Causes of the Great Depression

USA GDP annual pattern and long-term trend, 1920-40, in billions of dollars at constant prices.^[1]

The causes of the Great Depression are cause joel is gay are still a matter of active debate among economists. The specific economic events that took place during the Great Depression have been studied thoroughly: a deflation in asset and commodity prices, dramatic drops in demand and credit, and disruption of trade, ultimately resulting in widespread poverty and unemployment. However, historians lack consensus in describing the causal relationship between various events and the role of government economic policy in causing or ameliorating the Depression.

Current theories may be broadly classified into three main points of view. First, there is orthodox classical economics: monetarist, Austrian Economics and neoclassical economic theory, which focus on the macroeconomic effects of money supply, how central banking decisions lead to overinvestment (economic bubble), or the supply of gold which backed many currencies before the Great Depression, including production and consumption.

Second, there are structural theories, most importantly Keynesian, but also including those of institutional economics, that point to underconsumption and overinvestment (economic bubble), malfeasance by bankers and industrialists, or incompetence by government officials. The only consensus viewpoint is that there was a large-scale lack of confidence. Unfortunately, once panic and deflation set in, many people believed they could make more money by keeping clear of the markets as prices got lower and lower and a given amount of money bought ever more goods.

Keynesian explanation

British economist John Maynard Keynes in 1936 argued that there are many reasons why the self-correcting mechanisms that some economists claimed should work during a downturn may not work in practice. In his The General Theory of Employment, Interest and Money, Keynes introduced concepts that were intended to help explain the Great Depression. One argument for a noninterventionist policy during a recession was that if consumption fell due to savings, the savings would cause the rate of interest to fall. According to the classical economists, lower interest rates would lead to increased investment spending and demand would remain constant. However, Keynes states that there are good reasons why investment does not necessarily increase in response to a fall in the interest rate. Businesses make investments based on expectations of profit. Therefore, if a fall in consumption appears to be long-term, businesses analyzing trends will lower expectations of future sales. Therefore, the last thing they are interested in doing is investing in increasing future production, even if lower interest rates make capital inexpensive. In that case, according to Keynesians and contrary to Say's law, the economy can be thrown into a general slump.^[2] This self-reinforcing dynamic is what happened to an extreme degree during the Depression, where bankruptcies were common and investment, which requires a degree of optimism, was very unlikely to occur.

Monetarist explanations

In their 1963 book "A Monetary History of the United States, 1867-1960", Milton Friedman and Anna Schwartz laid out their case for a different explanation of the Great Depression. After the Depression, the primary explanations of it tended to ignore the importance of money. However, in the monetarist view, the Depression was “in fact a tragic testimonial to the importance of monetary forces.”^[3] In their view, the failure of the Federal Reserve to deal with the Depression was not a sign that monetary policy was impotent, but that the Federal Reserve exercised the wrong policies. They did not claim the Fed caused the depression, only that it failed to use policies that might have stopped a recession from turning into a depression. Ben Bernanke, the current Chairman of the Federal Reserve, thought Friedman was right to blame the Federal Reserve for its role in the Great Depression, stating on Nov. 8, 2002:

"Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again." ^[4]

Before the 1913 establishment of the Federal Reserve, the banking system had dealt with periodic crises in the U.S. (such as in the Panic of 1907) by suspending the convertibility of deposits into currency. The system nearly collapsed in 1907 and there was an extraordinary intervention by an ad-hoc coalition assembled by J. P. Morgan. The bankers demanded in 1910-1913 a Federal Reserve to reduce this structural weakness. Friedman suggests the untested hypothesis that if a policy similar to 1907 had been followed during the banking panic at the end of 1930, perhaps this would have stopped the vicious circle of the forced liquidation of assets at depressed prices. Consequently, in his view, the banking panic of 1931, 1932, and 1933 might not have happened, just as suspension of convertibility in 1893 and 1907 had quickly ended the liquidity crises at the time.”^[5] Essentially, the Great Depression, in the monetarist view, was caused by the fall of the money supply. Friedman and Schwartz write: "From the cyclical peak in August 1929 to a cyclical trough in March 1933, the stock of money fell by over a third." The result was what Friedman calls the "Great Contraction"— a period of falling income, prices, and employment caused by the choking effects of a restricted money supply. The mechanism suggested by Friedman and Schwartz was that people wanted to hold more money than the Federal Reserve was supplying. As a result people hoarded money by consuming less. This caused a contraction in employment and production since prices were not flexible enough to immediately fall. The Fed's failure was in not realizing what was happening and not taking corrective action.^[6]

