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THE HOW’S AND WHY’S OF THE GREAT ECONOMIC DEPRESSION , 1929……

--AMAN UPADHYAY 14773…

THE GREAT DEPRESSION

A HISTORICAL OVERVIEW.

First we will look upon a historical overview of it all.

It all started when the stocks market crashed on the so-called Black Tuesday—29th October 1929.

WHAT IS DEPRESSION ?

DEPRESSION IS A VERY SEVERE RECESSION; A PERIOD OF SEVERELY DECLINING ECONOMIC

ACTIVITY SPREAD ACROSSTHE ECONOMY (NOT LIMITED TO PARTICULAR SECTORS OR REGIONS) NORMALLY VISIBLE IN

A DECLINE IN REAL GDP,REAL INCOME, EMPLOYMENT, INDUSTRIAL PRODUCTION, WHOLESALE-RETAIL CREDIT

AND THE LOSS OF THE OVERALLCONFIDENCE IN THE ECONOMY.

BEFORE THE BEGINNING :::The Roaring Twenties (The Jazz Age) The Roaring Twenties were the period of

sustained economic prosperity and the distinctive cultural edge during the 1920s chiefly in US.

Normalcy returned to politics in the wake of hyper-emotional patriotism after World War I, jazz music blossomed, the flapper redefined modern womanhood and Art Deco peaked.

THE ADVENT OF GREAT DEPRESSION Misconception--It all started with the

crash of 1929 [ happening in three phases-Black Thursday, Black Monday and Black Tuesday] .

But it had already begun in the so-called roaring twenties.

As is typical of post-war periods, Americans in the Roaring Twenties turned inward, away from international issues and social concerns and toward greater individualism.

Prosperity could continue only if demand was made to grow as rapidly as supply.

Masses were encouraged in US to spend money on luxuries. The mass consumption kept the economy going through most of the 1920s.

But there was an underlying problem because the income was distributed unevenly.

Let us look at the causes of The Great Economic Depression::::::::::

CAUSES OF THE GREAT DEPRESSION1. HIGH TARIFFS AND WORLD WAR 1ST

DEBTS.

2. UNEQUAL DISTRIBUTION OF WEALTH.

3. OVER-PRODUCTION IN AGRICULTURE AND INDUSTRY.

4. STOCK MARKET CRASH and FINANCIAL PANIC.

5. MONETARY POLICY [Republican government].

1. High Tariffs

• United States maintained high tariffs on goods imported from other countries by passing Hawley-Smoot Act in 1922.

• If other nations could not sell their goods in the United States, they could not make enough money to buy American products or repay American loans.

• All major industrial countries pursued similar policies of trying to advance their own interests without regard to the international economic consequences.

World War 1st Debts

After World War I the United States became the world’s chief creditor .

Many American bankers were not ready for this new role.

They lent heavily and unwisely to borrowers in Europe, especially Germany, who would have difficulty repaying the loans.

These huge debts [ $ 10 billion {115 $ in current dollar} ] made the international banking structure extremely unstable by the late 1920s.

2.Unequal distribution of wealth

3. OVER –PRODUCTION IN AGRICULTURE AND INDUSTRY

Factories were producing products, but wages for workers were not rising enough for them to buy the goods.

Similarly farmers were producing more than people were consuming.

Farmers lost so much money that they couldn’t pay the mortgage on their farm.

The surplus products could not be sold overseas due to high tariff rates and lack of money in Europe.

4. STOCK MARKET CRASH

In 1928 and 1929, the Federal Reserve had raised interest rates in hopes of slowing the rapid rise in stock prices.

Panic selling began on “Black Thursday,” October 24, 1929. Many stocks had been purchased on margin, that is, using loans secured by only a small fraction of the stocks’ value.

The price declines forced some investors to liquidate their holdings, thus exacerbating the fall in prices.

Between their peak in September and their low in November, U.S. stock prices (measured using the Cowles Index) declined 33 percent.

Because the decline was so dramatic, this event is often referred to as the Great Crash of 1929.

The biggest reason why the economy deteriorated further after this is because people lost their trust in stocks.

The aggregate demand and hence supply reduced substantially.

