What Were The Principal Causes Of The Great Depression?

The Stock Market Crash of 1929

The great depression or the worldwide economic downturn started in the year 1929 and lasted for nearly ten long years. This is still now regarded as the largest and most severe depression ever experienced by industrialized western world (Irwin, 2017). The depression originated in the United States, however it gave rise to severe decline in the level of outputs, drastically high unemployment and an absolute deflation in almost all the countries around the world. The timings and extent of severity caused by the depression varied across different countries. It was longest and most severe in the United States and European countries while Japan and the Latin America faced a comparatively milder impact (Tindall and Shi, 2016). There, however, remains disputes among the scholars regarding the origin of the economic crisis as there are several researchers who have argued that the Great Depression started in Europe in the year 1928, which afterwards, spread to the United States. During the year of 1929 two million people lost their jobs in the United States. By the end of the year 1932, the number of jobless people crossed 13 million which is more than a 600% rise (Nanda and Nicholas, 2014). There were other major consequences as well. This essay aims to discuss the major reasons behind the Great Depression critically and in the final section aims to provide a concluding remark regarding the same.

Still now the economists continue to study Great Depression as there are still so many debates regarding finding the actual factor that caused it. Numerous economic theories have been advanced but there remains no single, universally accepted explanation of why the great depression took place (Coen-Pirani and Wooley, 2017).

While tracing out reasons behind the great depression, the stock market crash of 1929 is often considered responsible for it. The crash significantly destroyed large amount of wealth. Some of the economists argue that the crash, more importantly affected the health of the economy which in turn convinced the consumers and the organizations to pull back their expenditures specifically over the luxury goods like cars and expensive appliances. However, following Ohanian (2017), it can be stated that the crash, though being one of the significant causes of the Great Depression, was not the only reason and the depression occurred as a cumulative outcome of many other factors.

There are theorists who believe that the great depression was mainly caused by the tight monetary policy adopted by the United States to restrain the stock market speculations. As during the year of 929 the United States stock process had reached a level that the reasonable anticipations about the future earnings could not justify, the investors lost their confidence as a result of which the bubble of stock market burst. On October 24^th of 1929 panic selling started and that day has still been regarded as “Black Thursday” (Temin, 2014). This crash of the U.S. stock market contributed substantially in the reduction of aggregate demand of the country. The demand for durable goods and business investments fell sharply right after the crash. The most suitable explanation behind this is that the financial instability gave rise to substantial uncertainty about the future income of the population which as a result compelled the firms as well as the consumers to put off their spending on durable goods. However, the loss of wealth due to the fall in the stock price was comparatively lower, the crash may have reduced the level of spending by making the people feel that they are poor. As a result of the dramatic fall in the consumer and firm spending, the real output of United States have depicted a sharp decline in the year 1929 and kept on falling throughout 1930 (Benmelech et al., 2017).

Tight Monetary Policy

The factor that hit the aggregate demand of the United States in the year 1930 was the first four waves of panic in the banking sector. In this context it is relevant to mention that a banking panic may occur when the depositors lose confidence about the solvency of the banking system and demand their deposits to be returned to them in cash. Banks generally hold a fraction of deposits in hand and liquidate loans to raise the cash required. This liquidation process causes failure in the banking system (Babina et al., 2017). During the period of 1930 to 1933 the economy of United States faced four consecutive banking panics which lead to the closure of banks and it had been declared that the banks will reopen only after they were declared to be solvent by the government inspectors. This banking panic affected the US banking system significantly as by the end of 1933 almost one fifth of the banks which were operating even in 1930 were closed (Stuckler et al., 2012).

Naturally the banking panics are inexplicable and irrational events, however, there were some factors that contributed to this event. Some of the economists believe that a significant increase in the debt of farm along with the policies of U.S. government that encouraged the small banks had given rise to an environment where panic and skepticism could easily spread.

Coupled with the aforesaid factors the Federal Reserves also contracted the money supply in the U.S economy which posed a contractionary impact over the output of the economy. The picture below explains the role monetary collapse played during the great depression of United States. The figure clearly depicts that the supply of money and output together during the period of 1900 through 1940. It can be observed that during 1920 both money supply and GDP grew steadily but in 1930 both depicted a steep fall (Saint-Etienne, 2013). The fall in the supply of money affected the spending in numerous ways. While actual prices declined coupled with a rapid decline in the money supply the consumers and the businesses assumed that in future there would be a deflation and expected that wages and prices will also be very low in future.

