|The Great Depression is probably one of the most misunderstood events in American history. It is routinely cited as proof that unregulated capitalism is bad, and that only a massive welfare state, huge amounts of economic regulation, and other interventions, can save capitalism from itself. Among the many myths surrounding the Great Depression are that Herbert Hoover was a laissez faire president and that FDR brought us out of the depression.|
What caused the Great Depression? To get a handle on that, it's necessary to look at previous depressions and compare. The Great Depression was by no means the first depression this country ever had, but it was clearly the worst. What made it different than the rest? At the time of the Great Depression, government intervention in the economy was higher than it had ever been and a special government agency had been set up specifically to prevent depressions and their associated problems, such as bank panics. This agency was the Federal Reserve Board and it was to have been the loaner of last resorts for banks in order to prevent collapses as had happened during earlier depressions. But as we'll see, there is good reason to believe that the Fed's actions explain a lot of the problems that lead up to the Stock market crash and the subsequent depression.
Although there are many macroeconomics schools of thought, I'll be concentrating on two initially, Keynesian economics and Austrian School economics. Keynesian economics got its start during the Great Depression with the publication in 1936 of The General Theory of Employment, Interest, and Money, by John Maynard Keynes. Austrian School economics began much earlier, most notably with the publication in 1871 of Carl Menger's Principles of Economics. While the Austrian theory has never been mainstream (economist Paul Krugman refers to it as the economic equivalent of the phlogiston theory), its adherents are some of the harshest critics of Keynesian interventions, so it will serve as a good counterbalance until I can bone up on other schools of thought.
There are six depressions in American history that are thought to be the worst since detailed records of economic data started to be kept (around 1867), 1873-79, 1893-97 (actually two contractions separated by an incomplete expansion), 1907-08, 1920-21, 1929-33, and 1937-38. Although depressions vary on length and severity, the similarities are so profound that Nobel Laureate Robert Lucas has stated, "business cycles are all alike." Since it's been about 60 years since we've had a depression, one might think that the economy is being managed better than it used to be. It's not clear why the economy is being managed better. The Federal Reserve Board was created in 1913 and yet half of the worst depressions happened after its creation. A better candidate might be the adoption of Keynesian management techniques, which were not fully implemented until after the last severe contraction in 1937. But there are some indicators that that is not responsible either. Detailed studies have been done to compare post-war business cycles with prior ones. At least one indicates that there was no improvement.
A key insight into the difficulties of managing the economy was made by Robert Lucas. Looking at post-World War II business cycles, he argued that if one could choose between smoothing out the cycles completely and increasing the annual economic growth by 0.1%, the latter would make people better off overall. As we consider the different policy options, it is important to keep this insight in mind as one more trade off that has to be considered.
So what went wrong? It was in 1929 that the Fed realized that it could not sustain its current policy. When it started to raise interest rates, the whole house of cards collapsed. The Stock Market crashed and the bank panics began. But what would make this depression worse than all the rest? There was a depression in 1921, but no one remembers that one. What was different? As we'll see, there were a number of policies enacted over the next few years that, from both a free market and a Keynesian perspective, would do nothing to help America recover and do everything to exacerbate the depression. Over the next few years, the Fed would allow the money supply to contract by a third.
A free market advocate's response would be to do nothing and let the market work itself out. Ideally, what would happen is that businesses would realize that no one was buying and lower prices accordingly until people started buying again. The same thing would happen with labor and capital. Prices would be lowered until they reached the market clearing price and the economy would recover. Keynesians claim that some prices or wages will be "sticky" and may take a long time to reach their market clearing price, causing needless suffering along the way. The Keynesian prescription is two-fold. First, the Fed should inflate the money supply. Keynes even whimsically suggested leaving jars of money around where enterprising young boys could find them. However, this may not work if the depression is severe enough to enter what is called a liquidity trap. Under this scenario, no amount of running the treasury's printing press will restore order. In this case, the government should simply start spending money itself, thus "priming the pump" so to speak. As we'll see, Hoover (and later FDR) implemented a mixture of policies, some of which were Keynesian (increased government spending) and some of which were not (price supports and other attempts to keep prices and wages high).
FDR's policies seemed to work at first. The economy began to expand again in 1933 and continued to do so until May of 1937. At that point, a second depression began and lasted until June of 1938.