Flashbacks December 2008

The Great Depression

Atlantic articles from the 1930s reveal how Americans reinvented banking, restructured the economy, and dealt with challenges unsettlingly parallel to those of today.
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In recent weeks, our mounting economic woes have sent financial experts, journalists, and average citizens running to the history books in search of clues about the causes and potential fixes for our present mess. Many are seeing disturbing parallels between today’s state of affairs and the period that preceded the Great Depression of the 1930s. Not surprisingly, the onset of the Great Depression provoked a similar spate of economic soul searching. A series of Atlantic articles published in the aftermath of the 1929 stock market crash captures that era’s collective grappling with the situation—and reflects a broad range of thinking on the future of our economy, politics, and society.

In a February 1930 article entitled “The Revolution in Banking Theory,” Bernhard Ostrolenk sought to explain the forces at work behind the failure of so many banks during the previous decade. For the first century and a half of our history, he explained, the federal government, and most of the states, had prohibited "branch banking"—the ownership of one bank by another—instead fostering a system of small, independent “unit banks.” It was felt, Ostrolenk noted, that “each bank should be a local institution, locally financed and managed, drawing funds from local depositors and using its financial resources for the development of local business enterprises.”

The unit bank was well suited to financing the small, independent businesses that had dominated the American economic landscape throughout the 19th Century. But the trend toward centralization of the economy, set in motion during the Industrial Revolution, called for banks with far greater resources. Ostrolenk described the shifting economic situation as follows:

The independent retail stores have given way to chain stores; electricity, gas, water, and transportation are now supplied by public-utility corporations that are state-wide or regional in character. Local industries have merged with larger corporations.

And as for the nation’s banks:

The financing of these enterprises, once a profitable outlet for investment of the funds of the local banks, is now being done by central banking institutions, equipped to render adequate service to the larger business units.

Thus, the traditional unit bank began to disappear, replaced by the chain bank, described by Ostrolenk as “a group of banks owned by a holding company, a group of individuals, or by one person—not by a bank, as in branch banking.”

Ostrolenk emphasized that this restructuring of the national banking system “has sprung up in accordance with economic need.” The chain bank, he argued, was “an essential substitution for branch banking.” Still, as with any economic evolution, changes in the banking system had dire consequences for those left behind. “Within eight years,” Ostrolenk reported, “almost one sixth of the United States banks have been suspended with losses to the depositors.” Not surprisingly, the vast majority of these had been small unit banks.

Investment banking had undergone significant changes as well during that same period. In the January 1930 Atlantic, Edgar Lawrence Smith described how Wall Street’s lending practices had come to violate the basic principles of sound banking. In a well-conducted bank, he wrote,

When a man wishes to borrow…his credit is appraised and a loan is made proportionate to his credit standing. Banks rarely, if ever, make loans to people with whose affairs they are not reasonably familiar.

But during the high-flying ’20s, when a customer borrowed from a stockbroker to invest in the market, Smith observed, such caution was abandoned. Eager to cash in, individuals assumed large amounts of debt in order to purchase stock they should not have been able to afford. And stockbrokers, in pursuit of commissions and with an eye towards driving prices ever higher, readily extended these unwise loans, which were referred to as “debit balances.”

Debit balances thus underwrote a financial system that was unsustainable. For Smith, the collapse of the stock market could be traced back to abuses of the simple principle of credit. Solid credit, he explained, is based either “(1) upon the competence, character, and earning power of the borrower, or (2) upon documents representing genuinely self-liquidating transactions.”

In the case of debit balances, however, stockbrokers extended credit on neither ground. Instead, the ability of the borrowers to pay back the loan depended on “the general level of stock prices.” But those prices, Smith pointed out, were “a function of the volume of credit so granted.” The flaws in this system soon became tragically apparent, ruining many unwitting investors.

Smith was quite clear on the question of who bore the responsibility:

The community depends upon the fraternity of bankers to see to it that the credit of the community is not squandered, that it is sound in character and can be depended upon…No Federal Reserve or other system can be devised to protect the quality of credit if bankers throughout the country do not apply sound judgment in the making of each loan.

In an April 1931 Atlantic piece “Whirlwinds of Speculation,” Samuel Spring blamed the collapse on more structural causes, showing how the promise of fantastical profits—proving to be “more potent than experience or reason”—had driven speculative booms and busts in three distinct sectors of the economy.

Spring pointed to a common cycle in each outbreak of speculation. In the first stage, economic conditions conspire to create “an apparently miraculous opportunity for industries and investors permanently to enlarge earnings.” Adding to the frenzy, investors soon imagine “an urgent scarcity of the units of speculation—commodities or real-estate lots or sound common stocks.” Prices rise rapidly; credit becomes scarce—but can still be obtained “by diversion from other channels of trade.”

The final, fatal phase of a speculative boom, Spring wrote, is “a forced and rapid multiplication of the units of speculation”:

The pouring forth of this great torrent of new units of speculation results in the inevitable consequences dictated by the law of supply and demand … a consequent collapse due to the excess of sellers over buyers.

In this final part of the cycle, according to Spring, speculation attains its most delirious heights—and inflicts its most lasting damage. “The wilder the outpouring of new units of speculation, the more acute and distressing the consequent panic,” he argued.

But Spring was a committed capitalist, and he viewed speculation simply as “a necessary and a beneficent human instinct gone wrong.” Government intervention to control it, he argued, should be beyond consideration:

Fraud and coercion the State can restrain; but, unless we wish to go the road toward communism, the State must leave every buyer and every seller free to act as wisely or as foolishly as his intellectual and emotional capacities dictate.

Other Atlantic contributors, however, advocated an expanded role for the federal government so as to mitigate the social consequences of the economic downturn. Though labor advocates had been pushing for years for such protections as unemployment benefits and health insurance, the intense suffering that took place during the Great Depression gave their cause greater urgency.

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