Financial & Economic Crisis

Great Depression

The Great Depression was a worldwide economic downturn starting in 1929 in most places and ending at different times in the 1930s and early 1940s in different countries. It was the largest and most important economic depression in modern history, and is used in the 21st century as a benchmark in how far the world's economy can fall. The Great Depression originated in the United States; historians most often use as a starting date the stock market crash on October 29, 1929, known as Black Tuesday. The end of the depression in the U.S. is associated with the onset of the war economy of World War II, beginning around 1939.

The depression had devastating effects both in the developed and developing worlds. International trade was deeply affected, as were personal incomes, tax revenues, prices, and profits. Cities all around the world were hit hard, especially those dependent on heavy industry. Construction was virtually halted in many countries. Farming and rural areas suffered as crop prices fell by 40 to 60 percent. Facing plummeting demand with few alternate sources of jobs, areas dependent on primary sector industries such as farming, mining and logging suffered the most. However, even shortly after the Wall Street Crash of 1929, optimism persisted; John D. Rockefeller said that "These are days when many are discouraged. In the 93 years of my life, depressions have come and gone. Prosperity has always returned and will again."

The Great Depression ended at different times in different countries. The majority of countries set up relief programs, and most underwent some sort of political upheaval, pushing them to the left or right. In some states, the desperate citizens turned toward nationalist demagogues with the most infamous being Adolf Hitler who set the stage for World War II in 1939.

The Great Depression was not a sudden total collapse. The stock market turned upward in early 1930, returning to early 1929 levels by April, although still almost 30 percent below the peak of September 1929. Together, government and business sector actually spent more in the first half of 1930 than in the corresponding period of the previous year. But consumers, many of whom had suffered severe losses in the stock market the previous year, cut back their expenditures by ten percent, and a severe drought ravaged the agricultural heartland of the USA beginning in the northern summer of 1930.

In early 1930, credit was ample and available at low rates, but people were reluctant to add new debt by borrowing. By May 1930, auto sales had declined to below the levels of 1928. Prices in general began to decline, but wages held steady in 1930, then began to drop in 1931. Conditions were worst in farming areas, where commodity prices plunged, and in mining and logging areas, where unemployment was high and there were few other jobs. The decline in the American economy was the factor that pulled down most other countries at first, after that internal weaknesses or strengths in each country made conditions worse or better. Frantic attempts to shore up the economies of individual nations through protectionist policies, such as the 1930 U.S. Smoot-Hawley Tariff Act and retaliatory tariffs in other countries, exacerbated the collapse in global trade. By late in 1930, a steady decline set which reached the bottom by March 1933.

Facts and figures

As a result of the Great Depression:
13 million people became unemployed.
Industrial production fell by nearly 45% between 1929 and 1932.
Home-building dropped by 80% between 1929 and 1932.
From 1929 to 1932, about 5000 banks went out of business.

Causes of the Depression

There were multiple causes for the first downturn in 1929, including the structural weaknesses and specific events that turned it into a major depression and the way in which the downturn spread from country to country. In relation to the 1929 downturn, historians emphasize structural factors like massive bank failures and the stock market crash, while economists such as Peter Temin and Barry Eichengreen point to Britain's decision to return to the Gold Standard at pre-World War I parities (US$4.86 to £1).

Recession cycles are thought to be a normal part of living in a world of inexact balances between supply and demand. What turns a usually mild and short recession or "ordinary" business cycle into a great depression is a subject of debate and concern. Scholars have not agreed on the exact causes and their relative importance. The search for causes is closely connected to the question of how to avoid a future depression, and so the political and policy viewpoints of scholars are mixed into the analysis of historic events eight decades ago. An even bigger question is whether it was largely a failure on the part of free markets or largely a failure on the part of governments to curtail widespread bank failures, the resulting panics, and reduction in the money supply. Those who believe in a large role for the state in the economy believe it was mostly a failure of the free markets and those who believe in free markets believe it was mostly a failure of government that compounded the problem.

