Causes of The Great Depression and a Critical View on The New Deal

In the late 1920’s and through the early 1930’s, America experienced an extreme depression known as the Great Depression due to a mistake by the Federal Reserve Bank. In an attempt to bring the country out of depression, America’s president at the time, Franklin D. Roosevelt (FDR) enacted policies known as the New Deal. An important part of the New Deal was the monetary policy which effectively destroyed the Gold standard and put in its place fiat money. The reason why the Great Depression was so devastating was due to a mismanagement by the Federal Reserve Bank, and the New Deal responded incorrectly by allowing for more mismanagement to occur in greater amounts in the future, harming the economy.

The main cause for the Great Depression was due to a mistake by the Federal Reserve Bank. During a small economic downturn, people began withdrawing money from their bank accounts rapidly, and over time, some banks ran out of money and collapsed. This led to a massive run in which many people took moey out of their bank accounts. Eventually over a quarter of the banks in America crashed, plummeting America into the Great Depression. The government had already set up the Federal Reserve Bank to solve this problem before it, and it had worked in the past. This time, the Federal Reserve Bank did not intervene and watched as banks collapsed.

The M2 supply includes the physical currency, such as physical bills and coins, as well as the easily liquidated bank accounts which people owned. In the early years of the Great Depression, the M2 monetary supply declined rapidly due to people liquidating their bank accounts. The historical statistics of the United States recorded a major decline in the M2 supply, as seen below. [1]

The M2 supply went to the lowest ever value several years before WWII begins, which was the time in which America entered into the Great Depression. This means that most of the circulating money in the form of bank accounts was destroyed. Plenty of banks crashed due to the loss of money, and some people lost their money because they could not withdraw their money. Many banks went bankrupt. The entire problem with bank runs, in which people withdraw massive amounts of money over a short amount of time thereby bankrupting the banks could have been avoided.

The Federal Reserve Bank was created under Woodrow Wilson’s presidency for the very purpose of giving banks money in times of need. This policy had worked effectively before. In the television program Free to Choose, a bank manager in Utah was interviewed on how his bank survived a bank run. While Free to Choose is not an impartial and unbiased source, the interviewed bank manager is because he was a witness. The manager was managing the bank run as it was happening at his bank[9]. The bank received money from the Federal Reserve Bank and it did not crash. It did, however, change its strategies on how to distribute the cash when people chose to withdraw money. In the case of the Great Depression, the Federal Reserve acted stringently and decided not to lend banks money when they desparately needed it. At that moment, the government was attempting to reverse the amount of inflation that happened during the first world war. The graph below shows the incremental inflation for each year.[7]

In the 1920’s, after WWI, the rate of inflation decreased rapidly, even entering negative amounts, indicating deflation. Before 1929 (the year of the stock market crash) the dollar was still experiencing negative inflation. This leads to the conclusion that at the moment the government wanted to contract the currency, and chose not to give the banks money for this very reason. The Federal Reserve wrongly thought that the time was right for contracting the American dollar, but fatally mismanaged the money supply and unintentionally caused many banks to crash.

In one of the many New Deal policies, FDR abolished the gold standard. To his advisers, FDR once said, “Congratulate me. We are off the gold standard”(142, Hiltzik). The US Dollar was, at that time, backed by gold. It would be possible to exchange money for physical gold, and the price of gold did not change much. A part of the New Deal abolished the gold standard and replaced it with fiat money. In this system, the government determines the worth of the money, not the underlying gold. This put a greater responsibility of controlling the currency in the hands of the government. What has been seen with the previous mismanagement of the currency in the Great Depression continues in the future. The amount of inflation increases drastically, something many economists agree is not beneficial for long term economic growth. The government made another mistake by inflating the currency as a result of moving off the gold standard.

One way to measure inflation is by using the consumer price index, also known as the CPI. This attempts to capture how much inflation has occurred in prices with time. The cumulative inflation relative to 1899 is shown below. [7]

What can be clearly seen in this graph is that inflation went down or stayed somewhat stable after WWI, but after the Great Depression, the inflation went through the roof. The currency was not managed correctly by the government, giving the economy a relatively unstable dollar to use.

