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Understanding the Great Depression

The great depression is the period known to us right after the Oct 29th stock market crash of 1929 almost until the end of WW2, in fact – the depression started right in the middle of the interwar period. It is the worst economic phase in the 19th century according to economists and here is a brief summary about what really happened. 

(I will talk about it briefly first, but since there are many things about economics the depression can actually teach us, I will cover them separately after the summary)

The US experienced a huge boom in the stock market in the 1920s, wherein there was almost a growth of 20% each year in the 5-6 years leading up to the 1929 crash. On September 3rd 1929, the DJIA - Dow Jones Industrial Average - was at 381 – margin trading (financial invention at that time) giving way to excess liquidity, led to a lot of people heavily investing in the markets without their own money and there was an overall boom in confidence. However in 1929, fueled by a huge over valuation of stocks leading to over production and building inventory and also events in the UK market (The Hatry case fraud), panicking investors liquidated their holdings on what will be famously go down in history - “Black Thursday”- 24th October 1929. 

On Friday, efforts to buy in helped the markets to rally a little but it was not enough; on Monday and Tuesday - 28th and 29th October respectively, the markets crashed around 12% on both days, cumulatively a 25% crash over the 2 days - the steepest so far in the history of the markets. 

What followed was massive unemployment, starvation, mistakes by the fed, protectionist measures by the Herbert Hoover administration, and a bottoming of the market in 1932 to 41. (From 381 to 41, in a span of 4 years) and this level of 381 was not to be seen till 1954 now. 

Here is a glimpse of the market:

Some key questions come up:

  • What caused the crash?
  • What was done to get the economy on track?
  • What was the impact
  • How did the stock market react?
  • What are the teachings?


You must have all heard the term “asset bubble” and over valuation. Whenever the stocks are representing a value which is too high (even after considering the future earnings of those companies), there is a bubble - and when this happens at an aggregate stock market level, it is almost like a market bubble.

This is what happened in the 1920s. Reasons? A growing economy, increasing exports to Europe (Europe was just recovering from WW1), the growth of automobiles throughout the country which gave rise to more jobs and hence incomes (think Henry Ford), and most importantly, easy money since people were trading on HUGE margins (1:3). People were not basing decisions on the fundamentals of stocks, rather they were basing it on very bullish expectations that prices would continue to increase, and they wanted to be a part of the game. It had almost become a hobby. And since a lot of companies were able to raise cash easily from the stock markets, they invested into higher production capacities owing to a boost in the optimism across the economy. 

But by 1929, this had reached unsustainable levels. Companies were sitting on a lot of excess inventory and were forced to sell their products at a loss, share prices staggered and panic had set in. THE MARKET BUBBLE BURST.

What ensued after the crash?

Dow Jones Industrial Average Historical data

  • Unemployment rose to 25% (3% in 1929, 25% in 1933)
  • Wages fell 42%
  • Prices of items fell 10% a year each year from 1929 to 1933
  • Drought set in many places in USA
  • By 1931-32, Europe was also heavily impacted 
  • The DJIA reached 41 dollars on 8 July 1932, and it took at least another 30 odd years, one world war, a few other wars, a few more presidents to get the stock market to pre depression levels


The role (or lack thereof) of the Federal Reserve:

The Fed was introduced in 1913. For over 8 years of its initial existence, it barely interfered. However after WW1, it did introduce quite a few policies aiding monetary expansion and thereby injecting a lot of liquidity (more than needed) into the economy. In a sense, by keeping reserve requirements low, and interest rates low, it stimulated the economic rise of the 1920s leading to the overall crash. However right after the crash, the Fed resorted to becoming extremely restrictive and plugging out (much needed) liquidity from the economy, choking essential hope for a quicker recovery. 

The Fed’s reaction can be (perhaps) understood since it did not want to rescue irresponsible banks who were finding it hard to give customers back their fixed deposits. Banks usually keep 10% reserves incase customers ask for their money, it assumes naturally that everyone is not going to ask for their money at the same time, but when the market crashed in 1929 - people ran berserk and asked for their money back. (Where have we heard the quote ‘Cash is King’ before?)

Anyway - the Fed did not help much.

What did Herbert Hoover do, as a response to the crisis? 

Contrary to criticism that he did not do anything, 

  • He increased federal spending by 42% into public development programs like the reconstruction finance corporation.
  • He raised taxes.
  • He also enacted the Smoot-Hawley tariff act - extreme protectionist measures. It imposed massive duties on several products hence restricting and completely minimizing international trade - which drastically affected the economy - by 1934 - trade declined by 66%

What did Franklin D Roosevelt do once he took over in 1933?

  • The new deal - loosely based on Keynesian economics, he invested massively into public spending programs - many infrastructure projects were undertaken which fueled employment
  • He abolished the GOLD STANDARD system - by doing so he was able to inject money into the economy. (The gold standard is a very interesting concept - and will be covered separately)
  • Farmers were paid to STOP production to avoid a drop in agricultural prices
  • He instituted the Glass - Steagall act - which separated investment banks from retail banks so as to protect the people’s deposits. This is followed till date.

However, the measures, while they helped to instill confidence, were viewed as too less to actually spark a recovery. 

Economists also say that, just like Herbert Hoover, even Roosevelt tried to do too much in too little a time, instead of allowing the economy to take its own course to recover. 

So what finally gave in? How did the economy actually recover?

It was also during this time that several states in the US were struggling with ‘Dust Bowl’ – dust storms that caused drought and famine, killing crops & livestock - and this highly exacerbated  the situation. 

