Causes of the Great Depression

 

 

INTRODUCTION

 

Even after 96 years since the start of the Great Depression, there remains controversy about the causes. It is possible to draw up a list of probable causes but there is no consensus about the relative importance or the interaction of the causal variables.

 

GENERAL APPROACH

 

The basic approach of modern macroeconomic theory is to view a national economy as a relatively stable, self-equilibrating mechanism that is capable of sustained economic growth over a long period. Recessions and inflationary periods occur because of some kind of “external shock” to the system that impacts components of aggregate demand or aggregate supply. In this model, external shocks (exogenous variables) include the sudden and large increase in the cost of vital inputs such as oil, sudden and large changes in competition from imports or fall in the demand for exports, unexpected changes in nominal interest rates, monetary policy by the Fed, and fiscal policy (government spending, taxes, and deficits). In an economy with a large agricultural sector, like the U.S. in the 1920s, adverse weather could also be an external shock.

 

Monetary factors can play a large role. Both aggregate demand, especially autonomous consumption and investment, and aggregate supply can be influenced by monetary variables, usually summarized in the changes in nominal and real

(after inflation) interest rates. Monetarists also emphasized the importance of the growth rate of the money supply, which in turn is influenced by the monetary policy of the Fed and strategies of banks and depositors.

 

In the 1920s, monetary factors became important in a new way. There was a large expansion of consumer debt as families bought consumer durables, especially cars, on credit.

 

This list indicates possible causes. All of them (and more) have been mentioned as important contributors to the Great Depression. But this presents a problem of timing. That the US economy went into a recession in 1929 is not surprising; all industrial economies suffer periodic recessions. What was totally unexpected was that the recession worsened into the Great Depression and then lasted so long. So, the question really is how a series of external shocks caused, or contributed, to the length and the depths of the Great Depression.

 

Time to round up the usual suspects. The list includes:

 

International Factors, particularly the disruption caused by the First World War. Analysts have focused on the attempt of Great Britain and the United States to reestablish the gold standard. Coordination of these attempts by the central banks of the two countries had consequences for the U.S. domestic economy.

 

Internal Weaknesses. The culprits here include agriculture, construction, and the auto industry. The weakness in agriculture is related to a fall in export demand after World War One, bad weather, and high debt levels among farmers as they mechanize their farms in the 1920s. Farm failures in the 1920s led to the failures of about 6,000 small rural banks in the 1920s, before the onset of the Depression. Total construction expenditures probably peaked in 1925 and fell after the collapse of the Florida land boom. Residential construction recovered; the number of new permits peaked in the summer of 1929. Auto sales probably began to fall in the spring and summer of 1929, although special factors such as the reopening of Ford in 1928 and the working off of backlogs were at work here.

 

Monetary Factors. This has long been at the top of the causal factors because of the research of Milton Friedman and Anna Schwartz. The most dramatic component of this set of factors was four waves of mass bankruptcies in the banking system between 1930 and 1933, and the seeming paralysis of the Fed when faced with this disaster. The Fed also comes in for criticism for letting England attempt to reimpose the gold standard, which determined domestic money policy, and for increase in interest rates in 1928 and 1929 to slow down the bull stock market.

 

Stock Market. The collapse of stock market prices in October 1929 is seen as the immediate trigger of the Great Depression. It was certainly the most dramatic cause and worsened the recession that was already underway.

 

But it is hard to nail down exactly how the stock market collapse contributed to the length and depth of the depression. A fall in asset prices is usually a precondition for economic recovery. It is hard to find a strong link between the stock market crash and the banking crisis. The large money center banks in New York and Chicago that provided the funds to fuel stock market speculation were not among the thousands of banks that went under in the 1930s.

 

Fiscal policies. It is important here to differentiate the Great Depression and the New Deal. Further, it is helpful to think of the New Deal as consisting of two parts -  macroeconomic (fiscal) policies to get the US economy out of the depression and government programs to regulate and reorganize the private sector of the economy Many economists believe that the fiscal policies were inadequate, and in 1937 perverse enough to cause a nasty recession that prolonged the Great Depression. Some modern economic historians now believe that some new deal social legislation (particularly the NIRA of the early 1930s) may have actually prolonged the depression.

