The Great Depression

Paul Krugman's book frequently refers to the Great Depression but, surprisingly, does not give any extended analysis of it. The Wikipedia offers many alternative explanations, Keynesian, monetarist, Austrian, and debt deflation. To this it adds several less general theories -- income inequality (growth in the 1920's was too skewed toward the top, causing investment to outpace consumption), weakness of the banking system, and the gold standard (countries were forced to protect their supply of gold, regardless of the harm to their domestic economies). What it does not explain is a dirty little secret -- you don't have to choose between these theories. Each theory assumes a single, specific cause, when an epic fail on the scale of the Great Depression is almost always the result of a series of cascading failures. One can quibble about the importance of different factors proposed by different theories but still accept all as at least partially true. So I will recount the Depression freely adopting any of these theories where they work, but with a emphasis on the debt deflation theory, both because it comes closest to popular understanding of the Great Depression, and because of its obvious resonance with today's situation.

Whatever the excesses of the 1920's, the overall prosperity of the era was based on a solid foundation of techological advancement. It was in the 1920's that cars went from a rich man's luxury to something the general public could afford, that movies went from sleazy peep shows for the poor to a major industry and respected art form, that radio and telephones became widely available and commercial broadcasting began, that electricity and running water became universal in urban areas. It was, in short, when the 20th century really established itself. Productivity grew at an extraordinary rate, and major investments transformed the economy and society. But toward the end of the decade, return on actual investments in physical plant began falling. Invariably, this means that investment will fall and a recession will set in.

Why did return on investments fall? The inequality theory holds that growth had been too concentrated at the top, allowing investment to outrun consumption. The Austrian theory holds that credit was too easy, leading to investment at unsustainable rates. Another possibility is that the technological revolution that made the Roaring '20's possible had simply run its course and that a slowdown -- painful, no doubt, but not catastrophic -- was inevitable. Most theories, however, dismiss the falling return on tangible investments as simply another turn of the business cycle that might have led to an ordinary recession if other events had not intervened.

As returns on real investment fell, investors turned to speculation on the stock market. The stock market boom, regarded at the time as a sign of health, was actually an early symptom that the economy was in trouble. As everyone remembers, the stock market was driven to artificial heights by buying on the margin. Investors paying only part of the price of the stock they buy and borrowing the rest from the brokerage firm, to be repaid when the stock is sold, was a well-established practice that continues to this day. In the 1920's the "margin" was 10%, that is, investors could pay only 10% of the price of stock and borrow the rest. It was this practice that drove the stock to such dizzying heights. It was also this practice that might the crash so catastrophic -- suddenly the collateral backing all those debts had lost its value, but the debt remained.

The great amount of bad debt set of a vicious cycle of debt liquidation. Brokers called in loans, which could not be paid. Debtors withdrew money from banks to repay loans, causing banks to lose capital and have to call in loans. As banks came under further pressure, they held more cash and made fewer loans, limiting economic activity for lack of credit, which made more and more borrowers unable to repay. As deflation set in, debts became more onerous, and even debts that had once been good became unsupportable.

Yet the first major bank failure did not occur until over a year after the stock market crash. The New York Bank of the United States failed in December, 1930. The Bank had been involved in stock market trading to an uncertain degree, enough, in any event, to make depositors nervous and start a run. Bank runs proved highly contagious and rapidly spread, to many banks that had nothing to do with the stock market. The contagion was not purely psychological. Many farmers had overborrowed in 1919 when land prices were artificially inflated and long been struggling to keep up their mortgages. Small community banks, with no loans other than to farmers, had also been struggling. The economic downturn caused a drop in commodity prices. Drought further squeezed the farmers and led to a vicious cycle of defaults, foreclosures, and bank runs. This, in turn, led to further deflation, which made more debts bad, which continued the cycle.

