The Great Depression was a worldwide economic collapse that struck the United States particularly hard. American economic output and prices fell dramatically from 1929 to 1933 while the unemployment rate reached an all-time high and stayed high for over a decade. Economic historians have concluded that the Depression was caused mainly by the flawed policies of central banks, including the Federal Reserve, in response to a malfunctioning international gold standard, although additional economic weaknesses and policy mistakes were involved. The response to the crisis was a permanently enlarged national government. If you body slam a physically fit economy, will it break? The answer from the Great Depression seems to be: Almost.
The U.S. economy grew strongly during most of the 1920s, spurred by robust productivity growth derived from recently introduced technologies, including electrification and the internal combustion engine. It reached a peak in August 1929 and then began an unprecedented contraction that lasted until March 1933. During the contraction, wholesale prices fell nearly 37%, whereas retail prices fell about 28%. Real gross domestic product (GDP), the value of all final goods and services produced in the economy (adjusting for changes in prices), fell about 26.5%, dwarfing the size of previous and subsequent economic downturns. Not surprisingly, the unemployment rate exploded, reaching 25% in 1933, meaning that one out of four would-be workers was jobless. The official unemployment rate subsequently exceeded 10% until 1940 (although these numbers are inflated by counting emergency workers in government programs as unemployed).
Agriculture, the construction industry, and manufacturing were particularly hard hit. Prices paid to farmers fell by half, dropping the ratio of the prices they received to the prices they paid by more than a third. Industrial production fell by 45% (with output of durable goods, such as automobiles, falling 70–80%), and new housing starts dropped 82%. Gross investment plummeted by more than 80%, meaning that the capital stock actually shrank because depreciation outstripped new investment, although personal consumption fell much less rapidly, only 18%. Although almost everyone suffered, the economic pain was not shared evenly; investors saw the value of the Dow Jones Industrial Average fall over 80%, and soup lines swelled with unemployed workers, but deflation-adjusted hourly earnings of those with jobs were virtually unchanged. All in all, the Depression hit harder in the United States than anywhere else. From 1929 to 1932, total industrial production fell by 11% in Britain, 23% in Italy, 26% in France, 32% in Canada, 41% in Germany, and 45% in the United States.
Contemporaries lacked good explanations of the causes of the Great Depression, which often led them to adopt policies that only worsened the situation. However, economic historians have done much to cast light on the matter. The general consensus is that policy mistakes and a malfunctioning international financial system converted an ordinary business downturn into the Great Depression. As Peter Temin and Barry Eichengreen put it, “central bankers continued to kick the world economy while it was down until it lost consciousness.”
Traditional explanations of the Depression begin with the spectacular stock market crash of October 1929. The crash wiped out significant gains in asset prices and drove overleveraged investors into debt. It seems to have signaled a shift from optimism to pessimism in the economy, but most modern explanations see it as a secondary cause of the Depression. Another factor that may have played an important role in reducing aggregate demand is the dissipation of a home construction boom, which peaked in 1926. In addition, the enactment of the protectionist Smoot–Hawley Tariff has been blamed for exacerbating the recession, especially by inviting retaliatory tariffs among the country’s trading partners. However, modern explanations of the Depression begin with Milton Friedman and Anna Schwartz, whose book, Monetary History of the United States, 1867-1960, carefully documented how disruptions in the financial sector harmed the rest of the economy.
Friedman and Schwartz argued that several waves of banking failures, beginning in October 1930, led to a drastic decline in the money supply, which caused considerable damage to the overall economy. As these bank failures unfolded, depositors became increasingly wary of keeping their assets in uninsured banks. Banks moved to reassure depositors by holding more of these deposits as reserves and in assets like government bonds that were easy to quickly convert into money. This scenario caused the supply of loanable funds to shrink, driving up interest rates and making it nearly impossible for many businesses and households to borrow. Deprived of credit, businesses and consumers were forced to curb their hiring and spending, reducing the overall demand for output and pushing other businesses and households to cut back as the crisis snowballed. This drop in aggregate demand caused prices to fall, but the deflation seems to have only worsened the problem because debt levels were higher than in previous downturns, so the drop in prices meant that it was harder for borrowers to pay back their loans. Many defaulted, making creditors even more wary to lend. Others paid back their loans, but were forced to cut back spending elsewhere to do so, exacerbating the problem. The extensive, fairly new automobile loan market seems to have played an important role because many of these loans were structured so that missed payments could easily result in repossession and loss of the built-up equity in the car, even if most of the loan had been paid off. In addition, rapidly falling prices meant that investors could come out ahead by simply sitting on their cash, which would appreciate in value by the fall in prices without the risk of default that lending brought.