BANKING PANICS ::: A banking panic arises when many

depositors lose confidence in the solvency of banks [the degree to which the current assets of an individual or entity exceed the current liabilities of that individual or entity ] and simultaneously demand their deposits be paid to them in cash.

Banks, which typically hold only a fraction of deposits as cash reserves, must liquidate loans in order to raise the required cash.

This process of hasty liquidation can cause even a previously solvent bank to fail.

The United States experienced widespread banking panics in the fall of 1930, the spring of 1931, the fall of 1931, and the fall of 1932.

The final wave of panics continued through the winter of 1933 and culminated with the national “bank holiday” declared by President Franklin Roosevelt on March 6, 1933.

By 1933, one-fifth of the banks in existence at the start of 1930 had failed.

Macroeconomics explains why The Great Depression started…

It explains why The President of United States Hoover during 1929-1932 couldn’t suppress the growing economic disasters.

Let us analyze the theory of macroeconomics and the two models of it which were used to explain great depression………

MACROECONOMICS Macroeconomics, branch of economics

concerned with the aggregate, or overall, economy.

Macroeconomics deals with economic factors such as total national output and income, unemployment, balance of payments, and the rate of inflation.

Not even the most liberalized national economy works without macroeconomic co-ordination; it makes no sense to suppose that the world economy is any different.—Anthony Giddens……

THE TWO MODELS OF MACROECONOMICS :::

1.THE CLASSICAL MODEL

--prevalent since the beginning of economics.

2. THE KEYNESIAN MODEL --conceived by John Maynard Keynes.

The Classical Model was extremely successful until the world was hit by devastating economic conditions which The Classical Model failed to rectify.

This led to the advent of The Keynesian Model during the Great Economic Depression.

Let’s analyze them one by one.

What do you do as president if you are faced with :::::

• A stock market crash that produces headlines like “Stock prices slump $14,000,000,000 in nationwide stampede to unload “ ?

• Banks begin to close their doors all across the country?

• Unemployment approaches 25 % [from a mere 3%] and about 85,000 businesses collapse?

It would seem as though the solutions should have been obvious…..It seems reasonable, to most, for the government to help by printing money and/or by increasing its spending.

But why were theorists and policy makers so averse to any active fiscal and monetary responses?

The answer--policy makers, including president Hoover and Federal Reserve Chair Eugene Meyer, were guided in their thinking by the Classical model.

THE CLASSICAL MODEL

Classical economics is the body of macroeconomic thought associated primarily with 19th-century British economist David Ricardo.

His Principles of Political Economy and Taxation, published in 1817, established a tradition that dominated macroeconomic thought for over a century.

Imagine a highway where the vehicles travel at an average speed of 60 mph. The vehicles run smoothly for most part of the day.

At the peak hours during morning and evening the traffic slows down to an average of 25 mph.But we all know that it stabilizes itself when influx of vehicles decreases.

What happens in such traffic conditions can be seen as an

analogy to what happened while The Classical model was being

used by economists and governments.

They used to believe that the ship will sail itself.

They thought the depression will rectify itself if left untouched.

So what was the flaw in the classical model ???

• The major assumption of this model is that the economy is always at full

employment.

MEANING

Everyone who wants to work is working and all resources are being fully used to

their capacity.

The thinking goes something like this::::::

If competition is allowed to work, the economy will automatically gravitate toward full employment, or what economists call potential output - just like the expressway at an average speed of 60 miles per hour.

Ricardo focused on the long run and on the forces that determine and produce growth in an economy’s potential output.

Before the depression, the value of the New York Stock Exchange was 89 billion dollars.

In 1933, during the depression, that value had plummeted to 19 billion.

So the main problem of depression was lack of investment enthusiasm and buying.

Population of US had lost it’s confidence in the economy.

Most experts, including president Hoover, thought the stock market crash was part of a passing recession.So all he did was encourage businesses not to reduce workload and cut wages.But it further discouraged investment. In 1931 Hoover urged bankers to set up the National Credit Corporation so that big banks could help failing banks survive. But bankers were reluctant to invest in failing banks.

But the great depression was not a passing recession.

It needed something more for rectification than what classical model suggested.

