Great Depression causes, outcomes, and economic lessons

Great Depression

Today's global economic crisis frequently has been related to the Great Depression of the 1930s. Many of the symptoms appear to be the same -- stock market volatility, credit crunch and rapidly escalating unemployment among them. Yet, the two scenarios have more differences than similarities. The Great Depression may have arisen in the wake of a massive economic expansion, but many of the systems and safeguards of modern capitalism did not exist during the Great Depression. Neither did many of the social programs that help to insulate us now against the grinding poverty of that era. The breadth and depth of the Great Depression was unprecedented. Yet this disaster has had many positive consequences, in terms of the lessons that economists and policymakers learned. The first attempts at economic recovery failed because of faulty economic logic, and we still remember those mistakes today. This paper will examine the Great Depression. Its causes and outcomes will be examined. By doing this, the objective is to gain insight into the event and what it has meant for our understanding of economic systems, lessons that can still be applied today.

Antecedents

"Wall Street, usually as deserted and quiet on Sunday as a country graveyard, hummed with activity yesterday as bankers and brokers strove to put their houses in order after the most strenuous week in history, in which all previous records for the exchange of securities on the New York Stock Exchange, the Curb Market and over the counter were broken." -- New York Times

It was October 1929 and the stock markets had rocked and reeled, with unprecedented volatility and volume. The industry had put in the overtime in order to prepare for a week in which the markets stabilized themselves after the crisis of the preceding week. Nervousness had passed, the author concluded and the business of restoring faith in the economy was about to begin. The date was Monday October 28th. The market fell, and bankers promised to support the market the next day. That day, Tuesday October 29th, would become known as Black Tuesday. The New York Times was less optimistic on the morning of October 29th, noting "Stock prices virtually collapsed…most disastrous trading day in stock market history…billions of dollars of values were wiped out." (NYT, 1929).

In popular lore Black Tuesday was the primary antecedent to the Great Depression, but stock markets do not crash without cause. The crash was symptomatic of major structural deficiencies in the American economy. The collective responses of the market and the government over the next couple of years would bring the country into the worst economic climate the nation had seen.

The stock market crashed in large part because valuations were excessive. The years leading up to the crash had seen a speculative bubble in both stocks and real estate. The real estate bubble began to collapse in 1925, but the stock market bubble persisted. At the heart of the bubble was a combination of risk-taking and willful ignorance. Investors had ceased to become rational actors, and consequently drove stock valuations up to irrational levels.

Part of the problem was the prevalence of margin buying. Margin buying increases the risk of an investment. This was not a problem while stocks were on the rise, but when they failed, the investor generally defaulted. Credit was easy in the 1920s, a consequence of a robust economy. This easy credit was dispensed to investors who could not afford to lose. This points to a governance problem in the brokerage houses and banks of the day. Margin buying increased demand and much of that demand became speculative. When the fundamentals of the economy began to turn, neither regulators nor banks nor the government acted.

The strong growth that America enjoyed in the 1920s had become to slow by the end of the decade. Americans had become satisfied with their level of wealth. Cars and radios had diffused and consequently consumer demand fell. In the absence of further stimulus, GDP growth began to slow. This would inevitably bring stocks down, but speculative buying on margin distorted the market, keeping prices artificially high. This precipitated the crash, but signaled bigger problems in the U.S. economy.

The slowing of consumer demand growth at the time had contributed to a flattening of GDP growth until 1929, when it began to spike again (Carter, 2006). This spike was an aberration, however, rather than based on fundamentals. At the time of the stock market crash, the fundamentals in the U.S. economy were not poor, but Black Tuesday and the other "black" days surrounding it dramatically altered the American psyche.

Making matters worse was the impending Smoot-Hawley Act, which President Hoover was going to allow to be brought into law (Salesman, 2004). The prevailing economic order at the time -- laissez-faire economics -- was not congruous with such regulation. Thus, the impending Act caused concern among investors.

Laissez-faire was not without its own problems however. The philosophy is based on minimal government intervention in economic activities. The excessive use of margin and poor governance on the part of banks and brokers was in part a consequence of laissez-faire policies. Political leaders at the time did not understand the basic risk-return relationship -- lack of regulation increased risk. This worked well during the good times but the effects into the 1930s were catastrophic.

Economic Influence

The Great Depression had a profound influence on the way in which the U.S. economy functioned. The laissez-faire economic policies of the 1920s were abandoned. Regulations were increased. New taxes were developed. A social safety net was developed. Many Depression-era institutions still exist today.

The Securities Exchange Commission was created in response to the view that the stock market crash had contributed too much to the Great Depression. The excessive use of margin had encouraged speculation. Poor governance on the part of banks and brokerages allowed for a market failure where investors were not making rational decisions, resulting in a bubble.

A variety of new taxes were created to offset Roosevelt's social programs. The American psyche had been scarred by the abject poverty of such a wide proportion of the population. There was palpable fear and desperation. This resulted in the creation of a social safety net and massive infrastructure investment. To pay for this, payroll taxes were developed and this was followed by more taxes to pay down. Withholding taxes and broader income taxes also came out of this era.

