Government policy errors as a cause of the Great Depression

Any discussion of economics quickly reveals the widespread ignorance of college-educated Americans about its basics tenets and dynamics in our history.  This is odd, as Economics has long been one of the most popular undergraduate majors.

For a quick and relevant lesson, here is an excerpt from the IMF’s World Economic Outlook of April 2002.  It is the best discussion I have seen of recessions, both national and global, esp chapters I and III. 

This excerpt from chapter III, box 3.2:  “The Great Depression”, by Michael Bordo.  It focuses on the role of monetary policy and finance.  It does not discuss the role of fiscal policy, a major factor driving fast recovery in those nations who used it properly (such as Germany, driven by their evil genius ruler).

Policy errors can convert a normal cyclical downturn into a depression or Great Depression.   Let’s hope the new Administration shows greater wisdom than did the Hoover Administration.


Most economic historians concur that the Great Depression — at least the first stage — was caused primarily by monetary policy in the United States, propagated mostly by a series of banking panics, and then spread to the rest of the world via the international gold exchange standard.  [Many other causes of the Great Depression have been proposed, from more restrictive trade policy (Meltzer, 1976) to the stock market crash of 1929 (Galbraith, 1961).]

The U.S. Federal Reserve tightened monetary policy in early 1928, in response to the stock market boom that began in 1926 and the belief that banks should confine their lending strictly to commercial bills and not finance stock market speculation (the “real bills doctrine”). The contractions in central bank credit and the monetary base, along with a rise in the discount rate, precipitated a downturn in the U.S. economy starting in August 1929 (before the stock market crash of October 1929).

A series of banking panics beginning in October 1930 turned an otherwise serious recession into a depression. These panics, which resulted in the suspension of 9,000 banks (more than one-third of the total), exacerbated the economic contraction because they reduced broad money (Friedman and Schwartz, 1963). The U.S. Federal Reserve was insufficiently aggressive in trying to counter the collapse in broad money, for example via open market purchases.  (The reason for this policy failure is still being debated.)

The collapse of broad money reduced output through several channels:

  1. lower aggregate demand, which—in the face of nominal wage rigidity—decreased real output (Bernanke and Carey, 1996; Bordo, Erceg, and Evans, 2000);
  2. disruption of financial intermediation from the bank failures (Bernanke, 1983);
  3. asset price deflation, whereby declining asset prices reduced the value of collateral for bank loans, inducing weakened banks to engage in a fire sale of their loans and securities, leading to further asset price deflation (Bernanke and Gertler, 1989); and
  4. debt deflation, in which falling goods prices led to rising debt burdens in an environment where contracts were not fully indexed (Fisher, 1933) and rising ex ante real interest rates (Cecchetti, 1992).

The fall in broad money in the United States raised interest rates, leading to a capital inflow from the rest of the world, and reduced output, lowering U.S. demand for the rest of the world’s output. The United States ran persistent balance of payments surpluses with its main trading partners during 1929–31.

In the rest of the world, the combination of the gold outflow and the fall in exports to the United States caused aggregate demand to decline. This was exacerbated by a loss of confidence in the currencies of the reserve countries, leading central banks to convert their holdings of foreign exchange into gold, which caused a contraction in the world money supply. Countries that did not adhere to the gold exchange standard, such as Spain, experienced milder contractions (Choudhri and Kochin, 1980).

The gold exchange standard also exacerbated the contractions in other countries by preventing central banks from responding aggressively to the banking panics prompted by weakened bank balance sheets. Central banks were reluctant to extend liquidity support to banks, fearing a speculative attack that would force them off the gold standard—they were confined by “golden fetters” (Bernanke and James, 1991; Eichengreen, 1992).

At the same time, foreign depositors’ fears of either devaluation or the imposition of exchange controls (or both) fueled the spread of banking crises from Austria in May 1931 to Germany and other central European countries, and then to France and Belgium. Finally, the banking crises on the continent led to a speculative attack on the Bank of England’s gold reserves, leading the United Kingdom to suspend gold convertibility in September 1931.

The contagion even reached the United States, leading the central bank to raise its discount rate in order to protect its gold reserves— thereby aggravating the banking crisis already under way.

The Great Depression generally ended once countries left the gold exchange standard and adopted policies that restored confidence in the financial system and stimulated aggregate demand, including expansionary fiscal and monetary policies.

  • The United Kingdom and other countries in the sterling bloc, including Australia, Denmark, Finland, Norway, and Sweden, left gold in 1931 and started to recover.
  • The United States ended its link to gold in 1933 and effectively devalued by raising the price of gold, which in turn revalued the monetary gold stock and expanded the monetary base.

