Stock market crash = Where's my loonie?

[brittanymartinat]

:-/Ok so i really dont nderstand how a economic depression can happen. I mean i know what we talked about in class with the stock market crash, people losing money and what not but it doesnt make sense to me. I know im going to over-simplify here but just humour me for a minute . If Mr. Delainey has a chocolate bar and sells it to me for a loonie the loonie that i had, now Mr. Delainey has. If he goes to the store and buys a pop with that loonie, the loonie goes into the cash register and maybe goes to say i dont know, pay one of the store's employees. now the employee who was paid has the loonie. You see? Money cant be gone because it is never gone it just changes hands. Now say the 1930's depression comes about and all of a sudden that loonie is gone? how is it gone? someone must have it. Where is my loonie?

[Mr. Delainey]

You are correct by observing the money is still in circulation (to a degree). However, not all "Canadian" money stays in Canada. There are countries--like China for example--that actually collect Canadian currency because it is so strong right now. This is called currency speculation. You can buy and trade currency based on the fact that the value of that currency goes up and down. Buy low, sell high.

In terms of the Great Depression, the fundamental problem wasn't money supply. The real problem was access to credit. One of the causes of the Stock Market Crash (1929) was the fact that people were buying and trading bogus companies, i.e. Usually you'd expect a company to actually make something, yes? Well, not every company selling stock on the exchange actually made anything. Instead, your investments would go into someone's pocket, someone who may or may not actual establish a factory, etc.

People discovered that there were a lot of bogus companies selling stock. Consequently, people lost confidence in the stock market and tried to dump their stock at the same time. This led to a general collapse of the market. And with the collapse banks became reluctant to give loans (credit). You need credit (often) to start new businesses because the physical money supply possessed by an individual will often not be enough to cover the costs of starting a new business.

So to answer your question: although there's lots of money in circulation the majority of money is not in the hands of individuals...it is in the hands of people. Credit is important and essential because it is used to concentrate/focus wealth into the hands of an individual called an entrepreneur (who is willing to accept the risks/benefits of establishing a business).

Hope that helps. It's ultimately a case (I think) of credit creating concentration whereas money supply is dispersed.

[brittanymartinat]

So in other words what your saying is that the money wasnt gone. It was in the pocket of some rich guy who set up a scam company? I guess that makes sense. If the problem was that all the bogus companies ( i.e the pyramid scam ) were being set up and thats where everyones money was going via the stock market, so the "head"s of these scams were pocketing everyones money, then it makes sense that people would lose trust in the stock market, because that was the "tool" that these criminals were using to steal the money. so i guess consequently the people tried to protect their money by pulling it out of the stock market (via selling all their stock). So no stock holders to buy and sell = no stock market...ok.
So if thats the case then i guess if people are not trusting enough to invest in stock then why would they be trusting enough to buy or invest in other purchases yes? for fear of a repeat performance.
So if noone is buying
anything because they are not trusting others with their money, then nothing is being sold. When nothing is sold, people cant pay all of their employees, therefore they have to lay people off. This leads to unemployment. And of course the banks cant miss out on any of the action so you could be sure that they've heard what has happened and that no one has a job. therefore no one could make loan payments honestly and so since the bank are not going to give their money away (bankers have to make a living too.) the banks become very reluctant to give out loans and credit. ok that makes sense. and people are not just going to start spending again with no job. as much as a worker would want the economy stimulated, when it comes down to that or putting food on the table... well... ok im sorry if this was long or
too step by step but im just trying to get a firm undrstanding. ive been wondering about this for 2 years or more so... yeah .

[David Delainey]

Hi everyone, you have asked some very insightful questions. There are a number of discrete themes within your post. What caused the Depression? What is money? How did the Stock Market Crash cause or contribute to the overall malaise for the next decade?

I will break this into pieces - What is money? Firstly, the bills and coin in circulation is only a very small part of the money supply of a nation. The Bank of Canada calls this M1. A much much larger quantity of the "money supply" (M2, M3, etc) is more illusionary and really only exists as a debit or a credit on a piece of paper or on a computer. More specifically, your bank accounts, credit cards, letters of credit, bank loans, even PayPal, etc.