It was not a normal everyday traffic.....It needed help…….

THE KEYNESIAN MODEL OF ECONOMICS Economist John Maynard Keynes

observed that the economy is not always at full employment.

In other words, the economy can be below or above its potential.

During the Great Depression, unemployment was widespread, many businesses failed and the economy was operating at much less than its potential.

o When economist John Maynard Keynes was observing the Great Depression, he realized that the economy could be well below its potential for a long time.

o That something was causing it to get stuck.

o Just like that accident on expressway…….

He believed that great depression may be self-correcting in the long run like the classical economists were saying, but it was taking way too long.

In the meantime, people were losing jobs and were suffering.

He once said acidly “In the long run we are all dead”.

John m. keynes

Keynes became famous for his magnum opus "The General Theory of Employment, Interest, and Money“ which he published in 1936.

His theory is for governments to follow only for short periods of time.

Keynesian economics advocates a mixed economy – predominantly private sector, but with a role for government intervention during recessions.

The essence of Keynesian Economics is that markets on their own will not come to

balance because there are rigidities .

People lack foresight.

They resist change.

Perfect information doesn't exist.

People will also behave unethically for private gains.

This gave rise to a different understanding of the world.

Low wages

Low savings

Low capital formati

on

Low production

Government must intervene and invest during recessions to break this vicious cycle.

Keynes’s book shifted the thrust of macroeconomic thought from the concept of aggregate supply to the concept of aggregate demand.

The classical model stressed the supply side-Ricardo’s focus on the tendency of an economy to reach potential output.

Keynesian economics asserts that changes in aggregate demand can create gaps between the actual and potential levels of output, and that such gaps can be prolonged.

Keynes argued that the solution to the Great Depression was to stimulate the economy ("inducement to invest") through some combination of two approaches:

A reduction in interest rates (monetary policy)

Government investment in infrastructure (fiscal policy).

• Keynes believed that people[on losing their trust] should be encouraged to buy and invest i.e. to increase aggregate demand.

The stock market crash reduced the wealth of a small fraction of the population (just 5% of Americans owned stock at that time).

So why did all people become poor?

Because the crash reduced the consumption of the general population as well as consumer confidence throughout the economy.

So the main aim was to provide confidence to people again so that demands increase.

Fiscal policy also acted to reduce aggregate demand.

As consumption and income fell, governments found their tax revenues falling. So they did opposite to what should’ve been done.

They responded by raising tax rates in an effort to balance their budgets.

Higher tax rates tended to reduce consumption and aggregate demand.

Roosevelt became US president in 1933.

He passed various banking reform laws, emergency relief programs, work relief and agriculture reforms.

This was the first New Deal.

The second New Deal was just the opposite.

It focused on poor mass people more than the upper class people.

But the new deal imposed many restrictions leading to a fall in the investments made by businessmen.

So it actually prolonged the great depression instead of curbing it.

The New Deal blocked further reductions in wages and prices.

That stopped further reductions in nominal wages in 1933, thus stopping further shifts in aggregate supply.

With recovery blocked from the supply side, and with no policy in place to boost aggregate demand, it is easy to see now why the economy remained locked in a recessionary gap so long.

Keynes argued that expansionary fiscal policy

represented the surest tool for bringing the economy back to

full employment.

But the US government did not follow the Keynesian

economics because they did not believe that spending by government is the solution.

So how was US able to end the decade long Great Economic

Depression?

Because US was forced to follow the Keynesian model after Japan’s attack

on American forces on Pearl Harbor……

When US was dragged into the World

War II there was much sharperincrease in government purchases,

and the economy pushed quickly into an inflationary gap.

The expansionary fiscal policy had put a swift end to the worst macroeconomic nightmare in U.S. history………..

Even if that policy had been forced on the country by a war that would prove to be one of the worst episodes of world history.Pearl Harbor,

December 1941.

Many more models of macroeconomics were made in the aftermath of the Great Depression.

They were created to explain any particular economic upheaval which the existing models could not explain well enough.

Examples are ::1. Neoclassical model2. Neo-Keynesian model3. Phillips curve4. Disequilibrium macroeconomics

And many more………………