 

As you can see, even a list of possible factors looks complicated. To sort them out, let us ask a series of related questions.

 

1. Before 1929, how important were the international factors stemming from the disruptions caused by World War One? How important was the futile attempt to impose the gold standard? After 1929, how important was the fall of exports to the full and aggregate demand?

 

2. How important were purely domestic factors? Did the US economy exhibit any unusual structural weaknesses before the stock market collapse? What about the large increase in consumer credit in the 1920s? Did financial leverage in consumption (borrowing to buy autos and consumer durables like radios) and investment such as borrowing to buy stock on margin contribute to the economic collapse?

 

3. How important was the Fed's passivity in the face of monetary crises, particularly the wave of bank failures in the early 1930s? How were bank failures related to other variables, such as the collapse in stock market prices and changes in interest rates? 

 

4. What about reaction of the United States government to the lengthening recession? Why weren't fiscal policies more effective in turning the economy around? Worse, did national economic policies and programs prolong the depression? Did monetary policy change after 1933? 

 

5. Psychological factors. These are hard to quantify although modern economic models do try to estimate the impact of uncertainty and expectations on economic variables. As the depression deepened, economic decision makers exhibited shock and paralysis. Did fear (risk avoidance) mean that banks stopped lending and businesses stopped investing?

 

The Evidence

 

Before we try to answer the main question, let's look at the quantitative evidence to see if some of the suspects are not as guilty as accused.

 

Let's start with imports and exports (foreign trade). The evidence here is that the Great Depression was worldwide; foreign trade and international financial flows could have been propagating mechanisms that transmitted economic problems from country to country.

 

Propositions:

 

Imports and exports were just not that important to the American economy. Net exports (exports minus imports) were about 1% of GDP in 1929. The change in net exports accounted for very little of the change in real GDP in the early 1930s (Romer, “The Nation in Depression,” 30).

 

Imports and exports were mostly raw materials and agricultural products. The fall in imports was a result of the decrease in domestic production. The fall in exports hurt agriculture but most of the damage had already been done in the 1920s.

 

Probably the most popular explanation for the immediate cause of the Great Depression was the collapse of the stock market in October 1929. Certainly this was the most dramatic cause; investors got crushed. The New York Times average of selected industrial stock prices stood at 452 on the day after Labor Day, 1929. By mid-November the average had fallen to 224 and hit bottom at 58 in July 1932. General Motors fell from $91 a share to $8, US steel from $261 to $21, RCA (the high-tech stock of the 1920s) from $115 to 2 1/2 dollars, and the New York Central Railroad from $256 to $9.

 

But the relationship between the drop in stock prices and the drop in total output is more complicated. Economists believe that the US economy went into recession in the summer of 1929. Not everyone knew this but the fall in production of steel and autos was publicized in the business press. Industrial production fell 10% between October and December 1929. The stock market continued to fall in the fourth quarter of 1929 but staged a rally in the first quarter of 1930, even though total output continued to fall. What is likely is that the volatility of the stock market created uncertainty about the future. Consumers reduced their demand for houses and consumer durables like cars and appliances that entailed a large financial commitment (new debt or decreased savings). Total consumption fell drastically in 1930 - a total of 37% between July 1929 and December 1930 with most of the decrease occurring in consumer durables.

 

After the original crash and partial recovery in early 1930, the stock market began a long slide down. Big speculators, some of whom had pulled out of the market, came back to buy in the market in the 1930s whenever they thought the market had bottomed out. Contrary to earlier patterns, it took a long time to reach bottom. Many of the big speculators like Billy Durant and Jesse Livermore were wiped out before the market finally hit bottom in 1932 or as stock prices whipsawed as the economy rose and fell in the 1930s. This tends to suggest that after 1929, it was the contraction of the real economy that was driving stock prices, not the other way around. 

