Causes of the Great Depression

Topic Summary:
Main causes of the Great Depression

Although most people associate the Great Depression as a result of the Stock Market crash of 1929, many failed to realize that the depression was the result of many other contributing factors as well. A stock market crash do not necessarily always result in a depression, in 1987 there was a crash that did not lead the total economic chaos like that in 1929.
During the era of the ???Roaring Twenties??? America went through a Cultural Revolution. America was very prosperous and the people reflected in high spirits and gay times. The nation turned inward after the war and away from foreign issues and concerns. The nation??™s isolationism attitude also directly reflected the economic ideals of that time as well. The nation??™s new modern industry was able to mass-produce many different items and America was feeling independent on manufacturing as a whole. But because of this another problem rose, prosperity could continue only if demand was made to grow as rapidly as supply. Accordingly, people had to be pushed to abandon traditional values as saving, postponing pleasures and purchases, and buying only what they needed. Advertising methods that had been developed to build support for World War I were now being used to get people to buy new products such as automobiles, radios and household appliances. The resulting mass consumption kept the economy going through most of the 1920s. This whole time led to a sense of false prosperity. The people thought that if they cold keep tariffs high with the Hawley-Smoot tariff, they could also keep out foreign competition and increase American manufacturing and trading on the homefront. The idea was sell more American items to Americans and keep the prosperity with the U.S. borders. With the American high tariffs, the other countries retaliated with tariffs just as high towards American goods.
At this time the income was being distributed very inproportionally. The portion of the money going to the wealthy just got larger. This was due to mainly two factors: even though business showed large gains in productivity in the 20s, workers for a smaller share of the wealth. Huge cuts were also made in the top income-tax rates. Between the years of 1923 and 1929, manufacturing output increased 32 percent, but wages only increased by 8 percent. Under Coolidge, the Revenue Act of 1926 was passed that allowed banks to lend out about four million. The Revenue Act cut the taxes of those making $1 million or more by more than two-thirds. This new wide expansion of credit created the seed for the stock market collapse in 1929. With all the money circulating, and the reduced interest rates, the economy was stimulated. People were allowed to “buy now, pay later.” But this only put off the day when consumers accumulated so much debt that they could not keep buying up all the products coming off assembly lines. In 1929, American farmers who represented a quarter of the economy had already been in an economic depression since the early 20s. This made it difficult for them to take part in the consumer-buying race. After the war, the farmers found themselves competing in an over-supplied international market. The prices dropped ad they were often unable to sell their products for a profit.
After the war the United Stated as Europe??™s chief creditor. The foreign countries struggled to pay off their debts with weakened economies. Many of the American bankers were not familiar with this role as they lent heavily and unwisely to European borrowers in Europe. The huge debts made the international banking structure highly unstable. The U.S. also kept high tariffs on good from other countries at the same time that it was making foreign loans and trying to export goods. They failed to realize that if other nations could not sell their goods in the United States, they could not make enough money to buy American products or repay American loans. All major industrial countries pursued similar policies of trying to advance their own interests without regard to the international economic consequences. In 1927 the Federal Reserve Board hurt the economy by inserting more money into circulation. As a result people were put into debt and overspeculation skyrocketed. By sending false signals to businessmen, the credit expansion and reduced interest rates led to price increases. Soon the businesses couldn??™t keep up.
In the 1920s the overspeculation led to many people buying stocks with loaned money with a ten- percent margin. The money was loaned was used as the collateral for buy more and more stocks. The rising incomes of the wealth in American fueled rapid growth in the stock market. Soon the stock prices were transcending far beyond the worth of shares they represented. People were willing to pay the inflated prices because they thought the stock prices would continue to rise and they could sell them as a profit. Regular American were getting into the market fever and investing their parts into the economy. Since the market wasn??™t very stable, careful investors began to sell their stocks to take in their profits. The prices began to further decline as more and more stock was sold. On ???Black Thursday??? October 24, 1929, the prices continued to drop. Soon people realized what was happening and the panic broke. Thousands of investors were financially ruined, and by the end of the year, stock market values had dropped fifteen billion dollars.
Although the stock market crash announced the beginning of the Great Depression, deep economic problems had already begun a few months earlier to start the downward spiral. The credit portion of the nations consumers had been exhausted, and they were spending too much of their current income to pay for past, rather than new, purchases. Unsold inventories began to pile up in warehouses during the summer of 1929. Many of the banks which had speculated heavily with their deposits were wiped out by the falling prices, and these bank failures sparked a “run” on the banking system. Each failed bank, factory, business, and investor contributed to the downward spiral that would drag the world into the Great Depression. The crash almost hit the whole nation and forever changed the lives of countless Americans. The crash reduced the ability of the economy to fight off the underlying sicknesses of unevenly distributed wealth, agricultural depression, and banking problems.

