The Great Depression Crisis

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Table of Contents

Introduction
Economic History
Principle Causes of the Great Depression
The Crash of the Stock Market
The Run on the Bank and Monetary Policy
The Gold Standard
Recovery
References

Introduction

The year 1929 to 1939 marked the period when the western world was almost brought on its knees. Never in the history of civilization had the Western world experienced such a severe and prolonged period of depression.

The depression effects spread from United States to the rest of the world. Generally, there were spiraling rates of unemployment, reduced output and high levels of deflation across the globe. The economic and cultural crisis occurring as a result of the depression almost paralleled what was experienced during the Civil War.

Economic History

The effects of depression were felt at different times in different parts of the world. Europe and the United States were most affected. On the other hand, countries like Japan and those in Latin America were the least affected.

The depression was triggered by several factors such as inappropriate economic policies in United States that led to a decline of output, a fall in consumer demand and widespread financial panic (Duiker, 2007). The downturn was transferred to other parts of the world more conveniently due to the gold standard that was used by all countries to facilitate exchange of currency.

In retrospect, the great depression was brought to an end when the countries unanimously agreed to do away with the gold standard. Instead, a consensus of expanding the monetary policy was reached to reduce the likelihood of such an occurrence. New economic theories were adapted, new global economic institutions built and new microeconomic policies enacted and implemented (Romer, 1992).

The economic downturn began in the summer of 1929. The great depression was to wreck havoc from this period up to early 1933. Prices and output fell sharply. The United States experienced a 47% decline in industrial production and its GDP fell by 30%. Deflation which is the measure of a fall in wholesale price index had fallen by 33%. Unemployment is said to have gone up by 20% according to statistical reports (Keylor, 2001).

A person can understand best the severity of this depression when the foregoing statistical results are compared to the recession occurring from 1981 to 1982 in the United States. In between this period, GDP plummeted by 2%, unemployment had gone up by 10% and the prices increased dramatically though they suddenly started declining. The condition of gradual decline in prices after previously rising sharply is called disinflation.

A country like Great Britain had to endure prolonged periods of depression especially during the 20’s after having decided to revert to gold standard system with an overvalued currency (Crossley et al., 2009). However, the situation was less serious in Britain compared to United States if statistical evidence is anything to go by.

Statistics indicate that decline in industrial production in UK was a third that of the US. Though the effects of great depression were slightly felt in France, this country had difficulties recovering from slowed economic growth in 1932. This led to a substantial decline in prices and production from 1933 all the way to 1936.

Some countries in the Latin America were not spared from the effects of the great depression which occurred much earlier in comparison to United States i.e. in 1928 and 1929. Argentina and Brazil were least affected.

In Japan, the downturn occurred a little bit late i.e. in early 1930 and was not severe in comparison to United States and other parts of the globe. In every country that was affected, deflation of prices became similar to what was being experienced in United States. Wholesale prices plummeted by a margin of 30% in all developed countries from 1929 to 1933.

The reason why Japan was least affected was due to the flexibility of its price structure. This is what led to the occurrence of a rapid deflation from 1930 to 1931. It was this occurrence that prevented production in Japan from remaining low for a long period of time. Much of the prices of primary products such as cotton, rubber and others were sliced by half from 1929 to 1930(Keylor, 2001). This led to a decline in terms of trade for anyone who dealt with products of such nature.

Things began looking brighter in the mid – 1930’s. Output had begun rebounding and in the spring of 1933, recovery began to be experienced everywhere. In between 1933 and 1937, United Sates GDP is recorded to have grown at a steady rate of 9% annually. However, things worsened in between 1937 and 1938 but this condition did not last for long since it was replaced by a period of increased prosperity at the end of 1938.

The increase in output had stabilized by the end of 1942. The economy of Great Britain began improving a couple of years later after abandoning the gold standard in late 1931(Keylor, 2001). The same applied for most economies in Latin American which attained full recovery at the beginning of 1932.

In the fall of the same year, the economy of Japan and Germany had begun rebounding. Most European countries and Canada had their recovery go hand in hand with that of the United States that began in early 1933 (Crossley et al., 2009). Some developed countries and France in particular took longer to recover. This is because this country experienced depression much later and recovery began taking place at the fall of 1938.

Principle Causes of the Great Depression

The great depression was triggered primarily by a reduction in spending or aggregate demand. This forced manufacturers to shrink production after speculating a possible rise in inventories.

Other causes that led to a reduction in aggregate demand followed throughout the depression period and the effects were transmitted from the United States which was in essence the ‘epicenter’ of the depression to the rest of the world courtesy of the gold standard system. Other countries had unique factors that contributed to the escalation of depression.

The Crash of the Stock Market

Too much speculation in the stock market led the United States government to act by tightening its monetary policy. This move sparked a decline in output immediately after it was enacted in 1929. The economy was performing fairly well prior to the tightening of the monetary policy.

Mild recessions occurring in between 1924 and 1927 notwithstanding, the wholesale prices of goods continued to be stable for a whole decade. However, there were excesses in the stock market in that the prices of stocks were four times more at the end of the decade. In other words the stock prices were rising at an astronomical rate up from a low in 1921 and onto the peak that was reached by the close of 1929 (Findly & Rothney, 2006).

The Federal Reserve wanted to contain the spiraling stock prices and the stakeholders thought the best way to reach this end was to tighten monetary policy. This was in form of raising interest rates to a level that would make speculation to be difficult. The result was that sectors that were sensitive to interest rates drastically reduced their spending (borrowing).

These sectors included real estate, automobile and construction industry. This led to a decline in production. According to Crossley et al., (2009) a boom in housing construction may have also led to excessive supply of housing that consequently led to a decline in construction by the close of 1929.

