Chapter 4
The Great Depression
The Great Depression
The Great Depression began in the United States and rapidly
spread to the rest of the world.
By 1933 25% of the U.S. labour force was out of work.
By 1932 industrial production in the United States was at only
55% of its 1929 level.
For Germany industrial production was at 59% of the 1929
level. This does much to explain the failure of democracy in
Germany and was a major cause of the Second World War.
The Great Depression
Just when there seemed to be signs of recovery in
mid-1931 there was a financial crisis in Europe,
leading to the failure of the Gold Standard. This ended
any recovery and it took the Second World War to
restore full employment.
The Great Depression could therefore be regarded as
two depressions combined – one beginning in the U.S.
in 1929 and one in Europe in 1931.
The Great Depression
The United States and Germany were the most severely
affected countries but no one escaped unscathed.
In this chapter we will examine:
(1) the causes of the U.S. depression;
(2) why prices were not sufficiently flexible to restore
employment;
(3) international factors, including the causes of the
international crisis of 1931.
THE U.S. DEPRESSION
One group of economists, including those described as “Keynesians”,
emphasize non-monetary or “real” factors as the primary causes of
the depression. They believe that the U.S. economy had serious
structural weaknesses which made the economy extremely
vulnerable to an economic shock.
“Monetarist” economists (notably Milton Friedman) argue that the
1929 collapse was due to monetary factors. They believe that the
U.S. economy was otherwise sound.
But monetary and non-monetary explanations need not be mutually
exclusive.
Both monetary and non-monetary factors played a role.
THE U.S. DEPRESSION
The disputes between monetarist and non-monetarist
economists centre on the collapse in 1929.
There is general agreement that a second collapse in 1931,
which reinforced that of 1929, was caused by problems in the
International economy.
We will now consider seven non-monetary factors.
Nonmonetary Factors (1)
(Income Distribution, Credit)
In the decade before the Depression there was a heavy reliance on credit to
sell consumer durables (e.g. cars, refrigerators)
- Average real incomes rose during the 1920s but real wages hardly
changed.
 This increased income inequality
- The share of profits rose, the wage share fell.
 wage earners were not earning enough to buy the new consumer
durables
Sale on credit enabled them to buy goods but this made the economy
exceptionally vulnerable to a credit squeeze, such as would result from bank
failures or a stock market decline.
Nonmonetary Factors (2)
(Composition of Production)
(2) Composition of Production. In the 1920s
there was an increase in the production share
of consumer durables, which were usually
bought on credit.
- This made the economy still more vulnerable
to a collapse in credit.
Nonmonetary Factors (3)
(Corporate Structure)
(3) There had been a change in the corporate
structure. The 1920s saw a growth in holding
companies and investment trusts.
According to J.K. Galbraith holding companies
were inclined to cut back on investments in
operating companies in order to maintain
dividend payments.
Nonmonetary Factors (4)
(Economic Theory)
(4) Economic Orthodoxy. Mainstream
macroeconomics between the two world
wars emphasized balanced budgets
– a view which created an obstacle to more
vigorous policies to combat the depression.
Nonmonetary Factors (5)
(Agriculture)
(5) A weak agricultural sector.
World overproduction of primary products following the First
World War resulted in low agricultural prices, especially for the
Staples (such as wheat).
There was a chronically weak rural economy and in the 1920s
a much larger proportion of the US population depended
directly or indirectly on agriculture than is the case today.
Nonmonetary Factors (6)
(Construction)
(6) There was a decline in construction after 1925.
- There was a falling birth rate and a tightening of
immigration controls in the 1920s.
 The result was slower population growth, which
led to reduced demand for new accommodations.
Nonmonetary Factors (7)
(A Keynesian Explanation)
(7) Alvin Hansen (1939) proposed a more long
term explanation.
He argued that the success of the U.S. in the
19th century was due to an expanding population,
which led to growth in consumption, and an
expanding geographical frontier (the expansion to the
west) which provided investment opportunities.
Nonmonetary Factors
But population growth had slowed down by the 1930s
and opportunities for geographical expansion were
exhausted.
There was a need for increased government
spending to maintain demand.
- But in the 1920s government expenditure was
actually being reduced, not increased.
Monetary Factors (1)
(Too many small banks)
The monetarist view was put forward by Friedman and Schwartz in
the Monetary History of the United States. They emphasized the
following points:
(1) There were too many small, local banks
- They were vulnerable to bank runs.
- These banks provided credit for stock market speculation and credit to
farmers.
When the stock market crashed, borrowers were unable to repay loans
 banks were ruined.
Almost 9,000 banks failed between 1930 and 1933.
