An Economic Analysis of the Great Depression: Lessons for Today

Council for Economic Education March 21, 2009Mark C. Schug, Ph.D.University of Wisconsin-Milwaukee

Whatdunnit? The Great Depression Mystery

Focus: Understanding Economics in U.S. HistoryLesson 30

Whatdunnit?

In the 1920s, jobs were plentiful and the economy was growing and the standard of living was rising.

Between 1920 and 1929 homeownership doubled.

Most home-owning families enjoyed amenities such as electric lights and flush toilets.

60% of all households had cars, up from 26%.

More teenagers were attending high school.

Whatdunnit?

By 1933… One fourth of the labor

forces was unemployed. Families were losing

their homes and many were going hungry.

Adolescents who should be in school were riding around the country in freight cars, looking for jobs.

Whatdunit?

What happened?• The United states possessed the same

productive resources in the 1930s as it had in the 1920s.

• Great factories and productive machinery were still present.

• Workers had the same skills and were willing to work just as hard.

• How could life have become so miserable for so many in such a short period of time?

1920s

Prosperity of the 1920s was based largely on purchases of homes and cars.

Toward the end of the decade sales began to decline.

End of the 1920s

Machinery workers stand. Car sales people stand. Auto workers stand. Steel workers stand. Construction workers stand. Furniture sellers stand. Furniture workers stand. Clothing sellers stand. Restaurant workers stand. Grocery workers stand.

1929

Normally, people start buying again as automobiles wear out and incomes improve.

Expansion Begins Again

Machinery workers sit. Car sales people sit. Auto workers sit. Steel workers sit. Construction workers sit. Furniture sellers sit. Furniture workers sit. Clothing sellers sit. Restaurant and grocery

workers sit. Grocery workers sit.

What Are the Alleged Causes of the Great Depression?

The Stock Market Crash of October 29, 1929. Excessive borrowing to purchase stocks and

consumer goods. Overproduction of goods and services High tariffs which prevented imports and hurt

exports. Low farm prices and low wages, leading to an

uneven distribution of income.

Why did a mild recession in 1929 become the Great Depression of the 1930s? A Hint

Its mainly about money, banks, and the Federal Reserve System

How is Money Created?

Banks are not just businesses.

Hint: Banks Create Money100% Reserves

Assets Liabilities

Reserves $100.00 Deposits $100.00

Loans

Hint: Banks Create MoneyBank 1: 10% Reserves

Assets Liabilities

Reserves $10.00 Deposits $100.00

Loans $90.00

Hint: Banks Create MoneyBank 2: 10% Reserves

Assets Liabilities

Reserves $9.00 Deposits $90.00

Loans $81.00

The Fed

The Federal Reserve System was created in 1913.

The Fed has 4 partsBoard of Governors (Washington D.C.)Federal Open Market Committee (FOMC)Reserve Banks (12 members)Member Banks

Conducting Monetary Policy

Inflation: Enemy Number 1

The Federal Reserve System has 3 tools to control inflation:

1. Sets reserve requirements for banks. Raise reserve requirement = reduce

money supply Lower reserve requirement = increase

money supply

Conducting Monetary Policy

2. Manages the Federal Open Market Committee (FOMC).

The FOMC sets a target rate for the Federal Funds rate. This is the rate for loans made from bank to bank.

This is almost always what the media is referring to when it says the Federal Reserve "changing interest rates".

To increase the money supply, the Fed instructs the Open Market Desk at the New York Fed to buy bonds to try and hit the target rate.

To decrease the money supply, the Fed instructs the Open Market Desk at the New York Fed to sell bonds.

Conducting Monetary Policy

3. Sets the discount rate for members who borrow money from the Fed.

Banks can borrow funds to keep up their required reserves is by taking a loan from the Fed Reserve at the discount window.

The discount rate is usually higher than the federal funds rate.

Raise discount rate = reduce money supply Lower discount rate = increase money supply

Visual 30.2 Number of U.S. Banks Closing Temporarily or Permanently, 1920-1933

Year Number of Bank Closings

1920 168

1921 505

1922 367

1923 646

1924 775

1925 618

1926 976

1927 669

1928 499

1929 659

1930 1352

1931 2294

1932 1456

1933 4004

Visual 30.3 Money in Circulation

Year

Money in Circulation*

1929 $26.2

1930 $25.1

1931 $23.5

1932 $20.2

1933 $19.2

*Currency plus bank deposits, in billions of dollars.

Why Did the Fed Fail to Act?

1. The Board of Governors believed that many banks were unsound.

2. They wished to protect the value of the dollar by keeping interest rates high.

3. They wished to protect the nation against inflation which they thought was the main problem.

“We Did It.”

In 2002, at Milton Friedman’s 90th birthday Ben Bernanke, then Federal Reserve Board Governor, said:

“ I would like to say to Milton and Anna: Regarding the Great Depression, you were right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

The Crash of 08

After 24 Consecutive Quarters of Growth…

The Cliff

And then we went off the cliff.

