Cause Of The Great Depression Essay

The Great Depression was a period of unprecedented decline in economic activity. It is generally agreed to have occurred between 1929 and 1939. Although parts of the economy had begun to recover by 1936, high unemployment persisted until the Second World War.

Background To Great Depression:

  • The 1920s witnessed an economic boom in the US (typified by Ford Motor cars, which made a car within the grasp of ordinary workers for the first time). Industrial output expanded very rapidly. 
  • Sales were often promoted through buying on credit. However, by early 1929, the steam had gone out of the economy and output was beginning to fall.
  • The stock market had boomed to record levels. Price to earning ratios were above historical averages.
  • The US Agricultural sector had been in recession for many more years
  • The UK economy had been experiencing deflation and high unemployment for much of the 1920s. This was mainly due to the cost of the first world war and attempting to rejoin the Gold standard at a pre-world war 1 rate. This meant Sterling was overvalued causing lower exports and slower growth. The US tried to help the UK stay in the gold standard. That meant inflating the US economy, which contributed to the credit boom of the 1920s.

Causes of Great Depression

1. Stock Market Crash of October 1929

During September and October, a few firms posted disappointing results causing share prices to fall. On October 28th (Black Monday), the decline in prices turned into a crash has share prices fell 13%. Panic spread throughout the stock exchange as people sought to unload their shares. On Tuesday there was another collapse in prices known as 'Black Tuesday'. Although shares recovered a little in 1930, confidence had evaporated and problems spread to the rest of the financial system. Share prices would fall even more in 1932 as the depression deepened. By 1932, The stock market fell 89% from its September 1929 peak. It was at a level not seen since the nineteenth century.
  • Falling share prices caused a collapse in confidence and consumer wealth. Spending fell and the decline in confidence precipitated a desire for savers to withdraw money from their banks.
2. Bank Failures

In the first 10 months of 1930 alone, 744 US banks went bankrupt and savers lost their savings. In a desperate bid to raise money, they also tried to call in their loans before people had time to repay them. As banks went bankrupt, it only increased the demand for other savers to withdraw money from banks. Long queues of people wanting to withdraw their savings was a common sight. The authorities appeared unable to stop bank runs and the collapse in confidence in the banking system. Many agree, that it was this failure of the banking system which was the most powerful cause of economic depression.

50% fall in bank lending during the Great Depression. Period in grey - recessions.
  • Because of the banking crisis, Banks reduced lending, there was a fall in investment. People lost savings and so reduced consumer spending. The impact on economic confidence was disastrous.

Great Depression in US

Over 20% fall in US real GDP


Four consecutive years of negative growth 1929-32.

US unemployment rose from zero in 1929 to over 25% in 1932 - indicating the severity and seriousness of the decline in economic activity.

US Deflation

US price level. 1930-33 was a period of deflation (negative inflation) - fall in the price level.


Great Depression in the UK

The great depression in the UK was less severe because

There had been no boom in the 1920s (it was actually a period of low growth)

After leaving the Gold Standard in 1932, the UK economy recovered relatively well.


The UK also experienced a long period of deflation in the 1920s and 1930s. See: History of inflation

With falling output, prices began to fall. Deflation created additional problems.
  • It increased the difficulty of paying off debts taken out during the 1920s.
  • Falling prices encouraged people to hoard cash rather than spend (Keynes called this the paradox of thrift)
  • Increased real wage unemployment (workers reluctant to accept nominal wage cuts, caused real wages to rise creating additional unemployment)
Unemployment and Negative Multiplier Effect

As banks went bankrupt, consumer spending and investment fell dramatically. Output fell, unemployment rose causing a negative multiplier effect. In the 1930s, the unemployment received little relief beyond the soup kitchen. Therefore, the unemployed dramatically reduced their spending.

Global Downturn

America had lent substantial amounts to Europe and UK, to help rebuild after first world war. Therefore, there was a strong link between the US economy and the rest of the world. The US downturn soon spread to the rest of the world as America called in loans, Europe couldn't afford to pay back. This global recession was exacerbated by imposing new tariffs such as Smoot-Hawley which restricted trade further.

Different views of the Great Depression

Monetarists View

Monetarists highlight the importance of a fall in the money supply. They point out that between 1929 and 1932, the Federal Reserve allowed the money supply (Measured by M2) to fall by a third. In particular, Monetarists such as Friedman criticise the decisions of the Fed not to save banks going bankrupt. They say that because the money supply fell so much an ordinary recession turned into a major deflationary depression.

Austrian View

The Austrian school of Economists such as Hayek and Ludwig Von Mises place much of the blame on an unsustainable credit boom in the 1920s. In particular, they point to the decision to inflate the US economy to try and help the UK remain on the Gold standard at a rate which was too high. They argue after this unsustainable credit boom a recession became inevitable. The Austrian school doesn't accept the Friedman analysis that falling money supply was the main problem. They argue it was the loss of confidence in the banking system which caused the most damage.

Keynesian View

Keynes emphasised the importance of a fundamental disequilibrium in real output. He saw the Great Depression as evidence that the classical models of economics were flawed.
  • Classical economics assumed Real Output would automatically return to equilibrium (full employment levels), but the great depression showed this to be not true.
  • Keynes said the problem was lack of aggregate demand. Keynes argued passionately that governments should intervene in the economy to stimulate demand through public works scheme - higher spending and borrowing.
  • Keynes heavily criticised the UK government's decision to try balance the budget in 1930 through higher taxes and lower benefits. He said this only worsened the situation.
  • Keynes also pointed to the paradox of thrift.
Marxist View

The Marxist View saw the Great Depression as heralding the imminent collapse of global capitalism. With unemployment over 25%, Marxists held that this showed the inherent instability and failure of the capitalist model. Furthermore, they pointed to the Soviet Union as a country which was able to overcome the great depression through state-sponsored economic planning.

