San José State University
Department of Economics
Thayer Watkins
Silicon Valley
& Tornado Alley

The Great Depression of the 1930s and Its Origins

The terrible, terrible conditions which occurred in the United States and the rest of the world in the 1930's are known as the Great Depression. This depression was not only an economic catastrophe, it was social and political catastrophes as well. Its origins then were a mystery and even now among the general public are not clear. This document is an attempt to tell the story of the Depression and its origins in terms of statistics in the form of graphs and tables.

In identifying the cause of almost any event one finds not just one cause but a chain of causes, working backwards from the immediate cause and terminating with an ultimate cause. There may also be multiple causes for events in this chain.

The first statistic for demonstrating the decline of the economy into depression is the unemployment rate.

As the above graph indicates the economy descended from essentially full employment in 1929 when the unemployment rate was 3.2 percent into massive unemployment in 1933 when the unemployment rate reached 25 percent. The first question is why was there such high unemployment in 1933. The answer is that the economy was not producing as much output as it was capable of producing with full employment of the labor force. It was not producing as much as it could because it could not sell that amount.

The output of an economy is measured by its Gross Domestic Product (GDP) and the graph below shows the decline in production from its high point in 1929 to its low point in 1933.

The decline in GDP, while dramatic, is not so spectacular as the explosion in the unemployment rate. This is because the umemployment rate represents what was not produced that could have been produced. A graph showing the percentage of the labor force employed would look much the same as the GDP graph. While the Depression was a catastrophe it is well to keep in mind that at worst there was still 75 percent of the labor force who were employed. But, the important question is why production had fallen off so much in 1933 compared with 1929. Here it is instructive to look at the components of the demand for the nation's output. The output of any nation is purchased by four categories of buyers; consumers, business investors, governments and foreign buyers as exports. The purchases of U.S. output by foreign buyers is offset by American purchases of foreign production as imports. A glance at the table below tells what was happening to the components of demand.

1929 790.9 593.9 92.4 105.4 35.6 46.3 -10.7
1930 719.7 562.1 59.8 116.2 29.4 40.3 -10.9
1931 674.0 544.9 37.6 121.2 24.4 35.2 -10.8
1932 584.3 496.1 9.9 117.1 19.1 29.2 -10.1
1933 577.3 484.8 16.4 112.8 19.2 30.4 -11.2


The above table indicates that consumer purchases fell somewhat, governments' purchases did not fall at all compared with 1929 but there was a catastrophic collapse of investment purchases. Exports fell but imports fell as well so that there was not much of a change in net exports. It is investment purchases, the purchases of new equipment and buildings and inventory, which is the dramatic case, as shown below.

Consumer purchases fell also but this may well have been an effect of the Depression rather than a cause of it. People's incomes fell and quite naturally they reduced their purchases. It is therefore reasonable to look into the collapse of investment purchases for an explanation of the Depression. The collapse of investment purchases can be considered the immediate cause of the Depression. The next question is why did investment purchases collapse so dramatically.

Interest rates affect investment. They are not the only thing that determines the amount of investment and are not necessarily even the most important determinant of investment but they do affect investment and so interest rates need to be considered. The important thing concerning the effect of interest rates on investment is that it is not the nominal interest rate, the rate the lenders charge, that is important but instead it is this interest rate relative to the rate of inflation, the so-called real interest rate. The real interest rate is roughly the difference between the nominal rate and the rate of inflation. For the precise definiton of the real interest rate see Real Interest.

The problem in the early 1930's was that the rate of inflation was negative; i.e., there was deflation instead of inflation. This meant that borrowers would have to pay back more valuable dollars than the ones they borrowed.

192913.12 5.85 


As the above table shows the nominal interest rate was declining over the course of the economic decline from 1929 to 1933 but because the rate of inflation was negative the real interest rate was much higher than the nominal interest rate. The following graph shows the trends. In 1932 the real interest rate was almost 16 percent per year. The long term average real interest rate for the U.S. is about 3 percent.

The high real interest rates which came as a result of deflation could have been a major factor in the collapse of investment which was the immediate cause of the Depression. Once excess capacity and expectations of decreased sales develop the level of investment drops to zero. After excess capacity develops investment purchases will not rise even if the real interest rate drops. Nonzero investment in such circumstance is maintained only from the emergence of new products, for which there is no existing capacity, and the finishing up of investment projects that are already started.

To find a cause of the deflation in the early 1930s we should look at what was happening to the money supply during those years. For a quick look at those matters here is what happened to the money supply (M1) during those years. M1 is the amount of currency in circulation plus the amount of funds held in the form of demand deposits (checking accounts).

The Federal Reserve Banking System (the Fed) was created to stabilize the financial system and control the money supply. The Fed however probably did not know the money supply was decreasing. The Fed saw only the statistics on the monetary base, the currency in circulation plus the funds held as reserves by the banks with the twelve Federal Reserve Banks. What the monetary base was showing was this.

