The
causes of the Great Depression are a matter of dispute among economists. It has
become an essential part of a larger debate about economic crises, although the
popular belief is that the Great Depression was caused by the 1929 crash of the
stock market. Recessions and business cycles are thought to be a normal part of
living in a world of inexact balances between supply and demand. But what turns
a normal recession or 'ordinary' business cycle into a depression is a subject
of much debate and concern.
Current
theories may be broadly classified into two main points of view and several
heterodox points of view. There are demand-driven theories, most importantly
Keynesian economics. The consensus among demand-driven theories is that a
large-scale loss of confidence led to a sudden reduction in consumption and
investment spending. Once panic and deflation set in, many people believed they
could avoid further losses by keeping clear of the markets. Holding money
became profitable as prices dropped lower and a given amount of money bought
ever more goods, exacerbating the drop in demand.
Then
there are the monetarists, who believe that the Great Depression started as an
ordinary recession, but the significant policy mistakes by monetary
authorities (especially the Federal Reserve) caused a recession to descend into
the Great Depression. Related to this explanation are those who point to debt
deflation causing those who borrow to owe ever more in real terms.
Historical background
On
October 29, 1929 the stock markets in the United States crashed and the panic
struck. This day is known in history as Black Thursday. The overwhelming
optimism of the previous years had vanished in a moment. The new wealthy have
found themselves newly poor. Consumer spending had plummeted – especially for
luxury goods. Personal income, tax revenue, profits and prices dropped, while
international trade plunged by more than 50% and unemployment in the U.S. rose
to 25%. Harsh economic conditions lasted for more than a decade till early
1940s. This period in history of the United States is known as the Great
Depression.
It
was less than eight months that newly elected president Herbert Clark Hoover
took office. Hoover tried to combat the ensuing Great Depression with
government enforced efforts, public works projects such as the Hoover Dam, tariffs
such as the Smoot-Hawley Tariff, an increase in the top tax bracket from 25% to
63% and increases in corporate taxes. These initiatives did not produce
economic recovery during his term, but various sources claim that it served as
the groundwork for various policies incorporated in Franklin D. Roosevelt's New
Deal.
President
Franklin D. Roosevelt's began his 1932 campaign for the presidency espousing
orthodox fiscal beliefs. He promised to balance the federal budget, which
Herbert Hoover had been unable to do. When Roosevelt came into office, the
national deficit was nearly $3,000,000,000.
The Keynesians
Keynes
argued in General Theory of Employment Interest and Money that lower aggregate
expenditures in the economy contributed to a massive decline in income and to
employment that was well below the average. In such a situation, the economy
reached equilibrium at low levels of economic activity and high unemployment.
According
to the Keynesian economists point of view, the fiscal orthodoxy of budget
balancing did not match the reality of the economic situation of America with
nearly a quarter of its working population unemployed. They called on
governments to pick up the slack by increasing government spending and/or
cutting taxes.
From
1933 to 1937, president Roosevelt maintained his belief in a balanced budget,
but recognized the need for increased government expenditures to put people
back to work. Each year, Roosevelt submitted a budget for general expenditures
that anticipated a balanced budget, with the exception of government
expenditures for relief and work programs.
Treasury
Secretary Henry Morgenthau, Jr., and aides within the Treasury Department
favored an approach that sought to balance the federal budget. But other
advisers in the President's inner circle, including Harry Hopkins, Marriner
Eccles, and Henry Wallace, had accepted the recent theories of John Maynard
Keynes, who argued that technically advanced economies would need permanent
budget deficits or other measures (such as redistribution of income away from
the wealthy) to stimulate consumption of goods and to maintain full employment.
It was the reduction of federal spending that these advisers viewed as the
cause of the recession.
As
the economy improved, more Americans were working, and there was an anticipation
of increased tax revenues as a result of the recovery. From 1933 to 1937,
unemployment had been reduced from 25% to 14% - still a large percentage, but a
vast improvement. Roosevelt's reaction was to turn back to the fiscal orthodoxy
of the time, and he began to reduce emergency relief and public works spending
in an effort to truly balance the budget. The country then lurched into what is
now known as the Roosevelt Recession of 1937-1938. Unemployment threatened to
rise to pre-New Deal levels, and the economy came grinding to a halt.
Roosevelt
found these arguments compelling in the wake of the Recession. In his Annual
Message to Congress on January 3, 1938, President Roosevelt declared his
intention to seek funding for massive government spending without tax
increases.
