The sharp break in stock prices last fall appropriately compelled
a reassessment of economic prospects for the year ahead. In some quarters,
analysis has gone beyond mere reassessment to raise fundamental issues
about the likelihood of repeating the Great Depression of the 1930s.
The specter of the Great Depression, together with the stock market
crash of October 19, 1987, has understandably raised concern about
the possibility of another major economic collapse. This concern merits
close and sober scrutiny because of the potential to misunderstand
what happened during the earlier episode and, in turn, to devise ineffective
and inappropriate policy responses. More constructively, proper perspective
on 1929 should be valuable in determining the policy course for 1988
In This Essay
To attain this perspective, we first review the experience of the
October 1929 market Crash and of the Great Depression with the intent
of portraying a comprehensive picture. With this picture in place, alternative
explanations of the Depression can be considered to reach some tentative
conclusions about the relative merits of these explanations. Having
identified significant factors which contributed to the economic collapse,
an attempt is made to relate them to current circumstances and developments
as a guide to policies to pursue or avoid. It should be emphasized that,
while the review of the 1929 Crash and the Depression identifies policy
errors, both of commission and omission, avoidance of such errors does
not assure satisfactory economic performance in the year ahead. The
cyclical and institutional setting today is obviously much different
from 1929, so that assistance from even a deep and complete understanding
of that earlier episode is limited. Indeed, a review of the situation
raises concerns about some of the fundamentals of our current economic
circumstances and reemphasizes the value of pursuing, here and abroad,
sound and consistent macroeconomic policies.
The conclusion underscores the principal policy recommendations which
emerge. These include:
- maintaining the stability of the banking system;
- supporting normal credit extension practices and smoothly functioning
- assuring adequate growth of the money supply; and
- sustaining and enhancing international trade.
These recommendations, although in many ways unremarkable, may well
prove difficult to implement. Inherent competition among various economic
objectives, such as price stability, income stability, income equity,
and economic growth, as well as disagreements about the correct way
to achieve these goals, will provide a formidable challenge.
Even today, evidence on the Great Depression is not so conclusive
as to permit wholly objective and unequivocal interpretation. Therefore,
this essay is sometimes highly subjective. Moreover, in discussing current
circumstances, one necessarily must be selective and put aside a number
of interesting issues. The essay does not, for example, delve into the
causes of the October 1987 decline in stock prices nor attempt to assess
how well the markets performed during that experience. These topics
are taken up at length in the Report of the Presidential Task
Force on Market Mechanisms (the Brady Commission report). Rather,
we attempt here to present a policy maker's view of the lessons of the
Crash of October 1929 and the Great Depression and how they can be applied
in the aftermath of the stock price collapse of October 1987.
The Course of the Great Depression
The October 1987 collapse in stock prices conjured visions of 1929
and the Great Depression. Focus on this period is natural because the
32 percent decline in stock values between the market closes of October
13 and 19, 1987, was of the magnitude ofindeed, it actually exceededthe
October 1929 debacle. Focus on this period is also appropriate because,
despite all that has been learned since to help assure economic stability,
we cannot be completely confident that history will not repeat itself.
Consequently, this first section reviews events of the Depression era.
The stock market Crash of October 1929 is frequently credited with
triggering the Depression. The decline was severe and extended; from
their peak in September 1929, stock prices declined by 87 percent to
their trough in 1932. The performance of the economy over this period
was equally disheartening. Real economic activity declined by about
one-third between 1929 and 1933; unemployment climbed to 25 percent
of the labor force; prices in the aggregate dropped by more than 25
percent; the money supply contracted by over 30 percent; and close to
10,000 banks suspended operations. Given this performance, it is not
surprising that many consider these years the worst economic trauma
in the nation's history.
Policy makers did not stand idly by as the financial markets and the
economy unraveled. There are questions, though, about the appropriateness
and magnitude of their responses. Monetary policy, determined and conducted
then, as now, by the Federal Reserve, became restrictive early in 1928,
as Federal Reserve officials grew increasingly concerned about the rapid
pace of credit expansion, some of which was fueling stock market speculation.
