Causes of The Great Depression

Proposed events leading to the onset of the Great Depression

Mid 1920s: Great Britain, France, Germany, the United States and other nations return to the gold standard after suspension during World War I.

1925: Having returned to the gold standard, Britain tries to damper domestic activity to return the gold standard to its prewar rate. Finding it hard to pay for imports when demand is high, Britain raises its Bank Rate in attempt to attract short-term investment and maintain its gold reserves. This led to continued unemployment and civil unrest, leading to a strike in 1926.

1928: Federal Reserve policy turns contractionary in an effort to combat speculation in the NYSE and to prevent gold ouflows. The Fed raises interest rates, making borrowing more costly, and thus, dampering "speculative" investment. While this policy was unsuccessful in preventing speculation, it did result in tightening the money supply and causing price levels to fall.

Late 1920s: "Popular history regards the capital imports as a necessary offset to Germany's outflow of war reparations payments." (Transmission 89). Germany, however, succeeds in postponing its obligations. As a result, net capital inflow into the Germany economy hovers at 2 percent. Germany's Reichsbank thinks the net inflow to be risky, and attempting to curtail it, sharply reduces the amount of credit available on the German market.

Late 1920s: The contractions in the British, American, and German economies depress the economies of other countries through the gold standard. Depressions in other countries' economies were in part due to reduced demand for imports by Britain, America, and Germany and thus a reduced demand for these countries' exports.

August 1929: According to the National Bureau of Economic Research, the onset of a recession occurred.

Transmission of the Great Depression

The Great Depression in the United States: A Timeline

October 29, 1929: The stock market crashes, causing stocks to lose approximately 1/10 of their value.

February 1930: The Fed has cut interest rates from 6 to 4 percent and expands the money supply with a major open market purchase. Secretary of the Treasuary, Andrew Mellon, declares, "Liquidate labor, liquidate stocks, liquidate real estate."

June 17, 1930: Hawley-Smoot Tariff is passed, imposing a 40 percent tax on all inputs.

Late 1930: The first bank panic occurs, resulting in a wave of bankruptcies and a major contraction in the money supply.

1930: GNP falls 9.4 percent from 1929 levels. Unemployment rises from 3.2 to 8.7 percent.

Spring 1931: The second major banking panic occurs.

1931: GNP falls another 8.5 percent. Unemployment rises to 15.9 percent.

1932: GNP falls by a record 13.4 percent. Unemployment rises to 23.6 percent. Industrial stocks have lost 80 percent of their 1929 values. 40 percent of the banks that existed in 1929 have failed. The money supply and GNP have fallen 31 percent since 1929. The Fed makes its first major money supply expansion since 1929. In response to pressures from Congress, the Fed reverses its expansionary monetary policy and the economy relapses dramatically.

1933: Roosevelt is inaugurated and declares a Banking Holiday with the occurrence of the third bank panic in March. US leaves the gold standard. GNP only dips by 2.1 percent. Unemployment rises slightly to 24.9 percent.

1934: The road to recovery begins as GNP rises by 7.7 percent and unemployment falls to 21.4 percent. The Securities and Exchange Commission is created. Sweden becomes the first nation to recover fully from the Great Depression, by engaging in a policy of Keynesian deficit spending.

1935: The Banking Act of 1935, the National Labor Relations Act, and the Social Security Act are all passed. GNP rises by 8.1 percent and unemployment falls to 20.1 percent.

1936: GNP grows a record 14.1 percent. Unemployment falls to 16.9 percent. Germany becomes the second nation to recover fully from the Great Depression, through engaging in heavy deficit spending.

1937: Fearing inflation, the Fed raises interest raises successfully leading the US into another depression. GNP rises 5 percent. Unemployment falls to 14.3 percent.

1938: The effects of the yearlong recession are manifested. GNP falls 4.5 percent and unemployment rises to 19 percent. Britain becomes the third nation to recover, having engaged in major deficit spending.

1939: The US begins to emerge from the Depression borrowing and spending $1 billion in preparation World War II, which begins in 1939 with Hitler's invasion of Poland. GNP rises 7.9 percent. Unemployment falls to 17.2 percent.

A Few More Statistics

From 1929 to 1933, real output fell by about 30%.

From 1929 to 1933, unemployment rose from about 3% to about 25%.

From 1929 to 1933, the dollar deflated on average 10% per year.

