The Failure of the Stock Market - Essay Example

Running Head: Great Depression Great Depression Xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Name Xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Course Xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Lecture Xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Date Introduction The great depression is a severe economic downturn that occurred in the 1930s affecting most major economies all over the world. It affected various countries but the onset and effects were varied. According to Jensen (1989), the great depression was the “longest and deepest” economic crisis the world has ever experienced. The depression was so widespread and it devastated both rich and poor countries. The great depression was characterized by very low levels of aggregate demand as consumer confidence fell across the board. When the stock market crashed on October 29, 1929 referred to as black Tuesday its consequently led to the collapse of the banking sector as banks had invested in a bid to save the stock market. When some banks collapsed the public panicked and withdrew their deposits from those banks that had withstood the failure of the stock market. The effect of this massive withdrawal was the collapse of most of the remaining banks. Many people who had not been able to withdraw their money before the collapse of the banking became bankrupt overnight. When the banking system collapsed various industries lost their deposits and were no longer able to access credit. This shortage of capital to the industry led to the loss of employment and reduction of salaries. In turn, the amount of income to spend was reduced and businesses started to suffer from low demand. Lower consumer spending meant industries were not able to meet the wage bill and they lay off more workers. Finally, demand was so low that most companies had close to down making millions of workers unemployed. It is important to learn the causes that led to the great depression in order to avoid such a dire crisis in future. Unemployment hits many families very hard and people suffered as they struggled to put food on the table. In Germany the suffering caused by the great depression was greater and it led to increased support for the extremist Nazi Party. It is claimed that the great depression was one of the factors that led to the start of the Second World War. In this paper, some of the top contributory factors of the great depression are discussed. The paper details how each factor contributed to the great depression. Secondly, the paper discusses the reasons that the great depression was particularly severe on the German economy. The causes of the Great Depression Collapse of the Stock market in 1929 Prior to 1929, trading securities in the stock exchange was a sure way of becoming rich overnight. The United States had gone through a period of economic prosperity and optimism was high in the Stock market (White, 1990). In the 1920s the value of real estate in the US was on a continuous increase but by 1925, these prices had peaked and began to drop. The link between real estate and the economy meant that when real estate prices fall so does the price of stock. Furthermore, there was optimism in the Stock market as people could make fast profits in trading securities. This in turn led to speculative spending where American’s could buy stocks through credit. According to White (1990), brokers were lending up to 2/3 of the value of stock an investor was willing to purchase. The effect of this speculative behavior was that more than $8.5 billion was out on loan more than the total amount of currency circulating in the US economy (Bernanke, 2000). This had the effect of sustaining high stock prices while the money supporting this demand was loaned. In the month of September, the stock market had lost 17 per cent of its value (Romer, 1990). Despite, the stock market recovering 8.5 per cent of its value its resumed its decline soon after. Previously bankers had purchased shares in the Stock exchange to prevent slides in the value of the stock exchange. On 24th October 1929, an attempt to correct the slide in prices was made by bankers who choose Richard Whitney to purchase shares of blue chip companies including U. S steel (Romer, 1990). However, the slide was only stopped temporarily and when everybody learned of the bankers attempt to stabilize the stock market, the panic worsened. On trading resumed on Monday 28th most investors were aware of the banks move to correct the slide (Romer, 1990). On that day panic kicked in a record amount of shares were traded with the Dow Jones losing 13 per cent of its value. The events of Monday 28th catalyzed the panic and the next day the largest volume of shares traded in a single day was on offer at the stock exchange as everybody looked to avoid further losses in share prices. By the close of business on October 29th 1929, the stock market had lost $14 billion (White, 1990). The confidence of investors in the stock exchange was gone and there were so many shares of offer without anyone to buy them. By July 8, 1932, the stock exchange had lost 89 per cent of its value (Bernanke, 2000). In essence, the losses in the stock exchange mean American companies had lost a large part of their market capitalization. The collapse of the stock market and the efforts to save it are closely linked with other cause of the great depression. Near Collapse of the Banking System According to Calomiris and Mason (2003), the efforts of banks to save the stock exchange led to the widespread failure of the US banking system. Banks had come together and raised funds to buy the leading stock at the share market in hope of saving it. When the stock market collapsed the banks lost this money. Furthermore, the speculative practices of advancing people loans to buy stocks meant banks shouldered most of the 8.5 billion loaned to invest in the economy (Romer, 1990). When the stock market collapsed, those who had taken loans to engage in speculative trading were unable to repay their loans. In effect, depositors with these banks were unable to access their funds as they had been loaned to those who lost their money in the stock market crash. Just like in the stock market crash news that people were unable to access their money led to panic and everybody wanted to withdraw their money from the banks. The banks already experiencing losses from buying shares in a collapsing stock exchange and bad debts, the massive withdrawals led to the collapse of the few remaining banks in the United States. The bank that survived the massive withdrawal of deposits, were very reluctant to lend money to the public therefore further constricting liquidity in an economy that badly needed it (Calomiris and Mason, 1994). Lower consumer spending After, the stock market collapsed people