The Fed Caused the Great Depression

There is no greater myth in the American psyche than that free markets caused the Great Depression.  I hear this myth all the time, and there is exactly zero truth to it.  The Great Depression had three causes, none of which had anything to do with free markets.

The first, and most important cause, was the Federal Reserve.  Prior to the existence of the Federal Reserve, most recessions were caused by changes in the supply of gold.  Gold, at the time, was money, but it was also a commodity.  When we had a gold boom, the supply of gold, relative to other commodities, would grow, and when we had a gold bust, the supply of gold, relative to other commodities, would shrink.  If the supply of gold, relative to other commodities, changed too quickly, or unexpectedly, so too did the value of the dollar, and that could throw the entire economy into a period of price discovery, causing a recession.

The Federal Reserve was created, supposedly, to deal with changes in the supply of gold, and to keep a stable supply of money.  Unfortunately, the first thing the Fed did was to retract the supply of money, causing a recession in the 1910’s.  Not wanting another recession in the 1920s, the Fed expanded the supply of money, and the economy boomed.  Unfortunately, the banks did not loan out all of the cheap money, but rather borrowed from the Fed and invested what they borrowed into the stock market, causing a stock bubble that burst in 1929.

The stock market crash of October of 1929 did not cause the Great Depression, but it did cause a recession.  Unemployment rose to over nine percent (but did not hit ten percent), but then gradually came back down, and was under six percent by June, 1930 – by which time the recession was over.

Unfortunately, a lot of banks went out of business between October of 1929, and June of 1930, and as they went out of business, the supply of M2 money in the economy dropped by 1/3.  The Fed had the power to correct for that, and in fact that was the whole point of having the Federal Reserve, but the Fed did nothing.  This was the primary cause of the Great Depression.

Another, secondary cause, was the Smoot-Hawley Tariff Act of 1930.  We were the China of the day, with 80% of everything America produced being shipped overseas.  The very last thing our economy needed was a trade war, but the Smoot-Hawley Tariff Act gave us one.  We would have gone into a recession anyway, but the Smoot-Hawley Tariff Act deepened it.

The third cause was the Dust Bowl of the 1930s, which in turn was caused by the Homestead Acts of 1862, 1904, and 1909.  the Homestead Acts caused a lot of inexperienced farmers to migrate West, and with them came bad farming practices that wore out the land.  We were in a recession before the Dust Bowl, but the Dust Bowl deepened it.

Between these three things – the reduction in the M2 money supply, the Smoot-Hawley Tariff Act, and the Dust Bowl, we went into the deepest depression in our nation’s history.

Free market dynamics were not a cause, and in fact the New Deal prolonged the depression.  Social Security in particular prolonged the depression.

Social Security was a bit of a scam.  We only taxed about 4% of GDP in the early 1930s, and FDR needed revenue for his New Deal programs.  It’s hard to raise taxes during a depression, so FDR created Social Security.  Social Security taxes 12.4% of an employee’s wages (half paid by the employee and half by the employer), and when Social Security was first created there were no beneficiaries, as nobody had yet paid into the system.  All of the money going into Social Security was ‘invested’ in Federal Savings Bonds, which created a tremendous demand for federal debt, forcing Congress to spend money such that it could create the debt for Social Security to ‘invest’ in.  This funded the New Deal, and by sucking all of that money out of the economy, it prolonged the depression.

Not only did the free market not cause the Great Depression, but in a diverse economy, such as ours, free markets cannot cause depressions.  Every industry has its own boom and bust cycle.  While some industries are in a boom, others are in a bust, and vice versa.  It takes some kind of external shock to throw a diverse economy all into a bust at once, and there are only three things that can do that: a natural disaster, a rapid and/or unexpected change in the value of money, or government policy mistakes (sometimes by other countries).  Economies that are overly reliant on particular industries can go into recessions on their own, but not diverse economies like what the United States has.

There is also a myth that the Great Recession of 2008 was caused by free market excesses, but it was caused by government policies, started by Bill Clinton, that forced banks to give out housing loans they knew would not be repaid.  Bill Clinton is not the only one to blame but he is one of the people (http://content.time.com/time/specials/packages/article/0,28804,1877351_1877350_1877322,00.html).

It’s easy to blame the free market for recessions and depressions since the free market does not have a PR firm to protect it from falsehoods, but the free market is not to blame for the kinds of excesses that cause recessions and depressions.  Free markets cannot cause recessions or depressions.  Short of natural disasters, only government can do that.

 

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