Great Depression/Tutorials

For definitions of the terms shown in italics see the glossary on the Related Articles subpage [4].

Statistics of the US economy

Depression Data	1929	1931	1933	1937	1938	1940
Real Gross National Product (GNP) 1	101.4	84.3	68.3	103.9	103.7	113.0
Consumer Price Index 2	122.5	108.7	92.4	102.7	99.4	100.2
Index of Industrial Production 2	109	75	69	112	89	126
Money Supply M2 ($ billions)	46.6	42.7	32.2	45.7	49.3	55.2
Exports ($ billions)	5.24	2.42	1.67	3.35	3.18	4.02
Unemployment (% of civilian work force)	3.1	16.1	25.2	13.8	16.5	13.9

¹ in 1929 dollars
² 1935-39 = 100

Chart 1: GDP annual pattern and long-term trend, 1920-40, in billions of constant dollars

Causes and remedies

Economic doctrines of the time

Liquidationism

The prevailing attitude to recessions in the 1920s was the teaching of the Austrian School led by Friederich Hayek in London, and supported by eminent American economists. Hayek is quoted as saying

"...still more difficult to see what lasting good effects can come from credit expansion. The thing which is most needed to secure healthy conditions is the most speedy and complete adaptation possible of the structure of production.If the proportion as determined by the voluntary decisions of individuals is distorted by the creation of artificial demand resources [are] again led into a wrong direction and a definite and lasting adjustment is again postponed.The only way permanently to 'mobilise' all available resources is, thereforeto leave it to time to effect a permanent cure by the slow process of adapting the structure of production..."

- and Harvard's Joseph Schumpeter argued that there was:

" a presumption against remedial measures which work through money and credit. Policies of this class are particularly apt to produce additional trouble for the future;"

- and that:

"depressions are not simply evils, which we might attempt to suppress, but forms of something which has to be done, namely, adjustment to change."

That was the view of United States Secretary of the Treasury Andrew Mellon (who has been quoted as advising President Hoover that the depression would "purge the rottenness out of the system" ) and it was shared by Britain's Chancellor Phillip Snowden. They agreed that expansionary monetary and fiscal policies should be avoided because they would reduce investor confidence and hinder the process of liquidation, reallocation, and the resumption of private investment.

The Real Bills doctrine

Monetary theory in the 1920s was largely governed by the doctrine propounded by Adam Smith in his "Wealth of Nations":

"When a bank discounts to a merchant a real bill of exchange, drawn by a real creditor upon a real debtor, and which, as soon as it becomes due, is really paid by that debtor ; it only advances to him part of the value which he would otherwise be obliged to keep by him unemployed and in ready money, for answering occasional demands. The payment of the bill, when it becomes due, replaces to the bank the value of what it had advanced, together with the interest." .

- which was interpreted to mean that money issued against commercial paper cannot be inflationary because it merely responds passively to the needs of commerce.

Despite its disproof by David Ricardo and others , the real bills doctrine was so widely held that it was incorporated in the Federal Reserve Act 1913 . It was also the basis of the Reichsbank’s policy of issuing astronomical sums of money to satisfy the needs of trade at ever-rising prices during the German hyperinflation of 1922-1923.

The gold standard

(for an account of the history of the gold standard see the article on that subject)

By the 1920s, the gold standard had been endowed with an importance that went beyond any appreciation of its merits as a means of stabilising trade flows. According to Peter Bernstein its control over the affairs had "never been so absolute" and he quotes Joseph Schumpeter as calling it "a symbol of sound practice and a badge of honor and dignity" . Its only important opponent was John Maynard Keynes, who argued in a tract on monetary reform that price stability should take priority over exchange stability.

Contributory factors

Monetary policy

(this paragraph has been summarised from Ben Bernanke's speech to the Conference to Honor Milton Friedman, University of Chicago, Chicago, Illinois November 8, 2002 - Friedman's ninetieth birthday. [5])

In the spring of 1928 there was a significant tightening of monetary policy by the Federal Reserve Board that continued until the stock market crash of October 1929. The Board's reason for that action was not concern about inflation - which hardly existed at the time - but concern about speculation on Wall Street, prompted by the increases stock market prices and in bank loans to brokers. As Friedman and Schwartz noted ., "by July, the discount rate had been raised in New York to 5 per cent, the highest since 1921, and the System's holdings of government securities had been reduced to a level of over $600 million at the end of 1927 to $210 million by August 1928, despite an outflow of gold." Strong reservations about that policy had been expressed by one of the Board's members, Benjamin Strong, the influential Governor of the Federal Reserve Bank of New York, but Strong died in October and the policy was supported by his successor, George Harrison, and the discount rate was raised a further point to 6 per cent in the following year. That move was followed by a period of falling prices and weaker economic activity. According to Friedman and Schwartz "During the two months from the cyclical peak in August 1929 to the crash, production, wholesale prices, and personal income fell at annual rates of 20 per cent, 7-1/2 per cent, and 5 per cent, respectively." and after the stock market crash, economic decline became even more precipitous. (James Hamilton has shown that the Board's desire to slow outflows of gold to France had then resulted in massive flows of gold from abroad and a further tightening of monetary policy.)

