,000,000, and one of the largest insurance groups in the region, with
assets over $230,000.000. Questionable managerial and financial practices caused the
firm’s failure, which quickly forced the suspension of the Bank of Tennessee and its
affiliates.

III.5 Wealth Effect

The consequences were massive for almost everybody. The crash wiped out billions
of dollars of wealth in one day, and this immediately depressed consumer buying. The
failure set off a worldwide run on U.S. gold deposits (the dollar), and forced the
Federal Reserve to raise interest rates into the slump. Some 4,000 lenders were
ultimately driven to the wall. Also, the up-tick rule, which allowed short selling only
when the last tick in a stock’s price was positive, was implemented after the 1929
market crash to prevent short sellers from driving the price of a stock down in a bear
run (Bierman, 2008).

Financial markets and institutions have deteriorated from its peak in mid-September
of 1929 to its trough in late June 1932, the return on a broad index of large company
stocks (equivalent to the Standard and Poor's 500) fell by 86% (Cecchetti, 1997). As
money stock fell, spending on goods and services declined, which in turn caused
firms to cut prices and output and to lay off workers. The resulting decline in incomes
made it harder for borrowers to repay loans. Defaults and bankruptcies soared,
creating a vicious spiral in which more banks failed, the money stock contracted
further, output, prices and employment continued to decline.

In the business sector, the incidence of financial distress was uneven. Aggregate
corporate profits before tax were negative in 1931 and 1932, and after-tax retained
earnings were negative in each year from 1930 to 1933 (Chandler, 1971). But the
subset of corporations holding more than $50 million in assets maintained positive
profits throughout this period, leaving the impact to be borne by smaller companies.
Fabricant (1935) reported that, in 1932 alone, the losses of corporations with assets of
$50,000 or less equalled 33 percent of total capitalization; for corporations with assets
in the $50,000-$100,000 range, the comparable figure was 14 percent. This led to
high rates of failure among small firms.

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III.6 Real Economic Sector

The stock market crash reduced U.S. aggregate demand substantially. Consumer
purchases of durable goods and business investment fell sharply after the crash. A
likely explanation is that the financial crisis generated considerable uncertainty about
future income, which in turn led consumers and firms to put off purchases of durable
goods. Although the loss of wealth caused by the decline in stock prices was
relatively small, the crash may also have depressed spending by making people feel
poorer. As a result of the drastic decline in consumer and firm spending, real output in
the United States, which had been declining slowly up to this point, fell rapidly in late
1929 and throughout 1930. Thus, the decline in stock prices was one factor causing
the decline in production and employment in the United States.

Less money and increased borrowing costs reduced spending on goods and services,
which caused firms to cut back on production, cut prices and lay off workers. Falling
prices and incomes, in turn, led to even more economic distress. Deflation increased
the real burden of debt and left many firms and households with too little income to
repay their loans. Bankruptcies and defaults increased, which caused thousands of
banks to fail. In each year from 1930 to 1933, more than 1,000 U.S. banks closed
(Wheelock, 2010).

Temin (1989) highlighted that shocks (droughts, tariff wars, contractionary policies,
devaluations, declines in autonomous consumption and investment) battered the
economy in the early 1930s. England’s departure from the gold standard was a
particularly severe stimulus. These real shocks reduced asset values and pushed
marginal banks into insolvency. The banking crisis came to an end only after
economic recovery began in 1933.

Romer (1992) argued that the stock market crash created immediate income
uncertainty resulting in a decline in the purchase of consumer durables, for which
Romer provided substantial empirical support. Romer showed that there was a
dramatic decline in new automobile registrations and department store sales,
specifically in November 1929. This evidence suggested that some of the blame for
the contraction can be traced directly to the stock market crash of 1929 and
substantiates certain aspects of Temin's (1976) original hypothesis that the initial

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contraction in output in 1929 resulted from a collapse of consumption expenditure.
Romer's position is supported by evidence in Cecchetti and Karras (1994), who found
that there was a very large aggregate demand shock of non-monetary origin in
November 1929 that is largely responsible for the downturn of 1930.

III.6.1 Growth Rate

The economic collapse of the 1930s was extremely severe, if not the most severe in
American history. Figures 8, 9, and 10 plot GNP, the price level and the
unemployment rate from 1919 to 1939, as the figures show, after eight years of nearly
continuous expansion, nominal GNP fell 48 percent from 1929 to 1933. Real GNP
fell 33 percent and the price level declined 25 percent. The unemployment rate went
from under 4 percent in 1929 to 25 percent in 1933 (Romer, 1986a, 1986b). Real GNP
did not recover to its 1929 level until 1937. The unemployment rate did not fall below
10 percent until World War II (Darby, 1976; Kesselman and Savin, 1978).

Figure 8
Nominal and Real Gross National Product (1920-40)

Source: Calomiris (1989).

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 Figure 9
Implicit Price Index (1920-40)

Source: Calomiris (1989).