From 1929 to 1933, the money supply fell by about 30%.

In comparison to 1929 levels, production per worker fell 40 percent during the Depression.

To put this in perspective we can look at another deflationary episode in American history.

From 1973 to 1975, real output fell by about 3.4%.

From 1973 to 1975, unemployment rose from around 4% to 9%.

Warren, Harris G. Herbert Hoover and the Great Depression. New York, 1959.

The Effect of the Depression in North America

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Causes of the Great Depression: Monetary Forces

In 1963, Milton Friedman and Anna J. Schwartz published "The Monetary History of the United States," which examined the relationship between changes in the nominal money stock and changes in national income and prices. Friedman and Schwartz contended that changes in the money stock generated by Fed actions could explain the subsequent drops in prices and output that occurred during the Great Depression. They offered proof in the form of four major errors made by the Federal Reserve in the late 1920s and early 1930s. These errors included:

Friedman and Schwartz felt the Fed's first major policy error was in its tightening of monetary policy, beginning in the spring of 1928 and continuing until the crash in October of 1929. The Fed decided to raise the interest rates to try and prevent "speculative" investment on Wall Street. Friedman hardly saw the Fed's actions to be justified, however, because the US was just emerging from a recession and there were few signs of inflation. The Fed's contractionary monetary policies succeeded in driving the country into a recession without decreasing "speculative" investment.

The Fed's second major policy error was in its decision to ignore the plight of the banking system and to concentrate solely on preventing the loss of gold reserves to protect the dollar. The Fed raised the interest rate once more to discourage the liquidation of dollar-denominated assets. Their strategy was successful in preventing the loss of gold reserves.

The Fed's third major policy error was in its decision to reverse its initial decision to ease monetary policy in 1932. In April and June of 1932, the Fed decided to engage in open market purchases, thus increasing the money supply and easing monetary policy. However, the Fed reversed its policy of monetary ease later that year in the advent of pressure from Congress.

The Fed's fourth and final major policy error was in its continual neglect of problems in the US banking sector. The Fed stood idle and watched thousands of banks fail. However, the ability to ameliorate banks' problems was entirely within their control, as they could have either been more active in lending cash to banks or increased the cash in circulation. Instead, many Fed officials subscribed to the liquidationist thesis, positing that the weeding out of banks was a necessary step in the recovery of the banking system.

For many decades after the publication of "Monetary History," economists questioned the importance of monetary factors to the Great Depression. Common problems with Friedman and Schwartz's analysis included adjudicating whether the tightening of monetary policy was large enough to have had such great consequences. If monetary contractions could not account for the violence of the downturn, nonmonetary factors needed to be considered, as well. Another argument revolved around whether the large decline in the money supply was mostly a cause or an effect of declining output and prices. The emergence of research on the importance of the international gold standard helped to solidify Friedman and Schwartz's monetary hypothesis.

Bernanke's Remarks

Causes of the Great Depression: Adherence to the Gold Standard

In the 1980s, economic historians began to shift their emphasis from the causal role of US events in the Great Depression to developments around the world during the 1930s. Employing a comparative approach, new research began to highlight the important role of international monetary forces, in addition to domestic monetary policies, in explaining the Depression. Research indicated that the Great Depression could be clearly understood with attention to the operation of the international gold standard.

Temin's "Transmission of the Great Depression," defines the gold standard in terms of five attributes: there is free flow of gold between individuals and countries; fixed values of national currencies are maintained in terms of gold and therefore, in terms of each other; no international coordinating or lending organization exists; there is an asymmetry between countries experiencing balance-of-debt payments deficits and surpluses; and the adjustment mechanism is deflation rather than devaluation for a deficit country. The fifth condition, the resort to deflation over devaluation is seen as the most important factor in the transmission of the Great Depression. As the figures below demonstrate, while the rates of decline in the industrial production of four major countries are quite different, the rates of deflation in these four countries are strikingly similar. This can be attributed to the fact that "fixed exchange rates of the gold standard led to uniform changes in prices even though other factors affected the change in production" (Transmission 90).

