The Great Depression: Overview, Causes, and Effects (original) (raw)

What Was the Great Depression?

The Great Depression was a devastating and prolonged economic recession that followed the crash of the United States stock market in 1929. It lasted through 1941, the same year that the U.S. entered World War II.

The period was marked by several economic contractions, including the stock market crash of 1929, banking panics in 1930 and 1931. and the Smoot-Hawley Tariff that crashed world trade. Other events and policies helped to prolong the Depression during the 1930s.

Economists and historians often cite the Great Depression as the most significant, if not the most catastrophic, economic event of the 20th century.

Key Takeaways

Investopedia / Sabrina Jiang

It's hard to pinpoint exactly what caused the Great Depression but economists and historians generally agree that several factors led to this period of downturn. They include the stock market crash of 1929, the gold standard, a drop in lending, tariffs, banking panics, and contracted monetary policies of the Fed.

The 1929 Stock Market Crash

The U.S. stock market fell by nearly 50% and corporate profits declined by over 90% during a short depression known as the Forgotten Depression that lasted from 1920 to 1921. The U.S. economy enjoyed robust growth during the rest of the decade. The American public discovered the stock market and dove in headfirst during the Roaring Twenties period.

Speculative frenzies affected both the real estate markets and the New York Stock Exchange (NYSE). Loose money supply and high levels of margin trading by investors helped fuel an unprecedented increase in asset prices.

The lead-up to October 1929 saw equity prices rise to all-time high multiples of more than 19 times after-tax corporate earnings. Coupled with the benchmark Dow Jones Industrial Index (DJIA) increasing 500% in just five years, this ultimately caused the stock market crash.

The NYSE bubble burst violently on Oct. 24, 1929, a day that has come to be known as Black Thursday. A brief rally occurred on Friday the 25th and during a half-day session on Saturday the 26th but the following week brought Black Monday (Oct. 28) and Black Tuesday (Oct. 29). The DJIA fell by more than 20% over those two days. The stock market would eventually fall almost 90% from its 1929 peak.

Ripples from the crash spread across the Atlantic Ocean to Europe, triggering other financial crises such as the collapse of the Boden-Kredit Anstalt, Austria’s most important bank. The economic calamity hit both continents in full force in 1931.

The U.S. Economy Tailspin

The 1929 stock market crash wiped out nominal wealth, both corporate and private, and this sent the U.S. economy into a tailspin. The U.S. unemployment rate was 3.2% in early 1929. It soared to over 25% by 1933.

The unemployment rate remained above 18.9% in 1938 despite unprecedented interventions and government spending by both the Hoover and Roosevelt administrations. Real per capita gross domestic product (GDP) was below 1929 levels by the time the Japanese bombed Pearl Harbor in late 1941.

The crash likely triggered the decade-long economic downturn but most historians and economists agree that it didn't cause the Great Depression by itself. Nor does it explain why the slump's depth and persistence were so severe. A variety of specific events and policies contributed to the Great Depression and helped to prolong it during the 1930s.

Mistakes by the Young Federal Reserve

The relatively new Federal Reserve mismanaged the supply of money and credit before and after the crash in 1929, according to monetarists such as Milton Friedman and acknowledged by former Federal Reserve Chair Ben Bernanke.

The Fed was created in 1913 and it remained fairly inactive throughout the first eight years of its existence. Then it allowed significant monetary expansion after the economy recovered from the 1920 to 1921 depression.

The total money supply grew by 28billion,a61.828 billion, a 61.8% increase between 1921 and 1928. Bank deposits increased by 51.1%, savings and loan shares rose by 224.3%, and net life insurance policy reserves jumped by 113.8%. All this occurred after the Federal Reserve cut required reserves to 3% in 1917. Gains in gold reserves via the Treasury and Fed were only 28billion,a61.81.16 billion.

The Fed instigated the rapid expansion that preceded the collapse by increasing the money supply and keeping the federal funds interest rate low during the decade. Much of the surplus money supply growth inflated the stock market and real estate bubbles.

