9.1: The Great Depression

In the last lesson, we examined the business cycle. The ups and downs in economic activity are inevitable. The economy is like a yo-yo: every fall in activity is followed by a rise, and every rise is followed by a fall.

Prior to the 1930s, macroeconomists believed that a long-term economic depression was impossible. They thought that a market-driven economy was inherently stable and that government intervention was unnecessary. According to the Classical view, the economy "self-adjusts" to deviations from its long-term growth trend.

The cornerstones of Classical economic thought are flexible prices and flexible wages. If prices adjust in response to demand and wages fluctuate with employment levels, then both demand and employment have built-in stabilizers. These stabilizers prevent significant deviations from the economy’s long-run trend.

For example, if demand for goods and services declines, inventories will rise, leading to a drop in output. However, if prices are allowed to fall (as businesses cut prices to clear excess inventory), the law of demand will eventually halt the decline in demand. A similar stabilizing effect occurs in the labor market if wages are allowed to adjust. As unemployment rises, job seekers, it is presumed, will lower their wage expectations to find work. Just as declining prices in the product market curb inventory accumulation, falling wages will encourage hiring, thereby preventing prolonged unemployment.

In summary, the Classical view held that demand and employment could not remain depressed for long because falling prices and wages would revive markets and restore economic growth.

The Great Depression of the 1930s challenged the Classical perspective. The depression began in the United States with a stock market crash on October 29, 1929, but quickly spread to almost every country in the world. Over the next decade, incomes, profits, prices, and international trade all deteriorated. See figure 1.

Figure 1

Source: Figure from: Kindleberger, Charles P. The World in Depression, 1929-1939. Rev. ed. Berkeley: University of California Press, 1986.

The Classical theory could not explain why, even after 10 years of price and wage cuts, economies around the world could not rebound to their pre-1930 levels.

The employment situation in the United States during the Great Depression was catastrophic (see figure 1. The average unemployment rate for the decade was significantly higher than in any other period, reaching nearly 18%. At the peak of the crisis in 1933, unemployment soared to approximately 25%, meaning that one in four workers were without a job. Unlike other downturns, job losses during the Great Depression were prolonged, and many people faced extreme poverty, homelessness, and food insecurity. The severity of the crisis ultimately led to significant government intervention, including President Franklin D. Roosevelt’s New Deal programs, which aimed to provide relief, recovery, and reform to the shattered economy.

Recessions and Depressions

In the chapter on the business cycle, we broke down the ups and downs of economic activity into four stages. See figure 2.

Figure 2

Stages 2 and 3 represent expansion, while stages 1 and 4 represent recession. Since 1945, U.S. business cycle expansions have lasted an average of 64 months, while recessions have lasted only 10 months. It is optimal for an economy to spend most of its time in stages 2 and 3, with only a short period in stages 4 and 1.

The state of the U.S. economy during the 1930s was as far from optimal. From 1929 to 1937 the economy expanded for only 21 months and contracted for an agonizing 56 months. The unusual length and depth of this downturn is why it was labeled the “Great Depression.”