became afraid of purchasing items, while others had become bankrupt through the losses in either bank deposits or the stock market. As purchasing power decreased so did production in industries (Greasley, Madsen and Oxley, 2001). Consequently, industries needed fewer workers to produce lesser item and thus they laid of the excess workforce. In turn, the unemployed masses had almost nil purchasing power, therefore lowering demand for products. Most, industries had to close down as the market for their markets continued to contract. The closure of industries meant a further dent in spending power in the economy as workers lost their source of income. Massive Crop Failure Crop failure is given as another top cause of the great depression. In previous economic crisis farmers were the less severely affected as they produced what they ate. However, before the great depression the prices of farm produce had fallen as farms were farm production was too high and therefore farmers were heavily in debt (Egan, 2006). Crop failure was caused by the great drought that hit the Mississippi valley, which was accompanied by dry winds that would pick up dust and bury crops in more productive farms and areas (Egan, 2006). Farmers were forced to sell their farms for a fraction of their value to pay other debts and look for other ways of surviving. International trade Policy The Smoot-Hawley Tariff Act and America’s international trade policy are viewed as some of the other factors that caused the great depression. The Act enacted in mid 1930 was meant to protect American industries from competition by importing goods (Irwin, 1998). The act charged incredibly high taxes on goods imported into the United States and therefore it led to reduced international trade. In retaliation, other countries hiked tariffs on US imports causing a 61 percent drop in exports. This meant production in the US economy had dropped by an almost similar margin (Irwin, 1998). As shown earlier lower production always means jobs will be lost and consequently spending power will decrease. The effect of the high tariffs introduced by the act made it more difficult for European nations to import their goods to the US and therefore they were denied foreign exchange to repay the loans they owed American banks (Madsen, 2001). Why was depression particularly severe in Germany Germany was one of the Nations that were severely affected by the great depression. Several reasons are given as an explanation for Germany’s susceptibility to the great depression. At the end of the First World War Germany and Austria-Hungary the losers and alleged aggressors of the war were required to pay reparation payments to Nations allied to the United States in the War (Petzina, 1969). Secondly, the war rebuilding effort in Germany largely relied on loans from American banks (Petzina, 1969). According to Stachura, P. D. (1986), the Weimar Republic in Germany heavily relied on loans from the United States to fund its budget. The reluctance of American banks to issue loans started with the massive withdrawals in 1929 and the crash of the stock exchange were American banks made heavy losses. By 1929, American banks could no longer be able to loan Germany any more money and they were increasingly demanding for repayment of past debts (Petzina, 1969). The repayment of the loans means large amounts of cash and capital were retracted from the German economy, leaving its banks struggling to fund the economy. Additionally, the Smoot-Hawley Tariff Act made it harder for Germany to access the US market. At the time US was the largest consumer of German exports. With the American market lost and almost impossible to access credit, German industries had no choice but to drastically cut production or close down altogether. These companies were therefore forced to shed excess labor and by 1933 six million Germans had lost their jobs due to the effects of the Great depression (Stachura, 1986). As seen earlier, Germany was also required to make reparation payments to the USA and its European allies taking more capital from the German economy. It’s worth noting the policy response of the Weimar government to the depression may have actually worsened the situation in Germany. Instead of increasing Government spending, the Weimar government made spending cuts and wage cuts which can only dampen spending and production in the economy (Jensen, 1989). Conclusion It is clear no one single reason caused the great depression. The causes of the depression are greatly interlinked in a chain of events that caused the great depression. In this discussion the stock market crash of 1929 and the consequent failure of the banking system can be said to be the biggest causes of the Depression. Most of the other causes of the depression are mostly a consequence of the two interlinked factors. One common thing about the causes of the depression is their negative effect on production and in turn labor and spending power. Each of the causes of the great depression affected either the demand or the production of commodities. As discussed above the severe effects of the depression on the German economy was credited to the heavy reliance of the country’s economy on American loans. When the loans stopped flowing German industries could no longer support production leading to the highest unemployment rate among countries hit by the Great depression. Referencesa Bernanke, B (2000). Essays on the great depression. Princeton University Press. Calomiris, C. W., & Mason, J. R. (1994). Contagion and bank failures during the Great Depression: The June 1932 Chicago banking panic (No. w4934). National Bureau of Economic Research. Calomiris, C. W., & Mason, J. R. (2003). Consequences of bank distress during the Great Depression. The American Economic Review, 93(3), 937-947. Greasley, D., Madsen, J. B., & Oxley, L. (2001). Income uncertainty and consumer spending during the Great Depression. Explorations in Economic History, 38(2), 225-251. Irwin, D. A. (1998). The Smoot-Hawley tariff: A quantitative assessment. Review of Economics and Statistics, 80(2), 326-334. Jensen, R. J. (1989). The causes and cures of unemployment in the great depression. The Journal of Interdisciplinary History, 19(4), 553-583. Petzina, D. (1969). Germany and the Great Depression. Journal of Contemporary History, 4(4), 59-74 Romer, C. D. (1990). The Great Crash and the onset of the Great Depression. The Quarterly Journal of Economics, 105(3), 597-624 Smiley, G. (2002). Rethinking the Great Depression: A New View of Its Causes and Consequences. Chicago, IL: Ivan R. Dee. Stachura, P. D. (1986). Unemployment and the Great Depression in Weimar Germany. Macmillan. White, E. N. (1990). The stock market boom and crash of 1929 revisited. The Journal of Economic Perspectives, 4 (2), 67-83. 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