The Great Depression: Economic Collapse

In the 1930s, American capitalism practically stopped working.



For more than a decade, from 1929 to 1940, America's free-market economy failed to operate at a level that allowed most Americans to attain economic success. Those of us lucky enough to have not lived through the ordeal of the Great Depression may have a difficult time imagining the unprecedented depths of economic collapse and social disarray that mired America in the 1930s.

Miserable Statistics

The story of the Great Depression can be told with a litany of bleak statistics.



By 1933, the country's GNP had fallen to barely half its 1929 levelblank">A Monetary History of the United States. Free-market economists philosophically opposed to the heavy government interventionism unleashed by Keynesianism, Friedman and Schwartz made a compelling argument that the Great Depression had been caused less by a failure of aggregate demand than by a sharp constriction in the nation's money supply. Foolish decisions by the Federal Reserve, they argued, combined with hoarding of cash by individuals fearful of bank failures, caused the stock of money circulating in the economy to fall by one-third between 1929 and 1933.

This "Great Contraction," as Friedman called it, had a choking effect on employment, incomes, and prices, unnecessarily prolonging the Great Depression by years. The New Deal's Keynesian intrusion into the free market had done little to address the underlying money problem—a savvier monetary policy from the Federal Reserve, Friedman suggested, would have provided better medicine for America's economic sickness during the Great Depression.

At first, Friedman's monetarist ideas gained little traction in either the academic or political establishment, but since the 1970s, the free-market philosophy of Friedmanism has largely displaced Keynesianism to become the dominant economic orthodoxy of our time.



Over the years, historians and economists have explored many variants to the basic Keynesian (aggregate demand) and Friedmanist (monetarism) explanations for the Great Depression. They've blamed the misery of the 1930s on the rigidity of the gold standard, or on the unsustainably unequal distribution of wealth built up through the Roaring '20s, or on the instability in the American banking system, or on the high tariffs imposed after 1930 that choked off international trade.

While each explanation has its supporters and critics, the truth may be that the best explanation for the Great Depression is...all of the above.

After 1929, the American economy did suffer a broad collapse in aggregate demand and a sharp constriction in money supply. The effects of the downturn were amplified by the gold standard and maldistribution of wealth and bank failures and protectionism in trade. The search for one true underlying cause for the Great Depression may, in the end, be something of a chicken and egg problem. What is clear is that by 1932, just about everything in the American economy was broken.

Micro vs. Macro: Vicious Spirals

In different ways, both Keynesian and Friedmanist explanations for the Great Depression suggest that American capitalism broke down in the 1930s because of a tragic disconnect between the needs of the economy as a whole and the rational economic actions of the individuals struggling to survive within it.



When one farmer struggling to make his mortgage payment encountered falling prices for wheat, his rational response was to produce more wheat to make up the difference. But when millions of farmers did this, the resulting overproduction flooded the market, driving prices so low that no farmers could sell their crops at a price that justified the harvest.



When one factory owner encountered falling demand for his products, his rational response was to cut production and cut costs by laying off workers. But when thousands of factory owners did this, the resulting mass unemployment and poverty drove demand for all their products even lower.



When one worker encountered the high likelihood of losing his job, his rational response was to hoard his money, saving as much and spending as little as he could. But when millions of workers did this, the resulting lack of spending in the consumer economy destroyed markets for goods and caused employers to lay off more workers.



When one depositor learned that his bank might fail, potentially wiping out his savings, his rational response was to withdraw all his cash and put it in a shoebox. But when millions of depositors did this, the resulting runs on banks caused rampant bank failures and the constriction of the national money supply.



Deeply entrenched American ideologies held that individual successes or failures were determined by the hard work, prudence, and industriousness of the individual. During the Great Depression, almost the opposite became true—the hard work, industriousness, and prudence of each individual American tended to make the overall problems of the national economy worse. America's economy during the Great Depression became a seemingly intractable vicious spiral, in which the perfectly rational microeconomic decisions of millions of individuals combined to exacerbate the macroeconomic problems of the system as a whole.

And the failure of the system made misery for the individual almost inevitable.