A Common Fallacy about the Cause of the Great Depression


SmallIvy

Last night my son informed me that his teacher told them that the Great Depression was caused because of an imbalance in the distribution of wealth.  Because only a few people had most of the money, and because they would only buy a few things, the economy was bad.  If the money were distributed to more people, they would buy more goods and we wouldn’t have seen the Great Depression.  This is a similar argument often made by those who believe income redistribution, saying that taxing the wealthy heavily to redistribute their money to more people will create jobs and make the economy stronger since money in more hands will result in more spending.  Well, not so much.

The idea that you need to take money from one group and give it to another is based on the fallacy that the amount of wealth is a fixed.  The supposition is that: If individual A and B each hold 45% of the wealth, individual C can never gain more than 10% of the wealth unless he takes it from individuals A and B.  This is absolutely false.  Wealth is actually created and destroyed every day.  When everyone is working and doing things that are useful to other people, they are creating wealth.  When they are sitting idle, they are not.  When they are using things, they are destroying wealth.

As an example, imagine a village with five people and one house that a man named Bob occupies.  If the amount of wealth is fixed – one house – then the other people could never have a house unless they took it from Bob.  But you know this is not the case, since given a bit of time and the ability to gather the materials (imagine they live in a forest and can cut trees for lumber), they can use their time and physical exertion  to build more houses.  There is no reason that all five of them could not have a house.  There is no limit to the amount of wealth they can create by devoting their time and efforts to creating it.

So what caused the Great Depression (and more recently, the recession of 2008) and why did these two events drag on for so long?  The reason why jobs disappeared in both cases was that people were paying for things with borrowed money, and in doing so were creating a false demand for things.  When the ability to borrow more money disappeared, there was no longer a demand for the many of the things people were producing.  In order for the economy to recover and jobs to be created, people had to change from the things that they were producing before, which were no longer needed, and start producing things that were needed.  For example, maybe they were building yachts during the high times, but soap was more desirable after the crash.

Before the Great Depression, people were using margin to bet on the stock market.  In using margin, you put forth a percentage of the money needed to buy a stock and your brokerage firm lends you the rest of the money, charging you interest.  For example, perhaps you want to buy $10,000 worth of company XYZ, but you only have $5,000.  You therefore borrow $5,000 from your broker at 5% per year interest, combine it with the $5000 you have, and buy the shares.  The person on the other side of the trade now has $10,000 for his shares, even though you only had $5,000 to pay him.  If the price of the shares goes up, you can sell them and repay the brokerage firm with interest, keeping the profit.  If they go down, however, you’ll need to sell and pay the broker back for the money you borrowed, losing money on the deal.

When stocks were going up during the 1920’s, people were able to borrow even more money to buy even more shares.  There also came to be a sense that stocks would go up forever, so it made sense to borrow all that you could since you would always be able to make a profit and pay back the loan.  People also took some of their profits and used the money to buy things, causing jobs to be created to provide those goods and services and corporate profits to rise, causing stocks prices to rise still further.  Because the money being used to buy those shares, however, was not based on anything physical, as soon as people ran out of the ability to borrow they were not able to pay back the loans and share prices tumbled.  As stock prices fell, people lost more wealth and had to sell more shares to pay off loans.  People also stopped buying things because they were scared about their ability to make money in the future, so people who produced things the speculators were buying lost their jobs and factories closed.  This fed on itself as people lost jobs, conserved money and sat idle, not using their time to produce any wealth, so more people lost jobs.  From the peak to the trough, the stock market lost about 90% of its peak valuation.

The recession of 2008 (I refuse to call it the Great Recession since it was nothing compared to the Great Depression, and really not that bad compared to other recessions in the 1970’s) was also caused by borrowed money.  This time, people were borrowing money to buy houses, first as upgrades to their homes and later as speculations, and in doing so caused home prices to rise rapidly.  Because home prices went up, people then borrowed money against their homes to buy things.  Eventually they started using interest only loans (loans in which you pay only the interest each month) and even option ARMs (loans where you pay less than the interest due, so the loan value increases with time) in order to keep borrowing since the payments were too high for them to afford using standard loans, given the high home prices.  When people were no longer able to borrow more money to keep inflating housing prices, the market collapsed.  This time some people also stopped paying on their loans because the value of the house they owned was less than the loan amount, so they felt they were entitled to stop paying even if they were still able to make the payments.  (Never mind all of the vacations included in that loan amount.)