Figure 1: The GDP and Monetary Policy of United States

(Source: Romer and Romer, 2013)

A group of economists stresses in the fact that the Federal Reserve allowed a huge decline in the money supply in order to support the gold standard. Under the genre of gold standard each of the countries determines the value of its currency in terms of gold and enacts remedial monetary measures to preserve that fixed price (Romer and Romer, 2013). It is also a matter of fact that if the Federal Reserve implements an expansionary policy the people would think that the country has lost its faith on the gold standard. This could certainly lead to a significant gold outflow due to which the country would be forced to devalue its own currency.

Banking Panics

However be there are debates regarding the role played by the Gold Standard in limiting the monetary policy of the country but it can undoubtedly be regarded as the key factor that gave rise to the transmission of this American decline to the other countries as well. Under the system of gold standard an imbalance in the trade or flows of assets resulted in an international gold flows (Irwin, 2017).

As the economy of United States started to contract significantly there was a tendency of gold flow out of the other countries towards the United States. This happened because the major deflation in the United States in turn made the American products relatively attractive to the foreigners while the reduced income decreased the demand of America for the foreign products. In order to deal with the tendency towards the American trade surplus and outflows of foreign gold, the central banks raised the interest rates throughout the world (Nanda and Nicholas, 2014). In order to maintain this international gold standard it required a huge contractionary monetary policy throughout the world so as to match the happenings in the United States. The result of this was a drastic decline in the general price level and output throughout the world that in turn matched with the downturn in the United States.

Financial crisis coupled with banking panics took place in various countries along with United States. In the year 1931, difficulties regarding payment in Creditanstalt, the largest Australian bank emerged. This gave rise to a financial difficulty and affected a major portion of the Europe. This also acted as a key reason for Britain to abandon the gold standard. Similarly there were other countries as well like Austria, Hungary and Germany that suffered terrible banking panic (Coen-Pirani and Wooley., 2017). This banking panic as an overall outcome reduced the level of output and prices in numerous countries.

Conclusion

There are numerous reasons which have been pointed out by the economists behind the Great Depression. However, it is also a matter of fact that the banking panic and the stock market crash have always been identified as the common and most impactful factors that accumulated the depression. There are some economists who have argued that the protectionist policies of trade and the collapse of international trade are the major reasons behind the great depression. They have pointed that the Smoot-Hawley tariff, enacted in the 1930 increased the cost associated with imported goods. In response to that the trade partners of United States implemented retaliatory actions. Nevertheless, some of the theorists stated that this fact is already contained in the banking panic where the contractionary monetary policy was implemented by the Federal Bank.

Reference List

Babina, T., Garcia, D. and Tate, G.A., 2017. Friends during Hard Times: Evidence from the Great Depression.

Benmelech, E., Frydman, C. and Papanikolaou, D., 2017. Financial frictions and employment during the great depression (No. w23216). National Bureau of Economic Research.

Coen-Pirani, D. and Wooley, M., 2017. Fiscal Centralization: Theory and Evidence from the Great Depression. American Economic Journal: Economic Policy.

Irwin, D.A., 2017. Peddling protectionism: Smoot-Hawley and the great depression. Princeton University Press.

Moser, J.E., 2013. The great depression. A Companion to World War II, Volume I & II, pp.47-62.

Nanda, R. and Nicholas, T., 2014. Did bank distress stifle innovation during the Great Depression?. Journal of Financial Economics, 114(2), pp.273-292.

Ohanian, L.E., 2017. The Great Recession in the Shadow of the Great Depression: A Review Essay on Hall of Mirrors: The Great Depression, the Great Recession, and the Uses and Misuses of History, by Barry Eichengreen. Journal of Economic Literature, 55(4), pp.1583-1601.

Romer, C.D. and Romer, D.H., 2013. The missing transmission mechanism in the monetary explanation of the Great Depression. American Economic Review, 103(3), pp.66-72.

Saint-Etienne, C., 2013. The Great Depression, 1929-1938: Lessons for the 1980’s. Hoover Press.

Stuckler, D., Meissner, C., Fishback, P., Basu, S. and McKee, M., 2012. Banking crises and mortality during the Great Depression: evidence from US urban populations, 1929–1937. J Epidemiol Community Health, 66(5), pp.410-419.