The Great Depression and Monetary Policy

Introduction

The Great Depression was a worldwide economic collapse that began as early as 1928. The Great Depression was a deflationary spiral that forced dramatic falls in asset and commodity prices, dramatic drops in demand and credit, and disruption of trade, ultimately resulting in widespread poverty and unemployment. The Great Depression began in the United States when the stock market crashed on October 29, 1929. Once the decline in the U.S. economy occurred many other countries were pulled down along with it. However, the question that remains today is what turns a short recession into a great depression? The answer to this question is still a matter of active debate among economists because no one knows who to blame. Therefore, causes of the Great Depression are many.

Causes of the Great Depression

The Reason at that Time

(theoretical economists)

Economists and major central banks in the western world at the time of the Great Depression believed that economies were self-correcting and that the economy needed to go through a phase of liquidation before new economy growth could take place. In addition to the self-correcting economy, economists believed that deflation would correct the excesses of the prior economic boom before the Great Depression. Therefore, the economy would then reach equilibrium of wages and prices.

Monetarist Explanations

(Milton Friedman, Anna Schwartz, and Ben Bernanke)

The Great Depression was caused by a monetary contraction, which was the effect of poor policy making by the American Federal Reserve system exercising the wrong policies to stop a recession from turning into a depression. The monetary contraction occurred because people wanted to hold more money than the Federal Reserve was supplying therefore, people began hoarding money by consuming less. This caused a contraction in income, employment and production since prices were not flexible enough to immediately fall. The fall in the money supply between 1929 through 1933 (fell by over a third) became known as the “Great Contraction.”

Gold Standard

(Peter Temin and Barry Eichengreen)

Economists believe that the inter-war gold standard exaggerated the first economic shock and hindered any actions being taken to improve the Depression. Great Britain wanted to return to the gold standard. However, returning to the gold standard meant that the British economy would face deflationary pressure causing the lack of price flexibility and unemployment to increase. During the 1920s the policy makers planned on loosening monetary and fiscal policy, even though it would threaten countries ability to maintain its duty to exchange gold at its contractual rate. Therefore, for Great Britain to return to the gold standard the United States had to inflate their net inflow of gold as well because under the gold standard Britain could not inflate on its own since inflation under a gold standard causes gold outflows. Therefore, governments could not do anything and their economies collapsed before their eyes, unless they abandoned their currency’s link to gold. The expansions of the money supply lead to an unstable boom in asset prices (stocks and bonds) and in capital goods. The countries that abandoned the gold standard early enough suffered less from deflation and recovered more quickly. The synthetic interference in the economy by Great Britain and the United States with the gold standard system spread the problem to the rest of the world and made the road to recovery not easy.

Unequal Distribution of Wealth

(Waddill Catchings and William Trufant Foster)

Economists believed that the economy produced more than it could consume because the consumers did not have enough income causing an unequal distribution of wealth. The unequal distribution of wealth was caused by wages decreasing at a rate higher than productivity.

Productivity --> Profits --> The Stock Market (instead of consumer purchases)

^see the Keynesian Theory

In the end the cause of the Great Depression was overinvestment in industry created more space than could be profitably used combined with factories overproducing.

Debt

During the 1920s there were extensive purchases of businesses, factories, automobiles, furniture, home mortgages and stocks on credit. Although, these purchases boosted spending at the time it later on created consumer and commercial debt. Many business owners were drowning in debt when a price deflation occurred or demand for their product decreased. In result, business owners cut their current spending consequently lowering demand for new products. Therefore businesses, construction work, and factory orders slowly began to decline and in the end eventually failed.

Occurrences --> Results:

Massive layoffs --> Unemployment rates over 25%

Banks which financed a lot of debt --> Failed as debtors because they failed to pay debt

Bank depositors were worried about their deposits --> Began massive withdrawals

(Government guarantees and Federal Reserve banking regulations to prevent these types of panic were ineffective)

Bank failures --> loss of billions of dollars in assets (40% of money supply was destroyed)

Prices and incomes fell 20-50% Debt increased

Bank failures escalated as bankers kept calling in loans because their borrowers could not repay the money. Due to bad loans and the bleak future banks increased their capital reserves, which raised deflationary pressures. The cycle progressed and may have turned a small recession into a great depression. From 1929 to 1933 $140 billion disappeared because of uninsured bank failures. Throughout the Great Depression 9,000 banks failed.