The foregoing events made it almost impossible to gauge stock prices against anticipations of future earnings. Thus, when a minor event triggered a gradual reduction of prices by the fall of 1929, investors were no longer willing to take any risk. This happened in October 1929 and the stock market bubble finally burst due to pressure exerted by the monetary policy. Investors due to panic began selling their stock at very low prices.

This was sad mainly because most of the stock traded was bought using loans. The decline in stock prices was made worse by the fact that most investors were forced to liquidate their holdings (Findly & Rothney, 2006). On what is commonly called black Thursday on October 24, 1929, the prices had fallen by a record margin of 33% on the Cowles Index. The magnitude of the decline was so huge that the event taking place on this particular day was given the name of the Great 1929 Crash (Duiker, 2007).

American consumers were no longer capable of investing and in buying durable goods. The combined lack of spending by firms and individuals led to a sharp decline of output. Indeed, it was the great crash and the great depression combined with reduction of stock prices that led to unprecedented increase in unemployment and reduced output during this period (Keylor, 2001).

The Run on the Bank and Monetary Policy

By the close of 1930, great fear fell on all investors holding their money with the banks across the United States. The depositors due to widespread fear demanded their investments with the bank in the form of cash. Banks normally hold a small fraction of deposits in form of cash.

Thus, when faced with a situation where all depositors want their money immediately, banks are left with no choice but to initiate a process of quick liquidation of loans. This kind of action is very harmful in that even the strongest of the banks can end up closing.

There was a run on many banks across the United States from 1930 to 1932. The situation was so severe that President Roosevelt decided to close all banks on the 6^th of March 1933 (Adas, 2006). A bank would only be allowed to open after a rigorous process of vetting to ascertain its solvency. By the end of 1933, a third of the Banks in the United States had their doors closed permanently, never to open again.

The United States Federal Reserve failed to act promptly in order to contain the run on the bank. Consequently, people held more money than what they had as bank deposits. This led to a 33% shortage of money supply in US from 1929 to 1933. The situation was aggravated by the Federal Reserves decision to contract money supply.

Moreover, the Federal Reserve also raised interest rates thereby forcing most European countries including Britain to abandon the gold standard for the fear that the Dollar would as well be devalued. This led to a further reduction of money supply which in turn led to reduced output.

The Gold Standard

According to Adas (2006) the motive behind the contraction of money supply by the Federal Reserve was to try and preserve the gold standard system. This standard allowed individual countries to back their money in terms of gold. Under the system, an increase in demand of US products especially of stocks and bonds by foreign countries led to increased inflows of gold into the United States and vice versa.

The contraction meant that there would be large amounts of gold flowing from foreign countries and into the US. This is true because Americans found it difficult to purchase foreign goods and the deflation experienced throughout the country provided foreigners with an opportunity to purchase US goods.

Foreign countries reacted by raising their interest rates to counter possible US trade surplus and minimize the chances of weakening foreign currencies against the dollar. Thus, every other country that was privy to the gold standard systems was forced to reduce its money supply.

Recovery

To contain the ill effects of the great depression, governments across the globe were forced to devalue their currencies and expand their monetary policies. Countries that were quick to devalue their currencies and quick to abandon the gold standard recovered relatively fast.

Devaluation allowed countries to increase their money supplies with little regard to effects due to the exchange rates and the gold standard (Romer, 1992). However, recovery as a result of this action was quite slow in comparison to abandonment of the gold standard.

The Federal Reserve relaxed its monetary policy by increasing money supply between the periods of 1933 to 1937 by a margin of 42% (Findly & Rothney, 2006). This was possible because so much gold had found its way into the United States especially due to widespread instability that rocked Europe and that eventually led to the start of the Second World War. Similarly, other governments across the globe followed suit and increased their money supply.

This was made possible by lowering interest rates to encourage borrowing and investments so as to stimulate the economy by increasing output. Countries like Japan and Germany used Fiscal policies to stimulate economic recovery. However, this did not work well with the United Sates. Spending due to military activities increased the supply of money in most countries that went to war.

After the recovery, crucial measures were undertaken to cushion the depositor from losses in case a downturn of such a magnitude was to occur again in future. Banks were no longer allowed to trade in securities (Yetman, 2003). Furthermore, legislation was passed that allowed for the regulation of stock markets and banks were forthwith required to insure depositors’ money.

The depositor insurance policy received global acceptance and it led to increased depositor confidence. Moreover, governments around the globe resolved to increase government spending to impede any possible depression (Eichengreen & Sachs, 2008). Other measures such as reduction of taxes from time to time and monetary expansion would be used to curtail future deflationary effects.

References

Adas, M. (2006). Turbulent Passage: A Global History of the Twentieth Century. New York, NY: Longman.

Crossley, P. K., Lees, L. H., & Servos, J. W. (2009). Global Society: The World since 1900. Boston, MA: Houghton Mifflin.

Duiker, W. J., (2007). Contemporary World History. Boston, MA: Wadsworth.

Eichengreen, B., & Sachs, J. (2008). Exchange Rates and Economic Recovery in the 1930s. Journal of Economic History 4 (5), 925-946.

Findly, C. V., & Rothney, J. A. M. (2006). The Great Depression and the Second World War. Boston, MA: Wadsworth.

Keylor, R. (2001).The Twentieth-Century World, 4^th ed. Ardsley, NY: Transnational Publishers.

Romer, D. (1992). What Ended the Great Depression? Journal of Economic History. 52 (10), 757-784.

Yetman, J. (2003). The credibility of the monetary policy. Philadelphia, PA: University of Pennsylvania Press.

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