House Price Change

-20.0%

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

Default Rate

0%

1%

2%

3%

4%

5%

6%

Foreclosure Rate

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

1.4%

Doubling of Household Debt as a Share of Income

20%

40%

60%

80%

100%

120%

140%

Consumption

Causes of the Crash of 08?

The likely suspects:The erosion of

government regulations of conventional lending standards.

The Fed’s manipulation of interest rates during 2002-2006.

Causes of the Crash of 08?An SEC Rule change

adopted in April 2004 led to highly leveraged lending practices by investment banks and their quick demise when default rates increased.

Doubling of the Debt/Income Ratio of Households since the mid-1980s.

Is It 1929 All Over Again?

Primary causes of the Great Depression were:

Poor monetary policy Reduced money supply High interest rates Failure of Fed to act

Poor fiscal Policy Tax increase to balance the

budget Increasing protectionism

Smoot-Hawley tariff

Banks Are Not Lending

Today, the problem is not liquidity per se.

Many banks are holding Mortgage Backed Securities (MBS) and other bad paper.

Who do you trust?

So far …

Actions taken so far have been mainly aimed at increasing liquidity and spending rather than getting rid of bad assets.

What are the Characteristics of Money?

Medium of exchangeStandard of valueStore of value

What is Money?

M1CurrencyChecking accounts (63%)

M2: add inSavings accountsCDsMoney market accounts

Jobs of the Fed

Services to Banks Check clearing Loans to member

banks Services to

Government Federal checkbook Federal deposits Supervise members

banks

Conduct monetary policy Managing the

nation’s money supply.

Auction

Distribute 10 “dollars” in envelops to the class. Ask them to count the money but do not stress the amount they have.

Auction off one or two items (T-shirts?), recording the prices. Figure the average price.

Distribute 20 “dollars” to the class. Auction off one or two more items, recording

the prices. Figure the average price. Explain the price change according to the

amount of money in circulation.

Activity 30.3 What Would You Have Done?

1. The world financial system that emerged after World War I was based upon the gold standard. The United States and Great Britain guaranteed that they would exchange their currencies for gold at a fixed rate ($20.67) for an ounce of gold. Other major countries agreed to exchange their currencies for

gold, dollars or pounds. In 1927, several countries, most notably Germany and

Austria, experienced serious bank runs. To stabilize their currencies, they exchanged their dollars and pounds for gold. The United States experienced a serious loss of gold

To encourage foreign investors to buy American investments, the Federal Reserve Banks raised interest rates.

If you were an American business owner planning to build a new factory or buy new equipment, what would you have done after interest rates were increased?

Activity 30.3 What Would You Have Done?

2. The Federal Reserve lowered interest rates after a time, but in 1930 and 1931, when the American economy had already taken a downturn, more bank runs occurred in many countries, and again gold flowed out of the United States. To keep gold in the United States, the Federal Reserve Banks

again raised interest rates. What was the result?

Activity 30.3 What Would You Have Done?

3. Now imagine that you are an American citizen with a bank account. You read the newspapers. You see that banks are collapsing

in other countries and that the rate of bank failures in the United States has risen.

What might you do?

Activity 30.3 What Would You Have Done?

4. In 1932 Congress creates the Reconstruction Finance Corporation (RFC), which lends money to businesses that are in trouble, including banks. The law requires that the names of banks receiving loans

from the RFC must be published. You read in the newspaper that the bank in which your money

is deposited is receiving help from the RFC. What are you likely to do?

Overview

Overview of Focus: Understanding Economics in U.S. History

Demonstration of Lesson 30: Causes of the Great Depression

Implications for today

Today’s Stock Market Report

Paper stocks were stationary.

Fluorescent tubing dimmed in light trading.

Knives were up sharply. Elevators rose, while

escalators continued their slow decline.

Mining equipment hit rock bottom.

Diapers remain unchanged.

Today’s Stock Market Report

Coca Cola fizzled. Caterpillar stock inched

up a bit. Balloon prices were

inflated. Scott Tissue touched a

new bottom. And batteries exploded

in an attempt to recharge the market...

Table of Contents

Unit 1 Three World Meet

Unit 2: Colonization and Settlement

Unit 3: Revolution and the New Nation

Unit 4: Expansion and Reform

Unit 5: Civil War and Reconstruction

Table of Contents

Unit 6: The Development of the Industrial United States

Unit 7: The Emergence of Modern America

Unit 8: The Great Depression and World War II

Unit 9: Postwar United States

Unit 10: Contemporary United States

Federal Reserve Banks

New York Boston Philadelphia Richmond Atlanta Cleveland

Minneapolis Chicago St. Louis Kansas City Dallas San Francisco

Job Number One for the FED

Conduct monetary policy Managing the

nation’s money supply.