Description

Description

Between the years of 1930 and 1932, the correlation between price changes is seen to be much stronger than the correlation between production changes. "The standard deviation of price changes is smaller than the standard deviation of changes in the industrial production index in all three years [1930-1932], although the standard deviation of both series rose in 1932 as some countries abandoned gold" (Transmission 90). Some countries attributed falling prices to a decline in demand for their products in the industrialized world. Others, however, had to force their prices to fall in order to maintain the value of their currency. Hence, abandoning the gold standard proved to be the only way of halting the economic decline, as departure from the gold standard severed the connection between the balance of payments and the domestic price level. Abandonment of the gold standard allowed countries to change freely their interest rates and money supplies.

Those countries that abided by the gold standard ideology felt that devaluing their currency would have detrimental effects. While any single devaluation could have negative effects upon other countries, universal devaluation would have resulted in an increase in the value of world gold reserves and allowed world-wide economic expansion. When those in charge of the exchange rate did not abandon the gold standard soon enough, banks' gold reserves were depleted and they consequently failed.

Temin contends that there are three models that can be used to explain the spread of endogenous financial crises under the gold standard. No single model can be selected, because no model by itself captures the diversity of historical experience in the 1930s. The first model contends that international panics spread by means of the contagion of fear common to national panics. The second model's contention is a bit more complicated. Essentially, foreigners buy assets cheaply from banks in panic abroad. This causes foreigners to increase their consumption. However, foreign banks are not in a position to finance this increased demand, due to the temporary purchase of illiquid assets during the Depression. Foreigners will realize their banks are illiquid and initiate runs on the banks, spreading the panic for the original country in panic to the country trying to provide assistance. The third model posits that shocks to the gold standard in the largest industrial countries are counteracted by short-term capital movements. However, banking systems in smaller countries were more vulnerable and felt real effects of short-term capital movements.

Below are three maps, demonstrating the decline in countries' use of the gold standard between 1929 and 1934.

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Transmission of the Great Depression

A Few More Causes

An additional explanation posits that monetary effects were transmitted to the real economy in the form of increases in real wages as a result of a rapidly declining aggregate price level. A survey conducted by the National Industrial Conference Board (NICB) in April 1932, surveyed 1,718 firms regarding their wage adjustments between December 1929 and April 1932. Results indicated that 90 percent of firms had not adjusted their wage scales from December 1929 to the end of 1930. Two-thirds of the firms surveyed still had not adjusted their wage scales as late as September 1931. This theory posits that sluggish wage adjustments were strong contributing factors to the severity of the Great Depression. Research indicated that real wages tended to be higher and industrial production lower in the cases of those countries that remained on the gold standard. Countries that remained on the gold standard were forced to maintain tighter monetary policies, which induced sharper price declines and sharper increases in real wages due to the stickiness of wages.

Another explanation, provided by Bernanke, extends the Friedman-Schwartz work by examining an additional way in which financial crises could have affected ouput. Bernanke contends that "because markets for financial claims are incomplete, intermediation between some classes of borrowers and lenders requires nontrivial market-making and information-gathering services" (Nonmonetary Effects 257). As the real costs of intermediation increased, some borrowers found credit to be harder to obtain. This credit squeeze on aggegate demand aided in transforming the severe downturn into a protracted depression.

Sticky Wages

Bernanke's Explanation

The Effects of Tariffs

1882: The Tariff Commission was a failure.

1909: The Tariff Board was a failure and abolished.

1916: The Democratic Congress created a 6 man bi-partisan commission to "fact find" what tariffs should be altered or enacted.

1922: The Ford-McCumber Act gave the President the power to raise or lower tariffs up to 50% upon a recommendation from the commission.

1930: The infamous Hawley-Smoot Tariff Act was passed. This tariff is generally blamed for the depression. It did help to worsen the depression of the 1930's but there were already very high tariffs that had been put into place during the 1920s.

This tariff act in particular was disastrous because the increase in tariff rates, already very high, was too much for other countries to bear without retaliation. In 1931 the first retaliatory and violent tariffs were put into place by other countries against the U.S. to try to nullify the effect that the U.S. tariffs had on their exports. Twenty five countries would respond with their own tariffs within a year.

The tariffs were imposed in an effort to equalize the price of goods produced and imported into the U.S. The U.S. factories sought a tariff on the foreign counterparts to the good they produced. If domestic firms could eliminate the need to compete with foreign firms, they would be able to charge the price they wanted and individual firms could each have a much larger market share. With the decrease in efficiency due to decreased competitiveness and decreased market share (firms did not factor in that foreign countries would retaliate with their own tariffs) something would have to give. In heavy industry there were mass layoffs upwards of 30%; in agriculture, farmers had trouble selling their produce to pay off their high interest rate loans. Also, since many farmers relied on cheaper imports like cattle feed, the $30 million gain in agricultural profits due to the tariffs was overshadowed by a $300 million loss. This is before the retaliation tariffs imposed by other countries.