Key Terms:

The Stock Market Crash
The Stock Market Crash in October of 1929 is often cited as the beginning of the Great Depression, but did it actually cause it The answer is no. First, the stock price for a particular company merely reflects current information about the future income stream of that particular company. Thus, it is a change in available information that changes the stock price. When the Fed began to raise interest rates in early 1929, this began the tumble. However, a stock market crash could cause people to increase their liquidity preference which might lead them to hoard money.
Roaring Twenties
Society during the twenties had a false sense of prosperity. Overspeculating and buying on credit made, which made fiscal matters unreliable. So when the Federal Reserve over-inflated currency and the market were flooded with cheap goods, it brought the Crash of 1829, destroying the economy.
Dawes Plan
The Dawes plan was the merry-go-round of American credit. The complicated financial cycle had the United States loaning money to Germany, Germany paid reparations to France and Britain, and the former Allies paid war debts to the United States. The U.S. never received a full reimbursement from its debtors, and President Hoover had to declare a one-year debt moratorium. In debt and with high tariffs, the nation??™s economy became very unstable and lost its foundation of a strong currency.
Fordney-McCumber Act of 1922
It established an original average duty off 38.5 percent on nonfree goods. This was the beginning of the tightening trade belt and of economic warfare on the entire outside world. The United States began to practice economic isolationism, both at home and abroad, increasing the international financial chaos.
John Maynard Keynes
Keynes demonstrated that once banks realize that deflation has significantly impaired the value of their collateral, they become particularly anxious that the remainder of their assets should be as liquid and as free from risk as it is possible to make them. This reacts in all sorts of silent and unobserved ways on new enterprise. For it means that banks are less willing than they would normally be to finance any project and that in looking at the tracks of interest rates in the Great Depression, you can see a steady widening of the gap between safe interest rates on government securities and the interest rates that borrowing companies had to pay. Even though credit was ample ??“ in the sense that borrowers with perfect and unimpaired collateral could obtain loans at extremely low interest rates ??“ the businesses in the economy (few of which had perfect and unimpaired collateral) found it next to impossible to obtain capital to finance investment.
Secretary of Treasury Andrew Mellon
Expecting the recession of 1929-1930 to be self-limiting. Earlier recessions had come to an end when the gap between actual and trend production was as large as in 1930. Mellon and many other businessmen expected workers with idle hands and capitalists with idle machines to try to undersell their still at-work peers. Prices would fall. When prices fell enough, entrepreneurs would gamble that even with slack demand production would be profitable at the new, lower wages. Production would then resume. This, however, was a mistake because it would cause a production decline and wages for many workers were diminished.
buy on margin
Practice of buying stocks by paying 10 to 50 percent of the full price and borrowing the rest; common in the 1920s before the stock market crash of 1929. This was considered a cause of the depression because it lead to financial panic which was a major part of the depression, the lack of financial funds.
Debt-Deflation
Governments strained their muscles to balance their budgets ??“ thus further depressing demand ??“ and to reduce wages and prices ??“ in order to restore “competitiveness” and balance to their economies. In Germany the Chancellor ??“ the Prime Minister ??“ Heinrich Bruening decreed a ten percent cut in prices, and a ten to fifteen percent cut in wages, but every step taken in pursuit of financial orthodoxy made matters worse. For once the declines in wages and prices in the Great Depression had passed some critical value, they knocked the economy out of its normal business-cycle pattern. Severe deflation had consequences that were much more than an amplification of the modest five to ten percent falls in prices that had been seen in past depressions. When banks make loans, they allow beforehand for some measure of fluctuation in the value of the assets pledged as security for their loans: even some diminution of the value of their collateral will not cause banks to panic, because if the borrower defaults they will still be able to recover their loan principal as long as the decline in the value of the collateral is not too high. Banks become keenly aware that their loan principal is no longer safe: that if the borrower defaults, they no longer have recourse to sufficient collateral to recover their loan principal. If the borrower defaults, and if bank depositors take the default as a signal that it is time for them to withdraw their deposits, the bank collapses.
The unstable economy
The economy was not stable. National wealth was not spread evenly. Instead, most money was in the hands of a few families who saved or invested rather than spent their money on American goods. Thus, supply was greater than demand. Some people profited, but others did not. Prices went up and Americans could not afford anything. Farmers and workers did not profit. Unevenness of prosperity made recovery difficult.
Hoarding Money
People hoard money because they have a liquidity preference. I.e., people want to have their assets in a readily convertible form, such as money. There are several misconceptions about hoarding money. First hoarding is not the same thing as saving. If I put my money into a savings account, that money is lent out to someone else who then spends it. Second, hoarding, by itself, cannot cause a recession or depression. As long as prices and wages drop instantly to reflect the lower amount of money in the economy, then hoarding causes no problems. Indeed, hoarding can even be seen as beneficial to those who dont hoard, since their money will be able to buy more goods as a result of the lower prices.
If a country has a gold standard, then hoarding money can make the money supply drop dramatically since a gold standard makes the quantity of money difficult for the government to control.
National debt
This is the total debt of the federal government. The United States federal government, unpaid with war reparations, was now in debt. In order to regain the surplus in the national Treasury, the government had to inflate prices. The economic foundation was not stable, with overspeculation and buying on credit. Once the foreign market began to sell cheap products, the domestic stocks plummeted. The inflated prices of the nation??™s economy caused the debtors to lose catastrophic amounts of money

