The following tweet caught my eye:
I once wrote an entire book on the causes of the Great Depression, focusing on the role of the interwar gold standard and FDR’s labor market policies. In doing this research, I discovered that the question of causation is quite tricky. One can look for proximate causes, such as bad macroeconomic policy, or deeper causes, such as institutional failures. (In theory, a depression might also be caused by a natural phenomenon such as a plague or drought, but that was not the case with the Great Depression. It was clearly a human created problem.) Although we do not precisely know all of the factors that caused the Great Depression, we have a pretty good idea as to which hypotheses are not helpful.
Many people associated the stock market crash with the Depression due to the fact that it occurred at about the time it became apparent we were sliding into a deep slump. Note that I said “became apparent”; the Depression actually began a few months before the crash. In October 1987, we had a nice test of the theory that the stock crash was a causal element in the Depression. A crash of almost equal size occurred at almost exactly the same time of year, after a long economic expansion. Many pundits expected a depression, or at least a recession. Instead, the 1987 stock market crash was followed by a booming economy in 1988 and 1989.
Of course it’s possible to explain some difference in outcome to other factors at play, but when the difference is this dramatic (booming economy vs. the greatest depression in modern history), one has to wonder whether the hypothesis is of any value at all.
The same is true of the inequality/underconsumption hypothesis. Over the last 45 years, we’ve seen an interesting test of this theory. China has experienced a huge increase in economic inequality. More importantly, it has seen some of the lowest levels of consumption (as a share of GDP) ever observed. Even lower than other fast growing East Asian economies such as South Korea. Pundits have claimed that China’s consumption levels are too low, and that too many resources are being devoted to investment in areas of dubious merit.
That may all be true. Perhaps China should invest less and consume more. But it’s also clear that low levels of consumption in China have not caused a Great Depression. Indeed China’s had one of the fastest growing economies in the world since 1978.
Again, what impresses me about these two counterexamples (the US in 1987-89 and China since 1978) is not that things didn’t play out exactly as the historians might have expected based on their theory of the Great Depression. Rather what impresses me is that the results were almost 180 degrees removed from what might have been expected. That tells me that theories that stock market crashes and underconsumption cause depressions are essentially useless. They are ad hoc explanations with no real supporting economic theory and no predictive power. Why should a stock market crash cause 25% of workers to stop working? What is the mechanism? Why should high levels of investment cause real GDP to decline by 30% over 4 years? What is the mechanism? If they have no theoretical support and no predictive power, then why should we care what historians believe?
If you get creative enough you could find a causal mechanism running through aggregate demand. But then why not argue that a decline in aggregate demand caused the Great Depression? After all, that’s what actually did happen.
You might say that it’s important to know the cause of the Great Depression. But why? If the theories offered by historians provide no help in understanding the modern world, then how are they of any use?
More broadly, I distrust all theories of economic causation developed by non-economists (not just historians). These theories tend to rely on “common sense”. Thus many average people think that countries are rich because they are big, or because they have lots of natural resources. (Perhaps because that theory sort of fits the US.) But looking more broadly, rich countries don’t tend to be places with large populations or high levels of natural resources. They tend to be smaller countries in East Asia and Western Europe. The actual (institutional) factors that explain the varying wealth of nations are much harder to see, and hence tend to be ignored by non-economists.
READER COMMENTS
David Hibdon
Nov 22 2023 at 7:56pm
My waitress mother, in the late 1940s was not all that interest in how it started. But she knew why it lasted so long. Her main thought during the thirties (her teen years) that the government kept trying to keep commodity (food) prices high to protect bankers. And it regulated some things out of availability. She also wasn’t too fond of the threats , and occasional actions, to nationalize certain industries.
Floccina
Nov 23 2023 at 10:48am
Your comment interests me because it made me think of what my mother would say which was, there were plenty of goods and services available but no one had money. That seemed strange to her and it does get close to the problem and solution though she of course knew no economics.
Rajat
Nov 22 2023 at 8:31pm
Your quest to get people to think about the attribution of causation for macroeconomic instability through monetary policy counterfactuals is noble, but also ambitious, because few laypeople think of the central bank as capable of steering nominal demand. Not many (enough) people get exposed to the Ben Bernanke thought experiment. And it often suits central banks for people to think this way, so the challenges are hard to overcome.
