Causes of the Great Depression

A number of factors conspired to take the United States economy into a terrible depression in the 1930’s. The actual reason for the depression was a general loss of confidence in the American economy. The reason it got so bad was a general misunderstanding of recessions by American policy-makers of the time.

The U.S. economy was booming in the 1920’s. Stocks were regularly bought on margin and their value kept soaring. All investments fared well. The reason is cyclical—one stock looks good so I buy it. That makes the price rise and you see that this stock is performing well, so you buy it and the price rises more. This was happening across the entire market. People were buying thousands and tens of thousands of shares of stock for as little as 10% down. Unfortunately, that house of cards eventually tumbled and people lost ten times as much as they put in.

In the end, many people lost as much as ten times their initial investment in the crash of Black Tuesday. Having their confidences shaken and perhaps trying to cover there margins, they went en masse to banks. Since they were developing mistrust of the economic situation, many wanted there money out of banks and buried in their yards. The same thing that happened to the stock market was therefore propagated throughout the whole banking system. Banks ran out of cash and went bust. Few economic barriers (FDIC included) existed to prevent total collapse. The banks that did survive had to foreclose on a number of loans, collecting cars, land, and houses that nobody had the money to buy from the banks. As a result, these banks ended up with tons of property but no way to get cash from it. This cash shortage closed even more banks.

Let’s take a brief look at money. Money had inherent value then only inasmuch as the government promised to give $1 of gold for $1 in paper on demand. This meant that the money supply could never exceed the amount of gold the U.S. owned. Therefore, if the paper is no longer backed by anything it becomes inherently worthless and undesirable. Who wants paper when they could have gold (ironically we see many nations today dumping their gold supplies and buying U.S. dollars for the sake of stability)? In order to increase the money supply (with which to cover banks) FDR revoked the gold standard. Doing this forced people to place at least a limited amount of confidence back in the dollar (since a bill is only worth a dollar because the government says so and because it has to be so lest we have a barter-only economy). However, many people began hording gold and placing their confidence in it instead of bills. Many required payment in gold coin. To stop this and give the dollar more widespread acceptance, FDR issued an executive order confiscating all gold (besides personal jewelry) and replacing it with paper—a sort of reverse gold standard. This forced just a little bit more confidence in paper since there was no longer any choice in the matter.

With the economy falling in shambles and companies defaulting on loans, nearly all private and corporate investment ceased. Companies couldn’t afford to expand—in fact, many had to consolidate in order to cover the margins on their loans. In doing so they stopped hiring more people and began laying people off. Nobody else could afford to expand so unemployment sky-rocketed. With people willing to work for less money—than companies were currently paying, wages lessened too. At the same time prices rose in an attempt by companies to make some (small) amount of profit off the goods that few people could afford to buy anymore.

The prevailing opinion in government was that recessions were self-correcting. Eventually employment would reach equilibrium again and aggregate output would increase. As such, the government stood back and hoped the situation would correct itself. Eventually unemployment and inflation stopped declining—but not before the U.S. lost 1/3 of it’s output and 25% of the workforce was unemployed.

In the end, it was World War that brought us out of the Great Depression. With war at hand the government began pumping massive amounts of money into the economy. Production and inflation increased. To stop inflation, price-ceilings were set into effect. More jobs were available and wages rose. At the war’s end there was a brief recession while the economy reacted to a loss of the money the government had been pumping in. American optimism at victory was high and as such the faith of Americans in their country followed their increased patriotism. The market had finally corrected.