Figure 10
Percentage Change in Consumer Price Index (1919-2000)

Source: International Finance Corporation (www.ifc.org).

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The largest sustained drop in output has been nearly 30% in the early 1930s. Where,
consumer prices fell 28% from August 1929 to April 1933. The civilian
unemployment rate estimate of the 1933 peak exceeds 25%. International goods
markets broke down as well. From 1929 to 1932, exports fell from 6.8% to 4.5% of
gross output (Cecchetti, 1997).

Figure 11
GDP Index numbers (1929-38)

Source: Kehoe and Prescott (2001).

GDP of big countries such as U.S., Canada, Germany and France declined deeply in
the great depression as they slumped heavily as indicated in figure 11. The Crash of
1929 was the beginning of an economic domino effect that depressed the country’s
stock market, financial institutions, industry, agriculture, and government spending as
indicated in figure 12. The most direct consequence was seen in rising rates of
unemployment beginning in 1930 and extending through 1940.

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 Figure 12
GDP and Government Spending (1929-47)

Source: International Finance Corporation (www.ifc.org).

The government spending in the great depression shrank although GDP was slumping
which deepened the depression and extended it as indicated in table 3.

Table 3
Federal Spending 1929-38

Real GDP (in Federal Spending (in

Year Unemployment Rate
Million of Dollars) Million of Dollars)
1929 3.2% 951.7 3127
1930 8.9% 862.1 3320
1931 16.3% 788.8 3577
1932 24.1% 682.9 4659
1933 25.2% 668.6 4598
1934 22.0% 719.8 6541
1935 20.3% 778.2 6412
1936 17.0% 888.2 8228
1937 14.3% 932.5 7580
1938 19.1% 890.8 6840
Source: International Finance Corporation (www.ifc.org).

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Canada was severely impacted by both the global economic downturn and the Dust
Bowl; the Canadian industrial production fell to only 58% by 1932 from the 1929
level, hence making it the second lowest level in the world after the United States and
well behind nations such as Britain. That witnessed only a fall to 83% from the 1929
level. Total national income fell to 56% from the 1929 level, again worse than any
nation apart from the United States. Unemployment reached 25.2% at the depth of the
depression in 1933 according to table 4. During the 1930s, Canada adopted a highly
restrictive immigration policy (Berton, 2001).

Table 4
GDP 1929-33

Number of Per Capita Real GDP (in

Unemployment
Year Bank Personal Million of
Rate
Suspensions Income Dollars)

1929 659 3.2% 698 951.7

1930 1352 8.9% 619 862.1

1931 2294 16.3% 526 788.8

1932 1456 24.1% 399 682.9

1933 4004 25.2% 372 668.6

Source: International Finance Corporation (www.ifc.org).

III.6.2 Unemployment

Kindleberger (1986) indicated that the unemployment in 1927 was at the low level of
3.3%, while after the crash the unemployment rate had grown to one fifth of the
working population, with no State Insurance. In November 1934, the rate reached
23%. At best, the rate fell to 9% for short whiles but on average from 1930 to 1940
the unemployment rate was 15% as indicated in the following figure.

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 Figure 13
Unemployment Rate 1929-40

Source: International Finance Corporation (www.ifc.org).

The wage stickiness or the nominal rigidity of wages is a well known recent
macroeconomic phenomenon, but in the 1930s it was not part of the economic theory.
Classical economists were expecting almost perfect adjustment of the nominal wages
to the price level changes, even if they were downward oriented, as it was the case
during the economic downturns of the 19th century. But in the 1930s nominal wages
did not adjust to the decreasing prices, for various reasons. In 1930 and 1931, the first
two years of the deflation, nominal wages fell much less slowly than prices causing a
sharp increase in real wages (Bernanke, 1986). Looking at the four biggest
industrialized countries, U.S., UK, Germany and Japan, it can be observed that
product wages (nominal wages/ manufacturing prices) in these countries increased
until 1932 in (Japan (22%), U.S. (11%) and Germany (2%)) and in 1934 in UK
(10%). Then, product wages decreased as nominal wages were more rapidly
adjusting, and reached their 1929 levels in 1933, except in the U.S. where only a
partial adjustment occurred (Eichengreen, 1992).

Nominal wage stickiness and deflation combined to create an unplanned increase in

real wages, forced firms to restrict their employment as well as their output during the
Great Depression (Bernanke and Carey, 1996). Erceg and Evans (2000) showed that
the U.S. economy sticky wage hypothesis accounts for much of the joint decline in

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output, consumption, labor hours, investment, and the price level from 1929 to 1932.
As real wage was not allowed to fall during following years, the recovery was slow.

The real wage increase would have had a positive effect on the consumption demand.
Two objections can be provided to this assertion; 1) in an open economy, particularly
specialized in the exportation of manufacturing goods, real wage increase induces loss
of competitiveness. 2) the decline of output, provoked by decrease of demand pushed
firms to lay off part of their work force, which increased the unemployment rapidly,
and also to restrict the working hours for the remaining work force, decreasing their
current income (Eichengreen, 1992 and Bernanke, 1986).