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

In the 1920s when the U.S. economy began too weaken European countries found it too difficult to sell their goods to U.S. markets because the U.S. tariffs were so high. Without foreign exchange revenue to pay their loans, Europe failed to pay their debt. European demand for U.S. products began to decline because European industry and agriculture were booming. The Smoot-Hawley tariff reduced international trade and caused strict regulations. Foreign trade was only a small part of the U.S. economy therefore, the U.S. was not significantly hindered by the act however, with larger countries the Smoot-Hawley Tariff Act was a major factor. American exports declined from about $5.2 billion (1929) to $1.7 billion (1933) in addition prices also fell therefore, exports only fell by half. The hardest hit by this export collapse were farm products such as wheat, cotton, tobacco, and lumber. The export collapse caused many farmers in these product areas of expertise to default on their loans.

The Stock Market Crash

It is a well known fact that the economy was booming in the 1920s. There was a high level of optimism that made economists believe that the United States Federal Reserve would be able to stabilize its economy. The Federal Reserve worried about the extremely high and unstable level of the stock market, “It seemed better to the Federal Reserve in 1928 and 1929 to try to “cool off” the market by making borrowing money for stock speculation difficult and costly by raising interest rates. They accepted the risk that the increase in interest rates might bring on the recession that they hoped could be avoided if the market could be “cooled off”: all policy options seemed to have possible unfavorable consequences.” Sure enough on October 24 1929, also known as “Black Thursday,” a record of 12,894,650 shares were traded. Only five days later another catastrophic downturn of 16,410,000 shares were bought and sold.

Most people believe that the majority of Americans at the time owned stock, but in actuality less than 2% of population at the time of the crash held ownership in stock. So the question arises, why did the stock market crash have such an impact on the American people?

Effect on the American People

The crash undoubtedly generated uncertainty regarding future income. The uncertainty is said to be the reason why consumers and producers forwent purchases of durable goods. In agreement with the Keynesian mechanism, this decline in spending results in a drop of income.

GDP (A common measurement of national income) = C + I + G + (X – M)

According to Christina Romer, “there is indeed a statistically significant negative relationship between consumer spending on durables and stock market variability” (598)

According to this table one can see the negative affect the variability in the stock market has on consumer spending. Also the decline in purchases of durable goods is very evident. Purchases of perishable goods (food) rose immediately following the crash whereas purchases of durable goods plummeted and by Jan of 1930 automobile registrations were 24% lower than they were before the crash. Romer offers a very logical explanation for the decline of consumer purchases, “Consider a consumer deciding whether to buy a durable good that is available in varying levels of quality. When future income is temporarily uncertain and durables purchases are irreversible for long periods of time, there is a trade-off between purchasing the durable and waiting.” Therefore, if the consumer decides to make the purchase they may have bought the good at a quality level too luxurious or too modest for their future income level.

Business analysts conveyed their forecasts and thoughts about the future of the economy. In her article Romer takes a close look at the forecasts of five economists. She proves that there was obvious uncertainty among these forecasters. A forecaster from the Standard Trade stated, “With the opening of the new year, there is a wide conflict of opinion as to what is in store for the industry and commerce during the early part of 1930,” another forecaster noted, “Opinions may differ as to whether or not the stock market collapse… need necessarily be followed by a serious business recession.” The exposure to the forecaster’s conflicting opinions may have been a cause of the uncertainty among consumer and producers. Perhaps a reason for the conflicting predictions was due to Hoover’s response to the crash, “to promulgate optimistic forecasts and to encourage other to do so as well.” It is likely that several of the analysts participated in this positive propaganda. Other causes of the nationwide uncertainty were the “suspense and indecision created by the final outcome of the new rates included in the Hawley-Smoot tariff bill” and the “alarm about the continuing weakness in prominent commodity markets.”

