The Causes of the Great Depression

No event in history evokes the ideological split between Keynesians and neoclassical economists more than the Great Depression (see here and here). Ditto the split between progressives and conservatives. It was the traumatic effect of the Great Depression that made Keynes’ ideas attractive to people for the first time. They wanted to believe that government polices and actions could make the depression disappear. All that neoclassical adherents could offer was that the economy would heal itself if left alone, which at the time was less than comforting.

Many people date the beginning of the depression from the infamous October, 1929 crash of the stock market. Many others, myself included, would cavil the starting date really was when the banking system began to fail in the period between 1930 and 1932. Once the banking system failed it became extremely difficult for anyone to pay their debts, resulting in a general collapse of the economy. Nevertheless, the stock market crash of 1929 got the ball rolling. The start then was during the administration of Herbert Hoover, who (believe it or not) was a progressive Republican President in the mold of Theodore Roosevelt. Hoover’s policies in reaction to the growing depression were qualitatively quite similar to the policies of an equally progressive Franklin Roosevelt, who followed Hoover into office. Both believed in government intervention in the economy, but since the bad times began on Hoover’s watch, he caught the blame and Roosevelt was elected into office in 1932. Nevertheless, the policies of either President did very little to relieve the pain of the depression. The per capita GDP and the per capita income of the U.S. in 1939 were similar to what they were in 1930, although both measures fell in the years between to reach a minimum in 1933 (see here and here). There was then a period of growth until 1937 when a brief but severe recession occurred (sometimes called the depression within the Depression). With the approach of World War II, growth accelerated, although it was not until sometime in the middle of the war that previous levels of production in 1929 were surpassed.

Explanations for the major causes of the depression were many and varied and are still debated today. For a Keynesian the exact causes are not as important as what the government can do to spur economic demand. The demand-driven theories of the Keynesians say that whatever the original cause, fear and uncertainty are the forces that maintain the depression/recession. Businesses and individuals that see the possibilities for profits vanish will cease investments, layoff workers, and shutdown factories.  For the neoclassical economist, however, the original causes are extremely important, since they are the origins of the imbalances in supply and demand that created the economic crisis. If these imbalances remain, they will continue to cause the economy to fail.

One major effect of the depression was the failure of a large number of banks. Just after the stock market crash of 1929, many expected that the resulting recession would be of short duration. Beginning in November of 1930, however, a series of banks began to fail due to illiquidity of their assets. The banked assets of individuals and companies were not yet insured by the Federal Deposit Insurance Corporation (FDIC), which was yet to be formed. Congress created the FDIC in 1933 as a response to the bank failures between 1930 and 1932. As the general population became aware of the bank failures, many attempted to withdraw their assets from banks that did not have the funds on hand to comply. Fractional reserve banking meant that much of the deposited assets had been loaned out and were not immediately available. Because of this illiquidity, between 1930 and 1933 approximately one-third of all U.S. banks disappeared along with the un-withdrawn assets of their depositors.

In 1963 the economist Milton Friedman and his colleague Anna Schwartz published an extremely seminal work that offered yet another explanation for the Great Depression. Entitled A Monetary History of the United States, 1867-1960,  the book placed primary blame for the Great Depression on the Federal Reserve. Beginning in 1928 the Federal Reserve switched from a quantity of money theory of price stability to a real bills doctrine (see here and here and here) that required material goods to back all money creation. Concerning the real bills doctrine, Friedman and Schwartz wrote

The foregoing fallacy survives today in the notion that the Federal Reserve should use easy monetary policy to lower interest rates to target levels consistent with full employment. For just as the real bills doctrine calls for expanding the money stock with rises in the needs of trade, so does the interest targeting proposal call for increasing the money supply when the market rate of interest rises above its target level-this monetary expansion continuing until the rate disparity is eliminated.

The problem with the real bills doctrine as Friedman and Schwartz see it is that under it there are no limits to the quantity of money. Whatever amount of money a banker is willing to lend to produce new goods is justified under the doctrine. Also, the doctrine can be construed to mean that as the overall demand for goods falls, then so should the money supply. This is exactly what happened after 1928. According to Friedman and Schwartz, the money supply dropped by about one-third between 1929 and 1933. Not only was fractional reserve banking destroying banks’ liquidity, but so was the contraction in the nation’s money supply. This view of the culpability of the Federal Reserve seems to be currently dominant with both Keynesian and non-Keynesian economists, with the possible exception of some Keynesian economists favoring an expansionary monetary policy such as Paul Krugman.

Neoclassical economists point to the Great Depression as being caused by an agency of the government, the Federal Reserve. This has led many of them to suggest that the government in the form of the Federal Reserve should have some sort of strict objective monetary rule (see here and here and here and here) imposed upon it that limits both the creation and destruction of money. I will discuss this in a future post; but before that I need to look at why the Great Depression lasted so long, and why the Japanese lost two decades of economic growth so far, and why our current economic malaise has lasted so long.

GO TO HOME

Sharing is caring!