The 1929 Crash and the Great Depression

What you will learn

• The key dates and index levels of the 1929 crash and the fall to 1932.
• How buying shares with broker loans turned falling prices into forced selling.
• Why bank failures and a shrinking money supply made the depression so deep.
• Which rules and institutions were created afterwards, and what they mean for investors today.

Explanation

The boom and the crash

The Dow Jones Industrial Average (Dow), a price index of large US companies, reached 381.17 points on 3 September 1929. Shortly before, the economist Irving Fisher said that stock prices had reached "what looks like a permanently high plateau". On Thursday 24 October ("Black Thursday") the market opened about 11% lower before bankers organised buying support. On Monday 28 October the Dow fell 12.8%, and on Tuesday 29 October another 11.7%.

The crash was not one event but a three-year decline. The Dow closed at 41.22 on 8 July 1932, about 89% below its peak. It did not regain 381.17 in price terms until 23 November 1954, about 25 years later. Including dividends and the fall in consumer prices, a buyer at the peak recovered sooner in real terms, which is a good example of the distortions from lesson 1.

Broker loans

Many investors bought on margin: they paid part of the price and borrowed the rest from their broker, using the shares as security. By August 1929 brokers were lending small investors more than two-thirds of the value of the shares they bought. When prices fell, brokers demanded more money (a margin call) or sold the shares. Forced sales pushed prices lower, which triggered more margin calls. Margin mechanics are explained in the Risk Management course; here you see their effect on a whole market.

From crash to depression

A stock market crash alone does not create a depression. What made the 1930s so severe was the banking system. From 1930 onwards a series of bank runs (many depositors withdrawing money at once) spread across the United States, and more than 1,000 banks closed in each year from 1930 to 1933. There was no federal deposit insurance, so savers lost money and others withdrew cash in fear. The money supply fell sharply (by roughly a third, according to the classic study by Milton Friedman and Anna Schwartz), and the Federal Reserve did not act forcefully to stop it. Between 1929 and 1933 output fell by about one-third, unemployment reached about 25%, and consumer prices fell by about a quarter. Falling prices (deflation) made existing debts heavier in real terms, which caused more defaults.

What changed afterwards

• The Banking Act of 1933 (often called Glass–Steagall) separated commercial banking from investment banking and created federal deposit insurance.
• The Securities Act of 1933 and the Securities Exchange Act of 1934 required company disclosure, banned market manipulation and created the Securities and Exchange Commission (SEC), the US market regulator.
• Central banks learned that letting the banking system and money supply collapse deepens a crisis, a lesson applied in 2008 and 2020 (part B of this course).

Worked example

Hypothetical example: an investor in 1929 buys shares worth $10,000, paying $3,000 of his own money and borrowing $7,000 from the broker. The broker requires the investor's equity (share value minus loan) to stay at least 25% of the share value. Interest, fees and taxes are excluded.

The call starts when equity equals 25% of value: V − 7,000 = 0.25 × V, so V ≈ $9,333, a fall of only about 6.7%. A fall of 30% erases the investor's own money. The Dow fell 12.8% and 11.7% on two consecutive days, so many such accounts were closed within 48 hours. An unleveraged investor with $3,000 who held through the full 89% decline would have had about $3,000 × (41.22 ÷ 381.17) ≈ $324 left, a terrible loss but with the possibility of recovery. The leveraged investor was forced out near the start.

Common mistake

Practice activity

On paper: a hypothetical investor buys shares for $20,000 with $8,000 of her own money and a $12,000 loan. Minimum equity is 25% of the share value. (a) At what share value does the margin call start? What price fall is that? (b) What fall wipes out her equity? (c) Compare: how much would $8,000 without a loan be worth after an 89% fall?

Key takeaways

• The Dow fell about 89% from September 1929 to July 1932 and needed until 1954 to regain its peak in price terms.
• Broker loans turned falling prices into forced selling and wiped out leveraged investors early in the decline.
• Bank failures, a shrinking money supply and deflation turned the crash into the Great Depression.
• Deposit insurance, disclosure rules and a market regulator were direct responses to 1929–33.

Next step

The next lesson moves to Germany and the opposite monetary disaster: the hyperinflation of 1923.