The effects on the industrial areas of Britain were immediate and devastating, as
demand for British products collapsed. By the end of 1930 unemployment had more
than doubled from 1 million to 2.5 million (20% of the insured workforce), and
exports had fallen in value by 50%. In 1933, 30% of Glaswegians were unemployed
due to the severe decline in heavy industry. In some towns and cities in the north east,
unemployment reached as high as 70% as ship production fell 90%. The National
Hunger March of September-October 1932 was the largest of a series of hunger
marches in Britain in the 1920s and 1930s. About 200,000 unemployed men were sent
to the work camps, which continued operation until 1939 according to figure 14.

Figure 14
Output and Employment during the Great Depression (1929-39)

Source: International Finance Corporation (www.ifc.org).

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III.6.3 International Trade

As in the domestic economy, these problems disrupted the worldwide mechanism of

credit. International capital flows were reduced to a drop. This represented a serious
problem for many countries which resulted in contracting world trade. As indicated in
figure 15.

Figure 15
The Contracting Spiral Of World Trade
Total imports of 75 countries, monthly values in terms of the old U.S. gold $ (MM)

Source: Kindleberger (1986).

The countries in which banking crises occurred (the United States, Germany, Austria,
Hungary, and others) were among the worst hit by the depression. Moreover, these
countries held a large share of world trade and output. The U.S. alone accounted for
almost half of world industrial output in 1925-29, and its imports of basic raw
materials and foodstuff in 1927-28 made up almost 40 percent of the trade in these
commodities. The reduction of imports as these economies weakened exerted
downward pressure on trading partners (Bernanke, 2004a).

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As figure 16 points out due to the great depression, the world trade overall shrank
during the depression period 1929-33 and reached its lower amounts in 1933 due to
ineffective monetary policies.

Figure 16
World Trade 1929-33

Source: Woytinsky (1955).

Countries depending on agricultural and industrial exports such as Australia were one
of the hardest hit countries in the Western world, amongst the likes of Canada and
Germany. Falling export demand and commodity prices placed massive downward
pressures on wages. Furthermore, unemployment reached a record high of 29% in
1932, with incidents of civil unrest becoming common. After 1932, an increase in
wool and meat prices led to a gradual recovery.

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IV. Remedy Tools of The 1929 Financial Crisis

The 1929 crash brought the Roaring Twenties trembling to a halt. As tentatively
expressed by Kindleberger, in 1929 there was no lender of last resort effectively
present, which, if it had existed and was properly exercised, would have been key in
shortening the business slowdown that normally follows financial crises. The crash
marked the beginning of widespread and long-lasting consequences for the United
States. The decline in stock prices caused bankruptcies and severe macroeconomic
difficulties including business closures, firing of workers and other economic
repression measures. The resultant rise of mass unemployment and depression is seen
as a direct result of the crash, though it is by no means the sole event that contributed
to the depression; it is usually seen as having the greatest impact on the events that
followed. Therefore the Wall Street Crash is widely regarded as signaling the
downward economic slide that initiated the Great Depression.

Temin (1976) argued that the Federal Reserve could have done little to aid ailing
banks. Fundamental forces pushed banks into insolvency; monetary intervention
could not pull them out. Liquidity assistance could not eliminate loan losses. Open-
market expansion, even on a massive scale, could not lift the economy out of the
liquidity trap. Calomiris and Mason (2003); Eichengreen (1992); Romer (1992) and
Temin (1989) argued that the Federal Reserve could not aid ailing banks directly,
since illiquidity and contagion caused few bank failures, but that massive open market
expansions, such as those that the Roosevelt administration implemented after
abandoning the gold standard, could have enhanced economic progress, and thus,
indirectly alleviated the banking situation.

Richardson and Troost (2005) argued that even limited assistance from the Federal
Reserve might have mitigated banking panics. By acting as a lender of last resort and
extending loans to solvent but illiquid institutions, the Federal Reserve could have
kept ailing institutions afloat. A credible commitment to do so might have calmed
consumers, reassured bankers, raised the money multiplier, alleviated the credit
crunch, and eased the economic situation. Friedman and Schwartz (1963) and Meltzer
(2003) concluded that the Federal Reserve’s sins were of commission as well as
omission. The Federal Reserve not only neglected to aid ailing banks, but by raising
interest rates, reducing monetary base, and restricting discount lending, the Federal

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Reserve weakened all banks, and created conditions encouraging panics. As evidence,
these scholars highlight the Federal Reserve’s monetary contraction in 1928 and the
Federal Reserve’s defense of the gold standard in 1931.

Romer (1992) believed that government spending on World War II caused or at least
accelerated recovery from the Great Depression. However, some consider that it did
not play a great role in the recovery, although it did help in reducing unemployment.
The massive rearmament policies leading up to World War II helped stimulate the
economies of Europe in 1937–39. By 1937, unemployment in Britain had fallen to 1.5
million. The mobilization of manpower following the outbreak of war in 1939 finally
ended unemployment.

