The Great Depression, which started from the end of 1929 and ended midway through the 1940s, was the deepest and longest-lasting economic downturn in the history of the United States. As Keynes observed in 1931 ‘in the middle of the greatest economic catastrophe . . . of the modern world . . . there is a possibility that when this crisis is looked back upon by the economic historians of the future it will be seen to mark one of the major turning points’ (Keynes, 1931, p 3). Indeed, Keynes was right the Great Depression was marked as one of the major turning points in the financial history of the United States making Americans ask themselves every time things turned bad ‘Will it be 1929 all over again?’ (Galbraith 2009, page 25). The Wall Street Crash has for some time been thought of as the main consequence of the Great Depression (Field 1984), (Romer 1990). However, there has also been great opposition as to whether the Wall Street crash was responsible or merely acted as a catalyst of the Great Depression (Galbraith 2009), (Temin 1994), (Friedman and Schwartz 1963), (Keynes, 1936). This essay aims to illustrate how the Wall Street Crash was indeed not responsible for the Great Depression but acted as a catalyst since there are other factors which were vital to the downturn of the economy turning into the most severe depression of the past century. Some of those factors include the well-established views of the most important economists of the 20th century such as Friedman and Schwartz (1963) and Keynes (1936).
‘Tuesday, 29 October, was the most devastating day in the history of the New York stock market, and it may have been the most devastating day in the history of the markets’ (Galbraith 2009, p 133). For the first time ever had stock prices fallen so rapidly leaving the ticker unable to catch up with the pace of the selling that was taking place that day. It is said that the bell at the start of the day was not heard due to the constant shouting of “Sell! Sell! Sell!” that was going on in Wall Street. Economists have been struggling to explain what exactly happened that day and why the market dropped so quickly. By the end of the day the ticker was two and a half hours behind and a total of 16,410,030 sales had been recorded on the New York Stock Exchange. That was three times greater than the number which was once considered as fabulously great day and there were still sales which had not been recorded. Since then economists have argued greatly whether or not the great crash was responsible for the Great Depression. Christina Romer (1990) argues that a link does indeed exist and that the stock market crash was a cause of the great depression. She argues that the stock market crash caused great uncertainty and made households reluctant to purchase consumer durables. Thus, in the event that they became unemployed they would use up savings for living expenses, or take on additional debt. Mishkin (1978) further developed this point by arguing that the stock market crash changed the mood from optimism to pessimism causing consumers to restrict their purchases. In addition, consumers had built up their indebtedness prior to the crash only to find the value of their financial holdings dropping as a result of the stock market crash. This decline in liquidity led to consumers fearing their solvency and thus, postpone the purchase of durable goods and housing. This view is further supported by Field (1984) who suggested that the crash reinforced the depression by drastically raising the cost of equity finance and through its effect on household wealth, depressing less interest-sensitive components of consumption. In turn, (Fearon, 1987) believes that the level of debt between 1929 to 1933 was of particular importance and that the level of debt was high towards the start of the depression for both businesses and consumers. The stock market crash caused these levels of debt to increase dramatically in real terms as prices fell. These large increases of debt along with Kindleberger’s (1984) views that the crash put pressure on credit by making banks cut down loans so as to have extra liquidity and be able to cope if a collapse took place, caused a squeeze in consumers finances. In turn, this caused the level of investment in the economy to fall and thus causing the level of aggregate demand to fall. However, many economists have opposed the view that the stock market crash was responsible for the great depression. Galbraith (2009) believes that it is was somewhat a secondary event and that “cause and effect run from the economy to the stock market, never the reverse’ (1954, p.111). In turn, Temin (1994) argues that the stock market has gone up and down many times since the great crash without producing a similar movement in income. “If the crash of 1929 was an important independent shock to the economy, then the crash of 1987 should have been equally disastrous” (Temin 1994, p.7). These views are further supported by Friedman and Schwartz (1963) who along with John Maynard Keynes (1936) believe that the Wall street crash was not a cause of the depression. Indeed, it appears as if Wall Street could not have been responsible for the depression, since had the government adopted a more expansionary fiscal policy, then the crash would not have affected the state of the economy and confidence within the market would have remained high.
