What Caused the Great Depression?

Jean Caldwell and Timothy G. O’Driscoll

Economists and historians have struggled for almost 80 years to account “trough”), low prices create an incentive for the American Great Depression, which began in 1929 and lasted until the early for consumers to buy more, leading the years of World War II. The depth of this depression was unprecedented; in March, economy into recovery. 1933, more than one quarter of willing workers in the United States were unemployed, Events during the mid-1920s illustrate and another quarter could find only part-time work. Although conditions improved the high point (“peak”) of a business cycle. after this low point, high rates of unemployment continued to haunt the economy In these years, there was a great increase for many years. in the number of Americans who bought houses, home furnishings, appliances, Business Cycles and the Great chased the durables that they want and and automobiles. Towns and cities were Depression have no desire to buy more. At such times, growing rapidly, and state and local gov- Depressions (or recessions) occur when demand obviously will fall. ernments spent money to provide roads, there is not enough demand for all the Capital goods are goods such as factory sidewalks, and water and sewage services. goods and services that an economy pro- buildings, machinery, and equipment. The homes of town dwellers were con- duces. Inventories of unsold goods build These are goods that are used to produce nected to electricity and telephone ser- up, and manufacturers cut production other goods. Business firms invest in such vices. Spending by consumers, business by laying off workers and buying less of goods only when they feel that consum- firms, and state and local governments the raw materials that they use to make ers will buy what is produced by the new created plentiful, high-paying jobs. their products. Service providers, from capital goods. When that prospect seems In the late 1920s, demand was begin- doctors to hair stylists, have fewer clients, doubtful, demand for these goods falls. ning to soften for houses and automo- and their incomes fall. At some point in the course of a busi- biles. Cities and states had completed Most economists believe that such ness cycle, most economists believe, most of the efforts they had undertaken falling demand is a normal part of what demand will reverse. Durable goods to provide services for their citizens. In is commonly called a “business cycle.” eventually wear out and must be replaced. the summer of 1929, total spending in Demand for two kinds of goods—durable To supply new goods for consumers the American economy was falling, and goods and capital goods—tends to fluc- seeking replacements, manufacturers business firms began to cut production. tuate, and these fluctuations drive the purchase new equipment, rehire work- October’s stock market crash—signal- cycle. ers, and increase their purchase of raw ing to shareholders that business profits Durable goods are consumer goods materials. As demand increases, employ- would fall—probably made the recession that last a long time, such as automo- ment increases. In times of peak demand worse. There was a loss of wealth and, as biles, appliances, and home furnish- in a given sector of the economy, almost a result, people spent less, but the crash ings. Demand for such goods increases every potential worker who wants a job did not cause the recession. when consumers are feeling prosperous; can find one. At first, most observers thought that it falls when they are not feeling pros- There is also a price dimension to the the recession would be temporary. Stock perous. Many economists also believe business cycle. When demand is increas- prices began to rise again, and the unem- that durable goods markets can be “satu- ing, prices tend to rise; but when demand ployed, aided by local and private chari- rated”—that there are, in other words, is falling, prices normally go down, too. ties, were assured that “Prosperity is just times when most consumers have pur- At the low point of the business cycle (the around the corner”—that is, the down-

S o c i a l E d u c a t i o n 70 At left: A crowd of depositors gather in the rain outside the Bank of United States after its failure in 1931.

(World-Telegram staff photo/Library of Congress, Prints & Photographs Division, LC- USZ62-117261)

ward trend of the business cycle would Depression and the long failure of the The depression was particularly hit bottom and the economy would start American economy to return to full severe in the United States to recover. But this did not happen. Total employment. because the Federal Reserve demand stayed low. Business firms con- • The Keynesian Explanation. System was obligated to follow tinued to lay off employees, and many The Great Depression was caused the rules of the gold standard. firms went bankrupt. Then, in 1930, primarily by a fall in total banks began to fail in large numbers, demand. The decline in demand The Keynesian Explanation wiping out the savings of potential buyers was so severe that adequate The Keynesian explanation is based and further lowering demand. State and demand could be restored only by on the theories of John Maynard local relief funds were soon exhausted, large increases in government Keynes, a British economist who, in and many laid-off workers and their spending. 1936, published The General Theory families, who had only recently led com- of Employment, Interest, and Money. fortable lives, now faced hunger and even • The Monetarist Explanation. Keynes held that it was possible for total homelessness. As the economy worsened, The Great Depression may have demand in a modern economy to remain President Franklin Roosevelt initiated originated in a fall in total low indefinitely, leading to long periods of a series of relief measures, but recovery demand, but its length and sever- high unemployment. When workers were under Roosevelt’s New Deal was only ity resulted primarily from the unemployed, they spent very little; and partial. Throughout the 1930s business unwillingness of the Federal when business firms saw large numbers of activity remained low and unemploy- Reserve System to prevent bank unemployed workers, they were reluctant ment rates remained high. failures and to maintain a large to produce goods that probably would enough money supply. not be purchased. Businesses, therefore, Explanations for the Great cut production, and more workers lost Depression • The International Explanation. their jobs. According to Keynes, the Today there are three major schools The American depression was only way to create enough demand to of thought on the causes of the Great part of a larger global depression. employ the work force fully was for the

