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1.4 The Great Depression

The lessons from the history of economic thought teach us that one of the

main driving forces behind the evolution of new ideas is the march of events.

While theoretical ideas can help us understand historical events, it is also true

that ‘the outcome of historical events often challenges theorists and overturns

theories, leading to the evolution of new theories’ (Gordon, 2000a, p. 580).

The Great Depression gave birth to modern macroeconomics as surely as

accelerating inflation in the late 1960s and early 1970s facilitated the monetarist

counter-revolution (see Johnson, 1971). It is also important to note that

many of the most famous economists of the twentieth century, such as Milton

Friedman, James Tobin and Paul Samuelson, were inspired to study economics

in the first place as a direct result of their personal experiences during this

period (see Parker, 2002).

While Laidler (1991, 1999) has reminded us that there is an extensive

literature analysing the causes and consequences of economic fluctuations

and monetary instability prior to the 1930s, the story of modern macroeconomics

undoubtedly begins with the Great Depression. Before 1936,

macroeconomics consisted of an ‘intellectual witch’s brew: many ingredients,

some of them exotic, many insights, but also a great deal of confusion’

(Blanchard, 2000). For more than 70 years economists have attempted to

provide a coherent explanation of how the world economy suffered such a

catastrophe. Bernanke (1995) has even gone so far as to argue that ‘to understand

the Great Depression is the Holy Grail of macroeconomics’.

Although Keynes was a staunch defender of the capitalist system against

all known alternative forms of economic organization, he also believed that

it had some outstanding and potentially fatal weaknesses. Not only did it

give rise to an ‘arbitrary and inequitable distribution of income’; it also

undoubtedly failed ‘to provide for full employment’ (Keynes, 1936, p. 372).

During Keynes’s most productive era as an economist (1919–37) he was to

witness at first hand the capitalist system’s greatest crisis of the twentieth

century, the Great Depression. To Keynes, it was in the determination of the

total volume of employment and GDP that capitalism was failing, not in its

capacity to allocate resources efficiently. While Keynes did not believe that

the capitalist market system was violently unstable, he observed that it

‘seems capable of remaining in a chronic condition of sub-normal activity

for a considerable period without any marked tendency towards recovery or

towards complete collapse’ (Keynes, 1936, p. 249). This is what others

have interpreted as Keynes’s argument that involuntary unemployment can

persist as a equilibrium phenomenon. From this perspective, Keynes concluded

that capitalism needed to be purged of its defects and abuses if it

was to survive the ideological onslaught it was undergoing during the

interwar period from the totalitarian alternatives on offer in both fascist

Germany and communist Soviet Union.

Although a determination to oppose and overturn the terms of the Versailles

peace settlement was an important factor in the growing influence of

the Nazis throughout the 1920s, there seems little doubt that their final rise to

power in Germany was also very closely linked to economic conditions. Had

economic policy in the USA and Europe been different after 1929, ‘one can

well imagine that the horrors of Naziism and the Second World War might

have been avoided’ (Eichengreen and Temin, 2002). In Mundell’s (2000)

assessment, ‘had the major central banks pursued policies of price stability

instead of adhering to the gold standard, there would have been no great

Depression, no Nazi revolution, and no World War II’.

During the 1930s the world entered a ‘Dark Valley’ and Europe became the

world’s ‘Dark Continent’ (Mazower, 1998; Brendon, 2000). The interwar

period witnessed an era of intense political competition between the three

rival ideologies of liberal democracy, fascism and communism. Following

the Versailles Treaty (1919) democracy was established across Europe but

during the 1930s was almost everywhere in retreat. By 1940 it was ‘virtually

extinct’. The failures of economic management in the capitalist world during

the Great Depression allowed totalitarianism and extreme nationalism to

flourish and the world economy began to disintegrate. As Brendon (2000)

comments, ‘if the lights went out in 1914, if the blinds came down in 1939,

the lights were progressively dimmed after 1929’. The Great Depression was

‘the economic equivalent of Armageddon’ and the ‘worst peacetime crisis to

afflict humanity since the Black Death’. The crisis of capitalism discredited

democracy and the old liberal order, leading many to conclude that ‘if laissezfaire

caused chaos, authoritarianism would impose order’. The interwar

economic catastrophe helped to consolidate Mussolini’s hold on power in

Italy, gave Hitler the opportunity in January 1933 to gain political control in

Germany, and plunged Japan into years of ‘economic depression, political

turmoil and military strife’. By 1939, after three years of civil war in Spain,

Franco established yet another fascist dictatorship in Western Europe.

The famous Wall Street Crash of 1929 heralded one of the most dramatic

and catastrophic periods in the economic history of the industrialized capitalist

economies. In a single week from 23 to 29 October the Dow Jones

Industrial Average fell 29.5 per cent, with ‘vertical’ price drops on ‘Black

Thursday’ (24 October) and ‘Black Tuesday’ (29 October). Controversy exists

over the causes of the stock market crash and its connection with the

Great Depression in the economic activity which followed (see the interviews

with Bernanke and Romer in Snowdon, 2002a). It is important to remember

that during the 1920s the US economy, unlike many European economies,

was enjoying growing prosperity during the ‘roaring twenties’ boom. Rostow’s

 (1960) ‘age of high mass consumption’ seemed to be at hand. The optimism

visible in the stock market throughout the mid to late 1920s was reflected in a

speech by Herbert Hoover to a Stanford University audience in November

1928. In accepting the Republican Presidential nomination he uttered these

‘famous last words’:

We in America today are nearer to the final triumph over poverty than ever before

in the history of any land. The poorhouse is vanishing from among us. We have

not yet reached the goal, but, given a chance to go forward with the policies of the

last eight years, we shall soon with the help of God be in sight of the day when

poverty will be banished from this nation. (See Heilbroner, 1989)

In the decade following Hoover’s speech the US economy (along with the

other major industrial market economies) was to experience the worst economic

crisis in its history, to such an extent that many began to wonder if

capitalism and democracy could survive. In the US economy the cyclical

peak of economic activity occurred in August 1929 and a decline in GDP had

already begun when the stock market crash ended the 1920s bull market.

