Great Depression/Tutorials

The Economics of the Depression - causes and remedies

For the historical sequence of the events referred to, with links to accounts of those events, see the timelines subpage.

For definitions of the terms shown in italics see the glossary on the Related Articles subpage [10].

Causes

The economic doctrines of the 1920s

Liquidationism

The prevailing attitude to recessions in the 1920s was the teaching of the Austrian School led by Friederich Hayek in London, and supported by eminent American economists. Hayek is quoted as saying

"...still more difficult to see what lasting good effects can come from credit expansion. The thing which is most needed to secure healthy conditions is the most speedy and complete adaptation possible of the structure of production. If the proportion as determined by the voluntary decisions of individuals is distorted by the creation of artificial demand resources [are] again led into a wrong direction and a definite and lasting adjustment is again postponed.The only way permanently to 'mobilise' all available resources is, thereforeto leave it to time to effect a permanent cure by the slow process of adapting the structure of production..."

- and Harvard's Joseph Schumpeter argued that there was:

" a presumption against remedial measures which work through money and credit. Policies of this class are particularly apt to produce additional trouble for the future;"

- and that:

"depressions are not simply evils, which we might attempt to suppress, but forms of something which has to be done, namely, adjustment to change."

That was the view of United States Secretary of the Treasury Andrew Mellon (who has been quoted as advising President Hoover that the depression would "purge the rottenness out of the system" ) and it was shared by Britain's Chancellor Phillip Snowden. They agreed that expansionary monetary and fiscal policies should be avoided because they would reduce investor confidence and hinder the process of liquidation, reallocation, and the resumption of private investment.

The Real Bills doctrine

Monetary theory in the 1920s was largely governed by the doctrine propounded by Adam Smith in his "Wealth of Nations":

"When a bank discounts to a merchant a real bill of exchange, drawn by a real creditor upon a real debtor, and which, as soon as it becomes due, is really paid by that debtor ; it only advances to him part of the value which he would otherwise be obliged to keep by him unemployed and in ready money, for answering occasional demands. The payment of the bill, when it becomes due, replaces to the bank the value of what it had advanced, together with the interest." .

- which was interpreted to mean that money issued against commercial paper cannot be inflationary because it merely responds passively to the needs of commerce.

Despite its disproof by David Ricardo and others , the real bills doctrine was so widely held that it was incorporated in the Federal Reserve Act 1913 . It was also the basis of the Reichsbank’s policy of issuing astronomical sums of money to satisfy the needs of trade at ever-rising prices during the German hyperinflation of 1922-1923.

The gold standard imperative

(for an account of the history and effects of the gold standard see the article on that subject)

By the 1920s, the gold standard had been endowed with an importance that went beyond any appreciation of its merits as a means of stabilising trade flows. According to Peter Bernstein its control over the affairs had "never been so absolute" and he quotes Joseph Schumpeter as calling it "a symbol of sound practice and a badge of honor and dignity" , and Peter Temin quotes Benjamin, the Governor of the New York Federal Reserve Bank as saying (about the need for Britain to return to the gold standard, after the first word war) that "failure to resume gold payments...would be followed by a long period of unsettled conditions, too serious really to contemplate... - and incentives to governments ...to undertake various types of paper money experiments and inflation" . Its only important opponent was John Maynard Keynes, who argued in a tract on monetary reform that price stability should take priority over exchange stability.

Contributory factors

The aftermath of war

The first world war had an intense and lasting disruptive effect, leaving the international economy in an unusually fragile condition. There had been an unprecedented loss of life and productive manpower in Europe, 8 million men having been killed and 15 million incapacitated. The financial consequences had also been severe: budget deficits had multiplied, gold stocks had been depleted, onerseas assets had been sold, and the wartime allies owed nearly $2 billion to the United States (which, must be considered to have been a large sum, bearing in mind that prices are now about 20 times, and US output about 100 times what is was then), and productive capacity had suffered a consideable setback . Writing in 1919, John Maynard Keynes presented a graphic picture of the poverty and deprivation, and of a gloomy prospect for the years to come, remarking that

"We are thus faced in Europe with the spectacle of an extra-ordinary weakness on the part of the great capitalist class, which has emerged from the industrial triumphs of the nineteenth century, and seemed a very few years ago our all-powerful master" .

