Major Theories of the Causes of the Great DepressionScholars, to include economists and historians, have been struggling to come into accord regarding the origins and causes of the Great Depression. Generally, the debate has been divided between two general sets of theories based on two competing schools of thought in economics. The first are the demand-driven theories postulated by adherents of Keynesian economics and institutional economics, thus collectively forming the Keynesian theory. The second is the monetarist theory that generally blames the inaction of monetary authorities that led to the shrinking of the money supply. Note the following concise explanations:
1. The Keynesian Theory of the Great DepressionAdherents of the Keynesian theory or demand-driven theories have referenced the 1936 book “The General Theory of Employment, Interest, and Money” by John Maynard Keynes. They argue that the lower aggregate expenditures in the economy caused by a large-scale loss of confidence of individuals to consume and business organizations to invest had contributed to a substantial decline in income and employment. In addition, they argue that if the government intervened, particularly by spending more money to offset the amount of money lost by reduced consumptions and investments, unemployment rates would decrease.
2. The Monetarist Theory of the Great DepressionThose who argue for the monetarist theory base their position on numerous critical works, including the 1963 book “A Monetary History of the United States, 1867-1960” by Milton Friedman and Anna Schwartz. According to them, the Great Depression started as a normal economic recession but the fall of the money supply worsened the economic situation. Banks in the U.S. were failing due to credit defaults. People were hoarding and holding their money, thus reducing consumptions. The monetarist theory also blames the U.S. Federal Reserve for failing to increase the monetary base of the economy and injecting liquidity into the banking system.
Other Theories of the Causes of the Great DepressionApart from the competing Keynesian theory and monetarist theory, other theories have emerged to explain the origins and causes of the Great Depression. Some of these theories are general in their scope and they serve as alternatives to the mainstream Keynesian and monetarist theories. Others have a more specific approach to their explanation, thus complementing other general theories.
1. Heterodox Theories of the Great Depression
• Austrian School on the Great Depression: Austrian economist Friedrich Hayek and American economist Murray Rothbard discussed in their 1963 book “America’s Great Depression” that the U.S. Federal Reserve was primarily at fault. Although their argument shared similarities with the monetarist theory, they noted that the root cause of Depression of the 1930s was the expansion of the money supply in the 1920s that led to an unstable economic boom driven by credit.
• Marxist View on the Great Depression: Supporters of Marxism offer another alternative explanation of the causes of the Great Depression. Borrowing from the main ides postulated by Karl Marx, they argue that the expansive economic crisis was an offshoot of capitalism. Specifically, they contend that capitalism has a boom-and0buss pattern because it creates an unbalanced accumulation of wealth that leads further to excessive capital accumulation, thus resulting in a crisis.
2. Specific Theories and Explanations of the Great Depression
• Failure of the U.S. Financial Systems: Specific banking and financial practices have been blamed as a collective cause of the Great Depression, particularly in the classical works of Friedman and Schwartz, and modern reference works such as “The 100 Most Important American Financial Crisis” by business professor Quentin R. Skrabec
For example, during the 1920s, the stock market in the U.S. boomed because people were buying stocks on a margin or in other words, by owning stocks that involved purchasing only a margin of the price and borrowing the remaining balance from bank and brokers. The overindulgence toward the stock market translated to speculation, thus resulting in an economic bubble that made the stock market vulnerable. When the Wall Street crashed in 1929, other financial markets were affected, including the London Stock market.
It is also worth noting that the stock market crash of 1929 led to a decrease in consumption and investment confidence. Business uncertainty followed due to difficulties in securing sources of financing. This limited expansion opportunities and affected job security. The crash also caused a widespread bank panic in the U.S. in 1930 in which people withdrew their money from their banks. Thousands of banks went out of business starting as they liquidated their assets. Credit subsequently froze off that led to a shortage in money supply and further to deflation. The decline in prices forced companies to cut off their production volume and lay off their employees.
Adding to the stock market crash and the banking crisis is the monetarist view that the U.S. Federal Reserves failed to resolve the situation with its inability to pump in money to control the deflation by pumping in money to the banking system. Note that the Federal Reserves was also blamed for allowing a loose credit system to propagate in the U.S.
• Economic Problems from World War I: Another view claims that the World War I set the stage for the Great Depression. To be specific, the war left some involved countries in Europe under debts and economic troubles. When the war ended in 1918, allies of the U.S. owed large sums of money to American banks. Germany and Austria-Hungary were compelled to pay war reparations, but they lacked the capabilities to do so. American banks extended loans to European countries to pay their debts and reparation duties, as well as to keep their economies afloat, thus augmenting old debts and piling up new ones. However, the banking crisis in the U.S. exposed these countries to financial vulnerabilities, especially Great Britain, France, and Germany.