Gold Standard

The Gold Standard theory of the Depression attributes it to postwar deflationary policies. During World War I many European nations abandoned the gold standard, forced by the enormous costs of the war. This resulted in inflation, because it was not matched with rationing and other forms of forced savings. The view is that the quantity of money determined inflation, and therefore, the cure to inflation was to reduce the amount of circulating medium. Because of the huge reparations that Germany had to pay France, Germany began a credit-fueled period of growth in order to export and sell enough abroad to gain gold to pay back reparations. The United States, as the world's gold sink, loaned money to Germany to industrialize, which was then the basis for Germany paying back France, and France paying back loans to the United Kingdom and United States. This arrangement was codified in the Dawes Plan.

This had numerous economic consequences. However, what is of particular relevance is that following the war, most nations returned to the gold standard at the pre-war gold price, in part, because those who had loaned in nominal amounts hoped to recover the same value in gold that they had lent, and in part because the prevailing opinion at the time was that deflation was not a danger, while inflation, particularly the inflation in the Weimar Republic, was an unbearable danger. Monetary policy was in effect put into a deflationary setting that would over the next decade slowly grind away at the health of many European economies. While the British Banking Act of 1925 created currency controls and exchange restrictions, it set the new price of the Pound Sterling at parity with the pre-war price. At the time, this was criticized by John Maynard Keynes and others, who argued that in so doing, they were forcing a revaluation of wages without any tendency to equilibrium. Keynes' criticism of Winston Churchill's form of the return to the gold standard implicitly compared it to the consequences of the Versailles Treaty.

Deflation's impact is particularly hard on sectors of the economy that are in debt or that regularly use loans to finance activity, such as agriculture. Deflation erodes the price of commodities while increasing the real value of debt, which all came to the wall street stock market crash in 1929.

More recent research, by economists such as Peter Temin, Ben Bernanke and Barry Eichengreen, has focused on the constraints policy makers were under at the time of the Depression. In this view, the constraints of the inter-war gold standard magnified the initial economic shock and was a significant obstacle to any actions that would ameliorate the growing Depression. According to them, the initial destabilizing shock may have originated with the Wall Street Crash of 1929 in the U.S., but it was the gold standard system that transmitted the problem to the rest of the world.^[7]

According to their conclusions, during a time of crisis, policy makers may have wanted to loosen monetary and fiscal policy, but such action would threaten the countries’ ability to maintain its obligation to exchange gold at its contractual rate. Therefore, governments had their hands tied as the economies collapsed, unless they abandoned their currency’s link to gold. As the Depression worsened, many countries started to abandon the gold standard, and those that abandoned it earlier suffered less from deflation and tended to recover more quickly.^[8]

Neoclassical approach

Recent work from a neoclassical perspective focuses on the decline in productivity which caused the initial decline in output and a prolonged recovery due to government policies. These studies, many of which are collected in Kehoe and Prescott 2007^[9], decompose the economic decline into a decline in the labor supply, capital stock, and the productivity with which these inputs are used. The countries studied all suffered initially from dramatic drops in productivity, but the recovery in output was much slower than the recovery in productivity. Harold Cole and Lee Ohanian argue that in America the cartelization of industry suppressed the labor supply, dampening the recovery and prolonging the depression. Studies of France, Germany, Italy, and the UK show similar patterns, modified by country-specific policies. Together, this line of research rejects simple explanations that imply a decline in the capital stock or that imply no decline in hours worked.

Austrian School explanations

Austrian theorists who wrote about the Depression include Hayek and Murray Rothbard. Rothbard wrote "America's Great Depression" in 1963. In their view, the Great Depression was the inevitable outcome of the easy credit policies of the Federal Reserve during the 1920s. Since its enactment in 1913, the Federal Reserve had served as the central bank of the United States. The Federal reserve effectively regulated the amount of credit private banks could issue by providing overnight loans and strict reserve requirements.

