Chapter 46 [The 1929 Great Depression: Causes, Process, and Results, Part 2]

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[James Origins and Today] Chapter 46 - The 1929 Great Depression: Causes, Process, and Results, Part 2 (06/27/2023)

Modern mainstream economists saw the causes:

A reduction in the money supply (monetarism), and therefore banking crises, reduced credit, and bankruptcy.

Insufficient demand from the private sector and insufficient fiscal spending (Keynesians).

The passage of the Smoot-Hawley Tariff Act worsened what might otherwise have been a more "standard" recession (monetarists and Keynesians).

Insufficient spending, reduced money supply, and margin debt caused falling prices and further bankruptcies (Irving Fisher's debt deflation).

In April 1929, Willis C. Hawley and Reed Smoot, shortly before the Smoot-Hawley Tariff Act was passed.

The Smoot-Hawley Tariff Act was signed into law by President Herbert Hoover on June 17, 1930. It raised tariffs on more than 20,000 imported goods to the highest levels in history. At the time, 1,028 economists in the United States signed a petition opposing the act. After the act passed, many countries imposed retaliatory tariffs against the United States, causing both U.S. imports and exports to plunge by more than 50%. Some economists believe that the Smoot-Hawley Act was the catalyst that caused trade between the United States and Europe to collapse from its historical high in 1929 to its historical low in 1932. This collapse was accompanied by the beginning of the Great Depression.

American economists Milton Friedman and Anna J. Schwartz gave the monetarist explanation. They argued that the Great Depression was caused by a banking crisis, which led to the disappearance of one-third of banks, reduced bank shareholder wealth, and, more importantly, a 35% monetary contraction, which they called the "Great Contraction." This caused prices to fall 33% (deflation). By not lowering interest rates, not increasing the monetary base, and not injecting liquidity into the banking system to prevent its collapse, the Federal Reserve passively watched a normal recession turn into the Great Depression. Friedman and Schwartz believed that if the Federal Reserve had acted aggressively when the economic decline caused by the stock market crash began, 1929 might have been only an ordinary recession.

The Federal Reserve allowed several large public banks to fail, especially the failure of the Bank of United States in New York. This caused local panic and widespread bank runs, while the Federal Reserve stood by as banks failed.

Friedman and Schwartz believed that if the Federal Reserve had provided emergency loans to these major banks, or simply bought government bonds in the open market after major banks fell in order to provide liquidity and increase the quantity of money, the money supply of all the remaining banks would not have declined so quickly.

Because available funds were sharply reduced, businesses could not obtain new loans or even renew old loans, forcing many companies to stop investing. This explanation blames the Federal Reserve's inaction, especially the New York branch.

This view was supported by Federal Reserve governor Ben Bernanke in a speech honoring Friedman and Schwartz, where he made the following statement:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression, you were right. We are very sorry. The Great Depression was created by the central bank itself. But thanks to you, we will not do it again.

One reason the Federal Reserve did not act to limit the decline in the money supply was the gold standard. At the time, the amount of credit the Federal Reserve could issue was limited by the Federal Reserve Act, which required Federal Reserve notes to be backed 40% by gold. By the late 1920s, the Federal Reserve had nearly reached the credit limit that could be backed by the gold it held. This credit appeared in the form of Federal Reserve demand notes. A "promise of gold" is not as good as "gold in hand," especially when they had only enough gold to cover 40% of outstanding Federal Reserve notes. During banking panics, some demand notes were redeemed for Federal Reserve gold. Because the Federal Reserve had reached its allowed credit limit, any reduction of gold in its vaults had to be accompanied by a larger reduction in credit. On April 5, 1933, President Roosevelt signed Executive Order 6102, making private ownership of gold certificates, gold coins, and gold bullion illegal, reducing pressure on the Federal Reserve's gold.