Closing system

How bank failures contributed to the Great Depression

On the surface, everything was hunky-dory by the summer of 1929. The total wealth of the United States had nearly doubled during the Roaring Twenties, fueled, in part, by stock speculation eagerly undertaken by a wide range of citizens ranging from the Fifth Dowagers of the Avenue to Factory Workers. A Midwestern woman, a farmer, made an overnight profit of $ 2,000 ($ 31,000 in today’s dollars) betting on the stock of an auto maker.

When the bubble burst dramatically in October 1929, many economists, including John Kenneth Galbraith, author of The great crash 1929, blamed the decade-long global Great Depression that followed all those reckless speculators. Most saw the banks as victims, not culprits.

The reality is more complex. Of course, without all of this uncontrolled and irrational market speculation, the 1930s could be simply remembered as a time when the economy and prosperity stagnated. But why – and how – could these players dominate the stock market? And why has a market crisis turned into a systemic economic disaster that spanned a decade in which unemployment skyrocketed to 25% and the cost of goods and services plummeted? In 1933, a dozen eggs cost only 13 cents, up from 50 cents in 1929. Banks went bankrupt – between a third and half of all American financial institutions collapsed, wiping out the lifelong savings of millions of dollars. ‘Americans.

The familiar tale of the Great Depression places banks among the institutions that suffered from the fallout from the crisis. In fact, in the eyes of luminaries such as Ben Bernanke, an economic historian and former head of the Federal Reserve, the crisis affected only the banks – from the central bank (the Fed itself) to the smaller savings institutions. “Regarding the Great Depression… we did it,” Bernanke said in a 2002 speech, mostly referring to the role of the Fed. “We are sorry.”

Here are four ways the banks “did it”:

Banks have given too much credit

The rampant speculation that sparked the crash of 1929 and the Great Depression that followed could not have happened without the banks, which fueled the credit boom of the 1920s. New businesses – making new products like automobiles , radios and refrigerators – borrowed to support the continued expansion of production. They continued to borrow and spend even as corporate inventories skyrocketed (only 300% between 1928 and 1929) and American wages stagnated. Banks, ignoring the warnings, continued to subsidize them.

The banks also funded the speculation itself, providing the money individual investors needed to buy stocks on margin. This Midwestern farmer might have borrowed as much as 90% of the money she needed to overnight kill the auto inventory, funded by her local bank. Bank lenders discounted or played down the growing signs that Americans were overburdened. Farm incomes, in particular, plunged in the years leading up to 1929, and others found their wages stagnant. Their prosperity came only from their stock market wealth – which did not last.

READ MORE: Why the Roaring Twenties Left Many Americans Poorer

People gather outside the New York Stock Exchange on October 29, 1929, checking out the hysterical drop in stock prices.

Banks ignored the Federal Reserve

The Fed, which serves as America’s central bank, has tried to put the brakes on things, albeit too slowly and too late in the game. It has sent warning letters to banks to which the Fed itself has granted credit, warning to remove their collective feet from the accelerator pedals. The banks, with their eyes firmly fixed on the “easy” profits to be made by financing speculation, paid little heed to it. After all, wasn’t it a virtuous cycle? The more investment profits their clients generate, the more money they will have to spend on buying new homes or consumer goods. Why worry? By the time the Fed put the brakes on by raising interest rates in 1929, it was too late to stem the crash or the fallout on the banks.

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Banks did not maintain sufficient reserves

It sounds a bit geeky, but one of the ways that banks are contributing to the health of the economy – and helping to avert disasters like the Great Depression – is by managing their cash reserves. As a rule, banks keep only a small percentage of all the money that depositors entrust to them and lend the rest in search of profit; that’s how they earn their money. In ordinary times, banks rely on the ability to borrow from other financial institutions, or from the Federal Reserve, to cover any unexpected shortfall in reserves if their customers start dropping in and claiming their deposits. During the Depression, the pressure on these providers of relief capital was unsustainable; in addition, a large number of US banks had not joined the Federal Reserve system and therefore were unable to draw on their reserves to avoid the collapse.

It wasn’t until the stock market crashed and fearful Americans flocked to banks asking for their money – so they could tuck it under the mattress or use it to make up for massive stock losses – that the banks did what they did. They had not kept enough reserves to cope with the growing risks associated with soaring credit and speculation.

Ironically, once the banks started trying to correct their missteps, they made the problem worse. When the banks sought to protect themselves, they stopped lending money. Businesses couldn’t access capital and shut down, throwing millions of Americans out of work. These unemployed Americans couldn’t keep spending and the toxic downward spiral continued. As banks collapsed, it wasn’t just savings that were lost, but information: surviving institutions had no way of assessing which companies or individuals had good credit risks. .

READ MORE: What Caused the 1929 Stock Market Crash?

Sending of gold coins, valued at the time in six digits, from depositors of the Empire Trust Co. It was part of the flow back into the coffers of the Federal Reserve Bank during the stock market crisis.

Sending of gold coins, valued at the time in six digits, from depositors of the Empire Trust Co. It was part of the flow back into the coffers of the Federal Reserve Bank during the stock market crisis.

Banks must be fixed

If the banks led to the crash and the economic crisis that ensued until the Great Depression, then they needed to be corrected for the economy to begin to recover. In 1933, the wave of bank failures was stemmed by the decision of newly elected President Franklin D. Roosevelt to declare a four-day banking “holiday” while Congress debated and passed the Emergency Banking Act. , which formed the basis of the 1933 Banking Act, or Glass-Steagall Act. For their part, lawmakers demanded that banks join the Federal Reserve system and approved the creation of deposit insurance, so that future bank failures could not wreak havoc on family savings. They have also taken steps to curb speculation by banning commercial lenders from entering the stock market. Even before Roosevelt signed the new measures into law, Americans began returning accumulated money to surviving banks. The banking system had been saved, although it would take years for the economy itself to come out of the deep depression hole.

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