Early Reaction to the Depression

Herbert Hoover, President of the United States from 1928 to 1932, believed that there should be little government intervention in the economic activity of the country. He felt that the Depression would be a temporary period and that the country would soon return to prosperity. Hoover did little to prevent or discourage the Stock Market crash of 1929. Due to his aversion to government regulation of business, Hoover also did not stop abusive business practices after the crash or institute much-needed financial reforms. Hoping for “Voluntary Cooperation” from businesses, Hoover felt that the economy would eventually stabilize on its own, but few businesses were willing to take risks during the Depression.

Secretary of the Treasury Andrew Mellon advised President Hoover to instate shock therapy, which called for the liquidation of all labor, stocks, farming, real estate, and other assets. Mellon wanted to reorganize the entire economy and hoped that the Depression would make people more hardworking with better morals who would work diligently to reconstruct the economy. Mellon and other supporters of liquidation feared that increasing the money supply would only lead to more speculation in the stock market and in the overall economy without creating any increase in output.

In 1932 Congress passes laws that allowed the government to begin helping businesses. One of these laws created the Reconstruction Finance Corporation which loaned money to banks and businesses to prevent them from going bankrupt. Although Hoover had hoped that state and local governments would provide the unemployed with jobs, towards the end of his presidency he began supporting public works programs that created more jobs.

Monetary Policy

Keynesian Theory

In the early 1930’s, economist John Maynard Keynes began constructing theories that advocated more government intervention as a way of getting out of the Depression. He theorized that the government should run high deficits during a depression in order to stimulate the growth of the economy. During the Depression the private sector was too hesitant to invest, so the government must heavily invest, for example in large public works programs, in order to create jobs and increase economic activity. As investment increases, aggregate demand will increase. As aggregate demand increases output will increase, eventually bringing the country back to equilibrium.

Although Roosevelt created public works programs to stimulate the economy, Keynesians argue that he did not invest enough money in the economy to stabilize it.

Milton Friedman

Friedman argues that the government should have used monetary policy to pull the country out of the Depression. Many banks collapsed during the Depression because they ran out of reserves. According to Friedman, the government should have increased the money supply in order to prevent bank closures as well as to increase loans to failing businesses and consumers. The sharp decrease in the money supply during the Depression lead to a decline in economic activity, and increasing the money supply would have enabled more economy activity.

Gold Standard

In the past most money was paper, as it is now, but governments were obligated, is asked, to redeem that paper for gold. This placed an upper limit on the amount of currency the government could print which prevented inflation. During World War I, most countries went off the gold standard and made it a major postwar aim to reinstate it. “Other countries backed their paper money not with gold, but with other currencies—mainly U.S. dollars and British pounds—that were convertible into gold. As a result flexibility of governments was limited. A loss of gold (or convertible currencies) often forced governments to raise interest rates. The higher interest rates discouraged conversion of interest-bearing deposits into gold and bolstered confidence that inflation would not break the commitment to gold.”(1)

The Federal Reserve was put to blame for allowing 2/5 of the nation’s bank to fail between 1929 and 1933. From this time, the money supply dropped by 1/3, causing interest to increase and making it impossible to for many individuals and businesses to invest or spend. ” Friedman and Schwartz argue that it was this drop in the money supply that strangled the economy. They consider the depression mainly an American affair that spread abroad.” (1) In 1933, Roosevelt prohibited US citizens from owning gold and using it as a form of money. This action forced citizens to sell their gold to the government at $20.67 per oz., in 1934 Roosevelt raised the price of gold to $35 per oz.