A further increase in the fragility of the international economy was created by the return to the gold standard after its wartime suspension. The United States returned in 1919, and most other countries between 1924 and 1927 . A substantial disruption was caused by Britain's 1925 decision to return at the pre-war exhange rate of $4.86 (a decision that had been opposed by Keynes, who warned that it could leadto an international depression ). The hope that the gold standard would exert a stabilising influence as it had before the war was soon disappointed . It was a system with an inbuilt tendency to deflation. As explained by Peter Temin and others ., that was because, whereas countries with balance of payments deficits were forced to reduce deflate in order to preserve their gold reserves, surplus countries were free to "sterilise" gold inflows and so prevent any increase in their money supply. According to James Hamilton such sterilisation was, in fact practised from time to time by the two major surplus countries, the United States and France (that between them came to hold 60 per cent of the world's gold reserves) Countries with small gold reserves were especially vulnerable to gold outflows and the general strike of 1926 has been attributed to deflationary policies that were forced on the British government by its determination to stay on the gold standard .

Monetary policy

In 1927, the Federal Reserve increased the United States money supply by a reduction in interest rates and by vigorous open market operations . It did so partly in order to fend off what appeared to be an impending recession, and partly in response to a British request for help to stem the outflow of gold from Britain to the United States .

(the following has been summarised from Ben Bernanke's speech to the Conference to Honor Milton Friedman, November 8, 2002 [11] )

In the spring of 1928 there was a significant tightening of monetary policy by the Federal Reserve Board that continued until the stock market crash of October 1929. The Board's reason for that action was not concern about inflation - which hardly existed at the time - but concern about speculation on Wall Street, prompted by the increases stock market prices and in bank loans to brokers. As Friedman and Schwartz noted ., "by July, the discount rate had been raised in New York to 5 per cent, the highest since 1921, and the System's holdings of government securities had been reduced to a level of over $600 million at the end of 1927 to $210 million by August 1928, despite an outflow of gold." Strong reservations about that policy had been expressed by one of the Board's members, Benjamin Strong, the influential Governor of the Federal Reserve Bank of New York, but Strong died in October and the policy was supported by his successor, George Harrison, and the discount rate was raised a further point to 6 per cent in the following year. That move was followed by a period of falling prices and weaker economic activity. According to Friedman and Schwartz "During the two months from the cyclical peak in August 1929 to the crash, production, wholesale prices, and personal income fell at annual rates of 20 per cent, 7-1/2 per cent, and 5 per cent, respectively." and after the stock market crash, economic decline became even more precipitous. (James Hamilton has shown that the Board's desire to slow outflows of gold to France had then resulted in massive flows of gold from abroad and a further tightening of monetary policy.)

In September 1931 there was another tightening of monetary policy, following the UK's sterling crisis. A wave of speculative attacks on the pound had forced Britain to leave the gold standard and, anticipating that the United States might the next to do so, speculators turned their attention from the pound to the dollar. Central banks and private investors converted a substantial quantity of dollar assets to gold in September and October of 1931. The resulting outflow of gold reserves also put pressure on the U.S. banking system as foreigners liquidated dollar deposits and domestic depositors withdrew cash in anticipation of additional bank failures. According to Friedman and Schwarz: , "The Federal Reserve System reacted vigorously and promptly to the external drain. . . . On October 9, the Reserve Bank of New York raised its rediscount rate to 2-1/2 per cent, and on October 16, to 3-1/2 per cent--the sharpest rise within so brief a period in the whole history of the System, before or since (p. 317)." This action stemmed the outflow of gold but contributed to an increase in bank failures and bank runs, with 522 commercial banks closing their doors in October alone. The policy tightening and the ongoing collapse of the banking system caused a steep fall in the money supply and the declines in output and prices became even more precipitous.

In April 1932, when the Congress pressed the Board to ease monetary policy, and between April and June 1932, it made substantial open market purchases, which slowed the decline in the stock of money and reduced the yields on bonds and commercial paper. By August there were rises in wholesale prices and industrial production and there were other indications of increasing activity. However, the Board members did not favour a continuation of that policy and, when the Congress adjourned in July, they abandoned it. A sharp fall in economic activity followed towards the end of the year.

There was one more monetary tightening in early 1933. Fearing that the new President would abandon the gold standard, investors began to convert dollars to gold, putting pressure on both the banking system and the gold reserves of the Federal Reserve System. Bank failures and action to resist the gold drain further reduced the stock of money and there was another sharp reduction in economic activity. That tightening ended after President Roosevelt's March declaration of a national bank holiday and his abandonment of the gold standard; and there was then a renewed expansion of money, prices, and output.

The stock market boom and crash

As noted in the article on the crash of 1929, the stock market crash marked the end of a period of eight increasingly prosperous years, known as the "roaring twenties": a period of above-average growth of national income, exceptionally rapid growth in corporate earnings, and even more rapid growth in stock exchange prices. That trend intensified in the latter years, with stock prices rising from about 10 times corporate earnings in 1928 to 15 times or more in 1929. Then, in the June of 1929, industrial activity began a decline that continued throughout the rest of the year, and, in a few days in the autumn of 1929, the average share price on the New York stock exchange dropped by a staggering 30 per cent.

