The Stock Market Crash of October 24 29, 1929 is generally taken as the beginning of the decade-long economic downturn known as the Great Depression. While no single factor is sufficient to explain the Depression, there is compelling evidence to suggest that the policies of the Federal Reserve Bank may have "made a bad situation worse."
In the two years immediately following the Crash of 1929 there were several banking panics, in which a bank's depositors would withdraw (or attempt to withdraw) their money from their checking and savings accounts, which resulted in a multitude of bank failures. To understand the impact of these panics and failures, it is necessary to understand two closely related concepts: money supply and the Gold Standard.
Money supply is the total amount of money available in an economy and includes cash and assets that can be converted to cash. In the early years of the Great Depression the available money supply in the United States was held constant by the Gold Standard, which limited the money supply to the equivalent dollar value of gold reserves held by the government.
In a bank panic, depositors withdraw money from a bank but that money remains in circulation and the money supply is unchanged On the other hand, when a bank
fails the money that it has in deposits and the monetary value of its assets that are convertible into cash are removed from the economy and the money supply decreases. As the money supply decreases there is less money available for buying goods and services and, as a result, businesses will begin to suffer due to a decrease in consumer spending. As this reduced spending becomes more widespread it results in a deflationary cycle in which the supply of goods and services exceeds demand and prices fall.
There were, of course bank failures before the Stock Market Crash but the number of bank failures did not sharply increase until well into 1930. According to economists such as Milton Freidman, Anna Schwartz, and the current Chairman of the Federal Reserve, Ben Bernanke, this increase in bank failures was the direct result of the Federal Reserve's decision to reduce its short-term support of the banking industry by limiting the amount of money it would be willing to lend to banks while simultaneously raising the interest rate on the money that it was willing to loan.
As a consequence of the Federal Reserve's actions the number bank failures skyrocketed which, in turn, caused the money supply to decrease even further. The economy essentially imploded under the weight of debts that could not be paid, assets that had lost much of their value, and consumer spending that was sharply curtailed by unemployment. By March of 1933 1 in every 4 Americans was unemployed, the money supply had fallen by 27%, and economic output dropped by 29% from their pre-1929 levels.
The man behind the reasoning that led to the Federal Reserve's decision to reduce the flow of money to the banking industry at the very time it should have been doing everything that it could to increase that flow was the then-Secretary of the Treasury, Andrew Mellon.
Mellon firmly believed that the Darwinian concept of "survival of the fittest" could be applied to the banking industry, that "stronger" banks would survive and "weaker" banks would not. Although he admitted that his decision was "harsh," he thought it "necessary" to the eventual recovery of both the banks and the economy. He also advocated spending cuts to balance the federal budget and opposed public works projects as a measure to reduce unemployment. Even though Mellon realized that these policies were obviously ineffective, he supported an even greater economic blunder.
From 1930 to 1932 Mellon, along with President Herbert Hoover and against the advice of a large number of bankers and economists, drafted a tax plan that would supposedly balance the federal budget. Hoover, with the support of the Democratic majority in the House of Representatives, pushed the new income tax law through Congress in 1932. The Tax Law of 1932 raised the marginal income tax rates from 1.5% to 4% on the lower end, and from 25% to 63% at the top of the scale. In addition to being the largest peacetime tax increase in history, it was also an embarrassing failure and was a factor in the landslide victory of Franklin Roosevelt over Hoover later that same year.