1) Which were the primary causes of the Great Depression?
According to Walton and Rockoff, an acceptable explanation for the Great Depression has to distinguish between the initial forces, which brought a downturn in financial activity, and later events, that turned a downturn into a calamity. We can detect two issues on the economy that foreshadowed the real slump in economic activity. First, there was a decline in the construction industry that began 1925, that had a significant impact on the depression. Second, the agricultural sector suffered greatly, with falling world prices and massive indebtedness (422).
Walton and Rockoff posit that a minor slump in GDP could be expected, but no catastrophe had been on sight. Unexpectedly, the stock market crashed in 1929, after many booming years, that had even called for mild government intervention, in the form of raised interest rates. However, on the last days of October and the beginning of November, there was a sale panic in the stock market. Stock prices fell nearly 50%, wiping out the gains obtained in 1927 and 1928. Were it only the price drop, things might not have been so hard, but there was a unique psychological trauma: since the 1920s many Americans had come to believe that the economy had entered a ‘new era’ of continuous progress, and the soaring stocks were perceived as the proof of such improved living standards. The marketplace crashed and brought along the optimistic view, and people at large started to see the future with pessimism (424-425).
Moreover, the stock market crash was followed by terrible banking crises. In October 1930, many banks failed in the Southern and Midwestern U.S., which attracted little attention. But on December 11, the Bank of United States in New York failed, and that was then the largest American bank failure. The Federal Reserve, following the liberal economic recipes of the time – that suggested little to no intervention – decided not to lend funds to troubled banks. Walton and Rockoff indicate that the Fed should have lent as much as possible to the financial institutions, passing the clear message to bank clients that their banks would not fail (424-429).
Since the Federal Reserve did not follow this policy, the classic sign of a bank panic ensued: at times, a rumor that a bank was in trouble would send people running to the agencies to try to get their money out before it closed its doors. The fear of bank failures led individuals to convert deposits into cash, depleting bank reserves. Banks, in response to falling reserves, cut their lending and raised interest rates. The whole economy started to suffer from the credit shrinkage.
Graham, Hazarika, and Narasimhan published an article in which they defend that high leverage increased somewhat the chances of turning distressed during the Great Depression. The authors study the use of additional debt due to tax incentives (which they call the ‘debt bias’) and estimate that highly taxed companies used more debt during the Depression era.
Walton and Rockoff describe that events abroad reinforced the crisis in the United States. In May 1931, a major Austrian bank failed, and in July bank failures happened in Germany, and later still in England, which had to abandon the gold standard for the Sterling Pound. The U.S. dollar, still convertible into gold, fell under more strain, as an increasing number of people started to convert cash into gold. When President Roosevelt took office on March 4, 1933, more than 5,000 banks had failed since 1930, and the financial system had, for all practical purposes, stopped to work (429-430).
In other words, Walton and Rockoff describe that the United States was experiencing what was considered a minor economic downturn in specific sectors (agriculture and constructions), but the stock market crash and ensuing bank panic – fueled by the inaction of Federal Reserve officials – generated a terrible downward spiral that turned the recession into a brutal depression.
And in fact, the initial measures of Roosevelt seem to corroborate the ‘downward spiral’ thesis. The new president took a few measures to increase the confidence in the banking system, which included bank holidays, during which banks were supposedly inspected, and just the ones that were sound could be reopened. Panic subsided. President Roosevelt followed suit and created the Federal Deposit Insurance Corporation (FDIC) to insure bank deposits. As a result, the banking crisis nearly stopped: the number of bank failures fell to 61 in 1934, and remained flat onwards (Walton and Rockoff 430).
However, there is an alternative theory to the causes of the Great Depression that has been gaining much ground in the previous years. The Austrian school of economics, whose most prestigious member was Friedrich Hayek (Economics Nobel Prize winner of 1974), posits that the distortions built up throughout the economy in the 1920s caused the recession. Namely, the Federal Reserve offered much of the ‘easy money’ which fueled the stock and real estate price rise of the 1920’s that it followed in their view. For the Austrians, once the economy had become distorted, a necessary correction in the shape of a depression had been inescapable. Furthermore, Roosevelt’s New Deal policies that interfered with the adjustment of prices and reallocation of resources only served to slow the recovery, according to the Austrians, as described by Walton and Rockoff (430).
