When Herbert Hoover was elected President in 1928, the mood of the general public was one of optimism and confidence in the U.S. economy. Few saw any reason why prosperity should not continue. In his acceptance speech for the Republican party nomination for the presidency, Hoover had said:
"We in America today are nearer to the final triumph over poverty than ever before in the history of any land. The poorhouse is vanishing from among us."
Hoover's optimism and boosterism was shared by many in the beginning of 1929. An editorial in the New Year's edition of the "New York Times" on January 1, 1929 stated:
"It has been twelve months of unprecedented advance, of wonderful prosperity. If there is any way of judging the future by the past, this new year will be one of felicitation and hopefulness."
That same year John Jacob Raskob, Chief Executive of General Motors and head of the Democratic National Committee published an article entitled "Everybody Ought to be Rich" in the Ladies Home Journal. He suggested that every American could become wealthy by investing $15 a week in common stocks. Raskob failed to realize that the weekly salary of the average worker was only about $17-$22, but that's not important: the optimism was there.
For five years prior to 1929, the stock market had been characterized by rising prices; there was an enormous "bull market." (The opposite, a market characterized by falling prices, is called a "bear market.") We have six speculations to explain why so many people invested in the stock market during this time.
1. Rising stock dividends.
The stock market was propped up by new investors entering the market, who viewed it as an easy way to get rich quick. However, economic historians estimate that a relatively small number of Americans--about 4 million--had investments in the market at any one time. Rather, the constant influx of new investors coming in and old investors moving out ensured that new money was always floating around.
2. Increase in personal savings.
Higher wages meant that even average Americans now had surplus money to put into savings or invest in the stock market.
3. Relatively easy money policy.
At this time, banks made money more readily available at lower interest rates to more and more people. Although economists debate the actual influence of this phenomenon on the stock market, it's conceivable that many people took out loans not only to buy cars, but also to buy stock.
4. Over-production profits were invested in new production.
From 1925 on, industry was over-producing. In anticipation of eventually selling the surplus, business leaders funnelled their profits right back into industry, investing in factories, new machinery, and more workers, which led to even greater overproduction. This increased production gave the companies an aura of financial soundness, which encouraged Americans to buy more stock.
5. Lack of stock market regulation.
At this time there were no effective legal guidelines on the buying and selling of stock. Free from legal guidelines, corporations began printing up more and more common stock. Many investors in the stock market practiced "buying on margin," that is, buying stock on credit. Confident that a given stock's value would rise, an investor put a down payment on the stock, expecting in a few months to pay the balance of the initial cost plus receive a hefty profit. This turned the stock market into a speculative pyramid game, in which most of the money invested in the market wasn't actually there.
6. Psychology of consumption.
The psychology of consumption fed the optimism of investors and gave them an unquestioning faith in prosperity. When the crash did come, it was even more devastating because of this unquestioned faith.
The Stock Market Crash in October of 1929 is often cited as the beginning of the Great Depression, but did it actually cause it? The answer is no. First, the stock price for a particular company merely reflects current information about the future income stream of that particular company. Thus, it is a change in available information that changes the stock price. When the Fed began to raise interest rates in early 1929, this began the tumble.
However, a stock market crash could cause people to increase their liquidity preference which might lead them to hoard money.
People hoard money because they have a liquidity preference. I.e., people want to have their assets in a readily convertible form, such as money. There are several misconceptions about hoarding money. First hoarding is not the same thing as saving. If I put my money into a savings account, that money is lent out to someone else who then spends it. Second, hoarding, by itself, cannot cause a recession or depression. As long as prices and wages drop instantly to reflect the lower amount of money in the economy, then hoarding causes no problems. Indeed, hoarding can even be seen as beneficial to those who don't hoard, since their money will be able to buy more goods as a result of the lower prices.
If a country has a gold standard, then hoarding money can make the money supply drop dramatically since a gold standard makes the quantity of money difficult for the government to control.
At the time of the Great Depression, America had a 100% gold standard for its money. This meant that all cash was backed by a government promise to redeem it in a specific amount of gold (at the time, TBD ounces for one dollar). Because the amount of money circulating in the economy is wholly dependent on the amount of gold available, the money supply is very rigid. If people start to hoard money (see above) the money supply can drop drastically. As noted in the previous section on hoarding, this is not a problem as long as prices and wages drop instantly to reflect the lower amount of money circulating.
Despite rising wages overall, income distribution was extremely unequal.
Gaps in income had actually increased since the 1890s. The 1% of the population at the very top of the pyramid had incomes 650% greater than those 11% of Americans at the bottom of the pyramid. The tremendous concentration of wealth in the hands of the few meant that the American economy was dependent on high investment or luxury spending of the rich. However, both high spending and high investment are very susceptible to fluctuations in the economy; they are much less stable than people's expenses on daily necessities like food, clothing, and shelter. Therefore, when the market crashed and the economy tumbled, both big spending and big investment collapsed.
From the late 1870s on, there had been an ongoing movement of consolidations and mergers. During WWI, many would-be competitors were merged into huge corporations like General Electric, making competition nearly nonexistent. In 1929 two hundred of the biggest corporations controlled 50% of the corporate wealth in America. This concentration of corporate wealth meant that if just a few companies went under after the Crash, the whole economy would suffer.
Some quick definitions:
In the 1920s, banks were opening at the rate of 4-5 per day, but without many federal restrictions to determine how much start-up capital a bank needed or how much of its reserves it could lend. As a result, most of these banks were highly insolvent; between 1923 and 1929, banks closed at the rate of two a day. Until the stock market crash in 1929, prosperity covered up the flaws in the banking system.
World War I had turned the U.S. from a debtor nation into a creditor nation. In the aftermath of the war, the U.S. was owed more money--from both the victorious Allies and the defeated Central Powers--than it owed to foreign nations. The Republican administrations of the 1920s insisted on payments in gold bullion, but the world's gold supply was limited and by the end of the 1920s, the United States itself controlled most of the world's supply. Besides gold, which was increasingly in short supply, countries could pay their debts in goods and services. However, protectionism and high tariffs kept foreign goods out of the U.S. Recall that the Hawley-Smoot Act (1930) set the highest schedule of tariffs to date. This protectionism produced a negative effect on U.S. exports: if foreign countries couldn't pay their debts, they had no money to buy American goods.
Most American economists and political leaders in 1929 still believed in laissez-faire and the self-regulating economy. To help the economy along in its self-adjustment, President Hoover asked businesses to voluntarily hold down production and increase employment, but businesses couldn't keep up high employment for long when they weren't selling goods. There was a widespread belief that if the federal budget were balanced, the economy would bounce back. To balance the budget demanded no further tax cuts (although Hoover lowered taxes) and no increase in government spending, which was disastrous in light of rising unemployment and falling prices. Another problem with economic practices of the day was the commitment of the Hoover administration to remain on the international gold standard. Many suggested increasing the money supply and devaluing the dollar by printing paper money not backed by gold, but Hoover refused. Going off the gold standard was one of the first actions of new President Franklin Delano Roosevelt in 1933.
Notes Taken from University of Melbourne