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Between 1929 and 1933 the world economy collapsed. In country after country, although not in all, prices fell, output shrank, and unemployment soared. In the United States the rate of unemployment reached 25 percent of the labor force, in the United Kingdom 16 percent, and in Germany a staggering 30 percent. These rates are only roughly comparable across countries and with twenty-first century unemployment rates because of different definitions of unemployment and methods of collection; nevertheless, they show the extremity of the crisis. The recovery, moreover, was slow and in some countries incomplete. In 1938 the rate of unemployment was still at double-digit levels in the United States and the United Kingdom, although thanks to rearmament it was considerably lower in Germany. A number of previous depressions were extremely painful, but none was as deep or lasted as long. There were many recessions that came after, but none could begin to compare in terms of prolonged industrial stagnation and high unemployment. The consequences stemming from the Great Depression for economies and polities throughout the world were profound. The early appearance of depression in the United States and the crucial role of the United States in world trade make it important to consider the U.S. case in some detail.
The Great Depression in The United States
There had been severe depression in the United States before the 1930s. The most similar occurred in the 1890s. Indeed, the sequence of events in the 1890s foreshadowed what was to happen in the 1930s in some detail. Prices of stocks began to decline in January 1893, and a crash came in May and June after the failure of several well-regarded firms. The market continued to decline, and at its low point in 1896 had lost 30 percent of its value. The decline in the stock market was associated with a sharp contraction in economic activity. A banking panic intensified the contraction. There seem to have been two sources for the panic. First, fears that the United States would leave the gold standard prompted by the growing strength of the free silver movement led to withdrawals of gold from New York. In addition, a wave of bank failures in the South and West produced by low agricultural prices also undermined confidence in the banking system. Runs on banks spread throughout the country and the crisis ended with a general restriction of the conversion of bank notes and deposits into gold. The money supply fell, the economy slowed, bank and business failures multiplied, and unemployment rose. Although a recovery began in June 1894, the recovery was slow and uneven. By 1897 onethird of the railroad mileage in the United States was in receivership. It took until 1898 for the stock market to match its 1893 peak, and for annual real gross domestic product (GDP) per capita to match its 1892 level.
During the early 1930s events unfolded in a similar fashion. There were few signs in 1929, however, that a Great Depression was on the horizon. There had been a severe contraction in 1920–1921, but the economy had recovered quickly. There were minor contractions in 1923–1924 and 1926–1927, and the agricultural sector had struggled during the 1920s, but overall the economy prospered after the 1920–1921 recession. In 1929 unemployment in the United States was just 3.2 percent of the labor force; in many ways it was a vintage year.
The stock market boomed in the late 1920s and reached a peak in 1929; prices rose nearly 2.5 times between 1927 and its peak in 1929. Economic historians have long debated whether there was a bubble in the market in the late 1920s, meaning that prices of shares had risen more rapidly than “fundamentals.” Research conducted in 1993 by Peter Rappoport and Eugene White and other late-twentieth-century views have strengthened the case for a bubble. They have shown that many wellinformed investors doubted the long-run viability of prevailing prices. There were undoubtedly, however, many other investors who believed that the economy had entered a so-called New Age, as was said at the time, in which scientific and technical research would produce rising real incomes, rising profits, and an eventual end to poverty.
The crash of the stock market in the fall of 1929 was partly a reflection of the state of the economy—a recession was already under way—but the crash also intensified the slowdown by undermining confidence in the economic future. The major impact of the crash, as shown by Christina Romer in her 1990 work, was to slow the sale of consumer durables. The crash may also have influenced markets around the world by forcing investors to reassess their optimistic view of the future. In any case, the stock markets in most other industrial countries after having risen in the 1920s also fell to very low levels in the first half of the 1930s. The U.S. market lost two-thirds of its value by 1933, the German market (which had peaked before the American market) lost one half, and the British market, which did somewhat better, lost one-fifth.
The collapse of the American banking system then intensified the contraction. There were repeated waves of bank failures between 1930 and 1933 produced by the economic contraction, by the decline in prices, especially in the agricultural sector, and perhaps by a contagion of fear. As people withdrew their cash from banks to protect their wealth, and as banks increased their reserves to prepare for runs, the stock of money shrank. The collapse of the American banking system reflected a number of unique circumstances. First, laws that prevented banks based in one state from establishing branches in other states, and sometimes from establishing additional branches within a state, had created a system characterized by thousands of small independent banks. In contrast, most other countries had systems dominated by a few large banks with branches. In Canada where the system consisted of a small number of banks with head offices in Toronto or Montreal and branches throughout the country there were no bank failures. In addition, the young and inexperienced Federal Reserve System (it was established in 1913) proved incapable of taking the bold actions needed to end the crisis.
