Revisiting the US Stock Market Crash of 1929 — Cause of the Great Depression?

The stock market crash of 1929 marks an abrupt end to the United States’ roaring twenties, which is characterised by a decade of consumption and industrial growth. Following the stock market crash in 1929, the economy suffered from a decline in economic activity, as output and consumption levels fell significantly. 29% of the country’s real GNP disappeared between 1929–1933, while consumption fell by 18%. The subsequent period of economic contraction has been considered by some as a direct consequence of the crash. Others, however, have attributed the recession to the failure of financial markets in providing necessary credit and liquidity. This essay seeks to evaluate the different views that have emerged from the discussions and reflect upon the relationship between the two events. This essay will conclude by arguing that whilst the stock market crash of 1929 itself is not the sole cause of the Great Depression, it altered public expectations significantly, restricted consumption and investment as a result, and played an equally major role as monetary policy in leading to the Great Depression.

Although the October crash of 1929 saw the Dow Jones Industrial average fall by 36 per cent,[1] its effects on personal wealth was limited. Only 8% of the population held stocks at the time,[2] which meant that the drastic plunge in stock prices itself had little impact towards general income levels on a microeconomic level. Given that the general population’s ability to spend remained intact and unharmed by stock performances, how could the crash have impacted consumption and investment levels so dramatically?

According to Romer, consumption fell because future income was clouded by uncertainty as a result to the change in expectations following the collapse of stock prices that began in October 1929. She argues that the temporal uncertainty significantly impacted economic decisions, and led consumers as a whole to forgo purchases of durable goods.[3] The rationale behind her argument can be understood as follows. Unlike perishable goods, durable goods are purchases that stay with the consumer for the long term. Individuals would purchase a new car, for instance, then pay in instalments or incur the regular expenses in fuel and maintenance. Thus, depending on the individual’s future income, the car that was bought would either be too expensive or too inferior relative to the individuals’ income status. It follows that uncertainty in one’s future income would encourage consumers to postpone spending decisions on durable goods until the uncertainty is cleared. Similarly, producers delay investment decisions to purchase durable goods such as equipment for their businesses until they are more confident and certain about the outlook of the economy. As Romer points out in her paper, 4 out of 5 major business forecasters including Moody’s Investor Service and The Magazine of Wall Street became openly uncertain in their economic forecasts following the crash, which demonstrates the degree in which economic uncertainty dominated public sentiment at the time.

This model provides important theoretical grounding to account for the relationship between the stock market crash and the change in consumption levels. As shown in figures 1 and 2, output and consumer spending on durable goods such as automobiles fell dramatically between October 1929 and 1930. Notably, spending on perishable goods declined less significantly as seen by sales figures from ten-cent stores. This can be understood by the fact that individuals benefited from more wealth available from postponing consumption of durable goods to spend on perishable goods, which are nondurable purchases that do not themselves incur regular expenses.

Figure 1: Cumulative % Change in Consumer Spending (Romer, 1990)
Figure 2: % change in real output of consumer goods (Romer, 1990)

Romer provides further empirical evidence, as shown in figure 4, by running an econometric test on the relationship between consumer goods output and stock market fluctuations using the equation in figure 3 and sample data in the years leading up to the crash (periods 1891–1913 and 1921–1928). As shown, for the output of consumer durables, di (the coefficient estimate of Vt) is negative and statistically significant. It suggests that greater stock market volatility, i.e. wider variations between positive and negative movements weakens the output of consumer durable goods. The statistical evidence supports the argument that increased immediate uncertainty (as a result to increased stock market volatility that began in 1929) led consumers to forgo consumption of durable goods, which in turn reduced economic output.

Figure 3: Equation and variables for econometric test for uncertainty (Romer, 1990)
Figure 4: Results of econometric test for uncertainty (Romer, 1990)

Whilst the stock market crash itself was discussed extensively within Romer’s work, it is worth noting that it is not necessarily the crash itself that raised uncertainty, but the increased volatility in stock prices, which began with the crash of 1929. This aspect of Romer’s work is further explored by Ferderer and Zalweski who studied the behaviour of risk premiums at the time of the crash, which reflect confidence levels and expectations. As shown in figure 5, it could be observed that following the crash, the immediate rise of risk premiums was relatively small, which suggests only a gradual rise in the public’s sense of uncertainty. However, it also marked the beginning of a steep and continual rise in the risk premium leading up to early 1932. This suggests that the uncertainty is not a result of an isolated event but the “cumulative effect of a series of events that reinforce and magnify one another that produces uncertainty”.[4] Thus, despite earlier conclusions regarding the effects of uncertainty on consumption and investment created since the stock market crash, changes to aggregate demand should be understood by interpreting the effects of the stock-market crash in conjunction with other discreet events such as the banking crises of 1930 (C1 on figure 5) and 1931 (C2 on figure 5). This ties into the proceeding analysis of the role of monetary policy in preventing bank suspensions during the banking crises.

Figure 5: Risk premium 1929–1940 (Ferderer and Zalewski, 1994)

In contrary to Romer, who sought to explain the great depression by focusing on the decline in consumption, others such as Friedman and Schwartz have looked to alternative explanations based on monetary factors. They argue that restrictive monetary policy is considered as the cause of the recession’s significant decline in economic activity. Under the monetary view, the stock market crash of 1929 is at most considered as a by-product of tight money supply.

