Though economic activity was already declining moderately in many countries by early 1929, the crash of the stock market in the United States in October of that year initiated a worldwide crisis. The American economy had prospered in the late 1920s, but there were large inequalities in income and a serious imbalance between actual business investment and stock market speculation. Thus net investment — in factories, farms, equipment, and the like — actually fell from $3.5 billion in 1925 to $3.2 billion in 1929. In the same years, as money flooded into stocks, the value of shares traded on the exchanges soared from $27 billion to $87 billion. Such inflated prices should have raised serious concerns about economic solvency, but even experts failed to predict the looming collapse.

This stock market boom — or “bubble” in today’s language — was built on borrowed money. Many wealthy investors, speculators, and people of modest means bought stocks by paying only a small fraction of the total purchase price and borrowing the remainder from their stockbrokers. Such buying “on margin” was extremely dangerous. When prices started falling in 1929, the hard-pressed margin buyers had to either put up more money, which was often impossible, or sell their shares to pay off their brokers. Thousands of people started selling all at once. The result was a financial panic. Countless investors and speculators were wiped out in a matter of days or weeks.

The consequences were swift and severe. Stripped of wealth and confidence, battered investors and their fellow citizens started buying fewer goods. Prices fell, production began to slow down, and unemployment began to rise. Soon the entire American economy was caught in a spiraling decline.

The financial panic triggered an international financial crisis. Throughout the 1920s American bankers and investors had lent large amounts of capital to many countries. Once the panic broke, U.S. bankers began recalling the loans they had made to foreign businesses. Gold reserves began to flow rapidly out of European countries, particularly Germany and Austria, toward the United States. It became very hard for European businesses to borrow money, and panicky Europeans began to withdraw their savings from banks. These banking problems eventually led to the crash of the largest bank in Austria in 1931 and then to general financial chaos. The recall of loans by American bankers also accelerated a collapse in world prices when businesses dumped industrial goods and agricultural commodities in a frantic attempt to get cash to pay their loans.

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The financial crisis led to a general crisis of production: between 1929 and 1933 world output of goods fell by an estimated 38 percent. As this happened, each country turned inward and tried to manage the crisis alone. In 1931, for example, Britain went off the gold standard, refusing to convert banknotes into gold, and reduced the value of its money. Britain’s goal was to make its goods cheaper and therefore more salable in the world market. But more than twenty other nations, including the United States in 1934, also went off the gold standard, so few countries gained a real advantage from this step — though Britain was an exception. Similarly, country after country followed the example of the United States when in 1930 it raised protective tariffs to their highest levels ever and tried to seal off shrinking national markets for domestic producers. Such actions further limited international trade. Within this context of fragmented and destructive economic nationalism, a recovery did not begin until 1933 and it was a halting one at that.

Although opinions differ, two factors probably best explain the relentless slide to the bottom from 1929 to early 1933. First, the international economy lacked leadership able to maintain stability when the crisis came. Neither Britain nor the United States — the world’s economic leaders at the time — successfully stabilized the international economic system in 1929. The American decisions to cut back on international lending and erect high tariffs, as we have seen, had damaging ripple effects.

The second factor was poor national economic policy in almost every country. Governments generally cut their budgets when they should have raised spending and accepted large deficits in order to stimulate their economies. After World War II, this “counter-cyclical policy,” advocated by John Maynard Keynes, became a well-established weapon against downturn and depression. But in the 1930s orthodox economists who believed balanced budgets to be the key to economic growth generally regarded Keynes’s prescription with horror.