Ch. 12 EH

In the United States, the signs of the impending outbreak of an economic crisis were evident in 1928:

prices began to fall (existence of overproduction problems in many industries)
agriculture came to a standstill
the construction sector slowed down

But the very same time

profits continued to grow
access to credit was not expensive
much of the financial wealth took the path of speculative investments
speculative investments abounded on the stock market

On the other hand, the stock exchange system leapt forward, driven by three factors: a) the speculative actions of some big operators; b) easy credit policies; c) new money management systems, like investment trusts, a British innovation of the late 19th century.

The Bubble:

The crash was the result of a structural weakness in the US credit system.

US banking system -> presence of credit institutions that were not controlled by the Fed.

The stock market system was constantly expanding due to:

speculation by large operators
high appetite for risk (easy credit)
investment trusts operating with few rules and little transparency
The vitality of the stock -> perception that the economy was healthy

reality: value of share prices was not linked to the ability of companies to produce profits

Wall Street crash of 1929 and Great Depression

To avoid the worst, the Fed raised interest rates to bring stock market speculation under control, but the result was:

the attraction of new capitals to New York
weakening the gold stock on European countries

On 24 October and 29 October 1929 two waves of selling on the Wall Street stock market brought the system to its knees.

Pa decreased from 381 to 196 (base 100 in 1926)

The withdrawal of capital from the New York market was tumultuous. (Involved both American and foreign investors)

Many companies feared the worst -> They started a liquidity race and began to curtail their spending.

Inventories declined and at the same time production collapsed dramatically

In the automobile industry, for instance, it went from 440.000 units in August 1929 to 92.500 in December of the same year.
General Motor reacted with diversification

Visible effects were also in the property sector

The immediate consequence were

Beyond wall street and us economy

The fall of American prices
The stop of international trade → reduced by 70%

→ The crisis reached Europe and were now global

Commercial Balance was at risk:

Introduction of new tariffs → protectionism
Reduction of production (What is the consequence??)

Deflation

Particularly pernicious was deflation, i.e. the protracted decline in prices:

in industrial countries it discouraged investment and postponed consumption
in primary goods-producing countries it caused export revenues to plummet and made it more difficult to pay foreign debt and maintain any economic stability
more generally, deflation weakened the ability of debtors to repay debt, causing problems for creditors and the banking system
in the relatively interdependent world of the 1920s, the slowdown of one economy affected the others in a downward spiral
Economies were so interconnected at the time so a crisis in one nation quickly amplifies and spread to others and created a downward spiral

Reaction

In the months following the crash the gold standard forced central banks to pursue restrictive monetary policies.
No one thought of implementing expansionary monetary policies and everyone preferred to adopt spending review measures.
These defensive strategies produced liquidity crises and multiple bank failures (especially in the USA).
The tight control on capital flows had negative effects on international trade.

In Europe the crisis became particularly intense in 1931. Financial panic spread in the wake of the bankruptcy of the Austria Credit Anstalt and the German currency crisis. The reaction to the crisis was uncoordinated and disjointed.

Each government took its own decisions unilaterally, without thinking about the (possible) repercussions on other parties.

In September 1931 Great Britain abandoned the gold standard
In 1932 it abandoned free trade by adopting the so-called ‘imperial preference’ (Ottawa Conference).

The protectionist spiral contributed to the collapse of world trade and pushed many countries towards forms of autarchy.

countries wanted to protect their own industries against foreign competition.
put tariffs so people would buy country made products but this only made the crisis worse. Smoot-Hawley Tariff Act
disrupting international trade flows and hindering economic recovery.

Why protectionism? -> Bilateral Clearing agreement to control the commercial balance and to avoid that currency would leave the country.

Effects

F.D. Roosevelt the governor of New York

Realized the scale of poverty
Increased taxation on highest incomes

Other initiatives were taken by local administrator but the risk was the bankrupt

Only in 1931 Hoover realized how alarming was the Depression in Central Europe

Moratorium on debts (also German war’s reparations)
Golden Gate Bridge

But there was not anymore confidence in the financial system

Unemployment was certainly the most serious problem.

26% unemployed → 20% of them access to aid
20% of schoolchildren were malnourished

Insecurity and unemployment translated into a risk for democracy

Reaction

President Hoover, always convinced that the government should not intervene with

countercyclical policies, was forced to change his mind in the face of unemployment numbers, but the outcomes were not positive.

In 1932 (Reconstruction Finance Corporation), he created a federal fund to be allocated to the largest banks, which were supposed to help the smaller ones in turn. The resources were inadequate. Large banks allowed the smaller ones to fail.
The Fed decided to lower the discount rate to expand credit, but banks used liquidity to shore up their own accounts rather than granting credit.
Hoover also aimed for a balanced budget, which could be achieved by reducing service expenses or increasing taxes; both options would further depress the economy

International Relationships

On the international front, attempts to provide a common response to the crisis are weak:

In 1931, Hoover's moratorium on inter-allied and reparations payments, suspending payments for a year.
In 1932, the Lausanne Conference resulted in the abolition of German reparations.
In 1933, the London Economic and Monetary Conference witnessed a failed attempt to stabilize major currencies: the dollar, pound sterling, and the French franc.

In Europe

Chancellor Bruning of Germany (1930-32):

In 1931, effectively suspended the gold standard by imposing strict controls on currency and capital movements but did not use monetary policy to stimulate the economy, opting instead to reduce public spending and salaries.

Other related events:

The tax increase implemented by the U.S. President Herbert Hoover in 1932 to balance the budget.
France's steadfast adherence to the gold standard at the London Monetary Conference in 1933.
The ideology of the gold standard (financial orthodoxy) that led decision-makers to adopt counterproductive policies was, however, shared by broad segments of public opinion.

The beginning of the Welfare State

The Crisis of 1929 had revealed imperfections in the functioning of market mechanisms.
State intervention proved indispensable to correct market failures, giving rise to the concept of the welfare state.
According to the vision of John Maynard Keynes, states should have adopted countercyclical policies: Governments would have made public spending the engine of economic recovery: wages, consumption, and profits would have mutually supported each other (Keynesian multiplier).
In particular, Keynes criticized Say's Law, which posits that 'supply creates its own demand,' as, in his view, it does not function in a crisis context