Causes of the Great Depression

As opposed to the pseudo-scientific, Marxist idea that capitalism is inherently unstable and will lead inevitably to mass unemployment and strife, there is a general agreement among macroeconomists today that the Great Depression was the product of the Fed’s highly distortionary monetary policy. However the nature of this distortion is still a subject of debate.

Austrian economists like Ludwig von Mises and Friedrich Hayek argued that some kind of bust was the inevitable result of the Federal Reserve’s inflationary monetary policy through the 1920’s. Keynes had essentially no explanation for the onset of depression, invoking the catch-all of “animal spirits” in place of an explanation. Monetarists including Milton Friedman, like the Austrians, sought a monetary cause, but focused on deflationary monetary policy starting in 1929. Working out a full causal picture of this episode in American history, which incorporates both Austrian and monetarist insights, is crucial to understand the subtle role played by government intervention in fomenting the instabilities that are frequently pinned on the market itself.

Scott Sumner is a new brand of monetarist who has gained attention for his advocacy of a monetary policy aiming to stabilize a steady growth trend in the total dollar value of spending in the economy, as measured by nominal GDP (NGDP).  Deviations above this trend, by this logic, don’t indicate higher levels of real production, but simply excessive monetary pumping by the Fed; deviations below the trend indicate overly tight money. An essential question for examining the causes of the Great Depression, then, is what was happening to NGDP during the 1920’s. Sumner says that it was basically flat from 1920 to 1929, indicating no inflationary boom. But here is the full graph:

Taking 1920 as the baseline for his characterization of the decade is misleading, because it was the tip of a fleeting inflationary spike that accompanied government spending on WWI. But the Fed reverted that spike in short order by 1921. In fact the spike’s impact is overstated by the NGDP measure, which includes government outlays on the military that are somewhat decoupled from the rest of the consumption-oriented economy and are also more easily identified as fleeting by entrepreneurs planning for future consumption-oriented production. Subtracting government spending from NGDP indicates an even narrower spike.

Overall, what we have is an abrupt shift from a relatively stable pre-1915 NGDP growth path to a much steeper one over 1915-1929, saddled with an additional but quickly corrected spike in 1919-20. The sharpness of this correction itself contributed to subdued inflation expectations over the 1920’s that tended to increase the sucker-punch impact of what was in fact an expansionary monetary policy over that period (seen also in above-trend growth of the money supply measure M2). This was the monetary situation leading into the financial crash of 1929, consistent with the Austrian account of a distortionary boom brought on by loose money through the 1920’s at the hands of a newly created Federal Reserve. Contractionary policy starting in 1929 no doubt exacerbated the bust and was a major factor in the following decade-long slump, but this cannot exculpate the preceeding inflationary policy and the capital-market distortions it induced.