The 1920s were a prosperous time for the global economy, specifically the US economy. American companies were exporting greatly to European nations who were rebuilding after the World War. Unemployment was at an all-time low, and stock prices went up by nearly 10 times. In the 1920s. The era was called the ‘Roaring Twenties’, and the American public were investing heavily into the stock market. However, on Thursday, 24th October 1929, the US stock market collapsed, marking the beginning of the Great Depression.
So why did the Great Depression take place? The answer is that people were not buying stocks on fundamentals; they were buying in anticipation of rising share prices. Rising share prices simply brought more people into the markets, convinced that it was easy money. In mid-1929, the economy stumbled due to excess production in many industries, creating an oversupply. Essentially, companies were able to acquire money cheaply due to high share prices and invest in their own production with the requisite optimism.
This overproduction eventually led to oversupply in many areas of the market, such as farm crops, steel, and iron. Companies were forced to dump their products at a loss, and share prices began to falter. Due to the number of shares bought on margin by the general public and the lack of cash on the side-lines, entire portfolios were liquidated, and the stock market spiralled downwards.
The falling stock prices led to a large-scale loss of confidence and led to a sudden reduction in consumption and investment spending. Once panic and deflation set in, many people believed they could avoid further losses by keeping clear of the markets. Holding money became profitable as prices dropped lower and a given amount of money bought ever more goods, exacerbating the drop in demand. Monetarists believe that the Great Depression started as an ordinary recession, but the shrinking of the money supply greatly exacerbated the economic situation, causing a recession to descend into the Great Depression.
The lower aggregate expenditures in the economy contributed to a massive decline in income and to employment that was well below the average. In such a situation, the economy reached equilibrium at low levels of economic activity and high unemployment.
The situation was further exacerbated by the liquidity crisis that was faced at the same time. The banks were struggling and could not lower inflation rates, and reduced borrowing led to a massive deflation in the economy.
Recovery was a slow process. One of the main issues was that the value of the currency was tied to gold reserves. Countries losing gold were forced to contract. Those receiving gold, however, did not expand. This generated a net deflationary bias, as a result of which the depression was worldwide for those countries on the gold standard. As countries cut their ties to gold, which the U.S. did in early 1933, they were free to pursue expansionary monetary and fiscal policies, and this is the principal reason underlying the recovery.
Governments also started following Keynesian economics, and started spending more and focusing less on having a balanced budget. Though many countries were not too aggressive with their policies, the extra expenditure by the government helped stimulate a recovery.
The Great Depression showed the impact that mass hysteria could have on an economy. It also showed people that they should not blindly invest in stocks. Though the Great Depression taught great lessons, it was not the last time that a big recession would hit the world.