This policy stance essentially was maintained until the stock market
While there has been much criticism of Federal Reserve policy in the
Depression, its initial reaction to the October 1929 drop in stock values
appears fully appropriate. Between October 1929 and February 1930, the
discount rate was reduced from 6 to 4 percent. The money supply jumped
in the immediate aftermath of the Crash, as commercial banks in New
York made loans to securities brokers and dealers in volume. Such funding
satisfied the heightened liquidity demands of nonfinancial corporations
and others that had been financing broker-dealers prior to the Crash
and, of course, it helped securities firms maintain normal activities
The increase in required reserves, which necessarily accompanied the
bulge in the money supply resulting from the surge in bank lending to
securities firms, was met in part by sizable open market purchases of
U.S. government securities by the New York Federal Reserve Bank and
by discount window borrowing by New York commercial banks. According
to a senior official of the New York Fed at the time, that bank kept
its "discount window wide open and let it be known that member banks
might borrow freely to establish the reserves required against the large
increase in deposits resulting from the taking over of loans called
by others." As a consequence, the sharp run-up in short-term interest
rates that had characterized previous financial crises was avoided in
this case. Money market rates generally declined in the first few months
following October 1929.
By the spring of 1930, however, the distinctly easier monetary policy
that had characterized the Federal Reserve's response to the stock market
decline ended. Subsequent policy is more difficult to describe concisely.
Open market purchases of government securities became very modest until
large purchases were made in 1932. Further, although the discount rate
was reduced between March 1930 and September 1931, it then was raised
on two occasions late that year before falling back once again in 1932.
While the direction of monetary policy was somewhat ambiguous over
this period, what happened in financial markets was not. Three severe
banking panics occurred, the first in late 1930, another in the spring
of 1931, and the final crisis in March 1933. Overall, close to 10,000
banks suspended activity. And in the absence of significant efforts
to offset these failures, the money supply (of which 92 percent consisted
of bank deposits) fell by 31 percent between 1929 and 1933.
Unlike monetary policy and related financial disturbances, fiscal
policy did not play a particularly significant role during the Depression.
Federal government spending, including transfer payments, was small
before and during the 1929-1933 period. Moreover, changes in tax and
spending policies, and resulting fluctuations in the budget deficit,
were generally minor. Perhaps fiscal policy could have done more to
combat the Depression; in the event, it was not a major factor.
Causes of the Depression
There is not, at this point, anything approaching a consensus on the
causes of the depth and duration of the Depression. With the passage
of time, the Keynesian view that an inexplicable contraction in spendingbusiness
investment and personal consumptionled to the collapse in economic
activity has fallen into disfavor. A contraction in spending did of
course occur, but showing that the decline was a cause rather than a
reaction to a deeper economic malady is difficult.
Some claim the stock market collapse of October 1929 was the cause
of the spending contraction, but the evidence is suspect. Quantitatively,
the decline in share values, large and persistent as it was during the
Depression, does not seem sufficient to generate a downturn in the economy
of the scope of 1929-1933, even given the psychological trauma of the
stock market Crash. Furthermore, the economy in fact peaked in August
1929, two months before the severe decline in stock prices, suggesting
that causality may well have run from economic weakness to stock prices,
rather than vice versa.
The Monetarist View
Monetary factors currently dominate thinking about the causes of the
Depression. The conventional wisdom, if there is such a thing, attributes
the severity and extent of the Depression to monetary policy mismanagement,
and credits the Federal Reserve with turning a "garden variety" recession
into something much worse. There remains, however, considerable dispute
about this conclusion.
