Myths, Facts, and Questions Surrounding the Great Depression

Since the economic crisis began two years ago, the Great Depression has been brought up as a comparison to our current circumstances.  Now, I am not implying that the Great Depression never happened.  What I am implying is that there are several myths that have been created by mostly politicians that argue only government can protect us from an economic depression.  Let’s examine some of these claims one by one and then look at the statistics that tell the true story of the Great Depression.

Myth #1: The Stock Market Crash Caused the Great Depression

Popular versions of events tell us that the Great Depression was caused by the crash of the stock market.  However, like we have learned from this recession, several convergent factors cause the Great Depression.  First, asset prices bubbled in the economy after several years of high growth.  When the bubble burst, the capital invested in the economy began to be withdrawn from all corners.  The stock market crash was a by-product of that trend, not the cause.

As an example, in two days including the famous Black Thursday in 1929, the stock market declined by about 25%.  In October 1987 on Black Monday, the stock market fell almost 23% in one day.  However, economic growth in 1987 was 3.2%, followed by 4.1% in 1988, 3.6% in 1989, and 1.9% in 1990.  If stock market crashes caused depressions, economic growth should have been negative in the years following Black Monday.

In addition to this, our 60% stock market drop from mid 2008 to spring 2009 mostly occurred after the crisis had already started.  The reason I am so emphatic about making this point is because it has been propagandized that the rich cause these crisis through “greed.”  The facts are that no single individual or type of individual causes these crises.  It takes far more participation than that.  In addition to this, as Milton Friedman would say, “What is greed?  Of course it’s the other guy that’s greedy, never us.”

Myth #2: FDR’s New Deal Saved Us.

FDR, as part of his campaign promise, pumped up federal spending and created entitlement programs that were intended to help people and stimulate the economy.  FDR passed infrastructure bills, jobs bills, social security, bank laws, etc to prop up a struggling economy.  As you can see from the red portion of the below chart, federal spending exploded.


Many believed that this saved our economy and caused growth to rebound in the subsequent years.  However, as we are about to see, the economy has recovered before without government spending.

So, the economy went through near double-digit growth from 1934-36, and grew at an 8% clip for two years following the 1938 recession.  However, the American public wasn’t enjoying as much of these benefits as many would suggest.

As we can see from the unemployment chart, the unemployment rate reached a decade low of 14.6% in 1940.  This isn’t exactly an overwhelming recovery, but as you can see from the unemployment, growth, and government spending charts, World War II bailed us out of the depression.  This was because the economy had a legitimate demand for production (war equipment), labor (troops and factory workers), and efficient behavior.

If we take the World War II example into today’s crisis, I estimate it would take $7 to $8 trillion of government spending per year (we will have about $3.5 trillion per year to 2014) to have the effect that World War II had on crushing the depression.  The money would also need to have a productive cause behind it.  Can we afford it? Can you afford it?

We should add that a by-product of high government spending is inflation.  Inflation decreases the purchasing power of the consumer to consume goods and services.  With high government spending during the FDR era came inflation.  We even had inflation equivalent to that of 2006-2007 when deflationary pressures weighed so heavily on the economy from 1933-1940.

Yet, there are people (including those on the Federal Reserve) who believe that inflation as a result of the current government expenditures won’t come until “much later.”  Do we really believe this?

The fact is that World War II saved us through meaningful production, employment, and income growth.

QUESTIONS THAT ARISE

Q: Would bailouts in the 1930s have helped?

Would government bailouts have helped us get through the depression much easier? Who would we have bailed out?  As Milton Friedman pointed out, fear resulting from bank crashes caused further runs on the banks which made the recession turn into a depression.

These bank failures could have been stopped, as Friedman pointed out, by having the Federal Reserve buy long term treasury bonds from these banks in exchange for cash.  The failure of Bank of America was a major catalyst to bank runs, because of its name and the publicity it created when it crashed in 1930.  As Friedman pointed out in his documentary Free to Choose, if the Federal Reserve had exercised simple open market operations with the banks, the Bank of America would have been saved, currency would have been more adequately available to depositors, bank runs would have been much lower, and the economy would have clearly had room to recover on its own from 1934 onwards.

Decreases in the money supply have far greater negative effects than stock market crashes and the depreciation of assets.  Cushioning those dips with more accommodating monetary policy from 1929 to 1935 would have turned the Great Depression into the Panic of 1929 (like all other panics in American history).

Q: What would have happened if we let the free market go?

Nobody will ever know the answer to this question, however, it would be unfair to totally assume that things would have been worse without the government.

In late 1920, the economy experienced a sharp contraction in which the economy shrank by 16% in 1921, but bounced back with a 16% increase in 1923 on its way to the “Roaring Twenties.”  Yet, during this period, government spending did not increase.

How could this have happened?  How could the economy recover without the government?  Furthermore, there was a decent increase in government spending in 1929, but that clearly did not help us fight the upcoming depression.  We should also add that there was another deep recession and bank run in 1907 during Teddy’s administration.  The effects of that recession were a large part of the 1912 election.  However, TR is still considered a great President and the American economy had no trouble producing and recovering before World War I.

Maybe, in the end both the Keynesian and monetarist theories are equally effective in fighting recessions?  If that’s the case, however, wouldn’t you favor the strategy that involves spending less of your tax dollars?