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2.14 Causes and Consequences of the Great Depression

The Great Depression was the most significant economic catastrophe of

modern times to affect capitalist market economies and even today most

economists regard the 1930s worldwide slump, and the consequences of that

catastrophe, as one, if not the most important single macroeconomic event of

the twentieth century. The political and economic significance of this event is

reflected in the continuous outpouring of research on this traumatic historical

event (see Temin, 1976, 1989; Bernanke, 1983, 1995, 2000; Eichengreen,

1992a; 1992b; C. Romer, 1992, 1993; Bordo et al., 1998; Hall and Ferguson,

1998; Wheeler, 1998; Krugman, 1999; Cole and Ohanian, 1999, 2002a;

Prescott, 1999; James, 2001). It is easy to see why the interwar period in

general, and the Great Depression in particular, continue to exert such an

attraction to economists and economic historians:

1. the events of this period contributed significantly to the outbreak of the

Second World War which changed the political and economic world


2. the Great Depression was by far the most severe economic downturn

experienced by the world’s industrialized capitalist economies in the

twentieth century and the nature of the causes and consequences of the

worldwide slump in economic activity are still hotly debated;

3. it is generally recognized that the Great Depression gave Keynes (1936)

the necessary impetus to write the General Theory, a book that marks the

birth of macroeconomics. According to Skidelsky (1996a), ‘the General

Theory could not have been published ten years earlier. That particular

indictment of classical economics and, indeed, of the way the economy

behaved needed the great slump to crystallise it’;

4. the Great Depression is frequently used by macroeconomists to test their

models of aggregate fluctuations, while the whole interwar period provides

an invaluable data set for macroeconomic researchers;

5. there are always some commentators who periodically ask the question

‘could such an event ever happen again?’;

6. finally, after the 1930s experience the role of government in all market

economies increased considerably, leading to a fundamental and lasting

change in the relationship between the government and the private sector.

As a result, economic institutions at the end of the twentieth century

were very different from those in place in 1929. It is therefore with

considerable justification that Bordo et al. (1998) describe the Great

Depression as the ‘defining moment’ in the development of the US

economy during the twentieth century. In the macroeconomic sphere the

modern approach to stabilization policy evolved out of the experience of

the ‘great contraction’ of the 1930s (DeLong, 1996, 1998).

Economists have generally concluded that the proximate causes of the

Great Depression involved the interaction of several factors leading to a

drastic decline in aggregate demand (see Fackler and Parker, 1994; Snowdon

and Vane 1999b; Sandilands, 2002). The data in Table 2.1 reveal convincing

evidence of a huge aggregate demand shock given the strong procyclical

movement of the price level, that is, the price level falling as GDP declines.

Note also the dramatic increase in unemployment.

Bernanke and Carey’s data also show that in the great majority of countries

there was a countercyclical movement of the real wage. This pattern would

emerge in response to an aggregate demand shock in countries where price

deflation exceeded nominal wage deflation. Hence the evidence ‘for a nonvertical

aggregate supply curve in the Depression era is strong’ (Bernanke

and Carey, 1996). In Figure 2.7 we illustrate the situation for the US economy

in the period 1929–33 using the familiar AD–AS framework. The dramatic

decline in aggregate demand is shown by the leftward shift of the AD curve

during this period. Note that a combination of a falling price level and GDP

Table 2.1 US GDP, prices and unemployment: 1929–33

Year Real GDPa Price levelb Unemployment

$ billions %

1929 103.1 100.0 3.2

1930 94.0 96.8 8.9

1931 86.7 88.0 16.3

1932 75.2 77.6 24.1

1933 73.7 76.0 25.2


a Measured at 1929 prices.

b GDP deflator, 1929 = 100.

Source: Adapted from Gordon (2000a).

Figure 2.7 Aggregate demand failure in the US economy, 1929–33




P(1933) C





Y(1933) Y(1931)






could not arise from a negative supply shock (leftward shift of the AS curves)

which would reduce GDP and raise the price level.

In the debate relating to the causes of the Great Depression in the USA five

main hypotheses have been put forward, the first four of which focus on the

causes of the dramatic decline in aggregate demand:

1. The non-monetary/non-financial hypothesis. Here the focus is on the

impact of the decline in consumer and investment spending as well as the

adverse effect on exports of the Smoot–Hawley Tariff introduced in 1930

(see Temin, 1976; C. Romer, 1990; Crucini and Kahn, 1996); in chapter

22 of the General Theory, Keynes argued that ‘the trade cycle is best

regarded as being occasioned by a cyclical change in the marginal

efficiency of capital, though complicated and often aggravated by associated

changes in other significant short-period variables of the economic

system’, thus the ‘predominant’ determination of slumps is a ‘sudden

collapse in the marginal efficiency of capital’.