The Federal Reserve Board
The Federal Reserve Board (FRB) was ostensibly created to prevent bank panics and Depressions. It is possible that the FRB was actually responsible for the Depression. The FRB took several actions that, in retrospects, which were quite bad. The first thing it did was to inflate the money supply by about 60% during the 1920s. If the FRB had been a little more careful in expanding the money supply, it might have prevented the artificial Stock market boom and subsequent crash. Second, there are indications that the economy was starting to cool off on its own in early 1929, thus making the interest rate hike in TBD completely unnecessary and avoiding the subsequent crash. The third mistake the FRB made was in early 1931. The FRB raised interest rates, exactly the wrong thing to do during a contraction. Ironically, the countrys gold stock was increasing at this point all on its own, so doing nothing would have increased the money supply and helped the recovery. But even with all that bungling, it is not clear that we can lay responsibility for the Great Depression at the feet of the Fed.

public works programs
Government-funded projects to build public facilities central to President Franklin Roosevelt??™s New Deal job programs. This was a cause to the depression because it caused a depletion in the funds and used much of the needed money during the depression.
Malinvestment
“Malinvestment” is a term coined by the Austrian school of economics to sum up their explanation of the causes of business cycles. According to this theory, all business cycles are caused by government intervention in the market. Specifically, the central bank (the Fed in the case of the U.S.) artificially lowers the interest rate, flooding the economy with money. This money is then invested in capital goods that would not be justified at a market level of interest rates. The low interest rate cannot be sustained forever without an increase in inflation, so the Fed inevitably has to raise interest rates. When this happens, the investments that were “justified” under a lower interest rate must be liquidated. Any prevention of this liquidation by further government intervention will simply prolong the re-adjustment and thus exacerbate the recovery.
Sticky Prices/Sticky Wages
Prices and wages change in accordance to the scarcity of goods and labor relative to the amount of money that is available to buy them. For example, if the Federal Reserve Board increases the nations money supply, then prices and wages will tend to go up, reflecting the fact that more money is chasing the same amount of goods and labor. When the FRB does too much of this, it is called inflation. When the money supply goes down relative to the amount of goods and labor, eventually, the price of goods and labor will go down as well in the long run. But in the short run, prices and wages can “stick” at a higher level than the market clearing price or wage. When this happens, people buy less and employers hire less, thus causing cut backs in production and employment. There are a number of reasons, why prices and wages might stick. One reason is referred to as “menu costs,” meaning that it often costs money to change a price. A good example is a restaurant that has to print new menus every time the prices change.

The Smoot-Hawley Tariff
The Smoot-Hawley Tariff Act was passed in June of 1930. Since this occurred after the onset of the Depression, its hard to see how it could have caused it. However, since the real effect of the increased tariffs was to increase prices and increase price rigidity, it is easy to see how the Act could have exacerbated the Depression. Enacting the tariff was exactly the wrong thing to do and about 1,000 economists signed a petition begging Congress not to pass it.

The Gold Standard
At the time of the Great Depression, America had a 100% gold standard for its money. This meant that all cash was backed by a government promise to redeem it in a specific amount of gold (at the time, TBD ounces for one dollar). Because the amount of money circulating in the economy is wholly dependent on the amount of gold available, the money supply is very rigid. If people start to hoard money (see above) the money supply can drop drastically. As noted in the previous section on hoarding, this is not a problem as long as prices and wages drop instantly to reflect the lower amount of money circulating.