The issue of ending the depression and protecting the gold standard was something that the Federal Reserve came to faced with. They first issue was to enable easier credit and second was to tighten credit. “The mere hint that a country might abandon gold prompted speculators and international depositors to change local money into gold or a convertible currency. Deposit withdrawals spread panic and squeezed lending. It was a global process that ultimately forced all governments off gold. With the gold standard gone, governments had more freedom to stimulate their economies with an expansion of money and credit. The political inclination was to act sooner, rather than later, to halt a slump.” (1)

Rearmament Recovery

The massive rearmament policies to counter the threat from Nazi Germany helped stimulate the economies in Europe in 1937-39. By 1937, unemployment in Britain had fallen to 1.5 million. The mobilization of manpower following the outbreak of war in 1939 finally ended unemployment.

In the United States, the massive war spending doubled the GNP, masking the effects of the Depression. Businessmen ignored the mounting national debt and heavy new taxes, redoubling their efforts for greater output to take advantage of generous government contracts. Most people worked overtime and gave up leisure activities to make money after so many hard years. People accepted rationing and price controls for the first time as a way of expressing their support for the war effort. Cost-plus pricing in munitions contracts guaranteed businesses a profit no matter how many mediocre workers they employed or how inefficient the techniques they used. The demand was for a vast quantity of war supplies as soon as possible, regardless of cost. Businesses hired every person in sight, even driving sound trucks up and down city streets begging people to apply for jobs. New workers were needed to replace the 11 million working-age men serving in the military. These events magnified the role of the federal government in the national economy. In 1929, federal expenditures accounted for only 3% of GNP. Between 1933 and 1939, federal expenditure tripled, and Roosevelt's critics charged that he was turning America into a socialist state. However, spending on the New Deal was far smaller than on the war effort.

(http://www.martinfrost.ws/htmlfiles/aug2007/great_depression.html)

Strong’s Counter Cyclical Policy

Benjamin Strong was an experienced financial leader who became first governor of the Federal Reserve Bank of New York. “He chaired a committee of Federal Reserve Bank governors that coordinated System open market operations and represented the System in dealings with foreign central banks and Congress.(22) It is clear that, with his death, the Fed lost an experienced and forceful leader.” (2) Friedman and Schwartz would say that Strong’s policies may have prevented the monetary collapse and depression. Strong managed to discover how to maintain moderately stable price level through monetary policies in the U.S. and very few understood how. “Friedman and Schwartz agree with Fisher that Strong's death caused monetary policy to change significantly. They argue that Strong's aggressive open market purchases and discount rate reductions in 1924 and 1927 had quickly alleviated recessions, but that his death produced a sharply different policy during the Depression.

If Strong had still been alive and head of the New York Bank in the fall of 1930, he would very likely have recognized the oncoming liquidity crisis for what it was, would have been prepared by experience and conviction to take strenuous and appropriate measures to head it off, and would have had the standing to carry the System with him (pp. 412-13).” (2)

“The Fed's actions in 1924 mark its first use of open market operations to achieve general policy objectives. In that year, the Fed purchased $450 million of government securities and cut its discount rate (in three stages) from 4.5 percent to 3 percent. In testimony before the House Banking Committee in 1926, Benjamin Strong listed several reasons for these actions, including the following:

1) To accelerate the process of debt repayment to the Federal Reserve Banks by the member banks, so as to relieve this weakening pressure for loan liquidation.

2) To give the Federal Reserve Banks an asset which would not be automatically liquidated as the result of gold imports so that later, if inflation developed from excessive gold imports, it might at least be checked in part by selling these securities, thus forcing member banks again into debt to the Reserve Banks and making the Reserve Bank discount rate effective.

3) To facilitate a change in the interest relation between the New York and London markets... by establishing a somewhat lower level of interest rates in this country at a time when prices were falling generally and when the danger of a disorganizing price advance in commodities was at a minimum and remote.

4) By directing foreign borrowings to this market to create the credits which would be necessary to facilitate the export of commodities...

5) To render what assistance was possible by our market policy toward the recovery of sterling and the resumption of gold payment by Great Britain.

