Causes of the Great Depression

Based on Wikipedia: Causes of the Great Depression

In 2008, Ben Bernanke stood before an audience honoring two elderly economists and made an extraordinary confession. "Regarding the Great Depression," he said, "you're right. We did it. We're very sorry. But thanks to you, we won't do it again."

The chairman of the Federal Reserve—the most powerful central banker on Earth—was publicly admitting that his own institution had caused the worst economic catastrophe in American history.

This remarkable admission came seventy-five years after the fact. And yet economists still argue about exactly what happened. How could something so devastating remain so poorly understood for so long?

The Facts Everyone Agrees On

Let's start with what we know for certain. In October 1929, the American stock market collapsed. Panic spread. People rushed to sell their assets before prices fell further, which of course made prices fall further still. A vicious spiral began.

Then came deflation—a sustained drop in prices across the economy. This sounds like it might be good news. Cheaper stuff, right? But deflation is actually economic poison, for reasons we'll explore shortly.

Demand collapsed. Factories that had been humming along suddenly had no customers. Trade dried up between nations. By 1932, more than thirteen million Americans were unemployed. That's roughly one in four workers with no job and no income.

These facts are not in dispute. What economists have spent nearly a century arguing about is why it happened and why it lasted so long.

Two Tribes of Economists

The debate over the Great Depression breaks down, roughly, into two camps. Understanding their disagreement helps explain why economic policy remains so contentious today.

The first camp follows the ideas of John Maynard Keynes, a British economist who published his landmark book The General Theory of Employment, Interest and Money in 1936, right in the middle of the Depression. Keynesians focus on demand—the total amount of stuff people want to buy. They argue that when confidence collapses, people stop spending, and this creates a downward spiral that markets cannot fix on their own.

The second camp is the monetarists, most famously represented by Milton Friedman and his collaborator Anna Schwartz. They focus on the money supply—the total amount of dollars circulating in the economy. Their argument is simpler and more damning: the Federal Reserve screwed up. It let the money supply collapse by more than a third, strangling the economy.

These two explanations are not mutually exclusive. Both could be partly right. But they lead to very different policy conclusions, which is why the argument matters beyond academic circles.

The Keynesian Story: A Crisis of Confidence

Imagine you run a small factory making, say, refrigerators. Business has been good. You've been thinking about expanding—maybe adding a second production line. Interest rates are low, so borrowing money would be cheap.

Then the stock market crashes. You watch your savings evaporate. More importantly, you watch your customers' savings evaporate. Who's going to buy a new refrigerator now?

So you don't expand. In fact, you start laying off workers because orders have dried up. Those workers, now unemployed, certainly aren't buying refrigerators. Neither are their neighbors, who are suddenly worried about their own jobs.

This is the Keynesian nightmare: a self-reinforcing collapse. Everyone is acting rationally—saving money, cutting costs, avoiding risk—but the collective result is catastrophe.

Classical economists before Keynes believed that markets would self-correct. If people saved more money, interest rates would fall, making borrowing cheaper, which would encourage businesses to invest. Supply and demand would find a new balance.

Keynes pointed out the flaw in this reasoning. Why would any business invest in new production capacity when nobody is buying what they already produce? It doesn't matter how cheap loans are if you expect to lose money on whatever you build. The rational response is to hunker down and wait—which, of course, prolongs the crisis.

His solution was government intervention. If consumers and businesses won't spend, the government must. Build roads. Construct dams. Put people to work. The specific projects almost don't matter; what matters is getting money flowing again.

The Monetarist Story: The Fed's Fatal Error

Milton Friedman told a different story, one that placed the blame squarely on the Federal Reserve System.

To understand his argument, you need to understand what the Fed does. Established in 1913, the Federal Reserve is America's central bank. Among its many functions, it controls how much money exists in the economy. This might sound strange—doesn't money just exist?—but in a modern economy, most money is created through bank lending, and the Fed influences how much lending occurs.

