The Causes of the Great Depression - Example

The Great depression of the 1930s (Name of the Student) (Name of the Instructor) (Name of the course) (Code of the course) (Submission date) Introduction The great depression occurred between 1929 and 1933. In 1928, the American economy was looking optimistic with the stock prices on the rise. The market then was unregulated and this rise was largely as a result of speculation from the public. It was also due to good investment prospects and low interest rates. According to Crowley and Quah (2009) the Dow Jones index fell by about 12.8% in October 1929 which until then was the greatest fall in the American economy stock market. They further add that, the fall erased about five billion dollars from the stock market within 3 days. This was the start of a great depression that spread from the US to other world economies. The interdependence of the economies was pivotal in the spread since they relied heavily on trade with the US. The stock fall caused panic. Austria’s Credinstalt Bank succumbed to the pressure sending Germany down with it because the German government had been lending Austria in large amounts. Britain on the other hand lent German heavily and the slump was transmitted to Britain. Consequently, the British government devalued their currency against the Gold standard to counter the slump effects. The American government followed suit by devaluing their dollar too. More countries devalued their currencies, increased trade tariffs to encourage export and limit imports which led to a decline in international trade and the great depression. Over the years, various scholars have attempted to describe the causes of the great depression. There was the Keynesian model approach that succeeded the neo-classical approach used before the depression. This model drew criticisms from various economists that led to the development of the Friedman and Schwartz model and later the new-classical macro-economies also known as real business cycle. This paper analyses the causes of the great depression according to these economists and also analyses the reason behind Germany’s great hit by the depression. Keynesian approach Keynesian argued that the depression was as a result of the market failing to exploit all its resources. This meant that there was a high unemployment rate due to incapacitated production and not the employee’s refusal to work. The government should therefore intervene in the market to enable the market fully utilise the available resources and consequently absorb the unemployed. Interventions include tax cuts and increased government expenditure to support the fledgling private market. The government in this case failed to take such measures. Though President Roosevelt in later years gave farm subsidies but Keynesian blames him for late intervention and even then, the president did not aggressively pursue these measures leading to a prolonged depression. The production was at an all-time low with industrial production down to 37 percent between 1929 and 1930 (Christina, 1993). Low production led to high unemployment and therefore a decreased spending power. The low production rates are reflected in the table below which compares the rates between various countries during the depression. Fig 1: Production rates of various countries over the depression period 1930 Percentage change countries 5.1 to 10% 0.0 to 5% -0.1 to -5% -5.1 to -10% -10.1 to -15% -15.1 to -20% -20.1 to -25% New Zealand, Denmark, Norway, Greece, France, Chile, France. Romania, Estonia UK, Netherlands, Japan, Italy, Hungary, Finland Germany, Czechoslovakia, Belgium Poland, Canada, Austria USA 1931-1932 -0.1 to -10% -10.1 to -20% -20.1 to -30% -30.1 to -40% -40.1 to -50% -50.1 to -60% -60.1 to -70% New Zealand, Japan, Greece, UK, Sweden, Romania, Denmark Norway, Hungary, Chile, Finland, Estonia Italy, France, Belgium Netherlands, Austria Germany, Czechoslovakia, Canada USA, Poland 1933 15.1 to 20% 10.1 to 15% 5.1 to 10% 0.0 to 5% -5.0 to -10% USA Denmark, Finland, France, Germany, Japan, Romania, Netherlands UK, Hungary, Italy, Greece, Chile Sweden, Poland Norway, Austria, New Zealand Belgium, Estonia, Canada Czechoslovakia Note. From The nation in depression, Journal of economic perspectives (p. 142), by Christina, D.R. 1993. Friedman, Schwartz and the monetarists approach Friedman was of the view that the great depression was as a result of the money supply collapse and not American capitalism (Friedman & Schwartz, 1963). Friedman faulted the government on having had a tight federal policy in the few years preceding the depression. The panic that the depression inflicted led debtors to default their loan payments and those willing to deposit not do so. This led to the failure of 9000 banks during the 1930s (Crowley & Quah, 2009). Foreign countries placed high tariffs on American exports and in a counter move, the American government also placed high tariffs on their imports in the American Smooth-Hawley Traffic Act. The banks that