Trickle Down Economics

Trickle Down Economics

During the Great Depression, Hoover was faced with growing and increasingly harsh criticism. Because of this, Hoover finally decided to use federal resources to battle the depression. Believing that the economy suffered from a lack of credit, he urged Congress to create the Reconstruction Finance Corporation (RFC). Created by Congress in early 1932, the RFC gave more than a billion dollars of government loans to railroads and large businesses. The agency also lent money to banks so that they could extend more loans to struggling businesses. Hoover believe that if the government lent money to bankers, they would lend it in turn to businesses. Companies would then hire workers, production and consumption would increase, and the depression would end. This theory, known as trickle-down economics, held that money poured into the top of the economic pyramid would trickle down to the base.

Although the RFC put the federal government at the center of economic life, it did not work well under Hoover’s guidance. The RFC lent out billions, but all too often bankers did not increase their loans to businesses. Additionally, businesses often did not use the loans they received to hire more workers. In the end, the money did not trickle down to the people who needed it the most.

Stocks

The stock market can be complex, so let's start with some basic definitions. A share of stock is literally a share in the ownership of a company. When you buy a share of stock, you're entitled to a small fraction of the assets and earnings of that company. Assets include everything the company owns (buildings, equipment, trademarks), and earnings are all of the money the company brings in from selling its products and services.

Why would a company want to share its assets and earnings with the general public? Because it needs the money, of course. Companies only have two ways to raise money to cover start-up costs or expand the business: It can either borrow money (a process known as debt financing) or sell stock (also known as equity financing).

The disadvantage of borrowing money is that the company has to pay back the loan with interest. By selling stock, however, the company gets money with fewer strings attached. There is no interest to pay and no requirement to even pay the money back at all. Even better, equity financing distributes the risk of doing business among a large pool of investors (stockholders). If the company fails, the founders don't lose all of their money; they lose several thousand smaller chunks of other people's money.

Laissez-Faire

Laissez faire is the belief that economies and businesses function best when there is no interference by the government. It comes from the French, meaning to leave alone or to allow to do. It is one of the guiding principles of capitalism and a free market economy. It is the belief that each individual's self-interest to do better, strong competition from others, and low taxes will lead to the strongest economy, and therefore, everyone will benefit as a result.

When President Franklin D. Roosevelt and Congress passed the New Deal (a variety of programs aimed at fixing the economy of the United States during the Great Depression), the federal government broke from the tradition of laissez-faire, which had characterized most of American history. This changed the relationship between government and private business. Instead of being hands-off, now the federal government accepted responsibility for spurring economic growth, or pump priming. For the first time, the government had acted as an employer of the unemployed and a sponsor of work projects. FDR accepted the idea that the federal government had to do something to get the economy going again, and Democrats and many Republicans agreed. However, FDR’s rejection of laissez-faire policies led a number of New Deal critics to accuse him of promoting socialism.

Buying on Margin

Consumers were not the only Americans buying and selling in a big way. During the 1920s, the stock market enjoyed a dizzying bull market, a period of rising stock prices. More and more Americans put their money into stocks in an effort to get rich quick. My 1920, around 4 million Americans owned stocks.

The desire to strike it rich often led investors to ignore financial risks. As the market soared, people began buying on margin. By purchasing stock on margin, a buyer paid as little as 10 percent of the stock price upfront to a broker. The buyer then paid the broker for the rest of the stock over a period of months. The stock served as collateral, or security, for the broker’s loan. As long as the price of the stock rose, the buyer had not trouble paying off the loan and making a profit. But if the price fell, the buyer still had to pay off the loan. Buyers gambled that they would be able to sell the stock at a profit long before they loan came due. Buying stocks on the hope that their price will rise is called stock market speculation.

Speculation

By 1920, some economists were observing that soaring stock prices were based on little more than confidence. The prices had no basis in reality. Although other experts disagreed, it became clear that too much money was being poured into stock speculation, as investors gambled (often with money they did not even have) on high-risk stocks in hopes of turning a quick profit. If the market’s upward climb suddenly reversed course, many investors would face economic devastation.

On September 3, 1929, the stock market began to sputter and fall. Prices peaked and then slid downward in an uneven way. At the end of October, however, the slide gave way to a free fall. After the Dow Jones average dropped 21 points in one hour on October 23, many investors concluded that the boom was over. They had lost confidence – the very thing that had kept the market up for so long.

Supply and Demand

Supply and demand is perhaps one of the most fundamental concepts of economics and it is the backbone of a market economy.

The law of demand states that, if all other factors remain equal, the higher the price of a good, the less people will demand that good. In other words, the higher the price, the lower the quantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more.The chart to the right shows that the curve is a downward slope.

Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied. Producers supply more at a higher price because selling a higher quantity at a higher price increases revenue.