Social Education 71(2), pp 70–74 ©2007 National Council for the Social Studies 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 OCIAL E DUCATION 70 At left: A crowd of depositors gather in the rain out- side 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 ARCH 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 prevent- ing 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.