The problem with this policy is that the reserve rate and interest rates were centrally decided then uniformly applied to all banks. This central mechanism of interest rate and fractional reserve rate determination stands in stark contrast to market mechanisms which would be distributed and specific to each bank. Uniform central bank policies allowed banks with poor lending policies to have easy access to credit—as easy as conservative banks. Austrian theorists hold that the key cause of the Depression was the expansion of the money supply in the 1920s that led to an unsustainable credit-driven boom. In their view, the Federal Reserve, which was created in 1913, shoulders much of the blame. By the time the Fed belatedly tightened in 1928, it was far too late and, in the Austrian view, a depression was inevitable.

The artificial interference in the economy was a disaster prior to the Depression, and government efforts to prop up the economy after the crash of 1929 only made things worse. According to Rothbard, government intervention delayed the market’s adjustment and made the road to complete recovery more difficult.

Rothbard criticizes Milton Friedman's assertion that the central bank failed to inflate the supply of money. Rothbard asserts that the Federal Reserve purchased $1.1 billion of government securities from February to July 1932 which raised its total holding to $1.8 billion. Total bank reserves only rose by $212 million, but Rothbard argues that this was because the American populace lost faith in the banking system and began hoarding more cash, a factor very much beyond the control of the Central Bank. The potential for a run on the banks caused local bankers to be more conservative in lending out their reserves, and, Rothbard argues, was the cause of the Federal Reserve's inability to inflate.^[10]

Inequality of wealth and income

Two economists of the 1920s, Waddill Catchings and William Trufant Foster, popularized a theory that influenced many policy makers, including Herbert Hoover, Henry A. Wallace, Paul Douglas, and Marriner Eccles. It held that the economy produced more than it consumed, because the consumers did not have enough income. Thus the unequal distribution of wealth throughout the 1920s caused the Great Depression.^[11]^[12]

According to this view, wages increased at a rate lower than productivity increases. Most of the benefit of the increased productivity went into profits, which went into the stock market bubble rather than into consumer purchases. Say's law no longer operated in this model (an idea picked up by Keynes).

As long as corporations had continued to expand their capital facilities (their factories, warehouses, heavy equipment, and other investments), the economy had flourished. Under pressure from the Coolidge administration and from business, the Federal Reserve Board kept the discount rate low, encouraging high (and excessive) investment. By the end of the 1920s, however, capital investments had created more plant space than could be profitably used, and factories were producing more than consumers could purchase.

According to this view, the root cause of the Great Depression was a global overinvestment in heavy industry capacity compared to wages and earnings from independent businesses, such as farms. The solution was the government must pump money into consumers' pockets. That is, it must redistribute purchasing power, maintain the industrial base, but reinflate prices and wages to force as much of the inflationary increase in purchasing power into consumer spending. The economy was overbuilt, and new factories were not needed. Foster and Catchings recommended^[13] federal and state governments start large construction projects, a program followed by Hoover and Roosevelt.

Debt deflation

Irving Fisher argued that the predominant factor leading to the Great Depression was overindebtedness and deflation. Fisher tied loose credit to over-indebtedness, which fueled speculation and asset bubbles.^[14] He then outlined 9 factors interacting with one another under conditions of debt and deflation to create the mechanics of boom to bust. The chain of events proceeded as follows:

Debt liquidation and distress selling
Contraction of the money supply as bank loans are paid off
A fall in the level of asset prices
A still greater fall in the net worths of business, precipitating bankruptcies
A fall in profits
A reduction in output, in trade and in employment.
Pessimism and loss of confidence
Hoarding of money
A fall in nominal interest rates and a rise in deflation adjusted interest rates.^[14]

During the Crash of 1929 preceding the Great Depression, margin requirements were only 10%.^[15] Brokerage firms, in other words, would lend $9 for every $1 an investor had deposited. When the market fell, brokers called in these loans, which could not be paid back. Banks began to fail as debtors defaulted on debt and depositors attempted to withdraw their deposits en masse, triggering multiple bank runs. Government guarantees and Federal Reserve banking regulations to prevent such panics were ineffective or not used. Bank failures led to the loss of billions of dollars in assets.^[16] Outstanding debts became heavier, because prices and incomes fell by 20–50% but the debts remained at the same dollar amount. After the panic of 1929, and during the first 10 months of 1930, 744 US banks failed. (In all, 9,000 banks failed during the 1930s). By April 1933, around $7 billion in deposits had been frozen in failed banks or those left unlicensed after the March Bank Holiday.^[17]

Bank failures snowballed as desperate bankers called in loans which the borrowers did not have time or money to repay. With future profits looking poor, capital investment and construction slowed or completely ceased. In the face of bad loans and worsening future prospects, the surviving banks became even more conservative in their lending.^[16] Banks built up their capital reserves and made fewer loans, which intensified deflationary pressures. A vicious cycle developed and the downward spiral accelerated.

