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CAUSES OF THE GREAT DEPRESSION

Disagreement over the causes of the Great Depression began before the economic collapse that commenced in 1929 had even been given that name, and the disagreement has persisted ever since. Nor does the debate show any signs of imminent resolution in the early twenty-first century. Arguments over what caused the Great Depression are deeply entwined with economic, social, and political philosophy.

A major reason for the controversy is that the Depression seemingly disproved the efficacy of the unregulated free market. Defenders of the faith of classical free market economics are, therefore, obliged to seek elsewhere for the causes of the collapse of the economy following a decade of lowering taxes and lifting restrictions on business by successive Republican administrations. It is an article of dogma to them that an unfettered marketplace is self-correcting. Accordingly, devotees of Adam Smith's worldview must find fetters—some sort of government interference or regulation—on which to lay the blame.

WORLD WAR I AND THE ORIGINS OF THE GREAT DEPRESSION

Although it was in many ways eclipsed by the second installment of the twentieth century's world conflict, World War I (or "the Great War" as it was still known at the time of the Depression) was a major source of much of what happened in the world for most of the remainder of the century, including World War II and the Cold War. The role played by the Great War in helping to produce the Great Depression was also significant. Although the death toll from World War I was relatively small for the United States, the war was catastrophic for many European nations.

The war's economic impact was similarly profound. The war stimulated and distorted the economies not only of the belligerent nations, but those of many nonbelligerents as well. Wartime inflation was followed by postwar deflation in most countries. During the war and for several months after the armistice, demand for American farm products, especially grains, soared, as did prices. Such profitable conditions led American farmers to go deeply into debt to buy additional land and machinery. These happy circumstances for American farmers were, however, an artificial consequence of the war, which severely disrupted European agriculture. When the latter recovered rapidly after the war, the demand for the expanded production of American farms plummeted, helping (along with a sharp contraction in the money supply) to carry the economy into a sharp recession in 1920 and 1921. Agriculture was to remain in depressed conditions throughout the period of more general prosperity from 1923 to 1929.

The war also radically altered international finance. It transformed the United States for the first time from a net debtor nation into the world's largest creditor. Massive war debts owed by the British and French to American creditors were part of the economic landscape of the 1920s, as were the huge reparation payments the European victors demanded from Germany. The problem of war debts and reparations was a continuing irritant to the international economy in the twenties.

Perhaps more significant in its adverse effects on the world economy was the war's establishment of the United States in the role previously held by Great Britain as the world's banker or creditor-in-chief. This position carried with it responsibilities for which the Americans were ill prepared and that they were disinclined to shoulder. In particular, American political leaders of the twenties were committed to maintaining a favorable balance of trade, meaning that they wanted the nation to export more than it imported. This posture was, in the long term, incompatible with America's assumption of the position of the world's leading lender, because other countries had to sell more to the United States than they bought from it if they were to have the funds to repay the debts they owed to American creditors.

THE STOCK MARKET CRASH

This much can be stated categorically: Popular perceptions to the contrary notwithstanding, the stock market crash of October 1929 did not cause the Great Depression. Although hardly anyone realized it at the time, the economic contraction that became the Depression had already begun in the summer of 1929, when the economy started to slow considerably.

"You know," Herbert Hoover once remarked to journalist Mark Sullivan, "the only trouble with capitalism is the capitalists; they're too damn greedy." This is a truism that has been proven repeatedly, but it is also true that greed is a highly contagious disease against which few people's immune systems provide much protection. This is particularly the case when those already infected are actively working to spread the contagion, as many of them were in the 1920s. (Du Pont executive and Democratic National Chairman John J. Raskob, for example, wrote a 1929 article entitled, "Everybody Ought to be Rich.") The result was an epidemic of greed in the United States in the mid and late 1920s.

The first major outbreak of the disease in the decade occurred in Florida, where it took the form of real estate speculation. It began with the reality of the growing value of beachfront property in a place with warm winters that had been made accessible to well-to-do northeastern and midwestern residents by the development of the automobile and the construction of highways. Quickly, however, Florida real estate became a classic bubble in which prices rose far beyond realistic values, simply because they were rising. That is, speculators were willing to pay ever higher prices for land because they expected someone else to be willing to pay even more for it a week or a month later. The Florida bubble burst, as all bubbles that keep expanding ultimately must, following a severe hurricane in 1926, but the greed virus had already infected a different area: Wall Street (which was, in any case, its natural habitat).