survived refused to give loans to would be investors in an effort to build their bank reserves fearing worse times. The federal government supported the banks in this by discouraging loans and this only served to worsen the situation. Though the federal government later allowed banks to give credit, the damage had already happened. Many banks had collapsed and the public lost belief in the banking system. Friedman was of the view that this was a late move and should have happened during the economic boom preceding 1929. By draining reserves from other countries, Friedman and Schwartz (1963) argue that it led to transfer of the American depression abroad. The US defaulted use of the Gold standards in use at the time as a retaliation to Britain’s overvaluation of the sterling pound. This meant that, regardless of the amount of gold being imported, the money supply remained constant affecting the stock market. In August 1929, the federal government increased interest rates which reduced money stock abroad (Crowley & Quah, 2009). The monetarist approach was advanced by the economist Jacob Viner and other economists of a similar thought process thus the name monetarists. He argued that monetary forces drove the world into a depression and not the depression driving monetary forces. These forces could not be accounted for by the national economy of one country alone in this case the US, but rather by a collective worldwide economy. In the US credit was transferred to the wrong sectors. It was used in real estate and security rather than in the economy. This supports the argument of ill policies adopted by the federal government and only served to heighten the depression. There was an accelerating demand for exports from the US especially in production goods which triggered gold into the country. The government however tightened their monetary policy resulting to a worldwide effect. The resulting transfer of the depression was due to reliance on the gold standard that was controlled by Britain and the US. The other countries also had no adequate reserves of gold and this also put a threat on the devaluation of their currencies and deflation on their good prices. This triggered the depression in other countries. It is by this thought process that he refused to blame the gold standard alone arguing that it was its standard was managed internationally by several central banks and not nationally (Nerrozi, 2011). Real business cycle approach This approach is advanced by the new-classical macroeconomics school of thought. According to this approach the economy is subject to a business cycle and therefore the great depression cannot be termed as having started with the sharp decline in stock in 1929 but rather it comprises all of the 1930 years. Prescott an economist of this theory believed that the depression was caused by exogenous factors which he termed as shocks and secondly by ill economic policies adapted as a measure to curb the depression. The policies adapted increased the real wage rate and consequently lowered the employment rate (Pensieroso, 2007). Cole and Ohanian, economists of this theory blame president Roosevelt on enactment of the National Industrial Recovery Act and the National Labour Relations Act which they argue enabled cartels to dominate the market and increase the wage rate (Pensieroso, 2007). This worsened the business environment leading to a prolonged depression in the US. Harrison and Weder, other economists of this approach, argue that after the stock market fall, the economy went into normal recession but only worsened a year later after the American citizens lost all faith in their economy hitting a recovery. This despair led to the transition from a normal recession to a depression (Harrison and Weder, 2002). On the great depression being transferred to other countries, the real business cycle approach asserts that the depression was not as a result of monetary shock but rather a productivity shock. The cycle model adds that the productivity shock caused international depression in that it caused a shift of the labour demand curve. This productivity shock is a result of disruption in finances, decline in capital, and policies that disrupt the market forces. Just like in the US, they observed that an increase in the wage rate caused a decrease in the productivity levels during this time as producers could not meet the wage demand of the workers. The great depression in Germany German was badly hit by the economic depression because government at the time of the depression was paying reparations for World War I, poor fiscal policy, poor risk management policies and high default rate at the banks. Germany relied heavily on America in financing of the loans and when the depression hit, it was largely affected since the loans were no longer advanced to them. America was also demanding for payment of the already advanced loans. Germany faced increased external pressure not to default payments of the reparations or else face sanctions. There was