Why Did the Great Depression Happen?

At the height of the Great Depression, the unemployment rate in the United States was over 25% (US Bureau of the Census). Many of the people who did have jobs were reduced to working part-time. It was a terrible time in US history, certainly the worst economic time this country has ever seen. Why did it happen? It's All In the Numbers.

In January of 1930, there were 54.3 billion dollars in circulation in the US economy. By April of 1933, there were only 40.6 billion dollars in circulation (Friedman and Schwartz, "A Monetary History of the United States", pp. 712-714). That's a decline of 25%. The amount of money in circulation in the US declined by 1/4 in a little over 3 years.

If 25% of the world's gold supply suddenly vanished today, what would happen to the remaining gold in the world? It would rise rather dramatically in price. That is what happened to money during the Great Depression, and that is what caused the Great Depression.

From 1930 to 1933, money kept getting more and more valuable. As money kept getting more valuable, people become more and more reluctant to spend their money. Why spend something today that is continually increasing in value? As people continually spent less money, economic activity collapsed, and The Great Depression occurred.

Why Did the Money Supply Decline by 25%

In the 1800's and early 1900's, the United States Economy would periodically experience a banking crisis. Each time, something would happen in the economy to trigger the crisis. For example, a large company might go bankrupt, which would cause panic among depositors who had money deposited in banks that had loans outstanding to the bankrupt company. The panicked depositors would line up at the affected banks and demand their money. The banks did not have everyone's money readily available, as they lent out deposits to earn interest and make a profit. In order to raise cash to pay off the depositors, the banks would call in loans. If the borrowers could not pay back the loans, the banks would foreclose on the assets and sell them for whatever they could get to raise cash to pay the depositors. As the banks were forced to sell assets for whatever they could, asset prices would decline. The banks were forced to take writeoffs, and the amount of money in circulation in the economy would decline. As the amount of money in circulation declined, all exisiting money became more valuable. As long as money is gaining in value, people become very reluctant to spend money, and a recession (called contractions back then) would occur.

In 1913, the Federal Reserve was created to specifically deal with these declines in the money supply. The Federal Reserve was chartered to, "furnish an elastic currency" (Federal Reserve Act). When a banking crisis occurred, the Federal Reserve could step in and loan the banks whatever money they needed to pay off depositors. The banks would not have to call in loans and foreclose on assets, and the amount of money in circulation would not have to decline and economic growth could continue.

In the 1920's, people could buy stocks by borrowing 90% of the stock's price, using only 10% cash. By the late 1920's, more and more people began speculating in stocks using primarily borrowed money. A huge financial bubble built up in the stock market, fueled by the easily borrowed money. In order to deal with the financial bubble built up in the stock market, the Federal Reserve began to raise interest rates in 1928. As time went by and the higher rates took effect, economic growth slowed and corporate profits started to suffer in the latter half of 1929, which caused the stock market to crash in October.

Once the market crashed, most of the people who had borrowed 90% of the purchase price of their stocks had no hope of ever paying back the borrowed money. This caused a crisis of confidence in the banks, as many of them had loans outstanding to the speculators. As word got out, depositors started going to the banks and demanding their money. The banks responded just as they always had, by calling in loans to pay off the depositors, only this time something was different.

The Federal Reserve now existed. It was created to specifically deal with the crisis it now faced in late 1929 and early 1930. What did the Federal Reserve do? The exact OPPOSITE of what it was created to do. Instead of loaning the banks whatever money they needed to pay off depositors and keep the amount of money in circulation from declining, the Federal Reserve forced the banks to purchase government securities from the Federal Reserve. In order to pay for these securities, the banks had to use cash that went to the Federal Reserve and was no longer part of the money supply, causing the amount of money in circulation to decline to unprecedented levels. Instead of "an elastic currency", the Federal Reserve created an inelastic currency. Had the Federal Resrve not existed, the amount of money in circulation would never have declined anywhere close to the levels it did.

Why did the Federal Reserve do the exact opposite of what it was created to do, and pull even more money out of the economy?

In my opinion, the Federal Reserve saw assets continually plunging in value, the only assets holding up in value were government securities. The individuals running the Federal Reserve believed that they had to shore up the banks with solid assets, assets that were not declining in value, or the banks would cease to exist. So the Federal Reserve forced the banks to purchase government securities. The irony, of course, is that it was the Federal Reserve's actions which were causing asset values to plunge.

Can Another Great Depression Happen Today, or in the Future?

While anything is possible, the existence of the Federal Deposit Insurance Corporation (FDIC) virtually guarantees that the US economy will never suffer another Great Depression.

The Great Depression was caused by a massive decline in the amout of money in circulation. Today, the FDIC insures almost all deposits in the banking sytem up to $100,000. In addition, the FDIC separately insures many retirement accounts, like Indvidual Retirement Accounts (IRA's). The fact that so much of the money deposited in banks today is insured, makes a decline in the money supply comparable to what happened during the Great Depression very unlikely. Without a massive decline in the money supply, another Great Depression cannot occur.

Had the FDIC existed prior to late 1929, or early 1930, most of the people lined up to withdraw their money from the banks would have recieved every penny of their deposits. The amount of money in circulation would never have declined to the levels it did, and the Great Depression would never have happened.

The only way another Great Depression could occur, would be if the FDIC failed and went bankrupt. Politically, that will never happen, as the politicians would then force the Federal Reserve to come up with whatever funds where necessary to keep the FDIC solvent, and all depositors would recieve their money. Remember, it was the failure of the Federal Reserve to do what it was created to do back in 1929-1933, that resulted in the creation of the FDIC.

Finally, the very existence of this blog will go a long way towards ensuring that another Great Depression does not occur.