The Great Depression: Causes

Figure 1.--The uneven distribution of wealth was a facor in the Great Depression. Modern economists have come to the conclusion, however, that it was inappropriate monetary policy that turned a recession into the Great Depression. Interesting, monetary policy was not a major issue at the time. The public debate was more foicused on fiscal policy.

Economists still debate what caused the Depression. Several factors certainly played roles. The unequal distributions of wealth throughout the 1920s was a factor. The excessive stock market speculation and vulnerable financial system in the late 1920s was another factor. The persistent weakness of the farm sector also played a role. Perhaps what turned an economic down turn into the Great Depression was Government mismanagment of the crisis. President Hoover and Congress enacted the Smoot?? Harley tariff which imposed high protective tariffs. Foreign countries unable to sell to the United States enacted their own protective tariffs and international trade spiraled down, causing the economic down turn to entensify. The Federal Reserve was created to regulate the money supply. The Fed in response to the Stock Market Crash and economic decline severly cut the money supply by more than 25 pecent. One noted economnist believes that this was a very important factor not widely recognized at the time. The cause of the Depression is still a matter of economic debate. There is wide agreement on several important factors. The debate today is more about the relative importance of these major factors. Important to note that unlike some would like us to beliece, the Depression was not just caused by machinations of capitalist and bankers. The Government was also involved in a majpor way. Some economists believe that the Government may hve turned a recession, perhaps a serious recession, into the Great Depression.

Agricultural Boom and Bust (1915-29)

The Depression changed the lives of people who lived throughout rural America. The Depression in rural America actually began a decade before the Great Depression. The United States experienced after World War I experienced recession (1918-19) followed by a severe depression (1920-21). Urban America quickly recovered and enjoyed a secade of ecinimic expansion and growth. Rural America never recovered. This meant that when the the Stock Market creashed and the economy began to restrict that rural America was epecially vulnerable. And the subsequent drop in farm prices devetated rural America. Mny farmers were already behind on their mortgages and wil price declines they had no hope of keeping up payments or borrowing more money. And this only accentuated the economic spiral. Farmers unable to pay their mortgages put increasing pressure on banks, which were also troubled by defaults on loans to city residents. And this was made even worse when the farmers on the Great Plaines after the Depressiin began had to contend with a severe drought. Unappreciated by the pioneers that settled on the Great Planes after the Civil War, they were settling down on a fragil enviromental systm. The term eco-system had not yet entered the vocabulary. This was suddenly brought home by the dust storms and the new term Dust Bowl.

Industrial Boom and Bust (1915-29)

World War I did not cause an increase in American Industrial production to the same extent that it expanded agricultural production. Anerica did not gave alarge industry which is what the beligerant nations wanted. Orders did flow in for some industrial products. But orders also declined for the consumer products tht companies were exporting before the War. Consumers in the Allied countries could no longer afford these products. And the bekigerants iposed currency cintrols. The cental Powers were closed of the U.S. exportes by the Allied naval embargo. America did not expand its arms industry as it did in World War II. This was becaue therewas not enough time. The United States made no effort to mobilize before declaring war. The War only lasted a year and a half after we entered the United States declared war on Germany. America's industrial might had some impact in theWr, such as mass produced trucks. The United States has such a small arns industry that that Ameican Doughboys had to fight the War with British and French weapons. It was after the War in the Roaring 20s that American industry began wreckless expansion. The American export sector in the industrial heartland got drastically over-built in response to booming but unsustainable global demand for U.S. exports funded by debt raised on Wall Street during the 1920s. And the Government underwrote massive loans to Germany to finance the German World War I reparations. After the Wall Street Crash and unemployment grew in America abd overseas, massive ill-advised investments had to be written down. Over-built auto, steel, chemical and machinery capacity was idled. Major corporations faced with loss of markets and precipitous declines in revenue had to curtail or eliminate capital expenditutes (CapEx). This furtherreduced demand for goods and services in a hideous spiral.

Previous Administrations

President Hoover in the public mind received much of the blame for the Depression. He only took office a few months before the Wall Street crash, but he was Secretary of Commerce in the Cooldlidge Administration. There were three Republican presidents in the 1920s. Coolidge had replaced Presudent Harding who died in office and them was reelected on his own (1924). He was a popular president and escaped much of the blame as he was not in office whrn the economic crisis began. As he was president during much of the 1920s, his policies have to be assessed. All three Republican presidents (Harding, Coolidge, and Hoover) were fiscal conservatives. Hoover had however, to compromise his principles once the Depression began. What ever there other policies, their fiscal conservatism implemented by Treasury Secretary Andrew Mellon and efforts to pay off the debt ran up during World War I, put the United States Government on aound financial basis as it attemoted gto deal with the Depression crisis. The New Deal spending was in part possible beczuse of the fuscal prudence of his predecesors. Historians and economists are generally critical of Hsrding and Cooldlidge Coolidge for moving to undo the relatively mild regulatory system adopted during the Progrssive years (T. Roosevelt, Taft, and Wilson), both directly and through the new Rederal Reserve. In particular critics charge that the lack of regulation led to a feedinhg frency on Wall Street and unrestrained speculation. There was growth during the 1920s in housing and other areas. Critics charge that it was not sustauned growth. This has to be examined. Some Administration officials and many in Congress (both Democrats and Republicans) were comvinmced that markets were self regulating. Past economic history as well as the 2008-09 crisis demonstrated that they are not. The properregulations and limits on the regulatory burden, continue to be an issue today.