Accepted theory held that the money supply was equal to a multiple of the monetary base. The multiple was known as the money multiplier. The money multiplier was determined by, among other things, the fraction of deposits the Fed required banks to hold as reserves. Other factors that determined the money multiplier were the proportion of savings which the general public held as currency rather than as bank deposits and the amount of excess reserves held by the banks.

If the money multiplier remained constant then an increase in the monetary base would mean the money supplies would be increasing. It thus appeared to the Fed that the money supply was increasing and there was no problem concerning the money supply. However the money supply was a serious problem as shown by the statistics on the M2 money supply. The M2 money supply is the currency in circulation plus the funds held in checking and savings accounts in the banks.

The problem was what was happening to the money multiplier. The Fed in the late 1920's was trying to end the speculative bubble in the stock market. The Fed managers applied more restrictive monetary policy than they realized. The U.S. is unique in the number of its independent banks. The U.S. had about twenty five thousand banks in the 1920's. In contrast Japan in the 1980's had less than one hundred independent banks. The large number of independent banks was an artifical condition brought about by state legislation that prohibited interstate banking. Number of banks was declining in the prosperous times of the 1920's. The Fed welcomed the decline in banks. Often banks went out of business not because they went bankrupt but because the owners saw more profitable investment opportunities for their capital.

When the restrictive monetary policies of the Fed started to create bank closures due to financial conditions the Fed did not become alarmed. However, the banks and the banking public were alarmed. Some people withdrew their funds from the banks. The banks became worried about withdrawal of deposits and even runs on banks. The banks reacted by holding reserves in excess of what the Fed required. These factors decreased the money multiplier. The multiplier decreased so much that the money supply decrase in spite of the fact that the monetary base was increasing. For more details on these topics see Monetary Policy and the Money Supply and the derivation of the money multiplier.

Once the Fed's policies led to deflation and the collapse of investment purchases it was found that the Fed could not undo what it had done concerning investment purchases. For information on the recovery from the Great Depression see Depression Recovery.

The chain of causes of the Great Depression thus leads back to the restrictive monetary policies of the Federal Reserve System. Those policies led to fear of bank collapses which caused the money multiplier to decline thus leading to a decrease in the money supply. This decrease in the money supply led to deflation which raised the real interest rate to extraordinary levels. This drastically discouraged investment purchases causing the level to decline by about 90 percent. Businesses found they were not selling as much as they had been producing. This led to cutbacks in production and layoffs of the labor force. The decline in employment then resulted in reduced incomes and consequently reduced consumer purchases leading to further cutbacks in employment and reductions of income.

As is often the case the chain of causes may be extended backward indefinitely. The speculative bubble in the stock market in the late 1920's can be attributed to the easy money policy of the Fed starting in about 1927. The Fed initiated this easy money policy to accommodate Britain. Britain had decided to go back on the gold standard in 1926. This in itself would not have created a problem but Britain tried to value the pound relative to other currencies at the level that existed before world War I. This led to funds being taken out of pounds and being held in other currencies. To discourage that withdrawal Britain needed to increase the interest rates in Britain relative to the interest rates in other countries, particularly the United States. The disasterous action of trying to go back onto the gold standard at pre-World War I levels had led to a severe recession in Britain and a general strike. Britain did not want to exacerbate the economic recession by raising its interest rate so its representatives talked the Fed in the U.S. into taking actions to reduce the U.S. interest rates by pursuing easy money policies.

The National Income Accounts for
the Great Depression Years and Recovery in the U.S.
(1992 Prices)

1929 790.9 593.9 92.4 105.4 35.6 46.3 -10.7
1930 719.7 562.1 59.8 116.2 29.4 40.3 -10.9
1931 674.0 544.9 37.6 121.2 24.4 35.2 -10.8
1932 584.3 496.1 9.9 117.1 19.1 29.2 -10.1
1933 577.3 484.8 16.4 112.8 19.2 30.4 -11.2
1934 641.1 519.0 31.5 127.3 21.4 31.1 -9.7
1935 698.4 550.9 58.0 131.3 22.6 40.7 -18.1
1936 790.0 606.9 75.5 152.5 23.7 40.2 -16.5
1937 831.5 629.7 94.0 147.0 29.9 45.3 -15.4
1938 801.2 619.5 61.3 157.8 29.6 35.2 -5.6
1939 866.5 654.0 79.5 171.8 31.2 36.9 -5.7
1940 941.2 688.0 111.3 174.2 35.4 37.8 -2.4
1941 1101.8 737.1 137.3 288.0 36.4 46.5 -10.1
1942 1308.9 719.7 72.1 692.0 23.9 42.2 -18.3

For more on the economic analysis of the Great Depression and the recovery from it see Recovery.

HOME PAGE OF applet-magic
HOME PAGE OF Thayer Watkins