The Great Depression

The Great Depression began as a severe but not unprecedented financial panic and became, through a combination of policy failures and structural rigidities, the most devastating economic catastrophe in the history of industrial capitalism. Between 1929 and 1933, US gross domestic product fell by nearly 30%. Unemployment rose to 25%. Industrial production collapsed. The banking system experienced three waves of failures, with roughly 9,000 banks failing over the decade -- wiping out the savings of millions of depositors who had no insurance protection.

The gold standard was the central mechanism of catastrophe. Countries bound to gold could not expand their money supplies to counteract collapsing demand -- doing so would have required them to abandon convertibility and face the capital flight that followed. Instead, they competed to contract: raising interest rates to defend gold reserves, cutting government spending to balance budgets, and thereby amplifying the deflationary spiral that was already underway. Countries that left the gold standard earliest -- Britain in 1931, the United States in 1933 -- recovered earliest (Eichengreen, 1992).

The Federal Reserve's role in the Depression remains contested but damning. Friedman and Schwartz (1963) argued that the Fed's failure to prevent the banking panics -- which it had both the tools and the mandate to address -- caused the money supply to fall by one-third between 1929 and 1933, turning a recession into a depression. Ben Bernanke, in his academic work before becoming Fed chairman, extended this analysis to show how banking collapses disrupted credit markets in ways that further contracted economic activity (Bernanke, 1983). When Bernanke was honored at Friedman's 90th birthday dinner, he said: "You're right, we did it. We're very sorry. But thanks to you, we won't do it again."

The Federal Reserve could have prevented the Depression. It had the tools. It chose not to use them -- partly through intellectual error, partly through institutional inertia, and partly because the men in charge did not fully understand what they were watching unfold.Adapted from Liaquat Ahamed, Lords of Finance (2009)

The human consequences were staggering in ways that aggregate statistics cannot capture. Families lost homes to foreclosure, farms to forced sale, savings to bank failure. Unemployment, which provides no income in a pre-welfare-state America, meant genuine destitution for millions. The Dust Bowl -- a combination of drought and catastrophically poor agricultural practice that turned the Southern Plains into a desert -- forced hundreds of thousands from their homes simultaneously. The social fabric of communities organized around stable employment tore badly and in some cases did not recover for a generation.

The Depression's political consequences were as significant as its economic ones. It discredited the Republican Party for a generation, produced the New Deal coalition that would dominate American politics for forty years, and -- in Europe -- contributed to the conditions in which fascist movements came to power. It also generated the intellectual revolution associated with Keynes: the recognition that market economies could fail catastrophically and that governments had both the capacity and the obligation to intervene when they did.