Is the United States headed for another Depression? I hear this question periodically. It is usually asked when “the other party” is in power in Washington and someone disagrees with “the other tribe’s policies.” Allow me to talk a bit about the causes of the Great Depression and the state of the U.S. and the world at that time.
Even though the Great Depression didn’t officially begin until 1929, one cause of the Depression began with World War I in Europe from 1914 to 1918. In order to finance the effort, the U. S. government began selling Liberty Bonds in 1917. Because of a large public relations campaign plus the bonds could be purchased for as little at $50 or even 25-cent War Thrift Stamps or $5 War Saving Certificates, these bonds were the first investment many Americans ever made. These bonds were issued by the Treasury Department and relatively new Federal Reserve and raised $17B. (1) More later on the war bonds.
The Spanish Flu infected 500 million people (1/3 of global population) from February 1918 to April 1920 resulting in tens of millions of deaths globally and 675,000 deaths in the U.S. note. The flu reduced global GDP by 6% and private consumption by 8% while the U.S. impact was less at 1.5% decline in GDP and 2.0% in consumption. (2, 7)
The end of WWI as well as the Spanish Flu pandemic kicked off a decade of prosperity and consumption never before seen in this county. Americans fell in love with new products like radios, cars, refrigerators, vacuums, beauty products and clothing. Many products once only available to the wealthy like cars became available to a much broader market with expanding credit which allowed Americans to buy more expensive items over time –with interest--even if they could not afford to pay cash. Henry Ford’s assembly line brought the cost of his Model-T down to a level even his workers could afford. With more cars on the road, we needed more highways which required more infrastructure which in turn created more jobs. More people on the road led to more and different businesses like motels and restaurants. More cars meant the expansion of industries like glass, steel and rubber plus the oil fields of California, Oklahoma, and Texas created more jobs to supply our ever increasing needs for petroleum products.
The repayment of the Liberty Bonds plus the interest they earned gave a wider segment of the population comfort with investing. More jobs, higher wages and the new shorter eight-hour work day afforded more Americans additional leisure time and income. Advertising became a huge industry and encouraged Americans to spend. (3,7)
The U.S. economy grew by approximately 42% during the 20s. The United States produced almost half the world’s output. New construction grew from roughly $6.7 billion to roughly $10.1 billion. Unemployment hovered at roughly 4%. The U.S. was transitioning from a “traditional” rural agricultural economy to a “free market” that focuses more on supply and demand. Per-capital GDP rose from about $6,460 to $8,016. Life was good and getting better. (4,5,7)
The stock market, once only available to the wealthy person, changed its rules. Now instead of having to pay cash to buy shares, investors could borrow up to 80 or 90% of the cost of shares and only put down 10 to 20% of their own money. The public was coming from their positive experience investing in Liberty Bonds and anxious to expand their wealth. Now that investors only needed a 10% down payment to buy shares, they could use borrowed money to make even more money. (5,6,7)
Allow me to get nerdie and explain how this leverage can work to an investor’s advantage. Assume for example you put down $100 and borrow an additional $900 to buy $1,000 of stock. The stock goes up 10% to $1,100. You still owe $900 but your stock is worth $1,100 so sell out and have $200 profit. Your original $100 investment is now worth $200. You doubled your money if you cash in. WOW !!! So why not take the $200, borrow $1,800 to buy $2,000 of stock? If it goes up 10% to 2,200, your $200 grows to $400. Double WOW !!!
The Dow Jones Industrial Average went from roughly 71.95 early in 1921 to about 381 in October 1929. This is 20% per year growth. This would mean in my example, if you invested $100 and borrowed $900 to buy $1,000 of stock that goes up 20% to $1,200, your $100 investment has grown to $300. And this goes on for nine years. By 1929, everyone, individuals, companies and banks were investing. (5)
The economy is cooking. Your income is going up. Advertising is pulling at you to buy the “nice, new, shiny stuff.” You are feeling a bit competitive for more and nicer stuff than the neighbor or relatives….hence the phrase “Keeping up with the Jones.” Everyone is making money in the stock market. You want in on it. Plus, it only takes a 10% down payment. Investors began to think and act like the markets could only go up. Let the GOOD TIMES roll.
Jump to October, 1929. Numerous factors caused the stock market to not just take a pause in the upward momentum but actually decline a bit. But then a correction became an avalanche with a 13.47% decline one day followed by a 11.7% decline the next. (7)
Why such a dramatic decline? Remember all the investors that only put a 10% down payment? The banks and investment firms that loaned them 90% of the purchase want THEIR MONEY BACK PLUS INTEREST. Back to the example, your $1,000 of stock in now worth $900, so you sell in panic, the bank or brokerage firm gets their $900 and you get nothing. You just lost 100% of your investment. Because you and many others are selling, this forces the market down further.
