Explain how the economic prosperity of the 1920's was not truly built on a strong foundation using the key warning signs leading up to the Depression?
The prosperity of the 1920s was established, but to some degree, that prosperity was built on a foundation that wasn’t very solid. One of the issues that eventually brought down the economy is that too many people bought stocks without really investigating the true value of the companies in which they were investing. Many people had the attitude that they should buy any stock because the prices will keep rising because of the economic policies of the government. If the people had researched the companies in which they were investing more carefully, they would have realized the companies were overvalued.
Another aspect related to the stock market is that people continued to buy stocks even though they didn’t have the money to do so. They bought on margin, paying only ten percent of the actual costs and paying the balance on the installment plan. Thus, people willingly went into debt with some people investing their life savings in the stock market. At some point in time, a couple of crippling factors were going to kick into effect. Eventually, there would be too few new investors entering the market. During the 1920s, there were a lot of new investors. By the end of the 1920s, there weren’t many new investors coming into the market. This would eventually cause demand for stocks to drop along with their price. If the brokers were to call in their debts, most investors would have no choice but to sell their stocks in order to satisfy the margin calls. This would lead to many stocks being made available for sale, but few new buyers for the stock. This would lead to a significant drop in stock prices. This is where many people lost everything they had. Once the prices plummeted, what people believed to be their fortunes turned into nothing at all.
A third factor leading to the Great Depression was that banks invested their assets, including customers’ deposits, into the market. When the market collapsed, the banks didn’t have the cash to meet consumer demand. As a result, the banks failed, and more people lost their life savings.
Finally, poor decision-making by the Federal Reserve Board helped to create this allusion of a strong economy built on a solid foundation. The Federal Reserve Board should have acted to slow investment by raising interest rates in the 1920s. Instead, they kept them low, encouraging more investment. In the 1930s, the Federal Reserve Board should have lowered interest rates in order stimulate the economy. Instead, they raised them, causing the economy to slow down even more. The foundation of the economic prosperity of the 1920s wasn’t as strong as people believed.
Warning signs that a recession or depression might be on the way emerged in the late 1920s but were ignored amid a wave of optimism and boosterism.
First, inventories of goods began to rise. This was a loud warning sign, unheeded, that demand was slowing. People simply weren't buying as many cars, refrigerators, sofas, and other consumer goods as they had been earlier in the decade. As inventories piled up, factories would inevitably start producing fewer goods, which would lead to layoffs of workers. These unemployed workers would have less money in their hands to buy goods, so the economic cycle would spiral into a worse situation.
Piles of unsold goods were a drag on the economy. Businesses were selling fewer goods, meaning they too were making less money, suggesting a point would come when they would have to start laying off workers as well.
Second, stock prices began to decline by 1929. This was another very ominous sign. Because of loose (or absent) regulation, people could borrow money to buy stocks, then pay the loan off with the proceeds from the sale of the stock. This worked as long as the price of stocks rose. When the price of stocks dropped, people could no longer use their profits to pay off their loans. For example, by the fall of 1929, a person who had borrowed, say $1,000 dollars to buy stocks, might only realize $600 from the sale. Obviously, he wouldn't be able to pay off his loan. Banks too were investing heavily in the stock market on borrowed money (called buying on margin). When the stock market finally crashed on October 24, nobody had enough money to cover their losses and the entire economy collapsed, leading to the Great Depression.
If the government and business world had paid closer attention to the rising inventories and the complete instability of running a stock market on massive amounts of unsecured debt, the economic contraction could have been managed in a much less painful way. However, nobody wanted to face the fact that the money-making party wasn't going to last forever.