also increasing pressure to default the payments from within the country. By 1931, foreign debt had accumulated to near 100 percent with regard to GDP. Long-term imports reduced by about 75 percent in 1929 (Crafts & Fearson, 2013). Reparations limited Germany’s participation in foreign credit market but as long as the commercial debt remained small in relation to gains, Germany continued lending. This shadowed the repatriation payments as concentration was transferred to lending. This was contrary to the peace treaty which prompted German to place repatriations as first priority. The Dawes plan during the years up to 1930 provided transfer protection on reparations worsening the condition. This only increased current account deficits and meant high foreign debt. Production in industries dropped, raw materials plummeted and producers could therefore not produce exports. This led to collapse of the international trade. There were massive cuts in employment, fall in food prices affecting the agricultural farmers and banks closed (Harvey, 1998). In the summer of 1929, the German stock exchange had doubled in rates and this led to the banks over speculating growth. Their lending within a year tripled for people buying stock (Abramowski, 1991). This high lending was fuelled by the absence of banking regulation by the government especially on risk control. The Reichsbank which is the central bank of Germany only demanded banks to show their balances of which do not show the loan risk of the creditors. Banks suffered diminishing liquidity ratios however the central bank did not take measures to curb this trend. Banks could not access loan repayment from industrialists as they had already frozen their assets. Furthermore, foreign deposits in the German banks were high compared to the local deposits ranging between 30%-70% in various banks. This situation meant that German faced a massive withdrawal threat of the deposits had the foreign countries be hit by the crisis (Schnabel, 2004). The threat materialised and the banks suffered massive foreign withdrawals. This meant increased losses; however, the banks did not want to reflect this in their accounts. They reduced payment of pensions and to save face, some even offered dividends to the shareholders. This only reduced their liquidity levels and since they did not warn the central bank, the government could not intervene. The fall in the banking industry started with the Danat Bank going bankrupt. This led to the start of the 1931 financial crisis which saw the bankruptcy of most banks. The bankruptcy was majorly due to major creditors especially industrial investors defaulting their loans which amounted to millions of dollars (Kopper, 2011). The government is not solely to blame for lack of proper regulations on banks but banks too. A good example is the Danat Bank that lent RM 48 million to a single debtor, Nordwolle yet the bank had a reserve of RM 60 million, and RM 25 million equity. When Nordwolle defaulted the loan, Danat Bank went into bankruptcy. This shows that the banks lacked proper risk management regulations as well. The fiscal policy in German between 1929 and 1933 was more restrictive and played a significant role in the depression as well (komolos & Eddie, 1997). Government budget statistics showed high employment surplus in 1929. The government raised taxes in 1930, and in 1931 cut the public servants salaries three times downward. These measures undertaken by the government therefore resulted to a downward spiral of the economy. Conclusion The great depression is widely accepted as having resulted from the sharp stock market fall in the US in 1929. However, the new-classical macroeconomics theory differs with this acceptance. They argue that an economic crisis cannot happen within a short duration as between 1929 and 1933. They hence assert that the great economic depression lasted during all years in the 1930s. There is also significant difference between their arguments on the possible causes of the depression, however all models point to the agreement that the government did not do enough to curb the depression. They all point to gaps in policies which if otherwise avoided would have saved many nations of the depression effects. In all the countries affected, US and Germany were hid hardest. Germany’s inadequate policies on risk management by the government, and the banks, loan defaulters and reparations were a major cause of the depression. References Abramowski, G. (1998). Die kabinette marx III and IV. 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Pensieroso, L. (2007). Real business cycle models of the great depression: A critical survey. Journal of Economic Survey, 21 (1) 110-139. Nerrozi, S. (2011). From the great depression to Breton woods: Jacob Viner and international monetary stabilisation (1930-1945). European Journal of The History of Economic Thought, 18 (1), 55-84. Schnabel, I. (2004). The German twin crisis of 1931. Journal of economic history, 64 (2), 822- 871. Read More