Many explanations have been put forward for the failure of the Federal Reserve to stem the tide of bank runs and closures. Milton Friedman and Anna J. Schwartz in their classic Monetary History of the United States (1963) stressed an internal political conflict between the Federal Reserve Board in Washington and the New York Federal Reserve Bank that paralyzed the system. A 2003 study by Allan Meltzer stresses adherence to economic doctrines that led the Federal Reserve to misinterpret the fall in nominal interest rates during the contraction. The Treasury bill rate fell from about 5 percent in May 1929 to .10 percent in September 1933. The Federal Reserve viewed low rates as proof that it had made liquidity abundant and that there was little more it could do to combat the depression. The bank failures, which were concentrated among smaller banks in rural areas, or in some cases larger banks that had engaged in questionable activities, the Federal Reserve regarded as a benign process that would result in a stronger banking system. From 1930 to 1933 about 9,000 banks in the United States suspended operation and the money supply fell by one-third.
During the interregnum between the election of President Franklin Roosevelt in November 1932 and his taking office in March 1933 the banking system underwent further turmoil. In state after state governors proclaimed “bank holidays” that prohibited or limited withdrawals from banks and brought the banking and economic system to a standstill. The purpose of the holidays was to protect the banks from panicky withdrawals, but the result was to disrupt commerce and increase fears that the system was collapsing. By the time Roosevelt took office virtually all of the banks in the United States were closed and perhaps one-quarter of the labor force was unemployed. Roosevelt addressed the situation boldly. Part of his response was to rally the spirits of the nation. In his famous first inaugural address he told the people that “the only thing we have to fear is fear itself.” His address also promised work for the unemployed and reforms of the banking system. The administration soon followed through. Public works programs, which focused on conservation in national parks and building infrastructure, were created to hire the unemployed. In the peak year of 1936 approximately 7 percent of the labor force was working in emergency relief programs.
The banking crisis was addressed in several ways. Banks were inspected and only “sound” banks were allowed to reopen. The process of inspection and phased reopening was largely cosmetic, but it appears to have calmed fears about the safety of the system. Deposit insurance was also instituted. In 1963 Milton Friedman and Ann Jacobson Schwartz argued that deposit insurance was important in ending the banking crisis and preventing a new eruption of bank failures by removing the fears that produced bank runs. Once depositors were insured by a federal agency they had no reason to withdraw their funds in cash when there was a rumor that the bank was in trouble. The number of bank failures in the United States dropped drastically after the introduction of deposit insurance.
The recovery that began in 1933, although not without setbacks, was vigorous and prolonged. By the middle of 1937 industrial production was close to the 1929 average. Still, there was considerable concern about the pace of recovery and the level of the economy. After all, with normal economic growth the levels of industrial production and real output would have been above their 1929 levels in 1937. Unemployment, moreover, remained stubbornly high. With a few more years of continued growth the economy might well have recovered fully. However, another recession, the “recession within the depression,” hit the economy in 1937. By the trough in 1938 industrial production had fallen almost 60 percent and unemployment had risen once more. Mistakes in both fiscal and monetary policy contributed to the severity of the contraction, although the amounts contributed are disputed. The new Social Security system financed by a tax on wages was instituted in 1935, and the taxes were now put in place. The Federal Reserve, moreover, chose at this time to double the required reserve ratios of the banks. The main purpose of the increase was to prevent the reserves from being a factor in the future, to tie them down. The banks, however, were now accustomed to having a large margin of reserves above the required level and they appear to have cut their lending in order to rebuild this margin. The economic expansion that began in the summer of 1938, however, would last throughout the war and pull the economy completely out of the depression. Indeed, even before the United States entered the war as an active participant at the end of 1941, fiscal and monetary stimuli had done much to cure the depression.
The Depression Widens
Most market-oriented countries, especially those that adhered to the gold standard, were affected by the Great Depression. One reason was the downward spiral of world trade. The economic decline in the United States hit hard at firms throughout the world that produced for the American market. As the depression spread from country to country, imports declined further.
The gold standard, to which most industrial countries adhered, provided another channel for the transmission of the Great Depression. The reputation of the gold standard had reached unchallenged heights during the period of expanding world trade before World War I. Most countries, with the exception of the United States, had abandoned the gold standard during the war to be free to print money to finance wartime expenditures. After the war, the gold standard had been reconstructed, but in a way that left it fragile. Most countries decided not to deflate their price levels back to prewar levels. Hence the nominal value of world trade relative to the amount of gold in reserve was much higher after the war than before. Under the gold standard orthodoxy of the day central banks were supposed to place maintenance of the gold standard above other priorities. If a country was losing gold because its exports had fallen faster than its imports, the central bank was supposed to raise interest rates to protect its gold reserve, even if this policy exacerbated the economic contraction. Countries that gained gold might have lowered their rates, but they were reluctant to do so because lower rates would put their gold reserves at risk.