As an interesting aside, if everyone went to their bank tomorrow and asked to have all their "money" out of the bank and converted to bills - they couldn't do it! There is not enough paper money to make this happen. When people lose faith in banks and demand their money this is called a "run on the bank" and can often result in the bank going bankrupt. Another interesting point, is that under banking law, to protect against a run on the bank, if you go to your bank to convert your account to paper currency technically they don't have to do it immediately they can take several days to facilitate your request.

As a result, the nation's money supply is managed by the banking system and it grows and contracts with the policies of the banking community and with central bank policy. Thus a central bank, like the Bank of Canada or the Fed in the US, can increase or decrease the money supply through a variety of complex maneouvres which essentially allow the banking industry to lend more or less or by forcing the banks to hold more or less reserves backing up their loans. As perhaps, you can now appreciate a nation's overall money supply can grow and contract significantly given economic and banking policies while the amount of coin and bills in circulation do not change.

Money itself adds nothing to the real economy - the production and consumption of goods and services. It is only a fiat to allow for the easy exchange of these goods and services; however, if there is not enough money supply or too much money supply for a given amount or real economic activity, the result can have significant effects on the broader economy.

For example, if the money supply drops significantly it constricts the normal functioning of the economy because there is not enough money now to facilitiate all the billions of transactions. The economy has to shrink to account for the lower money supply and, in general, asset prices (houses, stocks, cars, etc) fall which is called deflation. If there is excess demand for money, as there would be in this case, the result can often be higher interest rates as well. Essentially, the "demand for money" is higher than the supply and the "price" of money or interest rates goes up. As you may be aware, higher interest rates can discourage economic growth by increasing the cost of financing for companies.

The opposite is true as well if there is excess money supply, the result is inflation and lower interest rates. In this case, there is too much money available allowing people to bid up asset values thus causing inflation. Essentially, there is more money available and it is worth less and its price, interest rates, goes down. Even with money the forces of supply and demand are in effect.


Another key point to understanding the Depression is that in the 1920's and early 1930's, the world operated under the Gold Standard which they don't do anymore. Essentially, the money supply of the nation (remember bills/coins plus bank accounts, paypal, loans, etc) had to be backed by a certain amount of hard gold bars as "reserves". As well, the world had a system of fixed exchange rates between countries. In essence an exchange rate is the price you would pay in Canadian dollars for US dollars. Today the world employs a floating exchange system (ie) the price of US dollars in terms of Canadian is allowed to float within a market. In the 1920's the Canadian dollar was fixed at $1 US dollar. Thus if the US increased interest rates higher than Canadian interest rates gold would flow into the US out of Canada because people could get more return for their money/gold in the US versus Canada. When the gold flowed out of Canada, for example, then the gold reserves of the US would go up and the gold reserves of Canada would go down. Since, the gold standard was in place if you had less gold then the banks would reduce the money supply in Canada thus raising interest rates in Canada as well. In essence, the US had exported their "tight money policy" to Canada.

Now extrapolate this to Europe and North America. In fact the US did increase interest rates rapidly in the late 1920's to discourage the rampant speculation that was occuring within asset markets, including the stock market, in the US. With the gold standard and fixed exchange rates, gold flooded out of Britiain, France, Germany, Canada, Austria, Hungary. This resulted in a subtantial increase in interest rates throughout out the world and in some cases this led to banking crisis in Germany and Austria in the early 1930's who were already suffering under the large Reparations dictated to them by the British and the French after WW I. In essence, the word suffered a massive reduction in its money supply due to the US action which operated to constrict the global economy substantially.

Unfortunately, this occurred at exactly the wrong time and the government's of the world did exactly the wrong things in response. I will explain in the next post.



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[Mr. Delainey]

Thanks Dave. That ladies and gentleman was my big brother who is a lot smarter than me.

[David Delainey]

So the world's money supply contracted and economic activity was restricted due to the US action in 1927 through 1929. The money supply issues caused all sorts of banking crisis in Europe where runs on the bank occurred and many individuals lost all their savings - it was an all out banking crisis.