Current theories may be broadly classified into three main points of view. First, there is orthodox classical economics including monetarist, Austrian Economics and neoclassical economic theory, all of which focus on the macroeconomic effects of money supply and the supply of gold which backed many currencies before the Great Depression, including production and consumption.

Second, there are structural theories, most importantly Keynesian, but also including those of institutional economics, that point to under-consumption and overinvestment (economic bubble), malfeasance by bankers and industrialists, or incompetence by government officials. The only consensus viewpoint is that there was a large-scale lack of confidence. Unfortunately, once panic and deflation set in, many people believed they could make more money by keeping clear of the markets as prices got lower and lower and a given amount of money bought ever more goods.

Third, there is the Marxist critique of political economy. This emphasizes contradictions within capital itself, which is viewed as a social relation involving the appropriation of surplus value, as giving rise to an inherently unbalanced dynamic of accumulation resulting in an over-accumulation of capital, culminating in periodic crises of capital devaluation. The origin of crisis is thus located firmly in the sphere of production, although economic crisis can be aggravated by problems of disproportionality of over-production in the manufacturing and related production sectors and the under-consumption of the masses.

Debt deflation

Irving Fisher argued that the predominant factor leading to the Great Depression was over-indebtedness and deflation. Fisher tied loose credit to over-indebtedness, which fuelled speculation and asset bubbles. He then outlined 9 factors interacting with one another under conditions of debt and deflation to create the mechanics of boom to bust. The chain of events proceeded as follows (1) Debt liquidation and distress selling (2) Contraction of the money supply as bank loans are paid off (3) A fall in the level of asset prices (4) A still greater fall in the net worth of business, precipitating bankruptcies (5) A fall in profits (6) A reduction in output both in trade and employment. (7) Pessimism and loss of confidence (8) Hoarding of money (9) A fall in nominal interest rates and a rise in deflation adjusted interest rates.

During the Crash of 1929 preceding the Great Depression, margin requirements were only 10%. Brokerage firms, in other words, would loan $9 for every $1 an investor had deposited. When the market fell, brokers called in these loans, which could not be paid back. Banks began to fail as debtors defaulted on debt and depositors attempted to withdraw their deposits en masse, triggering multiple bank runs. Government guarantees and Federal Reserve banking regulations to prevent such panics were ineffective or not used. Bank failures led to the loss of billions of dollars in assets. Outstanding debts became heavier, because prices and incomes fell by 20–50% but the debts remained at the same dollar amount. After the panic of 1929, and during the first 10 months of 1930, 744 US banks failed. Overall, 9,000 banks failed during the 1930s. By 1933, depositors had lost $140 billion in deposits.

Bank failures snowballed as desperate bankers called in loans which the borrowers did not have time or money to repay. With future profits looking poor, capital investment and construction slowed down or ceased completely. In the face of bad loans and worsening future prospects, the surviving banks became even more conservative in their lending. Banks built up their capital reserves and made fewer loans, which intensified deflationary pressures. A vicious cycle developed and the downward spiral accelerated. This kind of self-aggravating process turned a 1930 recession into a 1933 great depression.

The liquidation of debt could not keep up with the fall of prices which it caused. The very effort of individuals to lessen their burden of debt effectively increased it. The mass effect of their stampede to liquidate increased the value of each dollar they owed, relative to the value of their declining asset holdings. Paradoxically, the more the debtors paid, the more they owed.

Macroeconomists including Ben Bernanke, the current chairman of the U.S. Federal Reserve Bank, have revived the debt-deflation view of the Great Depression originated by Fisher.

