Macroeconomic tools explaining the Great Depression of the 1930s

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Macroeconomic tools explaining the Great Depression of the 1930s
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Macroeconomic tools explaining the Great Depression of the 1930s
The Great Depression is considered as the deepest, longest and most severe economic depression that hit the Western countries from 1929 to 1939. The effects were experienced across the world and it one of the worst economic calamities in the world’s history. In the depressions that had occurred previously like in the 1870s and 1890s, the real per capita gross domestic product (GDP) managed to return to their former levels within a span of five years (Christiano & Motto, 2004). However, the real per capita GDP in the 1930’s Great Depression was still lower than its 1929 level even after a period of ten years. This document will use macroeconomic tools to explain the Great Depression of the 1930s and the relevance of the episode to modern policy makers.
Episodes in the Great depression
Before the 1930s, a huge percentage of economic analysis was limited to microeconomics. Even in his book “The Wealth of Nations”, Adam Smith argued that the government should not interfere with market forces and customers should be allowed to make their individual choices (Galbraith, 2009). However, the 1930s Great Depression acted as a turning point prompting economists to analyze factors behind unemployment, money supply and other macroeconomic factors affecting the economy. In the 1920s, there was a boom in the U.S. stock market due to general optimism among economists and businessmen (Blanchard & Sheen, 2004). They firmly believed that the newly established Federal Reserve would lead to economic stabilization and that the upward trend in technological innovation will enhance the expanding markets and the rising standards of living. However, initial recession was brought by attempts by the U.S. Federal Reserve to raise interest rates in 1928 and 1929 so as to discourage stock speculation.


G-7 GDP in the Great Depression (Galbraith, 2009)
This caught most businesses and firms by surprise, creating a contagious effect that negatively impacted the whole economy. For instance, businesses cut down the plans they had made on further purchase of producer durable goods. On the other hand, companies which dealt in producer durables reduced their production capacities. Consumers who had lost their jobs as well as those who feared they would be retrenched reduced their purchases of consumer durables. Lastly, businesses which produced consumer durables were exposed to declining demand due to the actions of consumers (Galbraith, 2009). During the Great Depression, decline in prices, leading to deflation, initiated contraction effects in production which in turn led to addition decline in commodity prices.
During this time, the rate of decline in prices was 10% per annum, and calculations made by investors revealed that less profit would be earned if investments were done this year compared to next year when there would be a further 10% stretch of the dollar. As the international monetary system collapsed, panics continued to escalate within banking circles and doubt was cast on people’s credit (Cooper & Corbae, 2002). This reinforced the perception that was on the minds of the general public that it was time to ‘watch and wait’. Throughout the presidential term of Herbert Hoover, the slide to Depression was worsened by falling production, increased unemployment and falling prices.
A fully satisfactory explanation is yet to be given on why the depression occurred at this particular moment. If there was a possibility of such depressions occurring in a capitalist economy that is unregulated, why didn’t two or more Great depressions occur prior to the Second World War? Anna Schwartz and Milton Friedman argued that Depression is attributed to incredible sequence of blunders especially within the monetary policy (Greasley et al 2003). However, individual who were in control of the monetary policy during the early 1930s believed that they were using similar gold-standard rules as the ones used by their predecessors. If the individuals were wrong, why did they assume that their policies were similar to those used by their predecessors? On the other hand, if the individuals were correct, why was the Great Depression the only one of its kind? Both monetary and fiscal policies are needed to answer these fundamental questions (Okun, 1983). At the lowest point of the Depression, the situation almost became a collective insanity.
The first macroeconomic factor to be severely affected was employment. People remained idle since companies could not employ them to utilize their machines. Companies lacked the capacity of hiring workers to manage their machines due to unavailability of market for goods. The lack of market was caused by lack of income to spend among workers. In “The Road to Wigan Pier”, Orwell narrates who the effects of depression on employment in Britain (Christiano & Motto, 2004). He says that a huge number of men and women risked their lives by spending several hours scrambling in the mud looking for minute chips of coal for heating their houses. This free coal gained with difficulty was almost of much significance than food. Machinery that stood idle around them had the ability of doing more in five minute compared to what all people did that whole day. The Great Depression put a serious doubt on the survival of the political order and the viability of the economic system.
Monetary policy was another fundamental factor that was behind the 1930’s Great Depression. As already mentioned, the stock market in America boomed in the 1920s. The price levels reached a place where they stopped making sense based on the rules of thumb or traditional patterns for valuation. Several research studies argue that in September 1929, there was a market peak with 40% of stock market value not being justified by financial or economic analysis (Blanchard & Sheen, 2004; Greasley et al 2003). The Federal Reserve became concern with the high valuation in the stock market. There was a worrying feeling that a “bubble” constituent of the stock prices will suddenly burst. To start with, if the burst occurred, certain sections of the financial systems could be declared bankrupt, there would be damage in the network of financial intermediation, and investment would decline and consequently lead to recession. Therefore, the Federal Reserve decided to “cool off” the market raising interest rates to make borrowing money for stock speculation more expensive and difficult. However, they already knew that the rise in interest rates may lead to recession which they were trying to avoid by “cooling off” the market.


The U.S. macroeconomic indicators: The Great Contraction (Galbraith, 2009)
This implies that all policy options which at the disposal of Federal Reserve had some possibility of leading to negative consequences (Galbraith, 2009). In the subsequent years, Friedrich Hayek, a leading economist, argued that the Federal Reserve was behind the boom in the stock market, its subsequent crash and the Great Depression due to “easy money” policies. He adds that this action only prolonged a boom for another two years beyond its natural end. The collapse of the U.S. stock market in October 1929 was a clear indication that the economy had already passed the peak of the business cycle. The big worry of excessive speculation within the Federal Reserve led to unwarranted deflationary policies, leading to the adage: “destroying the village in order to save it” (Bolch, 2001). Therefore, after the stock market ultimately crashed in 1929, the first effect to take place was economic uncertainty about the next effect. Therefore, the most natural thing to do when something which most people do not understand occurs is to pause and wait until the event is made clearer.
Panic, debt and deflation
Throughout the whole period of depression, production per worker declined by more than 40% compared to what had been attained in 1929 (Davidson, 2009). Even as the level of unemployment consumed more than a quarter of American jobs, the government initially failed to stimulate ...