History 371 Hon

Devine

Fall 2010

Causes of the Great Depression: A Review

I. The International Economic Situation

The U.S. emerges from World War I as the “Engine of Prosperity” – it is the source of capital needed to sustain the European economies.

Circular flow of capital creates an unstable international economy:

▪ Germany pays reparations to France and Great Britain

▪ France and Great Britain pay war debts to the U.S.

▪ U.S. loans money to Germany to pay reparations

So long as the U.S. continues to lend money abroad, the system survives.

If an interruption occurs at any point in the cycle, the entire system collapses.

Some observers realized the instability of the system was dangerous and suggest an alternative:

▪ U.S. forgives French and British war debts

▪ France and Britain drastically reduce German reparation payments

▪ Europe focuses on reconstruction, using loans from the U.S. for tangible improvments

But political reality makes this impossible (You should be able to explain why.)

1922-1923 à Germany experiences hyperinflation

TWO Causes

1 The government is printing too much money.

▪ The more marks the government prints, the less they are worth.

▪ The less money is worth, the less goods it can buy. (This is another way of saying that prices go up.)

2. People expect inflation to get worse (they expect their money to decrease in worth)

▪ Since they expect the value of the money they’re holding to decrease, they try to spend

it at fast as they can before its value goes down further

▪ When money floods into the economy, prices of goods increase (More money chases

the same amount of goods, driving up the price of goods – this is inflation).

To combat destabilizing inflation, the German bank declares it won’t issue more money.

People decide their money will now retain its value, so they’re more willing to hold onto it.

In 1924, the Dawes Plan defers the reparations obligation: short term payments decrease; payments stretched out over a longer period. This makes it easier for Germany to pay.

This temporarily stabilizes the economic situation, but by 1928 U.S. investors no longer put their money into loans for Germany. They get a higher return by investing it in the stock market.

1929 à U.S. Stock Market Crashes. This has a global effect:

▪ U.S. Capital for foreign loans dries up, destabilizing the circular flow of money.

▪ Unable to count on U.S. loans, Germany faces difficulty making its reparation

payments.

▪ Unable to count on German reparation payments, France and Britain threaten to default

on their debt payments to the U.S.

▪ President Hoover finally suggests a one-year moratorium on reparations and debt

payments (1931); but this ends up being too little too late. Many worry what will

happen when the year is up.

1931 à Largest commercial bank in Austria is on the brink of bankruptcy. The Austrian government freezes the assets in the bank. The money is still there, but depositors can’t gain access to it.

A panic results. Depositors fear other banks will also freeze assets, so they rush to withdraw all of their money from other banks in Central Europe (primarily German banks). This further undermines the German economy and contributes to growing political instability, which the National Socialists [Nazis] exploit.

▪ Political instability in Europe follows the economic instability. Frightened investors

withdraw gold from Central European banks, sending much of it to the U.S. There are

now fewer dollars AND less gold in Europe.

II. Unwise Tariff Policies

▪ After the stock market crash, people fear a business slump. Consumers won’t buy as much if

they fear losing their jobs.

▪ This means consumers buy fewer imported products from Europe and as a result, the

Europeans have fewer dollars to pay off their debts to the U.S.

▪ As the economy slips in the U.S., many demand a higher tariff to protect American

businesses from cheaper foreign imports. Congress passes the Smoot-Hawley tariff which

significantly raises taxes on nearly all imported goods. This produces numerous harmful

unintended consequences:

▪ Prices go up in the U.S. People can’t afford to buy higher priced goods made in the

U.S., so the tariff fails to protect domestic businesses. Sales continue to slump.

▪ Europeans retaliate by slapping tariffs on U.S. products. Retaliatory tariffs hurt U.S.

more than Smoot-Hawley helps U.S. businesses à U.S. customers may not buy Swiss

watches, but the Swiss won’t buy U.S. automobiles. A net loss for the U.S.

▪ Europeans also retaliate by raising the prices on raw materials that the U.S. must import in order to make manufactured goods à rubber, tungsten (both needed in making cars). As a result, U.S. products cost more and U.S. customers can’t afford to buy them. Demand for products slackens. Production slows. Workers are laid off. Fewer people have money to buy U.S. goods…and the cycle spirals downward.

▪ Because high tariffs keep the Europeans from selling their goods in the U.S., they lose access to dollars. As a result, they have even more difficulty in paying their debts to U.S. lenders. Also, as a result of being shut out of the U.S. market, their factories produce less, forcing businesses to fire workers (who in turn can’t buy as much), and the European economies spiral downward as well.

III. U.S. Tax Policies

▪ During the 1920s, taxes decrease substantially, especially on the wealthy.

▪ The theory is that, with more money in their pockets, the wealthy will invest it in expanding American businesses, allowing companies to hire more workers. Prosperity will “trickle down.”

▪ To an extent, this works. But there are limits to how much can be produced and consumed when the vast majority of Americans do not make enough money to buy all that is produced in American factories. It is also hard to sell goods abroad since during the 1920s, the Europeans (our primary market for exports) don’t have the money to pay for our goods.

▪ Unwilling to expand production when demand is limited, many American businessmen put their money into speculating on Wall Street rather than into tangible investments like building factories. This results in the speculative frenzy that leads to the stock market crash of 1929.

▪ Prosperity during the 1920s is real, but also is fragile.

▪ Wages and standard of living rise; access to credit is easier and allows the middle class to buy products “over time” on the installment plan.

▪ By the end of the decade major sectors of the economy – automobiles and housing in particular – stop expanding. Demand slackens. Since so many other businesses depend on these two sectors, economic instability appears to be on the horizon.

▪ At the first sign of economic turmoil (the stock market crash of 1929), consumers fear for the future and stop buying. This sets off a downward spiral in the economy à fewer people buying, less needed to be produced, fewer workers needed, fear of losing one’s job keeps even those who still have jobs from buying, still less is needed to be produced, further lay offs…and the cycle continues.

IV. Lack of Economic Knowledge

▪ Few political leaders understood the wide ranging ramifications of the economic policies they pursued. For example, the Smoot-Hawley tariff and the freezing of assets in Austria.

▪ National governments looked out only for their own interests, disregarding (or failing to recognize) the fact that their policies had a global impact and were generating unintended consequences.