Here are some excerpts from Niall Ferguson's article published in the National Post today. I recommend reading all of it.
Lessons from the Great Depression
Over a three-year period beginning on Oct. 28, 1929, the U.S. stock market declined 89%. Why did it happen? And how can we prevent a similar cataclysm in our own era?
On Oct. 16, 1929, Yale University economics professor Irving Fisher declared that U. S. stock prices had "reached what looks like a permanently high plateau." Eight days later, on "Black Thursday," the Dow Jones Industrial Average declined by 2%. This is when the Wall Street crash is conventionally said to have begun, though in fact the market had been slipping since early September and had already suffered a sharp 6% drop on Oct. 23.
On "Black Monday" (Oct. 28) it plunged by 13%; the next day by a further 12%. In the course of the next three years, the U. S. stock market declined a staggering 89%, reaching its nadir in July, 1932. The index did not regain its 1929 peak until November, 1954.
What was worse, this asset price deflation coincided with, if it did not actually cause, the worst depression in all history. In the United States, output collapsed by a third. Unemployment reached a quarter of the civilian labour force, closer to a third if a modern definition is used. It was a global catastrophe that saw prices and output decline in nearly every economy in the world, though only the German slump was as severe as the American.
World trade shrank by two-thirds as countries sought vainly to hide behind tariff barriers and import quotas. The international financial system fell to pieces in a welter of debt defaults, capital controls and currency depreciations. Only the Soviet Union, with its autarkic, planned economy, was unaffected.
Why did it happen?
In perhaps the most important work of American economic history ever published, Milton Friedman and Anna Schwartz argued that it was the Federal Reserve System that bore the primary responsibility for turning the crisis of 1929 into a Great Depression. They did not blame the Fed for the bubble itself, arguing that with Benjamin Strong at the Federal Reserve Bank of New York a reasonable balance had been struck between the international obligation of the United States to maintain the restored gold standard and its domestic obligation to maintain price stability. By sterilizing the large gold inflows to the United States (preventing them for generating monetary expansion), the Fed may indeed have prevented the bubble from growing even larger. The New York Fed also responded effectively to the October, 1929, panic by conducting large-scale (and unauthorized) open market operations (buying bonds from the financial sector) to inject liquidity into the market.
However, after Strong's death from tuberculosis in October, 1928, the Federal Reserve Board in Washington came to dominate monetary policy, with disastrous results. First, too little was done to counteract the credit contraction caused by banking failures. This problem had already surfaced several months before the stock market crash, when commercial banks with deposits of more than $80-million suspended payments. However, it reached critical mass in November and December of 1930, when 608 banks failed, with deposits totalling $550-million, among them the Bank of United States, which accounted for more than a third of the total deposits lost. The failure of merger talks that might have saved the bank was a critical moment in the history of the Depression.
Secondly, under the pre-1913 system, before the Fed had been created, a crisis of this sort would have triggered a restriction of convertibility of bank deposits into gold. However, the Fed made matters worse by reducing the amount of credit outstanding (December, 1930 -- April, 1931). This forced more and more banks to sell assets in a frantic dash for liquidity, driving down bond prices and worsening the general position. The next wave of bank failures, between February and August of 1931, saw commercial bank deposits fall by $2.7-billion, 9% of the total.
Thirdly, when Britain abandoned the gold standard in September, 1931, precipitating a rush by foreign banks to convert dollar holdings into gold, the Fed raised its discount rate in two steps to 3.5%. This halted the external drain, but drove yet more U. S. banks over the edge: the period of August, 1931, to January, 1932, saw 1,860 banks fail with deposits of $1.45-billion.
Yet the Fed was in no danger of running out of gold. On the eve of the pound's departure, the U. S. gold stock was at an all-time high of $4.7-billion -- 40% of the world's total. Even at its lowest point that October, the Fed's gold reserves exceeded its legal requirements for cover by more than $1-billion.
Fourthly, only in April, 1932, as a result of massive political pressure, did the Fed attempt large-scale open market operations, the first serious step it had taken to counter the liquidity crisis. Even this did not suffice to avert a final wave of bank failures in the last quarter of 1932, which precipitated the first statewide "bank holidays," temporary closures of all banks........."
Please read the remainder of the column at National Post.com