The Great Bull Market of the late twenties was fueled by easy credit in the form of margin buying (buying stock by putting up a small percentage of its cost in cash and borrowing the rest "on margin," using the stock itself as collateral for the loan). In a rapidly rising market, the "leverage" provided by margin buying made the possibilities for huge profits extraordinary. By the time the Federal Reserve sought to dampen the speculative fever in 1928 and 1929 by raising interest rates, the mania had taken on a life of its own. "Nothing matters as long as stocks keep going up," the New York World said as 1929 began. "The market is now its own law. The force behind its advance are now irresistible."

Historian Maury Klein sums up the situation well in his book Rainbow's End (2001): "Put simply, too many people held too much stock on borrowed money." When the economy began to slow in the summer of 1929, it sent signals to Wall Street that were disregarded by most investors, but heeded by many of the richest insiders. Among those who quietly got largely out of the market before the bottom fell out were Raskob (who apparently thought that he ought to remain rich while "everybody" lost their shirts), Bernard Baruch, Joseph P. Kennedy, and President Hoover himself.

The crash was a response to an already begun, but as yet invisible to most observers, Depression. It amounted to a spectacular funeral for the "New Era" of eternal prosperity that had been proclaimed a few years earlier. Funerals, it is worth remembering, do not cause death; they recognize the decedent's passing, which has already occurred. Such was the relationship between the crash and the demise of prosperity.

The crash did, however, accelerate the downward spiral of the economy by wiping out much of the paper wealth of investors and by altering the previously euphoric outlook of so many people into one of pessimism, which led them to be much more cautious in their spending and investment. Both of these consequences of the crash further eroded demand.

MONETARY POLICY AND THE GOLD STANDARD

There is no question that the money supply can have profound effects on the economy. In the simplest terms, if the money supply is insufficient, prices must fall, which can lead to the sort of serious deflation that contributed to the Panic of 1893, the worst economic depression in American history prior to the Great Depression. If, on the other hand, the money supply grows faster than the demand for money, prices will rise, causing inflation. In the late 1920s and early 1930s, the most notable and recent example of the potentially catastrophic consequences of runaway price increases was the hyperinflation that had gripped Germany in 1922 and 1923, when the exchange rate between the German and American currencies went in less than two years from 192 marks to the dollar to 4.2 trillion marks to the dollar. Annualized for the two years, this was an inflation rate in excess of a trillion percent a year. By November 1923, German money was essentially worthless.

Germany's horrible experience with hyperinflation contributed to the coming of the Depression in two important ways. First, it wreaked havoc on the German economy and those of several other central European countries, and they never fully recovered from the effects for the remainder of the decade. Second, the German disaster caused other nations to be unduly concerned with avoiding inflation when the more dangerous economic predator lurking in the shadows of late twenties prosperity was actually deflation. In their efforts to defend their nations against inflation, political and economic leaders inadvertently strengthened the building forces of deflation.

In the decades prior to World War I, most major countries had been on the gold standard, meaning that their currencies were convertible to a set amount of gold. This meant that the value of all currencies on the gold standard had a stable exchange rate with other currencies that were tied to gold. The gold standard was abandoned by most of the belligerents during World War I (the United States, a late entrant into the war, remained on the gold standard), but there was a concerted effort to restore it after the war. Because of the major disruptions of the war, exchange rates were allowed to float from 1919 to well into the 1920s. Such floating rates provided some protection against the problems in one or a few countries spreading to other countries, but most nations' governments were committed to returning to the gold standard with fixed rates of exchange as rapidly as possible. Great Britain did so in 1925 and France followed in 1928. By 1929, forty-five nations were on the gold standard.

By 1929, much of the world's gold was rapidly flowing into the United States and France. Attempts by various countries to keep their currencies at prewar exchange rates led them into deflationary policies, intended to cheapen the prices of their products on the international market and so bring gold back into their countries to support their currencies. These deflationary actions contributed to a worldwide contraction in economic activity.

TECHNOLOGY AND THE DEPRESSION

Technology was in three major respects a significant factor in creating the conditions that produced the Great Depression.

First, new technologies provided much of the impetus for the unprecedented prosperity of the 1920s. The development of important new products that large numbers of people can be persuaded to buy is often the driving force in periods of economic boom, as appears to have been the case with personal computers and the Internet in the boom of the 1990s. The development of such new consumer products encourages investment in new plants and equipment and provides employment for large numbers of workers. This was plainly the case with the automobile in the 1920s. The motor car was not new in the twenties; nor was its method of mass production, which had been perfected prior to World War I. What was new in the decade following that war was the enormous expansion of the market for cars and the rapid development of numerous industries that were stimulated by the mass ownership of automobiles. Among these booming industries of the prosperity decade that preceded the Depression were petroleum (exploration, drilling, refining, and retailing); steel production; road and highway construction (which pulled along the cement industry); and motels, diners, and tourist attractions.