The global transmission of information and opinion provided a third, hard to measure, but potentially important channel. The severe slide on the U.S. stock market and other stock markets focused attention throughout the rest of the world on factors that might produce a decline in local markets. Waves of bank failures in the United States and central Europe forced depositors throughout the rest of the world to raise questions about the safety of their own funds. Panic, in other words, did not respect international borders.
Although these transmission channels assured that the whole world was affected in some degree by the depression, the experience varied markedly from country to country, as even a few examples will illustrate. In Britain output fell from 1929 to 1932, but the fall was less than 6 percent. The recovery, moreover, seems to have started sooner in Britain than in the United States and the growth of output from 1932 to 1937 was extremely rapid. Unemployment, however, soared in 1929 to 1931 and remained stubbornly high for the remainder of the decade. Although Britain was becoming less dependent on exports, exports were still about 15 percent of national product. The fall in exports produced by the economic decline in the United States and other countries, therefore, probably explains a good deal of the decline in economic activity in Britain. In September 1931 Britain devalued the pound and left the gold standard. The recovery in Britain began soon after. Export growth produced by a cheaper pound does not seem to have played a prominent part in the recovery, but a more expansionary monetary policy permitted by leaving gold does seem to have played a role. On the whole it may be said that the British economy displayed surprising resiliency in the face of the loss of its export markets.
Germany, on the other hand, suffered one of the most catastrophic declines. A severe banking crisis hit Germany in July 1931, punctuated by the failure of the Darmstädter-und Nationalbank on July 13. The German crisis may have been provoked by the failure of the Credit Anstalt bank in Austria in May 1931 and the subsequent run on the Austrian shilling, although economists have debated these factors. Germany soon closed its banks in an effort to stem the runs, and abandoned the gold standard. Germany, however, did not use the monetary freedom won by abandoning the commitment to gold to introduce expansionary policies. Between June 1930 and June 1933 the stock of money in Germany fell by nearly 40 percent. Prices and industrial production fell, and unemployment soared. Under the Nazis government spending, much of it for rearmament, and monetary expansion produced an extended economic boom that restored industrial production and full employment.
The experience of Japan where the depression was unusually mild has stimulated considerable interest. Unemployment rose mildly by Western standards between 1929 and 1933 and fell to 3.8 percent by 1938. Other indicators, such as the stock market, also rose between 1933 and 1938. Many observers have attributed this performance to the actions of Finance Minister Korekiyo Takahashi. In 1931 Takahashi introduced a stimulus package that included a major devaluation of the yen, interest rate cuts, and increases in government spending. The latter element of his package has led some observers to refer to Takahashi as a “Keynesian before Keynes.” Late twentiethcentury research has challenged the notion that Takahashi was able to break completely free of the economic orthodoxies of the day, but the strong performance of the Japanese economy remains an important signpost for scholars attempting to understand the factors that determined the course of events in the 1930s.
The factors previously stressed, the collapse of the banking system in the early 1930s, and the policy mistakes by the Federal Reserve and other central banks are of most relevance to what has come to be called the monetarist interpretation of the Great Depression. Some economists writing in the 1930s, such as Jacob Viner and Laughlin Currie, developed this view, concluding that much of the trouble could have been avoided if the Federal Reserve and other central banks had acted wisely.
In the aftermath of the publication of John Maynard Keynes’ General Theory (1936), however, an alternative interpretation held sway. The Keynesians argued that the breakdown of the banking system, although disturbing, was mainly a consequence of the collapse of aggregate demand. The behavior of the Federal Reserve was at most a secondary problem. The Keynesians blamed the fall in aggregate demand on the failure of one or more categories of autonomous spending. At first, attention focused on investment; later attention shifted to consumption. The answer to the Great Depression was public works financed, if necessary, by borrowing. The New Deal in the United States had spent a great deal of money and run up highly controversial deficits; 1956 calculations by E. Cary Brown, however, showed that a number of factors, including cuts in spending at the state and local level, had offset the effects of New Deal spending. Fiscal policy had failed to return the economy to full employment, according to Brown, “not because it did not work, but because it was not tried” (1956, pp. 863–866).