One of the most accepted views as the cause of the Great Depression is that of Friedman-Schwartz (1963) that the severity of the depression was caused by a decline in the nation’s stock of money due to the actions of the Federal Reserve. Friedman and Schwartz (1963) blame the Federal Reserve not only for initiating the restrictive policy that resulted in the 1929 downturn, but for maintaining a restrictive policy far into the Great Depression. They point out that the Federal Reserve did not undertake any expansionary open market operations until 1932, and even then, these were small-scale and short-lived. Indeed, the Federal reserve tried to slow down stock market speculation by increasing the interest rate thus reducing monetary growth causing the economic boom to come to an end. In addition, the Federal Reserve failed to forcefully use the discount window to make loans to banks. Since the Federal Reserve did not maintain bank reserves three huge bank failures occurred (1930, 1931 and 1933) as the frightened public drew money out of the banks. As a result, the money supply fell by one third. The Federal Reserve caused instability by intervening in the baking system since the banks could have coped by refusing to convert deposits into cash as they had done before in 1913. The policies which were introduced by the Federal Reserve where as if their aim was to destroy the banks. This was further the case when in 1936-1937 the Federal Reserve doubled the reserve requirements in the belief that this would have no effect on the money supply since by then the banks had gathered substantial excess reserves. Friedman and Schwartz (1963) argue that such a policy caused the banks to reduce their deposits by making fewer loans since they wanted to hold large excess of reserves to protect themselves from bank runs. This resulted in an even greater fall in the money supply and thus causing a sharp recession in 1937. If the Federal Reserve adopted a more vigorous monetary policy then it could have made the Great Depression less severe. By shoring up the banks more credit would have been made available for consumers thus increasing market confidence along with the demand for money. However, there have been some economists who have challenged Friedman and Schwartz such as Keynes (1936) and Temin (1976). Indeed, Temin (1976) argues that due to the fact that banks had been weakened in the 1920s by the agricultural recession caused by the low prices of farm products as well as by major instances of fraud, a more expansionary Federal Reserve policy in the early 1930s could not have prevented the collapse of the banking system. In addition, Temin (1976) uses the point that although nominal money supply fell after 1929, real money supply continued to rise until 1931 to back his claim, there is no evidence of contractionary monetary policy between the Wall Street crash and Britain’s abandonment of the gold standard in September 1931. Temin challenged the monetarist views and raised serious questions about the events that occurred up to and including September 1931, which showed that monetary factors alone could not account for the course of the depression to that date. Indeed, non-monetary factors such as the views of Keynes (1936) are more important than monetary during this period. Even though the monetarist case makes more sense after 1931 when the number of bank failures increased dramatically and the money supply fell severely, Temin (1976) and Keynes (1936) believe that this was caused by a falling demand for money, not a deficient supply. Indeed, monetarist views seem to face theoretical problems such as how exactly is the money supply within an economy measured. Thus, even though Friedman’s and Schwartz’s views of the causes of the Great Depression have become wildly accepted by economists they still fall behind the views of one of the most important economists of the 20th century, John Maynard Keynes.
The most important cause of the depression is best explained by Keynes (1936) who believed that it was caused by the government’s inability to respond to fall in the aggregate demand. Keynes view is that unemployment is determined by the level of national income which depends on the level of aggregate demand for goods and services in the economy. He believed that investment is the most volatile component of aggregate demand and that full employment is not possible if the level of investment is low. In addition, Keynes (1936) believed that the private sector has no self-correction mechanism, thus to guide the economy to full employment the government has to intervene by tax cuts or by increasing government spending. By doing so the economy can move closer to full employment since the level of aggregate demand within the economy will rise. This is due to the fact that Investment, Government Spending, Net exports along with Consumption are all components of the level of Aggregate Demand in an economy. Keynes saw the sharp decline in the level of investment after the boom of 1928-1929, especially noticeable in construction and consumer durable goods, as a main cause of the Great Depression. Since a depression had been prevented during the recessions of 1925 and 1927 by the substantial construction activity and consumer’s willingness to purchase durable goods. Thus, minor contractions in the economy did not lead to major depression. In turn, Keynes attributes the 1928-1929 boom to the high expenditure on consumer durables and although house building had dropped from the peak it reached in 1926, construction was still very high by historical standards. Thus, once these sectors eventually declined in 1929 it was inevitable that a recession would soon turn into a depression. Investors saw their future profits dropping thus causing them to turn their investments into cash which in turn resulted in a strain on all financial institutions especially banks, and set in a motion of a downward spiral. In addition, level of consumption within the economy fell further as prices dropped, as consumers were now only purchasing essential goods waiting for prices to hit rock bottom. Unemployment fell further after 1931 when agriculture incomes collapsed causing businesses to have no other option but invest less and by doing so laying workers off. Temin (1976) supported Keynes views and suggested that the decline in income and prices evident before the financial crisis of 1931 was mainly caused by a heavy fall in the level of consumption. Temin believed that this inexplicable low level of consumption depressed demand and undermined business confidence causing a downward spiral during 1930. Lastly, Krugman (2012) argues that the Great Depression was ended after the start of WW2 as government spending had risen so as to prepare the country for war. This supports Keynes views that had the government intervened by increasing spending then the depression would not have been so severe or may even have been prevented.
In conclusion, the collapse of the Stock Market in 1929 was to a very small extend responsible for the Great Depression as it only played a minor role. The Wall Street Crash is better described as the catalyst of the Great Depression that followed but not a main cause. It has been shown that there were other factors which were more important such as the bad policies adopted by the Federal Reserve in concept of the ideas developed by Friedman and Schwartz (1963). However, the main cause of the Great Depression was best explained by Keynes (1936) who proved that in times of depression the best the government could do is to adopt expansionary fiscal policy and not stimulus so as to be able to set the economy on the road to recovery. Therefore, the greatest economic depression that occurred in the history of the United States was mainly responsible by the lack of government intervention leading to a substantial fall in the level of aggregate demand within the economy thus causing a recession to turn into the Great Depression.