2. The monetary hypothesis of Friedman and Schwartz (1963) attributes the

huge decline in GDP mainly to an unprecedented decline in the nominal

money supply, especially following the succession of bank failures beginning

in 1930, which the Fed failed to counter by using expansionary

monetary policies. This prevented the deflation of prices from increasing

the real money supply which via the ‘Keynes effect’ would have acted as

a stabilizing mechanism on aggregate demand. An alternative monetary

hypothesis, initially put forward by Fisher (1933b), focuses on the impact

of the debt-deflation process on the solvency of the banking system.

3. The non-monetary/financial hypothesis associated in particular with the

seminal paper of Bernanke (1983). Bernanke’s credit view takes the

Fisher debt-deflation story as its starting point. Because many banks

failed during the slump, this led to a breakdown in the financial system

and with it the network of knowledge and information that banks possess

about existing and potential customers. Many borrowers were thus denied

available credit even though their financial credentials were sound

(see also Bernanke and James, 1991).

4. The Bernanke–Eichengreen–Temin Gold Standard hypothesis. In looking

for what made the depression a ‘Great’ international event it is necessary

to look beyond the domestic mechanisms at work within the USA. ‘The

Great Depression did not begin in 1929. The chickens that came home to

roost following the Wall Street crash had been hatching for many years.

An adequate analysis must place the post-1929 Depression in the context

of the economic developments preceding it’ (Eichengreen, 1992a).

5. The non-monetary neoclassical real business cycle hypothesis. This very

recent (and very controversial) contribution is associated in particular

with the work of Cole and Ohanian (1999, 2002a) and Prescott (1999,

2002). This approach highlights the impact of real shocks to the economy

arising from ‘changes in economic institutions that lowered the normal

or steady state market hours per person over 16’ (Prescott, 1999; see also

Chapter 6).

With respect to those explanations that emphasize the decline in aggregate

demand, much of the recent research on the Great Depression has moved

away from the traditional emphasis placed on events within the USA and

focuses instead on the international monetary system operating during the

interwar period. Because the Great Depression was such an enormous international

macroeconomic event it requires an explanation that can account for

the international transmission of the depression worldwide. According to

Bernanke (1995), ‘substantial progress’ has been made towards understanding

the causes of the Great Depression and much research during the last 20

years has concentrated on the operation of the international Gold Standard

during the period after its restoration in the 1920s (see Choudri and Kochin,

1980; Eichengreen and Sachs, 1985; Eichengreen, 1992a, 1992b; Eichengreen

and Temin, 2000, 2002; Hamilton, 1988; Temin, 1989, 1993; Bernanke,

1993, 1995, 2000; Bernanke and James, 1991; Bernanke and Carey, 1996;

James, 2001).

The heyday of the Gold Standard was in the 40-year period before the First

World War. The balance of payments equilibrating mechanism operated via

what used to be known as the ‘price specie flow mechanism’. Deficit countries

would experience an outflow of gold while surplus countries would

receive gold inflows. Since a country’s money supply was linked to the

supply of gold, deficit countries would experience a deflation of prices as the

quantity of money declined while surplus countries would experience inflation.

This process would make the exports of the deficit country more

competitive and vice versa, thus restoring equilibrium to the international

payments imbalances. These were the ‘rules of the game’. The whole mechanism

was underpinned by a belief in the classical quantity theory of money

and the assumption that markets would clear quickly enough to restore full

employment following a deflationary impulse. This system worked reasonably

well before the First World War. However, the First World War created

huge imbalances in the pattern of international settlements that continued to

undermine the international economic system throughout the 1920s. In particular

the war ‘transformed the United States from a net foreign debtor to a

creditor nation’ and ‘unleashed a westward flow of reparations and war-debt

repayments … the stability of the inter-war gold standard itself, therefore,

hinged on the continued willingness of the United States to recycle its balance

of payments surpluses’ (Eichengreen, 1992a).

To both Temin (1989) and Eichengreen the war represented a huge shock

to the Gold Standard and the attempt to restore the system at the old pre-war

parities during the 1920s was doomed to disaster. In 1928, in response to

fears that the US economy was overheating, the Fed tightened monetary

policy and the USA reduced its flow of lending to Europe and Latin America.

