There are many causes and misconceptions that have circulated around the Great Depression and the Great Recession. Below is an analysis of what caused both the events, and its resultant impact on the economy.
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Before going into the causes of the Great Depression, this is a good time to look into the misconceptions that have circulated around this event. Many authors have given their opinions on the cause, and unfortunately, some can be misleading the readers.
There continues to be much debate even today surrounding the causes of the Great Depression. This argument means that the exact cause of the Great Depression is still not identified, as many economists have different opinions on what really led to it. Also, getting to the bottom of these causes is essential to avoid such profound economic downturns in the future.
Below are some causes as explained by economists and researchers around the world.
One of the most important contributors to the Great Depression is the monetary policy followed by the Fed before and during the depression. There is always the question of whether the monetary policies caused changes in money supply, that in turn, is believed to be one of the biggest causes of the Great Depression. Some authors likes Fisher (1932) believe that the Fed should have prevented deflation during the Great Depression by increasing the money supply in the economy.
On the other hand, some economists argue that the excess availability of money during the previous decade led to the depression. The move by the Fed to artificially ease the money supply in 1928 was a mistake, because they argue, that such a situation leads to overproduction. Along with it, excessive borrowing to meet the financial obligations of the business caused massive misallocation in resources, so depression was a means of correcting this problem.
When the American economy was in a mild recession earlier, the Fed had made large amounts of open market purchases to increase the liquidity position of the economy. However, this turned out to be counter-productive because these liquidation measures did not improve the economy because that was not the only problem. Though liquidity was one aspect, there were other aspects that needed to be addressed too such as agricultural woes, unregulated nature of American businesses, stock market speculations that wee not governed by any regulatory body and a crowded banking system. Failure to do ensured that the liquidity position did not immediately stop the free-fall of the economy.
Another important cause of the Great Depression has been the bank failures. There has been mixed opinions on the impact of bank failures on the Great Depression. Some authors such as Ross (1998) and Garraty (1986) have contended that bank failures are insignificant for the larger macro-economy, though it has hurt small investors who lost their deposits in these failures. Generally, also the Keynesian explanations have agreed that bank failures had little role in the depression. Nevertheless, enormous amounts of banks failed during the Great Depression. It is estimated that 9,000 banks failed during the Great Depression, and people lost more than $140 billion during this time (Blinder & Zandi, 2010).
The economic impact of these bank failures was enormous on the economy. When banks failed, people lost their savings. Furthermore, banks could not lend money to businesses; hence, the corporate sector could not expand. Hence, they were forced to lay off people, and this brought the demand down for goods and services because people did not have the money to buy even the basic supplies needed for living. In this sense, bank failures led to a deflationary trend within the economy.
However, what these authors failed to see was the psychological impact of bank failures on the society as a whole. These bank failures created a panic that led people to believe that liquidity was essential in the economy. In turn, this belief caused the money supply to fall, which also contributed in a big way to the overall decline in economic activity. Also Bernanke (2000, p. 60) agreed that bank failures increased the cost of credit intermediation, which in turn, brought the national output down significantly. On the basis of this argument, it can be said that the Fed is responsible for the depression as it did not curb the panic that emanated from the banking failure. Had it taken steps to instill confidence in the minds of the people about the stability of the banks, depression could have been avoided or even mitigated to some extent.
The death of Fed's Governor Benjamin Strong just before the Depression was a big blow to the Fed. Had he lived through the Depression, things could have been much different because he had learned the technique of using monetary policy to maintain price stability in the economy. This strength of Governor Strong was evident in the way he maintained price levels in the country for seven years. In fact, many sections of the society did not even know about the existence of such a Governor or his policies, because life was easy with stable prices.
Economists such as Fisher, Friedman and Schwartz agree that the sudden death of Governor Strong led to significant changes in the monetary policy of the country. Their argument is that Strong's aggressive policies such as the open market purchases in 1924 and 1927 helped to reduce the impact of the recessions, so he would have taken the right measures to alleviate or even prevent the depression.
The reason for some economists to believe that Strong's death was the cause of the depression was because he was a strong financial leader with vast experience in the financial field. He served as an officer of Bankers Trust Company, and from there, became the first Governor of the New York Federal Reserve. His stature also made him a prominent figure in the international financial market, so his death was a blow to the morale of the Fed and the international market as a whole, especially at a time when the world was going through a financial crisis.
As with every other cause, there was a lot of opposition to this cause too. Many economists such as Temin, Brunner and Meltzer (Wheelock, 1992) brush aside Strong's death as a cause for the Great Depression because they argue that this was only a minor event during the Depression. To get a better understanding of whether Strong's death was a cause at all, it is important to understand Strong's monetary policy.
There were two important policies formulated by Strong, and both these policies received considerable attention from economists. The first policy is the changes that Strong made to the reserve funds in the early part of 1920s to limit the outflow of gold. During the 1920s, the US had a strong economy fueled in part by the demand for its goods from Europe. This demand helped the country to get a cushion of gold reserves, and the Fed used this reserve to stabilize price levels and inflation. Fed also helped an adverse flow of gold out of Britain, and this was done to help Great Britain come back to the gold standard. Furthermore, this limiting of gold outflow had an impact on the bank reserves too. As a result of this policy, the fluctuations in bank reserves were greatly reduced, and in turn, this helped to stabilize price levels within the economy.
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Another policy that received considerable attention was the aggressive open market purchases made by Strong in 1924 and 1927. These measures were followed by discount rate reductions and increases in bank reserves that led to an increase in money supply. The idea behind this move was to combat the recession that was prevailing in the US economy then. Strong and his team believed that these steps were necessary to kick start the economy and to get it going again.
Both these policies point to an effective effort that helped the economy to gain steam. Also, a look into the many testimonies Strong gave before the Congress shows that he had created a monetary policy that controlled fluctuations in the price levels of commodities. In a speech given to the American Farm Bureau in 1922, he explained monetary policy as,
“A tool that should insure that there is sufficient money and credit available to conduct the business of the nation and to finance not only the seasonal increases in demand but the annual or normal increase in volume. I believe that it should be the policy of the Federal Reserve System, by the employment of the various means at its command, to maintain the volume of credit and currency in this country at such a level so that, to the extent that the volume has any influence upon prices, it cannot possibly become the means for either promoting speculative advances in prices, or of a depression of prices” (Wheelock, 1992, p.18).
However, there have been times when his speeches and arguments give other views about the monetary policy. In one speech, he had said that the deflation that prevailed in the economy from mid-1920 to 1921 had positive effects, as it had helped to strengthen the monetary policy of the country. These statements, in many ways, show the ambiguity of Strong's thoughts and policies.
Therefore, it is hard to ascertain whether things would have been different had Strong been alive.
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