Thursday, October 16, 2014


The red bars are the years of GDP
decline, i.e., recession/depression.
The Depression started August 1929.
Martin Kelly posts, under, useful summaries about different points and periods  in American history. He recently posted on "The Causes of the Great Depression". Understanding the causes of the Depression is vital to avoid repeating the mistakes we made in the 1920s.

Since I am working on a biography of FDR's first Treasury Secretary, William H. Woodin, I was interested. Woodin faced the brunt of the initial Federal response to panic that greeted FDR's arrival in Washington. (I believe the stress killed him. He resigned for health reasons at the end of 1933 and died not much more than a year after FDR took office.)

I think some of Kelly's statements in his first two "Causes" about the timing of the Depression and the timing of bank failures are erroneous. Americans should remember the facts about their history correctly.  I will limit myself to the first two on his list.

Cause #1 - The "Stock Market Crash of 1929"

Kelly considers the stock market crash of October 1929 as the first cause of the Great Depression. Here are his words:
Many believe erroneously that the stock market crash that occurred on Black Tuesday, October 29, 1929 is one and the same with the Great Depression. In fact, it was one of the major causes that led to the Great Depression. Two months after the original crash in October, stockholders had lost more than $40 billion. Even though the stock market began to regain some of its losses, by the end of 1930, it just was not enough and America truly entered what is called the Great Depression.
The Depression of 1929-1933 ended with FDR's
New Deal. But the The Recession of 1937-1938,
resulted from a weakening of the New Deal.
 World War II revived the economy in 1938.
My Comment: The Bureau of Economic Analysis at the U.S. Department of Commerce has kept track of the size of the American economy, the Gross Domestic Product (GDP), since after World War II. GDP is a measure of all goods and services produced during a year.

Business cycles are dated by an independent Business Cycle Dating Committee, also known as the Wise Men although not restricted to men. It reports through the National Bureau of Economic Research.

The Committee dates the Great Depression by two declines in GDP.
  • The first was August 1929 (or more broadly the third quarter of the year) through March 1933 (the first quarter), lasting three years and seven months. Starting with the arrival of FDR, the economy was recovering from the 26.7 percent decline in the economy.
  • The second was the recession from May 1937 (second quarter) to June 1938 (second quarter), when the economic decline was a serious 18.2 percent. This was precipitated by lower profits, and by misguidedly tight fiscal and monetary policies.  
So... the misleading statements in Cause #1 in Kelly's post I think include the following:
  • The stock market crash occurred two months after the Depression started. Since the Depression started before the crash, something else was at work.
  • America did not enter the Great Depression at the end of 1930, but 18 months earlier.
  • The crash of the New York Stock Exchange is not a cause of anything except through the opinions of investors, of which it is simply an indicator. The cause of the Depression must be sought in the high value placed on stocks in the late 1920s, and the reason for the high level of speculation, i.e., borrowed money. The reliance of investors on debt subject to margin calls increased the riskiness of the stock market and added to the intensity of the revaluation of stock prices.
  • The $40 billion loss by investors in two months doesn't sound like a lot in today's stock market. It would be more meaningful to say that the 1929 high value of all stocks on the New York Stock Exchange was $87 billion and this valuation fell to $19 billion in 1933 - a drop of 78 percent. More than three-fourths of the value of listed stocks was wiped out.
Cause #2 - Bank Failures

One of the sources of the Great Depression is the instability of the banking system and therefore of the stock market that depended on it and the national economy that depended on both.
Throughout the 1930s over 9,000 banks failed. Bank deposits were uninsured and thus as banks failed people simply lost their savings. Surviving banks, unsure of the economic situation and concerned for their own survival, stopped being as willing to create new loans. This exacerbated the situation leading to less and less expenditures.
Bank failures virtually ended in 1933 with passage of the
Glass-Steagall Act, which created federal insurance of bank
deposits (via the FDIC) and, as a price for that, separated
banking from more speculative financial activities.
My Comment: The problem in making bank failures the cause of the Depression is  the timing. For A to cause B, A must precede B. The Depression is dated 1929-1933. There were no bank failures between 1926 and 1929 (see chart). The largest number of bank failures were the result of stress tests (bank examinations) by the Treasury's Comptroller of the Currency, in 1933, after the previously cited March 1933 end of the Depression.

