The Great Depression and Government Response - Example

INTRODUCTION In today’s global environment, one issue that is faced by the economy of almost every country is that of recession. On the one hand recession leads to a sharp decline in such macroeconomic variables as investment, GDP, employment levels, inflation, income and profits, and on the other hand it increases the level of bankruptcies and unemployment. The great depression (1929-1939) was the most severe form of depression that was ever experienced by the industrialized countries of the world. The depression that had been triggered by the crashing of the Wall Street in October 1929, immediately affected the output of industries such as construction, mining, shipping, agriculture, automobiles as well as other consumer durables (Anderson and James, 1980). Despite the fact that the depression had taken its roots in the United States, it rapidly spread to other industrialized countries across the globe and had a devastating effect on output and employment levels. The cultural and social effects of the great depression were also profound, requiring an immediate response from the governments to adopt various expansionary macroeconomic policies. Research proves that in the US, the great depression ranks as the second greatest crisis after the civil war. Regardless of the fact that the causes of the depression still remains controversial, a combination of such factors such as poorly regulated markets, consumer debt and the shortage of high growth industries created a recessionary business environment, leading to low investment confidence, reduced spending and a high level of uncertainty. What is important to understand here is how and why the Great Depression is credited with the evolution and development of macro-economics as a distinct field. It is felt by many scholars that it is the Great Depression that gave birth to macroeconomics as a separate and distinct field(Hamilton, 1992). To some extent it is thought by many that to this day, the Great Depression continues to influence the beliefs and policy recommendations of macroeconomists. It would not be incorrect to say that many of the contemporary systems of regulating banks and the Wall Street have been developed keeping the lesson learnt from the Great Depression in mind. In fact, macroeconomics gained attention after the Great Depression since it helped highlight all the main flaws that occurred in applying theories of microeconomics to the economy. According to the micro economists, the high level of unemployment that followed the Great Depression should have been regulated by Adam Smith’s “invisible hand”. According to this theory, workers should have revised their expectations of their wages downwards to the extent where firms would be willing to hire more people. However, what actually ended up happening was that because of the poverty and unemployment, demand for products dropped and so firms did not require additional workers. Moreover, since the workers were not willing to accept considerably lower wages for the same jobs as before, the wage rates were prevented from lowering to a more appropriate level. CAUSES OF THE GREAT DEPRESSION The causes of the Great Depression are still subject to debate and argument by various economists. One school of thought is that the onslaught was demand-driven, that is, the aggregate demand declined. However, many economists believe that the tight monetary policy of the US government, which was aimed at limiting the stock market speculations, played a major role in the occurrence of the depression. The 1920s did not witness any exceptional boom. The prices remained constant except the stock prices which rose fourfold from exceptionally low in 1921 to extremely high in 1929. In the last two years of the decade the Federal Reserve had to resort to increasing interest rates in the hopes of slowing down this boom. The higher rates depressed the spending on interest-sensitive areas like automobile and construction. Towards the end of 1929, the stock prices had reached unprecedented heights (Kindleberger, 1973). As a result some minor events led to large price declines and gradually investors lost all confidence. This way the stock bubble burst followed by panic selling. The reduced prices forced shareholders to liquidate the holdings and from September to November, US stock prices declined by 33 percent. This financial crisis offset uncertainty pertaining to future income leading to a sharp decrease in investment and purchase of durable goods. This drastic decline in consumption, the national output (real) fell sharply. Source: Roger P. Jr, 2011. Resource prices hitting our limits? The Economists Available at: http://www.economist.com/blogs/freeexchange/2011/10/resource-prices The decline in aggregate demand is also attributed to the panic attacks that seized the banks in 1930s, which were mainly caused by the loss of depositors’ confidence in the solvency of these banks. During this period, the central bank did little to ease these banking panics. Because people did not want to deposit money in banks the currency-to-deposit ratio increased and this is a major reason for the decrease of money supply by 31% between 1929 and 1933. Apart from this, the Federal Reserve tightened the money supply and increased interest rates in the fall of 1931. Some scholars believe that this tightening of monetary policy had an adverse effect on the national output. Some believe that this monetary policy was implemented deliberately to preserve the gold standard. GOVERNMENT RESPONSES INITIAL President Herbert Hoover was advised by the Secretary of the Treasury, Andrew Mellon, that the best response for combating the great depression was a ‘shock treatment’. There was a need for liquidating the labor, liquidating stocks, the farmers, real estate etc, so that the rottenness is purged out of the whole economic system. This will help in bringing down the cost of living, adjust the values and help enterprising people to pick up wrecks from people who are less competent (White, 1990). Hoover believed that it was imperative for the economy’s success to revive the public confidence, so that people would be willing to invest and raise production leading to high employment rate in the economy. However, masses were rather reluctant to invest as they saw unsold goods clogging their shelves. In 1932, the investment was 5% less than what it was in 1929. According to Hoover, business confidence can be restored with the help of a balanced federal budget; therefore, he reduced government spending and raised taxes. However, it exacerbated the conditions of a collapsing economy. The worsening condition forced Hoover to provide emergency loans to industry and even banks and increase spending on public welfare. However, the economists believe that it was a bit too late for such policies. It was Hoover suggestionto promote the idea of a central bank, which was led by firms rather than the government, so that it can store wealth as a security against the bank runs. Organizations felt that it was a strong idea, but still they were unable to capitalize on it due to lack of coordination among them. It was Hoover’s policies that made the active government an important need of the economy, if it was to overcome the disastrous effects of the depression. Hoover’s ideas were rejected by the President, who believed that it was not feasible for the government to directly aid people. According to him, there was a need for a "voluntary cooperation" between organizations and government. He emphasized that organizations should view the crash of market as a hiccup in the capitalism cycle, and work positively for the good of the economy. General GDP of US SOURCE: Romer, C. D. (1993).