The Great Depression was the deepest, longest and most widespread economic recession in the history of the Western world and lasted from 1929-1939.
The height of the Great Depression in the USA was 1933. At that time, unemployment reached 25%, deflation was recorded at 10% per annum and nominal GDP collapsed from $103 billion (in 1929) to $55 billion.
Below, we outline the main causes of the Great Depression.
Aggregate Demand and the Negative Multiplier
Aggregate demand was now taking a massive hit. The Wall Street Crash, combined with the banking crisis, depressed consumers’ and investors’ confidence. Subsequently, consumption, investment, AD, output and employment spiralled downwards, the Great Depression gathered full steam.
Because AD was falling to such a large extent, prices begun to fall, initiating a long period of deflation. This may not sound that bad, but the effects were disastrous. Since consumers expected deflation, there was reason for them to hoard money and wait to spend in the future when prices would be lower, further exacerbating the downward spiral of consumption and all the connected aggregate macro variables. Deflation also meant that anyone who still had debts from loans taken out before 1929 now owed more money in real terms, causing additional bankruptcies. Furthermore, real wage unemployment set in because workers would not accept nominal wage cuts.
Another contributing factor to the Great Depression was a major drought which ravaged the agricultural sector in the USA in the mid-1930s. Falling agriculture prices put many farmers out of business, leaving them unable to help in the recovery of the economy. Moreover, many farmers migrated to California in an unsuccessful hunt to find jobs, causing unemployment to rise further.
Although the Great Depression began in the USA, it spread across the world to other economies. Many economies borrowed heavily from the USA to rebuild their infrastructure after World War 1. Inevitably, when the USA asked for the debts to be repaid early, many economies defaulted on their loans and ran into their own financial problems; the US recession poisoned the global economy.
Moreover, in an effort to protect domestic industries and employment in the 1930s, the USA imposed the Smoot-Hawley tariff. This caused other economies to retaliate with their own tariffs and, subsequently, caused international trade to collapse.
The US economy began to recover in the mid-1930s when President Roosevelt signed the New Deal and created federal government programs and agencies which provided jobs for the unemployed. Additionally, the impending World War 2 encouraged even further increases in government spending. AD was finally on it’s way up, paving the way for a rise in jobs and output, pulling the US economy out of a recession.
Let us now turn to a summary of the different views on what caused and cured the Great Depression.
Keynes highlighted the reduction in AD as the prime cause for the Great Depression. AD was falling and creating such a large negative multiplier that the economy could not recover by itself and, consequently, was moving towards an equilibrium with high levels of involuntary unemployment. Keynes argued that the government should have intervened by increasing government spending to manage AD and boost the economy to maintain high levels of employment and output. In the USA, President Roosevelt did, indeed, engage in a bout of increased government spending on public works and farm subsidies, but Keynes argued that more spending was required.
Monetarists blame the Federal Reserve for the Great Depression. They argue that the stock market crash began as an ordinary recession but the Fed’s policies exacerbated it and created a deeper recession. Monetarists assert that the Fed’s monetary response was incorrect as they allowed the money supply to contract by roughly one-third, leading to deflation, a reduction in consumption and debt defaults. They also contend that the Great Depression was caused by the Fed allowing public banks to fail. Monetarists argue that the Fed should have acted and provided emergency funds to save big banks from going under. The Fed’s response was that, at the time, they were maintaining the gold standard and this prevented them from offering credit to save banks.
Austrian economists argue that the Great Depression was caused by the Fed allowing the money supply to expand in the 1920s. They assert that monetary expansion caused an unsustainable increase in credit which developed an asset market bubble, and the bubble inevitably burst in 1929. Ludwig von Mises commented on the stock market boom: “It is not a real prosperity. It is illusory prosperity. It did not develop from an increase in economic wealth, i.e. the accumulation of savings made available for productive investment. Rather, it arose because the credit expansion created the illusion of such an increase. Sooner or later, it must become apparent that this economic situation is built on sand.”
Ben Bernanke offered a debt-deflation theory of the Great Depression that has been heralded as a powerful explanation of the onset of the events that led up to the disaster. Bernanke builds on Fisher’s theory that dramatic reductions in the price level and nominal income leads to rising real debt burdens which, in turn, causes debtor insolvency, decreased AD, a further fall in the price level and, subsequently, a debt deflationary spiral. Bernanke adds to this theory by positing that a small decline in the price level reallocates wealth from debtors to creditors without harming the economy. However, serious deflation causes a major decrease in asset prices which decreases the nominal value of assets on banks’ balance sheets. Banks then react by restricting credit conditions and, in turn, this results in a credit crunch which does significant damage to the economy because it decreases investment and AD, creating a serious deflationary spiral.
New Neoclassical Synthesis
The New Neoclassical Synthesis suggests that the recovery from the Great Depression was due to the government’s management of the public’s expectations. When the US economy began to take an upswing in 1933 this was not due to monetary expansion as the money supply was still falling and interest rates had been low for years. The turnaround happened because President Roosevelt publicly announced that the government would boost spending. Consumers and investors believed Roosevelt and regained their confidence in the economy as they expected it to grow; this spurred on consumers and investors to spend and, consequently, AD, employment and output rose.