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| (picture source: http://en.wikipedia.org/wiki/Causes_of_the_Great_Depression) |
As
the Depression wore on, Franklin D. Roosevelt tried public works, farm
subsidies, and other devices to restart the US economy, but never completely
gave up trying to balance the budget. According to the Keynesians, this improved
the economy, but Roosevelt never spent enough to bring the economy out of
recession until the start of World War II.
The Monetarists
The
monetarists believe that the Great Depression started as an ordinary recession,
but that significant policy mistakes by monetary authorities (especially the
Federal Reserve), caused a shrinking of the money supply which greatly
exacerbated the economic situation, causing a recession to descend into the
Great Depression.
In
their 1963 book A Monetary History of the United States, 1867-1960, prominent
monetarists Milton Friedman and Anna Schwartz argue that people wanted to hold
more money than the Federal Reserve was supplying. As a result people hoarded
money by consuming less. This caused a contraction in employment and production
since prices were not flexible enough to immediately fall. The Fed's failure
was in not realizing what was happening and not taking corrective action.
The
Federal Reserve allowed some large public bank failures – particularly that of
the New York Bank of the United States – which produced panic and widespread
runs on local banks, and the Federal Reserve sat idly by while banks collapsed.
With
significantly less money to go around, businessmen could not get new loans and
could not even get their old loans renewed, forcing many to stop investing.
This interpretation blames the Federal Reserve for inaction, especially the New
York branch.
Before
the 1913 establishment of the Federal Reserve, the banking system had dealt
with these crises in the U.S. (such as in the Panic of 1907) by suspending the
convertibility of deposits into currency. Starting in 1893, there were growing
efforts by financial institutions and businessmen to intervene during these
crises, providing liquidity to banks that were suffering runs. During the
banking panic of 1907, an ad-hoc coalition assembled by J. P. Morgan successfully
intervened in this way. A call by some for a government version of this
solution resulted in the establishment of the Federal Reserve.
But
in 1928-32, the Federal Reserve did not act to provide liquidity to banks
suffering runs. In fact, its policy contributed to the banking crisis by
permitting a sudden contraction of the US money supply by over a third from
1929 to 1933.
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| (picture source: "Monetary Policy in the Great Depression: What the Fed did, and Why" by David C. Wheelock) |
At
that time, the amount of credit the Federal Reserve could issue was limited by
the Federal Reserve Act, which required 40% gold backing of Federal Reserve
Notes issued. By the late 1920s, the Federal Reserve had almost hit the limit
of allowable credit that could be backed by the gold in its possession. This
credit was in the form of Federal Reserve demand notes.
However,
purely monetarist explanations had been rejected by many economists. Monetary
factors are considered to be as much symptoms as causes. According to Keynesian
economist Paul Krugman, the work of Friedman and Schwartz became dominant among
mainstream economists by the 1980s but should be reconsidered in light of Japan's
Lost Decade of the 1990s.
Economist
Richard Koo wrote that Japan's "Great Recession" that began in 1990
was a "balance sheet recession". Despite zero interest rates and
expansion of the money supply to encourage borrowing, Japanese corporations in aggregate
opted to pay down their debts from their own business earnings rather than
borrow to invest as firms typically do. Corporate investment, a key demand
component of GDP, fell enormously (22% of GDP) between 1990 and its peak
decline in 2003. Koo argues that it was massive fiscal stimulus (borrowing and
spending by the government) that offset this decline and enabled Japan to
maintain its level of GDP. In his view, this avoided a U.S. type Great
Depression, in which U.S. GDP fell by 46%.
Conclusion
Both Monetarist and Keynesian schools have own element of
truth regarding the Great Depression. The money supply, which is of primary
concern for monetarists and the government stimulus, which is the main concern
for Keynesians, are both essential economic policy tools, which are
interdependent. When businesses were lacking incentives to invest and produce,
the stimulus provided by government spending during the presidency of Roosevelt
has had certain positive effects on the US economy. Probably, if the Federal
Reserve acted accordingly in the beginning of the Great Depression, the effect
of their actions on GDP would not be that devastating. At least, there might be
fewer bankruptcies caused by the lack of liquidity in the financial system. In
general it might be said, that there was a lack of incentive from both the
Federal Reserve and the US government to make proper action, which would
correspond to the scale of the economic disaster that the Great Depression was.
The size of the problem might simply be underestimated by the authorities. And
there were no suitable tools for firing an economic “bazooka” of that time.
Sources:
http://www.wikipedia.org
FDR: From Budget Balancer to Keynesian (http://www.fdrlibrary.marist.edu/aboutfdr/budget.html)
Monetary Policy in the Great Depression: What the Fed did, and Why" by David C. Wheelock (http://research.stlouisfed.org/publications/review/article/2560)
