Section [ ]. Introduction. The Great Depression’s Enigma
Many decades after it had ended, Great Depression continues to be a subject of heated disagreement among the economists who have been trying to ascertain the causes of its unset and unprecedented depth and duration.
If we look into the theories that have been proposed, it appears that economists have had more success in explaining the depth and duration of the crisis than its onset. For instance, [ ], Ohanian [ ] convincingly demonstrated that the Great Depression was so severe and lasted so long because of the high-wage policies of the successive administrations of Herbert Hoover and Franklin D. Roosevelt. Informed by the theory that economic downturns are caused by insufficient purchasing power, they tried to maintain wages at their pre-crisis levels. Hoover also initially tried to maintain employment which, in combination with his high-wage policies, may have exacerbated the rapid decline in private investment in 1930 discussed in more detail below.
Their actions led to real wages increasing while firms revenues were dropping rapidly [or stayed unchanged], leading to the necessity to lay off current workers or not hire those seeking employment. Mass unemployment directly results in a substantial reduction in the production of goods and services which was characteristic of the Great Depression.
The effects of those labor-market interventions were probably exacerbated in the course of the crisis by monetary factors, including banking panics, identified and discussed by, inter alia, [Friedman and Schwarz], Bernanke, [Eichengreen], [Sumner], [Lucas and [ ]] […]. Falling money supply (in particular caused by bank suspensions) may have led to some prices falling faster than the other leading to revenue declines for the affected businesses in addition to those caused by declining demand for their products and resulting, in a high-wage environment, in an imperative to lay off even more workers.
However, the key question that remains unresolved is what caused the initial economic downturn that resulted in the decreasing revenues for many firms and made them choose between laying off some workers or reducing the wages.
This question is not dealt with adequately by monetary theories of the depression mainly because the bulk of the preventable decline in money supply took place in 1931-32 when the crisis was already in full swing. It may be objected that money velocity fell in late 1929-1930 but this fall in velocity requires an external explanation.
The key category of explanations alternative to the one explored in this paper are various broadly Keynesian theories, advocated at different times by Fischer [], Keynes [], Krugman [], [ ]. These explanations may sometimes intertwine with the broadly monetarist ones. However, a major weakness of these explanations, is that, even if they stand on their own terms (while, in fact, all of them are highly controversial), like the monetary theories, they are even in principle much more suitable for explaining how a crisis can be exacerbated and prolonged rather than why it begins.
The theory of debt-deflation invokes the fact that deflation causes the nominal debt amounts to rise in real terms. This makes the affected firms allocate an increasing share of revenue to repaying the debts at the expense of investment. However, explanations of this type are essentially silent about what causes the deflation in the first place, thus they cannot explain the causes of the initial declines.
Liquidity trap explanations postulate that in certain conditions, economic agents may have an insatiable demand for money to hoard. The demand is insatiable in the sense that, no matter how much money is created by the economy’s money-creating mechanism, all the newly created money ends up being stocked up instead of being injected into the economic turnover.
There are two candidate non-mutually exclusive Keynesian explanations for what could spark economic crises but they do not appear to be satisfactory. First, some Keynesians believe that investors are at least partly driven by what Keynes called “animal spirits”, or irrationally optimistic or pessimistic expectations. When the former are suddenly replaced by the latter, firms reduce investment fearing the future. Leverage-based theories point to excessive indebtedness as the cause of downturns. According to them, when a large part of excessively indebted economic agents attempt to pay down their debts, this ends up to be self-defeating because it leads to deflation and an increase in the real debt burden.
The problem with the animal-spirit explanations is that there is little empirical evidence available to demonstrate that they are a real systemic phenomenon [ ]. In addition to this, with respect to the Great Recession in particular, the research that we conducted into how the business sentiment was reported in the New York Times suggests that even in 1930 business leaders did not harbor highly pessimistic expectations. To the contrary, the belief of most commentators appears to have been that the downturn that became vivid with the stock market crash in October 1929 was a passing phenomenon on the way to even more economic prosperity.
[According to Chernow , by the end of the 1920s out of the total US population of 120 million, only 1,5-3 million were involved in stock market speculation, and the losses associated with the stock market collapse of late 1929 were heavily concentrated among 600 000 margin accounts. Even if we accept for the sake of argument the logic that their inability to repay loans with which they purchased stocks outweighed the fact that people who would have bought those stocks at the pre-crash prices had more money to spend on other things, the scale of the problem does not appear to be significant enough to cause economy-wide trouble.
It may be countered that the crash in stock prices may have had its greatest impact through worsening the general attitude of business. However, there is a wealth of historical evidence of exactly the opposite. It can be argued with significant degree of confidence that the business largely considered the stock market crash as a temporary financial phenomenon with few repercussions for the wider economy.
For instance, as reported by Chernow , the [head partner] of the most important US banking business at the time [Morgan] Thomas Lamont dismissed the financial crisis thus: “I cannot but feel that it may after all be a valuable lesson and the experience gained may be turned to our future advantage…. There has never been a time when business as a whole was on a sounder basis.” An article in New York Times on 1 January 1930 quoted several key industry leaders who conveyed essentially the same message.11Business Leaders Find Outlook Good. The New York Times. Review Results of 1929. 1 January 1930. Retrieved from [ ]]
The leverage-based theories are puzzling because in every transaction involving debt there is a party that is the beneficiary of repayment. No matter how high the overall indebtedness is, it does not reduce the overall purchasing power of the economic agents, thus it is unclear how it could cause a severe downturn by itself.
An ingenuous attempt to fuse excessive leverage with psychological factors was made by Geanakoplos [ ] whose hypothesis is that there exists a continuum of investors from those who are risk-averse to those who are highly risk-prone. The latter make up the set of economic agents who make highly leveraged investments. If the position of the risk-prone investors deteriorates, the more risk-averse ones will not go into the type of investments their more risk-prone counter-parts would, which leads to an investment decline.
Genakoplos, however, does not provide an account of why the highly-leveraged investors start facing difficulties. He invokes the notion of “scary bad news” that increase the disagreement among economic agents as to the probability of negative outcomes but he provides an example (increased mortgage default losses) that itself requires an economic explanation. Hence, Geanakoplos’s theory does not seem to address the most important flaw of the Keynesian theories of crises.