According to Friedman and Schwartz, the Fed made a catastrophic mistake. Between August 1929 and March 1933, it allowed the money supply to fall by more than one-third. A third! Imagine if a third of all the dollars in your wallet, your bank account, and the entire economy simply vanished.

When money becomes scarce, strange things happen. People hoard whatever cash they can get. They consume less. Businesses can't get loans. The entire economy seizes up like an engine running without oil.

Why did the Fed let this happen? Partly through bad theory. After the death of Benjamin Strong, the influential governor of the New York Federal Reserve, the institution embraced something called the "real bills doctrine." This theory held that money should only be created when backed by tangible goods. It sounds prudent—almost morally virtuous—but in a crisis, it's suicidal. The economy was bleeding out, and the Fed refused to provide a transfusion.

The Ghost of J.P. Morgan

Here's the tragic irony. America had solved this problem before.

The Panic of 1907 was a severe banking crisis. Banks were failing. People were lined up outside, desperately trying to withdraw their savings before the money ran out. The entire financial system teetered on collapse.

Into this chaos stepped J.P. Morgan, the legendary financier. He was seventy years old, crusty, intimidating, and fabulously wealthy. He summoned the leading bankers to his private library—a gorgeous building that still stands in Manhattan—and essentially locked them in until they agreed to pool their resources and bail out the failing banks.

It worked. The panic ended. The lesson seemed clear: in a financial crisis, someone needs to provide liquidity—ready cash—to institutions facing runs.

The Federal Reserve was created, in part, to institutionalize this function. Instead of relying on the whims of elderly tycoons, the government would have an official lender of last resort.

But when the crisis came in 1929, the Fed didn't act. Bank after bank failed. A full third of all American banks vanished during the Depression. Each failure wiped out the savings of depositors and destroyed the credit that businesses needed to operate.

Ben Bernanke, who later became Fed chairman and whose academic specialty was the Great Depression, argued that these bank failures created "credit crunches" that rippled through the economy. Even businesses that were fundamentally sound couldn't get the loans they needed to survive.

The Debt Deflation Trap

Irving Fisher was one of the most respected economists of his era. He was also spectacularly wrong about the stock market crash, having proclaimed just days before Black Tuesday that stock prices had reached "a permanently high plateau." This misjudgment cost him his personal fortune and much of his professional reputation.

But Fisher spent the rest of his career trying to understand what had happened, and his analysis of debt and deflation remains influential today.

Here's the problem Fisher identified. When prices fall—deflation—debts become heavier in real terms. Imagine you borrowed $1,000 to buy a car. If prices fall by half, that car is now worth $500, but you still owe $1,000. In fact, that $1,000 can now buy twice as much stuff as when you borrowed it. Your debt has effectively doubled.

Now scale this up to an entire economy drowning in debt. Everyone is trying to pay off their loans, which means everyone is selling assets and cutting spending. But this selling and cutting causes prices to fall further, which makes debts even heavier, which forces more selling and cutting. It's a death spiral.

Fisher identified a sequence of doom: debt liquidation leads to distress selling, which contracts the money supply as loans are paid off, which causes asset prices to fall, which destroys business wealth, which causes bankruptcies, which reduces output and employment, which spreads pessimism, which causes hoarding, which—well, you get the idea.

The terrifying thing about this trap is that everyone is trying to do the responsible thing. Pay your debts. Cut your spending. Save for hard times. But when everyone does this simultaneously, they make the hard times worse.

The Bubble Before the Crash

No discussion of the Depression is complete without examining what came before: the Roaring Twenties.

This was an era of astonishing excess. The stock market soared. Real estate prices, especially in Florida, reached absurd heights. Credit was cheap and plentiful. A contemporary observer noted that "probably never before in this country had such a volume of funds been available at such low rates for such a long period."

The Florida land boom is particularly instructive. Speculators bought swampland sight unseen, convinced they could flip it for a profit. Prices multiplied fantastically. Then, in 1925, the bubble burst. The land was still swamp. Similar bubbles inflated in real estate markets across the country. One statistic from Chicago is remarkable: the city had over one million vacant housing plots despite having only 950,000 occupied ones.

