The Great Depression

Introduction

It should be noted that all of the cures have been tried and while we seem to be free of Depressions, it's not clear that business cycles have been eliminated.

Causes

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 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.

In the August 1990 issue of The Quarterly Journal of Economics, Christine D. Romer writes that "the negative effect of stock market variability is more than strong enough to account for the entire decline in real consumer spending on durables that occurred in late 1929 and 1930."

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 don't 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.

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, one ounce of gold was redeemable for twenty dollars). 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.

Hall and Ferguson write:

The existence of the gold standard linked economic conditions across countries to a much greater extent than is currently the case, and it is because of this linkage that the Depression was a worldwide event.

and:

Except for minor adjustments, and the temporary suspensions of gold payments during wartimes, the price of gold was held standard from the establishment of the new United States of America in 1791 until gold was revalued in 1933.

The Smoot-Hawley Tariff

In 1988, the Council of Economic Advisors proclaimed that the Smoot Hawley Tariff Act was "probably one of the most damaging pieces of legislation ever signed in the United States." The act was passed in June of 1930 and increased tariffs to a tax of 50 percent on goods imported into the United States. Since this occurred after the onset of the Depression, it's 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. Eventually, 60 other countries passed retaliatory tariffs in response.

The Federal Reserve Board

The Fed was ostensibly created to prevent bank panics and Depressions. Is it possible that the Fedwas actually responsible for the Depression? The answer is a qualified no. The Fed took several actions that, in retrospect, were quite bad. The first thing it did was to inflate the money supply by about 60% during the 1920's. If the Fed 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 Fed made was in early 1931. The Fed raised interest rates, exactly the wrong thing to do during a contraction. Ironically, the country's gold stock was increasing at this point all on its own, so doing nothing would have increased the money supply and helped the recovery.

Hall and Ferguson write that:

The Federal Reserve began expressing concern in early 1928 and at that time began a policy of monetary restriction in an effort to stem the stock market advance. This policy continued through May 1929. The monetary restriction was carried out by selling $405 million in government securities and raising the discount rate in three stages from 3.5 percent to 5 percent at all Federal Reserve banks.

and:

the monetary expansion of 1927 is considered by many economists to be an important factor in setting off the U.S. stock market advances of the lates 1920s.

Hall and Ferguson also write that:

But a further irony is the fact that the very existence of the Federal Reserve caused banks to wait for the central bank to act and not turn to the solutions they had devised in the face of the banking crises of the nineteenth century.

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.

Malinvestment

"Malinvestment"