The gold standard was abandoned as a result of the Great Depression. The rigidity of the standard was considered to be an impediment to recovery. The coming of World War Two resulted in the postponement of monetary system development until the Bretton Woods conference, which resulted in a modified version of the gold standard.

Economists have spent entire careers trying to understand the Great Depression. Keynesian economic theory derives largely from an explanation of the New Deal -- the government spending made up the difference in the balance of payments, raising the GDP as a result. The monetary supply theory was developed, attributing the bulk of the Depression to the structural problems in the banking system. The Federal Reserve's inaction with respect to increasing money supply is therefore held as a primary cause. This theory has guided Federal Reserve policy in recent years. This theory is similar to the Austrian school's money supply theory, which blamed the excess of money in the 1920s for the bubble and its subsequent burst.

The neoclassical view is that the decline in productivity in the late 1920s caused the Depression. In truth, it was likely a combination of all of these factors. Events as cataclysmic as the Great Depression are not caused by one or two antecedents. It takes a wide range of problems to back a nation into a corner like the Great Depression. The causes can thus be divided into two categories -- structural issues from the 1920s and government responses in the 1930s.

Roosevelt's famous inaugural address exemplifies the view of Hoover's responses to the crisis:

"So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself -- nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance." -- F.D. Roosevelt

The fear was twofold. The first fear was the consumer fear of the country's financial system. There was credit available in 1930 and the market was on the road to recovery. But consumers did not feel as comfortable as market participants, however, and kept their cash to themselves. It was not until Roosevelt's banking reforms that the fear began to fade. Had the government taken steps to alleviate the fear at the outset of the crisis, the impacts may not have been as bad.

The second fear was the fear of competition. Competition is the lifeblood of the market system. Trade increases availability and decreases prices. The retaliation for Smoot-Hawley reduced U.S. exports, putting significant strain on the economy. Equally important was the reduced availability and increased price of imported goods. The impacts of this response were devastating, taking a recession and turning it into Depression. The Fed's lack of willingness to increase the money supply may have also contributed to the Depression. Consumers were relatively unwilling to spend, so more money may not have helped, but businesses may have been able to keep their workers employed long enough for Roosevelt to take power and make the necessary banking and trade reforms.

Conclusion

The Great Depression is the benchmark for economic crisis and the most important event in 20th century U.S. history. From the depths of the Depression comes the basis of our current economic thought and many of our governmental institutions and programs (and taxes). There is no one root cause of the Depression. It was precipitated by poor governance and irrational investing and then exacerbated by a series of ill-conceived policies. Debate also remains as to the impact of the New Deal. Most of the world had already turned the corner by the time the New Deal was implemented and it is entirely possible that the U.S. would have turned the corner as well.

On balance, Roosevelt's greatest contribution to the ending of the Depression may have been the development of a regulatory framework for the banking industry. This restored some of the faith in the banking system. Consumers will did not have jobs, which meant that this restoration of confidence took a long time to trickle through the economy.

Ironically, it was Smoot and Hawley who made the greatest contribution of any politician or economist as a result of the Great Depression. Over one thousand economists had petitioned against their bill, but a clutch of selfish business interests made the Act happen anyway. It would be to their detriment, as export markets dried up. The value of open trade to the development and sustained success of the global economy would be taken much more seriously following Smoot Hawley. The end of the 20th century and the beginning of the 21st century have been driven by improved freedom of trade, a telling legacy of Smooth Hawley's brutal contribution to Depression-era suffering.

The greatest economic event of the 20th century was followed by the greatest event of any type. The New Deal had failed to provide employment for Americans despite the government-sponsored improvements to the GDP. The Depression, built on the bubble of 1920s excesses, declining consumption and incompetent government response during the Hoover era, came to an end as loudly as it began, with the coming of war. But the lesson we learned from the Depression are still remembered today, and our policies and actions reflect that.

Works Cited:

No author. (1929). Wall Street Hums on the Day of Rest to Catch up at Work. New York Times. Retrieved April 23, 2009 from http://www.nytimes.com/library/financial/102829crash-sunday.html

No author. (1929). Stocks Collapse in 16,410,030 Share Day, but Rally at Close Cheers Brokers; Bankers Optimistic, to Continue Aid. New York Times. Retrieved April 23, 2009 from http://www.nytimes.com/library/financial/103029crash-lede.html

Salesman, Richard M. (2004) "The Cause and Consequences of the Great Depression, Part 1: What Made the Roaring '20s Roar" The Intellectual Activist .

Carter, Susan. (2006). Historical Statistics of the U.S.: Millenial Edition. Retrieved April 23, 2009 from http://www.hyperhistory.com/online_n2/connections_n2/depression9.html

Wilson B. Brown and Jan S. Hogendorn. International Economics: In the Age of Globalization. Retrieved April 23 from http://www.google.com.au/books?id=5SoP6KUDwY4C&pg=PA246&dq=smoot+hawley&sig=GplUGJBCti3Tv3XN2saPicP5Lsw

U.S. Bureau of the Census, Historical Statistics of the United States, Colonial Times to 1957 (Washington, D.C., 1960), p.70.

Franklin D. Roosevelt's Inaugural Address, 1933 retrieved April 23, 2009 from http://historymatters.gmu.edu/d/5057/