Monetary Factors (2)
(Mistakes of the Fed)
(2) The U.S. Federal Reserve (the “Fed”) should have assisted
the banks by providing them with cheap credit.
It failed to do so.
After 1931 the Fed actually raised interest rates to stop the
outflow of gold (because of the international financial crisis of
that year).
Recent Explanations of the
Depression
We now look at some more recent
explanations:
(1) Credit Hypothesis (Bernanke)
(2) Deflationary Expectations (Temin)
(3) Stock Market Crash (Romer)
Credit Hypothesis
Ben Bernanke (recent head of the U.S. Federal
Reserve) put forward the Credit Hypothesis.
This has two main features:
(1) Deflation reduced the nominal value of
assets held in bank balance sheets – fear of
insolvency forced them to cut back on lending –
there was therefore a prolonged credit
squeeze.
Credit Hypothesis
(2) Bank failures – banks are the major source of
funds for small businesses and it requires time and
effort for them to acquire information about the
creditworthiness of these businesses– when banks fail
this information is lost
 businesses find it hard to obtain credit from other
banks.
Deflationary Expectations
Peter Temin emphasized the role of
deflationary expectations – if people expect
prices to continue falling they will postpone
purchases.
Temin believes that deflationary expectations
had set in by the start of 1931, so consumption
was depressed.
The Stock Market Crash
On “Black Thursday” (October 24, 1929) 12.9 million
shares were traded ( a record at that time).
On “Black Tuesday” (October 29, 1929) 16 million
shares were traded.
By 1932 the Dow-Jones Industrial Index had declined
by 89 per cent.
The Stock Market Crash
The Crash reduced private wealth by about ten
per cent but most economists believe this was
not enough to explain the severity of the
Depression.
Christina Romer, however, believes that the
main effect of the Crash was in generating
uncertainty about future incomes.
The Stock Market Crash
It was this uncertainty, rather than the
immediate decline in wealth, that caused
consumers to cut back purchases and
producers to cut back investment.
Wage Rigidity
An important question to ask is why, once the economic collapse had
occurred, it took ten years for the Depression to end.
The classical economists of the 19th century had believed that falls in
demand would only have only a brief effect on output and employment
because prices and wages would quickly fall to restore the economy to full
employment.
This had happened in earlier economic crises, such as the post-war
recession of 1920-21.
Wage Rigidity
But by 1929 wage rigidity had appeared and wages adjusted
only very slowly. Why was this so?
Various explanations have been suggested, including:
(1) More generous social programs made workers less willing
to accept wage cuts –but such policies did not exist in the
United States at that time.
Wage Rigidity
(2) Increased bureaucratization in large enterprises
(and large unions) made frequent wage adjustments
more difficult.
(3) Government and business leaders had become
converted to a “high wage” policy in the belief that
high wages would make it possible for employees to
buy goods.
International Aspects
We now come to the international factors which
prolonged the Depression.
International explanations focus on:
(1) Protectionism.
(2) Charles Kindleberger’s financial leadership model.
(3) The role of the Gold Standard.
(1) Protectionism
The Depression has often been blamed on
Protectionism – the Smoot-Hawley Tariff in
particular.
But while tariffs can result in inefficiency they
would only have a significant effect on U.S.
production if they prompted enough
retaliation to massively reduce exports.
Protectionism
There was retaliation against the Smoot
Hawley Tariff but U.S. exports fell by only 1.5%
of GDP over the next two years – nowhere near
enough to explain the Depression.
(2) Kindleberger
Kindleberger focused on financial leadership.
In his view the international economy is inherently unstable
 it needs strong leadership to provide stability.
The United Kingdom provided leadership before 1913
- It had a policy of free trade.
As indicated in Chapter 3, British international lending was
counter-cyclical.
But after 1918 the United Kingdom was too financially weak
to fill the leadership role.
Kindleberger
The United States could have provided
leadership but did not do so after the First
World War (though it did after the Second
World War).
Instead, it practiced protectionist policies.
And U.S. lending was pro-cyclical.
(3) The Gold Standard
The weaknesses of the inter-war gold standard were described in Chapter 3.
The fundamental problem was similar to the one currently facing the
Eurozone, which will be discussed later.
The gold standard was supposed to be symmetrical
– surplus countries would adjust through inflation
- deficit countries would experience deflation.
The Gold Standard and the Crash
of 1931
But in practice in the 1920s surplus countries
“sterilized” gold flows, forcing all the adjustments on
to deficit countries.
Eventually, in 1931, the international financial
system crashed, just as fragile signs of recovery
were beginning to emerge.
Financial Crisis of 1931
It shattered the fragile recovery .