Trade decline and the U.S. Smoot-Hawley Tariff Act

Many economists have argued that the sharp decline in international trade after 1930 helped to worsen the depression, especially for countries significantly dependent on foreign trade. Most historians and economists partly blame the American Smoot-Hawley Tariff Act enacted June 17, 1930 for worsening the depression by seriously reducing international trade and causing retaliatory tariffs in other countries. Foreign trade was a small part of overall economic activity in the United States and was concentrated in a few businesses like farming; however it was a much larger factor in many other countries. The average ad valorem rate of duties on dutiable imports during 1921–1925 was 25.9% but under the new tariff it jumped to 50% during 1931–1935.

In dollar terms, American exports declined from about $5.2 billion in 1929 to $1.7 billion in 1933; but as prices also fell, the physical volume of exports only fell by half. Hardest hit were farm commodities such as wheat, cotton, tobacco, and lumber. According to this theory, the collapse of farm exports caused many American farmers to default on their loans, leading to the bank runs on small rural banks that characterized the early years of the Great Depression.

U.S. Federal Reserve and money supply

Monetarists, including Milton Friedman and current Federal Reserve System chairman Ben Bernanke, argue that the Great Depression was caused by monetary contraction, the consequence of poor policymaking by the American Federal Reserve System and continuous crisis in the banking system. In this view, the Federal Reserve, by not acting, allowed the money supply as measured by the M2 to shrink by one-third from 1929 to 1933. Friedman argued that the downward turn in the economy, starting with the stock market crash, would have been just another recession. The problem was that some large, public bank failures, particularly that of the New York Bank of the United States, produced panic and widespread runs on local banks, and that the Federal Reserve sat idly while banks fell. He claimed that, if the Fed had provided emergency lending to these key banks, or simply bought government bonds on the open market to provide liquidity and increase the quantity of money after the key banks fell, all the rest of the banks would not have fallen after the large ones did, and the money supply would not have fallen as far and as fast as it did. With significantly less money to go around, businessmen could not get new loans and could not even get their old loans renewed, forcing many to stop investing. This interpretation blames the Federal Reserve for inaction, especially the New York branch.

One reason why the Federal Reserve did not act to limit the decline of the money supply was regulation. At that time the amount of credit the Federal Reserve could issue was limited by laws which required partial gold backing of that credit. By the late 1920s the Federal Reserve had almost hit the limit of allowable credit that could be backed by the gold in its possession. This credit was in the form of Federal Reserve demand notes. Since a "promise of gold" is not as good as "gold in the hand", during the bank panics a portion of those demand notes were redeemed for Federal Reserve gold. Since the Federal Reserve had hit its limit on allowable credit, any reduction in gold in its vaults had to be accompanied by a greater reduction in credit. Several years into the Great Depression, the private ownership of gold was declared illegal, reducing the pressure on Federal Reserve gold.

Austrian School explanations

Another explanation comes from the Austrian School of economics. Theorists of the "Austrian School" who wrote about the Depression include Austrian economist Friedrich Hayek and American economist Murray Rothbard, who wrote America's Great Depression in 1963. In their view, the key cause of the Depression was the expansion of the money supply in the 1920s that led to an unsustainable credit-driven boom. In their view, the Federal Reserve, which was created in 1913, shoulders much of the blame.

According to Friedrich Hayek’s opinion that he expressed in writing for the Austrian Institute of Economic Research Report in February 1929, the economic downturn was predicted to take place, stating that "the boom will collapse within the next few months."

Ludwig von Mises also expected this financial catastrophe, and was quoted as stating "A great crash is coming, and I don't want my name in any way connected with it," when he turned down an important job at the Kreditanstalt Bank in early 1929.

One reason for the monetary inflation was to help Great Britain, which, in the 1920s, was struggling with its plans to return to the gold standard at pre-World War I parity. Returning to the gold standard at this rate meant that the British economy was facing deflationary pressure. According to Rothbard, the lack of price flexibility in Britain meant that unemployment shot up, and the American government was asked to help. The United States was receiving a net inflow of gold, and inflated further in order to help Britain return to the gold standard. Montagu Norman, head of the Bank of England, had an especially good relationship with Benjamin Strong, the de facto head of the Federal Reserve. Norman pressured the heads of the central banks of France and Germany to inflate as well, but unlike Strong, they refused. Rothbard says American inflation was meant to allow Britain to inflate as well, because under the gold standard, Britain could not inflate on its own.

