The Great Depression - Research Paper Example

? The Great Depression Dec 10, The Great Depression Introduction The great depression (1929-1939) was the longest, most widespread, deepest and most severe period of economic slump in the history of United States, and indeed, the entire industrialized world. Economic historians attribute the 1929 sudden and total collapse of the stock market as the primary cause of the great depression. Nevertheless, it resulted from several causes, and indeed, some economists argue that the stock market collapse was merely a symptom rather than a cause. It began in the U.S but quickly spread to the entire world. It hit hard on major cities, especially those dependent on heavy industry. It took a toll on prices, tax revenue, personal income and profits. International trade shrunk by over 50% to 75%. Unemployment in the U.S increased to over 25%, while GDP fell by over 36%. Consumption declined and so did the industrial output. Additionally, it had political ramifications. It led to the election of President Roosevelt in U.S and the rise of Hitler’s Nazi regime in Germany. Historians argue that it was one of the major causes of the World War II. Not even Roosevelt’s New Deal could pull the U.S economy out of the depression. Countries began to recover in the mid 1930s. Ironically, the beginning of World War II marked the end of the Great depression. Causes Recessions in a business cycle are normal, and a product of balances between demand and supply. What turned normal events into a recession has been a subject of widespread debate. A combination of domestic and international factors was culpable for the great depression: structural weaknesses and individual events. a) Boom to Bust The period following World War I is widely regarded as an era of prosperity for the American people. U.S.A had just emerged as a leading superpower. Business started thriving and the quality of life improved dramatically. There were post war reconstructions and low interest rates which ignited the boom. President Coolidge in his state of the nation address in 1929 noted that the nation had never witnessed better prospects than it did then. Automobiles were growing cheaper and more popular. Stock prices were on an upward trend. In fact, the Dow Jones Industrial Average quadrupled between 1924 and 1927. The market experienced the biggest bullish run ever. Many people thought that this was a permanent phenomenon. Many investors were lured into the stock market, some investing on margin using loans. According to Suddah (2008), out of every 5 dollars loaned by banks, 2 were spent to buy stock. In essence, there was a huge supply of money, which primarily led to speculative stock prices. Besides stock markets, there was a boom in the real estate sector. There was a surge in the real estate sector particularly because of the low market interest rates. Why did the boom to bust contribute to the depression? Boom and bust is a normal feature of a capitalist economy. It was bound to end. It had been a period excessively easy monetary policy. There was a general absence of proper regulation in the monetary sector. It led to excessive speculation, where investors speculated that the share price would keep the upward trend. As a result of increased demand, the share prices became artificially higher: and did not reflect their real value. The speculative euphoria and the boom psychology created underlying weaknesses and imbalances within the economy. Consequently, the nation was not able to deal with the downward spiral in the economy. b) Stock Market Crash of 1929 The stock market crash is widely regarded as the major cause of the depression. The artificial prices of stocks were finally destroyed. What happened was that when the bull market came to an end, share prices began to fall as from September 3 1929. Speculators began sensing loses to their savings and even homes. On the Black Thursday, there were many people trying to offload their shares. That increased the supply while very few investors were willing to buy. Over 13 million shares exchanged hands that day. The price therefore suddenly plummeted downwards vertically. At the open of the black Tuesday, investors were trying to free up much needed liquidity. There was panic selling and this brought the price violently spiraled downwards. Many stocks became worthless, people losing even their entire life savings. Others who had taken loans to buy stocks lost everything they owned including businesses, furniture and cars. In total, over $ 25billion was lost in the 1929 crash. Subsequently, the crash dramatically reduced the consumption and by extension, America’s aggregate demand. It took toll on spending by the people who felt ‘poorer’. Reduced demand saw the production and general output dropped dramatically. Reduced production led to companies suffering financial setbacks, which culminated in millions of people losing their jobs. According to Keynes, businesses lost capital and so had to dismiss workers. Dismissed workers had less income to spend, and those with income tended to consume less. This led to reduced money supply in the economy. Moreover, reduced consumption led to low prices which led to reduced profitability by the companies. According to the aggregate supply-aggregate demand model, changes in price level causes changes in GDP. This, therefore, explains why the GDP plummeted downwards. c) Bank failures The stock market crash took toll on banks, and other financial institutions which had invested heavily in the stock market. In 1930s, there was a banking panic. Depositors who had lost faith in the banks started demanding back their deposits in cash. Generally, banks hold only small fractions of the deposit while the rest is invested elsewhere. This triggered a hasty liquidation by the banks. This process of hasty liquidation can cause even a previously solvent bank to fail (Romer, 2003). As result of increased demand for cash, banks faced liquidity crisis and could not pay up customer’s