There was a domino effect, moving from Austria to Germany to
Britain and, finally, to the United States.
It began in June with Austria with the failure of the Credit-Anstallt
(Austria’s largest bank).
Later in June Germany felt the effects.
Panic spread to German banks, which had close ties to Austria.
Confidence was undermined by the coincidental collapse of the North German Wool
Company.
By July several banks were insolvent.
The German government suspended reparations payments.
Financial Crisis of 1931
In August the crisis moved to the United Kingdom.
British banks had made advances to German banks.
Unfortunately two damaging reports came out at the same time:
(1) The Macmillan Committee reported that short-term obligations
of British banks exceeded their short-term claims.
(2) The May Committee reported that the government would face a
budget deficit, which violated the economic orthodoxy of the time.
 There was an outflow of gold reserves from London.
Britain forced off Gold (September).
Collapse of Gold Standard (1931)
This undermined confidence in the gold
standard and led to a flight of gold from U.S.
 U.S. Federal Reserve (the “Fed”) brought in
a credit squeeze to stop the outflow, which
plunged the U.S. deeper into the Depression.
 In April 1933 the new president, Franklin D.
Roosevelt suspended gold payments.
This effectively ended the gold standard.
Regional Currency Systems
With the collapse of the Gold Standard there was no longer a single
international monetary system. There were now four major
currency “blocs”:
(1) Sterling Area
(2) Dollar Area
(3) Exchange Control Area
(4) Gold Bloc (until 1936)
A Japanese yen bloc could also be added.
Regional Currency Systems
(1) Sterling Area
- Used pounds sterling as an international currency. Members
included:
United Kingdom
Commonwealth (except Canada)
Several small European countries
Much of the Middle East
(2) Dollar Area
- Used U.S. dollars as an international currency. Members included:
United States
Canada
Latin America
Regional Currency Systems
(3) Exchange Control Area
Used a system of exchange controls and bilateral agreements
(to be described shortly). It included:
Germany
+ Several countries in central and eastern Europe
(4) Gold Bloc
A few countries stayed on gold (for the time being).
The main members were France and Italy.
They now faced speculation as Britain and the U.S. had
previously.
 France was forced off gold in 1936.
Restrictions on Finance and Trade
The 1930s saw even more more restrictions on trade and
finance than the 1920s, though the end of the decade saw
Some shift towards cooperation. We will now look at:
(1) Exchange Controls.
(2) Bilateral Agreements.
(3) Trade restrictions.
(4) Attempts at international agreements.
(1) Exchange Controls
With exchange controls foreign currency
transactions are controlled by the central bank
or a government agency.
The obvious disadvantage is that this distorts
trade patterns
Exchange Controls
But in the context of the 1930s exchange controls had three
advantages:
(1) They prevented foreign exchange crises.
(2) They enabled governments to pursue expansionary
domestic policies without having to worry about the flight
of financial capital.
(3) They allowed artificially high exchange rates which
alleviated any fears of inflation and reduced foreign debt
service costs.
(2) Bilateral Agreements
Several countries entered bilateral agreements, of
which there were three main kinds:
(1) Compensation agreements – these were effectively
barter agreements.
(2) Clearing agreements.
- Each country in a bilateral clearing agreement would
maintain a bank account in the other country.
- It could use funds in this account only to buy the other
country’s goods.
Bilateral Agreements
Germany organized the Exchange Control Area
which utilized a system of clearing
agreements.
It was known as the Schacht System after the
Nazi Minister of Economy (and former
Currency Commissioner), Hjalmar Schacht.
Bilateral Agreements
(3) Payments agreements were another attempt at
international cooperation.
- They covered not just trade in goods but also types
of financial transactions, e.g. debt repayments.
-The only important payments agreement at this time
was the Anglo-German Agreement of 1934.
(3) Trade Restrictions
Most countries did not have exchange controls
but there was an increase in other kinds of
trade barriers. Examples are:
Smoot-Hawley Tariff (1930) – in U.S.
Import Duties Act (1932) – in U.K.
There was also an expanded use of import
quotas, i.e. quantitative restrictions.
(4) Attempts at Cooperation
There were few attempts at cooperation but there were some:
(1) The Bank for International Settlements (BIS) was created to manage
German reparations payments and promote cooperation between
central banks. It still performs the second of these functions.
(2) The Tripartite Monetary Agreement between France, United Kingdom,
United States was signed in 1936. It did not get far because of the
Second World War but it was a precursor to the Bretton Woods
Agreement.
(3) The Ottawa Agreement (1932) set up a system of tariff concessions
between Commonwealth countries which continued until 1973.
(4) Commercial companies set up cartels to divide up the world market.