[Global Financial History] The Great Depression and the Global Economic Crisis Were Due to Policy Failures

Monetary Economist Friedman
"Fed Responsible for the Expansion of the 1929 Great Depression"
Post-World War II Economic History Features
No Prolonged Deep Recession
Overcome Through Fed's Appropriate Response

Baek Young-ran, CEO of History Journal

The New York Times (NYT) once posed a provocative question on its front page: "1987, a replay of 1929?" At that time, stock prices plummeted to one-third of their peak value, causing Americans to lose $1 trillion. The nightmare of the Great Depression resurfaced. There was a brief but intense debate over the causes of the stock market crash. The most important economic event since World War II was the absence of a prolonged deep recession. Yet, we now face the madness and gloom of capitalism once again...

On October 16, 1929, Irving Fisher, an economics professor at Yale University, claimed that U.S. stock prices had "reached a plateau that will never decline." However, just eight days later, on Black Thursday, the Dow Jones Industrial Average astonishingly dropped by 23%, marking the first day in history when stock prices fell more than 10% in a single trading session.

In fact, the stock market had begun to slide since early September, and by October 23, it had already plunged 6%. This is considered the start of the Wall Street crash. Over the next three years, the U.S. stock market fell by 89%, reaching its lowest point in July 1932. U.S. production collapsed to about one-third of its previous level. One-third of the labor force was unemployed. Only the Soviet Union escaped the impact thanks to its self-sufficient and planned economy.

According to monetarist economist Milton Friedman, the Great Depression was fortunately a result of policy mistakes. In other words, proper policy implementation could have prevented such a crisis. Historical experience confirms the importance of sound policy. Friedman argued that the Federal Reserve (Fed) was responsible for turning the 1929 crisis into the Great Depression. While the stock bubble itself was not the Fed's fault, after Benjamin Strong's death, the Fed adopted flawed policies.

Benjamin Strong, the first president of the New York Federal Reserve Bank, diligently balanced the U.S.'s international obligation to maintain the gold standard with its domestic duty to stabilize prices. At that time, the Fed sterilized the large inflows of gold returning to the U.S. to prevent monetary expansion. Even during the panic, the Fed responded appropriately by purchasing bonds to inject liquidity. However, after Strong died of tuberculosis, the Federal Reserve Board in Washington failed in its monetary policy. Most notably, the Fed did not adequately respond to the credit contraction caused by bank failures.

The issue was already foreshadowed months before the stock market crash when commercial banks holding deposits exceeding $80 million suspended withdrawals. Despite this liquidity crunch, the Fed's gold reserves exceeded the legal minimum by over $1 billion, yet no measures were taken to provide liquidity. In November and December 1930, 608 banks failed, resulting in deposit losses of $500 million. Still, no appropriate policies were implemented to address the bank failures.

After the Great Depression, the Franklin Roosevelt administration enacted securities laws. These laws minimized new restrictions on the market while requiring all companies issuing securities to disclose extensive information, including financial statements, to potential investors. Transactions with related parties and various forms of market manipulation were prohibited. Credit transactions, common in the 1920s, were strictly limited.

However, the Fed misread these market movements. It raised interest rates from 5.5% to 6%. Unfortunately, the timing of this rate hike could not have been worse. The Fed was largely unaware that the U.S. economy had peaked in August 1929. It expected that tightening credit markets might reduce stock prices by about 10%, but certainly not by 90%. When aggressive investment institutions anticipated further declines and began selling, the Fed blamed them. The New York Stock Exchange's electronic trading system collapsed, and there were no trading halts to block sharp drops in futures and options markets. The situation worsened. Yet, surprisingly, nothing else happened afterward. Enthusiastic monetarists felt ominous but remained calm. Moreover, there was no recession. Everything soon returned to normal.

Less than a year after Black Monday, the Dow Jones recovered to pre-crash levels. Part of this recovery was thanks to Alan Greenspan, who succeeded Paul Volcker as Fed chairman. Greenspan responded swiftly and appropriately to the Black Monday crisis. His Fed was prepared to support the economy and financial system by supplying liquidity. New York banks and the market interpreted this as a signal that bailouts would be triggered if the situation worsened. The Fed's purchase of government bonds injected desperately needed cash. The borrowing cost from the Fed was also reduced by about 2%.

Wall Street breathed a sigh of relief. The feared "event" did not occur. Greenspan managed the October 1987 U.S. stock market crash, emerging market crises including Korea, the Russian default, and the dot-com bubble smoothly and appropriately. Had the financial markets collapsed and the recession prolonged, what would the global economy have looked like? His assertion that productivity gains can accelerate economic growth without intensifying inflation is both idealistic and realistic.

Baek Youngran, CEO of History Journal