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The Great Depression

Overview and economic explanations

The Great Depression

The Great Depression was a worldwide economic depression that took place from the late 1920s to the early 1930s. For decades, debates went on about what caused the economic catastrophe, and economists remain split over a number of different schools of thought. In broad terms, the event was most likely caused by overly optimistic investor sentiment and the availability of easy credit for consumers and businesses following World War I.

 

The Great Depression:

 

Investor optimism and consumer spending were likely spurred by the post-war years of the 1920s. Citizens and governments all over the world felt relieved that their livelihoods were no longer in danger, and shifted their focus to building new lives. Banks and creditors saw this newfound confidence as an opportunity to make credit more accessible and profit from their loaning business.

For almost a decade, loans and mortgages were granted to individuals and businesses with poor credit ratings. Eventually, sky-high consumer and national debt brought markets crashing and vanquished investor sentiment.

 

Wall Street Crash of 1929 (Black Tuesday)

Many consider the Wall Street Crash of October 29, 1929 as the official starting point of The Great Depression. Below is a historical chart of the Dow Jones Industrial Average, which shows the sharp dip in the index during The Great Depression from 1929 to the early 1930s.

 

The Great Depression: dow jones 1915-1950
Source: Macrotrends

 

From October 28 to 29, 1929, the Dow crashed by 25% overnight – an unprecedented loss that sent the US economy reeling. In June 1932, the Dow hit a historic all-time low of 789 points – down 85% from its 5507-point high in August of 1929. It would take almost 30 years for the Dow to recover to its pre-depression high in May of 1959.

Worldwide GDP fell by 15% over four years from 1929 to 1932. The unemployment rate in the US increased sixfold, peaking at a staggering 22%. Economies around the world ground to a halt and governments felt pressured to implement expansionary fiscal policies.

 

Main Economic Theories

There are three generally accepted economic explanations to The Great Depression:

 

Common Theory

The most widely accepted theory that explains The Great Depression is that governments are to be held responsible for changes in fiscal policy during all economic climates. Thus, they should aim to keep aggregate money supply and aggregate money demand growing at a steady pace in the long run. For instance, during a recessionary period, liquidity in the banking system should be increased and taxes should be cut in order to prevent the collapse of money supply and demand.

In the case of The Great Depression, most governments were either too slow to react or didn’t react at all. Some economists even argued that economic depressions were a good thing since (i) they forced failed investments to liquidate and (ii) they allowed capital and labor to be freed up from unproductive businesses and channeled into growing economic segments.

 

Monetarist Theory

The Monetarist Theory blames banks and the U.S. Federal Reserve for not taking measures to protect the economy during The Great Depression. As the money supply shrunk by 35% and CPI fell by 33%, the Fed took too long to respond and did not lower interest rates, increase the monetary base or inject liquidity into the banking system in time.

The delay allowed stock market indices to drop significantly, which led to investors panicking and selling off their securities. Cumulatively, these factors allowed what was an otherwise intense recessionary period into an unprecedented Great Depression.

 

Keynesian Theory

The Keynesian Theory was formulated by British economist John Maynard Keynes. It states that government’s top priority was to keep employment as high as possible during recessionary periods by running deficits. Keynes’ theory also noted that governments needed to increase public sector spending or sharply cut taxes.

 

Consensus

All three theories broadly seem to point to the governments’ and agencies’ lack of response during acute economic times. The consensus is that there should have been quick changes to interest rates, tax rates, and liquidity.

 

More Resources

Thank you for reading CFI’s guide to The Great Depression. Check out these additional resources to help you along your finance career path:

  • Economic Indicators
  • Market Economy
  • Network Effect
  • Quantitative Easing

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