The Great Depression

The Great Depression was the greatest and longest economic recession in modern world history. It began with the U.S. stock market crash of 1929 and did not end until 1946 after World War II. Economists and historians often cite the Great Depression as the most catastrophic economic event of the 20th century.

During the short depression that lasted from 1920 to 1921, known as the Forgotten Depression, the U.S. stock market fell by nearly 50%, and corporate profits declined over 90%. However, the U.S. economy enjoyed robust growth during the rest of the decade. The Roaring Twenties, as the era came to be known, was a period when the American public discovered the stock market and dove in head first.

Speculative frenzies affected both the real estate markets and the New York Stock Exchange (NYSE). Loose money supply and high levels of margin trading by investors helped to fuel an unprecedented increase in asset prices. The lead-up to October 1929 saw equity prices rise to all-time high multiples of more than 30-times earnings, and the benchmark Dow Jones Industrial Average increased 500% in just five years.

• The Great Depression was the greatest and longest economic recession in modern world history.
• The American public began a frenzy of investing in the speculative market in the 1920s.
• The 1929 market crash wiped out a great deal of nominal wealth for individuals and businesses alike.
• Other factors including inactivity followed by overaction by the Fed also contributed to the Great Depression.
• Both Presidents Hoover and Roosevelt tried to mitigate the impact of the depression through government policies.
• Neither the government policies or the beginning of WWII can be single-handedly credited with ending the depression.
• Trade routes created during WWII remained open and helped the market recover.

The NYSE bubble burst violently Oct. 24, 1929, a day that came to be known as Black Thursday. A brief rally occurred Friday the 25th and during a half-day session Saturday the 26th. However, the following week brought Black Monday, Oct. 28, and Black Tuesday, Oct. 29. The Dow Jones Industrial Index (DJIA) fell more than 20% over those two days. The stock market would eventually fall almost 90% from its 1929 peak.

Ripples from the crash spread across the Atlantic Ocean to Europe triggering other financial crises such as the collapse of the Boden-Kredit Anstalt, Austria’s most important bank. In 1931, the economic calamity hit both continents in full force.

The 1929 stock market crash wiped out nominal wealth, both corporate and private, and sent the U.S. economy into a tailspin. In early 1929, the U.S. unemployment rate was 3.2%; and by 1933, it had soared to 24.9%. Despite unprecedented interventions and government spending by both the Herbert Hoover and Franklin Delano Roosevelt administrations, the unemployment rate remained above 18.9% in 1938. Real per capita gross domestic product (GDP) was below 1929 levels by the time the Japanese bombed Pearl Harbor in late 1941.

While the crash likely triggered the decade-long economic downturn, most historians and economists agree that the crash alone did not cause the Great Depression. Nor does it explain why the slump's depth and persistence were so severe. A variety of specific events and policies contributed to the Great Depression and helped to prolong it during the 1930s.

The relatively new Federal Reserve (the Fed) mismanaged the supply of money and credit before and after the crash in 1929. According to monetarists such as Milton Friedman and acknowledged by former Federal Reserve Chairman Ben Bernanke.

Too-Easygoing in the '20s

Created in 1913, the Fed remained inactive throughout the first eight years of its existence. After the economy recovered from the 1920 to 1921 depression, the Fed allowed significant monetary expansion. Total money supply grew by $28 billion, a 61.8% increase between 1921 and 1928. Bank deposits increased by 51.1%, savings and loan shares rose by 224.3%, and net life insurance policy reserves jumped 113.8%. All of this occurred after the Federal Reserve cut required reserves to 3% in 1917. Gains in gold reserves via the Treasury and Fed were only $1.16 billion.

By increasing the money supply and keeping the interest rate low during the decade, the Fed instigated the rapid expansion that preceded the collapse. Much of the surplus money supply growth inflated the stock market and real estate bubbles. After the bubbles burst and the market crashed, the Fed took the opposite course by cutting the money supply by nearly a third. This reduction caused severe liquidity problems for many small banks and choked off hopes for a quick recovery.

