Great Depression/Tutorials

Output Chart

Chart 1: GDP annual pattern and long-term trend, 1920-40, in billions of constant dollars

Causes and remedies

Theoretical considerations

Scholars have not agreed on the exact causes and their relative importance. The search for causes is closely connected to the question of how to avoid a future depression, so the political and policy viewpoints of scholars are mixed into the analysis of historic events eight decades ago. Current theories may be broadly classified into two main points of view. First, there is orthodox classical economics, monetarist, Keynesian, Austrian Economics and neoclassical economic theory, which focuses on the macroeconomics of the money supply, including production and consumption. Second, there are structural theories, including those of institutional economics, that point to underconsumption and overinvestment (economic bubble), or to malfeasance by bankers and industrialists, or to failures of government.

There are multiple issues—what set off the first downturn in 1929, what were the structural weaknesses and specific events that turned it into a major depression, and how did the downturn spread from country to country.

In terms of the 1929 small downturn, historians emphasize structural factors and the stock market crash, while economists point to Britain's decision to return to the Gold Standard at pre-World War I parities ($4.86 per Pound). Although most analysts believe the Wall Street Crash of 1929 was the immediate cause triggering the Great Depression, there are other, deeper causes that explain the crisis. The vast economic cost of World War I weakened the ability of the world to respond to a major crisis.

Contributory factors

The Gold Standard

The gold standard theory of the depression has been summarised by Bernanke and Carey , broadly as follows.

In order to curb the New York stock market boom, the Federal Reserve Bank imposed a contraction of the money supply in the late 1920s and several other major countries followed suit. That contraction was transmitted to other industrialised countries as a result of the operation of the gold standard. A rush for the safety of gold prompted by the 1931 banking crisis, the sterilisation of gold inflows by countries with balance of payments surpluses, the substitution of gold for foreign exchange reserves, and runs on many banks, all led to increases in the gold reserves required to back the issue of money and consequently to sharp and unintended reductions in the international money supply. The resulting deflation was avoidable only by a countervailing money creation by central banks but, in the absence of international agreement to do so, countries could take that action only by abandonong the gold standard.

The New York Stock Market crash

Economists dispute how much weight to give the Wall Street Crash of 1929; most say it played some role. It clearly changed sentiment about and expectations of the future, shifting the outlook from very positive to negative, with a dampening effect on investment and entrepreneurship. In the long run, the market did not recover; it began almost continuously to head downwards until 1933, producing the greatest long-term market declines by any measure and erasing billions in assets.

Debt

Macroeconomists, such as Ben Bernanke, have revived the debt-deflation view of the Great Depression originated by Arthur Cecil Pigou and Irving Fisher. In the 1920s, in the U.S. the widespread use of the home mortgage and credit purchases of automobiles and furniture boosted spending but created consumer debt. People who were deeply in debt when a price deflation occurred were in serious trouble—even if they kept their jobs—and risked default. They drastically cut current spending to keep up time payments, thus lowering demand for new products. Furthermore the debts grew, because prices and incomes fell 20-50%, but the debts remained at the same dollar amount. With future profits looking poor, capital investment slowed or completely ceased. In the face of bad loans and worsening future prospects, banks became more conservative in lending. They built up their capital reserves, which intensified the deflationary pressures. The vicious cycle developed and the downward spiral accelerated. This kind of self-aggravating process may have turned a 1930 recession into a 1933 depression. For Irving Fisher, the only economist to predict, in 1928, that a "recession" was right around the corner, thought the depression was preventable:

I believe some of the crash was inevitable because of over-indebtedness, but the depression was not inevitable. The reason is that the deflation which went with the over-indebtedness was not necessary. We can always control the price level. Irving Fisher

Trade Decline and the U.S. Smoot-Hawley Tariff Act

Many economists at the time argued that the sharp decline in international trade after 1930 helped to worsen the depression, especially for countries dependent on foreign trade. Most historians and economists assign the American Smoot-Hawley Tariff Act of 1930 part of the blame for worsening the depression by reducing international trade and causing retaliation. Foreign trade was a small part of overall economic activity in the United States; it was a much larger factor in most other countries. The average rate of duties on dutiable imports for 1921-1925 was 26% but under the new tariff it jumped to 50% in 1931-1935.

In dollar terms, American exports declined from about $5.2 billion in 1929 to $1.7 billion in 1933; but prices also fell, so the physical volume of exports only fell in half. Hardest hit were farm commodities such as wheat, cotton, tobacco, and lumber. Many American farms had been heavily mortgaged as farmers bought overpriced land in the bubble of 1919-20, and defaulted.

U.S. Federal Reserve and money supply

Monetarists, including Milton Friedman and Ben Bernanke, stress the negative role of the American Federal Reserve System in not acting properly to prevent a small depression from turning into a large one. The money supply to fall by one-third from 1930 to 1931. With significantly less money to go around, businessmen could not get new loans and could not even get their old loans renewed, forcing many to stop investing. This interpretation blames the Federal Reserve not for causing the depression but for not taking aggressive action to restore the money supply. The Fed was not controlled by President Hoover or the U.S. Treasury; it was primarily controlled by member banks and businessmen and it was to these groups that the Fed listened most attentively regarding policies to follow. This monetarist approach certainly explains why the depression was agravated, but does not shed any light on why it began, in first place. Friedman argues that the downward turn in the economy starting with the stock market crash would have been just another recession. In general, he blames widespread runs on small local banks.

Rival explanations

Irving Fisher

An influential economist in the early 20th century, Irving Fisher is now best known for his forecast that there would be no stock market crash - that he made immediately before it happened , (although in his defence he has pointed out that only he had predicted the inevitability of a depression, although he had seriously underestimated its severity ). Fisher's explanation of the depression was that an economy with a high level of debt had suffered a shock that had led to a loss of confidence which had prompted the widespread liquidation of debts by "distress selling", causing a sharp fall in share prices and a contraction in bank deposits; and that this had triggered a deflation which increased the stock of debt in real terms. What had followed had been a perverse cycle of further price reductions which led to further pressure to liquidate debts, which led to further price falls, and so on, which he called "debt deflation" . . Fisher maintained throughout the 1930s that a financial crash need not affect the real economy provided that there was a sufficient expansion of the money supply . The shock to which Fisher attributed the onset of the depression was the sudden reversal of the Federal Reserve Bank's monetary policy that is discussed below. .

Lionel Robbins

Lionel Robbins of the London School of Economics was at the time an influential proponent of the theories of the Austrian School of economics (although he subsequently adopted Keynesianism). His protegé, Friederich Hayek, had developed a theory of recessions, which he used in 1934 to explain the then current depression .

Rival remedies

Deficit Spending

The British economist John Maynard Keynes argued that the low aggregate demand in the economy caused a multiple decline in income, keeping the economy in an equilibrium well below full employment. In this situation, the economy may reach perfect balance, but at a cost of a high unemployment. Keynesian economists were increasingly calling for government to take up the slack by increasing government spending. Although Keynes's specific policy prescriptions at the time were vague (Perelman 1989) , his basic approach was to let business be free to do as it would choose, while creating a macroeconomic climate in which investment would be brisk or, using Keyne's own words - which became famous - creating a macroeconomic environment capable of awakening the "animal spirits" of entrepreneurs. Animal spitirts are a particular sort of confidence, "naive optimism"; "the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death".John Maynard Keynes