Income Inequality and the Causes of the Great Depression

Introduction: The Great Depression as National Trauma

In a recent interview, presidential political advisor David Axelrod stated that President Obama "inherited the worst recession since the Great Depression…." (Jackson, 2012). In terms of American history, the Great Depression looms over the United States like some sort of mythological ogre — albeit an economic one — and this ogre frightens politicians and the public alike. Everyone has heard stories of brokers and bankers jumping out of windows to their deaths, of families forced to leave their homes to become migrant workers, and of people hiding money in their mattresses because they did not trust the banks. The Great Depression was a national trauma that has had long-lasting effects on the nation.

Economists, historians, and others have debated the causes of the Great Depression ever since it occurred, producing a number of theories — some extremely complicated and intricate — to explain the worst economic collapse in the history of the world. But the theory from which all others seem to sprout is a rather simple one: economic inequality. Whether one blames micro- and macroeconomic forces such as aggregate demand, instability of wages, or banking panics, all of these can trace their roots back to the fact that too much wealth was accumulated in the hands of too few people, who did not use it for the benefit of the national economy but for their own selfish gains.

The Great Depression is said to have begun with the stock market's "Great Crash" on October 29, 1929, but events had been heading toward such a collapse for some time. After almost seven years of rising stock prices, in September 1929 they began to slip downward. While most believed it was just an economic hiccup, by October the hiccup had become a sustained downward slide. October 19th saw a "sudden wave of selling…," and by Thursday, October 24th, a wave of panic selling erupted (Downing, 2001, p. 4). There was an attempt to stabilize the situation over the weekend, but by Tuesday — known as "Black Tuesday" — the market had crashed. In the three years immediately following the crash, American "real GDP fell by about 25%, and nominal GDP by about 50%…," with the unemployment rate peaking at just about 25% (Hall, 1998, p. 4). There was some recuperation of the economy in the years from 1934 to 1937, but by 1937 "output fell again, and the Great Depression was considerably prolonged in the United States" (Hall, 1998, p. 4). Ultimately, the Great Depression — which actually consisted of two separate recessions — kept economic output in the United States below average for more than twelve years.

Origins of the Crisis: The Economic Boom of the 1920s

The Great Depression actually had its roots in the 1920s, a period that saw a tremendous expansion in the American economy and the rise of the businessman. As Robert McElvaine stated in his widely read book The Great Depression: America 1929–1941, "The twenties cannot be comprehended without understanding that after two decades of reform sentiment, businessmen were once again in the saddle" (McElvaine, 2009). While there was at this time an attempt at what became known as "corporate welfare" — in which corporations provided workers with a number of generous benefits — the collapse of the stock market in 1929 led to the collapse of such programs. In the early 1920s, however, business was the "silver bullet" that was to lead America into a new era of prosperity.

The boom in business during the 1920s was largely the result of the Great War, or World War I, and the "vast series of shifts in the fundamental conditions of demand and supply…" (Robbins, 2007, p. 3). In the years during and immediately following the war, the global economy was unable to adapt to the new conditions that had developed — most particularly the depletion of capital and the lowering of productivity in the industrial sector — both of which led to the inability of the global economic system to adjust. These warning indicators were not recognized by the general population, and in the United States, there seemed to be an economic boom occurring.

The economic boom of the 1920s was not a genuine boom at all but a bubble created by the extension of credit. As time went on, credit became overextended. This credit was mostly provided by institutions other than banks — such as brokerage firms and mortgage companies — and could not expand indefinitely. It has been argued that the "depression only began when credit expansion ceased" (Rothbard, 2008, p. 23). The government could not back credit expansion continually for two main reasons: first, the longer the credit boom continued, the more economically serious and painful the eventual consequences; and second, the boom could not continue indefinitely because the public ultimately lost confidence in the economy. This is exactly what happened when the stock market crashed in 1929 — the credit bubble burst, deflation occurred, and with it came the subsequent economic calamities.

Credit Expansion, Savings, and the Money Supply

These calamities can be argued to have resulted from a contraction in the amount of money circulating in the economy. While some blame overproduction and others under-consumption, the result was that too many items were being produced and not enough money existed for people to purchase them. As business continued to expand during the twenties, more and more of those with means did not use their money to invest in new businesses; they left it to those extending credit to do so. Instead of productive investment, the wealthy in America began to put their money into savings. According to Keynesian economic theory, savings and investments are "indissolubly linked," with savings removing monetary resources from the general economy (Rothbard, 2008, p. 38). The increased availability of credit led to an increase in savings — or the hoarding of money by the wealthy — and when the credit bubble burst, there was no money available to sustain the good times.

Within these economic explanations of the Great Depression lies the concept of income distribution. It is almost universally accepted that the increase in credit, tied to the decrease in actual money in the economy, led to a situation where, when the credit bubble burst, there was not enough cash in the system to keep it going. This problem is intricately linked to the country's problem with income distribution. "The distribution-of-income problem refers to the fact that while most people were becoming better off, those at the top of the income scale were becoming relatively much more affluent than those in the lower income bracket" (Hall, 1998, p. 21).

Income Distribution and the Collapse of Consumption

It has been estimated that the total income accrued by the top 1% of income earners rose from 12% in 1922 to close to 14% in 1929. Over that same period, the percentage of total wealth held by the top 1% rose from 32% to nearly 40%. Most strikingly, in 1922 the top 1% of the population accounted for about 50% of all savings, but by 1929 that figure had risen to more than 80%. In other words, the top 1% of the economic scale in the United States accumulated more and more wealth during the 1920s and did not invest this wealth back into the economy — they hoarded it.

Another indication that wealth was accumulating in the hands of fewer and fewer individuals is the fact that workers' wages grew at a slower rate than worker output. Workers were producing more while their wages were not rising proportionately. The result was an increase in corporate profits, reflected in the amount of dividends paid to investors. In 1920, dividends constituted only a little more than 4% of national income; by 1929, that figure had risen to over 7%. Since the majority of dividends were paid to those within the top 5% of the economic bracket, the wealthy continued to grow wealthier, adding to the great imbalance in income distribution.

Many economists and historians point to the argument that as more wealth accumulates in the hands of a small number of high-income individuals, "the average aggregate propensity to consume falls" (Hall, 1998, p. 22). As workers produced more, they received proportionately less and were unable to continue consuming as they had in the past. Meanwhile, the wealthy received more but, because there were simply too few of them to consume all the goods produced, overall consumption decreased. This led to a situation of overproduction and under-consumption that many describe "as being instrumental in setting off the recession in 1929" (Hall, 1998, p. 22).