Great Depression

What was the 'Great Depression'

The Great Depression was the greatest and longest economic recession of the 20th century and, by some accounts, modern world history. By most contemporary accounts, it began with the U.S. stock market crash of 1929, and didn't completely end until after World War II, in 1946. Economists and historians often cite the Great Depression as the most critical economic event of the 20th century.

The Start: The Stock Market Crash

After the short depression of 1920-1921 – known as the Forgotten Depression, even though the stock market fell by nearly 50% and corporate profits declined over 90% – the U.S. economy enjoyed robust growth during the rest of the decade, furnishing much of the roar of the Roaring '20s. Along with an extremely loose money supply (more on that below), helping to fuel unprecedented rises in asset prices were high levels of margin trading by investors: This was a period when the American public discovered the stock market and dove in head first. Speculative frenzies formed in both the real estate markets and on the New York Stock Exchange (NYSE).  The lead-up to October 1929 saw equity prices rise to all-time high multiples of more than 30 times earnings, and the benchmark Dow Jones Industrial Average (DJIA) increase 500% in just five years.

The NYSE bubble burst violently on Oct. 24th, 1929, a day that came to be known as Black Thursday. The following week brought Black Monday (Oct. 28) and Black Tuesday (Oct. 29); the DJIA fell more than 20% over those two days. The stock market would eventually fall almost 90% from its 1929 peak.

Ripples from the crash spread across the Atlantic Ocean to Europe, triggering other financial crises; with the collapse of the Boden-Kredit Anstalt, Austria’s most important bank, in 1931, the economic calamity hit the Continent in full force.

What Caused the Great Depression?

The 1929 stock market crash wiped out a lot of nominal wealth, both corporate and private, and sent the U.S. economy into a tailspin. In early 1929, the measured U.S. unemployment rate was 3.2%; by 1933, it had soared to 24.9%. Despite unprecedented interventions and government spending by both the Herbert Hoover and Franklin Delano Roosevelt administrations, it was still above 18.9% in 1938. Real per capita gross domestic product (GDP) was below 1929 levels by the time the Japanese bombed Pearl Harbor, in late 1941.

While the crash likely triggered the decade-long economic downturn, most historians and economists agree that it alone did not cause the Great Depression, nor explain why the slump's depth and persistence were so severe. Instead, there were a variety of specific events and policies that set the country up for the Great Depression – and then helped prolong it during the 1930s.

Mistakes by the Young Federal Reserve

The relatively new Federal Reserve System mismanaged the supply of money and credit before and after the crash in 1929, according to monetarists such as Milton Friedman and as acknowledged by former Federal Reserve Chairman Ben Bernanke. Created in 1913, the Fed remained more or less inactive throughout the first eight years of its existence. After the economy recovered from the 1920-1921 depression, however, it allowed a major monetary expansion. Total money supply grew $28 billion, a 61.8% increase between 1921 and 1928. Bank deposits grew by 51.1%, savings and loan shares rose 224.3%, and net life insurance policy reserves jumped 113.8%. All of this took place after the Federal Reserve cut required reserves down to 3% in 1917: Gains in gold reserves via the Treasury and Fed were only $1.16 billion.

By increasing the money supply and keeping interest rates low during the decade, the Fed instigated the rapid expansion that preceded the collapse – much of the surplus money supply growth fueled stock market and real estate bubbles. After the bubbles popped, and the market crashed, the Fed took the opposite course by cutting the money supply by nearly a third, causing severe liquidity problems for many small banks and choking off hopes of a quick recovery. As Bernanke noted in a November, 2002 address, before the Fed existed bank panics were normally resolved within weeks: Large private financial institutions loaned money to the strongest smaller ones in order to maintain integrity in the system. In fact, the Panic of 1907 offered a similar scenario: When panic selling sent the NYSE spiraling downward and led to a bank run, investment banker J.P. Morgan stepped in to rally Wall Street denizens to move capital to banks lacking funds. Ironically, it was that panic led the government to create the Federal Reserve, in part to cut its reliance on individual financiers like Morgan.

But the Fed failed to assume that sort of cash-injecting, prop-up-the-system role between 1929 and 1932. Instead, it stood by, watched the money supply collapse and let literally thousands of banks fail (at the time, unit banking laws made it very difficult for institutions to grow and diversify enough to survive a massive withdrawal of deposits). The Fed's harsh reaction, while difficult to understand, may have occurred because it feared that bailing out careless banks would only encourage more fiscal irresponsibility in the future. Tough love, in other words. But one could argue that the Fed in effect set up the conditions that caused the economy to overheat, and then kicked the economy when it was down.

President Hoover's Blunders

Often characterized as a "do-nothing" President, Herbert Hoover did take action after the crash occurred. Between 1930 and 1932, he increased federal spending by 42%, engaging in massive public works programs such as the Reconstruction Finance Corporation and raising taxes to pay for them. He effectively banned immigration in 1930 to keep low-skilled workers from flooding the labor market. Unfortunately, many of his and Congress' other post-crash interventions – wage, labor, trade and price controls – damaged the economy's ability to adjust and reallocate resources.

One of Hoover's main concerns was that workers' wages would be cut following the economic downturn. In order to ensure high paychecks in all industries, he reasoned, prices needed to stay high. To keep prices high, consumers would need to pay more. Yet the public had been burned badly in the crash, and most people did not have the resources to spend lavishly on goods and services. Nor could companies count on overseas trade: Foreign nations weren't willing to buy over-priced American goods any more than Americans were.