Uneven Wealth Distribution

The uneven distribution of wealth in the 1920s existed on many levels. Money was distributed unevenly among the the rich and poor, between industry and agriculture within the United States, and between the United States. and Europe. Labor Unions were week and were unable to demand fair salaries. Corporation and the wealthy were able to influence Goverment policies and decissions whch help to maintain the concentration of wealth in a few hands. A Brookings Institution study found that in 1929 the very wealthy (the top 0.1 percent of Americans) had a combined income equal to the bottom 42.0 percent. That same wealthy class in 1929 controlled 34 percent of all bank savings, while 80 percent of Americans had no savings at all, no cuchiom for emergencies. The uneven distributionof wealth also acted to reduce demand in the economy. inplybput, wokers that earned little, spent little. A major reason for the large and growing gap between the rich and the working class in America was low wages. Here the ability of companies backed by Government to curtail the union movement was a major factor. Manufacturing output increased throughout the 1920s. From 1923-29 the average manufacturing output per worker in America increased 32 percent. At the same time average wages for workers, most without string unions, with manufacturing jobs increased only 8 percent. Thus, wages increased at a rate only as fourth as fast as productivity increased. Thus there were fewer consumers for the increasing supply of goods being produced. The benefits of the increasingly efficent production went into corporate profits. Stock ownership, however, was concentrated in the hands of the relatively small moneyed class. Corporate profits from 1923-29 rose 62 percent and dividends rose 65 percents. The growing disparity of wealth between the wealthy and working class created instabilities in the economy. This made the economy function inefficently. For an economy to function smoothly, total demand must equal total supply. In an economy with such disparate incomes, demand usually does not equal supply. There was in the 1920s an increasing oversupply of goods. The surplus products of industrialized countries could not be purchased by poorly paid workers. The wealthy were satisfied by spending only a small portion of their income. The American economy came to rely on credit sales, luxury spending, and exports. Savings and investment were not being efficently used.
Credit: Buying on credit was a relatively new concept in post-World War I Amrica, but it proved immensly popular. Two of the most popular items in the 1920s were cars and radios. Henr Ford's mass production methods even before World war I had brought cars within the buying power of the average person. Commercial radio appeared in the 1920s. Early radiod were large pieces of furniture full of expensive tubes. They were expensive, but everyone wanted one. By the end of the 1920s, about 60 percent of cars and 80 percent of radios in America were purchased on installments credit. Between 1925 and 1929 the total amount of outstanding installment credit more than doubled from $1.4 billion to abpout $3 billion. Installment credit allowed one to get the item that he wanted right awau and "telescope" payments into the future. This device created "artificial" demand for products which people could not normally afford. There was a hidden time bomb in the installment system. Workers had in effect less disposable income from their weekly pay packets as substantial amounts went tompay the installment loans. In an expanding economy this can be handled. But the real income of workers in the 1920s was not expanding rapidly and farm income was actually falling.
Luxury spending: The U.S. economy in the 1920s was increasingly dependant on luxury spending and investment by the wealthy. Workers have to spend much of their income on the necesities of life. Luxury spending and investment is much more affected by economic trends. Such spending and investment is fueled by economic expansion and rising stock markets. When the wealty begin to lose confidence in the narket they cut back on both purchases of luxury goods and investment. The stock market crash in October 1929 thus caused a very significan reduction in luxury spending which had been a major support of the 1920s boom.

Vulnerable Financial System

Americans bought company stock in increasing numbers during the 1920s. Many smaller investors who had never before purchased stocks entered the market. Many were unsophisticated investors who bought on rumors or tips and purchased on margin. Most had no idea how to assess a stock's value. Investors searched for ever greater returns and turned to speculative issues. Government agencies did nor carefully control the issuance of stocks. Nor did government agencies carefully regulate banks. Depositor accounts were not insured. In the stock market frenzy, investment capital was not in many cases being efficently used. When the stock market crash came (October 1929), many speculative investors were wiped out. Worse came when banks started closing and even conservative investors lost their life savings.