America's late entry into the war in 1941 finally eliminated the last effects from the
Great Depression and brought unemployment rate down to below 10%. In the United
States, massive war spending doubled economic growth rates, either masking the
effects of the Depression or essentially ending the Depression. Businessmen ignored
the mounting national debt and heavy new taxes, redoubling their efforts for greater
output to take advantage of generous government contracts.

It was inevitable that Hoover, the president who presided over an acute economic
depression, massive unemployment, and a failing financial system would fail to be re-
elected. So it was that Franklin Roosevelt came to power in the 1932 election. It fell
to his administration to try to revive the American economy.

President Hoover’s administration created the following reforms to eliminate the

negative impacts of the great depression:

o The Agriculture Marketing Act of 1929

o The Reconstruction Finance Corporation (RFC) of 1932

o The Federal Home Loan Bank Act of 1932

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President Roosevelt’s administration created the following reforms to eradicate the
devastating effects of the great depression:

o The Agricultural Adjustment Administration of 1933

o The Civilian Conservation Corps of 1933

o The Farm Credit Administration of 1933

o The Federal Deposit Insurance Corporation of 1933

o The Federal Emergency Relief Administration of 1933

o The National Recovery Administration of 1933

o The Public Works Administration of 1933

o The Tennessee Valley Authority of 1933

o The Emergency Banking Bill of 1933

o The Glass-Steagall Act of 1933

o The Farm Credit Act of 1933

o The National Industrial Recovery Act of 1933

o The Truth-in-Securities Act of 1933

o The Federal Communications Commission of 1934

o The National Mediation Board of 1934

o The Securities and Exchange Commission of 1934

o The Securities and Exchange Act of 1934

o The Trade Agreement Act. of 1934

o The Works Progress Administration of 1935

o The National Labor Relations Board of 1935

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 o The Rural Electrification Administration of 1935

o The Banking Act of 1935

o The Emergency Relief Appropriation Act of 1935

o The National Labor Relations Act of 1935

o The Social Security Act. of 1935

o The Soil Conservation and Domestic Allotment Act of 1936

o The Agricultural Adjustment Act of 1938

o The Fair Labor Standards Act of 1938

The study concentrates on the reforms related to the financial sector which is the core
of the research and will highlight the major financial reforms that facilitates hedging
the undesirable consequences of the depression.

The duration of the credit effects depends on the amount of time it takes to 1)
establish new or revive old channels of credit if it became low after a major
disruption, and 2) rehabilitate insolvent debtors.

IV.1 The New Deal Policies

After struggling through 1931-32, the financial system hit its low point in March
1933, when the newly elected President Roosevelt's bank holiday closed down most
financial intermediaries and markets. March 1933 was a watershed month in several
ways; it marked not only the beginning of economic and financial recovery but also
the introduction of truly extensive government involvement in all aspects of the
financial system (Chandler, 1970). It might be argued that the federally directed
financial rehabilitation which took strong measures against the problems of both
creditors and debtors was the only major New Deal program that successfully
promoted economic recovery. In any case, the large government intervention is prima
facie evidence that by this time the public had lost confidence in the self-correcting
powers of the financial structure.

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Shortly after President Roosevelt was inaugurated in 1933, drought and erosion
combined to cause the Dust Bowl, shifting hundreds of thousands of displaced
persons off their farms in the Midwest. From his inauguration onward, Roosevelt
argued that restructuring of the economy would be needed to prevent another
depression or avoid prolonging the current one. New Deal programs sought to
stimulate demand and provide work and relief for the impoverished through increased
government spending and the institution of financial reforms.

These reforms, together with several other relief and recovery measures, are called the
First New Deal. Economic stimulus was attempted through a new alphabet soup of
agencies set up in 1933 and 1934 and previously extant agencies such as the
Reconstruction Finance Corporation. By 1935, the "Second New Deal" added Social
Security (which did not start making large payouts until much later), a jobs program
for the unemployed (the Works Progress Administration, WPA) and, through the
National Labor Relations Board, a strong stimulus to the growth of labor unions. In
1929, federal expenditures constituted only 3% of the GDP. The national debt as a
proportion of GNP rose under Hoover from 20% to 40%. Roosevelt kept it at 40%
until the war began, when it soared to 128% (Berton, 2001)

Given that the 1929 crash marked the start of the Great Depression, there was an
association of stock market falls and economic calamity in the public imagination.
This created a sense that something must be done to prevent the equity market from
disrupting the U.S. economy to such a large extent in the future. Furthermore there
was a need to deal with the unsavory behavior in the securities markets uncovered by
the Pecora Hearings. Two programs of action were therefore needed:

o Something to prevent dislocations in the securities markets from damaging the

banking system.

o Something to make the securities markets more honest.