Why were the bank failures of the Great Depression so persistent and widespread? Some of the weakness emanated from the rural banking sector, which was wracked by turbulent trends in agricultural commodity prices and land values in the aftermath of World War I. These weaknesses were exacerbated by state-level laws that often restricted banks to a single branch, making it difficult for them to diversify the risks in their loan portfolios. In earlier recessions, banking panics had been averted when deep-pocketed financiers, like J. P. Morgan, stepped forward to lend money to banks and when some banks temporarily suspended the ability of depositors to withdraw their money. The Federal Reserve was established, in part, to take the place of financiers as a “lender of last resort,” and legislation ended the ability of most banks to close temporarily.
The traditional means of short-circuiting bank panics had been hamstrung by the federal government, and, critics argue, the Federal Reserve subsequently utterly failed in its duty to provide funds to the banking system as it began to crumble. The Fed’s leaders seem to have seen the deflation and bankruptcies of the era as a good sign for long-term economic health. The administration of President Herbert Hoover and the staff of the Federal Reserve included many “liquidationists,” who believed that overextended economic agents should be forced to rearrange their economic affairs and curb their speculative excesses. They viewed the bankruptcies, belt-tightening, and the entire downturn as an antidote, or even “penance,” for the excesses of the 1920s. This theory is exemplified by a well-known quotation from Treasury Secretary Andrew Mellon, who advised Hoover to “liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate… . It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life.” Accordingly, the Federal Reserve didn’t step in to add to the supply of loanable funds. Rather, in 1928 and 1929, it had acted to decrease the supply of credit available for stock market speculators and was slow to reverse course. Fed officials don’t appear to have fully realized that credit had become tight because they observed that banks were carrying excess reserves (unloaned funds) and charging fairly low interest rates. Although these nominal interest rates were low and falling, they masked the high price that borrowers paid due to the fact that deflation made it harder to pay back loans. Real interest rates were at unusually high levels, reaching 20% or more after adjusting for deflation, and banks’ excess reserves were a precautionary move, rather than a sign that there was plenty to lend.
Tellingly, when Britain left the gold standard in September 1931, the Fed increased its interest rate, rather than making credit easier to obtain, precipitating a new wave of bank failures. Barry Eichengreen, among others, has explained the Fed’s seemingly perverse behavior in light of the contemporary understanding of the gold standard. From 1870 until World War I, the international gold standard had worked exceptionally well in providing a financial environment that made global investment and trade unusually stable and secure, allowing strong, widespread economic growth. At the conclusion of the war, it was obvious to most central bankers, businessmen, and policymakers that a return to the gold standard was a prerequisite for a return to renewed growth and stability. The hyperinflation in Weimar Germany shortly after the war emphasized the dangers of currency that was not backed by an inflexibly supplied commodity, such as gold. To make the gold standard work, each country convinced investors that it was committed to redeeming its currency for a specific amount of gold, to protecting them from a loss in their investment due to devaluation of the currency. To do so, it needed to hold enough gold. When it ran a trade surplus with other countries on the gold standard, it attracted more gold, which expanded its money supply and drove up prices, reducing exports of its goods and bringing the system back into balance. When it ran a trade deficit, the opposite occurred—it lost gold, shrinking the money supply, forcing its prices downward, and making them easier to export, closing up the deficit.
