Causes of the Great Depression 

A number of factors conspired to take the United States economy into a terrible depression
in the 1930’s. The actual reason for the depression was a general loss of confidence in the
American economy. The reason it got so bad was a general misunderstanding of recessions
by American policy-makers of the time.

The U.S. economy was booming in the 1920’s. Stocks were regularly bought on margin and
their value kept soaring. All investments fared well. The reason is cyclical—one stock looks
good so I buy it. That makes the price rise and you see that this stock is performing well, so
you buy it and the price rises more. This was happening across the entire market. People
were buying thousands and tens of thousands of shares of stock for as little as 10% down.
Unfortunately, that house of cards eventually tumbled and people lost ten times as much as
they put in.

Black Tuesday, 1929. A wind came by and blew a few cards off the house of said cards.
People saw stocks were actually falling (something they hadn’t done in a long time) and the
trend reversed. People hurried to get out of stocks and minimize their losses. As this
happened, more people did the same which exacerbated the situations. J.P. Morgan made a
valiant effort to save the economy by putting the modern equivalent of tens of billions of
dollars into certain banks, but to no avail. Folks wanted out quickly at whatever cost.

In the end, many people lost as much as ten times their initial investment in the crash of
Black Tuesday. Having their confidences shaken and perhaps trying to cover there margins,
they went en masse to banks. Since they were developing mistrust of the economic situation,
many wanted there money out of banks and buried in their yards. The same thing that
happened to the stock market was therefore propagated throughout the whole banking
system. Banks ran out of cash and went bust. Few economic barriers (FDIC included)
existed to prevent total collapse. The banks that did survive had to foreclose on a number of
loans, collecting cars, land, and houses that nobody had the money to buy from the banks.
As a result, these banks ended up with tons of property but no way to get cash from it. This
cash shortage closed even more banks.

Let’s take a brief look at money. Money had inherent value then only inasmuch as the
government promised to give $1 of gold for $1 in paper on demand. This meant that the
money supply could never exceed the amount of gold the U.S. owned. Therefore, if the
paper is no longer backed by anything it becomes inherently worthless and undesirable. Who
wants paper when they could have gold (ironically we see many nations today dumping their
gold supplies and buying U.S. dollars for the sake of stability)? In order to increase the
money supply (with which to cover banks) FDR revoked the gold standard. Doing this
forced people to place at least a limited amount of confidence back in the dollar (since a bill
is only worth a dollar because the government says so and because it has to be so lest we
have a barter-only economy). However, many people began hording gold and placing their
confidence in it instead of bills. Many required payment in gold coin. To stop this and give
the dollar more widespread acceptance, FDR issued an executive order confiscating all gold
(besides personal jewelry) and replacing it with paper—a sort of reverse gold standard. This
forced just a little bit more confidence in paper since there was no longer any choice in the
matter.
With the economy falling in shambles and companies defaulting on loans, nearly all private
and corporate investment ceased. Companies couldn’t afford to expand—in fact, many had
to consolidate in order to cover the margins on their loans. In doing so they stopped hiring
more people and began laying people off. Nobody else could afford to expand so
unemployment sky-rocketed. With people willing to work for less money—than companies
were currently paying, wages lessened too. At the same time prices rose in an attempt by
companies to make some (small) amount of profit off the goods that few people could afford
to buy anymore.

The prevailing opinion in government was that recessions were self-correcting. Eventually
employment would reach equilibrium again and aggregate output would increase. As such,
the government stood back and hoped the situation would correct itself. Eventually
unemployment and inflation stopped declining—but not before the U.S. lost 1/3 of it’s
output and 25% of the workforce was unemployed.

In the end, it was World War that brought us out of the Great Depression. With war at hand
the government began pumping massive amounts of money into the economy. Production
and inflation increased. To stop inflation, price-ceilings were set into effect. More jobs were
available and wages rose. At the war’s end there was a brief recession while the economy
reacted to a loss of the money the government had been pumping in. American optimism at
victory was high and as such the faith of Americans in their country followed their increased
patriotism. The market had finally corrected.

Causes of Great Depression

The Great Depression was a period of unprecedented decline in economic activity. It is generally
agreed to have occurred between 1929 and 1939. Although parts of the economy had begun to
recover by 1936, high unemployment persisted until the Second World War.

Background To Great Depression:

* The 1920s witnessed an economic boom in the US (typified by Ford Motor cars, which made a
car within the grasp of ordinary workers for the first time). Industrial output expanded very rapidly.
Sales were often promoted through buying on credit. However, by early 1929, the steam had gone
out of the economy and output was beginning to fall.

* The stock market had boomed to record levels. Price to earning ratios were above historical
averages.

