The Great Depression (1929 1939)

By: Section C2, Group 9 - Abhash Nigam [FT13295] - Anand Solomon [FT13207] - Garima Yadav [FT13220] - Krishnan Chidambaram [FT13233] - Pranit Suneja [FT13258] - Ritu Pherwani [FT13270] - Sowmya Murthy [FT13246] - Tanvi Choudhary [FT13282

The Great Depression (1929)

The Great Depression (1929 1939) was a worldwide depression, it was the longest and most severe depression ever experienced by the industrialized Western world. Although the Depression originated in the United States, it resulted in drastic declines in output, severe unemployment, and acute deflation in almost every country of the globe.

Causes of the Great Depression

There is no single cause as agreed by economist and historians for the depression but there are sequence of events that contributed to the Great Depression.

Financial institution structures

The bank failures were mostly in rural America. The local banks present in rural India were highly vulnerable because of Structural weaknesses in the rural economy. Farmers, already deeply in debt, saw farm prices drop steeply in the late 1920s and their implicit real interest rates on loans skyrocket. Their land was already over-mortgaged (as a result of the 1919 rise in land prices), and crop prices were too low to allow them to pay off what they owed. Small banks, especially those tied to the agricultural economy, were in constant crisis in the 1920s with their customers defaulting on loans because of the sudden rise in real interest rates; there was a steady stream of failures among these smaller banks throughout the decade. The city banks also suffered from structural weaknesses that made them vulnerable to a shock. Some of the nation's largest banks were failing to maintain adequate reserves and were investing heavily in the stock market or making risky loans. Loans to Germany and Latin America by New York City banks were especially risky. Economists have argued that a liquidity trap might have contributed to bank failures. The panics caused a dramatic rise in the amount of currency people wished to hold relative to their bank deposits. This rise in the currency-to-deposit ratio was a key reason why the money supply in the United States declined 31 percent between 1929 and 1933. In addition to allowing the panics to reduce the U.S. money supply, the Federal Reserve also deliberately contracted the money supply and raised interest rates in September 1931. Scholars believe that such declines in the money supply caused by Federal Reserve decisions had a severe contractionary effect on output. In ordinary times, such as the 1920s, both the money supply and output tend to grow steadily. But, in the early 1930s, both plummeted. The decline in the money supply depressed spending in a number of ways. Perhaps most importantly, because of actual price declines and the rapid decline in the money supply, consumers and business people came to expect deflation that is, they expected wages and prices to be lower in the future. As a result, even though nominal interest rates were very low, people did not want to borrow because they feared that future wages and profits would be inadequate to cover the loan payments. This hesitancy, in turn, led to severe reductions in both consumer spending and

business investment spending. The panics surely exacerbated the decline in spending by generating pessimism and a loss of confidence. Furthermore, the failure of so many banks disrupted lending, thereby reducing the funds available to finance investment.

The Fall of Stock Market

In 1920s the stock market, although has the reputation of being a risky investment, it did not appear that way. With the mood of the country exuberant, after World War I the stock market seemed an infallible investment in the future. As more and more people invested in the stock market, stock prices began to rise. The strong bull market (when prices are rising in the stock market) enticed even more people to invest. And by 1928, a stock market boom had begun.Stock prices had risen more than fourfold from the low in 1921 to the peak reached in 1929 By the fall of 1929, U.S. stock prices had reached levels that could not be justified by reasonable anticipations of future earnings. As a result, when a variety of minor events led to gradual price declines in October 1929, investors lost confidence and the stock market bubble burst. Panic selling began on Black Thursday, October 24, 1929. Many stocks had been purchased on margin, that is, using loans secured by only a small fraction of the stocks value. As a result, the price declines forced some investors to liquidate their holdings, thus exacerbating the fall in prices. Masses and masses of people tried to sell their stock, but no one was buying. Between their peak in September and their low in November, U.S. stock prices declined 33%.

Disproportional Demand and Supply

The Federal Reserve Board was encouraging higher investment by the manufacturing industries, by keeping discount rates low. But by the end of 1920s, the plant spaces and factories had been expanded to such an extent that they were proving unprofitable. The major industries impacted here were the automobile sector and construction industry. Sale in automobiles was not growing at the same rate as production in the industry. Hence, there was surplus produce. There was a boom in housing construction in the mid-1920s which led to an excess supply of housing and a particularly large drop in construction in 1928 and 1929. Hence, this sector too was declining rapidly. At the same time, wages of citizens increased at a rate much lower than productivity increases. Most of these wages were put into the stock market rather than into consumer purchases. As a result, consumers did not have enough purchasing power. This purchasing power was also unequally distributed.