As central banks began to experience a loss of reserves due to payments

deficits, they responded in line with the requirements of the Gold Standard

and also tightened their monetary policies. And so the deflationary process

was already well under way at the international level by the summer of 1929,

and well before the stock market crashed so dramatically in October.

Eichengreen and Temin (2000) argue that once the international economic

downturn was under way it was the ‘ideology, mentalité and rhetoric of the

gold standard that led policy makers to take actions that only accentuated

economic distress in the 1930s. Central bankers continued to kick the world

economy while it was down until it lost consciousness.’ Thus the ultimate

cause of the Great Depression was the strains that the First World War

imposed on the Gold Standard, followed by its reintroduction in a very

different world during the 1920s. No longer would it be relatively easy, as it

had been before 1914, to engineer wage cuts via deflation and unemployment

in order to restore international competitiveness. The internal politics of

capitalist economies had been transformed by the war, and the working

classes were increasingly hostile to the use of monetary policies that were

geared towards maintenance of the exchange rate rather than giving greater

priority to employment targets. Hence the recession, which visibly began in

1929, was a disaster waiting to happen.

The Gold Standard mentalité constrained the mindset of the policy makers

and ‘shaped their notions of the possible’. Under the regime of the Gold

Standard, countries are prevented from devaluing their currencies to stimulate

exports, and expansionary monetary policies on a unilateral basis are also

ruled out because they would undermine the stability of a country’s exchange

rate. Unless the governments of Gold Standard countries could organize a

coordinated reflation, the only option for countries experiencing a drain on

their gold reserves was monetary contraction and deflation. But as Eichengreen

(1992a) points out, political disputes, the rise of protectionism, and incompatible

conceptual frameworks proved to be an ‘insurmountable barrier’ to

international cooperation. And so the recession, which began in 1929, was

converted into the Great Depression by the universal adoption of perverse

policies designed to maintain and preserve the Gold Standard. As Bernanke

and Carey (1996) argue, by taking into account the impact on economic

policy of a ‘structurally flawed and poorly managed international gold standard’,

economists can at last explain the ‘aggregate demand puzzle of the

Depression’, that is, why so many countries experienced a simultaneous

decline in aggregate demand. It was the economic policy actions of the gold

bloc countries that accentuated rather than alleviated the worldwide slump in

economic activity. Incredibly, in the midst of the Great Depression, central

bankers were still worried about inflation, the equivalent of ‘crying fire in

Noah’s flood’! In order to restore the US economy to health, President Herbert

Hoover was advised by Treasury Secretary Andrew Mellon to ‘liquidate

labour, liquidate stocks, liquidate the farmers, liquidate real estate … purge

the rottenness out of the system’ and as a result ‘people will work harder, and

live a more moral life’ (quoted by Eichengreen and Temin, 2000). Ultimately

these policies destroyed the very structure they were intended to preserve.

During the 1930s, one by one countries abandoned the Gold Standard and

devalued their currencies. Once they had shed their ‘golden fetters’, policy

makers were able to adopt expansionary monetary policies and reflate their

economies (the UK left the Gold Standard in the autumn of 1931, the USA in

March 1933, Germany in August/September 1931; and France in 1936).

Thus, while Friedman and Schwartz (1963) and others have rightly criticized

the Fed for not adopting more expansionary monetary policies in 1931,

Eichengreen (1992b) argues that, given the constraints imposed by the Gold

Standard, it is ‘hard to see what else could have been done by a central bank

committed to defending the fixed price of gold’. Research has shown that

economic recovery in the USA was largely the result of monetary expansion

(C. Romer, 1992) and also that those countries that were quickest to abandon

their golden fetters and adopt expansionary monetary policies were the first

to recover (Choudri and Kochin, 1980; Eichengreen and Sachs, 1985).

The Bernanke–Eichengreen–Temin hypothesis that the constraint imposed

by the Gold Standard prevented the use of expansionary monetary policies

has not gone unchallenged. Bordo et al. (2002a) argue that while this argument

is valid for small open economies, it does not apply to the USA, which

‘held massive gold reserves’ and was ‘not constrained from using expansionary

policy to offset banking panics’. Unfortunately, by the time the more

stable democracies had abandoned their ‘golden fetters’ and begun to recover,

the desperate economic conditions in Germany had helped to facilitate

Hitler’s rise to power. Thus, it can be argued that the most catastrophic result

of the disastrous choices made by economic policy makers during the interwar

period was the slaughter of humanity witnessed during 1939–45

(Eichengreen and Temin, 2002).