What caused the Great Depression?

Harvard University economist Greg Mankiw has a good column of the origins of the Great Depression in today's New York Times.

For my book from several years ago, "Deflation: What Happens When Prices Fall" I took a particular perspective on the cause of the Great Depression. I'm no scholar of the 1930s, but it's my take after reading the literature (or at least some of it).

The bottom line: There are worrisome parralels to now.


Booms and busts are inevitable with capitalism--it is in the nature of the beast. The National Bureau of Economic Research, a nonprofit organization and the official arbiter of the American business cycle, lists 16 downturns between 1854 and 1919. Deflations were commonplace whenever the economy turned down in the 19th and early 20th centuries. Indeed, during the short, sharp depression of 1920-21, prices fell by some 56% from mid-1920 to mid-1921, perhaps the steepest price plunge in U.S. history.

The question economists have long grappled with is what transformed a severe recession into the worst depression on record. The controversy has been fierce, fascinating, and illuminating. Among some well-known explanations: John Maynard Keynes blamed a collapse in business confidence and private investment in The General Theory of Interest, Money, and Employment. Milton Friedman and Anna Schwartz scorched an inept Federal Reserve; Peter Temin emphasized a collapse in consumer spending; Joseph Schumpeter argued the economy was plagued by "underconsumption" as highly productive business flooded the market with more goods than consumers had income; John Kenneth Galbraith's culprit was the bursting of an immense stock market bubble; Ben Bernanke subtly stressed the impact of credit expansion and contraction; and Charles Kindleberger identified the worldwide fall in commodity prices.

Each of these interpretations resonates, and much of the economic debate has been over primacy--the stock market crash? the banking panics? a deflationary spiral?--rather than role. The answer is unusually important, however. Trying to understand the Great Depression is no abstract puzzle. No one wants to go through another era where a quarter of the workforce is out of work, or create the kind of economic upheaval that gave a tragic opening to extremists like the Bolsheviks in Russia and the Nazis in Germany.

A common framework for understanding the causes of the tragedy has emerged among economists in recent years. Among the seminal contributors are Barry Eichengreen of the University of California, Berkeley, Peter Temin of the Massachusetts Institute of Technology, Jeffrey Sachs of Columbia University, and Michael Bordo of Rutgers University. The literature begins with the global nature of the depression. And as Eichengreen and Temin emphasize that means putting the international gold standard and central banks at the center of the story. "The constraints of the gold-standard system hamstrung countries as they struggled to adapt during the 1920s to changes in the world economy. And the ideology, mentalite and rhetoric of the gold standard led policymakers to take actions that only accentuated economic distress in the 1930s. Central banks continued to kick the world economy while it was down until lit lost consciousness... The modern literature on the Great Depression emphasizes mentalite, discourse, mass politics, and the eclipse of the nation state."

The gold standard was much more than a system for managing exchange rates and ensuring stable currency values. It had evolved into a totem, a secular religion, an ideological mindset that gave coherence to the world economy and trust in financial transactions. The experience of the latter part of the 19th century and early 20th century was that the gold standard played a vital role in the long boom of that period. Now, the gold standard had been discontinued during the First World War. But after the war, political and financial elites saw restoring the gold standard as critical for restoring healthy international relations among war weary nations. It was a reasonable, and disastrous, belief. For instance, the British government established in 1918 the Cunliffe Commission, headed up Lord Cunliffe, the former Governor of the Bank of England, to make currency recommendations once the war was over. The final report made clear that the only acceptable choice was a return to gold: "The adoption of a currency not convertible to gold or other exportable gold is likely in practice to lead to over issue and so to destroy the measure of exchangeable value and cause a general rise in all prices and an adverse movement in the foreign exchanges."

The Cunliffe Commission reflected the mentalite of the gold standard. The mindset of policymakers limited their choice of what was possible, and abandoning the gold standard during peacetime heresy. If gold was leaving a country, the right response for preserving the value of capital was to restrict credit with higher interest rates and reduce costs and prices by deflating the economy. The discourse of the gold standard reflected the reverence elites shared for the metal. The gold standard stood for everything that was good in society. Thrift. Sobriety. Civilization. International harmony. Abandoning gold meant giving in to society's worst tendencies, the license of the mob and the destruction of capital. The idea was so heretical that many elites couldn't even of not rushing to reestablish the gold standard now that war was over.