It is now clear that the stock market crash could not have contributed to the initiation of the downturn, because the downturn was already under way at the time of the crash. However the tightening of monetary policy in 1928 and 1929 was prompted by the belief by the staff of the Federal Reserve Bank that the preceding boom in stock prices was a speculative "bubble", and their wish to restrain it in order to achieve a soft landing". As a result of an analysis by McGrattan and Prescott , endorsed by Bernanke , there is now a consensus that their belief had been mistaken, and that market prices before the downturn in activity had been well justified by the real value of the companies concerned.

The extent to which the crash contributed to the subsequent severity of the depression has been examined by Peter Temin as noted below.

The Smoot-Hawley Tariff

The Smoot-Hawley Tariff Act of June 1930 raised U.S. tariffs to historically high levels. In his election campaign, Herbert Hoover had only promised to increase tariffs on agricultural products, but industrial lobbying persuaded Congress to raise tariffs on some 20,000 products, covering all sectors of the economy (contrary to the advice of many economists at the time [12] ) , and raising the average tariff rate on United States imports from 26% to 50%. . Following retaliation by 25 of America's trading partners, its exports fell by over 60% during the following two years

Rival explanations

Irving Fisher

(Irving Fisher (1867-1947) was an American economist, statistician and commentator on public events, and was Professor of Political Economy at Yale from 1898 to 1935. An influential economist in the early 20th century, he 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.

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.

.

Lionel Robbins

(Lionel Robbins (1898-1984) was Professor of Political Economy at the London School of Economics from 1929 to 1961. He was at first an influential proponent of the theories of the Austrian School of economics, but he subsequently adopted Keynesianism).)

Writing in 1934, Lionel Robbins argued that the expansionary action taken by Federal Reserve Bank in 1927 had set off a speculative boom, the inevitable consequences of which were the later downturns of stock prices, consumers' expenditure and economic activity. The conclusion of his analysis was that:

" ... it was ...deliberate "reflation" on the part of the Federal Reserve authorities, which produced the worst phase of this stupendous fluctuation. ...."

Although he thus assigned a single cause to the initial downturn in economic activity, he attributed its continued severity to multiple influences, including political uncertainties, trade protection, bad banking policies, fraud, and "...the cartelisation of industry, the growth of the strength of trade unions [and] the multiplication of state controls"; but particularly to the failure of wage rates to adjust to the fall in prices - which he called "the by-product of unemployment insurance".

He was later to decide that he had been mistaken, and to have said of his book, "The Great Depression", that: "this is a work I should now wish not to have written" .

Friedrich Hayek and the Austrian School

(Friedrich Hayek (1899-1992) was a British economist of the Austrian School, winner of the 1974 Nobel Prize in Economics , founder of the Institute for Economic Affairs, and author of "The Road to Serfdom ".)

The treatment of the depression by the Austrian School economists is usually attributed to Friedrich Hayek, who was Robbins' protegé at the time (although it is difficult to locate any of his writings on the subject). His theory of recessions was drawn upon by Robbins in writing "The Great Depression", and his analysis of the great depression may be assumed to have been similar to that of Robbins.

He is well known to have been one of the few economists to have predicted the recession, and he is often quoted as later saying that

"Up to 1927 I should have expected that the subsequent depression would be very mild. But in that year an entirely unprecedented action was taken by the American monetary authorities [who] succeeded, by means of an easy-money policy, inaugurated as soon as the symptoms of an impending reaction were noticed, in prolonging the boom for two years beyond what would otherwise have been its natural end. And when the crisis finally occurred, deliberate attempts were made to prevent, by all conceivable means, the normal process of liquidation."

The Austrian School analysis of the great depression has since been extensively developed by Murray Rothbard .

Keynes and the Keynesians

(John Maynard Keynes (1883-1946) was a Fellow of King's College, Cambridge, 1930-89 and author of The General Theory of Employment, Interest and Money and was the founder of macroeconomics.

An entirely different view of the situation was taken at the time by John Maynard Keynes. In an article to an English magazine in late 1930, he argued that the depression had been the result of a downturn in investment because the plans of savers had diverged from the plans of investors , and in a 1931 Chicago lecture, he explained that, in his view, that had been due to high interest rates, tight Federal Reserve monetary policies and diminishing returns to investment; and in his Treatise on Money he said that:

"The boom of 1928-29 and the slump of 1929-30 in the United States correspond respectively to an excess and a deficiency of investment",

and:

"I attribute the slump of 1930 primarily to the deterrent effect upon investment of the long period of dear money which preceded the stock market collapse, and only secondarily to the collapse itself, but the collapse having occurred, it greatly aggravated matters, especially in the United States, by causing a disinvestment in working capital" .

Later, in his 1936 General Theory , he attributed less importance to interest rates, arguing that the marginal efficiency of capital had fallen because of the large previous investment.