Thus the New Deal reforms included the Securities Acts of 1933-34 and the Banking
Acts of 1933-35.

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IV.1.1 The Securities Acts of 1933 – 1934 (Securities Regulation)

Two securities acts, the Federal Securities Act of 1933 and the Securities Exchange
Act of 1934, drastically changed the regulation of securities in America. Together
they created the Securities Exchange Commission (SEC) to oversee the securities
markets; required securities issuers to disclose all material information to securities
buyers; and made fraudulent or misleading disclosures illegal. In particular, issuers of
securities are required to register them with the SEC, and to provide the SEC with
audited financial statements, and with detailed information on the equities or bonds to
be issued. This meant that all companies that desired access to American capital
markets must give the SEC regular information on their financial condition, a
resource that has proven very useful to investors ever since.

IV.1.2 The Banking Acts of 1933 – 1935 (The Glass-Steagall Acts)

The Great Depression took a massive toll on U.S. banks. Over ten thousand failed or
had to merge, and the total number of banks fell by over a third. Clearly something
needed to be done to restore the public's confidence in the financial system. Therefore
the Banking Act of 1933 established wide-ranging deposit protection. Retail deposits,
providing they are not too big, are protected by a Federal Government Agency, the
Federal Deposit Insurance Corporation (FDIC). If the bank fails, the FDIC will take it
over: depositors' funds are not at risk. This allows retail investors to leave money with
a bank without worrying about its financial condition. In particular if there are rumors
about the possible failure of a bank, then retail depositors will not lose and so they
have no incentive to take their funds out. This helps to prevent a bank run where the
rumor of a bank failure causes deposits to be withdrawn and hence makes the rumor
true (Murphy, 2009).

On October 24, 1929, with the Dow Jones just past its September 3 peak of 381.17,
the market finally turned down, and panic selling started. In 1931, the Pecora
Commission was established by the U.S. Senate to study the crash causes. The U.S.
Congress passed the Glass-Steagall Act in 1933, which mandated a separation
between commercial banks, which take deposits and extend loans, and investment

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banks, which underwrite, issue, and distribute stocks, bonds, and other securities
(Kroszner and Rajan, 1993).

Securities were the most visible cause for the nation's financial distress. Therefore it is
hardly surprising that some politicians wanted to protect the banking system from the
dangers of securities trading, and so to allow it to function better should the equity
market suffer another crash. The Pecora Hearings gave those politicians who had
always distrusted the securities markets - including a certain Senator Carter Glass -
the excuse they needed to separate banking and securities dealing. Clauses were
added to the 1933 Banking Act to cleave the two asunder (Wigmore, 1985). In
particular - at least after a second bite of the cherry was taken in the Banking Act of
1935 - there were four main changes:

o Banks were forbidden from purchasing a significant amount of U.S. securities

for their own account, preventing them from speculating in the securities
markets with depositors' money.

o They could only purchase and sell securities when they had a direct customer
order.

o Securities issuance, including underwriting and selling equities or corporate

bonds, were forbidden to banks.

o Banks could not be affiliated with entities engaged principally in securities

underwriting, distribution, or dealing.

These provisions are collectively known as the Glass-Steagall Act as Senator Glass
was one of the main driving forces and Henry Steagall, as Chairman of the House
Banking and Currency Committee, helped him get the legislation passed. Together,
the Glass-Steagall provisions reduced the cost of deposit protection to the U.S.
government by making banks concentrate on banking rather than securities activity.
But they also split American financial services in two. If a person wanted to trade and
underwrite securities, a person could not take deposits and make loans. Without
Glass-Steagall, American banks would have continued to be active in securities
trading, as their European peers were. But post Glass-Steagall there was an
opportunity for specialist securities firms to grow up, the broker/dealers. These firms

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are not banks, they are regulated by the SEC rather than banking regulators. By the
1990s, the largest five of them were dominant players in Capital Markets.

In many countries, government regulation of the economy, especially of financial

markets, increased substantially during the Great Depression. The United States,
established the Securities and Exchange Commission in 1934 to regulate new stock
issues and stock market trading practices. The Banking Act of 1933 (the Glass-
Steagall Act) established deposit insurance in the United States and prohibited banks
from underwriting or dealing in securities. Deposit insurance, which did not become
common worldwide until after World War II, effectively eliminated banking panics as
an exacerbating factor in recessions in the United States after 1933 (Romer, 1990).

The Securities Act of 1933 comprehensively regulated the securities industry. This
was followed by the Securities Exchange Act of 1934 which created the Securities
and Exchange Commission. Though they were amended key provisions of both Acts
are still in force. Federal insurance of bank deposits was provided by the FDIC, and
the Glass-Steagall Act. The institution of the National Recovery Administration
(NRA) remains a controversial act to this day. The NRA made a number of sweeping
changes to the American economy until it was deemed unconstitutional by the United
States Supreme Court in 1935 (Berton, 2001).

Early changes by the Roosevelt administration included:

• Instituting regulations to fight deflationary "cut-throat competition" through

the NRA.