M a r c h 2 0 0 7 71 History of the United States, Milton Friedman and Anna Schwartz contended that actions taken by the Federal Reserve System both caused and perpetuated the depression. The Federal Reserve System raised interest rates in early 1928, which discouraged business borrowing and spending and brought about the decline in production that began that summer. Interest rates were raised again in 1930 and 1931. Furthermore, when banks began to fail in large numbers at the end of 1930, the Federal Reserve System did little to assist them. The Federal Reserve System had been established by Congress in 1913 for the express purpose of preventing bank failure caused by a “run” on the bank. A run occurred when many customers withdrew all their deposits in the form of cash, forcing the bank to close when all its cash was depleted. In such cases, Federal Reserve Banks were to supply banks with enough cash to meet the demands of their customers, thus A line of jobless and homeless men wait outside to get free dinner at New York’s preventing bank failure. But, according municipal lodging house in the winter of 1932. (AP Photo) to Friedman and Schwartz, the Federal Reserve Banks in the 1930s refused to national government to increase spend- and increase production, which, in turn, support banks that they thought were ing radically to compensate for the would employ more workers. An increase unlikely to repay them, forcing many decreased spending of consumers and in the number of employed workers basically sound banks into bankruptcy. business firms. Furthermore, the central would mean more consumer spending, When a bank fails, its deposits can no banking system (in the United States, the which would make increased government longer be spent; as a result, the amount Federal Reserve System) should create spending unnecessary. of money circulating in society goes new money for the national government The length of the Great Depression down, depressing demand for goods to borrow and spend. Rather than rais- in the United States seemed to con- and services. ing taxes, the government should take firm Keynesian theory. Unemployment The Great Depression lasted for a steps to create a deficit by cutting taxes, remained high throughout the 1930s; long time, according to the monetarists increasing spending, or some combina- the unemployment rate was 14.6 percent (Friedman and his followers), because tion. The Hoover administration did in 1940. Under Roosevelt, government bankers were reluctant to make new just the reverse. In 1932, the federal spending did increase, but by far too loans after 1933. Bankers made only government raised taxes drastically to little to achieve full employment. Only the safest and most conservative loans reduce the budget deficit resulting from when the American government began in these years because they believed the depression. to increase spending in preparation for that the Federal Reserve would not Previously, mainstream economists World War II did unemployment begin support them if they got into trouble. (generally referred to now as “classical” to fall to normal levels. In light of these Furthermore, as the economy began to economists) had held that, if demand developments, the Keynesian explana- improve in 1936, the Federal Reserve for products fell, the demand of busi- tion of the Great Depression was increas- System actually raised interest rates on ness firms for money to finance new pro- ingly accepted by economists, historians, loans, fearing inflation. duction would also fall. When demand and politicians. for loans fell, interest rates would go The International View down. According to the accepted eco- The Monetarist View Both the Keynesian and the monetarist nomic theory, lower interest rates would In 1963, a new book challenged the explanations identify the causes of the encourage business firms to borrow more Keynesian viewpoint. In A Monetary Great Depression within the framework