6) To check the pressure on the banking situation in the west and northwest and the resulting failures and disasters.(53)

The Fed undertook a second large purchase program in 1927, purchasing $300 million of government securities and reducing the discount rate again. Strong left no written justification for these operations.” (2)

Roosevelt and the New Deal

The First Hundred Days

In an attempt to turn the economy around after the Great Depression, at the beginning of his presidency, Roosevelt, held a special Congressional session to launch The New Deal and introduce scores of bills. These bills aimed to establish new government agencies, otherwise known as the “alphabet soup” to aid Americans in multiple facets of their lives. With these bills, Roosevelt aimed for the President to have more legislative power and influence than Congress. Historians refer to this period of time as the First Hundred Days. Some of the bills that were implemented were:

AAA (Agricultural Adjustment Act)—This was designed to aid American farmers and agricultural actors by stabilizing prices and limiting overproduction. To do so, the AAA initiated the first direct subsidies to farmers who did not plant crops. Later, United States Supreme Court decided that the AAA was unconstitutional in that it was an unnecessary invasion of private property rights.

CCC (Civilian Conservation Corps) – This agency was a public works project, overseen by the army. This project was intended to promote environmental conservation and well-being, while enticing you, unemployed men off of the streets. These men planted trees, built shelters, stocked rivers and lakes with fish, and cleaned beaches and campgrounds. The CCC housed them in tents and barracks, provided them with three square meals a day while paying them a small pay. The army's experience in managing and training large numbers of civilians would prove invaluable in WWII.

TVA (Tennessee Valley Authority)—This agency aimed to bring electricity to the rural areas of seven states along the Tennessee River by building damns and power plants. While the TVA did much good by providing many Americans with electricity while simultaneously providing thousands of unemployed construction workers, many private power companies were not pleased with this program and displayed clear distain for this program.

NIRA (National Industrial Recovery Act)--The NIRA established the NRA (National Recovery Administration) in order to stimulate production and competition by having American industries set up a series of codes to regulate prices, output, and general trade practices. With these codes, the government, in turn, would agree to enforce them. If companies decided to comply and cooperate, the government promised to eliminate anti-trust legislation. Section 7A of the NIRA recognized the rights of labor to organize and to have collective bargaining with management. This legislative attempt was the most controversial piece that resulted from the First Hundred Days as many claimed it was anti-American and resembled socialist and communist behavior. However, the NIRA did not violate private property nor our wage system.

The NIRA ultimately failed for three reasons and within two years was deemed unconstitutional:

1. They assumed businesses would govern themselves by utilizing the codes, which ultimately were established in the interest of protecting workers and consumers,. These codes were ultimately drawn up by the largest companies, which hurt small businesses.
2. Corporations rarely respected the rights of labor to organize. As a result of the multitude and complexity of these codes, the government didn’t enforce never imposed labor’s right to collective bargaining.
3. The NRA aimed to stabilize prices by lowering production. Instead the effort should have been aimed at redistributing money to American consumers and encouraging them to purchase goods.

The New Deal

Ultimately, Roosevelt's years in office in the 1930s were able to be divided into two periods, the First New Deal and the Second New Deal. The First New Deal (1933-1935) was considered his relief effort for the immediate problems of unemployment. The Second New Deal (1935-1937) and aimed to be FDR’s reform effort. This reform was not just a relief from social and economic problems but more a reformation of society. Historians tend to categorize these efforts as either measures for "relief" (short-term programs designed to alleviate immediate suffering), "recovery" (long-term programs to strengthen the economy back to its pre-crash level), or, "reform" (permanent structures meant to prevent future depressions). The New Deal ultimately aimed to save capitalism and the fundamental institutions that keep the economy and society on its feet from the disaster of the Great Depression. Both New Deals reflected the same concepts of Keynes’ Theory which aims to revitalize an economy by mass consumption based society by re-enabling the masses ability to consume. On March 20, 1933, The Economy Act was passed and proposed that it should be acknowledged that there are two federal budgets: “regular” (non-emergency) and “emergency” budget. In order to balance the “regular” federal budget, the act proposed to cut the salaries and pensions of government employees and veterans. The “emergency budget” was set in order to defeat the depression. Ultimately, this act saved $500 million a year and reassured those concerned with the deficit. In theory, this act seem as though it would be beneficial by balancing the budget, however, Roosevelt soon began to spend the deficits on the programs and agencies that he created. Roosevelt and others who contributed and believed in the New Deal never fully acknowledged the Keynesian argument for government spending as a means of recovery; most instead favored balanced budgets.