• Setting minimum prices and wages, labor standards, and competitive

conditions in all industries through the NRA.

• Encouraging unions that would raise wages, to increase the purchasing power
of the working class.

• Cutting farm production to raise prices through the Agricultural Adjustment

Act and its successors.

• Forcing businesses to work with government to set price codes through the
NRA.

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IV.2 The Reconstruction Finance Corporation (RFC)

Roosevelt had few of the scruples of modern central bankers. For instance, Roosevelt
explicitly declared that “the definitive policy of the government has been to restore
commodity price levels”. It was a priority, then to restore prices to the point where
firms could make money, wages could be paid, and debts serviced. Decision makers
were going to intervene in the markets, and the Reconstruction Finance Corporation
(RFC) was one of their instruments.

The RFC was the innovation of 1932. This was an independent agency of the U.S.
government, designed to assist in the revival of the U.S. financial system. At first it
simply lent banks against collateral, this was partly necessary as, at the time, many
U.S. banks were not members of the Federal Reserve System, and hence the FED
could not lend to them. The RFC was also hampered by a requirement that it publish
the names of those it lent to; making institutions reluctant to publicly declare their
need for RFC funds (Bernanke, 2004a).

Emergency Banking Act of 1933; Conservators for unsound banks rather than
bankruptcy and liquidation, preferred stock bought by RFC, and Federal Reserve
loans to banks, secured by financial assets (Federal deposit insurance soon after).

Lending banks money is of little use if they are not solvent. What they need then is
capital, and this is what the RFC started to provide in 1933. Legislation was changed
so that the RFC could inject capital into banks and this together with deposit
protection; put the banking system back on a firmer footing. It also made the RFC a
significant instrument of state capitalism; by 1935 it owned over a billion dollars of
capital (roughly two hundred billion in 2007 dollars) in over half of the banks in the
country (Todd, 1991).

As the thirties progressed, the importance of the RFC's role in the economy increased.
By 1938 it had disbursed over $10 Billion. It was the largest single investor in the
American economy. On the basis of its lending, it was the largest bank in the country.

In 1931, Hoover urged the major banks in the country to form a consortium known as
the National Credit Corporation (NCC). By 1932 unemployment had reached 23.6%,
and it peaked in early 1933 at 25%, a drought persisted in the agricultural heartland,

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businesses and families defaulted on record numbers of loans, and more than 5,000
banks had failed. Hundreds of thousands of Americans found themselves homeless
and they began congregating in the numerous Hoovervilles that had begun to appear
across the country (Bernanke, 2004a).

In response, President Hoover and Congress approved the Federal Home Loan Bank
Act, to spur new home construction, and reduce foreclosures. The final attempt of the
Hoover Administration to stimulate the economy was the passage of the Emergency
Relief and Construction Act (ERA) which included funds for public works programs
such as dams and the creation of the Reconstruction Finance Corporation (RFC) in
1932. The RFC's initial goal was to provide government secured loans to financial
institutions, railroads and farmers. Quarter by quarter, the economy went downward,
as prices, profits and employment fell, leading to the political realignment in 1932
that brought Franklin Roosevelt to power.

Although the government's actions set the financial system on its way back to health,
recovery was neither rapid nor complete. Many banks did not reopen after the holiday
and many that did open, did so, on a restricted basis or with marginally solvent
balance sheets. Deposits did not flow back into banks in great quantities until 1934,
and the government (through the Reconstruction Finance Corporation and other
agencies) had to continue to pump large sums into banks and other intermediaries.
Most important, however, was a noticeable change in attitude among lenders; they
emerged from the 1930-33 episode restrain and conservative. Friedman and Schwartz
(1963) have documented the shift of banks during this time away from making loans
toward holding safe and liquid investments. The growing level of bank liquidity
created an illusion of easy money; however, the combination of lender reluctance and
continued debtor insolvency interfered with credit flows for several years after 1933.

IV.3 Home Owners' Loan Corporation (HOLC)

There are few things more damaging than losing your home. And if a high foreclosure
rate is bad for society, it does not help the banks. Once bank sales of foreclosed
homes start to dominate the property market, liquidity evaporates, and prices
plummet. Mortgage collateral (houses) can no longer be sold for more than the loan

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they secure, causing losses for foreclosing lenders. President Hoover had already tried
to address the problem, but the Home Loan Bank Act of 1932 had done little.
Roosevelt wanted to do more to protect home owners from foreclosure.

The Home Owners' Loan Corporation (HOLC) was the result. Beginning in 1933, it
took over unaffordable mortgages and restructured them, extending the mortgage
term. The HOLC's government status allowed it to borrow cheaply. These savings
were passed on to mortgage borrowers too, resulting in much lower payments on the
restructured loans. The HOLC prevented the collapse of the property market. Like the
RFC, it grew furiously, eventually having a role in roughly 20% of all non-farm
mortgages (Bernanke, 2004a).