To be fair, I think the simple stock market crash causes recession/depression line is less commonly accepted today than it was in 1987, probably because of the experience following the 1987 crash. The more widely-accepted story today I think focuses more on leverage and debt, whether private debt (the bogeyman on the left) or public debt (on the right). Of course, there is always debt in modern economies, but housing debt owed by households seems to be the main concern and squares with most people’s high school economics-based understanding of high marginal propensities to consume, etc. A layperson might agree that the 1987 crash and the 2001 tech wreck did not cause (major) recessions, but that was because the debt was owed by corporates in the first instance and maybe a relatively small number of high-income households in the latter. But in the 1930s or 2008-9, the debt was owed by a wide range of over-geared households, and when equity or debt markets ‘crashed’, so did spending and employment. If people want to believe something, and it accords with intuition and at least some casual observation, it is extremely difficult to get people to budge. Even PhD-trained economists struggle to identify opportunity cost!
Scott Sumner
Nov 22 2023 at 8:37pm
“But in the 1930s or 2008-9, the debt was owed by a wide range of over-geared households, and when equity or debt markets ‘crashed’, so did spending and employment.”
But were households over-geared during the 1920s? Is there any evidence for that claim? Was private debt much different from 1987?
On the other hand, I agree with your claim that people go with their intuition
Rajat
Nov 22 2023 at 10:14pm
I can’t offer anything factual about levels of gearing in the past. But if you speak to a typical western intellectual or a person who works in financial markets – both of whom are the key categories of people who perpetuate incorrect explanations for the Great Depression and economic downturns in general – my experience has been that they accept the Galbraithian story that extreme levels of private leverage combined with the 1929 crash precipitated the Great Depression: The stories of people investing their life savings in the stock market and then going broke and living in penury, etc. Re 1987, my read of the popular narrative is that household investors were relatively uninvested in the stock market and ungeared due to the preceding two decades of stock market underperformance and the-then relatively recent recovery from the severe recession of the early 1980s. Rather, due to widespread moves towards financial deregulation across the west, corporates themselves borrowed heavily to engage in takeovers, etc. When the market crashed and some went broke they got taken over or went bankrupt, but because it was all just ‘funny money’ anyway and did not directly affect too many households, there was not the same harm done to real output. (Similar claims are often also made about the 2001 tech wreck.) The global fall in real interest rates and accompanying boom in house prices, which enlisted many more western households in much higher levels of borrowing than they had engaged in in the past, did not really get going until the mid-late 1990s.
Scott Sumner
Nov 23 2023 at 1:15am
Yes, I’m familiar with those stories, and with stories of people jumping out of windows on Wall Street. But are they representative? I doubt it.
The average person confuses causes and effects.
Kevin Erdmann
Nov 23 2023 at 1:14pm
If I understand what you’re saying, Rabat, I think this is a great point. You would think that smart insiders would have especially sharp insight. But their experience doesn’t really help them discern causality. So, they frequently are doomed by the same sloppy narratives as the typical layman, but with overconfidence. And reputation. The Typhoid Marys of mythology.
Kevin Erdmann
Nov 23 2023 at 1:42pm
Oops. Sorry. I think your screen name got autocorrected.
Creigh Gordon
Nov 24 2023 at 2:05pm
Let me propose a metric that might tie the Great Depression and the GFC, the ratio of private debt to public debt. In the 1920s the public debt was being paid down through budget surpluses, while private debt was growing due to increases in stock prices. Running up to 2008, the public debt was growing but private debt was exploding due to increase in housing prices.
Why might this be relevant? There are three ways to resolve a private debt. It can be forgiven, it can be paid in kind, or it can be cancelled out with an offsetting debt. In kind is characteristic of a barter economy and is rare in a modern one. In modern economies, debts are resolved by offering as payment either transfer of bank credit, which is a bank liability payable in currency, or currency itself, which is a Federal government liability. So either way private debts are payable with public liabilities, i.e. public debt.
When the ratio of public debt to private debt is reduced, either through budget surpluses or increases in private debt, private debts are harder to resolve, and financial crisis is more likely.
Kevin Erdmann
Nov 24 2023 at 2:28pm
The inverted yield curve and the synthetic CDO market, which used derivatives to create bonds to sell, suggest that debt was growing in 2006 and 2007 more because of savings than because of borrowing. Savers demanded more low risk fixed income securities than the market could produce through normal lending activity.
Kevin Erdmann
Nov 22 2023 at 9:54pm
I’ve been writing about an absurd ad hoc conclusion that might make the economic history books if current discussions are any indication.
Im seeing economists claim that inflation dropped suddenly from about 10% back near 2% in mid-2022 because the Fed had hiked the target rate to a bit over 1%.
Scott Sumner
Nov 23 2023 at 1:13am
Yes, it’s frustrating that economists continue to use interest rates as an indicator of monetary policy. NGDP is still growing at over 6%, whereas it would need to be 4% to achieve 2% inflation on a consistent basis.
HS
Nov 23 2023 at 11:19am
Something people can’t get past is the concept of “one size does NOT fit all”.
In other words, it’s extremely rare that any one thing caused a specific effect, especially in the world of economics.
