Reasons and Results of the Great Depression -1929-

 

Golden(!) Period of Expectations and Demand

The Great Depression was a very significant turning point for both almost all economies of the world and economics as a science also. Since there were loads of devastating effects of depression on most of economies over the world, it is still an important research topic for economists. Even there are still some ongoing arguments and disagreements about causes and onset of slumpflation, it could be firstly said that turning in a restrictive direction of U.S. monetary policy by increasing interest rate was starting effect of depression. This was directly related to FED's fearing of fast booming and unhealthy speculations in the stock markets. There was excessive credit creation at the start 1920s and it was fearful for FED. Then, along with increasing interest rate, a sudden restrictive monetary policy caused big stock market crash in 1929. Especially after World War I, US had become global net creditor and raising interest rate by US make debtor countries get into trouble because of golden standard regime. It could be said that deflation was a better situation than devaluation especially at the first days of depression for FED in that time because of golden standard.

On the other hand, in US, higher interest rates made investment and consumption decisions even worse and expectations got worse, as the time went on it became an aggregate demand shock and this insufficient demand caused deflation finally. Therefore, decreasing of prices had resulted decrease in output. So, deflation in the US caused price deflation abroad especially fragile countries, because US accounted for more than one of third of the global output demand. It is widely-accepted that even though onset of depression was related to stringent monetary policy, increase in the interest rate negative expectations about future and insufficient demand respectively, transmission of the depression to other countries was directly related to fixed exchange rate under gold regime.  In gold standards there was an inequality between countries’ balance of payment. For example, there were some gold rich countries and some countries which had not enough gold. Moreover, there was not a cooperation and solidarity institution like IMF in that time which could support countries which suffered from high interest rate and insufficient gold stocks. “In one of the most memorable acts of misguided monetary policy in history, the Federal Reserve raised interest rates sharply in October 1931 to protect the dollar in the midst of the greatest Depression the modern world economy has ever known. This action was not a technical mistake or simple stupidity; it was the standard response of central banks under the gold standard.” (Temin, 1993:10)

When US increased interest rate in 1929, in order to prevent outflow of golden, debtor and fragile countries had to increase their interest rate too in order to prevent depreciation value of their currency. Because of this, these countries also suffered from deflation and decreasing output, high unemployment and depression finally. “Monetary restriction by the Fed brought US foreign lending to a halt. “(Eichengreen, 1992:10) According to Temin, more than fixed exchange rates, commitment to the gold standard policy regime transmitted the Great Depression around the world. The single best predictor of how severe the Depression was in different countries is how long they stayed on gold. The gold standard was a Midas touch that paralyzed the world economy (Temin, 1993:13). For example, Spain did not suffer from the Great Depression because it was not on the gold standard.

Apart from that, recent studies have showed that in that time especially in US, there were not flexible wages as classical economists asserted. In first months of depression FED and government waited for an invisible hand and price mechanism to adjust markets. However, especially because of high rates of unionization and changing structure of economy after World War I had made wages rigid. Prices were decreasing because of dismal expectations also. As a natural result of these facts, depression got deeper and worse. Because of American roots of it, especially Japan and other European countries lived depression softer in comparison with United States even though they suffered high unemployment and deflation also. As a consequence of depression “Industrial production in the United States, in contrast, declined 21 percent in the first year of the Depression. Thus, the Depression was "great" in the United States sooner than elsewhere.” (Romer, 1993: 4) In 1931 and 1932 industrial production fall 62 percent in US also, unemployment reached 25 percent and almost one of third banks failed because of banking panic in the United States.

After 1930’s most of the countries which suffered from deep depression started to give up gold standard regime and implemented expansionary monetary policy along with expansionary fiscal policies in order to revive and increase effective demand as John M. Keynes suggested. So, Keynesian policies were very helpful and effective to overcome the Great Depression over the time and of course it is accepted that birth of macroeconomics was directly related to depression.

Birth and Rise of Macroeconomics

 
Economics as a term, is as old as humanity.  Despite the fact that Macroeconomics became important just after The Great Depression (1929), it is obvious that economists were tackling macroeconomic issues like inflation, unemployment and growth etc. even before 1929. For example, it is well known that Adam Smith who is one of the most famous classical economists, analysed macroeconomic variables and for example said that economy is always in full employment equilibrium in his most known book "Wealth of Nations" in 1776.

In the classical economic theory, it is not crucial and necessary to emphasize and analyse macroeconomic variables as an issue very much due to fact that whenever a disequilibrium emerges, “an invisible hand” brings it to the equilibrium level again owing to flexible prices, wages and interest rate. (Price Mechanism) According to classical economists, “every supply creates its own demand” (Say’s Law) and economy is always in full employment equilibrium, as a result of this there is not involuntary unemployment in economy. Moreover, the money is just a veil for they which creates only inflation if it is not controlled. They believe that government should not intervene free market because it will be just harmful for the economy. The event or disaster which changed almost every thing about economics was The Great Depression. It could be easily said that it was the birth of Macroeconomics as a science and J. M. Keynes as a popular economist. According to Mankiw  “The Great Depression had a profound impact on those who lived through it. In 1933, the U.S. unemployment rate reached 25 percent, and real GDP was 31 percent below its 1929 level. “
 
After 1929 and during the years of the Great Depression, it was realized that there was no invisible hand which brought the market to the equilibrium again and provided full employment output level. Keynesian revolution was the most important turning point in that period of time for Macroeconomics. On the contrary to classical approach, Keynes said that in order to overcome the depression, demand should be supported and fiscal policy has to be used. Because, he believed that prices and wages are not flexible and therefore there is no invisible hand in the economy which brings it to equilibrium level again. Moreover, on the contrary to classical theory, he said that every demand creates its own supply and full employment is an exceptional situation not a general equilibrium.

He asserted the idea that classical point of view about economics was an exceptional situation but his own views were general theory of economics. Therefore, Keynesian approach was accepted quite successful to overcome the great depression and almost all of countries applied his views and boomed success of their economies until 1970’s.
 
In the early 1970s, The Oil Crisis and its aftermath events emerged some monetary and neoclassical counter revolution against Keynesian theory.  Because Keynesian economists could not explain solution of stagflation issue which caused high inflation and high unemployment occurred at the same time. Then, as a natural result of this especially Phillips Curve was criticised because it was not accurate according to the New Classical and Monetarist economists. After 1980s, "expectations" and new approaches based on old classical theories in the economics became more popular and New-classical and Monetarist economists emerged based on traditional classical theory in fact. Even there are Real Business Cycle Theory, New Keynesians and New Classicals (rational expectations) in last the decades of economic evolution, it could be said that these all form of economic theories are arisen from new interpretations of two main economic theories: Classical and Keynesian approaches.
 
In conclusion, it is obvious that generally, today there is not a one-side macroeconomic system in the world economics like strict capitalism or socialism. It could be said that nowadays, wide-spread macroeconomic approach in the world is a mixed version of New-Classic micro approach and New Keynesian macroeconomic theory.