May 20, 2006

Explaining the Causes of the Great Depression

There are still many people who persist in propagating the myth that the Great Depression represented a failure of the capitalist system that could only be solved by active government intervention in the economy. Like all myths, the empirical data does not support that belief even as the belief has continued to reside in the superficial understandings of many people.

Lawrence Reed at the Mackinac Center for Public Policy wrote Great Myths of the Great Depression, a very approachable document for reading by the layman.

Milton Friedman won his Nobel Prize in Economics in part for his book, Monetary History of the United States, 1867-1960, in which he offered the first rigorous explanation of what caused the Great Depression.

In the third chapter of his book, Capitalism & Freedom, Friedman offers some highlights of what is in his more indepth study of the Great Depression:

However, in view of the importance which the Great Depression of 1929-1933 played in forming - or, I would say, deforming - general attitudes toward the role of government in economic affairs, it may be wroth indicating more fully...the kind of interpretation suggested by the evidence.

Because of its dramatic character, the stock market crash in October 1929, which terminated the bull market of 1928 and 1929 is often regarded as both the start and the major proximate cause of the Great Depression. Neither is correct. The peak of business was reached in mid-1929...

For something like the first year, the contraction showed none of those special features that were to dominate its later course. The economic decline was more severe than during the first year of most contractions, possible in response to the stock market crash plus the unusually tight monetary conditions that had been maintained since mid-1928...

...it is clear that the Reserve System should already have been behaving differently than it did, that it should not have allowed the money stock to decline by nearly 3 percent from August 1929 to October 1930...

The character of the contraction changed drastically in November 1930 when a series of bank failures led to widespread runs on banks, which is to say attempts by depositors to convert deposits into currency...

Prior to 1930, there had been no sign of a liquidity crisis, or any loss of confidence in banks. From this time on, the economy was plagued by recurrent liquidity crises...These [runs on banks] were important not only or even primarily because of the failures of the banks but because of their effect on the money stock...

This was precisely the kind of a situation that had led to a banking panic under the pre-Federal Reserve banking system...

...one of the major reasons for establishing the Federal Reserve System was to deal with such a situation...

The first need for these powers and hence the first test of their efficacy came in November and December 1930 as a result of the string of bank closings...The Reserve System failed the test miserably. It did little or nothing to provide the banking system with liquidity...It is worth noting that the System's failure was a failure of will, not of power...the System had ample power to provide the banks with the cash their depositors were demanding. Had this been done, the bank closings would have been cut short and the monetary debacle averted...

The [economic] figures for the first four or five months of 1931...have all the earmarks of the bottom of a cycle and the beginning of revival.

The tentative revival was however short-lived. Renewed bank failures started another series of runs and again set in train a renewed decline in the stock of money. Again, the Reserve System stood idly by. In the face of an unprecedented liquidation of the commercial banking system, the books of the [Reserve System] show a decline in the amount of credit it made available to its member banks...

After more than two years of severe economic contraction, the System raised the discount rate...more sharply that it has within so brief a period in its whole history before or since....It was also accompanied by a spectacular increase in bank failures and runs on banks...

A temporary reversal of policy in 1932 involving the purchase of $1 billion of government bonds slowed down the rate of decline. Had this measure been taken in 1931, it would almost surely have been sufficient to prevent the debacle just described. By 1932, it was too late to be more than a palliative and, when the System relapsed into passivity, the temporary improvement was followed by a renewed collapse terminating in the Banking Holiday of 1933...A system established in large part to prevent a temporary suspension of convertibility of deposits into currency - a measure that had formerly prevented banks from failing - first let nearly a third of the banks of the country go out of existence and then welcomed a suspension of convertibility that was incomparably more sweeping and severe than any earlier suspension...

All told, from July 1929 to March 1933, the money stock in the United States fell by one-third...it is literally inconceivable that money income could have declined by over one-half and prices by over one-third in the course of four years if there had been no decline in the stock of money. I know of no severe depression in any country or any time that was not accompanied by a sharp decline in the stock of money and equally of no sharp decline in the stock of money that was not accompanied by a severe depression.

The Great Depression in the United States, far from being a sign of the inherent instability of the private enterprise system, is a testament to how much harm can be done by mistakes on the part of a few men when they wield vast power over the monetary system of a country...

ADDITIONAL INFORMATION:

In the comments section below, Marc has added some important links that further elaborate on the causes for the Great Depression. In addition to the Lawrence Reed piece from the Mackinac Institute referenced above, Marc guides us to:

The Government and the Great Depression by Chris Edwards, Director of Tax Policy at the Cato Institute

The Fed's Depression and the Birth of the New Deal by Paul Craig Roberts and Lawrence Stratton

You can also learn more by reading FDR's Folly: How Roosevelt and His New Deal Prolonged the Great Depression.

ADDITIONAL INFORMATION II:

Professor Don Boudreaux from Cafe Hayek has more.

Comments, although monitored, are not necessarily representative of the views Anchor Rising's contributors or approved by them. We reserve the right to delete or modify comments for any reason.

First and most importantly, that the Great Depressions resulted from the failure of the capitalist system is not a "myth." It is the overwhelming consensus opinion that has held the field for the past 70 years.

Secondly, no matter how many times you say "myth, myth, myth" won't make it true. I understand the tactic of repeating something to the point that people start to believe you, but saying don't make it so.