Another place to look for calculating the inflation would be in the price of gold. The reason gold was used in the first place was because it was, for the most part, stable. Some gold was mined year to year and entered the supply of gold, but that only increased by about 1-4% per year. If the amount of gold remains relatively constant, then the price of gold reveals how much money is required to obtain the same quantity of gold. If the dollar is not worth very much, then more dollars will be needed to buy the same amount of gold. If the dollar is worth a lot, then less dollars will be required to purchase the same amount of gold. For one ounce of gold, the price of gold is shown below. [7]

During the New Deal, gold was forced to be $35 per ounce. Later on, the price of gold was freed and changed due to the worth of the dollar. What can be easily seen is that the price of gold remained relatively stable until after 1975 when it skyrocketed and since then changes more drastically. The graph clearly points toward the idea that inflation was rampant in the mid to late 20th century.

Inflation is not good for the economy. It slows down growth and hurts the everyday exchanges that occur with money. When people work for dollars, the employer pays them according to the worth of the dollar at the time. Later, the currency may become inflated, thereby decreasing the amount of worth the worker’s money actually has. This cripples the purchasing power of some, and decreases the amount of overall GDP (gross domestic product) growth. In addition, there are plenty of countries that inflated their currencies and received adverse effects.

While the 20th century did have a lot of inflation, some periods of time experienced worse inflation than others. Louis Woodhill writes in Forbes magazine that a slightly more stable dollar gave America 3.92% real GDP growth. When there was a falling dollar, the average GDP grew 1.75%. Woodhill also cites other occasions when the dollar was slightly less stable but ended up having a growth slightly less than 3.92%. While some bias may be considered because Woodhill seems to have a disagreement with Keynesian economics, he does name statistical facts which do not represent a bias. Woodhill’s studies find that higher inflation leads to less economic growth. [10]

There are also plenty of countries that tried to inflate their currency in order to be more economically strong. Hungary inflated its economy from 1945-1946. In an article by Jason Lankow, “In 1944, the Hungarian Pengo’s highest denomination was the 1,000 note. A year later it was 10,000,000. And by mid-1946, it was 100,000,000,000,000,000,000”[4]. A huge increase in the denominations printed means that people needed to use more and more paper money for a good (because the money is losing value), so the government makes the denominations larger to be more convenient for the people. The German government inflated its currency after WWI(1922-1923) with no positive results. In Lankow’s article, “It is estimated that by November 1923, the yearly inflation rate was considered 325,000,000%”[4]. A more recent example would be Zimbabwe. Zimbabwe inflated its currency extensively and is not considered an economic power today. In Lankow’s article, “In August 2008, the government removed ten zeros from the currency, and 10 Billion ZWD became equal to 1 New ZWD, with an estimated annual inflation rate of about 500 quintillion (18 zeros) percent, with a monthly rate of 13 billion percent.”[4] This means that the currency became so inflated that the government chose to simplify the currency by removing zeros from their currency, proving that the Zimbabwe dollar had definitive amounts of inflation. In all of these cases, the economies of Germany, Hungary, and Zimbabwe did not increase due to inflation and sometimes led to the governments instituting a new currency with less inflation.[4] Inflation does not help an economy become rich and prosperous because inflation has not empirically helped economies.

The Great Depression was caused by a disastrous mistake by the Federal Reserve system which ravaged banks and ruined America’s economy. Then, the government responded with a plan that led to more mismanagement in the form of inflation, which harms the economy in the long term by reducing the growth in Gross Domestic Product. The Great Depression was caused by a failure of the government, and was responded to incorrectly by putting more responsibility in the hands of the government which subsequently mismanaged the currency and created greater inflation and a decline in the growth of the GDP.

The New Deal did not only create a monetary policy. In fact, a good part of the policies enacted were projects created by FDR in order to jump start the economy. This raises some questions. To what extent were the fiscal policies of the New Deal useful for the economy? Did the regulations put in place by FDR help or hinder people’s standard of living in the long run? Did WWII end the Great Depression? The last question about WWII begs the question: “Does war help an economy?”