How important was Stock Market Crash of 1929?

The stock market crash of October 1929, was certainly a factor which precipitated events. It did cause a decline in wealth and severely affected confidence. However, changes in share prices were a reflection of the underlying boom and bust in the economy. Also, a collapse in share prices might not have caused the great depression if bank failures had been avoided. In October 1987, share prices fell by even more (22%) than black Monday. But, it didn't cause an economic recession.

Essays on the Great Depression by Ben S. Bernanke at Amazon.co.uk
Essays on the Great Depression by Ben S. Bernanke at Amazon.com

The Causes of the Great Depression

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The Causes of the Great Depression


Since the beginning of the Industrial Revolution early in the nineteenth century the United States ad experienced recessions or panics at least every twenty years. But none was as severe or lasted as long as the Great Depression. Only as the economy shifted toward a war mobilization in the late 1930s did the grip of the depression finally ease.
Stock prices had been rising steadily since 1921, but in 1928 and 1929 they surged forward, with the average price of stocks rising over 40 percent. The stock market was totally unregulated. Margin buying in particular proceeded at a feverish pace as customers borrowed up to 75 percent of the purchase price of stocks. That easy credit lured more speculators and less creditworthy investors into the stock market. The Federal Reserve board warned member banks not to lend money for stock speculation because if prices dropped, many investors would not be able to pay back their debts. No one listened. The stock market began sliding in early September, but people ignored the warning. Then on "black Thursday" (October 24, 1929) and again on "black Tuesday" (October 29, 1929) the ball dropped. More than 28 million shares changed hands in frantic trading. Overextended investors, suddenly finding themselves in heavily in debt, began selling their stocks. Many found that no one would buy anything at any price. Overnight, stock values fell from a peak value of 87 billion dollars to 55 billion dollars.
The crash was felt far beyond the trading floors. Speculators who borrowed money from the banks to buy their stocks could not repay the loans because they could not sell stocks. This caused many banks to fail. Since bank deposits were uninsured before the 1930s depositors' their money, which in many cases was all that many people had. The stock market crash intensified the course of the Great Depression in many ways. Besides wiping out the savings of thousands, it hurt commercial banks that had invested heavily in corporate stocks. It also caused a loss of confidence in the market prolonging the depression.

The downturn began slowly and almost unnoticeably. After 1927, consumer spending declined and housing construction slowed. Inventories piled up, and in1928 and 1929 manufacturers began to cut back on production and lay off workers. Reduced income and buying power in turn reinforced the downturn. By the summer of 1929 the economy was clearly in a recession.

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Although the stock market crash and its immediate consequences contributed to the Great Depression, longstanding weakness in the American economy accounted for its length and severity. Agriculture, in particular, had never recovered from the recession of 1920-1921. Farmers faced high fixed costs for equipment and mortgages incurred during the high inflationary war years. At the same time prices fell because of overproduction, forcing farmers to default on mortgage payments and risk foreclosure. Because farmers accounted for about one-forth of the nations gainfully employed workers in 1929, their difficulties weakened the general economic structure. Other industries also had experienced economic setbacks during the prosperous 1920s. The older industries such as textiles, mining, lumbering, and shipping faltered, newer and more successful consumer- based industries, such as chemicals, appliances, and food processing, proved not yet strong enough to lead the way to recovery.

The nations unequal distribution of wealth also contributed to the severity of the depression. During the 1920s the share of the national income going to families in the upper and middle-income brackets increased. Tax policies contributed to this concentration of wealth by lowering personal income tax rates, eliminating the wartime excess-profits tax, and increasing deductions that favored affluent individuals and corporations. In 1929, the poorest 40 percent of the population received only 12.5 percent of aggregate family income, whereas the wealthiest 5 percent received 30 percent. Many people would spend their entire yearly paychecks on consumer goods. When this stopped the economy was hurt. Once the depression began this unequal distribution of wealth prevented people from spending the amounts of money needed to revive the economy.
President Herbert Hoover blamed the severity of the depression on the international economic situation. The war battered international economy functioned only as long as American banks exported enough capital to allow European countries to repay their debts and to continue to buy American goods. As U.S. companies began to cut back production, they also cut back their purchases of raw materials and supplies from abroad and as a result many European economies collapsed. American financiers sharply reduced foreign investment and consumers bought less foreign goods, debt repayment became even more difficult. As European conditions worsened, demand for American exports fell drastically. Finally, when the Hawley-Smoot Tariff of 1930 raised rates to an all time high, foreign governments retaliated by imposing their own trade restrictions, further limiting the market for American goods especially agriculture products.

The United States was hit the hardest during this worldwide depression. From the height of the prosperity before the stock market crash in 1929 to the depths of the depression in 1932-1933, the U.S. gross national product was cut almost in half, declining from 103.1 billion dollars to 58 billion in 1932. Consumption expenditures dropped by 18 percent, construction fell by 78 percent, private investment plummeted by 88 percent, and farm income, already low, was more than cut in half. During this period 9,000 banks went bankrupt or failed. The consumer price index declined by 25 percent and corporate profits fell from 10 billion to 1 billion dollars. Most shocking was that unemployment rose from 3.2 percent to 24.9 percent from 1929 to 1933.

While the collapse of the stock market in 1929 may have triggered economic turmoil, it alone was not responsible for the Great Depression. The depression throughout the nation and the world was a result of a combination of factors that matured during the 1920s



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