But there had been many depressions before. Why was this one so much worse? The usual conservative/libertarian answer is government intervention, and they are essentially correct. In earlier depressions, there had been no central bank, and the federal government made up no more than 2% of the GDP. What this meant was that the federal government could not help in previous depressions, but neither could it harm anything. By the 1930's it had grown greatly in its ability to act for good or for ill, but did not know what it was doing.

In the absence of a central bank, private banks guaranteed each other, acting in concert to bail out any one that came under pressure, let the run prove contagious. (J.P. Morgan could be said to have acted as de facto central banker). The creation of a federal reserve system destroyed private agreements among banks to protect each other, yet the Fed failed to act to stem the spreading bank failures (partly because most of the banks going under were not To Big To Fail). The Fed was also constrained in how much it could do to expand the money supply by limited gold itssupplies. Herbert Hoover was by no means inactive in the face of the Depression, but he largely limited himself to moral suasion. He persuaded a large group of employers to refrain from wage cuts and large-scale layoffs and attempted to persuade banks to protect each other as they had done pre-1913. He also began a public works program, though on a much smaller scale than the New Deal. But he also sought to balance the budget under conditions of disasterously falling revenue, raising the top tax rate from 24% to 63%, which proved ruinous.

So, in effect, libertarians are saying because banks sometimes bailed each other out in the absence of a central bank, but the Fed failed to do so, we are better off without the Fed, and because Hoover's attempts to close the deficit made the Depression worse, we are better off with a government too small to affect anything. This is like observing that a car without a steering wheel will go more or less straight, but steering in the wrong direction is disasterous and therefore urging people to remove their steering wheels as a safety measure.

Franklin D. Roosevelt is also awkward for libertarians because his first term (at least) is characterized by such a rapid improvement in the economic situation. At the time FDR came to power, the finance system was in a state of full-on panic. About half the states had shut down their banks altogether to stop the bank runs, and others were joining fast. The day before he was inaugurated, stock exchanges in New York and Chicago shut down. FDR and Hoover agreed on the need for a national bank holiday, but not the terms. Roosevelt's first act upon becoming President was to declare a "bank holiday" temporarily closing all banks. He then called Congress into session, and they hastily passed the Emergency Banking Act, which allowed the Treasury Department to close down any unsound banks and merge them with sound banks, and the Federal Reserve to make enough loans to sound banks to keep them going. The Act was a stunning success. The bank panic promptly ceased, depositors flocked back to banks to return their deposits, and recovery began. Roosevelt also went off the gold standard to allow the Fed to expand the money supply as needed. So far as I know, even libertarians have a hard time arguing with any of that.

FDR undertook numerous programs, some successful, some not, including public works on a huge scale, the Civilian Conservation Corp, rural electrification, the encouragement of unions, establishment of federal labor law, and the like. Throughout his first term, economic growth was very rapid, although given the depth of the hole the US economy was in, climbing out would necessarily take some time. By 1936, the economy had returned to 1929 levels, although unemployment (always a "lagging indicator," as Ronald Reagan put it) remained high. But there can be no doubt that something went very wrong in 1937. The economy suffered a recession-within-a recovery. Economic activity shrunk rapidly, and unemployment rose dramatically. If the drop had continued another three to four years, it would have been every bit as bad as the 1929-1932 decline. But it did not. The recession reversed after about a year, and recovery began anew.




There is a general consensus that FDR was to blame for the 1937 recession, but disagreement on why. Keynesians blame it on Roosevelt moving prematurely to balance the budget. Monetarists blame it on the Federal Reserve acting prematurely to tighten monetary policy. Business leaders blamed it on anti-business policies including hostile taxes, threats of anti-trust actions, and widespread strikes. Of course, it is entirely possible that all these factors were at work, having a greater effect in combination than any one would have had singly. Empirically, there is no way to tell, because Roosevelt reversed all these policies at once. The economy soon recovered. (Preparations for WWII helped).

So what is a libertarian to do? They have one of two options. Either claim that growth would have been even higher without FDR's policies, or more convincingly blame Hoover's interventioninsm for starting the Depression, then jump ahead to 1937, and airbrush out FDR's embarrassing first term.