The principal remaining gold standard adherents were France, Belgium, the Netherlands, and Switzerland (the “gold bloc” countries), which had returned to gold in the late 1920s. After the United Kingdom, the United States, and much of the rest of the world devalued, France and the gold bloc countries were placed at an ever deteriorating competitive disadvantage. To preserve their gold reserves, they followed increasingly contractionary macroeconomic policies, which served to exacerbate the Depression. In the end, Belgium left gold in 1935 and France in 1936, followed by the Netherlands and Switzerland.

The pace of recovery from the Great Depression varied widely across countries, depending in part on macroeconomic and structural policies. In the United Kingdom, which left gold early, it took only a year for output to exceed its peak level before the recession began.

In the United States, recovery began in 1933 but was sluggish compared with the strength of the monetary expansion under way, and it took about three years for output to return to its previous peak level. Recent research suggests that the weak recovery and the following second stage of the Depression partly reflected New Deal policies that enhanced the monopoly power of firms and labor unions, which strongly reduced aggregate supply, especially in manufacturing (Bordo, Erceg, and Evans, 2000; Cole and Ohanian, 1999).


If you are new to this site, please glance at the archives below.  You may find answers to your questions in these.

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For more information from the FM site

To read other articles about these things, see the FM reference page on the right side menu bar.  Of esp interest these days:

Some Solutions

  1. Slow steps to nationalizing the US financial sector, 7 April 2008 — How this will change our society.
  2. Slowly a few voices are raised about the pending theft of taxpayer money, 21 September 2008
  3. How should we respond to the crisis?, 24 September 2008
  4. A solution to our financial crisis, 25 September 2008
  5. A quick guide to the “Emergency Economic Stabilization Act of 2008″, 29 September 2008
  6. The Paulson Plan will buy assets cheap, just as all good cons offer easy money to the marks, 30 September 2008
  7. The last opportunity for effective action before disaster strikes, 3 October 2008
  8. Prof Roubini prescribes first aid for America’s economy, 4 October 2008
  9. Effective treatment for this crisis will come with “The Master Settlement of 2009″, 5 October 2008
  10. Dr. Bush, stabilize the economy – stat!, 7 October 2008
  11. The new President will need new solutions for the economic crisis, 9 October 2008
  12. Results from the IMF meeting – just thin gruel, 12 October 2008
  13. The G-7 meeting was the last chance for action before the global recession, 12 October 2008
  14. A brief note about our financial system: Intermediation, disintermediation, and soon re-intermediation, 16 October 2008
  15. New recommendations to solve our financial crisis (and I admit that I was wrong), 23 October 2008 

3 thoughts on “Government policy errors as a cause of the Great Depression”

  1. Intriguing October 13 article by Robert J. Samuelson which confirms what you’ve been saying: “The Engine of Mayhem.” Crucial paragraph:

    The present challenge is far more complicated than merely quarantining dubious mortgage-related securities. What’s involved is a fundamental remaking of the global financial system, from one that was inherently fragile to one that rests on firmer foundations. But if the change proceeds too quickly and haphazardly, it risks a hugely destructive credit implosion.
    Fabius Maximus replies: Thank you for the link to this article! I have written about this in the following posts:

    * Effective treatment for this crisis will come with “The Master Settlement of 2009″, 5 October 2008
    * Results from the IMF meeting – just thin gruel, 12 October 2008
    * The G-7 meeting was the last chance for action before the global recession, 12 October 2008
    * A look ahead to the end of this financial crisis, 30 October 2008

  2. Another good Samuelson quote:
    “Deleveraging — a shift from excessive debt toward more capital — is inevitable and desirable in the long run. The trouble is that, in the short run, it could destabilize the economy if it proceeds too rapidly.”

    (That excessive debt is the ‘fictitious capital’ which Austrian school folk always warn against.)

    This also applies to labor adjustments. One of the most significant issues absent from most Great Depression talk is the missing change in labor — the increased production from tractor (capital) based agriculture resulted in lots of ‘Tom Joad’ type ex-midwest farmer-workers who were not yet getting manufacturing or service jobs.

    The share of farm employment as a % of all employed was going down thru the 20s, and went way down thru the 30s. Had there been a stimulus program to keep farm-workers on the old farms, I’m sure it would not have succeeded.

    Today, there are too many finance-workers. I fear the failout (slip bailout) is an attempt to save too many finance worker jobs. And of course, in a recession, it won’t be easy for finance folks to get other jobs, and certainly not as high-paying as before.

  3. Pingback: Pequeno rascunho econômico « É o vento, e nada mais.

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