The pronounced decline in the money supply between 1929 and 1933,
alluded to earlier, is given a preeminent role in the monetarist explanation
of the Depression. The argument is that, as an empirical matter, the
money stock is a significant determinant of economic developments. Its
fall during the Depression, coupled with a predictable decline in velocity,
led to the sharp contraction in output and nominal income, and the extraordinary
climb in unemployment. Consequently, had the Federal Reserve been aggressively
expansionary, so that growth in the money stock was maintained during
the period, the fall in economic activity could have been moderated
This monetarist explanation of the Depression has many adherents,
but nevertheless questions remain. More rapid growth in money may well
have been offset by an even more precipitous decline in velocity during
the Depression, so that the economy's path may not have changed as a
consequence. That is, if the downturn in business activity were determined
largely by nonmonetary factors, more money growth would not necessarily
have ameliorated the problem. "You can lead a horse to water, but you
can't make him drink" is often quoted by those who question the monetarist
interpretation of Fed policy.
In addition, the monetarist explanation does not explicitly specify
the channels through which changes in the money stock affect economic
activity. Presumably, when money is in short supply relative to demand,
there will be upward pressure on interest rates that will curtail consumer
and business spending, as well as money demand. This process helps to
equilibrate the money market and also implies a slowing in the economy.
But it is arguable if this pattern fits events during the Depression
all that well; market interest rates did not rise appreciably until
the latter half of 1931, when the decline in the economy was already
well under way. Moreover, the monetarist explanation is subject to the
same objection raised to the Keynesian view. It is not clear if the
contraction of the money supply was a cause of, or reaction to, economic
In contradistinction to emphasis on the money supply, a third school
of thought, which gives considerable weight to financial matters in
explaining the Depression, focuses on banking panics and the consequences
of the multitude of bank failures that occurred throughout the period.
It is not, however, that some bank creditors and owners lost their investments,
but rather that loans were called by banks experiencing liquidity and
solvency problems and, in a significant number of cases, borrowers could
not readily replace the funding. In these instances, such borrowers,
although perhaps fully credit-worthy, would have had to curtail activities
to adjust to the diminution in financing. Depending on circumstances,
such a curtailment in credit could translate into reductions in orders,
employment, and output that contribute to a prolonged downward spiral
in economic activity.
Emphasis on contraction in financial intermediation and mounting banking
problems is intuitively plausible, if not fully convincing. Such emphasis
provides a more likely channel of influence than focus on the money
supply "per se." Without question there were banking crises and closures
during the Depression, and it would not have been surprising if bankers
adopted very conservative lending policies in the wake of the Crash
and the first signs of weakness in business activity. There can be little
doubt that the Crash undermined confidence and instilled a far more
conservative attitude. There is, moreover, some empirical evidence which
can be interpreted as indicative of the significance of banking deterioration
in explaining the depth of the 1929-1933 malaise, but the evidence at
this stage is not overwhelming.
To this point in the essay the international dimensions of the Depression
have been largely ignored. But the Depression was a global phenomenon.
The international monetary system of the timethe gold exchange
standardwas a fixed-rate system which meant that, as long as the
rules were observed, economic conditions in various countries would
be closely related. Hence, problems in one large economy would be transmitted
to others and, ultimately, could feed back to exacerbate difficulties
in the country of origin.
Further, the severity of the Depression was in all likelihood magnified
by the Smoot-Hawley tariff imposed by the United States in 1930, and
similar beggar-thy-neighbor policies adopted by other countries
in response to U.S. policy. Imposition of such trade barriers and the
resulting constriction of international trade appear to have contributed
to the worldwide reduction in employment and output. While protectionism,
in and of itself, may not have caused the Depression, it was clearly
a contributory factor.
Several conclusions stand out from the 1929-1933 period and the research
devoted to it. First, it seems unlikely that a break in stock prices,
even a severe one, is sufficient to send the economy into depression.
The history of 1929-1933 suggests that the collapse of stock values,
although possibly a trigger mechanism, was not central to the sustained
downward spiral in business activity. Subsequent empirical research
has indicated that, while changes in equity prices have significant
wealth effects on consumer spending, such effects are not so large as
to produce the 1929-1933 pattern.
Second, explanations of the Depression which emphasize financial factors
are the most convincing. The trade restrictions of Smoot-Hawley and
"beggar-thy-neighbor" policies more generally were contributors to the
Great Depression, but probably not the major cause. Although a collapse
in international trade can have serious adverse consequences for the
level of economic activity, emphasis on trade barriers alone fails to
come to grips with the collapse of domestic demand which characterized
the period. While Keynesian explanations focus on weakness in demand,
they are also suspect. Whether the weakness was the cause of the economic
downturn or a result of a deeper problem is unclear.