The Fed took the opposite course by cutting the money supply by nearly a third after the bubbles burst and the market crashed. This reduction caused severe liquidity problems for many small banks and choked off hopes for a quick recovery.

World War II created international trading channels and reversed burdensome price and wage controls, which helped the country recover from the Great Depression.

The Fed's Tight Fist

As Bernanke noted in a November 2002 address, before the Fed existed, bank panics were typically resolved within weeks. Large private financial institutions would loan money to the strongest smaller institutions to maintain system integrity. That sort of scenario had occurred two decades earlier during the Panic of 1907.

At that time, investment banker J.P. Morgan stepped in to rally Wall Street denizens to move significant amounts of capital to banks that were lacking funds when frenzied selling sent the NYSE spiraling downward and led to a bank run. Ironically, it was that panic that led the government to create the Federal Reserve to cut its reliance on individual financiers such as Morgan.

The heads of several New York banks had tried to instill confidence after Black Thursday by prominently purchasing large blocks of blue-chip stocks at above-market prices. These actions caused a brief rally on Friday but the panicked sell-offs resumed on Monday. The stock market has grown beyond the ability of such individual efforts in the decades since 1907. Only the Fed was big enough to prop up the U.S. financial system.

The Fed failed to do so, providing no cash injection between 1929 and 1932. Instead, it watched the money supply collapse and let thousands of banks fail. This and a collapsing financial sector led to deflation and spurred the following depression. Banking laws at the time made it very difficult for institutions to grow and diversify enough to survive a massive withdrawal of deposits (otherwise known as a run on the bank).

The Fed's harsh reaction may have been the result of its fear that bailing out careless banks would encourage fiscal irresponsibility in the future. Some historians argue that the Fed created the conditions that caused the economy to overheat and then exacerbated an already dire economic situation.

Hoover's Propped-Up Prices

Herbert Hoover has often been characterized as a do-nothing president but he took action after the crash occurred. He implemented three major changes between 1930 and 1932:

Hoover was mainly concerned that wages would be cut following the economic downturn. He reasoned that prices had to stay high to ensure high paychecks in all industries. Consumers would have to pay more to keep prices high.

But the public was burned badly in the crash, leaving many people without the resources to spend lavishly on goods and services. Nor could companies count on overseas trade because foreign nations weren't willing to buy overpriced American goods any more than Americans were.

Many of Hoover's other post-crash interventions and actions by Congress, such as wage, labor, trade, and price controls, damaged the economy's ability to adjust and reallocate resources.

U.S. Protectionism

The bleak reality forced Hoover to use legislation to prop up prices and wages by choking out cheaper foreign competition. He signed the Smoot-Hawley Tariff Act of 1930 into law following the tradition of protectionists and in the face of the protests from more than a thousand of the nation's economists.

The act was initially intended to protect agriculture but it swelled into a multi-industry tariff, imposing huge duties on more than 880 foreign products. Nearly three dozen countries retaliated and imports fell from 7billionin1929tojust7 billion in 1929 to just 7billionin1929tojust2.5 billion in 1932. International trade declined by 66% by 1934. Not surprisingly, economic conditions worsened worldwide.

Hoover's desire to maintain jobs as well as individual and corporate income levels was understandable but he encouraged businesses to raise wages, avoid layoffs, and keep prices high at a time when they naturally should have fallen. The U.S. suffered one to three years of low wages and unemployment, plus cycles of recession/depression, before dropping prices led to a recovery.

The U.S. economy deteriorated from a recession to a depression when it was unable to sustain these artificial levels with global trade effectively cut off.

The New Deal

President Franklin Roosevelt promised massive change when he was elected in 1933. The New Deal program that he initiated was an innovative, unprecedented series of domestic programs and acts that were designed to bolster American businesses, reduce unemployment, and protect the public.

The New Deal was loosely based on Keynesian economics and the idea that the government could and should stimulate the economy. It set lofty goals to create and maintain the national infrastructure, full employment, and healthy wages. The government set about achieving these through price, wage, and even production controls.

Some economists claim that Roosevelt continued many of Hoover's interventions, just on a larger scale. He kept a rigid focus on price supports and minimum wages and removed the country from the gold standard, forbidding individuals to hoard gold coins and bullion. He banned monopolistic business practices and instituted dozens of new public works programs and other job-creation agencies.