Given that the crash came on top of an emerging recession, it was inevitable

that a severe contraction of output would take place in the 1929–30 period.

But this early part of the contraction was well within the range of previous

business cycle experience. It was in the second phase of the contraction,

generally agreed to be between early 1931 and March 1933, that the depression

became ‘Great’ (Dornbusch et al., 2004). Therefore, the question which

has captured the research interests of economists is: ‘How did the severe

recession of 1929–30 turn into the Great Depression of 1931–33?’ The vast

majority of economists now agree that the catastrophic collapse of output and

employment after 1930 was in large part due to a series of policy errors made

by the fiscal and monetary authorities in a number of industrial economies,

especially the USA, where the reduction in economic activity was greater

than elsewhere (see Bernanke, 2000, and Chapter 2).

The extent and magnitude of the depression can be appreciated by referring

to the data contained in Table 1.1, which records the timing and extent of

the collapse of industrial production for the major capitalist market economies

between 1929 and 1933.

The most severe downturn was in the USA, which experienced a 46.8 per

cent decline in industrial production and a 28 per cent decline in GDP.

Despite rapid growth after 1933 (with the exception of 1938), output remained

substantially below normal until about 1942. The behaviour of

unemployment in the USA during this period is consistent with the movement

of GDP. In the USA, unemployment, which was 3.2 per cent in 1929,

rose to a peak of 25.2 per cent in 1933, averaged 18 per cent in the 1930s and

never fell below 10 per cent until 1941 (Gordon, 2000a). The economy had

Table 1.1 The Great Depression

Country Depression Recovery Industrial

began* begins* production**

% decline

USA 1929 (3) 1933 (2) 46.8

UK 1930 (1) 1931 (4) 16.2

Germany 1928 (1) 1932 (3) 41.8

France 1930 (2) 1932 (3) 31.3

Italy 1929 (3) 1933 (1) 33.0

Belgium 1929 (3) 1932 (4) 30.6

Netherlands 1929 (4) 1933 (2) 37.4

Denmark 1930 (4) 1933 (2) 16.5

Sweden 1930 (2) 1932 (3) 10.3

Czechoslovakia 1929 (4) 1932 (3) 40.4

Poland 1929 (1) 1933 (2) 46.6

Canada 1929 (2) 1933 (2) 42.4

Argentina 1929 (2) 1932 (1) 17.0

Brazil 1928 (3) 1931 (4) 7.0

Japan 1930 (1) 1932 (3) 8.5

Notes:

* Year; quarter in parentheses.

** Peak-to-trough decline.

Source: C. Romer (2004).

fallen so far below capacity (which continued to expand as the result of

technological improvements, investment in human capital and rapid labour

force growth) that, despite a 47 per cent increase in output between 1933 and

1937, unemployment failed to fall below 9 per cent and, following the impact

of the 1938 recession, was still almost 10 per cent when the USA entered the

Second World War in December 1941 (see Lee and Passell, 1979; C. Romer,

1992). Events in Europe were also disastrous and closely connected to US

developments. The most severe recessions outside the USA were in Canada,

Germany, France, Italy, the Netherlands, Belgium, Czechoslovakia and Poland,

with the Scandinavian countries, the UK and Japan less severely affected.

Accompanying the decline in economic activity was an alarming rise in

unemployment and a collapse of commodity and wholesale prices (see

Aldcroft, 1993).

How can we explain such a massive and catastrophic decline in aggregate

economic activity? Before the 1930s the dominant view in what we now call

macroeconomics was the ‘old’ classical approach the origins of which go

back more than two centuries. In 1776, Adam Smith’s celebrated An Inquiry

into the Nature and Causes of the Wealth of Nations was published, in which

he set forth the invisible-hand theorem. The main idea here is that the profitand

utility-maximizing behaviour of rational economic agents operating under

competitive conditions will, via the ‘invisible-hand’ mechanism, translate

the activities of millions of individuals into a social optimum. Following

Smith, political economy had an underlying bias towards laissez-faire, and

the classical vision of macroeconomics found its most famous expression in

the dictum ‘supply creates its own demand’. This view, popularly known as

Say’s Law, denies the possibility of general overproduction or underproduction.

With the notable exception of Malthus, Marx and a few other heretics,

this view dominated both classical and early neoclassical (post-1870) contributions

to macroeconomic theory (see Baumol, 1999; Backhouse, 2002, and

Chapter 2). While Friedman argues that during the Great Depression expansionary

monetary policies were recommended by economists at Chicago,

economists looking to the prevailing conventional wisdom contained in the

work of the classical economists could not find a coherent plausible answer

to the causes of such a deep and prolonged decline in economic activity (see

Friedman interview at the end of Chapter 4 and Parker, 2002).