That's why policymakers couldn't grasp that the world economy had changed in fundamental ways that meant actions taken to shore up the system had the exact opposite effect. The First World War changed the face of politics. Before the Great War, a political, military, financial, and business elite dominated their nations, supported by the moneyed, property owning middle class. But the Victorian and Edwardian eras disappeared after traditional elites lost credibility with their blundering into a war that is still largely inexplicable, as well as and tolerating an unimaginable slaughter on the battlefield, from the Battles for Ypres to the Battle of Somme. An estimated 10 million soldiers were killed, twice that seriously wounded, and casualties among civilians totaled some 30 million. Says Ronald Jepperson, professor of sociology at Tulsa University: "World War I shattered the European Old Regime, the aristocratic political order that had persisted into the 20 century. The elites that had thrust their populations into war were thoroughly discredited as well as demoralized."

Britain's David Lloyd George captured this context in 1919, writing that "The whole existing order in its political, social, and economic aspects is questioned by the masses of people from one end of Europe to the other." The wartime mobilization of the population, coupled with the massive disruptions and widespread discontent, spawned populist movements of all colorations: liberal and soft-socialist parties in the more democratic countries; autocratic nationalist parties (both Left and Right) in the more authoritarian ones. "In all cases, if in different ways," adds Jepperson, "'public opinion' was now in part mass opinion--the latter a new restraint upon policy-making, as well as a new source of power for would-be reformers and revolutionaries of all stripes."

Revolution was in the air. The "lower classes" gained a voice after the First World War. Their opinions could no longer be ignored following the enormous sacrifices of the war. Membership in unions grew. Socialist and communist parties attracted followers, especially after the 1917 Bolshevik seizure of power in Russia, and fascists competed for support among the same disillusioned masses. Agitation for the right to vote rapidly spread. Women in the U.S. won the right to vote in 1919, and in England universal suffrage came about in 1927. As Keynes noted in 1923 "the conditions of the future are not those of the past."

Central banks are also critical to this accounting of the unprecedented collapse. Focusing on the United States, any analysis of the Great Depression today has to take into account Milton Friedman and Anna Schwartz's, A Monetary History of the United States, 1867-1960. The authors argue that the Federal Reserve transformed a cyclical contraction into a depression. In essence, the Great Depression stems from a decline in the money supply. The public lost confidence in banks. Depositors wanted their money back. The money supply contracted. Bank deposits weren't being used to expand credit and economic activity but to meet the public's panicked need for cash. Incomes fell, economic activity plummeted, more banks went out of business, yet the Fed refused to break the cycle of fear by acting as lender of last resort "[T] the experience was a tragic testimonial to the importance of monetary forces," write Friedman and Schwartz. "The drastic decline in the quantity of money during those years and the occurrence of a banking panic of unprecedented severity were not the inevitable consequences of other economic changes. They did not reflect the absence of power on the part of the Federal Reserve System to prevent them. Throughout the contraction, the System had ample powers to cut short the tragic process of monetary deflation and banking collapse. Had it used those powers effectively in late 1930 or even in early to mid-1931.... Such action would have eased the severity of the contraction and very likely would have brought it to an end at a much earlier date."

With the benefit of hindsight, it's unbelievable that the Fed would allow for the destruction of wealth, enterprise, and employment. Friedman and Schwartz strongly emphasize the ineptness of the Fed, and a struggle for power between the Federal reserve bank of New York and the Federal Reserve Board in Washington D.C. The scholars believe that had Benjamin Strong, the forceful head of the New York Fed not died in 1928, he might have taken the kind of bold action necessary to stem the depression's downward spiral. "The shift of power from New York to the other Banks might not have been decisive, if there had been sufficiently vigorous and informed intellectual leadership in the Board," write Friedman and Schwartz. "However, no tradition of leadership existed within the Board. It had not played a key role in determining the policy of the System throughout the twenties... There was no individual Board member with Strong's stature in the financial community or in the Reserve System, or with comparable experience, personal force, or demonstrated courage."

