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The Federal Reserve and the Great Depression: A Historical Analysis

Shows correlation between raising intrest rates and bond prices.

The role of the Federal Reserve during the Great Depression has been the subject of much debate and controversy.

In this post, we'll examine the actions taken by the central bank leading up to the stock market crash of 1929 and the subsequent depression, as well as its efforts to stimulate economic recovery.

1. The Federal Reserve and the Stock Market Bubble of 1929

In the years leading up to the stock market crash of 1929, the Federal Reserve implemented a series of near-zero interest rates.

This policy encouraged excessive borrowing and investing, particularly in the stock market, which ultimately contributed to the formation of a speculative bubble.

This led to investors borrowing money nearly interest-free, and investing it in the stock market at the time.

At the time of the bubble, the average market returns were around 20%! This is 8% above the S&P's average of 12% returns annually.

Since the average stock market returns were around 20% during this time, people could borrow money interest-free and make around 20%.

All investors had to do is pay off the original loan principle, then they'd keep the extra 20% returns.

This was a good strategy during these times, but what happens when the federal reserve pivots, and starts to raise interest rates?

All hell breaks loose is what happens!

Since investors were buying stocks on margin, they had SO MUCH RISK involved.

But, how?

When interest rates go up, businesses can't borrow as much due to higher borrowing costs.

This causes slower growth during these periods. This affects the stock markets and earning seasons.

Earnings can heavily affect a stock's price since it is the latest version of a company's financials.

Since companies started to release bad earnings + the rising rates, the markets started to tank.

Since the markets started to tank, investors on margin were taking huge losses on their investments. This affects both the investor AND the bank.

Since most investors on margin took losses during this fed pivot, they were losing most of their loan money.

This means they couldn't pay the banks back, AND they now started to have to pay interest on the lost money.

But how did this start the banking crisis as well?

Since banks were giving out loans to these investors, they were also the victims of these bad investing practices.

Investors started to default on their loans, and banks were starting to face liquidity issues. This is bad, of course, but it gets worse.

The banks were also heavily invested in the stock market instead of government bonds.

This is because they wanted to take the high risk of getting POSSIBLY NOT A GUARANTEED 20% annually (give or take of course) instead of taking a low-risk investment yielding 2-4% through bonds.

So, when the federal reserve pivoted, the stock market declined heavily, which led to banks holding these depreciating assets.

Banks were now out of liquidity in total. In 1930, The New York Times released an article talking about how the bank wouldn't let a depositor withdraw his money but instead suggested investing it in the stock market.

This caused FEAR in the markets. This started the bank runs, which led to investors lining up at the bank, waiting to withdraw their money.

Like we've seen recently with Silicon Valley Bank failing, these banks were forced to sell their assets for pennies on the dollar to give depositors their money. This caused these banks to take MASSIVE losses.

This + defaulted loans not being paid back dried up all liquidity in most banks.

The most popular, The Bank of The United States was the biggest victim.

Statistic: During the 1920s, margin debt in the stock market grew significantly, reaching a total of $8.5 billion by 1929.

Quote: "The Federal Reserve's mistakes contributed to the 'worst economic disaster in American history... the central bank failed to live up to its role as the guardian of financial stability." - Ben Bernanke, former Federal Reserve Chairman

Example: Investors, attracted by the low cost of borrowing, heavily invested in the stock market on margin, using borrowed money to buy stocks. This created an unstable financial environment that ultimately led to the crash.

*2. The Federal Reserve's Response to the Great Depression*

Following the stock market crash and the onset of the Great Depression, the Federal Reserve initially failed to take decisive action.

Critics argue that the central bank's inaction exacerbated the economic crisis.

However, as the depression deepened, the Federal Reserve eventually lowered interest rates and implemented various measures to stabilize the financial system and stimulate economic growth.

Statistic: The Federal Reserve lowered the discount rate from 6% in 1929 to 1.5% by 1934.

Quote: "Throughout the 1930s, the Federal Reserve did not use its powers aggressively to combat the Depression." - Christina D. Romer, economist and former Chair of the Council of Economic Advisers

Example: The Federal Reserve's decision to purchase government bonds in the open market helped increase the money supply, providing banks with more liquidity and easing credit conditions.

*3. The Good and the Bad: Evaluating the Federal Reserve's Actions*

While the Federal Reserve's policies in the 1920s contributed to the development of the stock market bubble and the subsequent crash, its later actions played a crucial role in helping the economy recover from the Great Depression.

Statistic: The U.S. economy began to show signs of recovery in 1933, with GDP increasing by 10.8% in 1934, 8.9% in 1935, and 12.9% in 1936.

Quote: "The Federal Reserve's actions during the Great Depression can be seen as both a cause and a cure for the economic crisis." - Barry Eichengreen, economist and professor of economics and political science

Example: The Federal Reserve's decision to expand the money supply and lower interest rates in the 1930s contributed to the stabilization of the financial system and the gradual recovery of the U.S. economy.

In conclusion, the Federal Reserve's role during the Great Depression was complex and multifaceted.

The roaring 20s were caused by the federal reserves' low-interest rate environment. This led to investors using margins to invest, which failed and dried up the bank's liquidity.

The Federal Reserve is definitely the biggest reason The Great Depression happened.

But, did they do enough to recover the economy?

They definitely helped stimulate the economy during the mid-1930s. This was because of them finally lowering rates, and increasing the money supply.

This action helped the economy recover and even led to in 1933, the Dow Jones Industrial Average return of 66.7%, which is still the highest annual return ever recorded for the index.

Learning and watching the Federal Reserve's actions is a great way to indicate where our economy was going.

If you saw the rising rates in 1929, you could've thought about shorting the economy as Jesse Livermore did.

Or, when you saw interest rates start to lower in 1933-1934 you could've bought into great companies like Ben Graham!

Always remember, STAY EDUCATED!

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