By the time of the 1929 crash, total debt in the United States had reached nearly 300 percent of the gross domestic product—a level not seen again until the early 2000s. The economy was a tower of IOUs, and when confidence cracked, the tower came down.

Austrian economists—a school of thought quite different from either Keynesians or monetarists—argue that the Depression was an inevitable hangover from this credit binge. You can't have a bust without a boom, they say. The twenties were the disease; the thirties were the painful cure.

Why Did Recovery Take So Long?

The Depression didn't end quickly. It dragged on for most of a decade, ending only when the massive government spending of World War II finally put everyone back to work.

This length is itself a puzzle. Economies usually recover from downturns. What made this one so persistent?

The Keynesian answer is that confidence, once shattered, is hard to rebuild. Businesses that have been burned won't invest. Workers who have been unemployed for years lose skills and connections. The longer a depression lasts, the harder it becomes to escape.

The monetarist answer focuses on policy errors. Even after the worst of the banking panics, the Fed kept money tight. The Roosevelt administration, despite its reputation for activist government, actually raised taxes in the middle of the Depression—exactly the opposite of what both Keynesians and monetarists would recommend.

There's also the question of expectations. If businesses expect prices to keep falling, they'll postpone purchases, waiting for better deals. If workers expect wages to keep dropping, they might resist pay cuts, leading to unemployment instead. These expectations can become self-fulfilling prophecies.

The Debate Continues

You might think that after ninety years, economists would have settled this argument. They haven't.

Surveys of economic historians find them roughly evenly split between Keynesian and monetarist explanations. Most now accept that both factors played a role. The modern synthesis incorporates elements of both theories, plus Fisher's debt deflation analysis and insights about expectations and confidence.

But the practical implications remain contested. When the 2008 financial crisis hit, policymakers faced eerily similar choices. Should the government spend massively? Should the Fed flood the economy with money? How much was too much? The ghosts of the Great Depression haunted every decision.

Ben Bernanke, remember, was the Fed chairman in 2008. His entire academic career had been devoted to understanding the thirties. He was determined not to repeat the Fed's earlier mistakes. So he opened the monetary floodgates, creating trillions of dollars through programs with names like "quantitative easing."

Critics warned of inflation. It never came—or at least, not until the entirely different circumstances of 2021-2022. The economy recovered, eventually, though more slowly than many hoped.

Was Bernanke right? Did his policies prevent a second Great Depression? Or would the economy have recovered anyway? Economists still argue about this too.

What We've Learned

Perhaps the most important lesson of the Great Depression is humility. The smartest economists of the 1920s, including Irving Fisher, completely failed to see it coming. The policymakers of the 1930s, including many intelligent and well-intentioned people, made it worse through policies they genuinely believed were sound.

We now know certain things with reasonable confidence. Letting the money supply collapse is catastrophic. Letting major banks fail in a panic can trigger cascading crises. Deflation, once it takes hold, is extremely dangerous and difficult to escape.

But we still struggle with the deeper questions. How much debt is too much? When does a boom become a bubble? How can you restore confidence once it's been lost?

These questions matter because the Great Depression wasn't a natural disaster. It wasn't an act of God or an unavoidable catastrophe. It was, at least in large part, a policy failure. Human beings made decisions that turned a stock market crash into a decade of misery for hundreds of millions of people.

They can make such decisions again. Or—and this is the hope that keeps economists arguing late into the night—we can learn enough from the past to avoid repeating it.

The stakes, after all, are higher than any academic debate. When Justice Louis Brandeis told a visitor in 1932 that "the worst took place before the crash"—meaning the delusions and lies of the 1920s had been worse than the depression itself—he was making a claim about truth and consequences. Bad ideas, unchallenged, can bring down economies. Good ideas, properly understood and applied, might save them.

That's why, nearly a century later, we're still arguing about what really caused the Great Depression. The answer matters for the next crisis, whenever it comes.