 

So the shock of the stock market crash wiping out large amounts of paper wealth and leading to fear and uncertainty about the future was probably important in the early stages of the Great Depression but not an important determining influence on the protraction of the Depression.

 

In the long run, the destruction of savings because of bank failures probably had an important effect on the large decrease in autonomous consumption. The large fall in the demand for housing and consumer durables led to a massive decrease in industrial production. Companies reacted by stopping virtually all new investment, cutting wages, and firing a large percent of the industrial workforce.

 

By the middle of 1930, it was known that the recession was becoming as nasty as the one in 1920–21. This meant that prices, including nominal interest rates and asset (stock and land) prices could be expected to fall. They did. This precipitated a relatively minor wave of bankruptcies in the banking system in October 1930. The failed banks were generally in rural Southern states, many controlled by one highly leveraged holding company. The economic damage was regional; the large big city banks involved in financing the stock market did not fail.

 

This gets us to one of the most controversial aspects of the Depression - the role of interest rates. Much of the discussion has been technical, revolving around the difference between real and nominal interest rates. In the first four years of the Depression, especially in 1931-33, private business investment collapsed. Economic theory says, however, that a fall in interest rates should eventually lead to higher levels of investment. This effect, however, was swamped by the fall in demand for consumer products, especially durables, and a fall in output prices. Industrial production fell about 60% between the peak in 1929 and the trough in 1932. Companies with large amounts of excess capital tried to reduce inventories and did not make large net new investments in fixed assets. But even when consumer demand began to revive in 1933, investment did not turn up right away. One reason was that banks, the major source of funds, had no incentive to make new long-term loans. The income on the new loans, a function of interest rates, was low. And the risk of default was still perceived as high. Also, the banks, by not loaning out funds, were still making a high real rate of return on their reserves. Assume you hold cash and prices are falling at 10% a year, as they did in 1931 and 1932. Your cash is worth 10% more per year in purchasing power; This is your real rate of return. Why lend it out to make an additional 2% but run the fairly large risk of losing all your money? Using this logic, banks were very reluctant to lend in the early 1930s and sat on excess cash.

 

Families, many of whom had lost all or part of their savings when the stock market crashed and banks failed (no deposit insurance until 1933), used the same logic and were understandably reluctant to deposit new savings in banks to earn low interest rates. So this source of savings was not available to be lent out to businesses for investment. Businesses were reluctant to invest in new fixed assets in 1931 and 1932 because of the very high real interest rates and the expectation that demand was not picking up and prices could continue to fall. Only in 1933 did demand increase, prices stopped falling and expectations turned positive. After that, there were large increases in total private investment until the recession of 1937-38.

 

Maybe the ultimate answer to why the Depression lasted so long was that economic recovery was subjected to a series of negative shocks that cut short the building of confidence in the future. There was the banking crisis of 1930, the banking crisis and international financial crisis of 1931, the total collapse of the banking system in early 1933, the negative psychological impact of the NRA on business in 1933-34, and the recession of 1937-38 caused by the Fed wanting higher interest rates and the Roosevelt administration attempting to balance the federal budget. In the background was the continuing disaster of agriculture caused by drought, dust storms, bankruptcies, lack of credit, and unprofitable prices.

 

Because of the influence of Friedman and Schwartz, probably no aspect of the Great Depression has caused more controversy, or stimulated more research, than the role of the Fed and monetary policy. With two exceptions - right after the stock market crash in October 1929 and for a brief period in 1932 (under political pressure) - the Fed did nothing to stem the fall in the money supply and the collapse of the banking system before 1933. Then between 1933 and 1937, the money supply grew rapidly, prices rose, and industrial production went up 79% between the bottom in March 1933 and the peak in July 1937. But the recession of 1937-38, due to a contractionary relapse in monetary and fiscal policy, delayed full recovery for at least three more years.