demands. This panic took toll on the banking sector. It led to failure of more than 550 banks. People lost their savings. Surviving banks stopped lending. As a result of loss of savings combined with other factors, there was reduced money supply in the economy. People began spending less, which by extension, led to reduced consumption and output by the companies. Additionally, the fall of the banks led to a widespread reduction in the supply of money in the economy which affected consumption greatly. d) Failure of International Trade Generally, countries were keen to protect their own domestic businesses from international competition. For instance, U.S enacted Smoot-Hawley Act which raised dramatically tariffs on imported products. Other countries retaliated by passing similar legislation. In essence, protectionist tendencies cropped up. These measures reduced international trade by more than half. It resulted to reduced international prices especially in raw materials which affected the farming sector. It proved to be a major economic blunder as it accelerated the economy into a depression. American exports declined sharply from more than $5.5 to $1.7 between 1929 to 1932. It also led to high unemployment particularly on export related businesses. e) Poor monetary policies The government made a series of poor monetary policies which Friedman and Schwartz attributes as the main cause for the great depression. First, to stimulate the economy in the early 1920s, the government unleashed a vast money and credit expansion. A huge supply of money increases capital, leads to high business expansion and hence, increases production and creates employment, which in turn creates money and increases disposable income. However, in the early 1920s, the government reversed its monetary policy. It sold government securities and halted bank’s credit expansion. It raised its discount rate to 6%. The effect of this was a reduction in supply of money from the economy. From 1929 to 1933, the money supply fell by 25% while the price level fell by 24%. Thus, the real money supply remained roughly constant and, as a result, the nominal interest remained roughly constant (Rothbard, 2000, p.25). Therefore, the real interest rate increased as the price level decreased, keeping investment and consumption very low According to Keynes (1936), the economy is driven by the aggregate demand or aggregate expenditures. Aggregate demand is made up of 3 core components: personal consumption, private investment and government expenditures. A strong aggregate demand results to a strong economy. If aggregate demand reduced, business firms find themselves with excess resources and have to cut back to avoid future surplus including on labor and thus results to high unemployment rate. According to Keynes, the culprit is always private investors. Private investors act in a herd like manner: can act with irrational exuberance or irrational lethargic (animal spirit). Investment lethargy triggers reduced investment, decreasing aggregate expenditure and thus causes economic downturn. This Keynesian theory well explains the stock market crash of 1929. Irrational decision by stockholders to sell in panic on black Tuesday was the result of the economic collapse. CONSEQUENCES The great depression had several consequences on the economy. Statistics alone cannot convey the real impact of the depression. It caused great human sufferings. It impacted heavily on the common man and the economy leading to the following: a) Lost savings People who had invested their life savings in the stock market made massive losses. Many were forced to sell their stock at throw away prices in panic. For instance, General Electric whose shares traded for $396 prior to the crash fell to $34 within three years. As a result, the economy lost over $74 billion worth of investor’s funds in 3 years. The similar story was replicated across the board. Additionally, the collapse of the banking resulted to massive losses for depositors. Importantly, it killed the confidence of the people in the economy nationally. b) Unemployment In 1925, unemployment rate was about 3%. By 1930 it had shot up to 25%. Unemployment among agricultural workers ascended to about 40%. Around 13 million workers could not find job at all. Even those who continued in employment were forced to take huge salary cuts. Women and immigrants were bore the greatest brunt. The cause of unemployment was the reduced production of the economy. As the number of people losing jobs rose, foreclosures and the number of people losing their homes rose. It is estimated that over 200,000 people were evicted in New York City alone. Americans faced a real threat of starvation. Unemployment led to a very high crime rate and migration. People from states such as Texas moved to California where it was easy to get job. c) Homelessness and basic necessities As stated, people lost their homes. Others, they could not afford rent when they lost their employment. Families moved in with relatives. Those without relatives had to live in shacks, and houses made of cardboard. Although food and clothing was cheap, there was basically no money to buy. Therefore, malnutrition and starvation became common (Smith, 2006). d) Increased role of the government The government increased its control in people’s lives. For instance, it encouraged people to form and join trade unions for collective bargaining through the Wagner Act. It implored upon the employers not to reduce the wages payable to employees in order to keep the disposable income high. Under Roosevelt, a certain percentage of income earned under the new deal was supposed to be remitted back to the family. The government also tightened the regulation of the financial sector through enactment of a series of legislation such as the securities Act of 1933. Securities and Exchange Commission was established to regulate the securities sector. In the banking sector, one of the defining moments was Roosevelt’s banking holiday, where all banks were closed