The cause of the Great Depression is easy to understand. There seem 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 are to explain, 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 am an Economics Professor, and I am working on my Ph.D. There are competing theories, and there is statical data to support the different ideas (Keynesian, Neo-classical), however, from a logical standpoint, there is the primary cause.
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?
- The depression in the 1930s was caused by excess expansion of credit during the 1920s. This overextension by banks caused an unnatural disequilibrium in the money markets that initially caused a boom then a bust. Booms are sure signs of impending busts when fueled by interest rates that were too low.
- 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.
Therefore, in one sentence, the Great Depression, as well as the 2008 Recession and other business cycles, were caused by: The Federal Reserve Bank set the observable interest rate lower than the natural rate of interest and this cause disequilibrium in the money market that caused disequilibrium in the real sector.
The monetary world matters because money is in every transaction. It is the blood of the economy. If over 700 banks failed, you could not expect the real sector (production and consumption) not to have been affected.
In an unfettered market supply and demand will bring individual markets to equilibrium, however, when the money market is out of balance, like a house of dominos other markets fall.
The Federal Reserve’s mismanagement of the supply of loanable funds was the cause. This is the root cause of the financial crisis of the 1930s and crisis of today. You do not have to have a Ph.D. in Economics to look around you and understand the boom and bust cycles of today parallels the past cycles. 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 (Keynes described this as a Liquidity Trap).
- This created a call in Consumption, Aggregate Demand was depressed and businesses failed.
- Therefore, aggregate demand or C+I+G dropped to 50% and unemployment went to 25%.
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 the 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 Trinity. Wicksell explained the relationship between the natural rate of interest and the bank rate. Although Wicksell was explaining a process of inflation and deflation, his ideas were extended by neo-Wicksellians and Austrians into modern business cycle theory. That is disequilibrium in the monetary markets leads to imbalance in the real sector.
In the real sector, markets adjust naturally when unregulated because of the price mechanism. However, the price of loanable funds is analogous to the interest rate. The interest rate is not controlled by the markets natural self-regulating mechanism but rather influenced by intervention by the central bank. Further repeated interventions create confusion when lags are a reality so economists can discern the true effect. This is because interest rates themselves are part of the econometric models which they use and the logic is circular.
The objective of the central bank policy is to match the bank rate with something called “R-Star” or the natural rate of interest. The natural rate of interest is the marginal productivity of capital in an economy where barter ratios are used. The issue is the natural rate of interest is a hypothetical idea used in econometric models. Therefore, estimating the natural rate of interest might not be possible.
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 the recent monetary policy. The Fed was wrong in every case in the last 20 years. They did not prevent the Internet stock bubble they helped it. They told us 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 that suffered from depression of “animal spirits’. When Consumption is low, this suppresses Aggregate Demand. When Aggregate Demand shifts to the left, a economic crissis follows. This is not true, because it was more of the 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 cause of the Great Depression was the money supply being tightened rather than loosened. The monetarist view is imprecise in explaining the initial reason. 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 overnight. It is not the bust that is the issue but the boom.
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 a monetarist view.
Bernanke 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 overexpansion 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 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 were 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.