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Why did the crash of 1929 turn into the Great Depression?

In the latest in his series on history's biggest financial crises, John Stepek looks at how the 1929 stockmarket crash sparked such a dramatic economic collapse.

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Today, we return to the Great Depression.

We have already looked at how the Crash of 1929 unfolded Black Thursday (24 October, 1929) gave way to mildly overcast Friday. But this unfortunately proved a brief period of respite before Black Monday and Black Tuesday saw the Dow Jones crater.

From there, it took another 25 years or so before the US market regained its pre-crash peak. And that's just in nominal terms (ie, not accounting for inflation).

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The big question for this edition of Money Morning is: why did the crash turn into such a dramatic economic collapse?

The economy was already wobbly

1987 was violent and terrifying to all the traders involved. But it didn't leave the US economy on its knees. Same for the dotcom bust. And in 2008, although the stockmarket crashed, it was just one of many worries the real problem was property-related bad debt.

So what was different about the crash of 1929?

As you might have guessed, it's not that simple. The crash contributed to the Depression, that's true. But it was also the result of existing economic frailty. So let's dig in and see if we can look at roughly what happened.

First things first despite the impression, the "roaring 20s" weren't all non-stop flapper dances, witty repartee, and prohibition-era cocktails for everyone. One of the biggest problems and one that has certainly been an issue following the 2008 crisis is the issue of overcapacity.

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One reason that farms were hit so hard suffering well before the rest of the US was hit by the depression was because they had increased production of food and other soft commodities aggressively during the war. Wartime was boom time for farmers they had no overseas competition and plenty of demand.

But after the war, imports were more readily available and there simply wasn't as much demand. As a result, farm repossessions rose sharply, as farmers were unable to keep up payments on the mortgages they had used to buy more land in order to expand production.

It's not really any different to any other resources cycle. When the price of metal and oil goes up, for example, suddenly all the big companies splash the cash on exploring for more. They waste too much money on the basis that the good times won't end. And when they do, they find that they have over-expanded at a time when the cash coming in the door is falling precipitously.

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So the farmers were already suffering. They spent most of the struggling in a deflationary environment. In fact, in 1929, unusually good harvests battered wheat prices, and Congress voted through a $100m relief package.

What happened by 1929 is that almost every industry was in the same boat. Basically, producers were making too much stuff. And once consumers could no longer borrow any more money to buy that stuff, the only way was down.

Well before the market crashed, steel production was falling, building was slowing, and car sales falling. Consumers were borrowed out, and the Fed was raising interest rates too (from 1928), partly because it was concerned about a bubble in the stock market.

The property market was already wobbly

the Florida real estate bubble

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That price bubble peaked in 1925, and investment and construction activity peaked in 1926 as a result. Meanwhile, repossessions rose consistently from that year onwards.

So by the time 1929 came around, the economy was over-indebted, several industries were in trouble, and household balance sheets had already been weakened by falling house prices.

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Importantly, though, notes White, the housing crash was not a big drain on the banking system. Mortgage loans were pretty conservative and the riskiest loans were held by investors rather than banks. So while the property market topped in 1926, it wasn't systemic.

So how did the crash help to tip this lot over the edge?

It certainly brought the underlying problems with the economy uncomfortably to light. And it devastated confidence. One thing to remember about the stockmarket particularly during boom times is that as long as it's going up, people will generate a certain comfort from it. They'll ignore the problems they see with their own eyes in favour of assuming that the stock market must be right.

So when the market crashes often after the biggest issues have become apparent it pulls away the final veil to reveal the unpleasantness below. There's nowhere to hide from reality anymore.

Equally, there was a lot of borrowed money in markets, and a lot of cross holdings (trusts owning stakes in other trusts, so that losses led to domino effects). That left a lot of people ruined or bankrupt. Companies could no longer raise capital cheaply through the stock market.

But the real problem just as with 2008 is that the banking system went bust. The volume of lending by banks collapsed after 1929 far more drastically than anything that happened in 2008.

However, that wasn't driven by the stockmarket alone. Indeed, for a little while, it looked as though the economy might simply recover from 1929. We'll look at that in more detail and the rolling bank crises of the early 1930s next time.

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