The Great Depression: 1929 to 1933
The Great Depression of 1929 to 1933 is a landmark event in the economic history of the world. Till date many organizations use the stress scenarios of this event in building their economic models.
Let us examine the causes and effects of the Great Depression of 1929.
Causes of the Great Depression:
A decline in the aggregate demand led to the Great Depression of 1929. A general loss of business confidence, stock market crash, gold standard, misplaced fiscal and monetary polices are cited as some of the reasons for the Great Depression.
Some the prominent causes are discussed below.
1. The Stock Market Crash 1929:
The Great Depression is a classic example of a correction in financial economy impacting the real economic activity. The stock market crash of Black Thursday, Oct 24, 1929 also called as the Great Crash caused a dent in the general business sentiment. This in turn led to decline in investment spending. The 'roaring twenties' during which many investors prospered in the stock markets came to an end with this great crash.This led to a decline in consumer spending and confidence.
The crash of 1929 led to a steady decline in the Dow Jones Industrial Average at least until 1934, and as we can see in the chart above, it took the best part of 25 years for the Dow Jones to climb back to the same level. 2. Gold Standard
The Gold Standard monetary system was probably the single biggest cause of the Great Depression. Under the Gold Standard, the currency was convertible into a fixed amount of gold which was fixed by the government of the day. The total quantity of currency in circulation had to backed by gold reserves of equivalent value.Foreign currency transactions were settled in terms of gold. So countries that ran trade deficit say large outflows of gold whereas countries that ran large trade surpluses say inflows of gold. To maintain the confidence in a currency and retain gold flows, the country had to limit the currency in circulation and raise interest rates. Modern day economics tells us that limiting the currency in circulation and raising interest rates leads to suppression of domestic demand and causes unemployment. The gold standard created a rigid system in which currencies were pegged to gold and did not provide enough flexibility for the monetary authorities to flex their muscle to ameliorate the demand situation.
Given below is a broad timeline of the Gold Standard.
The deflation caused by the stock market crash and deterioration of business sentiment in the United States was passed on to other nations through the Gold Standard. US goods were cheaper due to lack of domestic demand and as a result gold flowed into the US from other countries in Europe by way of exports from US. To prevent the outflow of gold other countries were forced to increase interest rates and resort to monetary contraction which resulted in suppression of their domestic demand. In this way a recession which started as a stock market correction in the US spread to the rest of the world. Even the United States had to resort to monetary contraction to restore confidence in the value of the dollar and prevent gold out flows, later on.
With the benefit of hindsight, the Gold Standard was a fundamentally flawed system. At some point the growth in currency circulation would have outstripped the gold reserves of the world. Fixed exchange rate mechanisms meant that efficiencies or inefficiencies in production and inflation could not be factored in to the currency exchange rates. Moreover protectionist policies and lack of co-operation between countries meant that the Gold Standard was bound to fail.
To be fair to the policy makers, monetary policy was still in formative stages and fiscal policy was reinvented by Keynes who came along only in 1936 with his General Theory of Employment, Interest and Money.
3. Bank Runs in 1930 - 35
Banking business is confidence business, when people lose faith in the banking system they latch on to whatever cash they can. This was a period when currency circulation was linked to gold reserves. When business sentiments were low and stock markets tumbled - production and consumption came to a virtual stand still - people wanted to hold on whatever cash they can. This resulted in banking panics in Europe and United States starting from 1930 and lasted till 1935. War time debt also meant that bank balance sheets were stressed with non performing assets.
4. International debt and trade
Countries resorted to protectionist policies in order to boost their exports and curb their imports. This led to dampening of demand for commodity exporting countries of Asia, Africa and Latin America. This was a period of great instability in international trade with countries resorting to competitive devaluation of their currencies to boost exports and prevent gold runs. Lack of international trust and co-operation in trade was among the principal causes that led to the Great Depression.
Debt incurred during the first world war led to the breakdown of the classical Gold Standard as countries minted money for military spending. Germany was forced to pay reparations to other European nations and they owed war time debt to America in turn. This meant that there were non-performing assets on bank balance sheets which in turn led to bank runs and loss of confidence in the financial system.
5. Real Estate Price Correction
Real Estate prices in the US also underwent a correction around the same period adding to the stock market panic which was like adding fuel to fire.
Economic Devastation
The impact of Great Depression on global economy was devastating and US economy suffered in particular. At the peak of the Great Depression in 1933, the national unemployment rate reached an unprecedented level of 25% in the US. Between 1929 and 1933 the US GDP declined from $104.56 billions to $57.154 billions. The precipitous decline in both aggregate demand and supply pushed the price levels to rock bottom.
The suffering and trauma experienced by people during the Great Depression was unimaginable and it cannot be captured in words. A series of documentary episodes on the Great Depression are available on the link below:
https://www.youtube.com/watch?v=VjH4pCatx0I
Critics often point out that relief measures undertaken by the administration of Herbert Hoover in the United States were insufficient and sometimes counterproductive.
In Europe and Asia, nations were fighting totalitarian and imperialistic forces during the first half of the century. Unlike the Americans, economic hardships were not new to people of other regions.
Recovery from the Great Depression
*As stated earlier, the single most important reason for the deepening of recession into the Great Depression was the linking of money supply to the Gold Reserves. This did not provide any flexibility to devalue currencies or reduce interest rates or monetary easing. So to recover from the Great Depression countries devalued currencies or abandoned Gold Standard.