S o c i a l E d u c a t i o n 72 of the American economy. However, that lost a large amount of gold reserves oring its commitments under the gold most nations of Europe and several faced lower business activity and higher standard. Deposits owned by foreign Latin American and Asian countries unemployment. customers were frozen, and Austrian also experienced depressions of vary- The post-World War I gold standard citizens were strongly discouraged from ing severity throughout the later 1920s was, in reality, a gold exchange standard. removing their funds from the bank. and the 1930s. Many of these nations, Not much new gold was being discovered, Panic spread then, and depositors most notably Germany, began to slide and yet the world economy was growing. began runs on banks in other countries. into recession in 1928 and 1929, while There really wasn’t enough gold to back Other central European nations soon the United States economy was still the currencies of all the gold-standard followed Austria’s example. Germany booming. nations. Therefore, the governments of froze gold exchanges, and in September, In 1992, Barry Eichengreen and Great Britain and the United States guar- Great Britain officially left the gold stan- Harold James published Golden Fetters: anteed to accept the currencies of other dard. Foreign depositors quickly began The Gold Standard and the Great nations under all conditions—they would making withdrawals from United States Depression, 1919-1932. The authors never suspend redemption of dollars and banks, fearing that the United States, too, placed the blame for the worldwide pounds for gold. The foreign exchange would “close the gold window.” depression on the return of European reserves of many nations, therefore, con- Most of the actions of the American nations to the gold standard after World sisted of gold and also of British pounds Federal Reserve System from 1931 to War I. The gold standard, which had and American dollars. 1933 can be traced to its adherence to been adopted by most developed nations Because a gold standard restrains the the rules of the gold standard. Instead during the latter half of the nineteenth amount of new money that can be cre- of abandoning those rules, as had most century, was a series of monetary rules ated and lent, and since great amounts of other countries, the Federal Reserve that established fixed rates of exchange money were needed by the combatants in raised interest rates to attract foreign among nations. Each participating nation World War I, those nations temporarily depositors. The increased rates did, agreed to exchange a given amount of went off the gold standard. By the mid- in fact, temporarily stop the gold flow its currency for an ounce of gold. For 1920s, each nation had resumed exchang- out of the country, but of course they example, the United States guaranteed ing its currency for gold at the same also discouraged borrowing, leading to exchange $20.67 for an ounce of gold; exchange rates that had existed before to more business failures and more job Great Britain exchanged £4.86 for each the war. This was a hardship for many losses. Banks failed, too, when they ounce of gold. This meant that if a British nations, since economic relationships could not collect on loans they had made. businessman wanted to buy something had changed. Some nations could not Only after the newly elected Franklin from the United States that had a $100 produce as much as they had produced Roosevelt abandoned the gold standard price tag (for example, 50 pipe wrenches), before the war and found it difficult to did recovery begin. he could buy gold worth 100 American produce enough exports to earn gold to Monetarists have argued that the dollars and exchange that gold for the back their currencies. Hardest hit were Federal Reserve System should not have wrenches. Or, more simply, he could just Germany, which had to pay reparations raised interest rates to stop the outflow buy 100 American dollars at a price of to the nations that had won the war, and of gold. But other economists point out 0.2058 pounds for each dollar. Since the new nations formed after the break- that only Congress and the president each nation that followed the rules of up of the Austro-Hungarian Empire. had the authority to abandon the gold the gold standard was willing to exchange Problems with the gold standard first standard. Only after Roosevelt substan- gold for a certain amount of currency, appeared in Austria, in May 1931, with tially altered the rules of the gold stan- each nation’s currency had a fixed price the failure of that nation’s largest bank, dard did economic recovery begin. The in terms of other currencies. the Credit-Anstalt. Rumors that the bank Emergency Banking Act of 1933 gave the There was a domestic problem, how- was in trouble caused both foreign and president power over foreign exchange. ever, for nations on the gold standard. domestic customers to demand their Roosevelt quickly prohibited Americans Banks used gold as reserves to back up deposits in the form of Austrian currency, from owning gold, and he devalued the the loans they made. When a nation’s which they then exchanged for the gold dollar; in effect, the United States was banks lost a lot of reserves to other coun- reserves of the Austrian government. no longer committed to following the tries because of the operations of the gold Gold, pounds, and dollars flowed out rules of the gold standard. standard, those banks had to reduce the of the country for more than a month. number of loans they made. Since most Austrian banks did not have a basis for Conclusion of these loans were made to business making new loans or renewing old ones, Apart from the events and policies cited firms, businesses then had to cut back and this situation led to business failures in the three interpretations discussed on production, laying off workers and and increasing unemployment. Finally above, a number of other factors contrib- reducing supply orders. Thus a nation the Austrian government stopped hon- uted to the causes and continuation of the

M a r c h 2 0 0 7 73 Great Depression. The Smoot-Hawley ask students what each approach seems Tariff, for example, reduced imports, but to explain best or explain least about the There are two inserts in the center of this also exports. Both President Hoover and Depression. Students can consider: would issue. The first insert consists of twelve President Roosevelt instituted policies to the Depression have been just another pages and includes two lesson plans, the keep prices and wages from falling, not low point in a business cycle, or at least first of which accompanies the preced- realizing that such policies had the effect have been less prolonged and devastat- ing article, and is titled “Whatdunnit? The of preventing the economy from adjusting ing, if the government had increased its Great Depression Mystery.” The second to change. Economic research continues spending? Or if the Federal Reserve had lesson plan, “The U.S. Constitution: Rules to add to our body of knowledge about prevented bank failures and maintained of the Game,” complements the opening the Great Depression, even as many a larger money supply? Or if there had article of this issue. questions remain. An excellent source been no gold standard? By examining the The second insert, placed by the for the new research and opinion on this known historical facts and developing American Bar Association, announces topic is Gene Smiley’s Rethinking the their own interpretations, students can the upcoming Law Day (May 1, 2007), and Great Depression, published in 2002.* further their understanding both of the provides a Law Day fact sheet, answers to We believe that teachers will find that history of the Great Depression and of questions, and classroom ideas for readers presenting the approaches described in some basic principles of economics. of Social Education. this article is a useful way of encourag- Both inserts are also pull-outs. ing students to review and analyze the Jean Caldwell is Professor Emerita at the causes and progression of the Great University of Central Oklahoma in Edmond. Timothy G. O’Driscoll is director of the Cen- Depression. Teachers might combine the ter for Economic Education at the University of elements of each approach in a single Wisconsin-Milwaukee. broad-based presentation introducing the Great Depression to their classes, or *Chicago: Ivan R. Dee, 2002 else outline the different approaches and

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