The Roosevelt administration also paid farmers and ranchers to stop or cut back on production. One of the most heartbreaking conundrums of the period was the destruction of excess crops despite the need of thousands of Americans for affordable food.

Federal taxes tripled between 1933 and 1940 to pay for these initiatives as well as new programs such as Social Security. These increases included hikes in excise taxes, personal income taxes, inheritance taxes, corporate income taxes, and an excess profits tax.

New Deal Success and Failure

The New Deal led to measurable results including financial system reform and stabilization. It also boosted public confidence.

Roosevelt declared a bank holiday for an entire week in March 1933 to prevent institutional collapse due to panicked withdrawals. This was followed by a construction program for a network of dams, bridges, tunnels, and roads. These projects opened up federal work programs, employing thousands of people.

The economy showed some recovery but the rebound was far too weak for the New Deal's policies to be deemed successful in pulling America out of the Great Depression. Historians and economists disagree on the reason:

A study by two economists at the University of California, Los Angeles estimated that the New Deal extended the Great Depression by at least seven years.

But it's possible that the relatively quick recovery that was characteristic of other post-depression recoveries may not have occurred as rapidly after 1929 because it was the first time the general public and not just the Wall Street elite lost large amounts in the stock market.

American economic historian Robert Higgs argued that Roosevelt's new rules and regulations came so fast and were so revolutionary that businesses became afraid to hire or invest.

Philip Harvey, a professor of law and economics at Rutgers University, suggested that Roosevelt was more interested in addressing social welfare concerns than in creating a Keynesian-style macroeconomic stimulus package.

Social Security policies enacted by the New Deal created programs for unemployment, disability insurance, old age, and widows' benefits.

The Impact of World War II

Looking at employment and GDP figures, the Great Depression appeared to end suddenly around 1941 to 1942. This was the time when the U.S. entered World War II. The unemployment rate fell from eight million in 1940 to just over one million in 1943. However, more than 16 million Americans were conscripted to fight in the Armed Services. The real unemployment rate in the private sector grew during the war.

The standard of living declined due to wartime shortages caused by rationing. Taxes rose dramatically to fund the war effort. Private investment dropped from 17.9billionin1940to17.9 billion in 1940 to 17.9billionin1940to5.7 billion in 1943 and total private-sector production fell by nearly 50%.

The notion that the war ended the Great Depression is a broken window fallacy but the conflict did put the U.S. on the road to recovery. The war opened international trading channels and reversed price and wage controls. Government demand opened up for inexpensive products and that demand created a massive fiscal stimulus.

Private investments rose from 10.6billionto10.6 billion to 10.6billionto30.6 billion in the first 12 months after the war ended. The stock market broke into a bull run after a few short years.

When Did the Great Depression Start?

The Great Depression began after the stock market crash of 1929, which wiped out both private and corporate nominal wealth. This sent the U.S. economy into a tailspin and the effects eventually trickled out beyond the U.S. border to Europe.

When Did the Great Depression End?

The Great Depression ended in 1941 at around the same time the United States entered World War II. Most economists cite this as the end date because it was the time when unemployment dropped and GDP increased.

How Did the Great Depression End?

Conventional wisdom says that the U.S. was jolted out of the Great Depression by New Deal job creation combined with a flood of government investment in the private sector in preparation for the country's entrance into World War II. This is disputed by some economists who assert that the Depression would have ended earlier with less government intervention.

The Bottom Line

The Great Depression was the result of an unlucky combination of factors including a flip-flopping Fed, protectionist tariffs, and inconsistently applied government interventionist efforts. The depression could have been shortened or even avoided by a change in any one of these factors.

The debate continues as to whether the interventions were appropriate. Yet many of the reforms from the New Deal exist to this day. They include Social Security, unemployment insurance, and agricultural subsidies.

The assumption that the federal government should act in times of national economic crisis has become strongly supported. This legacy is one of the reasons why the Great Depression is considered one of the seminal events in modern American history.