Nor was the automobile alone among new technologies that had been developed by the early 1920s in providing fuel for the economy of the decade. Radio, little more than a promising curiosity at the decade's start, had spread across the nation and into the homes of a majority of Americans by 1929. Along with the automobile and, to a lesser extent, a variety of new household appliances, the swift rise of radio to the status of "necessity" for middle-class life provided an enormous stimulus to the economy.

It should be noted that while the potential market for radios and electrical appliances was huge, it was limited to areas where electricity was available. Although all densely populated parts of the United States were electrified, large expanses of rural America were not, so rural Americans were not part of the potential market for electrical devices. Additionally, while there was no such access barrier to farmers buying automobiles (and many did buy them), the fact that agriculture remained economically depressed throughout the decade also reduced the potential market for automobiles among the nation's farmers.

A rapid economic expansion induced by the products of new technology can be great while it lasts, but it is, almost by definition, limited in its duration. Once most consumers have purchased the new products, demand for them must decline. Businesses involved in the industries can try to lessen the effects of a saturation of the market for their products by trying to expand the potential number of consumers through lower prices and installment purchase plans. They can also use the introduction of new models and planned obsolescence to churn the market with repeat customers. Both of these strategies were employed to considerable effect in the second half of the 1920s. Even so, the trajectory of new sales of a new technology will almost always be downward as the market for the product approaches saturation.

If an economic boom that has been stoked by one or more new technologies is to continue after the market for it or them has been largely supplied, new technologies that can be made to appear to be necessities for consumers must be introduced. The lack of such additional new products in the second half of the 1920s is the second way in which technology played a significant part in causing the Depression. In terms of the development of new or significantly improved products, the ten-year period beginning in 1925 was probably the least productive time in the twentieth century. The only major new product introduced during those years, as the economy moved from extraordinary boom to unprecedented bust, was the electric refrigerator.

If technological innovation failed to introduce much in the way of new products during the late 1920s and early 1930s, that did not mean that there was a hiatus in technological advance. On the contrary, there was great technological advance in the methods for producing the products that had already been developed. During the 1920s, productivity of industrial workers increased by 50 percent or more. And, even while huge numbers of workers were jobless in the 1930s and wages were very low, technological advances in manufacturing processes continued, resulting in another 25 percent increase in productivity in that decade.

The effects of this sort of technological advance on the economy tend to be the opposite of those of the development of new products, and the rapid innovation in productive processes in the 1920s was the third major contribution of technology in laying the groundwork for the Great Depression.

Certainly process innovation requires some new investment, but it is usually on a much smaller scale than that required for manufacturing new products. Furthermore, improvements in the technology of production usually lead to the number of machines and buildings used to make products being decreased. Most important, the whole point of such innovations in process is to increase productivity, so they almost invariably result in fewer workers being employed to manufacture a given quantity of the ultimate consumer product. In the six years from 1923 to 1929, output per person-hour of labor in manufacturing in the United States increased by nearly 32 percent.

To summarize the role of technology in the Depression: Technological advances that introduced new products greatly stimulated the economy of the 1920s, but the lack of new products in the late 1920s placed a drag on the economy when the market for the earlier innovations became largely saturated. Continuing advances in the technology of producing already existing goods contributed to an increase in unemployment and to a lessening of demand, both because of the unemployment itself and because increased productivity without corresponding wage increases reduced the share of national income going to potential consumers (i.e., workers who remained employed).

INCOME DISTRIBUTION AND "UNDER-CONSUMPTION"

Both types of technological advance—new products and new processes to make them—contributed to a fundamental shift in the economy. Put simply, mass production necessitates mass consumption. In this new economy, therefore, it was essential that a large portion of the population have both the desire and the means to buy products that were not, by any standards of the past, necessary for them to have. "Now you have taken over the job of creating desire," Hoover told advertisers in 1925. This meant that such traditional values as frugality and deferred gratification had to be undermined. Advertising served this objective by keeping "the customer dissatisfied," as a 1929 article by a General Motors executive put it.

The whole idea of the new consumption-driven economy seemed odd to some observers. "It still escapes me why a prosperity founded on forcing people to consume what they do not need, and often do not want," social critic Stuart Chase wrote in 1929, "is, or can be, a healthy and permanent growth."