Unfortunately, it happened at exactly the wrong time. After WW I the agricultural production of the world had been severely curtailed due to the destruction in Europe and Russia. This resulted in pretty strong prices for wheat and other commodities. These strong prices encouraged a rapid increase in new wheat supply from Canada (remember the wheat boom in the Canadian Prairies), the US, Australia and Argentina. However, by the mid to late 1920's production was recovering in Europe and Russia. The result was rapid drop in agricultural prices - too much supply prices fall. Many farmers could no longer afford to produce their crops and much hardship resulted around the world. In Canada and the US, this was made even worse by the climate issues - the extensive drought during the 1930's.

Lets summarize a bit now - falling global money supply restricited economic activity, increasing interest rates and a banking crisis in Europe resulted especially in Germany and Austria/Hungary which were very weak post WW I both politically and economically. At the same time, you have an agricultural crisis and a climate crisis. You can start to see why there was so much suffering during the period. But this is not the end of the story ...

By the 1930's not only was the world's agricultural and banking markets in crisis but the larger global industrial economy was entering into a recession which is a part of the normal increase and decrease in a nation's and the global economy - often called the "business cycle".

This cycle - repeated periods of boom followed by bust is a natural phenomenon of capitalist economies. It can be severe or it can be quite subtle. Overall, this is a very complex process. In simplest terms, during the boom or expansion period there is massive investment and consumption within the economy by government, business and individuals which results in increasing prices, inflation, increasing interest rates and in some cases unproductive investments by business, too much debt taken on by business and consumers, labour unions stike for higher wages, money supply becomes tight, the stock market becomes over-priced and abuses can occur amongst other issues. Usually, the economy wakes up to these issues and suffers a "shock" of some sort that forces a recession or contraction to cool the economy of its excesses. Consumers and business lose their "confidence" on the continued strong economies. They start delaying investment, they find themselves with too much debt, consumers buy less, interest rates are high increasing the cost of financing etc. Then businesses start contracting and lay off workers and hoard capital. Bankruptcies - business and personal occur. Individuals have no job so they consume less and they can't pay off their loans so the banks incur losses so they loan out less - a virtuous circle emerges.

By the late 1920's the world had experienced a rapid growth in its economy following the destruction of WW I and it was entering into a normal recessionary period. However, due to the rapid decrease in the global money supply, the resulting banking crisis and the agricultural crisis - the industrial recession became a very significant one resulting in great suffering in the large cities of the world. It was the perfect storm of economic catastrophe the significantly struck all sectors of the world economy which took years to recover.

Now we enter the last issue - the Great Depression probably would have only lasted a couple years in the early 1930's; however, the response by world governments to the crisis only made it worse and extended in by a whole decade.

More specifically, particularly the US and continental Europe instituted in an effort to protect their industry and farmers from the crisis of falling prices and poor economy instituted significant levels of tariffs on imports into their country. Essentially, tariffs are fees that governments lay on foreign products to make them more expensive then domestically grown or manufactured goods. These trade barriers accentuated the multiple crisis by further restricting many countries ability to sell their goods to other countries. This had a further effect of accentuating the agricultural crisis and the industrial recession by years.

So what caused the Great Depression? It wasn't the stock market crash even thought that did have a negative effect on global confidence and sentiment. In some ways, it was a symptom of the larger global issues.

It was very much a global event. It was a perfect storm of banking crisis, lower consumer confidence and higher interest rates due to the Gold Standard and the US tight money policy of the late 1920's. This accentuated three other simultaneous crisis - the climatic disaster of drought and pest in the prairies of Canada and the US; the agricultural price bust which was horrible for the farming communities around the world and the industiral recession which led to massive un-employment. This was further accentuated by bad governmental response to the crisis. In the first case, they set up trade barriers that had the effect of further discouraging the global economy and any potential recovery. As well, you must remember this was before the modern welfare state. There was no unemployment insurance or welfare. No big rescue packages, etc. As a result, the suffering was extreme, persistent and un-mitigated. Especially on the North American Prairies - arguably Saskatchewan suffered the most during this period on a GDP point of view than any other nation on earth.

You can see the parallels to our recent times - in response to the banking crisis of late 2008 what did they do? They increased the money supply dramatically, they reduced interest rates, they encouraged open borders and free trade and they enlarged the welfare state to mitigate the effects and encourage recovery. Who says we don't learn!