The third conclusion, though, is that even financial explanations
are not complete. It is not clear whether it was the persistent decline
in the money stock and its velocity that so disrupted economic activity
or, rather, the series of banking panics in those years that undermined
confidence and resulted in the loss of many institutions and the contraction
of credit for viable businesses and households. Reports of conditions
during the Depression and subsequent research do not as yet enable adequate
discrimination between these alternative financial explanations; it
is probably wise to allow for the veracity of both at this stage.
October 1987: Deja Vu All Over Again
The events of autumn 1987 can be weighed against the history of the
early 1930s. On the financial side, there are some striking similarities
between October 1929 (and its immediate aftermath) and October 1987.
In the words of the Brady Commission,
From the close of trading Tuesday, October 13, 1987 to the close
of trading Monday, October 19, the Dow Jones Industrial Average declined
by almost one third, representing a loss in value of all outstanding
United States stocks of approximately $1.0 trillion.
What made this market break extraordinary was the speed with which
prices fell, the unprecedented volume of trading and the consequent
threat to the financial system.
The fall in the stock market, as well as the tenor of the declineOctober
1929 was the Crash, after allwas comparable in the two cases.
Moreover, the Federal Reserve responded to the crises in basically
the same manner. The central bank aggressively supplied liquidity through
open market purchase of U.S. government securities, adding $2.2 billion
in nonborrowed reserves between the reserve periods ended October 7
and November 4. The Fed also made it clear to commercial banks that
the discount window was available should they encounter unusually heavy
reserve needs. On October 20, the day after the 508-point decline in
the Dow, these actions were accompanied by a statement of Alan Greenspan,
Chairman of the Board of Governors, indicating the System's intentions:
The Federal Reserve, consistent with its responsibilities as the
nation's central bank, affirmed today its readiness to serve as a source
of liquidity to support the economic and financial system. The
Federal Open Market Committee, the key monetary policy group in the
System, met daily via telephone conference call until October 30.
In the event, interest rates on short- and long-term instruments dropped
in the wake of the more generous provision of liquidity. For example,
the rate on three-month Treasury bills dropped from 6.74 percent on
October 13 to 5.27 percent October 30, the federal funds rate declined
by 179 basis points over this interval, and the rate on 30-year Treasury
bonds fell from 9.92 percent to 9.03.
And after some initial hesitation, bank lending to securities firms
expanded substantially during the week of October 19-23. Thus, firms
were able to finance the inventories of securities accumulated as they
satisfied their customers' sell orders.
As described above, aggressive open market purchases had been a hallmark
of the response to October 1929 as well. Moreover, the money supply
bulged in October 1987 as it had in 1929. Nevertheless, in both cases
investor preferences for safe and liquid investments increased as noted
by a distinct widening of interest rate spreads.
Policies for Future Stability
To this point, a cumulative downward spiral in today's business activity
and in prices has been avoided. Indeed, the resilience of the economy,
in the face of the enormous drop in stock values, has been impressive.
A key issue, however, is selection of policies that will maintain the
worldwide economic expansion and simultaneously extend the moderation
in inflation that has been achieved. And while there may be intellectual
agreement on at least some of the policies that should be adopted to
further these ends, implementation may prove difficult because of inherent
competition, if not conflict, among objectives.
A consensus has been building in recent years in favor of reducing
substantially the United States' federal budget deficit, particularly
if better balance in currency values and worldwide trade flows is to
be achieved. To be sure, in view of both the negative wealth effects
associated with the drop in stock values and the reductions to the outlook
made by most forecasters, some may feel that this is not an ideal time
to take major actions toward fiscal restraint. However, the risks of
such steps should not be exaggerated, as the lower interest rates resulting
from budget restraint could offset much of the drag otherwise applied
to the economy. And as a practical matter, it is unlikely that fiscal
policy makers will go too far too fast in the direction of restraint.
