Causes of the Great Depression

After reading Chapter 7 and Special Topic 6, write a 2-page paper answering the following question:

Contrary to a popular view, the Great Depression was not caused by the 1929 stock market crash. We have had similar reductions in stock prices to those in 1929 before and after the Great Depression. What historical events took place that directly led to the prolonged depressed conditions like those of the 1930s?

Below is Special Topic 6 Weekly Content:

The Great Depression is perhaps the most catastrophic economic event in American history. It is also one of the most misunderstood. Misconceptions abound with regard to what actually happened. The Great Depression is a tragic story about economic illiteracy and the adverse impact of unsound policies. People who do not learn from the lessons of history are prone to repeat them. If we want to avoid similar experiences in the future, it is vitally important that we understand the factors underlying the tragic events of this era.

The Economic Record of the Great Depression

Exhibit 1 presents data on the change in real GDP and the rate of unemployment during 1929–1940. As part (a) illustrates, real GDP fell by 8.6 percent in 1930, 6.5 percent in 1931, and a whopping 13.1 percent in 1932. By 1933, real GDP was nearly a third less than that in 1929. There was a temporary rebound during 1934–1936, but growth slowed in 1937 and real GDP fell once again in 1938. In 1939, a full decade after the disastrous downturn started, the real GDP per capita of the United States was about the same as it had been in 1929

Exhibit 1Real GDP and the Rate of Unemployment, 1929–1940

The change in real GDP (part a) and rate of unemployment (part b) figures during the Great Depression are shown here. These data illustrate both the severity and length of the economic contraction. For four successive years (1930–1933), real output fell. Unemployment soared to nearly one-quarter of the workforce in 1932 and 1933. Although real output expanded and the rate of unemployment declined during 1934–1937, the economy again fell into the depths of a depression in 1938. In 1939, a decade after the economic plunge started, 17.2 percent of the labor force was still unemployed and real GDP was virtually unchanged from the level of 1929.

Sources: Real GDP growth rates for are from www.bea.gov. The unemployment data are from the Bureau or Labor Statistics (BLS) at www.bls.gov.

While output was declining during the depression era, unemployment was soaring. As Exhibit 1, part (b), shows, the rate of unemployment rose from 3.2 percent in 1929 to 8.7 percent in 1930 and 15.9 percent in 1931. During 1932 and 1933, the unemployment rate soared to nearly one-quarter of the labor force. Even though real GDP grew substantially during 1934 and 1935, the unemployment rate remained above 20 percent during both of those years. After declining to 14.3 percent in 1937, the rate of unemployment rose to 19.0 percent during the downturn of 1938, and it was still 17.2 percent in 1939, a full decade after the catastrophic era began. The unemployment rate was 14 percent or more throughout the ten years from 1931 through 1940. By way of comparison, the unemployment rate has averaged less than 6 percent during the past quarter of a century, and it has never reached 11 percent since the Great Depression. Moreover, the statistics conceal the hardship and suffering accompanying the economic disaster. It was an era of farm foreclosures, bank failures, soup kitchens, unemployment lines, and even a sharply declining birthrate. America would never quite be the same after the 1930s.

Was the Great Depression Caused by the 1929 Stock Market Crash?

The prices of stock shares rose sharply during the 1920s. But this is not surprising because the 1920s were a remarkable decade of innovation, technological advancement, and economic growth. The production of automobiles increased more than tenfold during the 1920s. Households with electricity, telephones, and indoor plumbing spread rapidly throughout the economy. The first regularly scheduled radio programs were broadcast in the early 1920s, providing an amazing new vehicle for mass communication. Air conditioning received a boost from its use in “movie houses,” as theaters were called at the time. There is good reason why the decade was known as the “Roaring Twenties.” Perhaps more than any other era, the lives of ordinary Americans were transformed during the 1920s. To a large degree, the stock market was merely registering the remarkable growth and development of the decade.

The Great Depression was a prolonged period of falling incomes, high unemployment, and difficult living conditions. The decline in output and high unemployment were the most severe in American history. Why was the economy so weak for so long?

INTERFOTO/Alamy Stock Photo

Generations of students have been told that the Great Depression was caused by the stock market crash of October 1929. Is this really true? Let’s take a look at the figures. As Exhibit 2, part (a), shows, the Dow Jones Industrial Average opened in 1929 at 300, rose to a high of 381 on September 3, 1929, but gradually receded to 327 on Tuesday, October 22. A major sell-off started the following day, and the Dow began to plunge. By October 29, which is known as Black Tuesday, the Dow closed at 230. Thus, in exactly one week, the stock market lost nearly one-third of its value. A couple of weeks later on November 13, the Dow fell to an even lower level, closing at 199.