IV.4 The Federal Housing Administration (FHA)

There is a need to persuade American banks to get back into the lending business.
One of their concerns was clearly the plunging credit quality of individuals during the
depression. So the government set up the Federal Housing Administration (FHA) to
insure against the risk of default on mortgage loans. The ability to buy protection on
mortgage default from the government encouraged lenders to lend. For the first time
they could hedge the risk of non-performaning mortgages. In particular it meant that
lenders could be sure of a profit on an FHA insured loan, provided that the interest on
the mortgage was more than the cost of insurance, the cost of funding the loan, and
the cost of servicing it, they would make money with little risk (McElvaine, 1993).

The FHA helped in giving lenders a way of reducing the risk of mortgage lending, but
it did nothing to assist in funding. A lender still had to raise money if it wanted to
make new loans. That resulted in the foundation of the Federal National Mortgage
Association in 1934. This entity, which rapidly became known as Fannie Mae, was
originally part of the RFC. It purchased FHA-insured mortgages, freeing up cash, and
so allowing the lender to lend again.

Thus between the RFC, the HOLC, the FHA, and Fannie, a series of substantial
interventions recapitalized and re-liquefied the banking system, supported property

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prices, and encouraged banks not to limit their involvement in mortgages to
foreclosing on existing customers.

IV.5 The Federal National Mortgage Association (Fannie Mae)

Fannie created a secondary market for residential mortgages. Lenders no longer had
to keep all the loans they made. Provided Fannie would buy them, their loans could be
turned into cash, giving the primary lenders the confidence to keep lending whatever
the economic climate. In this sense the Roosevelt administration's reforms achieved
their aim. However there was a price. First, Fannie’s borrowings counted as
government debt and thus they inflated the size of government liabilities. And second,
the mortgage market split into those loans that were eligible for sale to Fannie, known
as conforming loans, and the rest.

The first thirty years of Fannie’s life were fairly orthodox. It bought FHA insured
mortgages, funding them with its borrowing. Its functions expanded gradually; in
1944 Fannie was permitted to buy mortgages insured by the Veterans' Association,
giving it a role in ensuring that ex-Service personnel could get a home loan. It was
also allowed to provide special assistance to the housing market buying uninsured
mortgages if this was necessary to prevent a decline in home building (Murphy,
2009).

Fannie was in some ways too good at its job. By 1968, it had a significant portfolio of
mortgages, and significant borrowing to fund them. The President at the time -
Lyndon Johnson - was worried about government finances, especially as the costs of
the Vietnam War were escalating. In a move that has echoes of the creative
accounting used by Enron more than forty years later, a structure was developed that
changed the appearance of the U.S. government finances without a significant change
in their substance.

The idea was a peculiar kind of semi-privatization which removed Fannie's debts
from the roll call of government liabilities. Fannie was split: a new entity, Ginnie
Mae, took over responsibility for buying FHA- and VA-insured loans; while Fannie
itself was left to support the broader secondary mortgage market by buying loans

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directly from the primary lenders. At the same time Fannie was listed and shares were
sold to investors.

However, unlike a true privatization, the government hinted that Fannie's liabilities
would continue to be backed by the U.S. Treasury. President Johnson could not
explicitly guarantee Fannie, which would not have removed the firm's liabilities from
the official calculation of government finances. But Johnson could give a nod and a
wink to the market. This ambiguity is part of the untidy border between government
and private enterprise that characterizes American capitalism.

Clearly a quasi-private Fannie would enjoy a monopoly position in the secondary

market. Therefore a competitor was set up to keep it honest: Freddie Mac. Both
agencies were permitted to buy conforming mortgages in the secondary market. The
status of Fannie and Freddie is acknowledged in the term used to refer to them and a
number of other similar agencies acting for the government: government sponsored
enterprise (GSE).

Fannie Mae and Freddie Mac have a variety of other advantages in addition to
implicit support from the government: they have their own regulator, the Office of
Federal Housing Enterprise Oversight, various tax breaks, and even an exemption
from SEC registration of their securities.

The problem with the structure Johnson ended up with, is that if things go well for
Fannie Mae and Freddie Mac, then their shareholders benefit, but if things go badly,
the taxpayer may end up footing the bill. Specifically if Fannie or Freddie (or both)
buy too many mortgages which go on to default, their capital will be eroded. If this
happens too fast or too far, their regulator will be forced to step in. The price of
Lyndon Johnson's accounting sleight of hand has been a considerable transfer of
wealth to Fannie and Freddie's shareholders and management (Murphy, 2009).

IV.6 Federal Home Loan Banks (FHLBs)

Hoover's 1932 Home Loan Bank Act created one final piece of financial system
architecture that will be important later, the Federal Home Loan Banks (FHLBs). The

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FHLB system was a kind of mini mortgage-based Federal Reserve system. Like the
FED, there are twelve regional banks (although the FHLB regions are different from
the FED districts); these regional FHLBs lent against collateral, but mortgage
collateral rather than bonds which are eligible at the FED window. The whole system
was government guaranteed, so the FHLBs could borrow cheaply.