The great depression, like WWII, was caused and ended by multiple factors.
Historians (and people) loved to point to single events which I suspect is to validate their personal geopolitical agendas.
Scott Sumner
Nov 24 2023 at 12:14pm
Agreed. In my book, I emphasized that the Great Depression had multiple causes—that’s one reason it was so severe.
spencer
Nov 23 2023 at 11:51am
We had pushing on a string during the GD. We had pulling on a string in 1987.
vince
Nov 23 2023 at 2:07pm
A quick search for a sample provided this book: https://openstax.org/details/books/us-history. It considers the Great Depression more of an indicator rather than a cause.
Causes of the Crash
The crash of 1929 did not occur in a vacuum, nor did it cause the Great Depression. Rather, it was a tipping point where the underlying weaknesses in the economy, specifically in the nation’s banking system, came to the fore. It also represented both the end of an era characterized by blind faith in American exceptionalism and the beginning of one in which citizens began increasingly to question some long-held American values. A number of factors played a role in bringing the stock market to this point and contributed to the downward trend in the market, which continued well into the 1930s. In addition to the Federal Reserve’s questionable policies and misguided banking practices, three primary reasons for the collapse of the stock market were international economic woes, poor income distribution, and the psychology of public confidence.
Creigh Gordon
Nov 23 2023 at 3:46pm
Does “underlying weakness…in the banking system really mean ” debts that can’t be paid”?
Creigh Gordon
Nov 23 2023 at 4:25pm
I guess what I’m thinking is that a financial crisis is what happens when the realization sets in that debts won’t be paid.
vince
Nov 24 2023 at 1:09pm
What I meant to write was that the text considers the stock market more of an indicator.
About banking, it goes on to say:
… Banks, facing debt and seeking to protect their own assets, demanded payment for the loans they had provided to individual investors. Those individuals who could not afford to pay found their stocks sold immediately and their life savings wiped out in minutes, yet their debt to the bank still remained
… over 90 percent of all banks had invested in the stock market. Many banks failed due to their dwindling cash reserves. This was in part due to the Federal Reserve lowering the limits of cash reserves that banks were traditionally required to hold in their vaults, as well as the fact that many banks invested in the stock market themselves. Eventually, thousands of banks closed their doors after losing all of their assets, leaving their customers penniless.
… While the stock market crash was the trigger, the lack of appropriate economic and banking safeguards, along with a public psyche that pursued wealth and prosperity at all costs, allowed this event to spiral downward into a depression.
… Historically, markets cycled up and down, and periods of growth were often followed by downturns that corrected themselves. But this time, there was no market correction; rather, the abrupt shock of the crash was followed by an even more devastating depression. Investors, along with the general public, withdrew their money from banks by the thousands, fearing the banks would go under. The more people pulled out their money in bank runs, the closer the banks came to insolvency.
… The contagion effect of the crash grew quickly. With investors losing billions of dollars, they invested very little in new or expanded businesses.
Scott Sumner
Nov 25 2023 at 12:50pm
That claim is completely wrong. The stock crash occurred more than a year before any banking problems developed.
vince
Nov 25 2023 at 2:29pm
I agree the text is vague about dates and could leave the impression that banks quickly failed, but it does say:
Eventually, thousands of banks closed their doors after losing all of their assets, leaving their customers penniless.
spencer
Nov 23 2023 at 5:07pm
Legal reserves on 12/1/1929 weren’t exceeded until 12/31/1933. Afterwards, the banks didn’t remain fully “lent-up” until 1942. There was a preponderance of excess reserves up until WWII.
Then Black Monday represented the sharpest monetary contraction, drop in legal reserves, since the GD.
The money multiplier was legal reserves divided by deposits. Anyone that thinks currency should be included in the monetary base doesn’t understand money and central banking.
Thomas L Hutcheson
Nov 25 2023 at 8:30am
That history books and most economic pundits are totally confused about the causes of the depression is the biggest non-news item of the day. I wish I had a nickel for every time a historis has told me that such and such inflation or debasement of the coinage “impoverished” people.
Sorry, but it was true long before Milton Friedman said it, inflation is a monetary phenomenon.
vince
Nov 26 2023 at 1:24pm
Here’s a link to the original paper: https://www.independent.org/pdf/research_articles/2023_11_08_mangess_etal_jefe-vol-21-num-2-fall-2022.pdf
Historians are much more likely to mention income inequality. Starting from about 1910, one source shows the Gini index peaking at almost 50% … in 1929.
Warren Platts
Nov 27 2023 at 2:39pm
A Minsky Trap? High levels of debt-fueled malinvestment in projects that cannot possibly pay for themselves might eventually lead to a collapse. And, due to rampant inequality, since wages & consumption are so low, consumption cannot pick up the slack in the real GDP.
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