In sharp contrast, Eichengreen and other scholar's emphasize the rationality of the decisions made by the Fed in light of the dictates of the gold standard. When the Fed was confronted with an outflow of gold, as it was in the fall of 1931 and in early 1933, maintaining true to logic of the gold standard meant raising U.S. interest rates even though some 13 million Americans or about a quarter of the workforce were unemployed. Yet the gold standard precluded central bankers from expanding the money supply to encourage domestic demand because, horror of horrors, that could lead to inflation. Remember, this is at a time when prices were falling at as high as a -10% annual rate. "Policies were perverse because they were designed to preserve the gold standard, not employment", says Eichengreen and Temin.

The mindset of financial and policy elites sheds light on one of the most infamous statements about letting the Depression run its course without government interference: "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate," said Andrew Mellon, President Herbert Hoover's treasury secretary. Following the boom of the 1920s, he believed the downturn "will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people." Sure, that's an easy perspective for one of the nation's wealthiest men to hold. Problem is, many of the best minds of the era also valued depressions as purgatives wiping away speculative excesses created during booms. The "depression is good for you: crowd included legendary economists like Joseph Schumpeter, Friedrich Hayek, and Lionel Robbins, according to a fascinating paper by Brad Delong, economist at the University of California, Berkeley and deputy assistant secretary in the Clinton Administration's Treasury Department.

Schumpeter, everyone's favorite economist during the heady years of the 1990s, was of the opinion that "depressions are not simply evils, which we might attempt to suppress, but... forms of something which has to be done, namely, adjustment to change." His contemporary Lionel Robbins wrote, "Nobody wishes... bankruptcies. Nobody likes liquidation as such... [But} when the extent of mal-investment and over-indebtedness has passed a certain limit, measures which postpone liquidation only make matters worse."

The experience of the 19th century also suggested that busts weren't all bad. Investment booms surrounded new technologies, but the return on investment is always uncertain. How many miles of canals should be dug? How many lines of railroads makes competitive sense. Which city will grab enough business to justify building skyscrapers? Business entrepreneurs and financial speculators gambled, sometimes going too far, excess capacity would be liquidated, creating conditions for another technology-led investment spree. Here's Brad DeLong on the pre-World War 1 business cycle. "There was uncertainty about the long run growth of the American economy, especially when settlement of the West is concerned. Railroads are sensitive to the growth of the regions they serve. Entrepreneurs did risk their fortunes and futures on their assessment of the quasi-rents to be earned from a particular line. Sometimes they guessed wrong: Jay Cooke and Co. failed because it had advanced more money for the construction of the Northern Pacific than it could recoup by selling Northern Pacific bonds. Its failure ushered in the panic of 1873 and the subsequent depression, which did not lift until five years had passed and construction resumed. Thus railroad booms and busts of the late nineteenth century are not inconsistent with a 'liquidationist' perspective. When long run rates of growth are unstable, investment for the future ought to be jagged, and ought to see periods of rapid expansion coupled with periods of quiescence and disinvestment."

This isn't to say the liquidationists were right. Just that the business cycle experience and the gold standard combined to drive central bankers in the U.S., as well as in Britain, France, Germany, Italy, and elsewhere to take the wrong actions.
Gradually, however, the human and productive toll grew too great, and the political agitation to insistent to ignore. In 1931, 47 countries adhered to the gold standard; by the end of 1932 the only major countries left were Belgium, France, Italy, the Netherlands, Poland, Switzerland, and the United States. Britain abandoned it commitment to gold in the fall of 1931. The United States went off the gold standard in 1933 with the election of President Franklin D. Roosevelt, who ignored the pleas of his predecessor Herbert Hoover to stick with gold. The rest of the gold bloc countries had abandoned the standard by the end of 1936. Indeed, the nation's that shook off their "golden fetters" first were also first to leave the Great Depression behind.

About the author

Chris Farrell is the economics editor of Marketplace Money.


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