The causes of the Great Depression in the early 20th century in the United States have been extensively discussed by economists and remain a matter of active debate. They are part of the larger debate about economic crises and recessions. Although the major economic events that took place during the Great Depression are widely agreed upon, the finer week-to-week and month-to-month fluctuations are often underexplored in historical literature, as aggregate interpretations tend to align more cleanly with the formal requirements of modern macroeconomic modeling and statistical instrumentation.Romer, Christina D. "What Ended the Great Depression?" *The Journal of Economic History* 52, no. 4 (1992): 757-784.
There was an initial stock market crash that triggered a "panic sell-off" of assets. This was followed by a deflation in asset and commodity prices, dramatic drops in demand and the total quantity of money in the economy, and disruption of trade, ultimately resulting in widespread unemployment (over 13 million people were unemployed by 1932) and impoverishment. However, economists and historians have not reached a consensus on the causal relationships between various events and government economic policies in causing or ameliorating the Depression.
Current mainstream theories may be broadly classified into two main points of view. The first are the demand-driven theories, from Keynesian and institutional economists who argue that the depression was caused by a widespread loss of confidence that led to drastically lower investment and persistent underconsumption. The demand-driven theories argue that the financial crisis following the 1929 crash led to a sudden and persistent reduction in consumption and investment spending, causing the depression that followed. Once panic and deflation set in, many people believed they could avoid further losses by keeping clear of the markets. Holding money therefore became profitable as prices dropped lower and a given amount of money bought ever more goods, exacerbating the drop in demand.
Second, there are the monetarists, who argue that the Great Depression began as an ordinary recession, but that significant policy mistakes by monetary authorities (especially the Federal Reserve) resulted in a sharp contraction of the money supply. This, they contend, transformed a downturn into a prolonged recession. Related explanations highlight the role of debt deflation, in which falling prices increased the real burden of debt on households and businesses.
In addition to the Keynesian and monetarist perspectives, several other schools of thought offer alternative explanations. Economists from the Austrian school argue that the depression was an inevitable correction of an unsustainable credit-fueled boom during the 1920s, and that subsequent policy interventions prolonged the crisis. Real Business Cycle theorists and some New Classical macroeconomists emphasize supply-side shocks, wage and price rigidities, and institutional factors such as labour market policies and regulation. These views, while differing in emphasis, contribute to a broader and more contested understanding of the causes and severity of the Great Depression.
General theoretical reasoning The two classical competing theories of the Great Depression are the Keynesian (demand-driven) and the monetarist explanation. There are also various heterodox theories that downplay or reject the explanations of the Keynesians and monetarists.
Economists and economic historians are almost evenly split as to whether the traditional monetary explanation that monetary forces were the primary cause of the Great Depression is right, or the traditional Keynesian explanation that a fall in autonomous spending, particularly investment, is the primary explanation for the onset of the Great Depression.Robert Whaples, "Where Is There Consensus Among American Economic Historians? The Results of a Survey on Forty Propositions", Journal of Economic History, Vol. 55, No. 1 (March 1995), p. 150 in JSTOR. Today the controversy is of lesser importance since there is mainstream support for the debt deflation theory and the expectations hypothesis that building on the monetary explanation of Milton Friedman and Anna Schwartz add non-monetary explanations.
There is consensus that the Federal Reserve System should have cut short the process of monetary deflation and banking collapse. If the Federal Reserve System had done that, the economic downturn would have been far less severe and much shorter.Robert Whaples, "Where Is There Consensus Among American Economic Historians? The Results of a Survey on Forty Propositions", Journal of Economic History, Vol. 55, No. 1 (March 1995), p. 143 in JSTOR.
Mainstream theories
Keynesian
In his book The General Theory of Employment, Interest and Money (1936), British economist John Maynard Keynes introduced concepts that were intended to help explain the Great Depression. He argued that there are reasons that the self-correcting mechanisms that many economists claimed should work during a downturn might not work.
One argument for a non-interventionist policy during a recession was that if consumption fell due to savings, the savings would cause the rate of interest to fall. According to the classical economists, lower interest rates would lead to increased investment spending and demand would remain constant. However, Keynes argues that there are good reasons that investment does not necessarily increase in response to a fall in the interest rate. Businesses make investments based on expectations of profit. Therefore, if a fall in consumption appears to be long-term, businesses analyzing trends will lower expectations of future sales. Therefore, the last thing they are interested in doing is investing in increasing future production, even if lower interest rates make capital inexpensive. In that case, the economy can be thrown into a general slump due to a decline in consumption.Keen 2000, p. 198. According to Keynes, this self-reinforcing dynamic is what occurred to an extreme degree during the Depression, where bankruptcies were common and investment, which requires a degree of optimism, was very unlikely to occur. This view is often characterized by economists as being in opposition to Say's law.
