What if unemployment reaches 25%¹, businesses and banks fail, and the economy loses its output value year after year? This sounds like an economic disaster, and it is! This actually happened in 1929 and it was called the Great Depression. It started in the United States and soon spread worldwide.
What was the Great Depression?
Before diving into a deeper explanation, let’s define what the Great Depression was.
The Great Depression was the worst and longest recession in recorded history. It started in 1929 and lasted until 1939 when the economy was fully recovered. A stock market crash contributed to the Great Depression by sending millions of investors into panic and disrupting the world economy.
Background of the Great Depression
On 4 September 1929, the stock market prices started falling, and that was the beginning of a recession that turned into a depression. The stock market crashed on 29 October 1929, also known as Black Tuesday. This day marked the official beginning of the Great Depression.
According to the Monetarist theory, espoused by economists Milton Friedman and Anna J. Schwartz, the Great Depression was a result of insufficient action by monetary authorities, particularly when dealing with federal reserves. This caused a reduction in the money supply and triggered a banking crisis.
In other words, there was less money to go around, which caused deflation. Due to this, consumers and businesses were no longer able to borrow money. This meant that the country’s demand and supply fell dramatically, influencing a drop in stock prices as people felt safer keeping the money to themselves.
In the Keynesian view, the Great Depression was caused by the decline in aggregate demand, which contributed to the decline of income and employment, and also to business failures.
The Great Depression lasted until 1939, and during this period there was a decline in the world’s GDP of almost 15%.² The Great Depression had a significant effect on the global economy as personal incomes, taxes, and employment declined. These factors affected international trade as it declined by 66%.³
It is important to know that a recession refers to a fall in real GDP for longer than six months. An economic depression is an extreme situation in which real GDP declines for several years.
Causes of the Great Depression
Let’s explore the key causes of the Great Depression.
The stock market crash
In the 1920s in the US, the stock market prices were rising significantly, which caused many people to invest in stocks. This provoked a shock on the economy as millions of people invested their savings or loaned money, which caused stocks prices to be at an unsustainable level. Due to this, in September 1929 the stock prices began to decline, which meant that many people rushed to liquidate their holdings. Businesses and consumers lost their confidence in banks, which resulted in reduced spending, job losses, businesses closing down, and an overall economic decline which turned into the Great Depression.⁴
Banking panic
Due to the crash in the stock market, consumers stopped trusting banks, which led them to withdraw their savings in cash immediately to protect themselves financially. This caused many banks, including the financially strong banks, to close down. By 1933, 9000 banks had failed in the US alone, and this meant that fewer banks were able to lend money to consumers and businesses. This, simultaneously, decreased the supply of money, causing deflation, a decrease in consumer spending, business failures, and unemployment.
The decline in aggregate demand
The decline in aggregate demand, or in other words, the decline in consumer spending, was one of the key causes of the Great Depression. This was influenced by the decline in stock prices.
To find out more about this topic, check out our explanations on Aggregate Demand.
The impact of the Great Depression
The Great Depression had devastating effects on the economy. Let’s study its main economic consequences.
Standards of living
During the Great Depression, people’s living standards dropped dramatically in a short period of time, especially in the US. One in four Americans was unemployed! Consequently, people struggled with hunger, homelessness increased, and overall hardships affected their lives.
Economic growth
Due to the Great Depression, there was a decline in economic growth overall. For instance, the US economy shrank by 50% during the years of depression. In fact, in 1933 the country only produced half of what it produced in 1928.
Deflation
As the Great Depression hit, deflation was one of the major impacts that resulted from it. The US Consumer Price Index fell by 25% during the time between November 1929 and March 1933.
According to monetarist theory, this deflation during the Great Depression would have been caused by the shortages of the money supply.
Deflation can have devastating effects on the economy including the decline in consumers’ salaries along with their spending, which causes an overall slowdown in economic growth.
Banking failure
The Great Depression had devastating effects on banks as it forced a third of the US banks to close down. This was because once people heard the news regarding the stock market crash, they rushed to withdraw their money in order to protect their finances, which caused even financially healthy banks to shut down.
Additionally, banking failures made depositors lose US $140 billion. This happened because banks used depositors’ money to invest in stocks, which also contributed to the stock market crash.
A decline in world trade
As global economic conditions worsened, countries put up trade barriers such as tariffs in order to protect their industries. In particular, nations heavily involved in international imports and exports felt the impact regarding the decline in the GDP.
Business failures during the Great Depression
Here are the key reasons why businesses failed during the Depression:
Overproduction and underconsumption of goods
In the 1920s there was a consumption boom powered by mass production. Businesses started to produce more than there was a demand for, which caused them to sell their products and services at a loss. This caused severe deflation, during the Great Depression. Because of deflation, many businesses shut down. In fact, more than 32,000 businesses failed in the US alone.⁵
This situation could also be characterised as a Market Failure since there was an inequitable distribution of resources that prevented the supply and demand curves from meeting at equilibrium. The result was underconsumption and overproduction, which also lead to the inefficiency of price mechanisms by causing products and services to be priced below their true value.
