Why did the American economy collapse in 1929?

Answer 1

The American economy of the '20s was distorted by various factors.

America's own war-time measures (from WWI) were not unwound. For example, during the war farmers had been encouraged to produce quantities for which, after the war, there was no longer demand, and the federal government subsequently acted to protect farmers from market forces.

Foreign governments (such as that of Great Britain) had gone off the gold standard to pay for the war without overt taxation, and were then trying to restore the original standard rather than fixing a new standard in keeping with where prices had gone. The United States tried to help its allies as they pursued this attempt, but this affected our own money supply.

America increased its own money supply, which ended-up distorting patterns of investment and creating an unsustainable false dawn of great prosperity. The market treated the new money as if it corresponded to an increase in real wealth, seeking investment. Huge sums were invested -- either directly in the means of production or in stocks and bonds -- based upon illusion. Investors and speculators, fooled by the false dawn (or trying to out-race the eventual collapse), borrowed with dramatically insufficient collateral to repay if their investments soured.

Contrary to popular myth, the Republicans of the '20s were technocrats in the tradition of Alexander Hamilton, rather than believers in market forces. They believed that, with control of the banking system and with other regulation, they had produced a better system.

One of their policies was protectionism. In particular, a bill by Republicans Reed Smoot and Willis Chatman Hawley which would dramatically increase tariffs on thousands of items, began to work its way through Congress. Even before it was signed into law by the President Herbert Clark Hoover, foreign governments began to effect retaliatory measures and knowledgeable investors began to withdraw their investments.

The process whereby the money supply had been allowed to expand went into a sort of reverse, and the money supply began to contract. but the central bank didn't really understand what was happening, and thus allowed the money supply to collapse. In this context, prices no longer directed economic activity to where it would do the most good.

Herbert Hoover was the foremost of the technocrats. In the wake of WWI, Hoover had done a magnificent job of organizing relief and recovery for Europe. (He is still considered a hero in parts of Europe.) But he didn't recognize that directing an economy that has been laid low by war or by similar catastrophe (which economy has a natural target, in the form of where things were before the war) is very different from that of directing other sorts of economies. In the early '20s, Hoover had been Secretary of Commerce, during which time the United States had gone into a sharp recession (for much the same reason that the economy would do so in the late '20s). Hoover tried to convince then-President Warren Gamiel Harding to accept aggressive policies to combat the recession, but by the time that Harding began to consent, the economy had already recovered. In 1929, Hoover was now President, and began taking the sort of steps that he had wanted taken in the previous recession.

Hoover believed that the down-turn was caused by deficiencies of the market itself, rather than by technocratic policies, and that wise administration could restore prosperity. Specifically, he believed that aggressive competition was driving-down wages and prices to levels incompatible with prosperity, and that these needed to be raised back up to restore prosperity. So he began pushing workers to unionize and businesses to form cartels, to reduce competition. And he otherwise acted to keep wages and prices from dropping. And, even though he felt that the Smoot-Hawley Tariffs were too high, he signed the bill into law to block foreign competition. The idea was that if wages and prices were high, then businesses and workers would have more money to spend, and that spending would restore the economy. In reality, business lost money because buyers reduced their purchases, and workers lost money because they lost their jobs. They were being priced out of the market. If policy had acted to keep the over-all price level from dropping, but allowed relative price changes, then this would have been very helpful. But, as it was, relative price adjustments were impeded.

And, if that weren't enough, the federal government balanced its budget not by reducing spending, but by raising taxes, so people were made even more poor. One of the reasons that the federal government didn't reduce its spending was that it tried to use public works -- government projects -- as a way to create employment. Of course, pretty much every dollar that went to a business or worker on such a project had come from some other business or worker. And these public works generally made less economic sense than the activity that they'd displaced.

(Roosevelt didn't actually adopt a dramatically different policy except that he took the United States off a true gold standard (moving us to a gold exchange standard) and stopped balancing the budget. Until 1938, he continued the policies of cartelization, unionization, and public works; so the process of economic recovery was very slow. In fact, in 1938, the economy went back into decline. Without blinking an eye, Roosevelt blamed business cartels and his administration went in the opposite direction, attacking businesses for charging the same price as others in their industry as engaged in collusion, attacking businesses for charging less as seeking monopoly, and attacking those who charged more on the theory that they could only do so if they had something of a monopoly. This madness (where no price was legal) continued unchecked into WWII, until the military told Roosevelt that we would lose the war if he didn't stop beating-up the companies that supplied the military.)