Did Monetary Forces Cause The Great Depression?
Jim Blair

For a divergent, Keynesian analysis of the causes of the Great Depression, see Steve Kangas' 'A Review of Keynesian Economic Theory' and also his 'Timelines of the Great Depression' (both coming soon).

Did Monetary Forces Cause the Great Depression?
By Peter Temin. (MIT). WW Norton & Company Inc. NY. 1976.
178 pages, plus appendices, bibliography and index. (Or "what I read on my vacation")

Not Enough Money?

This book discusses several popular theories of the cause of the Great Depression, starting with the classic "Monetary History of the United States 1867-1960" by Milton Friedman and Anna J. Schwartz. (1963). The Friedman thesis can be summarized as: a fall in the stock of money caused a fall in incomes which resulted in depression. The assumption is that the stock of money is a independent parameter which is determined by the Federal Reserve, and is unrelated to the demand for money.

After presenting a series of graph and tables of interest rates and money supply data, the book concludes (on page 126) that "there is no reason to think that the monetary stringency in 1929-30 was more severe than in other inter-war depressions and no evidence that bank failures in 1930 created such stringency. The monetary hypothesis, therefore, gives no reason why the downturn following 1929 differed from other inter-war downturns....(p137)...We conclude, therefore, that the banking panic of 1930 had no deflationary effect on the economy. Instead the data are consistent with the hypothesis that the demand for money was falling more rapidly than the supply during 1930 and the first 3 quarters of 1931."

Temin points out that the equations used by Friedman & Schwartz can as well be reversed to claim that the fall in the stock of money was the result of the Depression rather than the cause. And as William Hummel has posted on sci.econ newsgroup, the supply of money cannot be considered as independent of other factors. If people fear the future because they see a depression, they are less likely to want bank loans.

Failure of Demand?

Since the "lack of money" does not pass muster as the cause, Temin falls back on the J. M. Keynes thesis that it was a "failure of demand". People stopped buying goods, and this caused the Depression. But he admits that this thesis is also subject to the same reversal of causality. It can as well be claimed that people spent less because the economy was in a depression. I admit that I have never considered the Keynes thesis to be reasonable. It is in effect the claim that people were poor because they already had everything that they needed (and hence stopped buying): they were poor because they were so rich.

I mean, people then had a lot less "stuff" than people have today. So why did they have "too much" while today no one has enough? Is it not obvious that the more people have the more they feel that they need? Temin even points out that a commonly cited "oversupply" of housing in the late 1920's can't be considered as the "cause" of the Depression. People who already have a house just spend that money on other things.

The Farmers Did It?

There was a poor harvest in 1929. Did this trigger a general downturn? Agriculture was a larger sector of the total economy then. But the idea of lower food supplies as a cause of the Depression is hardly consistent with the idea of FDR a few years later. He wanted to reduce the food supply as a way to cure the Depression: the "logic" being that a lower supply of food would raise food prices and thus benefit farmers. And richer farmers would lead the overall economy to a recovery. So he actually instituted a program to burn crops and kill livestock as a way to combat the Great Depression!! (Hey, this wasn't my idea).

The Bubble Burst?

Another idea that Temin considers only to reject is that the stock market became a "bubble" that "burst" in 1929. The idea is that stocks became vastly over priced in the late 1920's, and then fell, triggering a reduction in wealth (and thus spending) resulting in the Depression.

He presents two arguments against this thesis. First, that the price/earning ratios of stocks remained approximately constant during the years from 1927 to 1932 (!). This was news to me. I too had heard and accepted the idea that the stock market was "over priced" in the late 1920's. But Temin (in Table 4) presents price and earning data from 4 different measures of the stock market (S&P Composite, S&P Industrial, Crowles Composite and Crowles Industrial) for the years from 1927 to 1932 to show that there was no clear pattern. Some price/earning ratios rose and some fell. Overall, it looks like stocks were probably priced higher relative to corporate earning in 1932 than in 1927. That is, the investors properly anticipated that corporate earning would decline in the future, and were correct to sell their stocks in 1929!. And stock prices in 1929 before the crash properly reflected the high corporate earnings: they were not "overpriced".

So (since cause and effect direction is the theme of the book), did the stock market crash cause the Depression? Or was it a result of the Depression? Did corporate earnings fall because the stock market crashed? Or did the stock market crash because investors correctly predicted that corporate earning would fall?

To discuss this, Temin (page 43) draws on John B. Kirkwood "The Great Depression: A Structural Analysis" (1972). Kirkwood claims that stock prices fell because expectations about the course of future business changed. "People who had been optimistic before October 1929 suddenly became pessimistic. Stock prices declined as a result, causing investment and income to decline. The Depression occurred because people expected it to occur."

Temin comments: "this is hardly an explanation of the Depression without a reason as to why expectations about the future changed in October 1929. We are left completely in the dark as to what this unknown factor might have been". But he indicates that IF there was an explanation as to why expectations of future economic growth changed from optimism to pessimism in the fall of 1929, then the crash of the market could explain the Depression.

Enter Smoot & Hawley?

The index of the Temin book does not contain either "Smoot" or "Hawley" or "Tariff". And there is no discussion of taxes except in the general terms that they are factors in economic equations. So it is no surprise that that he can't imagine what could have changed the outlook of investors in October of 1929. But, while the Smoot-Hawley Tariff was not passed until June, 1930, it had been working its way through Congress during 1929. As Jude Wanniski as pointed out, the law had been passed by the House of Representatives by 1929 and President Hoover had indicated that he would sign it. The majority of the Senate had indicated support, so the last chance to kill the bill was in Senate committee. And in October of 1929 it passed a critical Senate committee vote.

So could have the prospect of higher tariffs on imported goods and the predictable response of higher foreign tariffs on US exports, have been the "unknown factor" that Temin says could have triggered the Great Depression?

And even if the prospect of higher tariffs was only enough to trigger the October 1929 crash, it was later when the tariff actually took effect that the "recession" of 1930 was transformed into the Great Depression . The Smoot-Hawley Tariff plus the Hoover policy of raising taxes to 'balance the federal budget": the top income tax rate was increased from 25% to 64%. And if these weren't enough, the Federal Reserve reacted to the crisis by raising the rediscount interest rate, and FDR decided to end the depression by burning the crops and killing the livestock. I mean if there is a recession, what better way to counter it than to raise taxes, raise interest rates, and if that fails, burn the crops?

At any rate, causality here cannot be reversed: the Smoot-Hawley Tariff was clearly not passed as a result of the Depression. It was debated in Congress and its passage assured during the period of prosperity before the Great Depression started.

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