Causes of the Great Depression

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The Great Depression was the worldwide economic downturn that began in 1929 and ended at different points in the 1930s. The economic events of the Great Depression are largely agreed upon and the agreement has remained essentially unchanged since study of the period began: a deflationary spiral forced dramatic falls in asset and commodity prices, dramatic drops in demand and credit, and disruption of trade. However, the causes and relationship among them, as well as the role of government policy in causing or ameliorating the Depression, continue to be debated.

People have desired explanations for the Great Depression for many reasons. Debates in the 21st century about the best course of action to follow often use Depression examples (such as dire warnings of a second Great Depression if a specific agenda is not fulfilled.) Furthermore, economists trying to develop macroeconomic models use the ability to explain past events as evidence of validity.

Contents 1 Theories at the time 1.1 Keynesian Explanation 1.2 Monetarist Explanations 1.3 The Gold Standard 1.4 Austrian School Explanations 1.5 Overproduction and Underconsumption 1.6 Structural weaknesses in banking 1.7 Postwar deflationary pressures 1.8 The breakdown of international trade 2 Works cited 3 Bibliography: 3.1 World 3.2 USA 3.3 USA: role of Federal Reserve 4 External links 5 See also

[edit] Theories at the time

The view among theoretical economists at the time of the Great Depression was that economies were self-correcting and that the economy needed to go through a period of liquidation before new growth could take place in an economically healthy way. (Delong 1991) Economists of this opinion believed that deflation would correct the excesses of the previous economic boom and that the economy would right itself just as it had in the recessionary periods of the late 19th and early 20th centuries. In their view, the economy would reach equilibrium at a lower level of wages and prices.^[1] This was not just the view in the US but included people connected to all the major central banks in the western world.^[2]

Herbert Hoover, the American Secretary of Commerce, took a different view. He argued that fluctuations could be smoothed out by counter-cyclical government spending. He developed his ideas in the 1920s and applied them as President during the Depression. He believed that high wages would create the spending power to overcome a depression so he campaigned for business to keep wages high, which they generally did until 1931.^[3]

[edit] Keynesian Explanation

English economist John Maynard Keynes in 1936 argued that there are many reasons why the self-correcting mechanisms that many 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, then the rate of interest would fall. According to Keynes, 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 automatically increase as a response to a fall in consumption. 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 futures 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.^[4] 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.

In Keynes’s view, since private sectors cannot be counted on to create aggregate demand during a recession, the government has the responsibility to create demand during this time, even if it has to run a deficit. Keynes’s ideas were revolutionary at the time and his work was broadly influential. The Keynesian view of economics and the cause of the Depression were widely accepted until the 1970’s when simultaneous unemployment and high inflation lead to the shift to other economic views.

[edit] Monetarist Explanations

In their 1965 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.”^[5] In his 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, Chairman of the Federal Reserve, later acknowledged that Friedman was right to blame the Federal Reserve for the Great Depression.^[6] During the 1930s and early 1940s, however, Friedman was an articulate Keynesian and was a leading supporter of the Roosvelt policies.^[7]

Before the 1915 establishment of the Federal Reserve, the banking system had dealt with periodic crises in the US (such as in 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 panics at the end of 1930, perhaps this would have stopped the vicious circle of the forced liquefaction of assets at depressed prices. Consequently, in his view, the banking panics 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.”^[8]

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.^[9]

[edit] The Gold Standard

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 were a significant obstacle to any actions that would ameliorate the growing Depression. The initial destabilizing shock may have originated with the Crash of 1929 in the US, but it was the gold standard system that transmitted the problem to the rest of the world.^[10]

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 from less deflation and tended to recover more quickly.^[11]

[edit] Austrian School Explanations

One of the more widely known explanations comes from the Austrian School of economics. Austrian theorists who wrote about the Depression include Hayek and Murray Rothbard, who wrote America's Great Depression in 1963. In their view, the key cause of the Depression was the expansion of the money supply in the 1920’s that lead to an unsustainable credit driven boom. In their view, the Federal Reserve, which was created in 1913, shoulders much of the blame.