In order to get around the retaliatory tariffs, American firms would have to build factories abroad. This would not help those who needed jobs at home but it was a necessary measure on the part of firms to get around the high tariffs imposed by the foreign countries. More than 250 factories were built abroad between 1930 and 1932.

Warren, Harris G. Herbert Hoover and the Great Depression. New York, 1959.

The Dustbowl

First, a background on agriculture. Before and during the First World War, millions upon millions of acres farmland were bought and cultivated to feed the evergrowing demand. America was still very agriculturally based and Europe was at war and demanded agricultural products. Since Europe was more focused on industry compared to the U.S., American farmers could still make a profit at the inflated prices for land and high interest loans.

Later in the 20's, this large surplus of farmland, now no longer needed to support Europe, had trouble staying economically viable. Along with this, the large technological improvements greatly increased the manhour productivity on farms lowering the acreage demand. The shift in style of clothing away from wool and cotton further exacerbated the low demand problem. Unlike the factories, the farmer at the time had no means of price control. This means that the farmer had to sell at the lowest price at auctions but had to buy at the high retail prices. It was at this time the country was making a shift towards industry partly due to the increased demand from war-torn Europe and partly due to the lack of demand for more farms. Along with this, the U.S. government dropped their subsidies on agriculture goods and placed them on industrial goods instead. The Tariffs did not help out the situation either.

When there are high interest rates on loans like during the 1920's and 1930's, only those who have a high risk but high profit expectation will take the loans. This concept born out of the bad monetary policy had disasterous effects both on agriculture and industry. In terms of agriculture, the American farmer who was converting the primarily midwestern grazing land into cash-crop farms was betting that the trade barriers would fall and the government subsidy would remain on agricultural products. Their high risk high potential profit possibility blew up into dust when the cycles of nature and government policies went against them.

What the farmers did was they would remove the protective grass in order to plant crops like wheat thus creating an enormous potential for erosion. In the midwest there have been periodic dry spells every twenty years or so and this occurred at a time when there was less grass and trees to protect the ground from wind erosion and from the dirt being lifted off the ground. The productivity dropped drastically as farm ownership dropped by more than 30% during the 30's and productivity per acre dropped more than 10 fold due to the havoc the dust caused to plants.

Environmental and Economic Collapse in the 1930s

A World in Depression

Crash of 1929 vs 2000. Learning From Our Mistakes

There are many similarities leading up to the Crash of '29 and '00. The differences can start to be seen after the crash of '00, when correct counter cyclical monetary and fiscal policies were rapidly implemented.

In the 1920's one cannot point to a single factor as the cause for the crash and subsequent depression. There are the minor factors such as the increase in tariff rates, notably the Hawley-Smoot Tariff of 1930, the declining investment of U.S. funds abroad, and the decrease in loans to brokers. A business cycle downturn due to tight money would end up being the main driving force. One of the drawbacks of the tight monetary supply was that the demand for credit rose as the supply tightened. This drew more credit into the stock market and away from other less risky options. The tight monetary policy which started increasing in 1928 to control the credit lent to speculation would also change the expectations of investors. Once these expectations were changed to pessimism, however, it was like pushing a string; it was very hard to alter the expectations with changes in policy and the continuous bad policy that was enacted made it impossible.

During the "Roaring 20's" there was huge flows of investment capital into the U.S. There were leaps in technology like the radio, the automobile assembly line, and farming techniques which spurred many new business and investment opportunities. Had it not been for the instability of banks, which from 1923-1929 failed at an alarming rate of two per day and had no Fed backup, there would have been even more investment flows. In the late 1920's there was a turn from investing in the physical economy: transportation, manufacturing, etc., into investing back into the stock market. The corporations would take their money and re-invest it into the market to support the inflated price. Without the investing into the physical economy there was a growing disparity between the stock price and stock value.