Too Tight-Fisted in the '30s

As Bernanke noted in a November 2002 address, before the Fed existed, bank panics were typically resolved within weeks. Large private financial institutions would loan money to the strongest smaller institutions to maintain system integrity. That sort of scenario had occurred two decades earlier, during the Panic of 1907.

When frenzied selling sent the New York Stock Exchange spiraling downward and led to a bank run, investment banker J.P. Morgan stepped in to rally Wall Street denizens to move significant amounts of capital to banks lacking funds. Ironically, it was that panic that led the government to create the Federal Reserve to cut its reliance on individual financiers such as Morgan.

After Black Thursday, the heads of several New York banks had tried to instill confidence by prominently purchasing large blocks of blue-chip stocks at above-market prices. While these actions caused a brief rally Friday, the panicked sell-offs resumed Monday. In the decades since 1907, the stock market had grown beyond the ability of such individual efforts. Now, only the Fed was big enough to prop up the U.S. financial system.

However, the Fed failed to do so with a cash injection between 1929 and 1932. Instead, it watched the money supply collapse and let literally thousands of banks fail. At the time, banking laws made it very difficult for institutions to grow and diversify enough to survive a massive withdrawal of deposits or run on the bank.

The Fed's harsh reaction, while difficult to understand, may have occurred because it feared that bailing out careless banks would only encourage fiscal irresponsibility in the future. Some historians argue that the Fed created the conditions that caused the economy to overheat and then exacerbated an already dire economic situation.

Although often characterized as a "do-nothing" president, Herbert Hoover did take action after the crash occurred.

Propped-Up Prices

Between 1930 and 1932, he increased federal spending by 42% engaging in massive public works programs such as the Reconstruction Finance Corporation (RFC) and raising taxes to pay for the programs. The president banned immigration in 1930 to keep low-skilled workers from flooding the labor market. Unfortunately, many of his and Congress' other post-crash interventions—wage, labor, trade and price controls—damaged the economy's ability to adjust and reallocate resources.

One of Hoover's main concerns was that workers' wages would be cut following the economic downturn. To ensure high paychecks in all industries, he reasoned, prices needed to stay high. To keep prices high, consumers would need to pay more. The public had been burned badly in the crash, and most people did not have the resources to spend lavishly on goods and services. Nor could companies count on overseas trade, as foreign nations were not willing to buy overpriced American goods any more than Americans were.

Protectionism

This bleak reality forced Hoover to use legislation to prop up prices and hence wages by choking out cheaper foreign competition. Following the tradition of protectionists, and against the protests of more than 1,000 of the nation's economists, Hoover signed into law the Smoot-Hawley Tariff Act of 1930. The Act was initially a way to protect agriculture but swelled into a multi-industry tariff, imposing huge duties on more than 880 foreign products. Nearly three dozen countries retaliated, and imports fell from $7 billion in 1929 to just $2.5 billion in 1932. By 1934, international trade had declined by 66%. Not surprisingly, economic conditions worsened worldwide.

Hoover's desire to maintain jobs and individual and corporate income levels was understandable. However, he encouraged businesses to raise wages, avoid layoffs, and keep prices high at a time when they naturally should have fallen. With previous cycles of recession/depression, the United States suffered one to three years of low wages and unemployment before dropping prices led to a recovery. Unable to sustain these artificial levels, and with global trade effectively cut off, the U.S. economy deteriorated from a recession to a depression.

Voted into office in 1933, President Franklin Roosevelt promised massive change. The New Deal he initiated was an innovative, unprecedented series of domestic programs and acts designed to bolster American business, reduce unemployment, and protect the public.

Loosely based on Keynesian economics, its concept was that the government could and should stimulate the economy. The New Deal set lofty goals to create and maintain the national infrastructure, full employment, and healthy wages. The government set about achieving these goals through price, wage, and even production controls.

