Rampant Speculation and a Flawed Banking System
Throughout the 1920s, stock market speculation, or assuming the future success or failure of stocks, became commonplace throughout the United States for the first time in history. As a result, by the end of the decade, many investors had purchased massive quantities of shares of stock, but mainly through loans and a minimum investment of roughly 10%. Most assumed that once the prices on stock rose, they would be able to withdraw their earnings, pay back their loans and be left with a net profit. Most investors shared their method and infused thousands of borrowed dollars into the stock market on various industries and products that did not have time to mature and be considered a proven, even valuable, commodity.
The market also was not regulated as it is today. Unscrupulous agents frequently sold securities to investors which were essentially worthless. Some states had limited regulations known as Blue Sky Laws, which at least required providing a prospectus about the investment opportunity being offered. However, there was no nationwide framework to prevent these types of misdeeds. Combined with the problems caused by banks engaging in market speculation, it’s no surprise the above led to the creation of the Securities & Exchange Commission shortly after the start of Franklin Roosevelt’s presidency. The 1920s are the reason it was given a mandate to regulate the securities market.
Although the stock market crash has received the brunt of the blame for the Great Depression, unhinged market speculation by both banks and the general public were the core cause, especially for the severity. Farm incomes and wages were flat or declining in the 1920s. This created an environment where the average American could make more money from speculating on the stock market. Unlike today, banks were also playing the market. In the 1920s, banks increasingly used their customers’ deposit to engage in market speculation themselves. This was a major factor in banks being unable to payout the value of the funds owed to their depositors. Banks did not keep sufficient reserves and many hadn’t joined the Federal Reserve system. Even those banks in the Federal Reserve system only received warning letters in response to their high risk behavior. This also meant the banking system in America lacked a way to mount a coordinated response once the collapse started. In contrast, nations with more consolidated banking systems at that time, such as Canada, France, and the Netherlands experienced a milder, shorter depression.
As factory inventories built up, farm incomes failed to materialize, and corporate profits dwindled, the stock market plunged. Simultaneously, creditors who had supplied loans to investors began demanding the repayment of the loans after witnessing market earnings begin to spiral downward. Many of these creditors were the large number of banks who had wagered the funds of their depositors on the stock market. The financial system of the United States crumbled. When the Federal Reserve finally took meaningful action by raising interest rates from 5% to 6%, it was too late. The effect from this measure was that banks stopped lending, which dried up access to capital for businesses and it killed consumer spending. Both of which will make depressions worse.
These critical flaws in the American banking system became the impetus for the flurry of banking laws put into place by President Franklin Roosevelt almost immediately after he took power. In particular, the reckless use of reserves prompted the federal government to create the Federal Deposit Insurance Corporation (FDIC).