Much of FHLB lending is to the thrifts, the original aim was to liquefy mortgage
assets within the banking system and hence make mortgages more affordable. Unlike
the Federal Reserve System, the FHLBs are owned by the banks they support, so their
equity is held by over 8,000 financial institutions in the U.S., and is not publicly
traded (Rothbard, 2000).

The New Deal reforms enhanced the safety and efficiency of the American financial
system. Deposit protection removed the risk of losing their savings from many
Americans. The combination of the HOLC, the FHA, Fannie, and the FHLBs made
mortgages cheaper. Long term level pay structures slowly replaced the short term
interest only loans that predominated before the Great Depression. Home ownership
became part of the American Dream. Glass-Steagall separated securities trading and
underwriting from banking, enhancing the safety of the banking system.

However, the resulting system was enormously complicated. There were lots of
different types of institutions: depositary banks and broker/dealers; thrifts and FHLBs;
the FHA and Fannie. Different regulators abounded too: the Federal Reserve and the
OCC for banks, plus the FDIC; the SEC for the broker/dealers; a separate regulator
for the thrifts; what became the Federal Housing Finance Board for the FHLBs; and
the Office of Federal Housing Enterprise Oversight for Fannie and Freddie. Each
regulator had different rules, different concerns, and a jealous concern for the health
of its charges. It is perhaps inevitable that some regulators judge their importance by
the size and status of the firms they supervise and a regulator suggesting that the
whole class of firms under their charge is dangerous. This diversity of regulators may
therefore contribute to financial instability: they certainly make financial system
reform more difficult.

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Conclusion

The Great Depression was an economic downturn in most industrialized areas of the
world that started in 1929 and ended somewhere about 1939 (the end year in U.S. was
1933). It was the longest and most severe depression ever experienced by the
industrialized Western world. In U.S. this depression started with stock market
collapse on October 29, 1929, known as Black Tuesday.

The Great Depression, directly or indirectly, affected every country, developing or

developed, market prices and profits, international trade, personal income plunged by
half to two thirds. The biggest influence of the crisis was felt hard by industrialized
cities. Construction sector was almost halted by 80%. Rural economy suffered from
very low crop prices, which fell by about 60%. During Great depression 25% of
Americans were unemployed (Rothbard, 2000).

The Great Depression got worse by the misguided government policies, specifically,
the Federal Reserve allowing the money stock to collapse as panics engulfed the
banking system. If the Fed had stepped up to the plate and ensured that banks had
sufficient reserves to meet their customers’ withdrawal demands, the money stock
would not have declined, and the economy probably would not have sharply
contracted (Wheelock, 2010).

It is obvious that the economic institutions are very different nowadays than they were
in 1929. Many of the changes are surely the result of the depression itself. A few of
the more important things that clearly came out of this period are that the Federal
Reserve System is more centralized, there is deposit insurance and stronger bank
regulation, commercial and investment banking are separated, there is a pure paper
money standard, and there is unemployment insurance and social security.

The 1929 financial crisis remedy tools were the main seeds of the 2008 financial
crisis, since a wave of deregulation started to take place and passing the Glass-Steagal
Act in 1933 which mandated a separation between commercial banks (depositary
banks) and investment banks (non-depositary banks). Further, Fannie Mae was
created which involved in securitization practices.

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History has taught that expansionary monetary policy is one of the most useful tools
in aiding a fledgling economy. During the Great Depression, banks were allowed to
fail, while reserve requirements were increased. These policies caused a freeze in
lending and a drastic decline in the nation’s money supply. Romer’s (1992) research
on the Great Depression indicated that expansionary monetary policy aided in the
nation’s economic recovery. Cowen (2008) echoed this sentiment, noting that,
Roosevelt’s best policies were those designed to increase the money supply, get the
banking system back on its feet, and restore trust in financial institutions. The same
types of policies should be followed nowadays. Indeed, the Federal Reserve has been
very aggressive in implementing a loose money policy and has vowed to use every
tool in its arsenal. Additionally, the following policies could help restore confidence
in the economy and trust to the banking sector and overall economy (Diamond and
Countryman, 2009):

• Refrain form increasing income taxes.

• Avoid policies insulating domestic producers from foreign competition.

• Leverage to capital ratios should focus on the market liquidity of assets as well
as the maturity date of assets and debts.

• Creation of a Financial Product Safety Board.

• Improve financial disclosure and reduce the ability of firms to hold assets and
liabilities in off-balance sheet accounts.

• Creation of market for covered bonds as means for financing mortgages and
other infrastructure investments.

• Regulate financial innovation without being too restrictive.

• Plan an exit strategy to return government-owned shares of private banks and

other institutions to the private sector.

• Increase government spending in the short run by moving forward with

projects that have larger public benefits than public costs, extending
unemployment benefits, and encouraging increased private investment.

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