The Great Depression (1929–41) was the most severe period of economic decline in the history of the United States. During the Great Depression, U.S. output declined by one-third, the unemployment rate reached 25 percent, the STOCK MARKET declined by 40 percent, and over 9,000 banks failed. The depression brought an end to the Roaring Twenties, a period of euphoria in the country marked by increasing output and INCOME, Federal Reserve management of the MONEY SUPPLY, and significant technological advances. The causes of the depression are still being debated, and economists’ lists of the contributing factors include
• TARIFFs
• overproduction
• the FEDERAL RESERVE SYSTEM
• the gold standard
• malinvestment
• rigid wages and prices
• distribution of WEALTH and power
During the economic boom of the 1920s, U.S. manufacturers significantly increased their export activity. Previously there was sufficient domestic DEMAND for new industrial output, and U.S. firms largely ignored EXPORTING. With the decline in 1929, Congress passed the infamous SMOOT-HAWLEY TARIFF ACT increasing tariffs an average of 60 percent. European countries and Canada quickly reciprocated causing a collapse in international trade. Overproduction during the 1920s, both in industry and agriculture, resulted in declining prices. Declining prices are generally considered beneficial, reducing costs and controlling INFLATION. However, when price declines are widespread, DEFLATION occurs, and when deflation reaches a critical stage, it impacts financial markets, primarily banks. (At one point during the depression, prices fell 10 percent a year). Today many financial institutions make LOANS to businesses and deposit INSURANCE protects accounts, but in the 1920s, commercial banks almost exclusively provided business loans and FDIC insurance did not exist. When deflation occurs, the value of ASSETS decline. Eventually (as in Japan in the 1990s), banks have loans for which the collateral is worth less than the amount loaned; the result is bank failure. In the early 1930s, over 9,000 U.S. banks failed, with depositors losing everything they had in the failed banks. Seeing their life savings disappear, many reacted by withdrawing any funds left in existing banks, contributing to a run on the BANKING SYSTEM. Future savings were also hoarded, buried in Mason jars, stuffed in mattresses—put anywhere but in banks. Savings are needed for INVESTMENT, but without funds being deposited in banks, banks cannot lend anything to businesses for investment and thus increase the supply of MONEY, leading to problems for the Federal Reserve, the nation’s manager of MONETARY POLICY. In 1928 the Fed increased INTEREST RATES in order to discourage stock-market speculation. When the stock market finally crashed in October 1929, panic struck. Banks raised their interest rates on business loans, further discouraging private investment. The Fed “tightening” of the money supply again in 1931 exacerbated the situation, which one economist described as a period of “collective insanity.” There was no work, therefore there was no demand. Without market demand, there was no output and therefore no income. The flow of output and income in an economic system requires money, which is not an asset but primarily a medium of exchange between producers and consumers and among traders in international transactions. During the Great Depression, the world was on the gold standard, and each country limited its money supply based on its gold reserves. In the United States, 1 ounce of gold equaled $20. Under the gold standard, a country with a trade surplus received gold and therefore could expand its money supply. A country with a trade deficit transferred gold to its trading partners, reducing its money supply and, in theory, correcting its trade imbalance through lower prices. Since gold was in relatively fixed supply, the world’s money supply was more or less fixed. Thus monetary authorities had limited ability to increase the money supply when, during an economic downturn, an increase in the money supply could lower interest rates and stimulate economic activity. With the booming economy of 1920s, the Fed allowed a 60 percent increase in the money supply, a decision that critics suggest abetted stock market speculation and contributed to the collapse in 1929. According to the Austrian school of economic theory, it also led to malinvestment— investments that were not justifiable at prevailing interest rates but were considered rational when interest rates declined. Monetary policy designed to stimulate investment is a temporary action, and when interest rates later rose, these investments were no longer profitable and therefore liquidated. According to economists, rigid wages and prices contributed to the depression by not allowing markets to adjust. With the collapse of the stock market in 1929, consumers reduced their spending, causing a decrease in aggregate demand. Decreased spending along with flexible wages and prices would lower both, but businesses maintained prices in order to cover costs and workers resisted wage cuts, leading to both reduced sales and increased UNEMPLOYMENT. Probably the most controversial theory regarding the causes of the Great Depression is the issue of wealth and power distribution. The 1920s saw the heyday of the industrial capitalists. Even with constraints imposed by the SHERMAN ANTITRUST ACT (1890) and the CLAYTON ANTITRUST ACT (1914), a relatively small number of individuals and companies controlled significant amounts of the country’s wealth. Some economists suggest this contributed to the depression by concentrating demand in the hands of a small percentage of the population who, when the stock market crashed, pulled back their spending, furthering the decline. In addition, with a small number of large CORPORATIONs producing significant portions of the national output, the economy was adversely affected when a few of these companies declined. As British economist John Maynard Keynes observed in 1930, the world was “. . . as capable as before of affording for every one a high standard of living. . . . But today we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand.”