Friedman and Schwartz’s Monetary History, which provided an extraordinarily detailed account of the effects of monetary policies during the 1930s and put the Great Depression into the broader context of American monetary history, returned the collapse of the banking system to center stage. Their interpretation was challenged in turn by Peter Temin in Did Monetary Forces Cause the Great Depression (1976) who defended the Keynesian interpretation. Subsequent work, however, continued to emphasize the banking crisis. The 1983 research of Ben Bernanke, who later became chair of the U.S. Federal Reserve, was particularly influential. Bernanke argued that the banking and financial crises had disrupted the ability of the banking system to act as an efficient financial intermediary. Even sound businesses found it hard to borrow when their customary lender had closed its doors and the assets they could offer as collateral to another lender had lost value. The Bernanke thesis not only explained why the contraction was severe, but also why it took so long for the economy to recover: It took time for financial markets to rebuild the relationships that had been sundered in the early 1930s.
Research that took a more global view of the Great Depression, such as Peter Temin’s 1989 work, reinforced the case for viewing monetary forces as decisive. Barry Eichengreen’s Golden Fetters (1992), one of the most influential statements of this view, stressed the role of the gold standard in transmitting the Depression and inhibiting recovery. Countries faced with balance of trade deficits because of declining exports should have maintained their stocks of money and aimed for internal price stability. Instead they often adopted contractionary policies aimed at stemming the outflow of gold. Those countries that abandoned the gold standard and undertook expansionary monetary policies recovered more rapidly than those who clung to gold. The examples provided by countries, such as Japan, which avoided trouble because they had never been on gold or quickly abandoned it were particularly telling.
In the twenty-first century economists have turned to formal models, such as dynamic computable general equilibrium models, to address macroeconomic questions, and have used these models to formulate and test ideas about the Great Depression. The 2002 and 2005 work of Harold Cole and Lee Ohanian has received considerable attention in both academic and mainstream circles. It is too early to say, however, whether this work will serve to reinforce traditional interpretations of the Great Depression reached by other methods or produce entirely new interpretations. It is not too soon to predict, however, that the Great Depression will continue to attract the interest of scholars attempting to understand basic macroeconomic processes.
One cannot say for certain that another Great Depression is impossible, but important lessons have been learned and important changes made in the financial system that make a repetition highly unlikely. For example, it seems improbable that any modern central bank would allow a massive collapse of the banking system and deflation to proceed unabated as happened in a number of countries in the early 1930s.
- Bernanke, Ben S. 1983. Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression. American Economic Review 73 (3): 257–276.
- Bernanke, Ben S. 1995. The Macroeconomics of the Great Depression: A Comparative Approach. Journal of Money, Credit and Banking 27 (1): 1–28.
- Brown, E. Cary. 1956. Fiscal Policy in the Thirties: A Reappraisal. American Economic Review 46 (5): 857–879.
- Cole, Harold L., and Lee E. Ohanian. 2002. The U.S. and U.K. Great Depressions through the Lens of Neoclassical Growth Theory. American Economic Review 92 (2): 28–32.
- Cole, Harold L., Lee E. Ohanian, and Ron Leung. 2005. Deflation and the International Great Depression: A Productivity Puzzle. Minneapolis, MN: Federal Reserve Bank of Minneapolis.
- Eichengreen, Barry J. 1992. Golden Fetters: The Gold Standard and the Great Depression, 1919–1939. New York: Oxford University Press.
- Friedman, Milton, and Anna Jacobson Schwartz. 1963. A Monetary History of the United States, 1867–1960. Princeton, NJ: Princeton University Press.
- James, Harold. 1984. The Causes of the German Banking Crisis of 1931. Economic History Review 37 (1): 68–87.
- Kindleberger, Charles Poor. 1973. The World in Depression, 1929–1939. Berkeley: University of California Press.
- Meltzer, Allan H. 2003. A History of the Federal Reserve. Chicago: University of Chicago Press.
- Rappoport, Peter, and Eugene N. White. 1993. Was There a Bubble in the 1929 Stock Market? Journal of Economic History 53 (3): 549–574.
- Romer, Christina D. 1990. The Great Crash and the Onset of the Great Depression. Quarterly Journal of Economics 105 (3): 597–624.
- Romer, Christina D. 1993. The Nation in Depression. Journal of Economic Perspectives 7 (2): 19–39.
- Sicsic, Pierre. 1992. Was the Franc Poincaré Deliberately Undervalued? Explorations in Economic History 29: 69–92.
- Temin, Peter. 1976. Did Monetary Forces Cause the Great Depression? New York: Norton.
- Temin, Peter. 1989. Lessons from the Great Depression. Cambridge, MA: MIT Press.
- Temin, Peter. 1993. Transmission of the Great Depression. Journal of Economic Perspectives 7 (2): 87–102.
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