The cause of the great depression is easy to understand. There seems to be too many economists and experts bringing all kinds of theories and mystery to the great depression. There does not need to be. The purposes of this post is to explain simply, in layman terms to non-economists who do not sit in an ivory tower all day, what caused the great depression in the USA.

I heard that you lost a lot in the crash, says the Ritz bartender. Implying his moral lapses, Charlie replies that yes, he did, but I lost everything I wanted in the boom. –  F. Scott Fitzgerald

Fitzgerald believed moral lapse caused by easy credit destroyed the economy. He was not too far from the truth.

What caused the Great Depression?

  1. The depression in the 1930s was caused by excess expansion of credit during the 1920s. This over extension by banks caused an unnatural disequilibrium in the money markets that initially caused a boom then a bust.  Booms are sure signs of impeding busts when fueled by lose easy credit.
  2. When the financial crisis of 1929 hit, there was a panic. People withdrew money from banks, and banks went out of business. As banks got scared and tried to call their loans, more people withdrew money and more banks closed. It has a bank panic.

Do you want to answer the question why there was the Great Depression of the 1930s? Ask yourself this. What would you do if over 700 banks failed, and if you did not get your money out of the bank today, you would lose it all? There was no one backing you with FDIC back then. That is, all life savings would be gone forever. Me, I would run to the bank and take my money out. That is the answer. This perpetuated the downward spiral.

But what caused that bank craziness? The federal reserve mismanagement of the money supply of course. This is the root cause of the financial crisis of the 1930s and today.  You do not have to have a PhD in Economics to look around you and understand the crises of today parallels that. Irrational exuberance regarding credit and asset values. It was the Federal Reserve’s fault plain and simple. People acting on greed and excess during the boom and panic during the crash was only herd movements shepherded by the Fed.

In the end, the credit boom – bust (the cause) resulted in the following long-term economic problems:

  • Lending came to a halt. Business confidence went to zero and people hoarded cash.
  • Once this happens, demand was depressed and no one trusted or believed in anything.
  • Therefore, aggregate demand or C+I+G dropped to 50% and unemployment went to 25%.
causes of the Great Depression

State unemployment office of Florida during the great depression

The Austrian view of business cycles

America’s Great Depression was a book published by the Austrian school economist Murray Rothbard. It focused on the creation of the Federal Reserve in 1913 and the government monopoly on money and credit. If government controls credit, rather than the market, this leads to boom and bust cycles. In my mind it is one of the best treatments of the root causes of the great depression. It is also an argument for the elimination of the Federal Reserve and the return of free money.

I did my Master’s thesis on Kunt Wickell at Trintity. Wicksell explained the relationship between the natural rate of interest and the bank rate. Although Wicksell wanted inflation and deflation, his ideas could be extended to modern business cycle theory. That is disequilibrium in the monetary markets would lead to disequilibrium in the real sector.

In the real sector markets adjust natural is unregulated. However, in the banking sector if the money is controlled by the central bank, then you have to have a good understanding of something called the marginal productivity of capital and its relation to the bank lending rate.

History has shown us that the Fed is always wrong with the money supply and how to manage the economy from its ivory tower command center.  Think about recent monetary policy. The Fed was wrong in every case in the last 20 years. They did not prevent the Internet stock bubble, in fact they helped it. They told use that things were contained and under control in 2007 right before everything fell apart.

Alternative ideas on the great Depression

John Maynard Keynes – Keynesian believe it was this C+I+G aggregate demand being stuck at low levels was what caused the great depression. This is not true, as it was more of symptom. Further, their idea of expanding government or the G component of the equation was ridiculous. Remember, the New Deal did not bring the country out of the crisis. New Deal I was a failure and New Deal II today is equally ineffective for long-run US competitiveness.

Milton Friedman – Monetarists believed the great depression was caused by the money supply being tightened rather than loosened. This is not true. It certainly did not help the situation but the chain of events that caused this deep and prolonged depression was set into play ten years before. A disequilibrium of that magnitude does not happen over night.

Ben Bernanke -There are many other theories including everything from agricultural cycles, sun spots,  to saying deflation caused the depression.  Some of these might have been factors in the whole big equation, but not the root cause. For example, Ben Bernanke wrote a book Essays on the Great Depression. It was basically a monetarist view.

Bernacke needs to take a lesson from Adam Smith regarding the prevention of booms and busts. Central banking if you think it should exist, I do not, should focus on the role of prevention rather than fixing. Preventing an over expansion of credit and mania of speculation. You can blame regulation all you want, but who pushed the interest rate to a ridiculous 1% after 9/11 so we all could go shopping again? The Fed.

Further, he claimed deflation causes price uncertainty and people postpone major purchases as asset values are falling. But this is more a redistribution of wealth valuation rather than a cause of economic collapse. The debt deflation view is an Irving Fisher view supported by Ben Bernanke. It is wrong.

  • So the causes of the great depression of the 1930s was the same as the cause of the crisis of 2007. Mismanagement by the Federal reserve that resulted in a reckless disequilibrium in the financial sector with an expansion of credit.