The lessons of history, together with recent evidence of improvement
in our foreign trade performance, suggest the overwhelming desirability
of avoiding protectionist legislation in current circumstances, particularly
if it would provoke retaliation from some of our major trading partners.
In the long run, moreover, protectionism is likely to make our domestic
industries less rather than more competitive. But this recommendation
in favor of free trade conflicts with some business and labor sentiment
that competition in the prevailing institutional setting is unfairly
tilted in favor of foreign producers. Despite the merits of open markets,
it is not a foregone conclusion that we will even maintain those that
In the financial sphere, the gap between recommendation and implementation
is perhaps even wider. As discussed above, the experience of 1929-1933
suggests that allowing appreciable declines in the money supply may
be very costly. To be sure, the Depression years do not unequivocally
demonstrate that the decline in money was a principal cause of the economic
collapse, but they do suggest that there are material risks in permitting
such weakness in money. It follows, then, that the Federal Reserve should
be sufficiently accommodative to sustain growth in the money stock.
Unfortunately, this recommendation may conflict with the objective
of maintaining the international value of the dollar or even the more
humble goal of promoting stability in the foreign exchange market. That
is, there may be little room to encourage growth in money without simultaneously
triggering a flight from the dollar. More fundamentally, such a policy
course could contribute to a reacceleration of inflation, and thus could
risk compromising price stability, the paramount long-run objective
of monetary policy.
The Depression also illustrates the risks to the general economy of
banking crises and, of course, the safety net underpinning the banking
system was materially strengthened, with the introduction of deposit
insurance, as a consequence. Although the number of bank failures has
increased in recent years, the situation cannot accurately be described
as a panic, and such a development seems highly unlikely in view of
the safety net in place and the Federal Reserve's commitment to the
safety and soundness of the banking system.
Nevertheless, we should not be overly sanguine about the financial
situation. It is one thing to maintain banks and other financial institutions
as viable entitiesit is another to see to it that they continue
to provide services in their normal fashion and that financing remains
available to creditworthy customers at reasonable terms. Achieving this
latter objective may be more difficult than preventing bank runs or
containing bank failures. Confidence is key; lenders must be reasonably
sure, before they commit funds, that sound economic policies will be
pursued and that the environment will give customers an opportunity
Policy makers, of course, can try to assure bankers of this outcome,
but ultimately it is their actions, and the resulting performance of
the economy, that matter. This observation is just another way of saying
that the financial system works best when sound and stable policies
are pursued, and when market participants and business people can count
on such policies. As such, this recommendation is unremarkable, but
may prove far easier to state than to achieve.
On the surface at least, there are striking similarities between events
of October 1929 and October 1987. The traumatic severity of the decline
in equity values, the initial response of the Federal Reserve in terms
of discount window access and open market provision of reserves, and
the response of interest rates and quality spreads bear close resemblance
in the two episodes. Given the way 1929 played out, these observations
are not comforting.
Nevertheless, the similarities should not be exaggerated. The economy
today is quite differentinstitutionally, structurally, cyclicallyfrom
that of 1929. A contraction in economic activity was under way prior
to the market debacle of October 1929. In contrast, the cyclical expansion
in business that followed the recession of 1981-1982 remains intact
today. Moreover, examination of the Depression years can help us to
identify policies that minimize the risk of a slowdown in economic activity
and to avoid the major errors of the past. In this regard, the principal
recommendations that emerge from our admittedly subjective review of
- maintain our commitment to the stability of the banking system
through judicious use of the federal safety net of deposit insurance
and the discount window;
- support normal credit extension by banks and, more generally, smoothly
functioning financial institutions and markets through stable and
credible macroeconomic policies;
- provide adequate growth in the money supply consistent with prevailing
economic circumstances worldwide; and
- promote open markets for the international trade of goods and services.
Such a list of policy recommendations may seem unremarkable, in part
because the lessons of the past already have been taken to heart. Achievement,
however, is likely to prove a challenge.