Causes of the Great Depression

The Great Depression was a world wide economic downturn beginning in the late 1920's and only ended by the beginning of World War II in Europe. Finding the causes of this downturn, which is larger than any other during the period of economic record keeping that starts in the mid 19th century, has been called "the Holy Grail" of economics. Several theories have been advanced to describe the emergence of the Great Depression, many formulated in the decades since its occurance.

In general theories of the Great Depression can be classified into three groups: orthodox capitalist economics, which focus on the macro-economic effects of money supply, production and consumption, marxist and marxian theories which argue that the root causes of the Depression are based in the fundamental production relationships of capitalism, and heterodox theories, which argue that the Great Depression was caused by cyclical factors which reached a particularly acute point at that time.

All of these theories were prominent at the time, and guided different policy responses, thus even theories which are no longer widely accepted are documented and studied, if for no other reason than to examine why some of these theories failed so badly to cope with the economic stresses of the time.


Mainstream Economics

Credit Disruption Theories

One class of theories about the Great Depression is that a series of financial shocks disrupted the ability of the banking system to allocate credit, and that the result was a sharp contraction in the access to funds by business and the consumer.

The Stock Market Crash of 1929 as a trigger

In the popular imagination the Great Depression was started by the "Crash of 1929". On October 29, 1929 (the day also known as the Black Tuesday), share prices on Wall Street collapsed catastrophically, setting off a chain of bankruptcies and defaults that quickly spread overseas. The events in the United States were the final shock in a worldwide depression, which put hundreds of millions out of work across the capitalist world throughout the 1930s. In truth, economic instability had been growing for some time. However, the impact of the Crash of '29 was notable because Wall Street was where the wealthy of Europe had increasingly banked their gains. The Crash would dramatically reduce the total percentage of wealth held by the very top of the economic scale, and would create financial difficulties for many of them.

The market crash in the U.S. was the final straw for the already shaky world economy. There had been a series of financial crisis points through the 1920s including Germany suffering from hyperinflation, and turbulence associated with Britain attempting to re-establish the gold standard on a pre-war price basis. Many of the Allied victors of World War I were having serious problems paying off huge war debts, which had led to loan programs from the United States. In the late 1920s, the U.S. economy at first seemed immune to the mounting troubles, running a huge balance of trade surplus, but in 1930, what seemed like a cyclical downturn in the economy turned into a massive economic crisis.

Misallocation of Credit

One theory according to contemporary economists such as Peter Temin, as well as observers at the time such as John Maynard Keynes, is that international finance never recovered from the strains of World War I. After the world war there had been a rapid increase in industrialization, as well as sharp cuts in armaments by the major powers, which caused a dramatic increase in productive capacity, particularly outside Europe, without a corresponding increase in sustained demand. Fixed exchange rates and free convertibility gave way to a compromised gold standard that lacked the stability to rebuild world trade. According to this view, the major problem was that the world financial system did not have the ability to increase aggregate demand as fast as supply was increasing. There was an "over investment" in the late 1920s, which lead to a financial bubble that finally came crashing down into a vicious circle of deflation.

In 1929 the world's most prosperous nation was the United States. But despite the confidence in the United States and the apparent economic well-being in other countries, the world economy was in an unhealthy state. One by one, the pillars of the pre-war economic systemmultilateral trade, the gold standard, and the interchangeability of currencies—began to crumble.

The UK had returned to the gold standard in 1925 but had spent the previous five years managing the gold price down to its pre-war level. This forced a sharp deflation across the economy of the UK and the many other nations that used the Pound Sterling as their national unit of account.

The U.S. economy had been showing some signs of distress for months before October 1929. Commodity prices had been falling worldwide since 1926, reducing the capacity of exporters in the peripheral, undeveloped economies of Latin America, Asia, and Africa to buy products from the core industrial countries such as the United States and the United Kingdom. Business inventories were three times as large as they had been a year before (an indication that the public was not buying products as rapidly as in the past); and other indicators of economic health—freight carloads, industrial production, wholesale prices—were slipping downward.


Almost all theories of the Great Depression note that one contributing cause was the debt deflation trap: namely that money borrowed when prices are at a higher level, means repaying with more output. As Arthur Schlesinger noted, that amount of cotton that a farmer had to produce to pay off his loans rose by 30%. In theories of the Great Depression, such as those advanced by Benjamin Bernanke, it is this disruption, where people fear to borrow because they fear having to repay back in much more expensive dollars, that disrupts the credit process, and lies at the root of the Great Depression. The important difference between a pure monetary theory such as Friedman's and the wage misallocation theory, is that it is deflation itself that is the culprit that drives the contraction in the money supply: banks lend less, because people fear debt, and even if the Federal Reserve had eased, that this cycle would have continued unless monetary policy overshot and produced outright inflation. The solution, under this model, would have been similar to the monetarist model, namely have the Federal Reserve flood the American economy with liquidity, but it also would have required a matching devaluation of the dollar against gold, which is what Roosevelt did in 1933-1935, in order to end the fear that any inflation was "temporary". This devaluation would have had to have been even sharper than that which eventually occurred.

Since inflation, not deflation, was the primary fear at the time - the great inflationary shock from the First World War and its aftermath were still prevalent in every policy maker's mind - it is questionable whether any policy actors could have acted on this theory.

A maldistribution of purchasing power

One theory held by many at the time and since, including Franklin Roosevelt and his brain trust, holds that the fundamental maldistribution of purchasing power, the greatly unequal distribution of wealth throughout the 1920s, caused the Great Depression.