The idea that reduced capital investment was a cause of the depression is a central theme in secular stagnation theory.
Keynes argued that if the national government spent more money to help the economy to recover the money normally spent by consumers and business firms, then unemployment rates would fall. The solution was for the Federal Reserve System to "create new money for the national government to borrow and spend" and to cut taxes rather than raising them, in order for consumers to spend more, and other beneficial factors.Caldwell, J., & O'Driscoll, T. G. (2007). What Caused the Great Depression?. Social Education, 71(2), 70-74 Hoover chose to do the opposite of what Keynes thought to be the solution and allowed the federal government to raise taxes exceedingly to reduce the budget shortage brought about by the depression. Keynes proclaimed that more workers could be employed by decreasing interest rates, encouraging firms to borrow more money and make more products. Employment would prevent the government from having to spend any more money by increasing the amount that consumers would spend. Keynes' theory was then confirmed by the length of the Great Depression within the United States and the constant unemployment rate. Employment rates began to rise in preparation for World War II by increasing government spending. "In light of these developments, the Keynesian explanation of the Great Depression was increasingly accepted by economists, historians, and politicians".
Monetarist
In their 1963 book A Monetary History of the United States, 1867–1960, Milton Friedman and Anna Schwartz laid out their case for a different explanation of the Great Depression. Essentially, the Great Depression, in their view, was caused by the fall of the money supply. Friedman and Schwartz write: "From the cyclical peak in August 1929 to a cyclical trough in March 1933, the stock of money fell by over a third." The result was what Friedman and Schwartz called "The Great Contraction" — a period of falling income, prices, and employment caused by the choking effects of a restricted money supply. Friedman and Schwartz argue that people wanted to hold more money than the Federal Reserve was supplying. As a result, people hoarded money by consuming less. This caused a contraction in employment and production since prices were not flexible enough to immediately fall. The Fed's failure was in not realizing what was happening and not taking corrective action.Paul Krugman (February 3, 2007), "Who Was Milton Friedman?", New York Review of Books In a speech honoring Friedman and Schwartz, Ben Bernanke stated:
"Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression, you're right. We did it. We're very sorry. But thanks to you, we won't do it again."Ben Bernanke (Nov. 8, 2002), FederalReserve.gov: "Remarks by Governor Ben S. Bernanke", Conference to Honor Milton Friedman, University of Chicago — Ben S. Bernanke
After the Depression, the primary explanations of it tended to ignore the importance of the money supply. However, in the monetarist view, the Depression was "in fact a tragic testimonial to the importance of monetary forces". In their view, the failure of the Federal Reserve to deal with the Depression was not a sign that monetary policy was impotent, but that the Federal Reserve implemented the wrong policies. They did not claim the Fed caused the depression, only that it failed to use policies that might have stopped a recession from turning into a depression.
Before the Great Depression, the U.S. economy had already experienced a number of depressions. These depressions were often set off by banking crises, the most significant occurring in 1873, 1893, 1901, and 1907. Before the 1913 establishment of the Federal Reserve, the banking system had dealt with these crises in the U.S. (such as in the Panic of 1907) by suspending the convertibility of deposits into currency. Starting in 1893, there were growing efforts by financial institutions and business men to intervene during these crises, providing liquidity to banks that were suffering runs. During the banking panic of 1907, an ad hoc coalition assembled by J. P. Morgan successfully intervened in this way, thereby cutting off the panic, which was likely the reason why the depression that would normally have followed a banking panic did not happen this time. A call by some for a government version of this solution resulted in the establishment of the Federal Reserve.*
But in 1929–32, the Federal Reserve did not act to provide liquidity to banks suffering bank runs. In fact, its policy contributed to the banking crisis by permitting a sudden contraction of the money supply. During the Roaring Twenties, the central bank had set as its primary goal "price stability", in part because the governor of the New York Federal Reserve, Benjamin Strong, was a disciple of Irving Fisher, a tremendously popular economist who popularized stable prices as a monetary goal. It had kept the number of dollars at such an amount that prices of goods in society appeared stable. In 1928, Strong died, and with his death this policy ended, to be replaced with a real bills doctrine requiring that all currency or securities have material goods backing them. This policy permitted the U.S. money supply to fall by over a third from 1929 to 1933.