The Great Depression is considered the most severe economic crisis of the 20th century. The crisis is viewed to be triggered by the collapse of the New York Stock Exchange, however the Depression was a result of a deeper structural weakness. By 1933, the United States unemployment rate had risen to 25% and global trade fell by two thirds. By examining the interconnected mechanisms, it could be understood why the crisis which could have been an ordinary recession turned into a global scale event and how it influences governments in their responses to financial crises today.
The beginning of the Great Depression can be placed back to the boom in the United States known as the ‘Roaring Twenties’. Technological innovation and a rise in consumer confidence encouraged investors to believe that share prices would continue to increase. This optimism led to many individuals purchasing stocks on margin. Investors borrowed money to buy shares while contributing a small proportion themselves. Although leverage increased profits, it also magnified financial risk. Falling share prices triggered margin calls, forcing investors to sell assets to repay loans. As confidence decreased in October 1929, it created a cycle of panic selling. As a result, the Dow Jones Industrial Average lost almost a quarter of its value over two days, now known as ‘Black Monday’ and ‘Black Tuesday’.
However, the stock market crash alone cannot explain the Depression. Previous crashes had not caused decade-long global downturns. It could be viewed that the collapse actually exposed the excessive household debt within the American economy as well as overvalued financial assets. The crash caused a negative wealth effect, which reduced the consumption of households and investment for firms as confidence dissipated. Aggregate demand (AD) contracted sharply, pushing America into a recession. Instead, banking failures made the recession into the twentieth century’s worst economic crisis.
During the early 1930s, American banks failed en masse as falling asset prices had eroded their balance sheets. This was compounded by depositors rushing to withdraw their money due to the fear of losing their savings, it exacerbated the issue. Since banks operated on a ‘fractional reserve system’ which is where only a small proportion of deposits of cash are held, banks were not able to meet the sudden demand to withdraw deposits. Between 1930 and 1933 well over 9000 banks in the USA suspended their operations which completely wiped out household savings and restricted the supply of credit available. Due to the collapse in the supply of lending, businesses were unable to finance investment while households reduced consumption. Restricted lending reduced investment and consumption, further lowering AD and increasing unemployment. The contraction of the money supply intensified the downturn. Milton Friedman and Anna Schwartz argued that the ignorance of the Federal Reserve to provide liquidity to struggling banks allowed the money supply to fall by approximately one third between 1929 and 1933. Deflation increased the real burden of debt, discouraging consumption and investment. Lower prices reduce firms’ revenues, leading to further job losses. This is an endless cycle of the negative multiplier effect. Ben Bernanke argued that the collapse of financial intermediation prevented productive firms from accessing credit, worsening the recession. For this reason, the Great Depression cannot solely be caused by the crash of the New York Stock Exchange, but also the collapse of the financial system and the wiping of credit markets.
Although financial instability initiated the never-ending downturn, policy decisions by governments and central banks played a crucial role in actually prolonging the Great Depression. One of the greatest policy failures was the Federal Reserve’s contractionary monetary policy. Rather than acting as a lender of last resort, the Federal Reserve allowed banks to collapse and allowed for deflation to worsen. As interest rates remained high and the supply of credit remained low, investment in turn, decreased further shifting AD inwards and causing the real GDP of the USA to contract further. Fiscal policy had also contributed to the severity of the crisis. During the early years of the Depression, many governments prioritised balanced budgets over stimulating economic activity. This neoliberal approach reflected the belief at the time that government intervention should be as limited as possible as the markets are able to eventually restore to equilibrium. Economists such as Keynes argued otherwise, saying that during periods when the private sector is collapsing, governments must increase spending in order to offset the impact of a decrease in consumption and investment. In other words Keynes says to offset a negative multiplier effect, it is necessary for the government to kick start a positive multiplier to support an economic recovery. Roosevelt’s ‘New Deal’ (1933) was an attempt to do this by providing aid to households in order to improve confidence; however its impact on employment remained limited until demand within the economy increased in the run up to the Second World War. Hence the Great Depression demonstrated that an idle state and central bank can amplify an initial economic shock and cause a prolonged period of stagnation.
The Great Depression was not caused by a single event but due to the interaction of many economic failures that added on top of each other. It could be considered that the Wall Street Crash or even the ‘Roaring Twenties’ acted as the initial trigger, but the collapse of financial institutions, a lack of money supply and ineffective policy responses turned a financial shock into a prolonged period of economic stagnation. The crisis was able to demonstrate the dangers of financial speculation and caused demand to contract to the level that it did during periods of economic instability. The aftermath of the Great Depression has changed how economists think, mainly due to the rise in Keynesian ideas that the government and central banks must play a more interventionist role to stabilise an economy. Overall the Great Depression became the world’s worst economic crisis due to a self reinforcing cycle of falling growth, unemployment and confidence that never stopped declining.
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