In the Austrian view it was this inflation of the money supply that led to an unsustainable boom in both asset prices including stocks and bonds and capital goods. By the time the Fed belatedly tightened in 1928, it was far too late and, in the Austrian view, a depression was inevitable.

The artificial interference in the economy was a disaster prior to the Depression, and government efforts to prop up the economy after the crash of 1929 only made things worse. According to Rothbard, government intervention delayed the market's adjustment and made the road to complete recovery more difficult.

Furthermore, Rothbard criticizes Milton Friedman's assertion that the central bank failed to inflate the supply of money. Rothbard asserts that the Federal Reserve bought $1.1 billion of government securities from February to July 1932, raising its total holding to $1.8 billion. Total bank reserves rose by only $212 million, however Rothbard argues that this was because the American people lost faith in the banking system and began hoarding more cash, a factor beyond the control of the Central Bank. The potential for a run on the banks caused local bankers to be more conservative in lending out their reserves, and this, Rothbard argues, was the cause of the Federal Reserve's inability to inflate.

Business

Franklin D. Roosevelt, elected in 1932, primarily blamed the excesses of big business for causing an unstable bubble-like economy. Democrats believed the problem was that business had too much money, and the New Deal was intended as a remedy, by empowering labour unions and farmers and by raising taxes on corporate profits. Regulation of the economy was a favourite remedy. Some New Deal regulation by the NRA and AAA was declared unconstitutional by the U.S. Supreme Court. Most New Deal regulations were abolished or scaled back in the 1970s and 1980s in a bipartisan wave of deregulation. However the Securities and Exchange Commission, Federal Reserve, and Social Security won widespread support.

Lack of government deficit spending

British economist John Maynard Keynes argued in General Theory of Employment Interest and Money that lower aggregate expenditures in the economy contributed to a massive decline in income and to employment that was well below average. In this situation, the economy might have reached a perfect balance, at a cost of high unemployment. Keynesian economists called on governments during times of economic crisis to pick up the slack by increasing government spending and/or cutting taxes.

Massive increases in deficit spending, new banking regulation, and boosting farm prices did start turning the U.S. economy around in 1933, but it was a slow and painful process. The U.S. had not returned to 1929's GNP for over a decade and still had an unemployment rate of about 15% in 1940 — down from 25% in 1933.

Inequality of wealth and income distribution

Marriner S. Eccles, who served as Franklin D. Roosevelt's Chairman of the Federal Reserve from November 1934 to February 1948, detailed what he believed caused the Depression in his memoirs, Beckoning Frontiers (New York, Alfred A. Knopf, 1951):
As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth -- not of existing wealth, but of wealth as it is currently produced -- to provide men with buying power equal to the amount of goods and services offered by the nation's economic machinery.

Instead of achieving that kind of distribution, by 1929-30 a giant suction pump had drawn an increasing portion of currently produced wealth into a few hands. This served them as capital accumulations. However by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.

That is what happened in the 1920s. High levels of employment in that period were sustained with the aid of an exceptional expansion of debt outside of the banking system. This debt was provided by the large growth of business savings as well as savings by individuals, particularly in the upper-income groups where taxes were relatively low. Private debt outside of the banking system increased about fifty percent. This debt at high interest rates largely took the form of mortgage debt on housing, office, and hotel structures, consumer instalment debt, brokers' loans, and foreign debt. The stimulation to spend by debt-creation of this sort was short-lived and could not be counted on to sustain high levels of employment for long periods of time. Had there been a better distribution of the current income from the national product -- in other words, had there been less savings by business and the higher-income groups and more income in the lower groups -- we should have had far greater stability in our economy. Had the six billion dollars, for instance, that were loaned by corporations and wealthy individuals for stock-market speculation been distributed to the public as lower prices or higher wages and with less profits to the corporations and the well-to-do, it would have prevented or greatly moderated the economic collapse that began at the end of 1929.

