What are the main reasons behind the
Great Depression in 1929?

 

Introduction

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Modern economists see the Great
Depression as a combination of high unemployment, acute deflation and
reductions in outputs. Occurring from 1929 to 1939 following an average annual
growth of above 4.7%. Most of the growth was in the financial sector; this is
as firms financed themselves through bonds, stocks and loans due to their easy availability.
“Consequences of the Great Depression were not finally erased from the mind of
humanity until the end of the 1980s” (Rothbard, 2000) therefore its effects
were so dramatic that they lasted over 50 years. However, was the burst of
speculative bubbles the underlining cause of the Great Depression?

 

Speculative Bubbles

 

Firms financed themselves through the selling
of shares in order to fund their expansion; this was due to low interest rates
as well as business morale being high. The low interest rate led to a number of
small firms using credit to fund mechanization, largely in the agricultural
sector. The view that the public influence the stock market crash through loans
is seen as inaccurate with “general state of ‘easy money’ is mistaken; money
was easy for a few safe borrowers but difficult for everyone else.” (Bernanke,
1983). This argues that the issue of easy loans occurred between the banks and
only organisations and individuals with good credit scores, therefore the
systematic error occurred where those individuals exploited the weak system.
However, the public invested and speculated on these companies. As share prices
rose relative to growth, the financial sector experienced a boom as shares were
exchanged on the New York Stock Exchange. This was struck by the results of underperforming
businesses as well as a contractionary monetary policy, which was used to
reduce the rising stock prices and prevent hyperinflation.  This caused negative speculation and the
bursting of the speculative bubble.

“Many
people attribute the stock market crashes of 1929 and 1987 … may be
based on irrational criteria and subject to erratic behavior.” (Santoni,
1987) this provides an explanation on how behavioral economics can apply with
bounded rationality, as the public would speculate with limited information. The
impact of the stock market crash is fundamental in assessing the reasons behind
the Great Depression due to the aftermath effects the crash had on business and
consumer confidence as well as government policy, with a halt in the money
supply and increasing the interest rate in order to reduce irrational
investments. Specifically the halt in the money supply unbalanced the economy
on a whole.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

This led to businesses having to cut their
cost, which caused a significant miss allocation of resources where labour was
made redundant with 1,550 people unemployed in 1929, with an
unemployment rate of 3.13%, while in 1933 the number of people unemployed rose
to 12,830 with an unemployment rate of 24.75%. (Lebergott,
1948) which is seen as the main factor in the Great
Depression due to the dramatic decline in the welfare of the population. However,
neo classical economist don’t see the Great Depression being the fault of
private banks as they just served their purpose, they see the fault with the manner
in which the rest of the economy pushed their systems and services to breaking
point. This also led to deflation, as the increase in unemployment left parts
off the population with substantially lower disposable incomes. The fall in
national incomes led to a substantial fall in consumption, which is an
estimated 60% of aggregate demand and consequently reducing the national
output, resulting in deflation as seen in figure 1.

 

 Macroeconomic
instability

 

Prior to the Great Depression the
international economy was in turmoil where a variety of European countries,
such as Britain and France were in debt to the United States of America (US). This
led to the US increasing their tariff rates in order to salvage some of the
money they were owed. However this became problematic when other economies
began to mirror the increase in tariffs. This alluded to a world wide economic
crisis as the tariff rates cancelled out trade between different nations. “The global escalation of the tariff war precipitated
the collapse of world trade” (Crucini
and Kahn, 1996) this shows the
impact the increase in the tariffs had on trade which is essential in the real
output and the effect the fall had on the overall economy.

 

The global economy was also
harmed by the use of the gold standard, which is a monetary system in which a
currency is valued based on a fixed amount of gold. The gold standard was
adopted in the US and Germany in 1873 and was argued to be a stable system as
the system didn’t suffer any significant crisis. “In contrast,
the interwar gold standard, established between 1925 and 1928, had
substantially broken down by 1931 and disappeared by 1936.” (Kindleberger and Hubbard, 1992)

Therefore the problem wasn’t the gold standard itself
as an economic policy but how the policy functioned under an unstable period. With the money supply being based on a fixed
amount of gold the money supply is constricted and banks were unable to use an expansionary
monetary policy in order to stimulate economic activity, this would of enabled banks
to react better to the stock market crash with the mass withdrawal of funds. “Failure
of the fed to expand the money supply in the face of very serious deflationary
forces” (Robbins et al., 2009) therefore the inadequacy of the policy fuelled
the Great Depression. Where the adequate polices would have been an
expansionary monetary policy.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The lack of economic activity as
well as falls in international trade caused by the increase in tariff cost, the
supply of goods began to build. This caused excess supply to assemble due to
the law of supply as aggregate supply increases then the general price level
will decrease, as firms attempt to shift their surplus of goods. This developed
into a deflationary spiral as firms further cut their cost to reduce their
loss, additionally with the lack of consumption, inventories stacked up and the
excess working capital causes aggregate supply to shift to the right which has
the consequence of lowering the general price level, as seen in figure 2.

 

 

Conclusion

In
light of the analysis, the Great Depression has Intra-national and Inter-national
causes, with the Wall Street crash in the US but also the position of the world
economy, where both of these factors result in deflation. However, I believe
the main cause of the Great Depression was the state of the world economy. “Many countries continued to maintain
deflationary policies in the early 1930s as they tried to hold onto the Gold
Standard” (Temin, 2010) which expresses one the main problem of why the macro
economic instability led to Great Depression with the stationary gold standard,
as the governments were reluctant to get involved. This was due to Hoover’s
beliefs that the economy should be self-reliant, without the support of
government intervention, which would explain why a expansionary fiscal policy
wasn’t used, to prevent and slow the Great Depression.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Reference:

Bernanke, B. (1983) Non-Monetary Effects of the Financial Crisis
in the Propagation of the Great Depression,.

 

Crucini, M. and Kahn, J. (1996) Tariffs and aggregate economic
activity: Lessons from the Great Depression, Journal of Monetary
Economics, 38(3), pp. 427-467.

 

Kindleberger, C. and Hubbard, R. (1992) Financial Markets and
Financial Crises, Southern Economic Journal, 59(1), p. 127.

 

Lebergott,
S. (1948) Labor
Force, Employment, and Unemployment, 1929-39: Estimating Methods.” Monthly Labor Review, vol. 67, no. 1, 1948, pp. 50–53.

 

Robbins, L. and Weidenbaum, M. (2009) The Great Depression,
New Brunswick, Transaction.

 

Rothbard, M. (2000) America’s great depression, Auburn, AL,
Mises Institute.

 

Santoni, G. (1987), The
great bull markets 1924-29 and 1982-87: speculative bubbles or economic
fundamentals?, Review,
issue Nov, p. 16-30.

 

Temin, P. (2010) The Great Recession and the Great Depression,.