capitalism

214 Great Depression
GREAT DEPRESSION
The Great Depression was a worldwide economic collapse
that struck the United States particularly hard. American
economic output and prices fell dramatically from 1929 to
1933 while the unemployment rate reached an all-time high
and stayed high for over a decade. Economic historians
have concluded that the Depression was caused mainly by
the flawed policies of central banks, including the Federal
Reserve, in response to a malfunctioning international gold
standard, although additional economic weaknesses and
policy mistakes were involved. The response to the crisis
was a permanently enlarged national government. If you
body slam a physically fit economy, will it break? The
answer from the Great Depression seems to be: Almost.
The U.S. economy grew strongly during most of the
1920s, spurred by robust productivity growth derived from
recently introduced technologies, including electrification
and the internal combustion engine. It reached a peak in
August 1929 and then began an unprecedented contraction
that lasted until March 1933. During the contraction,
wholesale prices fell nearly 37%, whereas retail prices fell
about 28%. Real gross domestic product (GDP), the value
of all final goods and services produced in the economy
(adjusting for changes in prices), fell about 26.5%, dwarfing
the size of previous and subsequent economic downturns.
Not surprisingly, the unemployment rate exploded,
reaching 25% in 1933, meaning that one out of four wouldbe
workers was jobless. The official unemployment rate
subsequently exceeded 10% until 1940 (although these
numbers are inflated by counting emergency workers in
government programs as unemployed).
Agriculture, the construction industry, and manufacturing
were particularly hard hit. Prices paid to farmers fell by
half, dropping the ratio of the prices they received to the
prices they paid by more than a third. Industrial production
fell by 45% (with output of durable goods, such as automobiles,
falling 70–80%), and new housing starts dropped
82%. Gross investment plummeted by more than 80%,
meaning that the capital stock actually shrank because
depreciation outstripped new investment, although personal
consumption fell much less rapidly, only 18%. Although
almost everyone suffered, the economic pain was not
shared evenly; investors saw the value of the Dow Jones
Industrial Average fall over 80%, and soup lines swelled
with unemployed workers, but deflation-adjusted hourly
earnings of those with jobs were virtually unchanged. All in
all, the Depression hit harder in the United States than anywhere
else. From 1929 to 1932, total industrial production
fell by 11% in Britain, 23% in Italy, 26% in France, 32% in
Canada, 41% in Germany, and 45% in the United States.
Contemporaries lacked good explanations of the causes
of the Great Depression, which often led them to adopt
policies that only worsened the situation. However, economic
historians have done much to cast light on the matter.
The general consensus is that policy mistakes and a
malfunctioning international financial system converted an
ordinary business downturn into the Great Depression. As
Peter Temin and Barry Eichengreen put it, “central bankers
continued to kick the world economy while it was down
until it lost consciousness.”
Traditional explanations of the Depression begin with
the spectacular stock market crash of October 1929. The
crash wiped out significant gains in asset prices and drove
overleveraged investors into debt. It seems to have signaled
a shift from optimism to pessimism in the economy, but
most modern explanations see it as a secondary cause of the
Depression. Another factor that may have played an important
role in reducing aggregate demand is the dissipation of
a home construction boom, which peaked in 1926. In addition,
the enactment of the protectionist Smoot–Hawley
Tariff has been blamed for exacerbating the recession, especially
by inviting retaliatory tariffs among the country’s
trading partners. However, modern explanations of the
Depression begin with Milton Friedman and Anna
Schwartz, whose book, Monetary History of the United
States, 1867-1960, carefully documented how disruptions
in the financial sector harmed the rest of the economy.
Friedman and Schwartz argued that several waves of
banking failures, beginning in October 1930, led to a drastic
decline in the money supply, which caused considerable
damage to the overall economy. As these bank failures
unfolded, depositors became increasingly wary of keeping
their assets in uninsured banks. Banks moved to reassure
depositors by holding more of these deposits as reserves
and in assets like government bonds that were easy to
quickly convert into money. This scenario caused the supply
of loanable funds to shrink, driving up interest rates
and making it nearly impossible for many businesses and
households to borrow. Deprived of credit, businesses and
consumers were forced to curb their hiring and spending,
reducing the overall demand for output and pushing other
businesses and households to cut back as the crisis
snowballed. This drop in aggregate demand caused prices
to fall, but the deflation seems to have only worsened the
problem because debt levels were higher than in previous
downturns, so the drop in prices meant that it was harder for
borrowers to pay back their loans. Many defaulted, making
creditors even more wary to lend. Others paid back their
loans, but were forced to cut back spending elsewhere to do
so, exacerbating the problem. The extensive, fairly new
automobile loan market seems to have played an important
role because many of these loans were structured so that
missed payments could easily result in repossession and
loss of the built-up equity in the car, even if most of the loan
had been paid off. In addition, rapidly falling prices meant
that investors could come out ahead by simply sitting on