Great Depression for Kids
Buying on the installment plan: The 1920s (also known as the Roaring 20s) was a time of great prosperity for many. World War I was over. Factories no longer needed to produce supplies for the war. Factories began producing consumer goods - things for people to buy. There were exciting things to buy. There were many new inventions like refrigerators. To make it possible for people to buy a great many goods, especially expensive goods like houses and cars, the installment plan was offered by banks and other businesses. Here's how it worked: People could borrow money for a particular purchase, and then pay it back, a little each month, until the entire loan was repaid along with any interest charged. That let people buy whatever they wanted without waiting to save up enough cash for the entire purchase at one time, and allowed lenders to make money from interest - the extra money charged for the privilege of borrowing money.
Buying Stock: The stock market was also booming. Production was up. Companies were making money. Stocks in those companies were going up in value. A stock is a piece of ownership in a company. When you buy stock in a company, you are betting that the company will make money, and that the stock - your piece of the company - will go up in value. You can then sell your stock for more money than you paid for it. It's a simple concept. If you hand someone a ten dollar bill, and they hand you back a twenty dollar bill, most probably you will hand them as many ten dollar bills as you can find, as long as they keep handing you $20 bills for each $10 bill in return. Many new investors in the 1920s were excited by the idea of buying stock. That's what rich people did. They thought they too might get rich! It was an exciting prospect. The problem facing these new investors is that they did not have a lot of ten dollar bills to invest.
Buying Stock on Margin: The way to buy stock without having a lot of money invested up front was to buy stocks on margin. Margin meant you could pay a small amount in cash and borrow the rest from a brokerage house. The brokerage house handled all your transactions.
Here's how it worked: Brokerage houses would let you open an account with them. You put money into your account, and the brokerage house put money into your account. The money they put in was a loan that had to be paid back with interest. The amount they put in was based on your credit. If you had a good job and some assets - like a house, a car, some savings - they would loan you up to 90% of the value of the stocks provided you put your assets up as collateral - as a guarantee that you would pay the loans back. If you didn't pay them back, they took as many of your assets as they needed until the monies were repaid. This might have worried people under normal circumstances. But the Roaring 20s were booming. The brokerage houses offered what sounded like a great deal! Investors who bought stocks on margin only had to pay 10% in cash. The brokerage house loaned investors 90%. That was equal to putting in $10 into your own account, and having the brokerage house add $90. Now you had $100 to use to buy stock.
If your stocks went up, you made money. If your stocks went down, you lost money. Every time you bought or sold a stock, a transaction fee was charged by the brokerage house. As long as the brokerage house was making money on transaction fees and interest on the loans they had given you, they were in no hurry to have you repay the money you had borrowed, because they had borrowed the money they had loaned to you. Simple math - a brokerage house would borrow $5 and loan you $9. You added $1 of your own money, and bought stock for $10. That stock went up in value. You sold it for $20. The brokerage house charged you $2 for buying the stock and $2 for selling the stock. Still, that left $16 in your account. You owed the brokerage house the $9 they loaned you, but you still had $7 left over, and you only $1 to do it, which meant you made a $6 profit on a $1 investment. But you did not invest $1. You invested $100. That meant you had made $600 after costs! People were excited about buying on margin. Some people were smart. They paid back the brokerage house all the money they had borrowed the minute they could. Then, if they continued to play the stock market, it was slow and steady, using their own money. But most did not play it safe. They were in a hurry to get rich. They continued to buy more and more stocks on margin.
Here was the problem: If your account blew up (the value in your account disappeared - no money, worthless stocks), a brokerage house could and would demand you pay back all the money you owed them immediately. No installment plan. No negotiation. If you did not pay it all back immediately, the brokerage house could take you to court, start getting judgments against you, and seize your house, your car, your savings, and any other assets necessary to be repaid. Creditors (people to whom you owed money) could garnish your wages - they could get a court order to have your employer pay most of your paycheck directly to them instead of to you. That meant you did not have enough money left from your paycheck to pay your other bills, like your house payment. This ruined your credit. Since your credit was ruined, no bank would lend you money to tide you over until you paid back all your creditors. People who bought on margin were taking a tremendous risk.
The Stock Market Crash of 1929: It was only a question of time. People had bought too much on credit. They purchased houses and cars and clothes and new inventions. But how many refrigerators does any one family need? Many people slowed down buying. As a result, many factories slowed down production. They laid off workers. Professional investors began selling their stocks. The price of stocks began slowly to fall. As a result, other investors tried to sell the stock they held. They had to sell at a price considerably less than they had paid. They did not have enough personal savings to add to their accounts to cover the loss. In a panic, brokerage houses began to make large-scale margin calls, demanding that investors repay their loans immediately. Stock prices fell even further. On Tuesday, October 29, 1929, nicknamed Black Tuesday, stock prices collapsed. Around $15 billion dollars was lost in just one day due to falling prices. The crash lasted for four days. At the end, the stock market had lost more money in four days than was spent on the entire war effort in World War I. It was a disaster. People lost everything - their homes, their businesses, their cars, their savings - everything.
The Crash leads to the Great Depression: Of course that meant that many more people could not afford to buy goods. Factories laid off more workers. Some factories went out of business. Unemployment in one section led to unemployment in other sections. Without a job, people could not afford to pay for goods they had bought on the installment plan. The banks foreclosed. Many millions of people became homeless. The Stock Market Crash of 1929 was not the only cause of the Great Depression, but it certainly was one of the major causes.
See Also: The Roaring Twenties for Kids