The system worked well when input prices, especially wages, were sufficiently flexible. Returning to the gold standard after World War I proved difficult because several countries, especially Great Britain, found their prices out of alignment with the prewar exchange rates, necessitating deflation. However, deflation no longer equilibrated the system because wages didn’t fall enough, probably due to the rising power of labor unions in many European countries and the spread of internal labor markets and personnel departments in the United States. This shift in American labor market policies, designed in part to reduce turnover and increase the length of employment relations, has been attributed to a range of factors, including the reduction of immigration, technological changes, rising education and skill levels among workers, and diffusion of enlightened human resource policies. Thus, new political and economic realities meant that the traditional gold standard adjustment mechanism, deflation and wage cuts, no longer functioned as well as previously. Wages didn’t fall much; instead, unemployment swelled. Moreover, the countries with the most gold, America and France, didn’t adequately play by the rules of the game in the late 1920s, refusing to allow inflation to occur, thus creating a deflationary bias in the entire system. The United States didn’t take the lead in replacing weakened Britain in ensuring that the system functioned properly.
Accordingly, when deflationary pressures emerged during the Great Depression, countries began to abandon the gold standard. Evidence shows that the sooner a country abandoned the gold standard, the quicker recovery commenced. Unfortunately for the U.S. economy, it clung to the gold standard longer than most other countries, suspending convertibility of the dollar after Franklin Roosevelt’s inauguration in 1933. When Britain suspended the convertibility of the pound into gold in September 1931, the Fed knew that international investors feared the United States would soon join in abandoning the gold standard and thus devaluate the dollar in the process. Investors began to convert their dollar-denominated assets into gold, so the Fed acted to make the dollar more attractive through the sharpest increase in the rediscount rate in the system’s history. Unfortunately, this interest rate hike worsened the domestic banking crisis, making it harder for shaky banks to obtain credit. In October 1931, more than 500 banks closed, and in the 6-month period starting in August 1931, banks with deposits totaling almost $1.5 billion suspended operations. A final banking crisis hit in the period between Roosevelt’s election and his March 1933 inauguration. As bank runs spread from state to state and governors felt compelled to declare banking “holidays,” depositors lost confidence in the entire banking system.
Between 1930 and 1933, more than 9,000 banks failed—more than a third of the initial total. Ben Bernanke argues that this situation helps explain the subsequent longevity of the Great Depression. The loss of these banks made the economy much less efficient than it had previously been, making it considerably harder for individuals and businesses who had built up relationships with the failed banks to obtain credit, forcing them to cancel plans to buy and invest. In addition, the length of the Depression has been explained by a series of policy missteps. In a recent survey of economic historians, half agreed that, despite many policies that helped to right the economy, “taken as a whole, government policies of the New Deal served to lengthen and deepen the Great Depression.”
The policy they found most blameworthy was probably the National Industrial Recovery Act, enacted in June 1933, which aimed to rein in competitive forces, which many naively blamed for the economic collapse. The act allowed industries to draw up “codes of fair competition,” which effectively cartelized production in many sectors, significantly boosting goods’ prices and, thus, reducing the quantity of goods demanded and curtailing employment. The act was finally declared unconstitutional in May 1935. In addition, events suggest that the overall attitude of the Roosevelt administration and specific policies that threatened the security of property rights (such as the lack of response by government entities to sit-down strikes) discouraged investment, which jumped about 60% after the New Deal coalition suffered electoral defeats in 1938.
Amid the recovery, the economy suffered another steep downturn in 1937 when industrial production and wholesale prices fell by 33% and 11%, respectively, whereas unemployment rose 5%. This recession has been attributed to the Fed’s deflationary overreaction in doubling banks’ reserve requirements as a preemptive strike against inflation and the reduction in aggregate demand caused by the levying of social security payroll taxes several years before benefits were to begin being paid out.
Research concludes that this era might have been one of immense economic progress, as the years from 1929 to 1941 were, in the aggregate, the most technologically progressive of any comparable period in U.S. economic history. However, the scholarly consensus is that a series of policy mistakes and a malfunctioning international financial system made it an era of economic insecurity, opening the door to a permanently expanded economic presence of government.
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Originally published .