There were bank failures in 1925, but that's a long time before the onset of the Depression and a lot of growth occurred in the late 1920s.

An underlying problem was the belief by depositors that they should be able to convert their deposits into gold or currency without limit. But the attempt to do so made banks illiquid and insolvent.

Printing greenback dollars that were not backed by gold or silver was no longer controversial. It was problematic when Lincoln did it to pay the Union Army, but by 1929 paper dollars were well established. However, in the 1920s, depositors were still of the belief that some or all of their deposits were backed by gold or silver. Some of the dollars were marked "gold certificates" with a yellow color on a part of the bill to indicate their special status.

Some depositors still believed that if they asked for it they would be entitled to redemption of their money in gold. In fact, what started to happen in the 1920s and especially in the early 1930s, is that banks could not redeem demand deposits even with paper money. They were out of cash. Relatively few were insolvent, but many were illiquid.

The fear that a bank could fail and depositors could lose their money was a basic underlying flaw in the banking system, leading to "runs on banks".

So here I think is what is wrong with what Kelly said about bank failures as a cause of the Depression:
  • Bank failures were not the cause of the Depression - they were a symptom of problems in the banking system that contributed to the Depression. As Warren Buffett has said: "Only when the tide goes out do you find out who is not wearing a bathing suit.”
  • Bank failures did not occur "throughout the 1930s". They occurred mostly before FDR was inaugurated in March 1933. The banks that were closed by the Treasury's Comptroller of the Currency were already insolvent.
  • Bank deposits were uninsured only until 1933. But starting in 1933, the Glass-Steagall law created the Federal Deposit Insurance Corporation, insuring most deposits and virtually ending bank closings. In 1934, only 57 banks closed, and after that the FDIC's guarantee and oversight was enough.
The year 1933 was crucial. Withdrawals of paper money and gold from banks occurred in February 1933 at three times the previous rate of $5 million per day. That month, Louisiana declared a bank holiday, and then Michigan did the same, closing the banks for eight days. By the day that FDR took office, 400 more banks closed. In the month before the inauguration, $320 million was withdrawn, and most of it $226 million, was withdrawn in the last week.

On Inauguration Eve, March 4, 1933, at 1 a.m., FDR ended discussions with Hoover about the crisis and told everyone go to sleep. Instead, Secretary Woodin suggested to Barnard Professor Raymond Moley, leader of FDR's brains trust and the man who recruited Will Woodin to work for FDR that they go over to the Treasury to meet with outgoing Treasury Secretary Ogden Mills and his key staff, who were working on declaring a bank holiday the next day. Woodin and Moley found that the Treasury was following the lead of 21 governors who had announced a bank holiday on Monday. The Treasury had called the remaining governors. All but New York Governor Herbert Lehman had been persuaded to follow suit. Woodin and Moley asked  the President of the Federal Reserve Bank of New York to go to Lehman's house to ask him to agree to a bank holiday, which he did at 4:20 a.m. The bank holiday was now in effect in every state,  starting the next day, Monday, March 5.

FDR and Secretary Woodin followed the three-day national bank holiday (through Wednesday, March 7) with measures to stop the export and hoarding of gold. Woodin personally supervised printing more dollars in three shifts. The bank holiday was extended to Tuesday, March 13, and Woodin made it a priority that the Comptroller of the Currency would perform stress tests quickly so that the healthy banks could be reopened.

These measures restored calm. Confidence returned. The public began putting their money back in the banks. The country returned to a growth in its GDP. Moley said:
If ever there was a moment when things hang in the balance, it was on March 5, 1933 - when unorthodoxy would have drained the last remaining strength of the capitalist system. Capitalism was saved in eight days, and no other single factor in its salvation was half so important as the imagination and sturdiness and common sense of Will Woodin.  (Moley, After Seven Years, NY: Harper, 1939, Chapter V, p. 155.)