Production by the larger plants was much higher than the amount that consumers could purchase, and the market created by potential customers was too small for the amount of goods being produced. Also, certain mistakes by the government in monetary policies led to worsen the situation. They imposed a disproportionate tax system thereby increasing the inconsistency in incomes between the rich and modest. They also raised tariff rates to an extent that curbed foreign trade drastically.

Questions 1.) How do you relate macro-economic during the period of Great Depression? The Depression played a crucial role in the development of macroeconomic policies intended to temper economic downturns and upturns. Labour unions and the welfare state expanded substantially during the 1930s. In the United States, union membership more than doubled between 1930 and 1940. This trend was stimulated both by the severe unemployment of the 1930s and the passage of the National Labor Relations Act (1935), which encouraged collective bargaining. The United States established unemployment compensation and old age and survivors insurance through the Social Security Act (1935), which was passed in response to the hardships of the 1930s. In many countries, government regulation of the economy, especially of financial markets, increased substantially during the Great Depression. The United States, for example, established the Securities and Exchange Commission in 1934 to regulate new stock issues and stock market trading practices. The Banking Act of 1933 established deposit insurance in the United States and prohibited banks from underwriting or dealing in securities.

2) Why market forces failed to create its equilibrium in the great depression of 1929 ? (Why supply failed to create its own demand in great depression)? Under assumptions of Classical Economics (First school of Thought), Says Law states that, Supply creates its own Demand. But the Great depression of 1929 disproved this myth that the automatic working of market mechanism would ensure equilibrium in income at full employment of resources. During the great depression, there was continual fall in income, employment and output levels. Even though a country like USA was highly developed in terms of industries, power, transport, communication, finance and infrastructure, people had insufficient and unequally distributed purchasing power. This situation could not be explained by the Classical Says

Theory, and it led to the development of modern macroeconomic theory known as Keynesian Economics. This theory states that, in times when decisions made by private sectors lead to inefficient macroeconomic outcomes, a quick response is expected from the public sector for its rescue, in terms of monetary and fiscal policies. Contrary to Say's law, which is based on supply, Keynesian economics stresses the importance of effective demand, derived from actual disposable income of households rather than income gained at full employment. During the Great depression, another factor was that the decisions taken by the government, in terms of monetary policies, were wrong. They introduced a disproportionate tax system causing greater disparity between the rich and modest. They also increased tariff rates on foreign trade, all of this leading to worsen the crisis situation. Hence, the concept of Supply creates its own demand failed drastically.

3) Why cant an agriculture based economy be an economic power (Indian context)? Lets start with food and agriculture. Latest available statistics show that currently the agricultural sector contributes 25%; the industrial sector 26% and the service sector 49% to the national GDP. In popular saying, however, Indian economy is still called an agricultural economy despite the fact that this sector contributes the least to the GDP, percentage wise. This notion prevails because 65% of the population has a rural base with agriculture as its only vocation. This majority 65% agriculture-oriented portion of the population contributes only 25% to the national income while 75% of the national income comes from the minority 35% of the population engaged in the industrial and the service sectors. In other words, the extra 40% of the manpower engaged in agriculture is underemployed due to the great ruralurban divide. In the developed world, specifically in the USA, the agricultural sector contributes only 2% to the GDP with less than 3% of the work force engaged in that sector. Rest of the US national income, to the tune of 98%, is accounted for by the industrial and the service sectors. Judging by other indicators of productivity, China is not that far ahead. The proportion of irrigated land in agriculture is only 16 per cent higher in China. Gross cropped area under food crops was, however, 30 per cent lower, although yield was 2.87 times higher. Agricultural value added per agricultural worker is just 17 per cent more in China. While commercial energy use per capita in kg of oil equivalent is almost double in China, the efficiency in its use measured by its ratio to GDP is surprisingly higher in India. This obtains despite China having 2.35 times more of scientists and engineers in R&D activities than India.