Another author, Eddlem, posits that Hayek's ‘Monetary Theory and the Trade Cycle’ (published in 1929) predicted the Great Depression some time before it happened. Eddlem mentions the 1974 Nobel committee press release about Hayek’s award:
Perhaps, partly due to this more profound analysis, he was one of the few economists who gave warning of the possibility of a major economic crisis before the great crash came in the autumn of 1929. Von Hayek showed how monetary expansion, accompanied by lending which exceeded the rate of voluntary saving, could lead to a misallocation of resources, particularly affecting the structure of capital. This type of business cycle theory with links to monetary expansion has fundamental features in common with the postwar monetary discussion.
(qtd. in Eddlem)
Hayek defended that the Federal Reserve had favored an inflationary, easy-credit policy under the Hoover administration, accelerated by the Roosevelt presidency, that dragged out the Depression. The Austrian economist criticized the central banks that, instead of following a deflationary policy, undertook credit expansion. He claimed that the effect was the Depression lasting longer and remaining more severe than any preceding event (Eddlem).
2) Why did the Great Depression last so long?
Walton and Rockoff state that the usual account of the length of the Great Depression points to how far the economy had fallen, and the fact that there was a recession within the depression that pushed the end a few years forward (439). However, prominent economists such as Joseph Schumpeter (in the 1930s) and Robert Higgs (in the late 1990s) claim that the amount of private investment spending remained depressed for too long. This would have been the blame of the political weather of the New Deal, discouraging investment. The rhetoric and many measures of the New Deal were often antibusiness: President Roosevelt even criticized those who “received a disproportionate number of national income”, according to Walton and Rockoff (439-440). Businessmen resented undertaking investments for the long term since they feared earnings might be taken away by future legislation. This is an argument that the academia has been unable to prove or to disprove. However, policies such as the National Industrial Recovery Act (1933) and the National Labor Relations Act (1935) allowed for firm collusion and for wages to not decrease their value. Walton and Rockoff indicate that economic theory provides persistent unemployment as a consequence of such measures (440).
On the other hand, Monetarists blame the unusual length of the depression on the failure of the Federal Reserve’s monetary policy. If the Federal Reserve had increased the cash supply rapidly and steadily, as opposed to allowing it to plunge during the Great Crash of 1929–1932 and in the recession within the depression, the Great Depression would have never reached the proportions it did. The authors mention a 1983 work by Ben Bernanke (himself the chairperson of the Fed during the Great Recession, in the late 2000s), whose analysis of the banking system helps explain why the depression lasted so long. He posits the notion that bank lending takes into account long-term relationships between financial institutions and clients. When the bank system collapsed, it took time for the surviving banks to forge new relationships with borrowers. If the bank system been saved in the early depression (around 1930), lending could have been restored much sooner. Not surprisingly, that was the stance that Chairman Ben Bernanke took in the initial days of the Great Recession (Walton and Rockoff 441).
Finally, as previously mentioned, Eddlem points out that Hayek contended that the mistake had been the Federal Reserve option for an inflationary policy under the Hoover and the Roosevelt presidencies, which extended the Great Depression. The Austrian economist suggested - contrary to the monetarist stance - that central banks should have undertaken a restrictive monetary policy, with deflationary effects, instead of credit expansion.
As we can see, the schools of economic thought have divergent views of the same phenomenon, and as a result, each describes a different remedy to the same malaise. As a result of Bernanke's successful bout against the Great Recession, it is likely that his theory has gained much acceptance and will probably be the standard fare of basic Macroeconomics textbooks of the future. It should be noted, however, that the central bankers of the early XXI century have significantly gained from the experimenting and failing from their counterparts of the 1930s. Most of us have a firsthand account of the adverse impacts of the recent recession, hence to bear witness to the evolution of economic thought, and to realize its relevance to policymaking is good fortune and a privilege.
Works Cited
Eddlem, Thomas R. "Austrian Economics Rising: Austrian Economists Predicted the Great
Depression and America's Present Troubles, but Are Only Now Gaining Recognition." New American 26 Apr. 2010: 10+. Questia. Web. 10 May 2016.
Graham, John R., Sonali Hazarika, and Krishnamoorthy Narasimhan. "Financial
Distress in the Great Depression." Financial Management 40.4 (2011): 821+. Questia. Web. 10 May 2016.
Walton, Gary M., and Hugh Rockoff. History of the American Economy. 12th ed. Mason:
South-Western, 2014. Print.