This bleak reality forced Hoover to use legislation, the government's trump card, to try to prop up prices (and hence wages) by choking out cheaper foreign competition. Following in the unfortunate tradition of protectionists, and against the protests of more than 1,000 of the nation's economists, he signed into law the Smoot-Hawley Tariff Act of 1930. The Act started out as a way to protect agriculture, but swelled into a multi-industry tariff, imposing huge duties on more than 880 foreign products. Nearly three-dozen countries retaliated, and imports fell from $7 billion in 1929 to just $2.5 billion in 1932. By 1934, international trade had declined 66%. Not surprisingly, economic conditions worsened worldwide.

Hoover's desire to maintain jobs and individual and corporate income levels was certainly understandable. But he encouraged businesses to raise wages, avoid layoffs and keep prices high at a time when they naturally should have fallen (with previous recession/depression cycles, the U.S. suffered one to three years of low wages and unemployment before the dropping prices led to a recovery). Unable to sustain these artificial levels, and with global trade effectively cut off, the U.S. economy sank from a recession into a depression.

The Controversial New Deal

Sweeping into office in 1933, President Franklin Roosevelt promised massive changes, and indeed the New Deal he initiated was an innovative, unprecedented series of domestic programs and acts designed to bolster American business, reduce unemployment and protect the public. Loosely based on Keynesian economics, specifically on the idea that government can (and should) stimulate the economy, the New Deal set lofty goals to create and maintain the national infrastructure, full employment, and healthy wages through price, wage, and even production controls.

But one could argue that, essentially, Roosevelt continued many of Hoover's interventions – just on a larger scale. He kept in place a rigid focus on price supports and minimum wages, and took the U.S. off the gold standard, forbidding individuals to hoard gold coins and bullion. He banned monopolistic (some would say competitive) business practices, instituted dozens of new public works programs and other job-creation agencies, and paid farmers and ranchers to stop or cut back on production (one of the most heartbreaking conundrums of the period was the destruction of excess crops, despite the need of thousands for cheap food).

To pay for these initiatives, along with new programs like Social Security, federal taxes tripled between 1933 and 1940, including hikes in excise taxes, personal income taxes, inheritance taxes, corporate income taxes and an excess profits tax.

Along with re-instilling public confidence, the New Deal measures did achieve some measurable results: reforming and stabilizing the financial system (to prevent institutional collapses due to panicked withdrawals, Roosevelt declared a bank holiday for an entire week in March 1933); building a network of dams, bridges, tunnels and roads that still exists today; and providing employment via these and other projects. While the economy recovered somewhat, the rebound was far too weak for the New Deal policies to be unequivocally deemed successful in pulling America out of the Great Depression. (See The Economic Effects of the New Deal.)

Historians and economists disagree on why. Keynesians blame a lack of federal spending: Roosevelt didn't go far enough in his government-centric recovery plans, they claim. Others claim, conversely, that by trying to spark immediate improvement – instead of letting the economic/business cycle follow its usual two-year course of hitting bottom and then rebounding – Roosevelt, like Hoover before him, may have actually prolonged the pain. A 2004 UCLA study published in the Journal of Political Economy estimated that the New Deal extended the Great Depression by at least seven years. It is possible, though, the relatively quick recovery that characterized the aftermath of other depressions may not have occurred as rapidly post-1929, because it was the first time that the general public, and not just the Wall Street elite, lost large amounts in the stock market.

Historian Robert Higgs has argued Roosevelt's new rules and regulations came so fast and were so revolutionary – as were his decisions to seek third and fourth terms – that businesses became afraid to hire or invest. Philip Harvey suggests that Roosevelt was more interested in addressing social welfare concerns than creating a Keynesian-style macroeconomic stimulus package.

Impact of World War II

If you measure only gross domestic product (GDP) and employment, the Great Depression appeared to end suddenly around 1941-1942, right as the United States entered World War II. These are very misleading figures, however. True, the unemployment rate fell from eight million in 1940 to under one million in 1943. However, more than 16.2 million Americans were conscripted to fight in the armed services. In terms of the private sector, the real unemployment rate actually grew during the war.

Due to wartime shortages (caused mainly by rationing), the standard of living declined, and taxes rose dramatically to fund the war effort. Private investment activity dropped from $17.9 billion in 1940 to $5.7 billion in 1943, and total private sector production fell nearly 50%.

Although the notion that the war ended the Great Depression is a broken window fallacy (in fact, you could argue that real conditions grew worse in some ways), the conflict did start the U.S. on the road to recovery. It opened up international trading channels and reversed price and wage controls. Suddenly, the government wanted lots of things made inexpensively, and its demand acted as a massive financial stimulus.

When the war ended, the trade routes remained open. In the first 12 months afterwards, private investments rose from $10.6 billion to $30.6 billion. The stock market broke into a bull run in a few short years.

The Bottom Line

The Great Depression was the result of an unlucky combination of factors – a flip-flopping Fed, protectionist tariffs and inconsistently applied  government interventionist efforts. It could have been shortened or even avoided by a change in any one of these. While debates continue as to whether the interventions were too much or too little, many of the reforms from the New Deal, such as Social Security, unemployment insurance and agricultural subsidies, exist to this day – as does the assumption that the federal government should act in times of national economic crisis. This legacy is one of the reasons the Great Depression is considered one of the seminal events in modern American history.




'Great Depression'