Exhibit 2The Stock Market (Dow Jones Industrial Average), 1928–1940

The figures for the Dow Jones Industrial Average (DJIA) are shown here. Clearly, stock prices plunged in September–October 1929, but note how they recovered during the five months from mid-November 1929 through mid-April of 1930. However, this recovery reversed as the Smoot–Hawley tariff bill was debated, passed, and eventually signed into law on June 17, 1930. As part (b) shows, the Dow continued to fall throughout 1931 and 1932 and never reached 200 throughout the remainder of the decade.

Sources: www.finance.yahoo.com and www.analyzeindices.com.

However, it is interesting to see what happened during the next five months. From mid-November 1929 through mid-April 1930, the Dow Jones Industrial Average increased every month, and by mid-April the index had risen to 294, regaining virtually all of the losses experienced during the late October crash. This raises an interesting question: If the October crash caused the Great Depression, how can one explain that the stock market had regained most of those losses by April 1930?

But from mid-April throughout the rest of 1930, stock prices moved steadily downward and closed the year at 165. Apparently something happened during May–June 1930, which caused the stock market to head downward. We will return to this issue in a moment. Exhibit 2 part (b) presents data for the Dow Jones Industrials for 1931–1940. The index continued to fall in 1931–1932 and rebounded strongly in 1933 but then fluctuated between 100 and 200 for the remainder of the decade. Note the Dow stood at 131 at year-end 1940, even lower than the closing figure for 1930.

There have been several downturns in stock prices of the magnitude experienced during 1929, both before and after the Great Depression, and none of them resulted in anything like the prolonged unemployment and lengthy contraction of the 1930s. For example, the stock market price declines immediately before and during the recessions of 1973–1975 and 1982–1983 were as large as those of the 1929 crash, approximately 50 percent. But both of these recessions were over in about 18 months. Moreover, in 1987, the Dow Industrials fell from 2,640 on October 2 to 1,740 on October 19, a decline of 34 percent. Whereas the collapse of stock prices in 1987 was similar to the October 1929 crash, that is where the similarity ends. The 1987 crash did not lead to economic disaster. In fact, it was not even followed by a recession.

Of course, the 1929 decline in stock prices reduced wealth and thereby contributed to the reduction in aggregate demand and real output. But stock prices have fallen by 50 percent or more during other recessions, and the economy nonetheless moved toward a recovery within a year or two at the most. Thus, although the decline in stock prices may well have triggered the initial economic decline, the length and severity of the Great Depression were the result of other factors. We will now consider this issue in more detail.

Popular writers often argue that speculators drove the stock market to unsustainable highs in the late 1920s, but this view is an exaggeration. The price/earnings ratio for the Dow was 19 just before the crash. This places it at the upper range of normal but not at an unprecedented high. On October 9, 1929, The Wall Street Journal reported that railroad stocks were selling at 11.9 times earnings, which would place their P/E ratio toward the lower range of normal. RCA was the hot “high-tech” company of the era, and it earned $6.15 per share in 1927 and $15.98 per share in 1928. It traded at a high in 1928 of $420. This would imply a P/E ratio of 26, not unreasonable for a growth stock with outstanding future earning prospects.

Chapter Contents

ST06-3 Why was the Great Depression So Lengthy and Severe?

The length and severity of the Great Depression were the result of bad policies. There were four major policy mistakes that caused the initial downturn to worsen and the depressed conditions to continue on and on. Let’s take a closer look at each of them.

1. A sharp reduction in the supply of money during 1930–1933 and again in 1937–1938 reduced aggregate demand and real output. The supply of money expanded slowly but steadily throughout the 1920s. From 1921 through 1929, the money stock increased at an annual rate of 2.7 percent, approximately the economy’s long-term real rate of growth. There was even a slight downward trend in the general level of prices during the decade.

In spite of this price stability, the Fed increased the discount rate, the rate it charges banks for short-term loans, four times between January 1928 and August 1929. During this 20-month period, the discount rate was pushed from 3.5 percent to 6 percent. After the October stock market crash, the Fed aggressively sold government bonds, which drained reserves from the banking system and reduced the money supply. As Exhibit 3 part (a) shows, the money supply fell by 3.9 percent during 1930, by 15.3 percent in 1931, and by 8.9 percent in 1932. As banks failed and the money supply collapsed, the Fed did not inject new reserves into the system. Neither did it act as a lender of last resort. The quantity of money at year-end 1933 was 33 percent less than that in 1929.

Exhibit 3The M1 Money Supply and the Change in the General Level of Prices, 1925–1940

Note how the M1 money supply fell sharply during 1930–1933, rose during 1934–1937 but dipped again in 1938 (part a). The general level of prices followed the same pattern (part b). The sharp reduction in the supply of money and deflation during 1930–1933 changed the terms of loans, investments, and other economic activities that take place across time periods. This was a major factor underlying the initial plunge into the Great Depression. Further, the monetary contraction of 1938 stifled the recovery and contributed to still another downturn.