So that’s what caused the drops in the stock market and the loss of jobs, but why was the Great Depression and the recession in 2008 so much longer than most other recessions?  For example, there was another stock market crash in the 1920s that was just as severe, but the economy recovered in about a year.  Likewise, the recession of 2000 caused by the dot-com bubble burst was just as bad as that of 2008, but it was over in three years once President Bush dropped taxes and the Federal Reserve dropped interest rates.

The answer is the response of government to these events.  In the 1930’s, President Roosevelt and the Congress started regulating labor severely.  In order to preserve jobs and because it was felt that getting more money into people’s hands would increase business activity, there were restrictions on wages (minimum wages and specified wages for certain occupations) and it was very difficult to fire people.  There were also all sorts of cost controls and other measures done to “spur the economy.”  This meant you were in great shape if you had a job because it would be secure and your pay would be good, but it was difficult to find a job otherwise because businesses were reluctant to hire – both because they couldn’t pay the wages given the amount of business they had and because it would be difficult to get rid of someone who didn’t work out.  Because people weren’t spending their time producing things, they didn’t have anything to trade to others to encourage them to work as well, so the economy stalled.  The Great Depression ended as we entered War War II and many of these employment restrictions were eliminated to get people back to work to support the war effort.

Likewise, in 2008-2009, Obamacare was passed, just as the recession was just starting to end.  (Note that the stock market fully recovered by 2009.)  This made it much more expensive to hire employees since the employer would need to pay for expensive health insurance for them.  Because employers didn’t need to provide insurance if they had less than 50 full-time workers, the law actually encouraged businesses to stay small or the shrink.  Many businesses laid people off or converted them to part-time to stay under the employment cap.  Other businesses just closed down entirely because they couldn’t make a profit and pay the high insurance costs.

In addition, the implementation of the law was delayed and phased in due to (unconstitutional) executive actions to avoid having mass layoffs and high health insurance taxes levied in the middle of the 2010 and 2012 elections, creating a great deal of uncertainty.  Businesses are reluctant to hire when they don’t know what the cost of labor will be in the future, so the delay of the law and the unpredictable issuance of waivers made businesses to delay hiring and expansion, choosing instead to have current employees work harder and longer hours.

In addition to employers being reluctant to hire, there is little incentive for many people to find a job since the benefits they get from welfare programs provide as much income as many lower-wage jobs.  A driver for this was the long extension of unemployment benefits, meaning people didn’t need to find a new job as quickly as in the past, and so they spent more time idle.  Once unemployment benefit extensions finally ran out, many went to the Social Security Disability program (note that it ran out of money this year and money had to be taken from the retirement program).  With few people working, there is little wealth being created.  While the employment rate is back to historical averages, the economy continues to sputter since many people have just stopped looking for work or are only working part-time.   The less time people spend working, the less they produce and the less there is to trade and get the economy going.

So if you want to become more wealthy, you need to start producing something someone wants.  If there are no jobs available in your field, you get training to learn more desirable fields so that you can produce things that are needed.  If there are no jobs, you start making things and providing services that people want on your own.  If everyone did this, recessions would end quickly.    Wealth is not fixed.  Most people produce all of the wealth they enjoy through their own actions.

Your investing questions are wanted. Please send to vtsioriginal@yahoo.com or leave in a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

5 thoughts on “A Common Fallacy about the Cause of the Great Depression

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  1. Great post, very informative. I too don’t like the phrasing “Great Recession” for the same reasons you state. While unemployment is back to more normal levels the pool of labor is also at historically low levels due to many people just dropping out. I wonder what it would be if those people (minus retirees) were counted.

    1. Thanks for the kind words. I really don’t think it was purposefully deceptive on the part of the teacher. I just think many people don’t understand how an economy works and are easily seduced by ideas like there being a fixed amount of wealth or that because an owner makes $10 M he is taking advantage of his workers. These both sound good on the surface, but fail if you really dig into the details. Part of what I’m trying to do is to get the correct analyses out there so that people can make better economic and political decisions.

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