* The US Agricultural sector had been in recession for many more years

* The UK economy had been experiencing deflation and high unemployment for much of the
1920s. This was mainly due to the cost of the first world war and attempting to rejoin the Gold
standard at a pre world war 1 rate. This meant Sterling was overvalued causing lower exports and
slower growth. The US tried to help the UK stay in the gold standard. That meant inflating the US
economy, which contributed to the credit boom of the 1920s.

Causes of Great Depression

Stock Market Crash of October 1929

During September and October a few firms posted disappointing results causing share prices to fall.
On October 28th (Black Monday), the decline in prices turned into a crash has share prices fell 13%.
Panic spread throughout the stock exchange as people sought to unload their shares. On Tuesday
there was another collapse in prices known as 'Black Tuesday'. Although shares recovered a little in
1930, confidence had evaporated and problems spread to the rest of the financial system. Share
prices would fall even more in 1932 as the depression deepened. By 1932, The stock market fell 89%
from its September 1929 peak. It was at a level not seen since the nineteenth century.

* Falling share prices caused a collapse in confidence and consumer wealth. Spending fell and the
decline in confidence precipitated a desire for savers to withdraw money from their banks.

Bank Failures

In the first 10 months of 1930 alone, 744 US banks went bankrupt and savers lost their savings. In a
desperate bid to raise money, they also tried to call in their loans before people had time to repay
them. As banks went bankrupt, it only increased the demand for other savers to withdraw money
from banks. Long queues of people wanting to withdraw their savings was a common sight. The
authorities appeared unable to stop bank runs and the collapse in confidence in the banking system.
Many agree, that it was this failure of the banking system which was the most powerful cause of
economic depression.

* Because of the banking crisis, Banks reduced lending, there was a fall in investment. People lost
savings and so reduced consumer spending. The impact on economic confidence was disastrous.

Deflation

With falling output, prices began to fall. Deflation created additional problems.
 * It increased the difficulty of paying off debts taken out during 1920s

* Falling prices, encouraged people to hoard cash rather than spend (Keynes called this the
paradox of thrift)

* Increased real wage unemployment (workers reluctant to accept nominal wage cuts, caused real
wages to rise creating additional unemployment)

Unemployment and Negative Multiplier Effect.

As banks went bankrupt, consumer spending and investment fell dramatically. Output fell,
unemployment rose causing a negative multiplier effect. In the 1930s, the unemployment received
little relief beyond the soup kitchen. Therefore, the unemployed dramatically reduced their
spending.

Global Downturn.

America had lent substantial amounts to Europe and UK, to help rebuild after first world war.
Therefore, there was a strong link between the US economy and the rest of the world. The US
downturn soon spread to the rest of the world as America called in loans, Europe couldn't afford to
pay back. This global recession was exacerbated by imposing new tariffs such as Smoot-Hawley
which restricted trade further.

Different Views of the Great Depression

Monetarists View

Monetarists highlight the importance of a fall in the money supply. They point out that between
1929 and 1932, the Federal reserve allowed the money supply (Measured by M2) to fall by a third. In
particular, Monetarists such as Friedman criticise the decisions of the Fed not to save banks going
bankrupt. They say that because the money supply fell so much an ordinary recession turned into a
major deflationary depression.

Austrian View
Austrian school of Economists such as Hayek and Ludwig Von Mises place much of the blame on an
unsustainable credit boom in the 1920s. In particular, they point to the decision to inflate the US
economy to try and help the UK remain on the Gold standard at a rate which was too high. They
argue after this unsustainable credit boom a recession became inevitable. The Austrian school
doesn't accept the Friedman analysis that falling money supply was the main problem. They argue it
was the loss of confidence in the banking system which caused the most damage.

Keynesian View

Keynes emphasised the importance of a fundamental disequilibrium in real output. He saw the Great
Depression as evidence that the classical models of economics were flawed.

* Classical economics assumed Real Output would automatically return to equilibrium (full
employment levels); but the great depression showed this to be not true.

* Keynes said the problem was lack of aggregate demand. Keynes argued passionately that
governments should intervene in the economy to stimulate demand through public works scheme -
higher spending and borrowing.

* Keynes heavily criticised the UK government's decision to try balance the budget in 1930
through higher taxes and lower benefits. He said this only worsened the situation.

* Keynes also pointed to the paradox of thrift.

Marxist View

The Marxist View saw the Great Depression as heralding the imminent collapse of global capitalism.
With unemployment over 25%, Marxists held that this showed the inherent instability and failure of
the capitalist model. Furthermore, they pointed to the Soviet Union as a country which was able to
overcome the great depression through state sponsored economic planning.

How Important was Stock Market Crash of 1929?

The stock market crash of October 1929, was certainly a factor which precipitated events. It did
cause a decline in wealth and severely affected confidence. However, changes in share prices were a
reflection of the underlying boom and bust in the economy. Also a collapse in share prices might not
have caused the great depression, if bank failures had been avoided. In October 1987, share prices
fell by even more (22%) than black Monday. But, it didn't cause an economic recession.