Keynes' theory

English economist John Maynard Keynes attempted to both explains why depressions occurred and what could potentially prevent them. He felt as though the government should utilize its massive financial power, taxing and spending, to stabilize the economy. With this in mind, increased government spending at the lower income levels should handle a depression. This position on handling depressions is the opposite of the "trickle down" effect. Economists who agree with Keynes’ theory call this "counter-cyclical demand management” as they feel that that government’s financial impact can be used differently to counterweight current market forces.

The Second New Deal

The Second New Deal (1935-40s) was the restoration part of FDR’s plan. It attempted to end the Depression by restoring the economy from the bottom up. They planned to do so by turning those coined as non-consumers into consumers again. One of the main federal programs of the “Second” New Deal was the Works Progress Administration which aimed to hire unemployed men, for a variety of jobs, who were the breadwinners of their families in order to both strengthen the well-being and bond of the family as well as increasing consumer demand again. These men worked on the construction of public roads, buildings and parks. Between 1935-1943 over 8 million Americans worked with the WPA. In terms of economics, this program was aimed to create and manage counter-cyclical demand.

The Second New Deal, in 1935 included the Social Security Act which set up funds to federally-guarantee pensions to American workers. The Social Security Act, acted as a security blanket for older workers to increase consumer demand.

Finally, the National Labor Relations Act otherwise known as the Wagner Act of 1935 was implemented into the Second New Deal. Its purpose was to prevent employers’ from intimidating and coercing the breaking up of unions. This allowed for the protection of American workers right to collective bargain and be apart of a union. The ultimate goal of this program was to restore the economy from the bottom up by increasing working class worker’s wages.

Prevention of Another Depression

A UCLA professor of economics said, “President Roosevelt believed that excessive competition was responsible for the Depression by reducing prices and wages, and by extension reducing employment and demand for goods and services, so he came up with a recovery package that would be unimaginable today, allowing businesses in every industry to collude without the threat of antitrust prosecution and workers to demand salaries about 25 percent above where they ought to have been, given market forces. The economy was poised for a beautiful recovery, but that recovery was stalled by these misguided policies.”

 Unfortunately, with the implemented policies the Great Depression was dragged on longer than needed to be, however, they did a lot to improve the situation at hand. Economists calculated, by adjusting for annual increases in productivity, that according to the 1929 benchmark that prices and wages would have. Within the three years following the implementation of Roosevelt’s policies, wages in 11 major industries averaged about 25% higher than they otherwise would have been. Unemployment was 25% higher than it should have been while prices across 19 industries averaged 23% above where they should have been. With goods and services that much harder for consumers to afford, demand stalled and the gross national product floundered at 27 percent below where it otherwise might have been. What this information shows us is that the prices were artificially inflated prices and wages. Despite being deemed unconstitutional, many of Roosevelt’s policies continued as well as his illegal price fixing. Without these factors, the depression may have been significantly decreased. There is no way to really prevent another depression from happening, however, the government can learn from the mistakes already made and implement the policies to correct a problem before it gets to that magnitude.

Sources

http://www.yale.edu/ynhti/curriculum/units/1998/4/98.04.04.x.html

http://www.learninghaven.com/articles/great-depression.html

http://en.wikipedia.org/wiki/Great_Depression

http://www.econreview.com/events/banks1929b.htm

http://www.personal.kent.edu/~cupton/bbamacro/ma12_files/image001.gif

http://en.wikipedia.org/wiki/Great_Depression

http://www.gusmorino.com/pag3/greatdepression/

http://www.jstor.org/view/00028282/di976323/97p0016a/0

Business History Review 75 (Summer 2001): 325-351. Copyright 2001 by The President and Fellows of Harvard College