“The Nation in Depression.” Journal of Economic Perspectives 7(2), p19-39. The above graphs give a detailed view of the history of US. the graph shows that US economy was booming in 1920. The situation reflects what people thought of Republicans, and what course did the economy take after the republicans won the elections. What mattered most was whether the government could maintain the success of not. Many people believe that depression was grave due to the successful campaign. Moreover, Hoover and most of his Republican Party supported the tariffs, believing that the purchase of local products can stimulate the American economy. In 1930, Hawley-Smoot Tariff was enacted, establishing the highest average tariff in the history of America. This seemed to be a final blow to the collapsing European economies. Other economies retaliated by raising tariffs as well, which choked off the international trade such that during the years 1929-1939, value to world trade had reduced by more than half. NEW DEAL FROM 1932 By the election of 1932, Hoover has become so unpopular because of his actions that the decision of electing a Democratic presidential candidate Franklin Delano Roosevelt, was all but reassured. Roosevelt was successful in lifting the nation’s spirit by introducing New Deal. The president believed that some reform was needed for restructuring of the economy, so that any future depressions could be prevented. The ‘New Deal’ programs were introduced for stimulating demand and providing the basic relief and work to impoverished, by increasing government expenditure. Government spending would have to be increased through a reformed financial system, specifically the banks and Wall Street. The Securities Act of 1933 and 1934 facilitated a comprehensive regulation of the securities industry. FDIC provided the federal insurance of all bank deposits and together with Glass-Steagal Act, it instituted the ‘cut-throat competition’ that helped in reducing the prices as well as profits for organizations, motivating unions to raise pay, establish minimum prices, boost purchasing power and reduce farm production to surge up prices and facilitate a living from farming practices(Mishkin,1978). National Recovery Administration (NRA) was considered one of the most controversial New Deal agencies as it forced firms to collaborate with government in setting price codes, while NRA board had to establish labor codes and its standards. All these reforms including the recovery and relief measures were termed as First New Deal. The main focal point was the agencies initiating several set ups in the years 1933 and 1934, along with old agencies like Reconstruction Finance Corporation. In 1935, the "Second New Deal" was introduced to add Social Security, a relief agency, Works Progress Administration (WPA) and a National Labor Relations Board. National Labor Relations Board guaranteed the collective bargaining rights for the American workers, and the results were discernable. The workers (auto workers and coal miners) of Congress of Industrial Organizations witnessed an increase in their wages. Therefore, the ‘second new deal’ attempted to distribute higher wages among the masses to assist the bottom up restoration of economy. The main aim behind the New Deal was to surge up the demand, pump money into the economy with the help of various public welfare and relief programs. Economists are of an opinion that New Deal acted as a pain killer rather than providing a cure for the economic ills of the nation. Roosevelt was never a great supporter of British economist John Maynard Keynes, who suggested that when budget is unbalanced intentionally, it would boost demand only to a point where recovery could be made. There was an increase in US public debt from $22.5 billion in 1933 to $40.44 billion in 1939, but still Roosevelt was unwilling to bear any deficit spending. The level of unbalanced budget which Keynes advocated was forced on him by World War II. When government spending matched the suggestions of Keynes, it was then that the depression was brought to an end. The graph below shows the level of unemployment before and after the great depression. It shows the extent to which the first and second new deal improved the conditions of the economy. SOURCE: Romer, C. D. (1993).“The Nation in Depression.” Journal of Economic Perspectives 7(2), p34. Conclusion Great depression marked the period when economic activity in US was stagnant and in other countries, it reached all time low. The impact of depression and policies like New Deal influenced the relationship between the government and American people. The experience of depression seemed to leave a lasting mark on US with regard to the greater role of federal government, a political regime where Democrats will be the choice of majority for the next half century and greater support for the free market mechanism to avoid economic catastrophes. REFERENCES Anderson, B. L,. & James L. B,. 1980. “Money, Spending and the Great Depression.” Southern Economic Journal 47, p. 388-403. Hamilton, J. D., 1992. “Was the Deflation during the Great Depression Anticipated? Evidence from the Commodity Futures Market.” American Economic Review 82 (1), p..157-78. Kindleberger, C. P., 1973. The World in Depression, 1929–1939. Berkeley: University of California Press. Mishkin, F.S., (1978): “The Household Balance Sheet and the Great Depression.” Journal of Economic History 38( 4), p.918-37 Romer, C. D. (1993).“The Nation in Depression.” Journal of Economic Perspectives 7(2), pp. Roger P. Jr, 2011. Resource prices hitting our limits? The Economists Available at: http://www.economist.com/blogs/freeexchange/2011/10/resource-prices White, E. N.,1990. “The Stock Market Boom and Crash of 1929 Revisited.” Journal of Economic Perspectives 4(2), p.67-83. Read More