*Countries which abandoned gold standard or devalued their currencies were quicker to recover from the recession than other countries. Britain abandoned Gold Standard in 1931 and America devalued its currency in 1933. So Britain was able to recover from the depression two years before America. While countries of Latin America, Argentina and Brazil recovered by 1935 as they started devaluing their currencies much earlier than others. Belgium and France were hanging on to the Gold Standard, so it took a longer time for them to recover from depression.
*After the passage of the Gold Reserve Act between 1933 and 1937, the US experienced an inflow
of Gold, which considerably eased up the money supply and reduced
interest rates. This also restored a positive inflationary expectation
among businesses, consumers, borrowers and lenders which helped in the
recovery.
*The role played by fiscal policy in the economic recovery was limited.
In 1932 the conservative government of Herbert Hoover increased taxes to
balance budget deficits - probably the worst time to increase taxes.
Franklin D Roosevelt came out with his ambitious 'New Deal' by providing
employment through a few government projects, introducing minimum wages, discouraging price competition and rationalizing agriculture produce .This
lead to improvement in working conditions and minimum wages. Agriculture
production was also rationalized in order to prop up food prices. But
critics quickly point out although the federal fiscal deficits increased
in size, the size of the state fiscal deficits reduced neutralizing the
impact of increased federal spending. The overall spending as a
percentage of GDP was small and not sufficient. Remember Keynes came in
to the picture only in 1936. Also minimum wage policy was not a great
idea at this stage of recovery - it resulted in increased burden on
businesses. Rationalizing agricultural produce resulted in increased
food inflation and scarcity which prolonged recovery. Overall, fiscal policy could have done much more to speed up the recovery in the US but those were the days of fiscal conservatism.
*In 1938, the US experienced another mid recession as shown in the chart
above due to increase in monetary reserve requirements by the Federal
Reserve. The reserve requirements were increased to curtail the excesses
of stock markets which proved counterproductive at this stage of
economic recovery. The net result was that the recovery was prolonged and lasted for one full decade.
*Did the second world war help in the US economic recovery ? The answer
is no. The real GDP of US by 1939 (before the start of the second world
war) was higher than that of 1929. But the second world war did prop up
employment and propelled the US GDP towards its long term growth levels. Between 1939 to 1944 unemployment rate in the US reduced
from 17.2% to 1.20%. Also the Federal Reserve supported the war cause by maintaining an adequate supply of money and low interest rates. The excesses of war related spending also caused
the economy to overheat as experienced by high levels of inflation during the war years.
Impact on Global Economics
*Keynes' The General Theory of Employment, Interest and Money (rings a bell?) proposed that the excesses of economic troughs can be softened by increasing fiscal spending. By increasing the fiscal spending governments can help in reducing the unemployment levels, speed up recovery, increase output and set the economic engine in motion to reduce human suffering and trauma. Keynes' theory of 1936 saw the birth of macroeconomics and till today policy makers around the world resort to fiscal spending to thwart the impact of recessions.
*The role of 'welfare state' has assumed greater importance after the Great Depression. Keynes' ideas and theories conquered the White House(as well as other parts of the world!) by way of the Employment Act of 1946 which stated that the government would take all necessary steps to promote maximum employment, production and purchasing power.
*The Bretton Woods conference was convened in 1944 where representatives of 44 countries met in New Hampshire to sort out international trade and currency exchange related issues. Some of the key aspects of Bretton Woods Agreement are discussed below.
*The pitfalls of Gold Standard were fresh in the memory of the delegates so they abandoned Gold Standard. As per the new agreement, the price of an ounce of gold was fixed at $35. All other countries pegged their currencies to the US dollar. In effect, instead of pegging currencies to gold, countries pegged their currencies to the US dollar. In addition countries agreed to fix their currency exchange rates within a 1% band width. In order to prevent countries from resorting to competitive devaluation the Bretton Wood system introduced a fixed exchange rate system.
*In retrospect, this was a flawed system, without a flexible exchange rate regime, the price levels of the United States would get exported to the rest of the world. The Gold Standard was abandoned by Nixon in 1971 and by 1973 most countries had switched to floating rate currencies.
*The United States agreed to exchange gold for dollar (after the Gold Reserve Act of 1934 the US experienced gold inflows) and the dollar was the reserve currency of the world now. The US was concerned that after the world war unemployment levels would raise again and therefore wanted to promote its exports to Europe and the rest of the world. European economies including Britain and France were ravaged and critically ill after the second world war. (This is also cited as one of the reasons for the declaration of independence for many European colonies including India). So Europe accepted financial help from the US and the US readily agreed because they needed someone to buy their exports. In effect, the world was America-centric now, not Britain-centric any more.
*To prevent speculative inflows and outflows of 'hot money' capital controls were introduced.So cash flows had to be in the form of foreign direct investment not speculative in nature.
*The International Monetary Fund and the International Bank for Reconstruction and Development (World Bank) were established with contributions from member nations. The IMF was set-up with the idea of helping those countries which face foreign currency issues due to current account deficits. The IBRD was entrusted with the responsibility of overlooking the post war reconstruction.
*The failure of the Gold Standard system was caused by non co-operation between nations. Countries adopted 'beggar-thy-neighbour' policies to protect their domestic economies from foreign competition. Import duties, tariffs, currency devaluations were rampant on both sides of the Atlantic. So the Bretton Woods system aimed at low tariffs, fixed exchange rates to facilitate international trade and promote capitalism.
References:
1. https://www.britannica.com/event/Great-Depression
2. https://www.econlib.org/library/Enc/GoldStandard.html
3. https://fred.stlouisfed.org/series/M1109BUSM293NNBR
4. https://www.britannica.com/topic/gold-standard
5. https://www.federalreservehistory.org/essays/bretton-woods-created
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