One reason for the monetary inflation was to help Great Britain, who, in the 1920’s, was struggling with their plans to return to the gold standard at pre-war (WWI) parity. Returning to the gold standard at this rate meant that the British economy was facing deflationary pressure.^[12] According to Rothbard, the lack of price flexibility in Britain meant that unemployment shot up, and the American government was asked to help. The United States was receiving a net inflow of gold and inflated further in order to help Britain return to the gold standard. Montagu Norman, head of the Bank of England, had an especially good relationship with Benjamin Strong, the de facto head of the Federal Reserve. Norman pressured the heads of the central banks of France and Germany to inflate as well, but unlike Strong, they refused..^[13] Rothbard says American inflation was meant to allow Britain to inflate as well, because under the gold standard, Britain could not inflate on its own.

In the Austrian view it was this inflation of the money supply that led to an unsustainable boom in both asset prices (stocks and bonds) and in capital goods. 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 not only a disaster prior to the Depression, but 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.^[14]

Furthermore, 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 of 1932 which raised its total holding to $1.8 billion. Total bank reserves did only rise by $212 million, but Rothbard argues that this was due to the American populace losing faith in the banking system and 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.^[15]

[edit] Overproduction and Underconsumption

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 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 [Dorfman 1959]. Roosevelt scrawled in his copy, "Too good to be true—you can't get something for nothing," but while he wanted to economize, most of his advisors bought the theory and wanted to spend.

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^[16] federal and state governments start large construction projects, a program followed by Hoover and Roosevelt.

[edit] 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 as their customers defaulted on loans due to 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 Europe and Latin America by New York 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.

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".^[17] 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 pancakes 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 the largest long-term US 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.^[18]

[edit] Postwar deflationary pressures

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 of economic orthodoxy at the time was 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 a number of 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 hyperinflation experienced by Weimar Germany, 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 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.

[edit] The 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 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 all time, and the entire structure of reparations and war debts collapsed.

[edit] Works cited

[edit] Bibliography:

[edit] World

• Ambrosius, G. and W. Hibbard, A Social and Economic History of Twentieth-Century Europe (1989)
• Bordo, Michael, and Anna J. Schwartz, eds. A Retrospective on the Classical Gold Standard, 1821–1931 (1984) (National Bureau of Economic Research Conference Report)
• Bordo, Michael et al eds. The Gold Standard and Related Regimes : Collected Essays (1999)
• Brown, Ian. The Economies of Africa and Asia in the inter-war depression (1989)
• Davis, Joseph S., The World Between the Wars, 1919-39: An Economist's View (1974)
• Eichengreen, Barry. Golden Fetters: The Gold Standard and the Great Depression, 1919–1939 (NBER Series on Long-Term Factors in Economic Development), 1996, ISBN 0-19-510113-8
• Eichengreen, Barry, and Marc Flandreau, eds. The Gold Standard in Theory and History (1997)
• Feinstein. Charles H. The European economy between the wars (1997)
• Garraty, John A., The Great Depression: An Inquiry into the causes, course, and Consequences of the Worldwide Depression of the Nineteen-Thirties, as Seen by Contemporaries and in Light of History (1986)
• Garraty John A. Unemployment in History. (1978)
• Garside, William R. Capitalism in crisis: international responses to the Great Depression (1993)
• Haberler, Gottfried. The world economy, money, and the great depression 1919-1939 (1976)
• Hall, Thomas E. and J David Ferguson, The Great Depression: An International Disaster of Perverse Economic Policies (1998)
• Kaiser, David E. Economic diplomacy and the origins of the Second World War: Germany, Britain, France and Eastern Europe, 1930-1939 (1980)
• Keen, Steve 2001. Debunking Economics Pluto Press Australia Limited Sydney, Australia
• Kindleberger, Charles P. The World in Depression, 1929-1939 (1983);
• Meltzer, Allan H. 2003 A History of the Federal Reserve Volume I: 1913-1951 Chicago University Press, Chicago, IL
• Tipton, F. and R. Aldrich, An Economic and Social History of Europe, 1890–1939 (1987)

