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March 25, 2014
The Dismal Science
Depression History
by Adam Smith

It is fascinating how many untrue facts continue to circulate in our society even though the truth can be found with just a few clicks of a mouse.

For instance, it is widely heard that President Bush lied about weapons of mass destruction being in Iraq. But this is folly. Bush believed Iraq had the weapons and acted on those beliefs. The fact that he was wrong does not mean that he lied. But you hear this same untruth over and over.

The Great Depression is the most dreadful economic calamity to befall the United States. At its worst, the unemployment rate reached 25% and the economy shrank by 30%. The devastation to individuals and families was gruesome.

It has been 80 years now since the Great Depression, and while that event is not completely understood we do know that the stock market collapse in 1929 did not cause the Great Depression.

I am currently reading a book about the year 1927, and the author in passing made mention that in the 1920’s there was a bubble in the stock market that collapsed in 1929, causing the Great Depression. What?

It literally takes two minutes (search Great Depression and Federal Reserve) and read the introduction to the course the Fed has on the Depression and you learn that this is not true.

Open up high school text books and you can read the same garbage about the cause of the Depression. The stock market collapse of 1929 is flashy and dramatic, while the truth is not quite so spectacular.

The unemployment rate by year starting in 1929 is a follows:

1929 – 3%
1930 – 9%
1931 – 16%
1932 – 24%

Here is the best explanation for the Great Depression.

There was a collapse of the banking system in the United States. In 1930, there was no deposit insurance and people would panic if they heard a bank failed somewhere and run to their bank to get their money even if their bank was completely sound (this is called contagion).

There is a basic asymmetric information problem with banks. The people at the bank know how sound the bank is but the public doesn’t know. So it is rational for people to make a run on a bank since the first in line will get their money while those later in line will not get their money.

From 1925 to 1929, there were on average 650 banks that failed each year. From 1930 to 1933, on average 2200 banks failed each year. The money supply in the economy was shrinking fast so there was no cash around to loan or borrow, companies went bankrupt and laid off employees, and the economy shrank.

As the economy shrank, there were fewer people able to buy goods, more companies went under and it was a cycle into oblivion.

This was not the Federal Bank’s best moment. They could have prevented many of those banks from going under but were afraid that if they loaned money to the banks that the bank would go under and they would lose the money. The Fed shut the borrowing window to troubled banks allowing them to go under.

In 1933, President Roosevelt created the requirement for banks to have and provide deposit insurance (FDIC) and the banks finally stabilized with almost no bank failures until the Savings & Loan crisis of the 1980s.

We have come close twice to having another collapse of the banking system. One instance occurred in October 1987, when the stock market dropped 23% in one day. The story about what almost happened except for the intervening of the Fed is for another article, but we were standing on the edge of a very steep cliff that week.

The other was the recent crisis of 2008. Hopefully now you understand the need for TARP and the way the Fed has continually pushed money into the economy over the past five years. The past Fed Chair Ben Bernanke is an expert on the Great Depression and he was going to do everything he could not to repeat the same mistakes.

TARP pushed money back into the financial institutions, making sure they had the liquidity to survive. So anytime you hear someone denigrate TARP, remember the Depression.

Would you be willing to risk another depression (the current economy is bad enough) by eliminating a program that helped save our banks and has been repaid with interest? What exactly was the downside to TARP? Afraid the taxpayers were going to lose that money? That sounds exactly like the Feds in 1930 and that attitude worked out just great back then.

Another reason given for the Depression is the passing of the Smoot-Hawley Tariff Act. This law passed in 1930 (and bears the senator of Utah’s name) put heavy tariffs on imported goods. Other countries retaliated with their own tariffs, and global trade collapsed.

That whole idea of creating tariffs so we can bring back all that manufacturing from China, Japan, whatever, is always a loser for all countries. The economic pie for everyone will shrink. This was a contributing factor for the Depression and hurt the recovery.

The least important factor is the stock market collapse of 1929. The impact of the collapse was more emotional than material. It made people question the economy and where it was headed but was not a monetary cause for the Depression. The stock market collapse from 1987 was more dramatic than 1929, but because the fed acted appropriately it had little effect.

There is so much more about the Depression that is interesting. If there is one thing you learn from this article I hope it is that you do not get your economic ideas from talking heads on the television or radio or from books or textbooks that do not take the time to do the appropriate amount of research.

Economists have studied the Great Depression for decades and still there are areas of differing opinion about what happened in the 1930s. Economics is hard and complex. During an economic crisis, how does a person that only speaks in sound bites know what to do?

During the last crisis I ignored everyone and went to see what Doug Diamond had to say. Who is he? An economist at the University of Chicago and probably the best expert on financial institutions. From what I learned from reading his remarks it gave me a frame of reference that was invaluable.

Now you know the best explanation for what caused the Great Depression, what we learned from it, and understand how that learned information affects our current economic policies. Good luck trying to get someone to accept a thorough explanation of the banking collapse when “the stock market crash in 1929 caused the Depression” is so catchy.

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