Some economists claim that Roosevelt continued many of Hoover's interventions, just on a larger scale. He kept in place a rigid focus on price supports and minimum wages and removed the country from the gold standard, forbidding individuals to hoard gold coins and bullion. He banned monopolistic, some consider them competitive, business practices, and instituted dozens of new public works programs and other job-creation agencies.

The Roosevelt administration paid farmers and ranchers to stop or cut back on production. One of the most heartbreaking conundrums of the period was the destruction of excess crops, despite the need for thousands of Americans to access affordable food.

Federal taxes tripled between 1933 and 1940 to pay for these initiatives as well as new programs such as Social Security. These increases included hikes in excise taxes, personal income taxes, inheritance taxes, corporate income taxes, and an excess profits tax.

The New Deal re-instilled public confidence, as there were measurable results, such as reform and stabilization of the financial system. Roosevelt declared a bank holiday for an entire week in March 1933 to prevent institutional collapse due to panicked withdrawals. A program of construction of a network of dams, bridges, tunnels, and roads still in use followed. The projects offered employment for thousands via federal work programs.

Although the economy recovered to an extent, the rebound was far too weak for the New Deal policies to be unequivocally deemed successful in pulling America out of the Great Depression.

Historians and economists disagree on the reason. Keynesians blame a lack of federal spending—Roosevelt did not go far enough in his government-centric recovery plans. Conversely, others claim that by trying to spark immediate improvement, instead of letting the economic/business cycle follow its usual two-year course of hitting bottom and then rebounding, Roosevelt, like Hoover before him, may have prolonged the depression.

A study by two economists at the University of California, Los Angeles, published in the August 2004 Journal of Political Economy estimated that the New Deal extended the Great Depression by at least seven years. However, it is possible that the relatively quick recovery, characteristic of other post-depression recovers, may not have occurred as rapidly post-1929. This difference is because it was the first time that the general public, and not just the Wall Street elite, lost large amounts in the stock market.

Robert Higgs, an American economic historian, has argued that Roosevelt's new rules and regulations came so fast and were so revolutionary—as were his decisions to seek third and fourth terms—that businesses became afraid to hire or invest. Philip Harvey, a professor of law and economics at Rutgers University, has suggested that Roosevelt was more interested in addressing social welfare concerns than creating a Keynesian-style macroeconomic stimulus package.

According to the gross domestic product (GDP) and employment figures only, the Great Depression appeared to end suddenly around 1941 to 1942, just as the United States entered World War II. The unemployment rate fell from 8 million in 1940 to under 1 million in 1943. However, more than 16.2 million Americans were conscripted to fight in the Armed Services. In the private sector, the real unemployment rate grew during the war.

Due to wartime shortages caused by rationing, the standard of living declined, and taxes rose dramatically to fund the war effort. Private investment dropped from $17.9 billion in 1940 to $5.7 billion in 1943, and total private sector production fell by nearly 50%.

Although the notion that the war ended the Great Depression is a broken window fallacy, the conflict did put the United States on the road to recovery. The war opened international trading channels and reversed price and wage controls. Suddenly, there was government demand for inexpensive products, and the demand created a massive fiscal stimulus.

When the war ended, the trade routes remained open. In the first 12 months afterward, private investments rose from $10.6 billion to $30.6 billion. The stock market broke into a bull run in a few short years.

The Great Depression was the result of an unlucky combination of factors—a flip-flopping Fed, protectionist tariffs, and inconsistently applied government interventionist efforts. It could have been shortened or even avoided by a change in any one of these factors.

While debate continues as to whether the interventions were appropriate, many of the reforms from the New Deal, such as Social Security, unemployment insurance, and agricultural subsidies, exist to this day. The assumption that the federal government should act in times of national economic crisis is now strongly supported. This legacy is one of the reasons the Great Depression is considered one of the seminal events in modern American history.