• Overproduction and Technology Shock: Some have argued that the Great Depression stemmed from the notion that the economy was producing more than it can consume. There was a surplus of products in the market because majority of the population did not have enough income to consume. They based this idea from the 1920s book “Road To Plenty” by economists Waddill Catchings and William Trufant Foster. It argued that the global economy was overbuilt due to excessive investments in heavy industry capacity while keeping wages and earnings low due to lack of attention in small or independent businesses and agricultural activities.
Other economists have explained further the impacts of overproduction. Harry Jerome and Bernard C. Beaudreau separately discussed that production efficiency due to technolgical innovations such as Fordism were responsible for increasing production outputs while displacing workers, thus resulting in overproduction, underemployment, and underconsumption. Due to low demands and persistence of product surplus, companies were eventually forced to cut down production volumes, optimize operations, and lay off workers to save costs.
Also, in several parts of Europe, factors such as the economic problems from World War I, inability to borrow money from American banks, improvements in local manufacturing and agriculture, and international trade restrictions discouraged European countries from importing products from the U.S., thereby leading to a decline in American exports.
• Collapse of the Agricultural Sector: In the United States, agriculture prospered during World War I due to the growing demand for food. Wartime efforts necessitated food security. To capitalize on the agricultural boom and meet current and expected demands, landowners and farmers borrowed money from banks to expand their arable lands and acquire modern farming equipments. However, as explained in the 1934 book “The Great Depression” by British economist Lionel Robbins, the end of the war saw a downward trend in the price of agricultural products due to a decrease in overall demand amidst an abundance of supply. This left landowners and farmers with reduced incomes that rendered them unable to pay debts while reducing their purchasing power. Note that the mechanization of farming also left most farmers without a job, thus leading further to unemployment and underconsumption.
• The Gold Standard System: There is also the Gold Standard Theory of the Great Depression. Robbins explained that a gold standard system requires central banks receiving gold to expand credit while those losing gold to contract credit. During and after World War I, several European nations abandoned this standard to introduced a system based on the idea that inflation rate should be determined by the quantity of new money introduced. In other words, money can be created without gold or in more specifically, out of thin air at the expense of inflation. This new fiat money system was adopted to resolve the issue concerning the need to create money for wartime expenditures.
However, after the war, the U.S. and other European countries went back to the gold standard. Economists such as Ben S. Bernanke and Barry Eichengreen argued that the gold standard system, mainly by linking the currency of a nation to gold and fixing the foreign exchange rate to the gold standard, had managed to transmit the economic problems that began in the U.S. to the rest of the world. The gold standard simply left countries unable to create a new supply of money.
To support further the argument for the Gold Standard Theory of the Great Recession, Bernanke and James argued further that the earliness by which a country abandoned the gold standard reliably predicted its economic recovery. This argument was based on the fact that in 1931, Great Britain and countries in Scandinavia recovered earlier than countries that remained on the standard much longer, such as France and Belgium. In addition, countries that did not follow the standard, such as China, almost avoided the global economic crisis entirely.
• Protectionism and International Trade Policies: Policies that restricted international trade were also blamed for worsening the Great Depression. In June 1930, the U.S. government passed the Smooth-Hawley Tariff Act with an intention to protect American industry from imports. However, this law resulted in retaliation from other countries that passed their respective protectionist laws. The policies resulted in the decline in American exports, as well as in decline in exports from other countries. International trade came to a halt, thus resulting in fewer revenues for companies and industries and fewer jobs.
In addition, because there were countries, such as the U.S. and other countries in Europe, that refused to abandon the gold standard, there was no consensus in what currency or standard to use for trading goods and services in the international scene. The global financial markets froze up further alongside with international trade.
- Bernanke, B. S. with James, H. 2000. “The Gold Standard, Deflation, and Financial Crisis in the Great Depression: An International Comparison.” In B. S. Bernanke, Essays on the Great Depression. New Jersey: Princeton University Press. ISBN: 0-691-01698-4
- Catchings, W. & Foster, W. T. 1928. The Road To Plenty. Boston: Houghton Mifflin Co.
- Eichengreen, B. 1995. Golden Fetters: The Gold Standard and the Great Depression, 1919-1939. New York: Oxford University Press. ISBN: 0-19-506431-3
- Friedman, M. & Schwartz, A. 1963. A Monetary History of the United States, 1867-1960.
- Hayek, F. & Rothbard, M. 1963. America’s Great Depression. New Jersey: Van Nostrand.
- Jerome, H. 1934. Mechanization in the Industry. National Bureau of Economic Research
- Keynes, J. M. 1936. The General Theory of Employment, Interest, and Money. Britain: Palgrave MacMillan. ISBN: 978-0-230-00476-4
- Robbins, L. 1934. The Great Depression. New York: Books for Libraries
- Skrabec, Q. R. 2014. The 100 Most Important American Financial Crisis: An Encyclopedia of the Lowest Points in American Economic History. California: Greenwood Publishing. ISBN: 978-1-4408-3011-2