What Caused the Stock Market Crash of 1929?

The Stock Market Crash of 1929 is often described as a sudden shock. In reality, it was the inevitable conclusion of years of structural imbalance. By the late 1920s, the market had become a giant speculative bubble, inflated by easy credit, concentrated wealth, weak regulation, and a Federal Reserve unable and unwilling to act.

The causes are usually grouped into five categories: speculation and margin buying, income and wealth inequality, the agricultural depression that had been dragging on the economy since 1920, Federal Reserve policy mistakes, and unsustainable valuations of the stocks themselves.

Speculation and Margin Buying

The most direct cause was the speculative fever of the late 1920s. The Dow Jones Industrial Average rose from 198 at the end of 1926 to 381 by September 1929 — a gain of more than 90 percent in less than three years. Behind the index was an explosion of borrowing and leverage.

The mechanics of margin buying are simple and devastating. An investor could put down as little as 10 percent of a stock’s price and borrow the rest from a broker. A 10 percent rise doubled the buyer’s money; a 10 percent fall wiped it out, and the broker could issue a “margin call” demanding more.

By 1929, the volume of margin debt had reached extraordinary levels. The New York Federal Reserve estimated that in October 1929, broker loans totaled about $8.5 billion — an amount larger than the entire federal budget. Much of that credit came not from banks but from “call money” borrowed by brokers from corporations, foreign investors, and wealthy individuals seeking higher returns. The marginal lenders were the first to withdraw when the market fell.

Income and Wealth Inequality

The 1920s economy produced spectacular wealth for some Americans and modest gains for most. By 1929, the top 5 percent of American families received about 33 percent of all personal income. The top 1 percent owned roughly 40 percent of all stocks (estimates range from the high 30s to the mid-40s percent, depending on the measure). Many wealthy Americans had little to do with their money except invest it, and they invested aggressively in the bull market.

The concentration of wealth fed the bubble. The wealthy had cash to bid up stock prices, while the relative poverty of the bottom 90 percent meant consumer demand was weak — a gap filled by installment debt. The Republican administrations of Harding, Coolidge, and Hoover were committed to laissez-faire economics. The wealthy were the major political donors; the regulatory environment could not constrain speculation. The Investment Trusts Act of 1929 was passed in August 1929, too late and too weak to matter.

The Agricultural Depression That Wouldn’t End

The prosperity of the late 1920s was an urban and industrial story. For American farmers, the decade was a long, grinding catastrophe. Farm prices had collapsed in 1920 and never recovered. The Fordney-McCumber Tariff of 1922 had raised duties on agricultural products, prompting European retaliation and cutting off the export markets that farmers needed.

By 1929, the agricultural sector was in crisis. Farm income was about half what it had been in 1919. Mortgages were in default. Banks in the Midwest were struggling. The rural crisis did not directly cause the stock market crash, but it had made the American economy structurally weak. When the crash came, the agricultural sector offered no cushion; it deepened the fall. Many rural banks held large amounts of farm mortgages that were never going to be repaid; these weak banks would be among the first to fail in 1930 and 1931.

Federal Reserve Policy Mistakes

The Federal Reserve System, created in 1913, was only fifteen years old when the great bull market got underway. Its leadership was fragmented. Benjamin Strong, the influential president of the New York Federal Reserve Bank, died in October 1928, leaving a vacuum at the top.

Strong’s successors faced an unenviable choice. The stock market was clearly in a bubble. The Fed had no legal authority to regulate stock prices directly. Raising interest rates to curb speculation would hurt the legitimate economy. Cutting interest rates would feed the bubble. The Fed chose to do nothing, then in early 1929 made the fateful decision to tighten credit in the hope of slowing speculation.

The tightening backfired. Higher interest rates hurt the real economy — housing starts, in particular, peaked in 1928 and fell sharply in 1929 — without slowing the stock market, which was being driven by a flood of broker loans from non-bank sources. The result was a slowing economy and a still-inflated stock market more vulnerable than ever to a shock.

Unsustainable Valuations

The most fundamental cause of the crash was that stock prices had become detached from reality. By the summer of 1929, the typical blue-chip stock was trading at a price-to-earnings ratio above 30, far above the historical average of around 10. The market value of all stocks listed on the New York Stock Exchange had risen from about $27 billion in 1921 to more than $87 billion at the 1929 peak. That threefold increase in eight years had not been matched by an equivalent rise in corporate earnings.

These valuations were unsustainable. Companies’ earnings were growing at perhaps 5 to 7 percent a year; their stock prices were rising at 30 percent. The American economy was slowing, the housing market was contracting, and the agricultural sector was in crisis. The fall in stock prices was the only possible outcome.

The Warnings Ignored

A few voices had warned of impending disaster. Roger Babson, a financial adviser, gave a famous speech on September 5, 1929, at a financial conference in Wellesley, Massachusetts, predicting a “terrific crash.” The Dow dropped sharply that day but recovered within a week. Few took Babson seriously. The Harvard Economic Society continued to predict prosperity well into 1930. Even the insiders who saw the trouble coming often could not bring themselves to act. Joseph P. Kennedy Sr., the patriarch of the Kennedy family, was a sophisticated investor who understood that the market was in a bubble. According to family legend, he sold out of the market in the summer of 1929 and was widely mocked for doing so.

The Day the Bubble Broke

The bubble burst in late October 1929. On Black Monday, October 28, the Dow fell 12.8 percent — its largest single-day percentage loss in history to that point. On Black Tuesday, October 29, it fell another 11.7 percent on record volume. (On Black Thursday, October 24, the bankers’ intervention had actually pushed the index to a slightly higher close; the worst of the day’s selling had been absorbed before the close.) By the end of the worst week in American financial history, the market had lost about a third of its value. Read the full story in our account of Black Tuesday, October 29, 1929.

The crash was the inevitable conclusion of years of structural imbalance. The crash did not cause the Great Depression by itself; the policy failures that followed did. But without the underlying vulnerabilities, the crash would not have produced a depression at all.