The First Phase of the Great Depression

(The following is an edited excerpt of Mackinac Center President Lawrence W. Reed’s essay, "Great Myths of the Great Depression," which was updated and reissued by the Center this fall.)

Old myths never die; they just keep showing up in economics and political science textbooks. With only an occasional exception, it is there you will find what may be the 20th century’s greatest myth: Capitalism and the free-market economy were responsible for the Great Depression, and only government intervention brought about America’s economic recovery.

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To properly understand the events of the time, it is factually appropriate to view the Great Depression as not one downturn, but four consecutive downturns rolled into one. These four "phases" are "Monetary Policy and the Business Cycle"; "The Disintegration of the World Economy"; "The New Deal"; and "The Wagner Act." The first phase covers why the crash of 1929 happened to begin with.

Central Planners Fail at Monetary Policy

A popular explanation for the stock market collapse of 1929 concerns the practice of borrowing money to buy stock. Many history texts blithely assert that a frenzied speculation in shares was fed by excessive "margin lending." But Marquette University economist Gene Smiley, in his 2002 book "Rethinking the Great Depression," explains why this is not a fruitful observation:

"There was already a long history of margin lending on stock exchanges, and margin requirements — the share of the purchase price paid in cash — were no lower in the late twenties than in the early twenties or in previous decades. In fact, in the fall of 1928 margin requirements began to rise, and borrowers were required to pay a larger share of the purchase price of the stocks."

The margin lending argument doesn’t hold much water. Mischief with the money and credit supply, however, is another story.

Most monetary economists, particularly those of the "Austrian School," have observed the close relationship between money supply and economic activity. When government inflates the money and credit supply, interest rates at first fall. Businesses invest this "easy money" in new production projects and a boom takes place in capital goods. As the boom matures, business costs rise, interest rates readjust upward and profits are squeezed. The easy-money effects thus wear off and the monetary authorities, fearing price inflation, slow the growth of, or even contract, the money supply. This manipulation is enough to knock out the shaky supports under the economic house of cards.

Reckless money and credit growth constituted what economist Benjamin M. Anderson called "the beginning of the New Deal" — the name for the better-known but highly interventionist policies that would come later under President Franklin Roosevelt.

However, other scholars raise doubts that Fed action was this inflationary, pointing to relatively flat commodity and consumer prices in the 1920s as evidence that monetary policy was not so wildly irresponsible. Substantial cuts in high marginal income tax rates in the Calvin Coolidge years certainly helped the economy and possibly ameliorated the price effect of Fed policy.

Free-market economists who differ on the extent of the Fed’s monetary expansion in the early and mid-‘20s are of one view about what happened next: The central bank presided over a dramatic contraction of the money supply.

The Bottom Drops Out

The most comprehensive chronicle of the monetary policies of the period can be found in the classic work of Nobel Laureate Milton Friedman and his colleague Anna Schwartz, "A Monetary History of the United States, 1867-1960." Friedman and Schwartz argue conclusively that the contraction of the nation’s money supply by one-third between August 1929 and March 1933 was an enormous drag on the economy and largely the result of seismic incompetence by the Fed. The death in October 1928 of Benjamin Strong, a powerful figure who had exerted great influence as head of the Fed’s New York district bank, left the Fed floundering without capable leadership — making bad policy even worse.

At first, only the "smart" money — the Bernard Baruchs and the Joseph Kennedys who watched things like money supply and other government policies — saw that the party was coming to an end. Baruch actually began selling stocks and buying bonds and gold as early as 1928; Kennedy did likewise, commenting, "Only a fool holds out for the top dollar."

The masses of investors eventually sensed the change at the Fed, and then the stampede began. The distortions in the economy promoted by the Fed’s monetary policy had set the country up for a recession, but other impositions to come would soon turn the recession into a full-scale disaster. As stocks took a beating, Congress was playing with fire: On the very morning of Black Thursday, the nation’s newspapers reported that the political forces for higher trade-damaging tariffs were making gains on Capitol Hill.