How government caused the Great Depression

Originally published in the Herald-Mail

Thomas A. Firey Sep 23, 2014

Eighty-five years ago this month, the United States fell into the Great Depression, the worst economic crisis in the nation’s history. In two years, U.S. unemployment would rise above 15 percent and stay there for five years, topping out at 25 percent in 1933.[1] The nation’s economy would struggle for a decade.

But this month is not the anniversary of “Black Tuesday,” the stock market crash of Oct. 29, 1929, which people often blame for the Depression. The U.S. economy began contracting two months before Black Tuesday,[2] dragging the world economy along with it. The stock market crash was a result—not the cause—of the Depression, as investors sold off their holdings before they became worthless.

If Black Tuesday didn’t cause the Depression, what did? Over the last half-century, economists across the political spectrum have reached a broad consensus that government—primarily the U.S. and French governments and their central banks[3]—was to blame.

The roots of the Depression, like most horrors of the 20th century, lay in the Great War—what we call World War I. Before the war, most developed countries backed their currencies with precious metal, meaning a person could take his money to the government and convert it to gold (or sometimes silver) at a pre-established rate. Convertibility protected the value of money, making this “Classical Gold Standard” era a time of little inflation or deflation.

Once the war began, governments wanted to print money quickly and exchange it for war supplies. But convertibility allowed people to exchange the new money for gold at the pre-established rate, which could drain national gold reserves. To avoid that problem, most countries suspended conversion. The United States did not do so officially, but it discouraged “patriotic Americans” from exchanging their dollars for gold and thus joined the rest of the world in using the printing press to finance the war.

After the war, countries faced a problem: if they resumed conversion at the old exchange rate, then people could use the wartime money to make a run on national gold reserves. This left policymakers with a difficult choice: alter the exchange rate or abandon conversion altogether (risking hyperinflation), acquire more gold for conversion (which would be costly), or somehow reduce the amount of money in their economies (risking recession).

The United States[4] and France[5] chose the second option and in the late 1920s began acquiring gold from the rest of the world. About the same time, the U.S. Federal Reserve tightened banking requirements and raised interest rates, intending to slow the then-booming stock market and keep gold in American vaults.[6] Meanwhile, the gold-starved countries in the rest of the world faced both conversion problems and high interest on loans from the United States, which prompted them to raise their interest rates. Those actions reduced the supply of money in the U.S. and world economies, and consumers and borrowers cut their spending. The Depression ensued.

Ultimately, nations chose to devalue their currency or leave the gold standard altogether.[7] Once they did so, their money supplies expanded and their economies improved. The United States (1933) and France (1936) were among the last to devalue, and among the last to emerge from the Depression. The United States even suffered a “recession within the Depression” in 1937–1938 when it re-tightened the money supply.

The bungled return to the gold standard was not the only government action that fueled the Depression; U.S. banking regulation also bears blame. Most U.S. banks were overseen by state governments, under arguably the strictest rules in the world.[8] Among the rules were requirements that most banks be local and have few branches.[9] That made banks susceptible to local economic downturns: a bad harvest or idled factory could prompt a run on the local bank, which would fail. Panic then spread to neighboring towns, where residents would run on their banks, cause them to fail and spread panic farther. What should have been small, localized economic setbacks spawned the Depression’s waves of regional bank failures.[10]

Other U.S. government actions also fueled the Great Depression. Laws and regulations intended to keep wages high even though millions of people were out of work caused further unemployment, and a sharp hike in income taxes hurt consumers. The Glass-Steagall Act outlawed “universal” banks (where people could save, invest and buy insurance at the same place) and forced people to put their savings in deposit banks, which were more fragile than universal banks.[11] Those and other government interventions not only hurt the economy during the Depression, but for decades afterward, culminating in the 1970s Stagflation—the second-worst economic crisis in American history.

Today, as the United States slogs through another year of stagnant “economic recovery,” some politicians and commentators want more government involvement in the economy. That’s understandable; when the economy has been so bad for so long, people will hope for a miracle worker to save the day. But government caused the two worst economic crises in the nation’s history and cheered on the third: as financiers invested heavily in the 2000s housing bubble, government encouraged them to offer even more money to even riskier borrowers.

Given those failures, the last thing we should want is for politicians to have even more control over the American economy.

Thomas A. Firey is senior fellow for the Maryland Public Policy Institute.

[2] National Bureau for Economic Research Business Cycle Dating Committee. “U.S. Business Cycle Expansions and Contractions.

[3] Barry Eichengreen and Peter Temin. “The Gold Standard and the Great Depression.Contemporary European History 9(2): 183–207.

[4] Barry Eichengreen. “The Origin and Nature of the Great Slump Revisited.Economic History Review 45(2):213–239.

[5] Douglas A. Irwin. “The French Gold Sink and the Great Depression of 1929–32.Cato Papers on Public Policy 2: 3–56.

[6] Milton Friedman and Anna J. Schwartz. A Monetary History of the United States, 1860–1967. Princeton, NJ: Princeton University Press, 1963.

[7] Ben Bernanke and Harold James. “The Gold Standard, Deflation, and Financial Crisis in the Great Depression: An International Comparison.” In Financial Markets and Financial Crisis, ed. R. Glenn Hubbard, Chicago: University of Chicago Press, 1991.

[8] Charles Calomiris. U.S. Bank Deregulation in Historical Perspective. Cambridge, MA: Cambridge University Press, 2000.

[9] For an explanation of why regulators adopted those policies, see Thomas A. Firey, “The Magic of Money and the Fed Dilemma,Herald-Mail (Hagerstown, MD), July 31, 2013.

[10] Gary Richardson. “Bank Distress during the Great Depression: The Illiquidity–Insolvency Debate Revisited.Explorations in Economic History 44(4): 586–607.

[11] Eugene N. White. “Before the Glass-Steagall Act: An Analysis of the Investment Banking Activities of National Banks.” Explorations in Economic History 23(1): 33–55.