Third, if the excerpt from Milton F is supposed to demonstrate how the GD was not the result of capitalism as it was practiced at the time, I'm not sure you picked the most decisive quote. What the excerpt seems to be saying is that intervention was required earlier than happened. He says the liquidity crisis started in 1930, that it was one of the major reasons for the Fed Reserve system, and that the purchase of bonds in 1931 may have ameliorated much of the problem. This seems to argue for gov't intervention, not a capitalist solution.

So what caused the liquidity crisis, etc? Your excerpt does not say. Not to say Friedman doesn't put forth plausible case in the rest of his book, but your quote doesn't cut it. Which makes me wonder if you really understand the situation you are trying to argue.

Next, "overwhelming consensus" does not mean that everyone agrees with the theory. However, this theory has been so pervasive for so long, you will find it tossed off casually in pretty much any history book you read. I'm reading something called "The Disposable American" and the author uses it as the explanation for the GD in a very off-hand manner, as if he couldn't conceive of it being in the least controversial. That's not to say that this "proves" the theory; rather, it shows how thoroughly accepted the theory has been for the last 70 years.

Next, there is nothing remarkable that you can trot out a book or two to defend your case. I'm saying that if you go to a bookstore, pick up a book at random that deals with the period, you will come across an an explanation much closer to my position than to yours.

So what are you saying caused the GD again?

Next, there is the pattern. The American economy had been subject to periods of boom and bust since the 1880s. The Panic of 1894 was especially bad. The GD was the last, and by far the worst of these cyclical busts. The cyclical nature of these busts seems to indicate that the cause was inherent in the system. Can you dispute that? If so, bring it on.

Finally, the real tragedy of the GD wasn't that it happened. It was that Herbert Hoover, acting on accepted econ principles of the time, believed that it was not the gov't's responsibility to do anything about it. Because of this "laissez-faire" attitude, the Depression deepened and worsened and millions of people suffered. Whatever the cause, the lack of gov't action doomed millions of people to hunger, deprivation, humiliation, despair...I could go on. I know this. I've heard people's stories. I have relatives from Kansas who lived through it.

That is the real problem. Mr Hoover's solution was to continue to dress for dinner to keep up the country's morale.

So, whatever the cause, a lot of regulations were put into effect. The point was to prevent the widespread suffering that happened in the 1930s. This is called a safety net. Some people would call this welfare, but, you know what? We're talking about 25% unemployment rates. I don't want to experience that again. Because of this, I believe that the gov't should play a role in acting as a buffer between its citizens and real tragedy.

If you don't agree with that, then go take a look at this photo. Maybe that will change your mind. It's called Christmas Dinner, 1936.

http://www.amarilloart.org/cu_xmas_dinner.html

The people in this picture weren't lazy or immoral. They just got caught in some powerful currents that they were helpless to fight. And any single one of us who's last name isn't Bush or Kennedy could find himself in the same boat. So I say we keep the safety net.

Posted by: klaus at May 21, 2006 8:04 PM

Klaus:

Thanks for taking the bait on this posting.

If deciding who can best explain the true causes of the Great Depression comes down to your socialistic layman's drivel or Nobel Laureate Friedman, I will err on the side of the Nobel Laureate every time.

Time has proven Friedman's theories to be empirically accurate and there is not a socialist in this world who can muster an empirically valid argument to support a viable counter argument.

Thanks for providing me with the ammunition to drive home this point. Good luck to you.

Posted by: Donald B. Hawthorne at May 21, 2006 9:15 PM

klaus,
I know how much you like the research of nonpartisan institutions. In 1998 the Mackinac Center for Public Policy put out "Great Myths of the Great Depression." (PDF). Now, I know that you probably won't believe the arguments put forth (and cited) because it wasn't produced by one of your kinds of "nonpartisan" institutions. But other readers who may be interested in a more nuanced analysis should check it out. As sample: What was the great myth about the cause of the Great Depression?

Old myths never die; they just keep showing up in economics and political science textbooks. With only an occasional exception, it is there you will find what may be the twentieth century’s greatest myth: Capitalism and the free-market economy were responsible for the Great Depression, and only government intervention brought about America’s economic recovery.
According to this simplistic perspective, an important pillar of capitalism, the stock market, crashed and dragged America into depression. President Herbert Hoover, an advocate of “hands-off,” or laissezfaire, economic policy, refused to use the power of government and conditions worsened as a result. It was up to Hoover’s successor, Franklin Delano Roosevelt, to ride in on the white horse of government intervention and steer the nation toward recovery. The apparent lesson to be drawn is that capitalism cannot be trusted; government needs to take an active role in the economy to save us from inevitable decline.
The study explains that the causes of the GD were many and that chalking it up to a "failure" of capitalism is simplistic. In short, there were really four causes:
I. Monetary Policy and the Business Cycle
II. The Disintegration of the World Economy
III. The New Deal
IV. The Wagner Act
There's much more out there. The Cato Institute has come to similar conclusions, arguing that government intervention had much more to do with causing (than solving) the Great Depression. But perhaps most important is this Policy Review article that explains why so many historians and economists failed to (and still fail to) properly explain the GD. By the way, one of the authors of the aforementioned piece is Paul Craig Roberts. Someone who klaus has previously and approvingly cited (see the comments to this post).

Posted by: Marc at May 22, 2006 8:31 AM