[edit] USA

• Barber, William J. From New Era to New Deal: Herbert Hoover, the Economists, and American Economic Policy, 1921-1933. (1985).
• Ben S. Bernanke. Essays on the Great Depression (2000)
• Bernstein, Michael A. The Great Depression: Delayed Recovery and Economic Change in America, 1929-1939 (1989) focus on low-growth and high-growth industries
• Bordo, Michael D., Claudia Goldin, and Eugene N. White , eds., The Defining Moment: The Great Depression and the American Economy in the Twentieth Century(1998). Advanced economic history.
• Chandler, Lester. America's Greatest Depression (1970). economic history overview.
• De Long, Bradford Liquidation” Cycles and the Great Depression (1991)
• Dorfman, Joseph. Economic Mind in American Civilization (1959) vol 4 and 5 cover the ideas of all American economists of 1918-1933.
• Jensen, Richard J. "The Causes and Cures of Unemployment in the Great Depression," Journal of Interdisciplinary History 19 (1989) 553-83. online at JSTOR in most academic libraries
• McElvaine Robert S. The Great Depression 2nd ed (1993) social history
• Mitchell, Broadus. Depression Decade: From New Era through New Deal, 1929-1941 (1964), standard economic history overview.
• Parker, Randall E. Reflections on the Great Depression (2002) interviews with 11 leading economists
• Singleton, Jeff. The American Dole: Unemployment Relief and the Welfare State in the Great Depression (2000)
• Warren, Harris Gaylord. Herbert Hoover and the Great Depression (1959).
• 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

[edit] USA: role of Federal Reserve

• Chandler, Lester V. American Monetary Policy, 1928-41. (1971).
• Epstein, Gerald and Thomas Ferguson. "Monetary Policy, Loan Liquidation and Industrial Conflict: Federal Reserve System Open Market Operations in 1932." Journal of Economic History 44 (December 1984): 957-84. in JSTOR
• Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867-1960 (1963)
• Paul J. Kubik, "Federal Reserve Policy during the Great Depression: The Impact of Interwar Attitudes regarding Consumption and Consumer Credit." Journal of Economic Issues . Volume: 30. Issue: 3. Publication Year: 1996. pp 829+.
• Mayhew, Anne. "Ideology and the Great Depression: Monetary History Rewritten." Journal of Economic Issues 17 (June 1983): 353-60.
• Meltzer, Allan H. A History of the Federal Reserve, Volume 1: 1913-1951 (2004) the standard scholarly history
• Rothbard, Murray N. A History of Money and Banking in the United States: The Colonial Era to World War II (2002)
• Rothbard, Murray N. 1963 America's Great Depression D. Van Nostrand Company, Princeton, NJ
• Steindl, Frank G. Monetary Interpretations of the Great Depression. (1995).
• Temin, Peter. Did Monetary Forces Cause the Great Depression? (1976).
• Wicker, Elmus R. "A Reconsideration of Federal Reserve Policy during the 1920-1921 Depression," Journal of Economic History (1966) 26: 223-238, in JSTOR
• Wicker, Elmus. Federal Reserve Monetary Policy, 1917-33. (1966).
• Wells, Donald R. The Federal Reserve System: A History (2004)
• Wueschner; Silvano A. Charting Twentieth-Century Monetary Policy: Herbert Hoover and Benjamin Strong, 1917-1927 Greenwood Press. (1999)

[edit] External links

• An Overview of the Great Depression from EH.NET by Randall Parker
• Great Myths of the Great Depression by Lawrence Reed
• Economic Depressions: Their Cause and Cure by Murray Rothbard (1969)
• The Prophet of the Great Depression by Frank Shostak (October 4, 2006)
• Banking and the Business Cycle (in PDF) by Phillips, McManus, and Nelson (1937
• Theories on the Great Depression: Harris, Sklar and Carlo by Reuben L. Norman, Jr. (June 26, 1998)

[edit] See also

• Great Depression
• Classical economics
• Marxist economics
• Neoclassical economics
• Keynesianism
• Monetarism
• Neo-Keynesian Economics
• Smoot-Hawley Tariff Act
• List of holy grails