The time came when there were no more poker chips to be loaned on credit. Debtors therefore were forced to curtail their consumption in an effort to create a margin that could be applied to the reduction of outstanding debts. This naturally reduced the demand for goods of all kinds and brought on what seemed to be overproduction, but was in reality under-consumption when judged in terms of the real world instead of the money world. This, in turn, brought about a fall in prices and employment.

Unemployment further decreased the consumption of goods, which further increased unemployment, thus closing the circle in a continuing decline of prices. Earnings began to disappear, requiring economies of all kinds in the salaries and wages, and time of those employed. And thus again the vicious circle of deflation was closed until one third of the entire working population was unemployed, with our national income reduced by 50 per cent, and with the aggregate debt burden greater than ever before, not in dollars, but measured by current values and income that represented the ability to pay. Fixed charges, such as taxes, railroad and other utility rates, insurance and interest charges, clung close to the 1929 level and required such a portion of the national income to meet them that the amount left for consumption of goods was not sufficient to support the population.

Response measures

Early response

Secretary of the Treasury Andrew Mellon advised President Hoover that shock treatment would be the best response: "Liquidate labour, liquidate stocks, liquidate the farmers, liquidate the real estate.... That will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people." Hoover rejected this advice, and started numerous programs, all of which failed to reverse the downturn.

Hoover launched a series of programs to increase farm prices, which failed, expanded federal spending in public works such as dams, and launched the Reconstruction Finance Corporation (RFC) which aided cities, banks and railroads, and continued as a major agency under the New Deal. To provide unemployment relief he set up the Emergency Relief Agency (ERA) that operated until 1935 as the Federal Emergency Relief Agency. Quarter by quarter the economy went downhill, as prices, profits and employment fell, leading to the political realignment in 1932 that brought to power the New Deal.

The New Deal

Shortly after President Roosevelt was inaugurated in 1933, drought and erosion combined to cause the Dust Bowl, shifting hundreds of thousands of displaced people off their farms to the mid-west. From his inauguration onward, Roosevelt argued that restructuring of the economy would be needed to prevent another depression or avoid prolonging the current one. New Deal programs sought to stimulate demand and provide work and relief for the impoverished through increased government spending and institute financial reforms. The Securities Act of 1933 comprehensively regulated the securities industry. This was followed by the Securities Exchange Act of 1934 which created the Securities and Exchange Commission. Although it was amended, key provisions of both Acts are still in force. Federal insurance of bank deposits was provided by the FDIC, and the Glass-Steagall Act. The institution of the National Recovery Administration (NRA) remains a controversial act to this day. The NRA made a number of sweeping changes to the American economy until it was deemed unconstitutional by the Supreme Court of the United States in 1935.

Early changes by the Roosevelt administration included:
- Instituting regulations to fight deflationary "cut-throat competition" through the NRA.
- Setting minimum prices and wages, labour standards, and competitive conditions in all industries through the NRA.
- Encouraging unions that would raise wages, to increase the purchasing power of the working class.
- Cutting farm production to raise prices through the Agricultural Adjustment Act and its successors.
- Forcing businesses to work with government to set price codes through the NRA.