awaiting inspection by the government inspectors. The government also established welfare systems. Since then, the government took more responsibility for the economic and social well being of the people. e) Reduced international trade As stated, protectionist measures cropped up with countries keen to protect their domestic markets. This was done though increasing tariffs and implementing quota systems. International trade shrunk by more than one half. The gold standard was abandoned and countries continued to devalue their currency in order to spur money supply. International trade broke up into regional trading blocs determined by political allegiance. f) Political ramifications The great depression had heavy political ramifications. In U.S, republicans paid the price, and President Roosevelt was voted into overwhelmingly under the promise of a ‘new deal’ but which historians argue was a protest vote against the republicans. In Germany, it led to Adolf Hitler’s rise to power. In the international plane, it strained relationship between major countries as result of reduced international trade, and is in fact attributed to as the leading cause of World War II. Germany and Japan adopted militaristic foreign policy leading to the World War II. The recovery Between 1933 and 1938, the real GNP of U.S grew at an average of 8% and 10% between 1938 and 1941. The recovery was largely due to increased aggregate demand especially monetary changes (Romer, 1992). Increasing supply of money at the beginning of 193 stimulated the consumption and lowered real interest rates. With consumption increasing, companies were able to increase output and new jobs began to be created. Several events led to the recovery. a. New Deal The New Deal was ushered in by President Roosevelt. In inculcated massive infrastructural projects such as work progress administration (WPA), Civilian Conservation Corps (CCC), and Public Works Administration (PWA). The core objective of these projects was primarily to create employment opportunities. For instance, under CCC, workers received $30 a month and were obligated to send $25 to their families. Under WPA, wages ranged between 45 and $70. In Texas, one of the States that was hit hard by the depression, CCC created more than 100, 000 jobs while WPA employed over 600,000 people in the same State. These projects increased the supply of money in the economy by increasing the purchasing power of the people. These projects were based on the Keynesian theory. Keynes argues that in such circumstances, the government should not attempt to balance its budget. Instead, it should spend, even if it means running on deficit budgets, so that it can boost the aggregate demand. The New Deal though did nothing much to turn around the economy, it reduced the sufferings of Americans and laid the ground for welfare state. b. The role of financial policies Governments were keen to spur economic growth through the use of financial policies. They included the use of devaluation where countries devalued their currencies regardless of the gold standard. Countries increased the supply of money with no concern of the exchange rates. Between 1933 and 1937, money supply in the U.S increased by approximately 42%. Credit rates were lowered and credit became more widely accessible. c. World War II Ironically, World War II marked the end of the great depression. This was due to increased armament. Before the U.S entry into the war, there was a great demand for arms from its allies. The aggregate demand rose dramatically. There was swift construction of defense related industry across the country. As a results, job opportunities rose. The entry of U.S into the war turned around the economies for instance of Texas. Millions of troops trained in the clear skies of Texas. The demand of goods and services by the troops increased urbanization and more job opportunity for the American citizens. There was also expansion of defense related industries such as petro-chemicals and oils generally leading to the sprouting of industries across the U.S. Soldiers in battle fields needed food, which meant the rise of agriculture. Germany was another country that heavily relied on rearmament. In Japan, military spending rose by 31% between 1932 and 1934. These events boosted increased the aggregate demand in the economy by boosting consumption, private investment and government expenditure. The strong aggregate demand meant a stronger economy. Companies started producing, as consumption rose. As profitability rose, more jobs were created. More jobs meant an increase in disposable income and an even more increase in consumption. That marked the end of the great depression. Concluding Remarks The great depression taught the world great economic lessons. It painfully exposed the consequences of poor regulation of the financial sector, and poor financial policies. The nexus of producers globally in a capitalistic economy was laid bare; as it was clear a slump in one market affects the entire globe. The depression heavily affected the common man, and the ramifications were clear on the political platform. Importantly, the depression and the subsequent recovery asserted the Keynesian theory and the aggregate demand-aggregate supply model. It is clear that the strength of the economy is a product of the aggregate demand in the economy. Together with the Second World War, the Great Depression goes into the history as one of the key defining moments of the 20th century. References Friedman, M., Schwart, A. (2008). A Monetary History of the United States, 1867-1960. Princeton University Press. Print. Romer, C. (1992). What Ended the Great Depression? Journal of Economic History 5: 757-784. Rothbard, M.(2000). America’s Great Depression Fifth Edition. Auburn: Mises Institute. Print Smith, R. (2006). The Great Depression. Teacher Created Resources. Print. Suddah, C. (2008). “The Crash of 1929”.Time. Wednesday, Oct. 29, 2008. http://content.time.com/time/nation/article/0,8599,1854569,00.html Read More