In September 1931 there was another tightening of monetary policy, following the UK's sterling crisis. A wave of speculative attacks on the pound had forced Britain to leave the gold standard and, anticipating that the United States might the next to do so, speculators turned their attention from the pound to the dollar. Central banks and private investors converted a substantial quantity of dollar assets to gold in September and October of 1931. The resulting outflow of gold reserves also put pressure on the U.S. banking system as foreigners liquidated dollar deposits and domestic depositors withdrew cash in anticipation of additional bank failures. According to Friedman and Schwarz: , "The Federal Reserve System reacted vigorously and promptly to the external drain. . . . On October 9, the Reserve Bank of New York raised its rediscount rate to 2-1/2 per cent, and on October 16, to 3-1/2 per cent--the sharpest rise within so brief a period in the whole history of the System, before or since (p. 317)." This action stemmed the outflow of gold but contributed to an increase in bank failures and bank runs, with 522 commercial banks closing their doors in October alone. The policy tightening and the ongoing collapse of the banking system caused a steep fall in the money supply and the declines in output and prices became even more precipitous.

In April 1932, when the Congress pressed the Board to ease monetary policy, and between April and June 1932, it made substantial open market purchases, which slowed the decline in the stock of money and reduced the yields on bonds and commercial paper. By August there were rises in wholesale prices and industrial production and there were other indications of increasing activity. However, the Board members did not favour a continuation of that policy and, when the Congress adjourned in July, they abandoned it. A sharp fall in economic activity followed towards the end of the year.

There was one more monetary tightening in early 1933. Fearing that the new President would abandon the gold standard, investors began to convert dollars to gold, putting pressure on both the banking system and the gold reserves of the Federal Reserve System. Bank failures and action to resist the gold drain further reduced the stock of money and there was another sharp reduction in economic activity. That tightening ended after President Roosevelt's March declaration of a national bank holiday and his abandonment of the gold standard; and there was then a renewed expansion of money, prices, and output.

The Gold Standard

The gold standard theory of the depression has been summarised by Bernanke and Carey , broadly as follows.

In order to curb the New York stock market boom, the Federal Reserve Bank imposed a contraction of the money supply in the late 1920s and several other major countries followed suit. That contraction was transmitted to other industrialised countries as a result of the operation of the gold standard. A rush for the safety of gold prompted by the 1931 banking crisis, the sterilisation of gold inflows by countries with balance of payments surpluses, the substitution of gold for foreign exchange reserves, and runs on many banks, all led to increases in the gold reserves required to back the issue of money and consequently to sharp and unintended reductions in the international money supply. The resulting deflation was avoidable only by a countervailing money creation by central banks but, in the absence of international agreement to do so, countries could take that action only by abandonong the gold standard.

I believe some of the crash was inevitable because of over-indebtedness, but the depression was not inevitable. The reason is that the deflation which went with the over-indebtedness was not necessary. We can always control the price level. Irving Fisher

Trade Decline and the U.S. Smoot-Hawley Tariff Act

Many economists at the time argued that the sharp decline in international trade after 1930 helped to worsen the depression, especially for countries dependent on foreign trade. Most historians and economists assign the American Smoot-Hawley Tariff Act of 1930 part of the blame for worsening the depression by reducing international trade and causing retaliation. Foreign trade was a small part of overall economic activity in the United States; it was a much larger factor in most other countries. The average rate of duties on dutiable imports for 1921-1925 was 26% but under the new tariff it jumped to 50% in 1931-1935.

In dollar terms, American exports declined from about $5.2 billion in 1929 to $1.7 billion in 1933; but prices also fell, so the physical volume of exports only fell in half. Hardest hit were farm commodities such as wheat, cotton, tobacco, and lumber. Many American farms had been heavily mortgaged as farmers bought overpriced land in the bubble of 1919-20, and defaulted.

Rival explanations

Irving Fisher

An influential economist in the early 20th century, Irving Fisher is now best known for his forecast that there would be no stock market crash - that he made immediately before it happened , (although in his defence he has pointed out that only he had predicted the inevitability of a depression, although he had seriously underestimated its severity ). Fisher's explanation of the depression was that an economy with a high level of debt had suffered a shock that had led to a loss of confidence which had prompted the widespread liquidation of debts by "distress selling", causing a sharp fall in share prices and a contraction in bank deposits; and that this had triggered a deflation which increased the stock of debt in real terms. What had followed had been a perverse cycle of further price reductions which led to further pressure to liquidate debts, which led to further price falls, and so on, which he called "debt deflation" . . Fisher maintained throughout the 1930s that a financial crash need not affect the real economy provided that there was a sufficient expansion of the money supply . The shock to which Fisher attributed the onset of the depression was the sudden reversal of the Federal Reserve Bank's monetary policy that is discussed below. .

Lionel Robbins

Lionel Robbins of the London School of Economics was at the time an influential proponent of the theories of the Austrian School of economics (although he subsequently adopted Keynesianism). His protegé, Friederich Hayek, had developed a theory of recessions, which he used in 1934 to explain the then current depression .

Rival remedies

Deficit Spending

The British economist John Maynard Keynes argued that the low aggregate demand in the economy caused a multiple decline in income, keeping the economy in an equilibrium well below full employment. In this situation, the economy may reach perfect balance, but at a cost of a high unemployment. Keynesian economists were increasingly calling for government to take up the slack by increasing government spending. Although Keynes's specific policy prescriptions at the time were vague (Perelman 1989) , his basic approach was to let business be free to do as it would choose, while creating a macroeconomic climate in which investment would be brisk or, using Keyne's own words - which became famous - creating a macroeconomic environment capable of awakening the "animal spirits" of entrepreneurs. Animal spitirts are a particular sort of confidence, "naive optimism"; "the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death".John Maynard Keynes