The liquidation of debt could not keep up with the fall of prices which it caused. The mass effect of the stampede to liquidate increased the value of each dollar owed, relative to the value of declining asset holdings. The very effort of individuals to lessen their burden of debt effectively increased it. Paradoxically, the more the debtors paid, the more they owed.^[14] This self-aggravating process turned a 1930 recession into a 1933 great depression.

Macroeconomists including Ben Bernanke, the current chairman of the U.S. Federal Reserve Bank, have revived the debt-deflation view of the Great Depression originated by Fisher.^[18]^[19]

Structural weaknesses in banking

Economic historians (especially Friedman and Schwartz) emphasize the importance of numerous bank failures. The failures were mostly in rural America. Structural weaknesses in the rural economy made local banks highly vulnerable. Farmers, already deeply in debt, saw farm prices plummet in the late 1920s and their implicit real interest rates on loans skyrocket; their land was already over-mortgaged (as a result of the 1919 bubble in land prices), and crop prices were too low to allow them to pay off what they owed. Small banks, especially those tied to the agricultural economy, were in constant crisis in the 1920s with their customers defaulting on loans because of the sudden rise in real interest rates; there was a steady stream of failures among these smaller banks throughout the decade.

The city banks also suffered from structural weaknesses that made them vulnerable to a shock. Some of the nation's largest banks were failing to maintain adequate reserves and were investing heavily in the stock market or making risky loans. Loans to Germany and Latin America by New York City banks were especially risky. In other words, the banking system was not well prepared to absorb the shock of a major recession.

Economists have argued that a liquidity trap might have contributed to bank failures.^{[citation needed]}

Economists and historians debate how much responsibility to assign the Wall Street Crash of 1929. The timing was right; the magnitude of the shock to expectations of future prosperity was high. Most analysts believe the market in 1928-29 was a "bubble" with prices far higher than justified by fundamentals. Economists agree that somehow it shared some blame, but how much no one has estimated. Milton Friedman concluded, "I don't doubt for a moment that the collapse of the stock market in 1929 played a role in the initial recession".^[20] The debate has three sides: one group says the crash caused the depression by drastically lowering expectations about the future and by removing large sums of investment capital; a second group says the economy was slipping since summer 1929 and the crash ratified it; the third group says that in either scenario the crash could not have caused more than a recession. There was a brief recovery in the market into April 1930, but prices then started falling steadily again from there, not reaching a final bottom until July 1932. This was the largest long-term U.S. market decline by any measure. To move from a recession in 1930 to a deep depression in 1931-32, entirely different factors had to be in play.^[21]

Breakdown of international trade

When the war came to an end in 1918, all European nations that had been allied with the United States owed large sums of money to American banks, sums much too large to be repaid out of their shattered treasuries. This is one reason why the Allies had insisted (to the consternation of Woodrow Wilson) on demanding reparation payments from Germany and Austria–Hungary. Reparations, they believed, would provide them with a way to pay off their own debts. However, Germany and Austria-Hungary were themselves in deep economic trouble after the war; they were no more able to pay the reparations than the Allies were able to pay their debts.

The debtor nations put strong pressure on the United States in the 1920s to forgive the debts, or at least reduce them. The American government refused. Instead, U.S. banks began making large loans to the nations of Europe. Thus, debts (and reparations) were being paid only by augmenting old debts and piling up new ones. In the late 1920s, and particularly after the American economy began to weaken after 1929, the European nations found it much more difficult to borrow money from the United States. At the same time, high U.S. tariffs were making it much more difficult for them to sell their goods in U.S. markets. Without any source of revenue from foreign exchange with which to repay their loans, they began to default.

Beginning late in the 1920s, European demand for U.S. goods began to decline. That was partly because European industry and agriculture were becoming more productive, and partly because some European nations (most notably Weimar Germany) were suffering serious financial crises and could not afford to buy goods overseas. However, the central issue causing the destabilization of the European economy in the late 1920s was the international debt structure that had emerged in the aftermath of World War I.