Sources: Change in the money supply is from December to December. The data are from Milton Friedman, and Anna J. Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963); for CPI data: www.bls.gov.

Predictably, this huge monetary contraction placed downward pressure on prices. As Exhibit 3 part (b) illustrates, the general level of prices fell by 2.3 percent in 1930, 9.0 percent in 1931, and 9.9 percent in 1932.

Economic activity takes place over time. The deflation during 1929–1933 meant that many people who bought businesses and farms in the late 1920s were unable to pay for them as the prices of their output fell during the 1930s. In essence, the monetary contraction caused unexpected changes in economic conditions. As a result, many people who undertook investments and borrowed funds suffered losses and were unable to fulfill their contracts. As the gains from trade dissipated and aggregate demand plunged, so, too, did output and employment. By 1933, real GDP was 29 percent lower than the 1929 level, and the unemployment rate had soared to nearly 25 percent.

During 1934–1937, the Fed reversed itself and expanded the supply of money. The monetary expansion halted the deflation, and the general level of prices increased. So, too, did the level of economic activity. Real GDP expanded and the unemployment rate fell during 1934–1937. But the Fed doubled the reserve requirements between August 1936 to May 1937, leading to another decline in the money supply and the general level of prices. This caused the economy to falter again and pushed the unemployment rate to almost 20 percent in 1938.

Sound monetary policy is about price stability—following a monetary policy that keeps the inflation rate low and steady. The Federal Reserve totally failed the American people during the 1930s. The severe monetary contraction led to near double-digit deflation. This was followed by a shift to monetary expansion, which generated inflation, but the Fed soon shifted again toward contraction, which caused still more deflation. Essentially, the monetary instability of the 1930s generated uncertainty and undermined the exchange process.

2. The Smoot–Hawley trade bill of 1930 increased tariffs and led to a huge reduction in the volume of international trade. Signed into law on June 17, 1930, the Smoot–Hawley trade bill increased tariffs by more than 50 percent on approximately 3,200 imported products. Many of these tariff increases were in dollars per unit, so the subsequent deflation pushed them still higher relative to the price of the product.

Senator Reed Smoot and Congressman Willis Hawley (shown here) spearheaded legislation passed in June 1930 that increased tariff rates by an average of more than 50 percent. They thought their bill would “save jobs” and promote prosperity. Instead, it did the opposite, as other nations retaliated with higher tariffs on American products and world trade fell substantially.

Library of Congress, National Photo Company Collection, LC-DIG-mpcc-17371

Like their protectionist counterparts today, President Herbert Hoover, Senator Reed Smoot, and Congressman Willis Hawley argued that the trade restrictions would “save jobs.” As Congressman Hawley put it, “I want to see American workers employed producing American goods for American consumption.” The proponents of the Smoot–Hawley legislation also believed the higher tariffs would bring in additional revenue for the federal government.

More than 100 years before the Great Depression, Adam Smith and David Ricardo explained how nations gained when they specialized in the production of goods they could supply at a low cost while trading for those they could produce only at a high cost. Trade makes it possible for both trading partners to generate a larger output and achieve a higher living standard. Moreover, a nation cannot reduce its imports without simultaneously reducing its exports. If foreigners sell less to Americans, then they will earn fewer of the dollars needed to buy from Americans. Thus, a reduction in imports will also lead to a reduction in exports. Jobs created in import competing industries will be offset by jobs lost in exporting industries. There will be no net expansion in employment. The view that import restrictions will generate a net creation of jobs is fallacious.

Having read both Smith and Ricardo, the economists of 1930 were well aware of the benefits derived from international trade and the harm generated by trade restrictions. More than a thousand of them signed an open letter to President Hoover warning of the harmful effects of Smoot–Hawley and pleading with him not to sign the legislation. He rejected their pleas, but history confirmed the validity of their warnings.

The higher tariffs did not generate additional revenue, and they certainly did not save jobs. The import restrictions harmed foreign suppliers, and predictably they retaliated. Sixty countries responded with higher tariffs on American products. By 1932, the volume of U.S. trade had fallen to less than half its earlier level. As a result, the federal government actually derived less revenue at the higher tariff rates. Tariff revenues fell from $602 million in 1929 to $328 million in 1932. Similarly, output and employment declined and the unemployment rate soared. The unemployment rate was 7.8 percent when Smoot–Hawley was passed, but it ballooned to 23.6 percent of the labor force just two years later. Moreover, the “trade war” helped spread the recessionary conditions throughout the world.

