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| Causes |
| The Stock Market Crash The Stock Market Crash in October of 1929 is often cited as the beginning og the Great Depression, but did it actually cause it? It did not. The stock price of a company only reflects current information about the future revenue of that company. Therefore, the available information changes the stock price. And when the government raised the interest rates in early 1929, the future revenue of the companies were decreased causing the market to slide. Hoarding Money People hoard money because they have a liquidity preference. I.e., people want to have their assets in a readily convertible form, such as money. There are several misconceptions about hoarding money. First hoarding is not the same thing as saving. If I put my money into a savings account, that money is lent out to someone else who then spends it. Second, hoarding, by itself, cannot cause a recession or depression. As long as prices and wages drop instantly to reflect the lower amount of money in the economy, then hoarding causes no problems. Indeed, hoarding can even be seen as beneficial to those who don't hoard, since their money will be able to buy more goods as a result of the lower prices. If a country has a gold standard, then hoarding money can make the money supply drop dramatically since a gold standard makes the quantity of money difficult for the government to control. The Gold Standard At the time of the Great Depression, America had a 100% gold standard for its money. This meant that all cash was backed by a government promise to redeem it in a specific amount of gold (at the time, one ounce of gold was redeemable for twenty dollars). Because the amount of money circulating in the economy is wholly dependent on the amount of gold available, the money supply is very rigid. If people start to hoard money (see above) the money supply can drop drastically. As noted in the previous section on hoarding, this is not a problem as long as prices and wages drop instantly to reflect the lower amount of money circulating. The Smoot-Hawley Tariff The Smoot-Hawley Tariff Act was passed in June of 1930. Since this occurred after the onset of the Depression, it's hard to see how it could have caused it. However, since the real effect of the increased tariffs was to increase prices and increase price rigidity, it is easy to see how the Act could have exacerbated the Depression. Enacting the tariff was exactly the wrong thing to do and about 1,000 economists signed a petition begging Congress not to pass it. The Federal Reserve Board The Fed was ostensibly created to prevent bank panics and Depressions. Is it possible that the Fed was actually responsible for the Depression? The answer is a qualified no. The Fed took several actions that, in retrospect, were quite bad. The first thing it did was to inflate the money supply by about 60% during the 1920's. If the Fed had been a little more careful in expanding the money supply, it might have prevented the artificial Stock market boom and subsequent crash. Second, there are indications that the economy was starting to cool off on its own in early 1929, thus making the interest rate hike in TBD completely unnecessary and avoiding the subsequent crash. The third mistake the Fed made was in early 1931. The Fed raised interest rates, exactly the wrong thing to do during a contraction. Ironically, the country's gold stock was increasing at this point all on its own, so doing nothing would have increased the money supply and helped the recovery. But even with all that bungling, it is not clear that we can lay responsibility for the Great Depression at the feet of the Fed. Malinvestment "Malinvestment" is a term coined by the Austrian school of economics to sum up their explanation of the causes of business cycles. According to this theory, all business cycles are caused by government intervention in the market. Specifically, the central bank (the Fed in the case of the U.S.) artificially lowers the interest rate, flooding the economy with money. This money is then invested in capital goods that would not be justified at a market level of interest rates. The low interest rate cannot be sustained forever without an increase in inflation, so the Fed inevitably has to raise interest rates. When this happens, the investments that were "justified" under a lower interest rate must be liquidated. Any prevention of this liquidation by further government intervention will simply prolong the re-adjustment and thus exacerbate the recovery. Very few economists hold this view. Sticky Prices/Sticky Wages Prices and wages change in accordance to the scarcity of goods and labor relative to the amount of money that is available to buy them. For example, if the Federal Reserve Board increases the nation's money supply, then prices and wages will tend to go up, reflecting the fact that more money is chasing the same amount of goods and labor. When the Fed does too much of this, it is called inflation. But what happens if the money supply goes down relative to the amount of goods and labor? Eventually, the price of goods and labor will go down as well in the long run. But in the short run, prices and wages can "stick" at a higher level than the market clearing price or wage. When this happens, people buy less and employers hire less, thus causing cut backs in production and employment. There are a number of reasons why prices and wages might stick. One reason is referred to as "menu costs," meaning that it often costs money to change a price. A good example is a restaurant that has to print new menus every time the prices change. |
| Causes Of The Great Depression |