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 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

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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