By 1939, the WW2 was about to set in. Many economists credit the world war to have had a massive positive impact on the US economy and some say it was even the reason how the great depression subsided - although it does seem like a broken window fallacy.

As per Investopedia, the broken window fallacy is as below:

In Bastiat's tale, a boy breaks a window. The townspeople looking on decide that the boy has actually done the community a service because his father will have to pay the town's glazier to replace the broken pane. The glazier will then spend the extra money on something else, jump-starting the local economy. The onlookers come to believe that breaking windows stimulates the economy.

Bastiat points out that further analysis exposes the fallacy. By forcing his father to pay for a window, the boy has reduced his father's disposable income. His father will not be able to purchase new shoes or some other luxury good. Thus, the broken window might help the glazier, but at the same time, it robs other industries and reduces the amount spent on other goods.

Bastiat also noted that the townspeople should have regarded the broken window as a loss of some of the town's real value.

Moreover, replacing something that has already been purchased represents a maintenance cost, not a purchase of new goods, and maintenance doesn't stimulate production.

In short, Bastiat suggests that destruction doesn't pay in an economic sense.

There are many theories which suggest that it was due to WW2 that unemployment drastically fell, thereby leading to a recovery, coupled with an enormous increase in war spending. Proponents of the broken window fallacy and critics of Keynesian economics, however suggest that post the war, the government actually reduced taxes and spending, hence giving money in the hands of the public which fueled consumption. 

However, how it actually happened still remains a mystery - for most people. Here’s our view:

The war might have actually helped bring down unemployment since a lot of people actually did get pulled off into the war itself, and not to mention into all the war-time related factories. This might have helped the economy garner some momentum. But we also feel it was strongly because the natural course of the economic cycle was allowed to take course - and that post the war, there was actually more money in the hands of people which boosted consumption in an optimistic post war scenario. Additionally, the USA was recovering from the dust bowl that had engulfed it in a pretty miserable situation in the mid-1930s. 

Many countries had also detached themselves from the GOLD standard in the 1930s - which helped them to recover faster. Some economists believe that the recovery of countries was strongly tied to when they gave up the gold standard. (Britain’s economy actually recovered faster since it was one of the first which gave it up in 1931 - when it had run out of gold reserves owing to its overvalued currencies). France, USA, Switzerland etc came out of subsequently.

I did want to take out some time to write about how the GOLD STANDARD actually played a pivotal role in transmitting the effects of this depression throughout the world: you see, if the economies at that time were on a free floating mechanism, the impact could have been minimized and it may have not been as severe as it actually was. But unfortunately in a gold standard - economies are heavily inter linked. 

So - what exactly is the GOLD standard and how does it actually work? And why was the gold standard playing a role with the transmission of the depression? 

The Gold standard is a fixed exchange rate system which pegs the value of a currency with certain amount of gold. Example: 1 dollar = 1.5 ounces of gold. This enables an economy to trade with other economies in a fairly consistent manner. Assuming the pound was pegged to 2 ounces of gold, if USA wanted to trade with Britain and wanted to import a basket costing 8 pounds, and the British wanted to import a shoe from USA costing 12 dollars; here is how the situation would play out. 

USA would need to hand over 16 ounces of gold to Britain, and Britain would hand over 18 ounces of gold to USA. In essence, Britain would run a deficit of gold since its import > export in terms of gold. And hence if this sustained, Britain would actually run out of gold reserves over time. 

Hence, Britain’s government would need to intervene either by adjusting its interest rates (it can lower interest rates - leading to increase in money supply and reduced prices, and thereby boosting exports - therefore restoring equilibrium). It can also wait for the economy to readjust itself (if there is a gold deficit, money supply will come down and hence exports will eventually become cheaper and boost the economy). Here, we evaluate the interconnectedness economies had due to the gold standard by the below graph:

In the context of the great depression and the world wars, here is what we need to note. 

The gold standard worked just fine, until WW1. It was temporarily suspended then since the countries had to pump in money into the economy to sustain momentum. Since the GS allows you to print only a LIMITED amount of money (that which can be backed by a particular ratio of gold reserves), economies gave up the GS since they did not want this restriction and wanted to be freely available to pump money. 

Excessive pumping of money led to differing levels of inflation in countries. Thus, when the war was over and the Government actually wanted to reinstate the gold standard, it did so, but now the exchange rates did not reflect the actual worth of currencies. Due to this, issues started to arise. For example, the British pound currency was overvalued and the Franc was undervalued. 

Hence France ran a BOP surplus, and Britain, a deficit. Soon Britain had to give up the GS because it no longer had enough gold reserves to sustain the deficit. It gave up the GS in 1931. Similarly, USA wanted to pump in more money in 1933 into the economy, hence decided to give up the GS, and in doing so actually pegged the US dollar at a higher currency to the gold (i.e - it devalued the dollar, with the objective of making its exports more competitive)


  • A LOT is at stake when financial institutions are left loosely inspected
  • Assets which form a bubble eventually WILL collapse
  • Financial innovations like margin trading need to be exercised with utmost caution
  • Keynesian economics - the usefulness of the same definitely has been questioned and the great depression is a big reminder that aimlessly pumping money into the economy may not help
  • While war will simulate the economy - it SHOULD not be looked upon as a savior of the economy
  • There is a huge interconnectedness between the different countries - back then because of the fixed exchange rate system, but now because of the globalized nature of our economy and reliance on trade
  • Sometimes, it may take more than 30 years for an economy to regain back to the same stock levels, as was the case with the great depression


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