As White points out, the US stock market became an alternative source of financing in the 1920s as a result to regulations that barred commercial banks from providing large long-term loans to firms.[5] Equally, such regulations played a key role in aggravating the economic downturn as the Federal Reserve made no open market purchases and supressed borrowing and bank loans during the great depression. With the lack of credit and liquidity, firms are unable to sustain and finance their regular consumption and investments, meaning decline in economic activity could only continue between 1929–1933.

Evidence from Mississippi provides an illuminating account of the role of tight monetary policy in limiting economic activity in the United States. As one of the few states that were divided amongst two Federal Reserve districts as shown in figure 6, different portions of Mississippi (i.e. northern and southern portions) were governed separately by the St. Louis and Atlanta Feds, which applied different policies to the area lying within their jurisdiction. Using the relevant economic data from both districts, the effects of the different monetary policies are clear. As shown in figure 6, there were less banks suspensions in the 6th Federal Reserve District where the Atlanta Fed injected liquidity into the banking system following Bagehot’s rule to act as a lender of last resort, whilst more banks were suspended in the 8th Federal Reserve District where the St. Louis Fed adhered to the Real Bill view that credit should contract during a recession.[6] Restrictive monetary policy in the 6th Federal Reserve District also resulted in a less significant decline in wholesale trade as shown in figure 7. In contrary, the percentage decrease in the number of wholesale firms and sales between 1929–1933 is more significant in the 8th Federal Reserve District. Without money supply from the Fed, banks and businesses suffered from the lack of monetary support that is necessary to sustain their economic activities during a downturn. This study provides clear quantitative evidence on the impact of tight money supply in causing increased downward pressure on economic activity during the recession.

Figure 6: Juridical division of Mississippi (Richardson et. al., 2009)
Figure 7: Comparing decline in economic activity (Richardson et. al., 2009)

Notably, the restrictive provision of credit has been prevalent through non-monetary channels. In particular, Bernanke drew our focus on the role of Cost of Credit Intermediation (CCI), arguing that the disruption of 1930–33 increased the CCI and reduced the effectiveness of the banking sector in performing intermediation services between borrowers and lenders. Lenders, for instance, are unable to identify good borrowers from bad borrowers as risk of default (and relevant costs) increased during the recession. As a result, banks reduced loans and credit supplied to households, farmers and small businesses.[7] Building upon Friedman and Schwartz’s theoretical grounding, Bernanke offers an alternative account of how credit, money supply and consequently business investment became limited.

The evidence thus far show that on one hand, the stock market crash did increase income and economic uncertainty, and lead to postponed consumption and investment decisions, thus a reduction in economic output. On the other, the great depression could also be attributed to tight monetary policy, which restricted growth and economic activity. The final part of the essay will consider the empirical work conducted by Cecchetti and Karras, whose conclusions combine and synthesise explanations from both sides. Using an econometric model, their paper decomposes output and account for output movements separately in relation to aggregate supply shocks, money supply shocks, money demand shocks and IS (nonmonetary aggregate demand) shocks.[8] The findings as shown in figure 8, gives the fraction of the change in output due to the 4 separate factors.

Figure 8: Decomposition of Output Fluctuations (Cecchetti and Karras, 1994)

Cecchetti and Karras concludes that during the initial downturn (from October 1929 to December 1931), money supply shocks and IS shocks are equally (and solely) responsible for movements in output, accounting for 59.8% and 45.5% of the change in output respectively. This supports the view that both the monetary view (concerned with money supply shock) and Romer’s argument (concerned with IS shock as a result to the uncertainty that began with the crash) should be equally accepted.

To conclude, the stock market crash of 1929 itself did not lead to the Great Depression. Nonetheless, it generated the beginning of a continual rise of uncertainty throughout 1929–1932, which had a detrimental impact on consumption and investment behaviour. This was coupled with restrictive monetary supply that was perpetuated through both monetary and non-monetary channels. Jointly, these events led to a cumulative negative effect on economic output and depressed overall economic activity.


[1] George Soros, “After Black Mondy”, Foreign Policy, 70/1 (1988), p.65.

[2] George D. Green, “The Economic Impact of the Stock Market Boom and Crash of 1929”, paper presented to the Federal Reserve bank of Boston (1971), p.198.

[3] Christina D. Romer, “The Great Crash and the Onset of the Great Depression”, The Quarterly Journal of Economics, 105/3 (1990), p.597.

[4] J. Peter Ferderer and David A. Zalewski, “Uncertainty as a Propagating Force in The Great Depression”, The Journal of Economic History, 54/4 (1994), p. 833.

[5] Eugene N. White, “The Stock Market Boom and Crash of 1929 Revisited”, The Journal of Economic Perspectives, 4/2 (1990), p.69.

[6] Gary Richardson and William Troost, “Monetary Intervention Mitigated Banking Panics during the Great Depression: Quasi‐Experimental Evidence from a Federal Reserve District Border, 1929–1933”, Journal of Political Economy, 117/6 (2009), p.1068.

[7] Ben S. Bernanke, “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression”, The American Economic Review, 73/3 (1983), p.257.

[8] Stephen G. Cecchetti and Georgios Karras, “Sources of Output Fluctuations During the Interwar Period: Further Evidence on the Causes of the Great Depression”, The Review of Economics and Statistics, 76/1 (1994), pp.81–83.

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