 

If monetary policies were inadequate to deal with the devastation in financial markets before 1933, what about fiscal policy after 1933? The evidence suggests that the national budget deficits, and work relief programs, were nowhere large enough to get the country out of the Depression. This is not a criticism of Roosevelt because there were political constraints on what he could do. Even running the budget deficits he did run exposed him to harsh criticism and political risk. Also, the states, seeing the federal government take over the responsibility of dealing with mass unemployment, became more conservative, balancing their budgets or running surpluses. So the total fiscal effect was even less than the inadequate one implied by just looking at the federal government's fiscal policies.

 

SPECULATION ON THE RELATIVE IMPORTANCE OF CAUSES OF THE GREAT DEPRESSION

 

Maybe the ultimate answer is that the American economy was still in the transitional stage between a 19th century economy (agriculture important and many local small businesses, including small banks) and a 20th century economy of huge corporations developing new technology. Since the 1870s, public groups, mostly state governments and various political reform movements, and private groups (investment banks like J. P. Morgan and engineering-trained managers at companies like Du Pont, General Electric and General Motors) tried to bring “order” and “stability” and “control” to the competitive chaos of the marketplace. Morgan and the new engineers/managers attempted to create huge corporations and oligopolistic industries to eliminate “ruinous competition.” Politicians tried to regulate them, starting with the railroads, but economic change was occurring too quickly. Whole new manufacturing industries - steel, chemicals, oil, electrical equipment, autos and communication technologies, telephones, radio - were being created. Laisser-faire social policy, including lack of antitrust, in the 1920s was an inadequate response to gigantic corporations like General Motors, US Steel, General Electric, and Ford.

 

The banking system also grew rapidly. The number of banks nearly tripled between 1900 and 1920, reaching an incredible 30,000 in 1920. Weak, local banks were both unregulated and protected from competition from larger banks. Political reform movements generally looked backward to the period before big corporations dominated the economic landscape. Despite a large increase in the 1920s in the number of families investing in stocks, no laws were passed to protect small investors from insider trading and price rigging.

 

So maybe the basic problem was that the traditional ways of thinking about the American economy were increasingly inadequate or even anachronistic. The economic problems of agriculture and the related structural problems of rural banks (small, undercapitalized, not diversified, dependent on farmers’ financial needs) could not be addressed with a philosophy that glorified the small farmer and protected the small businessman, and supported a policy of laissez-faire. Large corporations and holding companies were often highly leveraged, either in the financial sense (much debt) or the structural sense of large upfront capital investment needing a high capacity utilization rate to make a profit. Sometimes both. The result was that even a relatively mild fall in demand, say, 10 to 15%, could trigger a fall in output that meant the difference between a large profit and a loss. With high fixed costs, reducing labor costs by lowering wages or firing workers only lessened the short-term loss; for the macro economy, these private strategies just made the Depression worse. It not surprising that a fall in consumer demand led to a fall in private investment. It is also not surprising that industrial production, both of consumer goods and capital goods, was hit harder than the overall economy.

 

There were no policies in place to deal with the economic and social consequences of mass unemployment, the huge number of bank failures (5,100 in 1930-32), and the wipeout of family savings and assets. Private welfare and state programs were inadequate. Often, traditional government reaction, or lack of reaction, just made the situation worse.

 

The shocks to the economic system over the first three years of the Depression were too severe for the economy to handle. The stock market crashed, wiping out $40 billion in wealth in an economy of $100 billion. Real estate prices, including the value of farmland, declined drastically, leading to foreclosures and the collapse of thousands of banks. Savings disappeared when banks failed. Banks refused to make new loans because of very low interest rates and the high probability of new loan defaults. Excess reserves piled up in the banking system. Private investment disappeared at the bottom of the Depression; there was massive excess capacity and a large decline in aggregate demand. Public investment was not large enough to replace the $15 billion per year in business investment.

 

Many of the programs of the New Deal were proposed by reformers before the Great Depression. A few of the reforms were enacted as wartime measures during World War I but were repealed after the end of the war. Much of the public policy and regulatory structures we have today were first advocated as a reaction to the economic problems generated by the Second Industrial Revolution beginning in the 1870s and revealed by the Great Depression. Let us hope that it will not be necessary for us to experience another Great Depression before we can deal with the economic problems generated by the current transformation of the American economy.