According to this view, wages increased at a rate that was a fraction of the rate at which productivity increased. As production costs fell quickly, wages rose slowly, and prices remained constant, the bulk benefit of the increased productivity went into profits. As industrial and agricultural production increased, the proportion of the profits going to farmers, factory workers, and other potential consumers was far too small to create a market for goods that they were producing.

Even in 1929, after nearly a decade of economic growth, more than half the families in America lived on the edge or below the subsistence level—too poor to share in the great consumer boom of the 1920s, too poor to buy the cars and houses and other goods the industrial economy was producing, too poor in many cases to buy even the adequate food and shelter for themselves. 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 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.

An increase in margin buying, the act of borrowing money from lenders in order to buy stocks, helped many people invest in the roaring stock market of the 1920s. When the stock market began to decline, the lenders panicked and demanded their money back. This increased the sales of stocks to pay off the loans, but many people remained in debt, and the lenders could not get their money back.

According to this view the root cause of the Great Depression was a global overinvestment in capacity compared to wages and earnings from independent businesses, such as farms. The solution that it proposed is largely the one taken in the New Deal - redistribute purchasing power, maintain the industrial base, but devalue the currency against gold and use government regulation to force as much of the inflationary increase in purchasing power into wages. It is generally seen as being opposed to the more strictly monetary solution proposed by Milton Friedman.

The Federal Reserve and the Money Supply

Another theory of the Great Depression, forwarded most notably by economists Milton Friedman and Anna Schwartz, involves the quantity theory of money. According to this theory, most of the depression's severity was caused by poor decision-making at the Federal Reserve.

For the first four years of the Depression, the Federal Reserve Board contracted the money supply at a time when Friedman says they should have been expanding it. Note Friedman and Schwartz:

"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. A corollary of this theory rejects the Gold Standard theory of the depression. It is a notable development because it implies that the depression's severity was caused by the Federal Reserve's mismanagement of the economy, not the absence of management. This theory is popular among the Monetarist school of economics. Many give credence to Friedman's theory because the theory has robustly explained most subsequent U.S. recessions and inflations.

The contraction in money supply is a factor in most theories of the Great Depression, and it is another way of saying that there was a tremendous fall in aggregate demand. From the perspective of monetarist explanations for the Depression, the depth of the financial collapse could have been averted by monetary policy, rather than requiring what eventually did happen, namely the use of regulations and fiscal policy to stabilize the economic activity in the US and other nations. According to the monetarist formulation, the root cause of the global downturn was the failure to reë³´ablish the gold standard at a level higher than the pre-war level, in order to account for inflation. This view was held by many observers at the time, even those who supported a return to the gold standard.

The debate over this theory centers on the question as to whether easing of monetary policy would have actually corrected structural imbalances in the economy, or whether it would have simply led to a secondary bubble which would have collapsed later, after increasing the US deficit and depleting US gold stocks. To monetarists, there were no structural imbalances to cure, the problem was strictly an ordinary downturn extended into a deeper one through poor monetary policy.

A lack of diversification

Another theory attributes the Depression to a serious lack of diversification in the American economy of the 1920s. Prosperity had been excessively dependent on a few basic industries, notably construction, automobiles and radio; in the late 1920s, those industries began to decline. Between 1926 and 1929, expenditures on construction fell from $11 billion to under $9 billion. Automobile sales began to decline somewhat later, but in the first nine months of 1929, they declined by more than one third. Once these two crucial industries began to weaken, there was not enough strength in the other sectors of the economy to take up the slack. Even while the automotive industry was thriving in the 1920s, some industries, agriculture in particular, were declining steadily. While the Ford Motor Company was reporting record assets, farm prices plummeted, and the price of food fell precipitously.

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 in its own right. 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 hyper-inflation 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 Keynes and others, who argued that in so doing, they were forcing a revaluation of wages without any tendency to equilibrium. Keynes' criticism of 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.

But the deflationary pressures — the industrialization of the United States, the spread of internal combustion, the return to gold, the rapid expansion of German productive capacity — do not account for the severity of the drop in business after 1930 under most models.

The credit structure

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 mortgaged, 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.

Although most American bankers in this era were staunchly conservative, some of the nation's largest banks were failing to maintain adequate reserves and were investing recklessly in the stock market or making unwise loans. In other words, the banking system was not well prepared to absorb the shock of a major recession. The banking system as a whole, moreover, was only very loosely regulated by the Federal Reserve System at this time.

The breakdown of international trade

Another factor contributing to the Great Depression was America's position in international trade. Protectionist impulses would drive nations to protect domestic production against competition from foreign imports by erecting high tariff walls. The Hawley-Smoot Tariff Act of June 1930 raised U.S. tariffs to unprecedented levels and ignited a worldwide tariff war with other countries adopting retaliatory trade restrictions of their own. Smoot-Hawley practically closed U.S. borders and, with retaliatory tariffs from U.S. trading partners, caused the immediate collapse of the most important export industry, American agriculture.

One theory posits that the Smoot-Hawley tariff's negative effects on agriculture were especially harmful 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 Hawley-Smoot Tariff Act would bring disastrous economic repercussions; however, this did not stop the act from being signed into law.

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.

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 the perhaps historically vindicated Woodrow Wilson) on demanding reparation payments from Germany and Austria. Reparations, they believed, would provide them with a way to pay off their own debts. But Germany and Austria 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.

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.

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

In the scramble for liquidity that followed the Great Crash, funds flowed back from Europe to America, and Europe's fragile economies crumbled.

Cyclical Theories


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