The subsequent development of the Keynesian explanation, taking account of the banking crisis, - as described by Peter Temin in 1976 - was on the following lines.

The fall in spending produced a fall in real income and prices by the multiplier process and that led to a decrease in the demand for money. The monetary base (high powered money) continued to increase (except, briefly, in 1930) but the banking panics reduced the amount of money that the monetary base could support , helping to bring the supply of money into line with demand (but equibrium would have been reached by other means if there had been no banking crisis). The international collapse further reduced activity by reducing US exports.

.

(The contribution of John Maynard Keynes to the debate is further described below, under the heading of "Remedies".)

Milton Friedman and the Chicago School

(Milton Friedman (1912-2006) was the winner of the 1976 Nobel Prize in Economics and leader of the Chicago School of Economics and was the founder of modern monetarism.)

A different approach to the problem was taken in the 1960s by economists at the Chicago School of Economics. In their book on The Monetary History of The United States they had demonstrated that fluctuations in nominal income were largely generated by fluctuations in the supply of money , and in its chapter on "The Great Contraction" they argue that the Federal Reserve had mistakenly followed restrictive policies which had led to a decline in the quantity of money by a third, leading to the collapse of a third of the United States banking system and thus to a much more severe downturn in economic activity than would otherwise have happened. They attributed the Bank's adoption of those policies to its officials' belief in "liquidationism" and to the fact that they were not considered to have any duty towards banks that were not members of the Federal Reserve System.

In the monetarist explanation, a conventional short-term recession was converted into a depression by the banking panic which led to an increase in the banks' reserves and a consequent fall in the supply of money at a given level of the monetary base. That fall in the money supply led to falls in incomes and prices. The international depression put pressure on the dollar and the American depression was intensified by the restrictive monetary policies adopted to counter that pressure.

Ben Bernanke

(Ben Bernanke (1953 - ), now Chairman of the Board of Governors of the Federal Reserve System was previously Professor of Economics and Public Affairs and Chair of the Economics Department at Princeton University from 1996 to 2002.)

Barry Eichengreen

(Barry Eichengreen (1952 - ) has been Professor of Economics and Political Science at the University of California, Berkeley since 1987, and was Senior Policy Adviser to the International Monetary Fund from 1997 to 1998.)'

Barry Eichengreen and his colleague Jeffrey Sachs take the gold standard to have been the mechanism by which the great depression came to infect countries outside the United States. They found that countries that stayed longest on the exchange rates, (such as Switzerland and Poland), had high real wages and low output, whereas those that abandoned it early (such as Japan, Australia, New Zealand and Argentina) had lower real wages and higher output by the mid-30s. They argue that although it would be right to regard the currency devaluations of countries that left the gold standard as beggar—thy—neighbour actions, they benefited the system as a whole and would have hastened recovery from the great depression had they been adopted more widely

counterfactual

credit boom

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.

relative to the Depression, the direct macroeconomic effects of the tariff were small. If Smoot-Hawley had significant macroeconomic effects, these operated instead through its impact on the stability of the international monetary system and the efficiency of the international capital market.

Peter Temin

(Peter Temin (1937 - ) is a Professor of Economics at the Massachussets Institute of Technology and was formerly head of its economics department. He has written widely as an economist and economic historian.)

Temin argues , the gold standard was the mechanism by which a 1914-18 shock was made to lead a 1929 crisis. He considers the primary propagating mechanism of the depression itself to have been the late-1930 failure of the Bank of the United States, resulting from its reckless behaviour in the 1920s. He assigns a secondary role to the 1929 stock exchange crash, arguing that it had reduced private wealth by only 10 per cent, which would not have had a sufficient effect on consumers' expenditure to account for the very sharp fall that occurred in 1930. He also argues that the effect of retaliation against the Smoot-Hawley tariff must have been small - on the grounds that, with exports only 15 per cent of GDP, their fall by 1.5 per cent of 1929 GDP could not have had more than a small effect upon the US economy.

Charles Kindleberger

(Charles Kindleberger (1910-2003) was Professor of Economics at the Massachussetts Institute of Technology from 1951 to 1976 and had previuosly served as an economist at the Federal Reserve Bank of New York and the Bank for International Settlements.)

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.

Remedies

Retrenchment

Hayek's comment on Roosevelt's reflationary policy has been quoted as:

"..still more difficult to see what lasting good effects can come from credit expansion. The thing which is most needed to secure healthy conditions is the most speedy and complete adaptation possible of the structure of production.If the proportion as determined by the voluntary decisions of individuals is distorted by the creation of artificial demand resources [are] again led into a wrong direction and a definite and lasting adjustment is again postponed.The only way permanently to 'mobilise' all available resources is, thereforeto leave it to time to effect a permanent cure by the slow process of adapting the structure of production..."