Let’s say you couldn’t sell fast enough and your $1,000 of stock goes to $800 but you still owe the $900 you borrowed. The lender wants their money and you get a “margin call” which means sell out the position and clean out your bank account or sell the refrigerator or car to pay your debt. This all, in turn, creates more selling. (5, 7)
Another significant factor that could have contributed to the Great Depression, could be the U.S. banking system and the failure of the Federal Reserve to act. Prior to June 16, 1933 bank deposits were not insured and the banking industry was lightly regulated. Banks began creating affiliates to get involved in the stock market and hired thousands of brokers to sell stocks to middle America using money borrowed from the bank. By 1929, there are 17,583 state banks and 8,150 national banks. Because so many people were using borrowed money to buy stocks, banks began to run low on cash. When the stock markets began to crash, investors couldn’t pay their bank loans. Savers with money deposited in banks got scared and went to get their money out of the banks. Remember, no deposits were insured. Remember, banks were low on cash. Remember, with few regulations, banks had limited amounts of assets (cash and liquid investments) they could use to give depositors their cash upon demand. One bank in Nashville, TN was the first to close their doors. Rumors and truth of bank failures spread like wild fire. The run on the banks had begun and continued until 1933. (6,7)
The bank failures were exasperated by the actions or some might say failure to act by the Federal Reserve System (Fed) which was created in 1913 to provide the nation with a safe, flexible and stable monetary and financial system. The “Fed” is supposed to accomplish this by lending money to banks during times of money shortages and direct interest rates up to slow an overheating economy (bring down inflations) or lower interest rates to stimulate a stagnant economy (during a recession). During the last few years of the 1920s, the Fed increased interest rates to attempt to discourage people from borrowing more money to buy stocks. However, when banks began to fail because they could not pay cash to their depositors, the Fed did not step in to offer loans to the banks to keep them afloat leading to a failure in confidence of the banking system. In all, about 9,000 banks failed and $6.8 billion of deposits were lost….this is $72.4B in today’s dollars). (7,9)
The start of the Great Depression, unemployment rose to 25%. Banks, businesses and farms failed or went bankrupt. People stood in line for bread. What caused the Great Depression? Could it had been too much borrowed money for consumer items, speculation on stocks with borrowed money, and lax regulation. It was probably made worse by protectionist trade policies in the Smoot Hawley Act which increased tariffs on 900 items by 40% to 50%. This combined with reactionary tariffs forced global trade down by 65% and some would say led to the start of World War II. (8)
Can The Depression happen again? Anything is possible. However, in many ways we have learned some lessons.
In 1933, newly elected Franklin Roosevelt with the help of Congress passed some critical legislation that protected banks, their customers, and investors:
- Federal Deposit Insurance Corporation (FDIC) insures bank deposits to give depositors confidence their money is protected to prevent another “run on the banks.” (6)
- Glass-Steagall Act separated investment banking from commercial banking to prevent banks from speculative investing. (8)
- Securities Act of ’33; Securities Exchange Act of ’34; Investment Company Act of ’40 and Sarbanes-Oxley Act of ’02 were all enacted to protect investors; maintain fair, orderly and efficient markets; and facilitate capital formation. None of which existed in 1929. (10)
- While the Federal Reserve failed to act to provide liquidity to the banking and capital markets in the early days of the Depression, during the Financial Crisis of 2008 and current recession caused by COVID-19, the FED has acted aggressively to keep capital market functioning and money flowing in the economy. It appears the lessons of the Depression are still begin remembered today. (11)
- Finally, buying stock on margin with borrowed money is not longer practiced by the majority of investors. In the ‘20s everyone was encouraged to buy on margin with borrowed money. Today, you must apply to open a margin account and if approved for the account must put down 50% to 60% on each trade. (12)
The economy acts in cycles of expansion and contraction while the stock market grows and declines….not always at the same time. That can probably not be avoided. However, the probability of an economic downturn escalating to another Great Depression has been minimized in many ways as mentioned before. The some things to consider is:
- Live not just within your means but below your means.
- Have a cash reserve adequate to cover your expenses for up to six months.
- Other than long-term debt like a mortgage, try not to buy anything you cannot pay cash for.
- If you have consumer debt on credit cards, pay it off as soon as possible and only charge what you can pay off next month.
- Unless you plan to work until you die, save / invest as much money as possible. How much money will you need to support you when you quit working? This may require saving 10% to 50% of your income. So, make a plan.
If your situation allows and you do all of the above , a Depression may not destroy you financially. In fact, times of turmoil and fear are opportunities to prosper further while all around you panic.
Wollman Wealth Designs is a financial planning and investment advisory firm affiliated with Voya Financial Advisors (soon to be known as Cetera Wealth Partners) located in Escondido, CA and partnering with clients around the country. Please email or call us with questions.
The views and opinions expressed are those of the author, and the information should not be construed as individual investment advice, or as the opinion(s) of Voya Financial Advisors.