In the 90's there was a similar trend of huge investment in the U.S. economy. There were also similar technology leaps like the internet bringing us closer together through mass communication. In the late 80's we had banking failures which the Fed helped to cover up and rolled over the unpayable debt. In the 90's corporations chose to go the way of those in the late 20's; they re-invested into the stock market instead of using their available funds to increase the physical economy. Corporations used accounting loopholes to hide debt and rewarded top executives with stock options, both of these actions inflated stock prices. This created the "bubble" that was similar to that of 1929; it was a facade over the declining physical economy.

Just before both crashes there was a three-month rally with soaring prices with many investors playing the "greater fool" game until they became that fool. In the "greater fool theory" speculators would buy stocks that they knew were overpriced because they guessed that someone else would be willing to buy it for an even more absurd price, that someone else would be an even greater fool. At a point, when expectations change, the buying stops and people begin to panic and sell what they can. This leads others to domino in the same fashion.

When faced with a situation with very high real interest rates or are in a position to make higher profits, corporations will naturally invest in the aspects of their business that yield the highest rate of return first and invest on down from there with what money they have left. The re-investing in both eras is a natural reflex of the firm, albeit caused by different factors. The lack of investment in the physical economy is just a cost of the risky yet potentially profitable investment. In 1929 when the expected profit was seen to be much lower than previously expected there was a panic. The same is true for 2000 but since the real interest rate was much lower the loss was not as substantial.

After both of the crashes we can start to see some very different actions. The Fed of '29 reduced liquidity, tightened monetary policy, and ignored the Banks cry for help. The Fed of '00 essentially put up a "wall of money" creating easy money by lowering interest rates and ensured adequate liquidity for the banking system, and congress enacted expansionary fiscal policy by lowering taxes. In the 1920's and 30's we had increased tariffs, but in the 1990's and 2000's we have NAFTA and other efforts to decrease tariffs. After the crash of '29 we had the "natural disaster" of the dust bowl, and after the crash of '00 we had 9/11.

The wall of money and increase in the money supply was not a Fed handout post 2000 crash. This wall of money was actually just a promise to provide liquidity, the Fed only gave confidence, which gave optimism and the expected fall was not as hard as that of 1929 when the pompous economic leaders of the time were thought to be out of touch and disengaged. For example, the Treasury Secretary Andrew Mellon said in 1929, "I see nothing in the present situation that is either menacing or warrants pessimism."

Review of Similiarities Between the Two Crashes

'29 Crash Revisited

A Graphical Comparison of the Crash of 1929 and Crash of 2000

The top graph shows us the crash of '29, the bottom the crash of '00. They both rise or "bubble" in the same manner and crash similarly, although the crash of 2000 was not as severe as I explained above.

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Works Cited

Bernanke, Ben S. "The Macroeconomics of the Great Depression." Journal of Money, Credit and Banking 27 (1995): 1-26. Jstor. Dickinson College, Carlisle. 10 Nov. 2006.

Bernanke, Ben S. "Money, Gold, and the Great Depression." Washington and Lee University. H. Parker Willis Lecture in Economic Policy. Washington and Lee University, Lexington, VA. 2 Mar. 2004. 15 Nov. 2006 <http://www.federalreserve.gov/boarddocs/speeches/2004/200403022/default.htm>.

Bernanke, Ben S. "Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression." The American Economic Review 73 (1983): 257-276. Jstor. Dickinson College, Carlisle. 12 Nov. 2006.

Bernstein, Michael A. The Great Depression. Cambridge: Cambridge UP, 1987.

Bordo, Michael D., Christopher J. Erceg, and Charles L. Evans. "Money, Sticky Wages, and the Great Depression." The American Economic Review 90 (2000): 1447-1463. Jstor. Dickinson College, Carlisle. 10 Nov. 2006.

Brunner, Karl. The Great Depression Revisited. Boston: Martinus Nijhoff, 1981.

Delong, J. Bradford. "Sliding Intot the Great Depression." Slouching Towards Utopia? Feb. 1997. University of California at Berkeley. 15 Nov. 2006 <http://econ161.berkeley.edu/TCEH/Slouch_Crash14.html>.

Kindleberger, Charles. Monetarism Vs. Keynesianism. London: George Allen and Unwin, 1985.

Temin, Peter. "Transmission of the Great Depression." The Journal of Economic Perspectives 7 (1993): 87-102. Jstor. Dickinson College, Carlisle. 23 Nov. 2006.

"Timelines of the Great Depression." 23 Nov. 2006 <http://www.huppi.com/kangaroo/Timeline.htm>.