Great Depression in The United States - Causes

Causes

Current theories may be broadly classified into two main points of view. First, there is orthodox classical economics, monetarist, Keynesian, Austrian Economics and neoclassical economic theory, which focuses on the macroeconomic effects of money supply, including Mass production and consumption. Second, there are structural theories, including those of institutional economics, that point to underconsumption and over-investment (economic bubble), or to malfeasance by bankers and industrialists.

There are multiple originating issues: what factors set off the first downturn in 1929, what structural weaknesses and specific events turned it into a major depression, how the downturn spread from country to country, and why the economic recovery was so prolonged.

In terms of the initial 1931 downturn, historians emphasize structural factors and the stock market crash as well as bank failures, while economists point to Britain's decision to return to the gold standard at pre–World War I parities ($10.98 Pound). The vast economic cost of World War I weakened the ability of the world to respond to a major crisis.

Banks began to fail in October 1930 (one year after the crash) when farmers defaulted on loans. There was no federal deposit insurance during that time as bank failures were considered quite common. This worried depositors that they might have a chance of losing all their savings, therefore, people started to withdraw money and changed it into currency. As deposits taken out from the bank increased, the money multiplier decreased, which means that money circulation slowed down. This led to a decrease in the money supply, and an increase in interest rate and a significant decrease in aggregate investment.

The US government's commitment to the gold standard prevented it from engaging in expansionary monetary policy. High interest rates needed to be maintained, in order to attract international investors who bought foreign assets with gold. However, the high interest also inhibited domestic business borrowing.

Economists dispute how much weight to give the stock market crash of October 1929. According to Milton Friedman, "the stock market in 1929 played a role in the initial depression." It clearly changed sentiment about and expectations of the future, shifting the outlook from very positive to negative, with a dampening effect on investment and entrepreneurship, but some feel that an increase in interest rates by the Federal government could have also caused the slow steps into the downturn towards the Great Depression. Thomas Sowell, on the other hand, notes that the rise in unemployment had peaked at 9% two months after the crash, and had fallen to 6.3% by June – he blames the later unemployment rate on the tariffs that Hoover passed against the advice of economists in that same month, and says that six months after their implementation unemployment rose to the double digit figures that characterized that decade. Recent research has pointed to the effects of capital taxation on property, capital stock, excess profits, undistributed profits, and dividends on the severity of the Great Depression, noting such taxation's role in significant declines in investment and equity values and nontrivial declines in gross domestic product and hours of work.

The US interest rates were also affected by France's decision to raise their interest rates to attract gold to their vaults. In theory, the U.S. would have two potential responses to that: Allow the exchange rate to adjust, or increase their own interest rates to maintain the gold standard. At the time, the U.S. was pegged to the gold standard. Therefore Americans converted their dollars into francs to buy more French assets, the demand for the U.S. dollar fell, and the exchange rate increased. The only thing the US could do to get back into equilibrium was increase their interest rates.