These reforms, together with several other relief and recovery measures were called the First New Deal. New regulations and attempts at economic stimulus through a new alphabet soup of agencies set up during 1933 and 1934 and previously extant agencies such as the Reconstruction Finance Corporation did not halt economic stagnation. By 1935, the "Second New Deal" added Social Security, a national relief agency (the Works Progress Administration, WPA) and, through the National Labour Relations Board, a strong stimulus to the growth of labour unions. Unemployment declined by over one-third in Roosevelt's first term from 25% to 14.3% between 1933 and 1937, but faster than the economic upturn came 1938's "recession within a depression" and unemployment zoomed to 19%, then declined to some extent until the draft to fight World War II lowered it further. In 1929, federal expenditures constituted only 3% of the GDP. Expenditures as a proportion of GDP tripled during 1933-1939, accompanied by sizable deficits. The debt as a proportion of GNP rose under Hoover from 20% to 40%. Roosevelt kept it at 40% until the war began, when it soared to 128%. After the Recession of 1937, conservatives were able to form a bipartisan conservative coalition to stop further expansion of the New Deal and, by 1943, had abolished all of the relief programs. In 1946, large-scale relaxation of government wartime economy, including a sharp reduction of taxes, allowed for increased innovation in consumer goods and a marked increase in consumer spending. Unemployment rates also returned to normal levels.

Gold standard
Every major currency left the gold standard during the Great Depression. Great Britain was the first to do so. In September 1931 facing speculative attacks on the pound and depleting gold reserves, the Bank of England stopped exchanging pound notes for gold and the pound was floated on foreign exchange markets.

Great Britain, Japan, and the Scandinavian countries left the gold standard in 1931. Other countries, such as Italy and the United States, remained on the gold standard until 1932-1933, while a few countries in the so-called "gold bloc", led by France and including Poland, Belgium and Switzerland, stayed on the standard until 1935-1936.

According to later analysis, the earliness with which a country left the gold standard reliably predicted its economic recovery. For example, Great Britain and Scandinavia, which left the gold standard in 1931, recovered much earlier than France and Belgium, which remained on gold much longer. Countries such as China, which had a silver standard, almost avoided the depression entirely. The connection between leaving the gold standard, the severity of depression and the length of time for recovery has proven to be consistent for dozens of countries, including developing countries. This partly explains why the experience and length of the depression differed between national economies.

Recovery

The massive rearmament policies to counter the threat from Nazi Germany helped stimulate the economies of Europe during 1937-1939. By 1937, unemployment in Britain had fallen to 1.5 million. The mobilization of manpower following the outbreak of war in 1939 finally ended unemployment.

In the United States, the massive war spending doubled the GNP, either masking the effects of the Depression or essentially ending the Depression. Businessmen ignored the mounting national debt and heavy new taxes, redoubling their efforts for greater output to take advantage of generous government contracts. Productivity soared: most people worked overtime and gave up leisure activities to make money after so many hard years. People accepted rationing and price controls for the first time as a way of expressing their support for the war effort. Cost-plus pricing in munitions contracts guaranteed businesses a profit no matter how many mediocre workers they employed or how inefficient the techniques they used. The demand was for a vast quantity of war supplies as soon as possible, regardless of cost. Businesses hired every person in sight, even driving sound trucks up and down city streets begging people to apply for jobs. New workers were needed to replace the 11 million working-age men serving in the military. These events magnified the role of the federal government in the national economy. In 1929, federal expenditures accounted for only 3% of GNP. Between 1933 and 1939, federal expenditure tripled, and Roosevelt's critics charged that he was turning America into a socialist state. However, spending on the New Deal was far smaller than on the war effort.

Political consequences

The crisis had many political consequences, among which was the abandonment of classic economic liberal approaches, which Roosevelt replaced in the United States with Keynesian policies. It was the main factor in the implementation of social democracy and planned economies in European countries after World War II. Although Austrian economists had challenged Keynesianism since the 1920s, it was not until 1974, when the Nobel Prize in Economic Sciences was awarded to Friedrich Hayek notably for being "one of the few economists who gave warning of the possibility of a major economic crisis before the great crash came in the autumn of 1929, and the beginning of monetarism, that the Keynesian approach was politically questioned, leading the way to neo-liberalism.

 

 
This article uses material from the Wikipedia article "Great Depression"

 

 

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