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Bad Medicine

November 2023
2min read

As the bull market in Wall Street increased in intensity, the Federal Reserve moved to dampen it. It raised the discount rate (what it charged member banks to borrow at the Fed) three times in 1928, until it reached a then-high 5 percent. This increase in the cost of money had the effect of slowing down the economy noticeably in early 1929. But Wall Street was by now in a world of its own, and the bull market turned into a classic bubble. The Fed did nothing to intervene, even though banks were borrowing at 5 percent in order to loan money to speculators at 12 percent.

As all bubbles do, this one finally burst. The Dow Jones Industrial Average reached its high on September 3,1929, a peak it would not attain again for 25 years. The next day the market broke sharply. It trended downward for several weeks until October 24, known afterward as Black Thursday, when prices went into free fall. Bankers raised a pool of $20 million to try to steady the market, and it worked for a few days. But on Tuesday, October 29, there was no stopping the collapse. By the time the dust settled, the Dow index had dropped about 29 percent.

Although the stock market crash changed the psychology of the country, it did not precipitate the Great Depression that followed. Indeed, the crash was an artifact of the contracting economy, not its cause. Instead, several mistakes in Washington converted an ordinary recession into the greatest economic calamity in the nation’s history.

First, the new President, Herbert Hoover, had promised to seek relief for hard-pressed farmers by raising tariffs on agricultural products. When the bill reached Congress, a special-interest feeding frenzy developed, and what emerged, called the SmootHawley tariff after its sponsors, was the highest tariff in our history. A thousand economists, predicting disaster, petitioned Hoover not to sign the bill.

This time the economists were right. Other countries immediately retaliated. Tariffs rose around the globe, causing a near collapse in world trade, which would remain lower in 1939 than it had been in 1914. In 1929 the United States exported $5.2 billion dollars worth of goods; in 1932, a mere $1.6 billion. Smoot-Hawley, instead of protecting American jobs, was destroying them by the hundreds of thousands.

The Hoover administration’s second mistake was its insistence on trying to balance the federal budget in the face of steeply falling revenues as the economy contracted. The tax increase of 1932 was the greatest in terms of percentage in American history. And of course it did not balance the budget. Instead, it caused the economy to contract even more severely.

Finally, the Federal Reserve did nothing. It kept interest rates high while the money supply shrank by a third. In other words, it continued to treat the patient for fever long after he had begun to freeze to death.

The result of these policy missteps was calamity. The gross national product, which reached $87.2 billion in 1929, had by 1932 fallen by more than half, to $42.8 billion. Unemployment, a mere 3.2 percent in 1929, rose to 24.8 percent in 1933. Nearly one worker in four had no job to go to. The stock market, over 380 in September 1929, reached as low as 41.22 in late 1932, a plunge of nearly 90 percent. All the gains in the market since the first day the Dow Jones had been calculated, in 1896 (when it had closed at 40.94), were gone.

So desperate were things on Wall Street that in late 1932 the interest rate paid on U.S. Treasury bills—short-term obligations—turned negative. Treasury bills are sold at a discount and mature at face value. But in late 1932 they were selling for above 101, to mature at par. The only explanation is that people with capital to invest were so worried about the future that they were willing to pay a premium in order to put their money into the safest of all possible investments, the short-term obligations of a sovereign power.

The collapse of the nation’s banking system shows most vividly how close the American economy came to irretrievable disaster in those terrible years. More than 1,300 banks closed their doors in 1930, unable to meet their obligations. Two thousand more followed in 1931. In 1932 no fewer than 5,700 banks failed, carrying with them into oblivion the hopes, dreams, and economic security of millions of American families.

By March 1933 a nationwide banking panic was under way, as people withdrew their money from all banks, sound and unsound alike. One of the first acts of the new Roosevelt administration, inaugurated on March 4, was to shut all the banks in the country until they could be examined. The hope was that once sound banks were found to be in good condition and allowed to reopen, depositors would leave their money in them, and the banking system could function once again. It worked, and a national financial catastrophe was narrowly averted.

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