Persuading people that they should buy what they had not even known they wanted was, however, only the first step in achieving the level of mass consumption needed to soak up the products of mass production. Effective demand requires money as well as motivation to buy. For this reason, as an economy becomes more dependent on mass consumption, it should move toward a less concentrated distribution of income. In the 1920s, just the opposite was happening. The slice of the national income pie going to the richest one percent of Americans grew from 12 percent in 1920 to 19 percent in 1929. This increasing maldistribution of income posed a serious threat to prosperity.

If a sufficient number of customers with desire and money to buy what the nation's industry was producing could not be found at home, a possible solution would be to sell the excess abroad. But several obstacles blocked this route: First, as the world's principal lender, the United States could not continually export more than it imported; second, tariff barriers constrained international trade; third, other industrial countries were facing similar problems of overproduction and so they, too, sought to export more than they imported.

In the absence of some means of transferring a larger share of income to those who would buy the products coming off assembly lines—through taxation, higher wages, or deficit spending by the government, all of which went against the grain of popular thinking and the dominant political and economic philosophy of the era (indeed, tax cuts on upper income brackets in the Coolidge years helped to increase the maldistribution)—the only way to keep the economy going seemed to be to allow people who did not have enough money to buy products to buy them anyway. Advertising led people to hunger for products; credit let them, however briefly, satisfy that hunger. Selling products on credit became ever more popular as the twenties wore on. This process kept demand within shouting distance of supply for a few years beyond when the imbalance would otherwise have hit. But in postponing the day of reckoning, the rising burden of debt made the eventual fall much harder.

As he left a post-crash meeting of industrialists called by President Hoover on November 21, 1929, Henry Ford succinctly stated a major cause of the Great Depression then underway: "American production has come to equal and even surpass not our people's power to consume, but their power to purchase."

TARIFFS AND THE DECLINE OF INTERNATIONAL TRADE

Once the Depression had begun, the policies and actions of various governments around the world in reaction to it worsened the situation. Tariff barriers—led by the Hawley-Smoot Tariff in the United States, passed in 1930—were erected to protect domestic markets. These impediments to international trade added to the deflationary forces already at work, and the world economy slipped ever deeper into depression.

CONCLUSION

"One cannot recall when a new year was ushered in with business conditions sounder than they are today," the Wall Street Journal gushed on January 4, 1929. Exactly two months later, Herbert Hoover proclaimed in his inaugural address that he had "no fears for the future of our country. It is bright with hope." Following the stock market crash less than eight months later, President Hoover reassured the nation in the same terms the Journal had used at the year's outset, saying that the economy was "fundamentally sound."

The most comprehensive answer to the question of what caused the Great Depression is that conditions by the last year of the 1920s were quite the opposite of these optimistic pronouncements. Had the economy in fact been "fundamentally sound," the stock market crash would surely have produced some deleterious economic fallout, but the decline would not have been nearly as steep, deep, or prolonged as it turned out to be. The unfortunate truth was that, in a variety of ways outlined in this entry—from international banking, war debts, and reparations, through the effects of the gold standard on money supply, the wild speculation of the decade's orgy of greed, the lack of major new products combined with rapid increases in productivity, the economy's new dependence on mass consumption, and widespread consumer debt, to the growing maldistribution of income, the economy was fundamentally unsound in 1929. That many-faceted unsoundness caused the Great Depression.

See Also: EUROPE, GREAT DEPRESSION IN; INTERNATIONAL IMPACT OF THE GREAT DEPRESSION; KEYNESIAN ECONOMICS; LAISSEZ-FAIRE; MONETARY POLICY; SCIENCE AND TECHNOLOGY; STOCK MARKET CRASH (1929).

BIBLIOGRAPHY

Chandler, Lester V. America's Greatest Depression, 1928–1941. 1970.

Eichengreen, Barry. Golden Fetters: The Gold Standard and the Great Depression, 1919–1939. 1992.

Fearon, Peter. War, Prosperity, and Depression: The U.S. Economy, 1917–1945. 1987.

Friedman, Milton, and Anna Jacobson Schwartz. A Monetary History of the United States, 1867–1960. 1963.

Galbraith, John Kenneth. The Great Crash: 1929. 1955.

Hall, Thomas E., and J. David Ferguson. The Great Depression: An International Disaster of Perverse Economic Policies. 1998.

Kindleberger, Charles P. The World in Depression, 1929–1939, rev. edition. 1986.

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McElvaine, Robert S. The Great Depression: America, 1929–1941, rev. edition. 1993.

Smiley, Gene. Rethinking the Great Depression. 2002.

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Temin, Peter. Lessons from the Great Depression. 1989.

ROBERT S. MCELVAINE