Reducing the Money Supply

The Federal Reserve was created to regulate the money supply. The Fed in response to the Stock Market Crash and economic decline severly cut the money supply by more than 25 pecent. Monetary policy was not a major issue at the time. Political discourse was more focused on fiscal policy (taxes and spending). It now appears that monetary policy was the key factor. One noted economnist believes that this turned what might have been a severe recession into the Great Depression. [Friedman] Another important economist aggrees and believes that inappropriate tight monetary policy/increased in value of debt which help intensify a deflationary spiral. [Bernanke, Essays] This was a factor that was not widely recognized at the time and for quite some time after the Depression. It is difficult to believe that this ws not a factor in the Depression. And perhaps if the Fed had eased rather than tightened it might have moderated the dimensions of the Depression. Friedman and his disciple, Ben Bernanke, clearly beliece that it was the primary factor. Bernanke of course put this theory into action with Quatatative Easing during the financial crisis of 2008-09. [Bernanke. Courage.] It clearly staved off financial disaster. What is not yet clear is if it has prevented disaster or meerly postponed it and perhaps set he stge for an even more serious financial crisis. Less popular today is the idea that more imprtant was undetmining markets. The U.S. export sector in the industrial heartland got drastically over-built in response to booming but unsustainable global demand for U.S. exports funded by debt raised on Wall Street during the 1920s. Also because the farm belt became a bubble when Washington’s war loans during 1915-1920 turned it into the granary of the world. In the 1920s, agriclture was a much larger sector than is the case today.

International Trade

The international financial system was as a result of World War I seriously weakened. America had come out of the War an economic collosus. The economies of the European powers had been devestated. This included both the victorious Allies and the defeated Central Powers. The Allies had borrowed heavily from U,S. banks and after the War the United States demanded repayment. THe Allies at the Versailles Peace Conference forced Germany to accept guilt for starting the War and imposed huge reparations on Germany to pay for the war damages and to help reay the war debt to America. Germany was prostrate and in no condition to pay the repartriation imposed. American loans to the new German Republic were used to finance the repatrratins payments. For a time this worked, but the whole system was disrupted by the Wall Street crash. American banks could no longer afford huge loans to Germany. America at the time was the most important country in the world ecoinomy. Exporters like Britan Germany, and Japan depended on the U.S. market. The economic down-turn in America affected their exports. Worse was to come. The U.S. Congress enacted the Smoot-Hartley tariff. (President Hoover wanted higher tariffs on agricultural products, but not on manufactured goods. Even so, pressured by important Republicans and the ibndustrial lobby, President Hoover signed the bill into law.) The new law imposed high protective tariffs (1930). This in effect exported the American down turn abroad. Foreign countries unable to sell to the United States responded by enacting their own protective tariffs and international trade spiraled down. As a result, the recession intensifird.

The Gold Standard

A factor affecting both monetary policy and international trade was the gold standard. At the time of the Wall Street Crash it was regarded with almost religious reverence by the almost all important financial thinkers. The one major exception was British economist John Maynard Keynes. The major central bankes all supported the gold standard: Hjalmar Schacht (German Reich Bank), Montagu Norman (Bank of England), Benjamin Strong (American Federal Reserve), and Emile Moreau (Banque de France). One author argues that the commitment of the major financial institutions to the Gold Standard was especially disatrous in turning a recession into the Great Depression. [Ahamed] The gold standard not only acted to restrict intentional trade, but was a major factor in the vicious deflation which adversely affected domestic economomies. One by one the spiraling interntional crisis forced the major world powers off the Gold Standdard, eventually even Britain. America was the last to go. President Hoover was committed to the Gold Standard and admently refused to take America off of it. Govenor Roosevelt in the 1932 campaign had pledged to maintain the Gold Standard. The President in his First Hundred Days took the prelininary steps to take America off the Gold Standard (1933). One adviser, Lewsis Douglas was shocked, exclaiming, "It is the end of Western civilization." By the time the new president moved to take America off the gold standard, the damage had been done. The international financial system was in disaray and more omniously, the financial crisis had brought Adolf Hitler to power as the new Germsan Chancellor.

Bankers and Financers

President Roosevelt and many Democrats suceeded in placing the blame for the Depression on bankers and businessmen. A similar phenomenon can be see with President Obama and the liberal Dmocrats during the Great Recesion (2007- ). In the case of President Roosevelt it was because the science of economics was not suffucetly advance to identify the causes of marlet fluctuations. In the case pf Preident Obama and the liberal DEmocrats it is a mixture of ideologicl regidity and political advantage. It is now clear that Government officils and Congressional leaders played a major role in both causing the Depression and prolonging it. hey pursued policies which turned a moderate recession into the Great Depressipn. At the time ghis was not undertood and the politicans who brought about the Depression did their best to blame babkers and financeers. One of the men at the top of the Governmnt hit list was the president of City Bank, Charles E. Mitchell. He had saved the Bank from losses incurred lending money to Cuban sugar planters. He built City into America's first financial supermarket. He became the main target of the Pecora Commission hearings. He was then arrested, but not convcted for income tax evasion. Congress passed the Glass-Stegall Act (933). This prohibited the blending of banking and securities trading, a financial strategy that Mitchell had championed.


Ahamed, Liaquat. Lords of Finance: The Bankers Who Broke the World (2009).

Bernanke, Ben. Essays on the Great Depression (Princetoin University Press). Bernanke is a former Princeton University economist appointed to chair the Federal Reserve by President Bush. He is widely considered the pre-eminent living scholar of the Great Depression.

Bernanke, Ben. The Courage to Act.

Friedman, Milton.


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Created: 5:08 PM 10/15/2008
Last updated: 2:42 PM 1/21/2016