The Smoot-Hawley Tariff Act was especially harmful to agriculture because it caused farmers to default on their loans. This event may have worsened or even caused the ensuing bank runs in the Midwest and West that caused the collapse of the banking system.

Prior to the Great Depression, a petition signed by over 1,000 economists was presented to the U.S. government warning that the Smoot-Hawley Tariff Act would bring disastrous economic repercussions; however, this did not stop the act from being signed into law.

The high tariff walls critically impeded the payment of war debts. As a result of high U.S. tariffs, only a sort of cycle kept the reparations and war-debt payments going. During the 1920s, the former allies paid the war-debt installments to the United States chiefly with funds obtained from German reparations payments, and Germany was able to make those payments only because of large private loans from the United States and Britain. Similarly, U.S. investments abroad provided the dollars, which alone made it possible for foreign nations to buy U.S. exports.

In the scramble for liquidity that followed the 1929 stock market crash, funds flowed back from Europe to America, and Europe's fragile economies crumbled.

By 1931, the world was reeling from the worst depression of recent memory, and the entire structure of reparations and war debts collapsed.

Notes

^ Carter, Susan (2006). Historical Statistics of the US: Millennial Edition.
^ Keen 2000, p.198.
^ Friedman 1965, p.4.
^ Speech by Ben Bernanke, November 8, 2002, The Federal Reserve Board, retrieved January 1, 2007 saying on Nov. 8 2002
^ Friedman 2007, p.15.
^ Paul Krugman, "Who Was Milton Friedman?" New York Review of Books Volume 32, Number 32 · February 3, 2007 online community
^ Eichengreen 1992, p.xi
^ Bernanke 2002, p.80
^ Kehoe, Timothy J. and Edward C. Prescott. Great Depressions of the Twentieth Century Federal Reserve Bank of Minneapolis, 2007.
^ Rothbard, A History of Money and Banking in the United States, pp.293-294.
^ Dorfman 1959
^ Allgoewer, Elisabeth (May 2002). "Underconsumption theories and Keynesian economics. Interpretations of the Great Depression" (PDF). Discussion paper no. 2002-14.
^ The Road to Plenty (1928)
^ ^a ^b ^c Fisher, Irving (October 1933). "The Debt-Deflation Theory of Great Depressions". Econometrica. 1: 337–357. doi:10.2307/1907327.
^ Fortune, Peter (Sept-Oct, 2000). "Margin Requirements, Margin Loans, and Margin Rates: Practice and Principles - analysis of history of margin credit regulations - Statistical Data Included". New England Economic Review. {{cite journal}}: Check date values in: |date= (help)
^ ^a ^b "Bank Failures". Living History Farm. Retrieved 2008-05-22.
^ "Friedman and Schwartz, Monetary History of the United States", 352
^ Bernanke, Ben S (June 1983). "Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression". The American Economic Review. 73 (3). The American Economic Association: 257–276. {{cite journal}}: Unknown parameter |month= ignored (help)CS1 maint: date and year (link)
^ Mishkin, Fredric (December 1978). "The Household Balance and the Great Depression". Journal of Economic History. 38: 918–37.
^ Parker, p.49.
^ White, 1990.

References

Secular Stagnation and Great Depression, R. L. Norman, Jr.
Dorfman, Joseph. Economic Mind in American Civilization (1959) vol 4 and 5 cover the ideas of all American economists of 1918-1933.
Friedman, Milton and Anna Jacobson Schwartz, A Monetary History of the United States, 1867-1960 (1963)
Keen, Steve 2001. Debunking Economics Pluto Press Australia Limited Sydney, Australia
Meltzer, Allan H. 2003 A History of the Federal Reserve Volume I: 1913-1951 Chicago University Press, Chicago, IL
Rothbard, Murray N. 1963 America's Great Depression D. Van Nostrand Company, Princeton, NJ
Rothbard, Murray N. A History of Money and Banking in the United States: The Colonial Era to World War II (2002)
White, Eugene N. "The Stock Market Boom and Crash of 1929 Revisited" Journal of Economic Perspectives, Vol. 4, No. 2 (Spring, 1990), pp. 67–83; examines different theories

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