Blog Discussion: Economic Theories of the Great Depression

 

Which do you see? Post-World War I demographic shifts?
A restoration of the gold standard? Poor monetary policy?
...a bat?

As one of the most impactful financial collapses in world history, economic theories concerning the origin, nature, and close of the Great Depression. It has captured the minds of economists for generations: “to understand the Great Depression is the Holy Grail of macroeconomics.”[1] Practically, the Great Depression functions as an economic Rorschach test; so many factors were all at play before October 1929 – all realistically influencing the situation in some way or another – that economists can interpret the collapse according to whichever economic model they personally champion. As such, analysis of the crash becomes quite difficult, as so many conflicting narratives abound.

One theory postulated since the onset of the Depression itself is that World War I was a direct antecedent to the Great Depression. It is essentially seen as an historic truism that the war reparations placed on Germany by the Treaty of Versailles were a precursor to World War II;[2] in this same vein, the turmoil of the interwar period may be seen as influencing factors upon the market collapse in 1929. Writing in the throes of the Depression itself in 1931, respected economist Edwin F. Gay lists a host of conditions caused by World War I that directly influenced the burgeoning financial collapse:

…the depletion of man-power, the stimulus to over-capacity of some essential industries…the forcing process in the industrial development of regions cut off from their former sources of supply and of the newly-created states, the widespread monetary disorders, and the staggering burden of internal debts and foreign obligations.[3]

These reasons, particularly that of de-population and post-war debts, certainly create a compelling argument. It seems apparent that, at first reflection immediately after the onset of the Depression in 1929, the “war to end all wars” concluded ten years prior may have had knock-on effects, despite the initial recovery of the “Roaring Twenties.”

Such a position is far from universally acclaimed – in fact, with the passage of time and the distance growing between economists and the Depression itself, economists have gradually de-emphasized the First World War’s influence on the Great Depression. In January 1945, shortly before the fall of the Third Reich, David J. Dallin already begins to question this theory, stating that while the “events in Germany played a minor role” in the stock market crash, “the American stock exchange catastrophe was predetermined by the preceding tremendous boom…a crisis was inevitable.”[4]

Milton Friedman and Anna Jacobson Schwartz’s seminal Monetary History of the United States would fundamentally change the discussion of monetary policy leading to the Great Depression; virtually every analysis after the 1963 economic history would hinge heavily upon Friedman and Schwartz’s work. This text argues that the Federal Reserve exacerbated the Great Depression precipitously, particularly in the squeeze of 1930 – Friedman and Schwartz argue that a contraction similar to the Panic of 1907 would have likely ensued without the Federal Reserve, but the Reserve’s interference mitigated this contraction, leading to overconfident banks, which in turn led to more serious crises throughout the 1930s as the Depression began to spiral further and further out of control.[5]

Economist Heywood Fleisig similarly argued in 1976 that war debts created “a structure that produced a larger decline in income from any given shock,” but that America was still centrally important to the collapse: “a world without war debts would still have had a large depression; world depressions, like many other things, do not succeed unless the United State [sic] cooperates.”[6] This statement also rings true, as the intertwining of the American and European economies through interwar policies such as the Dawes Plan would ensure that a collapse in the American economy would have a ripple effect, particularly if, as Fleisig asserts, these debts ensured that any shock would harm the broader system more dramatically.

Writing in 1995, Ben Bernanke (chairman of the Federal Reserve during the Great Recession in 2007-2008; recipient of the 2022 Nobel Prize in Economic Sciences) demonstrates just how fully the tradition of Friedman and Schwartz had come to dominate the discussion. Firmly in their ideological school, Bernanke argues that bad monetary policy prolonged the effects of the Great Depression far longer than they should have been. Bernanke is extremely bearish on the idea of the gold standard, stating that the interwar return to the gold standard tied international economies together and extended the downward turn of the economy, with the Depression being “the largely unintended result of an interaction of poorly designed institutions, shortsighted policy-making, and unfavorable political and economic preconditions.”[7] He also argues that countries that abandoned the gold standard would recover much more quickly than those who did not.[8]

Economists such as Ben Bernanke argued that the
gold standard, not war debts, exacerbated the
economic collapse of the 1930s.

One way in which the world war theory remained viable long after economists moved away from such a position is through that of Robert Higgs’s ratchet hypothesis, which sees crises as opportunities for the expansion of government; after the crisis abates, such growth does not dissipate. Writing in 1985, Higgs demonstrates how the government used World War I, the Great Depression, and World War II to greatly expand its power. Expanses in several different fields – transportation, labor, agriculture, industry, credit, and international trade – made during the First World War would largely remain in place after the war’s end.[9] While not a direct antecedent to the Depression, the broadening of the government would lead to a much larger base for further expansion during the Great Depression, which would also carry on into World War II, etc. This ratchet phenomenon demonstrates a secondary cause on the Depression, certainly, but an influence nonetheless.

All told, the causes of the Great Depression were multivariate and exceptionally complex, with a host of different perspectives and deeply-held opinions regarding the economic collapse’s origins and, therefore, its resolution. While initial economists were more open to crediting World War I as a major cause on the onset of the collapse, later generations of economists would begin to downplay this theory in favor of other rival theories. The most notable of these would be Milton Friedman and Anna Schwartz’s Monetary History of the United States, which argued that bad monetary policy (largely through the Federal Reserve) extended the Depression far beyond what it initially could have been. This theory has become very influential on future generations of economists, including Ben Bernanke, whose focus on the interwar return to the gold standard presents a more contemporary argument for the cause of the Great Depression.

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[1] Ben S. Bernanke, “The Macroeconomics of the Great Depression: A Comparative Approach,” Journal of Money, Credit and Banking 27, no. 1 (February 1995), 1.

[2] Largely through hyperinflation in the Weimar Republic.

[3] Edwin F. Gay, “The Great Depression,” Foreign Affairs 10, no. 4 (July 1932), 530.

[4] David J. Dallin, “Politics and World-Economy in the Great Depression of 1929-1934,” Review of Politics 7, no. 1 (January 1945), 21.

[5] Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States (Princeton: Princeton University Press, 1963), 167-168, 311-312.

[6] Heywood Fleisig, “War-Related Debts and the Great Depression,” American Economic Review 66, no. 2 (May 1976), 57.

[7] Bernanke, 3-4.

[8] Ibid., 4.

[9] Robert Higgs, “Crisis, Bigger Government, and Ideological Change: Two Hypotheses on the Ratchet Phenomenon,” Explorations in Economic History 22, no. 1 (January 1951), 20-21.