9.9 — The Great Depression

Between 1929 and 1933, United States industrial production fell by about 47 percent. Unemployment reached roughly 25 percent of the workforce. Around 9,000 banks failed. World trade fell by around two-thirds in value.

Germany's unemployment reached roughly 30 percent. In the September 1930 election, with unemployment rising fast, the Nazi vote went from 2.6 percent to 18.3 percent. In July 1932, with unemployment near its peak, it reached 37.3 percent.

The Depression is not only an economic episode. It is a substantial cause of the Second World War, and this chapter treats it as both.

What set it off

The 1920s American boom was real and it was built on credit.

Consumer credit expanded enormously — cars, radios and appliances bought on instalment plans, which was new.

Stock speculation was leveraged. Buying "on margin" meant putting down as little as 10 percent and borrowing the rest from a broker, using the shares themselves as collateral. A 10 percent fall wipes out the investor's entire stake and triggers a margin call — a demand for more cash, which forces selling, which pushes prices down further.

And agriculture was already depressed through the 1920s, from overexpansion during the First World War and falling commodity prices.

The crash came in late October 1929 — Black Thursday on the 24th, Black Tuesday on the 29th — with the Dow falling by around a quarter over those days and by roughly 89 percent from its 1929 peak to its 1932 trough.

And the crash alone was not the Depression. A stock market fall is a loss for shareholders, who were a small minority of the population. What turned it into a decade-long catastrophe was what happened afterwards.

Why it became a depression

Four mechanisms, and they compound.

1. Bank failures and the collapse of money

Around 9,000 American banks failed between 1930 and 1933.

Each failure destroyed deposits — there was no deposit insurance — so people who had done nothing wrong lost their savings. Survivors withdrew cash from banks that were still standing, causing more failures.

And this is the crucial part: because bank deposits are money (Chapter 9.2), destroying banks destroys money. The US money supply fell by roughly a third between 1929 and 1933.

Milton Friedman and Anna Schwartz's Monetary History made this the central explanation, and it is now broadly accepted as at least a major cause: the Federal Reserve, which existed precisely to prevent this, did not act as lender of last resort (Chapter 9.2's Bagehot rule), and in some cases tightened. Ben Bernanke, later chairman of the Federal Reserve, said at Friedman's ninetieth birthday: you're right, we did it, we're very sorry, and we won't do it again. He then had the chance to prove it in 2008 (Chapter 12.8).

2. The gold standard

Chapter 9.7's constraint, doing maximum damage.

A country on gold, losing reserves, must raise interest rates and contract credit to defend the peg — precisely the opposite of what a depression requires.

The evidence is unusually clean. Countries that left gold early recovered early. Britain left in September 1931 and its recovery began soon after. The United States effectively devalued in 1933. France, which stayed in the gold bloc until 1936, had the worst and longest depression of the major economies. The correlation between the date of leaving gold and the date of recovery is one of the strongest findings in macroeconomic history.

3. Protectionism

The Smoot-Hawley Tariff Act of 1930 raised US tariffs sharply on thousands of goods.

Over a thousand economists signed a public letter urging Hoover to veto it. He signed it.

Retaliation followed — Canada, France and others raised their own tariffs. World trade fell by around two-thirds in value between 1929 and 1934.

Economists debate how much of the Depression's depth Smoot-Hawley caused — trade was a modest share of US GDP — and its role in spreading the contraction internationally and in poisoning economic relations is not much disputed. It is the reason the post-war order was built around trade agreements (Chapter 9.10 and 9.12).

4. Deflation and debt

US prices fell by around 25 percent.

Chapter 9.8 gave the mechanism. A farmer with a mortgage fixed in dollars, whose crop prices have halved, is repaying twice as much in real terms. Defaults rise, banks fail, credit contracts, spending falls, prices fall further. Fisher's debt-deflation spiral, running for four years.

What made it worse

The policy response, almost throughout, was the opposite of what is now understood to be correct.

Budget balancing. The orthodoxy held that a government should cut spending and raise taxes to balance the budget in a downturn. Hoover raised taxes in 1932. Britain cut public sector pay and unemployment benefit in 1931. Germany's Chancellor Brüning pursued severe austerity by decree from 1930 to 1932, with the explicit aim of demonstrating that reparations could not be paid — and the political consequence was the Nazi vote.

Wage cuts. The theory was that lower wages would restore employment. In aggregate, cutting wages cuts spending, which cuts demand, which cuts employment further.