Banks refusing to lend money to business
Banks refused to lend money to businesses because of the lack of confidence in the economy. This contributed to the business failures. Moreover, those businesses that already had loans were struggling to repay them due to the low-profit margins, which also contributed not only to the businesses failures but also the banks’ failures.
Increase in unemployment
During the Great Depression, there was a constant increase in unemployment because businesses lowered their production due to low demand. As a result, there was an increasing number of people out of employment, which caused many businesses to fail.
Tariff wars
In the 1930s the US government created the Smooth-Hawley tariff, which aimed to protect American goods from foreign competition. The tariffs for foreign imports were at least 20%. As a consequence, more than 25 countries raised their tariffs on American goods. This led many businesses involved in international trade to fail and overall caused international trade to decline by at least 66% worldwide.
A tariff is a tax created by one country regarding the goods and services imported from another country.
Unemployment during the Great Depression
During the Great Depression, the demand for goods and services shrunk, which meant that businesses did not make as much profit. Therefore, they didn’t need as many employees, which led to layoffs and increased unemployment overall. This type of non-voluntary and demand deficient unemployment is referred to as cyclical unemployment, in this section we can find out more about it.
Cyclical unemployment
Cyclical unemployment is also called Keynesian unemployment and demand deficient unemployment. This type of unemployment is caused by a deficiency in aggregate demand. Cyclical unemployment usually occurs when the economy is either in recession or depression.
The Great Depression had a big impact on the increase in cyclical unemployment. Figure 1 shows that the Great Depression caused a drop in consumer and business confidence, which resulted in a drop in aggregate demand. This is illustrated in figure 1 when the AD1 curve shifts to the AD2.
Furthermore, Keynesians believe that if the prices of goods and the wages of employees are inflexible, this will cause the cyclical unemployment and the drop in aggregate demand to continue, causing the national income equilibrium to drop from y1 to y2.
On the other hand, anti-Keynesian or free-market economists reject the Keynesian theory. Instead, free-market economists argue that cyclical unemployment and a decrease in aggregate demand are temporary. This is because these economists believe that the employees’ wages and prices of goods are flexible. This would mean that by reducing labour wages, the businesses’ cost of production would fall, which would influence the SRAS1 curve shift to SRAS2, along with the prices of goods falling from P1 to P2. Thus, the output would increase from y2 to y1, and cyclical unemployment would be corrected along with aggregate demand.
Fig. 1 - Cyclical unemployment
From the beginning of the Great Depression in 1929 when the unemployment in the US reached its peak of 25%, employment didn’t increase until 1933. Then it peaked in 1937, but declined again and made a comeback in June 1938, although it didn’t recover fully up until Word War II.
We could argue that the period between 1929 and 1933 aligns with Keynesian theory, which states that cyclical unemployment can’t recover due to the inflexibility of wages and prices. On the other hand, during the period between 1933 and 1937 and 1938 up until World War II, cyclical unemployment decreased and made its full recovery. This could align with the free-market economists’ theory that the aggregate demand can be increased by reducing the cost of goods and lowering their prices, which overall should reduce cyclical unemployment.
To find out more about cyclical unemployment, take a look at our explanations on Unemployment.
The Great Depression facts
Let’s look at some facts about the Great Depression as a short summary.
- During the period between 1929–33, the US stock market lost almost its full value. To be exact, it reduced by 90%.⁶
- Between 1929 and 1933, one in four or 12,830,000 Americans were out of employment. Moreover, many people who were employed had their hours cut from full-time to part-time.
- Around 32,000 businesses faced bankruptcy and 9,000 banks failed in the US alone.
- Hundreds of thousands of families were unable to pay mortgages ad they were evicted.
- On the day of the crash, 16 million shares were traded on the New York stock exchange market.
Great Depression - Key takeaways
- The Great Depression was the worst and longest recession in recorded history. It started in 1929 and lasted until 1939 when the economy was fully recovered.
- The Great Depression started on 29 October 1929, when the stock market crashed. This day is also known as Black Tuesday.
- According to the Monetarist theory, the Great Depression was a result of insufficient action by monetary authorities, particularly when dealing with federal reserves. This caused a reduction in the money supply and triggered a banking crisis.
- In the Keynesian view, the Great Depression was caused by the decline in aggregate demand, which contributed to the decline of income and employment and business failures.
- The key causes of the Great Depression are the stock market crash, banking panic, and the decline in aggregate demand.
- The impacts that the Great Depression had on the economy were: a significant drop in living standards, a decline in economic growth, deflation, banking failures, and a decline in world trade.
- The key reasons why businesses failed during the Great Depression are overproduction and underconsumption of goods, banks refusing to lend money to businesses, an increase in unemployment, and tariff wars.
- During the Great Depression, unemployment reached 25% in the United States due primarily to a demand deficiency.
Sources
1. Greg Lacurci, Unemployment is nearing Great Depression levels. Here’s how the eras are similar — and different, 2020.
2. Roger Lowenstein, History Repeating, Wall Street Journal, 2015.
3. Office of the Historian, Protectionism in the Interwar Period, 2022.
4. Anna Field, The main causes of the Great Depression, and how the road to recovery transformed the US economy, 2020.
5. Us-history.com, The Great Depression, 2022.
6. Harold Bierman, Jr., The 1929 Stock Market Crash, 2022
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