There was substantial opposition to the Smoot–Hawley bill, and the Senate vote was close (44 – 42). Last minute changes in the rate schedules were made in order to gain the final votes needed for passage. Some businesses, seeking to gain advantage at the expense of consumers and foreign rivals, lobbied hard for the legislation. But, like the economists, other business leaders recognized that trade restrictions would harm rather than help the economy.

As we previously discussed, stock prices had increased for five straight months following the November 1929 lows, and by mid-April of 1930, the Dow Jones Industrials had returned to the level just before the October 1929 crash (see Exhibit 2). But as the Smoot–Hawley bill moved through Congress and its prospects for passage improved, stock prices moved steadily downward. In fact, the reduction in stock prices following the debate and passage of Smoot–Hawley was even greater than that of the 1929 October crash. By year-end 1930, recovery was nowhere in sight, and the Dow Jones Industrial index had fallen to 165, down from 294 in mid-April.

The combination of highly restrictive monetary policy and the Smoot–Hawley trade restrictions were enough to push the economy over the cliff, but Congress and the president were not through.

3. A large tax increase in the midst of a severe recession made a bad situation worse. Before the Keynesian revolution, the dominant view was that the federal budget should be balanced. Reflecting the ongoing economic downturn, the federal budget ran a deficit in 1931, and an even larger deficit was shaping up for 1932. Assisted by the newly elected Democratic majority in the House of Representatives, the Republican Hoover Administration passed the largest peacetime tax rate increase in the history of the United States. As Exhibit 4 indicates, the lowest marginal tax rate on personal income was raised from 1.5 percent to 4 percent in 1932. At the top of the income scale, the highest marginal tax rate was raised from 25 percent to 63 percent. Essentially, personal income tax rates were increased at all levels by approximately 150 percent in one year! This huge tax increase reduced both the after-tax income of households and the incentive to earn and invest.

Exhibit 4Marginal Income Tax Rates, 1925–1940

The lowest and highest marginal tax rates imposed on personal income are shown here for the period before, and during, the Great Depression. Note how the top marginal rate was increased from 25 percent in 1931 to 63 percent in 1932. Real GDP fell by 13.3 percent in 1932, and the unemployment rate soared to nearly a quarter of the labor force (see Exhibit 1). In 1935, the top rate was pushed still higher to 79 percent.

Sources: The Tax Foundation, www.taxfoundation.org; and the IRS at www.irs.gov.

Fiscal policy analysis indicates that a tax increase of this magnitude in the midst of a severe downturn will be disastrous. Review of Exhibit 1 shows that this was indeed the case. In 1932, real output fell by 13 percent, the largest single-year decline during the Great Depression era. Unemployment rose from 15.9 percent in 1931 to 23.6 percent in 1932.

In 1936, the Roosevelt Administration increased taxes again, pushing the top marginal rate to 79 percent. Thus, during the latter half of the 1930s, high earners were permitted to keep only 21 cents of each additional dollar they earned. Moreover, the 1936 tax legislation also imposed a special tax on the retained earnings of corporations, a major source of funds for business investment. These 1936 tax increases further reduced both income levels and the incentive to earn and invest, prolonging the Great Depression and increasing its severity.

4. Price controls, anticompetitive policies, and constant structural changes during the Roosevelt administration generated uncertainty and undermined the normal recovery process. President Roosevelt was elected in 1932, and many history books still credit his New Deal policies with bringing the Great Depression to an end. Numerous policy changes were instituted during the Roosevelt years, and some of them were helpful. In 1933, President Roosevelt revalued the price of gold from $20 per ounce to $35 per ounce, and this contributed to the expansion in the money supply during the years immediately following. The Roosevelt administration also passed the Federal Deposit Insurance program, which provided depositors with protection against bank failures and reduced the occurrence of “bank runs.”

The Agricultural Adjustment Act of 1933 sought to increase the prices of farm products by reducing their supply. Under this act, 6 million baby pigs were slaughtered in 1933. Did this help bring the Great Depression to an end?

Franklin D. Roosevelt Library, courtesy of the National Archives and Records Administration

However, it is equally clear that many of the major initiatives of the Roosevelt administration were counterproductive and prolonged the Great Depression. Roosevelt perceived that falling prices were a problem, but he failed to recognize that this was because of the monetary contraction. Instead, he tried to keep product prices high by reducing their supply. Under the Agricultural Adjustment Act (AAA) passed in 1933, farmers were paid to plow under portions of their cotton, corn, wheat, and other crops. Potato farmers were paid to spray their potatoes with dye so that they would be unfit for human consumption. Healthy cattle, sheep, and pigs were slaughtered and buried in mass graves in order to keep them off the market. In 1933 alone, 6 million baby pigs were killed under the Roosevelt agricultural policy. The Supreme Court declared the AAA unconstitutional in 1936, but

 

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