And the American Dust Bowl compounded it (Chapter 1.9): semi-arid grassland ploughed up, drought, and topsoil blown away in storms that darkened the sky as far as Chicago. Hundreds of thousands of people were driven off the land, and Steinbeck's The Grapes of Wrath is about that migration.

Keynes

John Maynard Keynes's General Theory of Employment, Interest and Money, 1936, is the most influential economics book of the twentieth century.

His core argument, in plain terms.

An economy can settle at an equilibrium with high unemployment and stay there. The classical view was that wages and prices would adjust until everyone who wanted work had it. Keynes argued that this may not happen, and if it does, as he put it in another context, in the long run we are all dead.

The reason is the paradox of thrift. Saving is virtuous for an individual and destructive for everyone at once. One person's spending is another's income. If everyone cuts spending simultaneously, total income falls, so people save even harder, and the economy contracts further. What is rational individually is catastrophic collectively.

Investment depends on expectations, which are unstable. Businesses invest on the basis of what Keynes called animal spirits — a spontaneous urge to action rather than a calculation, because the future genuinely cannot be calculated. When confidence collapses, investment collapses regardless of how low interest rates go.

Hence the liquidity trap. At very low interest rates, monetary policy stops working — people hold cash rather than spend or invest it, and cutting the rate further does nothing.

So the state must spend. When private demand collapses, government spending can replace it, financed by borrowing, until confidence returns. And the multiplier means the effect exceeds the spending: money paid to a builder is spent at a shop, whose owner spends it elsewhere.

His most provocative formulation — that the Treasury could fill old bottles with banknotes, bury them in disused coal mines, and leave it to private enterprise to dig them up — was making a point rather than a proposal: even useless spending beats no spending in a depression, and there is no shortage of useful things to build.

How it actually ended

Honestly: mostly by rearmament and war, which is uncomfortable and is what the record shows.

The New Deal from 1933 did a great deal — deposit insurance, the separation of commercial and investment banking under Glass-Steagall, securities regulation, social security, public works, and rural electrification. It restored confidence and it built lasting institutions. It did not end the Depression — US unemployment was still around 14 percent in 1937, and a premature attempt to balance the budget that year produced a sharp renewed recession.

Germany's recovery under the Nazi regime from 1933 was rapid and was built on public works, rearmament, conscription removing men from the labour market, and suppressed consumption and trade unions. It was Keynesian in effect and militarist in purpose, and it was financed by devices that concealed the deficit and would have been unsustainable without war.

And the Second World War ended it everywhere. Government spending on a scale nobody had contemplated, total mobilisation of labour including women, and full employment. US GDP roughly doubled in real terms during the war.

The lesson drawn afterwards was that the state could deliver full employment and that it should — which produced the post-war consensus and the institutions of Chapter 9.10.

India's Depression

Rarely covered and it matters.

India was on a fixed exchange rate to sterling and was governed by a colonial administration committed to orthodoxy (Chapter 6.17).

Agricultural prices collapsed — Indian farmers were producing for world markets in jute, cotton, wheat and oilseeds, and world prices fell by half or more.

And land revenue was fixed in cash. A farmer whose crop revenue halved still owed the same assessment, which meant borrowing, mortgaging and selling land. Rural indebtedness rose sharply and land transferred to moneylenders.

The one striking response: Indians sold gold. Distress sales of household gold produced large exports through the early 1930s — the colonial government presented this as evidence of Indian prosperity, and it was distress liquidation. The episode is one of the sharpest illustrations of the gap between a colonial administration's reading of India and what was actually happening in villages.

Where this shows up in your life

Deposit insurance, banking regulation, securities disclosure requirements and unemployment insurance all exist because of this decade.

The consensus that a central bank must act as lender of last resort in a crisis was formed here and was applied in 2008 and in 2020, both times explicitly with reference to the 1930s.

And the political lesson is the one this volume treats as most important. Mass unemployment for years destroys political systems. Germany's democracy did not fall to an argument; it fell with unemployment at 30 percent. Chapter 12.8 shows a milder version of the same mechanism after 2008, and Chapter 16.3 states it generally: economic catastrophe is the reliable precondition for political catastrophe, and a system that cannot protect people from it will not survive it.

What the next page covers

In July 1944, while the war was still being fought, 730 delegates from 44 countries met at a hotel in New Hampshire to design the economic system that would follow it. Chapter 9.10 covers Bretton Woods and the dollar world — what was agreed and what Keynes proposed and lost, how the fixed-rate system worked and why it collapsed in 1971, what the IMF and World Bank actually do and the honest record of their conditionality, and why the dollar remains the world's reserve currency five decades after it stopped being convertible into anything.