Great Depression

What is the 'Great Depression'?

The Great Depression was the greatest and longest economic recession in modern world history. It began with the U.S. stock market crash of 1929 and did not completely end until 1946 after World War II. Economists and historians often cite the Great Depression as the most catastrophic economic event of the 20th century.

The Beginning: The Stock Market Crash

During the short depression that lasted from 1920 to 1921, known as the Forgotten Depression, the U.S. stock market fell by nearly 50%, and corporate profits declined over 90%. However, the U.S. economy enjoyed robust growth during the rest of the decade spurring much of the "roaring '20s." Loose money supply and high levels of margin trading by investors helped to fuel an unprecedented increase in asset prices. This was a period when the American public discovered the stock market and dove in head first. Speculative frenzies affected 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 increased 500% in just five years.

The NYSE bubble burst violently on October 24, 1929, a day that came to be known as Black Thursday. The following week brought Black Monday (October 28) and Black Tuesday (October 29). The Dow Jones Industrial Index 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 such as the collapse of the Boden-Kredit Anstalt, Austria’s most important bank. In 1931, the economic calamity hit both continents in full force.

What Caused the Great Depression?

The 1929 stock market crash wiped out nominal wealth, both corporate and private, and sent the U.S. economy into a tailspin. In early 1929, the 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, the unemployment rate remained 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 the crash alone did not cause the Great Depression, nor does it explain why the slump's depth and persistence were so severe. A variety of specific events and policies contributed to the Great Depression and helped to prolong it during the 1930s.

Mistakes by the Young Federal Reserve

The relatively new Federal Reserve (the Fed) mismanaged the supply of money and credit before and after the crash in 1929, according to monetarists such as Milton Friedman and acknowledged by former Federal Reserve Chairman Ben Bernanke. Created in 1913, the Fed remained inactive throughout the first eight years of its existence. After the economy recovered from the 1920 to 1921 depression, the Fed allowed significant monetary expansion. Total money supply grew by $28 billion, a 61.8% increase between 1921 and 1928. Bank deposits increased by 51.1%, savings and loan shares rose by 224.3% and net life insurance policy reserves jumped 113.8%. All of this occurred after the Federal Reserve cut required reserves 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 the stock market and real estate bubbles. After the bubbles burst and the market crashed, the Fed took the opposite course by cutting the money supply by nearly a third. This caused severe liquidity problems for many small banks and choked off hopes for 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  would loan money to the strongest smaller institutions to maintain system integrity. In fact, the panic of 1907 offered a similar scenario: when panic selling sent the New York Stock Exchange 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 that led the government to create the Federal Reserve to cut its reliance on individual financiers such as Morgan.

But the Fed failed to prop up the system with a cash injection between 1929 and 1932. Instead, it watched the money supply collapse and let literally thousands of banks fail (at the time, 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 fiscal irresponsibility in the future. Some argue that the Fed created the conditions that caused the economy to overheat and then exacerbated an already dire economic situation.

President Hoover's Blunders

Although 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 the programs. The President 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. To ensure high paychecks in all industries, he reasoned, prices needed to stay high. To keep prices high, consumers would need to pay more. 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 were not willing to buy over-priced American goods any more than Americans were.

This bleak reality forced Hoover to use legislation to prop up prices (and hence wages) by choking out cheaper foreign competition. Following the tradition of protectionists, and against the protests of more than 1,000 of the nation's economists, Hoover signed into law the Smoot-Hawley Tariff Act of 1930. The Act was initially 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 by 66%. Not surprisingly, economic conditions worsened worldwide.

Hoover's desire to maintain jobs and individual and corporate income levels was understandable. However, 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 of prices led to a recovery). Unable to sustain these artificial levels, and with global trade effectively cut off, the U.S. economy deteriorated from a recession to a depression.

The Controversial New Deal

Voted into office in 1933, President Franklin Roosevelt promised massive change. 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, 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.

Roosevelt, some economists claim, 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 removed the U.S. from the gold standard forbidding individuals to hoard gold coins and bullion. He banned monopolistic, some consider them 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 such as 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.

The New Deal re-instilled public confidence, and there were measurable results: reform and stabilization of the financial system (Roosevelt declared a bank holiday for an entire week in March 1933 to prevent institutional collapses due to panicked withdrawals); construction of a network of dams, bridges, tunnels and roads that still exist today and employment. Although the economy recovered to an extent, 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 the reason. Keynesians blame a lack of federal spending: Roosevelt did not go far enough in his government-centric recovery plans. 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 prolonged the depression. A 2004 University of California 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, however, that 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 that 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.

The Impact of World War II

According to gross domestic product (GDP) and employment only, the Great Depression appeared to end suddenly around 1941 to 1942, just as the United States entered World War II. 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 the private sector, the real unemployment rate grew during the war.

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

Although the notion that the War ended the Great Depression is a broken window fallacy (some consider that conditions worsened), the conflict did put the U.S. on the road to recovery. The War opened up international trading channels and reversed price and wage controls. Suddenly, there was government demand for inexpensive products, and the demand created 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, and 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 factors. While debate continues as to whether the interventions were appropriate, many of the reforms from the New Deal, such as social security, unemployment insurance and agricultural subsidies, exist to this day. The assumption that the federal government should act in times of national economic crisis is now strongly supported. This legacy is one of the reasons the Great Depression is considered one of the seminal events in modern American history.

'Great Depression'

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